All Eyes On Gas
The potential for a slowdown in US natural gas drilling remains the number one concern in the energy markets. Canada has already seen a tremendous pullback in activity, but most operators in the US appear to be waiting until the end of winter heating season–around the last week of March–to firm up their drilling plans.
Although I see scope for a slowdown or moderation of US drilling activity, this is nothing new; the selloff in North America-levered service names in the past six months has priced in much of that decline. I see an important buying opportunity emerging this spring in the North America-levered names—the very names I recommended avoiding for most of 2006.
In This Issue
While we wait for a broader buying opportunity, I recommend sticking to companies levered to international markets or very specific high-growth subindustries. In this issue, I’ll examine those stocks as well as a new Portfolio addition.
In addition, with many of my long-time recommendations showing solid gains, I’ll examine some important strategies for locking in gains without giving up too much potential upside. Specifically, we’ll look at using stops and the options market to manage winners.
As I detailed in the previous issue, North America-levered gas companies aren’t the most lucrative businesses to invest in at the moment. However, some companies provide services or equipment instead of actually drilling, helping them to expand into other markets. And with supplies dwindling, there could be some additional action in the market that I’ll be keeping an eye on. See Baker’s Bust.
There are still ways to play the gas industry without being susceptible to the slowdown in North American drilling. I already have a few plays in the Portfolios to cover this, but I’m making a new addition as well. See How To Play It.
Timing the market can be tough. Sometimes you get out of a stock too soon; other times, you hold in too long. And it can be rough to watch as the stock performs better once you’ve taken your money off the table. However, there is one alternative investment strategy that can help to protect your investment should the stock continue to run. See Take Losses, Ride Winners.
Options are one way to invest in a company while protecting your gains. Here I outline two different options strategies for you to review. However, you should only use options if you are comfortable with such aggressive investment advice. See Inevitable Corrections.
Several Portfolio holdings, as well as a few field bet plays, have some put and call options worth considering. I provide my recommendations here. See How To Play It.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
Baker’s Bust
In the most recent issue of The Energy Strategist, Be Selective, I examined earnings releases and conference calls for a handful of oil and gas services and drilling firms. The main conclusion: The only area of real weakness in the global energy markets is North American gas drilling. Canadian drilling activity has, in particular, slowed down notably over the past six months.
Meanwhile, international markets–particularly Russia, the Middle East and Africa–are still booming, and there’s no sign of a slowdown at all. Deepwater oilfield developments are also ongoing; deepwater operators are unlikely to modify their development or spending plans even if oil were to drop toward the mid-40s. And, as I’ve noted before, I seriously doubt oil prices will dip below $50 per blue barrel (bbl) this year for any significant length of time.
I’ve been worried about the potential for such a slowdown for well more than a year now. This is exactly why I’ve recommended largely avoiding services and drilling names levered to North America throughout 2006.
Last week, oil services and equipment firm Baker Hughes offered up yet another illustration of the growing weakness in North American drilling. The company reported results that were far weaker than expected; the stock sold off close to 10 percent on the news amid heavy trading volume. Baker’s results and conference call provided yet another piece of the puzzle: a more complete view as to exactly what’s going on in North America and how we should play the trends.
For those unfamiliar with Baker Hughes, it’s a huge global player in a number of key services and equipment businesses. The company’s Hughes Christensen unit manufactures and sells advanced drill bits; it’s a leader in certain key subsegments of that market. This market requires a little background on drilling for oil and gas.
As I’ve mentioned before, oil and gas don’t exist underground in some giant cavern. Rather, hydrocarbons are trapped inside the tiny pores and crevices of rock. The oil (or gas) bearing rock in a given oilfield is known as reservoir rock.
In a typical reservoir, you’ll find a layer of impermeable rock above the oil-bearing reservoir rock. This rock is typically called cap rock. Oil and gas can’t travel through this cap rock layer; hydrocarbons are trapped in the reservoir rock.
Therefore, when you drill for oil, you’re drilling through several layers of different types of rock. The dominant means of drilling for oil or gas globally is rotary drilling.
In rotary drilling, as the name suggests, a bit is actually rotated or turned and quite literally cuts and shaves away these rock layers. As you can imagine, drill bits aren’t exactly low tech; bits are carefully selected based upon the rock composition of a typical reservoir and are typically lined with diamond or tungsten teeth to handle the actual cutting. Below is a photo of a typical drill bit.
Source: National Energy Technology Laboratory, Baker Hughes
In addition to bits, Baker Hughes makes drilling fluids, sometimes called drilling muds. Again, this requires a bit of explanation.
Imagine the drill bit at the bottom of the well, cutting away at the rock. As the drill cuts, it produces little rock particles. If these particles just built up in the well, you can imagine they’d quickly block the well and cause all sorts of problems.
In addition, when you encounter oil or gas in a typical field, it’s under immense geological pressure. This natural pressure would force the oil into the well and to the surface. If that escape route isn’t controlled, you end up with a blowout–an uncontrolled gushing of hydrocarbons to the surface.
Blowouts are dangerous because hydrocarbons have a nasty tendency to ignite when gushing through the surface of a well. Also, blowouts represent a massive waste of oil and gas.
The way both problems get solved is through the use of drilling mud. A liquid (or thick liquid) is actually pumped down the well pipe under pressure as the well is being drilled. This mud actually flows through the drill bit and picks up the small shavings of rock left by the drill.
The mud then flows (under pressure) back to the surface through the space surrounding the well pipe. This empty space around the well pipe is known as the annulus.
The drilling mud also creates a balancing pressure in the well itself. This means that the pressurized mud actually prevents (or limits) the flow of oil or natural gas into the well during the drilling process. Basically, the mud counterbalances the natural geological pressures in the reservoir.
The term drilling mud, still in wide use today, comes from the fact that early operators literally used muddy water as drilling fluid. The story goes that Texas operators would dig a pit, fill it with water and then tempt cattle to walk back and forth through the pit, creating a muddy mixture ideal for drilling fluid.
But modern drilling fluid technology is a different matter entirely; the cattle have long since been retired from this function. Muds are weighted very carefully based on the pressures and unique characteristics of a particular reservoir.
If a mud is too heavy, it can slow down drilling or actually clog some of the pores and channels of the reservoir rock, inhibiting oil flow. If the fluid is too light, it won’t properly counterbalance the reservoir pressures; that may result in a blowout.
Also, by including special chemicals in the fluid, operators can aid the cutting of reservoir rock. As you can imagine, the situation is complicated even further when you’re talking about extreme deepwater reservoirs where hydrocarbons are under even more extreme pressures.
In addition to these products, Baker also provides products used to control sand found in wells: so-called submersible pumps, used to extract oil from mature reservoirs and variety of other drilling- and production-related chemicals and equipment. The company also handles some traditional services functions, such as using sophisticated equipment to evaluate a reservoir as a well is being drilled.
Obviously, Baker’s lineup of products and services are sensitive to oilfield activity. The more drilling projects ongoing globally, the better the company performs.
Baker Hughes, like most services and equipment companies, is not directly sensitive to oil and natural gas prices; the company produces no oil or natural gas. The company only has exposure to commodity prices to the extent that higher prices encourage more drilling activity.
As I noted above, Baker severely missed its fourth quarter estimates and guidance. The key point is that the reason wasn’t overall revenues or sales but profitability and profit margins. Or more specifically, Baker’s problem can almost entirely be attributed to weaker-than-expected profit margins in the North American market. (North America accounts for a bit more than half of Baker’s overall revenues; most of that is US revenues.)
Baker’s management team stated that the company experienced “pushback” on pricing during the quarter. Given strong drilling activity in the US and Canada during the past few years, the company has been able to push through a series of price increases for its products and services.
Baker has had significant pricing power, and that’s helped push up profit margins. But in the most recent quarter, weakness in natural gas prices prompted many of Baker’s customers to refuse price increases or, in fact, ask for price cuts.
To make matters worse, several other firms sell drill bits, mud and similar products and services. It seems that some of these suppliers have been more willing to discount their products. Baker held firm on price increases, and therefore, management believes that the company gave up a bit of market share in the quarter to more aggressive competitors.
My guess is that the most-extreme competition was on lower-end products, not the most-advanced drill bits and muds Baker makes. I actually believe that management took the right move here in holding firm on price; nevertheless, it’s certainly costing the company short term.
The net result of all this is that Baker has seen a weakening in the pace of price increases. Although prices aren’t actually falling, the company says that prices aren’t rising at anywhere close to the pace of what’s been happening in the past few years.
Baker went on to make two additional key points:
Internationally, Baker’s results were also a bit weaker than some analysts had projected. But outside the US, Baker’s problem is a high-quality one.
Basically, the company just doesn’t have enough manufacturing capacity to meet demand. The company has taken steps to build out its global manufacturing footprint; in fact, Baker has a long-term strategic goal of expanding its global business. This should, over time, reduce the company’s dependence on US and Canadian revenues.
Management is forecasting 52 percent revenue growth in Russia this year on top of 36 percent growth in Saudi Arabia and 70 percent growth in Qatar and Libya. Bottom line: Although North America remains problematic, the global business at Baker continues to boom and is slowed only by manufacturing bottlenecks.
