Engineering and Construction
Crude oil prices have fallen nearly $10 in the past two weeks. As I suggested in a flash alert last week, Flash Alert: Tankers Up, Crude Down, and reiterate below, crude weakness could continue into the new year. But this temporary downdraft will be nothing more than a blip on the radar screen; the bull market in oil prices remains intact.
And energy investors have nothing to fear. Oil prices are still elevated and will be even if we see a pullback into the $70s. Prices in that range are more than sufficient to generate continued interest in major oil development projects worldwide. If anything, spending is set to actually accelerate even further in the coming years in key markets such as deepwater drilling.
With that in mind, any pullback in energy-related stocks is an absolute gift for investors–an opportunity to jump into some high-quality names at bargain prices. In prior issues, I’ve examined some of the sectors most leveraged to the long up-cycle in spending on exploration and development. Specifically, I’ve highlighted, and profited from, the oil services and equipment stocks.
In this week’s issue, I’ll take a look at another sector: engineering and construction (E&C). E&C firms plan, engineer and construct complex deepwater field developments and subsea pipelines.
As crude oil prices continue to fall in what’s likely just a correction for the commodity, pullbacks in the energy market can be expected. In last week’s flash alert, I noted two ways to play the pullback. I reiterate those plays here and introduce a purer play for interested subscribers. See Gaining Leverage.
The big growth in the global oil and gas markets is to be found offshore and overseas. And despite the higher costs involved with such activity, deepwater drilling should grow significantly in the next few years. Here’s a rundown on that section of the market. See Where’s the Growth?
I recommend several services plays in the Wildcatters Portfolio, but there’s another way to play this sector. I list several international plays that are worth looking into; I’ll continue to track these plays in the How They Rate Table as well. See Playing E&C.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
It’s totally normal for bull markets to correct from time to time. One of my favorite examples of this is the bull market in the Nasdaq Composite between 1990 and 2000. This bull run resulted in a total return just shy of 800 percent for the decade, just under 25 percent annualized. But note the chart of the index below.
Source: Bloomberg
I’ve labeled just a handful of the corrections in the Nasdaq that occurred during the 1990s. These all look meaningless in the context of my long-term chart, but I assure you, a 15 to 20 percent pullback doesn’t feel that meaningless when it occurs.
Of course, the key takeaway from all this is that those investors who bought the dips in the Nasdaq during the long bull run were rewarded handsomely. Those who panicked and sold missed a huge potential gain.
The factors that will bring oil lower are twofold. First, demand is starting to show at least some tentative signs of falling in response to higher commodity prices.
The International Energy Agency (IEA) recently cut its oil demand forecasts for most regions of the world; oil demand in the fourth quarter is now expected to be about 500,000 barrels per day less that previously projected. The IEA is looking for about 2.3 percent global growth in demand for 2008.
These downward revisions to oil demand are really a function of the global growth scare I discussed at length in the most recent issue of The Energy Strategist. Clearly, the US economy is slowing down, and that slowdown is likely spreading into Europe to some extent. Lower growth spells lower crude oil demand.
That said, I expect continued strong growth in developing markets to power further growth in oil demand. This will serve as an offset to the US and developed market slowdown.
Far too many investors remain US-centric when it comes to oil. The simple fact is that the US is no longer the driver of oil demand growth; almost all of the consumption growth in the past five years has come from the developing world, particularly Asia. Nonetheless, perception is reality, and I expect the market to become increasingly concerned about an oil demand slowdown as we head into 2008 whether that softening actually occurs or not.
Then, there’s the supply side of the equation. As I noted in the last issue of TES, Organization of the Petroleum Exporting Countries (OPEC) has remained extraordinarily disciplined in recent months. It just hasn’t been shipping oil to the west as aggressively as it would normally at this time of the year.
That, coupled with disappointing growth in non-OPEC supplies, has led to an unusual counter-seasonal drawdown in global oil inventories. That inventory tightness has, in turn, been a tailwind for crude prices.
But I’m starting to see evidence of more OPEC supply heading west. The obvious indication of this is global oil tanker rates.
Source: Bloomberg
This is a chart of the Baltic Dirty Index of tanker rates. The continued, obvious spike suggests some shortage of tankers available to haul oil.
This suggests that Persian Gulf nations have started to book ships for the long journey to the US; tanker owners are able to charge higher rates to lease their ships as a result. With tanker rates now at their highest level in well more than a year, it looks like there’s an end-of-the-year scramble to book tankers.
I would guess these shipments will begin showing up in US oil inventories in the first part of 2008. An easing of supply tightness in crude oil will put further downward pressure on crude oil.
I also expect weakness in crude oil to continue to keep a lid on rallies in energy-oriented stocks near term. Certainly, oil stocks and oil prices aren’t perfectly correlated. After all, crude prices rose well into November even as the Philadelphia Oil Services Index (OSX) topped out in October.
I recommend playing these trends in two basic ways. First, I recommend taking steps to hedge your portfolio against a near-term pullback in the group. And second, it’s high time to start compiling a shopping list of new oil- and gas-leveraged stocks to buy on any dip.
As to the second point, the engineering and construction stocks I highlight below are intended to be part of that shopping list. I expect to start getting more aggressive in my recommendations of these stocks during the next few weeks.
As for hedges, I recommended two new plays in last week’s flash. The first is tanker operator Frontline (NYSE: FRO). Frontline has the vast majority of its ships leased under spot-rate contracts. Tanker operators have a choice to hire ships under term contracts, locking in a fixed rate for several years, or to accept the prevailing rates on the spot market.
Obviously, as the chart of the Baltic Dirty Index above indicates, tanker spot rates are highly volatile. However, companies concentrated in this area can earn far higher returns on their ships during strong tanker markets.
In this case, I’m looking to play a continued run-up in tanker spot rates into the new year. Frontline offers real leverage to that spike in rates and should continue to see a pop in the coming weeks. Note this is an aggressive trade idea rather than a long-term play; that’s why I chose to recommend it as part of my more aggressive Gushers Portfolio.
My second play on the oil pullback is a short exchange traded fund (ETF) that tracks the inverse of the Dow Jones Oil & Gas Index, a basket of the largest oil- and gas-related stocks in the US market. The ProShares UltraShort Oil & Gas ETF (AMEX: DUG) tends to rise by double the percentage that the Dow Jones Oil & Gas Index falls.
ETFs trade on the major exchanges just like stocks. They’re simple to buy and sell. Your broker should charge you no more to buy these ETFs than to purchase any other stock.
By purchasing UltraShort Oil & Gas, we can partially hedge our long-side exposure to the industry. Specifically, I’m looking for the stocks in my three model Portfolios to broadly outperform the industry as a whole. But if this bout of selling continues for a few more weeks, even the fundamentally attractive names I recommend will get pulled lower.
Remember, as I said earlier, fundamentals go out the window during global selloffs of this nature. Exposure to this UltraShort ETF will guard against such an eventuality.
The other point to remember about hedges is that the best thing that can happen is for us to lose money. The reason I say that is hedges are, by definition, designed to go up in value when the rest of your portfolio declines in value.
If we lose money on this ETF, it suggests that many of the recommendations in the TES model portfolios are actually going up. This is also why I don’t recommend buying this ETF unless you’re long a significant number of TES Portfolio recommendations.
For a purer play on further declines in oil prices, subscribers should consider shorting the US Oil Fund (AMEX: USO). This ETF tracks the performance of crude oil prices, not crude oil stocks. Alternatively, for those unwilling to short stocks, the April 2008 70 put options (UN APR) offer an alternative way to play downside in this ETF.
I chose to recommend the short ETF rather than a short in oil for two reasons. First, in my experience, the majority of subscribers are reluctant to go short stocks; these short ETFs offer a more comfortable means to hedge the portfolios.
