Strengthening Headwinds
The global selloff in stocks since the end of 2007 has been among the most severe in stock market history. Few sectors have been immune to the volatility, and the energy patch is certainly no exception; the panic is palpable.
Although I’ve taken steps to hedge risks, book profits and even play the downside in oil, most The Energy Strategist picks have seen big swings over the past month as a result of this globally synchronized selloff.
First, the bad news: I expect further downside in some energy-related stocks and sharply increased volatility over the next few weeks. I’m also looking for oil prices to pull back into the $70s before this move is over, perhaps even breaking $70 per blue barrel (bbl) on a short-term basis.
This isn’t a new outlook. I’ve been calling for an oil price correction since my Nov. 27, 2007, flash alert, “Tankers Up, Crude Down,” and reiterated that call in last week’s flash alert.
But there’s a silver lining to these clouds. The old saw on Wall Street is that you should buy “when there’s blood in the streets.” In other words, periods of extreme market volatility and panic invariably offer the best opportunities.
Many of the fundamentally best-positioned energy plays are getting hit hard mainly because of spillover selling from the broader market indexes rather than any changes to fundamental value or growth prospects. This is setting us up for an outstanding buying opportunity in the group; we’ll soon be able to pick up some of the best in the business at valuations we could only dream of just a few weeks ago.
Second, as I pointed out in the most recent issue, the energy sector isn’t a homogenous group. Careful stock picking and focus can really shine during periods of market volatility.
And finally, don’t be fooled into thinking you can’t profit from the downside in oil and energy-oriented stocks. Last Friday, I recommended taking some gains off the table in my recommended Halliburton short position, booking a 15 percent gain in the process. I also recommended doubling up on your shorts in the US Oil Fund (AMEX: USO). In past cycles, we’ve made plenty of money on the short side, and I see more opportunities in the coming weeks.
The energy sector is still strong, despite what might be inferred from the recent selloff. Utilities and consumer staples are also suffering this fate. See Synchronized Selling.
Indicators are pointing toward a recession, but that doesn’t mean we should avoid energy altogether. Instead, there are several demand factors that should make this a buying opportunity, especially for the long term. See It’s the Economy.
I’ve highlighted the US Oil Fund as a great short on the energy market at this time, but there are other ways to play it. I recommend taking a look at two different plays on oil—an exchange traded fund and a put option—to hedge against drops in oil prices. See How to Play It.
Schlumberger’s quarterly conference calls are usually a great indicator of what to expect in the pressure-pumping sector. It’s still expensive—which is why we got out when we did last year—but there may be an opportunity to jump back in this year. I also hold two other companies in the portfolios that are worth a second look. See Services, Drillers and Gas.
Alternatives was one of the best-performing sectors in energy last year, and the field bet was certainly no slouch. Just remember that these should played speculatively as a collection. See Alternative Field Bet.
However, despite these steps, the TES portfolios have been hit in the first few weeks of 2008. I’m often asked how these stocks can be trading lower even though oil remains at relatively lofty levels and global exploration spending and drilling activity remain robust.
The answer is simply that during global selloffs such as we’ve witnessed during the past three weeks, stocks have a tendency to head lower as a herd, regardless of fundamentals and market sector.
The recent bout of selling has been exacerbated by the fact that energy stocks were among the best performers in the S&P 500 last year. Therefore, many investors and institutional traders have significant profits in these stocks, profits that still far exceed any losses incurred over the past few weeks. As illogical as it may sound, when institutional players are looking to protect gains and raise their cash position, they have a tendency to sell down their winners.
In other words, the energy sector is being used as a source of cash, and investors are throwing the babies out with the bathwater.
Check out the charts below for a closer look.
Source: Bloomberg
Source: Bloomberg
These charts depict the Philadelphia Utility Index and S&P 500 Consumer Staples sector, respectively. Both sectors are considered defensive.
Utilities are in a government-regulated business and tend to generate stable cash flows in good economies and bad. These stocks also traditionally throw off big dividend yields; investors park cash in the group when times get tough.
Consumer staples stocks include companies producing everything from alcoholic beverages to shampoo. Spending on such items typically holds up well during economic slowdowns and recessions.
For the first few days of 2008, both groups actually rallied, likely benefiting as money rotated out of sectors seen as more cyclical and economy sensitive. What’s equally clear is that both sectors have been hit hard in the past two weeks, despite these defensive qualities.
That’s a sure sign that traders are looking to reduce their exposure to stocks, even those groups unlikely to be overly affected by the current global economic and credit headwinds. Both groups’ generally good performances in the latter half of 2007 are another sign that institutional investors are desperately looking to raise cash regardless of fundamentals. There’s simply no appetite for risk in the current environment.
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Source: Bloomberg
The leading economic indicator (LEI) is actually a composite of 10 key economic indicators. The list includes housing starts, consumer expectations, jobless claims and even the performance of the US stock market.
The chart shows the year-over-year percent change in leading economic indicators. As evidenced from this chart, the LEI tends to turn negative just ahead of or coincident with US recessions.
For example, the LEI turned negative on a year-over-year basis in June 1989; a US recession followed in July 1990 and lasted through March 1991. Similarly, the December 2000 dip in the LEI below zero foreshadowed the March-November 2001 recession.
Like every indicator, the LEI is far from infallible. For example, a short dip below zero in 1996 turned out to be a false alarm. However, the indicator is right more than it’s wrong, and we can’t ignore the slump since late 2007.
The LEI officially broke below zero in November. I believe that this presages at least a minor US recession in 2008.
Contrary to the view publicly espoused by the European Central Bank (ECB), I just don’t see Europe remaining totally immune either. The largest economy in Europe is Germany, and leading indicators in that nation are also deteriorating. For example, retail sales were down 5.6 percent year-over-year in November, the latest month for which we have reliable data.
In the UK, the housing market remains an important concern. The housing market in London was even more extended than red-hot US markets such as Florida and Southern California. Check out the chart of the Halifax (HBOS) House Price Index below.
Source: Bloomberg
This is one of the most-watched indicators of house prices in Britain. Although it hasn’t turned negative yet, a steady downtrend in mortgage approvals strongly suggests that it will turn lower outright in 2008. Therefore, the UK will have to contend with a round of falling house prices just like the US.
The currency markets don’t believe that Europe will be immune from the weakness either. The euro has been selling off relative to the dollar in recent weeks, a sure sign expectations are growing that the eurozone economy is weakening rapidly and the ECB will eventually follow the US Federal Reserve and Bank of England by cutting interest rates. This weakness has continued despite repeated hawkish comments from ECB officials during this time period.
Amid all that transatlantic gloom, the gut reaction of many is to avoid so-called “cyclical” sectors such as energy. That may be the correct play in the next few weeks, but it’s the wrong reaction longer term.
The first point to note is that, unlike prior cycles, the primary engine of oil demand growth isn’t the US or Europe. Check out the chart below for a closer look.
Source: BP Statistical Review of World Energy 2007
This chart shows the growth in oil demand between 2000 and 2007 for a number of different countries and regions. Countries in the Organization of Economic Cooperation and Development (OECD) are generally considered the developed countries; oil demand grew roughly 1.37 million barrels per day during this time period. That represents total cumulative growth of just less than 2.9 percent.
The non-OECD countries that make up the developing world are, however, a different story entirely. Consider that over the same time period, demand from non-OECD nations soared nearly 7.5 million barrels per day or more than 21 percent. That’s more than seven times the rate of growth in the developed world.
Furthermore, note that oil demand in the US is up less than 900,000 barrels per day over the past seven years, while demand in the European Union (EU) is up less than 500,000. And most of the growth in EU demand didn’t come from developed EU countries, such as Britain, Germany and France, but from the new entrants, such as Poland, the Czech Republic and Hungary. In fact, demand actually fell in Germany and France over this time period.
The OECD isn’t the driver of oil demand growth. Moreover, in an absolute sense, the OECD is losing its dominance of the global oil market. Check out the chart below for a closer look.
Source: BP Statistical Review of World Energy 2007
This chart shows OECD oil consumption as a percent of total global consumption. The higher this ratio, the more important the developed world is to global oil demand. A ratio less than 50 percent would indicate that developing world demand is higher than OECD demand.
The trend here is clear. OECD demand was three-quarters of the total in the late 1960s and early ’70s. Now, it accounts for less than 60 percent of global demand, and that ratio has been falling precipitously since the late ’90s.
Of course, the ratio remains more than 50 percent, indicating that the developed world does still consume more oil than developing countries. But that’s changing: Sometime early in the coming decade, non-OECD oil demand will exceed that in the OECD.
