Energy stocks enjoyed a tremendous rally between 2004 and mid-2008, generating enormous wealth for investors. The move represents the strongest up-cycle in earnings for the group since the 1970s.

But that cycle wasn’t a one-off phenomenon. In coming years, the energy business will continue to experience powerful, lengthy up-cycles punctuated periodically by nasty pullbacks. The sector just endured one of those down-cycles, but recent evidence from key players in the energy patch indicates the downside is drawing to a close.

Historically, the best time to buy the group is a few months before industry fundamentals trough; I believe that golden opportunity will present itself over the next few weeks.

In This Issue

The outlook for the broader markets and global economy is the primary driver of energy stocks right now. I take a look at where share prices in the energy patch have been and where they’re headed. See The Big Picture.

Oil services remains a cyclical industry. I break down the prospects for North American and overseas operations, while explaining why the next few weeks represent a golden buying opportunity. See The Oil Service Cycle.

Contango, backwardation and the coming price squeeze: Where oil prices are headed over the next year and what it means for oil-services stocks. See A few Words about Oil.

The correlation between gas exploration and production stocks and the 12-month natural gas strip. See Gas and Gas E&Ps.

The latest news affecting the TES model portfolios and what to do about it. See Portfolio Update and Themes.

The Big Picture

The primary drivers of energy stocks right now aren’t company- or even sector-specific forces but the outlook for the broader markets and global economy.

On that front, the news has been broadly positive. As I explained in the July 22, 2009 issue of The Energy Strategist, Improving Tone, recent economic data indicate that the US economy is poised for a short, cyclical recovery over the next few months. News from abroad, particularly from emerging markets, likewise suggests that growth will reaccelerate this year.

Of more near-term importance, second-quarter earnings results largely beat analysts’ forecasts.


Source: Bloomberg

The blue bars on the graph represent the percentage of companies in the S&P 500 that beat consensus earnings forecasts for the quarter. It’s typical that the majority of S&P 500 companies beat estimates; large-cap firms spend considerable time managing earnings expectations and guiding analysts’ estimates. By slightly underestimating internal earnings projections, companies increase the likelihood that they’ll beat those forecasts. Looking back over the past 15 quarters, roughly 67 percent of S&P 500 companies beat their earnings estimates.

But more than three-quarters of S&P 500 stocks beat expectations in the second quarter–the highest percentage of the past three years

The graph’s purple bars represent the average earnings surprise for the quarter. Positive numbers indicate that the average S&P 500 stock beat expectations; negative numbers indicate the opposite. In the second quarter, the average company in the S&P 500 beat estimates by 10.5 percent, easily the highest average surprise of that period.

Of course, earnings results weren’t quite as rosy as these statistics suggest. While the average S&P 500 company beat expectations, only one sector–the S&P 500 Health Care sector–actually showed year-over-year earnings growth.

And although an unusually large percentage of firms in the S&P 500 beat earnings estimates, only around half beat their revenue estimates. A good deal of the earnings upside stemmed from aggressive cost-cutting rather than an outright improvement in final, end-market demand. This should come as little surprise to readers. In Improving Tone, I highlighted the role of cost-cutting when I analyzed CSX Corporation’s (NYSE: CSX) second-quarter earnings and conference call.

This cycle, energy companies were quick to downsize their business and cost structures to reflect weak market conditions, helping many firms to maintain higher profit margins than in previous down-cycles. These companies are in an excellent position to capitalize on the economy’s eventual upturn; thanks to super-lean cost structures, any actual revenue growth will quickly translate into profits

That said, two key points underpinned the market’s positive reaction to second-quarter earnings. First, as I noted in last week’s issue of Personal Finance Weekly, Earnings Leverage, Wall Street analysts clearly panicked earlier this year and cut their estimates for US companies too far. For several quarters, the steady flow of earnings estimates cuts and downside revisions acted as a key headwind for the market. It now appears we’re more likely to see a stream of upside revisions.

This is certainly true for many major energy companies. Take oil-services giant Schlumberger (NYSE: SLB), for example.

Source: Bloomberg

This chart tracks analysts’ consensus estimates for Schlumberger’s 2010 earnings. As you can see, analysts steadily cut their estimates until late April but have upped expectations slowly and steadily since then. Don’t discount the importance of analyst revisions as an upside catalyst for stocks and the market in general.

