Regional Oil & Gas - DBS Research 2020-03-10: Oil Prices ~ Manic Panic Over, What Next?


Regional Oil & Gas - Oil Prices ~ Manic Panic Over, What Next?

Big changes to sector preferences in near term

  • Pandemonium in crude oil markets yesterday after the breakdown of OPEC+ talks in Vienna last week, followed by Saudi Arabia’s moves to ignite market share wars over the weekend.
  • Unprecedented double trouble scenario of possibly significantly higher oil supplies along with weak demand conditions in coming months rears its head amid global outbreak of COVID-19.
  • We believe though that crude oil prices are unlikely to remain at the mid-US$30 level for long, but recovery will be kept in check by depressed demand outlook.
  • Refineries, airlines and crude oil tanker counters should benefit in this environment; brace for pain in the upstream, oilfield services and equipment sectors.

All-out panic in oil markets

  • Oil markets plunged into chaos yesterday in a manic Monday that saw the biggest drop in oil prices since 1991, with Brent down more than 30% at one point to below US$30 per barrel (bbl), before recovering somewhat to close at around US$36/bbl (down 20% in a day). The breakdown of OPEC+ talks late last week and aggressive posturing by Saudi and Russian officials over the weekend sent the market into panic mode on expectations that the supply taps will open wide again.

How far higher can OPEC+ oil supply really go?

  • Over the last few years, OPEC’s discipline in maintaining capacity cuts through production quotas for members has been a key factor in stabilising the oil market, barring a few months in 2018 when they decided to increase production to counter new sanctions on Iran, but it was a move they quickly realised was a mistake. Hence, while it is surprising that they would choose to risk repeating the mistake, there is no doubt that the world will drown in oil should there be unrestrained production among OPEC countries.
  • Based on our estimates, Saudi alone has the potential to increase supply by more than 2.0 million barrels per day (mmbpd) from current levels, Iraq and UAE by around 0.4mmbpd each, and Kuwait by another 0.2mmbpd, ignoring other smaller member states. That makes a total of 3.0mmbpd spare capacity from just 4 countries. While this spare capacity cannot be pumped overnight, OPEC (excluding Iran, Venezuela and Libya) can easily add 1.5-1.8mmbpd in 2Q20 and 2.2- 2.5mmbpd in 2H20 if they do not adhere to production discipline.
  • Among non-OPEC countries that were part of the erstwhile OPEC+ alliance, Russia can potentially increase production by around 0.4-0.5mmbpd over the course of the year if it gets into the market share game.
  • Elsewhere, extended unplanned supply outages in Libya has been ignored by the market to a large extent, but Libya’s output could very well normalise to around 1.0mmbpd, from the level of 0.2mmbpd in February, in a few months once the country’s political situation stabilises. Further downside in Iran’s crude oil output on the contrary will likely be a non-factor, given increased global scrutiny on Iran and stricter adherence to US sanctions on the country. US sanctions on Rosneft’s trading arm will remove another 0.3-0.4mmbpd or so of Venezuelan oil from the market, but that amount is grossly insufficient to move the needle.

What about US shale?

  • Russia’s walking away from further steep production cuts serves key political purposes that is hard to miss, signalling strongman tactics ahead of the impending national referendum on constitution amendments. At the same time, this will land a blow to the US shale patch, which has been gaining market share while the OPEC+ alliance has been managing its output over the last many months. US oil companies have survived against all odds when Saudi Arabia last swamped the market with crude oil back in 2015-2016 as capital market financing was still readily available.
  • This time, however, we may finally see heavily indebted players in the sector crumble with the market’s disenchantment with the sector, while it should take at least three months for US production to fall given
    1. oil price hedges that US producers have in place, and
    2. the general time it takes to drill and frack wells suggests a four-six month time lag between a fall in oil prices and US output.
  • Suffice to say, US production growth will come off sharply if WTI remains in the US$30-35/bbl range, as the majority of US oil producers can only drill new wells profitably when WTI is at least US$40/bbl (Brent > US$45/bbl). This is also evidenced by the fact that US oil production back in 2015 had peaked around April 2015, 3-4 months after the 2015 trough in oil prices. US oil production currently at a run rate of around 13.0mmbpd could possibly exit 2020 at a run rate of 12.5mmbpd or lower. This implies that overall annual average growth in US shale production in 2020 could be less than 0.5mmbpd (compared to 2019 average of 12.2mmbpd). 2021 could very well see a decline in US production as capex budgets are cut.
  • On the flip side, supply responses in other parts of the world will be slower. Unlike shale producers which tend to be more nimble and agile, the long cycle nature of other crude oil resources, such other conventional onshore fields out of the Middle East, offshore shelf and deepwater resources indicates that it will take more time for a reduction in supply to follow suit, likely in 4Q2020 at the earliest.

Could the OPEC+ alliance change its stance?

