Oil and gas rally: New dawn or false start?

This article first appeared in The Edge Malaysia Weekly, on April 29, 2019 - May 05, 2019.
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OIL and gas-related counters have yielded an average total return of 53.4% year to date, vastly outperforming the local equity benchmark, which declined 1.9%. The sector’s improvement so far this year has also been huge compared with the meagre 0.9% increase a year ago.

Not surprisingly, in recent weeks, O&G counters have been among the most actively traded on Bursa Malaysia, with a number of them charting strong gains amid a rise in crude oil prices. To be sure, the gains have come on the back of a “low base effect” given the depths to which most O&G counters had sunk.

Petra Energy Bhd, Dayang Enterprise Holdings Bhd, Scomi Energy Services Bhd and KNM Group Bhd are among the top performers so far this year.

But some investors remain sceptical about the sustainability of prices at current levels — Brent crude is trading at US$75.22 a barrel, or a five-month high.

Their reservations stem from past experience as previous rallies had proved to be false starts.

When crude oil prices rose to US$65 a barrel levels in February last year, the share price of O&G-related companies surged, prompting investors to rush into some of them, only to be let down by weaker-than-expected earnings.

But investor interest remained as oil prices continued to creep up past the US$80 mark towards the end of September, until they collapsed to below US$60 at the end of last year, serving as a reminder of how fragile the oil market could be.

A lot of attention is now centred on US President Donald Trump’s efforts to block Iranian oil exports by imposing sanctions and discouraging the importers. The ensuing shortage of supply could be the catalyst for the next “O&G play”.

In the wake of the US sanctions on Iran, Toby Wu, a senior analyst at investment platform eToro, observes that geopolitics has once again dominated the global crude oil market, and that the second round of sanctions on Venezuela, a civil war in Libya and the cessation of waivers for Iran oil imports have led to a steady rise in oil prices.

“Although the US, Saudi Arabia and the United Arab Emirates have agreed to take action to increase oil production to make up for the lack of Iranian oil on the market, they will definitely adjust their output more favourably and let the price continue to rise a bit,” Wu says in a commentary on oil prices.

Saudi Arabia’s response that it is open to increasing production, but only after assessing the impact of new US sanctions on the oil market, shows that the Saudi Arabia and Russia-led Opec+ alliance has learnt from its past mistake when it increased production to offset Iran sanctions, only to be blindsided by waivers issued by the US.

Wu believes Iran’s threats to close the Strait of Hormuz would also affect the transport of 15.5 million barrels of crude oil a day, which would be a huge potential risk for the oil market. “If Iran shuts it down, indeed, oil prices would soar to an unimaginable level,” he cautions.

MIDF head of research Mohd Redza Abdul Rahman agrees that those factors could push oil prices further north.

Indeed, current prices have already run ahead of some projections, including that of S&P Global Ratings for this year of US$70 a barrel, and that of Petronas of US$60 to US$70.

However, as the oil price rally is not driven by demand but more by supply-side factors, most investors doubt its sustainability.

“Our base is that the price of Brent crude will soon retrace back below US$70 per barrel as the US and key Opec (Organization of the Petroleum Exporting Countries) members increase supply, and because of still-subdued global growth,” says Rob Subbaraman, an analyst at Nomura global markets research, in a recent report.

The uncertainty over the sustainability of the oil rally has led to volatile trading activity as many O&G-related companies have seen a surge in volume and prices, followed by some profit-taking.

Take Sapura Energy Bhd, Velesto Energy Bhd, Bumi Armada Bhd and Hibiscus Petroleum Bhd. After their disappointing performance last year, they appear to be on more solid ground. One of the few O&G companies involved in exploration and production, Hibiscus Petroleum has risen 42.9% so far this year as it could benefit directly from the rise in oil prices.


Analysts remain cautious

Despite impressive year-to-date returns, some analysts are maintaining their cautious outlook.

In the case of Dayang Enterprise for example, Bloomberg data indicates that the 12-month target price for the stock is RM1.23, substantially lower than its current price of RM1.41.

Analysts have adopted a more conservative stance, even though most of them agree that the group’s outlook remains solid with an order book of RM2.9 billion and potential for variation orders.

Sean Lim Ooi Leong, an analyst with Hong Leong Investment Bank Research, observes in a March report that the share price could “take a breather” because of weaker quarter-on-quarter earnings and slower contract flows. “Since our upgrade to ‘buy’ in October last year, the share price has delivered a peak return of 200% before declining 18%. Therefore, [we] downgrade the stock to ‘sell’ as we believe the market is currently pricing in much stronger earnings expectations, which may not be sustainable,” says Lim.

Other than Dayang Enterprise, Bumi Armada also saw a surge in interest. At least three analysts have upgraded the stock to a “buy”, with an average 12-month target price of 25 sen, representing a potential gain of 8.7% from its current price of 23.5 sen.

Sapura Energy and Barakah Offshore Petroleum Bhd too appear to be recovering from their massive debt hangover.

Following a rights issue by Sapura Energy, which raised at least RM4 billion, Permodalan Nasional Bhd (PNB) and its associated funds have emerged as the single largest shareholder, with a combined 40% stake. PNB’s institutional and financial heft helped slash Sapura Energy’s debt and restore its balance sheet to a much healthier level.

Barakah Offshore managed to secure a white knight to inject fresh capital into the group under a debt restructuring exercise.

For MIDF’s Redza, the run-up in the share price of these companies is related to the belief that they are likely to benefit from higher oil prices, particularly from an increase in Petronas’ capital expenditure (capex) programme.

“The question is, will Petronas embark on expediting the capex now or will it spread out the contracts? Where it will spend on the supply chain is another important question,” says Redza.


Who benefits from higher oil prices?

Key beneficiaries of improved oil prices are mainly owners of oilfields and oil rigs as their revenues are directly dependent on oil prices.

“Firstly, let’s talk about the upstream business. It does not involve [an] increase in production but a [potential] shift in demand,” Redza says, referring to the upside potential should the US and China come to an agreement in their current trade impasse.

“Those involved in services (such as long-term contracts for vessels or floating production storage and offloading) might not benefit much from the rise in oil prices, unless there are new contracts that increase their order books,” he adds.

Moreover, Redza observes, an increase in oil prices will be the bane of downstream players because they will need to renegotiate prices to enable them to pass on the higher costs to their clients.

He says companies such as Hibiscus Petroleum are strong beneficiaries as they own oilfields and are able to produce their own oil.

To MIDF, O&G players such as Petronas Gas Bhd and Petronas Dagangan Bhd could see more interest in view of their share price weakness as well as high dividend yield prospects, as well as expectations of a recovery in manufacturing activities, which will fuel demand for gas.

Another local analyst with an investment bank says support service players such as Barakah Offshore, Sapura Energy, Velesto Energy, Bumi Armada and Dagang NeXchange Bhd will also benefit as these companies have undergone some restructuring to put them in a better position to bid for jobs and to take advantage of the increase in activity in the O&G space.


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