Oil and gas sector
Maintain neutral: While the overall sector’s valuation has come down in the past six months due to market selldown, we believe a bottom has yet to be formed with more incoming earnings disappointments and volatility in crude oil prices expected. 

Investors should limit their exposure to the sector for the time being, unless they adopt a longer investment horizon (more than one year) to justify the bottom-fishing approach. 

For now, we prefer players with more resilient earnings profile, namely Dialog Group Bhd, Yinson Holdings Bhd and Bumi Armada Bhd.

Brent crude price resumed its downwards trend after rebounding to the US$60-US$70 (RM253-RM295) per barrel level in second quarter 2015 (2Q15), reflecting the market’s fears of a potential fresh supply from Iran post the lifting of sanctions. 

We believe crude oil prices will remain at these levels at least until late 2016 given the economic slowdown in China, high US crude inventory and the Organization of the Petroleum Exporting Countries’ (Opec) near-term decision to maintain its production level. 

Significant production cuts in crude oil are not expected in the near term with the drop in US rig counts plateauing while the US production decline of 400,000 barrels per day hardly making a dent as the supply surplus in the global oil market is expected to be at around two million barrels per day. 

We anticipate more meaningful decline in production, especially in non-Opec countries as the lag effect of current capital expenditure (capex) cuts by oil majors take effect over the longer term. 

Sector valuations have not bottomed yet with big caps currently trading at 14.2 times on average and small caps at 12 times, still relatively higher than big caps/small caps’ target price-earnings ratios (PERs) of 10 times/7 times based on our regression analysis at US$40 a barrel oil price assumption. 

We believe that the oil and gas (O&G) sector has not bottomed yet with more earnings disappointments expected.

A gloomy quarter for the sector with dismal 2Q15 results seen in the sector with eight out of 18 players under our coverage coming below expectations, in particular offshore service vessels  players and jack-up rig asset owners, owing to reduction in asset utilisation and discounts in charter rates. 

Downstream-related players fared better in the quarter, such as Dialog (TP: RM1.65) and Yinson (TP: RM3.89), which were within expectations due to their stable earnings profile backed by locked-in contracts. 

Petronas Dagangan Bhd (TP: RM22.15) beat expectations in the quarter due to favourable Mean of Plats Singapore movement. Overall, things could get worse in second half 2015 (2H15) as more assets reach the tail end of their contracts with poor prospects of contract renewals amid the approaching monsoon season.

After rallying to US$60-US$70 a barrel in 2Q15, Brent crude prices resumed the downtrend post the peak US summer driving season. 

This has sent local O&G sector market valuations (excluding downstream and Petroliam Nasional Bhd stocks) down to an average of 9.2 times 2016 PER.

We believe the low oil price environment would remain at least until late 2016 after considering several factors such as incoming Iranian oil supply, which could add 400,000-600,000 barrels a day to the market in six months after sanction lifting, slowdown in China oil demand, high US crude inventory, and Opec’s will to maintain or maybe even increase its output to defend market share. 

Therefore, instead of hoping for a sharp rebound in oil prices, industry players have to realign their costing structure and business model to survive in a prolonged oil price slump for the medium term.

Those hoping for significant cuts in crude oil production might be disappointed at least until late 2016 with Opec refusing output cuts while producing above its ceiling target of 30 million barrel a day in the past few months. 

Beyond 2016, however, a turning point in world oil supply could be seen as effects of capex cuts by oil majors in the world starts to set in, resulting in oil production decline in the longer run. — Kenanga Research, Sept 2

This article first appeared in digitaledge Daily, on September 3, 2015.