A more important consideration for energy stocks is simply an understanding of where we are in the current cycle. Energy stocks typically rally long before business bottoms out and begins to improve because the stock market is always anticipating, not reacting to, current headlines.

The Oil Services Cycle

The energy business is still cyclical, though the nature of these cycles has changed markedly in recent years.

Here’s a graph of annual pretax profit margins for oil services giant Halliburton (NYSE: HAL) going back to the mid-1980s.

Source: Bloomberg

This graph depicts two distinct phases: the period from 1988 to 2004 and the period after 2004.

The first phase shows several short-cycles. For example, margins for Halliburton expanded into 1991 and then declined into negative territory by the end of 1994. And from 1993 to the end of 1997, Halliburton and other services firms enjoyed another prominent up-cycle, followed by yet another down-cycle that lasted through 1999.

Each of these cycles was relatively short, roughly two to three years in duration. It’s also notable that there was no broader uptrend; margins at the peak year of each cycle correspond roughly to prior peaks, and margins near the trough of each cycle were also roughly equivalent.

After 2004, the up-cycle was far more pronounced, lasting much longer than the short cycles of the 1980s and 1990s. Meanwhile, margins soared to levels that were well-beyond prior cyclical peaks. 

These cycles drive stock performance. Investors made plenty of money playing the short-cycles of the 1980s and 1990s by purchasing Halliburton during down-cycles and riding the stock back up as margins improved. But a great deal more money was made buying Halliburton and other oilfields services stocks after 2004; the long cyclical move attracted a great deal more money to the sector.

I’ve never claimed that the services industry–or, more broadly, the energy business–has evolved into a perpetual growth machine. Rather, one of the core precepts of The Energy Strategist is that the post-2004 cycle was not a one-off phenomenon. The industry no longer faces the short-cycle of the 1980s and 1990s; the new paradigm will bring longer cyclical upturns punctuated by short, cyclical declines.

Further, margins at the peak of these cycles will be far higher, on balance, than at the peaks of the short cycles of the 1990s. By extension, margins at cyclical troughs will also be far higher than during previous cyclical downturns. In other words, the current environment for energy resembles the industry’s cyclical pattern during the big energy stock rally of the 1970s and early 1980s.

Right now the multibillion-dollar question is, where we currently sit in this cycle? The short answer is that pretax profit margins for oil services companies largely topped out in the third to fourth quarter of 2008, depending on which firm is under the lens. Since then, the oil patch has been in a cyclical downturn that I expect to bottom out over the next two to three quarters. Share prices will rally in earnest months before profitability improves; the stock market is a forward-looking mechanism, anticipating future conditions rather than reacting to current realities.

Among oil-services companies it’s important to distinguish between North American and overseas operations. In North America, oil-services firms operate in classic short-cycle conditions  because most drilling projects in this region are relatively small, short-term deals.

North American producers can cancel projects quickly in reaction to commodity prices. Most activity in North America tracks natural gas prices, not crude oil; a fall in gas prices can lead to a dramatic decline in activity in only a few months. Because oil and gas services firms are sensitive to drilling and development activity, their fortunes can change on a dime due to volatile commodity prices.

The international cycle is longer. Projects that drive profits for the big services companies are typically large-scale, multi-year deals. As a group, international producers tend to be less sensitive to commodity prices in the short term. This is particularly true for the large integrated oil companies (IOCs) and national oil companies (NOCs), which have the cash and credit to continue drilling regardless of near-term pullbacks in pricing. And NOCs such as Brazil’s Petrobras (NYSE: PBR) often view oil developments as long-term national priorities.

Petrobras continues to spend money on developing its huge deepwater reserves, ignoring near-term price swings. And Mexico’s Pemex has demonstrated its commitment to developing additional fields in the wake of declining production from the super-giant Cantarell field. Drilling activity in Brazil and Mexico has held remarkably steady despite the gut-wrenching fluctuations in commodity prices. I describe the resilience of these and other key markets at great length in the April 1, 2009 issue, Islands of Growth.

In the case of most North American oil services companies, I suspect the cycle bottomed either in the second quarter or will do so in the third quarter. As I noted in Buying Coal and Natural Gas, the North American rig count has plummeted 60 percent over the past year because of slumping natural gas prices. (For those unfamiliar with the term, a rig count is simply the total number of rigs actively drilling for oil or natural gas in a particular market). The graph below provides a closer look at what’s going on today.

