This article first appeared in The Edge Malaysia Weekly on July 24, 2017 - July 30, 2017

THE free fall in Brent crude and West Texas Intermediate crude oil prices in mid-2014 precipitated a 30% cut in capital expenditure worldwide in 2015 and 2016, the result of which — fewer projects and less expansion — is evident now.

Oil prices have since strengthened, hovering at US$48.81 (Brent crude) and US$46.41 (WTI) per barrel at the time of writing.

Nevertheless, when Wah Seong Corp Bhd (WSC), which is involved in the niche business of coating oil and gas pipes, secured a €600 million (RM2.87 billion) gas pipeline project from Nord Stream 2 AG (NS2) in the current soft market and trailing geopolitical tensions, eyebrows were raised.

In the past, the company coated pipes for both the oil and gas segments of the industry but with the recent contract win, it is pivoting to the gas sector. Accounting for 93% of its RM3.5 billion order book, the Baltic Sea gas pipeline, which connects Ust-Luga in Russia to Greifswald in Germany, is expected to generate earnings for the company until its financial year ending Dec 31, 2019 (FY2019).

“I think we are one of the few companies that are lucky to have a high order book, and our business is quite global. Of course, we are said to be small but we have got the NS2, and North America (Mexico) projects,” group managing director and CEO Chan Cheu Leong tells The Edge.

“They were all shocked at how a small Malaysian company could clinch such deals but our track record plays a big part in this industry. Without it, it would be difficult to bid for projects in the sector. We have major operations, not just sales offices. We have three plants in Europe — in Norway, Finland and Germany.” These will be re-commissioned this month.

Though WSC faces margin compression in the NS2 project, Chan says it is profitable because pipe-coating has become more competitive. “Pipe coating is a niche market … there aren’t many players. So, yes, there will be margin compression. This is expected in oil and gas companies, that reduction in margin for the project to work. Otherwise, it won’t fly.

“But we are a coating applicator ... we use a lot of materials and we push that down to our suppliers to make savings for the client. Having that balance, our margins are more compressed because of the market factor. But we are in it for the profits, too.”

According to Kenanga Research analyst Sean Lim, more than 82,500 pipe joints have been received for coating at WSC’s production plant in Kotka, Finland, and Mukran, Germany.

The Kotka plant will reach its full production capacity in the near term, doubling its current output, while the coating plant in Mukran was scheduled for its pre-qualification test this month, to be followed by commercial production in August.

Chan says WSC’s oil and gas project is funded entirely by NS2, a consortium largely led by Gazprom, which has already paid €54.7 million, and is also footing the acquisition of both the production plants.

Last year, WSC secured an additional contract amounting to RM260.7 million from Norway’s Statoil ASA for the Johan Sverdrup export pipelines project that will be executed at its facility in Kuantan, Pahang.

Its 49% joint venture Bayou Wasco Insulation LLC was awarded a US$74 million pipe-coating project by Royal Dutch Shell plc for the Appomatox oil reserve in the Gulf of Mexico.

These projects are likely to lift WSC’s earnings in its financial year ending Dec 31, 2017 (FY2017). The company is expected to return to the black after posting a net loss for the first time in 10 years in FY2016 .

In its first quarter ended March 31, 2017 (1QFY2017), net profit surged 301.4% year on year to RM9.5 million, although revenue slipped 7.1% to RM316.8 million. WSC attributed the rise in profit in its oil and gas division to the commencement of several projects as well as cost rationalisation and improved contributions from joint ventures.

As for the company’s 26.97%-owned Petra Energy Bhd, Chan says it is profitable and has zero gearing. “You look at our investment in Petra. It is producing about 10,000 to 12,000 barrels of oil per day, and its cost is probably US$10 to US$25 per barrel.

“All the capex has been recouped and even then, it has been asked to impair. It is okay because in terms of cash flow, it is okay.”

Chan recalls some positive developments during the slow period when many oil companies had to take drastic steps to restructure their business, rationalising their operations so that costs came down 20% to 30%. This meant that unlike in the past, when oil prices needed to be US$60 to US$70 for them to be profitable, their operations were sustainable at US$50 to US$60 per barrel.

