Reality Check
US economic data have improved steadily in recent months, and energy companies have posted strong third-quarter earnings and maintained bullish outlooks. But fear continues to dominate the ticker. Open the newspaper on any given day and you’ll probably read stories about falling oil prices and weak demand growth. Don’t believe the hype: Oil prices remain well north of $100 per barrel, the supply-demand balance remains incredibly tight and there are few signs of demand destruction–even in the developed world.
One theme that has emerged from the scores of conference calls I’ve listened to this earnings season: Management teams at prominent energy firms are frustrated that their stock prices have taken a beating despite strong results and an improving outlook.
In the short run, the latest twists and turns in the EU sovereign-debt crisis will continue to drive markets. Greece’s surprise decision to put the latest budget cuts and bailout proposal up to referendum was the latest development to jangle investors’ already anxious nerves. Bearish investors are right about one thing: Stock prices would suffer across all sectors and industries in the event of a second global recession and credit crunch. Even our favorite names in the energy patch wouldn’t escape the carnage.
Fortunately, the worst-case scenario isn’t the most likely scenario. Not only did the US economy strengthen in the third quarter, but EU leaders also understand what’s at risk in the sovereign-debt crisis and will continue to take the necessary steps to prevent a disorderly sovereign default.
Focus on the good news: Most of the growth-oriented stocks in the model Portfolios have discounted financial Armageddon and are poised for a significant upsurge as investors’ fears subside.
In This Issue
The Stories
1. Schlumberger’s (NYSE: SLB) quarterly conference calls are a treasure trove of useful information about emerging trends in the energy patch. The company’s latest call was no exception. See Oil and Gas Services.
There’s more to the world than oil services. Here’s our analysis and commentary on third-quarter earnings from six other Portfolio holdings. See 2. Liquefied Natural Gas, 3. Drilling and Equipment, and 4. The Producers.
5. Want to know which stocks to buy right now? See Fresh Money Buys.
The Stocks
Schlumberger (NYSE: SLB)–Buy < 100
Weatherford International (NYSE: WFT)–Buy < 28
BG Group (LSE: BG/, OTC: BRGYY)–Buy < GBp1,650
Oil Search (ASX: OSH, OTC: OISHF)–Buy < AUD8
Nabors Industries (NYSE: NBR)–Buy < 25
Cameron International Corp (NYSE: CAM)–Buy < 62
Occidental Petroleum Corp (NYSE: OXY)–Buy < 105
EOG Resources (NYSE: EOG)–Buy < 125
Sandridge Mississippian Trust I (NYSE: SDT)–Buy < 28
Key Takeaways:
- The North American market remains strong, particularly Canada. Nevertheless, management noted that pricing power has moderated in the pressure-pumping business.
- The fundamentals of the services business remain bullish, thanks to elevated oil prices that support ongoing capital investment. Macro-level fears continue to drive the stock’s performance, but the company has continued to turn in a strong performance.
- The recovery in international demand remains lumpy, but pricing power has improved in some markets.
- The exploration cycle will heat up in 2012, particularly in deepwater regons. Schlumberger expects an influx of new rigs to drive growth in offshore services.
Schlumberger reported third-quarter earnings of $0.98 per share, excluding about $0.02 in one-off charges. This marks an increase of $0.11 over the second quarter. At the same time, the Bloomberg consensus estimate called for earnings per share of $1.00. Schlumberger’s revenue was roughly in-line to slightly above analysts’ expectations; profit margins were the source of this shortfall, particularly in the Middle East.
New CEO Paal Kibsgaard broke with the company’s tradition of not commenting on earnings and revenue expectations for the coming quarter, stating that some analysts’ estimates for the fourth quarter were “somewhat on the optimistic side.” Those comments should prompt analysts to moderate expectations their forecasts for the fourth quarter.
At first blush, these results weren’t particularly inspiring. However, a closer look at the third-quarter numbers and management’s commentary during the subsequent conference call suggest that the outlook isn’t so dour.
For one, dry-docking and mobilization expenses related to Schlumberger’s WesternGeco geophysical services division accounted for much of the firm’s disappointing performance in the Middle East. A number of modest delays to onshore projects also weighed on results. Such delays are common on major projects and don’t reflect slowing demand. Even when international demand for services is at its peak, the results are lumpy from quarter to quarter.
A review of Schlumberger’s results and outlook suggests that Kibsgaard’s warning to analysts is merely an effort to lower expectations, as opposed to an acknowledgment of weakening business conditions. Overall, management was upbeat throughout the conference call and Q-and-A session.
Here’s a more detailed analysis of some of the key takeaways from Schlumberger’s conference call to discuss third-quarter results.
Volatility in Schlumberger’s Stock Price
Shares of Schlumberger and other oil-services stocks have endured gut-wrenching volatility over the past year. The Philadelphia Stock Exchange Oil Service Sector Index almost doubled from its summer 2010 low to its April 2011 high, before pulling back as much as 40 percent in early October.
Management teams rarely comment on the company’s stock price during quarterly conference calls, but Schlumberger’s management discussed this unsettling volatility at length during its Oct. 21, 2011, call. That wasn’t the only surprise. Former CEO Andrew Gould also participated in the conference call after indicating that the second-quarter call would be his last. Here’s Gould’s take on the recent volatility in Schlumberger’s share price:
Well, I think it’s not just our stock. I think there are a lot of quality stocks there’s a dislocation between market sentiment and the underlying realities. And that dislocation, as I said earlier, I think is largely due to uncertainty which everybody hates which is why some form of resolution to the European sovereign debt crisis, which is going to come, is likely to be an event that will settle people’s nerves. But a lot of industries, not just ours, the fundamentals are not nearly as bad as people seem to imagine. They’re anticipating the worst.
Gould articulates the same point I’ve made in recent issues of The Energy Strategist: The volatility in shares of Schlumberger and other services stocks might make sense if business conditions had shown signs of deterioration. But as I discussed at length in Supply and Demand Revisited, Brent crude oil has consistently commanded more than $100 per barrel in recent months, reflecting tight supply-demand conditions in the global oil market. All of this adds up to robust drilling activity around the globe.
