Earnings in Review
Editor’s Note: The Energy Strategist is published twice per month, 24 times annually. As a result, twice a year we take a production break for one week, so your next issue will be released on August 22.
Of course, I frequently supplement regular issues with special flash alerts. Be assured that I’ll be monitoring the markets carefully and issue a flash alert if I see any points that need to be addressed.
By Elliott H. Gue
The past two weeks have marked the height of second quarter earnings season for the energy patch. Broadly, earnings from the group have been strong and, despite high expectations going into the reports, have managed to surprise to the upside.
This quarter’s reports also once again highlight the need for selectivity and careful stock picking. For example, consider the oil services industry and the Philadelphia Oil Services Index (OSX). The top three stocks in the index are up 83.2 percent this year, compared with a 1.6 percent loss from the bottom three performers.
That’s a huge spread for what many consider to be a homogenous group. Although the energy bull market is still in its early innings, there will continue to be clear winners and clear losers.
Stocks in The Energy Strategist model portfolios continue to act well despite some significant weakness in the broader markets. For the most part, the epicenter of this weakness is the financial space, sparked by fears regarding subprime lending and tightened credit markets.
But no matter how strong the fundamental growth prospects, energy stocks will never be totally immune to a selloff in the broader markets. This is especially true given the fact that some of my favorites have seen huge run-ups in the past month or two.
Ultimately, any selloffs in the energy patch will prove to be outstanding buying opportunities just as they were last summer and in the fall of 2005. In the meantime, we can protect ourselves and continue to profit.
I suggest that all subscribers review the flash alert I sent out July 20, entitled Schlumberger and Hedges. In it, I outline my favorite ways to lock in gains in our biggest winners while leaving our upside open.
There are some notable laggard groups this year, including uranium, coal and natural gas. I see outstanding opportunities in each, and I don’t see much additional downside, regardless of what happens in the broader markets. In this week’s issue, I’ll take a closer look at some important points and trends to emerge from this quarter’s earnings releases and corporate conference calls.
You’ve received several e-mails from me since my last regular TES issue that touch on the coal industry. Here’s a recap of the current situation and what I see for it going forward. See Coal.
The North American gas market and pressure pumping were the topics of endless chatter during quarterly calls, mainly because these remain the only markets showing any sign of a slowdown. However, several US firms have ended up surprisingly well despite their exposure to our neighbor to the north. But as drilling decreases, so will Canadian production. See Oil and Gas Services.
Oil reserves are getting more and more difficult, expensive and complex to produce, requiring far-more-advanced technology. Although there are some downsides, most of the service firms specializing in such technology look solid. See Special Services.
Several of my alternative energy recommendations have also reported earnings. The future looks bright for most, and the field bets for alternatives and biofuels continue to do well. See Additional Reports.
In this issue I’m recommending or reiterating my recommendation on the following stocks:
It’s been a busy two weeks for the energy patch; I sent out two flash alerts covering earnings news since your last issue of TES, both available in the archives section of the Web site. The July 26 alert, Earnings Deluge, contained a long section dedicated to the coal markets.
To summarize, coal prices and coal mining stocks have been weak recently. The primary reason for that weakness is bloated inventories of coal at US utilities.
Just as with bloated inventories of natural gas in storage, this is mainly a prolonged hangover from the warm winter of 2005-06 that reduced demand for winter heating. Of course, higher-than-normal supplies tend to put downward pressure on prices.
As with any commodity, when demand falls, price falls. Lower prices eventually reduce the economic attractiveness of mining or producing the commodity; this leads to reduced production and falling supplies.
Finally, a decrease in supply shores up pricing; this is a classic commodity cycle. The reason that commodity cycles tend to persist is that supply can only adjust slowly to changes in demand.
So, for example, a rapid ramp-up in oil demand from the emerging markets in the past few years helped catalyze rising oil prices. But it takes many years to bring a new deepwater development on line.
Rising oil prices have resulted in more spending on exploration and development, but it will still take years for supply to adjust. To complicate matters, the world’s easy-to-produce oil reserves have been largely produced, and many large, onshore fields are seeing flat or declining production.
It’s become far more difficult and technically complex to bring new projects online. Therefore, supply is adjusting even more slowly than it normally would, and oil is in a prolonged up-cycle. Although this is a vastly oversimplified summary, the basic rationale for a long cycle is clear.
Coal is currently seeing a short-term correction in what I believe to be a multi-year uptrend. Coal production doesn’t adjust immediately to a falloff in demand. Coal miners have high, fixed and upfront costs to bring a mine into production.
To make the mine economic, the miners naturally want to maximize production and revenues. Some mines that are profitable when operating at full capacity won’t cover their fixed costs when operating at 70 or 80 percent of capacity. This is why production remained strong for a time despite weak demand through the winter of 2005-06.
In addition, the utilities had quite a scare in late 2005, with several reporting record-low inventories of coal. The utes likely built up inventories more than they normally would because of the fear that a supply disruption would put them in a tight inventory situation again in the fall of 2006. They padded their inventories to try to prevent a repeat of the coal shortage issues experienced at the end of 2005.
But that didn’t happen, and ute demand for coal began to taper off. Many of the bigger miners began cutting production outright toward the end of 2006 to adjust supplies to weaker demand. Others delayed projects or closed down higher-cost mines.
This gradual process has now been underway for just less than a year. And for reasons I outlined at great length inlast week’s flash alert, I expect production to fall quickly as we move into the latter part of 2007.
This is just the production reduction needed to bring current supplies in line with demand and shore up pricing. Therefore, we’re near the bottom of this mini-down-cycle in coal.
And, of course, there are a number of upside catalysts for coal. A hot end to the summer or a colder-than-normal winter could pull increased demand for coal. Or an active hurricane season in August and September could easily cause a spike in natural gas prices.
In such an event, utilities would likely choose to burn more coal. At any rate, I don’t see coal prices heading much lower than current levels, and I don’t see much additional downside for the coal stocks.
As I noted in last week’s flash alert, my recommended stop was touched forPeabody Energy, yielding a small profit based on my recommended entry point in the fall of 2006. Whenever we’re stopped out of a stock in TES, I re-evaluate the fundamental story for the stock to see if anything has really changed.
In this case, I see limited additional downside for Peabody. And upon further examination of its latest quarter and that of the other coal miners, I see the fundamental bullish story unchanged.
The company is every bit as attractive as when I last profiled it in the May 2 issue of TES, King Coal. I’m now adding Peabody back to the Wildcatters Portfolio as a buy recommendation.
I promised to elaborate on two points I made in last week’s flash alert: the expiration of the synfuel credit and the coal master limited partnerships (MLPs).
The synfuel credit was a tax credit put into place more than 20 years ago in reaction to the last oil shock. The idea was to encourage development of coal-based fuels that would reduce dependence on imported oil supplies; originally, Congress planned to subsidize the development of liquid fuels derived from coal.
But that’s not exactly how the law turned out. The IRS ruled that companies only needed to significantly change the chemical composition of coal to qualify for the credit. This involves simply treating the coal chemically.
Rather than build coal-to-liquids (CTL) plants, many companies simply devised ways to treat normal coal and qualify for the synfuel credit. This coal could then be burned just like conventional steam coal in a power plant.
The effect of this subsidy is that some mines have been operating solely to qualify for this credit; some of these mines would be totally uneconomic without the credit. As it currently stands, the synfuel credit is scheduled to expire at the end of 2007. Several of the miners have stated that they see this expiration as a further tightening of supplies toward the end of the year.
It’s important to note that there’s a major difference between the existing synfuel credit and the coal gasification and liquefaction industries I’ve covered before in TES. The original law was meant to promote CTL technology in the US. But that didn’t happen mainly because oil prices fell in the 1980s, and it wasn’t economic to spend money on such facilities.