Baker, like almost every other company operating in North America, is adopting a wait-and-see approach on the US and Canada. Management reiterated that the activity going forward would be very dependent on how high natural gas inventories are at the end of the winter heating (draw) season. This will govern how much, if at all, producers reduce their drilling activity.
A final, key point is worth noting. As noted above, the potential for a North American slowdown has been an ongoing topic in TES for more than a year now. We even profitably shorted BJ Services and Patterson-UTI last summer.
However, with the slowdown now upon us, I believe a good portion of the weakness is already priced into these stocks. The slowdown is a well-known, discounted fact; everyone is talking about it.
Most North American-levered names have been hit hard since last May, and analysts have spent most of the past six months downgrading their earnings estimates. The bar of expectations has been lowered.
Although I’m not ready to buy into the North American story just yet, I am looking for an outstanding buying opportunity to emerge this spring. The snapback in the group could well be the most-profitable play in the oil and gas space in 2007.
In fact, the fundamentals for the natural gas market are already setting up nicely. Check out the chart of US natural gas in storage below.
Source: Dept of Energy
I show four different lines on this chart–2007 gas inventories, the five-year high in inventories, the five-year low in inventories and the five-year average. Because inventories of gas were at five-year highs for all of 2006, the five-year high represents inventories last year.
US natural gas inventory withdrawals have been running at a higher-than-normal pace in recent weeks because of the extreme cold snap that gripped the Northeast and Midwest in the latter days of January through the first part of February. In fact, withdrawals reported in some weeks have approached record high levels.
Natural gas inventories remain above the five-year average. However, I do believe it’s notable that gas in storage is now significantly lower than it was one year ago. The winter of 2006 was extremely warm, and the first part of this year’s winter led some to look for a repeat of 2006 temperatures. That hasn’t quite happened—this winter is looking more normal on average—and inventories have started to normalize.
In addition to the weather trend, Canadian production is falling sharply thanks to the severe scale-back of drilling activity in that market. Based on the reports from key services firms that I’ve outlined in the past two issues, I suspect the ultimate decline in Canadian production will be more severe than the market expects. And production from the US Rockies is also off considerably because of extremely cold temperatures and winter storms.
Forecasts are now showing a warming trend over the next week or so; these more-average temperatures aren’t enough to reverse the normalization trend unless we get warmer weather through the first half of March. We’ll likely see inventories exit the winter heating season above normal but under last year’s totals.
The bottom line is that there’s already been a moderation in North American gas-related activity; there’s room for additional weakness into spring as the winter heating season ends. By late April or early May, the market focus will shift to the summer cooling season and the outlook for the 2007 hurricane season; the interim “shoulder” season isn’t typically a strong period for oil- and gas-related stocks.
But with this weakness already a well-known fact, stocks levered to the North American market are already depressed. With the worst news priced in, there’s not much downside risk from current levels.
Meanwhile, a number of factors, including further cold snaps, faster-than-expected production declines or forecasts of a hot, stormy summer, could push prices higher. This is the buying opportunity for North America-levered names I will be watching for the next two months.
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How To Play It
But we don’t have to just sit and wait for a spring buying opportunity in gas-levered names. I see several themes that look promising regardless of weather patterns in the US and Canada.
First up, there’s the deepwater. I highlighted deepwater drilling at great length in the January 3 issue of TES, The Deep End. Suffice it to say that the deepwater is one of the key final exploration frontiers for the oil and gas business.
The deepwater is one of the only regions where I see scope for major significant discoveries in the next five years. Better still, as new deepwater drilling rigs come out of shipyards during the next few years, it will open up the possibility of more deepwater exploration.
To play deepwater, my favorites are FMC Technologies and Seadrill. (Please note the symbol for FMC Technologies is FTI, not FMC; make sure you’re buying the correct stock.) Both stocks were outlined at some length in the January 3 issue; the basic story is unchanged since that time.
To review, FMC Technologies makes subsea equipment–valves, pipes and equipment used to control the flow of oil and gas from deepwater wells. Last week, FMC reported fourth quarter earnings. The company not only beat expectations but raised its guidance for 2007 from $3.80 to $4 per share up from its prior estimate of $3.70 to $3.90.
On that basis, the company is trading at less than 17 times this year’s earnings–not expensive for a company that’s growing around 25 percent to 30 percent annually. The company’s backlog stands at $2.7 billion; that’s a record high and represents some nine months worth of revenues. FMC remains one of my favorite plays on the deepwater story; I’m raising my “buy under” price to 70 and reiterating my buy recommendation.
Seadrill is a Norwegian firm that owns a fleet of deepwater rigs. Simply put, it’s the only contract driller that has a significant number of deepwater rigs available for lease in the 2008-09 period. These rigs are in high demand and short supply right now; contract drillers have been successfully boosting the day-rates–the daily fee charged for leasing the rigs–they’re charging during the past three years.
The company’s been signing contracts for its rigs to take effect as soon as the rigs are released from the shipyard. Seadrill has been getting day-rates in the $500,000-to-$550,000-per-day range for its rigs. Seadrill remains a buy.
In addition to deepwater plays, I see further upside in stocks with an international focus. Topping the list is Schlumberger, the technological leader of the oil and gas services business. Schlumberger is better diversified than peers like BJ Services and Baker Hughes and has extensive operations in just about every oil and gas producing region of the world.
To the extent the company does have exposure to the US and Canada, it’s focus tends to be in areas such as the deepwater Gulf of Mexico and high-tech onshore services; these are areas unlikely to be impacted by a slowdown in North American drilling. As I highlighted this company in-depth in the most recent issue of TES, I won’t reiterate all those details here. Suffice it to say that the stock remains leveraged to my favorite services themes and is the must-own name in the services business.
I also see Petroleum Geo-Services and Tenaris as relatively immune to the North American drilling slowdown. Petroleum Geo owns a fleet of seismic ships. Although the company doesn’t report until next Monday, Schlumberger indicated that the seismic business was red-hot during its call last month. And Petroleum Geo works mainly in overseas markets. Petroleum Geo’s focus in this area should pay off; the stock remains a buy.
Tenaris makes seamless pipes used in the oil and gas business. Although pipes may seem to be a commodity, that’s not exactly the case; the extreme temperatures and pressures encountered in many deep wells require the use of specially designed seamless pipes. Tenaris specializes in such advanced equipment.
Though headquartered in Luxembourg, Tenaris operates all over the world. In fact, the company tends to locate its manufacturing facilities near major oil-producing regions. By manufacturing pipe locally, the company cuts down on transport costs and can tailor its output to local market needs.
When it comes to the US market, one problem Tenaris has encountered is US “anti-dumping” legislation, which limits the company’s ability to import pipes it makes abroad into the US. Tenaris has begun to get around this problem by purchasing US rivals; last week, Tenaris agreed to purchase US rival Hydril for $2 billion.
Hydril specializes in the manufacture of high-end, high-pressure connections and control equipment. The company sells a good deal of production into the deepwater Gulf of Mexico.
The other positive is that Hydril has manufacturing capacity in the US; this will help ease some of the bottlenecks currently caused by US anti-dumping regulations. Because the focus of the Hydril business is deepwater and premium markets, I don’t see the added exposure to North America (now more than half of revenues) as a major negative.
Nonetheless, Tenaris is now trading at or above my recommended buy under price and is up some 30 percent from its recommended price. I’m not willing to raise that buy under target until after the company reports earnings; for now, I’m cutting Tenaris to a hold. I would also suggest that subscribers with significant profits in Tenaris consider adopting one of the hedging strategies outlined later in this report to protect gains.
It’s also time to start tentatively dipping our toes into the North American gas market. Specifically, I am adding proppant manufacturing firm Carbo Ceramics (NYSE: CRR) to my aggressive Gushers Portfolio.
As I outlined above, oil and gas exist in the pores and crevices of reservoir rocks. When an operator spuds a well, the oil and/or gas–under tremendous geologic pressure–flows through the rock into the well and to the surface.
But if the pores in a rock aren’t well connected, there are few channels through which the hydrocarbons can travel. Although there may well be plenty of gas in the ground, that gas is essentially locked in the pores of the rock and unrecoverable.
But there are ways to produce such reservoirs. In fracturing, operators pump a gel-like liquid under tremendous pressure into the ground. That gel actually enters the reservoir and cracks the reservoir rock. By cracking or fracturing the reservoir rock, the operator creates channels through which gas can flow.
But that brings us to another problem. Once a reservoir is fractured and the operator reduces the pressure of the fracturing liquid, those channels and cracks typically begin to close up again. This, of course, reduces the efficacy of the fracturing work.
This is why operators tend to put small particles into the gel-like fracturing liquid. These particles also enter the reservoir and get stuck in the channels opened during fracturing. As the pressure is released, the particles essentially prop open the channels; that’s why these particles are called proppant.
