As we see increasing risks  on counterparty, orderbook replenishment and E&P assets, we downgrade t SELL (vs Neutral) with an unchanged MYR2.20 TP (17% downside).  We  also highlight  further  uncertainties  to the  gas sales agreement as the LNG industry has turned bearish  within the  one-year  horizon.  The  company  paid  MYR2.9bn  for  Newfield’s assets, and these offset the positives of an oil price recovery.

Risks  more  apparent.  On  top  of  SapuraKencana  Petroleum’s(SapuraKencana)  >1x high net gearing, we view  risks  highlighted in  our previous reports  as heightening . In the environment  now, we  fear for  its long -term  pipelay  contracts  stability  as  Petrobras  has cancelled/renegotiated  various  service  contracts  (Brazil:  47%  of orderbook).  We  are  unsure  how  protected  the  service  contractors  are from termination clauses.  ~40% of its 17 operational rigs are  also  up for renewal (three by  FY16,  3-4 by FY17). W eaker exploration & production (E&P)  earnings  and  asset  impairment  possibilities  could  arise  in  the earning quarters.  Latest foreign shareholding  fell  to 20% (from 23%, exSeadrill)  and  Tan  Sri  Mokhzani  Mahathir’s  resignation  from  the  board could provide uncertainties on Kencana Capital’s holdings (>10%).

Bearish gas outlook.  Despite our 2015 USD72/barrel (bbl) assumption(2016:  USD80/bbl),  we  see  SapuraKencana  facing  substantial  risk  on liquefied natural ga (LNG).  The >3trn cu ft  (tcf)  gas reserves for SK408 and SK310  are sizable  in  total  oil & gas (O&G)  future production profileestimates. While we  cannot predict exactly when  it  will sign a  gas sales agreement  (GSA)  with  Petronas,  we  note  that  expectations  for  Asia demand for LNG  are  now  bearish.  Japan spot LNG already contracted >40%  YoY  to  average  USD10/m  British  thermal  units  (MMBtu)  in January and  some LNG producers are facing difficulty in  locking in longterm GSAs  with Asian buyers. Industry experts think  LNG, which tracks oil price  on  a  half-year  lagged  basis,  will  fall  by  another  30%  in  2015. Note  that  SapuraKencana  paid  MYR2.9bn  for  Newfield’s  assets.  While we  believe  the  GSA  (to  be  signed  per  well)  will  likely  be  long-term tenures, another uncertainty is the offtake  level  negotiated between  the signing parties.

Downgrade  to  SELL,  MYR2.20  TP  (implied  10x  FY16F  P/E).  Our FY16F/FY17F  earnings  are  lowered  by  6-7%  as  we  value upstream  at an  8%  discount  to  our  oil  price  assumption  (pending  the  GSAs).  Our SOP  is  unchanged as we  reduce  our net debt assumptions attributable to the holding company. SOP  comprises E&P  (MYR0.91/share DCF for Malaysia  and  Vietnam  producing  fields),  5x  EV/EBITDA  for  offshore construction (OCSS) and tender rigs, and 8x P/E for fabrication.

We revised upstream valuations by  revising our  2015/2016 oil price assumptions  to USD72/bbl/USD80/bbl (previously USD80-90/bbl)  respectively  and apply a discount on  the  O&G  prices  given  the  uncertainties  on  the  monetisation  of  gas  assets.  We reduced  our  net  debt  assumptions  attributable  to  the  holding  company  as  we  had used P/E and DCF in some segments. We believe further negative sentiment  could push the stock down to its low of MYR2.20.

Stress test scenario. Assuming  Brent crude at USD40/bbl, 25% cut in rig day rates and  cancellation  of  pipelay  contracts  from  Brazil,  this  will  bring  a  MYR1.99  TP(implied 9x P/E). A sustained oil price  uptrend to  USD90-100/bbl  scenario, rewarding
terms in the GSA  and orderbook could boost TP to MYR4.02 (implied 18x P/E). Our forecasts are 9%  more conservative  than  consensus, as we  expect weak  earnings from  the  energy  division  from  4QFY15  (Jan)  through  1HFY16  based  on  lower  oil
prices.

LNG vs oil price comparison.  According to an industry specialist from  Resources, the  LNG  price  equivalent to  an oil price  of  USD100/bbl  would be  something  in the order of USD15 per gigajoule. Although there is no simple comparison for  prices of
gas  vs  oil,  given  the  different  market  dynamics  and  formulas,  we  see  signs  of shortening  contract  tenures  at  2-5  years  from  10-25  years,  and  falling  LNG  spot prices of 40-50%, as an oversupply glut is a concern.

Source: RHB