However, seeing that oil prices are susceptible to global changes, Chan reckons that the group’s future lies in the gas business, which abounds with opportunities, including open orders for 350,000 tonnes of pipe in North America.

“We are confident because after two years of facing challenges, we have become tougher. We find that gas is more resilient in the industry than oil. And being thermal, it is clean ... it is also at a huge discount to oil, its price is just one-third that of oil. The disparity between gas and oil is [related to] the infrastructure of gas; to bring gas from the field to the end consumer in Europe, North America and the Gulf of Mexico is basically our business.

“You can look at pipe coating, predominantly, it is gas. So, I think it is gas, given its future potential. And North America gas pipelines, about 100,000km of them, are coming up under the new US regime, which is more liberal towards the oil and gas sector,” he says.

“The world has a lot of gas under the ocean, hence the fight in the South China Sea but the issue is how to tap the gas. You need infrastructure to extract the gas and transport it to the end consumer.”

Chan points out that a lot of gas comes from Russia but it is not on the radar screen because it is not sanctioned. This made the NS project very controversial “but the first NS happened and now NS2 is happening”.

“There was no delay, so gas is definitely needed in Europe. Of course, there is a lot of political friction because the US is also trying to sell gas, the Middle East too, but building pipelines is still the cheapest option.

“When things improve, even the market in the North Sea area will be brimming with gas projects. So, these are the areas we are covering. Wherever the demand is, we are already positioned there,” he says.

And because gas is clean energy, which is fundamental, the consumer must be ready to pay a premium, he adds.

In FY2016, WSC suffered a net loss of RM228.3 million on revenue of RM1.3 billion. While the group attributed its dismal performance in FY2016 to the weakness in the oil and gas market, its renewable energy and industrial trading segments were also hit by fewer secured contracts and impairment losses from equipment and leasehold buildings.

Being in a niche market is a plus point for WSC because the competitors are few — the biggest being Canada-based ShawCor Ltd’s Bredero Shaw Ltd — but there are also challenges when the sector is under pressure.

MIDF Amanah Investment Bank analyst Aaron Tan says pipe-coating is probably the least important job that an oil and gas player would consider investing in to conserve its reserves during a downturn. “It is at the bottom of the value chain when capex is low. They might consider repairing a portion of the pipe that is damaged rather than change the whole thing.”

Tan sees WSC’s choice to position itself in the gas sector in the future as a good move but highlights that gas prices are “dirt cheap” even in good times.

Natural gas prices are less volatile than crude oil prices, and trading is also relatively low. At press time, Nymex natural gas closed at US$3.03 per MMBtu, up 12.6% year to date.

“The capex for oil extraction is low but processing it is expensive, whereas gas extraction is expensive but processing it is cheap. To focus on the gas sector, WSC has to reach a certain level,” remarks Tan.

The pipe-coating business is high risk when things are slow, he says, adding that the NS project is controversial because it traverses a few EU countries that are against it as it could cause an even higher reliance on Russian gas, strengthening that country as a major gas exporter to Europe. To date, the NS2 project lacks the formal approval of Denmark, Sweden and Finland, whose territories would be traversed by the pipeline.

Due to the political sensitivity of the project, there is a possibility that it could be delayed or its deadline extended, thus affecting WSC’s earnings recognition.

In addition, says Tan, gas producers prefer to use floating liquefied natural gas facilities to transport LNG, which is a cheaper option than building pipelines.

In any case, MIDF reintroduced WSC to its small-cap universe in May with a “trading buy” call. “We believe WSC offers investors the opportunity to benefit from potentially volatile share price movements premised on project activity levels. Earnings risk is manageable because it is a good paymaster while the ratings downside involves the project being delayed,” says Tan.

Another analyst comments that though there is a lot of investment in the gas sector, it is not straightforward because of the intense competition. “It also depends on the usage of LNG vessels or gas pipes. Transporting gas in LNG vessels would incur high costs due to the regassification process whereas gas pipes could be cheaper but that depends on location and distance. The profit margin is also compressed due to the competitive nature where undercutting occurs to bag contracts. It is a client’s market now, so the contract value could be high but the profits could come under pressure.”

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