Malaysia Oil & Gas – Still All About Oil Prices

Recent politics among OPEC nations, and between OPEC and non-OPEC producers, have added to the uncertainties in the timing of an oil price recovery. While the global industry has reacted to lower oil prices, the local sector is fundamentally unexciting and still in overcapacity. Maintain MARKET WEIGHT, noting stock movements have a high correlation (+0.60) with oil price. Brent is trading within the global industry’s two-year assumption of US$55-70/bbl.

WHAT’S NEW
Malaysia’s position in context to the current environment. Recent events by OPEC vs the high-cost producers re-iterate a strong focus on market share, dashing hopes of a quick rebound in oil prices and when the oversupply will truly be narrowed. Petronas, which maintains its US$55/bbl Brent assumption, incurred a RM12.1b capex in 1Q15 (- 8% yoy; 55% domestic, 45% overseas). Petronas guided for capex to drop 15% yoy in 2015 (2014: RM64b) and a 30% opex reduction. In response, offshore contract flows have slowed and high-cost upstream projects (RSC, EOR, high-CO2) were shelved/replanned to be feasible at lower breakeven prices. Contractors are facing the risk of reduced service rates.

Developments. Petronas remains commited to projects such as RAPID in the local downstream scene. It awarded 28 RAPID infrastructure packages. PETCHEM EPCC contracts are expected to be awarded by 1Q16. However, the upstream side is less exciting as contract flows are small and structured as called-out, short-term tenures. Scomi Energy is re-optimising its Ophir RSC (at a cost of timing delays) to be feasible at US$55/bbl vs the previous breakeven price of >US$70/bbl. Some OSV contracts were renewed at a 15-20% discount in charter rates. Rig contracts had been terminated early or revised with discounts on charter rates.

ACTION
Maintain MARKET WEIGHT - still an oil price play. With lesser contracts, we view Malaysia’s upstream service players are facing an overcapacity and lagging behind international peers in terms of opex rationalisation and capacity realignments. The sector is still unexciting fundamentally and is not yet safe from further earnings downgrades. We see earnings expectations or contract wins to remain muted and expect the sector to continue to be dictated by oil price movements within a one-year horizon. We believe the sector is trading in line with the US$65/bbl Brent range since OPEC’s June decision, which is within the industry’s 2-year assumption of US$55-70/bbl. We note the sector has a high positive correlation (+0.60 to +0.87) to Brent movements during the Oct 14-May 15 period (ie correlated to both the downtrend and uptrend of oil prices).

Top BUY and SELL. We like Dialog, given: a) its track record as a defensive proposition to oil price (please see Page 2 on defensive plays), and b) it being a prime beneficiary of Southeast Asia’s key storage hub with potential for further development of its Pengerang terminal. SELL MMHE, given: a) orderbook replenishment concerns and low utilisation in its East Yard, and b) investors will have to bear the delays of large contract awards and a discount to earnings (even if they secure a large contract) as recognition is backloaded according to the company’s square accounting method.

Defensive plays. Yinson, MISC and Dialog are defensive plays, given their lower or negative correlation (less than 0.50) to Brent, according to our analysis. Dialog benefits from rising oil prices due to an oil contango play on its storage terminals and upstream activities, while enjoying abundant business opportunities from downstream customers during periods of low oil prices. MISC has a diversified mix of businesses whereby its petroleum tanker rates and storage business benefit from lower oil prices, despite suffering from lower LNG earnings as its LNG carriers could see lower utilisation and lower charter rates on renewed tenure. Yinson’s proven project execution and its status as a purer proxy to FPSO, which lies in the production capex, render it more defensive vs Bumi Armada which has a sizeable exposure to OSV and T&I operations.

The US$55-60/bbl range could be a psychological barrier to a few Malaysian counters, as: 
a) our channel checks suggest some upstream projects related to Petronas will be reassessed and replanned to reflect the US$55/bbl breakeven price, and this affects players with RSC and PSC exposure, and 

b) US$60/bbl is the breakeven point for the upstream production of SapuraKencana, the largest integrated local player.

ESSENTIALS
More oil to come. Last week, OPEC made an unsurprising decision to retain its production quota of 30m b/d, taking into account that the quota had been exceeded by >1m b/d since Mar 15. Speculation on Iran’s sanction removal could prompt the nation to pump up production to >3.5m b/d vs 2.8m b/d currently. Iran and Libya are some of the other OPEC nations that announced their intention to boost production volumes. These events reiterate a strong focus to defend market share against the higher-cost producers, dashing hopes of a quick rebound in oil prices and complicating the timing of when the oversupply will truely be narrowed.

Question remains on oversupply. The International Energy Agency (IEA) forecasts oil demand to surge to >94m b/d by 2H15 to bring oil demand to 93.9m b/d in 2015 (+1.4m b/d from 2014), with China and the US among the biggest demand drivers. The market had initially expected the demand surge and a production slowdown to narrow the oversupply and drive an oil price recovery from the 1Q15 average of US$57/bbl Brent. We estimate 1Q15 oversupply at 2.0m b/d, based on the IEA’s 1Q15 figures. We are at the peak of the oversupply now as the IEA estimated Apr 15’s world supply at 95.7m b/d vs a slightly lower average 2Q15 demand estimate of 92.6m b/d, a difference of more than 3m b/d.

Intensifying fight for market share among producers. The current environment is shifting the dynamics whereby the more efficient or lower-cost producers continuing with their production, rather than waiting for better margins from higher oil prices. According to the market share data based on the IEA’s Apr 15 numbers, Saudi Arabia recorded higher crude production of 10.0m b/d in April (2014: 9.5m b/d). The combined production volume of Iran, Iraq and Libya amounted to about 7.2m b/d (2014: 6.6m b/d). Although OPEC as a whole saw its market share increased to 39.5% (2014: 39.1%), this was lesser than its historical 60% market share. Also, conventional and tight oil production in the US remained high at 12.6m b/d in Apr 15 (2014: 11.8m b/d) and market share remained high at 13.2% (2014: 12.6%). The market share of Russia, another large oil producer, remained stable at 11.6%.

What is the industry’s view? The latest 1Q15 investor guidance of key global major O&G companies indicated conservative estimates of US$55-70/bbl Brent for capital budgeting within 2015/16. Prices assumed for longer-term capital budgeting, in order to be free cash flow-positive, are at US$55-90/bbl. In the new normal of lower oil prices, many international companies have entered into capital conservation vs expansion previously, and view the indusry downcycle will be prolonged.

SECTOR CATALYSTS
The bull camps on oil prices believe: 
a) shale production will face a meaningful decline from late-15, following a 53% yoy drop in the US rig count to 871 rigs (-58% drop in oil rigs, -30% drop in gas rigs), 

b) ongoing restructuring of Saudi Aramco could revamp Saudi oil policy, and 

c) improving demand growth from India and economic outlook in Europe.

RISKS
The bear camps on oil prices believe: 
a) the US shale production may not decline fast enough despite the rig decline as per Baker Hughes data, 

b) over-expectations on oil demand growth, ie from China’s growth forecast, and the end of the US driving season. 

If Brent falls back to US$40/bbl (-40% decline) and applying a 0.6x correlation to the decline, we see a 20-25% downside risk to Malaysia’s O&G stock prices. (Read Report)

Source : UOB KayHian Research

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