Drilling Down
The Federal Reserves’ discount rate cut Aug. 17 granted the broader markets a temporary reprieve from the selling, but the picture remains unsettled at best. The action during the past few weeks has been driven by a classic credit panic; access to financing, even for high credit-quality corporate and consumer borrowers, all but disappeared.
In addition to the immediate credit woes, the market is undergoing a growth scare just as it did in May 2006 and June 2006. The fear is that rising credit costs, coupled with a weakening housing market, will hit consumer spending, resulting in a further slowdown in US growth and, perhaps, a recession.
I can’t rule out more bad news on the credit front. And September is seasonally the worst month of the year for stocks, so it wouldn’t be surprising to see the broader averages retest or undercut the lows from last week.
And, as I pointed out in the Aug. 16 flash alert, Babies and Bathwater, the energy patch isn’t immune from this selloff. Although the fundamentals for oil and natural gas haven’t changed appreciably during the past few weeks, investors have been using the group as a funding currency.
But there’s an upside to all this. We’ve seen several broader market selloffs during the past few years and several corrections for the energy patch. But these short-term gyrations don’t change the fact that energy commodities, and related stocks, are currently in a long-term up-cycle that will last well into the coming decade. In bull markets, corrections are top-notch buying opportunities.
Just as in every other stock market selloff, institutional traders and managers sell their winners to raise cash. The energy patch has been a big winner so far this year, so it’s a logical target during a liquidity crunch.
But the action Aug. 16 and the morning of Aug. 17 looked like pure panic. One of the classic indicators of market panic is the S&P Volatility Index (VIX). The VIX is a measure of volatility priced into the S&P options market; when the VIX spikes, it indicates rising anxiety among traders.
Last week, the VIX hit 37.50 intraday, its highest level in years. Such spikes typically mark lows for the broader market; I suspect that the worst of the recent crisis is already in the rearview mirror.
Indeed, those with the foresight to buy the pullbacks in the energy patch during the past few years have been rewarded with stellar gains. In The Energy Strategist, we’ve been fortunate enough to pick up new recommendations during several of these corrections–most recent, during the early 2007 pullback in the energy group. Although the volatility can be scary during these buying opportunities, the potential rewards more than offset the risk.
I believe that we’re once again seeing just such an opportunity in the energy patch. During the past few months, I’ve recommended taking some partial gains in TES model Portfolio recommendations and raising our recommended stops to lock in gains. Now is the time to start putting some of that cash to work.
I’ve discussed natural gas on several occasions this summer, but some points are worth repeating. Several scenarios still loom that could quickly change the outlook for natural gas prices. See Natural Gas.
Several stocks have been beaten down because of the drop in natural gas prices. I’ve recommended avoiding most North American-leveraged companies. However, there’s one company I recently saw fit to move from the How They Rate Table to a full Portfolio recommendation. I explain why. See Value in Gas.
Nabors Industries has been in similarly weak markets and valuations within the past decade. However, it didn’t have the same international exposure it has today. This is a great risk/reward opportunity. See Valuation and Upside.
Exploration and production companies offer a direct play on natural resources such as natural gas liquids. One company exploiting the reserves of areas such as the Barnett Shale and taking advantage of the master limited partnership structure is worth a closer look. See The Producers.
Several Portfolio holdings have been stopped out since the last issue. Here’s a quick rundown on the stocks and what I see going forward. See Portfolio and Stops Update.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
Source: Energy Information Administration (EIA), Bloomberg
This chart shows US crude oil inventories. The dark-blue line represents weekly US oil inventories for 2007; the other three lines represent the five-year high in oil inventories, the five-year low and the five-year average. It’s clear that oil inventories are still far above average for this time of year; in fact, inventories are still at five-year record highs.
However, as I’ve pointed out on several occasions, these inventories aren’t high because of a lack of demand for crude in the US. Rather, a wave of refinery outages and shutdowns this year meant that US refiners weren’t able to refine crude into gasoline as quickly as normal. The crude just welled up in storage even as gasoline inventories sunk to multiyear record lows.
The conventional wisdom has been that, once the refinery bottlenecks began to clear, gasoline inventories would begin to rise and refiners would start working through the overhang of crude oil. Inventories of crude would drop.
As the chart indicates, crude inventories have been dropping during the past few weeks at a far faster-than-normal pace. Crude oil inventories are normalizing and that suggests that refiners are starting to work through the excess crude in storage. But check out the chart of gasoline stocks below.
Source: EIA, Bloomberg
This chart shows gasoline inventories on exactly the same type of seasonal chart as the crude oil chart above. What’s interesting here is that, although crude oil inventories are plummeting right now, gasoline stocks aren’t moving higher. In fact, current US gasoline stocks are close to record lows and still considerably below average for this time of year.
I won’t belabor the point by throwing up another chart of distillate inventories. Recall that distillates include heating oil and diesel fuels. Suffice it to say that distillate inventories aren’t building as quickly as normal for this time of year; we’re not seeing the normal build in heating oil inventories ahead of the winter season.
All told, the US picture for oil and related refined products still looks relatively tight. Supplies of crude, gasoline and heating oil certainly aren’t excessive. This is one factor that continues to support oil prices.
Internationally, the picture is even more bullish. The International Energy Agency’s (IEA) monthly oil market reports have been painting a continued bullish supply/demand balance for crude oil. On the supply front, the Organization of the Petroleum Exporting Countries (OPEC) continues to restrain production and looks unlikely to boost output at its September meeting.
Meanwhile non-OPEC production growth has been steadily revised lower because of delays in new field startups and faster-than-expected declines at existing fields. Non-OPEC oil production estimates have been consistently overly optimistic in recent years. Consider that back in late 2006, the IEA projected non-OPEC supply growth for 2007 of more than 1.7 million barrels per day; now, their estimates are for growth of 600,000 barrels per day this year.
The IEA estimates that OPEC countries have around 34.7 million barrels per day of potential production; this is the maximum amount OPEC can produce if it operates all fields at full capacity. Currently, OPEC is producing around 30 million barrels per day. But the OPEC call—a measure of how much oil OPEC needs to produce to meet demand—typically rises into the winter months.
The IEA estimates that the OPEC call will be just shy of 33 million barrels per day by the end of 2007. OPEC then has a choice: The group can increase production to try to meet that growing demand, or it can hold down production to levels under the call. If the group chooses the former option, spare capacity—the difference between potential production and actual production—will shrink to less than 2 million barrels of oil per day, a dangerously low level.
And it’s even worse than that. A good portion of that spare capacity is for heavy and/or sour grades of crude. This crude has limited marketability because not all countries have the capability to refine it. Therefore, actual spare capacity is likely far lower than these official figures.
And if OPEC decides not to boost output to the OPEC call, that would mean oil supplies aren’t sufficient to meet demand. This would have the effect of further drawing down global crude oil inventories. Either scenario would be bullish for crude.
Meanwhile, when it comes to demand, some continue to fret over the impact of a US economic slowdown on global oil consumption. However, the US isn’t really the area from which oil demand growth has been coming.
Consider that global oil demand has surged from 79.2 million barrels per day in 2003 to 83.7 million last year–a total increase of 4.5 million barrels per day. In the same time period, Chinese oil demand has increased 1.65 million barrels per day; China alone accounts for more than a third of oil demand growth during the past year.
Non-Organization for Economic Co-operation and Development (OECD) countries—a proxy for the emerging markets—accounted for more than 3.8 million barrels per day of the total increase in demand, 85 percent of the total. That means developing markets–not the US or European Union–have been behind the jump in oil demand during the past few years.
My point is that, as these economies continue to grow and mature, they’ll demand more crude. The increase in demand will more than swamp any temporary loss of demand from the US or Europe.
Bottom line: Crude oil prices could drop to the mid- to upper 60s short term because of concerns regarding global growth. But the fundamentals of tight supply and demand are intact; I’m looking for $80 crude before the end of 2007.
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Suffice it to say that natural gas prices have been weak mainly because of an overhang of gas stored in the US. By far the cleanest and most straightforward measure of natural gas prices is the so-called 12-month strip.
This is simply the average of the next 12 months’ natural gas futures prices. Gas demand is seasonal, and prices tend to be higher in the peak demand winter heating season. The strip takes this seasonality into account.
The current strip price is at $7.60 per million British thermal units (MMBtus). The chart below shows the strip during the past two years.