Fears about the macroeconomic outlook continue to drive the binary risk-on/risk-off trade. A weak economic data point or a discouraging development in efforts to address the EU sovereign-debt crisis is enough to send traders en masse to the safety of US Treasury securities. On the other hand, any encouraging macroeconomic news sends investors rushing into fast-moving names that stand to benefit the most from an improvement in the global economy.
Schlumberger’s shares have been caught in this vicious cycle. Check out this graph comparing the stock’s historical price-to-sales ratio to the mean price-to-sales ratio for this period and the standard deviation 1.5 percent above and 1.5 percent below this average. These standard deviations roughly delineate when the stock is undervalued or overvalued.
Source: Bloomberg
In 2007 and 2008, the stock’s valuation tended to hug the upper bound of this range. This elevated valuation reflected rising oil and natural-gas prices and a shortage of capacity to perform basic services related to exploration and development.
When the stock’s valuation collapsed in the back half of 2008, the move reflected the collapse in commodity prices amid the global credit crunch and recession.
But the most recent trading action is more difficult to explain. In early 2011, shares of Schlumberger hovered around the five-year average for price to sales, before plummeting to levels last seen in 2008-09. Although the stock has traded higher in absolute terms, its price-to-sales multiple remains at levels that prevailed during the Great Recession.
The current business environment doesn’t mesh with the stock’s depressed valuation. In fact, the price of Brent crude oil is almost three times its 2008-09 low. Moreover, the supply-demand balance in the global oil market suggests that oil prices will remain elevated for some time. Former Schlumberger CEO Andrew Gould drove this point home during the company’s Oct. 21, 2011, conference call:
I think we’ve said before and I’ll say again that the thing our customers dislike most, just like financial markets, is uncertainty. And I think that you have to assume before 2012 starts, the European Union will come to some sort of resolution on their sovereign debt crisis. And if you couple that to the fact that actually the supply situation is probably the tightest it has been since 2006, it’s certainly tighter now than it was in 2008. And if you look at the US inventories yesterday, they went below the five year average both for products and crude for the first time since 2008. So absent a really deep cut in demand, which would basically mean the developing countries going into recession, there’s no reason at this point in time to suppose that international activity is not going to remain pretty robust in the year to come.
The Oct. 19, 2011, issue of The Energy Strategist advanced a similar argument: Although estimates for oil demand have declined of late, expectations for supply growth have diminished to an even greater extent. In fact, the world has less spare productive capacity today than it did when oil prices surged in 2008.
Gould’s observation that the decline in US oil and refined-product inventories has buoyed the price of West Texas Intermediate (WTI) crude oil also bodes well for North American producers. The spread between the price of Brent crude oil and WTI had widened to as much as $30 per barrel in recent months. Although this anomalous discount should narrow in coming months, WTI will likely trade at prices that are roughly $10 per barrel lower than the price of Brent crude oil. Our updated forecast calls for WTI to eclipse $100 per barrel by the end of 2011.
Check out this graph comparing US oil and refined-products inventories in 2011 to the five-year average, as well as the maximum and minimum storage levels over this period.
Source: Energy Information Administration
US inventories of oil and refined products in recent weeks dropped to slightly less than the five-year average for the first time since 2008. This development is hardly consistent with weak demand growth, especially when the decline occurred despite the release of large volumes of crude oil from the US Strategic Petroleum Reserve this summer. Storage utilization in Cushing, Okla., the delivery point for WTI, has also declined in recent weeks–another indication that inventories are being drawn down.
The current multiple on Schlumberger’s stock reflects investors’ emotions rather than the company’s business prospects. Investors began to embrace the firm’s bullish outlook in the spring, but a late-summer growth scare prompted sentiment to reverse in September.
We stand by our bullish outlook for Schlumberger and note that it’s difficult to find data to support the bearish case against the company. Although pricing power in the North American market could moderate as additional capacity enters the market, this softness is more of a concern for Halliburton (NYSE: HAL) and shouldn’t lead to a total collapse in profitability.
Meanwhile, elevated oil prices continue to support the exploration and development cycle, a key growth driver for Schlumberger. Management also noted that profit margins have started to firm up in some geographic segments.
At these levels and at this stage in the cycle, Schlumberger’s stock is an outstanding buy. But the stock needs a catalyst that will prompt investors to focus on the strength of the company’s business, as opposed to the latest headlines about Greece. Although the EU continues to take two steps backward for every one step forward in addressing the sovereign-debt crisis, policymakers appear to understand the risk to the global economy and ultimately should move to stabilize the situation in the fiscally weak Club Med nations.
Such a development should prompt investors to emphasize the realities of a strengthening US economy, a Chinese economy on course for sustainable growth and a tightening supply-demand balance in global crude oil markets. All these factors should precipitate a re-rating of Schlumberger and other hard-hit energy names.
North America
North America has been a bright spot for the oil-services industry in recent quarters, thanks to robust activity in North Dakota’s Bakken Shale and other prolific shale oil plays. In fact, North Dakota produced almost 450,000 barrels of oil per day in August, up almost 30 percent since the end of 2010. The state trails only Texas, Alaska and California in terms of annual oil output.
This incredible animation from Energy Information Administration demonstrates how rapidly drilling activity and oil output have increased in the Bakken Shale. Investors unfamiliar with these unconventional fields should consult the Oct. 20, 2010, issue of The Energy Strategist, Rough Guide to Shale Oil.
Rising oil production in the Bakken Shale and other unconventional plays has translated into a surge in demand for oil services and equipment. Depending on the characteristics of the field, a horizontal oil well in a shale formation can be up to 10 times as service-intensive as a vertical well in a conventional field. Services related to hydraulic fracturing are essential to extracting hydrocarbons locked in shale and other tight formations.
Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing oil or natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant–typically sand, ceramic material or sand coated with ceramic material–ensures that these passages remain open.
Rapidly growing demand for pressure pumping has outstripped supply in the nation’s hottest shale plays, enabling services firms to push through price increases. Rising prices and activity levels translates into fat margins and impressive earnings growth.
Though important, pressure pumping isn’t the only product category that’s benefited from rising demand and supply shortages. Management also noted that Schlumberger has pushed through price increases on wireline services, a product category that provides data on reservoir characteristics and the effectiveness a particular fracturing job.
