Oil & Gas Sector - OCBC Investment 2016-08-25: (1) All Eyes On The Banks

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OIL & GAS SEMBCORP INDUSTRIES LTD U96.SI

Oil & Gas Sector - All Eyes On The Banks

• Where are you in the value chain?
• Bank support critical
• Risk of “amend and extend” for bonds 

Market speculation to support oil prices for now 

• OPEC members are meeting major exporting non-OPEC countries at the International Energy Forum in Algeria from 26-28 Sep to discuss the oil market situation, including any possible action that may be required to stabilize the market. 
• At present, while many market watchers are expecting a low possibility of curtailed output by OPEC, we expect market speculation to continue till the end of Sep. We believe this would deter short-selling in oil, offering some support for oil prices.

When you recover depends on where you are in the value chain 

• However, beyond this, times remain tough for fabricators, asset owners and service providers along the oil and gas value chain, though with varying degrees of stress. The newbuilding spree in the last few years for rigs and offshore support vessels, supported by favourable payment terms, have resulted in a significant oversupply of assets.
• Order flow has dwindled and is likely to remain so until oil prices show signs of a sustained recovery. Confidence has to come back to oil and gas companies first, who will then award projects, benefiting companies lower down the value chain. The asset owners first need to see an uptick in demand first before they are willing to place orders with the fabricators.

Still hanging on 

• So far, owners or lenders who will sell for desperate consideration are still rare, and it is difficult for buyers to justify paying more than a token price for an asset – however promising its long-term potential – which could be sitting idle for an indeterminable period and consuming cash in the meantime. 
• On the other hand, unless forced by lenders, owners are reluctant to sell, and lenders are loath to liquidate loans at fractions below par. Under such circumstances, transactions are likely to involve equity consideration, or equity-like securities such as warrants or convertibles, or transfer of debt, rather than pure cash considerations.

Risk of “amend and extend” for bonds 

• Meanwhile, we have seen some investor interest in the bonds of companies vs. their equity, but we caution that a lot depends on banks’ willingness to support, and investors will likely need to hold the bonds till maturity, besides the risk of “amend and extend” prior to maturity.
• Local banks currently still seem keen to support the sector, and we would look out for companies with heavy reliance on foreign banks. 
• In this report, we also do a quick stock take of companies’ financial positions and debt servicing abilities. 
• Maintain NEUTRAL on the broader sector given the dim outlook and depressed valuations.

OIL MARKET 

Non-OPEC production has been falling 

• On the supply side, non-OPEC production has been falling, and the primary driver is US onshore production where the collapse in drilling activity is finally impacting tight oil production. The overall decline in global E&P spending is also impacting non-OPEC production elsewhere, but OPEC production remains strong. Risk of further increase in supply can also be found from recent rhetoric by both Iran and Libya.
• Specifically, Iran plans to double its crude exports, while Libya’s state-owned producer mentioned its readiness to reopen oil ports and restore crude oil output.
• US oil production has fallen over the course of the year, while shale production has also been adversely affected. Although the recent recovery in crude oil prices has encouraged more oil rigs in the US to turn operational, OCBC Treasury Research and Strategy believes that this increase is unsustainable, given 
  1. more headwinds to oil price due to risk-off sentiments, and 
  2. the supply glut is still present at this juncture.

Rebalancing to continue but may be a drawn out process 

• Looking ahead, rebalancing of the oil market should continue, as illustrated by Exhibit 6, though a continued rise in US rig count could mean a more drawn out rebalancing process. World production in recent years has outpaced consumption but US-based EIA sees supply and demand reaching parity next year. The risk, however, is a fall-off in global economic growth. On the demand side, as crude oil is a growth-related commodity, it will take negative cues from events that suggest headwinds to global economic growth, such as Brexit. Europe as a whole commands about 15% of global oil consumption, or about 1.5 times the production of Saudi Arabia. North America accounts for the largest share at 24% of global oil demand.
• In terms of forecasts, OCBC Treasury Research and Strategy still expects oil prices to end the year at around US$50/bbl, before rallying to above US$60/bbl next year on the acceleration of further rebalancing of the market.

How long can certain countries last with low oil prices? 