The bottom line is that growth in demand from the developed world hasn’t been powering the oil market in recent years. Rather, the secular growth in demand from the developing world has been the key driver.
The real question when it comes to the oil market is to what extent the recent downturn in the US and EU will infect developing economies. In the case of oil demand growth, the spillover will be limited.
The key point to remember is that growth in oil demand in a country like China is a secular shift, not a cyclical spike. Consider the chart below of oil demand in various countries in terms of barrels per capita, per year.
Source: BP Statistical review of World Energy 2007, United Nations, US Census Bureau
Note the huge and obvious discrepancies in the chart. The average American consumes nearly 25 barrels of oil (1,050 gallons) per person per year, and the average European uses somewhere in the 11-to-12 barrels-per-year range. Japan sits somewhere in the middle, using closer to 15 barrels per capita per year.
The contrast with developing countries such as China, India and even Brazil couldn’t be starker. India uses less than one barrel per consumer per year, and China consumes barely two barrels.
Of course, this is developing over time. Consider that, in 2000, China’s oil consumption was just around 1.3 barrels of oil per person per year; that move from 1.3 to two barrels added nearly 2.7 million barrels per day in demand to the global oil market. And in 1997, Indian demand was less than 0.6 barrels per person per year.
The simple fact is that energy demand inevitably rises as a nation develops economically. Consider the case of Japan. In 1950, Japanese oil demand was between one and 1.5 barrels per person per year, and by 1965, it had climbed to more than four barrels. The main driver of that growth was Japan’s strong postwar economic recovery and renaissance.
Now, imagine if China and India, with populations of more than 1 billion each, eventually use even half of the EU average. The wall of demand growth would be tremendous.
Although there will undoubtedly be bumps along the way, I expect demand growth in the developing world to follow the same path as it did in Japan during the postwar period. The trend will take many years to develop, just as it did in Japan, but the implications for world oil demand will be game-changing. Another key difference will, of course, be the availability of supply.
I won’t belabor that point because I highlighted it at some length in the most recent issue of TES, Taking Stock of 2007. To make a long story short, during the rapid run-up in Japanese demand for oil, global supplies were far more abundant. US oil production rose to a record 11.2 million barrels per day in 1972, and the giant oilfields of Saudi Arabia, Kuwait and Iran were relatively young.
All of these fields were still capable of generating huge production growth with basic technology and recovery methods. All the demand growth from the developed world, as well as Japan, could be met by increased Middle Eastern supplies.
That’s not the case today. The world’s large, onshore fields are mature. The world’s “easy” oil has already been heavily exploited.
Going forward, producers will need to rely on advanced well designs, deepwater production and unconventional reserves to meet global demand growth. Producing these reserves will be expensive and require the use of the most-advanced oilfield technologies available today.
Such complex projects are also subject to heavy delays. For example, note that the Kashagan project in Kazakhstan was originally scheduled to be completed in 2005. The current estimate is for a project startup in 2010 with full output not attained for several years after that.
In fact, in every one of the last five years, non-OPEC production growth forecasts have disappointed estimates because of faster-than-expected declines of mature fields and ongoing delays to new project startups. The world’s producers are finding that increasing oil production isn’t an easy matter.
Although I’m not sure that global oil production has truly peaked yet, I do believe the world is a lot closer to that point than many would care to admit. In addition, the idea that global oil production can easily and quickly expand to 100 or 120 barrels of oil per day to meet rapidly growing demand is pure fiction.
Bottom line: The combination of secular growth in demand and constrained supplies will keep oil prices relatively high in coming years. A cyclical downturn in the US and/or Europe won’t alter that picture in the long run. Therefore, pullbacks in oil and energy-oriented stocks are buying opportunities.
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That means taking outright short positions in stocks that are fundamentally vulnerable and buying into stocks with strong valuation support that can see upside even if oil pulls back sharply.
Longer term, it’s time to assemble a watch list of stocks we’re interested in buying on a pullback. That list would include the stocks I highlighted in the most recent issue of TES. An optimal buying opportunity will present itself sooner or later, but for the reasons highlighted earlier, I don’t believe we’re quite there yet.
Although the long-term supply and demand picture is bullish for oil, a recession in the US coupled with a stock market correction or “bear” market will have major psychological impacts on commodity prices and related stocks. Specifically, in the short run, oil price movements are heavily US-centric; traders watch US inventory and demand data extraordinarily closely. Check out the chart below.
Source: Bloomberg, Dept of Energy
This chart shows current oil inventories compared to the five-year average, the five-year minimum and the five-year maximum.
US crude oil inventories dropped precipitously after midyear 2007. By the end of the year, crude oil stocks were well under the average and toward the lower end of their five-year range.
On a more global basis, the picture was similar. Check out the chart below.
Source: International Energy Agency
This chart shows oil inventories for all developed (OECD) countries over the past several months. I’ve highlighted the inventories for October in red for ease of illustration. It’s clear that inventories sank well below average levels in October.
The main reasons for that decline are twofold. First, production from non-OPEC sources was disappointing last year because of faster-than-projected declines from mature oil producers such as Norway and Mexico, coupled with delays to important new non-OPEC projects.
Second, OPEC has remained disciplined in recent months. The organization hasn’t been increasing oil supplies to meet demand; the excess of demand over supply has, therefore, been met via inventory drawdowns in the developed world. The inventory drawdown was more pronounced in the fourth quarter because oil demand typically rises into yearend; global oil demand in the fourth quarter averaged 86.94 million barrels per day compared to 85.25 million barrels per day in the third.
But signs are that supplies are finally beginning to ease. As you can see from the chart of oil inventories above, inventories surged 4.3 million barrels in the US for the week ended Jan. 11 and 2.3 million barrels for the week ended Jan. 18. Both inventory builds were higher than expected.
Also according to the Energy Information Agency (EIA), oil imports have averaged about 10 million barrels per day over the past month, roughly 219,000 barrels per day more than the same time frame a year ago. That marks a significant jump in import supply.
Another key factor I continue to watch is tanker rates, as measured by the Baltic Dirty Index. See the chart of that index below.
Source: Bloomberg
Remember that tanker rates aren’t leveraged to oil prices; they’re leveraged to demand for moving oil. When OPEC keeps supplies constrained, oil prices tend to rise, but tanker rates fall simply because less oil is getting shipped from the Middle East. This is why tanker rates remained weak throughout the third quarter of 2007 and into the fourth quarter of last year.
In late 2007, we saw tanker rates spike higher sharply to the highest level since 2005. This was a sure sign that more shipments were moving from the Middle East.
That spike was followed by a severe pullback in spot tanker rates; this isn’t unusual as tanker rates are notoriously volatile. But note that tanker rates have slowed their descent lately and remain higher than they were for most of 2007 and, for that matter, 2006.
I’m looking for a secondary spike in rates over the next four to six weeks. This will be a sure sign that OPEC is shipping more oil. All told, I’m watching for a continued normalization of the US and global oil inventory picture in coming months.
And, I do expect that, in the very short term, US and EU oil demand growth could be weak. Oil demand isn’t particularly sensitive to economic growth in the developed world, and growth in developing countries is likely to remain strong.
However, there’s a risk that high prices coupled with weakening growth could slow US and EU demand at the margin; at least from a sentiment perspective, this will tend to have a negative impact on oil prices. In short, this is more of a short-term “headline” risk, but it’s worth considering.
And finally, I see one additional bearish trend for oil prices: The dollar has been rallying against the euro. I see that continuing, because it’s highly unlikely that the weakness in the US economy won’t spread to Europe. Eventually, Europe will cut rates alongside the Fed, and the economy there will also fall into recession–both trends that tend to weaken the euro.
In addition, there’s the well-known concept of the US dollar “smile.” Basically, this means that the US dollar tends to outperform other currencies when US growth is much stronger than global growth, such as during the late ’90s.
Ironically, the dollar also tends to outperform during recessions, as was the case in 2001. Currency trades are a bit beyond the scope of this newsletter, but suffice it to say, there’s a strong possibility the dollar could bounce further in the next few months.
Because oil is priced in US dollars, a weak dollar tends to be a positive for oil prices. I examined the daily correlation between the dollar index and West Texas Intermediate oil prices over the past three years.
The result: The correlation between the dollar index and oil is roughly -0.25. That means that a 1 percent rise in the value of the dollar index will tend to result in a 0.25 percent decline in oil prices. The correlation was statistically significant; a further bounce in the dollar is negative for oil.