Source: Bloomberg

As you can see, drilling activity has collapsed over the past year and troughed at around the same number of rigs as at the bottom of the 2002 cycle. Since then, there has been a small uptick in rigs working in North America.

There are two main reasons for the uptick in the rig count. First, the number of rigs drilling for crude oil has increased from the lows recorded earlier this year, mainly because oil prices have recovered from their lows to between USD60 and USD75 a barrel.

Second, the Canadian rig count slumped to unprecedented lows early this year and is now showing signs of a snapback. To give you an idea of just how bad the drilling market in Canada was, at one point in the second quarter the average Canadian rig count reached just 63 rigs–the lowest level since 1999. More recently the Canadian rig count underwent its seasonal rise and now stands at 170 rigs, helping to push the North American rig count off its lows.

I wouldn’t expect a more meaningful uptick in the rig count until gas prices return to $5 to $6 per million British thermal units. As I noted in the previous issue of TES, I look for that recovery to occur over the next two quarters or so. However, I also don’t anticipate further downside in the rig count; producers have scaled back their activity to the lowest sustainable level. In other words, the North American cycle is bumping along a bottom.

Commentary from the major oil services firms gives credence to this thesis. In Weatherford International’s (NYSE: WFT) second-quarter conference call, CEO Bernard Duroc-Danner noted:

I don’t expect Canada to be a good market anytime soon. I don’t think that it’s going to fall off the map either. But in Q3 and Q4, it will be better than Q2, simply because it cannot be as bad as Q2. It’s not possible. And therefore, the negative numbers coming out of Canada, a combination of that, and together with the fact we are not sitting on our hands, will mean that North American margins will be helped…there’s a decent probability that you see margins in North America that are positive in Q3 and Q4 and along the lines of what you suggested.

Although the Weatherford CEO’s comments hardly herald the onset of a new bull market, he does acknowledge that North America has troughed based solely on a snapback in Canadian activity from unusually depressed levels. In fact, Weatherford’s CEO actually used the term “trough” in his prepared remarks to describe the company’s North American operations.

Duroc-Danner also asserts that a seasonal upturn in activity and continued cost-cutting could enable the company’s North American operations to achieve profit margins in the mid-single digits through the remainder of 2009.

Declining activity and margins in Weatherford’s North American segment had been a major headwind over the past year. Other oil services firms faced similar challenges. The key takeaway for investors: Although North America won’t drive results any time soon, it’s unlikely to be as much of an impediment going forward.

And Duroc-Danner isn’t the only CEO who’s made this point. Schlumberger’s CEO Andrew Gould made similar comments during that firm’s second-quarter call. Gould stated that he doesn’t believe Schlumberger’s margins in North America will go any lower.

That being said, international business is the primary driver for both Weatherford and Schlumberger. Schlumberger generated only 22 percent of its revenues from North America in 2008. And although Weatherford’s North American business accounted for 46.5 percent of sales last year, the region is rapidly declining in importance for as the company downsizes its legacy Canadian and North American business and builds its international operations. In fact, North America account for less than 30 percent of Weatherford’s net income in the second quarter.

The more important (and tougher-to-answer) question is, where do we sit in the cycle for international operations? If margins on international operations were to stabilize and tick up, such a development would likely prove a key driver for Weatherford and Schlumberger, our two recommended oil-services stocks.

The second-quarter conference calls provided additional insight into the international cycle, though Schlumberger and Weatherford offered slightly different outlooks. I expect international margins to trough over the next two to three quarters. The second half of 2010 will mark the beginning of a new uptrend. This outlook suggests that oil-services stocks will experience a big run-up in the final months of 2009, well before margins actually bottom.

Let’s examine the viewpoint offered by Schlumberger’s CEO Andrew Gould. As longtime TES readers are aware, I have the utmost respect for Schlumberger as a company and Mr. Gould’s take on the state of the business; given its scope, the firm has an unparalleled perspective on conditions in just about every imaginable oil or gas-producing region of the world.

In the first quarter of 2009, Gould predicted that the current cycle outside of North America would resemble prior down-cycles for these markets–that is, the total down-cycle would last roughly 18 months and, peak to trough, would result in a roughly 50 percent decline in Schlumberger’s margins.