And second, the TES portfolios represent a portfolio of stocks. The DUG ETF is a more direct hedge against the risk of a short-term pullback.
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These are the giant firms that actually plan and build the infrastructure needed to produce complex fields in the deepwater and international markets. Crude oil prices would have to drop back under $45 for a sustained period before having any impact on spending in such markets. In fact, firms conducting many of the international and deepwater oil projects have actually factored in oil prices of just $40 or so when determining the feasibility of their projects.
One of the longest-standing and most-often-repeated themes in TES is the end of “easy” oil. The basic thesis is that the world isn’t literally running out of oil (or gas); rather, growing production is becoming more complex, expensive and time-consuming. Deepwater is a prime example of the end of easy oil thesis in action.
No producer would bother to spend billions on a deepwater development if it could simply grow production cheaply from simple-to-produce onshore fields. But the fact is that deepwater is one of the final exploration frontiers of the global energy markets. Many of the most promising actual new reserves of oil that have been found in recent years are located in the deep.
According to Offshore Magazine and a recent survey published by energy analysts Douglas-Westwood, total global deepwater oil production will grow from 4.5 million barrels per day in 2007 to more than 8 million barrels per day in 2011. Over the same time period, deepwater gas production will nearly double from 1.6 million barrels of oil equivalent per day (boe/d) to some 3 million boe/d in 2011.
And check out the chart “US Oil Production by Source.”
Source: Energy Information Administration (EIA)
This chart shows Energy Information Administration (EIA) estimates for US oil production out to 2030. The EIA is projecting that US oil production will remain generally flat overall out to 2030.
But production onshore, from Alaska and from the shallow-water Gulf of Mexico, is expected to fall. In fact, there’s only one subsegment of US oil production that’s expected to show meaningful growth between now and 2030: the deepwater Gulf of Mexico.
Although growth in deepwater production has already been impressive, one factor that’s been hampering even faster growth is a lack of availability for deepwater drilling rigs globally. These are the advanced technologically complex rigs needed to drill wells in the deepwater.
The supply of such rigs will remain tight for at least the next five years; however, availability is set to gradually improve through the end of 2010. The reason is that a number of new-build deepwater drilling rigs are scheduled for delivery between the end of 2008 and the end of 2010.
Most of these new rigs have already been reserved under contract by major oil producers. These rigs are absolutely necessary for these firms to undertake deepwater projects.
Producers have been willing to pay day-rates exceeding $600,000 per day to hire these rigs. That’s proof of the high demand for more deepwater drilling work and development. As these new rigs are developed and start heading for projects, I’m looking for growth in deepwater activity to pick up notably.
During third quarter earnings season, companies had nothing but bullish comments on the outlook for deepwater activity and spending. As longtime subscribers are well aware, I pay particular attention to comments from the world’s largest oil services firm, Schlumberger. The reason is that this company operates in every imaginable geographic region and business line. It has the best bird’s-eye view of what’s going on in the energy markets.
Schlumberger’s CEO Andrew Gould suggested in the company’s Oct. 19 conference call that the only real limit on expansion of offshore activity was a lack of equipment and resources. Specifically, he indicated that it would take time for all these new deepwater rigs to enter service and ramp up to maximum efficiency. And Gould also stated that there was a shortage of capacity to build everything from offshore platforms to flow lines used to carry oil and gas from deepwater wells to the surface.
Unfortunately, many investors seemed to misinterpret Gould’s comments, which I highlighted in the Nov. 7 issue of TES, Coal and Services. Gould said that he expected to see delays because of inefficiencies in ramping up new rigs and installing needed equipment.
These delays aren’t caused by a lack of demand but, rather, are the result of demand exceeding supply. Schlumberger indicated that the growth is there but there will be periodic interruptions caused by lack of infrastructure.
But this is actually bullish for companies leveraged to the deepwater. Gould felt that these shortages would simply serve to lengthen the deepwater spending cycle. Ultimately, rising demand, coupled with constrained supply, suggests that companies that enable deepwater drilling will be able to charge more for their services and equipment.
All told, Douglas-Westwood estimates that global spending on deepwater projects will be around $108 billion between 2008 and the end of 2012. The chart “Deepwater Spending” breaks down that spending by specific area.
Source: Offshore Magazine, Douglas-Westwood
Note that many deepwater developments are now so-called hub-and-spoke projects. Basically, it’s expensive and time-consuming to build new floating offshore oil and gas platforms, so building a dedicated platform for a specific project would require a very large reserve target. Otherwise, the cost of building the platform would render the project uneconomic.
But there’s an alternative. Companies can build a single platform to collect oil and gas production from multiple fields and many wells. Each of these wells can be produced using subsea equipment that’s installed directly on the seafloor. Oil and gas produced from these far-flung fields is then transported by subsea pipe to a single floating platform.
A perfect example of this is Enterprise Product Partner’s Independence Hub and Trail. This floating platform and network of pipelines collects gas from several smaller deepwater gas fields in the Gulf of Mexico for eventual transport to the Gulf Coast.
At any rate, there’s a severe shortage of floating platforms to handle and process production from offshore wells. According to Douglas-Westwood, global energy companies will spend more than $28 billion between now and the end of 2012 building new platforms.
And that’s just for the platforms themselves. Companies will also need to lay subsea pipes to connect wells to platforms and platforms to the shore. More than $32 billion–$6.5 billion per year–will need to be spent laying pipe over the next five years alone.
In addition, considerably more spending will be needed to build and install subsea equipment. (I explained this market at some length in the Jan. 3 issue of TES, The Deep End.)
Alongside deepwater spending, the other big growth market for the energy industry is large-scale international projects. Consider the chart “Liquids Production Growth 2004-2030.”
Source: EIA
This chart shows the EIA’s estimates for annualized growth in oil liquids and natural gas liquids production for a number of key oil-producing countries and regions. What’s obvious from this chart is that most of the growth will come from outside North America and Western Europe.
Some of the biggest jumps in production will come from Brazil, the Middle East, West Africa and the Caspian. The reason these regions will see production growth is that these nations hold the lion’s share of global oil reserves. Check out the chart “Global Oil Reserves by Country.”
Source: BP Statistical Review of World Energy
This chart shows global conventional oil reserves broken down by country. The picture is very similar to the chart of projected production above; most of the world’s key oil reserves are located outside the US and European Union (EU). Nearly two-thirds of global oil reserves are, in fact, found in the Middle East.
Not surprising, oil producers tend to go where the oil is. Many of the reserves held in markets like the Middle East and Africa are actually owned by fully or partly state-owned national oil companies (NOC). As I outlined in the most recent issue of TES, traditionally the major integrated oil companies such as ExxonMobil and Chevron Corp have partnered with NOCs to exploit these reserves.
Typically, integrateds have negotiated some sort of production-sharing arrangement with the NOCs. This allows the NOC and integrated partners to share the proceeds of any oil or gas sales. As you probably already noticed, most of the big integrated oil projects I highlighted in the most recent issue of TES are partnerships between the integrateds and various NOCs.
Lately, however, there’s been a notable wave of resource nationalism worldwide. Sometimes this takes the form of combative rhetoric and actions, such as we’ve witnessed out of Venezuela during the past few years. But the more responsible NOCs have pursued a different path to developing their projects: Instead of partnering with integrateds oils, these NOCs are hiring global oil services firms to manage projects for them.
This business is known as integrated project management (IPM); it’s one of the fastest-growing markets for most of the major services firms. In IPM projects, a services firm will manage and schedule a project on behalf of an NOC client. This includes performing certain services, contracting with other services firms for parts of the project and ordering necessary equipment and materials.
