We maintain our OVERWEIGHT rating on the sector. We have revised our average Brent crude forecast for 2024-2025 to USD81-77/bbl from USD84-80/bbl due to a weaker global demand outlook. Nevertheless, we believe OPEC+ will push to defend crude prices at current levels, even if it requires extending production cuts into 2025 should demand weaken further. These oil price levels remain supportive of local upstream investment, particularly given the under-investment by producers since the early 2020s. We continue to favour upstream maintenance and pipe-coating players due to their more defensive business nature, as well as the midstream storage segment, which is benefiting from a structural increase in demand for storage in the region driven by geopolitical factors. That aside, we believe that the sector is currently trading at an attractive level of 8.5x two-year-forward PER, significantly below its 5-year historical mean. Our sector top picks are DIALOG (OP; TP: RM3.18), DAYANG (OP; TP: RM3.80) and WASCO (OP; TP: RM1.70).

1. Upstream

Brent crude price forecast trimmed. We have trimmed our Brent crude forecast to USD80/bbl for CY24 (from USD84/bbl) and USD77/bbl (from USD80/bbl) for CY25, as we have re-adjusted for a weaker global demand outlook (particularly from China). In our base case, we expect crude demand to increase by 1.4m bbls per day in 2025 (lower than 1.3m bbls per day expected by the Energy Information Administration (EIA)), which could result in a slight surplus in the market, assuming supply grows by 2.4m bbls per day (with a gradual unwinding of OPEC+ production cuts). In our view, the forecast remains sufficiently conservative, as the supply side is our wildcard; OPEC+ could always look to extend their production cuts further if the demand outlook deteriorates. We maintain the view that OPEC+ will not allow Brent crude prices to trade below USD70/bbl, as this would negatively impact their national budgets.

Base case assumptions. We expect the voluntary OPEC+ production cuts to continue throughout 2024, before increasing production in 2025, leading to a better-supplied oil market in 2025. Our expectations for 2025 are largely aligned with the EIA, with production anticipated to increase by 2.4m bbls per day, driven by a 0.8m bbl per day increase from OPEC+ and a 1.6m bbl per day growth from non-OPEC+ countries. The production growth from non-OPEC+ countries will mainly be underpinned by the United States, Canada, Guyana, and Brazil. Overall, we maintain that OPEC+ will continue playing a key role in balancing the crude oil market, while non-OPEC+ countries ramp up production due to favourable crude oil prices.

Petronas is disciplined on capex spending but with head-room for domestic spending. Petronas has maintained a cautious approach to spending amid macroeconomic uncertainties, committing to preserving value through cost rationalisation and value-focused investments. With its operating cash flows intact and an approved dividend of RM32b for FY24 (compared to RM40b in FY23), we believe the group can still ramp up its domestic investments, even if it underspends on its RM60b annual capex target. The new energy capex is expected to remain manageable at 18%, while foreign capex, particularly for the Canada LNG project, is expected to enter its final phase by the end of FY24. According to Business Times, the Canada LNG project will generate cash flows in 2025.

Sarawak remains a key strategic area for Petronas. We believe these developments will allow Petronas to redirect more of its capex budget into the domestic market, which has been under-invested in the last five years, to prevent a steep natural production decline in Malaysia. Regarding ongoing discussions between Petronas and Sarawak over the state’s gas distribution, Petronas has emphasised that both parties remain strategic partners in the development of hydrocarbon resources. Therefore, we expect upstream capex in Sarawak’s offshore areas to remain intact in the longer term, although slight delays may occur in the short term as the details of the agreement are still being finalised. In our view, this would be a short-term hiccup for upstream service providers in Malaysia and they remain in a favourable position in the domestic upstream market due to the tightening availability of contractors, and we anticipate a ramp-up in activities in 2025 overall.

Upstream topside maintenance and HUC awaiting major contract award. The upstream services market, particularly maintenance and hook-up and commissioning (HUC) services, experienced a significant increase in activities in 2024 and we expect this trend to continue in 2025. The Pan Malaysia umbrella contract worth up to RM10b with a duration up to a total of 10 years could be up for grabs before the end of 2024 as Petronas and other oil producers look to award the next cycle of major upstream maintenance jobs which have been delayed for two years already. Hence, we believe that the new cycle of contract could be awarded and if not Petronas will award another year of contract extension with favourable contract terms, both still a boon to upstream maintenance activities and margins. In our view, DAYANG (OP; TP: RM3.80) will be in the pole position to win the majority of the umbrella contract due to their project execution track record as well as their advantage as a Sarawak-based contractor.

Demand for energy infrastructure will drive the demand for pipelines. According to Mordor Intelligence, over 122,000 km of pipelines are either under construction or in the planning stages globally, with the majority focused on natural gas infrastructure, particularly in the Asia Pacific and North American regions. Additionally, a significant portion of the global pipeline network is ageing, with up to 40% of pipelines worldwide being over 40 years old. As a result, we anticipate a structural increase in demand for pipes globally, and as long as crude prices remain conducive, spending on pipe-coating will ramp up. Consequently, we believe the pipe-coating industry will benefit from this structural trend, with incumbent players, such as WASCO (OP; TP: RM1.70), poised to capitalise on this due to their significant market power, as the industry is dominated by 3-4 key players globally.