Schlumberger’s gross margins topped out around 32 percent in the third quarter of 2008. If we assume an 18-month cycle with the third quarter of 2008 as the top, we would expect to Schlumberger’s international margins to bottom out at around 16 percent in the first part of 2010.

In Schlumberger’s second-quarter conference call, several analysts asked the management team if this was still a logical expectation. Management indicated that those forecasts remain valid:

Analyst: your prophecy for non-North American was a typical eastern hemisphere correction if you will, 18 months taking to unfold, margins down basically 50 percent from the recent peak which would imply margins somewhere in frankly, the high teens and margins to bottom either first or second quarter of next year…

Andrew Gould: …in what I know today, that’s for the rest of 2009 it is probably reasonable to assume I am a little less pessimistic.

Gould’s response suggests that, if anything, Schlumberger is a bit less pessimistic in its outlook than it was at the end of the first quarter. The CEO attributes this improved sentiment to higher-than-expected oil prices, a development that improves the outlook for international activity.

That being said, Schlumberger’s management team attached a major caveat to its forecast, stating that ongoing volatility in oil prices makes it unlikely that its customers will sanction any major expenditure in the near term. Mr. Gould stated on several occasions that Schlumberger’s outlook depends a great deal on year-end oil prices because crude prices will impact whether or not companies decide to delay or cancel major projects:

…If there is an element of doubt in predicting beyond the end of the year, it is the fairly rapid recovery that’s taken place in the oil price. As I said in the comment this time, I think there is too much volatility in the oil price at the moment to sanction much increase in spending. But if at the end of the year it persists at the higher end of the range that we’ve seen so far this year, then I do think that it might, if you like, not lead to the same reduction in activity next year that I was perhaps originally thinking of. But it really does depend on where the oil price is at the end of the year and not where it is now.

There’s no question that crude oil prices have been extremely volatile of late. Over the past two months, for example, prices have been as low as the upper USD50s per barrel and as high as the the mid-USD70s. And just over six months ago, crude was trading in the USD30s per barrel. At prices that low, few oil or gas exploration and development projects were economic. And with such wild price swings, it’s difficult for companies to decide whether to embark on a multibillion dollar project.

To complicate matters, most producers’ cash flows have decline sharply over the past 12 months. To undertake any large-scale projects, these companies would likely need to borrow money or dip into cash reserves, spending above their cash flow. Without a clear indication that cash flows will improve in the near term, firms might be unwilling to approve these expenditures.

Because most companies start forming their 2010 budgets in the latter months of 2009, the level of crude oil prices at that time will be a key determinant in this decision-making process.

Although Schlumberger doesn’t specify a magic price threshold, Gould’s comments imply that crude prices need to approximate recent levels in the low USD70s to support a jump in activity. Later on in the conference call, the management team reiterates this sentiment more explicitly. The good news is that if oil prices do remain around USD70, Schlumberger believes the turn in margins could happen more quickly than it anticipated earlier in the year.

Weatherford’s CEO Bernard Duroc-Danner was somewhat more bullish on international activity and margins:

We’ve come to the conclusion that more than two-thirds of our business, maybe 70 percent, in international markets which has been in one way or another either mechanically or by negotiation or simply new business re-priced. And the remaining, let’s just say, 30, 35 percent or our business is not likely to be re-priced in ’09 and therefore by the time it gets re-priced, market conditions may be different. 

 

So it strikes us that by and large the pricing effect in the international markets, with a few exceptions there are always exceptions, is behind us. That’s statement one. Two, in general, I don’t think the market is red hot, not at all, but the tone is decent in the international markets, the tone is better, which is also an environment which is less conducive to major pricing concessions. So between the analytical work and then the tone, I feel reasonably confident that pricing changes, at least insofar as Weatherford is concerned, are behind us.

Duroc-Danner indicates that Weatherford has already priced most of its business for the remainder of the year, limiting exposure to additional downside. At the same time, the CEO takes a constructive view of its customers’ tone, suggesting that it’s seeing a pick-up in (or at least a stabilization of) interest surrounding new projects as a result of the uptick in oil prices.

Duroc Danner goes on to quantify the expected trends in margins over the next few quarters, noting that CFO Andrew Becnel estimates that non-North American margins will fall 100 basis points (1 percent) in the third quarter and be flat to higher in the fourth quarter.

