A Turn for the Better
This is exactly what’s happening right now in the energy patch. Although first quarter earnings releases from most energy stocks were dismal, there are “green shoots” within the numbers. In other words, there are signs that we’ll see a turn in fundamentals later in 2009 and moving into 2010.
Since late last year, I’ve been gradually getting more aggressive buying stocks in the group, and that’s starting to pay off as the sector really takes off in anticipation of this recovery.
Although there will likely be short-term setbacks and plenty of volatility, I don’t think the upside is finished just yet. By year’s end I see the sector trading higher still.
And if this is like past cycles, the gains for my favorite plays could be dramatic.
More and more data suggest we’ve seen the worst of it as far as crude oil prices are concerned. Natural gas continues to lag, but even on that front recent statistics indicate we’re heading for a turn. See Bottom’s Up.
The world’s biggest producer is buying uranium on the spot market, and a major investment house recently revised upward its growth forecast for China, which is bullish for coal. You won’t read much about uranium and coal in the traditional media, so get your fix–and your paths to profits–here. See Uranium and Coal.
Care to know what the CEO of the world’s biggest services outfit had to say about the direction of the industry in 2009 and 2010? See Oil Services and Drilling.
One master limited partnership (MLP) recommendation brought home a disappointing report card, but the group as a whole continues to treat investors well. Find out what went wrong in one case, and what’s right with the majority of TES MLP holdings. See Portfolio Update.
The evidence continues to mount that the low is in for most energy-related commodities, including crude oil, natural gas, some grades of coal and uranium.
Market sentiment on crude oil was the first to turn positive. Not surprisingly, oil-levered names were the first to show leadership in the energy industry.
Stocks with heavy exposure to natural gas and the North American market lagged until early April. As recently as a month ago, when I attended the Energy Information Administration’s (EIA) 2009 Energy Conference in Washington, DC, sentiment toward the natural gas markets among most market participants was bearish. Although gas prices languish under USD4 per Million British thermal units (MMBtu), gas-levered stocks such as Nabors Industries (NYSE: NBR), BJ Services (NYSE: BJS) and even Halliburton (NYSE: HAL) have begun to outperform the broader energy indexes.
While the bullish take on natural gas I’ve outlined in recent weeks remains an out-of-consensus position, this recent action suggests that some market participants are at least becoming less bearish on natural gas. There’s less willingness to bet against a recovery in the North American natural gas market than was the case early in 2009.
It’s important to remember that the prices of commodities will always lead fundamentals. The crude oil market is rallying despite still-bloated inventories and continued demand destruction in the developed world because there’s a growing expectation that US demand will stabilize in the latter half of 2009 and a widening realization that Chinese demand is recovering faster than most market participants had expected.
Natural gas-levered equities are rallying despite the fact that inventories are rising toward bloated levels just as the market enters injection season, a period of weak gas demand when the US traditionally sees inventories rise. Market participants are beginning to price in the fact that a rapid drop in the US rig count spells a faster-than-anticipated fall in US natural gas supply.
You should always pay particular attention to markets that rally despite bad news. Although some data released by the EIA in recent weeks suggests that US output is beginning to fall, the widely watched EIA-914 Monthly Natural Gas Production Report wasn’t particularly bullish.
Source: Energy Information Administration
EIA-914 offers an early read on US natural gas production; the data set also includes production information for major gas-producing states such as Texas and Louisiana. The important point to remember about EIA-914 is that it’s highly volatile and often subject to significant revisions from month to month.
This fact has been exacerbated in 2009 because of a change in methodology the EIA uses to calculate production totals for some states. Another complicating factor is that it took far longer than most industry participants expected for Gulf of Mexico production volumes to recover from last summer’s hurricanes; Gulf production was likely still recovering into the February/March period of 2009.
To compensate for the hurricane effect, I’ve excluded Gulf volumes from my chart above. The data shows continued month-over-month growth in US natural gas production. The most recent data, for February, shows a 0.91 percent month-over-month increase in production following a 0.8 percent decline in January and a 1.32 percent decline in December.
I see two potential explanations. One is simply that the data is a blip and remains distorted due to the factors I just outlined. If that’s the case, look for a big revision when the next report is issued at the end of May.
Second, the jump in production could be due to one of the factors I highlighted in the previous issue of TES: Companies that drilled wells during the drilling boom of last summer/early fall finally put wells into production in February. This could be due to delays in building out the necessary pipeline infrastructure. After all, the US gas-directed rig count–the total number of rigs drilling for natural gas in the US–only topped out in late October 2008, so it’s logical to assume it took a few months for a falling rig count to translate into falling production.
But the news from EIA-914 report isn’t all bearish. The chart shows a big downside spike in production in September 2008 followed by a big jump in October. This is due to the fact that the hurricanes affected onshore production and gas processing as well as offshore production. September saw land-based volumes shut in; the big jump in October represents those volumes coming back online. Since that time, however, there’s a general decline in production.
The most bullish factor of all is that the market totally ignored the data and rallied off recent lows near USD3 per MMBtu. This is an indication that most market participants expected gas production to remain robust into early 2009. The real question remains about the future; check out my chart of the US gas-directed rig count below.
Source: Baker Hughes, Bloomberg
I’ve highlighted this chart on several occasions, most recently in the previous issue; suffice to say the rig count has fallen at a record pace, dramatically since early this year. Because the most recent EIA-914 survey reflects only preliminary February data, it doesn’t yet reflect a good chunk of this decline.
