Has O&G sector bottomed out?

This article first appeared in The Edge Malaysia Weekly, on December 10, 2018 - December 16, 2018.
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AT the time of writing, the meeting of the Organisation of the Petroleum Exporting Countries in Vienna had yet to reach any decisions on oil production cuts — which, if implemented, would be the first in five years.

Russia, the largest producer in Opec+, is reportedly resistant to committing to a big production cut, as demanded by the organisation’s de facto leader, Saudi Arabia.

Markets dealt with the inconclusive outcome by pushing crude oil prices lower to US$59.50 per barrel last Friday, down 3.3% from a day earlier.

From mid-August until early October, crude oil prices had a good run and appeared on the brink of a steady comeback — until volatility hit. Since Oct 3 when prices hit a four-year high of US$86.29, prices have tumbled 31%.

The uncertainty of whether Opec+ would come to a consensus on output cuts ahead of the Vienna meeting hurt market sentiment, as did renewed concerns over a supply glut.

Nevertheless, experts are of the view that oil prices will rebound going forward, and are projecting average prices of above US$70 per barrel next year.

“The important thing for petrol producers is that oil prices are stable. That will mean that their activities will not be disrupted,” says Areca Capital CEO Danny Wong.

Locally, the oil and gas (O&G) sector has been disappointing for investors this year. Market observers say that, despite the recovery in crude prices and a pickup in global oil activity, oil and gas companies have posted lacklustre earnings.

But the dismal year and volatile market notwithstanding, fund managers believe that the prospects are brighter.

TA Securities chief investment officer Choo Swee Kee is now more positive on the sector as he believes the worst is over. “With the recovery in oil prices this year [compared with the last], a lot of oil majors have been planning their capital expenditure for the next few years. I think in terms of that, the outlook won’t change,” he says.

Fitch Solutions Macro Research has projected a pickup in oil exploration activity next year, compared with 2018. “Revenue will be boosted by higher oil prices, while still-compressed services costs will flatter margins and bolster cash flows. This will give companies greater flexibility to increase their capex and assume more risk,” it says in a recent report.

Wong, who also takes the view that the domestic O&G sector will recover next year, points out that most local companies are service-oriented. With Petroliam Nasional Bhd seen to be giving out more contracts in the last year, he believes the situation should stabilise for the sector.

But, while the outlook looks better, experts caution investors to take gearing levels into consideration as many industry players are still plagued by high gearing.

“Those with high gearing are particularly vulnerable in the current situation, especially if their top line cannot cover the debt they have to repay. Many of these highly geared companies have taken up term loans or issued bonds that are nearing maturity.

“During the good days of the oil boom, they didn’t have to worry about it because jobs were abundant. But now, the market is slightly more bearish and banks are not giving out loans that easily, so, these companies may have a problem managing their gearing,” says Wong.

His advice to investors is to avoid companies with high gearing. However, investors could consider companies that are in the process of restructuring or have completed their restructuring.

TA’s Choo adds that investors should look at whether the assets of the company, which were financed with debt, are being deployed. If the assets are generating income, he says, that should not be a concern.

Looking at companies with a market capitalisation above RM300 million, Velesto Energy Bhd stands out among those that have restructured their balance sheets. Velesto made a RM1.8 billion cash call in January last year and its net gearing currently stands at 38%.

A big operator, Sapura Energy Bhd, is in the middle of a restructuring exercise. It announced a RM4 billion cash call involving a rights issue of Islamic convertible preference shares and new ordinary shares, sweetened by free detachable warrants.

Among the companies with a market cap exceeding RM300 million, Bumi Armada Bhd’s net gearing stands out at 201.74% based on the latest Bursa Malaysia filing, double the others’ of below 100%.

Bumi Armada recently came under scrutiny for missing a proposed October deadline to restructure US$500 million worth of unsecured short-term loans. Although the company has a large order book of RM21 billion, many are concerned that the order book might not generate enough cash flow to service the debt.

Although net gearing is an issue to be monitored, it is worth noting that most domestic O&G players continue to be dependent on the capital expenditure activity of Petronas.

“Before Budget 2019, many were expecting Petronas to scale up activity [with oil prices recovering], but with the RM30 billion special dividend to be given to the government next year, scaling up is now unlikely to happen,” says an analyst with a local research house, adding that he is “overweight” on downstream players and those involved in service maintenance.

“The growth story for RAPID [Petronas Refinery and Petrochemical Integrated Development] is strong for the downstream players, plus Petronas is unlikely to ramp up its upstream activities with the RM30 billion special dividend it will be paying out next year. My top picks are companies like Serba Dinamik Holdings and Dialog Group Bhd,” he adds.

Kenanga Research takes a similar view. In a recent report, it highlights that, as Petronas is tightening its capital expenditure to continue cost optimisation efforts, there appears to be a greater potential for additional job flows in the brownfield space.

“With prudent financial management in mind, to facilitate higher dividend commitments, we reckon that Petronas is more likely to ramp up production at existing fields to drive output, rather than sanctioning high capex investments and multiyear timelines for new oilfield investments.

“As such, we see this landscape playing out better for players with a high local exposure and brownfield-dependent nature, such as Dayang Enterprise Holdings or Uzma Bhd, while local downstream players, such as Serba Dinamik or Dialog, would also mostly remain unaffected by Petronas’ capital expenditure cuts,” it says.

Meanwhile, Maybank IB Research says in a report that Dialog and Yinson Holdings Bhd are its key “buy” calls in the sector due to their earnings, balance sheets, cash flow resilience and growth, as well as undemanding valuations.



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