- “The market” has done well this year. The S&P, the best of the bunch, is up just a smidgen over 10%.
- The sector that has the greatest history of “reversion to the mean” is the Energy sector.
- We discussed the Equipment Manufacturers and the Storage and Transport Firms in Part I.
- Now let’s review Supply & Demand Factors in Oil & Gas, and the Drillers and other Service Providers.
Supply and Demand in the Oil and Gas Sector
I'm not saying Friday's headline on Marketwatch is the new reverse indicator a la the cover of Business Week, but I am delighted to see the banner headline titled "Oil, other commodities will be in the dumps for another decade." The conclusions of the article rest upon two conclusions: global growth is slowing, thus demand is declining, while supply is increasing due to technology.
The laws of supply and demand have not been rescinded. But for the prognostication above to be accurate, we must amend it to "Global growth is going through one of its regular contractions before it leaps ahead yet again, temporarily reducing demand." At the same time, the technology exists to increase supply, but the biggest world producers have neither the money nor the ability to use it.
For the Demand argument, I need point only to the projection that no one seems to dispute: there are going to be more people on this earth next year than this year. And the next… and the next… etc. It takes energy to grow food, it takes energy to transport it to market, it takes energy to keep those people clothed and sheltered and safe from the weather. Not only that, most people want to actually improve their lot in life. This involves mobility; if it's upward mobility it involves greater transportation options and so on. The world is going to need more oil and gas.
It is also going to need more renewables, but the industrialized nations of most of the Northern Hemisphere do not have enough consistent sun in winter, means of storage of the winds that blow at the wrong time for consumption, and have already created about as much hydro as they can. There will be breakthroughs, of course, in the storage of renewable energy, but those changes will most likely be incremental and expensive.
Moving now to the Supply side, I read everywhere that because the U.S. has chosen neighbors wealthy in natural resources and is itself roaring ahead to extract oil and gas from what I call Nature's Giant Batteries so conveniently dispersed around the country, that we must be in a supply glut forever.
That is at best myopic and more likely just plain silly. Pundits are all over the board noting how Brazil is "going to" produce massive amounts of energy from its offshore fields and Libya is "getting back" to normal production and the Saudis "could" watch the price of oil fall to gain market share. Here's the other side of this equation to consider:
- I've spent some time in Saudi Arabia and I can assure you the Saudis have two resources: sand and oil. You can only sell so much sand to the condo owners in Miami, so they better be smart stewards of the one thing they have that buys them desalinized water, food, and everything else they need to survive. I can also assure you they are smart. Why pump out more and more of a finite asset at lower and lower prices? All this talk of the Saudis trying to undercut U.S. shale production is just talk. More likely they are posturing, very short term, for the upcoming OPEC meeting, where a crumbling cartel will squabble among themselves for more production and the Saudis will show that they need to keep a lid on it and keep prices higher rather than lower.
- Russia is the largest producer of oil and gas (soon to be overtaken by the U.S.). Putin thinks he's living the dream, but he's really living in a fantasy world. Without Western technology, Russia's 2nd-generation E&P technology and thus production will only decline. Until Russians stop electing autocratic father figure czars, their production will continue to slide. Putin brags that Russia has $450 billion in reserves. True, but he fails to mention they're losing about $40 billion a month with prices at these levels. Even Russians, used to graft, corruption and hard times, have a breaking point.
- After the U.S., Russia and Saudi Arabia, the next biggest producer is Iran. If there is a nuclear deal, likely a blow to the Iranian mullahs self-image and global prestige, Iran's oil could re-enter all the world's markets and be competitive. But if they drag their feet or claim to comply and don't, Iran will be a smuggler of oil, or sell only to the Chinese and their neighbors, placing them in direct competition with Russia for the money to prop up their regime. Geopolitically, we could do worse.
- China is next and uses pretty much all the oil it produces.
- The 6th-biggest producer is Canada, a democratic nation with far more resources than their population needs for domestic use. Fortunately for both sides, their neighbor to the south is the most industrialized and developed and thus the biggest consumer of energy.
- Next is Iraq. Now there's a steady-Eddie nation that can be depended upon for steady supply. At least oil from what, by all rights, should be but is not the independent nation of Kurdistan looks to be secure and growing. We'll see what happens when the Islamic State is just a bad memory and Iraq's central government can re-enter the Middle East game of Torment the Kurds.
- Looking at the next seven largest producers which, along with the first seven, account for much more than half of all global production, Kuwait and UAE look like secure sources of supply for now, as long as they keep buying off terrorists to attach The West rather than their own regimes. Venezuela is a basket case, which might come apart at the seams any day now. They need $120 oil to stay afloat and, according to the IMF, they lose $700 million with every $1 decline in the price of oil. Venezuela hasn't invested in infrastructure since Hugo Chavez decided to buy votes rather than invest in the future. I see their production falling, not rising. Mexico has a similar problem. Unlike Venezuela, they are doing something about it but they are still declining in production until they let those 109 tracts this March to international firms, and begin in late 2015 or 2016 to see increased production. Brazil? Dilma Rousseff's re-election pretty much ensures more graft, more delays, and less production. Nigeria can't even control Boko Haram and protect their most important asset, their schoolchildren. I doubt they can protect their oil supply.
