Earning Their Keep
Quarterly earnings season is always a busy time of year; most of the companies in my coverage universe report results and host conference calls over a period of two to three weeks.
Fourth-quarter earnings season is busiest of all because management teams usually detail their outlook for the year ahead. But the importance of this information can’t be overstated: Key trends that drive stock performance throughout the year emerge in these calls.
Coal mining and services firms were the first energy-related sectors to report fourth-quarter results. In this issue, I’ll examine the trends underway in both industries and outline how to play those moves.
In This Issue
The Stories
Fourth-quarter earnings and conference calls from two railroad companies indicate that conditions are improving in certain US coal markets. See Coal: Don’t Buy American Yet.
Coal companies with exposure to China are the best bet for growth investors. See Looking Up Down Under.
International margins in the oil and gas services sector appear to have bottomed. I recap fourth-quarter earnings from my favorite names. See You’ve Been Served.
The Stocks
Peabody Energy (NYSE: BTU)–Buy @ 52
Arch Coal (NYSE: ACI)–Hold
Bucyrus (NSDQ: BUCY)–Buy @ 66
Nabors Industries (NYSE: NBR)–Buy @ 28
Baker Hughes (NYSE: BHI)–Buy @ 51
Weatherford International (NYSE: WFT)–Buy @ 26
Suncor Energy (NYSE: SU)–Buy @ 43
Coal: Don’t Buy American (Yet)
Railroad companies are among the first to report earnings results each quarter; the group provides valuable color on the health of the economy in general and coal markets in particular.
Railroad volume statistics can tell us if commodities and goods are moving and what areas of the economy show signs of relative strength or weakness. And almost all the coal burned in US power plants and used in steel mills is transported from mines via rail–industry statistics are early indicators of changes in supply and demand conditions.
Fourth-quarter results from US railroads furnished two main takeaways: overall freight volumes remain weak but are showing signs of improvement, and the US coal market is still plagued by an oversupply that will take much of 2010 to work out.
Every quarter, I make a point of listening to the conference calls of at least one East Coast rail company, such as CSX Corp (NYSE: CSX) or Norfolk Southern Corp (NYSE: NSC), and a West Coast rail company–for example, Union Pacific Corp (NYSE: UNP). This quarter, railroad operators on both coasts offered a similar take on broader economic conditions, but commentary on coal markets diverged significantly.
Last year, Union Pacific’s freight volumes were the lowest in a decade, but fourth-quarter carloadings–a basic measure of rail activity–were the strongest of the year in terms of absolute volumes and on a year-over-year basis.
Union Pacific breaks down its business into six categories; the graph below depicts volumes in each segment.
Source: Union Pacific
Keep in mind that these volumes figures are compared to results from the fourth quarter of 2008. This is a relatively easy comparison, as freight volumes began to plummet at the end of 2008 amid a deepening financial crisis.
Although volumes remained weak through all of 2009, data from the Association of American Railroads (AAR) suggests the collapse in activity bottomed out in the April or May time for most goods and commodities. This will make the year-over-year volume comparisons relatively easy through at least the first quarter of 2010. Nonetheless, the shift from declining volumes to growth is a key inflection point to watch.
On a year-over-year basis, volumes grew in only two of Union Pacific’s six operating segments. Agriculture was supported by strong demand for US soybean exports to Asia–a product of robust domestic yields and damage to South America’s soybean fields.
In addition, Union Pacific noted an uptick in shipments of ethanol and dried distillers grain (DDG), a by-product of ethanol production. Part of this increase occurred because Verasun Energy, a bankrupt ethanol producer, transferred all of its former plants to new and financially sound management. The ethanol industry is big business for railroads, which ship corn, ethanol and DDG to and from production facilities.
Improving farm economics, resurgent demand for agricultural exports and higher ethanol mandates should all support the agriculture segment in 2010. And strength in this area also bodes well for my favorite biofuels plays, outlined in the Dec. 2, 2010, issue, Bumper Crop.
Automotive volumes were also higher year over year, thanks primarily to a wave of industry re-stocking after last summer’s Cash for Clunkers program depleted dealerships’ lots. But Union Pacific’s management noted that US auto sales improved even when the effects of Cash for Clunkers are backed out; this trend bodes well for 2010. Auto parts shipments likewise increased 2 percent.
Within the chemicals segment, fertilizer volumes were down 7 percent–largely because of the late corn harvest. As a result of the late harvest, farmers have delayed applying fertilizer until the spring planting season in March or April.