There are many types of proppant out there. One of the early types used was just specially coated sand particles. But Carbo Ceramics (NYSE: CCR) makes a highly specialized ceramic proppant. Modern-day ceramic materials are very strong, light and durable; it should come as little surprise that ceramics are also used to manufacture bulletproof vests and armor for automobiles.
Without going too deep into technicalities, suffice it to say that ceramic proppants work more effectively than other types. Such proppant is also more expensive; however, that’s not a big issue. Even if an operator can boost production by 2 percent to 5 percent, it’s often well worth the extra expense of buying ceramic proppant.
On February 1, Carbo reported blowout earnings for the fourth quarter. What’s interesting is that while the US rig count rose about 16 percent in 2006, the actual volume of proppant sold by Carbo rose 24 percent; the company is growing at a faster pace than the market.
Canadian revenues were also up despite a drop in the rig count there. In addition, Carbo pushed through 9 percent price increases in 2006, a good sign that it’s maintaining pricing power.
In fact, Carbo’s biggest problem in the US is building out manufacturing capacity fast enough to meet demand. Carbo is clearly picking up market share in the proppant business and has no trouble pushing through price increases.
In addition to simple proppant sales, the company has a services arm. It models fracturing jobs in individual reservoirs to help operators decide how best to fracture a given reservoir. This business dovetails nicely with its proppant sales.
And finally, Carbo’s business in Russia is booming. Sales of proppant there rose nearly 40 percent in the fourth quarter. And right now, Carbo is losing money or is only weakly profitable on its sales there because the company doesn’t have manufacturing capacity in Russia. Because of tariffs and simple logistical challenges, it’s not practical to export proppant to Russia from the US or Europe.
But Carbo’s first Russian manufacturing facility is scheduled to start up in the first quarter of this year. This capacity will allow the company to rapidly ramp up sales. The beauty of this is that fracturing is in its infancy in Russia compared to the US; there’s a huge opportunity for expansion in this market.
Despite strong operational performance, Carbo is down close to 40 percent from its 2006 highs and is trading at less than 18 times earnings; the stock has been hit by concerns it would be hurt by a slowdown in gas drilling.
Because of the combination of rising market share, rising pricing power and expansion opportunities in Russia, I believe fears of a US drilling slowdown are overdone and largely pricing in. Carbo Ceramics is a buy in the Gushers Portfolio.
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Take Losses, Ride Winners
One of the greatest dilemmas facing all traders and investors is knowing when to sell a stock and take a profit. Most of us know that old Wall Street saw it’s a good idea to cut our losers short and let our winners run; however, the risk of giving back a huge gain tempts many investors to take profits off the table long before a stock has finished its run.
I can tell you from personal experience that there are few things more frustrating than taking a nice profit on a stock only to watch it double or triple in the ensuing months. That “nice” gain suddenly doesn’t look so impressive. Similarly, nothing is more demoralizing than building up big gains over a multi-month period only to watch them evaporate quickly when the stock reverses.
The good news is that there are more choices than simply “buy” and “sell.” Using the options market, there are other steps you can take to protect your gains while leaving your portfolio open to more upside.
In TES, I don’t recommend options in the three model Portfolios. All returns are calculated assuming you simply take the recommended positions and set stop orders according to the advice posted in the Portfolio tables, updated in the newsletter and via flash alerts on an ongoing basis.
That said, options can be a useful tool for investors. In fact, one of the most common questions I receive from subscribers concerns how to use options to play the energy patch. This is why, from time to time, I explain some options strategies I’ve found useful in the past and give specific recommendations with reference to the TES model Portfolios.
Sadly, many traders and investors look at the options market as an aggressive speculator’s casino. And options can certainly be used in that manner. But options can also be used as a protective mechanism for those looking to hedge against a pullback.
A perfect example of this is a flash alert I sent out May 2, 2006, entitled Hold ‘Em Or Fold ‘Em? In that flash alert, I explained an options strategy known as put insurance. This is a strategy for protecting gains in your big winners without giving up much upside if the stock continues to run.
If you’re interested in reviewing that strategy in action, I updated those recommendations in the Aug. 23, 2006, issue of TES. For the most part, if you’d followed the options strategies outlined in the May 3 report, you’d have severely limited the damage caused by the May/June selloff in the energy patch and, for that matter, global markets in general.
In this week’s issue, I will re-examine options and how to use them to limit your risk and maximize your gains. I strongly suggest that newer subscribers interested in options review the two articles—from May and August—referenced above. Both are available in the archives or by clicking the links in the text above. I will, however, again review put insurance below with updated examples from the current Portfolios.
And for subscribers already familiar with the put insurance strategy, I’m also outlining another options strategy this week. This strategy, known as call replacement, also allows for booking gains without giving up the chance for more upside.
Before I delve into these two strategies in more depth, it’s worth noting a few points. First, I know that many subscribers simply don’t feel comfortable trading options. That’s not only understandable but a desirable reaction; you can do real damage to your portfolio trading options if you’re not aware of how this market works.
If that’s the case, I recommend starting off slowly and deliberately. I’d recommend following the strategies I outline on paper to get a better feel for how they work and to become more comfortable with the risks involved.
Alternatively, consider using one strategy or the other on a single stock or a small portion of your portfolio to get more comfortable. I believe this will pay off in the end.
Moreover, remember that our first line of defense–whether it’s protecting profits or guarding against losses–remains my updated stop recommendations and flash alerts. I’ll always send out a special alert if I change my outlook on a particular stock or see reasons for concern.
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Inevitable Corrections
As I’ve outlined on numerous occasions, demand for oil and gas is booming while the world’s ability to expand supplies and production is, at best, limited. Other groups I’ve highlighted in TES are also in long-term uptrends, including agricultural products (biofuels), oil and gas services, alternative energies and uranium.
The great commodity bull markets throughout history have lasted for at least 15 to 20 years. This current up-cycle has more than a few good years left in which to run.
But that doesn’t mean there won’t be corrections. Long-term readers are well aware that we’ve seen three significant energy corrections during the past 12 months. The most-recent correction for the Philadelphia Oil Services Index (OSX) lasted from May through October of last year and resulted in declines of roughly 30 percent on average. Although that doesn’t seem like much in the context of the near tripling of the same index since mid-2004, the correction certainly felt scary at the time.
The important thing to remember is that no great bull market has been immune to such corrections. Even the Nasdaq in the 1990s and gold in the ’70s saw corrections of as much as 35 percent in the context of a longer-term trend higher.
Typically, these pullbacks mark outstanding buying opportunities; however, holding through such selloffs is tough. These corrections are precisely why it’s so difficult for most investors to let their profits run. But there are a few key ways to protect your portfolio against pullbacks.
First, not all energy subgroups will correct at the same time. Consider that, for example, uranium-related stocks have been on fire since early last fall, while many oil- and gas-related issues have simply traded sideways. And my master limited partnership (MLP) recommendations–highlighted in depth in the Nov. 22, 2006, issue –have scarcely seen a down month during the past year.
The energy sector isn’t a homogenous group; these stocks don’t all move in a pack, following the price of crude. Therefore, it’s important to consider my favorite themes outside the oil and gas space when constructing a portfolio.
Second, I would also caution new subscribers to be careful to follow the buy targets I outline in the Portfolio tables. I know some of my recommended stocks are now trading above their “buy under” prices. Many have moved aggressively higher in just the past few months and are too extended to purchase. I recommend buying only the companies that are still under my targets.
And don’t despair. There will be plenty of opportunities to jump into new recommendations in the next few months. I also change my buy under recommendations on an ongoing basis, raising these levels when appropriate.
Third, keep an eye on my recommended stop orders. Stops are nothing more than orders you place with your broker to sell you out of a stock automatically when a certain price is touched.
For example, let’s say you own a theoretical stock, ABC, at $100 and place a stop at $85. Your position in ABC would be immediately sold as soon as the stock trades at or below $85. This is a way of limiting your losses on a stock even if you’re nowhere near your computer or telephone.
Over time, I trail my stop recommendations in the Portfolios. In other words, let’s say you own stock ABC at $100 and the stock pops to $135. I may then recommend raising your stop to $120. In this case, if the stock falls back to $120, you’d be out for a 20 percent gain. But if the stock keeps moving higher, you’d still be along for the ride. By periodically raising your stops as your stocks rise, you can lock in incremental gains over time.
Finally, of course, I do recommend taking partial gains on stocks from time to time. In other words, after a big run, it can be a good idea to take some of your profits off the table, leaving some money in the stock to benefit from further gains.
But raising our stops, adhering to target prices and booking some partial gains from time to time aren’t the only ways to protect gains on trades. These strategies are just the first line of defense. If you’re willing to play the options market, here are two additional strategies to consider:
Strategy #1: Put Insurance
The best way to illustrate this strategy is with a simple example. Assume you purchased 200 shares of oilseed processor Bunge (NYSE: BG) on my original recommendation at a price of about $57.27 roughly one year ago. That stake would have cost you roughly $11,450. With Bunge at around $80.50, your 200 shares are now worth $16,100, a gain of $4,650 or just above 40 percent.
I still see more upside in Bunge; in fact, as of this issue, I’m raising my “buy under” recommendation to 78. The stock is only trading at around 18 times this year’s earnings estimates, and those estimates are rising quickly.