Source: Bloomberg
It’s clear that natural gas prices fell steadily from their post-hurricane highs in the low teens through the beginning of this year. Since then, gas prices have stabilized in the $7-to-$9 region.
This hasn’t been good news for firms with heavy gas production. And it hasn’t been good news at all for services and drilling firms with significant leverage to North American markets; American drilling activity is highly leveraged to the price of gas.
But this is all old news. Longer term, natural gas demand is rising faster than production. Natural gas is also a clean-burning fuel that will benefit from increasingly stringent environmental regulations. And because burning gas emits less than half the carbon of burning coal, gas is also a prime beneficiary of legislation aimed at capping carbon-dioxide emissions.
In the short term, I see plenty of potential catalysts for natural gas prices to go higher. For a detailed treatment of these points, check out the issues I referenced above. Here’s a brief summary:
On the supply front, if gas prices were to tumble below $6 per MMBtu for any length of time, then that would make many North American gas projects totally uneconomical. The resulting further decline in drilling activity would very quickly reduce supplies.
And short of a very deep recession with a large impact on demand for gas in the US or another record warm winter, I don’t see gas demand falling significantly from current levels.
Bottom line: I expect natural gas strip prices to be well supported in the $6.50-to-$7 per MMBtu range. And if any of the scenarios I outlined above occur, natural gas could easily trade right back to its 2005 highs in short order.
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As I noted above, traders are selling off their winning stocks to raise cash. This flight to cash has negatively impacted stocks such as Schlumberger and FMC Technologies that have been big winners this year.
But stocks leveraged to the North American natural gas markets haven’t been big winners. Sentiment surrounding many of these stocks is extremely bearish.
In fact, some stocks in the group are now trading at valuations unseen in years; the group is pricing in a great deal of bad news. Ironically, sleeper value plays are less vulnerable to cash selling.
The fact that gas prices are weak and drilling activity domestically is down is certainly no secret to anyone. Analysts have already slashed their earnings estimates to reflect lower gas prices and weaker activity. And managements at most of the North America-leveraged names indicated that they see little signs of a turnaround, at least in Canada, until mid-2008.
But there’s an old saw on Wall Street that a known fundamental is a useless fundamental. By the time all the bad news is well known and obvious to the public, the market has already priced it into the stock.
This weakness in gas prices and gas drilling is one reason that I’ve largely avoided North America-leveraged names in the TES model Portfolios. And it’s definitely not time to jump headlong into just any North American-leveraged firm.
Despite the selloff in this niche and tempting valuations, there are plenty of stocks that are vulnerable to more downside or represent dead money at best. A perfect example is pressure-pumping specialist BJ Services, a stock I recommended avoiding in the most-recent issue of TES.
To profit, you must be selective and look for stocks with downside valuation support and plenty of upside leverage to firming natural gas prices, as well as a resurgence in drilling activity. Nabors Industries is exactly that sort of candidate.
I highlighted the stock in the Aug. 10 issue of The Energy Letter, Opportunities Knock Again, and added the stock to the Gushers Portfolio in last week’s flash alert. But it’s high time for a more-comprehensive review of this stock and my rationale for jumping into Nabors now after more than two years of recommending that investors avoid this name.
Nabors is the world’s largest contract land driller, with a total of more than 600 land rigs operating worldwide. The company also has a small offshore drilling business and manufactures rigs and equipment in-house.
I explained the offshore contract drilling business at some length in the Jan. 3 issue of TES, The Deep End. To summarize, oil and gas producers don’t typically own their own rigs; instead, producers lease rigs from the contract drillers for a daily fee known as a day-rate.
The basic business model is the same both on- and offshore. The difference is clearly that a deepwater drilling rig takes longer to build, has more advanced technology and is far more expensive than a land rig. Day-rates for deepwater rigs–or, for that matter, shallow-water jackups–are far higher than for land rigs.
But it’s not that simple. There are many different kinds of land rigs. Some are designed to be carried on trucks, while others are transportable by helicopter.
And, more important, different rigs have different capabilities. More-advanced, “high-specification” rigs, for example, have more powerful drilling equipment and can drill deeper wells. Different types of land rigs can earn vastly different day-rates.
Like offshore rigs, there are also differences between geographic markets. The North American drilling market is enormous mainly because mature US fields require aggressive drilling to be productive. Consider that, of the 3,144 drilling rigs currently operating worldwide, 2,116 are in the US and Canada.
But the US and Canadian market is also more volatile and commodity sensitive. North America consists mainly of small operators with small, short-term projects.
Because most land drilling in the region targets gas, demand for rigs and day-rates is highly sensitive to gas prices. This is why this market has weakened so aggressively during the past year.
But international markets are entirely different. International operations typically require higher-specification rigs than North American work; basic, low-power rigs just can’t do the job.
The larger integrated oil companies and state-owned national oil companies (NOCs) tend to dominate international business. These firms are typically willing to sign multiyear contracts with land drillers at a pre-set day-rate; such contracts are typically called term contracts. Day-rates on term contracts are extraordinarily attractive right now and certainly far higher than what’s available in North America.
But let’s get back to Nabors. More than three-quarters of Nabors’ rigs are located in the US or Canada and only 19 percent are active internationally. That figure makes Nabors look totally dependent on this market.
But that figure is quite misleading; the number of rigs is less important than the type and specification of rigs in operation. Check out the chart below, which breaks down the contribution from each of Nabors’ contract drilling business units in the second quarter.
Source: Nabors Industries, Bloomberg
It’s clear from these charts that on a revenue and income basis, Nabors’ business in the lower 48 states is still its largest and most important. This chunk of Nabors’ business has deteriorated somewhat during the past year because of, as you’d expect, weakening natural gas prices and the moderation of the US active rig count.
Although the US drilling market has remained far more robust than Canada, activity has significantly declined. This is evident from Nabors’ most-recent report and conference call.
In the second quarter, the driller had 229 drilling rigs operating in the lower 48 states, down from 249 in the first quarter and 255 rigs in the year-ago quarter. Another metric that goes hand in hand with actual rigs operating is the profit margin on these rigs; this is simply the difference between the day-rate that Nabors charges and the cost of operating the rig.
In the second quarter, Nabors’ average margins in the US were $9,600 per day per rig, down from $10,800 a year ago. It’s obvious that the declining rig count and activity levels have put pressure on Nabors’ pricing power.
Nonetheless, a margin of $9,600 is high and healthy by historical standards. It’s only weak in comparison to the day-rates that Nabors was able to earn when gas prices were soaring and there was a shortage of rigs in 2005 and into early 2006.
Management stated unequivocally that there would be further margin deterioration in the remainder of the year. The reason is that the company was less aggressive cutting prices than some of its competitors; maintaining margins did cost Nabors some business. Current guidance is for US land drilling margins to decline by a further $1,000 per day by the end of 2007.
But none of this weakness or margin erosion was unexpected. Analysts already had factored that into their models before the company even reported.
And Nabors’ margins in the US are likely to remain far healthier than any of its competitors for one simple reason: the quality of its rigs. This is a major positive point for Nabors and a key part of my rationale for recommending the stock.
Around two-thirds of Nabors’ US rigs are high-specification rigs, and many of these were purpose built for certain producers with particular projects in mind. Some of the hottest natural gas reserves in the US right now include unconventional plays such as the Barnett Shale, located near Fort Worth, Texas.
Producing in Barnett is economic, even at current gas prices. But drilling wells in the region requires the use of more-capable drilling rigs designed with specific, specialized functionality.
Nabors’ strategy in these hot drilling markets is impressive. The company first agrees to design and build a high-specification rig for a specific purpose and secures a term contract for that rig at an attractive, pre-set day-rate. By securing a multiyear term contract before the rig is even built, Nabors essentially locks in the profitability of the rig; it’s not forced to speculate by building rigs and hoping the spot market for day-rates is strong when the rig is completed.
By signing term contracts guaranteeing a certain day-rate, Nabors effectively allows the producer to finance the construction of the rigs. This is the basic strategy Nabors has been consistently using to build up its high-specification fleet.
Demand for these fit-for-purpose rigs remains strong: Nabors has 81 new rigs under construction right now, all with signed term contracts to support profitability. Around 24 of these rigs will go into service by the end of 2007, and eight additional rigs will be activated at the beginning of 2008. In the second quarter, Nabors signed contracts for three more such rigs.