Union Pacific’s industrial products business was awful, reflecting a weak economy and disruption of residential construction. Some of the most important products shipped in this category include steel (down 32 percent), rocks (down 29 percent) and cement (down 37 percent). Any meaningful improvement in this segment would require an uptick in residential and non-residential construction.
At the same time, continued economic stabilization should put a floor under industrial shipments in 2010. And management noted that much of the infrastructure spending authorized in last year’s stimulus package won’t get underway until this year; monies spent non-residential construction projects such as roadways should support demand for gravel and other key industrial products. Union Pacific expects modest growth in this area.
Intermodal volumes–freight shipped using multiple modes of transport–fell overall, primarily because of a decline in international revenues. This trend reflects a slackening in US imports. As demonstrated by last Friday’s GDP release, US exports are growing much faster than imports and overall trade activity is down.
Domestic intermodal volumes jumped as shippers switched some of their cargo from trucks to cost-efficient railroads. As international trade recovers and the long-standing business shift from trucks to trains continues, intermodal volumes should improve.
Comparing last year’s carloadings to data from 2007–the last year before the global recession–is also informative. The table below presents this data for various categories of products that Union Pacific transports.
Source: Union Pacific
Some products in this table show no sign of a turn in demand. For example, carloadings in the crushed stone, gravel and sand category deteriorated relative to 2007. Volumes of coal shipments also deteriorated steadily throughout 2009.
However, decline rates moderated somewhat in the final two quarters of 2009. And aside from coal, key categories such as autos, agricultural products, chemicals and intermodal showed signs of improvement between the second and fourth quarters of 2009.
Furthermore, data from the Association of American Railroads (AAR) indicates that in the first three weeks of 2010, total carloadings are off 3.2 percent from 2009 levels and 19.4 percent from 2008. The railroad industry is healthier than it was last spring, but this improvement hardly indicates a roaring economy.
Management at CSX likewise expressed cautious optimism regarding the US economy and noted that although volumes were down 7 percent in the fourth quarter, post-Thanksgiving carloadings were on par with the preceding year. The graph below depicts volumes across CSX’s four main business lines.
Source: CSX
CSX’s data demonstrates the same basic trends in intermodal and automotive volumes that Union Pacific reported.
The merchandise category is a bit of a catch-all term, encompassing products as diverse as forest products, metals, grains and ethanol. As with Union-Pacific, strong grain and ethanol volumes offset weakness in lumber and other construction-related cargoes.
CSX and Union Pacific’s fourth-quarter results are broadly consistent with my view that the US economy is enjoying a tepid cyclical recovery from the nasty recession that prevailed from 2007 to 2009.
Broadly speaking, this is good news. But coal is the most important product category for energy-focused investors.
Year-over-year declines in coal shipments accelerated at both CSX and Union Pacific in the back half of 2009. Although these declines came on the heels of historically robust coal volumes in 2008, the drop-off was painful nonetheless.
What’s ailing the US coal industry? Demand has plummeted over the past year, and US utilities have high inventories on hand–hardly the recipe for a strong market. Let’s examine the demand side of the equation first.
Source: Energy Information Administration
This graph shows the year-over-year change in US electricity generation broken down by fuel type through October 2009, the latest data released by Energy Information Administration (EIA). The yellow bars represent total US electricity generation; the purple bars represent power generated from natural gas; and the blue bars represent power generated from coal.
Total US electricity generation turned negative on a year-over-year basis in summer 2008, when the economy weakened and power demand fell. This headwind pressured generation from both coal- and gas-fired plants fairly evenly until February 2009.
Although year-over-year power generation remained negative from February to October 2009, coal-fired generation fared far worse than gas-fired generation. In fact, gas demand from electric power plants generally has been higher on a year-over-year basis since early 2009.
These trends represent a vicious one-two punch for US coal. First, the overall drop in US electricity consumption caused by the recession lowered demand for coal. Second, the cheap natural gas prices that prevailed in 2009 prompted some generators to favor gas over coal–a phenomenon known as fuel-switching. Accordingly, coal demand fell faster than electricity demand, while gas demand ticked higher.
Seeking to lock in prices and supplies, utilities typically contract with coal miners to receive a specific amount of coal over a multi-year time frame. Though logical, this approach sometimes forces utilities to accept coal deliveries when their stockpiles are building and demand is on the wane. These conditions persisted last year. According to data from CSX, utilities on the East Coast have stockpiled roughly 90 million tons of coal–a normal level would be around 60 to 70 million tons.