As you might expect, Schlumberger is a huge player in IPM now. In the firm’s second quarter conference call, management stated that its total budget of IPM projects stood at $4.8 billion through the end of the decade. Schlumberger went on to state that it brought in $3.8 billion in new contracts in the first half of the year.
Originally, the IPM business concentrated almost totally on customers in Latin America, but it’s growing rapidly. Although Schlumberger didn’t offer a complete breakdown of its backlog in its third quarter conference call, management did indicate that it’s seen a pickup in interest in other regions, particularly Africa and some parts of central Asia.
My point in highlighting all this is that growing interest in IPM is just another sign of strong demand for international oil and gas development projects, both in deepwater and on land. It also suggests another key trend: rising complexity. In other words, NOCs are increasingly targeting smaller, more complex reserves.
These firms don’t have the capability and know-how to produce these fields in-house. That’s exactly why they’re hiring companies such as Schlumberger to handle project management for them.
The final point to note about international projects is that these projects tend to be large-scale, multi-year deals. In North America, drilling projects outside deepwater tend to be small incremental deals. Because these projects are short term in nature, they’re highly dependent on commodity pricing.
So, for example, weak natural gas prices over the past year and a half have resulted in a notable slowdown in North American drilling activity. See the chart below.
Source: Bloomberg, Baker Hughes
This chart illustrates the North American rig count—the number of rigs actively drilling for oil or gas in North America. You can see that this measure grew strongly through about the middle of 2006 and has since moderated.
There are also a few other notable declines on this chart. These correspond to periods of weakness for natural gas.
As noted above, because of the larger size and longevity of international projects, producers are unlikely to cancel them at the first sign of commodity weakness. Several services firms have suggested we’d need to see oil prices fall below $45 per barrel to see a meaningful slowdown in international activity or major project cancellations.
Bottom line: The bulk of capital spending on oil and gas development will be concentrated mainly in deepwater markets and in large-scale international projects in markets such as the Middle East and Africa.
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But there’s another sector with leverage to these explosive trends: oil- and gas-focused E&C firms. These companies handle the construction of offshore platforms and pipelines needed to produce deepwater fields. They also provide crucial infrastructure needed to handle complex new developments in international markets.
Alongside the services and equipment firms, E&C companies stand to benefit from the rapid ramp-up in global spending on oil and gas infrastructure. Most of the biggest players are actually based in Europe, though several trade on the major US exchanges as American Depositary Receipts. The following table offers a list of the biggest players along with some key data on each.
Source: Bloomberg
Given the strength in deepwater and international markets, I prefer E&C companies with strong leverage to these growth areas. I’m adding all of the firms in the table above to my coverage universe. Here’s a rundown of each:
Saipem (Milan: SPM, OTC: SAPFF)
I highlighted Italy-based Saipem in the Oct. 24 issue of TES, Liquid Gold, specifically in reference to its liquefied natural gas business (LNG). Although that’s certainly an attractive market, there’s a lot more to Saipem than just LNG.
The company divides its business into three main units: onshore, offshore and drilling. The first two business units are far and away the most important for Saipem in terms of revenues, profits and growth potential. Onshore and offshore operations accounted for more than 90 percent of 2006 revenues, 77 percent of operating income and 81 percent of the company’s backlog of projects.
It’s important to note that Saipem’s onshore business is focused on large-scale international projects. This business unit includes the construction of major LNG gasification and regasification terminals, as well as large-scale oil and gas pipelines and refineries.
Global refining capacity is in chronic shortage, as I explained in the March 21 issue of TES, Looking Refined. Building and handling upgrades of new refineries is a major growth market for Saipem.
And the company has exposure to some of the most sought-after international onshore contracts.
A perfect example is Saipem’s operations in Saudi Arabia’s Khurais field. The firm has built a massive gas oil separation plant to handle production from this field. And the company also builds out infrastructure related to Saudi Arabia’s water injection system into Khurais.
Saudi Arabia has been using water floods to boost production from its fields for decades. This involves pumping water into the field under pressure to help move oil toward wells. It also increases subsurface pressures and increasing production rates.
Of course, there isn’t much water to be found in the middle of Saudi Arabia’s desert. Saipem has constructed 430 kilometers of seawater pipeline to feed water injection systems at Khurais. And the company has also built the pumping stations that actively force water into the oilfield.
This is just one example of the type of large-scale international project on which Saipem concentrates; in Saudi Arabia alone, Saipem has a total of 22 ongoing contracts.
And then there’s the offshore business. Saipem is a major manufacturer of floating production storage and offloading (FPSO) platforms. Basically these are floating platforms used to produce oil and gas from offshore fields, store them temporarily and then offload them for transport to shore. As noted above, spending on such platforms is expected to be strong during the next five years.
Saipem handles several types of FPSO contract. For example, the company offers turnkey engineering, construction and commissioning services. Saipem will actually design, build and tow a purpose-built FPSO into position on behalf of the operator.
Alternatively, Saipem offers a fleet of FPSO vessels that it will lease to operators for a fee. Both businesses have been booming thanks to high demand for platforms to handle new deepwater developments.
And Saipem also lays subsea pipelines. Examples would include the Medgaz offshore pipeline project that will connect Algerian oil and gas to Spain and the Blue Stream pipeline that will run under the Black Sea in waters of more than 6,000 feet from Russia to Turkey.
The company recently managed to leverage its strong position in the Saudi Arabian onshore business to grab a huge contract for offshore construction. Saudi Arabia has been ramping up its offshore spending and activity in recent years; Saipem is well placed to take advantage.
Specifically, Saipem has garnered a contract to build a series of offshore platforms and pipelines. Although the contract starts at a bare minimum of $400 million per year, the potential for this contract is far higher.
Finally, Saipem’s drilling unit is an on- and offshore contract drilling business. Saipem owns a series of jackup, semisubmersible and land-based drilling rigs that it leases out to producers for a particular day-rate. Day-rates, especially for deepwater rigs, have been rising in the past few years across the contract drilling industry, and Saipem is certainly no exception.
Overall, some 40 percent of Saipem’s backlog is to do work for large NOCs–one of the strongest markets I can imagine for overall spending growth. Another 43 percent is with major international integrated oil companies. And only about 8 percent of the backlog is for projects in America; Saipem’s most important markets are the Middle East and Africa.
Revenues have soared 53 percent in the first half of 2007 compared to the same period a year ago, with profit rising 65 percent. Meanwhile, the company’s backlog of unfilled projects currently stands at more than EUR13.3 billion (USD19.3 billion).
With strong leverage to large international oil and gas projects and offshore development coupled with a track record of growth, Saipem rates a buy in the How They Rate Table. I’m looking for an opportunity to add the stock to the Wildcatters Portfolio in the next few weeks.
Acergy (Oslo: ACY, NSDQ: ACGY)
Acergy provides E&C services for offshore oil and gas developments with a particular focus on deepwater developments. Acergy’s most important business is what’s known as SURF–subsea umbilicals, risers and flowlines. SURF accounted for nearly two-thirds of operating revenues in 2006.
SURF relates only to wells that are developed with subsea completions, meaning that the well is installed directly on the seafloor. This would apply primarily to deepwater developments.
When wells are installed on the seafloor, operators need ways to control the well remotely. This is done via electrical and hydraulic systems; the operator can, for example, slow production or open valves and increase production as needed.
Umbilicals are nothing more than electrical and hydraulic cables that connect a surface-based platform to subsea wells.
The term riser refers to a flexible steel pipe that connects underwater pipelines or wells to surface-based floating production platforms. Risers actually carry oil and/or gas from subsea developments to the surface.
Finally, flowlines are smaller diameter pipes used to transport oil and gas underwater. Obviously, all subsea developments require the installation of SURF. Acergy’s heavy concentration in this area gives it extraordinary leverage to deepwater.