The CEO asserted that he doesn’t anticipate margins declining that far in the third quarter and projected that they would be slightly higher into the fourth quarter. But whether you side with the CEO or the CFO, both assessments imply that the third quarter will mark the trough in international margins.

There are a few potential reasons for the discrepancies between Weatherford and Schlumberger’s outlooks. One is simply that Andrew Gould at Schlumberger has tended to be a bit less bullish on broader sector commentary than his peer at Weatherford. In other word’s Gould’s commentary may simply reflect cautious optimism.

Business mix is another possible explanation. Both Weatherford and Schlumberger indicated that pricing pressure from integrated oil companies (IOCs)–firms like Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX)–is harsher than with national oil companies (NOCs) like Petrobras and Pemex. As I explained at some length in Islands of Growth, Weatherford has benefited from longer-term service contracts with NOCs–for example, its work on the Chicontepec project in Mexico.

These contracts, known as integrated project management (IPM) deals, involve managing most of a particular project on behalf of an NOC. National oil companies tend to prefer this arrangement because it allows them to access the technical expertise of an international oil services firm for a simple fee without giving up ownership to actual production volumes. Traditionally, NOCs have partnered with big IOCs on such deals in exchange for giving the IOC a stake in production, but the IPM structure has become increasingly popular alternative in recent years.

The company noted that it has several IPM projects slated to ramp up in the back half of the year. These deals represent a stable source of revenue and demand for Weatherford.  Schlumberger also has a number of these deals in the works, but it’s a much bigger company. It’s possible that Weatherford has more confidence in the second half of 2009 because of its long-term deals with NOCs.

The varying prospects for exploration and development activities may also contribute to the two firms’ divergent outlooks. Although this generalization has lost some of its weight over the years, the market has traditionally viewed Schlumberger as a major beneficiary of exploration spending. In other words, when companies are actively exploring for oil or gas, Schlumberger’s core business lines tend to benefit. Weatherford has been more closely aligned with trends in field development–that is, enhancing production from existing plays.

Development spending tends to recover before exploration expenditures because investing money into producing additional wells increases volumes and generates cash flow almost immediately. Exploration expenditures also lead to additional production and cash flow, but the payback isn’t as immediate.

At any rate, the proof is in the proverbial pudding. Schlumberger’s North American revenues declined $619 million in the second quarter of 2008, by far the worst performance of any of its geographic segments. However, the company also saw revenues fall across its business footprint, including a $288 million drop in Europe/Africa and a $132 million decline in the Middle East.

Like Schlumberger, Weatherford suffered a massive 44 percent drop in its North American revenues. But international revenues were actually up 17 percent compared to a year ago. This increase was led by a 72 percent jump ($198 million) in Latin American revenues due to the previously discussed IPM deals.

Whether you choose to believe Schlumberger’s characterization of the current environment or Weatherford’s, it appears that international markets are at, or within a quarter or two of, an important cyclical low. A big decline in oil prices through year-end is the only event that might derail such a recovery.

Oil-services stocks also tend to bottom out long before before the global rig count stabilizes and begins to recover.

Source: Bloomberg

This chart depicts the price of Schlumberger’s stock compared to its pretax profit margins from late 1996 through to early 2001. As I explained earlier in today’s report, the period from 1998 through late 1999 marked a down-cycle for the oil services business. As you can see Schlumberger’s margins over this time period, measured on the right-hand scale of my chart, fell from around 17 percent to about 6 percent.

The second line (scaled on the left-hand axis) traces Schlumberger’s stock price. As you can see, Schlumberger topped out in late 1997, around nine months before the company’s margins reached a cyclical peak. Similarly, Schlumberger’s stock found a bottom at the end of 1998, roughly six to eight months before margins bottomed out.

This basic pattern suggests that even if margins don’t trough until the first or second quarter of next year, Schlumberger’s stock should move higher over the next few months in anticipation of that bottom.

Bottom line: The cycle for oil services stocks appears to be at or near its lows. This bodes well for both TES recommendations in the oil-services space. Buy Schlumberger and Weatherford International at current prices. The oil-services sector remains my favorite long-term play in the energy industry; these firms will benefit directly from the increasing technical complexity of oilfield development.

A Few Words about Oil

Over the past six months, I’ve spilled considerable ink discussing the outlook for oil prices and my view that prices will generally rally through 2009 and top USD80 a barrel by year-end. 