No market moves in a straight line higher; however, the oil market moved in about as close to a straight line as I can imagine last year. Corrections in bull markets of as much as 30 percent or more are to be expected, especially for markets as technically overextended as oil.
I believe these factors suggest a fall in oil prices to the $70 area. Although I still suspect oil prices will average above $80 this year, this correction could feel severe at times.
These factors are behind my recommendation to short the US Oil Fund, an exchange traded fund (ETF) that tracks oil prices. For those unfamiliar with shorting stocks, please check out the section entitled “Pair Trades, Shorts and Puts” in the June 14, 2006, issue of TES for a detailed primer.
As of last Friday, I’ve also recommended you double your position in my recommended oil short. In other words, if you normally commit $10,000 to each TES recommendation, I’m recommending that you place $20,000 in this oil short.
Adding to this position is particularly important if you have heavy exposure to energy stocks. And I see more downside for oil than for energy stocks from current levels.
For those who are unwilling play shorts, an alternative would be to purchase the US Oil Fund July 70 put options (UNA SR). Put options gain in value as the price of the underlying security–in this case, the US Oil Fund–declines. Therefore, a selloff in oil would spell a gain for these puts.
If you do decide to play the puts, be sure to use a smaller dollar position. To approximate the short position, use a 2-to-1 ratio. In other words, if you would normally look to short 200 shares of the US Oil Fund, buy four put contracts, which is equivalent to 400 shares, to approximate the same position.
And finally, if you’re uncomfortable either shorting the US Oil Fund or buying the puts, consider the UltraShort Oil & Gas ProShares (AMEX: DUG). This is an ETF that shows performance equal to double the inverse of the Dow Jones Oil & Gas Index. In other words, the ETF rises when oil- and gas-related stocks pull back. The chart below shows the stocks that are in the Dow Jones Oil & Gas Index.
Source: Bloomberg
There are two key points to keep in mind about this ETF. First, it’s leveraged; it will gain in value at twice the rate that the stocks in the Dow Jones Index decline in value. Therefore, it’s highly volatile.
I recommend setting a stop loss around $36 if you hedge using the ProShares. Note that stop is more than 20 percent from the current trading price of the ETF; you should set your position size accordingly.
The second point to note is the UltraShort Oil & Gas ProShares track the performance of energy stocks, not energy commodities. So when oil prices fall, that doesn’t necessarily mean that the value of the ProShares will rise.
Because I see more downside and less risk in oil prices from current levels, I prefer the short in the US Oil Fund to the purchase of the UltraShort Oil & Gas ProShares. For traders with IRA or 401(k) accounts that don’t allow shorting, however, purchasing UltraShort Oil & Gas ProShares is a useful means to hedge against further downside in energy holdings.
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I sold out of Schlumberger last year in the mid-$90s. I’m not ready to jump back in just yet, but that doesn’t mean we can’t profit from management’s comments.
Schlumberger was early in calling the downturn in North America pressure-pumping services. (For those unfamiliar with pressure pumping, I explained it at great length in the Feb. 21, 2007, issue of TES, All Eyes on Gas.) Pressure pumping is key to producing the hot, unconventional US reserves such as the Barnett Shale and Rockies tight gas.
The problem is that there’s overcapacity in this market; Schlumberger was early to see that overcapacity develop. Investors who listened to that call and connected the dots avoided a nasty selloff in stocks such as BJ Services with heavy exposure to pressure pumping.
As I noted in last week’s flash alert, Schlumberger was hit hard after announcing earnings on Friday. The company missed estimates by 2 cents and traded as low as $72.30 on Friday before rebounding to near $80. As always, management’s comments during the conference call were instructive.
There was continued weakness in North American operations, particularly margins in the pressure-pumping business. This was totally expected; North American drilling activity is a good basic measure of demand for services in the region.
Onshore drilling activity in the US and Canada tends to target gas, rather than crude oil. Continued weakness in gas prices has been a major damper on this market in recent quarters. When you couple that with overcapacity in markets like pressure pumping, you have the recipe for poor performance.
But Schlumberger has only limited exposure to North America, and that’s mainly to the strongest markets. That includes projects in the deepwater Gulf as well as more complex onshore projects where smaller firms can’t compete effectively on a technology basis with Schlumberger.
It wasn’t weakness in North America that surprised the market Friday. Instead, it was some rather bearish comments on international growth prospects. What truly amazes me is that Schlumberger repeated almost the exact same comments it made back during its last conference call in October. (I analyzed that call at length in the Nov. 7, 2007, issue of TES, Coal and Services.)
In both calls, Schlumberger’s management team stated point blank that analysts’ expectations remained too high for international growth near term. But the reason for that has nothing to do with a lack of demand; rather, it’s the lack of availability of deepwater rigs and skilled labor—a factor I explained in the most recent issue of TES, actually quoting from Schlumberger’s October call.
Basically, there just aren’t enough deepwater rigs to handle all the projects producers would like to undertake in 2008. And it’s unreasonable to expect that as soon as a new rig is delivered and a crew hired, that rig will operate at maximum capacity and efficiency.
Such logistical issues will result in project delays and constraints on Schlumberger’s near-term growth. Logistical issues are particularly acute offshore; this is the area where Schlumberger earns the highest profit margins.
Management sees 2008 as a transition year for the market. International growth will remain strong, but logistical issues raise the risk that it won’t be quite strong enough to meet the most bullish Wall Street forecasts.
Management went on to say that Schlumberger’s outlook for international growth hasn’t changed appreciably since its last call; rather, it felt that Wall Street expectations hadn’t been reduced enough to reflect the potential logistical issues in 2008. Check out the chart below for a closer look.
Source: Bloomberg
This chart shows consensus analyst estimates for Schlumberger. The white line on the upper-right corner in the chart represents the estimates for 2008. As you can see, these estimates have remained basically flat for months.
Estimates for 2009—represented by the yellow line on the chart—have actually risen slightly since last fall. This is despite the fact that Schlumberger offered the exact same warning back in October about logistical issues offshore.
I recommended selling out of Schlumberger last year at more than $90. But in light of the stock’s 30 percent-plus selloff from its highs of more than $114, the firm is starting to look interesting again. This year is the only year where I really see the potential for a growth shortfall; Friday’s fall finally prices in that risk.
Let’s build a worst-case scenario for Schlumberger. The consensus Wall Street estimates for Schlumberger’s 2008 earnings is $4.97 per share; the lowest Street estimate is $4.75. Based on that lowest estimate, the stock currently trades at about 17 times 2008 earnings.
The stock has historically traded at a premium to other international-focused oil services giants, such as Halliburton, Baker Hughes and Weatherford. On average, these three stocks currently trade at 15.5 times 2008 earnings. Alternatively, Schlumberger’s long-term earnings growth rate is at least 15 percent. Its stock should trade at least in line with that.
Based on these factors, Schlumberger, at a bare minimum, should fetch a valuation for 15 to 16 times earnings. Using the absolute lowball 2008 estimates, that implies a price of around $70 to $75 per share.
Another way to look at the stock is price-to-sales. Based on that metric, Schlumberger has traded as low as 3.4 times sales in the past three years. Based on $19.60 in sales per share for 2007, that equates to $67 per share.
It’s quite possible that Schlumberger could undercut that valuation on a short-term basis during a global synchronized selloff, but I see $67 to $72 as rock-bottom valuation support based on the most-pessimistic assumptions. I certainly don’t see that as a long-term target, but rather a sort of floor.
For now, I recommend standing aside, but I’m looking for a move to that range as an opportunity to jump back into Schlumberger.
But Schlumberger’s call has far more importance than just its implications for Schlumberger’s stock itself. I see two additional points from that call that are worth noting.
First, Schlumberger made it clear that the company sees a US recession as a fait accompli. Nevertheless, Schlumberger just doesn’t see any major impact on its business.
The reason is Schlumberger’s prime projects are large-scale international deals that aren’t particularly dependant on commodity pricing; a pullback in oil to $60 from $100 won’t be cause to cancel or delay a multi-billion-dollar deepwater deal. In most cases, the economics of these deals were calculated assuming oil prices in the $40s.
And no producer in its right mind would give up access to a deepwater rig right now; they’re in short supply and high demand and cost upward of $500,000 per day to lease. Therefore, such deals aren’t commodity sensitive at all.
Schlumberger’s management stated that: “[A]ny drop in OECD demand for oil and gas will be more than offset or will be countered by the increase in India, China and the Middle East to a point that it will not affect the oil price to a level where out customers will seriously curtail their plans.” In other words, it would take a global economic recession to really impact demand for international oil services; that possibility is remote at best.