This has no effect on my recommendation for the world leader in CTL and gas-to-liquids projects, Sasol. (I discussed Sasol at some length in the April 12, 2006, issue of TES, Finding New Btus.)
These technologies remain promising, particularly with oil at current levels. Liquefying natural gas also has environmental benefits because liquefied gas doesn’t emit as much sulphur oxide, nitrous oxide or carbon dioxide as burning conventional, crude-derived fuels.
In addition, Sasol recently put together a deal to earn about 1 million tons of carbon-dioxide credits annually. For those unfamiliar with carbon credits, they’re part of a global cap-and-trade scheme to control emissions of greenhouse gasses under the Kyoto Protocol. The so-called Clean Development Mechanism of the Kyoto Protocol allows carbon-dioxide mitigation schemes in developing countries to earn credits that can be sold into the developed world.
So, for example, the carbon credits Sasol earns could be sold to European companies that are polluting above their allowed maximum. The project has been registered under the Kyoto Protocol.
Sasol produces a chemical known as nitric acid; one of the by-products of that production is the emission of nitrous oxide, a gas with 310 times the warming effect of carbon dioxide. Therefore, every ton of nitrous oxide emission reductions results in 310 tons of carbon credits.
Using a novel treatment on its two nitric acid plants in South Africa, Sasol is able to all but eliminate its emissions of nitrous oxide by converting the gas to harmless nitrogen and oxygen, generating a million tons of credits in the process. This is yet another positive for Sasol; the company remains a buy in my Proven Reserves Portfolio.
I also recommend two coal MLPs in the TES Portfolios, Natural Resource Partners and Penn Virginia Resources. Recall that coal MLPs don’t mine coal; rather, they own coal reserves and lease the mining rights out to coal miners in exchange for a royalty fee. Although royalties are impacted somewhat by coal prices and demand for coal, the coal-focused MLPs offer far more steady cash flows than traditional coal mining stocks and are sheltered from the worst of the commodity’s volatility.
Recently, the coal MLPs have been able to engage in some aggressive acquisitions of new reserves. Basically, coal-mining firms own large swathes of coal reserves that are just sitting on their balance sheets as assets.
And, particularly in the East, many miners need cash as the downturn in coal pricing has really hit the Eastern miners hardest; see last week’s flash alert for more details.
One way to solve both issues is to arrange a sale-leaseback with a coal MLP. The deal goes something like this: First, the miner sells a coal reserve to the MLP for a one-time cash payment. Then, that MLP immediately leases the reserve back to the miner under a long-term lease agreement.
This type of transaction is common in the real estate industry. Some companies use sale-leaseback deals to unlock value in their real estate holdings.
In this case, these deals can benefit both the miner and the MLP. The miners get the cash infusion they need to undertake needed mine improvement work and shore up their balance sheets. The MLP, in turn, gets a valuable asset and a steady stream of royalty lease payments for a long period of time. These payments can be used to back up higher tax-advantaged distributions for the MLP holders.
Because coal prices have come down, there are now more coal miners in the market looking for such deals. And the terms of these deals are likely far more attractive than they would have been a year ago with sky-high coal prices. Both Natural Resource Partners and Penn Virginia Resources remain buys.
Finally, it’s worth briefly mentioning Consol Energy. Consol produces mainly high-sulphur coal and had a very limited market up until recently because many utilities simply couldn’t burn that coal. The reason is that, unless you have some advanced scrubbers on your coal plants, burning high-sulphur coal would require buying large amounts of expensive sulphur credits.
But with scrubber capacity gradually building throughout the industry, Consol’s coal is fast becoming a viable alternative for scrubbed plants. And, of course, Consol would benefit from tightened supply in the coal market. Keep buying Consol Energy.
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The services stocks remain among my favorite groups longer term. As oil and gas reserves become more technically complex to produce, exploration and development work requires higher services content. In other words, producers need the services firms now more than ever.
I have outlined my basic expectations for the oil and gas services stocks on several occasions. Most recent, I previewed points to watch for this quarter in the July 5 issue of TES, A Quarter in Review. And in the July 20 flash alert, I offered a review of service giant Schlumberger and suggestions on how to hedge some of the big winners in the TES Portfolios.
With most of the releases from this group now in, the basic trends I’ve been discussing in TES for some time continue to hold true. Namely, international activity remains ultra-strong while still-weak natural gas prices continue to put pressure on activity in North America.
More specific, Canada remains far and away the weakest market in the world right now, dragging down the results of just about any services firm with even a modicum of exposure there. Within North America, the weakest service function is fracturing mainly because of a rapid ramp-up in capacity to perform such work in the past few years. (I explained this in depth in the July 5 issue.)
I was somewhat surprised to see that the US managed to remain relatively strong for the services firms even as Canada weakened. BJ Services is the purest play on pressure pumping and fracturing of any major services firm. To make matters worse, the firm derived around 60 percent of its 2006 revenues from the US and 12 percent from Canada. As such, it’s exposed to the weakest region of the world and leveraged to the single most-challenged business line in the services industry.
The company actually reported that US revenues were essentially flat for the quarter. Management stated that US revenues were buoyed by strong activity in a few key, core regions such as the Barnett Shale and the Rockies. Based on comments from BJ Services and Halliburton, it seems that fracturing work in these areas involves a greater deal of technical complexity.
For example, producers in these areas appear to be drilling more horizontal and directional wells rather than simply trying to produce with cheaper but less-efficient vertical wells. It seems that the major service firms operating in the region–including Schlumberger, BJ Services and Halliburton–are better placed to bid on these more complex projects than some of the small, recent pressure-pumping startups. This may account for the relative resilience of operations in these areas.
Meanwhile, of course, Canada was a complete and utter disaster. Revenues in Canada collapsed 71 percent in the quarter to the lowest levels since the second quarter of 2002.
But even in the US, smaller pressure-pumping firms are bidding aggressively on more basic projects. It appears they’re actually charging rates significantly below what BJ Services charges for the same work.
BJ’s management admitted that about half its work is more basic and half is more complex. So, although superior competency will help BJ, it will still feel margin pressure from its smaller competitors.
I’m also growing concerned about a few additional points. First, BJ stated in its call that it would like to regain market share as the pressure-pumping business weakens. The company admitted that part of grabbing this share will be cutting prices to more competitive levels.
Right now, BJ services is seeing quarterly pricing declines of 3 to 5 percent for its fracturing business, but this could easily accelerate if a real price war kicks off. There’s just too much pressure-pumping capacity and too many competitors for current North American demand.
This potential is supported by BJ’s latest job turndown statistics. Basically, job turndowns occur when a company offers BJ a price for a certain project or contract and the firm rejects the offer.
Last quarter, job turndowns averaged $8 million per month; now, they stand at $6 million per month. That suggests that BJ is turning away less work and is probably having to cut prices to get the jobs.
Second, BJ Service, like most services firms, prices many of its pressure-pumping jobs under one-year contracts. Therefore, it’s already starting to look at pricing for contracts in 2008.
If the environment doesn’t improve soon, I expect the producer to demand more generous pricing terms on these contracts. Even if the North American market sees an improvement in early 2008, weak pricing could persist for months into 2008. Pricing will remain sticky on the downside even after the industry recovers.
Finally, it’s worth noting that both Halliburton and BJ Services have been cutting their labor force and capacity in Canada. A good bit of that capacity is being reallocated to the US market, where activity has held up far better. This just adds more capacity to an already-oversupplied market.
BJ does have an interesting international business and performance for the quarter internationally was impressive. But it’s not a large enough piece of the company to make much of a difference.
Bottom line: BJ trades at a huge valuation discount when compared to other oilfield service names, so it’s pricing in a lot of bad news. Also, I wouldn’t be at all surprised to see a larger firm interested in picking up fracturing technology to step in and buy up BJ.
