Posted on 08 Jun 2009
THE recent oil price run-up does not reflect a real recovery. We think the drivers have been capital asset re-allocation as investors switch to commodities as an inflation hedge and rising optimism of a global economic recovery which may prove premature.
We see the oil price strength as driven by investors buying into commodities as a protection against inflation and the weakening US dollar (see currency chart).
The much expected pick-up in global economic activities later this year and next year is to be underpinned by strong fiscal impulses as countries implement their economic stimulus packages.
However, the strength and sustainability of the economic recovery remains in question and growth projections are still below long-term global gross domestic product growth amid constraints from factors such as the still fragile banking system, rising unemployment and private sector debt de-leveraging.
Fundamental data signals weakness ahead.
The global oil market is still suffering a demand destruction cycle in a flooded supply state.
Global oil consumption is now at its 35-month low, last seen on May 6 (see global oil demand trend chart).
Oil producers, notably Opec members, have responded to demand contraction by decreasing oil output in an effort to stabilise the price.
Total production cuts since last October amount to 3.3 million barrels per day (bpd), representing 80% of the agreed 4.2 million bpd cut.
The global oversupply situation (see global oil demand and supply table on opposite page) has dampened exploration and production (E&P) activity. Global E&P spending is projected to fall by 12% year-on-year to US$400mil based on a survey of 357 oil companies.
Independent oil companies and smaller oil companies, in particular, will make the sharpest cuts.
Access to funds has dried up considerably as banks are now imposing tighter credit terms.
This has led to suspension, deferment or cancellation of projects and procurement of new assets, especially speculative orders due to the inability to obtain funding or to service or refinance loans.
The business focus of the oil majors is now more on cost containment (overhead expenses, wages, headcount) and project re-evaluation exercises (material costs, internal rates of return).
As such, new job flows have slowed considerably and suppliers face pressures to reduce costs.
The re-evaluation of tender exercises, which started in November, has reduced order visibility and distorted the replenishment cycle.
Re-evaluated projects, which will be contracted out later, would likely be lower in value after taking into account cost deflation.
For example, the price of steel is down 60% from its July 2008 peak.
We believe orderbooks for the local oil and gas (O&G) service providers had peaked in the second half of 2008 and earnings are set to fall on rising replenishment risks. Orderbook and sales contractions, already evident in this year’s first quarter results (see orderbook table), will continue over the next few quarters.
Earnings of the short- to medium-term order-driven operators such as in offshore fabrication and process equipment will be affected by this down-cycle.
Earnings visibility will be shortened to below 12 months. In addition, margins could erode as players intensify efforts to maintain capacity utilisation in the midst of the weak market.
The fortunes for vessel, rig, supply base and tank farm operators are better due to the nature of their contracts, which are for longer periods exceeding 12 months.
However, we note that capacity to grow could be hampered by their heavily-geared balance sheets due to extensive investment over the past few years.
Drawing these threads together, we think the O&G sector is past its peak and is moving into a period of falling demand, declining orders and deteriorating financial liquidity.
The sector is set for a down-cycle.
The recent rally in O&G stocks, boosted by the surge in oil price, improved market liquidity, initial cheap valuations and high betas, have led to 24%-108% appreciation in share prices.
The aggregate four price-earnings multiple re-rating has taken the sector to 10 times, well above the 6 times trough in December and is now at 10-year historical mid-cycle valuations.
With global recovery prospects still hazy, we see minimal upside from the current valuations which already reflect mid-cycle valuations.
Global oil demand has to sustain at a higher output of 85 million bpd and return to a higher growth path to justify higher valuations.
We remain underweight on the O&G sector.