The fundamentals of the Brazilian market, where Bunge is a major player, have improved markedly during the past year. Ultimately, Bunge is a premier play on both the strengthening agricultural industry and the growing biofuels market; the stock should ultimately trade into the $90s. I outlined my case for owning Bunge at some length in the Sept. 20, 2006, issue Fueled By Food.
But if you’re in the stock at $57.27, you’re probably anxious to lock in some solid gains. At the same time, you don’t want to miss out on the potential for further gains in Bunge.
The July 2007 $80 put options (BG SP) on Bunge are currently trading at around $4.50. This option gives you the right (but not the obligation) to sell Bunge at $80 a share at any time between now and July 21.
Options are traded in contracts covering 100 shares, so each contract costs roughly $450 at this time. To cover your 200 shares, you could purchase two contracts for $900. Here are the three possible scenarios for the stock:
By purchasing the puts, you’re paying $900 to insure yourself against a decline in Bunge during the next five months. Like any insurance policy, you’re giving up some upside to protect your downside. So, if Bunge continues to rise or stays put near $80.50, this insurance policy will cost you $900. But if Bunge falls significantly, the puts will protect the vast majority of your gains in the stock.
But the scenarios I outlined are only the beginning. Consider the possibility that Bunge pulls back $15 or so in the next three months and then looks to be a good value once again. You could then sell your options and book a profit. If the stock started to rally again, you’d again have all that upside potential. Options are a highly flexible hedging tool.
In addition, you can perform a strategy known as rolling down. I highlighted this strategy at great length in the August 23 issue of TES.
A few ground rules worth considering:
Strategy #2: Call Replacement
In this strategy, you actually sell out of your stock holding completely and book a gain. You then use call options to re-create your long in the stock for a much lower cost. Again, this strategy is best illustrated with an example; I’ll use Wildcatter Portfolio holding Tenaris.
Again, I still like Tenaris. In fact, as I outlined in the text above, I think the company’s most recent acquisition will prove to be a solid move longer term. That said, my original recommendation on Tenaris was at a price of $36.75; the stock is up nearly 30 percent since that time.
Assume you purchased 300 shares of Tenaris at $36.75 for a total cost of $11,025 before commissions. With the stock now hovering around $47.50, those same 300 shares would now be worth $14,250 for a gain of $3,225. While you certainly want to ride Tenaris if there’s more upside, that’s a sizeable 30 percent gain that’s worth protecting.
To execute a call replacement, you would first sell all 300 shares of Tenaris and book the full $3,225 profit on the stock. Meanwhile, the September 2007 $50 call contracts (TSW IJ) are trading at $4.30, or $430 per contract. These calls give you the right but not the obligation to buy 100 shares of Tenaris at $50 per share at any time between now and Sept. 22, 2007. If you immediately buy three contracts, the total cost would be $1,290.
The net effect of these two transactions is that you would book a gain of $1,935 ($3,225 minus $1,290) and would own three Tenaris call contracts. The total value of the 300 shares of Tenaris is $14,250, while the calls are worth just $1,290.
You’re also freeing up close to $13,000 in capital that you can use for other purposes or to buy another stock. In essence, you’re replacing a $14,000 stock position with a $1,300 call options position.
Here are the three possible scenarios for the options position:
One point to keep firmly in mind is that the other benefit of this position is that it frees up capital for buying other recommended stocks while lowering your overall downside and preserving most of your upside potential.
Those more familiar with how options are priced will also recognize a key issue with this strategy: Buying the three call contracts I highlighted isn’t exactly equivalent to owning 300 shares of Tenaris. To fully understand why this is, the case would mean delving into some relatively complex options theory. I suspect most readers would find that more than a little dry and unnecessary.
Suffice it to say that the relevant metric is a statistic known as delta. Delta measures an option’s sensitivity to a change in the price of the underlying stock.
The current delta of the above-referenced call options is 50 cents, or $50 per contract. That means that a $1 move higher in Tenaris would result in a $50 move higher in the value of each call contract purchased–a $150 move for the three contracts.
But to further complicate matters, delta isn’t a constant. Delta will move as Tenaris moves in price, as time passes and as the volatility of Tenaris changes over time. That’s where things start to get a bit complicated. If any readers would like a more detailed explanation of options theory, I’d be more than happy to produce a report on the issue. Simply drop me an e-mail at energystrategist@kci-com.com, and I’ll get to work on it.
The important point to understand from all this is the trade-off you face. If you purchase more call contracts, your cost will be higher but your potential upside will be greater.
For example, if you purchase five Tenaris call contracts instead of three, your cost would be $2,150. After taking your profit of $3,225 on the stock, your overall minimum profit would be $1,075 ($3,225 profit on the stock minus $2,150 cost of the options).
This is the least you could make; you would make $1,075 if your calls end up expiring worthless. If you purchased five contracts instead of three, here are your outcomes at expiration:
Therefore, by purchasing more options, you increase your upside significantly. However, the trade-off is that you also increase your downside risk or rather decrease the minimum profit from the position.
By purchasing three contracts, you’re booking more gains in the stock but do leave some upside on the table. Just as with put insurance, this strategy is flexible; you can choose to take larger gains and reduce your risk significantly by purchasing fewer calls. Alternatively, you could purchase more calls and, therefore, take on more risk.
Please note a few key points about this strategy:
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How To Play It
Finally, I’m not outlining these strategies because I see an imminent correction in the energy patch. In fact, I see many groups–such as the services companies and drillers–as stocks just coming off important lows and due for considerably more upside.
It takes some time to gain a comfort level with options strategies. It may also take some time to set up the necessary trading permissions with your broker. If you’re interested in these strategies, you will need to set up options trading permissions with your broker; most call it “level 2” options clearance.
Here’s a list of some of the portfolio’s biggest winners with suitable option strategies for protecting gains in each:
American Commercial Lines (NSDQ: ACLI): It’s current profit stands at roughly 35 percent. The January 2008 37.50 puts (ZQR MU) offer insurance for about $410 per 100 shares owned. Alternatively, you can sell your ACLI common stock and purchase the January 2008 37.50 calls (ZQR AU) for around $610 per contract. Please note that these figures account for a 2-to-1 stock split effective Feb. 12, 2007.
Syngenta (NYSE: SYT): Biofuels field bet holding Syngenta is up around 25 percent from my original recommendation in September. The September 35 puts (SYT UG) offer insurance for about $180 per 100 shares owned.
Mosaic (NYSE: MOS): Biofuels field bet Mosaic is up more than 55 percent from my original recommendation. The January 2008 25 puts (LXW ME) offer insurance for $220 per 100 shares owned. Alternatively, you could sell your Mosaic common stock and buy the January 2008 22.50 calls for $590 per contract.
Potash Corp (NYSE: POT): Biofuels field bet Potash is up 65 percent since the September recommendation. The January 2008 $160 put options (WPT ML) offer downside insurance for about $1,600 per 100 shares owned.
Bunge: See detailed example above for put insurance ideas on Bunge.
Tenaris: See above for call replacement strategies for Bunge. Alternatively, for put insurance, consider the September 2007 $45 puts (TSW UI), trading at about $370 per 100 shares insured.
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Although I see scope for a slowdown or moderation of US drilling activity, this is nothing new; the selloff in North America-levered service names in the past six months has priced in much of that decline. I see an important buying opportunity emerging this spring in the North America-levered names—the very names I recommended avoiding for most of 2006.
In This Issue
While we wait for a broader buying opportunity, I recommend sticking to companies levered to international markets or very specific high-growth subindustries. In this issue, I’ll examine those stocks as well as a new Portfolio addition.
In addition, with many of my long-time recommendations showing solid gains, I’ll examine some important strategies for locking in gains without giving up too much potential upside. Specifically, we’ll look at using stops and the options market to manage winners.
As I detailed in the previous issue, North America-levered gas companies aren’t the most lucrative businesses to invest in at the moment. However, some companies provide services or equipment instead of actually drilling, helping them to expand into other markets. And with supplies dwindling, there could be some additional action in the market that I’ll be keeping an eye on. See Baker’s Bust.
There are still ways to play the gas industry without being susceptible to the slowdown in North American drilling. I already have a few plays in the Portfolios to cover this, but I’m making a new addition as well. See How To Play It.
Timing the market can be tough. Sometimes you get out of a stock too soon; other times, you hold in too long. And it can be rough to watch as the stock performs better once you’ve taken your money off the table. However, there is one alternative investment strategy that can help to protect your investment should the stock continue to run. See Take Losses, Ride Winners.
Options are one way to invest in a company while protecting your gains. Here I outline two different options strategies for you to review. However, you should only use options if you are comfortable with such aggressive investment advice. See Inevitable Corrections.