Weekly storage data is beginning to suggest that production volumes are falling aggressively. Check out my chart below for a closer look.
Source: Bloomberg
To create this chart, I looked at consensus analyst expectations for weekly US natural gas storage data going back to early December 2008. I then compared these estimates to the actual data released by the EIA each Thursday. A positive figure means US gas in storage increased more than analysts’ expectations or decreased less than expected. All else equal positive numbers would be bearish for gas prices, indicating oversupply.
The trend here is clear: There are a large number of big positive numbers in the first half of this chart, particularly in early January. But the frequency of big positive numbers diminishes as we move into late March and early April.
Analysts take a large amount of data into consideration when making gas storage estimates. The list includes weather trends, economic growth, and production trends. Broadly speaking, it appears that analysts were overestimating gas demand or underestimating gas supply in January and February of this year.
My guess is it was a combination of both. The rapidity with which industrial demand for natural gas declined in the first quarter of this year took many analysts by surprise. Meanwhile, the pent-up gas production flowing from shale plays also surprised to the upside. Even some of the coldest winter weather in many years couldn’t offset these trends.
The increasing accuracy of recent estimates suggests two trends: Analysts economic expectations have fallen in line with reality, and the pent-up supply issue is abating. As I pointed out in the April 22 issue, the Fed’s Beige Book indicated some glimmers of hope for industrial gas demand; petrochemical demand, for example, appears to be bottoming. Moreover, if you’re an industrial consumer of natural gas you’re probably happy to see gas prices under USD4 per MMBtu rather than above USD10, as was the case last summer. Lower prices should encourage greater gas consumption.
Analysts have slashed their estimates for US economic growth over the past six months. As I highlighted two weeks ago and in the April 27, 2009 PF Weekly, I suspect the US economy is stabilizing and setting up for a recovery late this year and into 2010. This means analysts’ estimates for the economy may finally be hitting bottom and reflect reality rather than hope.
I also suspect the US gas-directed rig count has fallen to a level that’s curbing production meaningfully. I’ll continue to watch how the EIA gas storage data compares to estimates in coming weeks. However, if I’m reading these trends correctly, we should begin to see gas storage builds that come in under expectations. If that happens, it would give me even more confidence in projecting natural gas at USD6 to USD8 by year’s end.
While both uranium and coal get far less press than oil and natural gas, both markets deserve investors’ attention.
Source: Bloomberg
This chart shows the spot price of uranium in US dollars per pound over the past few years. As you can see, prices appear to have found a low in the upper USD30s to USD40 per pound, as I projected in the January 21, 2009 issue, Uranium Revisited. This represents the cash cost of production for most major uranium producers, with the possible exception of Canadian giant Cameco (NYSE: CCJ). I still look for prices to recover to the USD60 to USD70 range in coming months.
According to Trade Tech, a firm that publishes data on the global uranium markets, volumes of uranium traded in April surged on a total of 20 transactions reported. Even more encouraging is the fact that Trade Tech reported that utilities were the most active buyers. Utility demand is a far better predictor of fundamental demand/supply conditions than speculative demand from buyers looking simply to profit from a long-term rise in prices. The obvious conclusion is that utilities are grabbing uranium at current spot prices because they feel the price is unlikely to go much lower.
Cameco is the world’s largest pure-play uranium producer; it churns out about 20 million pounds of uranium annually out of a total world market of less than 200 million pounds. Its outlook for uranium supply, demand and prices contains invaluable information for investors in the sector.
During Cameco’s May 1 earnings release conference call, management offered a number of interesting tidbits. First, during the big run-up in uranium prices back in 2007 the company purchased little if any uranium on the spot market. But in the first quarter of 2009 the company was a significant acquirer, as the following quote indicates:
…[W]hile we are reporting lower net earnings than [the] comparable quarter of 2008, a major component of that changes relates to opportunities Cameco finds in the uranium market. Our reason for purchasing [spot uranium] in the first quarter was for one purpose only, to seize trading opportunities which our marketing staff identified. When we enter the market to take advantage of trading opportunities, we often acquire uranium at prices significantly higher than our production cost. This action results in our reported unit cost of sales being driven higher. And of course that flows through to margins and earnings.
Cameco is simply saying that current uranium spot prices–even at recent lows–are significantly higher than its production costs. When it actively buys uranium, the cost of its inventory goes up; its cost of sales rises and depresses profit margins.
Cameco wouldn’t be making these purchases if it felt uranium prices had more downside. The company is essentially speculating that the price of uranium is likely to rise from current levels.
Because Cameco knows a lot more about the uranium market and has more perfect information than I or any other analyst does, I prefer to bet with the company. In other words, if Cameco is buying uranium, you should consider following its lead.
Another interesting comment from the company’s call relates to the source of uranium demand. Consider the following:
…I believe that about half of the purchases [of uranium in the spot market] that have taken place have been made by utilities…a good portion of that would have to be attributed to the Chinese. And in their case, they’re certainly looking to stockpile significant quantities of inventory for the Chinese program.
It seems that the Chinese utilities are also convinced uranium prices have bottomed and are likely to head higher. The Chinese have been extremely smart and strategic when it comes to locking up natural resource supplies they know they’ll need in coming years. It’s not a bad idea to follow China’s lead into uranium.