Nabors has also been careful to point out that even once term contracts expire, high-specification rigs are easier to contract and sport higher margins than commodity, less-capable rigs. Consider the case of some of the legacy rigs Nabors owns in the US that the company calls “old-and-tired” rigs.
Right now, 55 percent of its old-and-tired rigs are sitting idle, unable to get a contract at a decent price. Nabors has plans to get rid of these rigs entirely over time, first cannibalizing the rigs for spare parts and eventually scrapping them.
Given the overhang of less-capable rigs sitting idle right now, it’s no wonder that day-rates for such rigs are getting hit far harder than for the high-specification rigs. That’s bad news for some of Nabors’ competitors with heavier exposure to less cutting-edge rigs. That list would include Patterson-UTI and Bronco Drilling; both stocks are rated sells in the How They Rate Table.
Bottom line: Nabors’ US business is holding up well, supported by a solid foundation of term contracts and high-specification rigs with better day-rate prospects. Even better, when drilling activity does reaccelerate, Nabors will be best positioned to take advantage because the firm owns the high-specification rigs needed to produce North America’s hottest and fastest-growing reserves.
But the real shining star of Nabors’ business is its international operations. Right now, international operations account for slightly less than a quarter of the driller’s profits. But management has stated that operating profits from international operations will actually equal or exceed profits from the lower 48 states by the end of 2008.
International revenues are on fire. During its second quarter call, management likened strength in international markets to North America a year and a half ago, before falling gas prices put the drilling boom on hold there.
As I noted above, international projects are supported by long-term term contracts that offer attractive margins for drillers. In fact, the driller saw margins actually rise by $1,000 on average per rig in the second quarter; that’s a sign that there’s no lack of pricing power abroad. And Nabors has a number of international contracts scheduled to roll over soon, likely to higher day-rates.
The company has put together a widely diversified international business with operations in North Africa, Saudi Arabia, Russia, Latin America and, just recently, Russia. In many of these markets, Nabors has a leading market share.
The company has the scale and international network to bid on the most-attractive international projects. This is an advantage that smaller competitors just can’t match.
Of course, the rig quality is even more important internationally than in the US. When oil and gas prices began to rally after 2003, US and Canadian drilling activity picked up quickly. What many contractors did was simply take older low-specification rigs out of storage and put them into service; these rigs worked reasonably well on some basic North Americans projects. And the shortage of land rigs meant that drillers could earn respectable day-rates from basic rigs.
This isn’t true internationally because projects can’t be drilled with basic rigs. Because Nabors has the largest fleet of high-specification rigs of any driller, it’s well placed to bid on these contracts.
Also, Nabors has a track record of successfully building and putting new fit-for-purpose rigs into service. This reputation is another selling point when it comes to bidding on overseas contracts.
Nabors’ international operating income soared 30 percent between the first and second quarter this year; profits rose more than 70 percent over the same quarter a year ago. And management is looking for growth of well more than 50 percent next year. The boom in these markets will help offset weakness in margins in North America.
The driller has even been able to directly arbitrage US weakness and international strength by taking rigs out of the US or Canadian markets, upgrading them and putting them to work internationally on term contracts. Ten rigs are slated to do just that between now and the end of the year.
Finally, we can’t complete a discussion of the firm’s recent results without mentioning Canada. Canada is by far the weakest drilling market anywhere in the world right now. Check out the chart below.
Source: Bloomberg, Baker Hughes
This chart shows the Canadian active rig count during the past few years, a measure of how many rigs are actively drilling for oil or gas in the nation. The rig count is down 33 percent since last year at this time.
Canada’s weakness has been an enduring theme during the past few quarters; I highlighted this fact in the Aug. 1 issue of TES. Nabors was no exception, and the driller actually lost money there this quarter, dropping $8 million in the second quarter compared to a $20 million gain last year.
Canadian drilling activity generally picks up seasonally going into the latter half of the year. But Nabors and most other companies with exposure to the region have stated that this year’s seasonal pickup is likely to be less pronounced than most years. Nabors expects profit in Canada this year to be down 50 percent or more.
The good news is that Canada is only a small part of Nabors’ business, and because the company isn’t operating commodity rigs, it’s not exposed to the very worst of the weakness. Nabors also has been able to move some rigs to the US market or internationally where day-rates are far stronger.
And, of course, Canada’s weakness isn’t a surprise for investors. The slowdown in Canada is one reason that this stock has fallen so far this year. I suspect that Canada’s weakness is already priced into the stock.
There are clearly some areas of weakness for Nabors, including Canada and, to a lesser extent, the US. But the driller isn’t getting much credit for its still-strong term business, fleet of high-specification rigs and rapidly growing international business. These strong points aren’t insignificant; as I noted above, international markets will overtake the US lower 48 states in importance next year.
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The lowest earnings estimate I can find for Nabors this year is $3.25, with an estimate of $3.50 for next year. This isn’t the consensus estimate–those figures are much higher–but the lowest earnings estimate from the most bearish analyst out there. Using the lowest 2007 estimates, Nabors has been trading at around 8.3 to 9.3 times earnings in recent weeks and has hit this same valuation on several occasions since the end of last year.
Before that, the last time Nabors has traded with a price-to-earnings ratio (P/E) in this region was in the final two quarters of 2001. Again, at that time, natural gas was trading as low as just less than $2 per MMBtu compared with the current strip in the mid-$7s.
The North American rig count was at less than 1,000 compared with more than 2,000 today. Before that, Nabors traded at this same P/E back in 1998; again, at that time, gas prices were depressed under $2 per MMBtu and the rig count had collapsed.
But Nabors didn’t have the attractive term contracts and international business back in 1998 and 2001. The company had limited ability to hide from a weak North American business.
To make a long story short, Nabors stock seems to be pricing in a total collapse in business conditions and gas prices. That’s the definition of the worst-possible news in my book.
As I outlined above, I don’t see that happening this year or next year. And I see more upside than downside for natural gas.
If we use the Street’s most-bearish earnings forecasts for this year and apply a 7.5 P/E–less than in either 1998 or 2001–that yields an absolute valuation downside of about $24.50 per share, around 10 to 12 percent under where its currently trading. That’s the absolute valuation floor I see for this stock; interesting, this is just under technical support on the charts in the $27 region.
But consider the upside. If gas prices recover and drilling activity picks up in North America, Nabors could easily soar. At a minimum, I see upside to its early 2006 highs of more than $40 per share. But Nabors could easily earn north of $5 annually in a strong drilling market and has routinely sported a P/E well north of 10 times.
I see no reason why Nabors can’t trade in the mid-$50s within a year, assuming a turn in the gas business. Ten percent downside for a shot at 80 percent-plus in upside is just the sort of risk/reward proposition for which I’m looking.
Also, consider that the stock historically begins to rally in earnest before the rig count actually starts to recover–usually around six to nine months before. Therefore, a mid-2008 turn for the gas markets implies the stock starts running within the next month or two. Nabors Industries is a buy recommendation in the aggressive Gushers Portfolio.
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For those unfamiliar with the E&P industry, check out the Dec. 6, 2006, issue of TES, Looking for Some Upside, and the June 20 issue for a look at the European E&P industry.
One of the fastest-growing E&P companies in my coverage universe is natural gas-focused Quicksilver Resources (NYSE: KWK). Quicksilver, like current recommendations EOG Resources and XTO Energy, has a large position in the Barnett Shale of Texas.
The Barnett Shale is what’s called a resource play. Gas in the region is widely distributed, so the risk of any individual well coming up dry is minimal. Resource plays routinely have well success rates of more than 90 percent.
The company’s Barnett projects have been driving its production growth in recent quarters. Management indicated that, in the second quarter, total company volume topped 208 million cubic feet per day, up 27 percent over the second quarter of last year and above the company’s own guidance. That growth seems impressive enough on its own, but its Barnett assets were the big leader, showing more than 50 percent year-over-year growth in production volumes.
I also like the fact that Quicksilver indicated in its call that its drilling operations are becoming more efficient in the region. The company has experimented with drilling wells that are located closer together.
Quicksilver has reduced the spacing of the wells. Initial results show that these tighter-spaced wells produce just as prolifically as its older, more-widely spaced wells. This is good news because it means that the wells aren’t cannibalizing production from one another; tighter spacing just boosts the amount of gas the company can produce in the region.
