Oil & Gas Sector - OCBC Investment 2017-12-01: 2018 Outlook ~ Awaiting Contract Wins


Oil & Gas Sector - Awaiting Contract Wins

  • Recovery started in 2H17.
  • To continue next year.
  • Significant contract wins needed for sustained recovery.

Indeed, 2017 saw signs of recovery in sentiment 

  • A few years post the oil and gas downturn which started in earnest in 3Q14, we trace the series of events and review our year-end report titles for each year. In end 2014, we sounded caution on the broader sector with our report “Go for quality in 2015”, followed by “Patience needed; expect more trading opportunities” in end 2015. Last year, we headlined our report with “2017 to be as newsflow heavy”, and also mentioned that 2017 could see a recovery in sentiment, especially in the second half of the year. 
  • Indeed, we saw a pickup in share prices of the large caps starting early this year, which took a breather in the middle of the year, readying for another spurt in 3Q17. Understandably, most of the mid and smaller cap stocks remained subdued due to continued bond and company restructuring. 
  • Still, what was witnessed in 2017 remains rather tame by historical standards, and we believe that the share price recovery for big caps is mainly a normalisation from previously oversold levels, along with some hope that new contracts will be secured again, though in fits and starts.

Valuations have recovered, especially for KEP and SMM

  • With the better industry outlook, sector valuations have recovered, especially for Keppel Corp and SMM. At the end of last year, Keppel Corp was trading at 0.85x forward P/B, SCI at 0.75x, and SMM at 1.1x. Currently, Keppel Corp is trading at about 1.1x, SCI at 0.8x and SMM at 1.4x. This is still relatively low compared to historical valuations, though we note that it will take time for the continued recovery of the sector. 
  • Valuations are undemanding, and as mentioned in our earlier reports, there is more upside risk compared to the downside in the medium term.



  • With rising global oil demand and production cuts by OPEC, the crude oil glut has narrowed. Brent crude closed at its highest level in more than two years in late Oct, settling at more than US$60/bbl for the first time since Jul 2015.
  • Brent crude has performed better than WTI this year, having risen from US$55/bbl at the start of this year to about US$63/bbl currently, while WTI, which started the year at US$52/bbl is now hovering around US$57/bbl. The spread between both crudes has widened due to a combination of factors – rising U.S. production, U.S. refiners taking in less crude in the aftermath of recent hurricanes, and increasing constraints on the capacity to transport additional crude oil from Cushing to the U.S. Gulf Coast. The resulting high levels of crude oil stocks for this inland crude oil is likely affecting prices, compared to waterborne crude oil like Brent. 
  • Looking ahead, new pipeline capacity is to be brought online in 1Q18, and the spread may then narrow.
  • As for US oil production, we mentioned we could have seen a bottom in our earlier year-end report after falling for most of 2015 and 2016. The U.S. oil rig count continues to increase and U.S. oil production may reach new highs next year. This should constrain significant increases in oil prices.
  • Continued increases in the U.S. rig count also suggest that companies are beginning to invest capital in E&P projects. Most increases in rigs over the past six months occurred in the Permian, which now holds nearly as many active rigs as the rest of the United States combined, including both on-and-offshore rigs.

Conservative view for 2018 

  • As expected, the oil market continued to rebalance this year. However, despite the recent increase in Brent crude oil prices to more than US$60/bbl, the U.S. Energy Information Administration (EIA) forecasts Brent prices to ease somewhat in the coming months and to average US$56/bbl in 2018. This is because EIA expects global oil supply growth to outpace global oil demand growth in 2018, contributing to global oil inventories rising by a forecast 0.3mb/d in 2018, compared with an estimated 0.2mb/d draw in 2017. 
  • Still, global economic developments, geopolitical events, and crude oil production dynamics in the U.S. and in other major producers in the coming months have the potential to push oil prices higher or lower than the current price forecast.


  • The offshore rig market comprises of three main segments – jack-ups, semi-submersibles and drillships, and we will look at each in turn.
  • Unlike the other rig types, the utilization rate for shallow-water rigs has rebounded significantly in the earlier part of this year, before hovering around the 70% level. This recovery is mainly due to
    1. increased contracting activity due to oil and gas companies adopting to the lower oil price environment and hence first targeting the cheaper and less time-intensive shallow water segment,
    2. rate of scrapping of older jack-up rigs has been growing over the past few years, reducing the oversupply situation in the market. 
  • Despite this, average day rates have not recovered to the same degree. This is because offshore contractors have grown more competitive in pursuing new contracts for their idle rigs that they are willing to accept low rates.
  • For harsh environment jack-ups, the utilization rate remains low at around 30%, according to IHS Markit. On a more encouraging note, day rates started to recover in the middle of this year.
  • For ultra-deepwater semi-submersibles, the utilization rate remains low, though there seems to be an uptick in recent months (40% in Oct). Average day rates remain at a record low, and this is unlikely to change till oil prices recover in a more significant way.
  • As for the drillship segment, the fall in utilization rate has not been as steep as semi-subs, and is currently at about 60%. Day rates remain low and the outlook remains dim.


  • 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. 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.
  • In general, the OSV market remains very challenging, affected by significant vessel overcapacity, low utilization and day rates around the level of operating expenses for the vessels. For the Asia-Pacific OSV market, utilization is about 41%, and it has been creeping up due to recovering demand in the last six months. Average day rates in SE Asia remain at historical lows (except for the small AHTS vessels).