Several Portfolio holdings, as well as a few field bet plays, have some put and call options worth considering. I provide my recommendations here. See How To Play It.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
- Carbo Ceramics (NYSE: CRR)
- FMC Technologies (NYSE: FTI)
- Petroleum Geo Services (NYSE: PGS)
- Seadrill (Oslo: SDRL, OTC: SDRLF)
- Schlumberger (NYSE: SLB)
- Tenaris (NYSE: TS)
Baker’s Bust
In the most recent issue of The Energy Strategist, Be Selective, I examined earnings releases and conference calls for a handful of oil and gas services and drilling firms. The main conclusion: The only area of real weakness in the global energy markets is North American gas drilling. Canadian drilling activity has, in particular, slowed down notably over the past six months.
Meanwhile, international markets–particularly Russia, the Middle East and Africa–are still booming, and there’s no sign of a slowdown at all. Deepwater oilfield developments are also ongoing; deepwater operators are unlikely to modify their development or spending plans even if oil were to drop toward the mid-40s. And, as I’ve noted before, I seriously doubt oil prices will dip below $50 per blue barrel (bbl) this year for any significant length of time.
I’ve been worried about the potential for such a slowdown for well more than a year now. This is exactly why I’ve recommended largely avoiding services and drilling names levered to North America throughout 2006.
Last week, oil services and equipment firm Baker Hughes offered up yet another illustration of the growing weakness in North American drilling. The company reported results that were far weaker than expected; the stock sold off close to 10 percent on the news amid heavy trading volume. Baker’s results and conference call provided yet another piece of the puzzle: a more complete view as to exactly what’s going on in North America and how we should play the trends.
For those unfamiliar with Baker Hughes, it’s a huge global player in a number of key services and equipment businesses. The company’s Hughes Christensen unit manufactures and sells advanced drill bits; it’s a leader in certain key subsegments of that market. This market requires a little background on drilling for oil and gas.
As I’ve mentioned before, oil and gas don’t exist underground in some giant cavern. Rather, hydrocarbons are trapped inside the tiny pores and crevices of rock. The oil (or gas) bearing rock in a given oilfield is known as reservoir rock.
In a typical reservoir, you’ll find a layer of impermeable rock above the oil-bearing reservoir rock. This rock is typically called cap rock. Oil and gas can’t travel through this cap rock layer; hydrocarbons are trapped in the reservoir rock.
Therefore, when you drill for oil, you’re drilling through several layers of different types of rock. The dominant means of drilling for oil or gas globally is rotary drilling.
In rotary drilling, as the name suggests, a bit is actually rotated or turned and quite literally cuts and shaves away these rock layers. As you can imagine, drill bits aren’t exactly low tech; bits are carefully selected based upon the rock composition of a typical reservoir and are typically lined with diamond or tungsten teeth to handle the actual cutting. Below is a photo of a typical drill bit.
Source: National Energy Technology Laboratory, Baker Hughes
In addition to bits, Baker Hughes makes drilling fluids, sometimes called drilling muds. Again, this requires a bit of explanation.
Imagine the drill bit at the bottom of the well, cutting away at the rock. As the drill cuts, it produces little rock particles. If these particles just built up in the well, you can imagine they’d quickly block the well and cause all sorts of problems.
In addition, when you encounter oil or gas in a typical field, it’s under immense geological pressure. This natural pressure would force the oil into the well and to the surface. If that escape route isn’t controlled, you end up with a blowout–an uncontrolled gushing of hydrocarbons to the surface.
Blowouts are dangerous because hydrocarbons have a nasty tendency to ignite when gushing through the surface of a well. Also, blowouts represent a massive waste of oil and gas.
The way both problems get solved is through the use of drilling mud. A liquid (or thick liquid) is actually pumped down the well pipe under pressure as the well is being drilled. This mud actually flows through the drill bit and picks up the small shavings of rock left by the drill.
The mud then flows (under pressure) back to the surface through the space surrounding the well pipe. This empty space around the well pipe is known as the annulus.
The drilling mud also creates a balancing pressure in the well itself. This means that the pressurized mud actually prevents (or limits) the flow of oil or natural gas into the well during the drilling process. Basically, the mud counterbalances the natural geological pressures in the reservoir.
The term drilling mud, still in wide use today, comes from the fact that early operators literally used muddy water as drilling fluid. The story goes that Texas operators would dig a pit, fill it with water and then tempt cattle to walk back and forth through the pit, creating a muddy mixture ideal for drilling fluid.
But modern drilling fluid technology is a different matter entirely; the cattle have long since been retired from this function. Muds are weighted very carefully based on the pressures and unique characteristics of a particular reservoir.
If a mud is too heavy, it can slow down drilling or actually clog some of the pores and channels of the reservoir rock, inhibiting oil flow. If the fluid is too light, it won’t properly counterbalance the reservoir pressures; that may result in a blowout.
Also, by including special chemicals in the fluid, operators can aid the cutting of reservoir rock. As you can imagine, the situation is complicated even further when you’re talking about extreme deepwater reservoirs where hydrocarbons are under even more extreme pressures.
In addition to these products, Baker also provides products used to control sand found in wells: so-called submersible pumps, used to extract oil from mature reservoirs and variety of other drilling- and production-related chemicals and equipment. The company also handles some traditional services functions, such as using sophisticated equipment to evaluate a reservoir as a well is being drilled.
Obviously, Baker’s lineup of products and services are sensitive to oilfield activity. The more drilling projects ongoing globally, the better the company performs.
Baker Hughes, like most services and equipment companies, is not directly sensitive to oil and natural gas prices; the company produces no oil or natural gas. The company only has exposure to commodity prices to the extent that higher prices encourage more drilling activity.
As I noted above, Baker severely missed its fourth quarter estimates and guidance. The key point is that the reason wasn’t overall revenues or sales but profitability and profit margins. Or more specifically, Baker’s problem can almost entirely be attributed to weaker-than-expected profit margins in the North American market. (North America accounts for a bit more than half of Baker’s overall revenues; most of that is US revenues.)
Baker’s management team stated that the company experienced “pushback” on pricing during the quarter. Given strong drilling activity in the US and Canada during the past few years, the company has been able to push through a series of price increases for its products and services.
Baker has had significant pricing power, and that’s helped push up profit margins. But in the most recent quarter, weakness in natural gas prices prompted many of Baker’s customers to refuse price increases or, in fact, ask for price cuts.
To make matters worse, several other firms sell drill bits, mud and similar products and services. It seems that some of these suppliers have been more willing to discount their products. Baker held firm on price increases, and therefore, management believes that the company gave up a bit of market share in the quarter to more aggressive competitors.
My guess is that the most-extreme competition was on lower-end products, not the most-advanced drill bits and muds Baker makes. I actually believe that management took the right move here in holding firm on price; nevertheless, it’s certainly costing the company short term.
The net result of all this is that Baker has seen a weakening in the pace of price increases. Although prices aren’t actually falling, the company says that prices aren’t rising at anywhere close to the pace of what’s been happening in the past few years.
Baker went on to make two additional key points:
- Although US drilling activity hasn’t really fallen much yet, companies are taking advantage of the uncertainty surrounding gas prices to test the services and equipment companies. Basically, producers are trying to see if they can demand–and receive–any sort of break on prices.
- Second, Baker Hughes reiterated the extreme weakness in the Canadian market. This has been an issue for several companies this year, including BJ Services and Nabors Industries.
Internationally, Baker’s results were also a bit weaker than some analysts had projected. But outside the US, Baker’s problem is a high-quality one.
Basically, the company just doesn’t have enough manufacturing capacity to meet demand. The company has taken steps to build out its global manufacturing footprint; in fact, Baker has a long-term strategic goal of expanding its global business. This should, over time, reduce the company’s dependence on US and Canadian revenues.
Management is forecasting 52 percent revenue growth in Russia this year on top of 36 percent growth in Saudi Arabia and 70 percent growth in Qatar and Libya. Bottom line: Although North America remains problematic, the global business at Baker continues to boom and is slowed only by manufacturing bottlenecks.
Baker, like almost every other company operating in North America, is adopting a wait-and-see approach on the US and Canada. Management reiterated that the activity going forward would be very dependent on how high natural gas inventories are at the end of the winter heating (draw) season. This will govern how much, if at all, producers reduce their drilling activity.
A final, key point is worth noting. As noted above, the potential for a North American slowdown has been an ongoing topic in TES for more than a year now. We even profitably shorted BJ Services and Patterson-UTI last summer.
However, with the slowdown now upon us, I believe a good portion of the weakness is already priced into these stocks. The slowdown is a well-known, discounted fact; everyone is talking about it.
Most North American-levered names have been hit hard since last May, and analysts have spent most of the past six months downgrading their earnings estimates. The bar of expectations has been lowered.
Although I’m not ready to buy into the North American story just yet, I am looking for an outstanding buying opportunity to emerge this spring. The snapback in the group could well be the most-profitable play in the oil and gas space in 2007.
In fact, the fundamentals for the natural gas market are already setting up nicely. Check out the chart of US natural gas in storage below.
Source: Dept of Energy
I show four different lines on this chart–2007 gas inventories, the five-year high in inventories, the five-year low in inventories and the five-year average. Because inventories of gas were at five-year highs for all of 2006, the five-year high represents inventories last year.