It’s also important to note that SURF doesn’t just apply to new purpose-built projects. Acergy also handles subsea tieback deals, which I explained above. The company will install all the pipelines, risers and unbilicals needed to connect new subsea wells to existing platforms.
Outside of SURF, Acergy also handles conventional work in the shallow water, performs maintenance and inspection work on subsea wells and pipelines, and even installs larger diameter subsea pipelines, known as trunklines, to transport hydrocarbons over longer distances.
But despite Acergy’s strong leverage to the red-hot deepwater market, the stock recently stumbled after releasing disappointing guidance for 2008 and 2009 earnings last week. The disappointment related to two main issues: some execution difficulties at its Mexilhao project in Brazil and some likely delays to contract awards in West Africa.
Mexihao was a project to install a trunkline in Brazil. Unfortunately, Acergy appears to have underestimated the costs of this project when it originally bid, so the project isn’t as profitable as first supposed.
In addition, the company encountered some logistical difficulties when installing this trunkline. That further pushed costs higher.
At any rate, management has decided to take its lumps in the fourth quarter and booked this contract assuming it had zero profit margins. This will confine the damage mainly to just the fourth quarter.
In West Africa, there have been some delays to major projects that the industry has long been anticipating. Some of these projects have started to come through now.
Acergy recently received a contract for a $670 deepwater contract award in Angola. More awards are expected in 2008 and 2009.
But the E&C business can be a lumpy one. Earnings in any given quarter are highly dependent on a handful of large-scale projects. If one of those projects slips, it can have a dramatic effect.
Of course, this isn’t a sign of a lack of demand or growth potential. These contracts will definitely be awarded; it’s just a matter of timing.
I’m not overly concerned about this lumpiness. In fact, the selloff in Acergy following this announcement looks overdone.
That’s especially true when you consider that Acergy is one of the more cheaply valued firms and has outstanding leverage to one of my favorite energy themes–deepwater.
I’m never one to try to catch the proverbial “falling knife,” but I’m also looking for an opportunity to jump into this stock on the first sign of stabilization. For now, I’ll track Acergy in the How They Rate Table as a buy recommendation.
SBM Offshore (Amsterdam: SBMO, OTC: SBFFF)
SBM is involved in essentially two business lines: the installation of FPSOs and long-term leasing of FPSOs. Roughly 70 percent of total revenues come from turnkey construction and installation of FPSOs, with the remainder from leasing platforms.
I’ve already highlighted the growth potential for the FPSO business with respect to several of the companies in the table above; there’s no need to repeat that analysis here. Suffice it to say that SBM is a leader in this market.
SBM is building some 11 FPSOs for turnkey supply. These platforms are scheduled for delivery between the end of this year and the middle of 2010.
One the lease side, SBM has 16 FPSOs under construction, with firm lease contracts already signed for each one. This is far and away the largest backlog of lease FPSO newbuilds in the industry.
The company also has an existing fleet of 16 FPSOs already out on leases. Some of these platform leases expire in the next three to four years, and SBM will have the opportunity to demand a higher lease fee. SBM Offshore will be tracked in the How They Rate Table as a buy recommendation.
Subsea 7 (Oslo: SUB, OTC: SBEAF)
Like SBM, Subsea 7 is leveraged almost exclusively to deepwater project work. The company operates in a number of key markets, including subsea construction and pipe laying.
The company offers construction services, including design of facilities, survey and installation of pipelines, and the design and construction of flowlines. The company’s I-Tech unit owns a fleet of robotic submarine vessels known as remotely operated vehicles (ROV). These ROVs are used to perform all sorts of services from inspecting underwater equipment to repairing damaged wells.
As of the end of September, Subsea has a $4.23 billion backlog of work, up from less than $3.5 billion at the end of September a year ago. I see no reason to expect a slowdown in the basic business given its leverage to deepwater. I’m adding Subsea 7 to the How They Rate Table as a buy recommendation.
Technip (Paris: TEC, OTC: TNHPY)
Like Saipem, Technip offers a mixture of on and offshore services. The offshore business looks solid, and growth prospects remain stellar.
The company offers SURF products and services; demand remains strong in global markets for these products. Technip reported record margins of 17.1 percent in the most recent quarter, suggesting it retains significant pricing power.
But the onshore business looks more troubled. Management recently guided margins flat for 2008, citing execution difficulties in key markets, such as Qatar.
In Qatar, Technip is building LNG trains to export gas from the giant North Field; this single contract represents 15 percent of revenues for the quarter and 17 percent of the company’s backlog. Unfortunately, Technip stated that worker productivity has been lower than expected and extremely hot temperatures hampered progress.
Technip has considerable risk in terms of its large onshore contracts because many are done on what’s called a lump sum turnkey basis. That means the firm gets a lump sum for doing the deal; if costs exceed estimates or productivity is weak, it cuts into margins.
Although the same risk exists for Saipem and others, Saipem appears to be doing a better job of managing that risk. One sign that that’s the case: Saipem’s operating margins are significantly superior to Technip’s at this time.
Bottom line: Technip’s long-term prospects are good, but I prefer Saipem to Technip at this time. I’ll track Technip as a hold in the How They Rate Table.
Wood Group (London: WG/, OTC: WDGJF)
Wood Group operates essentially three divisions: engineering and production, well support and gas-turbine services. These divisions account for 58 percent, 22 percent and 20 percent of revenues in 2006 respectively.
The engineering and production division handles subsea construction and services, LNG gasification and re-gasification trains and refiner newbuilds and upgrades. Overall demand in this segment has been strongly led by, as you might expect, a solid showing from subsea work. Wood Group, based in London, also has a sound position in the North Sea, particularly in maintenance and modifications to existing offshore facilities.
Well support is leveraged to mature well development. Basically, Wood Group installs electric submersible pumps that are used to pump oil to the surface after natural underground pressures decline to the point that they’re no longer sufficient to sustain economic production rates.
The company also handles logging services. Such services are used when drilling a well to ascertain certain characteristics of the reservoir, how best to produce the reservoir and if the well is likely to be economic.
Finally, there’s the gas-turbine services division. This division handles maintenance and servicing of gas turbines, compressors and other rotating equipment. This sort of equipment is installed on drilling rigs, at refineries and in pipelines.
There’s nothing wrong with any of Wood Group’s businesses, but it’s not as leveraged to deepwater and international growth as some of the other stocks in the table above. In addition, on a pure valuation basis, it ranks near the top of its peer group. I’ll track Wood Group as a hold in the How They Rate Table.
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And energy investors have nothing to fear. Oil prices are still elevated and will be even if we see a pullback into the $70s. Prices in that range are more than sufficient to generate continued interest in major oil development projects worldwide. If anything, spending is set to actually accelerate even further in the coming years in key markets such as deepwater drilling.
With that in mind, any pullback in energy-related stocks is an absolute gift for investors–an opportunity to jump into some high-quality names at bargain prices. In prior issues, I’ve examined some of the sectors most leveraged to the long up-cycle in spending on exploration and development. Specifically, I’ve highlighted, and profited from, the oil services and equipment stocks.
In this week’s issue, I’ll take a look at another sector: engineering and construction (E&C). E&C firms plan, engineer and construct complex deepwater field developments and subsea pipelines.
In This Issue
These same firms are also behind building new refineries, liquefied natural gas capacity and even gas and coal-to-liquids plants. In short, the best in the business are levered to the strongest possible markets in the energy patch.As crude oil prices continue to fall in what’s likely just a correction for the commodity, pullbacks in the energy market can be expected. In last week’s flash alert, I noted two ways to play the pullback. I reiterate those plays here and introduce a purer play for interested subscribers. See Gaining Leverage.