Schlumberger’s strong momentum in the North American market continued in the third quarter, with revenue up 15 percent sequentially and margins surging 179 basis points in the region. These results indicate that Schlumberger is enjoying an uptick in volume and raising the prices it charges for these services.
Nevertheless, the company’s management team has expressed concern that pricing on pressure pumping eventually would peak and begin to moderate, largely because the services industry would build too much capacity. The economics in the space were so attractive that any incremental pressure-pumping capacity quickly paid for itself several times over.
These worries haven’t prevented Schlumberger from making its hay while the sun is shining. The firm has expanded its pressure-pumping capacity substantially in 2011 and has transitioned its units from 12-hour days to 24-hour days to meet demand. As a result, Schlumberger’s crews completed 20 percent more fracturing stages in the third quarter.
Until recently, Schlumberger’s caution hinged on a potential slowdown in pricing gains, as opposed to evidence that prices had moderated. But Schlumberger reported flat prices for pressure pumping had flattened in some oil- and liquids-rich plays. Management also indicated that that pricing for these services had declined modestly in shale gas plays.
Any overcapacity in this business line would show up in gas-rich formations first because many producers have scaled back their drilling activity in favor of more remunerative liquids-laden fields.
Although Halliburton (NYSE: HAL) should continue to perform reasonably well, the firm’s bias toward the North American market and pressure pumping could cause its revenue and profitability metrics to lag in coming quarters. Management’s downbeat tone during Halliburton’s conference call to discuss third-quarter likewise supports this thesis.
From early 2011 to July, shares of Halliburton outperformed those of its larger rival. However, Schlumberger’s stock has fared better since then, and we expect this outperformance to continue.
Nevertheless, investors shouldn’t extrapolate a moderation in pricing in one service line to a bearish growth outlook for the whole of North American oil services.
Weatherford International (NYSE: WFT), for example, should enjoy additional upside because of its industry-leading suite of artificial-lift solutions that enhance output from oil and gas reservoirs in which the natural geologic pressures have dissipated. Horizontal wells drilled in oil and liquids-rich shale plays generate twice the artificial-lift sales as traditional North American wells. Expect robust drilling activity in these unconventional plays to support fast-rising demand for artificial lift.
The Canadian market has also strengthened considerably. Check out this graph of the Canadian active rig count.
Source: Bloomberg
The Canadian rig count evinces seasonal fluctuations, with drilling activity peaking early in each year and bottoming in May. As you can see, the Canadian rig count’s seasonal high has increased in each of the past three years. In 2011, the rig count is up an average of 20 percent to 30 percent higher from year-ago levels.
Much of this drilling activity is occurring in oil- and liquids-rich plays, especially the Canadian oil sands. Of the Big Four oil services companies, Weatherford International benefits the most from robust activity north of the border, largely because of its acquisition of Precision Drilling Services in 2005.
Despite these upside catalysts, a handful of execution missteps and an overblown tax restatement have ensured that shares of Weatherford International trade at a substantial discount.
Source: Bloomberg
As you can see, the stock trades at a price-to-sales ratio that’s almost two standard deviations below its long-term average. If the stock appreciates to a level that reflects its historical price-to-sales ratio, the shares would be worth more than $30 apiece. Buy Weatherford International up to 28.
Schlumberger CEO Paal Kibsgaard likewise noted several pockets of continued strength in the North American market, a useful reminder that revenue growth in the region doesn’t hinge solely on pricing in the pressure-pumping business.
Accordingly, we prefer Weatherford International to Halliburton for its exposure to Canada.We see basically a higher level of uncertainty surrounding North America [compared to international markets]. Now, in North America we’re quite positive on Canada and the Gulf of Mexico. We think both of them are going to be quite strong for the next year. And we have, obviously, very good market position in both these markets. So I would say that the main uncertainty we see is around pressure pumping pricing and this is really linked to the amount of new horsepower capacity that is coming into the market.
International Markets: Non-Linear Growth
The watchword for Schlumberger’s international operations is nonlinear. Revenue growth is notoriously lumpy in international markets, with occasional project delays and higher-than-expected costs considered part and parcel of the business. The increasing technical complexity of many exploration and development projects will likely increase the incidence of project delays and unexpected cost increases.
These inevitable hiccups often mark great buying opportunities for investors.
Schlumberger’s international operations grew third-quarter revenue by 2 percent from year-ago levels, but profit margins declined by 56 basis points. Whereas sales corresponded with most analysts’ expectations, profitability fell short of expectations. A closer look at the numbers indicates that this weakness was concentrated in the Middle East and Asia, where revenue declined 4 percent and profit margins fell by 276 basis points sequentially.
The majority of weakness stemmed from the company’s WesternGeco geophysical services subsidiary, which had some of its contracted projects postponed until the fourth quarter of this year and the first quarter of 2012. In addition, costs associated with dry-docking seismic ships for maintenance and mobilizing crews for upcoming assignments projects increased costs.
Excluding these temporary obstacles in the seismic business, revenue in the Middle East and Asia was higher on a sequential basis.
CEO PAAL Kibsgaard’s also reassured investors that these recent challenges don’t stem from weakening demand for seismic data and geophysical services:
[I]n general, I would say that we are still quite positive when it comes to our seismic business. Now if you look at the marine [seismic] market, Q4 and Q1 are normally softer quarters as the vessels finish off mainly the North Sea seaso. Now this year, we were expecting higher activity in West Africa and Gulf of Mexico would present some opportunity to test pricing.
Now what we have seen in reality is that the ramp up of activity in both places has been slower than expected, but we don’t see this as being structural. There’s basically a delay in signing of contracts and also somewhat slower mobilization of additional vessels into the Gulf of Mexico. So I think we will see the normal softness that we see every year in Q4 and Q1 on marine. But looking forward to Q2 and Q3 of 2012, the slate is already filling up quite nicely there. There is very good tender activity for all the main basins, North Sea, Barents Sea, Angola, Brazil and so forth. So the outlook for 2012 is I think still quite positive. We were hoping to get some pricing traction at the end of this year. I think this is now pushed out a couple of quarters. But beyond that, we remain still quite optimistic and positive on the seismic market.
Demand for seismic services has improved in recent quarters, and the company’s backlog increased about 3 percent sequentially in the third quarter, but management noted that pricing power likely won’t return until mid-2012.