US natural gas inventory withdrawals have been running at a higher-than-normal pace in recent weeks because of the extreme cold snap that gripped the Northeast and Midwest in the latter days of January through the first part of February. In fact, withdrawals reported in some weeks have approached record high levels.
Natural gas inventories remain above the five-year average. However, I do believe it’s notable that gas in storage is now significantly lower than it was one year ago. The winter of 2006 was extremely warm, and the first part of this year’s winter led some to look for a repeat of 2006 temperatures. That hasn’t quite happened—this winter is looking more normal on average—and inventories have started to normalize.
In addition to the weather trend, Canadian production is falling sharply thanks to the severe scale-back of drilling activity in that market. Based on the reports from key services firms that I’ve outlined in the past two issues, I suspect the ultimate decline in Canadian production will be more severe than the market expects. And production from the US Rockies is also off considerably because of extremely cold temperatures and winter storms.
Forecasts are now showing a warming trend over the next week or so; these more-average temperatures aren’t enough to reverse the normalization trend unless we get warmer weather through the first half of March. We’ll likely see inventories exit the winter heating season above normal but under last year’s totals.
The bottom line is that there’s already been a moderation in North American gas-related activity; there’s room for additional weakness into spring as the winter heating season ends. By late April or early May, the market focus will shift to the summer cooling season and the outlook for the 2007 hurricane season; the interim “shoulder” season isn’t typically a strong period for oil- and gas-related stocks.
But with this weakness already a well-known fact, stocks levered to the North American market are already depressed. With the worst news priced in, there’s not much downside risk from current levels.
Meanwhile, a number of factors, including further cold snaps, faster-than-expected production declines or forecasts of a hot, stormy summer, could push prices higher. This is the buying opportunity for North America-levered names I will be watching for the next two months.
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How To Play It
But we don’t have to just sit and wait for a spring buying opportunity in gas-levered names. I see several themes that look promising regardless of weather patterns in the US and Canada.
First up, there’s the deepwater. I highlighted deepwater drilling at great length in the January 3 issue of TES, The Deep End. Suffice it to say that the deepwater is one of the key final exploration frontiers for the oil and gas business.
The deepwater is one of the only regions where I see scope for major significant discoveries in the next five years. Better still, as new deepwater drilling rigs come out of shipyards during the next few years, it will open up the possibility of more deepwater exploration.
To play deepwater, my favorites are FMC Technologies and Seadrill. (Please note the symbol for FMC Technologies is FTI, not FMC; make sure you’re buying the correct stock.) Both stocks were outlined at some length in the January 3 issue; the basic story is unchanged since that time.
To review, FMC Technologies makes subsea equipment–valves, pipes and equipment used to control the flow of oil and gas from deepwater wells. Last week, FMC reported fourth quarter earnings. The company not only beat expectations but raised its guidance for 2007 from $3.80 to $4 per share up from its prior estimate of $3.70 to $3.90.
On that basis, the company is trading at less than 17 times this year’s earnings–not expensive for a company that’s growing around 25 percent to 30 percent annually. The company’s backlog stands at $2.7 billion; that’s a record high and represents some nine months worth of revenues. FMC remains one of my favorite plays on the deepwater story; I’m raising my “buy under” price to 70 and reiterating my buy recommendation.
Seadrill is a Norwegian firm that owns a fleet of deepwater rigs. Simply put, it’s the only contract driller that has a significant number of deepwater rigs available for lease in the 2008-09 period. These rigs are in high demand and short supply right now; contract drillers have been successfully boosting the day-rates–the daily fee charged for leasing the rigs–they’re charging during the past three years.
The company’s been signing contracts for its rigs to take effect as soon as the rigs are released from the shipyard. Seadrill has been getting day-rates in the $500,000-to-$550,000-per-day range for its rigs. Seadrill remains a buy.
In addition to deepwater plays, I see further upside in stocks with an international focus. Topping the list is Schlumberger, the technological leader of the oil and gas services business. Schlumberger is better diversified than peers like BJ Services and Baker Hughes and has extensive operations in just about every oil and gas producing region of the world.
To the extent the company does have exposure to the US and Canada, it’s focus tends to be in areas such as the deepwater Gulf of Mexico and high-tech onshore services; these are areas unlikely to be impacted by a slowdown in North American drilling. As I highlighted this company in-depth in the most recent issue of TES, I won’t reiterate all those details here. Suffice it to say that the stock remains leveraged to my favorite services themes and is the must-own name in the services business.
I also see Petroleum Geo-Services and Tenaris as relatively immune to the North American drilling slowdown. Petroleum Geo owns a fleet of seismic ships. Although the company doesn’t report until next Monday, Schlumberger indicated that the seismic business was red-hot during its call last month. And Petroleum Geo works mainly in overseas markets. Petroleum Geo’s focus in this area should pay off; the stock remains a buy.
Tenaris makes seamless pipes used in the oil and gas business. Although pipes may seem to be a commodity, that’s not exactly the case; the extreme temperatures and pressures encountered in many deep wells require the use of specially designed seamless pipes. Tenaris specializes in such advanced equipment.
Though headquartered in Luxembourg, Tenaris operates all over the world. In fact, the company tends to locate its manufacturing facilities near major oil-producing regions. By manufacturing pipe locally, the company cuts down on transport costs and can tailor its output to local market needs.
When it comes to the US market, one problem Tenaris has encountered is US “anti-dumping” legislation, which limits the company’s ability to import pipes it makes abroad into the US. Tenaris has begun to get around this problem by purchasing US rivals; last week, Tenaris agreed to purchase US rival Hydril for $2 billion.
Hydril specializes in the manufacture of high-end, high-pressure connections and control equipment. The company sells a good deal of production into the deepwater Gulf of Mexico.
The other positive is that Hydril has manufacturing capacity in the US; this will help ease some of the bottlenecks currently caused by US anti-dumping regulations. Because the focus of the Hydril business is deepwater and premium markets, I don’t see the added exposure to North America (now more than half of revenues) as a major negative.
Nonetheless, Tenaris is now trading at or above my recommended buy under price and is up some 30 percent from its recommended price. I’m not willing to raise that buy under target until after the company reports earnings; for now, I’m cutting Tenaris to a hold. I would also suggest that subscribers with significant profits in Tenaris consider adopting one of the hedging strategies outlined later in this report to protect gains.
It’s also time to start tentatively dipping our toes into the North American gas market. Specifically, I am adding proppant manufacturing firm Carbo Ceramics (NYSE: CRR) to my aggressive Gushers Portfolio.
As I outlined above, oil and gas exist in the pores and crevices of reservoir rocks. When an operator spuds a well, the oil and/or gas–under tremendous geologic pressure–flows through the rock into the well and to the surface.
But if the pores in a rock aren’t well connected, there are few channels through which the hydrocarbons can travel. Although there may well be plenty of gas in the ground, that gas is essentially locked in the pores of the rock and unrecoverable.
But there are ways to produce such reservoirs. In fracturing, operators pump a gel-like liquid under tremendous pressure into the ground. That gel actually enters the reservoir and cracks the reservoir rock. By cracking or fracturing the reservoir rock, the operator creates channels through which gas can flow.
But that brings us to another problem. Once a reservoir is fractured and the operator reduces the pressure of the fracturing liquid, those channels and cracks typically begin to close up again. This, of course, reduces the efficacy of the fracturing work.
This is why operators tend to put small particles into the gel-like fracturing liquid. These particles also enter the reservoir and get stuck in the channels opened during fracturing. As the pressure is released, the particles essentially prop open the channels; that’s why these particles are called proppant.
There are many types of proppant out there. One of the early types used was just specially coated sand particles. But Carbo Ceramics (NYSE: CCR) makes a highly specialized ceramic proppant. Modern-day ceramic materials are very strong, light and durable; it should come as little surprise that ceramics are also used to manufacture bulletproof vests and armor for automobiles.
Without going too deep into technicalities, suffice it to say that ceramic proppants work more effectively than other types. Such proppant is also more expensive; however, that’s not a big issue. Even if an operator can boost production by 2 percent to 5 percent, it’s often well worth the extra expense of buying ceramic proppant.
On February 1, Carbo reported blowout earnings for the fourth quarter. What’s interesting is that while the US rig count rose about 16 percent in 2006, the actual volume of proppant sold by Carbo rose 24 percent; the company is growing at a faster pace than the market.
Canadian revenues were also up despite a drop in the rig count there. In addition, Carbo pushed through 9 percent price increases in 2006, a good sign that it’s maintaining pricing power.
In fact, Carbo’s biggest problem in the US is building out manufacturing capacity fast enough to meet demand. Carbo is clearly picking up market share in the proppant business and has no trouble pushing through price increases.
In addition to simple proppant sales, the company has a services arm. It models fracturing jobs in individual reservoirs to help operators decide how best to fracture a given reservoir. This business dovetails nicely with its proppant sales.
And finally, Carbo’s business in Russia is booming. Sales of proppant there rose nearly 40 percent in the fourth quarter. And right now, Carbo is losing money or is only weakly profitable on its sales there because the company doesn’t have manufacturing capacity in Russia. Because of tariffs and simple logistical challenges, it’s not practical to export proppant to Russia from the US or Europe.
