Uncertainty pushes crude oil higher, but can it stay up?

This article first appeared in The Edge Malaysia Weekly, on October 2, 2017 - October 08, 2017.
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IT has been a long and deep trough for the oil and gas industry, but could the end finally be in sight as crude oil prices move higher?

Last week, Brent crude shot up to US$59.02 a barrel — the highest in nearly 27 months. And already, reports have begun to herald the end of low oil prices.

Some, like Citigroup Inc’s head of global commodities research, Ed Morse, have even begun to warn of a potential supply gap next year.

Morse warns that countries like Libya, Nigeria, Venezuela, Iran and Iraq may already be pumping near-maximum capacity and that weak investment in exploration and development could hinder production increases in the near future.

This could compound the growing volatility of oil prices due to increased uncertainty in the Middle East.

Since the 72nd session of the UN General Assembly last week, the possibility of sanctions against Iran by the US has re-emerged, threatening to throttle the supply of about two million barrels per day.

Another 650,000 barrels per day of Qatari oil could also be affected if tensions between the small Gulf state and its Arab neighbours escalate.

On top of that, there is also the unlikely possibility of a civil war breaking out in Iraq’s northern Kurdish region, which produces roughly 600,000 barrels per day, or nearly 12% of Iraq’s total production.

The Iraqi government has already threatened military action against the Kurds, who held a referendum for independence last week, a vote that was not recognised by Iraq.

Topping off the geopolitical risks are rising tensions between Pyongyang and Washington as the leaders of both nuclear-armed nations traded pointed barbs.

Coupled with a temporary suspension of production in Houston, Texas, due to Hurricane Harvey last month, and the ongoing production cut by Opec, crude oil posted its fifth consecutive weekly gain.

This raises questions about the direction of oil prices. After hovering between US$40 and US$50 for the past two years, is it time for crude oil to break out above the US$60 level?

If so, how high can it go, and will it mark the end of low crude oil prices? What does it mean for the oil and gas industry?

Looking at exploration and production (E&P) stocks like Hibiscus Petroleum Bhd, the market at least appears to be pricing in a brighter future for such companies.

Hibiscus Petroleum surged as much as 46% last week before settling marginally lower at 64.5 sen on Thursday. The company generates the bulk of its income from the Anasuria Cluster in the UK, its first producing field.

In stark contrast was the 12.9% fall in Sapura Energy Bhd’s share price to RM1.49 last week on a disappointing set of results. While Sapura Energy has some exposure to E&P, most of its earnings come from leasing drilling rigs.

The group’s second-quarter core profit came in at RM36.9 million, bringing the first half earnings to a mere RM42.9 million — substantially lower than the full-year market expectation of RM226 million.

Only six of the group’s rigs were in use, down from seven last year. Another 10 stacked rigs remain unutilised.

“As the tender rig T-12 will be dropping out of Chevron’s contract next quarter, the group’s rig utilisation will drop further to 33%,” writes AmInvestment Bank in a report last week.

The takeaway is that companies that own and lease assets for E&P activity are still feeling the pinch from years of low oil prices.

“Until the oversupply of oil resolves itself and the oil majors start splashing out on capital expenditure again, it is going to be slow going for companies like Sapura Energy,” says Lee Cherng Wee, an analyst with JF Apex Securities.

“Even if oil prices rise in the short term, Sapura Energy is not going to benefit immediately. Oil prices would need to rise and stay up to support Sapura Energy,” explains Lee.

Sapura Energy does benefit slightly from its E&P division but the unit’s overall contribution is still small. However, this will improve once the unit hits first gas in the B15 field, most likely in November.

Lee is not optimistic about Sapura Energy’s outlook and has a “hold” call on the stock with a target price of RM1.48.

In contrast, Liaw Thong Jung, Maybank IB Research’s associate director and regional head for oil and gas services, has a “buy” call on the company with a target price of RM2.

“If oil prices go up, the immediate beneficiaries would be companies in the E&P space. Of companies under our coverage, Sapura Energy is a good beneficiary — it is a hybrid involved in upstream as well as services,” he explains.

However, he cautions that a longer-term view is needed to see value in Sapura Energy.

“Service providers normally see a lag effect of about a year between an increase in oil prices and an improvement in their bottom line from new jobs.

“We are at the bottom of the trough and this is a cyclical industry. Sapura Energy has shown sustained order book replenishment and its tender pipeline is improving.”

On top of that, the monetisation of the group’s gas assets — SK408 (Gorek and Larak) field — is expected to be a catalyst.

That said, Liaw’s top picks in the sector remain the safe bets — companies like Dialog Group Bhd and Yinson Holdings Bhd.

Both boast relatively stable and predictable income streams and strong balance sheets that have weathered the oil and gas downturn. However, such stocks are also less sensitive to the upside potential of a rebound in oil and gas prices.

Even after a recent rally, Hibiscus Petroleum is valued at an estimated 4.89 times forward earnings. It is not well covered by analysts but two reports on the stock have put its target price at between 85 sen and RM1.06.

The surge in trading activity in the stock more likely points to something bigger than merely keeping up with the rise in crude oil prices, say observers. Perhaps, it has to do with the anticipated conclusion of a 50% acquisition of participating interest in four existing oilfields off Sabah’s shores from Shell Sabah Selatan Sdn Bhd for US$25 million. This deal was announced almost a year ago.

However, crude oil prices still face headwinds. “The global economy is still growing slowly, so demand for oil is flat for the foreseeable future,” comments Lee.