THE oil and gas (O&G) sector was rocked by the global financial crisis as commodity prices including crude oil prices tumbled, with the price of Tapis spot oil plummeting 55 per cent from an all-time high of US$153 per barrel in mid-July this year to US$68.70 per barrel currently.

This sudden price reversal for crude oil stems from the liquidity crisis, which sparked the unwinding of commodities futures contract while the massive failures of US and global financial institutions reawakened the possibility of an impending global recession.

On Oct 7 this year, the Energy Information Administration (EIA) from the US Department of Energy projected West Texas Intermediate (WTI) crude oil prices at an average of US$112 per barrel for 2008 and 2009, barring “a major worldwide economic downturn that significantly impacts global demand”.

The department noted that oil markets were expected to remain tight due to sluggish production growth despite the current economic slowdown.

The EIA’s projection has clearly been over-optimistic in the light of further declines in crude oil prices since then.

In our view, crude oil prices should bottom out around US$50 per barrel, which is generally taken as the break even point for the production of crude oil in deep water activity.

This should be a psychological barrier for crude oil prices as future global supply may be curtailed by the contraction of new investments into the O&G industry.

Opec has indicated that crude oil supply may be cut by one million barrels a day to maintain an ‘ideal’ price range of US$70 per barrel to US$90 per barrel.

O&G players may face defaults or order cancellations from clients who are unable to raise working capital facilities against the backdrop of today’s global liquidity squeeze.

Norway’s Seven Marine ASA was reported to be facing difficulties in raising financing for projects despite its charter-backed contracts, while MPF Corp, a builder of offshore-drilling ships, filed for Chapter 11 in Houston because of rising costs in completing a floater.

While the O&G companies under our coverage have indicated the absence of such default problems from their customers presently, rising risks premiums have contributed to the plunge in stock prices.

As long as crude oil prices remain above US$60 per barrel, we are convinced that oil producing countries will continue to ramp up their O&G exploration and production activities.

Short-term gyrations of prices are unlikely to derail the constant search for new reserves and production from conventional fields.

The is on top of relatively untapped deep water offshore blocks throughout the region.

Malaysia, the first in the region to venture into deep waters, is currently developing eight deep water fields, which could involve capital expenditures of up to RM50 billion.

After conducting a review of the O&G companies under our coverage for possible negative earnings impact from the global financial crisis and impending economic recession, we have reduced our financial year forecast 2009-2010 (FY2009F–FY2010F) earnings by three to 14 per cent for Alam Maritim, Coastal Contract, Kencana Petroleum and Scomi Group (Scomi).

We have lowered our assumption of charter rate increases for Alam Maritim and slower ship sales for Coastal Contract while Scomi’s earnings could be compressed by rising overseas competition.

Besides our earnings downgrade, we have downgraded our target prices for O&G stocks given the global compression in price earnings (PE) valuations.

The worst affected by our review is Dialog Group with its target price reduced by 57 per cent as we switched to a PE based valuation of 10 times versus an earlier SOP methodology.

The target prices of Alam Maritim, Boustead Heavy Industries, Coastal Contract, Kencana Petroleum, Sapura Crest Petroleum, Scomi, Tanjung Offshore and Wah Seong have been reduced by 30 to 50 per cent as the forward PE multiple benchmark was lowered by five to eight times, similar to our recently cut of 44 per cent to KNM’s target price.

We maintain Petronas Gas’ target price given its defensive earnings structure backed by its major shareholder while Ramunia’s valuation lies in its fabrication yards, which will be unlocked by MISC’s proposed reverse takeover.

Despite the swings in the price of crude oil, slowdown in the global economy and financial and liquidity squeeze, we believe the massive O&G contract awards will still continue to be announced over the foreseeable future.

The O&G industry takes a long-term view to its capital expenditures and investments given the years required to develop oil fields.

Hence, we maintain our OVERWEIGHT call on the sector with our top pick being Ramunia followed by Kencana Petroleum, KNM and SapuraCrest Petroleum.

We also like Boustead Heavy Industries Corporation, Coastal Contract and Scomi.

We have downgraded our call on Alam Maritim and Dialog to HOLD due to our lower target prices.