But Carbo’s first Russian manufacturing facility is scheduled to start up in the first quarter of this year. This capacity will allow the company to rapidly ramp up sales. The beauty of this is that fracturing is in its infancy in Russia compared to the US; there’s a huge opportunity for expansion in this market.
Despite strong operational performance, Carbo is down close to 40 percent from its 2006 highs and is trading at less than 18 times earnings; the stock has been hit by concerns it would be hurt by a slowdown in gas drilling.
Because of the combination of rising market share, rising pricing power and expansion opportunities in Russia, I believe fears of a US drilling slowdown are overdone and largely pricing in. Carbo Ceramics is a buy in the Gushers Portfolio.
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Take Losses, Ride Winners
One of the greatest dilemmas facing all traders and investors is knowing when to sell a stock and take a profit. Most of us know that old Wall Street saw it’s a good idea to cut our losers short and let our winners run; however, the risk of giving back a huge gain tempts many investors to take profits off the table long before a stock has finished its run.
I can tell you from personal experience that there are few things more frustrating than taking a nice profit on a stock only to watch it double or triple in the ensuing months. That “nice” gain suddenly doesn’t look so impressive. Similarly, nothing is more demoralizing than building up big gains over a multi-month period only to watch them evaporate quickly when the stock reverses.
The good news is that there are more choices than simply “buy” and “sell.” Using the options market, there are other steps you can take to protect your gains while leaving your portfolio open to more upside.
In TES, I don’t recommend options in the three model Portfolios. All returns are calculated assuming you simply take the recommended positions and set stop orders according to the advice posted in the Portfolio tables, updated in the newsletter and via flash alerts on an ongoing basis.
That said, options can be a useful tool for investors. In fact, one of the most common questions I receive from subscribers concerns how to use options to play the energy patch. This is why, from time to time, I explain some options strategies I’ve found useful in the past and give specific recommendations with reference to the TES model Portfolios.
Sadly, many traders and investors look at the options market as an aggressive speculator’s casino. And options can certainly be used in that manner. But options can also be used as a protective mechanism for those looking to hedge against a pullback.
A perfect example of this is a flash alert I sent out May 2, 2006, entitled Hold ‘Em Or Fold ‘Em? In that flash alert, I explained an options strategy known as put insurance. This is a strategy for protecting gains in your big winners without giving up much upside if the stock continues to run.
If you’re interested in reviewing that strategy in action, I updated those recommendations in the Aug. 23, 2006, issue of TES. For the most part, if you’d followed the options strategies outlined in the May 3 report, you’d have severely limited the damage caused by the May/June selloff in the energy patch and, for that matter, global markets in general.
In this week’s issue, I will re-examine options and how to use them to limit your risk and maximize your gains. I strongly suggest that newer subscribers interested in options review the two articles—from May and August—referenced above. Both are available in the archives or by clicking the links in the text above. I will, however, again review put insurance below with updated examples from the current Portfolios.
And for subscribers already familiar with the put insurance strategy, I’m also outlining another options strategy this week. This strategy, known as call replacement, also allows for booking gains without giving up the chance for more upside.
Before I delve into these two strategies in more depth, it’s worth noting a few points. First, I know that many subscribers simply don’t feel comfortable trading options. That’s not only understandable but a desirable reaction; you can do real damage to your portfolio trading options if you’re not aware of how this market works.
If that’s the case, I recommend starting off slowly and deliberately. I’d recommend following the strategies I outline on paper to get a better feel for how they work and to become more comfortable with the risks involved.
Alternatively, consider using one strategy or the other on a single stock or a small portion of your portfolio to get more comfortable. I believe this will pay off in the end.
Moreover, remember that our first line of defense–whether it’s protecting profits or guarding against losses–remains my updated stop recommendations and flash alerts. I’ll always send out a special alert if I change my outlook on a particular stock or see reasons for concern.
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Inevitable Corrections
As I’ve outlined on numerous occasions, demand for oil and gas is booming while the world’s ability to expand supplies and production is, at best, limited. Other groups I’ve highlighted in TES are also in long-term uptrends, including agricultural products (biofuels), oil and gas services, alternative energies and uranium.
The great commodity bull markets throughout history have lasted for at least 15 to 20 years. This current up-cycle has more than a few good years left in which to run.
But that doesn’t mean there won’t be corrections. Long-term readers are well aware that we’ve seen three significant energy corrections during the past 12 months. The most-recent correction for the Philadelphia Oil Services Index (OSX) lasted from May through October of last year and resulted in declines of roughly 30 percent on average. Although that doesn’t seem like much in the context of the near tripling of the same index since mid-2004, the correction certainly felt scary at the time.
The important thing to remember is that no great bull market has been immune to such corrections. Even the Nasdaq in the 1990s and gold in the ’70s saw corrections of as much as 35 percent in the context of a longer-term trend higher.
Typically, these pullbacks mark outstanding buying opportunities; however, holding through such selloffs is tough. These corrections are precisely why it’s so difficult for most investors to let their profits run. But there are a few key ways to protect your portfolio against pullbacks.
First, not all energy subgroups will correct at the same time. Consider that, for example, uranium-related stocks have been on fire since early last fall, while many oil- and gas-related issues have simply traded sideways. And my master limited partnership (MLP) recommendations–highlighted in depth in the Nov. 22, 2006, issue –have scarcely seen a down month during the past year.
The energy sector isn’t a homogenous group; these stocks don’t all move in a pack, following the price of crude. Therefore, it’s important to consider my favorite themes outside the oil and gas space when constructing a portfolio.
Second, I would also caution new subscribers to be careful to follow the buy targets I outline in the Portfolio tables. I know some of my recommended stocks are now trading above their “buy under” prices. Many have moved aggressively higher in just the past few months and are too extended to purchase. I recommend buying only the companies that are still under my targets.
And don’t despair. There will be plenty of opportunities to jump into new recommendations in the next few months. I also change my buy under recommendations on an ongoing basis, raising these levels when appropriate.
Third, keep an eye on my recommended stop orders. Stops are nothing more than orders you place with your broker to sell you out of a stock automatically when a certain price is touched.
For example, let’s say you own a theoretical stock, ABC, at $100 and place a stop at $85. Your position in ABC would be immediately sold as soon as the stock trades at or below $85. This is a way of limiting your losses on a stock even if you’re nowhere near your computer or telephone.
Over time, I trail my stop recommendations in the Portfolios. In other words, let’s say you own stock ABC at $100 and the stock pops to $135. I may then recommend raising your stop to $120. In this case, if the stock falls back to $120, you’d be out for a 20 percent gain. But if the stock keeps moving higher, you’d still be along for the ride. By periodically raising your stops as your stocks rise, you can lock in incremental gains over time.
Finally, of course, I do recommend taking partial gains on stocks from time to time. In other words, after a big run, it can be a good idea to take some of your profits off the table, leaving some money in the stock to benefit from further gains.
But raising our stops, adhering to target prices and booking some partial gains from time to time aren’t the only ways to protect gains on trades. These strategies are just the first line of defense. If you’re willing to play the options market, here are two additional strategies to consider:
Strategy #1: Put Insurance
The best way to illustrate this strategy is with a simple example. Assume you purchased 200 shares of oilseed processor Bunge (NYSE: BG) on my original recommendation at a price of about $57.27 roughly one year ago. That stake would have cost you roughly $11,450. With Bunge at around $80.50, your 200 shares are now worth $16,100, a gain of $4,650 or just above 40 percent.
I still see more upside in Bunge; in fact, as of this issue, I’m raising my “buy under” recommendation to 78. The stock is only trading at around 18 times this year’s earnings estimates, and those estimates are rising quickly.
The fundamentals of the Brazilian market, where Bunge is a major player, have improved markedly during the past year. Ultimately, Bunge is a premier play on both the strengthening agricultural industry and the growing biofuels market; the stock should ultimately trade into the $90s. I outlined my case for owning Bunge at some length in the Sept. 20, 2006, issue Fueled By Food.
But if you’re in the stock at $57.27, you’re probably anxious to lock in some solid gains. At the same time, you don’t want to miss out on the potential for further gains in Bunge.
The July 2007 $80 put options (BG SP) on Bunge are currently trading at around $4.50. This option gives you the right (but not the obligation) to sell Bunge at $80 a share at any time between now and July 21.
Options are traded in contracts covering 100 shares, so each contract costs roughly $450 at this time. To cover your 200 shares, you could purchase two contracts for $900. Here are the three possible scenarios for the stock:
- Bunge rallies to $95 by July options expiration. Because you still own the 200 shares of stock, your profit is now $7,550 on the stock assuming an entry at $57.27. Your put options would expire worthless giving you a total profit of $6,650 ($7,550 minus $900), or 58 percent.
- Bunge trades at around $80.50. As outlined above, your profit on those 200 shares would be roughly $4,650. But with the options expiring worthless, your total profit would be $3,750 ($4,650 minus $900) or about 33 percent.