When you couple these comments from Cameco and Trade Tech with the quotes I highlighted from Shaw Group (NYSE: SGR) in the previous TES, you have compelling evidence that a nascent bull market in uranium is now underway.
Since I updated my commentary in the January 21, 2009 issue the buy-rated plays in my Uranium Field Bet are up more than 50 percent, but that rally came from extraordinarily depressed levels; if uranium prices top USD60 in coming months I see another 50 to 75 percent of upside for the group.
I recommend a small number of stocks involved in the uranium industry as part of what I call a field bet. The concept is simple: The uranium mining business is highly risky and full of company-specific pitfalls.
Explorers with even the most promising reserves can come up empty-handed and get crushed. And even firms with producing mines or mines near production can get hit by project delays and escalating construction and raw materials costs. Some stocks I’ve recommended in field bets have lost more than 90 percent of their value.
Of course, potential rewards are equally big; some field bet plays have produced gains of more than 800 percent. A few of those big gains make up for the inevitable losers.
Although I rarely sell stocks outright from field bets, I do periodically recommend taking profits in exceptional performers.
To play the Uranium Field Bet, I recommend taking small positions in several or all of the buy-rated stocks in the table below. A reasonable stake in any particular play would be approximately 10 to 20 percent of the amount you’d normally commit to a TES recommendation; I calculate the official returns using a 20 percent level stake.
I’ve listed the plays in the table including a risk rating. These categories should help you size your positions according to risk.
Source: The Energy Strategist, Bloomberg
For details on these companies, check out the January 21, 2009 issue, Uranium Revisited.
In addition, it’s worth offering an update on Field Bet pick Shaw Group, which saw some volatility last week. The company did release one bit of negative news last week concerning one of the nuclear power plant projects it’s working on.
Basically, one of the Progress Energy (NYSE: PGN) plants the firm has contracts for has been delayed due to a Nuclear Regulatory Commission (NRC) ruling that the company can’t proceed on site work until it receives approval for its operating license. The total delay for the project is likely to be 20 months.
Shaw says the delay won’t impact 2009 earnings guidance and that the ruling is unique to the plant; management doesn’t foresee similar delays for other projects. The NRC also noted that the ruling for this Florida plant was based on geologic characteristics at the particular site; this suggests it’s a one-off issue.
I suggest the stock got hit mainly because it’s seen a nice run, and this bit of adverse news is seen as a good reason to take profits. Any dip offers an opportunity to buy the stock or add to positions–a short-term selloff here doesn’t indicate fundamental deterioration in the business. I still like Shaw Group as a buy on dips under USD30.
Coal prices and the share prices of coal-mining firms have rallied considerably since April 22. Two weeks ago, I highlighted earnings results from Peabody Energy (NYSE: BTU), the largest coal-mining firm, and from railroad CSX (NYSE: CSX).
Both companies noted that a big drop in demand for steel spelled falling metallurgical coal prices. At the same time, utilities currently have large inventories of coal on their plant sites and are likely looking to reduce shipments to normalize those inventories.
I also highlighted two potentially bullish points: a nascent recovery in steel demand, particularly from China, and further cutbacks in production plans from major US mining firms. Since that time, confidence surrounding both of these “green shoots” for the coal industry has increased.
On May 4, Goldman Sachs (NYSE: GS) upgraded the coal industry. Among the most prominent reasons cited for the upgrade was an upside revision to their forecast for Chinese economic growth–Goldman is now looking for 8.3 percent growth in 2009 and 10.9 percent in 2010. This is a significant upside revision when you consider that Goldman was previously looking for Chinese growth of just 6 percent this year. Goldman is just one of several prominent investment banks to raise GDP forecasts for China in 2009.
I’ve been arguing that the Chinese economy is recovering at a faster-than-expected pace for some time. In the March 4, 2009 issue I highlighted the rapid improvement in Chinese economic indicators such as lending growth and the Purchasing Managers Index (PMI). And in the March 18 issue I noted the big jump in Chinese electricity demand.
I’ve also summarized the analysis of my colleague Yiannis Mostrous, an expert on Asia and editor of Emerging Markets Speculator, on a few occasions. Yiannis has been calling for Chinese economic growth in the 7 to 8 percent range for months now.
Bottom line: The China recovery story is now taking hold and that’s bullish for both steel demand and for coal prices generally.
As to my second point, several mining firms have announced significant production cutbacks since the April 22 TES. The biggest cutbacks in percentage terms have been from high-cost operators in Appalachia, but even the big, low-cost operators such as Peabody have cut back. This should help to rebalance the US coal market and keep inventories at the utilities under control.
Also note the following chart.
Source: Bloomberg
This chart shows the short interest in Massey Energy (NYSE: MEE), one of the stocks favorably highlighted in Monday’s report from Goldman. As you can see, the short interest–the number of shares sold short–has been rising in recent weeks for Massey. This would represent traders betting on a decline in Massey’s share price.
When traders close a short position they must buy the stock on the open market, a process known as covering a short. When many shorts cover simultaneously it can prompt what’s known as a short squeeze; short-covering pushes the stock higher and causes even more shorts to cover. This self-reinforcing cycle can push stocks dramatically higher in a short period of time.
This appears to be exactly what happened after Goldman upgraded the group. Certainly there was no fundamental shift that can explain the big run-up in prices over just a few trading days.