Kibsgaard and his team also highlighted signs of strength in Iraq, Saudi Arabia and East Asia. In Iraq, the firm had several existing contracts renewed and won three major new deals. On a sequential basis, Schlumberger posted double-digit revenue growth in Iraq. Meanwhile, its profit margins approached those in other parts of the Middle East. Other services firms continue to lose money in Iraq while trying to build scale.
The expected uptick in Saudi Arabia’s rig count has also proceeded as expected, with “limited slippage.” And strong exploration and development activity in East Asia, particularly Vietnam, also bodeextraextraps well for future growth.
More important, Kibsgaard noted that Schlumberger was able to push through some price increases during the quarter:
I think what we said in an earlier quarter is that we expected to see pricing traction toward the end of this year. That’s what we said earlier. And what I am saying this quarter is that we are actually seeing some signs of it. There are really two signs I would highlight. First of all, higher demand and higher sales of our high-end technology so there’s a lot more sellables of technology from basic technology to high end. And secondly, we’re also testing pricing on specific contracts, typically smaller contracts with reasonable success.
Kibsgaard’s comment underscores the advantage of Schlumberger’s cutting-edge technologies in winning business and expanding margins in the early stages of the international up-cycle.
For example, the firm’s HiWay fracturing technology that improve well performance while reducing the amount of water, proppant and chemicals used in the process has gained traction among its US customer base. In the third quarter, Schlumberger fractured more than 800 stages using the HiWay system for more than 20 clients. The company is also rolling out HiWay in Russia, North Africa and the Middle East. Without giving away specifics, management indicated that the firm would introduce a number of exciting technologies in 2012.
Investors also shouldn’t be skeptical of the international recovery because Schlumberger is testing price increases on smaller deals–such a gradual approach is common. That Schlumberger has delivered higher prices rather than predicting price increases is an encouraging sign for 2012.
Deepwater and Exploration
Of the Big Four services firms, Schlumberger has the most exposure to deepwater exploration and production, business lines that Kibsgaard highlighted for their strength:
Now if I look at the next 12 to 18 months or 2012 in particular, firstly at the international markets, so provided there is no major impact from the European debt crisis on our business and we haven’t seen any impact yet, we basically maintain quite a positive outlook on the international markets. And this is really driven by our customers that have a long-term view in areas such as Saudi Arabia, Brazil, Russia, Iraq and West Africa. And this trend is also further supported by strong underlying trends in both exploration and deepwater.
I think in exploration, there’s a clear need to add reserves for our customers after the investment levels over the past years have been severely cut. And I think they’re generally encouraged by the string of exploration successes globally that we’ve seen in the past couple of quarters. And similarly on the deepwater side, 2011 is going to see the highest number of newbuild arrivals ever. The total number is going to be around 36, which obviously will have a positive impact on the deepwater activity in 2012. We also see quite positive trends for contracts for these newbuild arrivals and also for overall utilization and rig rates.
There are four key takeaways from this quote. First, the EU sovereign-debt crisis hasn’t affected Schlumberger’s business, nor has it limited the company’s ability to raise capital. In fact, the firm recently issued $1.1 billion worth of five-year bonds that yield less than 2 percent and $1.6 billion worth of 10-year bonds that yield 3.3 percent.
Second, companies skimped on exploration and development after commodity prices collapsed in late 2008 and early 2009. This traumatizing experience made firms reluctant to commit to expensive, multiyear projects until energy prices remained elevated for an extended period. That oil remained above $100 per barrel amid the EU sovereign-debt crisis and fears of a US recession suggests that higher oil prices are here to stay.
Producers have also announced a number of major oil and gas discoveries in deepwater fields in the North Sea and the Gulf of Mexico, as well as plays offshore Brazil and Southeast Asia. Although these finds won’t add to production for years to come, these successes should encourage other companies to step up their exploratory efforts.
Finally, activity has suffered from a shortage of ultra-deepwater rigs needed to explore promising developments worldwide. With a record 36 new rigs–about 16 percent of the current fleet–slated to enter the market in 2012, more companies will be able to explore ultra-deepwater regions.
Even more encouraging, producers have booked ultra-deepwater rigs that haven’t left the shipyard under multiyear contracts at attractive day-rates–a powerful indication of pent-up demand. This bodes well for Schlumberger, as well as our favorite contract driller, SeaDrill (NYSE: SDRL)
Schlumberger’s earnings release and subsequent conference call highlighted a number of positive trends which suggest that the business outlook isn’t as dire as the mainstream media would have you think. The recent pullback over broader market panic offers an opportunity to pick up shares of the world’s leading oil-services firm at a bargain price. Buy Schlumberger under 100.
BG Group (LSE: BG/, OTC: BRGYY)
Key Takeaways:
- Demand for liquefied natural gas (LNG) expected to continue to grow in Asia and South America, particularly in Brazil and Argentina.
- Queensland-Curtis LNG export terminal still expected to send out its first shipment in 2014. If need be, company can dip into its flexible LNG portfolio to meet customer demand.
- First permanent floating production, storage and offloading vessel in Lula field producing at higher rate than originally estimated. Recent extended well tests confirm yet again that Guara is a world-class play.
Wildcatters Portfolio holding BG Group posted solid third-quarter results, with operating profits across the firm’s three divisions up 17 percent from year-ago levels to USD1.9 billion.
Although the company’s liquefied natural gas (LNG) segment posted a 14 percent decline in operating profits on a year-over-year basis, better-than-expected results prompted management to increase the division’s full-year profit estimate to USD2.4 billion from USD2.2 billion. In the third quarter, the company sold only 11 percent of its available LNG cargos into the US market, compared to 22 percent in the penultimate quarter of 2010.
BG Group expanded its LNG shipments to Asian markets by roughly one-third in the first nine months of 2011, taking advantage of what CFO Fabio Barbosa described as a “multi-speed world” during the company’s Oct. 25, 2011, conference call. Barbosa also emphasized that Asian and South American demand for LNG should continue to grow in coming years. During the quarter, the company inked an agreement with Gujarat State Petroleum Corp to provide the Indian outfit with up to 2.5 million metric tons per annum (mmtpa) of LNG over a 20-year period. As is typical for the region, the contract features oil-indexed prices.