That means it’s certainly not a short here. However, until there’s some sign of a turn, I’d continue to avoid the stock; BJ Services looks to be a value trap.
And with respect to Canada, there isn’t much agreement on exactly when there may be a real recovery. As you might expect, this was a common question posed at least once in every conference call I listened to.
Most management teams agreed that there would be some seasonal uptick in activity going from the second quarter into the third quarter of the year. But this is a normal seasonal uptick, not really a sign of a turn.
Here’s what I find a bit worrying for the pressure-pumping business. The company that expressed far and away the most optimism on Canada and drilling activity there was Wildcatters Portfolio holding Weatherford.
Because Weatherford is the most exposed to Canada of any of the oil services firms I follow, this is an important comment to listen to. CEO Bernard Duroc-Danner stated the following answer to an analyst’s question:
And although Weatherford does express optimism for gas as well, one must take care to remember that the company doesn’t participate at all in the fracturing business in Canada. Therefore, his comments don’t really pertain to fracturing at all. I see the fracturing market as a unique case, weakened as much by excess capacity and a price war as by the decline in gas drilling activity.
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But given the factors outlined above, fracturing margins could remain under pressure even if gas prices were to rally. If that sounds crazy, consider that gas prices generally did rally from the beginning of the year through mid-May. But over this same time period, BJ Services actually massively underperformed the other services names.
But although the outlook for pressure pumping is dubious, I found little to dislike about the conference call with Gushers Portfolio recommendation Carbo Ceramics.
The firm’s primary business involves selling specialized ceramic proppants into the fracturing industry. (I explained what proppants are in the July 5 issue.) The company also has a subsidiary called Pinnacle Technologies that offers software, engineering and monitoring services used to plan fracturing work and evaluate the effectiveness of jobs.
Carbo’s basic proppant revenues were up slightly over the same quarter one year ago. Canadian proppant volumes declined 66 percent in the quarter, but that was offset by strong proppant sales in the US. Just as with BJ and Halliburton, I suspect that this is due to strong demand for ceramic proppant in those key, hot, gas-producing plays in the US.
Ceramic proppant is more advanced than conventional proppants made of coated sand. Using such proppants can increase the efficiency of fracturing jobs and have a real impact on well production rates; of course, the ceramic proppant costs more.
Right now, the market for ceramic proppants is smaller than for conventional proppant, but it stands to reason that such proppant has a larger market share in more technically complex fracturing.
Both BJ Services and Halliburton mentioned the use of lightweight proppants as a differentiating characteristic in fracturing jobs. This is how Carbo maintained strength in a weak North American market.
Carbo also mentioned that it’s conducting more field trials with US producers this year. The company typically conducts such trials to demonstrate the potential effectiveness of its proppant against conventional proppant materials.
An increase in field trials is a signal of a potential pickup in interest from producers; this bodes well for the future. And unlike the pressure-pumping firms, Carbo appears not to need aggressively price cuts to compete; pricing was up 1 percent across the board.
The Russian business is also on track. Carbo has built a factory there, and volumes are ramping up as scheduled.
Carbo is pleased with the quality of material coming out of the factory. The company stated that its intention is to sign long-term supply agreements for its Russian proppant business and that profit margins in Russia would be roughly equivalent to the rest of the world.
These long-term contracts should offer Carbo a stable stream of international revenues. And there’s upside to proppant margins eventually as the technology gains greater adoption in Russia.
Finally, the real stand out in Carbo’s call was its Pinnacle Technologies division. The division reported a 36 percent jump in sales when compared to the second quarter of 2006. Again, Pinnacle would be involved with more technically complex jobs and is insulated from the epicenter of the weakness in fracturing.
Pinnacle is also involved in the potentially huge market for carbon sequestration. Basically, one idea for limiting emissions of carbon dioxide is to inject the gas into depleted oil or gas reservoirs where it will become permanently locked underground. But part of sequestering carbon is monitoring stored carbon on an ongoing basis to make sure the gas isn’t leaking and that underground pressures remain manageable.
Pinnacle uses advanced equipment, software and satellite technology to monitor slight changes in the shape of the Earth’s surface because of underground liquid and gas movement. This is the same basic technology used to monitor the progress of reservoir production and fracturing jobs.
These technologies would be sensitive enough to reliably detect leaks from a reservoir. Pinnacle already has a job underway in the San Juan Basin of the US and management has stated that it’s receiving considerable interest from other firms with carbon sequestration projects in the works.
Carbo Ceramics is outperforming the pressure-pumping firms in terms of holding the line on pricing. It’s also likely that, over time, ceramic proppant will continue to gain share from conventional proppant. Carbo can continue to see growth even if the overall fracturing market remains weak.
Of course, the North American gas market and pressure pumping were the topics of endless chatter during quarterly calls mainly because these remain the only markets showing any sign of a slowdown.
I highlighted Schlumberger in the July 20 flash alert. This remains my favorite long-term name in the services industry.
However, the stock is currently somewhat extended, and those who got in near my recommendation earlier this year have significant profits to protect. In the flash alert, I recommend ways to hedge your position and guard against the possibility of a correction in the stock.
I continue to recommend buying Weatherford at current levels. As I noted above, Weatherford is the most-exposed big services firm to Canada. This is mainly the result of its acquisition of Precision Drilling’s energy services division back in 2005.
But that exposure is clearly dropping. Management pointed out that 25 percent of Weatherford’s business was in Canada in the first quarter of 2006.
In the most recent quarter, however, the nation accounted for less than 10 percent of the total. And, as noted above, Weatherford was highly constructive on a recovery in the Canadian market, likely centered on heavy oil projects and deep natural gas wells.
Meanwhile, the real story for Weatherford remains the Eastern Hemisphere markets such as Africa, the Middle East and Asia. The company’s Eastern Hemisphere business posted year-over-year revenue growth of 40 percent, and management reiterated expectations that the level of growth would continue through the end of 2007.
Weatherford has been consistently posting higher growth than its peer group in key Eastern Hemisphere markets. This appears to still be a case of the company playing catch-up.
In other words, when Weatherford bought Precision, it was able to use its existing sales force and relationships with foreign producers to push key Precision services to international customers. In my opinion, Weatherford’s acquisition of Precision has been among the very best and most accretive in the energy services industry.
Some of the key services functions that Weatherford has been really pushing internationally are directional drilling, underbalanced drilling and completion. As the term directional drilling suggests, these are services related to the drilling of non-vertical wells.
Years ago, most Eastern Hemisphere markets could produce prolific oil and gas reserves using simple, cheap, vertical wells, but that’s no longer the case. Directional drilling is now becoming the standard.
I’ve explained underbalanced drilling before in TES, most recently in the April 18 issue, More Bullish Signs. Basically, it’s a way to produce mature wells more effectively.
And finally, the term completion refers to any equipment and hardware installed in a well to maximize production. This could include screens and filters designed to prevent sand from clogging well. Alternatively, it could mean intelligent wells that are able to sense whether they’re producing oil or water and shut down or slow production to compensate.
There are some key emerging technologies for Weatherford. When asked what the most significant technological development for the company was this year, CEO Duroc-Danner replied solid expandables.
To explain this market, consider that when a well is drilled, particularly a deep well, the drill bit likely passes through several different geological layers. Some of these layers may be areas of unusually low or high pressures; alternatively the drill bit may pass through multiple deposits of water, oil and gas each of differing pressures and temperatures.
To isolate certain zones that may cause trouble, operators install what’s known as casing. Basically, this is a very heavy sort of pipe that’s cemented in place in the well. This insulates, for example, high-pressure zones so that fluid doesn’t flow into the well and cause problems.
The problem with this is that casing is thick, heavy gauge pipe. You may have to install several lengths of casing to isolate a given area of the well; there may also be multiple areas that need to be isolated.
