Be Selective
Fourth quarter earnings season is an important time for all publicly traded companies. Not only do firms announce their results for 2006, but typically they also offer a look ahead—an examination of the trends and crosscurrents that are likely to affect business in 2007. A careful analysis of these reports is invaluable, highlighting some of the more-important investing themes for the year ahead.
We’re now in the middle of earnings season for the energy patch. Most of the companies I recommend and cover have already or will soon release their results and forecasts. In this issue, I’ll take a look at some of the key reports and conference calls so far and analyze what these reports mean for my recommended companies.
In This Issue
I’ve long maintained a bullish stance on the oil services industry but a bearish stance on companies overexposed to the volatile North American market. After months of anticipation, the slowdown in the North American market is evident, and services firms leveraged to the market are feeling the pain.
However, with that news now well known, I’m looking for a stellar buying opportunity in the group during the next few months. In the meantime, I continue to like a handful of internationally focused services firms that are benefiting from strong growth in oilfield activity overseas and in deepwater developments.
In addition, I’ll be taking a closer look at transports and coal mining firms. On the transport front, I see scope for continued upside in light of recent results; railroads still benefit from hauling record amounts of coal out of the Powder River Basin.
On the coal-mining front, I continue to recommend avoiding companies leveraged to Central Appalachia and focusing on more-diversified miners. With winter weather temperatures finally gripping the Eastern Seaboard, coal demand is rising, and I see the potential for a big run in the group into spring.
I’ll also take a look at one of the most-innovative deals in the master limited partnership (MLP) space of the past year: Enterprise Product Partner’s decision to spin-off Duncan Energy Partners.
Finally, in this issue, I’m pleased to include a special guest article from GS Early, editor of The Real Nanotech Investor. He’s an expert when it comes to all things related to technology. Below he examines some new battery technologies and their potential far-reaching impacts on energy storage and fuel-efficient vehicles.
They say investing in energy is all about predicting oil and natural gas prices’ direction. They also say that oil and gas stocks move as a group. But both are myths. See Tread Carefully.
Transportation and energy are closely linked. I review the importance of railroad, barges and airlines in regards to energy. See Transports
One of my top performing oil and gas services company said in its recent conference call that the world is running out of easy oil. Analysts are concerned with how weak commodity prices will affect gas drilling. And signs of weakness in North America are starting to emerge. See Oil And Gas Services
My main coal mining recommendation recently held a conference call in which it was asked about the potential to acquire new mines in Central Appalachia. When the management of the country’s biggest coal miner tells you it’s steering clear of a certain region, though, you’d best follow its lead and avoid companies exposed to such areas. See Coal
Master limited partnerships (MLPs) have been one of my favorite long-term income plays in the energy patch. Now, one of my MLP recommendations has mastered a new way to increase cash flow and still retain the majority of its assets–resulting in another addition to my Portfolios. See Enterprising Enterprise
Although battery technologies don’t currently have the storage capabilities required to make them a solid alternative energy source, there are companies attempting to make headway in that field. GS Early has recently written on such developments; I include his article here. See The Future Of Energy.
In this issue, I’m recommending/reiterating my recommendation on the following stocks:
In this issue, I’m also recommending avoiding or selling the following stocks:
Tread Carefully
Perhaps one of the most-frustrating myths about investing in the energy patch is that it’s all about predicting the direction of oil and natural gas prices. One commonly held belief is that oil and gas-related stocks all move as a group–basically, in the same direction as the underlying commodities. For that matter, I’ve heard plenty of times from those believing that nuclear power, alternative energy and other nonhydrocarbon energy plays also follow oil and natural gas prices.
If that were the case, there would be little value in stock-picking or sector selection. The evidence, though, suggests otherwise–in fact, selectivity is the key to playing the group. A big picture outlook on commodity prices is important, but it’s only one piece of the puzzle.
In the early stages of the energy bull market, most stocks in the group moved higher. However, as time has passed, divergences in performance have become more obvious, and the stocks have seen vastly different performances.
For example, consider the 15 oil and gas services stocks that make up the Philadelphia Oil Services Index (OSX). This is the most widely followed index of large capitalization oil services names; the index includes a mixture of contract drillers, pure services stocks and some oil and gas equipment firms. My chart below compares the performance of the top 3 and bottom 3 OSX components during the past year.
Source: Bloomberg, The Energy Strategist
I created these two indexes using an equal weighting–the indexes aren’t sorted by market capitalization. It’s clear that if you had invested in the three top oil services stocks in early 2006, you’d currently be up more than 20 percent. While that’s off the highs registered in May, it’s still an impressive performance.
If, however, you’d been buying the worst three stocks in the OSX, that investment would be down close to 18 percent. That’s nearly a 40 percent return spread between the best- and worst-performing OSX stocks.
Keep in mind that the OSX is a relatively specific index that focuses on just one relatively small part of the energy business–services and contract drillers. If the difference between the best and worst performers in a relatively homogenous group can be that large, you can imagine how large the differences are between stocks in different energy subsectors.
I didn’t just pick the OSX out of the blue; in fact, the return spreads in different groups in the energy patch are even more stark. I reproduced a similar chart of coal stocks below.
Source: Bloomberg
One long-standing theme of this newsletter has been to prefer coal companies with a diversified geographical exposure to those with operations concentrated in Central Appalachia (CAPP). The “CoalWorst” index above is formed by equal weighting three coal mining firms focused on the CAPP region; “CoalBest” is formed of two diversified miners.
I’ll discuss and update this viewpoint below as well as my favorite plays in the group. For now, suffice it to say, coal is a volatile group that’s given to large swings in sentiment. There’s a time to own these names and a time to sell them.
However, the chart above illustrates that when you own coal stocks, it’s best to focus on quality, diversified names. The CoalBest index outperformed the CoalWorst during the January through May run-up last year and the vicious decline in the group after the middle of the year. The final tally: Both groups are down somewhat, but the better stocks are off less than 15 percent while the CAPP-focused miners are off more than 60 percent.
My point in bringing this up is simply that far too many investors focus solely on the macro picture for oil and natural gas and ignore the fact that the energy patch is a diverse group, perhaps one of the most-diverse sectors in the market today. There are real, fundamental reasons behind the wide divergence in performance among the stocks highlighted in my two charts above.
To fully understand what’s going on and how to profit from it requires reviewing how individual companies are performing and where the strengths and weaknesses are. Earnings season is a great time to sort out these moving parts–company reports and conference calls can give us a better picture of how to position ourselves and what stocks to buy.
But analyzing company reports involves a lot more than just finding what businesses are strong and which are weak. It’s also a matter of discerning how stocks react to news and their earnings releases.
For example, companies that report great news and then see their stocks sell off sharply may already be priced for perfection. On the flip side are companies that actually rally after reporting negative news–these stocks may well be washed out, with the worst-possible news baked into the stock.
In the past few issues, I’ve focused mainly on some of my long-term favorite themes–specifically, I’ve reviewed my favorite ways to play nuclear power, biofuels, alternative energy and deepwater drilling. For newer subscribers unfamiliar with these recommendations, I recommend checking out the last issue of TES “Another Alternative”. It has many links to relavent articles in the archives.
Below I’ll take a closer look at some of the major themes that have emerged recently across the various sectors I cover in TES. Specifically, the energy patch is in the middle of fourth quarter earnings season, and I’ll examine some key trends highlighted in the slew of earnings news and conference calls released during the past few weeks.
Back To In This Issue
Transports
Many investors don’t even consider the transportation industry when they think of energy stocks. That’s a mistake. Transportation and energy are industries that are inextricably linked. I highlighted the transports at some length in the July 12, 2006, issue of TES Beyond Oil and Gas, but the theme is worth reviewing.
Consider the railroads. Close to 70 percent of the coal moved in the US is transported by railroad; coal (by weight) is by far the most-important commodity moved by railroad in the US. Increasingly, coal is being moved longer distances in the US.
The reason is simple: The Eastern half of the US burns a great deal of coal, and traditionally, most of the coal supplied to the region has come from the CAPP coal district. CAPP is an area encompassing such states as West Virginia, Pennsylvania, Kentucky and Virginia. Railroads in the east would connect mines in these states to power plants all across the Eastern Seaboard and parts of the Midwest.
This basic arrangement has been going on for more than a century, and I suspect it will continue for years to come. However, there’s a problem with CAPP coal supplies. Check out my chart below.
Source: EIA
The chart shows coal production from the three main producing regions of the US: Appalachia, Interior and the western US. Note that up until roughly a decade ago, the Appalachia region was the most-important coal-producing region of the US. But that’s rapidly changing as production from the western coal region has soared in recent years.
According to the Energy Information Administration (EIA) estimates that this basic trend is likely to continue. The West will continue to be America’s dominant coal-producing region with that dominance increasing over time. Meanwhile, production from the Appalachia region in the East has actually declined in recent years, a trend the EIA also expects to continue.
The problem with Appalachia isn’t that there’s no coal there or that the coal is largely of poor quality. In fact, its high-grade coal is about the best you’ll find anywhere in the world.
Appalachia, though, is a mature coal-mining region that’s been exploited for more than a century. Coal seams in the area are thinning, and much of the mining is done underground.
Underground mine work takes skilled labor, and even then it’s dangerous work. Costs of mining in the region are rising while many producers struggle to meet production goals.
The primary western coal mining region is the PRB, located in such states as Wyoming and Montana. Coal in this region is located close to the surface and is far easier to mine. Labor requirements are lower on a per-ton basis, and it’s easier and faster to train miners for surface operations.
Better still, much of the coal mined from the region is low in sulphur–this is important because sulphur emissions are controlled by the government, and burning low sulphur coal is one of the most-straightforward means of cutting those emissions.
To make a long story short, as time goes on, more and more of that PRB coal will have to move east to satisfy demand. Steadily falling production from CAPP will only exacerbate the situation. The PRB will be filling that gap.
Also accelerating demand is the fact that a number of new coal plants are scheduled to be built in the east to satisfy rapidly growing power demand. More coal plants spell rising demand for coal. The vast majority of that coal will be moved by rail eastward. That’s a much longer and more-profitable route for the rails than hauling coal from CAPP to East Coast power plants.
But coal is certainly not the only commodity moved by rail. Agricultural products–such as corn, wheat and soybeans–are key determinants of rail demand. Grains have to be hauled from Midwestern farms to export ports. And increasingly, ethanol is becoming a key corn consumer in the US.
