Oil and Gas sector: May be volatile but a floor will remain (OCBC)

China may become largest driver of oil prices in a decade. Though China is the second largest consumer of oil, its per capita oil consumption is only about a tenth of the US, hence there exists a huge potential for demand growth. Assuming the country's urbanization strategy remains on track, we estimate that China may become the largest driver of oil prices over the next five to ten years. Indeed, we find that the correlation between China's industrial growth and the WTI oil price has increased from 0.45 in May 2001-2006 to 0.65 in May 2006-2011, and we would increasingly look to the country's forecasted economic growth for signals in the oil price.

Oil price volatility theme to resurface in the future. However, the influence of speculators in the oil market has increased over the years. World production of oil has not kept up with demand growth, and the impact of speculation can be greater felt in a tight demand-supply situation. Coupled with the increased sensitivity of oil prices to supply disruptions, unless we see an easing in the demand-supply situation, we believe that volatility in oil prices may be increasingly prevalent in the future.

How will this affect capital expenditure? Undeniably, the volatility of oil prices negatively impacts investments in the oil and gas sector. However, supposing the developed countries continue their fragile economic recoveries and China's growth remains on track, we believe that oil prices should remain above US$75/bbl which should sustain most capital expenditure in the sector. In particular, in the upstream offshore segment, we expect the rig order momentum to remain strong; the increasing number of permit approvals in the US Gulf of Mexico should spur interest in semisubmersibles, probably by early next year. Demand for large production platforms is also holding up, and Sembcorp Marine's subsidiary, SMOE, has been bidding for work as well.

Maintain Overweight. We maintain our Overweight rating in the offshore oil and gas sector given its solid long-term fundamentals. Under our sector coverage, Keppel Corporation [BUY, FV: S$13.00] and Sembcorp Marine [BUY, FV: S$6.30] remain as our preferred picks, as they are well-positioned to benefit from the positive outlook of the jack-up and semi-submersible rig market, FPSO conversion and production platform segments. Meanwhile, Ezion Holdings [BUY, FV: S$0.84] is a promising counter for investors looking at small- and mid-cap plays as we expect a jump in FY11-12 core earnings with deliveries of its liftboats.