The big growth in the global oil and gas markets is to be found offshore and overseas. And despite the higher costs involved with such activity, deepwater drilling should grow significantly in the next few years. Here’s a rundown on that section of the market. See Where’s the Growth?
I recommend several services plays in the Wildcatters Portfolio, but there’s another way to play this sector. I list several international plays that are worth looking into; I’ll continue to track these plays in the How They Rate Table as well. See Playing E&C.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
- Acergy (Oslo: ACY, NSDQ: ACGY)
- Frontline (NYSE: FRO)
- ProShares UltraShort Oil & Gas ETF (AMEX: DUG)
- Saipem (Milan: SPM, OTC: SAPFF)
- SBM Offshore (Amsterdam: SBMO, OTC: SBFFF)
- Subsea 7 (Oslo: SUB, OTC: SBEAF)
- US Oil Fund (AMEX: USO)
Gaining Leverage
My basic thesis in last week’s flash alert was that crude oil prices are likely to continue falling into the first part of 2008. I don’t believe this is the end of the long-term bull trend in the commodity; rather, it’s simply a correction of what’s been a tremendous run in the past year.It’s totally normal for bull markets to correct from time to time. One of my favorite examples of this is the bull market in the Nasdaq Composite between 1990 and 2000. This bull run resulted in a total return just shy of 800 percent for the decade, just under 25 percent annualized. But note the chart of the index below.
Source: BloombergI’ve labeled just a handful of the corrections in the Nasdaq that occurred during the 1990s. These all look meaningless in the context of my long-term chart, but I assure you, a 15 to 20 percent pullback doesn’t feel that meaningless when it occurs.
Of course, the key takeaway from all this is that those investors who bought the dips in the Nasdaq during the long bull run were rewarded handsomely. Those who panicked and sold missed a huge potential gain.
The factors that will bring oil lower are twofold. First, demand is starting to show at least some tentative signs of falling in response to higher commodity prices.
The International Energy Agency (IEA) recently cut its oil demand forecasts for most regions of the world; oil demand in the fourth quarter is now expected to be about 500,000 barrels per day less that previously projected. The IEA is looking for about 2.3 percent global growth in demand for 2008.
These downward revisions to oil demand are really a function of the global growth scare I discussed at length in the most recent issue of The Energy Strategist. Clearly, the US economy is slowing down, and that slowdown is likely spreading into Europe to some extent. Lower growth spells lower crude oil demand.
That said, I expect continued strong growth in developing markets to power further growth in oil demand. This will serve as an offset to the US and developed market slowdown.
Far too many investors remain US-centric when it comes to oil. The simple fact is that the US is no longer the driver of oil demand growth; almost all of the consumption growth in the past five years has come from the developing world, particularly Asia. Nonetheless, perception is reality, and I expect the market to become increasingly concerned about an oil demand slowdown as we head into 2008 whether that softening actually occurs or not.
Then, there’s the supply side of the equation. As I noted in the last issue of TES, Organization of the Petroleum Exporting Countries (OPEC) has remained extraordinarily disciplined in recent months. It just hasn’t been shipping oil to the west as aggressively as it would normally at this time of the year.
That, coupled with disappointing growth in non-OPEC supplies, has led to an unusual counter-seasonal drawdown in global oil inventories. That inventory tightness has, in turn, been a tailwind for crude prices.
But I’m starting to see evidence of more OPEC supply heading west. The obvious indication of this is global oil tanker rates.
Source: BloombergThis is a chart of the Baltic Dirty Index of tanker rates. The continued, obvious spike suggests some shortage of tankers available to haul oil.
This suggests that Persian Gulf nations have started to book ships for the long journey to the US; tanker owners are able to charge higher rates to lease their ships as a result. With tanker rates now at their highest level in well more than a year, it looks like there’s an end-of-the-year scramble to book tankers.
I would guess these shipments will begin showing up in US oil inventories in the first part of 2008. An easing of supply tightness in crude oil will put further downward pressure on crude oil.
I also expect weakness in crude oil to continue to keep a lid on rallies in energy-oriented stocks near term. Certainly, oil stocks and oil prices aren’t perfectly correlated. After all, crude prices rose well into November even as the Philadelphia Oil Services Index (OSX) topped out in October.
I recommend playing these trends in two basic ways. First, I recommend taking steps to hedge your portfolio against a near-term pullback in the group. And second, it’s high time to start compiling a shopping list of new oil- and gas-leveraged stocks to buy on any dip.
As to the second point, the engineering and construction stocks I highlight below are intended to be part of that shopping list. I expect to start getting more aggressive in my recommendations of these stocks during the next few weeks.
As for hedges, I recommended two new plays in last week’s flash. The first is tanker operator Frontline (NYSE: FRO). Frontline has the vast majority of its ships leased under spot-rate contracts. Tanker operators have a choice to hire ships under term contracts, locking in a fixed rate for several years, or to accept the prevailing rates on the spot market.
Obviously, as the chart of the Baltic Dirty Index above indicates, tanker spot rates are highly volatile. However, companies concentrated in this area can earn far higher returns on their ships during strong tanker markets.
In this case, I’m looking to play a continued run-up in tanker spot rates into the new year. Frontline offers real leverage to that spike in rates and should continue to see a pop in the coming weeks. Note this is an aggressive trade idea rather than a long-term play; that’s why I chose to recommend it as part of my more aggressive Gushers Portfolio.
My second play on the oil pullback is a short exchange traded fund (ETF) that tracks the inverse of the Dow Jones Oil & Gas Index, a basket of the largest oil- and gas-related stocks in the US market. The ProShares UltraShort Oil & Gas ETF (AMEX: DUG) tends to rise by double the percentage that the Dow Jones Oil & Gas Index falls.
ETFs trade on the major exchanges just like stocks. They’re simple to buy and sell. Your broker should charge you no more to buy these ETFs than to purchase any other stock.
By purchasing UltraShort Oil & Gas, we can partially hedge our long-side exposure to the industry. Specifically, I’m looking for the stocks in my three model Portfolios to broadly outperform the industry as a whole. But if this bout of selling continues for a few more weeks, even the fundamentally attractive names I recommend will get pulled lower.
Remember, as I said earlier, fundamentals go out the window during global selloffs of this nature. Exposure to this UltraShort ETF will guard against such an eventuality.
The other point to remember about hedges is that the best thing that can happen is for us to lose money. The reason I say that is hedges are, by definition, designed to go up in value when the rest of your portfolio declines in value.
If we lose money on this ETF, it suggests that many of the recommendations in the TES model portfolios are actually going up. This is also why I don’t recommend buying this ETF unless you’re long a significant number of TES Portfolio recommendations.
For a purer play on further declines in oil prices, subscribers should consider shorting the US Oil Fund (AMEX: USO). This ETF tracks the performance of crude oil prices, not crude oil stocks. Alternatively, for those unwilling to short stocks, the April 2008 70 put options (UN APR) offer an alternative way to play downside in this ETF.
I chose to recommend the short ETF rather than a short in oil for two reasons. First, in my experience, the majority of subscribers are reluctant to go short stocks; these short ETFs offer a more comfortable means to hedge the portfolios.
And second, the TES portfolios represent a portfolio of stocks. The DUG ETF is a more direct hedge against the risk of a short-term pullback.
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Where’s the Growth?
To put it simply, the big growth in the global oil and gas markets is to be found offshore and overseas. These are the markets that are least leveraged to commodity price volatility and are seeing the fastest production growth. One of the best ways to play this growth theme: oil- and gas-related E&C companies.These are the giant firms that actually plan and build the infrastructure needed to produce complex fields in the deepwater and international markets. Crude oil prices would have to drop back under $45 for a sustained period before having any impact on spending in such markets. In fact, firms conducting many of the international and deepwater oil projects have actually factored in oil prices of just $40 or so when determining the feasibility of their projects.