Ethanol cannot be transported by pipeline due to the fact that it corrodes pipe and has a nasty habit of evaporating too easily. So ethanol is primarily moved by rail. Rising demand for foodstuffs and biofuels is another major force behind growing rail demand.
When it comes to playing the railroads, my two favorites are Wildcatters Portfolio recommendation Union Pacific and fellow western rail Burlington Northern Santa Fe. These two railroads are the big players in the PRB and stand the most to gain from rising demand for PRB coal. Both also have large agricultural transport businesses and are benefiting from growing biofuel demand.
These two railroads reported earnings and held their conference calls in late January. They highlighted some of the same basic trends.
Specifically, the coal business continues to be the strongest product line for both companies. Union Pacific and Burlington Northern reported record tonnage hauled out of the PRB in the fourth quarter. In recent years, the two rails have been improving their track networks in the region so that they’re capable of hauling more coal–these investments are necessary to keep pace with demand.
A glaring lack of rail transport capacity has been the biggest impediment to greater use of PRB coal. Both railroads plan to continue addressing this bottleneck by pursuing aggressive capital spending plans to improve and upgrade their tracks. Given continued strong demand for western coals, these two railroads have been able to raise prices charged for shipping coal and are currently recovering close to 90 percent of their fuel (diesel) costs through special fuel surcharges.
The coal transport business is a contract business; railroads sign multiyear contracts to haul coal to utilities. As older contracts roll over, the rails have been able to demand increasingly attractive pricing and fuel surcharges on newer deals.
For Union Pacific and Burlington Northern, roughly 5 to 15 percent of their coal-related hauling contracts are renewed each year. Pricing has been and should continue to rise gradually over time to reflect the positive environment.
Both railroads also reported strength in the transport of agricultural products. Some of this was because of strength in the export market. As my chart below shows, Chinese corn consumption continues to rise inexorably.
But domestic demand is also ultrastrong; Union Pacific reported 50 percent growth in shipments of ethanol and 64 percent growth in shipments of dried distiller’s grain (DDG), a by-product of ethanol production used to feed livestock.
Source: Bloomberg
During the conference calls for both companies, analysts focused on three potential areas of weakness: A notable slowdown in domestic intermodal, slowing industrial volume and coal inventories and the weather.
A notable slowdown in domestic intermodal: Union Pacific and Burlington Northern reported weakening volume growth in domestic intermodal transport and industrial transport. Intermodal transport involves the carrying of goods across multiple modes of transport. On the domestic front, that typically means goods that are transported partly by truck and partly by rail. Much of this traffic is consumer goods of varying descriptions.
The truckers have been having a terrible run of late. The obvious slowdown in economic growth in the latter half of 2006 spells lower volumes of freight carried by truck. Last October, truck tonnage slipped 4 percent year-over-year, the largest decline in five years.
And there’s also a big shortage of skilled drivers. Labor costs in the trucking industry are soaring, and experienced truckers are in high demand. The trucking firms are now getting squeezed on the cost and the demand sides of the equation. To make matters worse, a price war has kicked off with truckers cutting prices to try and raise demand.
Since the railroads are another link in the domestic intermodal supply chain, weakness in the trucking industry has obvious implications for domestic rail demand. First, lower truck volume spells lower intermodal volumes to pass on to the rails. Second, a price war among the truckers could theoretically limit the rails’ ability to hike hauling prices on goods transported–they actually compete with truckers to a limited extent on some shorter-haul routes.
Slowing industrial volumes: According to both companies, slowing industrial volumes can be attributed primarily to weakness in the housing market. Union Pacific reported an 11 percent reduction in car loadings in its industrial segment led by a 28 percent reduction in lumber loadings, a 13 percent drop in shingles and roofing materials and an 11 percent reduction in rock transport.
Burlington Northern’s management team described the downturn in lumber and other building product demand as “steep” in the fourth quarter. Both companies are factoring in continued weakness in industrial products as we head into the first half of 2007.
Coal inventories and the weather: As noted above, demand for coal remains robust, and normal contract rollover continues to power pricing increases for both firms. Nonetheless, analysts on both conference calls repeatedly asked management to give more specific guidance on coal demand for 2007. Because the coal business has been leading the rail renaissance, any sign of a prolonged downturn in the coal business would be problematic.
Both Union Pacific and Burlington Northern reported some problems early in 2007 due to a series of winter storms affecting their western networks. Unlike in the East, places such as Colorado and Wyoming saw a nasty start to the winter season. Both rails are recovering from this problem; it’s only a short-term issue.
The more profound question has to do with coal demand. Warm winter weather across the East in December and early January reduced heating demand. As I’ve noted in prior issues, this led to a reduction in demand for natural gas and rising inventories of gas. That, in turn, put pressure on gas pricing.
Coal has seen a similar pattern–lower heating demand spells lower demand for electricity and rising coal stockpiles at the nation’s power plants. The key question is whether rising inventories of coal will serve to crimp demand for coal transported from the West.
So far, the answer appears to be that it hasn’t affected transport demand. Both Union Pacific and Burlington Northern saw record volumes coming out of the West in the fourth quarter. Keep in mind that although inventories are building, they’re building back up from record lean levels of a year ago.
Some utilities saw their inventories run dangerously low in late 2005. There’s a good chance that utilities are taking advantage of the warmer weather to pad their inventories and avoid getting into a similar situation again this year.
But these two rails suggested that if warm winter weather continues through the rest of the first quarter, there would be an impact. Based on management comments, it appears that that impact would be worst in the East.
There’s still some pent-up demand for low-sulphur western coal. And moreover, the reduction in coal demand would likely lead to a lower growth rate in coal transported, not an actual year-over-year decline in volumes.
My take on the railroad industry remains largely unchanged. We’ve already seen a sharp drop in demand for shipping products leveraged to the housing business. Both Union Pacific and Burlington Northern have exposure to these areas, but that exposure isn’t big enough to offset strong growth in coal and agricultural product demand. Union Pacific, for example, only gets around 2 percent of its revenues from lumber.
Weakness in these areas is already a well-known fact and was the subject of considerable chatter during their recent conference calls. The stocks, however, rallied despite that negative tone. This is a good signal that this bad news is already baked in.
Furthermore, recent economic data suggest a reacceleration in economic growth as we head into 2007. Since both Union Pacific and Burlington Northern have offered fairly dire guidance for their industrial products and domestic intermodal segments, there’s a lot of room for an upside surprise if economic growth continues to firm up.
One area that worries me is coal demand. However, a warm early January in the East has given way to bitterly cold weather during the past three weeks–some of the coldest weather of the past decade. Looking at the 10-day weather forecasts for New York, Washington, DC, Chicago and Boston reveals that these cities are only expected to see one day of above-average temperatures during the next 10 days.
We’re already seeing the effects of colder weather in the form of higher demand for natural gas and falling inventories. Coal demand is also rising.
Bottom line: The picture for coal demand is improving, and western coal demand will remain resilient.
I slightly prefer Union Pacific to Burlington Northern at this time because it’s in the middle of an operational turnaround plan that’s been leading to improved efficiency at the railroad. One of the most-commonly quoted measures of railroad financial performance is what’s known as the operating ratio, a measure of operating expenses as a percentage of total revenues. The lower the operating ratio, the more efficient the railroad.
Another metric to pay attention to is velocity, literally how fast trains are moving (in miles per hour) across the network. The faster the velocity the more capacity a railroad can handle and the higher potential profits. Another way to look at this is that, by making operational improvements, a train operator can move more goods without hiring more employees or buying new locomotives.
Union Pacific kicked off a restructuring plan to improve its operations in late 2005. At that time, Union’s operating ratio was in the mid-80s. In the fourth quarter, the company’s operating ratio fell below 80 for the first time since 2003 while velocity increased by 7 percent over the third quarter. The turnaround plan is starting to bear fruit, and management is looking for operating ratios to continue falling towards the mid-70s by the end of the decade.
Union’s operating efficiency still lags that of Burlington. Burlington’s operating ratio is already in the mid-70s. But the stock has room to play catch-up as ratios continue to improve toward industry-best levels.
Union Pacific also has less exposure than Burlington to consumer-related intermodal products. Much of Burlington’s consumer business is driven by imports from abroad–an area that hasn’t slowed down at all. It remains slightly more exposed to the domestic side than Union Pacific.
I continue to see the potential for more upside in Union Pacific. Please note my revised buy target and stop recommendations listed in the Portfolio table.
Barges
Along a similar vein, I remain bullish on barge operator American Commercial Lines. Just like the rails, barges are used to transport both coal and agricultural commodities in and around the US. And because rail capacity has been ultra tight in recent years, some capacity has shifted to barges. Barges are also typically cheaper for certain routes.
The two largest single commodities for American Commercial are coal and grain shipments, accounting for about 40 percent of all revenues. Other bulk commodities include products as diverse as fertilizer, salt and cement.
In addition to barge revenues, American Commercial also has a subsidiary that constructs barges. The barges American Commercial builds are destined for its own fleet as well as for sale to other barge contractors.
I currently have American Commercial Lines rated hold only because the stock has run a great deal from my recommendation last summer. I’ll be re-evaluating that recommendation in light of the company’s earnings report and conference call today. For now, American Commercial remains a hold; note my raised stop recommendation in the Portfolio table.
Airlines
The final subgroup I cover within the transports is the airlines. Airlines are an excellent play on stable or falling oil and refined product prices.
Airlines continue to benefit from rising demand for air travel, coupled with the elimination of the overcapacity that’s plagued the group for years. Although airlines have traditionally been poor investments, they’ve been taking steps to improve their fate in recent years.
The biggest problem airlines have faced is overcapacity; too many planes flying too many routes. Overcapacity leads to fierce competition and falling fares. This is the prime reason few airline stocks have made money traditionally.
But domestic air carriers have been rationalizing capacity in recent years, cutting flights and retiring planes. With demand still rising, planes are fuller than they’ve been in any year since 2000. And for the first time since 2000, the airlines actually made money last year.
The renaissance in the airlines has been somewhat masked by rising fuel prices during the past few years; jet fuel is an airline’s largest single cost center. It’s testament to the improvement in this industry that the airlines have managed to boost fares fast enough to compensate for rapidly rising fuel prices in 2004, 2005 and the first half of 2006.