Management also noted that the company continues to make progress on its Queensland-Curtis LNG (QCLNG) export terminal in Australia and reiterated that the project is on course to send its first shipment in 2014. The firm has already booked all of QCLNG’s 8.5 mmtpa of capacity under long-term contracts and indicated that weather-related disruptions to the associated exploration and production program in Queensland’s Surat Basin wouldn’t delay the project.
Queensland suffered devastating flooding in late 2010 and early 2011 that inflicted extensive damage to much of the region’s logistical and transportation infrastructure. Management indicated that BG Group’s scaled-back, four-rig drilling program should sink about 150 wells in 2011. In 2012 the company will have 12 rigs at its disposal and aims to drill more than 500 wells.
And unlike some competitors that have resorted to expensive acquisitions to boost production for their East Coast LNG terminals, BG Group can dip into its flexible LNG supply to ensure that its customers receive their allotted LNG cargos.
However, management acknowledged that a strong Australian dollar and tight labor market has led to higher costs on the project.
The company’s exploration and production operations grew its third-quarter revenue 28 percent from year-ago levels, thanks to a 1 percent increase in output and higher price realizations on oil and natural gas liquids.
BG Group and its partners’ first permanent floating production, storage and offloading (FPSO) vessel in the Lula field offshore Brazil yielded more than 35,000 barrels of oil equivalent per day during the third quarter, well above the amount forecast by Petrobras (NYSE: PBR). These results give credence to management’s claims that strong well results will reduce the number of wells BG Group must drill to hit its production targets in the area. Two additional FPSO vessels are on schedule for deployment in 2013.
Meanwhile, an extended well test in the Guara field flowed 30,000 barrels of oil equivalent per day and produced 2.8 million barrels of oil equivalent output over a five month period. In early October, an extended well test got under way in the Carioca discovery.
As evidence mounts regarding the prolific nature of the fields in Brazil’s Santos Basin, speculation that BG Group might sell some of these assets has intensified. Management remained coy on this subject.
On Oct. 31, the company announced that former Schlumberger CEO Andrew Gould will become its next chairman. Chief among Gould’s initial challenges will be naming a successor to current CEO Sir Frank Chapman, who has indicated that he will retire in a few years when he turns 60.
Buy BG Group under GBp1,650 on the London Stock Exchange or USD133 in the over-the-counter market.
Oil Search (ASX: OSH, OTC: OISHF)
Key Takeaways:
- Lower oil production volumes because of expected disruptions related to Papua New Guinea LNG Project.
- Oil Search continues to interpret and assess seismic data from the basin area of the Gulf of Papua. Drilling will likely occur in 2012. Company is in preliminary talks with a handful of international operators regarding a potential farm-in deal on these assets.
- The company’s ambitious drilling program gets under way in the fourth quarter and could provide a number of upside catalysts over the next two years.
Gushers Portfolio holding Oil Search’s total oil and gas production slipped to 1.49 million barrels of oil equivalent in the third quarter, down 16 percent from the 1.77 million barrels of oil equivalent that the company extracted in the second quarter of 2011. The firm’s third-quarter operating revenue also tumbled 26.1 percent sequentially to USD160.2 million because of lower oil production (down 19 percent) and a slight decline in price realizations.
However, this decline in output didn’t stem from reservoir issues. Rather, the firm temporarily shuttered two processing facilities servicing the Agogo and Moran Unit fields to modify the facilities to collect associated gas from these oil fields and transport this feedstock to the Papua New Guinea (PNG) LNG Plant when that facility is completed. Oil Search finished these modifications in August. Management emphasized that the company’s full-year production should come in toward the high end of the forecast 6.2 to 6.7 million barrels of oil equivalent.
But we added Oil Search’s shares to the model Portfolios because the stock represents a pure play on rising LNG demand in Asian emerging markets. The first phase of the ambitious PNG LNG project is under construction, fully financed and will be operated by Proven Reserves Portfolio holding ExxonMobil Corp (NYSE: XOM). Oil Search has a 29 percent stake in this endeavor.
All of the LNG facility’s 6.6 mmtpa capacity is booked under long-term supply agreements with major gas consumers in Japan, China and Taiwan. This feedstock will come from the Hides, Angore and Juha fields, as well as natural gas coproduced by Oil Search’s oil fields. As all of these fields are conventional onshore plays, the technical risks associated with this project are less than those depending on extensive offshore developments.
The biggest upside for shares of Oil Search could come from efforts to add trains to the PNG LNG project, an endeavor that hinges in part on Oil Search’s ambitious exploration and appraisal efforts in the Highlands region of PNG and in the Gulf of Papua basin.
In the fourth quarter of 2011, Oil Search will sink the P’nyang South appraisal well. The firm has a 38.5 percent stake in the well, while ExxonMobil has a 49 percent interest and JX Holdings (Tokyo: 5020) has a 12.5 percent interest. The Trapia 1 exploration well–in which Oil Search has a 52.5 percent interest and ExxonMobil has a 47.5 percent interest–will spud in the first quarter of 2012.
The second prong of Oil Search’s PNG exploration and appraisal program will occur offshore. The company is assessing seismic data from the region and is in preliminary discussions with a handful of international operators regarding farm-in opportunities.
Additional details on the company’s onshore and offshore exploration programs could serve as a meaningful upside catalyst in coming years. Oil Search’s local shares rate a buy up to AUD8 for aggressive investors, while the company’s American depositary receipt, which represents 10 local shares, rates a buy up to USD85.
Key Takeaways:
- Fleet upgrade continues with write-off of more than 100 third-tier rigs.
- Demand for new rigs remains strong, thanks to robust drilling activity in US shale plays.
- Nabors Industry continues to pursue term contracts with producers in an effort to capitalize on strong demand and buffer against potential weakness.
- The oft-predicted international turnaround continues to prove elusive.
Gushers Portfolio holding Nabors Industries is the world’s leading land drilling contractor and one of the largest land well-servicing and work-over contractors in the US and Canada. In the third quarter, the company generated operating revenue of $1.63 billion, up 50 percent from year-ago levels and 19 percent sequentially.
