Oil and Gas - DBS Research 2016-09-06: Darkest before dawn

Oil & Gas Sector EZION HOLDINGS LIMITED 5ME.SI SEMBCORP INDUSTRIES LTD U96.SI

Oil and Gas - Darkest before dawn

Given the narrowing gap between supply and demand, we now expect oil prices to average between US$45-50/bbl in the second half of 2016 (2H16), a notch higher than YTD average of US$42.55/bbl. In 2017, we expect a further recovery in oil prices to an average of US$50-55/bbl, as convergence of oil supply-demand trends gather momentum in the second half of 2017 (2H17).

We believe oil prices will likely move upwards at a faster trajectory towards the end of this decade. Our longer term oil price forecast is currently around US$60-65/bbl, but we reckon there is more upside risk in the longer term than downside risk, in view of the recent massive cuts in capex and marginal cost of oil production.

Any recovery in the industry must originate from the source of cash flows into the ecosystem – in other words oil prices and oil majors’ capex. Higher cash flows from these ‘top of the waterfall’ sources will then filter down to service players and shipyards through the value chain.
Key Inflexion points:

#1: M&A activity leading to industry consolidation.
- M&A and industry consolidation typically occur at the bottom of the cycle. We think the next 6-12 months will present more consolidation opportunities as more O&G companies are increasingly in distress, creating attractive buyout opportunities
#2: Oil majors increasing capex spend.
- Oil majors must increase capex budgets, otherwise oilfield equipment services and asset owners will continue to suffer. As oil prices move towards US$60/bbl, we believe oil majors may consider revising up future capex estimates by mid-2017.
#3: Accelerating fleet retirement to scrap older vessels and rigs.
- For asset owners in particular rig and OSV players, the acceleration of fleet retirement is required to drive market equilibrium in a market which is flooded with oversupply of offshore support vessels.
#4: Higher vessel utilisation and day rates.
- Rig utilisation typically lagged oil prices by 7-24 months.
- The lag effect this time could be closer to the two year mark, similar to the 2008 period. This implies a potential recovery for the service asset players only in late-2017 or early-2018.

Higher oil prices would directly benefit exploration and production (E&P) companies.
However, we believe this has been largely priced in until we see another leg of oil price uplift. The refiners could benefit from near term inventory gains but margin contraction can be expected in the longer term as oil prices creep up. Our top pick in this segment is BCP (BUY; TP: Bt39) for its undemanding valuation and laggard share price performance.

While Keppel Corp (Keppel) and Sembcorp Marine (SMM) are trading near AFC valuations, there remains uncertainties revolving the extent of damage from Brazil and potential customer default.
In addition, rig orders – the key earnings driver for shipyards, are unlikely to return in the next 1-2 years amidst an unprecedented supply glut. A turnaround for rig orders to return requires the acceleration of rig retirement, cancellations of speculative build and higher oil prices.

Many OSV owners are already operating below breakeven levels and it might take 12-24 months before meaningful recovery in utilisation and day rates kick in. As such, the cost competitiveness and balance sheet strength of the OSV players are extremely vital at this stage.

Companies have adopted two action plans to combat the weak outlook: Firstly, stepping up their cost-cutting measures and initiatives, and secondly, diversifying beyond the oil & gas sector.
SCI (BUY; TP: S$3.10) remains our preferred pick among the large cap O&M plays. SCI offers stability through its utility business and potential re-rating of O&G sector through 61% owned SMM. SCI’s utilities business is valued at an undemanding 0.7x P/B and 8x FY16F PE vs historical mean PE of 11x.
Ezion (BUY; TP: S$0.58) has trumpeted its plans to enter the Chinese offshore windfarm market, having forged strategic partnerships with Chinese state-owned power provider, China Huadian and its subsidiary Sinotrans, to facilitate the entry in to the alternative energy business.

Pei Hwa Ho DBS Vickers | Suvro SARKAR DBS Vickers | Singapore Research Team DBS Vickers | http://www.dbsvickers.com/ 2016-09-06

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