My play on the group is UAL Corp (NSDQ: UAUA), the parent of United Airlines. My thesis in recommending the stock last October was that fuel prices had stabilized in the $55 to $65 region and that was enough to remove the only major headwind to the group.
Another non-operational factor that’s been helping UAL and the other airlines is takeover talk. Specifically, US Airways made a bid to buy Delta out of bankruptcy in November. UAL has some highly attractive routes and hubs; it, too, is a likely merger partner.
This recommendation has performed well for us. I recommended selling out of half the position for a roughly 30 percent gain in late November. But lately there have been a few headwinds for the group.
Specifically, fuel prices are rising again, hurting sentiment on the group. Second, US Air’s takeover offer for Delta has hit some snags; Delta is vehemently fighting the bid, cooling merger speculation in the group. Finally, a series of vicious winter storms in the west in the fourth quarter hurt profitability at several carriers, including UAL. I’m now recommending you sell out of the remaining half position in UAL and accept a profit of about 45 percent.
To play the air renaissance, I now prefer exposure to aircraft leasing companies. Topping that list is AerCap Holdings (NYSE: AER), a stock I highlighted in a Jan. 10, 2007, flash alert. Here’s a brief review.
AerCap Holdings is the world’s largest publicly traded aircraft leasing firm. The company owns 109 aircraft and 61 aircraft engines. In addition, AerCap has close to 100 new planes on order and manages an additional 110 airplanes. In short, within a few years, the company will have a total fleet of more than 300 planes and some 70 aircraft engines.
AerCap rents these planes and engines to major airline carriers under terms known as an operating lease. Under an operating lease, the lessee (the airline) bears all the ongoing costs of maintenance; the lessor (AerCap) gets the plane back at the end of the lease’s term and can re-lease the plane or sell it.
AerCap gets to retain the terminal value of the plane at the expiration of the lease. In total, the company currently leases its planes to 100 different air and cargo carriers based all over the world.
Aircraft leasing has become more popular in recent years. According to AerCap, about 30 percent of the world’s fleet of airplanes is currently under operating leases; that number is expected to expand to more than 40 percent by 2020.
Better still, demand for air travel in markets like China and India is truly booming. Millions of developing market consumers are now able to afford air travel for the first time. AerCap has focused a good deal of its recent leasing activity on these markets; growth is particularly strong in Asia/Pacific markets.
Finally, because of rising demand for airplanes, most of the major manufacturers are already booked up for the next few years. They can’t build any more planes than they’ve already committed to. If airlines wish to expand their fleet, they have to deal with leasing operators like AerCap that have some spare capacity. AerCap Holdings remains a buy.
Back To In This Issue
Oil And Gas Services
In last Friday’s edition of The Energy Letter “No Easy Way” I highlighted Wildcatter Portfolio recommendation Schlumberger’s (NYSE: SLB) recent conference call and earnings report. Specifically, the company offered up the most-direct support yet for the thesis that the world is running out of “easy” oil.
I’ve highlighted this argument on a few occasions, most recently in the Jan. 3, 2007, issue The Deep End. To summarize, the world has traditionally depended on production from a handful of large, onshore oil fields to satisfy most of its demands. But those fields are now rapidly aging, and production is falling.
To fill the gap, the world will increasingly depend on harder-to-produce reserves; deepwater wells, artic drilling and unconventional plays–such as the oil sands and oil shale–are just a few examples. Or, in some cases, it’s more a matter of employing more-advanced technologies to more fully exploit existing fields.
This long-term trend bodes well for the services business. Specifically, any companies that control the technology and/or equipment needed to produce more complex reservoirs effectively are well placed to thrive in a post-easy oil era.
Schlumberger tops the list. It should come as little surprise that the stock was among the top three performers in the OSX index during the past year–one of the names in my best of the OSX index above.
Schlumberger’s management team made the following statement in its opening comments on the conference call:
Source: Schlumberger Conference Call Jan. 19, 2007
Schlumberger is endorsing the end of easy oil thesis. The company states that it sees no overall shortage of oil or gas, but that extracting those reserves will be expensive and require more-advanced techniques. The statement also seems to endorse continued growth in the Eastern Hemisphere, countries like Russia and Saudi Arabia have been ramping up their spending in recent years to maintain their production.
But these concepts are longer term in nature. The most closely watched data point to come out of Schlumberger’s call was the company’s outlook for drilling activity and profitability in North America. Projects in the Eastern Hemisphere tend to be large-scale, multiyear deals; such projects aren’t terribly sensitive to commodity prices. In other words, most such projects would continue to go ahead whether oil is at $45 or $70.
But the same can’t be said for North America. In the US and Canada, drilling projects tend to be smaller scale; many deals are undertaken by small, so-called “checkbook” operators that only manage a handful of wells. Such producers are extraordinarily sensitive to commodity pricing. If oil and gas prices fall, such players can and do decide to delay or cancel drilling plans.
The primary concern among most analysts has been that weakness in commodity prices and, in particular, the price of natural gas would start to have a more-profound impact on gas drilling activity. These concerns have continued to snowball in light of the fact that inventories of natural gas in storage remain higher than average; a warm start to the winter only exacerbated this issue. Check out my chart below for a closer look at current gas inventories.
Source: EIA, Bloomberg
This chart shows US gas in storage for every year from 2002 through 2007. It’s clear that inventories of gas remain well above the five-year average. While colder weather has begun to moderate this situation, it will likely take a few more weeks of bitterly cold weather to bring inventories back under control.
This inventory overhang was also the case for most of 2006; a warm winter in 2005-06 is what initially caused the excess inventories to build up. That excess supply is the reason that gas prices have been capped in recent quarters.
The market has been looking for signs of weakness in North America for more than a year now. The vulnerability of this area has also been an ongoing theme of TES. I highlighted it in great depth in the June 14, 2006, issue The Good, the Bad, The Ugly. This is also why I recommended shorting BJ Services (NYSE: BJS) and Patterson-UTI (NSDQ: PTEN) last summer; we covered both shorts in the fall for a profit.
However, only lately have any real signs of problems emerged. The likelihood is that producers had hedged enough of their production using the futures market to maintain production for a time; recently lower prices have begun to pinch.
The first signs of weakness appeared in two areas of the gas drilling market: coal bed methane (CBM) wells and Canadian shallow gas. Both types of play are considered higher-cost plays; these were the first plays to get hit by falling gas prices.
But the real damage was limited; any drilling rigs released by CBM or shallow-gas operators were immediately booked by producers operating in other markets.
We’re now seeing some more real signs of weakness in North America, particularly in the Canadian market. Schlumberger stated that it’s seen no real weakness yet in the US land market while Canadian weakness has deepened during the past few months. But just because the US hasn’t weakened yet doesn’t mean it never will.
Schlumberger stated that it has a plan A and plan B for 2007–which plan it follows depends entirely upon what happens during the next four to six weeks. Schlumberger suggested that most US producers are waiting to see where gas inventories stand at the end of the winter heating season–sometime around mid-March.
If inventories are still excessive, it’s likely US producers will look to tighten their belts further. If, however, the slowdown in Canadian production–coupled with the final arrival of winter weather normalizes inventories–there’s room for continued growth.
This same basic theme was echoed by other companies in the services business, most particularly, BJ Services. BJ Services specializes in the pressure pumping business.
Oil and natural gas don’t exist underground in giant caverns or lakes; instead, hydrocarbons are found inside the pores, cracks and crevices of underground rock formations. The more holes and cracks in a rock, the more porous that rock is.
But just because there are pores in a reservoir rock filled with oil and gas doesn’t mean that it’s easy to produce. Specifically, if those pores aren’t well connected, it’s difficult for hydrocarbons to flow through the reservoir rock into the well. Rocks with well-connected pores are termed “permeable.”
Pressure pumping is a way of producing reserves that lack permeability more effectively. This problem is the case with many important gas plays, like the Barnett Shale and Rockies tight gas. One of the more common pressure pumping services is fracturing–this involves pumping a gel-like liquid into an impermeable formation to actually crack the reservoir rock and create channels that make it easier for the gas or oil to flow to the well. Pressure pumping improves the permeability of the reservoir.
While some pressure pumping work is done outside the US—with Russia being one of the more talked-about new markets–right now this is primarily a North American business. Companies that specialize in this market are the most exposed to any downturn in US and Canadian drilling activity. That list would most certainly include BJ Services.
The company is highly focused on North American pressure pumping. Unlike Schlumberger and some of the other internationally focused services firms, BJ doesn’t have an ultra-strong, commodity-resistant Eastern Hemisphere business to fall back on.
BJ echoed Schlumberger’s comments about the North American market. It highlighted several areas of weakness:
In light of these comments, it’s hardly surprising that BJ missed estimates by 6 cents and cut its 2007 capital spending plans from $700 million to $650 million. The company also stated that its guidance for 20 percent revenue growth this year is at risk if gas prices average under $7.50 per million British Thermal Units (MMBtu), the price on which its basing all its projections.
Schlumberger’s management team has long highlighted the potential risk of the US pressure pumping market. Since the business has been so strong in recent years, companies have been adding capacity in the form of pumping trucks and compressor equipment; this is the equipment that’s needed to handle pressure pumping jobs. According to BJ, the company added 15 to 18 percent capacity in 2006; management believes some smaller players added even more capacity than that.
This isn’t much of a problem when the industry is red hot–there’s more than enough demand to absorb all that supply. But if rising supply meets falling demand, the result can be disastrous: serious pricing erosion. That’s exactly what’s been happening of late.
Rising expectations that this would be the case is exactly why BJ Services was such a poor performer last year; the company was one of the worst three performers in the OSX index. Even more problematic, consider the case of Calfrac Well Services (Toronto: CFW).
Source: stockcharts.com
Calfrac is a Canadian company specializing in the pressure pumping market. The extreme weakness in Canadian drilling, coupled with growing overcapacity in pressure pumping, explains the swoon in the stock during the past year. While BJ’s US business is still growing and helping to offset weakness in Canada, Calfrac doesn’t have that advantage.
The same basic problem applies to contract drillers focused on North American land drilling projects. Land drilling rigs are relatively cheap and easy to build; a flood of new rigs has been activated in the US and Canadian markets during the past few years. Day rates–the fee charged for renting the rigs–have been rising mainly because demand has been so high.