Consider that each subsequent length of casing you lower into a well needs to be of slightly smaller diameter than the length before it. If this weren’t the case, the casing simply wouldn’t fit.
Over time, the more lengths of casing you install, the thinner the diameter of the well. Therefore, when the well reaches its final depth, the well diameter might be smaller than optimum to produce efficiently. You can imagine how this could be an issue for a deeper well.
Weatherford’s solid expandables technology offers a solution to this problem. Basically, it’s a type of metal casing that can be placed in the well and expanded to fit the shape of the well itself.
This expandable will isolate trouble zones so that the operator can continue to drill the well without much loss of well diameter. Once the final intended depth of the well is attained, the operator can go back and case the individual segments.
The point is that the entire well can be drilled with very little loss of diameter. This is just the sort of high-tech service function that’s in high demand right now, and Weatherford has a very real competitive advantage.
CEO Duroc-Danner mentioned that the wells the firm is drilling today are increasingly prone to problems. This is really just another part of the end of easy oil thesis.
Oil reserves are getting more and more difficult, expensive and complex to produce, requiring far-more-advanced technology. Weatherford’s service offerings fit well with this theme.
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When I first recommended Bunge, the company was going through some difficult times. While North American operations were in decent shape, Bunge’s massive position in Brazil was a drag on earnings.
A rapid appreciation in the Brazilian real hurt farm incomes because most commodities are priced in dollars. As Brazilian farmers’ finances weakened, so did their purchases on fertilizer from Bunge; the company even had some problems with bad debts.
Again, the company saw a hiccup this past spring because of a very unusual phenomenon that developed between the spot price of soybeans and soybean futures. I explained that problem at great length and reiterated my buy recommendation in an April 23 flash alert, Agribusiness Update.
But the company has since recovered, and the stock is on fire. A farmer aid package passed by the Brazilian government last year helped shore up farmers’ finances, while a strong run in key agricultural commodities such as soybeans and corn helped boost revenues.
The minor hiccup experienced last spring faded soon thereafter. Check out the chart of soybeans below.
Source: Bloomberg
The dramatic run in soybeans since the beginning of October last year has really helped Brazilian farmers. This, in turn, has helped Bunge this year.
In the company’s July 26 quarterly report and conference call, management commented that fertilizer volumes have soared and prices for fertilizer are on the rise globally. Continued strong fertilizer volumes and pricing are also expected for the second half of 2007; Bunge raised its guidance for the remainder of the year.
Moreover, strong agricultural prices are offsetting some of the weakness in the Brazilian real, shown below.
Source: Bloomberg
This chart depicts Brazilian reals per US dollars. When the line is falling, it indicates a strengthening real.
For example, last March, it took nearly 2.8 real to buy $1. Now, it takes less than 1.9 real–a dramatic move in the currency.
I suspect that if agricultural prices weren’t this high, Brazilian farmers would be suffering a real depression. I also heard a few points in the Bunge call that I didn’t like.
First, despite the improvement in soybean prices, Bunge stated that farmers continue to face high debt levels. Management also indicated that the company was restricting credit given to farmers given that high debt level and, I suspect, a desire not to be left holding the proverbial bag again if Brazilian farm economics were to deteriorate or if real appreciation took a further bite.
Second, Bunge’s other business is processing oilseeds like soybeans into products like edible oils and soybean meal. Although management said that demand remains strong, it also suggested it’s exposed to commodity price inflation and having a tough time passing through all its costs to consumers.
Granted, I’m pulling just a few negative comments out of what was generally a bullish call. It’s clear to me that the company is recovering from a bad year in 2005 and early 2006.
In addition, I’m a big believer in the duel-demand drivers behind the agriculture industry—demand for biofuels coupled with growing demand for meat and foodstuffs from the developing world. This tidal wave of demand will put upward pressure on agricultural commodity prices and on key farm inputs such as fertilizer and pesticides for years to come.
But when it comes to Bunge, I’m becoming increasingly concerned that the stock is pricing in a lot of this good news. Consider this chart of Bunge’s quarterly price-to-earnings ratio over the past few years.
Source: Bunge, Bloomberg
Although I think some expansion in multiples is justified by the fact that Bunge is seeing a true business recovery, the company’s multiple has basically doubled recently. This suggests that investors may be pricing in all the best news, making Bunge vulnerable to a fall at the first whiff of bad news. Any of the minor elements outlined above could certainly catalyze such a move.
The stock is trading above my buy target and has been for some time. I’m now cutting my recommendation on Bunge to a hold from buy.
In addition, I recommend that all subscribers take half of their remaining position in Bunge off the table; for example, if you own 200 shares, sell 100 shares and book the more than 60 percent gain. I’m raising my recommended stop on the remaining position in Bunge from 60 to 85.50.
Again, however, my outlook for Bunge is more company-specific than a general concern about agriculture. Check out the biofuels field bet for a closer look at my favorite plays in the industry. I originally outlined this play in the Sept. 20, 2006, issue of TES, Fueled by Food.
When you buy into the field bet, remember the premise behind these plays. My goal in the field bets is to offer broad exposure to a long-term theme. I offer some more speculative picks mixed with some steadier plays.
I recommend buying all of the picks and simply allocating a smaller-than-normal position size to each. Specifically, I recommend putting 20 to 25 percent of what you’d normally allocate to a TES recommendation into each field bet play. This gives you broad exposure to the sector without all the risk.
The system has worked well. One of my plays in the biofuels field bet has been an almost total bust. However, the other plays have seen such dramatic run-ups that the field bet as a whole has been a big winner since its inception last year.
Solar power firms, including TES recommendations SunPower and MEMC Materials, markedly outperformed the broader markets during the height of the selling last week. Both firms are part of the alternatives field bet.
Both firms recently reported blowout earnings results. MEMC manufactures polysilicon and polysilicon wafers, the raw material used to produce both solar cells and semiconductor chips.
The company has plans to add to its manufacturing capacity while negotiating long-term supply agreements for a good piece of its capacity. These long-term agreements should serve to smooth out cyclicality and margins over time.
In addition, MEMC has focused on manufacturing flexibility. It has the capability of switching a good chunk of its manufacturing operations to serve either the solar or polysilicon industries.
SunPower still has the most-efficient cells in the solar business. Its cells are the most efficient in terms of converting sun energy into electrical power. And SunPower also produces cells that use less polysilicon, a major advantage given the fact that the industry is currently experiencing a shortage of polysilicon.
In its July 20 conference call, SunPower’s management announced further capacity additions to meet demand and results generally exceeded expectations. But the most important catalysts for the stock have been the steady stream of bullish news items to emerge in the past few months. The list includes high energy prices, increased attention on global warming legislation and the likelihood of an energy bill promoting alternatives in the US.
Both SunPower and MEMC remain buys as part of the alternatives field bet.
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Of course, I frequently supplement regular issues with special flash alerts. Be assured that I’ll be monitoring the markets carefully and issue a flash alert if I see any points that need to be addressed.
By Elliott H. Gue
The past two weeks have marked the height of second quarter earnings season for the energy patch. Broadly, earnings from the group have been strong and, despite high expectations going into the reports, have managed to surprise to the upside.
This quarter’s reports also once again highlight the need for selectivity and careful stock picking. For example, consider the oil services industry and the Philadelphia Oil Services Index (OSX). The top three stocks in the index are up 83.2 percent this year, compared with a 1.6 percent loss from the bottom three performers.
That’s a huge spread for what many consider to be a homogenous group. Although the energy bull market is still in its early innings, there will continue to be clear winners and clear losers.
Stocks in The Energy Strategist model portfolios continue to act well despite some significant weakness in the broader markets. For the most part, the epicenter of this weakness is the financial space, sparked by fears regarding subprime lending and tightened credit markets.