Finally there is at least one piece of good news I see beyond North America in the supply equation: Barring major accidents, Norway just keeps leapfrogging others in their E&P technology and producing apace around the world.
Summing up, I don't see the supply side as being as strong and secure as most other analysts. As a student of realpolitik, while North America looks better and better (I see a future in which Canada, the U.S. and Mexico, form a triumvirate of low-cost-of-transmission, secure-lines-of-supply, nations), the rest of the world looks like it always has -- volatile, with demand constantly rising, but supply ever in question.
That said, let's move along to the Drillers and Service firms…
Oil & Gas Drilling Firms
I am a big fan of the oil service firms and drillers because they can do well whether it's the majors or the independents who find success in the oil patch - and, indeed, whether or not any of them find success! If you are a drilling rig provider and I'm Exxon, I pay you upfront whether or not I ever find a drop of oil. And if I go bankrupt because I never find a thing? Too bad, so sad, someone else rents your rigs!
The drillers probably provide the most diverse offerings of all, whether they be land drillers or offshore drillers. These are the firms that provide equipment and crew to the major integrated oil firms as well as to independent explorers and producers. Why is there this specialization? Why don't the huge integrated firms like Exxon (XOM), Chevron (CVX), BPÂ (BP), Royal Dutch Shell (RDS.A) (RDS.B), Total (TOT), Statoil (STO) and Conoco Phillips (COP) just buy them up and keep them in-house? There are lots of reasons. Insurance, geopolitics, risk and liability and simply the common-sense reason that it's cheaper to hire specialists to do specific jobs and be able to pick and choose among the best offerings at any point in time, rather than being stuck propping up your own subsidiary in something as specialized as this field has become.
Among our top choices for offshore drillers are Schlumberger (SLB), Oceaneering Intl (OII), Seadrill (SDRL), Atwood Oceanics (ATW) and Transocean Ltd. (RIG). Our emphasis is on U.S. companies and those international firms with at least 50% of their operations in the U.S. or U.S. waters. After all, the U.S. is now the largest producer of natural gas in the world and our oil and gas exports hit a new high last month.
Whether oil prices are up or down, there are many new opportunities around the world, especially in the offshore and offshore-deep arenas. Mexico in particular is moving much faster than most observers predicted in opening up their exploration prospects to foreign firms. Pemex is keeping about 90% of the nation's proved and probable reserves. In my opinion, that's not where the value lies. They "should" be seeking to joint venture with better-positioned, deeper-pocketed, more hi-tech firms in the vast areas as yet unexplored. It looks as if "Round One" of the bidding will include 109 exploration tracts (and 60 producing tracts) by mid-2015. The drillers, currently suffering from the lowest day rates for their rigs in recent memory, stand to see a serious uptick in utilization as Mexico and Brazil add to their demand for rigs.
While the demand is likely to remain weak for the rest of 2014 and possibly into the first quarter of 2015, I consider this an opportunity to buy cheaply into what I believe will be a boom by summertime. Which drillers will benefit most? I believe the biggest, with the deepest pockets, and the best reputations will weather the under-utilization storm and emerge stronger than ever when day rates once again accelerate. Don't be fooled by charts like this one:
This chart comes from Pacific Drilling (PACD), a great little company we have owned in our Aggressive Growth portfolio. They can be forgiven for being a bit self-serving. The chart purports to show that the "old fleet" of rigs held by the likes of Transocean, Noble (NE), Rowan (RDC), Diamond Offshore (DO) and Ensco (ESV) make them uncompetitive against those with the newest high specification drillers. What the company doesn't mention is that they own just 7 rigs, and their peer competitor, Ocean Rig (ORIG), has just 10. For comparison, Diamond Offshore has 49 and Transocean has 79. Who do you think Pemex and Petrobras (PBR) (Brazil's national oil company) are going to be most comfortable partnering with - huge firms with decades of experience and reputation or the younger firms planning to expand their fleet by 14% next year (with the addition of 1 more rig.)
That's not to disparage PACD. I see it as a very possible takeover choice for a firm like RIG or DO. Both need to increase their share of newer rigs and it's a heck of a lot easier to buy a company, even at a slight premium, and gain shiny new rigs immediately than to place orders with shipyards at unknown-today cost for something that will take another two years to build and deliver.
Of all the companies in this space, I like Transocean best. RIG has the most potential based on its available equipment, its worldwide presence, and its new build schedule into 2017. Their management has been hampered by the Icahn raid, but is still doing a good job of running their business. Seventy-nine rigs, many stacked right now, still counts for a lot when an oil major wants to drill tomorrow, not six months from now.