But Nabor’s (NYSE: NBR) and Patterson-UTI, both land drillers with major exposure to North America, announced weaker-than-expected results for the fourth quarter. This is yet another sign of a slowdown in this market.
I’ve now spilled considerable ink highlighting the growing weakness in the North American market. But despite these negative commentaries on North America, I’m not recommending you short these stocks at this time. In fact, I’m upgrading BJ Services, Nabor’s or Patterson-UTI from sells to holds inside in coverage universe How They Rate.
The reason is simple: The worst news is now out on these names. For months, analysts, investors and companies speculated on the potential for a North American slowdown. It was the anticipation of that pullback in activity that caused the stocks to underperform so markedly last year.
This is also why I recommended avoiding or shorting all the North America levered names last year. I see the recent announcements that a slowdown is upon us as the final straw–the long-awaited slowdown in North American drilling is finally evident for all to see.
There’s an old saw on Wall Street that says it’s always darkest before the dawn. In other words, the news is always worst just as a stock bottoms out; at that magic moment, the worst news is in the stock, and there are few bulls left to sell out. Take a look at the two charts below.
Source: stockcharts.com
Source: stockcharts.com
Both of these companies announced some very weak results since the beginning of the year. Analysts were projecting that BJ Services would earn close to $0.85 per share in the first quarter of this year last summer. Now, estimates for the quarter are closer to $0.75 and continue to fall.
Estimates for the second quarter have dropped from about $0.76 to $0.68 during the same time frame. And the recent miss resulted in a host of additional downgrades for the stock—it now has the lowest-average recommendation of any stock in the OSX index. In short, sentiment isn’t currently positive for either BJ Services or Nabor’s.
Yet, despite all the negative news, both stocks have been working higher since the beginning of the year. This suggests to me that, as I outlined above, the North American slowdown was already a well-known fact–something that investors had been projecting for months now.
Before recommending these stocks as buys in the Portfolios, I want to see a more meaningful sign that the market is looking beyond near-term gas weakness. But given just how badly these stocks have been beaten up during the past year and how negative the sentiment is, I think it’s a very bad idea to be shorting North American gas-levered names at this time.
Bottom line: After more than a year of recommending investors avoid such stocks, I’m now more inclined to look for a buying opportunity. In addition, if the winter remains cold and inventories continue to normalize, the recovery rally in stocks like BJ Services should be impressive. Finally, Canada is America’s largest source of imported gas right now; the sharp drop in activity there is already filtering through in the form of moderating production. Stay tuned during the next few months as I’ll be looking for an opportunity to recommend jumping in.
The one stock levered to North America that I’m recommending is offshore driller Rowan Companies (NYSE: RDC). Rowan owns a fleet of so-called jackup rigs. Such rigs are used for drilling in waters below 300 feet deep. Traditionally, Rowan has focused its attention on the shallow water Gulf of Mexico market.
But, during the past year or so, the returns available for jackup rigs in international markets–such as Saudi Arabia and the North Sea–have been higher and more stable than in the Gulf of Mexico. International producers have been offering longer-term contracts for jackups at very attractive rates.
Rowan has mobilized several of its rigs for work outside the US. Other contractors that traditionally handle Gulf of Mexico work have done the same. In addition, many jackups were damaged in the vicious 2005 hurricane season; several damaged rigs will likely never be put back into service. The result: The supply of rigs in the Gulf of Mexico has been falling steadily for more than a year now.
Shallow water drilling in the Gulf of Mexico often targets natural gas, and it’s not the cheapest market to drill. Day rates in the Gulf of Mexico spiked throughout most of 2005 and early 2006 but have moderated somewhat since that time as a result of falling gas prices.
Gulf-focused jackup drillers–Todco (NYSE: THE), Ensco (NYSE: ESV) and Rowan are the biggest players in this market–have been hit as a result.
But signs are that it’s starting to change. Day rates have begun to tick higher in the Gulf–some of the more-advanced jackup rigs have seen higher day rates lately. I suspect this trend could gain steam if there’s any significant up-tick in Gulf of Mexico drilling activity.
The reason is simply that moderating demand has masked the massive drop-off in available rigs in this market. A falling supply of rigs in the Gulf has put a floor under day rates. Unlike the land rig market, there’s little scope for supply of rigs to grow during the next few years. On any up-tick in demand, there’s a significant potential for a real supply squeeze in the Gulf. The last such squeeze occurred during the spring/summer of 2005 and was profitable for the Gulf-focused jackup drillers.
Rowan should see a big run if gas inventories moderate and prices stabilize as I expect. Meanwhile, the stock is already pricing in a lot of bad news despite the fact that Rowan’s foreign contracts are highly profitable and cash-generative for the company.
I don’t see much downside from current levels. Rowan rates a buy in the Gushers Portfolio.
While North America is a turnaround story at this time, international markets continue to see acceleration. Again, Schlumberger’s call was instructive in this regard.
Schlumberger stated that although it saw some pockets of weakness in the North American land market, the deepwater Gulf remains red hot. Deepwater activity is making up for a good deal of the weakness onshore; management stated that it has confidence that there will be no moderation in deepwater activity despite the slowdown onshore.
The company’s seismic mapping business (highlighted in the most recent issue of Portfolios. Clearly, as I mentioned above, Schlumberger is the top services play with diversified geographic exposure and most-advanced, state-of-the-art technologies in areas like seismic. Schlumberger remains a buy.
And given the extreme strength in Schlumberger’s seismic business, I also recommend Petroleum Geo-Services (NYSE: PGS), an offshore and deepwater seismic specialist with a strong position in Europe. Petroleum Geo doesn’t have quite the technological superiority that Schlumberger does in seismic, but there’s more than enough demand to go around. Petroleum Geo has also seen high demand for its ships; the company has pricing power. Keep buying Petroleum Geo-Services.
When it comes to deepwater work, Norway’s Seadrill (Oslo: SDRL; OTC: SDRLF) is the only contract driller in the world right now with significant spare capacity of deepwater rigs available for hire in 2008 and 2009. While some other operators have a few rigs available over this time period, Seadrill has by far the most uncommitted capacity.
Many of Seadrill’s rigs are still under construction right now. However, the company has managed to secure contracts at very attractive day rates for these rigs; as soon as they’re built, the rigs are headed out on contract. That just underscores the extreme strength and high activity in this market. Buy Seadrill.
Finally, you can’t complete a deepwater project without sub-sea equipment—this equipment is a maze of high-pressure valves and pipes that regulate the flow hydrocarbons from deepwater wells. As explained at length in the Jan. 3, 2007, issue The Deep End, my favorite play in this market is FMC Technologies (NYSE: FTI). FMC Technologies rates a buy.
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Coal
I discussed the coal industry at some length above in writing about the transports, so I won’t belabor those points again. Suffice it to say that I prefer miners with exposure to Western coal mining regions; these firms have less exposure to the rapid price inflation and falling spot coal prices that continue to plague the eastern miners. My favorite coal-mining name is Peabody Energy, one of the world’s largest coal miners.
Although eastern miners’ stocks have fallen a good deal over the past year, I see the group as a value trap. I still see additional downside in these stocks. In fact, we’ve already seen some smaller, privately held “checkbook” operators in Central Appalachia (CAPP) go bankrupt; I wouldn’t be surprised to see one of the larger publicly traded miners end up in the same boat.
One of the most profound comments out of Peabody Energy’s call was when the CEO was asked about the potential to acquire new mines in CAPP. The questioner noted that because of weak fundamentals in the region, mine prices have fallen considerably over the past year; he asked if the mines were cheap enough to tempt Peabody.
But Peabody answered with a fairly emphatic “no.” Management stated unequivocally that it sees the potential for better and safer investment returns in other coalfields in the US and internationally. The company said that despite the decline in coalmine valuations, it has no interest in CAPP mines. The company made similar comments during an analyst day meeting earlier in the month.
If one the world’s largest coal-mining firms with operations all over the world isn’t buying CAPP, I see no reason to jump in either. Peabody’s management has the ability to see exactly what’s going on and what business conditions are like in all the major coal-mining regions of the US. Therefore, this experienced management team has more knowledge of what represents good value than any analyst in my view.
I defer to Peabody here and recommend avoiding all CAPP-focused miners, such as International Coal Group, James River Coal, Massey Energy and Alpha Natural Resources.
The other interesting point to note from Peabody’s call was the company’s extreme geographic flexibility. For example, Peabody noted the weakness in US coal prices and has cut back its output from the Powder River Basin to match demand.
The company is also taking advantage of the temporary weather-induced weakness to install new equipment at its mines. This modern equipment can cut fuel usage and raise mining productivity. In the near term, these investments will mean lower operating costs; longer term, as coal demand returns, these same investments will render higher production.
Peabody also bought a large Australian mining firm, Excel Energy, last year. This company produces coal in Australia; much of that coal is destined for export to China and other parts of Asia.
Coal prices for export from Australia to China have, unlike US coal prices, been improving as of late. So, although the US is weaker than it was a year ago because of warm weather, Peabody can make up some of that with its fast-growing Australian operations. As the world’s largest exporter of coal, Australia is a prime beneficiary of Asia’s tremendous growth in demand.
Longer term, Peabody has been eyeing investments in even more unusual locales such as Mongolia. Management reports that Mongolia has some extraordinarily high-quality reserves, perfect for export into other parts of Asia.
Peabody’
We’re now in the middle of earnings season for the energy patch. Most of the companies I recommend and cover have already or will soon release their results and forecasts. In this issue, I’ll take a look at some of the key reports and conference calls so far and analyze what these reports mean for my recommended companies.
In This Issue
I’ve long maintained a bullish stance on the oil services industry but a bearish stance on companies overexposed to the volatile North American market. After months of anticipation, the slowdown in the North American market is evident, and services firms leveraged to the market are feeling the pain.
However, with that news now well known, I’m looking for a stellar buying opportunity in the group during the next few months. In the meantime, I continue to like a handful of internationally focused services firms that are benefiting from strong growth in oilfield activity overseas and in deepwater developments.
In addition, I’ll be taking a closer look at transports and coal mining firms. On the transport front, I see scope for continued upside in light of recent results; railroads still benefit from hauling record amounts of coal out of the Powder River Basin.