I’m encouraged by some of the fundamental improvement I’m seeing in the coal industry. To play this trend, I recommended covered calls on Peabody Energy in the March 4 issue. This trade involved buying Peabody and selling the June USD25 calls on the stock for about USD3.35 each. (Take a look at the December 24, 2008 TES, Buy Income Super Oils and Gas, for a quick primer on covered calls.)
Peabody was trading at USD23.14 when I made this recommendation. Buying the stock at that price and selling the calls for USD3.35 lowered your cost basis to about USD19.79 (USD23.14 minus USD3.35). The maximum profit on this trade would occur if Peabody closes above USD25 on Friday, June 19, 2009, the expiration date for the June options.
If that happens, you’ll receive USD25 per share for the Peabody stock you own. Based on a cost basis of USD19.79, we’re talking about a profit of 26.5 percent (USD25 divided by USD19.79). That’s a solid profit for a trade lasting a little more than three months.
Peabody now trades at USD32.21, the options trade at around USD7.80. If you sell Peabody and buy back the options you sold, your total proceeds would be USD24.41 (USD32.21 minus USD7.80). That works out to a profit of 23.5 percent, close to the maximum profit for this trade.
It simply isn’t worth waiting another month and 10 days for that remaining 3 percent profit. There’s also the risk that if Peabody drops back below USD25 you’d give back a significant portion of your profits. Given that I still see upside for Peabody by year’s end, I recommend you roll your covered calls up and out.
To do this, simply buy back the June USD25 call option on Peabody (Symbol: BTU FY) for a cost of around USD7.80. Then, immediately sell the January 2010 USD40 call (LLW AH) for around USD3.80.
The effect of this transaction will be to adjust your cost basis in Peabody to USD23.79 (USD19.79 plus USD7.80 minus USD3.80). There are two possible paths for Peabody by January 15, 2010.
- Peabody remains under USD40. In this case, you’ll still own Peabody stock on January 15 at a cost basis of $23.79. The stock would need to fall 26 percent from current levels before you’d start losing money.
- Peabody rallies above USD40. In this case, you’d receive USD40 per share for the stock you hold. Your total profit would be 68 percent (USD40 divided by USD23.79). This is the maximum potential profit on this covered call recommendation.
Please note that this trade is only valid for those who entered Peabody on my March 4 covered call recommendation. If you don’t feel comfortable with options, avoid this recommendation entirely. I do like Peabody long-term as an outright buy candidate; however, I’ll likely wait for a dip before recommending it given the extreme near-term upside momentum in the stock.
In the April 1 issue I highlighted the oil services industry and offered my long-term rationale for owning the sector. I also took a look at a few key islands of growth within the sector, including Mexico, Brazil’s deepwater and Iraq.
And in the April 22 issue I reviewed the earnings release for what’s long been one of my favorite plays in the oil services group, Weatherford International (NYSE: WFT). Weatherford is extraordinarily well-placed in Mexico, a market that’s set to grow even if oil and gas prices remain stuck at current depressed levels for a few more months.
The company also noted signs of bottoming in some of its other key markets. After a brief dip following its earnings release, Weatherford stock has rallied more than 20 percent.
Weatherford now trades at about 21 times projected 2009 earnings. But this is based on extremely depressed earnings estimates, a consequence of the severe slowdown in drilling activity forecast for this year. A fairer valuation metric is based on 2010 earnings estimates, when drilling activity should begin to pick up to more normal levels; on that basis, Weatherford trades at about 16 to 17 times consensus estimates.
This valuation doesn’t appear expensive when you consider that the average multiple for the stock since its 2002 lows is closer to 25 times earnings. I’m raising my buy-under target for Weatherford from USD17.50 to USD20.
More broadly, although oil services have rallied significantly since early April, I remain bullish the group. While the Philadelphia Oil Services Index (OSX) is up more than 60 percent from its early December lows, the index continues to trade at less that 1.5 times this year’s estimated sales. The long-term average for the index is around 2.5 times sales; the index still looks relatively cheap based on any meaningful metric.
Of course, valuations are only part of the story. Just because a stock or index looks cheap doesn’t mean it can’t get cheaper. What we really needed to get more bullish on the group was some sort of a fundamental sign of a turn. I started to see evidence of this back in late March and early April. Since that time, earnings reports from the big oil services and contract drilling firms have offered further evidence of a turn in the works.
Long-time readers know that I follow earnings reports and conference calls from Schlumberger (NYSE: SLB) extremely closely each quarter. Schlumberger is the world’s largest oil services company and has operations in just about every conceivable oil- or gas-producing region of the world. The company also has a habit of offering extraordinarily detailed reports and conference calls that provide great insight into conditions in the energy business.
Schlumberger beat earnings expectations slightly, posting adjusted earnings per share of around USD0.78 compared to expectations of about USD0.74. The stock reacted well to the release, rallying close to 7 percent the first day of trading after releasing results. And that wasn’t just a one-day wonder; Schlumberger has continued to rally since its April 24 release and is now up about 15 percent since that time.
Schlumberger confirmed many of the same trends that Weatherford did in its call two days earlier. Management noted extreme weakness in Schlumberger’s North American markets and pressure to reduce prices it charges for basic services. Overall North American profit margins collapsed by 8.58 percent to 13.7 percent in the quarter.