Second, Schlumberger hinted at a potential stabilization in North America. Specifically, Schlumberger said it already started booking business for 2008, including pressure-pumping services. Management stated that it felt it had a better handle on pricing in this market than it did at its last call because some of the business was already booked.
Schlumberger went on to say that it was highly unlikely profit margins in the US would decline as precipitously in 2008 as they did in 2007. Moreover, the firm feels that activity in North America will simply plateau near current levels; there won’t be a massive fall off in rig counts or drilling activity this year. Schlumberger saw the rig count at a level that can sustain needed production.
As I noted earlier, Schlumberger is heavily exposed to the most attractive markets in North America, so its take on this market may not fully represent the environment for all firms with operations in the area. I know from prior calls that commodity drillers—contract drillers with older, less-advanced rigs—and firms offering basic, low-tech services are getting hit harder than average. However, this is the first time in more than a year that I’ve heard Schlumberger say anything positive at all about North American land activity.
At the same time, there’s been some nascent improvement in the US natural gas markets. Gas prices remain stuck in a long-term trading range, as the chart below illustrates.
Source: Bloomberg
This chart shows the 12-month natural gas “strip.” The strip is nothing more than the average of the next 12 months of natural gas prices.
The strip is by far the most useful measure of gas prices out there because most producers use the futures market to hedge their production. Using an average futures price more closely approximates the prices they can earn for the gas they sell.
The natural gas strip is well off its late 2005, early 2006 highs in the teens. Gas prices haven’t exactly slumped lately, but they’ve been trading between $7 and $9 per million British thermal units (MMBtu). And as I noted in the Jan. 11 issue of TEL, Where’s the Gas?, gas prices remain depressed relative to crude oil.
The main problem with natural gas has been bloated inventories. Check out the chart below for a closer look.
Source: Bloomberg, Dept of Energy
As you can clearly see, inventories of gas remained near the high end of the historical range for most of 2007 and certainly well above average levels. This is a continued hangover from the warm winter of 2005-06. This excess supply put pressure on gas.
Lately, we’ve seen inventories fall toward more average levels. I must emphasize that this trend is still in its early stages; a cooler-than-projected January is the main driver of the inventory drawdown.
The point to keep in mind is that the weakness in natural gas prices and drilling activity is a well-known phenomenon. Some stocks levered to North American natural gas drilling are already pricing in a continued nasty fundamental environment over the next several months.
For example, check out the earnings estimates for Nabors Industries, a land contract driller I highlighted in depth in the Aug. 22, 2007, issue of TES, Drilling Down.
Source: Bloomberg
This chart shows Nabors’ earnings estimates for 2008 over the past few months. Analysts have been steadily revising lower their estimates for the stock over the past three to four months. The bar of expectations for Nabors is a great deal lower than for a stock like Schlumberger; everyone is well aware that Nabors’ US business is weak.
At the same time, there’s room for upside. Nabors has a large, rapidly growing international business; it’s not totally dependant on the North American rig count and North American gas prices for growth. Schlumberger stated in its call last week that the international drilling environment is, for the most part, strong.
What’s more, Nabors tends to own high-tech rigs that are less vulnerable to falling drilling activity than most commodity rigs. And Nabors also has a large number of built-for-purpose rigs. These are rigs that Nabors built and has contracted under longer-term deals at attractive day-rates. These contracts offer a large measure of stability.
Bottom line: I see value in Nabors at current levels. The stock is trading at rock-bottom valuations, and current estimates already assume a great deal of weakness for its core business.
There’s room for Nabors to beat expectations, and I see relatively limited downside even if it doesn’t. Meanwhile, Nabors hasn’t been a big winner, so it’s less likely to see profit-taking in the current environment.
The final component of the story is the stabilization of the North American gas drilling market that Schlumberger highlighted in its call last week. Nabors Industries remains a buy under 31 with a stop at 22.50.
Meanwhile, there’s Weatherford, another stock that I recommend in the growth-oriented Wildcatters Portfolio. I highlighted my rationale for owning this stock in the most recent issue of TES, so I won’t rehash those arguments here.
Suffice it to say that Weatherford was hit by spillover selling from Schlumberger. However, the stock was never as richly valued; it hasn’t pulled back as severely as Schlumberger. I also see Weatherford as less exposed to the offshore logistical issues Schlumberger highlighted in its call last week.
Continue to buy Weatherford. I’ll have more on the company following its earnings release Friday.
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Since the beginning of the year, the stocks in the alternative field bet have been hit far harder than most energy-related stocks for three primary reasons. The first is simply, as noted above, that traders had big gains in these names and, looking to raise cash, sold off their winners. Remember that alternatives were among the market’s best performers last year.
The second is these stocks sport high valuations. For example, SunPower trades at 37 times next year’s earnings estimates. Although I believe that’s justified given its sky-high growth potential, high price-to-earnings stocks have a tendency to get hit hardest during big selloffs.
Finally, there’s some lingering disappointment that the US Energy Act, passed late in 2007, didn’t include more direct support for renewables. Some were looking for a renewable fuels mandate—a requirement that utilities generate a certain percentage of their power using technologies such as wind or solar. Although the bill included incentives for alternatives, the mandate was stripped out of the final version.
Moreover, some tax credits for renewable energy in the US are scheduled to expire at the end of this year. These credits weren’t all extended in last year’s bill, but not because there’s no political will to extend the credits. Neither Republicans nor Democrats are willing to oppose such credits, particularly in an election year where energy is a hot-button issue. We’ll likely see legislation that extends the renewable tax credits this year.
It’s also highly likely that a renewable mandate and some sort of carbon legislation will eventually become law in the US in 2009, if not sooner.
Meanwhile, several states have existing tax credits for renewables, and there are more considering such measures. Spain is also planning to institute a generous solar subsidy plan this year; that country could be another big market for solar.
Short-term issues aside, I don’t see the political tailwinds for alternative energy abating in 2008. In fact, it’s far more likely we’ll see even bigger subsidies in some countries like the US and Spain.
Alternative energy stocks are ultimately driven by government subsidies and politics. Neither wind nor solar will ever replace fossil fuels, but government mandates and subsidies can, for better or worse, certainly continue to power strong growth.
One additional point is worth noting: Please be aware of my concept of a field bet. I recommend three in TES—uranium, alternatives and biofuels. Instead of just picking one or two highly-leveraged plays on these high-potential sectors, I recommend casting a much wider net. By investing in several plays of differing risk levels, we can diversify our risk and maximize our chances of hitting a few big winners.
The key is to buy all of the plays in the field bet, and account for the risk by placing a relatively small amount in each pick. Depending on your risk tolerance, I recommend placing a fifth to a third of what you’d normally put in a TES recommendation into each pick. I’m also careful to identify picks that I consider to be riskier.
Another important component of these plays is that I periodically recommend taking partial profits in field bet recommendations. For example, one of the biofuel field bet plays—Potash Corp—has more than tripled since it was recommended in late 2006, so in the Sept. 19, 2007, issue, Down on the Farm, I recommended selling a stake in the stock to book partial gains.
By handling the field bet plays in this way, we can play some of the most exciting, high-growth themes around without betting the farm on any single play.
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Speaking Engagements
If you aren’t able to escape the winter chill to The World Money Show at Orlando’s Gaylord Palms Resort, Feb. 6-9, 2008, I’ll be discussing infrastructure, partnerships, utilities, resources and energy, and to telling you what to buy and what to sell in 2008 in webcasts available following the show at www.moneyshow.com.
And it’s Time: Vegas, Baby! I’m heading to the desert paradise with my colleagues Neil George and Roger Conrad May 12-15, 2008, for the Las Vegas Money Show at Mandalay Bay. I’ll keep you posted with more details in an upcoming issue.
Although I’ve taken steps to hedge risks, book profits and even play the downside in oil, most The Energy Strategist picks have seen big swings over the past month as a result of this globally synchronized selloff.
First, the bad news: I expect further downside in some energy-related stocks and sharply increased volatility over the next few weeks. I’m also looking for oil prices to pull back into the $70s before this move is over, perhaps even breaking $70 per blue barrel (bbl) on a short-term basis.
This isn’t a new outlook. I’ve been calling for an oil price correction since my Nov. 27, 2007, flash alert, “Tankers Up, Crude Down,” and reiterated that call in last week’s flash alert.
But there’s a silver lining to these clouds. The old saw on Wall Street is that you should buy “when there’s blood in the streets.” In other words, periods of extreme market volatility and panic invariably offer the best opportunities.