And Quicksilver has also streamlined its drilling operation, cutting the time it takes to drill a well by 15 percent from average 2006 levels. That’s allowed the producer to consistently beat forecasts for the number of wells it can drill in a given quarter.
This year, Quicksilver expects to drill far more than the 180 wells it had originally planned to drill in the Barnett. Next year, the company has plans to accelerate drilling even more aggressively in the region; it has plenty of acreage left to exploit.
And there’s another point to keep in mind when it comes to the Barnett Shale play. Quicksilver stated in its second quarter call that its production from the region was 54 percent gas, 44 percent natural gas liquids (NGLs) and 2 percent condensate.
NGLs are hydrocarbons like propane, butane and natural gasoline that exist naturally in the natural gas of the Barnett Shale region. Gas that contains a large amount of NGLs is called wet gas, while gas light on NGLs is called dry gas.
NGLs can be removed from the gas stream and sold separately. But here’s the key: The value of NGLs tends to be tied more closely with crude oil than with natural gas prices. Therefore, this large NGL production is of huge value to Quicksilver and makes it less dependant on natural gas prices.
But Quicksilver isn’t just another Barnett play nor is it just another way to play a turn in gas prices. I see several more key positive catalysts for the stock in the next six to eight months.
First, Quicksilver has a shale play in West Texas that it’s testing and test drilling to see if it’s economical to produce. Although this is still the early stages of that play, the reserve looks promising and management expects to provide more information by the first quarter of 2008.
Quicksilver’s decision to put some of its assets into a master limited partnership structure (MLPs) is another catalyst. I recommend several MLPs in the TES model Portfolios and explained the group at length in the Nov. 22, 2006, issue of TES, Leading Income.
Suffice it to say that MLPs pay no corporate-level taxation and pass through the majority of their cash flows to investors as tax-advantaged distributions. The ideal asset to put into an MLP is something that generates consistent, strong cash flows; these cash flows underpin distributions.
Quicksilver has two assets that look ideal for such a structure. In August, the company placed its midstream assets–pipelines and gas processing facilities–into an MLP, Quicksilver Gas Services. Quicksilver Resources still owns a 75 percent stake Quicksilver Gas Services and raised nearly $90 million in its initial public offering of the MLP.
There are benefits to both sides from this deal in my view. Quicksilver gets cash to fund its drilling and expansion program and will still benefit from the cash flows of its midstream assets via its holding in the MLP.
Meanwhile, MLP holders get to own pipelines and processing facilities hooked up mainly to Quicksilver’s wells. All that production growth coming for Quicksilver means more volume flowing through the MLPs assets; more volume means higher distributions for the owners of the MLP.
In addition, Quicksilver owns a mature gas shale play in Michigan. This region has been heavily explored and depleted and won’t show much further growth in production. In fact, mainly because Quicksilver has been diverting its spending to the Barnett Shale, production from its Michigan reserves have been declining in recent quarters.
But the reserves are absolutely ideal for an MLP. Mature wells in the region offer reliable production for many years; these are long-lived assets. And by investing in better infrastructure, it would be possible to halt, or nearly halt, production declines.
Quicksilver is considering an MLP for these assets as well, and the listing of that partnership is another potential catalyst for the stock. Fast-growing Quicksilver Resources is added to the Gushers Portfolio as of this issue as a buy up to 44.
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I also recommended raising stops on many Portfolio recommendations to lock in further gains. Here’s a rundown:
Bunge (NYSE: BG)–In the Aug. 1 issue of TES, I recommended selling half your position in Bunge for a gain of roughly 60 percent on the stock. I also recommended raising your stop on the stock to $85.50 to lock in a solid 50 percent gain on the other half of the position. Bunge triggered the stop last week and is now considered sold from the TES model Portfolios for a total gain of around 55 percent.
For the reasons I outlined in the Aug. 1 issue, I don’t recommend jumping back into Bunge at this time.
General Maritime (NYSE: GMR)–This midsized tanker operator triggered my recommended $25 stop last week. If you look at the Proven Reserves Portfolio, this looks like a big loser given the entry price at $46.01. But that’s misleading because the entry price hasn’t been adjusted for the dividends and special dividends paid since my May 2005 recommendation.
If you bought the stock back then and held, you have earned roughly $2,500 in dividends for every 100 shares held. That works out to $25 per share; on an adjusted basis, the entry price is closer to $21.
All told, the stock was stopped out for a paltry 11.4 percent gain if you assume dividends reinvested. If you stuck the dividend cash in a money market fund, you’re up 14.7 percent.
Although this is an annoyingly volatile sector, I still believe in the long-term value of the tanker business. I also like General Maritime’s strategy of signing half of its ships to term contracts at specified, fixed rates. This reduces their exposure to the wild ups and downs of the spot tanker market.
Management has also sold off its older ships and is focusing on managing its most-profitable tankers. And finally, the company has established a minimum quarterly dividend for a shareholder that reduces the uncertainty surrounding its payout.
Spot tanker rates typically bottom out in August or September, so the stocks tend to outperform into fall. I see this as an excellent time to jump back into General Maritime; buy the stock below 28. It’s currently yielding more than 8.5 percent.
Schlumberger (NYSE: SLB)–This is without a doubt the finest oil services firm in the world. It’s also the best play I can think of on my “end of easy oil” thesis. Its high-tech, exploration-leveraged services are ideal for this environment.
That’s why it was so hard for me to recommend taking a third of your profits off the table for a near 70 percent gain in the July 20 flash alert, Schlumberger and Hedges. I also recommended raising the stop to $85.50 to lock in a gain; that stop has since been triggered for a 50 percent gain on the remaining two-thirds position.
I fully expect to recommend jumping back into Schlumberger late this year. But for now, the stock is extended and is vulnerable to selling by any investors looking to raise cash. I recommend accepting those nice gains for Schlumberger and standing on the sidelines for now.
Union Pacific (NYSE: UNP)—This railroad is a key transporter of coal, grains and ethanol in the US. It remains an excellent play on growth in ethanol, use and the need to transport coal from Western mines to Eastern utilities. I outlined my detailed case for the rails last summer in the July 12, 2006, issue, Beyond Oil and Gas.
The transports aren’t as leveraged to the economy as most pundits seem to believe. And for the most part, their second-quarter earnings releases were solid, indicating strong pricing trends and improving efficiency. Another endorsement for the group and the bull case is that billionaire Warren Buffett has been buying these stocks aggressively this year.
But the knee-jerk reaction is to sell these stocks at the first sign of an economic slowdown. That’s why I recommended taking some cash off the table and raising stops in a May 17 flash alert, Portfolio Updates and Changes. Union Pacific finally triggered that stop, handing us a total gain of nearly 30 percent including dividends.
I recommend standing aside on Union Pacific for now. But I’m watching the company and a number of other transports carefully. I anticipate a tremendous buying opportunity this fall. After all, who wants to bet against Buffett?
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In addition to the immediate credit woes, the market is undergoing a growth scare just as it did in May 2006 and June 2006. The fear is that rising credit costs, coupled with a weakening housing market, will hit consumer spending, resulting in a further slowdown in US growth and, perhaps, a recession.
I can’t rule out more bad news on the credit front. And September is seasonally the worst month of the year for stocks, so it wouldn’t be surprising to see the broader averages retest or undercut the lows from last week.
And, as I pointed out in the Aug. 16 flash alert, Babies and Bathwater, the energy patch isn’t immune from this selloff. Although the fundamentals for oil and natural gas haven’t changed appreciably during the past few weeks, investors have been using the group as a funding currency.
But there’s an upside to all this. We’ve seen several broader market selloffs during the past few years and several corrections for the energy patch. But these short-term gyrations don’t change the fact that energy commodities, and related stocks, are currently in a long-term up-cycle that will last well into the coming decade. In bull markets, corrections are top-notch buying opportunities.
Just as in every other stock market selloff, institutional traders and managers sell their winners to raise cash. The energy patch has been a big winner so far this year, so it’s a logical target during a liquidity crunch.
But the action Aug. 16 and the morning of Aug. 17 looked like pure panic. One of the classic indicators of market panic is the S&P Volatility Index (VIX). The VIX is a measure of volatility priced into the S&P options market; when the VIX spikes, it indicates rising anxiety among traders.