But no matter how strong the fundamental growth prospects, energy stocks will never be totally immune to a selloff in the broader markets. This is especially true given the fact that some of my favorites have seen huge run-ups in the past month or two.
Ultimately, any selloffs in the energy patch will prove to be outstanding buying opportunities just as they were last summer and in the fall of 2005. In the meantime, we can protect ourselves and continue to profit.
I suggest that all subscribers review the flash alert I sent out July 20, entitled Schlumberger and Hedges. In it, I outline my favorite ways to lock in gains in our biggest winners while leaving our upside open.
In This Issue
There are some notable laggard groups this year, including uranium, coal and natural gas. I see outstanding opportunities in each, and I don’t see much additional downside, regardless of what happens in the broader markets. In this week’s issue, I’ll take a closer look at some important points and trends to emerge from this quarter’s earnings releases and corporate conference calls. You’ve received several e-mails from me since my last regular TES issue that touch on the coal industry. Here’s a recap of the current situation and what I see for it going forward. See Coal.
The North American gas market and pressure pumping were the topics of endless chatter during quarterly calls, mainly because these remain the only markets showing any sign of a slowdown. However, several US firms have ended up surprisingly well despite their exposure to our neighbor to the north. But as drilling decreases, so will Canadian production. See Oil and Gas Services.
Oil reserves are getting more and more difficult, expensive and complex to produce, requiring far-more-advanced technology. Although there are some downsides, most of the service firms specializing in such technology look solid. See Special Services.
Several of my alternative energy recommendations have also reported earnings. The future looks bright for most, and the field bets for alternatives and biofuels continue to do well. See Additional Reports.
In this issue I’m recommending or reiterating my recommendation on the following stocks:
- Carbo Ceramics (NYSE: CRR)
- Consol Energy (NYSE: CNX)
- MEMC Materials (NYSE: WFR)
- Natural Resource Partners (NYSE: NRP)
- Peabody Energy (NYSE: BTU)
- Penn Virginia Resources (NYSE: PVR)
- Sasol (NYSE: SSL)
- Schlumberger (NYSE: SLB)
- SunPower (NSDQ: SPWR)
- Weatherford (NYSE: WFT)
- BJ Services (NYSE: BJS)
- Bunge (NYSE: BG)
- Halliburton (NYSE: HAL)
Coal
It’s been a busy two weeks for the energy patch; I sent out two flash alerts covering earnings news since your last issue of TES, both available in the archives section of the Web site. The July 26 alert, Earnings Deluge, contained a long section dedicated to the coal markets. To summarize, coal prices and coal mining stocks have been weak recently. The primary reason for that weakness is bloated inventories of coal at US utilities.
Just as with bloated inventories of natural gas in storage, this is mainly a prolonged hangover from the warm winter of 2005-06 that reduced demand for winter heating. Of course, higher-than-normal supplies tend to put downward pressure on prices.
As with any commodity, when demand falls, price falls. Lower prices eventually reduce the economic attractiveness of mining or producing the commodity; this leads to reduced production and falling supplies.
Finally, a decrease in supply shores up pricing; this is a classic commodity cycle. The reason that commodity cycles tend to persist is that supply can only adjust slowly to changes in demand.
So, for example, a rapid ramp-up in oil demand from the emerging markets in the past few years helped catalyze rising oil prices. But it takes many years to bring a new deepwater development on line.
Rising oil prices have resulted in more spending on exploration and development, but it will still take years for supply to adjust. To complicate matters, the world’s easy-to-produce oil reserves have been largely produced, and many large, onshore fields are seeing flat or declining production.
It’s become far more difficult and technically complex to bring new projects online. Therefore, supply is adjusting even more slowly than it normally would, and oil is in a prolonged up-cycle. Although this is a vastly oversimplified summary, the basic rationale for a long cycle is clear.
Coal is currently seeing a short-term correction in what I believe to be a multi-year uptrend. Coal production doesn’t adjust immediately to a falloff in demand. Coal miners have high, fixed and upfront costs to bring a mine into production.
To make the mine economic, the miners naturally want to maximize production and revenues. Some mines that are profitable when operating at full capacity won’t cover their fixed costs when operating at 70 or 80 percent of capacity. This is why production remained strong for a time despite weak demand through the winter of 2005-06.
In addition, the utilities had quite a scare in late 2005, with several reporting record-low inventories of coal. The utes likely built up inventories more than they normally would because of the fear that a supply disruption would put them in a tight inventory situation again in the fall of 2006. They padded their inventories to try to prevent a repeat of the coal shortage issues experienced at the end of 2005.
But that didn’t happen, and ute demand for coal began to taper off. Many of the bigger miners began cutting production outright toward the end of 2006 to adjust supplies to weaker demand. Others delayed projects or closed down higher-cost mines.
This gradual process has now been underway for just less than a year. And for reasons I outlined at great length inlast week’s flash alert, I expect production to fall quickly as we move into the latter part of 2007.
This is just the production reduction needed to bring current supplies in line with demand and shore up pricing. Therefore, we’re near the bottom of this mini-down-cycle in coal.
And, of course, there are a number of upside catalysts for coal. A hot end to the summer or a colder-than-normal winter could pull increased demand for coal. Or an active hurricane season in August and September could easily cause a spike in natural gas prices.
In such an event, utilities would likely choose to burn more coal. At any rate, I don’t see coal prices heading much lower than current levels, and I don’t see much additional downside for the coal stocks.
As I noted in last week’s flash alert, my recommended stop was touched forPeabody Energy, yielding a small profit based on my recommended entry point in the fall of 2006. Whenever we’re stopped out of a stock in TES, I re-evaluate the fundamental story for the stock to see if anything has really changed.
In this case, I see limited additional downside for Peabody. And upon further examination of its latest quarter and that of the other coal miners, I see the fundamental bullish story unchanged.
The company is every bit as attractive as when I last profiled it in the May 2 issue of TES, King Coal. I’m now adding Peabody back to the Wildcatters Portfolio as a buy recommendation.
I promised to elaborate on two points I made in last week’s flash alert: the expiration of the synfuel credit and the coal master limited partnerships (MLPs).
The synfuel credit was a tax credit put into place more than 20 years ago in reaction to the last oil shock. The idea was to encourage development of coal-based fuels that would reduce dependence on imported oil supplies; originally, Congress planned to subsidize the development of liquid fuels derived from coal.
But that’s not exactly how the law turned out. The IRS ruled that companies only needed to significantly change the chemical composition of coal to qualify for the credit. This involves simply treating the coal chemically.
Rather than build coal-to-liquids (CTL) plants, many companies simply devised ways to treat normal coal and qualify for the synfuel credit. This coal could then be burned just like conventional steam coal in a power plant.
The effect of this subsidy is that some mines have been operating solely to qualify for this credit; some of these mines would be totally uneconomic without the credit. As it currently stands, the synfuel credit is scheduled to expire at the end of 2007. Several of the miners have stated that they see this expiration as a further tightening of supplies toward the end of the year.
It’s important to note that there’s a major difference between the existing synfuel credit and the coal gasification and liquefaction industries I’ve covered before in TES. The original law was meant to promote CTL technology in the US. But that didn’t happen mainly because oil prices fell in the 1980s, and it wasn’t economic to spend money on such facilities.
This has no effect on my recommendation for the world leader in CTL and gas-to-liquids projects, Sasol. (I discussed Sasol at some length in the April 12, 2006, issue of TES, Finding New Btus.)
These technologies remain promising, particularly with oil at current levels. Liquefying natural gas also has environmental benefits because liquefied gas doesn’t emit as much sulphur oxide, nitrous oxide or carbon dioxide as burning conventional, crude-derived fuels.