I like Seadrill a lot, as well. Part of that is because they gave us a whopping capital gain during the last exploration explosion, part of it is their 19% (yes, 19%) yield, which is only a 45% dividend payout ratio. However, SDRL is highly-leveraged, with way too much of an addiction to debt, and in this business, trailing earnings are not a valid harbinger of current earnings. That dividend may not be sustainable, especially since the company predicts no uptick in rig usage until the summer of 2015. Of course, they could slash the dividend by 50% and still be paying a 9.5% yield. But, caveat emptor, much of their debt is floating-rate which, if interest rates rise rapidly, would force them to retrench. Among the positives, however, are a large high specification fleet and high insider ownership. At these prices, SDRL as a speculative play makes sense. (As does little PACD, for an equally speculative, if different, reason - its size.)
Let me at least briefly touch upon Noble, Rowan, Ensco and Diamond Offshore. Noble has a well-diversified fleet, but has to date only been able to obtain below-average day rates and has multiple stacked rigs. It is likely a fine long-term holding, but I think we'll do better with others.
Rowan is one of the better mid-cap drillers and has handled this downturn very well - better than most of its peers. It has a preponderance of jackup rigs, which is seen as a negative by many analysts. I don't agree with them. When a client needs rigs, they don't always need the latest and greatest for the mundane effort of dealing with not-as-deep drilling as the new rigs are designed for. Rowan has a fine job of staggering contracts.
Ensco is a solid company, but I need to see better asset utilization before I buy them. I think they over-stacked too early in the game and lost opportunity to other firms. We'll see if they play it a little smarter going forward.
Diamond Offshore, maligned by most analysts, was the surprise of my research these past few months. Its fleet is old and the company doesn't seem that aggressive. But under the current depressed conditions for the industry, DO has a higher credit rating, better interest coverage, and more assets than any of those I surveyed except, by some parameters, RIG. The rigs they have stacked are nearly fully depreciated, so they have negligible revenue impact. They are a proven entity which has been through similar downturns many times in the past and know how to weather these downturns. And they have a history of using such downturns as an opportunity to buy more-highly-leveraged firms in their space. Finally, they are well-regarded internationally so it's likely they will be at or near the top of the shopping list for firms and governments around the globe.
We own RIG, SDRL and have already traded DO once this past month. At 32, we'd be longer-term buyers.
Among land drillers, there are many contenders but few players of serious size. According to the U.S. Energy Information Administration, it costs about $31 to produce a barrel of oil equivalent (BOE) on land versus about $51 offshore. However, while the odds of finding more BOEs of energy on land is higher than for offshore, that one offshore success will eclipse the lower price on land. The deep oceans and the Arctic north are the relatively unexplored parts of the planet. I'm convinced that's where the elephant finds will be made. But they're going to run through a lot more tubing, chemicals, drilling mud, fracking proppants and everything else on the onshore side of the business. That's why, in this, I like almost all the bigs like BHI that also have a decent number of land rigs as well as purer plays Nabors (NBR), Patterson-UTI (PTEN), and our old favorite of 35 years, Helmerich & Payne (HP). We are buying PTEN, NBR and nibbling at high-priced, high-class, still-hasn't-declined HP.
Oilfield and Offshore Services
There is inevitably some overlap in all these sub-sectors. Some equipment makers offer oilfield services, some drillers offer their own proprietary equipment, as do some of these service firms. But I have grouped them in the manner I have because this is where their "primary" revenues come from. And in the land and sea energy services business, nobody compares with giant Schlumberger. Whether in offshore exploration and production, land-based conventional, or land-based unconventional, SLB has an integrated package that goes from soup to nuts, and also provides a la carte offerings all along the way. The company has active operations in 85 countries. In many of these they've been serving customers since before WWII.
SLB is not alone in this area, of course. Others vie for the seismic survey, logging, drilling technologies, well completion, reservoir evaluation and optimization and project management space. Chief among them are Baker Hughes, FMC, and Halliburton, already discussed. Another is GE (GE). While a serious competitor, as investors it doesn't represent a pure play - oil and gas comprise just 13% of GE's total revenue. But if you add in GE's "Energy Infrastructure" and other "Energy" areas, which include nuclear, wind, solar, etc., at 41%, "energy" is more than half of GE's sales and climbing. If you also like their health care, water and power, aviation and financial services units, GE, down 2% over the past 12 months, is worth a look.
This is an amazingly concentrated sub-sector. Between them, the five companies above control 79% of the market for oilfield and marine services. Add the only other sizable competitor, Fluor Corp (FLR) and that market share jumps to 86.5%, leaving just 13.5% for the other 25 or so companies in this space to squabble over. FLR, down 12% over the TTM (trailing 12 months), is a strong contender, and one that is more diverse than the others listed here in that it also serves the chemicals, transportation, mining, manufacturing and life sciences industries. It is basically an engineering and construction firm, with half of its revenues coming from government and industry and the other half from oil and gas. It is the smallest of these half dozen giants in enterprise value, has the highest PE but the lowest P/S ratio, and an ROA, ROE, and net margin lower than the others. There's no getting around it: In this area, SLB shines above all others.
We're buying SLB, HAL and FTI.
Energy ETFs, Integrated Oils, Special Situations and Canadian Firms
I'm afraid I've run out of hours in the day. I promise to discuss these 4 areas in a forthcoming article or, more likely, two or three in the coming weeks. Until then, do your due diligence and… much success in your investing!
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