Last week, the VIX hit 37.50 intraday, its highest level in years. Such spikes typically mark lows for the broader market; I suspect that the worst of the recent crisis is already in the rearview mirror.
Indeed, those with the foresight to buy the pullbacks in the energy patch during the past few years have been rewarded with stellar gains. In The Energy Strategist, we’ve been fortunate enough to pick up new recommendations during several of these corrections–most recent, during the early 2007 pullback in the energy group. Although the volatility can be scary during these buying opportunities, the potential rewards more than offset the risk.
I believe that we’re once again seeing just such an opportunity in the energy patch. During the past few months, I’ve recommended taking some partial gains in TES model Portfolio recommendations and raising our recommended stops to lock in gains. Now is the time to start putting some of that cash to work.
In This Issue
All told, the US picture for oil and related refined products still looks relatively tight. Internationally, the picture is even more bullish. In my opinion, crude will likely hit the $80 mark before the end of the year. See Bubbling Crude.I’ve discussed natural gas on several occasions this summer, but some points are worth repeating. Several scenarios still loom that could quickly change the outlook for natural gas prices. See Natural Gas.
Several stocks have been beaten down because of the drop in natural gas prices. I’ve recommended avoiding most North American-leveraged companies. However, there’s one company I recently saw fit to move from the How They Rate Table to a full Portfolio recommendation. I explain why. See Value in Gas.
Nabors Industries has been in similarly weak markets and valuations within the past decade. However, it didn’t have the same international exposure it has today. This is a great risk/reward opportunity. See Valuation and Upside.
Exploration and production companies offer a direct play on natural resources such as natural gas liquids. One company exploiting the reserves of areas such as the Barnett Shale and taking advantage of the master limited partnership structure is worth a closer look. See The Producers.
Several Portfolio holdings have been stopped out since the last issue. Here’s a quick rundown on the stocks and what I see going forward. See Portfolio and Stops Update.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
- General Maritime (NYSE:GMR)
- Nabors Industries (NYSE: NBR)
- Quicksilver Resources (NYSE: KWK)
- Bunge (NYSE: BG)
- Schlumberger (NYSE: SLB)
- Union Pacific (NYSE: UNP)
Bubbling Crude
Before we delve into details on individual stocks, let’s take a quick look at the outlook for crude oil. First, check out the chart below.Source: Energy Information Administration (EIA), Bloomberg
This chart shows US crude oil inventories. The dark-blue line represents weekly US oil inventories for 2007; the other three lines represent the five-year high in oil inventories, the five-year low and the five-year average. It’s clear that oil inventories are still far above average for this time of year; in fact, inventories are still at five-year record highs.
However, as I’ve pointed out on several occasions, these inventories aren’t high because of a lack of demand for crude in the US. Rather, a wave of refinery outages and shutdowns this year meant that US refiners weren’t able to refine crude into gasoline as quickly as normal. The crude just welled up in storage even as gasoline inventories sunk to multiyear record lows.
The conventional wisdom has been that, once the refinery bottlenecks began to clear, gasoline inventories would begin to rise and refiners would start working through the overhang of crude oil. Inventories of crude would drop.
As the chart indicates, crude inventories have been dropping during the past few weeks at a far faster-than-normal pace. Crude oil inventories are normalizing and that suggests that refiners are starting to work through the excess crude in storage. But check out the chart of gasoline stocks below.
Source: EIA, Bloomberg
This chart shows gasoline inventories on exactly the same type of seasonal chart as the crude oil chart above. What’s interesting here is that, although crude oil inventories are plummeting right now, gasoline stocks aren’t moving higher. In fact, current US gasoline stocks are close to record lows and still considerably below average for this time of year.
I won’t belabor the point by throwing up another chart of distillate inventories. Recall that distillates include heating oil and diesel fuels. Suffice it to say that distillate inventories aren’t building as quickly as normal for this time of year; we’re not seeing the normal build in heating oil inventories ahead of the winter season.
All told, the US picture for oil and related refined products still looks relatively tight. Supplies of crude, gasoline and heating oil certainly aren’t excessive. This is one factor that continues to support oil prices.
Internationally, the picture is even more bullish. The International Energy Agency’s (IEA) monthly oil market reports have been painting a continued bullish supply/demand balance for crude oil. On the supply front, the Organization of the Petroleum Exporting Countries (OPEC) continues to restrain production and looks unlikely to boost output at its September meeting.
Meanwhile non-OPEC production growth has been steadily revised lower because of delays in new field startups and faster-than-expected declines at existing fields. Non-OPEC oil production estimates have been consistently overly optimistic in recent years. Consider that back in late 2006, the IEA projected non-OPEC supply growth for 2007 of more than 1.7 million barrels per day; now, their estimates are for growth of 600,000 barrels per day this year.
The IEA estimates that OPEC countries have around 34.7 million barrels per day of potential production; this is the maximum amount OPEC can produce if it operates all fields at full capacity. Currently, OPEC is producing around 30 million barrels per day. But the OPEC call—a measure of how much oil OPEC needs to produce to meet demand—typically rises into the winter months.
The IEA estimates that the OPEC call will be just shy of 33 million barrels per day by the end of 2007. OPEC then has a choice: The group can increase production to try to meet that growing demand, or it can hold down production to levels under the call. If the group chooses the former option, spare capacity—the difference between potential production and actual production—will shrink to less than 2 million barrels of oil per day, a dangerously low level.
And it’s even worse than that. A good portion of that spare capacity is for heavy and/or sour grades of crude. This crude has limited marketability because not all countries have the capability to refine it. Therefore, actual spare capacity is likely far lower than these official figures.
And if OPEC decides not to boost output to the OPEC call, that would mean oil supplies aren’t sufficient to meet demand. This would have the effect of further drawing down global crude oil inventories. Either scenario would be bullish for crude.
Meanwhile, when it comes to demand, some continue to fret over the impact of a US economic slowdown on global oil consumption. However, the US isn’t really the area from which oil demand growth has been coming.
Consider that global oil demand has surged from 79.2 million barrels per day in 2003 to 83.7 million last year–a total increase of 4.5 million barrels per day. In the same time period, Chinese oil demand has increased 1.65 million barrels per day; China alone accounts for more than a third of oil demand growth during the past year.
Non-Organization for Economic Co-operation and Development (OECD) countries—a proxy for the emerging markets—accounted for more than 3.8 million barrels per day of the total increase in demand, 85 percent of the total. That means developing markets–not the US or European Union–have been behind the jump in oil demand during the past few years.
My point is that, as these economies continue to grow and mature, they’ll demand more crude. The increase in demand will more than swamp any temporary loss of demand from the US or Europe.
Bottom line: Crude oil prices could drop to the mid- to upper 60s short term because of concerns regarding global growth. But the fundamentals of tight supply and demand are intact; I’m looking for $80 crude before the end of 2007.
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Natural Gas
I’ve discussed natural gas and the natural gas markets on numerous occasions this summer, so I won’t rehash all those points here. For new subscribers unfamiliar with the supply-and-demand balance for gas, check out the June 20 issue, Europe’s Gas and the Aug. 1 issue, Earnings in Review.Suffice it to say that natural gas prices have been weak mainly because of an overhang of gas stored in the US. By far the cleanest and most straightforward measure of natural gas prices is the so-called 12-month strip.
This is simply the average of the next 12 months’ natural gas futures prices. Gas demand is seasonal, and prices tend to be higher in the peak demand winter heating season. The strip takes this seasonality into account.
The current strip price is at $7.60 per million British thermal units (MMBtus). The chart below shows the strip during the past two years.
Source: Bloomberg
It’s clear that natural gas prices fell steadily from their post-hurricane highs in the low teens through the beginning of this year. Since then, gas prices have stabilized in the $7-to-$9 region.
This hasn’t been good news for firms with heavy gas production. And it hasn’t been good news at all for services and drilling firms with significant leverage to North American markets; American drilling activity is highly leveraged to the price of gas.
But this is all old news. Longer term, natural gas demand is rising faster than production. Natural gas is also a clean-burning fuel that will benefit from increasingly stringent environmental regulations. And because burning gas emits less than half the carbon of burning coal, gas is also a prime beneficiary of legislation aimed at capping carbon-dioxide emissions.