The performance in North America is nothing unexpected or unusual. Weatherford noted the very same weakness in its North American markets. Because most land-based activity in North America targets natural gas, not oil, gas prices are the key to determining drilling activity in the region. The active rig count in North America has collapsed, and that spells falling demand for the sort of services Schlumberger performs.
Schlumberger also noted in its prepared statements that it doesn’t see a significant recovery in North America taking hold until 2010. When asked for more detail during the Q&A section of the call, Schlumberger CEO Andrew Gould noted:
…I think everyone is going to have a really tough time in the second quarter with North American margins just on the basis of very, very low activity. And actually, I think that cost reduction will allow us to stabilize North America margins. But it’s going to take either removal of capacity or a fairly substantial increase in the rig count to move pricing power back the other way…I don’t know what’s going to happen in North America this year, and I don’t think I’ll have any idea until we see some improvement in industrial demand for gas.
As Mr. Gould suggests, Schlumberger is working to cut costs in North America. This has involved a significant decrease in headcount; Schlumberger stated it has plans for further layoffs in North America in coming quarters, which should help the firm stabilize profitability in North America despite extraordinarily low levels of activity.
Schlumberger’s projection that drilling activity and the rig count are unlikely to mount a significant recovery until 2010 seems logical to me. As I noted earlier, the 50 percent-plus drop in the active rig count since last summer is just beginning to result in lower gas production. Lower production eventually spells higher prices and margins, but this process takes time.
It’s likely we’ll see the rig count bottom out in the second or third quarter of this year and then remain at relatively depressed levels for a few months. In a sense, the industry is looking for a level of activity that will bring supply and demand for gas back into some sort of a balance.
Schlumberger also noted that it sees industrial gas demand as the key data point to watch to spot a turn in gas prices. Industrial gas demand includes the use of gas in the production of plastics and other basic industries; check out my chart below for a closer look.
Source: Bloomberg
This chart depicts the year-over-year change in US industrial production. This indicator offers a good look at industrial gas demand in the US. As you can see, this indicator is currently at levels unseen since the bottom of the 1974 recession. In fact, the year-over-year change in the index is actually worse than it was back then.
While I expected industrial demand to be weak this year, I didn’t anticipate quite this level of decline. Nonetheless, industrial production would recover alongside the broader economy. In the last two issues of TES and in the April 27, 2009 PF Weekly, I highlighted a number of indicators that suggest the US economy is stabilizing.
This should bring about a turn in industrial production for the better by the end of 2009. This is broadly consistent with stabilization in the North American services business by the end of the year and a recovery into 2010.
Another market Schlumberger highlighted as extremely weak is Russia. Again, this shouldn’t come as a huge surprise, as Weatherford also noted weakness in this market. What’s encouraging is that Schlumberger also appears to see some evidence of a turn in Russian activity. Check out the following quote from the question-and-answer segment of the Schlumberger earnings conference call:
…I would agree that the Russian oil companies because of the devaluation of the ruble against the dollar have made huge ruble profits and will over the next few months. I also think that the decline in Russian production is now becoming a recognized fact. And without being in any way certain, because there are a lot of uncertainties still to be resolved, it is not impossible that towards the end of the year we see some mild recovery in Western Siberian activity.
At first blush this quote doesn’t seem particularly bullish, and it certainly doesn’t reflect the same level of conviction in a turn for Russia as comments made by Weatherford CEO Bernard Duroc-Danner a few days earlier. But Schlumberger’s Gould is typically less optimistic than Duroc-Danner or, at least, has a tendency to offer more conservative outlooks on general business conditions. Given that tendency, this quote does reveal some confidence in at least a mild recovery in Russian activity by the end of the year.
Weakness in Russia and North America was expected; these regions performed roughly in line with analysts’ expectations. One region that did outperform is the Eastern Hemisphere, a region that includes the Middle East and Africa. In this region, profit margins appeared to hold up far better than analysts had expected.
But this isn’t totally a reflection of activity levels. In fact, Schlumberger did note that its customers in the Eastern Hemisphere have also been curtailing activity and asking for lower prices for the sorts of services Schlumberger performs. The reason margins were so high was that Schlumberger began cutting headcount and other costs in the Eastern Hemisphere in the fourth quarter of 2008. But, due to long-term contracts, customers didn’t start asking for cost concessions until the first quarter if this year.
This means the full positive impact of cost-cutting was felt in the first quarter, while the full effect of price reductions wasn’t–it’s all a matter of timing. As Schlumberger admitted, it will be difficult for the company to repeat its first quarter margin performance in the second quarter. The decline is, however, nothing like the collapse in activity witnessed in North America and Russia; cycles in the Eastern Hemisphere tend to be far less volatile and violent than in North America.
On a positive note, Schlumberger did state that it sees a “normal” cycle unfolding in the Eastern Hemisphere. As Mr. Gould noted:
…I don’t have any reason today not to think that this is not like any other Eastern Hemisphere cycle. So let’s leave aside North America. Eastern Hemisphere cycles typically take about 18 months to roll over. And if you consider that this cycle started in Q4 of last year, then it follows the pattern of all other previous cycles it will roll over in Q2 of next year.
In other words, Schlumberger does see a decline in margins and activity due to falling commodity prices. But the company also sees that cycle turning back to the upside in the first half of 2010.
