This article first appeared in The Edge Malaysia Weekly, on February 15 - 21, 2016.

US crude oil futures crashed last week, dropping below the US$27 per barrel mark for the second time this year. As at Friday evening, WTI futures were at US$27.1 per barrel, down almost 72% from two years ago.

And from the look of things, there is unlikely to be a sustained recovery any time soon.

Last month, the Organization of the Petroleum Exporting Countries (Opec) increased crude oil production by 280,000 barrels per day to 32.63 million bpd. Iran, freed of sanctions last month, turned up production along with Saudi Arabia and Iraq. The International Energy Agency (IEA) estimates that year on year, the supply from Opec has risen nearly 1.7 million bpd.

Against this backdrop, it is not surprising that the oil and gas (O&G) stocks on Bursa Malaysia, once the darling of investors, have crumbled. The question is, are these stocks attractively valued yet?

Conversely, are the O&G stocks priced for a paradigm where oil prices stay depressed between US$30 and US$40 per barrel for the medium to long term? What if crude oil prices fell further?

After all, Standard Chartered last month published one of the most pessimistic crude oil forecasts in the market yet — US$10 a barrel. The last time oil was at this price was during the 1997/98 Asian financial crisis.

“It is still too early for bottom fishing O&G stocks. Crude oil prices could fall further. The world is physically running out of storage space. In an industry where you can’t stop producing and there is nowhere to store, the price could fall quite drastically,” says Affin Hwang Asset Management Bhd’s head of equity strategies and advisory, Gan Eng Peng.

In other words, oil prices might be low but Gan thinks there is still a substantial downside risk for O&G stocks.

Furthermore, he argues, the effects of the low oil prices have not been fully felt yet or reflected in the prices of Malaysian O&G stocks.

“In late 2014, when crude oil prices first fell to US$50 to US$60 a barrel, it took six to seven months for the effects on the income statements of O&G stocks to be felt. Now, at this new low level (around US$30 per barrel) where oil prices are below cost for about half the producers, there are other factors to take into consideration. Not only will there be capex (capital expenditure) and cost reductions but there is also the potential for bankruptcies, which would create counter-party risk,” he says.

Ironically, low crude oil prices are unlikely to deter production. The Saudis, for example, are producing at record levels, jostling with rival Iran. In the US, the number of drilling rigs may have dropped but production continues to creep upwards, suggesting that frackers are not willing to call it quits just yet.

Even at US$30 a barrel, many producers could cover their operating cost. New projects might not be feasible but most existing wells will still be pumped for the foreseeable future.

Hence, any foray into O&G stocks will have to be done within a US$30-per-barrel paradigm.

“There will be trading opportunities in O&G stocks but only for a short-term bounce. There may also be some trading opportunities in M&A (mergers and acquisitions) activities,” says Gan. “I would rule out a V-shaped recovery. The O&G industry was in a bubble. And when bubbles burst, the industry takes many years to recover, as we have seen before. Take the tech bubble. It burst in 2004 but the industry only recovered in recent years.”

For short-term trading positions, Sapura­Kencana Petroluem Bhd’s shares have among the strongest correlation with crude oil prices — about 0.84 times. As at last Friday, the stock closed at RM1.80, down almost 40% in the past one year and valuing the company at 17 times earnings.

“For us, SapuraKencana is interesting for trading at certain levels. It is a good proxy for the ringgit’s strength as well,” says Gan.

It is worth noting that SapuraKencana has a high earnings risk due to its exposure to Brazil’s financially troubled Petrobras. Recall that SapuraKencana had a long-term, 50% joint venture with Seadrill for six US$300 million pipelay support vessels. Thus, Petrobras made up US$3.8 billion worth of backlog in contrast to SapuraKencana’s estimated RM21 billion order book.

While SapuraKencana’s greenfield-related projects might be at risk of impairments, it has demonstrated its ability to replenish its order book to some degree. Earlier this month, the group secured maintenance and drilling contracts worth US$382 million (RM1.583 billion), bringing its total jobs bagged this year to RM2.1 billion.

That said, SapuraKencana’s high net gearing of 1.3 times, coupled with impairment risks from its exploration and production segment, continues to be of big concern to analysts.