In the short term, I see plenty of potential catalysts for natural gas prices to go higher. For a detailed treatment of these points, check out the issues I referenced above. Here’s a brief summary:
- Canadian drilling activity has come to a near standstill since mid-2006. Because Canadian wells have a 30 percent annualized decline rate, reduced activity is already starting to impact production. There are simply not enough new wells coming on line to offset natural production declines from existing wells.
- Category 5 Hurricane Dean missed the main US gas-producing assets in the Gulf of Mexico. But this was a powerful hurricane and serves as a reminder that, just because 2006 was a light year for hurricane activity, doesn’t mean that 2007 will be similarly quiet. With the most-active part of hurricane season still ahead, there’s still a very real possibility of a disruption to production.
- The winter of 2005-06 was very mild, and last year’s winter was basically average after a warm start. A cold start to the season this year could change the natural gas storage picture in a matter of weeks.
- A cold winter in Europe would spell higher gas demand there and higher imports of liquefied natural gas (LNG). This would divert LNG supplies from the US market.
- Russian natural gas supplies to Europe could be disrupted by a political dispute or simply because of a cold winter in Russia itself. This would spell higher LNG imports into Europe and less LNG for the US.
- Further action on carbon-dioxide legislation in the US would make natural gas-fired plants more attractive and would lead to further building of gas-fired plants in the US.
On the supply front, if gas prices were to tumble below $6 per MMBtu for any length of time, then that would make many North American gas projects totally uneconomical. The resulting further decline in drilling activity would very quickly reduce supplies.
And short of a very deep recession with a large impact on demand for gas in the US or another record warm winter, I don’t see gas demand falling significantly from current levels.
Bottom line: I expect natural gas strip prices to be well supported in the $6.50-to-$7 per MMBtu range. And if any of the scenarios I outlined above occur, natural gas could easily trade right back to its 2005 highs in short order.
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Value in Gas
During market corrections, I like to look for value plays and turnaround candidates. Stocks with exposure to the North American gas markets or drilling activity have been beaten down of late. The sector is a prime hunting ground for such plays.As I noted above, traders are selling off their winning stocks to raise cash. This flight to cash has negatively impacted stocks such as Schlumberger and FMC Technologies that have been big winners this year.
But stocks leveraged to the North American natural gas markets haven’t been big winners. Sentiment surrounding many of these stocks is extremely bearish.
In fact, some stocks in the group are now trading at valuations unseen in years; the group is pricing in a great deal of bad news. Ironically, sleeper value plays are less vulnerable to cash selling.
The fact that gas prices are weak and drilling activity domestically is down is certainly no secret to anyone. Analysts have already slashed their earnings estimates to reflect lower gas prices and weaker activity. And managements at most of the North America-leveraged names indicated that they see little signs of a turnaround, at least in Canada, until mid-2008.
But there’s an old saw on Wall Street that a known fundamental is a useless fundamental. By the time all the bad news is well known and obvious to the public, the market has already priced it into the stock.
This weakness in gas prices and gas drilling is one reason that I’ve largely avoided North America-leveraged names in the TES model Portfolios. And it’s definitely not time to jump headlong into just any North American-leveraged firm.
Despite the selloff in this niche and tempting valuations, there are plenty of stocks that are vulnerable to more downside or represent dead money at best. A perfect example is pressure-pumping specialist BJ Services, a stock I recommended avoiding in the most-recent issue of TES.
To profit, you must be selective and look for stocks with downside valuation support and plenty of upside leverage to firming natural gas prices, as well as a resurgence in drilling activity. Nabors Industries is exactly that sort of candidate.
I highlighted the stock in the Aug. 10 issue of The Energy Letter, Opportunities Knock Again, and added the stock to the Gushers Portfolio in last week’s flash alert. But it’s high time for a more-comprehensive review of this stock and my rationale for jumping into Nabors now after more than two years of recommending that investors avoid this name.
Nabors is the world’s largest contract land driller, with a total of more than 600 land rigs operating worldwide. The company also has a small offshore drilling business and manufactures rigs and equipment in-house.
I explained the offshore contract drilling business at some length in the Jan. 3 issue of TES, The Deep End. To summarize, oil and gas producers don’t typically own their own rigs; instead, producers lease rigs from the contract drillers for a daily fee known as a day-rate.
The basic business model is the same both on- and offshore. The difference is clearly that a deepwater drilling rig takes longer to build, has more advanced technology and is far more expensive than a land rig. Day-rates for deepwater rigs–or, for that matter, shallow-water jackups–are far higher than for land rigs.
But it’s not that simple. There are many different kinds of land rigs. Some are designed to be carried on trucks, while others are transportable by helicopter.
And, more important, different rigs have different capabilities. More-advanced, “high-specification” rigs, for example, have more powerful drilling equipment and can drill deeper wells. Different types of land rigs can earn vastly different day-rates.
Like offshore rigs, there are also differences between geographic markets. The North American drilling market is enormous mainly because mature US fields require aggressive drilling to be productive. Consider that, of the 3,144 drilling rigs currently operating worldwide, 2,116 are in the US and Canada.
But the US and Canadian market is also more volatile and commodity sensitive. North America consists mainly of small operators with small, short-term projects.
Because most land drilling in the region targets gas, demand for rigs and day-rates is highly sensitive to gas prices. This is why this market has weakened so aggressively during the past year.
But international markets are entirely different. International operations typically require higher-specification rigs than North American work; basic, low-power rigs just can’t do the job.
The larger integrated oil companies and state-owned national oil companies (NOCs) tend to dominate international business. These firms are typically willing to sign multiyear contracts with land drillers at a pre-set day-rate; such contracts are typically called term contracts. Day-rates on term contracts are extraordinarily attractive right now and certainly far higher than what’s available in North America.
But let’s get back to Nabors. More than three-quarters of Nabors’ rigs are located in the US or Canada and only 19 percent are active internationally. That figure makes Nabors look totally dependent on this market.
But that figure is quite misleading; the number of rigs is less important than the type and specification of rigs in operation. Check out the chart below, which breaks down the contribution from each of Nabors’ contract drilling business units in the second quarter.
Source: Nabors Industries, Bloomberg
It’s clear from these charts that on a revenue and income basis, Nabors’ business in the lower 48 states is still its largest and most important. This chunk of Nabors’ business has deteriorated somewhat during the past year because of, as you’d expect, weakening natural gas prices and the moderation of the US active rig count.
Although the US drilling market has remained far more robust than Canada, activity has significantly declined. This is evident from Nabors’ most-recent report and conference call.
In the second quarter, the driller had 229 drilling rigs operating in the lower 48 states, down from 249 in the first quarter and 255 rigs in the year-ago quarter. Another metric that goes hand in hand with actual rigs operating is the profit margin on these rigs; this is simply the difference between the day-rate that Nabors charges and the cost of operating the rig.
In the second quarter, Nabors’ average margins in the US were $9,600 per day per rig, down from $10,800 a year ago. It’s obvious that the declining rig count and activity levels have put pressure on Nabors’ pricing power.
Nonetheless, a margin of $9,600 is high and healthy by historical standards. It’s only weak in comparison to the day-rates that Nabors was able to earn when gas prices were soaring and there was a shortage of rigs in 2005 and into early 2006.
Management stated unequivocally that there would be further margin deterioration in the remainder of the year. The reason is that the company was less aggressive cutting prices than some of its competitors; maintaining margins did cost Nabors some business. Current guidance is for US land drilling margins to decline by a further $1,000 per day by the end of 2007.
But none of this weakness or margin erosion was unexpected. Analysts already had factored that into their models before the company even reported.
And Nabors’ margins in the US are likely to remain far healthier than any of its competitors for one simple reason: the quality of its rigs. This is a major positive point for Nabors and a key part of my rationale for recommending the stock.
Around two-thirds of Nabors’ US rigs are high-specification rigs, and many of these were purpose built for certain producers with particular projects in mind. Some of the hottest natural gas reserves in the US right now include unconventional plays such as the Barnett Shale, located near Fort Worth, Texas.
Producing in Barnett is economic, even at current gas prices. But drilling wells in the region requires the use of more-capable drilling rigs designed with specific, specialized functionality.