  • The current fall in oil price is just based on the expectation of higher supply; higher supply has not come in yet and will likely not come in before April 2020. So far, in terms of concrete actions, Saudi Arabia is providing deep discounts of around US$8/bbl to European buyers to take market share from Russia and has hinted at increasing production to around 11.0mmbpd in coming months unless there is consensus on production cuts. How long Saudi and its OPEC allies can retain this aggressive posturing is hard to estimate, especially after yesterday’s free fall in oil prices. But, suffice to say, Russia can take the pain of lower oil prices longer than most OPEC members.
  • OPEC’s leading producers need crude oil prices to be significantly higher than where they are now to balance their fiscal budgets, which ranges between US$55/bbl for Kuwait to US$84/bbl for Saudi Arabia. Thus, they would definitely be keen to start throttling production again in unison to shore up crude oil prices. Russia on the other hand, with its more diversified economy, is comfortable with crude oil prices at US$40-45/bbl. Hence it would take longer and lower oil prices to force Russia back to the negotiating table.
  • In all likelihood, the best case scenario for OPEC members would eventually be to go back to the production cuts that were in place (1.7mmbpd cuts in total from October 2018 reference levels with 1.2mmbpd from OPEC and 0.5mmbpd from Russia led non-OPEC allies) and try to agree on a lower level of additional cuts than the imposing 1.5mmbpd they proposed last week for the rest of 2020. Maybe another 0.5- 1.0mmbpd of additional cuts in total with minimal cuts from Russia could be something palatable.
  • As of now, it is anybody’s guess when the OPEC+ alliance will reconvene again (June meeting was unconfirmed), if at all. However, we believe Saudi Arabia’s fragile fiscal position erodes its ability to withstand a protracted stand-off with Russia and a resolution may be forthcoming in 3-6 months’ time. Till then, it is volatility all the way.

Will oil prices stick around at the mid-30s level?

  • Unlikely for a long period, in our opinion, as we do not believe that OPEC will turn on its taps too wide in practicality beyond the current posturing. We think a relatively quick bounce towards the US$40/bbl mark is in the offing, as seen in the recent past when oil price tested the US$30/bbl mark. The most recent case was in January 2016, when oil price recovered to more healthy levels within weeks. Of course, we also rule out a strong V-shaped recovery back to US$50/bbl+ levels, as demand conditions currently are probably the worst since post-GFC period in 2009.
  • Our latest oil price forecasts can be found in our report published yesterday: Regional Oil and Gas: OPEC+ fails to deliver.

Who are the beneficiaries in this scenario?

  • We were initially pessimistic on the refinery sector, as we had anticipated acute refining margin compression due to COVID-19 induced demand destruction and a less-than-proportionate supply response by refineries in the region. However, with the latest development, we now expect
    1. increased supply from the Middle East and
    2. sharp discounts on Middle East Official Selling Prices to widen the light-heavy crude oil differential considerably.
  • Refineries should see an improvement in refining margins in 2Q2020 onwards (though they would incur a massive inventory loss in 1Q2020). This is especially the case for complex Chinese refineries as there is a floor price of US$40/bbl in the crude oil price component which is used to set retail fuel prices. However, this assumes that the rapid proliferation in COVID-19 cases out of China in the region does not ravage demand beyond our expectations.
  • The airline sector would certainly gain from the plunge in crude oil prices, though the impact would vary according to their jet fuel hedging position. Chinese airlines generally do not hedge their fuel requirements, hence they should immediately enjoy cost savings in 2Q2020 onwards. At the same time, domestic flights seem to be normalising as the situation comes under control.
  • Crude oil tanker companies should see an uplift in demand, as cheaper crude oil prices would prompt for a reduction in indigenous production, and consequently more imports. The steepening contango in crude oil prices, versus a backwardation in January, means that crude oil storage is now a lucrative play again.

Apart from the upstream names, which sectors will be the hardest hit in this scenario?

  • Oilfield service providers – depressed operating cash flows among upstream players will translate into lower capital investments and consequently less projects and lower work volume for service providers, especially players that are more exposed to exploration and development capital spending.
  • Shipyards and equipment manufacturers – similar to service providers, shipyards and O&G equipment manufacturers will likely see lesser order wins as the entire O&G value chain tightens its purse strings; companies with inadequate contract coverage and elevated gearing will come under the most pressure.

Have O&G valuations hit bottom yet?

  • In an attempt to access valuations of oil and gas (O&G) stocks in the current oil price environment, we draw reference from the trough levels back in 2016, when oil prices plunged to sub- US$30/bbl levels. At that time, O&G names especially upstream players hit their troughs as oil price dropped to US$28/bbl at end Jan-2016. This was followed by a V-shaped recovery with oil prices rising back to the US$50/bbl level in early Jun-2016 while stocks regained lost ground earlier in early Apr-2016.
  • See table in attached PDF report that illustrates the implied trough levels assuming we are in similar scenario.
  • Overall, we are not far from the price points and in fact some of the O&G stocks are already trading below trough levels. Several observations:
    • Malaysia O&G names were among the worst hit yesterday, falling > 30%. In particular, Hibiscus (Target Price RM0.82; +100%) is already trading 15% below our hypothetical trough level.
    • While CNOOC (Target Price HK$11.50; +31%) is still approx. 11% away from the implied trough, its current per barrel all-in cost is 15% lower than 2016’s on higher production. This remains one of our preferred names on a rebound in oil prices.
    • Service providers saw steeper declines on fears of insolvency risks in a prolonged low oil price environment. Nevertheless, HK-listed names like Anton (Target Price HK$1.20; +90%) and Hilong (Target Price HK$1.40; +150%), which have fallen 7%/28% below implied trough levels, have just reissued bonds and extended their maturity to end 2022, thus removing near term refinancing pressure.
    • Keppel Corp (SGX:BN4)’s (Target Price S$7.50; +33%) share price looks appealing now offering 30% upside to Temasek’s partial offer price of S$7.35. Assuming the deal goes through and 39% of shareholdings are divested @ S$7.35 to Temasek, shareholders are effectively paying ~S$4.90/share at current share price. Though, this hinges on a successful partial offer. See Keppel Corp Share Price; Keppel Corp Target Price.
    • Yangzijiang (SGX:BS6) (Target Price S$1.50; +78%) is not impacted by oil price as it builds merchant ships and not O&G offshore platforms. Valuation is attractive at 14% below 2016’s trough level. See Yangzijiang Share Price; Yangzijiang Target Price.

Suvro Sarkar DBS Group Research | Pei Hwa HO DBS Research | Paul YONG CFA DBS Research | 2020-03-10
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