- Bunge sells off to $65 by July. In this event, you’re still showing a profit of $1,550 on your 200 shares of Bunge. But your options would be worth $15 each, or $1,500 per contract ($80 minus $65 equals $15). Your two options would be worth $3,000, a profit of $2,100 after deducting your $900 purchase price. Therefore, your total profit in Bunge would be $3,650. That’s $2,100 on the options and $1,550 on the stock.
By purchasing the puts, you’re paying $900 to insure yourself against a decline in Bunge during the next five months. Like any insurance policy, you’re giving up some upside to protect your downside. So, if Bunge continues to rise or stays put near $80.50, this insurance policy will cost you $900. But if Bunge falls significantly, the puts will protect the vast majority of your gains in the stock.
But the scenarios I outlined are only the beginning. Consider the possibility that Bunge pulls back $15 or so in the next three months and then looks to be a good value once again. You could then sell your options and book a profit. If the stock started to rally again, you’d again have all that upside potential. Options are a highly flexible hedging tool.
In addition, you can perform a strategy known as rolling down. I highlighted this strategy at great length in the August 23 issue of TES.
A few ground rules worth considering:
- If you don’t feel comfortable with this strategy, don’t execute the trade or consider only using it to cover one of your stocks.
- If you aren’t comfortable with the concept or idea of options, consider starting out small or just avoid the idea entirely.
- Do NOT buy the options unless you’re also long the stock.
- Do NOT buy the options unless you’re showing at least a 20 percent gain in that stock.
- If you do make this trade, cancel all outstanding stop orders on the underlying stock.
- Buy one contract for every 100 shares of stock you own to fully cover your position.
Strategy #2: Call Replacement
In this strategy, you actually sell out of your stock holding completely and book a gain. You then use call options to re-create your long in the stock for a much lower cost. Again, this strategy is best illustrated with an example; I’ll use Wildcatter Portfolio holding Tenaris.
Again, I still like Tenaris. In fact, as I outlined in the text above, I think the company’s most recent acquisition will prove to be a solid move longer term. That said, my original recommendation on Tenaris was at a price of $36.75; the stock is up nearly 30 percent since that time.
Assume you purchased 300 shares of Tenaris at $36.75 for a total cost of $11,025 before commissions. With the stock now hovering around $47.50, those same 300 shares would now be worth $14,250 for a gain of $3,225. While you certainly want to ride Tenaris if there’s more upside, that’s a sizeable 30 percent gain that’s worth protecting.
To execute a call replacement, you would first sell all 300 shares of Tenaris and book the full $3,225 profit on the stock. Meanwhile, the September 2007 $50 call contracts (TSW IJ) are trading at $4.30, or $430 per contract. These calls give you the right but not the obligation to buy 100 shares of Tenaris at $50 per share at any time between now and Sept. 22, 2007. If you immediately buy three contracts, the total cost would be $1,290.
The net effect of these two transactions is that you would book a gain of $1,935 ($3,225 minus $1,290) and would own three Tenaris call contracts. The total value of the 300 shares of Tenaris is $14,250, while the calls are worth just $1,290.
You’re also freeing up close to $13,000 in capital that you can use for other purposes or to buy another stock. In essence, you’re replacing a $14,000 stock position with a $1,300 call options position.
Here are the three possible scenarios for the options position:
- Tenaris keeps running, reaching $60 per share by September expiration. Your three calls are now worth $10 each ($60 minus $50), or $1,000 per contract. That means the three-contract position is now worth $3,000 and your profit is $1,710 ($3,000 minus $1,290). Including your profit on the stock, your total profit on Tenaris would be $4,935 ($3,225 plus $1,710). This compares to $6,975 if you’d held onto the stock.
- Tenaris stays put at $47.50. Your options would expire worthless, leaving you with a total profit of $1,935 ($3,225 profit on the stock minus $1,290 cost for the options).
- Tenaris falls back to $37.50. Your calls would be worthless; however, you did already book a significant $3,225 gain on the stock. Your total profit would be $1,935 ($3,225 profit on the stock minus $1,290 for the options).
One point to keep firmly in mind is that the other benefit of this position is that it frees up capital for buying other recommended stocks while lowering your overall downside and preserving most of your upside potential.
Those more familiar with how options are priced will also recognize a key issue with this strategy: Buying the three call contracts I highlighted isn’t exactly equivalent to owning 300 shares of Tenaris. To fully understand why this is, the case would mean delving into some relatively complex options theory. I suspect most readers would find that more than a little dry and unnecessary.
Suffice it to say that the relevant metric is a statistic known as delta. Delta measures an option’s sensitivity to a change in the price of the underlying stock.
The current delta of the above-referenced call options is 50 cents, or $50 per contract. That means that a $1 move higher in Tenaris would result in a $50 move higher in the value of each call contract purchased–a $150 move for the three contracts.
But to further complicate matters, delta isn’t a constant. Delta will move as Tenaris moves in price, as time passes and as the volatility of Tenaris changes over time. That’s where things start to get a bit complicated. If any readers would like a more detailed explanation of options theory, I’d be more than happy to produce a report on the issue. Simply drop me an e-mail at energystrategist@kci-com.com, and I’ll get to work on it.
The important point to understand from all this is the trade-off you face. If you purchase more call contracts, your cost will be higher but your potential upside will be greater.
For example, if you purchase five Tenaris call contracts instead of three, your cost would be $2,150. After taking your profit of $3,225 on the stock, your overall minimum profit would be $1,075 ($3,225 profit on the stock minus $2,150 cost of the options).
This is the least you could make; you would make $1,075 if your calls end up expiring worthless. If you purchased five contracts instead of three, here are your outcomes at expiration:
- Tenaris keeps running, reaching $60 per share by September expiration. Your five calls are now worth $10 each ($60 minus $50), or $1,000 per contract. That means the five-contract position is now worth $5,000 and your profit is $2,850 ($5,000 minus $2,150). Including your profit on the stock, your total profit on Tenaris would be $6,075 ($3,225 plus $2,850). This compares to $6,975 if you’d held onto the stock.
- Tenaris stays put at $47.50. Your options would expire worthless, leaving you with a total profit of $1,075 ($3,225 profit on the stock minus $2,150 for the options).
- Tenaris falls back to $37.50. Your calls would be worthless; however, you did already book a significant $3,225 gain on the stock. Your total profit would be $1,075 ($3,225 profit on the stock minus $2,150 for the options).
Therefore, by purchasing more options, you increase your upside significantly. However, the trade-off is that you also increase your downside risk or rather decrease the minimum profit from the position.
By purchasing three contracts, you’re booking more gains in the stock but do leave some upside on the table. Just as with put insurance, this strategy is flexible; you can choose to take larger gains and reduce your risk significantly by purchasing fewer calls. Alternatively, you could purchase more calls and, therefore, take on more risk.
Please note a few key points about this strategy:
- Use this strategy sparingly. While it might seem like a good idea to replace your entire portfolio with options and free up all that cash, it isn’t. Options are highly leveraged instruments and you can make and lose money quickly.
- Only use this strategy for stocks on which you have a 20 percent or higher gain.
- I regard this strategy as higher risk than put insurance; don’t do the trade unless you feel comfortable with it.
- Pick either put insurance OR call replacement; don’t try to do both strategies at once.
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How To Play It
Finally, I’m not outlining these strategies because I see an imminent correction in the energy patch. In fact, I see many groups–such as the services companies and drillers–as stocks just coming off important lows and due for considerably more upside.
It takes some time to gain a comfort level with options strategies. It may also take some time to set up the necessary trading permissions with your broker. If you’re interested in these strategies, you will need to set up options trading permissions with your broker; most call it “level 2” options clearance.
Here’s a list of some of the portfolio’s biggest winners with suitable option strategies for protecting gains in each:
American Commercial Lines (NSDQ: ACLI): It’s current profit stands at roughly 35 percent. The January 2008 37.50 puts (ZQR MU) offer insurance for about $410 per 100 shares owned. Alternatively, you can sell your ACLI common stock and purchase the January 2008 37.50 calls (ZQR AU) for around $610 per contract. Please note that these figures account for a 2-to-1 stock split effective Feb. 12, 2007.
Syngenta (NYSE: SYT): Biofuels field bet holding Syngenta is up around 25 percent from my original recommendation in September. The September 35 puts (SYT UG) offer insurance for about $180 per 100 shares owned.
Mosaic (NYSE: MOS): Biofuels field bet Mosaic is up more than 55 percent from my original recommendation. The January 2008 25 puts (LXW ME) offer insurance for $220 per 100 shares owned. Alternatively, you could sell your Mosaic common stock and buy the January 2008 22.50 calls for $590 per contract.
Potash Corp (NYSE: POT): Biofuels field bet Potash is up 65 percent since the September recommendation. The January 2008 $160 put options (WPT ML) offer downside insurance for about $1,600 per 100 shares owned.
Bunge: See detailed example above for put insurance ideas on Bunge.
Tenaris: See above for call replacement strategies for Bunge. Alternatively, for put insurance, consider the September 2007 $45 puts (TSW UI), trading at about $370 per 100 shares insured.
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