Nabors’ strategy in these hot drilling markets is impressive. The company first agrees to design and build a high-specification rig for a specific purpose and secures a term contract for that rig at an attractive, pre-set day-rate. By securing a multiyear term contract before the rig is even built, Nabors essentially locks in the profitability of the rig; it’s not forced to speculate by building rigs and hoping the spot market for day-rates is strong when the rig is completed.
By signing term contracts guaranteeing a certain day-rate, Nabors effectively allows the producer to finance the construction of the rigs. This is the basic strategy Nabors has been consistently using to build up its high-specification fleet.
Demand for these fit-for-purpose rigs remains strong: Nabors has 81 new rigs under construction right now, all with signed term contracts to support profitability. Around 24 of these rigs will go into service by the end of 2007, and eight additional rigs will be activated at the beginning of 2008. In the second quarter, Nabors signed contracts for three more such rigs.
Nabors has also been careful to point out that even once term contracts expire, high-specification rigs are easier to contract and sport higher margins than commodity, less-capable rigs. Consider the case of some of the legacy rigs Nabors owns in the US that the company calls “old-and-tired” rigs.
Right now, 55 percent of its old-and-tired rigs are sitting idle, unable to get a contract at a decent price. Nabors has plans to get rid of these rigs entirely over time, first cannibalizing the rigs for spare parts and eventually scrapping them.
Given the overhang of less-capable rigs sitting idle right now, it’s no wonder that day-rates for such rigs are getting hit far harder than for the high-specification rigs. That’s bad news for some of Nabors’ competitors with heavier exposure to less cutting-edge rigs. That list would include Patterson-UTI and Bronco Drilling; both stocks are rated sells in the How They Rate Table.
Bottom line: Nabors’ US business is holding up well, supported by a solid foundation of term contracts and high-specification rigs with better day-rate prospects. Even better, when drilling activity does reaccelerate, Nabors will be best positioned to take advantage because the firm owns the high-specification rigs needed to produce North America’s hottest and fastest-growing reserves.
But the real shining star of Nabors’ business is its international operations. Right now, international operations account for slightly less than a quarter of the driller’s profits. But management has stated that operating profits from international operations will actually equal or exceed profits from the lower 48 states by the end of 2008.
International revenues are on fire. During its second quarter call, management likened strength in international markets to North America a year and a half ago, before falling gas prices put the drilling boom on hold there.
As I noted above, international projects are supported by long-term term contracts that offer attractive margins for drillers. In fact, the driller saw margins actually rise by $1,000 on average per rig in the second quarter; that’s a sign that there’s no lack of pricing power abroad. And Nabors has a number of international contracts scheduled to roll over soon, likely to higher day-rates.
The company has put together a widely diversified international business with operations in North Africa, Saudi Arabia, Russia, Latin America and, just recently, Russia. In many of these markets, Nabors has a leading market share.
The company has the scale and international network to bid on the most-attractive international projects. This is an advantage that smaller competitors just can’t match.
Of course, the rig quality is even more important internationally than in the US. When oil and gas prices began to rally after 2003, US and Canadian drilling activity picked up quickly. What many contractors did was simply take older low-specification rigs out of storage and put them into service; these rigs worked reasonably well on some basic North Americans projects. And the shortage of land rigs meant that drillers could earn respectable day-rates from basic rigs.
This isn’t true internationally because projects can’t be drilled with basic rigs. Because Nabors has the largest fleet of high-specification rigs of any driller, it’s well placed to bid on these contracts.
Also, Nabors has a track record of successfully building and putting new fit-for-purpose rigs into service. This reputation is another selling point when it comes to bidding on overseas contracts.
Nabors’ international operating income soared 30 percent between the first and second quarter this year; profits rose more than 70 percent over the same quarter a year ago. And management is looking for growth of well more than 50 percent next year. The boom in these markets will help offset weakness in margins in North America.
The driller has even been able to directly arbitrage US weakness and international strength by taking rigs out of the US or Canadian markets, upgrading them and putting them to work internationally on term contracts. Ten rigs are slated to do just that between now and the end of the year.
Finally, we can’t complete a discussion of the firm’s recent results without mentioning Canada. Canada is by far the weakest drilling market anywhere in the world right now. Check out the chart below.
Source: Bloomberg, Baker Hughes
This chart shows the Canadian active rig count during the past few years, a measure of how many rigs are actively drilling for oil or gas in the nation. The rig count is down 33 percent since last year at this time.
Canada’s weakness has been an enduring theme during the past few quarters; I highlighted this fact in the Aug. 1 issue of TES. Nabors was no exception, and the driller actually lost money there this quarter, dropping $8 million in the second quarter compared to a $20 million gain last year.
Canadian drilling activity generally picks up seasonally going into the latter half of the year. But Nabors and most other companies with exposure to the region have stated that this year’s seasonal pickup is likely to be less pronounced than most years. Nabors expects profit in Canada this year to be down 50 percent or more.
The good news is that Canada is only a small part of Nabors’ business, and because the company isn’t operating commodity rigs, it’s not exposed to the very worst of the weakness. Nabors also has been able to move some rigs to the US market or internationally where day-rates are far stronger.
And, of course, Canada’s weakness isn’t a surprise for investors. The slowdown in Canada is one reason that this stock has fallen so far this year. I suspect that Canada’s weakness is already priced into the stock.
There are clearly some areas of weakness for Nabors, including Canada and, to a lesser extent, the US. But the driller isn’t getting much credit for its still-strong term business, fleet of high-specification rigs and rapidly growing international business. These strong points aren’t insignificant; as I noted above, international markets will overtake the US lower 48 states in importance next year.
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Valuation and Upside
I believe Nabors Industries’ stock is pricing in all the bad news for its North American business. In the Aug. 10 issue of The Energy Letter and in last week’s flash alert, I outlined a valuation case based on book value. I won’t rehash those arguments here; rather, let’s look at valuation in another way.The lowest earnings estimate I can find for Nabors this year is $3.25, with an estimate of $3.50 for next year. This isn’t the consensus estimate–those figures are much higher–but the lowest earnings estimate from the most bearish analyst out there. Using the lowest 2007 estimates, Nabors has been trading at around 8.3 to 9.3 times earnings in recent weeks and has hit this same valuation on several occasions since the end of last year.
Before that, the last time Nabors has traded with a price-to-earnings ratio (P/E) in this region was in the final two quarters of 2001. Again, at that time, natural gas was trading as low as just less than $2 per MMBtu compared with the current strip in the mid-$7s.
The North American rig count was at less than 1,000 compared with more than 2,000 today. Before that, Nabors traded at this same P/E back in 1998; again, at that time, gas prices were depressed under $2 per MMBtu and the rig count had collapsed.
But Nabors didn’t have the attractive term contracts and international business back in 1998 and 2001. The company had limited ability to hide from a weak North American business.
To make a long story short, Nabors stock seems to be pricing in a total collapse in business conditions and gas prices. That’s the definition of the worst-possible news in my book.
As I outlined above, I don’t see that happening this year or next year. And I see more upside than downside for natural gas.
If we use the Street’s most-bearish earnings forecasts for this year and apply a 7.5 P/E–less than in either 1998 or 2001–that yields an absolute valuation downside of about $24.50 per share, around 10 to 12 percent under where its currently trading. That’s the absolute valuation floor I see for this stock; interesting, this is just under technical support on the charts in the $27 region.
But consider the upside. If gas prices recover and drilling activity picks up in North America, Nabors could easily soar. At a minimum, I see upside to its early 2006 highs of more than $40 per share. But Nabors could easily earn north of $5 annually in a strong drilling market and has routinely sported a P/E well north of 10 times.
I see no reason why Nabors can’t trade in the mid-$50s within a year, assuming a turn in the gas business. Ten percent downside for a shot at 80 percent-plus in upside is just the sort of risk/reward proposition for which I’m looking.
Also, consider that the stock historically begins to rally in earnest before the rig count actually starts to recover–usually around six to nine months before. Therefore, a mid-2008 turn for the gas markets implies the stock starts running within the next month or two. Nabors Industries is a buy recommendation in the aggressive Gushers Portfolio.
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The Producers
As the term suggests, exploration and production (E&P) firms are companies that actually go out buy up reserves and produce oil or gas. I’ve highlighted the sector on several occasions in TES and outlined my basic philosophy for investing in E&Ps.For those unfamiliar with the E&P industry, check out the Dec. 6, 2006, issue of TES, Looking for Some Upside, and the June 20 issue for a look at the European E&P industry.