In addition, Sasol recently put together a deal to earn about 1 million tons of carbon-dioxide credits annually. For those unfamiliar with carbon credits, they’re part of a global cap-and-trade scheme to control emissions of greenhouse gasses under the Kyoto Protocol. The so-called Clean Development Mechanism of the Kyoto Protocol allows carbon-dioxide mitigation schemes in developing countries to earn credits that can be sold into the developed world.
So, for example, the carbon credits Sasol earns could be sold to European companies that are polluting above their allowed maximum. The project has been registered under the Kyoto Protocol.
Sasol produces a chemical known as nitric acid; one of the by-products of that production is the emission of nitrous oxide, a gas with 310 times the warming effect of carbon dioxide. Therefore, every ton of nitrous oxide emission reductions results in 310 tons of carbon credits.
Using a novel treatment on its two nitric acid plants in South Africa, Sasol is able to all but eliminate its emissions of nitrous oxide by converting the gas to harmless nitrogen and oxygen, generating a million tons of credits in the process. This is yet another positive for Sasol; the company remains a buy in my Proven Reserves Portfolio.
I also recommend two coal MLPs in the TES Portfolios, Natural Resource Partners and Penn Virginia Resources. Recall that coal MLPs don’t mine coal; rather, they own coal reserves and lease the mining rights out to coal miners in exchange for a royalty fee. Although royalties are impacted somewhat by coal prices and demand for coal, the coal-focused MLPs offer far more steady cash flows than traditional coal mining stocks and are sheltered from the worst of the commodity’s volatility.
Recently, the coal MLPs have been able to engage in some aggressive acquisitions of new reserves. Basically, coal-mining firms own large swathes of coal reserves that are just sitting on their balance sheets as assets.
And, particularly in the East, many miners need cash as the downturn in coal pricing has really hit the Eastern miners hardest; see last week’s flash alert for more details.
One way to solve both issues is to arrange a sale-leaseback with a coal MLP. The deal goes something like this: First, the miner sells a coal reserve to the MLP for a one-time cash payment. Then, that MLP immediately leases the reserve back to the miner under a long-term lease agreement.
This type of transaction is common in the real estate industry. Some companies use sale-leaseback deals to unlock value in their real estate holdings.
In this case, these deals can benefit both the miner and the MLP. The miners get the cash infusion they need to undertake needed mine improvement work and shore up their balance sheets. The MLP, in turn, gets a valuable asset and a steady stream of royalty lease payments for a long period of time. These payments can be used to back up higher tax-advantaged distributions for the MLP holders.
Because coal prices have come down, there are now more coal miners in the market looking for such deals. And the terms of these deals are likely far more attractive than they would have been a year ago with sky-high coal prices. Both Natural Resource Partners and Penn Virginia Resources remain buys.
Finally, it’s worth briefly mentioning Consol Energy. Consol produces mainly high-sulphur coal and had a very limited market up until recently because many utilities simply couldn’t burn that coal. The reason is that, unless you have some advanced scrubbers on your coal plants, burning high-sulphur coal would require buying large amounts of expensive sulphur credits.
But with scrubber capacity gradually building throughout the industry, Consol’s coal is fast becoming a viable alternative for scrubbed plants. And, of course, Consol would benefit from tightened supply in the coal market. Keep buying Consol Energy.
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Oil and Gas Services
The services stocks remain among my favorite groups longer term. As oil and gas reserves become more technically complex to produce, exploration and development work requires higher services content. In other words, producers need the services firms now more than ever. I have outlined my basic expectations for the oil and gas services stocks on several occasions. Most recent, I previewed points to watch for this quarter in the July 5 issue of TES, A Quarter in Review. And in the July 20 flash alert, I offered a review of service giant Schlumberger and suggestions on how to hedge some of the big winners in the TES Portfolios.
With most of the releases from this group now in, the basic trends I’ve been discussing in TES for some time continue to hold true. Namely, international activity remains ultra-strong while still-weak natural gas prices continue to put pressure on activity in North America.
More specific, Canada remains far and away the weakest market in the world right now, dragging down the results of just about any services firm with even a modicum of exposure there. Within North America, the weakest service function is fracturing mainly because of a rapid ramp-up in capacity to perform such work in the past few years. (I explained this in depth in the July 5 issue.)
I was somewhat surprised to see that the US managed to remain relatively strong for the services firms even as Canada weakened. BJ Services is the purest play on pressure pumping and fracturing of any major services firm. To make matters worse, the firm derived around 60 percent of its 2006 revenues from the US and 12 percent from Canada. As such, it’s exposed to the weakest region of the world and leveraged to the single most-challenged business line in the services industry.
The company actually reported that US revenues were essentially flat for the quarter. Management stated that US revenues were buoyed by strong activity in a few key, core regions such as the Barnett Shale and the Rockies. Based on comments from BJ Services and Halliburton, it seems that fracturing work in these areas involves a greater deal of technical complexity.
For example, producers in these areas appear to be drilling more horizontal and directional wells rather than simply trying to produce with cheaper but less-efficient vertical wells. It seems that the major service firms operating in the region–including Schlumberger, BJ Services and Halliburton–are better placed to bid on these more complex projects than some of the small, recent pressure-pumping startups. This may account for the relative resilience of operations in these areas.
Meanwhile, of course, Canada was a complete and utter disaster. Revenues in Canada collapsed 71 percent in the quarter to the lowest levels since the second quarter of 2002.
But even in the US, smaller pressure-pumping firms are bidding aggressively on more basic projects. It appears they’re actually charging rates significantly below what BJ Services charges for the same work.
BJ’s management admitted that about half its work is more basic and half is more complex. So, although superior competency will help BJ, it will still feel margin pressure from its smaller competitors.
I’m also growing concerned about a few additional points. First, BJ stated in its call that it would like to regain market share as the pressure-pumping business weakens. The company admitted that part of grabbing this share will be cutting prices to more competitive levels.
Right now, BJ services is seeing quarterly pricing declines of 3 to 5 percent for its fracturing business, but this could easily accelerate if a real price war kicks off. There’s just too much pressure-pumping capacity and too many competitors for current North American demand.
This potential is supported by BJ’s latest job turndown statistics. Basically, job turndowns occur when a company offers BJ a price for a certain project or contract and the firm rejects the offer.
Last quarter, job turndowns averaged $8 million per month; now, they stand at $6 million per month. That suggests that BJ is turning away less work and is probably having to cut prices to get the jobs.
Second, BJ Service, like most services firms, prices many of its pressure-pumping jobs under one-year contracts. Therefore, it’s already starting to look at pricing for contracts in 2008.
If the environment doesn’t improve soon, I expect the producer to demand more generous pricing terms on these contracts. Even if the North American market sees an improvement in early 2008, weak pricing could persist for months into 2008. Pricing will remain sticky on the downside even after the industry recovers.
Finally, it’s worth noting that both Halliburton and BJ Services have been cutting their labor force and capacity in Canada. A good bit of that capacity is being reallocated to the US market, where activity has held up far better. This just adds more capacity to an already-oversupplied market.
BJ does have an interesting international business and performance for the quarter internationally was impressive. But it’s not a large enough piece of the company to make much of a difference.
Bottom line: BJ trades at a huge valuation discount when compared to other oilfield service names, so it’s pricing in a lot of bad news. Also, I wouldn’t be at all surprised to see a larger firm interested in picking up fracturing technology to step in and buy up BJ.
That means it’s certainly not a short here. However, until there’s some sign of a turn, I’d continue to avoid the stock; BJ Services looks to be a value trap.
And with respect to Canada, there isn’t much agreement on exactly when there may be a real recovery. As you might expect, this was a common question posed at least once in every conference call I listened to.
Most management teams agreed that there would be some seasonal uptick in activity going from the second quarter into the third quarter of the year. But this is a normal seasonal uptick, not really a sign of a turn.