Schlumberger, like Weatherford, also noted that not all parts of its business are performing poorly. Specifically, Schlumberger noted in its prepared remarks:
[D]ecreases were partially offset by increased revenue in the Mexico/Central America GeoMarket due to efficiency gains on IPM [integrated project management] projects and in the Brazil GeoMarket as the result of a robust demand for high technology Drilling and Measurement and Wireline Services on offshore activity…
Not surprisingly, Schlumberger noted strength in Mexico and Brazil for exactly the same reasons I outlined in the April 1 issue (Islands of Growth). Schlumberger will certainly benefit from these markets’ continued strength. A group of more leveraged plays includes Weatherford International as well as Gushers Portfolio holding Dril-Quip (NYSE: DRQ) and Wildcatters holding National Oilwell Varco (NYSE: NOV).
I explained what both companies do in the April 1 issue, and I continue to rate both stocks as buys. Despite Dril-Quip’s recent advance, it still looks inexpensive on any valuation metric and is leveraged to deepwater, one of the most resilient sub-sectors of the energy business. Buy Dril-Quip under USD40 and National Oilwell Varco under USD36.
Another positive point from the Schlumberger call was that although customers are being aggressive in asking the company for price reductions, they’re not getting reductions that are as big as they might hope. In response to a question, Mr. Gould replied:
I think the best way I can say this because I don’t want to give you a number [for price reductions] that is much less than some of our dear customers are announcing. Some of the announcements they’ve made as objectives, they are not achieving in terms of price reductions from the service industry. I would say that anything to do with deepwater probably has the most capacity to resist [demands for price reductions]. Anything to do with land markets has the least capacity to resist and jack-ups would be somewhere in between.
This suggests two bullish points for Schlumberger. First, while customers are asking for big price decreases, they’re not necessarily getting all of the price cuts they wish for. It certainly sounds like some customers are overestimating what’s achievable.
Second, the biggest price drops are coming for bulk land markets. The most obvious such market is the US, where we’re already seeing major drops in profit margins; as I noted earlier, this is already priced into earnings estimates.
This also strikes me as excellent news for US and Canadian oil and natural gas producers. After all, bringing a well into production, particularly a complex unconventional well, requires contracting for several different types of services. I explained many of the necessary services in the August 20, 2008 and September 3, 2008 issues. For new subscribers unfamiliar with unconventional gas plays and services such as pressure pumping, hydraulic fracturing and horizontal drilling, I suggest reading those two issues for background.
To make a long story short, the cost of these services is a major component of overall well costs. Although US and Canadian producers face major headwinds in the form of depressed oil and gas prices, these pressures are partly offset by falling services costs. As oil and gas prices recover, it will likely take a quarter or two before services firms are in position to start ratcheting up prices yet again. This will have the effect of boosting profit margins for exploration and production (E&P) firms.
My favorite North American E&Ps include EOG Resources (NYSE: EOG), Suncor Energy (NYSE: SU) and XTO Energy (NYSE: XTO). EOG and XTO are both low-cost producers in some of the hottest US and Canadian unconventional gas plays. Suncor is a leader in the Canadian oil sands industry; I profiled the company in the March 18, 2009 issue and in a subsequent Flash Alert, A New Canadian Giant.
Finally, Schlumberger’s pricing comments further back up my contention that deepwater, particularly deepwater Brazil, remains a key area of growth going forward.
All told, Schlumberger’s comments point to a bottom in most major oilfield services markets between the end of 2009 and the first half of 2010; markets will likely bottom at different times. Some markets–notably Brazil, deepwater generally, and Mexico–will continue to growth straight through the cycle. Stocks traditionally lead the fundamentals, so this adds weight to my view that the recent rally in the energy patch should continue. Based on a strong report and the prospects for an industry turn, I reaffirm my buy rating on Schlumberger.
Nabors Industries (NYSE: NBR) is a contract drilling firm that owns primarily land rigs. The stock was once a recommendation in the TES Portfolio and is now a buy in How They Rate.
Long-time readers know that oil and gas production companies rarely own their rigs. Certainly, those that do don’t own enough rigs to handle all of their drilling projects. Instead, producers lease rigs from contract drilling firms like Nabors for a daily fee known as a day-rate. Most operators work with a mix of term and spot contracts; spot deals are one-off contracts, while term deals involve locking up rigs at a fixed day-rate for a number of years.
I offered an explanation of the environment facing offshore drillers–contract drillers that lease rigs used to drill offshore–in the April 1 issue. Nabors is in a different market, primarily working with land rigs.
Land rigs are far cheaper and faster to build than offshore rigs, especially the deepwater rigs used to drill in areas such as Brazil’s Santos basin. However, that doesn’t mean there isn’t real differentiation in capability between land rigs. Higher-power and higher-cost land rigs are needed to drill long horizontal wells that are used to produce gas in North America’s prolific shale fields.
Nabors works both internationally and in North America. But 63 percent of its revenue comes from the US. The big drop in the US gas-directed rig count since last summer is bad news for the firm. The company has been forced to idle rigs because there’s just no demand for those rigs in the current depressed natural gas price environment.
Idling rigs temporarily is known as warm-stacking, while idling rigs for a long period of time, or potentially forever, is known as cold-stacking. Nabors has done a little bit of both in recent months.
But Nabors has been hurt less than most of its land-focused contract drilling peer group in recent quarters. The reason is two-fold: a focus on term contracts for highly capable rigs and strong overseas growth.
