The dip in the oil sector globally has brought smiles to consumers' faces due to reduced gas prices that allow them to enjoy more miles on the road. But on the other hand, it has increased the worry lines on the foreheads of investors, as they are unable to see the bottom end yet and are clueless as to what to do. Not to mention that the nature of business in the oil sector is quite different than the other production-oriented sectors, since the business is more dependent on the ever-changing global economic affairs. It is not a product which can be produced in the close perimeters of the factory and then placed on the shelves of the stores to be sold to consumers at free will.
The supply of oil depends on a number of aspects like natural resources and their exploration factors. It is also relative to the supply and demand. Hence, judging the health of an oil company without accounting for these factors would be unfair. The thumb rule to be remembered is that natural resources are limited and depleting, but demand is not moving downwards; if we average it out on a long term basis, the gains from oil companies will always have an upside. The main mantra of investment in this sector is patience and an eye for opportunity to take advantage of temporary dip phase like the one we have now. Let us take you through one such company where you can en-cash the current dip in the long run.
Current Status of Baker Hughes
Baker Hughes (BHI, Financial), one of the four big oil services companies, reported disappointing Q3 2014 results as the company missed consensus EPS estimates by 10%. The report stated, "the Company reported adjusted EPS of $1.02 against street estimates of $1.13. Devaluation of the Russian ruble, activity disruptions in Iraq and Libya, and activity delays in the Gulf of Mexico all contributed to lower than expected results."
This made me dive deeper into the details of the company and the reality is Baker Hughes missed the quarter largely due to factors that are beyond the control of the company or extrinsic factors mentioned earlier. Gulf of Mexico loop currents, Russian sanctions, chaos in Libya, and wars in Syria and Iraq are indeed beyond management's ability to predict or manage. However, if we take away these extrinsic factors and then plot the movement of the company, then the deduction states that the company reported a good quarter with strong revenues in the U.S. and Eastern part of the globe showing good improvement in the troubled pressure pumping segment. Hence, the major culprits for the dipping quarterly health of the company are actually the external factors which will change with time.
Insight of the Extrinsic factors
Revenue exhibited notable strength through the ongoing repair activities of the company's onshore facilities during the third quarter, as evidenced by the reactivation of the last idle pump and no disruptions in production and extraction due to propane availability. However, the upside from onshore function was diminished by weakness in high margin Gulf of Mexico activity. Still, the company’s claim of achieving 15% margin targets in Q4 of this year stands tall based on expectations of a partial recovery in the GoM. The company started witnessing net price rise in the last few weeks of Q3 and is optimistic of seeing the inactive extraction fleets getting back into activity by the year end.
The company’s revamping process of its troubled pressure pumping business is almost near completion. The loop current in the Gulf of Mexico had forced the company to shut down drilling in 13 deep-water rigs on account of unfavorable digging ambience in Q3 resulting in losing out on profitable extraction. If we take away the adverse effect of loop current, the company expanded its margins for North American onshore business by about 150bps. With GoM rigs returning to production, Baker Hughes should comfortably achieve the targeted North American margins of 15% by the end of next quarter. Currently, the pressure pumping function is almost through by 80-85%, with logistics improved, equipment retrofitted, and customer mix overhauled.
Forward Earnings Indicators for 2015
Though the oil major has been a laggard in its peer group in the last few years, it has undergone key structural changes under the able leadership of Martin Craighead. Baker Hughes has ended the losing streak in the eastern part of the globe, optimizing utilization of its domestic pumping facilities and enhanced profitability within each geo political market, while product innovation has taken the lead as evidenced by the recent low flow ESP introductions. Despite these bright sides, the investors are still speculative about the fate of the company due to the global slowdown in the sector causing a nose dive in its share prices.
However, while dealing with investment portfolios in such companies, it would be prudent to also take a look at the recent and upcoming mitigating factors which can usher in noteworthy upside. First, the new contracts in Brazil and Norway should partially offset the market weakness. The company is slated to scale up its deep-water direction drilling and LWD work by 50% through the year-end, while in Norway a new completion contract is supposed to go underway in the first quarter of the next year. Questions were also raised on the aggressive bidding by the company to acquire shares in Brazil and the downside fears due to potential start-up costs. Yet the company's share is already running above its current contractual rate of 25%. The company already has the infrastructure to facilitate 50% of the share since it held this level of share about a year and a half ago. The fact that the company has the experience of holding 50% share of this sector in the past as well also reduces the risk of probability of not being able to deliver the expected volume of work.
In the Eastern hemisphere, the financial graph of Baker Hughes has started its profitability run after a long streak of losses in the oil services market. The company lost about 40bps of share between 2010 and 2013. Still, it managed to bounce back to regain a solid 80bps in 2014. The latest Norwegian contract, share gains in Asia Pacific and Africa, and its low exposure to the Russian crisis should help it see the upside in 2015.
The Bottom-line
The negative impact of the Q3 results for the company is overdone. The company missed analysts’ expectation due to factors that are beyond management's control. The company’s share prices are currently at highly oversold levels and present a good opportunity to buy in. Baker Hughes has lagged behind in its peer group for a very long time, but under the able leadership of Martin Craighead, the company has seen positive fundamental changes to increase the chances of an upside from here on. With the repairing process of the company's onshore business nearing its end, Baker Hughes is set to gain shares in the international market in 2015, strengthened by the recent contract wins in Brazil, Norway and Africa.
Once the external adversities starts settling down by the year end, Baker Hughes expects to see sequential growth in revenue and margins in all geopolitical markets driven by cost to output ratio improvement and year-end product sales. As of now, we suggest a strong buying in the company at the current attractive levels and hold through 2015, to capitalize on the gains which would result from the restructuring process and the extrinsic aspects returning to normalcy.