One of the longest-standing and most-often-repeated themes in TES is the end of “easy” oil. The basic thesis is that the world isn’t literally running out of oil (or gas); rather, growing production is becoming more complex, expensive and time-consuming. Deepwater is a prime example of the end of easy oil thesis in action.
No producer would bother to spend billions on a deepwater development if it could simply grow production cheaply from simple-to-produce onshore fields. But the fact is that deepwater is one of the final exploration frontiers of the global energy markets. Many of the most promising actual new reserves of oil that have been found in recent years are located in the deep.
According to Offshore Magazine and a recent survey published by energy analysts Douglas-Westwood, total global deepwater oil production will grow from 4.5 million barrels per day in 2007 to more than 8 million barrels per day in 2011. Over the same time period, deepwater gas production will nearly double from 1.6 million barrels of oil equivalent per day (boe/d) to some 3 million boe/d in 2011.
And check out the chart “US Oil Production by Source.”
Source: Energy Information Administration (EIA)This chart shows Energy Information Administration (EIA) estimates for US oil production out to 2030. The EIA is projecting that US oil production will remain generally flat overall out to 2030.
But production onshore, from Alaska and from the shallow-water Gulf of Mexico, is expected to fall. In fact, there’s only one subsegment of US oil production that’s expected to show meaningful growth between now and 2030: the deepwater Gulf of Mexico.
Although growth in deepwater production has already been impressive, one factor that’s been hampering even faster growth is a lack of availability for deepwater drilling rigs globally. These are the advanced technologically complex rigs needed to drill wells in the deepwater.
The supply of such rigs will remain tight for at least the next five years; however, availability is set to gradually improve through the end of 2010. The reason is that a number of new-build deepwater drilling rigs are scheduled for delivery between the end of 2008 and the end of 2010.
Most of these new rigs have already been reserved under contract by major oil producers. These rigs are absolutely necessary for these firms to undertake deepwater projects.
Producers have been willing to pay day-rates exceeding $600,000 per day to hire these rigs. That’s proof of the high demand for more deepwater drilling work and development. As these new rigs are developed and start heading for projects, I’m looking for growth in deepwater activity to pick up notably.
During third quarter earnings season, companies had nothing but bullish comments on the outlook for deepwater activity and spending. As longtime subscribers are well aware, I pay particular attention to comments from the world’s largest oil services firm, Schlumberger. The reason is that this company operates in every imaginable geographic region and business line. It has the best bird’s-eye view of what’s going on in the energy markets.
Schlumberger’s CEO Andrew Gould suggested in the company’s Oct. 19 conference call that the only real limit on expansion of offshore activity was a lack of equipment and resources. Specifically, he indicated that it would take time for all these new deepwater rigs to enter service and ramp up to maximum efficiency. And Gould also stated that there was a shortage of capacity to build everything from offshore platforms to flow lines used to carry oil and gas from deepwater wells to the surface.
Unfortunately, many investors seemed to misinterpret Gould’s comments, which I highlighted in the Nov. 7 issue of TES, Coal and Services. Gould said that he expected to see delays because of inefficiencies in ramping up new rigs and installing needed equipment.
These delays aren’t caused by a lack of demand but, rather, are the result of demand exceeding supply. Schlumberger indicated that the growth is there but there will be periodic interruptions caused by lack of infrastructure.
But this is actually bullish for companies leveraged to the deepwater. Gould felt that these shortages would simply serve to lengthen the deepwater spending cycle. Ultimately, rising demand, coupled with constrained supply, suggests that companies that enable deepwater drilling will be able to charge more for their services and equipment.
All told, Douglas-Westwood estimates that global spending on deepwater projects will be around $108 billion between 2008 and the end of 2012. The chart “Deepwater Spending” breaks down that spending by specific area.
Source: Offshore Magazine, Douglas-WestwoodNote that many deepwater developments are now so-called hub-and-spoke projects. Basically, it’s expensive and time-consuming to build new floating offshore oil and gas platforms, so building a dedicated platform for a specific project would require a very large reserve target. Otherwise, the cost of building the platform would render the project uneconomic.
But there’s an alternative. Companies can build a single platform to collect oil and gas production from multiple fields and many wells. Each of these wells can be produced using subsea equipment that’s installed directly on the seafloor. Oil and gas produced from these far-flung fields is then transported by subsea pipe to a single floating platform.
A perfect example of this is Enterprise Product Partner’s Independence Hub and Trail. This floating platform and network of pipelines collects gas from several smaller deepwater gas fields in the Gulf of Mexico for eventual transport to the Gulf Coast.
At any rate, there’s a severe shortage of floating platforms to handle and process production from offshore wells. According to Douglas-Westwood, global energy companies will spend more than $28 billion between now and the end of 2012 building new platforms.
And that’s just for the platforms themselves. Companies will also need to lay subsea pipes to connect wells to platforms and platforms to the shore. More than $32 billion–$6.5 billion per year–will need to be spent laying pipe over the next five years alone.
In addition, considerably more spending will be needed to build and install subsea equipment. (I explained this market at some length in the Jan. 3 issue of TES, The Deep End.)
Alongside deepwater spending, the other big growth market for the energy industry is large-scale international projects. Consider the chart “Liquids Production Growth 2004-2030.”
Source: EIAThis chart shows the EIA’s estimates for annualized growth in oil liquids and natural gas liquids production for a number of key oil-producing countries and regions. What’s obvious from this chart is that most of the growth will come from outside North America and Western Europe.
Some of the biggest jumps in production will come from Brazil, the Middle East, West Africa and the Caspian. The reason these regions will see production growth is that these nations hold the lion’s share of global oil reserves. Check out the chart “Global Oil Reserves by Country.”
Source: BP Statistical Review of World EnergyThis chart shows global conventional oil reserves broken down by country. The picture is very similar to the chart of projected production above; most of the world’s key oil reserves are located outside the US and European Union (EU). Nearly two-thirds of global oil reserves are, in fact, found in the Middle East.
Not surprising, oil producers tend to go where the oil is. Many of the reserves held in markets like the Middle East and Africa are actually owned by fully or partly state-owned national oil companies (NOC). As I outlined in the most recent issue of TES, traditionally the major integrated oil companies such as ExxonMobil and Chevron Corp have partnered with NOCs to exploit these reserves.
Typically, integrateds have negotiated some sort of production-sharing arrangement with the NOCs. This allows the NOC and integrated partners to share the proceeds of any oil or gas sales. As you probably already noticed, most of the big integrated oil projects I highlighted in the most recent issue of TES are partnerships between the integrateds and various NOCs.
Lately, however, there’s been a notable wave of resource nationalism worldwide. Sometimes this takes the form of combative rhetoric and actions, such as we’ve witnessed out of Venezuela during the past few years. But the more responsible NOCs have pursued a different path to developing their projects: Instead of partnering with integrateds oils, these NOCs are hiring global oil services firms to manage projects for them.
This business is known as integrated project management (IPM); it’s one of the fastest-growing markets for most of the major services firms. In IPM projects, a services firm will manage and schedule a project on behalf of an NOC client. This includes performing certain services, contracting with other services firms for parts of the project and ordering necessary equipment and materials.
As you might expect, Schlumberger is a huge player in IPM now. In the firm’s second quarter conference call, management stated that its total budget of IPM projects stood at $4.8 billion through the end of the decade. Schlumberger went on to state that it brought in $3.8 billion in new contracts in the first half of the year.