Offshore support vessel market is still strong. The domestic upstream service players are already observing a strong pick-up in demand from Petronas and other oil producers. The short-term daily charter rate (DCR) for accommodation work boats (AWB) was quoted at RM150,000 for shorter-duration charters (three months or less), exceeding the levels seen during the previous bull market in 2013-2014. Mid-sized anchor handling tug supply (AHTS) vessels, with approximately 5000 bhp, are seeing recent transacted DCRs of RM40,000 or below, still lower than their previous peak of RM47,000. This implies that the majority of demand is still directed towards brownfield maintenance jobs rather than greenfield projects. Assuming oil prices stay above USD70/bbl, we believe that the demand for OSV will still ramp up and given the tight supply in the market we do not discount the possibility of further upside in DCRs in 2025. Given the strong charter rates, we think the next leg up could be shipbuilding, where we recently wrote an unrated note for SYGROUP.

KL Energy Index hammered down unjustifiably. The KL Energy Index (Bursa) has corrected by 15.5% from its recent peak of 1,001.5 in May 2024, largely in line with the movement in Brent crude prices, which are down by 12.3% from their short-term peak of USD86.5/bbl. In our view, this sell-down is overdone, as the earnings outlook for the majority of the component companies remains highly robust for both 2024 and 2025, particularly for upstream service providers. To illustrate, the Bursa Malaysia Energy Index has declined 14% from the recent peak, which is lower than the fall in Brent crude prices of 21% off its 2024 YTD peak. However, if we exclude the top three companies with larger weighting due to more stable business nature (DIALOG, YINSON and ARMADA) of midstream and FPSOs, the next three names with major weightings in the index (DAYANG, KEYFIELD and HIBISCUS) dropped by 22% on average. We believe that this is unjustified given that a 21% decline in oil prices do not necessary translate into a 21% decline in capex by oil & gas producers.

Consistent with our view on Brent crude, we believe that the macro environment still supports a ramp-up in upstream capex spending overall. The KL Energy Index is now trading at 8.5x two-year forward PER, which is below the 5-year average PER of approximately 14x. We believe that this discount to the average PER is unwarranted, given that the sector's fundamentals remain on an upward trend heading into 2025. In addition, we believe sector fundamentals remains largely intact for 2025 as the supply of upstream service providers are alrready insufficient to meet the increasing demands from Petronas and other oil producers in Malaysia.

2. Downstream

Supply overhang persists, and demand recovery is still tepid. Downstream product prices, which bottomed out in 2023, are seeing early signs of recovery, but HDPE and LLDPE (polyolefin products) prices are still hovering around USD1,000/mt due to lingering concerns about global economic growth, particularly in the Chinese economy. China will continue to dominate new capacity start-ups in the petrochemical sector, adding 31.2m mt per annum (compared to 210m mt globally) by 2025. As a result, the upside for polyolefin prices will remain limited in the near to medium term until the demand outlook improves significantly in 2025.

Urea prices back to historical averages. Urea prices are expected to range between USD250-300/mt in 2025, aligning closely with the averages seen before 2020 (pre-COVID). We do not anticipate a recurrence of China's export restrictions on fertilisers, as seen in 2022. Additionally, feedstock cost pressures from natural gas have eased, with Henry Hub natural gas prices recently recorded at USD2-2.40/MMBTU. The lower cost incentivises natural-gas-based urea producers to ramp up production, expanding global supply. On the demand side, we expect growth to remain aligned with the long-term trend of 2% per annum.

Still focusing on upstream services. We continue to advocate focusing on the upstream services subsegment within the local oil and gas sector, particularly in the more defensive upstream maintenance and pipe coating segments, which are likely to be more insulated from the potential negative impact of the PETROS overhang. Upstream maintenance activities are expected to ramp up into 2025, while the pipe coating business is set to see significant growth as global investments in offshore piping infrastructure are sustained to replace ageing assets. Typically among our coverage, VELESTO (OP; TP: RM0.30) will be the most sensitive to the changes in crude oil prices as drilling activities (particularly exploration drilling) are highly correlation to crude oil prices.

Additionally, we favour the midstream segment, particularly tank terminals, due to the structural increase in demand for tank terminal capacities in the ASEAN region, driven by changes in trade behaviours spurred by ongoing global geopolitical tensions. The surge in projects related to low-carbon storage also presents growth opportunities for tank terminal operators. While the downstream segment is showing early signs of recovery, we believe it is still too early to take a long-term positive view on this sector due to persisting global economic uncertainties.

Our sector top picks are as follows: -

i. DIALOG given the recovery in the spot tank terminal markets, gradually improving prospects of further expansion in capacities under Pengerang Phase 3 and turnaround in margins for its EPCC, plant maintenance and specialist product businesses,

ii. DAYANG is well-positioned due to its exposure to brownfield maintenance activities in the upstream sector, specifically in hook-up & commissioning and topside maintenance. Its earnings growth will also be boosted by its marine division, which benefits from the booming offshore support vessel (OSV) subsegment.

iii. WASCO remains attractive as its pipe-coating business is largely driven by global capex investments, which are still on an upward trend. In our view, the recent sell-down is overdone, with its FY25F PER at 6.8x, significantly below its 5-year historical average of 11.3x.

Source: Kenanga Research - 2 Oct 2024