Many of the fundamentally best-positioned energy plays are getting hit hard mainly because of spillover selling from the broader market indexes rather than any changes to fundamental value or growth prospects. This is setting us up for an outstanding buying opportunity in the group; we’ll soon be able to pick up some of the best in the business at valuations we could only dream of just a few weeks ago.
Second, as I pointed out in the most recent issue, the energy sector isn’t a homogenous group. Careful stock picking and focus can really shine during periods of market volatility.
And finally, don’t be fooled into thinking you can’t profit from the downside in oil and energy-oriented stocks. Last Friday, I recommended taking some gains off the table in my recommended Halliburton short position, booking a 15 percent gain in the process. I also recommended doubling up on your shorts in the US Oil Fund (AMEX: USO). In past cycles, we’ve made plenty of money on the short side, and I see more opportunities in the coming weeks.
In This Issue
In this issue, I’ll take a closer look at some beaten-down, gas-oriented names that have limited downside risk at current levels even if the market continues to come under pressure.The energy sector is still strong, despite what might be inferred from the recent selloff. Utilities and consumer staples are also suffering this fate. See Synchronized Selling.
Indicators are pointing toward a recession, but that doesn’t mean we should avoid energy altogether. Instead, there are several demand factors that should make this a buying opportunity, especially for the long term. See It’s the Economy.
I’ve highlighted the US Oil Fund as a great short on the energy market at this time, but there are other ways to play it. I recommend taking a look at two different plays on oil—an exchange traded fund and a put option—to hedge against drops in oil prices. See How to Play It.
Schlumberger’s quarterly conference calls are usually a great indicator of what to expect in the pressure-pumping sector. It’s still expensive—which is why we got out when we did last year—but there may be an opportunity to jump back in this year. I also hold two other companies in the portfolios that are worth a second look. See Services, Drillers and Gas.
Alternatives was one of the best-performing sectors in energy last year, and the field bet was certainly no slouch. Just remember that these should played speculatively as a collection. See Alternative Field Bet.
Synchronized Selling
Over the past two and a half months, I’ve taken several steps to hedge downside risk in the TES portfolios and book gains in the most-extended recommendations. As I stated in a Nov. 12, 2007, flash alert, Shorting Halliburton, most stocks in the energy patch enjoyed an impressive run-up last year and were pricing in the best possible news. Even though I’m convinced the energy bull market is far from over, these periods of overexuberence typically mark short-term tops.However, despite these steps, the TES portfolios have been hit in the first few weeks of 2008. I’m often asked how these stocks can be trading lower even though oil remains at relatively lofty levels and global exploration spending and drilling activity remain robust.
The answer is simply that during global selloffs such as we’ve witnessed during the past three weeks, stocks have a tendency to head lower as a herd, regardless of fundamentals and market sector.
The recent bout of selling has been exacerbated by the fact that energy stocks were among the best performers in the S&P 500 last year. Therefore, many investors and institutional traders have significant profits in these stocks, profits that still far exceed any losses incurred over the past few weeks. As illogical as it may sound, when institutional players are looking to protect gains and raise their cash position, they have a tendency to sell down their winners.
In other words, the energy sector is being used as a source of cash, and investors are throwing the babies out with the bathwater.
Check out the charts below for a closer look.
Source: Bloomberg
Source: Bloomberg
These charts depict the Philadelphia Utility Index and S&P 500 Consumer Staples sector, respectively. Both sectors are considered defensive.
Utilities are in a government-regulated business and tend to generate stable cash flows in good economies and bad. These stocks also traditionally throw off big dividend yields; investors park cash in the group when times get tough.
Consumer staples stocks include companies producing everything from alcoholic beverages to shampoo. Spending on such items typically holds up well during economic slowdowns and recessions.
For the first few days of 2008, both groups actually rallied, likely benefiting as money rotated out of sectors seen as more cyclical and economy sensitive. What’s equally clear is that both sectors have been hit hard in the past two weeks, despite these defensive qualities.
That’s a sure sign that traders are looking to reduce their exposure to stocks, even those groups unlikely to be overly affected by the current global economic and credit headwinds. Both groups’ generally good performances in the latter half of 2007 are another sign that institutional investors are desperately looking to raise cash regardless of fundamentals. There’s simply no appetite for risk in the current environment.
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It’s the Economy
Near-term cash requirements aside, the root cause of what’s really troubling global markets and killing risk appetite is the specter of a US-led recession. Although some investors love to scour every minutiae of economic news released, I prefer to look at just a handful of simple indicators. First, check out the chart of US Leading Economic indicators below.Source: Bloomberg
The leading economic indicator (LEI) is actually a composite of 10 key economic indicators. The list includes housing starts, consumer expectations, jobless claims and even the performance of the US stock market.
The chart shows the year-over-year percent change in leading economic indicators. As evidenced from this chart, the LEI tends to turn negative just ahead of or coincident with US recessions.
For example, the LEI turned negative on a year-over-year basis in June 1989; a US recession followed in July 1990 and lasted through March 1991. Similarly, the December 2000 dip in the LEI below zero foreshadowed the March-November 2001 recession.
Like every indicator, the LEI is far from infallible. For example, a short dip below zero in 1996 turned out to be a false alarm. However, the indicator is right more than it’s wrong, and we can’t ignore the slump since late 2007.
The LEI officially broke below zero in November. I believe that this presages at least a minor US recession in 2008.
Contrary to the view publicly espoused by the European Central Bank (ECB), I just don’t see Europe remaining totally immune either. The largest economy in Europe is Germany, and leading indicators in that nation are also deteriorating. For example, retail sales were down 5.6 percent year-over-year in November, the latest month for which we have reliable data.
In the UK, the housing market remains an important concern. The housing market in London was even more extended than red-hot US markets such as Florida and Southern California. Check out the chart of the Halifax (HBOS) House Price Index below.
Source: Bloomberg
This is one of the most-watched indicators of house prices in Britain. Although it hasn’t turned negative yet, a steady downtrend in mortgage approvals strongly suggests that it will turn lower outright in 2008. Therefore, the UK will have to contend with a round of falling house prices just like the US.
The currency markets don’t believe that Europe will be immune from the weakness either. The euro has been selling off relative to the dollar in recent weeks, a sure sign expectations are growing that the eurozone economy is weakening rapidly and the ECB will eventually follow the US Federal Reserve and Bank of England by cutting interest rates. This weakness has continued despite repeated hawkish comments from ECB officials during this time period.
Amid all that transatlantic gloom, the gut reaction of many is to avoid so-called “cyclical” sectors such as energy. That may be the correct play in the next few weeks, but it’s the wrong reaction longer term.
The first point to note is that, unlike prior cycles, the primary engine of oil demand growth isn’t the US or Europe. Check out the chart below for a closer look.
Source: BP Statistical Review of World Energy 2007
This chart shows the growth in oil demand between 2000 and 2007 for a number of different countries and regions. Countries in the Organization of Economic Cooperation and Development (OECD) are generally considered the developed countries; oil demand grew roughly 1.37 million barrels per day during this time period. That represents total cumulative growth of just less than 2.9 percent.
The non-OECD countries that make up the developing world are, however, a different story entirely. Consider that over the same time period, demand from non-OECD nations soared nearly 7.5 million barrels per day or more than 21 percent. That’s more than seven times the rate of growth in the developed world.
Furthermore, note that oil demand in the US is up less than 900,000 barrels per day over the past seven years, while demand in the European Union (EU) is up less than 500,000. And most of the growth in EU demand didn’t come from developed EU countries, such as Britain, Germany and France, but from the new entrants, such as Poland, the Czech Republic and Hungary. In fact, demand actually fell in Germany and France over this time period.
The OECD isn’t the driver of oil demand growth. Moreover, in an absolute sense, the OECD is losing its dominance of the global oil market. Check out the chart below for a closer look.
Source: BP Statistical Review of World Energy 2007
This chart shows OECD oil consumption as a percent of total global consumption. The higher this ratio, the more important the developed world is to global oil demand. A ratio less than 50 percent would indicate that developing world demand is higher than OECD demand.
The trend here is clear. OECD demand was three-quarters of the total in the late 1960s and early ’70s. Now, it accounts for less than 60 percent of global demand, and that ratio has been falling precipitously since the late ’90s.
Of course, the ratio remains more than 50 percent, indicating that the developed world does still consume more oil than developing countries. But that’s changing: Sometime early in the coming decade, non-OECD oil demand will exceed that in the OECD.