• As the rebalancing process will take time, a question then is how long can certain oil exporters last? Currently, almost all spare production capacity (~2%) is held by Saudi Arabia, whose market share strategy contributed to the plunge in oil prices. Should they wish to stick to this strategy, they would need to take into account their reserves and the likelihood of success in raising funds such as bond issuances and the listing of Saudi Aramco.
• OPEC members’ 2015 net export revenue (US$404b; -46% decline from 2014) was the lowest since 2004, with significant implications for the fiscal condition of member countries that rely heavily on oil sales to fund social programs and import other goods and services. Certainly, the effect of oil price declines vary across OPEC member states, as petroleum exports count for as little as 5% (Indonesia) to 99% (Iraq) of total export revenues in 2015. Countries with sizeable financial assets, such as the Gulf States (Saudi Arabia, Kuwait, Qatar, and the UAE), are affected to a lesser degree than other oil producing countries such as Iraq, Nigeria, and Venezuela that do not have significant financial reserves. Government deficits, high reliance on oil revenue, and asset coverage of government spending are indicators of geopolitical stress exposure. Therefore, countries with fewer financial assets are more exposed to geopolitical stress than countries with greater financial assets. 
• A study by the EIA found that at current low oil prices, Ecuador and Venezuela are the most at risk. Russia has about 10 months in terms of asset coverage, while Saudi Arabia has about two years or so. 

RIG SECTOR 

• The global jack-up fleet has remained stable at about 530-540 units since early 2015 after many deliveries in the preceding years. However, total demand has dropped from 450 units during the onset of the oil plunge to about 330 units currently. This has caused the utilization rate to plunge from about 90% in mid-2014 to about 62% currently.
• As for floaters, the global fleet has dropped from about 325 in mid-2014 to about 300 units currently, but total demand has dropped from 276 units during the onset of the oil plunge to about 176 units currently. This has caused the utilization rate to plunge from about 85% in mid-2014 to about 60% currently.
• The outlook for the offshore drilling market remains challenging, as oil and gas companies remain focused on maintaining their capital allocation policies, reducing their costs and limiting spend on exploration and development. Hence the risks of project delays, contract renegotiations and terminations will continue. For instance, Transocean saw the terminations of five contracts in 2015 and six contracts in 1H16. Outlook statements by offshore drillers in general are still cautious and none have called for a bottom yet.

OFFSHORE SUPPORT VESSEL SECTOR 

Anchor handling tug supply (AHTS) segment 

• Demand for OSVs is driven by production support, rig support and, to some extent, offshore and subsea construction support. Continuous production support is by far the most important driver for OSVs, whereas rig support is the main driver for the AHTS segment. Demand for rig support has dropped substantially, thus contributing negatively to AHTS demand. Compared to the steep decline in previous quarters, however, the decrease in demand for large AHTS vessels has slowed down since the earlier part of this year, according to our talks with industry players.
• Supply has remained relatively stable in 1H16, and as such average utilization remained at about 60-65%.

Platform supply vessel (PSV) segment 

• PSVs are used to support fields that are already in production, and hence supply factors, rather than demand, are likely to be most damaging over the coming years. The global order book remains substantial amidst weak demand for PSVs. According to Clarksons, one-year PSV global term charter rates (average rates for all regions, weighted by regional share of deployment) for 3,200 DWT PSVs stood at US$10,780/day at the end of May 2016, down 45% since the start of 2015 and 8% since the start of 2016.
• Like the large AHTS segment, the decrease in demand for larger PSVs also saw a slowdown, but unlike AHTS, more PSVs were delivered so far this year – indeed the market has been watching the significant PSV orderbook relative to the AHTS segment for a while. Meanwhile, over the last year, only two PSV newbuilds were placed since Jun 2015.
• The plunge in newbuild orders has impacted players such as VARD Holdings, Nam Cheong Ltd and ASL Marine, which have tried to diversify in one way or another. VARD Holdings is now securing aquaculture related orders and cruise ship vessels with the help of its parent Fincantieri. In comparison, Nam Cheong has not diversified as well as VARD.

Bourbon calls bottom of the market in subsea and crewboat segments 

• Meanwhile, in one of the most encouraging signs in the sector so far, in early Aug during its 2Q16 earnings call, Bourbon Offshore said it believes the bottom of the market has been reached in some segments of the offshore vessel industry. In particular, it said that the bottom of the market in the subsea segment was reached in 1Q16, and it is anticipated that the improvement in utilization rates in 2Q16 will continue in quarters to come.
• As for the crewboat segment, the bottom was in 2Q16; reduced helicopter activity for cost savings and the increase of activity in production of existing fields are expected to improve the use of crewboats going forward.
• Bourbon anticipates that the bottom of the deep and shallow water OSV segments will be in 3Q16, due to the late cyclical nature of this business.
• The group operates in 45 countries, with a fleet of more than 510 vessels and 34 operating affiliates. As such, many market watchers took notice when this leader of the OSV industry made these comments.

A recovery will come, but will it be soon enough for some? 