At the end of the second quarter, about 70 percent of Nabors Industries’ land rigs in the Lower 48 were tier-one or tier-two rigs. In the third quarter, the company retired 104 tier-three rigs, many of which had been used only sparingly in recent years, as well as 84 well-servicing rigs and about 60 trucks.
Whereas demand for these older, low-specification rigs was practically nonexistent, frenzied drilling in liquids-rich US shale plays continues to support robust demand for newly built units. During a conference call to discuss third-quarter results, CEO Eugene Isenberg noted that 216 of the company’s rigs working at the end of October 2011 and that the firm is “continually getting requests for built-for-purpose rigs.”
This momentum should continue into next year. Management noted that the spread between the day-rates offered under term contracts and those offered in the spot market was negligible in the hottest US unconventional plays. With the contracts on about 95 of Nabors Industries’ land rigs slated to expire in 2012, the company has ample opportunity to book new deals that offer superior terms to the day-rates that prevailed even a few years ago.
At the same time, management learned its lesson from the Great Recession and has dramatically increased the percentage of the firm’s revenue that’s covered by term contracts. Nabors Industries’ pressure pumping operations have even secured 13 extended contracts and more are in the works.
As Isenberg acknowledged during an Oct. 26, 2011, conference call, “We’re trying to make hay while the sun shines and do what we can to convert into multiyear contracts.” Prevailing rates in the pressure pumping business support investment in additional capacity, though management acknowledged that the industry will likely overbuild at some point.
Better still, about 75 percent of the firm’s current income in the US and Canada comes from oil and liquids–commodities that still command elevated prices.
Nabors Industries’ international division posted a sequential decline in operating income, largely because of project delays in the Middle East and weak demand for its shallow-water assets. Nevertheless, management stuck by its previous forecast that the company will have 30 rigs working in Saudi Arabia by the second quarter of 2012.
We remain bullish on Nabors Industries’ near-term growth prospects and rate the stock a buy up to 25.
Cameron International Corp (NYSE: CAM)
Key Takeaways:
- All four divisions posted sales growth in the third quarter, but execution issues weighed on the process and compression division’s third-quarter revenue and profit margins.
- Third-quarter order intake of $2 billion was the third-highest in company history. Backlog also swelled to the second-highest level on record.
- Profit margins on subsea equipment sales will decline in the fourth quarter, as Cameron International works through “low-calorie” backlog.
- More than 20 major projects are up for award in 2012; Cameron International should win its fair share of this business.
- The firm’s long-term growth story remains intact: Spending on deepwater exploration and production should remain robust in coming years, and demand for aftermarket parts and maintenance should strengthen as a result of Macondo disaster.
Wildcatters Portfolio holding Cameron International Corp posted third-quarter net income of $164.5 million and revenue of $1.69 billion, each of which represented a roughly 10 percent increase from year-ago levels.
The company’s valves and measurement division generated about three quarters of the uptick in revenue, as sales increased across all four of the segment’s business lines. Drilling and production services continued to benefit from robust demand in the North American onshore market and for aftermarket products and services, while sales of subsea equipment fell 18 percent. Cameron International’s process and compression services division posted a slight uptick in sales, though shipment delays pushed some revenue back to the fourth quarter and weighed on profitability.
The equipment company also booked $2 billion worth of orders during the three-month period–the third-best quarter on record–swelling its backlog to $5.79 billion, the second highest level in the firm’s history. Short-cycle business lines led the way during the quarter.
Nevertheless, the company’s solid performance was marred by concerns about flat margins in the valves and measurement division and a patch of lower-margin subsea work in the company’s backlog. Management indicated that these “low-calorie” jobs would weigh on profitability in the fourth quarter.
Despite these short-term concerns, Cameron International’s diverse business footprint and exposure to key secular growth trends in offshore and deepwater drilling make the stock an excellent pick for investors seeking long-term growth. Six of Cameron International’s 11 business lines offer exposure to deepwater the space, and the company holds the No. 1 or No. 2 market share in the majority of its product categories. Meanwhile, the firm usually generates about two-thirds of its revenue outside North America.
Investors tend to focus on the drilling and production systems segment, which includes drilling systems, offshore systems and surface systems. Although the company’s surface (onshore) sales benefited from robust demand in US shale plays, the offshore segment is the star of the show because of the potential for huge project awards.
Management has indicated that it expects major project awards over the next 18 months offshore Brazil, West Africa, Australia and Asia-Pacific. This could be a boon for sales of the company’s subsea equipment, which include trees, wellheads and controls, among other items. CEO Jack Moore shared his bullish outlook for major project awards during a recent conference call to discuss third-quarter results:
I’d say there’s a couple in Asia that should book that I think are close. We feel that they–it’s pretty much determined who’s going to win them. It’s just a matter of making it a formality. But there’s 20 plus major projects out there that we’re tracking that could evolve over the next 18 months. And that’s a big number relative to what we’ve seen in the past. And just considering where they are with the tendering process, that’s probably more of a–the biggest near-term reality we’ve seen over the last many years, maybe ever. But those things aren’t always predictable. Some of this could slide into ’13 if things don’t evolve. But there is a big number that we’re tracking and it is all over the world…. [There’s] a plethora of opportunities.
Moore also indicated that the firm would be selective in its bids and noted that he expected pricing to firm up once some of its competitors have beefed up their inventory of orders.
The Macondo oil spill in the Gulf of Mexico gifted Cameron International with a new growth opportunity, though the failure of blowout preventer (BOP) that it manufactured was a big part of the disaster.
A BOP is a large, heavy device that’s installed directly on the seafloor above a deepwater well during the drilling process and removed after the well is completed. The BOP is an emergency mechanism that, once activated, seals off a well and prevents hydrocarbons from escaping by ramming a rod with a rubber seal into the well. These devices include several backup mechanisms.
Cameron International’s BOPs boast an installed base of roughly 50 percent on offshore rigs; new rules requiring original equipment manufacturers to service this equipment on a regular basis should bolster the company’s aftermarket revenue. Nevertheless, some analysts have noted that competitor National Oilwell Varco’s (NYSE: NOV) BOPs appear to be winning share in the new sales market, largely because of its rival’s ability to offer comprehensive, top-side drilling systems.