Although I recognize the potential for another pullback such as the ones we saw in June and early July, investors should regard any hiccup as a buying opportunity. Predicting oil prices is far from an exact science, but this outlook has proven correct thus far–at least directionally.

Of course, there are still plenty of pundits who point to the weekly inventory reports released by the Energy Information Administration (EIA) and note that crude oil supplies are more than ample and prices should be falling, not rising. For the most part, these pundits appear frustrated that crude continues to rally, doubling off its lows, even as inventory figures continue to get worse. One common “explanation” for this supposed disconnect is the activity of “speculators,” a theory I explode in the July 29, 2009 issue of The Energy Letter, “Don’t Buy Oil Speculation.”

These analysts are quite correct to point out that US oil inventory figures appear bearish right now. Here’s a chart of oil inventories over the past few years.


Source: Bloomberg

Although oil inventories have declined significantly from the record levels set earlier this year, there remains more oil in storage than is normal for this time of year. This glut will have to decline notably over the next few months to bring the US oil market back into balance.

Motor gasoline inventories are also above average for this time of year, albeit not to the extent of crude oil inventories. And stocks of distillates–heating oil and diesel–are also above average. The traditional interpretation of these data points is that high inventories are bearish for oil prices because they represent an excess of supply.

I would agree with the bears that the current oil supply picture for crude appears bloated. Come commentators have also observed that global oil demand remains extremely weak and shows no sign of a change or stabilization. This, I believe, is an inaccurate statement. In its most recent report, the EIA released data showing that US demand for oil and related products fell 3 percent from a year ago. This is a far cry from earlier this year and late 2008, when demand was down 10 percent compared to 12 months earlier.

Meanwhile, demand for the most important refined product, motor gasoline, has actually been running flat to higher in recent weeks on a year-over-year basis. Not a great showing, but hardly as bad as some of the bears would have you believe.

And, as I’ve noted over the past few issues, demand appears to be recovering in some emerging markets more quickly than in the US. Nonetheless, a glutted supply picture and a tepid recovery in demand is hardly a reason for oil prices to rally 100 percent off their late 2008 lows.

I believe there are four fundamental explanations for the current price of oil:

1. The elimination of extreme contango that occurred earlier this year;
2. The improvements in global credit markets;
3. Continued expectations for a recovery of demand into 2010 as discussed above; and
4. Legitimate intermediate-term supply concerns that necessitate oil prices near their marginal cost of supply.

I’ve written about the concepts of contango and backwardation in the crude oil futures market on several occasions. Contango is a condition where near-month crude oil futures trade at a significant discount to crude oil futures several months into the future.

The best way to illustrate contango is with a simple graph.

To generate this graph, I took the price of crude oil futures expiring 32 months in the future and subtracted the near-month futures price. Futures expiring 32 months from today represent the price you would pay today for crude oil to be delivered 32 months in the future (May 2013).

The current price of those futures is in the low USD80s a barrel. This implies, among other things, that the market expects crude oil prices to rise generally over the next 32 months.

Front-month futures measure the current price of crude oil–that is, the price of crude oil for delivery on the next available (monthly) delivery date.

When this spread is positive and high, the oil market is said to be in contango; negative numbers indicate backwardation. The average value between 1991 and 2009 is around negative 35 cents; on average, the market trades at a slight backwardation.

There are two spikes in the graph above. The first was a downside spike that occurred last fall. This happened when a short squeeze in the near-month futures contract pushed near-month oil prices sharply higher but had little effect on longer-dated contracts. In other words, this was really a short-lived technical aberration.

More interesting is the sustained contango evident late in 2008 and early in 2009. At its highest point, my simple ratio topped USD35 a barrel, an all-time high. The main driver of this contango was that near-month futures plunged amid pessimism about short-term supply and demand conditions and the ongoing credit crunch. Meanwhile, long-date futures remained relatively high and stable because traders were confident that prices would eventually normalize to higher levels.

But contango has fallen slowly and steadily since the end of last year and now stands at just USD12 a barrel–less than half its late 2008 levels. Though still above average levels, the contango has normalized.