On the coal-mining front, I continue to recommend avoiding companies leveraged to Central Appalachia and focusing on more-diversified miners. With winter weather temperatures finally gripping the Eastern Seaboard, coal demand is rising, and I see the potential for a big run in the group into spring.
I’ll also take a look at one of the most-innovative deals in the master limited partnership (MLP) space of the past year: Enterprise Product Partner’s decision to spin-off Duncan Energy Partners.
Finally, in this issue, I’m pleased to include a special guest article from GS Early, editor of The Real Nanotech Investor. He’s an expert when it comes to all things related to technology. Below he examines some new battery technologies and their potential far-reaching impacts on energy storage and fuel-efficient vehicles.
They say investing in energy is all about predicting oil and natural gas prices’ direction. They also say that oil and gas stocks move as a group. But both are myths. See Tread Carefully.
Transportation and energy are closely linked. I review the importance of railroad, barges and airlines in regards to energy. See Transports
One of my top performing oil and gas services company said in its recent conference call that the world is running out of easy oil. Analysts are concerned with how weak commodity prices will affect gas drilling. And signs of weakness in North America are starting to emerge. See Oil And Gas Services
My main coal mining recommendation recently held a conference call in which it was asked about the potential to acquire new mines in Central Appalachia. When the management of the country’s biggest coal miner tells you it’s steering clear of a certain region, though, you’d best follow its lead and avoid companies exposed to such areas. See Coal
Master limited partnerships (MLPs) have been one of my favorite long-term income plays in the energy patch. Now, one of my MLP recommendations has mastered a new way to increase cash flow and still retain the majority of its assets–resulting in another addition to my Portfolios. See Enterprising Enterprise
Although battery technologies don’t currently have the storage capabilities required to make them a solid alternative energy source, there are companies attempting to make headway in that field. GS Early has recently written on such developments; I include his article here. See The Future Of Energy.
In this issue, I’m recommending/reiterating my recommendation on the following stocks:
- AerCap Holdings (NYSE: AER)
- American Commercial Lines (NSDQ: ACLI)
- Burlington Northern Santa Fe (NYSE: BNI)
- Duncan Energy Partners (NYSE: DEP)
- Enterprise Products Partners (NYSE: EPD)
- FMC Technologies (NYSE: FTI)
- Peabody Energy (NYSE: BTU)
- Petroleum Geo-Services (NYSE: PGS)
- Rowan Companies (NYSE: RDC)
- Schlumberger (NYSE: SLB)
- Seadrill (Oslo: SDRL; OTC: SDRLF)
- Union-Pacific (NYSE: UNP)
In this issue, I’m also recommending avoiding or selling the following stocks:
- Alpha Natural Resources (NYSE: ANR)
- International Coal Group (NYSE: ICO)
- James River Coal (NSDQ: JRCC)
- Massey Energy (NYSE: MEE)
- UAL Corp (NSDQ: UAUA)
Tread Carefully
Perhaps one of the most-frustrating myths about investing in the energy patch is that it’s all about predicting the direction of oil and natural gas prices. One commonly held belief is that oil and gas-related stocks all move as a group–basically, in the same direction as the underlying commodities. For that matter, I’ve heard plenty of times from those believing that nuclear power, alternative energy and other nonhydrocarbon energy plays also follow oil and natural gas prices.
If that were the case, there would be little value in stock-picking or sector selection. The evidence, though, suggests otherwise–in fact, selectivity is the key to playing the group. A big picture outlook on commodity prices is important, but it’s only one piece of the puzzle.
In the early stages of the energy bull market, most stocks in the group moved higher. However, as time has passed, divergences in performance have become more obvious, and the stocks have seen vastly different performances.
For example, consider the 15 oil and gas services stocks that make up the Philadelphia Oil Services Index (OSX). This is the most widely followed index of large capitalization oil services names; the index includes a mixture of contract drillers, pure services stocks and some oil and gas equipment firms. My chart below compares the performance of the top 3 and bottom 3 OSX components during the past year.
Source: Bloomberg, The Energy Strategist
I created these two indexes using an equal weighting–the indexes aren’t sorted by market capitalization. It’s clear that if you had invested in the three top oil services stocks in early 2006, you’d currently be up more than 20 percent. While that’s off the highs registered in May, it’s still an impressive performance.
If, however, you’d been buying the worst three stocks in the OSX, that investment would be down close to 18 percent. That’s nearly a 40 percent return spread between the best- and worst-performing OSX stocks.
Keep in mind that the OSX is a relatively specific index that focuses on just one relatively small part of the energy business–services and contract drillers. If the difference between the best and worst performers in a relatively homogenous group can be that large, you can imagine how large the differences are between stocks in different energy subsectors.
I didn’t just pick the OSX out of the blue; in fact, the return spreads in different groups in the energy patch are even more stark. I reproduced a similar chart of coal stocks below.
Source: Bloomberg
One long-standing theme of this newsletter has been to prefer coal companies with a diversified geographical exposure to those with operations concentrated in Central Appalachia (CAPP). The “CoalWorst” index above is formed by equal weighting three coal mining firms focused on the CAPP region; “CoalBest” is formed of two diversified miners.
I’ll discuss and update this viewpoint below as well as my favorite plays in the group. For now, suffice it to say, coal is a volatile group that’s given to large swings in sentiment. There’s a time to own these names and a time to sell them.
However, the chart above illustrates that when you own coal stocks, it’s best to focus on quality, diversified names. The CoalBest index outperformed the CoalWorst during the January through May run-up last year and the vicious decline in the group after the middle of the year. The final tally: Both groups are down somewhat, but the better stocks are off less than 15 percent while the CAPP-focused miners are off more than 60 percent.
My point in bringing this up is simply that far too many investors focus solely on the macro picture for oil and natural gas and ignore the fact that the energy patch is a diverse group, perhaps one of the most-diverse sectors in the market today. There are real, fundamental reasons behind the wide divergence in performance among the stocks highlighted in my two charts above.
To fully understand what’s going on and how to profit from it requires reviewing how individual companies are performing and where the strengths and weaknesses are. Earnings season is a great time to sort out these moving parts–company reports and conference calls can give us a better picture of how to position ourselves and what stocks to buy.
But analyzing company reports involves a lot more than just finding what businesses are strong and which are weak. It’s also a matter of discerning how stocks react to news and their earnings releases.
For example, companies that report great news and then see their stocks sell off sharply may already be priced for perfection. On the flip side are companies that actually rally after reporting negative news–these stocks may well be washed out, with the worst-possible news baked into the stock.
In the past few issues, I’ve focused mainly on some of my long-term favorite themes–specifically, I’ve reviewed my favorite ways to play nuclear power, biofuels, alternative energy and deepwater drilling. For newer subscribers unfamiliar with these recommendations, I recommend checking out the last issue of TES “Another Alternative”. It has many links to relavent articles in the archives.
Below I’ll take a closer look at some of the major themes that have emerged recently across the various sectors I cover in TES. Specifically, the energy patch is in the middle of fourth quarter earnings season, and I’ll examine some key trends highlighted in the slew of earnings news and conference calls released during the past few weeks.
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Transports
Many investors don’t even consider the transportation industry when they think of energy stocks. That’s a mistake. Transportation and energy are industries that are inextricably linked. I highlighted the transports at some length in the July 12, 2006, issue of TES Beyond Oil and Gas, but the theme is worth reviewing.
Consider the railroads. Close to 70 percent of the coal moved in the US is transported by railroad; coal (by weight) is by far the most-important commodity moved by railroad in the US. Increasingly, coal is being moved longer distances in the US.
The reason is simple: The Eastern half of the US burns a great deal of coal, and traditionally, most of the coal supplied to the region has come from the CAPP coal district. CAPP is an area encompassing such states as West Virginia, Pennsylvania, Kentucky and Virginia. Railroads in the east would connect mines in these states to power plants all across the Eastern Seaboard and parts of the Midwest.
This basic arrangement has been going on for more than a century, and I suspect it will continue for years to come. However, there’s a problem with CAPP coal supplies. Check out my chart below.
Source: EIA
The chart shows coal production from the three main producing regions of the US: Appalachia, Interior and the western US. Note that up until roughly a decade ago, the Appalachia region was the most-important coal-producing region of the US. But that’s rapidly changing as production from the western coal region has soared in recent years.
According to the Energy Information Administration (EIA) estimates that this basic trend is likely to continue. The West will continue to be America’s dominant coal-producing region with that dominance increasing over time. Meanwhile, production from the Appalachia region in the East has actually declined in recent years, a trend the EIA also expects to continue.
The problem with Appalachia isn’t that there’s no coal there or that the coal is largely of poor quality. In fact, its high-grade coal is about the best you’ll find anywhere in the world.
Appalachia, though, is a mature coal-mining region that’s been exploited for more than a century. Coal seams in the area are thinning, and much of the mining is done underground.
Underground mine work takes skilled labor, and even then it’s dangerous work. Costs of mining in the region are rising while many producers struggle to meet production goals.
The primary western coal mining region is the PRB, located in such states as Wyoming and Montana. Coal in this region is located close to the surface and is far easier to mine. Labor requirements are lower on a per-ton basis, and it’s easier and faster to train miners for surface operations.
Better still, much of the coal mined from the region is low in sulphur–this is important because sulphur emissions are controlled by the government, and burning low sulphur coal is one of the most-straightforward means of cutting those emissions.
To make a long story short, as time goes on, more and more of that PRB coal will have to move east to satisfy demand. Steadily falling production from CAPP will only exacerbate the situation. The PRB will be filling that gap.
Also accelerating demand is the fact that a number of new coal plants are scheduled to be built in the east to satisfy rapidly growing power demand. More coal plants spell rising demand for coal. The vast majority of that coal will be moved by rail eastward. That’s a much longer and more-profitable route for the rails than hauling coal from CAPP to East Coast power plants.
But coal is certainly not the only commodity moved by rail. Agricultural products–such as corn, wheat and soybeans–are key determinants of rail demand. Grains have to be hauled from Midwestern farms to export ports. And increasingly, ethanol is becoming a key corn consumer in the US.
Ethanol cannot be transported by pipeline due to the fact that it corrodes pipe and has a nasty habit of evaporating too easily. So ethanol is primarily moved by rail. Rising demand for foodstuffs and biofuels is another major force behind growing rail demand.