CEO Jack Moore highlighted the magnitude of this opportunity for Cameron International and other original equipment manufacturers (OEM) during an Oct. 27, 2011, conference call:
[W]hat you’re going to see are the more frequent repair cycles than we’ve seen in years past. And then the discipline to use OEMs [for this service]. Our challenge–and I think [the challenge is the same for] everyone in our industry that’s in OEMs–is to ramp up your ability to handle it. I mean you go from $250 million a year kind of run-rate to $500 million and that’s a huge strain on a service organization…So it’s how well you do getting there and holding onto that business. And I think that’s what we’re putting a lot of emphasis and investment on right now. So the potential for us to see significant aftermarket opportunities in 2012, ’13 and beyond from where we are today and where we’ve been, is huge. It could be double–easily double–from where we’re at.
The timing of these aftermarket opportunities will hinge on the delivery of new vessels with Cameron International’s content and when the warranties on these products expire.
An uptick in orders for FPSO vessels such as those used offshore Brazil would also be a boon for the company, particularly the firm’s valves and measurement business. Much of these orders would come from projects offshore Brazil and West Africa. Cameron International’s Cynara membrane technology, which it added to its portfolio when it acquired NATCO in 2009, could help solve the carbon dioxide separation challenges Petrobras has encountered in its pre-salt fields.
Sales volumes in the valves and measurement division also continues to benefit from energy-focused master limited partnerships’ huge investments in midstream infrastructure to support rapidly rising production from US shale oil and natural gas plays.
Management has positioned the company to take advantage of the boom in deepwater drilling offshore West Africa and Brazil. The firm already boasts the only facility in the African nation of Angola that can design, assemble and test subsea equipment, and continues to invest considerable amounts to boost its presence in Brazil.
Cameron International Corp rates a buy up to 62 for growth-oriented investors with a longer time horizon.
Occidental Petroleum Corp (NYSE: OXY)
Key Takeaways:
- Strong production growth from domestic drilling program in California, the Permian Basin and the Bakken Shale. Lower-than-expected well costs in the area outside Elks Hill, Calif., prompted the company to step up drilling.
- Relatively low-cost production base in North America, with exception of initial foray into Bakken Shale.
- About 60 percent of Occidental Petroleum’s oil production is indexed to the price of Brent crude oil and other international benchmarks. The remainder of the company’s output is indexed to the price of West Texas Intermediate crude oil.
Wildcatters Portfolio holding Occidental Petroleum Corp is an international oil and gas exploration and production company that also operates a US chemicals business and owns midstream assets.
The company reported third-quarter core income of $2.6 billion, up from $1.8 billion a year ago and flat with the prior quarter. Although the firm’s price realizations on oil declined 6 percent from the second quarter to about $97 per barrel and NGL prices fell 3 percent to about $56 per barrel, a 2 percent sequential increase in overall production offset this weakness. About 60 percent of the company’s oil output tracks the price of Brent crude oil, while 40 percent of its production is indexed to the price of West Texas Intermediate crude oil.
Occidental Petroleum’s domestic exploration and production operations were the star of the third quarter, flowing a record high of 436,000 barrels of oil equivalent per day–a 15 percent uptick from year-ago levels. Management expects its US assets to yield between 3,000 and 4,000 additional barrels of oil equivalent per day during each month of the fourth quarter.
The company’s US upstream operations offer plenty of upside. The leading producer of hydrocarbons in Texas, Occidental Petroleum’s operations within the state are centered in the Permian Basin, an area with a long production history that’s been revitalized by advances in squeezing oil from mature wells. Management estimates that the company is responsible for roughly 20 percent of the oil produced in the Permian.
Carbon dioxide (CO2) injections account for about 60 percent of the company’s Permian output, while 30 percent is generated by water flooding. Both technologies facilitate production in mature fields by artificially increasing well pressure. Primary drilling and production account for just 10 percent of output, though Occidental Petroleum’s acreage contains over 2,000 prospective drilling sites. The firm also pursues a substantial drilling program in the promising Wolfberry and Bone Springs areas.
But the firm’s most exciting domestic opportunity is in California, where it has a growing inventory of more than 3,700 drilling locations, the majority of which are prospective for oil and located in areas that are held by production. Few investors would regard California as a huge energy producer–probably because the population boom of the 1940s and huge oil discoveries in the Middle East distracted many producers from developing the area.
Beginning in 1998 with the acquisition of its Elk Hills acreage from the government, Occidental’s geologists have made some unprecedented discoveries in the state, including a massive conventional find in Kern Country that management estimates could contain upward of 175 to 250 million barrels of oil equivalent.
And that says nothing about the approximately 870,000 acres the company holds in prospective shale plays. A long history of seismic activity in the area has essentially pre-fractured the field, substantially lowering costs. The company has identified 520 geologically viable shale drilling locations in California, roughly 250 of which are outside Elk Hills and Kern County. In 2011 management expects to drill 154 shale wells outside Elk Hills proper–47 more wells than the company projected at the beginning of the year.
The average shale well outside Elk Hills yields an initial production rate of between 400 and 400 barrels of oil equivalent per day and costs about $3.5 million. Lower-than-expected costs explain why the company exceeded its initial drilling guidance to such an extent.
Occidental Petroleum’s 13-rig development program in North Dakota’s Williston Basin continues apace, and management expected the play to yield up to 10,000 barrels of oil equivalent per day in the fourth quarter. The firm will continue to add acreage through bolt-on transactions but won’t pursue a whole-company takeover.
During Occidental Petroleum’s conference call to discuss third-quarter earnings, CEO Stephen Chazen provided little insight into the company’s plans for 2012–save that the firm plans to reduce the amount of capital allocated to natural gas-only fields in the US. Chazen lamented, “[It] just drives you nuts to give it [natural gas] away for $3.50 [per million British thermal units.”
Temporary project delays and disruptions in the Middle East and Colombia weighed on the company’s international oil and gas output during the third quarter. If these assets had produced at their expected capacity, Occidental Petroleum’s total output would have increased by at least another 10,000 barrels of oil equivalent per day.
Management continues to leverage the firm’s experience in maximizing production from mature fields to win business in the Middle East. The firm inked a 30-year contract with the Abu Dhabi National Oil Company to participate in the development of the Shah natural gas field, one of the region’s largest. The company will have a 40 percent stake in the play, and management expects capital expenditures of roughly $4 billion. But the field won’t enter production until 2014.
