Excerpts from analyst's report

150_1Lee-YuejerOSK-DMG analyst: Lee Yue Jer, CFA (left)Jesalyn Wong

Oil & gas industry players are mostly of the view that we are seeing the bottom of a normal oil & gas business cycle. Amidst the chaos some companies will emerge stronger. Meanwhile, oil prices are beginning to recover as traders cover shorts on news of plunging rig counts in the US.

We posit an incoming paradigm shift – it could be shallow water, shale, then deepwater in order of increasing costs as shale production technologies improve and their costs continue to fall. 

Sentimental capitulation. When oil prices were at USD90/bbl, nobody predicted a fall to USD50/bbl. Now that we have reached this point, the mass media has turned fearful, talking more about USD40/bbl oil and below. We believe that this is the final capitulation stage which always comes ahead of a recovery.

 Chasing away the bears. We prefer to reason using first principles instead of by analogy. The fallacious latter methodology draws parallels between this crash and that of the 1980s, where prices stayed low for a decade. However, basic economic principles give us confidence that i) long-run oil prices have to cover marginal costs, ii) marginal costs are those of deepwater/shale production today, iii) therefore long-run prices have to recover to cover the costs of the marginal barrel of production in demand.

The 11-18% spare capacity situation in the 1980s does not apply today. The high natural decline rates (>50%/year) of shale wells will also act to curb supply growth this year as active rig counts plummet.

Deepwater may take a back seat to shale. Technological improvements and accessibility of shale production (which is all onshore today) means that the marginal cost curve for shale producers has been rapidly shifting downwards (from >USD100/bbl before 2010 to c.USD80/bbl by 2014) even before the oil-price crash. “Necessity is the mother of invention” and the existential crisis facing most shale producers will drive innovation and productivity improvements in their bid to stay relevant.

oldwell2.15Giken is focused on drilling next to old wells in Indonesia and its breakeven cost is just c.USD20/bbl.
Photo: Company
We see a larger scope for cost reductions and technological improvements in the relatively new shale production space vs deepwater. With shale’s marginal cost range now comparable with deepwater, but falling faster, we think that margins for deepwater players will remain under pressure for an extended period.

An Arabic saying to guide investments. At the Oil & Gas Assembly last week, an eloquent speaker quoted a saying in Arabic, “If you have a vision, then have determination, for the corruption of that vision is hesitation”. We find this particularly applicable for stock selection.

Our Top Picks are companies with a clearly defined strategic vision, and a strong industry position from which to execute that vision.

These are Giken Sakata, Ezion, Nam Cheong and Keppel. Marco Polo Marine has potential for event-driven high alpha. Least preferred today are Vard and Ezra due to their operational weight towards deepwater exposure.

Recent story: GIKEN SAKATA: "Oil price immunity for at least 22 months more"

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