And consider that since late 2008, oil prices have rallied from roughly USD40 a barrel to roughly USD70 barrel, an increase of about USD30 a barrel. Over the same period, the contango has closed by roughly USD 23 a barrel, suggesting that much of the recent rally in oil prices stems from the crude oil market reverting to normal. In other words, it was the extreme depressed prices that persisted in late 2008 that were aberrant, not the current prices closer to USD70 a barrel.

Normally, under such extreme conditions of contango, traders would do a riskless arbitrage trade, purchasing oil at depressed prices on the spot market and immediately selling long-dated crude oil futures to lock in higher prices. A trader able to store the oil could realize a risk-free profit. By performing this basic arbitrage, traders would push up near-month oil prices (buying oil at spot) and push down longer-dated prices (selling long-dated futures), closing the severe contango. My best guess as to why this didn’t happen to a greater extent: The credit crunch made it tough for the banks and financial institutions to finance this type of trade. 

Another explanation is that the ongoing credit crunch simply caused widespread panic in stock and commodity markets and pushed prices down to unsustainably low levels. After all, recall that at the time the onset of the next Great Depression seemed a palpable threat.

Although it’s impossible to pinpoint an exact cause, it’s interesting that crude oil prices have tracked improving US credit conditions closely since the beginning of 2009.

Source: Bloomberg

This graph plots the TED spread against crude oil spot prices. The TED spread is the difference between the yield on three-month US Treasuries and the three-month London Interbank Offered Rate (LIBOR). The three-month US Treasury yield is essentially a risk-free interest rate. LIBOR is the rate that banks charge to lend each other money. The higher the TED spread, the more pervasive the sense of fear in credit markets.

Rather than plot the actual TED spread, I’ve graphed the inverse of the TED spread, depicted by the blue line. Because this line is an inverse, a rising TED spread line indicates improving credit conditions.

As you can see, the improvement in the TED spread and the rally in oil prices (orange line, left-hand scale) have tracked one another closely since the beginning of the year. This suggests that a big part of the rally in crude oil prices was a normalization in credit markets and, therefore, falling probability of a second Great Depression.

The final rationale for the current price of crude is that a price near USD70 a barrel roughly corresponds to the marginal cost of supply–the level needed to prevent a significant decline in oil supplies over the coming years.

I’ve written extensively about the potential for a production shortfall in 2010 due to the big slowdown in spending on oil exploration and development in late 2008 and thus far in 2009. The delay and cancellation of major projects will weigh on future supplies.

In the second-quarter conference call, Schlumberger’s management noted this point:

The thing that worries me more than anything else is our customers’ cash flows. Because even our very largest customers are having to borrow or dip into their war chest to sustain their spending. And they will only go on doing that for a certain period of time. And therefore, if we don’t have a fairly substantial improvement in the oil price, by the end of this year, then the risk is that cash flows will be such that they will not actually increase at all in 2010. So, that’s why I am so insistent that it hinges on the level of the oil price at the end of this year.

 

Now, in terms of supply, you’ve seen the easy stuff go away, the heavy oil, the tar sands and all the rest of it, which is a fairly substantial chunk of production that was originally included in the sort of 2012 estimate. And I think what we are seeing now is a very definite caution on the part of our customers which leads them to postpone fairly substantial projects. If they don’t see an increase in their cash flow, they are going to go on doing that. And my point is that if that happens, it’s just going to accelerate the supply decline. And if that occurs at a moment when demand starts to grow, the crossover could be quite violent.

In other words, customers have been delaying and canceling projects due to weak commodity prices and falling profitability and cash flows. If customers’ cash flows don’t improve by year-end, this pattern could continue into 2010, further constricting future oil supplies. If demand does stabilize, as I suspect it will, that supply just won’t be sufficient–the perfect recipe for a price squeeze. The price level that Schlumberger suggest will be needed to stabilize activity levels is around USD70 a barrel.

As I’ve noted repeatedly in this advisory, I expect this price squeeze to come in 2010–the only question is one of magnitude. If demand improves and exploration and production activity stabilizes and picks up into early 2010, we should see USD100 oil next year. If E&P activity continues to sink and there’s another leg down in activity, the eventual spike would be much higher. In that case, it would soon become clear that oil prices at USD150 a barrel wasn’t just a one-off aberration.

Gas and Gas E&Ps

In recent weeks, a number of readers have asked me to explain the apparent disconnect between natural gas prices and the price of companies that produce natural gas.