As to the first point, Nabors had the foresight to build and sign many of its best, most capable rigs under term contracts at attractive rates last year.
While these term contracts will gradually roll off over the next 18 to 24 months, they offer a measure of earnings resilience that most land drillers just don’t have. Moreover, there are a few areas of growth, or at least relative stability, in the US drilling market. As Nabors management noted in its April 22 conference call:
Our new rigs continue to perform exceptionally well, as evidenced by the drilling records we are setting, particularly in the shales. This has resulted in improved market share in this important area, namely the shales. In particular, the Haynesville shale, we currently have more than 30 rigs working, which is more than three times our major domestic competitors, H&P [Helmerich and Payne (NYSE: HP)] or Patterson [Patterson-UTI (NSDQ: PTEN)] each have.
The company went on to say that the Haynesville is one of the only regions of the US that offers positive returns for operators at sub-USD4 natural gas prices. Therefore, it’s one of the only areas to show some resilience in terms of drilling activity despite the weak commodity price environment. Bottom line: Nabors’ focus on term contracts and highly capable rigs able to drill in key shale plays gives it a significant leg up on the competition.
Internationally, Nabors is seeing some weakness in terms of falling drilling activity. However, the drop in activity is far less meaningful than in the US. In fact, the company is looking for operating income to grow by 20 percent year-over-year in its international markets. Some 87 percent of the gross margin it plans to earn overseas is already locked in for 2009 via long-term contracts.
Nabors handily beat expectations due to these two major factors. The stock remains my favored land drilling play, and I’m looking for a short-term pullback as an opportunity to jump into the stock. For now, I’ll continue to track Nabors Industries in How They Rate as a buy recommendation.
In addition to company-specific news, Nabors also offered further backing for the idea that the US drilling market will be finding a bottom over the next couple of quarters. Nabors CEO Eugene Isenburg stated:
I think we’re asymptotically approaching it [the low in the rig count]. I think we’re–I don’t know, you don’t know, nobody knows. But basically the signs we see, most of the customers, or at least many of them, have adapted, you know a sort of cut and slash approach…I think your analysis of the second derivative [change in the rate of change] moving in a favorable direction is right on if you want to describe it that way. And I mean one week doesn’t make a future, but this is the first week we’ve had more rigs up than down…
Nabors indicates that most of the decline in the rig count is already behind the market. As I noted in the April 22 issue, the second derivatives are favorable; this means that the rate of decline in the US rig count is beginning to moderate. This data points to a bottom in North American activity by the third quarter, followed by a recovery into 2010.
Mr. Isenburg went on to indicate that he sees a normalized gas price being in the USD6 to USD7 per MMBtu range. This is the level we need to reach to stabilize the rig count and encourage drilling in some of the more productive, lower-cost shale plays.
Nabors’ positive comments about the economics of the Haynesville and Marcellus shale plays has me looking at Petrohawk Energy (NYSE: HK) and Range Resources (NYSE: RRC) as possible additions to the Portfolio in coming weeks. I discussed both stocks in the September 3, 2008 issue (UNLOCKING SHALE), in which I also provided a detailed review of the major US shale plays. To make a long story short, Petrohawk is a leader in the Haynesville, and Range Resources is a leader in Marcellus.
For now, we have some exposure to both plays via the recommended Chesapeake Energy 6.375 Percent Bond of 06/15/15 (CUSIP: 165167BL0) and Chesapeake Energy 4.5 Percent Convertible Preferred (NYSE: CHK D). Both high-yield securities were covered in the November 19, 2008 issue.
Wildcatters holding National Oilwell Varco (NYSE: NOV) saw an initial dip following its earnings release but has since bounced back and regained most of those losses. The stock is still showing a profit from my April 1 recommendation.
The company builds key components used on deepwater rigs; therefore, all the positive commentary I noted about the resilience of deepwater spending is a big positive for National.
The main issue in the first quarter report that prompted the selloff in the stock was lower-than-expected new orders of rig equipment. But orders for new rig equipment are notoriously lumpy from quarter to quarter; I don’t see this as any real evidence of declining demand. Meanwhile, with a backlog of unfilled orders totaling close to USD10 billion, National Oilwell still has plenty of work on its plate.
In addition, the company’s commodity-sensitive Petroleum Services and Supplies business should see a bottom later this year if I’m correct about a bottom in the making for the North American drilling market.
The stock was a strong outperformer going into its earnings release and, therefore, the slightly weaker than expected orders data was a good excuse for many traders to book some gains. But the rationale for owning the stock is intact and undiminished. Use this temporary dip as an opportunity to buy National Oilwell under 36.
More worrying was the recent announcement out of Eagle Rock Energy Partners (NSDQ: EROC) that it’s slashing its quarterly distributions to 2.5 cents per unit per quarter from 41 cents. Eagle Rock is a master limited partnership (MLP), a high-income-producing group that owns primarily midstream energy assets such as pipelines, storage and processing facilities.
All told, my buy-rated MLPs have produced a solid 28 percent gain so far this year; however, Eagle’s weak showing is still a bitter pill to swallow.
The midstream business typically offers stable, fee-based revenues. But there’s one exception: Some companies involved in a business known as gathering and processing (G&P) can be exposed to commodity prices.