Originally, the IPM business concentrated almost totally on customers in Latin America, but it’s growing rapidly. Although Schlumberger didn’t offer a complete breakdown of its backlog in its third quarter conference call, management did indicate that it’s seen a pickup in interest in other regions, particularly Africa and some parts of central Asia.
My point in highlighting all this is that growing interest in IPM is just another sign of strong demand for international oil and gas development projects, both in deepwater and on land. It also suggests another key trend: rising complexity. In other words, NOCs are increasingly targeting smaller, more complex reserves.
These firms don’t have the capability and know-how to produce these fields in-house. That’s exactly why they’re hiring companies such as Schlumberger to handle project management for them.
The final point to note about international projects is that these projects tend to be large-scale, multi-year deals. In North America, drilling projects outside deepwater tend to be small incremental deals. Because these projects are short term in nature, they’re highly dependent on commodity pricing.
So, for example, weak natural gas prices over the past year and a half have resulted in a notable slowdown in North American drilling activity. See the chart below.
Source: Bloomberg, Baker HughesThis chart illustrates the North American rig count—the number of rigs actively drilling for oil or gas in North America. You can see that this measure grew strongly through about the middle of 2006 and has since moderated.
There are also a few other notable declines on this chart. These correspond to periods of weakness for natural gas.
As noted above, because of the larger size and longevity of international projects, producers are unlikely to cancel them at the first sign of commodity weakness. Several services firms have suggested we’d need to see oil prices fall below $45 per barrel to see a meaningful slowdown in international activity or major project cancellations.
Bottom line: The bulk of capital spending on oil and gas development will be concentrated mainly in deepwater markets and in large-scale international projects in markets such as the Middle East and Africa.
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Playing E&C
On several occasions in TES, I’ve highlighted the oil services industry and companies such as Wildcatters Portfolio recommendation Weatherford as a prime way to play growth in deepwater and international projects. I’ve also discussed various oilfield equipment firms and contract drillers with exposure to these strengthening markets, including Wildcatters Chart Industries and Dresser-Rand.But there’s another sector with leverage to these explosive trends: oil- and gas-focused E&C firms. These companies handle the construction of offshore platforms and pipelines needed to produce deepwater fields. They also provide crucial infrastructure needed to handle complex new developments in international markets.
Alongside the services and equipment firms, E&C companies stand to benefit from the rapid ramp-up in global spending on oil and gas infrastructure. Most of the biggest players are actually based in Europe, though several trade on the major US exchanges as American Depositary Receipts. The following table offers a list of the biggest players along with some key data on each.
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Engineering and Construction Firms
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|||||
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Company (Exchange: Symbol)
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Next Year Est. P-to-E
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Revenue Growth (%)
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Five-Year Sales Growth (%)
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Percent Offshore
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Percent Non-North America
|
| Saipem (Milan: SPM, OTC: SAPFF) |
17.1 | 66.0 | 41.1 | 43.0 | 98.0 |
| Acergy (Oslo: ACY, NSDQ: ACGY) |
13.3 | 43.2 | N/A | 70.0 | 92.0 |
| SBM Offshore (Amsterdam: SBMO, OTC: SBFFF) |
21.1 | 31.2 | 14.9 | 100.0 | 58.0 |
| Subsea 7 (Oslo: SUB, OTC: SBEAF) |
12.6 | 29.8 | N/A | 100.0 | 94.0 |
| Technip (Paris: TEC, OTC: TNHPY) |
15.8 | 28.8 | 14.0 | 49.0 | 80.0 |
| Wood Group (London: WG/, OTC: WDGJF) |
18.5 | 25.7 | 25.9 | N/A | 56.0 |
Source: Bloomberg
Given the strength in deepwater and international markets, I prefer E&C companies with strong leverage to these growth areas. I’m adding all of the firms in the table above to my coverage universe. Here’s a rundown of each:
Saipem (Milan: SPM, OTC: SAPFF)
I highlighted Italy-based Saipem in the Oct. 24 issue of TES, Liquid Gold, specifically in reference to its liquefied natural gas business (LNG). Although that’s certainly an attractive market, there’s a lot more to Saipem than just LNG.
The company divides its business into three main units: onshore, offshore and drilling. The first two business units are far and away the most important for Saipem in terms of revenues, profits and growth potential. Onshore and offshore operations accounted for more than 90 percent of 2006 revenues, 77 percent of operating income and 81 percent of the company’s backlog of projects.
It’s important to note that Saipem’s onshore business is focused on large-scale international projects. This business unit includes the construction of major LNG gasification and regasification terminals, as well as large-scale oil and gas pipelines and refineries.
Global refining capacity is in chronic shortage, as I explained in the March 21 issue of TES, Looking Refined. Building and handling upgrades of new refineries is a major growth market for Saipem.
And the company has exposure to some of the most sought-after international onshore contracts.
A perfect example is Saipem’s operations in Saudi Arabia’s Khurais field. The firm has built a massive gas oil separation plant to handle production from this field. And the company also builds out infrastructure related to Saudi Arabia’s water injection system into Khurais.
Saudi Arabia has been using water floods to boost production from its fields for decades. This involves pumping water into the field under pressure to help move oil toward wells. It also increases subsurface pressures and increasing production rates.
Of course, there isn’t much water to be found in the middle of Saudi Arabia’s desert. Saipem has constructed 430 kilometers of seawater pipeline to feed water injection systems at Khurais. And the company has also built the pumping stations that actively force water into the oilfield.
This is just one example of the type of large-scale international project on which Saipem concentrates; in Saudi Arabia alone, Saipem has a total of 22 ongoing contracts.
And then there’s the offshore business. Saipem is a major manufacturer of floating production storage and offloading (FPSO) platforms. Basically these are floating platforms used to produce oil and gas from offshore fields, store them temporarily and then offload them for transport to shore. As noted above, spending on such platforms is expected to be strong during the next five years.
Saipem handles several types of FPSO contract. For example, the company offers turnkey engineering, construction and commissioning services. Saipem will actually design, build and tow a purpose-built FPSO into position on behalf of the operator.
Alternatively, Saipem offers a fleet of FPSO vessels that it will lease to operators for a fee. Both businesses have been booming thanks to high demand for platforms to handle new deepwater developments.
And Saipem also lays subsea pipelines. Examples would include the Medgaz offshore pipeline project that will connect Algerian oil and gas to Spain and the Blue Stream pipeline that will run under the Black Sea in waters of more than 6,000 feet from Russia to Turkey.
The company recently managed to leverage its strong position in the Saudi Arabian onshore business to grab a huge contract for offshore construction. Saudi Arabia has been ramping up its offshore spending and activity in recent years; Saipem is well placed to take advantage.
Specifically, Saipem has garnered a contract to build a series of offshore platforms and pipelines. Although the contract starts at a bare minimum of $400 million per year, the potential for this contract is far higher.
Finally, Saipem’s drilling unit is an on- and offshore contract drilling business. Saipem owns a series of jackup, semisubmersible and land-based drilling rigs that it leases out to producers for a particular day-rate. Day-rates, especially for deepwater rigs, have been rising in the past few years across the contract drilling industry, and Saipem is certainly no exception.
Overall, some 40 percent of Saipem’s backlog is to do work for large NOCs–one of the strongest markets I can imagine for overall spending growth. Another 43 percent is with major international integrated oil companies. And only about 8 percent of the backlog is for projects in America; Saipem’s most important markets are the Middle East and Africa.
Revenues have soared 53 percent in the first half of 2007 compared to the same period a year ago, with profit rising 65 percent. Meanwhile, the company’s backlog of unfilled projects currently stands at more than EUR13.3 billion (USD19.3 billion).