To alleviate this glut of coal, most utilities are limiting new deliveries of coal. As demand returns, normal usage should begin to reduce stockpiles.
Making matters worse, global coal supplies were ultra-tight in the first half of 2008. European utilities struggled to obtain coal from South Africa and other exporters, which were fetching higher prices for the commodity in energy-hungry Asia.
To fill the gap, European utilities and other coal buyers turned to the US; both railroads and coal-mining firms benefited from burgeoning exports. But this business dried up during the financial crisis, closing another outlet that could help to normalize coal supplies.
Although both CSX and Union Pacific suffered from weakness in the domestic coal market, the latter firm’s management sounded much more upbeat about the prospects for coal demand going forward. CSX doesn’t expect any respite from bloated coal inventories.
During CSX’s fourth-quarter conference call, one analyst asked if the extremely cold weather across much of the US might help increase demand, reduce production and bring inventories back in-line with demand. CSX’s Chief Commercial Officer Clarence Gooden responded:
One the producer side, there was about a two or three week period when it was extremely cold in the central and northern Appalachian coal fields, particularly in the surface mining, [and] we did see impacts on the production level, both from the inability of the producers to mine the coal, as well as, once the coal got into the cars–even being weather treated–[it was frozen]. So this impacted us for a very short period of time.
On the consumption side of the house….the inventories are extremely high for this time of the year, number one. Number two is that with demand itself being down on the industrial side and the commercial side of the house, we’re not seeing the electricity generation we would like to see…So we really have not seen any impact on the coal inventories at the utilities.
In other words, even the worst winter weather since the late 1970s wasn’t enough to impact production or electricity demand enough to have a meaningful effect on inventories.
In response to another query, CEO Michael Ward stated that he has been with the company for 32 years and couldn’t recall an inventory overhang this large–implying that it would be difficult to forecast how long it would take for this problem to correct.
But Union Pacific offered a more upbeat outlook in its fourth-quarter conference call. Although management highlighted the same basic challenges as CSX, Executive Vice President of Sales and Marketing John Korelski offered the following assessment:
We’re not really counting much at this point on volume growth in coal, but the recent reports indicate that this severe cold weather, both here and around the world, may have put more of a dent in stockpiles than what we might be expecting. So if we see some improved industrial production and a more normal summer burn, there may even be a little opportunity out there for us in the coal business.
Union Pacific’s conference call occurred the day after CSX’s call, so this apparent discrepancy generated a significant number of questions during the subsequent Q-and-A segment. Management stuck by this statement, noting that some of its customers had relatively normal inventories and were accepting new shipments.
Union Pacific’s management also went on to note that inventories appeared to be drawing down quickly as a result of the cold weather worldwide–almost the exact opposite to what CSX noted.
I see three potential reasons for Union Pacific’s optimism:
- Inventories at utilities in CSX’s market on the East Coast are more bloated than the inventories at utilities in the Midwest and Southwest markets that Union-Pacific serves;
- Union Pacific’s management also pointed out that inventories of Powder River Basin (PRB) coal–the railroad’s main cargo–aren’t as glutted as stocks of Appalachian coal; and
- Utilities in the Northeast and Southeast are able to switch a larger portion of their generating capacity from coal to gas, while many of Union Pacific’s customers don’t have this luxury. That is, the effect of gas fuel-switching has been more pronounced in regions served by CSX.
My conclusion is that the US thermal coal market–coal used in power plants–remains weak overall, but the prospects for a recovery in the market for PRB coal appear brighter than coal sourced from Appalachia. I will continue to monitor this trend closely in coming months; if Union Pacific continues to enjoy stronger coal volumes than CSX and Norfolk Southern, my hypothesis would be confirmed.
Although PRB coal appears enjoy better prospects than Appalachian coal this year, the real growth is overseas. Results from two US-based coal mining firms–Wildcatters Portfolio bellwether Peabody Energy (NYSE: BTU) and Arch Coal (NYSE: ACI)–support this thesis.
Peabody Energy earned of $0.41 per share in the fourth quarter, well above expectations for about $0.285. Earnings estimates for 2010 and 2011 have trended steadily higher and accelerated after those results, a sign that analysts are increasingly confident in Peabody’s prospects.