The bottom line is that growth in demand from the developed world hasn’t been powering the oil market in recent years. Rather, the secular growth in demand from the developing world has been the key driver.
The real question when it comes to the oil market is to what extent the recent downturn in the US and EU will infect developing economies. In the case of oil demand growth, the spillover will be limited.
The key point to remember is that growth in oil demand in a country like China is a secular shift, not a cyclical spike. Consider the chart below of oil demand in various countries in terms of barrels per capita, per year.
Source: BP Statistical review of World Energy 2007, United Nations, US Census Bureau
Note the huge and obvious discrepancies in the chart. The average American consumes nearly 25 barrels of oil (1,050 gallons) per person per year, and the average European uses somewhere in the 11-to-12 barrels-per-year range. Japan sits somewhere in the middle, using closer to 15 barrels per capita per year.
The contrast with developing countries such as China, India and even Brazil couldn’t be starker. India uses less than one barrel per consumer per year, and China consumes barely two barrels.
Of course, this is developing over time. Consider that, in 2000, China’s oil consumption was just around 1.3 barrels of oil per person per year; that move from 1.3 to two barrels added nearly 2.7 million barrels per day in demand to the global oil market. And in 1997, Indian demand was less than 0.6 barrels per person per year.
The simple fact is that energy demand inevitably rises as a nation develops economically. Consider the case of Japan. In 1950, Japanese oil demand was between one and 1.5 barrels per person per year, and by 1965, it had climbed to more than four barrels. The main driver of that growth was Japan’s strong postwar economic recovery and renaissance.
Now, imagine if China and India, with populations of more than 1 billion each, eventually use even half of the EU average. The wall of demand growth would be tremendous.
Although there will undoubtedly be bumps along the way, I expect demand growth in the developing world to follow the same path as it did in Japan during the postwar period. The trend will take many years to develop, just as it did in Japan, but the implications for world oil demand will be game-changing. Another key difference will, of course, be the availability of supply.
I won’t belabor that point because I highlighted it at some length in the most recent issue of TES, Taking Stock of 2007. To make a long story short, during the rapid run-up in Japanese demand for oil, global supplies were far more abundant. US oil production rose to a record 11.2 million barrels per day in 1972, and the giant oilfields of Saudi Arabia, Kuwait and Iran were relatively young.
All of these fields were still capable of generating huge production growth with basic technology and recovery methods. All the demand growth from the developed world, as well as Japan, could be met by increased Middle Eastern supplies.
That’s not the case today. The world’s large, onshore fields are mature. The world’s “easy” oil has already been heavily exploited.
Going forward, producers will need to rely on advanced well designs, deepwater production and unconventional reserves to meet global demand growth. Producing these reserves will be expensive and require the use of the most-advanced oilfield technologies available today.
Such complex projects are also subject to heavy delays. For example, note that the Kashagan project in Kazakhstan was originally scheduled to be completed in 2005. The current estimate is for a project startup in 2010 with full output not attained for several years after that.
In fact, in every one of the last five years, non-OPEC production growth forecasts have disappointed estimates because of faster-than-expected declines of mature fields and ongoing delays to new project startups. The world’s producers are finding that increasing oil production isn’t an easy matter.
Although I’m not sure that global oil production has truly peaked yet, I do believe the world is a lot closer to that point than many would care to admit. In addition, the idea that global oil production can easily and quickly expand to 100 or 120 barrels of oil per day to meet rapidly growing demand is pure fiction.
Bottom line: The combination of secular growth in demand and constrained supplies will keep oil prices relatively high in coming years. A cyclical downturn in the US and/or Europe won’t alter that picture in the long run. Therefore, pullbacks in oil and energy-oriented stocks are buying opportunities.
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How to Play It
The playbook for the current environment is simple: We must separate short-term considerations from long-term trends. In the short term, we want to hedge ourselves against further pullbacks in oil prices and profit-taking in last year’s big winners. The desire to reduce risk and raise cash will trump long-term secular demand growth and supply considerations for at least the next few weeks.That means taking outright short positions in stocks that are fundamentally vulnerable and buying into stocks with strong valuation support that can see upside even if oil pulls back sharply.
Longer term, it’s time to assemble a watch list of stocks we’re interested in buying on a pullback. That list would include the stocks I highlighted in the most recent issue of TES. An optimal buying opportunity will present itself sooner or later, but for the reasons highlighted earlier, I don’t believe we’re quite there yet.
Although the long-term supply and demand picture is bullish for oil, a recession in the US coupled with a stock market correction or “bear” market will have major psychological impacts on commodity prices and related stocks. Specifically, in the short run, oil price movements are heavily US-centric; traders watch US inventory and demand data extraordinarily closely. Check out the chart below.
Source: Bloomberg, Dept of Energy
This chart shows current oil inventories compared to the five-year average, the five-year minimum and the five-year maximum.
US crude oil inventories dropped precipitously after midyear 2007. By the end of the year, crude oil stocks were well under the average and toward the lower end of their five-year range.
On a more global basis, the picture was similar. Check out the chart below.
Source: International Energy Agency
This chart shows oil inventories for all developed (OECD) countries over the past several months. I’ve highlighted the inventories for October in red for ease of illustration. It’s clear that inventories sank well below average levels in October.
The main reasons for that decline are twofold. First, production from non-OPEC sources was disappointing last year because of faster-than-projected declines from mature oil producers such as Norway and Mexico, coupled with delays to important new non-OPEC projects.
Second, OPEC has remained disciplined in recent months. The organization hasn’t been increasing oil supplies to meet demand; the excess of demand over supply has, therefore, been met via inventory drawdowns in the developed world. The inventory drawdown was more pronounced in the fourth quarter because oil demand typically rises into yearend; global oil demand in the fourth quarter averaged 86.94 million barrels per day compared to 85.25 million barrels per day in the third.
But signs are that supplies are finally beginning to ease. As you can see from the chart of oil inventories above, inventories surged 4.3 million barrels in the US for the week ended Jan. 11 and 2.3 million barrels for the week ended Jan. 18. Both inventory builds were higher than expected.
Also according to the Energy Information Agency (EIA), oil imports have averaged about 10 million barrels per day over the past month, roughly 219,000 barrels per day more than the same time frame a year ago. That marks a significant jump in import supply.
Another key factor I continue to watch is tanker rates, as measured by the Baltic Dirty Index. See the chart of that index below.
Source: Bloomberg
Remember that tanker rates aren’t leveraged to oil prices; they’re leveraged to demand for moving oil. When OPEC keeps supplies constrained, oil prices tend to rise, but tanker rates fall simply because less oil is getting shipped from the Middle East. This is why tanker rates remained weak throughout the third quarter of 2007 and into the fourth quarter of last year.
In late 2007, we saw tanker rates spike higher sharply to the highest level since 2005. This was a sure sign that more shipments were moving from the Middle East.
That spike was followed by a severe pullback in spot tanker rates; this isn’t unusual as tanker rates are notoriously volatile. But note that tanker rates have slowed their descent lately and remain higher than they were for most of 2007 and, for that matter, 2006.
I’m looking for a secondary spike in rates over the next four to six weeks. This will be a sure sign that OPEC is shipping more oil. All told, I’m watching for a continued normalization of the US and global oil inventory picture in coming months.
And, I do expect that, in the very short term, US and EU oil demand growth could be weak. Oil demand isn’t particularly sensitive to economic growth in the developed world, and growth in developing countries is likely to remain strong.
However, there’s a risk that high prices coupled with weakening growth could slow US and EU demand at the margin; at least from a sentiment perspective, this will tend to have a negative impact on oil prices. In short, this is more of a short-term “headline” risk, but it’s worth considering.
And finally, I see one additional bearish trend for oil prices: The dollar has been rallying against the euro. I see that continuing, because it’s highly unlikely that the weakness in the US economy won’t spread to Europe. Eventually, Europe will cut rates alongside the Fed, and the economy there will also fall into recession–both trends that tend to weaken the euro.
In addition, there’s the well-known concept of the US dollar “smile.” Basically, this means that the US dollar tends to outperform other currencies when US growth is much stronger than global growth, such as during the late ’90s.
Ironically, the dollar also tends to outperform during recessions, as was the case in 2001. Currency trades are a bit beyond the scope of this newsletter, but suffice it to say, there’s a strong possibility the dollar could bounce further in the next few months.
Because oil is priced in US dollars, a weak dollar tends to be a positive for oil prices. I examined the daily correlation between the dollar index and West Texas Intermediate oil prices over the past three years.
