This article first appeared in The Edge Financial Daily, on March 21, 2016.

Oil and gas sector
Maintain underweight: Five oil and gas (O&G) companies beat our forecasts for the fourth quarter of calendar year 2015 (4QCY15), but we remain cautious about Bumi Armada Bhd and Malaysia Marine and Heavy Engineering Holdings Bhd, which reported strong 4QCY15 earnings, but were largely driven by non-recurring events amid still-weak fundamentals. 

Petronas Chemicals Group Bhd, SapuraKencana Petroleum Bhd and Petra Energy Bhd also beat our forecasts on robust operations, but weak petrochemical and crude prices could be a bane of their earnings in the coming quarters. This report marks a transfer of analyst coverage. 

Petroliam Nasional Bhd (Petronas) scaled back spending on weak crude prices. Its core earnings fell 67% year-on-year (y-o-y) in the fourth quarter, but had not fully reflected the scale of the decline in crude prices, due to a time lag between benchmark prices and actual average selling prices. Our forecasts suggest that Petronas’ operating cash flow could fall 40% y-o-y in 2016E (estimate), which we think is the key reason behind its decision to cut spending by RM50 billion in 2016E to 2019E. This is negative for O&G equipment and service (OES) players, and those servicing exploration and development activities should be hit the hardest. 

Lopsided bargaining power of the oil majors and difficulties in enforcing O&G contracts lead us to conclude that OES players will not be able to resist pressure to cut service rates. This is especially so in Malaysia, with Petronas being the largest customer in the country. Oil surpluses should persist through 2017, though the US Energy Information Administration (EIA) cut Brent forecasts. Sixty-eight per cent of global oil reserves are subeconomic at less than US$40 (RM162) per barrel prices, but the oil market should stay oversupplied. Gulf-state producers are unlikely to cut production, as they remain profitable at current prices. Sixty billion barrels of oil equivalent of US oil reserves could attain commercial viability if crude prices rebound to US$60 per barrel. The EIA has cut its Brent forecasts to US$34 per barrel in 2016E, and US$40 per barrel in 2017E (also our view), driven by a larger inventory build. Price-to-book valuation permanently de-rated; our top pick is Petra Energy. Most of the O&G stocks are trading below book value, and we believe this represents a permanent de-rating on long-term repricing of oil. Petra Enegry is our only “buy” in the sector after our downgrade of SapuraKencana to “hold” (from “buy”). — Affin Hwang Capital, March 18