Peabody operates mines in the Illinois Basin and the Powder River Basin of the western US with the PRB, by far the more important region for domestic coal production. But Peabody’s international operations, particularly its mines in Australia, have fueled much of the company’s growth in recent years. Australia is the world’s largest exporter of both steam coal for power plants and metallurgical coal used to produce steel. By dint of its location, the country is the key supplier of coal to fast-growing Asian markets such as China and India.
At the beginning of Peabody’s fourth-quarter conference call, CEO Gregory Boyce, went through a laundry list of positive data points concerning Asian coal demand. Chinese coal imports more than tripled in 2009, reaching 125 million tons, and December marked a record month for coal imports. Meanwhile, Indian imports of thermal coal also soared 70 percent.
Growth rates of that magnitude beg the question of whether that level of demand is sustainable over the long term. Boyce answered that question up front, noting that he sees a paradigm shift in terms of the China’s import patterns. When asked to clarify that position, Boyce noted:
…it’s our view that as China looked at the constraints of satisfying China’s energy needs solely on the back of thermal coal transport and delivery out of northern China, I think they’ve come to the conclusion in the plan that they will convert their northern coal reserves to higher value products such as electricity for the north, electricity in the central part of China as well as coal-to-gas for industrial products and they will increase and enhance their import capabilities in southern China.
This is an interesting shift for China. The country boasts large coal reserves, but much of that coal has to be transported by rail from the north of the country to industrial customers in the southern and coastal regions–a substantial inconvenience, especially when the weather disrupts shipment.
Boyce appears to suggest that more of the coal produced in the northern China eventually will be consumed in that region. Provinces in the interior, north and west of China are less developed than the south and east, but the central government aims to stimulate growth in these rural provinces. The shift in the pattern of coal imports may indicate that development in these rural provinces is beginning to translate into growing demand for electricity and coal.
If more coal is consumed in the northern and interior provinces, however, that would mean that less coal is available to ship to the south. It appears that China has been using some coal imports to fill that gap. And Boyce’s suggestion that China is already improving import infrastructure in the south suggests this may be more than just a short-term fix.
Peabody would benefit immensely if this shift bears out; until recently, China was a net exporter of coal.
Peabody’s management also noted that China has been grabbing vital resources aggressively–including Australia’s Felix Resources, a company that appeared in our model Portfolios until it was finally acquired by Yanzhou Coal Mining (NYSE: YZC). China spent $8 billion in coal-related acquisitions and investments last year–a clear indication that the nation is aware that it will need foreign coal resources to meet growing demand.
And investors forget about India all too often, a major mistake; India is expected to be the fastest growing importer of coal over the next few years, and inventories of coal at Indian power plants remain tight. As I noted earlier, Indian thermal coal imports soared 70 percent in 2009 to a record 80 million tons.
Amid all this demand and tight inventories in China and India, seaborne coal prices–both thermal and metallurgical–are rising in Asia. Management noted that thermal prices out of Newcastle, Australia are nearing USD100 per metric ton, up 40 percent since the beginning of the fourth quarter. Peabody recently sold some metallurgical coal in Chin at USD200 per metric ton, well above its 2009 average price of USD135.
Accordingly, Peabody’s management boosted its targets for export sales of both thermal coal and metallurgical coal. In 2009, Peabody sold 6.9 million tons of metallurgical coal and expects to sell 7.5 to 8.5 million tons in 2010. Thermal coal export totaled 9.6 million tons in 2009, and Peabody is looking to sell 12 to 13 million tons this year. That implies growth as high as 30 percent next year for Australian exports.
In addition, management stated that it has 4.5 to 5.5 million un-priced metallurgical tons for 2010 and 9 to 10 million in 2011. For thermal coal, some 6.5 to 7.0 million tons remain un-priced for this year and 9 to 10 million tons for 2011. Un-priced tons represent coal that hasn’t been sold under long-term supply contracts; this excess should benefit from the recent surge in Asian seaborne coal prices.
A critical time of year is approaching for Asian coal miners. Typically, benchmark prices are set in April and serve as the basis for pricing supply contracts. Given the recent strength in Asian coal demand, solid benchmark pricing could be an important catalyst for Peabody and other stocks in the coming months.
Peabody has taken steps to enhance its export capacity. For example, the Newcastle Coal Infrastructure Group’s port facility is on track to ramp up this year; Peabody’s 18 percent stake provides another outlet for exporting coal. All told, Peabody is looking to roughly double its Australian export capacity to 15 million tons of metallurgical coal and 17 million tons of thermal coal by 2014.