The result: The correlation between the dollar index and oil is roughly -0.25. That means that a 1 percent rise in the value of the dollar index will tend to result in a 0.25 percent decline in oil prices. The correlation was statistically significant; a further bounce in the dollar is negative for oil.
No market moves in a straight line higher; however, the oil market moved in about as close to a straight line as I can imagine last year. Corrections in bull markets of as much as 30 percent or more are to be expected, especially for markets as technically overextended as oil.
I believe these factors suggest a fall in oil prices to the $70 area. Although I still suspect oil prices will average above $80 this year, this correction could feel severe at times.
These factors are behind my recommendation to short the US Oil Fund, an exchange traded fund (ETF) that tracks oil prices. For those unfamiliar with shorting stocks, please check out the section entitled “Pair Trades, Shorts and Puts” in the June 14, 2006, issue of TES for a detailed primer.
As of last Friday, I’ve also recommended you double your position in my recommended oil short. In other words, if you normally commit $10,000 to each TES recommendation, I’m recommending that you place $20,000 in this oil short.
Adding to this position is particularly important if you have heavy exposure to energy stocks. And I see more downside for oil than for energy stocks from current levels.
For those who are unwilling play shorts, an alternative would be to purchase the US Oil Fund July 70 put options (UNA SR). Put options gain in value as the price of the underlying security–in this case, the US Oil Fund–declines. Therefore, a selloff in oil would spell a gain for these puts.
If you do decide to play the puts, be sure to use a smaller dollar position. To approximate the short position, use a 2-to-1 ratio. In other words, if you would normally look to short 200 shares of the US Oil Fund, buy four put contracts, which is equivalent to 400 shares, to approximate the same position.
And finally, if you’re uncomfortable either shorting the US Oil Fund or buying the puts, consider the UltraShort Oil & Gas ProShares (AMEX: DUG). This is an ETF that shows performance equal to double the inverse of the Dow Jones Oil & Gas Index. In other words, the ETF rises when oil- and gas-related stocks pull back. The chart below shows the stocks that are in the Dow Jones Oil & Gas Index.
Source: Bloomberg
There are two key points to keep in mind about this ETF. First, it’s leveraged; it will gain in value at twice the rate that the stocks in the Dow Jones Index decline in value. Therefore, it’s highly volatile.
I recommend setting a stop loss around $36 if you hedge using the ProShares. Note that stop is more than 20 percent from the current trading price of the ETF; you should set your position size accordingly.
The second point to note is the UltraShort Oil & Gas ProShares track the performance of energy stocks, not energy commodities. So when oil prices fall, that doesn’t necessarily mean that the value of the ProShares will rise.
Because I see more downside and less risk in oil prices from current levels, I prefer the short in the US Oil Fund to the purchase of the UltraShort Oil & Gas ProShares. For traders with IRA or 401(k) accounts that don’t allow shorting, however, purchasing UltraShort Oil & Gas ProShares is a useful means to hedge against further downside in energy holdings.
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Services, Drillers and Gas
Longtime readers know that one of the companies I watch closely is oilfields service giant Schlumberger. This company operates in every imaginable oil- or gas-producing country in the world and has an unparalleled perspective on trends in the global energy markets.I sold out of Schlumberger last year in the mid-$90s. I’m not ready to jump back in just yet, but that doesn’t mean we can’t profit from management’s comments.
Schlumberger was early in calling the downturn in North America pressure-pumping services. (For those unfamiliar with pressure pumping, I explained it at great length in the Feb. 21, 2007, issue of TES, All Eyes on Gas.) Pressure pumping is key to producing the hot, unconventional US reserves such as the Barnett Shale and Rockies tight gas.
The problem is that there’s overcapacity in this market; Schlumberger was early to see that overcapacity develop. Investors who listened to that call and connected the dots avoided a nasty selloff in stocks such as BJ Services with heavy exposure to pressure pumping.
As I noted in last week’s flash alert, Schlumberger was hit hard after announcing earnings on Friday. The company missed estimates by 2 cents and traded as low as $72.30 on Friday before rebounding to near $80. As always, management’s comments during the conference call were instructive.
There was continued weakness in North American operations, particularly margins in the pressure-pumping business. This was totally expected; North American drilling activity is a good basic measure of demand for services in the region.
Onshore drilling activity in the US and Canada tends to target gas, rather than crude oil. Continued weakness in gas prices has been a major damper on this market in recent quarters. When you couple that with overcapacity in markets like pressure pumping, you have the recipe for poor performance.
But Schlumberger has only limited exposure to North America, and that’s mainly to the strongest markets. That includes projects in the deepwater Gulf as well as more complex onshore projects where smaller firms can’t compete effectively on a technology basis with Schlumberger.
It wasn’t weakness in North America that surprised the market Friday. Instead, it was some rather bearish comments on international growth prospects. What truly amazes me is that Schlumberger repeated almost the exact same comments it made back during its last conference call in October. (I analyzed that call at length in the Nov. 7, 2007, issue of TES, Coal and Services.)
In both calls, Schlumberger’s management team stated point blank that analysts’ expectations remained too high for international growth near term. But the reason for that has nothing to do with a lack of demand; rather, it’s the lack of availability of deepwater rigs and skilled labor—a factor I explained in the most recent issue of TES, actually quoting from Schlumberger’s October call.
Basically, there just aren’t enough deepwater rigs to handle all the projects producers would like to undertake in 2008. And it’s unreasonable to expect that as soon as a new rig is delivered and a crew hired, that rig will operate at maximum capacity and efficiency.
Such logistical issues will result in project delays and constraints on Schlumberger’s near-term growth. Logistical issues are particularly acute offshore; this is the area where Schlumberger earns the highest profit margins.
Management sees 2008 as a transition year for the market. International growth will remain strong, but logistical issues raise the risk that it won’t be quite strong enough to meet the most bullish Wall Street forecasts.
Management went on to say that Schlumberger’s outlook for international growth hasn’t changed appreciably since its last call; rather, it felt that Wall Street expectations hadn’t been reduced enough to reflect the potential logistical issues in 2008. Check out the chart below for a closer look.
Source: Bloomberg
This chart shows consensus analyst estimates for Schlumberger. The white line on the upper-right corner in the chart represents the estimates for 2008. As you can see, these estimates have remained basically flat for months.
Estimates for 2009—represented by the yellow line on the chart—have actually risen slightly since last fall. This is despite the fact that Schlumberger offered the exact same warning back in October about logistical issues offshore.
I recommended selling out of Schlumberger last year at more than $90. But in light of the stock’s 30 percent-plus selloff from its highs of more than $114, the firm is starting to look interesting again. This year is the only year where I really see the potential for a growth shortfall; Friday’s fall finally prices in that risk.
Let’s build a worst-case scenario for Schlumberger. The consensus Wall Street estimates for Schlumberger’s 2008 earnings is $4.97 per share; the lowest Street estimate is $4.75. Based on that lowest estimate, the stock currently trades at about 17 times 2008 earnings.
The stock has historically traded at a premium to other international-focused oil services giants, such as Halliburton, Baker Hughes and Weatherford. On average, these three stocks currently trade at 15.5 times 2008 earnings. Alternatively, Schlumberger’s long-term earnings growth rate is at least 15 percent. Its stock should trade at least in line with that.
Based on these factors, Schlumberger, at a bare minimum, should fetch a valuation for 15 to 16 times earnings. Using the absolute lowball 2008 estimates, that implies a price of around $70 to $75 per share.
Another way to look at the stock is price-to-sales. Based on that metric, Schlumberger has traded as low as 3.4 times sales in the past three years. Based on $19.60 in sales per share for 2007, that equates to $67 per share.
It’s quite possible that Schlumberger could undercut that valuation on a short-term basis during a global synchronized selloff, but I see $67 to $72 as rock-bottom valuation support based on the most-pessimistic assumptions. I certainly don’t see that as a long-term target, but rather a sort of floor.
For now, I recommend standing aside, but I’m looking for a move to that range as an opportunity to jump back into Schlumberger.
But Schlumberger’s call has far more importance than just its implications for Schlumberger’s stock itself. I see two additional points from that call that are worth noting.
First, Schlumberger made it clear that the company sees a US recession as a fait accompli. Nevertheless, Schlumberger just doesn’t see any major impact on its business.
The reason is Schlumberger’s prime projects are large-scale international deals that aren’t particularly dependant on commodity pricing; a pullback in oil to $60 from $100 won’t be cause to cancel or delay a multi-billion-dollar deepwater deal. In most cases, the economics of these deals were calculated assuming oil prices in the $40s.