Over the long haul, Occidental Petroleum’s expertise in maximizing production from onshore fields should enable it to grow its business in the Middle East. Meanwhile, the Permian Basin provides a solid production base and plenty of opportunity to expand through bolt-on acquisitions.
With a credible plan and the asset base to generate average annual production growth of 6 percent to 8 percent over the next five years, Occidental Petroleum Corp rates a bargain under 105.
Key Takeaways:
- An early mover in a number of prolific shale oil plays, EOG Resources continues to post strong output growth and lower its production costs. These trends should continue into 2012.
- A new railway offloading terminal in St. James, La., should enable the firm to achieve higher price realizations on its output from the Eagle Ford and Bakken Shale in the back half of 2012.
Shares of EOG Resources plummeted 31 percent between the end of the second quarter and the beginning of the fourth quarter.
Some of this correction stemmed from investors de-risking their portfolios amid concerns that economic growth in the developed world had slowed and that the EU sovereign-debt crisis would escalate into a global credit crunch. The artificially depressed price of West Texas Intermediate crude oil didn’t help matters, nor did a weak second quarter marred by weather-related disruptions to operations in the Bakken Shale.
But EOG Resources’ third-quarter results reminded investors that the company remains the preeminent play on rising production from oil-rich unconventional fields. The firm posted third-quarter revenue of $2.6 billion–a 51 percent improvement from a year ago–and a demonstration of what the firm can accomplish when it’s firing on all cylinders.
EOG Resources grew its third-quarter oil production by 54 percent from the prior year, while the company’s liquids output also increased by 49 percent. More important, crude oil accounted for 80 percent of the uptick in liquids output.
An early mover in the Eagle Ford shale of south Texas, EOG Resources’ assets in the region yielded 53,000 barrels of oil equivalent output, 78 percent of which was crude oil and 11 percent of which were natural gas liquids.
Meanwhile, the productivity of the company’s wells continues to improve. The firm recently sank three of its best wells to date, each of which featured initial production (IP) rates of about 3,000 barrels of oil per day. New wells consistently flow at IP rates of 1,500 barrels of oil per day to 2,000 barrels of oil per day.
Papa attributed these improvements to the company’s growing understanding of the play’s geology. The firm also began experimenting with reducing the spacing between wells, an approach that appears to improve IP rates.
Equally important, EOG Resources’ first-mover status in the Eagle Ford and other plays reduces its cost base. Operational excellence also continues to lower the cost of production. For example, the company has reduced the time it takes to drill and case a well in the Eagle Ford to about 13 days, which translates into substantially lower costs. Contracts for pressure pumping likewise have reduced costs by about $0.5 million per well and limit downtime between drilling and completion. Management estimates that the average Eagle Ford well now costs the company about $5.5 million.
EOG Resources’ drilling costs could decline even further in the Eagle Ford, Marcellus Shale and Permian Basin once the firm’s sand production facility opens in December 2011. Shortages of sand for hydraulic fracturing and rising prices for this key component have been fact of life in the hottest US shale plays. Using its own sand will improve operational efficiency and lower well costs by another $0.5 million.
The company has also tackled midstream challenges in the Bakken Shale and Eagle Ford, partnering with NuStar Energy LP (NYSE: NS) to develop a rail offloading terminal in St. James, La., with a maximum capacity of 100,000 barrels of oil per day. Not only will this capacity support EOG Resources’ rising production from these regions, but the company will be able to market its oil output based on the price of Louisiana Light Sweet crude oil–a varietal that currently commands a higher price than West Texas Intermediate.
CEO Mark Papa deserves all the credit in the world for his prescient decision to invest heavily in emerging oil-rich shale plays at a time when his peers continued to drill with abandon in a number of prolific shale gas fields.
Why should you invest in EOG Resources? Papa aptly summed up the company’s strengths during a recent conference call to discuss third-quarter results:
Our business plan continues to be simple and consistent. We’ve completed the organic conversion to a liquids-based company by exploiting our world class domestic on-shore horizontal oil positions, while preserving all of our core North American natural gas resource play assets and maintaining a low net debt to cap ratio. This is manifested in very high year-over-year crude oil production growth rates; the best in the industry for a company our size.
We continue to have zero interest in growing North American natural gas volumes in a $4 environment. We believe that debt adjusted production growth per share is a useless metric to evaluate E&P performance considering the value discrepancy between crude oil and natural gas which is currently trading at 22 to 1. What counts is profitable liquids growth, particularly crude oil.
The company’s preliminary plan for 2012 reflects this long-term strategy. Management expects to allocate about 90 percent of the firm’s capital budget to drilling activity in oil-rich formations. Assuming that oil prices remain around $85 per barrel, the company expects its investments to generate production growth of about 27 percent. Much of this activity will occur in the Eagle Ford, as the company works to hold its acreage by production.
Buy EOG Resources up to 125.
The stocks recommended in the three model Portfolios represent my favorite picks. The three Portfolios are designed to target different levels of risk: Proven Reserves is the most conservative; the Wildcatters names entail a bit more volatility; and Gushers are the riskier plays but have the most potential upside.
I realize that this long list of stocks can be confusing; subscribers often ask what they should buy now or where they should start. To answer that question, I’ve compiled a list of Fresh Money Buys that includes both stocks and some hedge recommendations designed to limit your risk amid market downturns.
I’ve classified each recommendation by risk level–high, low or moderate. Conservative investors should focus the majority of their assets in low- and moderate-risk plays, while aggressive investors should layer in exposure to my riskier and higher-potential plays. Hedges are appropriate for investors looking to offset exposure to energy stocks.
Also, note that stocks that exceed my buy target for more than two consecutive issues will either be removed from the list or the buy target will be increased.
Source: The Energy Strategist, Bloomberg
Sandridge Mississippian Trust I (NYSE: SDT) surged after the company announced a quarterly distribution of $0.816423 per unit with an ex-dividend date of Nov. 15 and a payable date of Nov. 30. I covered the stock at length in the Oct. 6, 2011, issue The Yield Issue. Sandridge Mississippian Trust was also the October Stock of the Month.
This announcement had attracted attention from investors; I am raising my buy target on SandRidge Mississippian Trust I to 28 from 24.
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