When it comes to playing the railroads, my two favorites are Wildcatters Portfolio recommendation Union Pacific and fellow western rail Burlington Northern Santa Fe. These two railroads are the big players in the PRB and stand the most to gain from rising demand for PRB coal. Both also have large agricultural transport businesses and are benefiting from growing biofuel demand.
These two railroads reported earnings and held their conference calls in late January. They highlighted some of the same basic trends.
Specifically, the coal business continues to be the strongest product line for both companies. Union Pacific and Burlington Northern reported record tonnage hauled out of the PRB in the fourth quarter. In recent years, the two rails have been improving their track networks in the region so that they’re capable of hauling more coal–these investments are necessary to keep pace with demand.
A glaring lack of rail transport capacity has been the biggest impediment to greater use of PRB coal. Both railroads plan to continue addressing this bottleneck by pursuing aggressive capital spending plans to improve and upgrade their tracks. Given continued strong demand for western coals, these two railroads have been able to raise prices charged for shipping coal and are currently recovering close to 90 percent of their fuel (diesel) costs through special fuel surcharges.
The coal transport business is a contract business; railroads sign multiyear contracts to haul coal to utilities. As older contracts roll over, the rails have been able to demand increasingly attractive pricing and fuel surcharges on newer deals.
For Union Pacific and Burlington Northern, roughly 5 to 15 percent of their coal-related hauling contracts are renewed each year. Pricing has been and should continue to rise gradually over time to reflect the positive environment.
Both railroads also reported strength in the transport of agricultural products. Some of this was because of strength in the export market. As my chart below shows, Chinese corn consumption continues to rise inexorably.
But domestic demand is also ultrastrong; Union Pacific reported 50 percent growth in shipments of ethanol and 64 percent growth in shipments of dried distiller’s grain (DDG), a by-product of ethanol production used to feed livestock.
Source: Bloomberg
During the conference calls for both companies, analysts focused on three potential areas of weakness: A notable slowdown in domestic intermodal, slowing industrial volume and coal inventories and the weather.
A notable slowdown in domestic intermodal: Union Pacific and Burlington Northern reported weakening volume growth in domestic intermodal transport and industrial transport. Intermodal transport involves the carrying of goods across multiple modes of transport. On the domestic front, that typically means goods that are transported partly by truck and partly by rail. Much of this traffic is consumer goods of varying descriptions.
The truckers have been having a terrible run of late. The obvious slowdown in economic growth in the latter half of 2006 spells lower volumes of freight carried by truck. Last October, truck tonnage slipped 4 percent year-over-year, the largest decline in five years.
And there’s also a big shortage of skilled drivers. Labor costs in the trucking industry are soaring, and experienced truckers are in high demand. The trucking firms are now getting squeezed on the cost and the demand sides of the equation. To make matters worse, a price war has kicked off with truckers cutting prices to try and raise demand.
Since the railroads are another link in the domestic intermodal supply chain, weakness in the trucking industry has obvious implications for domestic rail demand. First, lower truck volume spells lower intermodal volumes to pass on to the rails. Second, a price war among the truckers could theoretically limit the rails’ ability to hike hauling prices on goods transported–they actually compete with truckers to a limited extent on some shorter-haul routes.
Slowing industrial volumes: According to both companies, slowing industrial volumes can be attributed primarily to weakness in the housing market. Union Pacific reported an 11 percent reduction in car loadings in its industrial segment led by a 28 percent reduction in lumber loadings, a 13 percent drop in shingles and roofing materials and an 11 percent reduction in rock transport.
Burlington Northern’s management team described the downturn in lumber and other building product demand as “steep” in the fourth quarter. Both companies are factoring in continued weakness in industrial products as we head into the first half of 2007.
Coal inventories and the weather: As noted above, demand for coal remains robust, and normal contract rollover continues to power pricing increases for both firms. Nonetheless, analysts on both conference calls repeatedly asked management to give more specific guidance on coal demand for 2007. Because the coal business has been leading the rail renaissance, any sign of a prolonged downturn in the coal business would be problematic.
Both Union Pacific and Burlington Northern reported some problems early in 2007 due to a series of winter storms affecting their western networks. Unlike in the East, places such as Colorado and Wyoming saw a nasty start to the winter season. Both rails are recovering from this problem; it’s only a short-term issue.
The more profound question has to do with coal demand. Warm winter weather across the East in December and early January reduced heating demand. As I’ve noted in prior issues, this led to a reduction in demand for natural gas and rising inventories of gas. That, in turn, put pressure on gas pricing.
Coal has seen a similar pattern–lower heating demand spells lower demand for electricity and rising coal stockpiles at the nation’s power plants. The key question is whether rising inventories of coal will serve to crimp demand for coal transported from the West.
So far, the answer appears to be that it hasn’t affected transport demand. Both Union Pacific and Burlington Northern saw record volumes coming out of the West in the fourth quarter. Keep in mind that although inventories are building, they’re building back up from record lean levels of a year ago.
Some utilities saw their inventories run dangerously low in late 2005. There’s a good chance that utilities are taking advantage of the warmer weather to pad their inventories and avoid getting into a similar situation again this year.
But these two rails suggested that if warm winter weather continues through the rest of the first quarter, there would be an impact. Based on management comments, it appears that that impact would be worst in the East.
There’s still some pent-up demand for low-sulphur western coal. And moreover, the reduction in coal demand would likely lead to a lower growth rate in coal transported, not an actual year-over-year decline in volumes.
My take on the railroad industry remains largely unchanged. We’ve already seen a sharp drop in demand for shipping products leveraged to the housing business. Both Union Pacific and Burlington Northern have exposure to these areas, but that exposure isn’t big enough to offset strong growth in coal and agricultural product demand. Union Pacific, for example, only gets around 2 percent of its revenues from lumber.
Weakness in these areas is already a well-known fact and was the subject of considerable chatter during their recent conference calls. The stocks, however, rallied despite that negative tone. This is a good signal that this bad news is already baked in.
Furthermore, recent economic data suggest a reacceleration in economic growth as we head into 2007. Since both Union Pacific and Burlington Northern have offered fairly dire guidance for their industrial products and domestic intermodal segments, there’s a lot of room for an upside surprise if economic growth continues to firm up.
One area that worries me is coal demand. However, a warm early January in the East has given way to bitterly cold weather during the past three weeks–some of the coldest weather of the past decade. Looking at the 10-day weather forecasts for New York, Washington, DC, Chicago and Boston reveals that these cities are only expected to see one day of above-average temperatures during the next 10 days.
We’re already seeing the effects of colder weather in the form of higher demand for natural gas and falling inventories. Coal demand is also rising.
Bottom line: The picture for coal demand is improving, and western coal demand will remain resilient.
I slightly prefer Union Pacific to Burlington Northern at this time because it’s in the middle of an operational turnaround plan that’s been leading to improved efficiency at the railroad. One of the most-commonly quoted measures of railroad financial performance is what’s known as the operating ratio, a measure of operating expenses as a percentage of total revenues. The lower the operating ratio, the more efficient the railroad.
Another metric to pay attention to is velocity, literally how fast trains are moving (in miles per hour) across the network. The faster the velocity the more capacity a railroad can handle and the higher potential profits. Another way to look at this is that, by making operational improvements, a train operator can move more goods without hiring more employees or buying new locomotives.
Union Pacific kicked off a restructuring plan to improve its operations in late 2005. At that time, Union’s operating ratio was in the mid-80s. In the fourth quarter, the company’s operating ratio fell below 80 for the first time since 2003 while velocity increased by 7 percent over the third quarter. The turnaround plan is starting to bear fruit, and management is looking for operating ratios to continue falling towards the mid-70s by the end of the decade.
Union’s operating efficiency still lags that of Burlington. Burlington’s operating ratio is already in the mid-70s. But the stock has room to play catch-up as ratios continue to improve toward industry-best levels.
Union Pacific also has less exposure than Burlington to consumer-related intermodal products. Much of Burlington’s consumer business is driven by imports from abroad–an area that hasn’t slowed down at all. It remains slightly more exposed to the domestic side than Union Pacific.
I continue to see the potential for more upside in Union Pacific. Please note my revised buy target and stop recommendations listed in the Portfolio table.
Barges
Along a similar vein, I remain bullish on barge operator American Commercial Lines. Just like the rails, barges are used to transport both coal and agricultural commodities in and around the US. And because rail capacity has been ultra tight in recent years, some capacity has shifted to barges. Barges are also typically cheaper for certain routes.
The two largest single commodities for American Commercial are coal and grain shipments, accounting for about 40 percent of all revenues. Other bulk commodities include products as diverse as fertilizer, salt and cement.
In addition to barge revenues, American Commercial also has a subsidiary that constructs barges. The barges American Commercial builds are destined for its own fleet as well as for sale to other barge contractors.
I currently have American Commercial Lines rated hold only because the stock has run a great deal from my recommendation last summer. I’ll be re-evaluating that recommendation in light of the company’s earnings report and conference call today. For now, American Commercial remains a hold; note my raised stop recommendation in the Portfolio table.
Airlines
The final subgroup I cover within the transports is the airlines. Airlines are an excellent play on stable or falling oil and refined product prices.
Airlines continue to benefit from rising demand for air travel, coupled with the elimination of the overcapacity that’s plagued the group for years. Although airlines have traditionally been poor investments, they’ve been taking steps to improve their fate in recent years.
The biggest problem airlines have faced is overcapacity; too many planes flying too many routes. Overcapacity leads to fierce competition and falling fares. This is the prime reason few airline stocks have made money traditionally.
But domestic air carriers have been rationalizing capacity in recent years, cutting flights and retiring planes. With demand still rising, planes are fuller than they’ve been in any year since 2000. And for the first time since 2000, the airlines actually made money last year.
The renaissance in the airlines has been somewhat masked by rising fuel prices during the past few years; jet fuel is an airline’s largest single cost center. It’s testament to the improvement in this industry that the airlines have managed to boost fares fast enough to compensate for rapidly rising fuel prices in 2004, 2005 and the first half of 2006.
My play on the group is UAL Corp (NSDQ: UAUA), the parent of United Airlines. My thesis in recommending the stock last October was that fuel prices had stabilized in the $55 to $65 region and that was enough to remove the only major headwind to the group.
