THE recent crude oil price slump, which saw prices falling by 50% since November to just below US$50 per barrel last week, is especially troubling for companies involved in upstream exploration and production (E&P) activities. As these become less economically viable, a shutdown in planned drilling projects could follow.

This is worrying for companies such as UMW Oil and Gas Bhd (UMWOG) and Perisai Petroleum Teknologi Bhd, both of which are taking deliveries of new premium jackup rigs over the next two years. Jackup utilisation rates are currently at about 74% globally compared with 85% a year ago, according to oil and gas data provider Rigzone.

At present, UMWOG (fundamental: 1.45; valuation: 0.6) and Perisai (fundamental: 0.35; valuation: 1.2) face a multitude of unfavourable developments in the industry, namely the incoming oversupply of rigs, the softening in demand for E&P works amid low crude prices and Petroliam Nasional Bhd’s (Petronas) move to cut its capital expenditure by 15% to 20% this year.

Both UMWOG’s and Perisai’s jackup rigs, which are worth hundreds of millions of ringgit and are usually financed via long-term debt, would need to be operational immediately in order to recoup costs. Both companies were previously reliant on long-term charters with Petronas and now face intense competition for the same tenders.

The average DCR in the region stands at about US$140,000 to US$150,000 for a short-term lease that typically lasts 100 days.

UMWOG has two new builds scheduled for delivery this year. Naga 7 was to be delivered last month and Naga 8 in September. Perisai’s next jackup rigs, PP102 and PP103, will enter the market in mid-2015 and mid-2016, respectively.

According to Bloomberg, 10 jackup rig contracts are due to expire in Malaysian waters by the end of this year. Four of the rigs are chartered by Petronas and six out of the 10 will expire by the first half of this year (1H15).

While UMWOG’s Naga 7 will immediately be put to work after securing a six-month works contract, it is crucial for Perisai to charter out PP102 by the first half of this year. In a Jan 6 note, RHB Research points out that Perisai faces a significant earnings downgrade should PP102 fail to get a contract this year.

“Its earnings are highly dependent on PP102 obtaining a contract. We have given the company the benefit of the doubt and are imputing 100 days of charter for PP102 this year, but we recognise a downside risk should a charter fail to materialise,” says the research house, which has a “sell” rating on Perisai’s stock, with a fair value of 35 sen.

In spite of the bearish factors, the shares of both companies have rebounded strongly over the past month and appreciated despite the continuing decline in Brent crude prices. Between Jan 1 and 28, the shares of Perisai and UMWOG appreciated 6.64% and 15% respectively, while Brent crude fell 11.6% during the same period.

There are signs that the shares are now trading at attractive valuations, especially if oil prices were to quickly rebound as they did in 2008 (from US$36 per barrel to US$100 in less than 1.5 years). Such a recovery would trigger a fresh round of E&P spending and a spike in demand for drilling activity, which would potentially propel oil and gas stocks to their previous highs.

During the 2008-09 financial crisis, global oil and gas supply capacity outpaced plummeting demand brought about by the global credit crunch, causing projects to stall and new works contracts to be deferred.

The situation is comparatively better now for the upstream segment, with Petronas operating more than 100 production-sharing contracts and the development of marginal fields which began in 2011.

Credit Suisse managing director and co-head of global oil and gas David Hewitt believes that the outlook for Malaysian rig operators is brighter than for their regional counterparts.

“If the shares are at low valuations, the upside is the potential of mergers and acquisitions as a viable investment strategy. If there is a rebound in prices, the oil majors can quickly reallocate sums and restart previous opportunities. The prevailing themes for the smaller players are leveraging, cash-in-hand, and their ability to survive bad times,” he says.

Hewitt adds that Petronas, as an unlisted state-owned oil corporation unlike its Chinese counterparts, has its own key drivers and can be the catalyst for growth in the domestic E&P segment.

Fundamentals for UMWOG and Perisai show a vast difference in their valuation and financial condition. Net debt to equity for Perisai stands at 129.2%, compared with 28% for UMWOG, which is still flush with cash following its November 2013 listing.

However, this also means that UMWOG’s stock is trading at a large premium to its assets. Its book value per share is RM1.40 compared with its closing price of RM2.70 on Jan 28. This translates into a price-to-book multiple of 1.97 times.

In contrast, Perisai’s book value per share is 91 sen, far above its Jan 28 closing of 48.5 sen. While this is due to the earnings uncertainty faced by its upcoming rigs, the stock’s undervaluation could also mean a limited downside risk for now

Note: The Edge Research’s fundamental score reflects a company’s profitability and balance sheet strength, calculated based on historical numbers. The valuation score determines if a stock is attractively valued or not, also based on historical numbers. A score of 3 suggests strong fundamentals and attractive valuations. Go to www.theedgemarkets.com for more details on a company’s financial dashboard.

This article first appeared in The Edge Malaysia Weekly, on February 2 - 8 , 2015.

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