And no producer in its right mind would give up access to a deepwater rig right now; they’re in short supply and high demand and cost upward of $500,000 per day to lease. Therefore, such deals aren’t commodity sensitive at all.
Schlumberger’s management stated that: “[A]ny drop in OECD demand for oil and gas will be more than offset or will be countered by the increase in India, China and the Middle East to a point that it will not affect the oil price to a level where out customers will seriously curtail their plans.” In other words, it would take a global economic recession to really impact demand for international oil services; that possibility is remote at best.
Second, Schlumberger hinted at a potential stabilization in North America. Specifically, Schlumberger said it already started booking business for 2008, including pressure-pumping services. Management stated that it felt it had a better handle on pricing in this market than it did at its last call because some of the business was already booked.
Schlumberger went on to say that it was highly unlikely profit margins in the US would decline as precipitously in 2008 as they did in 2007. Moreover, the firm feels that activity in North America will simply plateau near current levels; there won’t be a massive fall off in rig counts or drilling activity this year. Schlumberger saw the rig count at a level that can sustain needed production.
As I noted earlier, Schlumberger is heavily exposed to the most attractive markets in North America, so its take on this market may not fully represent the environment for all firms with operations in the area. I know from prior calls that commodity drillers—contract drillers with older, less-advanced rigs—and firms offering basic, low-tech services are getting hit harder than average. However, this is the first time in more than a year that I’ve heard Schlumberger say anything positive at all about North American land activity.
At the same time, there’s been some nascent improvement in the US natural gas markets. Gas prices remain stuck in a long-term trading range, as the chart below illustrates.
Source: Bloomberg
This chart shows the 12-month natural gas “strip.” The strip is nothing more than the average of the next 12 months of natural gas prices.
The strip is by far the most useful measure of gas prices out there because most producers use the futures market to hedge their production. Using an average futures price more closely approximates the prices they can earn for the gas they sell.
The natural gas strip is well off its late 2005, early 2006 highs in the teens. Gas prices haven’t exactly slumped lately, but they’ve been trading between $7 and $9 per million British thermal units (MMBtu). And as I noted in the Jan. 11 issue of TEL, Where’s the Gas?, gas prices remain depressed relative to crude oil.
The main problem with natural gas has been bloated inventories. Check out the chart below for a closer look.
Source: Bloomberg, Dept of Energy
As you can clearly see, inventories of gas remained near the high end of the historical range for most of 2007 and certainly well above average levels. This is a continued hangover from the warm winter of 2005-06. This excess supply put pressure on gas.
Lately, we’ve seen inventories fall toward more average levels. I must emphasize that this trend is still in its early stages; a cooler-than-projected January is the main driver of the inventory drawdown.
The point to keep in mind is that the weakness in natural gas prices and drilling activity is a well-known phenomenon. Some stocks levered to North American natural gas drilling are already pricing in a continued nasty fundamental environment over the next several months.
For example, check out the earnings estimates for Nabors Industries, a land contract driller I highlighted in depth in the Aug. 22, 2007, issue of TES, Drilling Down.
Source: Bloomberg
This chart shows Nabors’ earnings estimates for 2008 over the past few months. Analysts have been steadily revising lower their estimates for the stock over the past three to four months. The bar of expectations for Nabors is a great deal lower than for a stock like Schlumberger; everyone is well aware that Nabors’ US business is weak.
At the same time, there’s room for upside. Nabors has a large, rapidly growing international business; it’s not totally dependant on the North American rig count and North American gas prices for growth. Schlumberger stated in its call last week that the international drilling environment is, for the most part, strong.
What’s more, Nabors tends to own high-tech rigs that are less vulnerable to falling drilling activity than most commodity rigs. And Nabors also has a large number of built-for-purpose rigs. These are rigs that Nabors built and has contracted under longer-term deals at attractive day-rates. These contracts offer a large measure of stability.
Bottom line: I see value in Nabors at current levels. The stock is trading at rock-bottom valuations, and current estimates already assume a great deal of weakness for its core business.
There’s room for Nabors to beat expectations, and I see relatively limited downside even if it doesn’t. Meanwhile, Nabors hasn’t been a big winner, so it’s less likely to see profit-taking in the current environment.
The final component of the story is the stabilization of the North American gas drilling market that Schlumberger highlighted in its call last week. Nabors Industries remains a buy under 31 with a stop at 22.50.
Meanwhile, there’s Weatherford, another stock that I recommend in the growth-oriented Wildcatters Portfolio. I highlighted my rationale for owning this stock in the most recent issue of TES, so I won’t rehash those arguments here.
Suffice it to say that Weatherford was hit by spillover selling from Schlumberger. However, the stock was never as richly valued; it hasn’t pulled back as severely as Schlumberger. I also see Weatherford as less exposed to the offshore logistical issues Schlumberger highlighted in its call last week.
Continue to buy Weatherford. I’ll have more on the company following its earnings release Friday.
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Alternative Field Bet
The alternatives field bet (listed in the last issue if TES) was one of the most successful recommendations in TES last year, up 107.5 percent. As a result, I recently recommending taking some partial profits in SunPower Corp (NSDQ: SPWR), US Geothermal (OTC: UGTH) and Vestas Wind Systems (Denmark: VWS, OTC: VWSYF).Since the beginning of the year, the stocks in the alternative field bet have been hit far harder than most energy-related stocks for three primary reasons. The first is simply, as noted above, that traders had big gains in these names and, looking to raise cash, sold off their winners. Remember that alternatives were among the market’s best performers last year.
The second is these stocks sport high valuations. For example, SunPower trades at 37 times next year’s earnings estimates. Although I believe that’s justified given its sky-high growth potential, high price-to-earnings stocks have a tendency to get hit hardest during big selloffs.
Finally, there’s some lingering disappointment that the US Energy Act, passed late in 2007, didn’t include more direct support for renewables. Some were looking for a renewable fuels mandate—a requirement that utilities generate a certain percentage of their power using technologies such as wind or solar. Although the bill included incentives for alternatives, the mandate was stripped out of the final version.
Moreover, some tax credits for renewable energy in the US are scheduled to expire at the end of this year. These credits weren’t all extended in last year’s bill, but not because there’s no political will to extend the credits. Neither Republicans nor Democrats are willing to oppose such credits, particularly in an election year where energy is a hot-button issue. We’ll likely see legislation that extends the renewable tax credits this year.
It’s also highly likely that a renewable mandate and some sort of carbon legislation will eventually become law in the US in 2009, if not sooner.
Meanwhile, several states have existing tax credits for renewables, and there are more considering such measures. Spain is also planning to institute a generous solar subsidy plan this year; that country could be another big market for solar.
Short-term issues aside, I don’t see the political tailwinds for alternative energy abating in 2008. In fact, it’s far more likely we’ll see even bigger subsidies in some countries like the US and Spain.
Alternative energy stocks are ultimately driven by government subsidies and politics. Neither wind nor solar will ever replace fossil fuels, but government mandates and subsidies can, for better or worse, certainly continue to power strong growth.
One additional point is worth noting: Please be aware of my concept of a field bet. I recommend three in TES—uranium, alternatives and biofuels. Instead of just picking one or two highly-leveraged plays on these high-potential sectors, I recommend casting a much wider net. By investing in several plays of differing risk levels, we can diversify our risk and maximize our chances of hitting a few big winners.
The key is to buy all of the plays in the field bet, and account for the risk by placing a relatively small amount in each pick. Depending on your risk tolerance, I recommend placing a fifth to a third of what you’d normally put in a TES recommendation into each pick. I’m also careful to identify picks that I consider to be riskier.
Another important component of these plays is that I periodically recommend taking partial profits in field bet recommendations. For example, one of the biofuel field bet plays—Potash Corp—has more than tripled since it was recommended in late 2006, so in the Sept. 19, 2007, issue, Down on the Farm, I recommended selling a stake in the stock to book partial gains.
By handling the field bet plays in this way, we can play some of the most exciting, high-growth themes around without betting the farm on any single play.
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Speaking Engagements
If you aren’t able to escape the winter chill to The World Money Show at Orlando’s Gaylord Palms Resort, Feb. 6-9, 2008, I’ll be discussing infrastructure, partnerships, utilities, resources and energy, and to telling you what to buy and what to sell in 2008 in webcasts available following the show at www.moneyshow.com.
And it’s Time: Vegas, Baby! I’m heading to the desert paradise with my colleagues Neil George and Roger Conrad May 12-15, 2008, for the Las Vegas Money Show at Mandalay Bay. I’ll keep you posted with more details in an upcoming issue.