While the Asian side of the business looks exciting, the US side looks to be stable and has prospects for improvement. Peabody has already sold all of its planned 2010 production under longer-term contracts, and management indicated that it doesn’t need to price its coal aggressively–the company can afford to wait until supply and demand dynamics improve.
And Peabody’s management highlighted some recent improvements in the US thermal coal markets, noting that US coal inventories fell at a record pace in December due to cold weather and higher prices for natural gas.
Moreover, Peabody estimates that US coal production fell 105 million tons in 2009 and will decrease 20 to 25 tons this year. Such a decline in output will come when some miners are unable to replace expired supply contracts with equally profitable deals. Management also noted that permitting delays and high production costs were weighing on profitability, especially on the East Coast.
Finally, management noted that a cold winter and gradual economic recovery could increase demand for coal by 60 to 80 million tons. Based on that forecast, the US market could be back in balance by year-end. And remember, the inventory situation is far better for PRB coal, the core of Peabody’s US business.
At this point, some readers may be wondering about the potential for US coal producers to export thermal and metallurgical coal to Asia. Unfortunately, that’s not an option.
Historically, the US hasn’t been a huge exporter of thermal coal, but the US export market for both thermal and metallurgical coal boomed in 2007 and 2008. The bulk of these exports went to Europe; shipping costs to Europe are more favorable than to Asia. And that’s where the unfulfilled demand was. In 2007 and 2008, surging Asian demand diverted South African coal from Europe, forcing these buyers to turn to the US.
This time around, Asian demand is accelerating and South Africa and other traditional exporters taking advantage of the high prices available in the region. But this time around Europe’s economy remains relatively weak and coal inventories are on the high side. Until demand in the Atlantic basin–the US and EU–begins to improve, US thermal coal exports likely will remain depressed.
Peabody’s management explained the pricing situation rather succinctly in its conference call: Given current shipping rates, US thermal coal prices would need to rise 15 to 20 percent from current levels before it would makes economic sense for US miners to export coal. Based on this assessment, Peabody expects exports of thermal coal to be lower.
The situation differs for metallurgical coal, which has benefited from rising demand for steel in Asia. Prices for metallurgical coal should continue to surge, and Peabody’s management sees an opportunity to increase exports this year.
Peabody is the largest US coal-mining firm and the only one with significant exposure to the burgeoning coal trade between Australia and Asia. In fact, it’s one of the largest coal mining firms in Australia, too. The company also has USD1 billion in cash and one of the cleanest balance sheets in the industry, putting the firm in a good position to expand its Asian operations organically or via acquisitions.
In my view, Peabody has the “right” US exposure. The PRB is the least glutted coal market in the country, and Peabody has a conservative contract strategy that’s allowed it to maintain margins through this weak coal market environment. Peabody’s shares recently pulled back in the wake of weak results from fellow US mining giant Arch Coal, but the comparison between these two firms is utter. Buy Peabody under 52 with a stop at 32.
Longtime subscribers should also note that the Peabody Covered Call trade I recommended roughly one year ago is officially closed, yielding a total profit of 68.1 percent. I explained this position and why it was closed in the Jan. 6, 2010, issue, The Crystal Ball.
Unlike Peabody, Arch Coal reported fourth-quarter earnings of $0.11 per share, missing expectations for $0.156 and prompting analysts to slash their estimates. PRB coal accounts for roughly 80 percent of Arch’s production, and its management expects cold weather and a return of demand will ameliorate conditions by the second half.
There are two big problems I see with Arch. First, with no direct exposure to Australia, Arch’s only opportunity to tap Asia’s demand would be if the export market picks up–and exports will take time to recover.
Second, because metallurgical coal accounts for roughly 3 percent of its output, Arch has only limited exposure to exports of this high-value coal. Longer-term, I like Arch’s exposure to PRB thermal coal as eastern production volumes are in decline–western mines will need to replace that supply. But I see the improvement in the US coal market as a story that unfolds in the second half of 2010.
For years, Arch and Peabody were regarded as similar companies due to their exposure to the PRB; the knee-jerk reaction when one of these two firms reports weak results is to lower expectations for the other.
But Peabody spun off its eastern mining operations entirely and made a series of aggressive investments in Australia–these companies no longer bear much similarity. Arch Coal is a hold in “How They Rate.”