Here’s what I find a bit worrying for the pressure-pumping business. The company that expressed far and away the most optimism on Canada and drilling activity there was Wildcatters Portfolio holding Weatherford.
Because Weatherford is the most exposed to Canada of any of the oil services firms I follow, this is an important comment to listen to. CEO Bernard Duroc-Danner stated the following answer to an analyst’s question:
I think actually the oil and the heavy oil segments where our sense that activity will be disproportionably strong…..the [natural] gas is more uncertain as it really depends on the gas market in North America in general. However the reservoirs whether the deep gas or the shallow gas, the reservoirs that are unattended, show decline in productivity and in production rates. It’s not tenable. And you don’t have a long-term viable solution without working the gas side. So I think the worst we could be is maybe off by a quarter or so, maybe two quarters, that’s the worst we could be and I don’t think that’s going to happen, I really don’t.
The CEO is projecting the Canadian market to bottom out in the fourth quarter of 2007 or early in the first quarter of 2008. But as the answer above demonstrates, he seems far more confident in the oil side of the business than the gas side. And although Weatherford does express optimism for gas as well, one must take care to remember that the company doesn’t participate at all in the fracturing business in Canada. Therefore, his comments don’t really pertain to fracturing at all. I see the fracturing market as a unique case, weakened as much by excess capacity and a price war as by the decline in gas drilling activity.
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Special Services
As I’ve outlined before, I expect gas prices have little downside from current levels and it wouldn’t take much to push gas back above $10 per million British Thermal Units. The accelerating well decline rates Mr. Duroc-Danner highlights are one factor that supports this argument; with gas drilling activity down, production from Canada will fall rapidly. This is especially true if the heavy oil industry—a major consumer of gas—recovers as the CEO suggests.But given the factors outlined above, fracturing margins could remain under pressure even if gas prices were to rally. If that sounds crazy, consider that gas prices generally did rally from the beginning of the year through mid-May. But over this same time period, BJ Services actually massively underperformed the other services names.
But although the outlook for pressure pumping is dubious, I found little to dislike about the conference call with Gushers Portfolio recommendation Carbo Ceramics.
The firm’s primary business involves selling specialized ceramic proppants into the fracturing industry. (I explained what proppants are in the July 5 issue.) The company also has a subsidiary called Pinnacle Technologies that offers software, engineering and monitoring services used to plan fracturing work and evaluate the effectiveness of jobs.
Carbo’s basic proppant revenues were up slightly over the same quarter one year ago. Canadian proppant volumes declined 66 percent in the quarter, but that was offset by strong proppant sales in the US. Just as with BJ and Halliburton, I suspect that this is due to strong demand for ceramic proppant in those key, hot, gas-producing plays in the US.
Ceramic proppant is more advanced than conventional proppants made of coated sand. Using such proppants can increase the efficiency of fracturing jobs and have a real impact on well production rates; of course, the ceramic proppant costs more.
Right now, the market for ceramic proppants is smaller than for conventional proppant, but it stands to reason that such proppant has a larger market share in more technically complex fracturing.
Both BJ Services and Halliburton mentioned the use of lightweight proppants as a differentiating characteristic in fracturing jobs. This is how Carbo maintained strength in a weak North American market.
Carbo also mentioned that it’s conducting more field trials with US producers this year. The company typically conducts such trials to demonstrate the potential effectiveness of its proppant against conventional proppant materials.
An increase in field trials is a signal of a potential pickup in interest from producers; this bodes well for the future. And unlike the pressure-pumping firms, Carbo appears not to need aggressively price cuts to compete; pricing was up 1 percent across the board.
The Russian business is also on track. Carbo has built a factory there, and volumes are ramping up as scheduled.
Carbo is pleased with the quality of material coming out of the factory. The company stated that its intention is to sign long-term supply agreements for its Russian proppant business and that profit margins in Russia would be roughly equivalent to the rest of the world.
These long-term contracts should offer Carbo a stable stream of international revenues. And there’s upside to proppant margins eventually as the technology gains greater adoption in Russia.
Finally, the real stand out in Carbo’s call was its Pinnacle Technologies division. The division reported a 36 percent jump in sales when compared to the second quarter of 2006. Again, Pinnacle would be involved with more technically complex jobs and is insulated from the epicenter of the weakness in fracturing.
Pinnacle is also involved in the potentially huge market for carbon sequestration. Basically, one idea for limiting emissions of carbon dioxide is to inject the gas into depleted oil or gas reservoirs where it will become permanently locked underground. But part of sequestering carbon is monitoring stored carbon on an ongoing basis to make sure the gas isn’t leaking and that underground pressures remain manageable.
Pinnacle uses advanced equipment, software and satellite technology to monitor slight changes in the shape of the Earth’s surface because of underground liquid and gas movement. This is the same basic technology used to monitor the progress of reservoir production and fracturing jobs.
These technologies would be sensitive enough to reliably detect leaks from a reservoir. Pinnacle already has a job underway in the San Juan Basin of the US and management has stated that it’s receiving considerable interest from other firms with carbon sequestration projects in the works.
Carbo Ceramics is outperforming the pressure-pumping firms in terms of holding the line on pricing. It’s also likely that, over time, ceramic proppant will continue to gain share from conventional proppant. Carbo can continue to see growth even if the overall fracturing market remains weak.
Of course, the North American gas market and pressure pumping were the topics of endless chatter during quarterly calls mainly because these remain the only markets showing any sign of a slowdown.
I highlighted Schlumberger in the July 20 flash alert. This remains my favorite long-term name in the services industry.
However, the stock is currently somewhat extended, and those who got in near my recommendation earlier this year have significant profits to protect. In the flash alert, I recommend ways to hedge your position and guard against the possibility of a correction in the stock.
I continue to recommend buying Weatherford at current levels. As I noted above, Weatherford is the most-exposed big services firm to Canada. This is mainly the result of its acquisition of Precision Drilling’s energy services division back in 2005.
But that exposure is clearly dropping. Management pointed out that 25 percent of Weatherford’s business was in Canada in the first quarter of 2006.
In the most recent quarter, however, the nation accounted for less than 10 percent of the total. And, as noted above, Weatherford was highly constructive on a recovery in the Canadian market, likely centered on heavy oil projects and deep natural gas wells.
Meanwhile, the real story for Weatherford remains the Eastern Hemisphere markets such as Africa, the Middle East and Asia. The company’s Eastern Hemisphere business posted year-over-year revenue growth of 40 percent, and management reiterated expectations that the level of growth would continue through the end of 2007.
Weatherford has been consistently posting higher growth than its peer group in key Eastern Hemisphere markets. This appears to still be a case of the company playing catch-up.
In other words, when Weatherford bought Precision, it was able to use its existing sales force and relationships with foreign producers to push key Precision services to international customers. In my opinion, Weatherford’s acquisition of Precision has been among the very best and most accretive in the energy services industry.
Some of the key services functions that Weatherford has been really pushing internationally are directional drilling, underbalanced drilling and completion. As the term directional drilling suggests, these are services related to the drilling of non-vertical wells.
Years ago, most Eastern Hemisphere markets could produce prolific oil and gas reserves using simple, cheap, vertical wells, but that’s no longer the case. Directional drilling is now becoming the standard.
I’ve explained underbalanced drilling before in TES, most recently in the April 18 issue, More Bullish Signs. Basically, it’s a way to produce mature wells more effectively.
And finally, the term completion refers to any equipment and hardware installed in a well to maximize production. This could include screens and filters designed to prevent sand from clogging well. Alternatively, it could mean intelligent wells that are able to sense whether they’re producing oil or water and shut down or slow production to compensate.
There are some key emerging technologies for Weatherford. When asked what the most significant technological development for the company was this year, CEO Duroc-Danner replied solid expandables.