Source: Bloomberg

This graph depicts near-month natural gas futures and the stock price of XTO Energy (NYSE: XTO), a natural gas producer in the TES Portfolios. As I pointed out on my chart, XTO’s shares have rallied since late June even though near-month futures prices have slumped to a new low of $3.08 per million British thermal units.

This divergence isn’t all that surprising because near-month futures prices aren’t all that relevant to XTO’s profits. The company doesn’t sell natural gas solely in the month of August; in fact, since demand for gas tends to be relatively weak this time of year, prices tend to be low. But this doesn’t mean natural gas won’t command higher prices in a few months, when heating season kicks off.

The graph below depicts XTO’s stock price and the 12-month natural gas strip.

Source: Bloomberg

The 12-month natural gas strip is the average price of the next 12 months of natural gas futures. In other words, this measure factors in not only low near-term futures prices but also futures expiring in the coming winter months, when gas prices are much higher.

Although the correlation isn’t perfect, the level of disconnect evident in the first graph just isn’t there. Notice that the gas trip bottomed out in late April and has traded sideways since then. XTO Energy also has traded in a range over this period, and the stock reacted to both the July rally in gas and the subsequent sell-off.

I highlighted my outlook for natural gas and my favorite stocks in the group in the previous issue of TES; I won’t belabor the point by repeating that analysis here. Suffice it to say that investors should not look at the natural gas ticker on CNBC every morning and panic about their gas-focused exploration and production (E&P) holdings. It’s the strip, not near-month gas that really dictates performance.

Portfolio Updates and Themes

One key takeaway from Schlumberger’s second-quarter conference call is that deepwater spending continues to hold up well amid volatile oil and gas prices. The company expressed a remarkably high level of confidence in the outlook for its deepwater business.

In addition to Schlumberger itself, this bodes well for Gushers recommendation Dril-Quip (NYSE: DRQ), which manufactures subsea equipment used to develop deepwater plays. For new subscribers unfamiliar with this recommendation, April 1 issue of TES offers a full rundown of the business. Dril-Quip rates a Buy under USD45.

Another beneficiary of ongoing strength in deepwater is contract driller Noble (NYSE: NE). Day rates for its deepwater rigs should remain relatively high and resilient to the cyclical downturn in commodity prices. I explained the drilling industry and Noble in the June 17 issue of TES, “The Drilling Dozen.” Noble rates a Buy under USD37.

In July, the short and sharp energy pullback stopped us out of National Oilwell Varco (NYSE: NOV) for a small profit. At the time, I noted that I still liked Oilwell’s prospects and the stop-out was largely due to short term volatility. As I explained in the April 1 issue, National Oilwell is a major beneficiary of deepwater spending; I am looking to reenter the name over the next few weeks. For now, National Oilwell will be tracked in my How They Rate coverage universe as a Buy, but look for me to add it to the TES portfolios in the near future.

Finally, in my August 11 Flash Alert, “A Lucky Australian Coal Firm,” I noted that a takeover deal for Gushers recommendation Felix Resources (AUS: FLX; OTC: FLRFF) appeared imminent and the stock was suspended from trading for most of last week.

The bidder turned out to be Yanzhou Coal Mining (NYSE: YZC), and details of the deal were finally released late last week.

Yanzhou offered Felix shareholders an all-cash deal worth AUD16.95 per Felix share. In addition to that money, Felix would also be pay an AUD1 dividend in two installments between now and the date the deal closes. That puts the full value of the offer at AUD17.95.

The good news: If the deal closes at that price, the profit on this recommendation would be about 35 percent in Australian dollars.

The bad news: Although that’s a decent profit in just a few short months, it’s a lower offer than many expected. I had been looking for a price in the AUD19 to AUD20 range, and other analysts believe Felix could be worth AUD 20 to AUD 25.

Management recommends that shareholders approve the deal, but it will still take months to close. Given the lowball price, I see a significant possibility that either a competing bidder will emerge with a higher offer, or Yanzhou will boost its offer price to cajole Felix shareholders into accepting the deal.

 The stock currently trades at a 5 percent discount to its takeover price. Because the deal is all-cash, holding on won’t cost us anything. If another bidder emerges, we could easily see an additional AUD1 to AUD2 upside per share. Felix Resources is a Hold. We’ll see if our patience is rewarded with a better deal.