Another coal-related recommendation is Bucyrus (NSDQ: BUCY), a firm that makes coal mining equipment. The company purchased Terex Mining’s equipment division late last year for $1.3 billion, essentially doubling its market share.
Bucyrus reports its results in about a week, and that announcement will offer more color on its opportunities to expand and integrate the Terex purchase. Because Bucyrus sells equipment all over the world, it’s in a good position to benefit from coal regardless of pricing dynamics.
Shares of Bucyrus have pulled back lately, following the broader market. Despite the sharp selloff, the stock is still up some 54 percent since I recommended it in September. It’s healthy for a stock to correct after such an impressive run. Because the company’s fundamentals are intact, this pullback is an opportunity. Buy Bucyrus under 66.
In summary, I would say that the miners were more upbeat than the railroads regarding the prospects for a recovery in the coal markets toward the end of 2010. This might be because some of the statistics showing the big December US coal inventory drawdown were released after the railroads reported.
I have always liked railroad stocks as a play on fuel efficiency, agriculture/biofuels and coal. If we continue to see big draw-downs in US coal inventories, I’ll look to add one a rail company to the model Portfolios in anticipation of stronger commentary about coal movements.
One of my favorite sectors for long-term growth is oil service. The rising complexity of new oil and natural gas projects increases the service intensity of wells; in other words, these companies have the opportunity to make more money with each new well drilled.
In the short to intermediate term, investors should remember that the oil and gas services industry is a cyclical group. Although a long-term secular uptrend is in place, there are fluctuations around that trend. I have written about this phenomenon before–for example, in the May 6, 2009, issue, “A Turn for the Better.”
Down-cycles in international oil services (i.e., activities outside North America) usually last about 18 months. The most recent downturn began in the fourth quarter of 2008, and margins are already showing signs of hitting a trough; I continue to expect margins to increase in the first or second quarter of 2010. Historically, the stocks lead this process by several months.
In short, 2010 should be a good year for the group, and the overall pattern should resemble the last major cycle, which occurred the late 1990s. Check out the graph below.
Source: Bloomberg
This graph tracks the Philadelphia Oil Services Index over two separate time periods. The purple line represents the period from the beginning of 1998 to the end of 2000; the blue line depicts the current cycle from the beginning of 2008 to present.
Although the price scales for the Oil Services Index are different, the patterns are remarkably similar. The services names rallied in early 2008 just as they did a decade earlier, then collapsed amid a global economic slowdown and drop-off in spending. Back in 1998, oil prices fell sharply just as in the second half of 2008. And as prices fell, producers cut back on services spending.
But back in 1998, the services stocks found a bottom and began to rally months before demand turned higher and about nine months before the industry’s profit margins began to improve. The current cycle almost exactly the same.
There is no doubt the economic cycle was more severe in 2008 than what happened 10 years earlier. However, there are fundamental similarities between 2008-2010 and 1998- 2000 from the industry’s point of view. Accordingly, I expect the price patterns to be broadly equivalent as well. When margins began to bottom out in 1998, stocks reached an inflection point. It appears we’re converging on that point in this cycle, opening up the potential for a similar rally in 2010.
These moves didn’t come without a few pullbacks in 1998, and I expect some similar volatility from time to time in this cycle. But these moves don’t change the broader pattern.
The model Portfolios include three oil-services names: Schlumberger (NYSE: SLB), Weatherford International (NYSE: WFT) and Baker Hughes (NYSE: BHI).
I always scrutinize Schlumberger’s results and conference call with particular care because the company has its hands in just about every services market in the world. Therefore, its quarterly reports offer an outstanding bird’s eye view of trends underway across the industry.
Schlumberger’s fourth-quarter report was solid. The company grew its earnings 4 percent from the fourth quarter, driven by growth in most of its key geographic markets. North American revenues were up 6 percent, thanks to strength in US drilling activity–a point I’ve highlighted in recent issues. Latin America revenues grew 5 percent, and it appears that Brazil is emerging as a key growth market for several services firms.
Europe/Africa was flat sequentially, though activity around West Africa, an emerging deepwater region, was solid. In the Middle East and Asia, an uptick in “exploration and deepwater” activity yielded a 7 percent increase in revenues.