With strong leverage to large international oil and gas projects and offshore development coupled with a track record of growth, Saipem rates a buy in the How They Rate Table. I’m looking for an opportunity to add the stock to the Wildcatters Portfolio in the next few weeks.
Acergy (Oslo: ACY, NSDQ: ACGY)
Acergy provides E&C services for offshore oil and gas developments with a particular focus on deepwater developments. Acergy’s most important business is what’s known as SURF–subsea umbilicals, risers and flowlines. SURF accounted for nearly two-thirds of operating revenues in 2006.
SURF relates only to wells that are developed with subsea completions, meaning that the well is installed directly on the seafloor. This would apply primarily to deepwater developments.
When wells are installed on the seafloor, operators need ways to control the well remotely. This is done via electrical and hydraulic systems; the operator can, for example, slow production or open valves and increase production as needed.
Umbilicals are nothing more than electrical and hydraulic cables that connect a surface-based platform to subsea wells.
The term riser refers to a flexible steel pipe that connects underwater pipelines or wells to surface-based floating production platforms. Risers actually carry oil and/or gas from subsea developments to the surface.
Finally, flowlines are smaller diameter pipes used to transport oil and gas underwater. Obviously, all subsea developments require the installation of SURF. Acergy’s heavy concentration in this area gives it extraordinary leverage to deepwater.
It’s also important to note that SURF doesn’t just apply to new purpose-built projects. Acergy also handles subsea tieback deals, which I explained above. The company will install all the pipelines, risers and unbilicals needed to connect new subsea wells to existing platforms.
Outside of SURF, Acergy also handles conventional work in the shallow water, performs maintenance and inspection work on subsea wells and pipelines, and even installs larger diameter subsea pipelines, known as trunklines, to transport hydrocarbons over longer distances.
But despite Acergy’s strong leverage to the red-hot deepwater market, the stock recently stumbled after releasing disappointing guidance for 2008 and 2009 earnings last week. The disappointment related to two main issues: some execution difficulties at its Mexilhao project in Brazil and some likely delays to contract awards in West Africa.
Mexihao was a project to install a trunkline in Brazil. Unfortunately, Acergy appears to have underestimated the costs of this project when it originally bid, so the project isn’t as profitable as first supposed.
In addition, the company encountered some logistical difficulties when installing this trunkline. That further pushed costs higher.
At any rate, management has decided to take its lumps in the fourth quarter and booked this contract assuming it had zero profit margins. This will confine the damage mainly to just the fourth quarter.
In West Africa, there have been some delays to major projects that the industry has long been anticipating. Some of these projects have started to come through now.
Acergy recently received a contract for a $670 deepwater contract award in Angola. More awards are expected in 2008 and 2009.
But the E&C business can be a lumpy one. Earnings in any given quarter are highly dependent on a handful of large-scale projects. If one of those projects slips, it can have a dramatic effect.
Of course, this isn’t a sign of a lack of demand or growth potential. These contracts will definitely be awarded; it’s just a matter of timing.
I’m not overly concerned about this lumpiness. In fact, the selloff in Acergy following this announcement looks overdone.
That’s especially true when you consider that Acergy is one of the more cheaply valued firms and has outstanding leverage to one of my favorite energy themes–deepwater.
I’m never one to try to catch the proverbial “falling knife,” but I’m also looking for an opportunity to jump into this stock on the first sign of stabilization. For now, I’ll track Acergy in the How They Rate Table as a buy recommendation.
SBM Offshore (Amsterdam: SBMO, OTC: SBFFF)
SBM is involved in essentially two business lines: the installation of FPSOs and long-term leasing of FPSOs. Roughly 70 percent of total revenues come from turnkey construction and installation of FPSOs, with the remainder from leasing platforms.
I’ve already highlighted the growth potential for the FPSO business with respect to several of the companies in the table above; there’s no need to repeat that analysis here. Suffice it to say that SBM is a leader in this market.
SBM is building some 11 FPSOs for turnkey supply. These platforms are scheduled for delivery between the end of this year and the middle of 2010.
One the lease side, SBM has 16 FPSOs under construction, with firm lease contracts already signed for each one. This is far and away the largest backlog of lease FPSO newbuilds in the industry.
The company also has an existing fleet of 16 FPSOs already out on leases. Some of these platform leases expire in the next three to four years, and SBM will have the opportunity to demand a higher lease fee. SBM Offshore will be tracked in the How They Rate Table as a buy recommendation.
Subsea 7 (Oslo: SUB, OTC: SBEAF)
Like SBM, Subsea 7 is leveraged almost exclusively to deepwater project work. The company operates in a number of key markets, including subsea construction and pipe laying.
The company offers construction services, including design of facilities, survey and installation of pipelines, and the design and construction of flowlines. The company’s I-Tech unit owns a fleet of robotic submarine vessels known as remotely operated vehicles (ROV). These ROVs are used to perform all sorts of services from inspecting underwater equipment to repairing damaged wells.
As of the end of September, Subsea has a $4.23 billion backlog of work, up from less than $3.5 billion at the end of September a year ago. I see no reason to expect a slowdown in the basic business given its leverage to deepwater. I’m adding Subsea 7 to the How They Rate Table as a buy recommendation.
Technip (Paris: TEC, OTC: TNHPY)
Like Saipem, Technip offers a mixture of on and offshore services. The offshore business looks solid, and growth prospects remain stellar.
The company offers SURF products and services; demand remains strong in global markets for these products. Technip reported record margins of 17.1 percent in the most recent quarter, suggesting it retains significant pricing power.
But the onshore business looks more troubled. Management recently guided margins flat for 2008, citing execution difficulties in key markets, such as Qatar.
In Qatar, Technip is building LNG trains to export gas from the giant North Field; this single contract represents 15 percent of revenues for the quarter and 17 percent of the company’s backlog. Unfortunately, Technip stated that worker productivity has been lower than expected and extremely hot temperatures hampered progress.
Technip has considerable risk in terms of its large onshore contracts because many are done on what’s called a lump sum turnkey basis. That means the firm gets a lump sum for doing the deal; if costs exceed estimates or productivity is weak, it cuts into margins.
Although the same risk exists for Saipem and others, Saipem appears to be doing a better job of managing that risk. One sign that that’s the case: Saipem’s operating margins are significantly superior to Technip’s at this time.
Bottom line: Technip’s long-term prospects are good, but I prefer Saipem to Technip at this time. I’ll track Technip as a hold in the How They Rate Table.
Wood Group (London: WG/, OTC: WDGJF)
Wood Group operates essentially three divisions: engineering and production, well support and gas-turbine services. These divisions account for 58 percent, 22 percent and 20 percent of revenues in 2006 respectively.
The engineering and production division handles subsea construction and services, LNG gasification and re-gasification trains and refiner newbuilds and upgrades. Overall demand in this segment has been strongly led by, as you might expect, a solid showing from subsea work. Wood Group, based in London, also has a sound position in the North Sea, particularly in maintenance and modifications to existing offshore facilities.
Well support is leveraged to mature well development. Basically, Wood Group installs electric submersible pumps that are used to pump oil to the surface after natural underground pressures decline to the point that they’re no longer sufficient to sustain economic production rates.
The company also handles logging services. Such services are used when drilling a well to ascertain certain characteristics of the reservoir, how best to produce the reservoir and if the well is likely to be economic.
Finally, there’s the gas-turbine services division. This division handles maintenance and servicing of gas turbines, compressors and other rotating equipment. This sort of equipment is installed on drilling rigs, at refineries and in pipelines.
There’s nothing wrong with any of Wood Group’s businesses, but it’s not as leveraged to deepwater and international growth as some of the other stocks in the table above. In addition, on a pure valuation basis, it ranks near the top of its peer group. I’ll track Wood Group as a hold in the How They Rate Table.
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