Gradual recovery in 2018; continued flow of orders needed 

  • Looking ahead in 2018, we expect the sector to continue its gradual recovery, as oil majors adapt to the lower oil prices environment and are better positioned to proceed with final investment decisions. 
  • Orders are still mainly expected from the non-drilling segment as recovery in the drilling market will still take time. However, should there be significant contract wins in 2018 for Keppel Corp (KEP) and Sembcorp Marine (SMM), we see chances for trading opportunities like the price spikes we saw this year especially for the latter. A sustained recovery will only ensue with a continued flow of contract wins, which will drive a re-rating of related stocks in the sector.
  • Sembcorp Marine securing orders that used to be stronghold of the Koreans Under the current competitive bidding environment, Sembcorp Marine recently managed to secure the coveted Johan Castberg project, which was regarded as one of the few “rays of light” that could have illuminated the darkness at Korean shipyards. When Statoil released the tender to several yards initially, the odds then were in favour of the Koreans.
  • However, Sembcorp Marine won the bid with a US$490m price tag, outbidding the Koreans. We believe that Sembcorp Marine's new Tuas yard and relatively stronger financial position vis a vis the Korean yards place it in a better position to secure contracts than before.

Take comfort in the big caps 

  • We first turned less negative on Sembcorp Marine in Dec 2016 when we upgraded our rating from Sell to Hold, and later upgraded it to Buy on 23 Feb 2017. Keppel Corp was also upgraded to Buy on 22 Feb. On a sector-wide basis, we maintain NEUTRAL given continued unease over the small-mid cap space.
  • Speculation of a potential merger of the two yard groups continues, and we also await the results of SCI’s strategic review. 
  • Our preferred picks are Keppel Corp [Rating: BUY; Fair Value Estimate: S$8.41] and Sembcorp Industries [Rating: BUY; Fair Value Estimate: S$3.59], though we note that a faster-than-expected recovery in oil price or contract flows would benefit Sembcorp Marine [Rating: BUY; Fair Value Estimate: S$2.26] the greatest.

Keppel Corporation – Rating: BUY; Fair Value: S$8.41 

  • Property is currently the top contributor to Keppel Corp’s earnings at 68% in 3Q17, followed by Investments at 18% and Infrastructure at 14%. The O&M division broke even in the quarter, but there is scope for the segment to fare better should new order flows start to flow in again.
  • Meanwhile, the group continues to recycle assets to seek higher returns and we remain positive on its strategy. The Tianjin Eco-City project is also bearing fruit, with average selling prices of Eco-City residential land having increased significantly since 2016.
  • KEP is also establishing a new business unit, Keppel Urban Solutions (KUS), which aims to be an end-to-end integrated master developer of smart, sustainable precincts in Asia-Pacific so as to capitalize on the mega trends of rapid urbanization and the increasing global focus on sustainability. KUS will leverage on Keppel’s more than two decades of experience as the master developer of large scale projects in Asia, including the China-Singapore Suzhou Industrial Park, Sino-Singapore Tianjin Eco-City, Sino-Singapore Jinan Eco-City, as well as Keppel Bay in Singapore.

Sembcorp Industries - Rating: BUY; Fair Value: S$3.59 

  • 2017 has been an eventful year for Sembcorp Industries (SCI). In the utilities segment, several assets commenced operations including the 1,320 MW power plant in Chongqing, but the focus this year has mostly been on India. Marine started securing significant new orders in 3Q17, and we are hopeful of more to come. As for urban development, the segment has delivered a solid performance this year and its pipeline continues to look healthy.
  • With the group’s moves in India, it is not surprising if SCI were to undertake an IPO of its Indian business. An Oct report by India’s LiveMint mentioned that SCI is preparing to list its Indian unit, which consists of thermal and renewable power assets. However, the greater focus will still be on the results of the strategic review, which should be known by the end of this year. There has been speculation of a potential privatization or divestment of the marine business, as well as possible divestments of non-core assets and utilities assets in more mature markets to invest in marine or other emerging market utilities assets.
  • Another possible investment that has been speculated on is the LNG business in Singapore, with its bright future prospects and SCI’s natural fit for this business, given its relevant expertise and established track record. Ever since our downgrade to Hold on 3 Nov, SCI’s share price has corrected 10% compared to the STI’s flattish performance. As such we upgraded our rating to BUY on 21 Nov 2017 (see report: Sembcorp Industries - Upgrade With Price Correction).

Sembcorp Marine - Rating: BUY; Fair Value: S$2.26 

  • Sembcorp Marine (SMM) continues to receive active enquiries for projects relating to floaters, production platforms, gas solutions and specialized shipbuilding. SMM is also in advanced discussions with several prospective customers relating to its Gravifloat technology and are hopeful that initial orders will materialize in the foreseeable year. Meanwhile, net gearing remained at 1.3x in 3Q17. The group has also received the US$500m payment from Borr Drilling; with this, net gearing will fall to 1.0x.
  • Our fair value estimate of S$2.26 is based on 1.8x FY18F book, which is still lower than the five-year historical average of 2.1x. Barring a sharp decline in oil prices, the worst is over for SMM, which does not deserve a P/B valuation close to the -1 s.d level.

Low Pei Han CFA OCBC Investment | http://www.ocbcresearch.com/ 2017-12-01
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