Despite the good news that RM2.8 billion worth of fabrication projects have been handed out by national oil company Petroliam Nasional Bhd (Petronas) recently, neither industry players nor analysts are exactly elated.

That's because the sector is still dogged by concerns about the flagging global economy, thinning margins and higher financing costs.

Analysts are mostly anxious that project execution should remain unhindered, which will be key for these oil and gas (O&G) service providers to maintain or enhance their profit margins.

For Kencana Petroleum Bhd, for example, the good news is that a US$235 million (about RM846 million) offshore drilling services contract and RM288 million worth of fabrication works of offshore facilities from Petronas Carigali Sdn Bhd are in the bag. But analysts remain cautious because Kencana must be able to maintain its margins through a cloudy future.

“Service providers could be affected by order cancellations and collection defaults due to tighter credit financing,” says Aseambankers in its recent note. The research house downgrades the O&G sector to “underweight”.

Similarly, ECM Libra Investment Research, which maintains a “neutral” stance on the sector, is concerned about thinning fabrication margins on the back of rising material and labour costs.

Industry players expect programmed spending by oil majors to continue but there are risks of delays and cutbacks in expenditure. On a global scale, a number of corporations such as Petrobas, Chesapeake Energy and Petrohawk Energy have postponed or scaled back their capital expenditure (capex) plans.

“The packages awarded by Petronas recently are not that huge, except for those that went to Malaysia Marine and Heavy Engineering Sdn Bhd and Sime Darby Engineering Sdn Bhd, which both took large chunks of the project,” says an industry player.

Moving forward, he says that while approved jobs will continue, the outlook for the O&G sector next year does not look bright as the economy takes a dive and energy prices could tumble further. "Companies that have secured jobs recently will be able to keep themselves busy for the next two years, but come 2010, I am not certain whether there will be strong order book growth," says the analyst.

With slowing growth prospects driving the crude oil price down, the writing on the wall is clear for the O&G players: the record prices seen during 1H2008 were too good to last. True to form, the price of Nymex crude oil has fallen from its peak of US$145 per barrel in July to about US$64 per barrel currently.

But while many question the sustainability of the high oil price, others anticipate that prices will reach US$200 per barrel.

Nevertheless, the higher oil prices have translated into bumper profits for the world's leading oil companies. US-based Exxon Mobil’s profits jumped 58% to a record US$15 billion for the three months from July to September. Europe's top oil company, Royal Dutch Shell, saw profits for the same period climb 22% to more than US$8 billion.

Since the record high in July, however, prices have been sliding. Oil prices hit a 17-month low last week on concerns that a slowing world economy would cut demand for energy. There are also concerns about supplies.

The Financial Times quoted a draft of the International Energy Agency's annual world energy outlook that production would fall by 9.1% a year without extra investment. A number of oil-producing countries are reportedly finding it harder to finance new projects because of the recent sharp fall in the oil price.

But how much further will the oil price fall? And what is the break-even level for oil producers?

With the volatile market sentiment, not many dare to predict how low prices will go. But Aseambankers note that crude oil prices are unlikely to breach the US$40 per barrel threshold, below which exploration and production (E&P) spending would freeze.

“On average, we have found that the US$40 per barrel floor price appears to be the historical low for the crude oil price — in current dollar terms — during the previous episodes of global or US recessions,” it says.

Aseambankers estimates oil prices to trade between US$70 and US$80 per barrel for 2009 based on the current outlook for the global economy by the International Monetary Fund (IMF) which predicts that emerging economies, underpinned by Asia, will continue posting growth albeit at a slower pace.

For Petronas, the research house holds that the oil firm’s average cost of production for the local O&G fields is lower than the US$40 per barrel threshold. “At US$40 per barrel, Petronas still makes money. Bear in mind that the US$40 per barrel price level used by oil majors in project analysis (for offshore fields) generally has a generous built-in internal rate of returns,” it says.
However, Aseambankers reckon that should oil fall below this threshold over the next one to two years, E&P investments will still continue.

It believes that with prices at between US$50 and US$80 per barrel, most conventional and unconventional O&G activities such as deepwater oil sands and marginal fields will still be viable.

But if prices dip below US$50 per barrel, Aseambankers says capex programmes could slow down for new projects and tenders may see slower decision-making, revisions and deferrals. At this level, it believes development for marginal fields and oil sands projects will not be viable.

While the swings in oil prices should not have a direct impact on service providers, they are affected by capex cutbacks by oil majors, the adverse effect of the global economic slowdown and the credit crunch.

For instance, some offshore fabricators and shipyard owners in Singapore and China are already facing financing problems and a few have filed for bankruptcy.

Nevertheless, all is not gloom as local O&G players are expected to be more insulated than their regional peers and will benefit from Petronas’ higher capex moving forward despite the falling crude oil prices.

Petronas says its capex in local upstream activities during the FY2008 ended March 31, rose by 12% to RM21.54 billion from RM19.24 billion last year. The company adds that of the RM21.54 billion, RM12.06 billion or 56% was spent on development and production projects, RM1.52 billion or 7.1% was on exploration activities, and the balance on operations.

Aseambankers expects Petronas’ capex to increase by between 18% and 31% in FY2009. “We expect Petronas to spend from RM45 billion to RM50 billion for FY2009. So far, the signs are headed in that direction. Putting things into perspective, the greater need to replenish production will overshadow bearish crude oil trends and to a lesser extent, profitability,” it adds.

The research house estimates that raising production by 100,000 barrels per day can boost government coffers by as much as RM5 billion while every US$1 per barrel drop in average crude oil prices will lower the country’s export earnings by RM450 million annually.