Another non-operational factor that’s been helping UAL and the other airlines is takeover talk. Specifically, US Airways made a bid to buy Delta out of bankruptcy in November. UAL has some highly attractive routes and hubs; it, too, is a likely merger partner.
This recommendation has performed well for us. I recommended selling out of half the position for a roughly 30 percent gain in late November. But lately there have been a few headwinds for the group.
Specifically, fuel prices are rising again, hurting sentiment on the group. Second, US Air’s takeover offer for Delta has hit some snags; Delta is vehemently fighting the bid, cooling merger speculation in the group. Finally, a series of vicious winter storms in the west in the fourth quarter hurt profitability at several carriers, including UAL. I’m now recommending you sell out of the remaining half position in UAL and accept a profit of about 45 percent.
To play the air renaissance, I now prefer exposure to aircraft leasing companies. Topping that list is AerCap Holdings (NYSE: AER), a stock I highlighted in a Jan. 10, 2007, flash alert. Here’s a brief review.
AerCap Holdings is the world’s largest publicly traded aircraft leasing firm. The company owns 109 aircraft and 61 aircraft engines. In addition, AerCap has close to 100 new planes on order and manages an additional 110 airplanes. In short, within a few years, the company will have a total fleet of more than 300 planes and some 70 aircraft engines.
AerCap rents these planes and engines to major airline carriers under terms known as an operating lease. Under an operating lease, the lessee (the airline) bears all the ongoing costs of maintenance; the lessor (AerCap) gets the plane back at the end of the lease’s term and can re-lease the plane or sell it.
AerCap gets to retain the terminal value of the plane at the expiration of the lease. In total, the company currently leases its planes to 100 different air and cargo carriers based all over the world.
Aircraft leasing has become more popular in recent years. According to AerCap, about 30 percent of the world’s fleet of airplanes is currently under operating leases; that number is expected to expand to more than 40 percent by 2020.
Better still, demand for air travel in markets like China and India is truly booming. Millions of developing market consumers are now able to afford air travel for the first time. AerCap has focused a good deal of its recent leasing activity on these markets; growth is particularly strong in Asia/Pacific markets.
Finally, because of rising demand for airplanes, most of the major manufacturers are already booked up for the next few years. They can’t build any more planes than they’ve already committed to. If airlines wish to expand their fleet, they have to deal with leasing operators like AerCap that have some spare capacity. AerCap Holdings remains a buy.
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Oil And Gas Services
In last Friday’s edition of The Energy Letter “No Easy Way” I highlighted Wildcatter Portfolio recommendation Schlumberger’s (NYSE: SLB) recent conference call and earnings report. Specifically, the company offered up the most-direct support yet for the thesis that the world is running out of “easy” oil.
I’ve highlighted this argument on a few occasions, most recently in the Jan. 3, 2007, issue The Deep End. To summarize, the world has traditionally depended on production from a handful of large, onshore oil fields to satisfy most of its demands. But those fields are now rapidly aging, and production is falling.
To fill the gap, the world will increasingly depend on harder-to-produce reserves; deepwater wells, artic drilling and unconventional plays–such as the oil sands and oil shale–are just a few examples. Or, in some cases, it’s more a matter of employing more-advanced technologies to more fully exploit existing fields.
This long-term trend bodes well for the services business. Specifically, any companies that control the technology and/or equipment needed to produce more complex reservoirs effectively are well placed to thrive in a post-easy oil era.
Schlumberger tops the list. It should come as little surprise that the stock was among the top three performers in the OSX index during the past year–one of the names in my best of the OSX index above.
Schlumberger’s management team made the following statement in its opening comments on the conference call:
…maintaining the production base for both oil and natural gas in the face of accelerating decline rates, poorer quality or more difficult reservoirs, and eroding reserve replacement ratios will mean that any moderation activity will be short-lived and self-correcting
While we remain of the opinion that there is no overall shortage of oil and gas reserves, the world is realizing that the period of cheap hydrocarbon energy has ended, and newer and higher sustained levels of investment are necessary to meet demand and guarantee future supplies.
We, therefore, expect to continue to see significant growth in 2007, particularly in the Eastern Hemisphere, for exploration, development, and production enhancement related services, where technologies are key to improving our customer’s performance and reducing their technical risk.
Source: Schlumberger Conference Call Jan. 19, 2007
Schlumberger is endorsing the end of easy oil thesis. The company states that it sees no overall shortage of oil or gas, but that extracting those reserves will be expensive and require more-advanced techniques. The statement also seems to endorse continued growth in the Eastern Hemisphere, countries like Russia and Saudi Arabia have been ramping up their spending in recent years to maintain their production.
But these concepts are longer term in nature. The most closely watched data point to come out of Schlumberger’s call was the company’s outlook for drilling activity and profitability in North America. Projects in the Eastern Hemisphere tend to be large-scale, multiyear deals; such projects aren’t terribly sensitive to commodity prices. In other words, most such projects would continue to go ahead whether oil is at $45 or $70.
But the same can’t be said for North America. In the US and Canada, drilling projects tend to be smaller scale; many deals are undertaken by small, so-called “checkbook” operators that only manage a handful of wells. Such producers are extraordinarily sensitive to commodity pricing. If oil and gas prices fall, such players can and do decide to delay or cancel drilling plans.
The primary concern among most analysts has been that weakness in commodity prices and, in particular, the price of natural gas would start to have a more-profound impact on gas drilling activity. These concerns have continued to snowball in light of the fact that inventories of natural gas in storage remain higher than average; a warm start to the winter only exacerbated this issue. Check out my chart below for a closer look at current gas inventories.
Source: EIA, Bloomberg
This chart shows US gas in storage for every year from 2002 through 2007. It’s clear that inventories of gas remain well above the five-year average. While colder weather has begun to moderate this situation, it will likely take a few more weeks of bitterly cold weather to bring inventories back under control.
This inventory overhang was also the case for most of 2006; a warm winter in 2005-06 is what initially caused the excess inventories to build up. That excess supply is the reason that gas prices have been capped in recent quarters.
The market has been looking for signs of weakness in North America for more than a year now. The vulnerability of this area has also been an ongoing theme of TES. I highlighted it in great depth in the June 14, 2006, issue The Good, the Bad, The Ugly. This is also why I recommended shorting BJ Services (NYSE: BJS) and Patterson-UTI (NSDQ: PTEN) last summer; we covered both shorts in the fall for a profit.
However, only lately have any real signs of problems emerged. The likelihood is that producers had hedged enough of their production using the futures market to maintain production for a time; recently lower prices have begun to pinch.
The first signs of weakness appeared in two areas of the gas drilling market: coal bed methane (CBM) wells and Canadian shallow gas. Both types of play are considered higher-cost plays; these were the first plays to get hit by falling gas prices.
But the real damage was limited; any drilling rigs released by CBM or shallow-gas operators were immediately booked by producers operating in other markets.
We’re now seeing some more real signs of weakness in North America, particularly in the Canadian market. Schlumberger stated that it’s seen no real weakness yet in the US land market while Canadian weakness has deepened during the past few months. But just because the US hasn’t weakened yet doesn’t mean it never will.
Schlumberger stated that it has a plan A and plan B for 2007–which plan it follows depends entirely upon what happens during the next four to six weeks. Schlumberger suggested that most US producers are waiting to see where gas inventories stand at the end of the winter heating season–sometime around mid-March.
If inventories are still excessive, it’s likely US producers will look to tighten their belts further. If, however, the slowdown in Canadian production–coupled with the final arrival of winter weather normalizes inventories–there’s room for continued growth.
This same basic theme was echoed by other companies in the services business, most particularly, BJ Services. BJ Services specializes in the pressure pumping business.
Oil and natural gas don’t exist underground in giant caverns or lakes; instead, hydrocarbons are found inside the pores, cracks and crevices of underground rock formations. The more holes and cracks in a rock, the more porous that rock is.
But just because there are pores in a reservoir rock filled with oil and gas doesn’t mean that it’s easy to produce. Specifically, if those pores aren’t well connected, it’s difficult for hydrocarbons to flow through the reservoir rock into the well. Rocks with well-connected pores are termed “permeable.”
Pressure pumping is a way of producing reserves that lack permeability more effectively. This problem is the case with many important gas plays, like the Barnett Shale and Rockies tight gas. One of the more common pressure pumping services is fracturing–this involves pumping a gel-like liquid into an impermeable formation to actually crack the reservoir rock and create channels that make it easier for the gas or oil to flow to the well. Pressure pumping improves the permeability of the reservoir.
While some pressure pumping work is done outside the US—with Russia being one of the more talked-about new markets–right now this is primarily a North American business. Companies that specialize in this market are the most exposed to any downturn in US and Canadian drilling activity. That list would most certainly include BJ Services.
The company is highly focused on North American pressure pumping. Unlike Schlumberger and some of the other internationally focused services firms, BJ doesn’t have an ultra-strong, commodity-resistant Eastern Hemisphere business to fall back on.
BJ echoed Schlumberger’s comments about the North American market. It highlighted several areas of weakness:
- Canadian pressure pumping revenues plummeted 19 percent; wells drilled in Canada fell more than 22 percent.
- Customers in the US and Canada chose not to keep drilling through the holiday season. During the past few years, drillers have continued working straight through Christmas and New Year’s–this is a significant decline in activity levels.
- Declines in activity spread from coal-bed methane wells and shallow gas drilling to other regions in Canada. CBM and shallow gas only account for 20 percent of revenues; if the activity declines keep spreading, BJ will feel the pinch.
- BJ feels that it won’t be able to push through another round of significant price increases in 2007 unless the gas-pricing environment improves more markedly.
In light of these comments, it’s hardly surprising that BJ missed estimates by 6 cents and cut its 2007 capital spending plans from $700 million to $650 million. The company also stated that its guidance for 20 percent revenue growth this year is at risk if gas prices average under $7.50 per million British Thermal Units (MMBtu), the price on which its basing all its projections.
Schlumberger’s management team has long highlighted the potential risk of the US pressure pumping market. Since the business has been so strong in recent years, companies have been adding capacity in the form of pumping trucks and compressor equipment; this is the equipment that’s needed to handle pressure pumping jobs. According to BJ, the company added 15 to 18 percent capacity in 2006; management believes some smaller players added even more capacity than that.
