Sunday, 18 November 2018


A few things in life are inevitable. Among them are death, taxes, and Bursa Malaysia's oil and gas stocks simultaneously going up (and later, down). It's hard to anticipate, but you will see it when it occurs. It can be driven by something totally sentiment related, or it can be based on underlying fundamentals of the companies. But they are cyclical, and many of us do not truly understand what this means.

The most popular oil and gas counters on Bursa Malaysia currently are the downtrodden, money losing companies who were kings in the glory days of US$100 oil but are now burdened by onerous debts. In some cases, they are unfairly valued due to sentiment. In others, their operating models are fatal in the long run; too much leverage, but too little cash flow to show for it. They are doomed to issuing ever larger rights issues to fill their cash deficits, resulting in ever larger dilution of shares.

This is the fate faced by these companies, specifically firms with exposure in the upstream oil and gas segment.

But a cyclical sector such as oil and gas always provides new opportunities. There are moments when you can buy any counter indiscriminately to capitalise on the catalyst. Alternatively, there are instances where an internal catalyst in the firm's business turns it into a value investing opportunity. And there are  also those crazy times when you can just buy DIALOG without thinking of these trading and short termist angles. Seriously, just buy DIALOG.

 How can you disagree with a doctor? Check out his slides.

But in this post we will focus on a few of these upstream firms and how their stocks react to external, or internal, stimuli.

But first, a brief digression on global crude oil prices.


The short, uninformed answer is yes: you must always pay attention to crude oil prices. But they are only effective as indicators up to a point. That's the thing about catalysts; they are temporary.

The oil market is notoriously cyclical, and are fundamentally dictated by the supply and demand situation. They are also influenced by real secular trends; cycles can take as many as 20 years to complete the boom and bust phases. The most recent ones? Six years (2008 to 2014) and close to three years now from trough to recovery (2014 to the second quarter of 2018).

Business planners and budgeting managers at the oil and gas companies you know and love so much do not look at absolute prices of crude oil on any given day. They look at the quarterly or (if they are smart) annual average prices for crude oil.

The upstream segment is an inherently risky business; you're basically forced to guesstimate / anticipate the long term price trajectory of crude oil. You then commit to invest vast sums of money on assets that you hope will generate enough cash flow to pay off existing debts.

For companies with oil and gas vessels (ships, drilling rigs, tender rigs, floating storage offshore production rigs, and other exotica), they will go into debt to finance these rigs, and then generate cash from these assets to pay off long term debts. Residual income will be counted as profits, if any, after excluding operating expenses.

In an environment of steadily rising oil prices, this business strategy works wonders. Higher demand for upstream services brings charter rates for these ships through the roof. As crude oil becomes more expensive, companies can make a lot of money from fees gained for their services. This is the upcycle.

Guess how it's been from March 2016 onwards? Source.

But then the obvious happens (you do realise what cyclical means, right?). In an environment of steadily falling oil prices, the business model is turned on its head. Now your debt load and repayment obligations are rising faster than cash flow generated from the assets you have. Your interest payment on the debt for this quarter is RM50 mil, but your company doesn't earn enough to repay this amount.

The debt load keeps mounting, and you're hurt at the same time from lower demand, hence lower charter rates. If it gets bad enough you may have to essentially go bust, or perhaps find drastic solutions to raise equity. (Editor's Note : Or if you're in Singapore, your company will go into a bankruptcy-but-almost-not-really stage).

In other words, assuming the debt level and asset value is the same,

Oil price upcycle: High debt and leverage + High demand for assets financed with those high debts   = value creation

Oil price downcycle: High debt and leverage + Low demand for assets financed with those high debts = value destruction

Which brings us to the present day and the state of these once loved oil and gas stocks. Just to give you a clue as to the impact that it has had on Malaysian upstream firms: one was unceremoniously dumped by its parent company, another lost billions in market cap but still rewarded its founders richly, yet another had to drastically reinvent itself by acquiring oil fields, and another was caught in a two-year turmoil with shareholders before finally establishing itself as a serious oil and gas firm.