With volumes and revenues growing sequentially, the decline in profit margins has decelerated. Schlumberger’s management is sticking by its long-held prediction that international oil services margins will bottom out in the second quarter of 2010 and turn higher in the second half. This sets up 2011 as a year of strong year for revenues and margins.
A few key takeaways from Schlumberger’s conference call are worth noting. First, Schlumberger is widely regarded as the service major most leveraged to exploration– activities surrounding the search for new oil and gas fields. This is not to say that Schlumberger doesn’t have exposure to the development of existing wells; rather, Schlumberger can be expected to see the most revenue and earnings upside when exploration picks up.
In the wake of a downturn, spending on exploration tends to lag spending on development; as oil prices recover, companies look to increase production from existing fields–usually the cheaper option. Only when prices remain high for an extended period do companies allocate more money to exploration.
This appears to be happening. Schlumberger’s management has noted in prior quarters that oil prices would need to remain between USD70 and USD80 a barrel before their customers would increase spending. The company attributed its sequential earnings growth to increased exploration and deepwater spending.
Management also expressed confidence that oil prices would remain around current levels, a catalyst for spending on exploration. Schlumberger enjoys significant earnings leverage to this trend, particularly in three markets: Russia, offshore and deepwater plays, and emerging opportunities such as Iraq.
The strength in deepwater activity shouldn’t surprise subscribers; I wrote extensively about key deepwater plays in the Oct. 7, 2009, issue, The Golden Triangle. Recent announcements of deepwater successes in West Africa from fellow portfolio holding Anadarko Petroleum (NYSE: APC) underline the potential in deepwater plays in the Gulf of Mexico and off the coasts of Brazil and West Africa.
Regarding opportunities in Russia, CEO Andrew Gould stated:
…Russia was able to sustain its domestic production in 2009 through the addition of new fields in Eastern Siberia, notably Vankor. But at the same time, production in Western Siberia decreased fairly dramatically and they are going to have to spend a lot more in Russia, in Western Siberia, if they want to sustain the production level in 2010.
That’s why we’re feeling fairly optimistic on Russia, coupled with the fact that it will be another good year for us in Sakhalin, and there are still quite a few new projects in Eastern Siberia.
Some commentators have trumpeted Russia’s record oil production in 2009, but the country produced more oil than Saudi Arabia because the Desert Kingdom is in OPEC and has cut output to comply with quotas. The gist of this misguided analysis is that with Russian oil production rising, the oil markets are oversupplied.
This is absolute rubbish. Russian production is up due to the start-up of a major project in Siberia and a handful of smaller oil projects. Meanwhile, mature fields in eastern Russia continue to decline at a rapid pace. With fewer project start-ups in 2010, declining production from mature fields will erode this vaunted expansion.
Of course, that’s not to say Russia isn’t an exciting and key market. Schlumberger and Weatherford both noted significant upside potential in terms of activity levels in Russia now that oil prices are healthy. But don’t jump to the erroneous conclusion that last year’s production growth marks the beginning of a flood of Russian oil volumes that will push prices lower.
Management’s comments on opportunities in Iraq were also interesting. The company has been talked down expectations for growth in spending in Iraq for the past two quarters. The analyst community was excited about Iraq’s first round of oil contract awards. Schlumberger’s management was asked repeatedly what sort of opportunities it saw in Iraq but maintained that the country was a story for the future–not 2010 or 2011.
The company has changed its position. Iraq’s second round of bidding in December yielded seven major contracts, including deals with Royal Dutch Shell (NYSE: RDS A) to develop the Majnoon field, China National Petroleum Corporation to develop the Halfaya field, and Lukoil (OTC: LUKOY) to develop West Qurna.
These contracts include a target production level from each field and relatively rapid milestone production requirements. In other words, producers will have to drill aggressively to meet minimum production targets over the next couple of years. This should translate into a lot of spending on services, and these contracts will carry attractive prices the lack of infrastructure and security risks in Iraq.
The company remains cautious on global gas markets, highlighting all of the usual risks, including the potential for US gas production to respond quickly to any uptick in demand and LNG imports from a number of new export facilities opened in recent years. I discussed the natural gas market at length in the previous issue, among others.Management noted the recent jump in the US gas-directed rig count–the number of rigs actively drilling for gas in the US–may plateau over the next few quarters. The North American cycle is completely different from the international cycle; North American drilling activity hinges on short-term projects and is highly leveraged to gas prices.