This isn’t much of a problem when the industry is red hot–there’s more than enough demand to absorb all that supply. But if rising supply meets falling demand, the result can be disastrous: serious pricing erosion. That’s exactly what’s been happening of late.
Rising expectations that this would be the case is exactly why BJ Services was such a poor performer last year; the company was one of the worst three performers in the OSX index. Even more problematic, consider the case of Calfrac Well Services (Toronto: CFW).
Source: stockcharts.com
Calfrac is a Canadian company specializing in the pressure pumping market. The extreme weakness in Canadian drilling, coupled with growing overcapacity in pressure pumping, explains the swoon in the stock during the past year. While BJ’s US business is still growing and helping to offset weakness in Canada, Calfrac doesn’t have that advantage.
The same basic problem applies to contract drillers focused on North American land drilling projects. Land drilling rigs are relatively cheap and easy to build; a flood of new rigs has been activated in the US and Canadian markets during the past few years. Day rates–the fee charged for renting the rigs–have been rising mainly because demand has been so high.
But Nabor’s (NYSE: NBR) and Patterson-UTI, both land drillers with major exposure to North America, announced weaker-than-expected results for the fourth quarter. This is yet another sign of a slowdown in this market.
I’ve now spilled considerable ink highlighting the growing weakness in the North American market. But despite these negative commentaries on North America, I’m not recommending you short these stocks at this time. In fact, I’m upgrading BJ Services, Nabor’s or Patterson-UTI from sells to holds inside in coverage universe How They Rate.
The reason is simple: The worst news is now out on these names. For months, analysts, investors and companies speculated on the potential for a North American slowdown. It was the anticipation of that pullback in activity that caused the stocks to underperform so markedly last year.
This is also why I recommended avoiding or shorting all the North America levered names last year. I see the recent announcements that a slowdown is upon us as the final straw–the long-awaited slowdown in North American drilling is finally evident for all to see.
There’s an old saw on Wall Street that says it’s always darkest before the dawn. In other words, the news is always worst just as a stock bottoms out; at that magic moment, the worst news is in the stock, and there are few bulls left to sell out. Take a look at the two charts below.
Source: stockcharts.com
Source: stockcharts.com
Both of these companies announced some very weak results since the beginning of the year. Analysts were projecting that BJ Services would earn close to $0.85 per share in the first quarter of this year last summer. Now, estimates for the quarter are closer to $0.75 and continue to fall.
Estimates for the second quarter have dropped from about $0.76 to $0.68 during the same time frame. And the recent miss resulted in a host of additional downgrades for the stock—it now has the lowest-average recommendation of any stock in the OSX index. In short, sentiment isn’t currently positive for either BJ Services or Nabor’s.
Yet, despite all the negative news, both stocks have been working higher since the beginning of the year. This suggests to me that, as I outlined above, the North American slowdown was already a well-known fact–something that investors had been projecting for months now.
Before recommending these stocks as buys in the Portfolios, I want to see a more meaningful sign that the market is looking beyond near-term gas weakness. But given just how badly these stocks have been beaten up during the past year and how negative the sentiment is, I think it’s a very bad idea to be shorting North American gas-levered names at this time.
Bottom line: After more than a year of recommending investors avoid such stocks, I’m now more inclined to look for a buying opportunity. In addition, if the winter remains cold and inventories continue to normalize, the recovery rally in stocks like BJ Services should be impressive. Finally, Canada is America’s largest source of imported gas right now; the sharp drop in activity there is already filtering through in the form of moderating production. Stay tuned during the next few months as I’ll be looking for an opportunity to recommend jumping in.
The one stock levered to North America that I’m recommending is offshore driller Rowan Companies (NYSE: RDC). Rowan owns a fleet of so-called jackup rigs. Such rigs are used for drilling in waters below 300 feet deep. Traditionally, Rowan has focused its attention on the shallow water Gulf of Mexico market.
But, during the past year or so, the returns available for jackup rigs in international markets–such as Saudi Arabia and the North Sea–have been higher and more stable than in the Gulf of Mexico. International producers have been offering longer-term contracts for jackups at very attractive rates.
Rowan has mobilized several of its rigs for work outside the US. Other contractors that traditionally handle Gulf of Mexico work have done the same. In addition, many jackups were damaged in the vicious 2005 hurricane season; several damaged rigs will likely never be put back into service. The result: The supply of rigs in the Gulf of Mexico has been falling steadily for more than a year now.
Shallow water drilling in the Gulf of Mexico often targets natural gas, and it’s not the cheapest market to drill. Day rates in the Gulf of Mexico spiked throughout most of 2005 and early 2006 but have moderated somewhat since that time as a result of falling gas prices.
Gulf-focused jackup drillers–Todco (NYSE: THE), Ensco (NYSE: ESV) and Rowan are the biggest players in this market–have been hit as a result.
But signs are that it’s starting to change. Day rates have begun to tick higher in the Gulf–some of the more-advanced jackup rigs have seen higher day rates lately. I suspect this trend could gain steam if there’s any significant up-tick in Gulf of Mexico drilling activity.
The reason is simply that moderating demand has masked the massive drop-off in available rigs in this market. A falling supply of rigs in the Gulf has put a floor under day rates. Unlike the land rig market, there’s little scope for supply of rigs to grow during the next few years. On any up-tick in demand, there’s a significant potential for a real supply squeeze in the Gulf. The last such squeeze occurred during the spring/summer of 2005 and was profitable for the Gulf-focused jackup drillers.
Rowan should see a big run if gas inventories moderate and prices stabilize as I expect. Meanwhile, the stock is already pricing in a lot of bad news despite the fact that Rowan’s foreign contracts are highly profitable and cash-generative for the company.
I don’t see much downside from current levels. Rowan rates a buy in the Gushers Portfolio.
While North America is a turnaround story at this time, international markets continue to see acceleration. Again, Schlumberger’s call was instructive in this regard.
Schlumberger stated that although it saw some pockets of weakness in the North American land market, the deepwater Gulf remains red hot. Deepwater activity is making up for a good deal of the weakness onshore; management stated that it has confidence that there will be no moderation in deepwater activity despite the slowdown onshore.
The company’s seismic mapping business (highlighted in the most recent issue of Portfolios. Clearly, as I mentioned above, Schlumberger is the top services play with diversified geographic exposure and most-advanced, state-of-the-art technologies in areas like seismic. Schlumberger remains a buy.
And given the extreme strength in Schlumberger’s seismic business, I also recommend Petroleum Geo-Services (NYSE: PGS), an offshore and deepwater seismic specialist with a strong position in Europe. Petroleum Geo doesn’t have quite the technological superiority that Schlumberger does in seismic, but there’s more than enough demand to go around. Petroleum Geo has also seen high demand for its ships; the company has pricing power. Keep buying Petroleum Geo-Services.
When it comes to deepwater work, Norway’s Seadrill (Oslo: SDRL; OTC: SDRLF) is the only contract driller in the world right now with significant spare capacity of deepwater rigs available for hire in 2008 and 2009. While some other operators have a few rigs available over this time period, Seadrill has by far the most uncommitted capacity.
Many of Seadrill’s rigs are still under construction right now. However, the company has managed to secure contracts at very attractive day rates for these rigs; as soon as they’re built, the rigs are headed out on contract. That just underscores the extreme strength and high activity in this market. Buy Seadrill.
Finally, you can’t complete a deepwater project without sub-sea equipment—this equipment is a maze of high-pressure valves and pipes that regulate the flow hydrocarbons from deepwater wells. As explained at length in the Jan. 3, 2007, issue The Deep End, my favorite play in this market is FMC Technologies (NYSE: FTI). FMC Technologies rates a buy.
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Coal
I discussed the coal industry at some length above in writing about the transports, so I won’t belabor those points again. Suffice it to say that I prefer miners with exposure to Western coal mining regions; these firms have less exposure to the rapid price inflation and falling spot coal prices that continue to plague the eastern miners. My favorite coal-mining name is Peabody Energy, one of the world’s largest coal miners.
Although eastern miners’ stocks have fallen a good deal over the past year, I see the group as a value trap. I still see additional downside in these stocks. In fact, we’ve already seen some smaller, privately held “checkbook” operators in Central Appalachia (CAPP) go bankrupt; I wouldn’t be surprised to see one of the larger publicly traded miners end up in the same boat.
One of the most profound comments out of Peabody Energy’s call was when the CEO was asked about the potential to acquire new mines in CAPP. The questioner noted that because of weak fundamentals in the region, mine prices have fallen considerably over the past year; he asked if the mines were cheap enough to tempt Peabody.
But Peabody answered with a fairly emphatic “no.” Management stated unequivocally that it sees the potential for better and safer investment returns in other coalfields in the US and internationally. The company said that despite the decline in coalmine valuations, it has no interest in CAPP mines. The company made similar comments during an analyst day meeting earlier in the month.
If one the world’s largest coal-mining firms with operations all over the world isn’t buying CAPP, I see no reason to jump in either. Peabody’s management has the ability to see exactly what’s going on and what business conditions are like in all the major coal-mining regions of the US. Therefore, this experienced management team has more knowledge of what represents good value than any analyst in my view.
I defer to Peabody here and recommend avoiding all CAPP-focused miners, such as International Coal Group, James River Coal, Massey Energy and Alpha Natural Resources.
The other interesting point to note from Peabody’s call was the company’s extreme geographic flexibility. For example, Peabody noted the weakness in US coal prices and has cut back its output from the Powder River Basin to match demand.
The company is also taking advantage of the temporary weather-induced weakness to install new equipment at its mines. This modern equipment can cut fuel usage and raise mining productivity. In the near term, these investments will mean lower operating costs; longer term, as coal demand returns, these same investments will render higher production.
Peabody also bought a large Australian mining firm, Excel Energy, last year. This company produces coal in Australia; much of that coal is destined for export to China and other parts of Asia.
Coal prices for export from Australia to China have, unlike US coal prices, been improving as of late. So, although the US is weaker than it was a year ago because of warm weather, Peabody can make up some of that with its fast-growing Australian operations. As the world’s largest exporter of coal, Australia is a prime beneficiary of Asia’s tremendous growth in demand.
Longer term, Peabody has been eyeing investments in even more unusual locales such as Mongolia. Management reports that Mongolia has some extraordinarily high-quality reserves, perfect for export into other parts of Asia.
Peabody’
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