Macro Analysis /

Pakistan Strategy: Major supply disruption in global crude oil market, positive for E&Ps

    Saad Ali
    Saad Ali

    Head of Research

    Intermarket Securities
    16 September 2019
    • In a major development for global oil markets, the biggest crude-processing facilities of Saudi Arabia were struck by drone attacks. This has reportedly pulled out about half of the country’s oil supply – 5.7mn barrels or 5% of global supply – from the market. According to reports, it may take weeks for Saudi to restore the lost production. In short, this event has pushed international oil market into temporary deficit. Brent has spiked as a result. We think oil prices could rise further, if the event leads to an escalation of geopolitical tensions in the Middle East, and there are delays in major oil producers using their emergency reserves. 
    • However, this is not a new normal. Prior to this event, the oil demand outlook was in the doldrums amid an economic slowdown in major economies. Oil was arguably set for a correction, in our view. While the event could push oil prices to new near-term highs, it may not be sustainable once the supply issues subside, in our view. Also, high oil prices could be self-destructive and threaten a further slowdown in global demand growth. Note Brent peaked at US$85/bbl in Oct’18 ahead of an anticipated 3mn barrels of supply cut from Iran due to US sanctions, which did not fully materialise. Brent fell more than 30% in the following 3 months.    

    The event will yield price discovery in the E&P sector

    • For E&Ps in Pakistan, this is a major event and will likely improve stock price discovery in the sector, which until now was trading close to trough valuations. For instance, the largest E&P traded at 1.5x FY20 EV/EBITDA and 4.5x P/E, at last close. Also, Pakistan E&Ps have recently been locked in a slow production growth period and needed price catalysts for earnings growth, in our view. Nonetheless, we see high oil prices as temporary. 
    • Refer to the tables below for sensitivity of the three covered E&Ps. We highlight that Pakistan Oilfields (POL, Buy, TP PKR415) is the biggest beneficiary, given 60%+ contribution from oil and other liquids. Even its gas production, on aggregate, is relatively based on newer Petroleum policies which are more sensitive to oil prices. Based on a long-term oil price assumption of US$65/bbl, our top pick is Oil & Gas Development (OGDC, Buy, TP PKR180/sh). We like OGDC despite its lowest sensitivity to oil prices – because of (i) undemanding valuations, and (ii) a more reliable payout policy than its close peer (PPL, Buy, TP PKR165/sh). Note OGDC’s low sensitivity will be a virtue when international oil prices normalize. 

    We also caution that oil prices above US$80/bbl may not be sustainable given weak global demand; at that level, it could be an opportune time to reduce positions in the sector, in our view.   

    Red flag for the Economy if oil prices remain high

    • This event materially alters the inflation and in turn interest rate outlook. There is also the risk that interest rates can rise further, even though SBP has maintained real interest rates above 2%. Given that higher oil prices can swell the current account deficit as well (above US$1bn per month is an alarming level), we do not rule out further currency adjustment either.
    • We estimate that every US$10/bbl will increase local petrol prices by PKR15/liter or 13% (assuming GST is maintained at 17%). This alone will push the CPI by 0.40bps, by our estimate. About 10% higher oil prices can add US$1.5-2.0bn of imports annually and thus CAD (despite Saudi deferred oil payments). The only silver lining could be higher tax revenues from petroleum sales for the government, which could help in limiting fiscal deficit, in our view. We estimate about PKR50bn of additional revenues from petroleum sales, if crude oil prices average US$10/bbl higher than earlier expected.    

    Back to defensives

    • We think investors should remain Overweight on E&Ps, banks and textiles, and avoid cyclicals like cement, autos and steel (despite their trough valuations). Higher oil prices will push input costs (power, transport) and also lower demand for petroleum products. If interest rates remain high for long, leveraged companies in cement and steel sectors will be hurt. Oil marketing companies will enjoy significant inventory gains, but will ultimately see weaker sales and more competition for market share, in our view. An accelerated buildup in circular debt cannot be ruled out as well. Our top picks are OGDC, POL, MCB, ABL, HUBC, ENGRO and APL.