One of the fastest-growing E&P companies in my coverage universe is natural gas-focused Quicksilver Resources (NYSE: KWK). Quicksilver, like current recommendations EOG Resources and XTO Energy, has a large position in the Barnett Shale of Texas.
The Barnett Shale is what’s called a resource play. Gas in the region is widely distributed, so the risk of any individual well coming up dry is minimal. Resource plays routinely have well success rates of more than 90 percent.
The company’s Barnett projects have been driving its production growth in recent quarters. Management indicated that, in the second quarter, total company volume topped 208 million cubic feet per day, up 27 percent over the second quarter of last year and above the company’s own guidance. That growth seems impressive enough on its own, but its Barnett assets were the big leader, showing more than 50 percent year-over-year growth in production volumes.
I also like the fact that Quicksilver indicated in its call that its drilling operations are becoming more efficient in the region. The company has experimented with drilling wells that are located closer together.
Quicksilver has reduced the spacing of the wells. Initial results show that these tighter-spaced wells produce just as prolifically as its older, more-widely spaced wells. This is good news because it means that the wells aren’t cannibalizing production from one another; tighter spacing just boosts the amount of gas the company can produce in the region.
And Quicksilver has also streamlined its drilling operation, cutting the time it takes to drill a well by 15 percent from average 2006 levels. That’s allowed the producer to consistently beat forecasts for the number of wells it can drill in a given quarter.
This year, Quicksilver expects to drill far more than the 180 wells it had originally planned to drill in the Barnett. Next year, the company has plans to accelerate drilling even more aggressively in the region; it has plenty of acreage left to exploit.
And there’s another point to keep in mind when it comes to the Barnett Shale play. Quicksilver stated in its second quarter call that its production from the region was 54 percent gas, 44 percent natural gas liquids (NGLs) and 2 percent condensate.
NGLs are hydrocarbons like propane, butane and natural gasoline that exist naturally in the natural gas of the Barnett Shale region. Gas that contains a large amount of NGLs is called wet gas, while gas light on NGLs is called dry gas.
NGLs can be removed from the gas stream and sold separately. But here’s the key: The value of NGLs tends to be tied more closely with crude oil than with natural gas prices. Therefore, this large NGL production is of huge value to Quicksilver and makes it less dependant on natural gas prices.
But Quicksilver isn’t just another Barnett play nor is it just another way to play a turn in gas prices. I see several more key positive catalysts for the stock in the next six to eight months.
First, Quicksilver has a shale play in West Texas that it’s testing and test drilling to see if it’s economical to produce. Although this is still the early stages of that play, the reserve looks promising and management expects to provide more information by the first quarter of 2008.
Quicksilver’s decision to put some of its assets into a master limited partnership structure (MLPs) is another catalyst. I recommend several MLPs in the TES model Portfolios and explained the group at length in the Nov. 22, 2006, issue of TES, Leading Income.
Suffice it to say that MLPs pay no corporate-level taxation and pass through the majority of their cash flows to investors as tax-advantaged distributions. The ideal asset to put into an MLP is something that generates consistent, strong cash flows; these cash flows underpin distributions.
Quicksilver has two assets that look ideal for such a structure. In August, the company placed its midstream assets–pipelines and gas processing facilities–into an MLP, Quicksilver Gas Services. Quicksilver Resources still owns a 75 percent stake Quicksilver Gas Services and raised nearly $90 million in its initial public offering of the MLP.
There are benefits to both sides from this deal in my view. Quicksilver gets cash to fund its drilling and expansion program and will still benefit from the cash flows of its midstream assets via its holding in the MLP.
Meanwhile, MLP holders get to own pipelines and processing facilities hooked up mainly to Quicksilver’s wells. All that production growth coming for Quicksilver means more volume flowing through the MLPs assets; more volume means higher distributions for the owners of the MLP.
In addition, Quicksilver owns a mature gas shale play in Michigan. This region has been heavily explored and depleted and won’t show much further growth in production. In fact, mainly because Quicksilver has been diverting its spending to the Barnett Shale, production from its Michigan reserves have been declining in recent quarters.
But the reserves are absolutely ideal for an MLP. Mature wells in the region offer reliable production for many years; these are long-lived assets. And by investing in better infrastructure, it would be possible to halt, or nearly halt, production declines.
Quicksilver is considering an MLP for these assets as well, and the listing of that partnership is another potential catalyst for the stock. Fast-growing Quicksilver Resources is added to the Gushers Portfolio as of this issue as a buy up to 44.
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Portfolio and Stops Update
Since the beginning of this summer, I’ve recommended taking partial profits on several TES Portfolio recommendations. With the market and energy sector on fire going into mid-July, I felt it only prudent to recommend locking in some gains.I also recommended raising stops on many Portfolio recommendations to lock in further gains. Here’s a rundown:
Bunge (NYSE: BG)–In the Aug. 1 issue of TES, I recommended selling half your position in Bunge for a gain of roughly 60 percent on the stock. I also recommended raising your stop on the stock to $85.50 to lock in a solid 50 percent gain on the other half of the position. Bunge triggered the stop last week and is now considered sold from the TES model Portfolios for a total gain of around 55 percent.
For the reasons I outlined in the Aug. 1 issue, I don’t recommend jumping back into Bunge at this time.
General Maritime (NYSE: GMR)–This midsized tanker operator triggered my recommended $25 stop last week. If you look at the Proven Reserves Portfolio, this looks like a big loser given the entry price at $46.01. But that’s misleading because the entry price hasn’t been adjusted for the dividends and special dividends paid since my May 2005 recommendation.
If you bought the stock back then and held, you have earned roughly $2,500 in dividends for every 100 shares held. That works out to $25 per share; on an adjusted basis, the entry price is closer to $21.
All told, the stock was stopped out for a paltry 11.4 percent gain if you assume dividends reinvested. If you stuck the dividend cash in a money market fund, you’re up 14.7 percent.
Although this is an annoyingly volatile sector, I still believe in the long-term value of the tanker business. I also like General Maritime’s strategy of signing half of its ships to term contracts at specified, fixed rates. This reduces their exposure to the wild ups and downs of the spot tanker market.
Management has also sold off its older ships and is focusing on managing its most-profitable tankers. And finally, the company has established a minimum quarterly dividend for a shareholder that reduces the uncertainty surrounding its payout.
Spot tanker rates typically bottom out in August or September, so the stocks tend to outperform into fall. I see this as an excellent time to jump back into General Maritime; buy the stock below 28. It’s currently yielding more than 8.5 percent.
Schlumberger (NYSE: SLB)–This is without a doubt the finest oil services firm in the world. It’s also the best play I can think of on my “end of easy oil” thesis. Its high-tech, exploration-leveraged services are ideal for this environment.
That’s why it was so hard for me to recommend taking a third of your profits off the table for a near 70 percent gain in the July 20 flash alert, Schlumberger and Hedges. I also recommended raising the stop to $85.50 to lock in a gain; that stop has since been triggered for a 50 percent gain on the remaining two-thirds position.
I fully expect to recommend jumping back into Schlumberger late this year. But for now, the stock is extended and is vulnerable to selling by any investors looking to raise cash. I recommend accepting those nice gains for Schlumberger and standing on the sidelines for now.
Union Pacific (NYSE: UNP)—This railroad is a key transporter of coal, grains and ethanol in the US. It remains an excellent play on growth in ethanol, use and the need to transport coal from Western mines to Eastern utilities. I outlined my detailed case for the rails last summer in the July 12, 2006, issue, Beyond Oil and Gas.
The transports aren’t as leveraged to the economy as most pundits seem to believe. And for the most part, their second-quarter earnings releases were solid, indicating strong pricing trends and improving efficiency. Another endorsement for the group and the bull case is that billionaire Warren Buffett has been buying these stocks aggressively this year.
But the knee-jerk reaction is to sell these stocks at the first sign of an economic slowdown. That’s why I recommended taking some cash off the table and raising stops in a May 17 flash alert, Portfolio Updates and Changes. Union Pacific finally triggered that stop, handing us a total gain of nearly 30 percent including dividends.
I recommend standing aside on Union Pacific for now. But I’m watching the company and a number of other transports carefully. I anticipate a tremendous buying opportunity this fall. After all, who wants to bet against Buffett?
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