North American services pricing is already improving due to the recent uptick in horizontal and directional gas drilling activity in the US–a phenomenon I discussed at length in 2010: The Year for Natural Gas. But Schlumberger’s management sees the potential for the rig count to level off in coming quarters, which would likely mean a deceleration in pricing gains for North America.
This view doesn’t necessarily conflict with my prediction that gas-levered stocks will perform well this year. I haven’t called for a massive surge in gas prices–prices around USD7 per million British thermal units should be sufficient to ensure profitable production for key shale plays.
And although drilling activity may not soar in terms of total rigs deployed, we should see a continued shift towards drilling complex, horizontal wells. As these wells are more involved to produce, demand for services could increase even if the rig count doesn’t.
And management brought up an important point during the conference call: Drilling these complex, horizontal wells is extremely tough on equipment–the company is raising service costs to compensate for broken equipment. This eliminates some of the overcapacity of equipment that’s plagued the US market in recent years, tightening the market.
This trend should benefit our gas-levered service and equipment plays. Nabors Industries (NYSE: NBR) is a contract driller that focuses on leasing powerful rigs needed to drill US shale and unconventional gas plays.
While vertical rigs sit idle, current estimates are that upwards of 80 percent of land rigs capable of drilling shale plays are being utilized. I expect Nabors to highlight signs of an uptick in day rates when it reports on February 17. Buy Nabors under 28.
Baker Hughes (NYSE: BHI) reported a stellar quarter in January and offers significant exposure to shale-related drilling activity, thanks to its pending purchase of BJ Services (NYSE: BJS). BJ is a market leader in hydraulic fracturing. The deal is expected to close this March.
And Baker Hughes’ international business finally appears to be hitting its stride. The company’s international operations had underperformed the other service majors in recent years, despite a series of well-regarded service lines.
Baker Hughes has adopted the model used by Schlumberger and focuses on selling its products via geographic markets rather than by products. Accordingly if the company is selling drill-bits in a key market like Brazil, its local sales force can cross-sell drilling fluids or other well-related services. Previously, Baker wasn’t bundling its services enough or leveraging its strong market share in certain service lines.
Improvement in the North American market and a new strategy for international growth justify a higher price target for the stock. Buy Baker Hughes under 51.
As I noted in a recent Flash Alert, Weatherford International posted disappointing earnings in the fourth quarter, but the market overreacted to this setback–shares now represent a great value.
Weatherford’s management team highlighted some of the same trends that Schlumberger’s executives pointed out–namely, opportunities in Russia and the potential for growth in Iraq. Weatherford is particularly well-placed to benefit from growth in Russia after its recent acquisition of the oil services division of TNK-BP.
TNK-BP was previously only selling services to BP’s (NYSE: BP) Russian joint venture, but Weatherford will sell these services and infrastructure to other operators. This shift will likely take some time to bear fruit but positions Weatherford to benefit from the next Russian up-cycle.
The main drivers of the company’s weak results were start-up costs and delays to international projects. Weatherford is heavily exposed to national oil companies (NOCs) and integrated project management (IPMs) deals–agreements where it manages all or some of projects on behalf of NOCs. It takes time and money to buy equipment and relocate assets when these new projects are just getting off the ground. With a number of large new projects getting underway, start-up costs were high.
Project delays were another challenge. Some stemmed from inclement weather, in other instances NOCs postponed projects for what management called “idiosyncratic” reasons. Such delays are common in the oil industry.
I don’t think that any of this is a long-term problem for Weatherford, and it doesn’t reflect a fundamental weakness in the company’s business or the oil services cycle in general. Every few quarters, one of the big services firms gets hit by this type of company-specific hiccup, prompting a selloff. Buy Weatherford under 26.
As most of the exploration and production companies report result over the next few weeks, I’ll have more to say about that group in the next issue of The Energy Strategist.
That being said, Portfolio holding Suncor Energy’s (NYSE: SU) fourth-quarter earnings missed expectations. My early read is that this was due primarily to weaker-than-expected production from some former Petro-Canada assets, which Suncor acquired last year.
Over the long term, I like Suncor’s focus on the oil sands; it’s one of the only regions of the world that’s likely to see real production growth in coming years.
Another key catalyst for the stock will be its planned sale of many of Petro-Canada’s international and gas-levered properties. Suncor has stated that interested parties have inquired about the properties, and it is on-track to meet its targets in terms of proceeds from these sales. As sales are announced, I expect the stock to respond positively. Buy Suncor under 43.
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