Gathering lines are small-diameter pipelines that collect oil and natural gas from individual wells. Before it’s suitable for injection into the nation’s pipeline network, gas requires processing. Processors remove impurities from the gas and separate natural gas liquids (NGL) from the gas stream. NGLs include valuable saleable hydrocarbons such as propane.
Not all companies involved in G&P have real exposure to commodity prices; it depends entirely on the types of contracts they’ve signed and their service territories.
Gathering can provide some sensitivity to oil and gas prices because gatherers get paid based on the volumes of gas they collect from wells; when gas prices fall, companies cut back on drilling, and that spells lower volumes.
That being said, the prices firms pay for gathering services isn’t directly related to commodity prices, and the dropoff in volumes of gas produced has been far less than the fall in the price of gas–gathering has only modest exposure to commodity prices. Further, gatherers operating in promising regions near unconventional gas plays are unlikely to see a significant falloff in volumes.
Processing gas involves separating NGLs such as propane and butane from methane, the main component of natural gas. Some processors charge a simple fee for processing gas that’s based largely on the volumes processed–these are stable, commodity-insensitive deals.
The problem comes from a contract type known as percent of proceeds (POP). Some POP contracts are written in such a way that the processor actually buys the natural gas at the wellhead from producers and then processes and sells the gas and NGLs. A prearranged percentage of the proceeds from those sales is then paid to the producers.
Obviously this business isn’t as sensitive to commodity prices as actual production. The reason is that when oil and gas prices fall, the processor earns less revenue from selling gas and NGLs; however, the cost of the gas it buys also falls, offsetting some of that headwind. But the falling value of both gas and NGLs has hurt margins.
I explained this dynamic in the December 3, 2008 issue. In that issue, I highlighted Eagle Rock as well as Hiland GP (NSDQ: HPGP) and Williams Partners (NYSE: WPZ) as the three MLPs I recommend at the most risk due to G&P exposure.
I cut Hiland to a hold because of this exposure and stated that Eagle Rock was the next most vulnerable. I felt that Eagle Rock would be able to maintain its distribution until at least the middle of 2009. The reason is that Eagle Rock has some upstream operations–actual production of oil and gas–that provide it with upside because it’s hedged most of its 2009 production at attractive prices. In addition, Eagle appeared to be seeing decent drilling activity at some of the key fields served by its gathering systems.
And just a few weeks ago in its first quarter conference call management indicated that it wouldn’t have to cut distributions drastically this year. This gave me further reason to hold onto Eagle Rock.
The change for Eagle Rock appears to have happened when natural gas prices fell below USD4 per MMBtu. Using extensive hedges of natural gas and oil exposure at its processing business as well as its upstream operation, the company had effectively removed its direct commodity exposure. But there’s one risk management couldn’t hedge: volumes. If producers using Eagle Rock’s gathering lines stop drilling, less volume flows across its lines.
What happened is that as gas prices dropped below USD4, producers in the Austin Chalk, a region extensively served by Eagle Rock, suddenly stopped drilling. The profitability of this gathering business absolutely collapsed.
To compensate, Eagle Rock is cutting distributions to shore up its cash position. This will keep the company out of any liquidity problems through at least the end of 2009 and into 2010. The company will look to restore its distribution as soon as commodity prices recover and drilling activity resumes. Eagle Rock may also have to pay some distributions in arrears; the company is required to pay a minimum quarterly distribution or make up the difference in future quarters if it fails to pay that minimum.
Obviously, I’m not impressed with the quick deterioration in Eagle’s business or the sudden about-face in outlook from management. However, it would be a mistake to dump the stock at the current time.
If I’m correct about commodity prices recovering by year’s end, we could see Eagle Rock restore its dividend by early 2010. If that happens, the stock has the scope to trade back to the mid-teens. I’m cutting Eagle Rock Energy Partners to a hold but recommend you keep it in anticipation of a second-half recovery.
I’ve also reviewed the results and business conditions for the other MLPs I recommend. I’m confident that Williams Partners’ general partner Williams Companies (NYSE: WMB) is willing to support the MLP through the current tough times so that it’s able to maintain distributions. Because Williams is a big company, it has more scope to assist its MLP. Moreover, Williams Partners’ exposure to the G&P business is less concentrated than Eagle Rock’s.
All the other MLPs I recommend have little or no exposure to G&P. To the extent that they do have exposure it’s covered by attractive fee-based contracts. I’m maintaining my buy recommendations on the following MLPs:
- Duncan Energy Partners (NYSE: DEP)
- Enterprise Products Partners (NYSE: EPD)
- Kinder Morgan Energy Partners (NYSE: KMP)
- Natural Resource Partners (NYSE: NRP)
- NuStar Energy (NYSE: NS)
- Teekay LNG Partners (NYSE: TGP)
- Tortoise Energy Infrastructure (NYSE: TYG)
- Linn Energy (NSDQ: LINE)
- Sunoco Logistics (NYSE: SXL)
- Williams Partners LP (NYSE: WPZ)
The goods news in all of this is that the MLPs continue to perform well as a group. Although Eagle Rock was hit hard, that low has been more than made up for by a strong showing from the other recommended MLPs.
The average buy-rated MLP in the TES Portfolios is up 28 percent so far this year, and that includes Eagle Rock’s hit. This compares favorably to the 26 percent gain for the Alerian MLP Index over the same time period.
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