• The CEOs of the largest oil and gas companies have expressed the view that even if the harsh downturn is not yet over, there are some signs of improvement. The drastic reduction of the level of investments by oil and gas companies in the past couple of years has resulted in persistently low prices and a significant oversupply of OSVs. Instead of focusing on additional cost cutting campaigns, some of them are now thinking of the future. However, recovery will take some time to impact the OSV industry due to its late cyclical nature.
• In the meantime, companies continue to face financial difficulties. For instance, US-based Tidewater recently breached its 3.0x minimum interest coverage ratio covenant contained in its revolving credit and term loan agreement, debt owed by its subsidiary Troms Offshore and a 2013 senior note agreement. Limited waivers were obtained till 18 Sep 2016 to negotiate a new credit agreement package.
• To a certain extent, the fate of OSV companies also depends on their geographical focus. On a regional basis, demand for vessels has not dropped off as significantly in the Middle East, which is shallow water and dominated by the large NOCs. Lifting cost is also acceptable at oil prices levels around US$50/bbl. In comparison, the North Sea has been among the hardest hit regions.
• In Norway, industrial group Aker is attempting to merge acquired OSV owner Solstad Offshore with Rem Offshore. Solstad is presently the sixth largest Norwegian OSV owner by fleet value, while Rem is ranked ninth, according to figures provided by VesselsValue. A merger would create the industry’s fourth largest behind DOF, Farstad and Siem.

OILFIELD SERVICES 

Schlumberger and Halliburton call for bottom 

• In the oilfield services segment, the world’s two largest providers of oilfield drilling and fracking services have now declared that the worst may be over. Around the end of Jul, Schlumberger said that the oil industry appears to have reached the bottom of the cycle, and Halliburton said the North American market reached its lowest point in 2Q16 and is poised for modest growth the rest of this year. 
• Do note, however, that these companies have significant exposure to the North American market and could benefit from a rising US rig count, as seen in recent times. As big players in the oilfield services market, they could also have significant bargaining power with their customers, the oil and gas companies.

FINANCING MARKET 

What is happening in the offshore financing market? 

• Despite the plunge in asset values since the onset of the market downturn, it has been a difficult time for project financiers in the offshore market due to the challenge in searching for segments in the industry that can generate a return on investment that will attract investors to place their equity.
• The traditional sale and leaseback arrangement that used to be popular several years ago is hardly used nowadays, mainly because of the quiet charter market. A charter market is required to generate a positive cashflow to the shipowner after deducting financial and operating costs.
• At the same time, investors need to be comfortable with the counterparty risk and the residual value exposure at the end of the charter, unless there is a put option/purchase obligation with a bankable counterpart. In today’s market, ticking the boxes just seems a bit more difficult.

A question of timing 

• That said, there are opportunities in the offshore market, but is the timing right yet? There is still a large order book with low scrapping numbers, and the charter market remains very quiet. Many offshore owners are looking for alternative sources of funds and many funds are looking for distressed offshore deals. However, most of the financial challenges so far have been sorted out between the senior lenders/bondholders and the owners, if they were sorted out at all. There have only been a few cases of direct equity purchases, some of which are merely nibbles of beatendown company stocks.
• So far, owners or lenders who will sell for desperate consideration are still rare, and it is difficult for buyers to justify paying more than a token price for an asset – however promising its long-term potential – which could be sitting idle for an indeterminable period and consuming cash in the meantime. On the other hand, unless forced by lenders, owners are reluctant to sell, and lenders are loath to liquidate loans at fractions below par.
• Under such circumstances, transactions are likely to involve equity consideration, or equity-like securities such as warrants or convertibles, or transfer of debt, rather than pure cash considerations.

Bond market largely closed to many companies now 

• Till the end of 2017, the maturity schedule for energy and offshore marine issues totals ~S$1.1b. With bond markets remaining largely closed to offshore marine issuers (there were no new bond issues from the sector in 1H16), it could be challenging for some of the issuers to refinance their bonds. With the Swiber incident, a common question that we get is also “who are the companies with bonds coming up for maturity?”, and Exhibit 17 answers this question.

Bargains in the bond market? 

• A binary outcome Bond prices have also plunged alongside equities. Liquidity is thin and potential investors are likely required to hold the bonds till maturity, during which they would face the risk of bond extension requests by cash strapped companies. Assuming the company still enjoys the full support of its financiers and does not restructure its bonds prior to maturity, investors may be able to pick up some return within a relatively short time frame.
• Meanwhile, it would also be useful to review some nearer-to-home casualties of the oil price collapse so far, as well as the financial positions and debt servicing abilities of companies in the sector.

Low Pei Han CFA OCBC Investment | http://www.ocbcresearch.com/ 2016-08-25

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