To explain this market, consider that when a well is drilled, particularly a deep well, the drill bit likely passes through several different geological layers. Some of these layers may be areas of unusually low or high pressures; alternatively the drill bit may pass through multiple deposits of water, oil and gas each of differing pressures and temperatures.
To isolate certain zones that may cause trouble, operators install what’s known as casing. Basically, this is a very heavy sort of pipe that’s cemented in place in the well. This insulates, for example, high-pressure zones so that fluid doesn’t flow into the well and cause problems.
The problem with this is that casing is thick, heavy gauge pipe. You may have to install several lengths of casing to isolate a given area of the well; there may also be multiple areas that need to be isolated.
Consider that each subsequent length of casing you lower into a well needs to be of slightly smaller diameter than the length before it. If this weren’t the case, the casing simply wouldn’t fit.
Over time, the more lengths of casing you install, the thinner the diameter of the well. Therefore, when the well reaches its final depth, the well diameter might be smaller than optimum to produce efficiently. You can imagine how this could be an issue for a deeper well.
Weatherford’s solid expandables technology offers a solution to this problem. Basically, it’s a type of metal casing that can be placed in the well and expanded to fit the shape of the well itself.
This expandable will isolate trouble zones so that the operator can continue to drill the well without much loss of well diameter. Once the final intended depth of the well is attained, the operator can go back and case the individual segments.
The point is that the entire well can be drilled with very little loss of diameter. This is just the sort of high-tech service function that’s in high demand right now, and Weatherford has a very real competitive advantage.
CEO Duroc-Danner mentioned that the wells the firm is drilling today are increasingly prone to problems. This is really just another part of the end of easy oil thesis.
Oil reserves are getting more and more difficult, expensive and complex to produce, requiring far-more-advanced technology. Weatherford’s service offerings fit well with this theme.
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Additional Reports
Agribusiness giant Bunge is one of my longest-standing recommendations in TES. The stock is up more than 60 percent since it was originally recommended in early 2006. As a huge oilseed processor and a major player in the fertilizer market, Bunge is a great long-term play on growth in biofuels such as ethanol and biodiesel, as well as growing food demand in Asia.When I first recommended Bunge, the company was going through some difficult times. While North American operations were in decent shape, Bunge’s massive position in Brazil was a drag on earnings.
A rapid appreciation in the Brazilian real hurt farm incomes because most commodities are priced in dollars. As Brazilian farmers’ finances weakened, so did their purchases on fertilizer from Bunge; the company even had some problems with bad debts.
Again, the company saw a hiccup this past spring because of a very unusual phenomenon that developed between the spot price of soybeans and soybean futures. I explained that problem at great length and reiterated my buy recommendation in an April 23 flash alert, Agribusiness Update.
But the company has since recovered, and the stock is on fire. A farmer aid package passed by the Brazilian government last year helped shore up farmers’ finances, while a strong run in key agricultural commodities such as soybeans and corn helped boost revenues.
The minor hiccup experienced last spring faded soon thereafter. Check out the chart of soybeans below.
Source: Bloomberg
The dramatic run in soybeans since the beginning of October last year has really helped Brazilian farmers. This, in turn, has helped Bunge this year.
In the company’s July 26 quarterly report and conference call, management commented that fertilizer volumes have soared and prices for fertilizer are on the rise globally. Continued strong fertilizer volumes and pricing are also expected for the second half of 2007; Bunge raised its guidance for the remainder of the year.
Moreover, strong agricultural prices are offsetting some of the weakness in the Brazilian real, shown below.
Source: Bloomberg
This chart depicts Brazilian reals per US dollars. When the line is falling, it indicates a strengthening real.
For example, last March, it took nearly 2.8 real to buy $1. Now, it takes less than 1.9 real–a dramatic move in the currency.
I suspect that if agricultural prices weren’t this high, Brazilian farmers would be suffering a real depression. I also heard a few points in the Bunge call that I didn’t like.
First, despite the improvement in soybean prices, Bunge stated that farmers continue to face high debt levels. Management also indicated that the company was restricting credit given to farmers given that high debt level and, I suspect, a desire not to be left holding the proverbial bag again if Brazilian farm economics were to deteriorate or if real appreciation took a further bite.
Second, Bunge’s other business is processing oilseeds like soybeans into products like edible oils and soybean meal. Although management said that demand remains strong, it also suggested it’s exposed to commodity price inflation and having a tough time passing through all its costs to consumers.
Granted, I’m pulling just a few negative comments out of what was generally a bullish call. It’s clear to me that the company is recovering from a bad year in 2005 and early 2006.
In addition, I’m a big believer in the duel-demand drivers behind the agriculture industry—demand for biofuels coupled with growing demand for meat and foodstuffs from the developing world. This tidal wave of demand will put upward pressure on agricultural commodity prices and on key farm inputs such as fertilizer and pesticides for years to come.
But when it comes to Bunge, I’m becoming increasingly concerned that the stock is pricing in a lot of this good news. Consider this chart of Bunge’s quarterly price-to-earnings ratio over the past few years.
Source: Bunge, Bloomberg
Although I think some expansion in multiples is justified by the fact that Bunge is seeing a true business recovery, the company’s multiple has basically doubled recently. This suggests that investors may be pricing in all the best news, making Bunge vulnerable to a fall at the first whiff of bad news. Any of the minor elements outlined above could certainly catalyze such a move.
The stock is trading above my buy target and has been for some time. I’m now cutting my recommendation on Bunge to a hold from buy.
In addition, I recommend that all subscribers take half of their remaining position in Bunge off the table; for example, if you own 200 shares, sell 100 shares and book the more than 60 percent gain. I’m raising my recommended stop on the remaining position in Bunge from 60 to 85.50.
Again, however, my outlook for Bunge is more company-specific than a general concern about agriculture. Check out the biofuels field bet for a closer look at my favorite plays in the industry. I originally outlined this play in the Sept. 20, 2006, issue of TES, Fueled by Food.
When you buy into the field bet, remember the premise behind these plays. My goal in the field bets is to offer broad exposure to a long-term theme. I offer some more speculative picks mixed with some steadier plays.
I recommend buying all of the picks and simply allocating a smaller-than-normal position size to each. Specifically, I recommend putting 20 to 25 percent of what you’d normally allocate to a TES recommendation into each field bet play. This gives you broad exposure to the sector without all the risk.
The system has worked well. One of my plays in the biofuels field bet has been an almost total bust. However, the other plays have seen such dramatic run-ups that the field bet as a whole has been a big winner since its inception last year.
Solar power firms, including TES recommendations SunPower and MEMC Materials, markedly outperformed the broader markets during the height of the selling last week. Both firms are part of the alternatives field bet.
Both firms recently reported blowout earnings results. MEMC manufactures polysilicon and polysilicon wafers, the raw material used to produce both solar cells and semiconductor chips.
The company has plans to add to its manufacturing capacity while negotiating long-term supply agreements for a good piece of its capacity. These long-term agreements should serve to smooth out cyclicality and margins over time.
In addition, MEMC has focused on manufacturing flexibility. It has the capability of switching a good chunk of its manufacturing operations to serve either the solar or polysilicon industries.
SunPower still has the most-efficient cells in the solar business. Its cells are the most efficient in terms of converting sun energy into electrical power. And SunPower also produces cells that use less polysilicon, a major advantage given the fact that the industry is currently experiencing a shortage of polysilicon.
In its July 20 conference call, SunPower’s management announced further capacity additions to meet demand and results generally exceeded expectations. But the most important catalysts for the stock have been the steady stream of bullish news items to emerge in the past few months. The list includes high energy prices, increased attention on global warming legislation and the likelihood of an energy bill promoting alternatives in the US.
Both SunPower and MEMC remain buys as part of the alternatives field bet.
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