Stocks To Play For Oil Price Leverage
Apart from large-cap O&M stocks such as Keppel and Sembcorp Marine, Singapore has a diverse range of oil-related stocks in the upstream and downstream sectors with a combined market cap of $2.5b. The majority of these companies generated strong positive free cash flow in 2021 and half of them were in a net cash position as at end-21. With oil and gas prices expected to remain high in 2022, these companies’ financials should remain robust. Maintain sector OVERWEIGHT.
WHAT’S NEW
• Oil and gas – Still influential. As the dominant source of our energy needs for the better part of the last 70 years, crude oil has held influence over the politics and economic strategies of nations, frequently proving the source of instability, dispute and war. In the past five years, the volatility in oil prices has been tremendous, vacillating from a low of US$19.33/bbl to a high of US$127.98/bbl. In 2022, oil prices have risen 37% and have been a key contributor to global inflation. Natural gas prices have also increased materially with the US Henry Hub sport price up 48% ytd while the monthly Japan LNG import prices have risen 71% over the Jan-Apr 22 period.
• Oil and gas prices outlook. Despite the upstream industry having suffered a nine-year period of underinvestment over 2014-21 (see chart on RHS) when capex halved, forecasts indicate that the industry is still unwilling to spend with capex expected to only increase by 5% CAGR over the 2021-24 period. With such anaemic levels of spending, the implication is that oil and gas prices will stay higher for longer.
• How to play the higher oil price theme in Singapore. The modern day oil industry is multi-faceted along its value chain, from upstream to downstream, ie exploration and production (E&P), offshore marine (O&M), refining, chemicals and pipelines. In Singapore however, only E&P and O&M companies are listed on the SGX with investors having to look internationally for exposure to refining, chemicals and pipeline companies. In the comps table below and on the last page of this report, we provide a list of such
companies.
• Apart from Keppel and Sembcorp Marine, there are 14 other oil price plays in Singapore with a total market capitalisation of just over S$2.5b (see table on page three). These small and mid-cap companies are largely in the downstream/offshore marine space with only three E&P companies. While E&P companies directly benefit from higher oil and gas prices, O&M companies only benefit when higher levels of activity and capex flow through from the upstream companies.
• No debt and generating lots of cash. Two notable characteristics of these 14 companies are that: a) half of them were debt free as at end-FY21, and b) the majority of the companies generated double-digit free cash flow yield in FY21. It would appear that some capex has been flowing into Singapore’s O&M companies in 2021 and ytd.
• Positive free cash flow generation in 2021. With the exception of Penguin, all the companies profiled in the comparable companies table on the previous page generated positive free cash flow (FCF) in 2021. In our view, this potentially points to an equally strong year in 2022 given that oil prices remain high, thus underpinning the robust activity levels that has continued in the O&M sector this year.
• High free cash flow yield. As a result of the positive FCF, we note that the majority of companies generated double-digit FCF yield (see chart on RHS). Note however that ASL Marine’s FCF is deceptively high given that it has very high depreciation: in FY21, its depreciation of S$33m was almost as much as its current market capitalisation of S$38m. In addition, we highlight its very high net debt levels of S$288m as at end-Dec 21 and resultant high interest cost of S$11.3m for 1HFY22.
• Lots of cash. Half of the companies that we looked at were in a net cash position as at the end of their fiscal year 2021. Three companies in particular – Baker Tech, China Aviation and Dyna-Mac – had net cash levels that were more than 40% of their market capitalisation. Should these companies continue their strong financial performance in 2022, the probability of higher dividends cannot be ruled out. We believe that activity levels in the industry have remained high and thus it will be interesting to see if Singapore’s oil-related names have continued to benefit from this in the upcoming 1H22 results season.
ESSENTIALS
• What drives crude oil prices? Economics dictate that it is a simple demand and supply equation; however, given that the Organization of the Petroleum Exporting Countries (OPEC) produces about 40% of the world’s crude oil (and its exports are about 60% of total oil that is globally traded), it has the ability to affect oil prices unlike in other commodity markets. By actively managing oil production in its member countries by setting production targets, we have historically seen that oil prices have increased in times when OPEC production targets are reduced. Importantly, Saudi Arabia, OPEC’s largest producer, can frequently affect oil prices via its indications of changes in crude oil production.
• Spare capacity is important… OPEC’s spare capacity allows the world to respond to price shocks caused by events that endanger oil supply. As seen in the chart on the front page, OPEC’s spare capacity in the 2003-08 period was at or below 2mmbpd (ie <3% of global oil supply), thus squeezing prices higher and into the US$140/bbl levels. This was only alleviated by the Global Financial Crisis in 2008-09 which materially dampened demand. Since then, OPEC’s spare capacity has gradually been squeezed lower and only rising back above 5mmbpd as demand fell due to the onset of COVID-19 in 2020. However, as the global economy recovered, oil demand has rapidly increased, which led to lower levels of spare capacity and thus higher oil prices.
• …and is forecast to be low. Saudi Arabia has usually kept more than 1.5-2.0mmbpd of spare capacity on hand to manage oil prices. However with the US EIA forecasting OPEC’s spare capacity to remain low at 2.75-3.0mmbbl over the 2Q22-4Q23 period, we believe that oil prices will remain high given the tight physical market.
RISKS
• Global recession. A global recession, perhaps triggered by the US Fed raising interest rates too aggressively in an effort to combat inflation, could lead to a deterioration in oil and gas demand and thus lower prices.