As a group, Malaysian upstream oil and gas counters most definitely have lost at least 70% of their collective market cap over the past three years (Editor's Note : DIALOG and YINSON being the clear exceptions) ; we're talking about tens and tens of billions of ringgit in value lost. But just recently we were finding ourselves in a rising oil environment. Each day brings news about crude oil being the highest since such and such (highest since the big fall in 2014, to be precise).


Just to give one example, indiscriminate buying of oil and gas counters tends to happen when this type of news comes out:

This is what indiscriminate buying looks like. This is a list of top traded stocks by volume from 2 October at 12:30PM, or the midday break. More than half of the companies you see here are upstream oil and gas counters (and their company warrants).

We're sorry to say that this is not a post about trading oil and gas stocks profitably. Consider this a handy reminder that the boom and bust cycles are fleeting. One month everybody's cherishing oil and gas counters; the next month investor sentiment is totally destroyed. And we mean this literally, as you can see below.

The definition of volatility, wild sentiment, and boom-bust: Brent Crude Oil price per barrel chart, mid-August to 17 November, 2018. Source.


Indiscriminate buying is temporary, and in case you don't already realise this, they will be followed by indiscriminate selling in the short term. There will have been a large number of speculations and uninformed investors chasing this easy angle. If you're one of these people, here's our message: if you want to chase the latest and hippest trends, go open your Pinterest account, not your Bursa Malaysia trading account.

We have found that any extensive buying activity in oil and gas stock, specifically as a reaction towards oil prices reaching new highs, is extremely short lived. The average timespan is less than two weeks (10 trading days), or the typical contra period for speculative capital to flow in the market.

At the same time, those holding these counters are exposed to the volatility in crude oil prices. If you bought these stocks simply as a proxy for crude oil prices, you will be king for a day, but a pauper for the rest of your life. You're exposed to the volatility in the stock, as well as volatility in the commodity. And unless you're a wizard at predicting the movement of crude oil prices - you're not - you're exposed on both sides (the volatility of the stock as well as the commodity).

In other words, don't simply buy oil and gas counters as proxy to current oil prices. We think it's a dumb move, and we're also referring to ourselves as we've made the same mistake before.


Remember Part I? Well here are the headlines barely a month and a half after the whole world was rejoicing the new dawn of constantly higher crude prices.

To get back to our original point, this is a lousy cycle to trade. Although it's fairly well-known that HIBISCUS and REACH are the stocks most susceptible to movements in crude oil, due to their oil-producing asset owner status, we thought it's worth putting a selection of oil and gas counters into a comparison chart.

Black is Brent Crude (ICE prices), with HIBISCUS and REACH represented in orange and blue respectively. The two stocks closely follow the trajectory of Brent, with a similar decline of around 15% over the past month.

Note that DIALOG's movement is fairly benign, while SAPRNG started from a low base due to its already low stock price due to other issues. PETRON, another downstream player, is largely influenced by their earnings performance, it seems.

The point is this : it's not worth buying HIBISCUS and REACH if you consider them proxies to crude oil price. Whether in an upcycle or downcycle, speculative capital flows means that their upward movement is not sustainable in an environment of weak oil prices. Even if you buy them to express a long term bullish viewpoint on crude oil prices, your timeframe may be as long as two years.

To know how bad the impact of the recent bust in crude prices has been, check out the following closing prices for selected upstream oil and gas counters on 16 November 2018. These are the ones you can compare with the 1 October prices.

You can see here that the one-and-a-half month decline is between 20% and a devastating 50% or more (look at BARAKAH in particular).  There is little earnings-related sentiment here; we believe that these purely reflect the shift in crude prices for the most part. And for the majority of the companies listed here, in the long term it hardly matters if oil prices go up; they are encumbered by huge debt loads and assets that are not really performing.

So when is actually a right time to buy into oil and gas counters? To put it simply, there are two options.

1) Buy when the stock is experiencing a price shock. We traded this angle profitably with SAPNRG.

2) Buy when crude oil itself is experiencing a price shock. If and when this happens (like in late 2014, or some say, right now), there is still downside to the oil and gas stocks that you see above. If bad enough, even solid companies like DIALOG can come under pressure. The shock must be bad enough that fear overwhelms reason. And when that happens, it is time to buy into fear.

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