In contrast, one of the most defensive O&G stocks is Dialog Group Bhd, which has virtually no correlation with crude oil prices.

“We like companies like Dialog. We think it has one of the best management teams in terms of strategic foresight and execution capability but it is expensive. We think its business — tank storage — will do well. It is a foreign currency business with low costs,” says Gan. “And Dialog spent it in the old ringgit environment. It built cheaply, basically. I think the profits will come through this year. It is expensive but I think that is a result of it delivering what it promised over the years.”

Gan is “underweight” on the O&G sector at the moment, thus there are not many stocks that he is looking at. However, he points out that there is good value in Petron Malaysia Refining & Marketing Bhd.

“Petron is basically the old Esso petrol station plus the refinery business. Since San Miguel of the Philippines took over the business, it has changed the name to Petron, cleaned it up and made it a little better. Now, it is the third largest petrol station operator in Malaysia. It has over 500 petrol stations and counting. We like Petron because it is cheap and it is growing.”

At its close last week of RM6.81 per share, Petron was valued at only 11.7 times earnings. That is substantially cheaper than Petronas Dagangan Bhd, which is currently valued at over 35 times earnings.

“The second part of the [Petron’s] business — refining — is doing well. It is like making lemonade out of lemons. Globally, the refining business is doing well. The working capital requirement, which is oil, has come down significantly. Cheap oil is good for this business. The hard part is figuring out how long the cycle will last. Refiners either make lots of money or lots of losses,” remarks Gan.

Another stock that he has his eye on is Bumi Armada Bhd, which specialises in floating, production, storage and offloading (FPSO) vessels.

“We think it is a high-risk trading position. A lot of it depends on the company’s ability to execute the few large contracts that it has. If it is able to do it, it has the probability to double or triple over the next two to three years,” says Gan. He highlights the potential for an M&A exercise involving Bumi Armada, which could use the support of a stronger partner.

In O&G, however, the elephant in the room are the offshore support vessel (OSV) players, which mushroomed during the sector’s boom years.

“FPSOs are specialised for client requirements. They are custom-built. FPSOs are unlikely to find themselves out of a job. OSVs, however, are heavily commoditised. There is no reason for an oil producer to pick one OSV over another. That is why the charter rates for OSVs have fallen drastically,” says an oil and gas analyst.

Vessels are also notoriously expensive to be left idle. Even with a skeleton crew, one small OSV could cost around RM50,000 a month to keep on standby. This does not even include the financing cost.

The market for rigs is not doing well either. A report by MIDF Research shows that rig utilisation in Southeast Asia was only around 50% as at the end of last month. As at end-December, day charter rates for jack-up rigs had fallen to US$90,000, down from over US$150,000 in late 2014.

“Utilisation rates for jack-up rigs in Southeast Asia have declined from as high as 100% in early 2014 to current lows of nearly 60%. In Malaysia, the utilisation rate for jack-up rigs is about 29% with 17 of 24 rigs either ready stacked or cold stacked. For the 43 rigs currently in Malaysia — consisting of jack-ups, tenders, semi-subs, drill ships and semi-tenders — the total utilisation rate is about 30%,” writes MIDF.

Due to the weak indicators, the research house is adopting a cautious stance on rig owners and operators like UMW Oil & Gas Bhd and Perisai Petroleum Teknologi Bhd

“Only four of UMW Oil & Gas’s eight rigs are currently operational — all four are operating in Malaysian waters,” writes MIDF.

The report notes that UMW Oil & Gas is looking to deploy its rigs in the Middle East. Perisai Petroleum’s sole jack-up rig is already deployed in the North Malay Basin but the company will be taking delivery of two new jack-up rigs, the Perisai Pacific 102 and Perisai Pacific 103, by end-1Q2016 and 3Q2016 respectively.

Thus, the potential downside risk for O&G stocks with high exposure to upstream work is still relatively high compared with existing valuations. That said, within the O&G sector, there are still some stocks that are able to fall back on sound fundamentals during the downturn. The only problem is, these stocks are expensive.

Between the two, it seems that buying opportunities in the sector are scarce. However, as the corporate results come through over the next few quarters and shares react, there could be more opportunities in the future.

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