The Longest Cycle
To understand the energy markets today, investors need only look back to the 1970s; it’s been 30 years since the fundamentals for the energy markets have been as compelling as they are today.
That’s great news for investors. Oil companies were among the market’s strongest performers in the ’70s; the group’s bull market lasted more than a decade.
Expect the current up cycle to last at least as long and offer well-placed investors the strongest long-term opportunities of any major industry group.
In the ’80s and ’90s, there were several short cycles in energy. The up cycles were invariably caused by some disruption in supply or short-term demand spike.
A perfect example is the California power crisis at the beginning of this decade; a gas shortage in that market led to some extreme price spikes. Those price spikes, in turn, prompted energy companies to step up drilling activity, particularly in the Gulf of Mexico.
This isn’t the cycle at work in the energy markets today. The current rally in energy prices isn’t just another one-off, localized demand spike. This time, the rise in demand is persistent and global.
Meanwhile, current reserves and supplies are insufficient to meet that demand, despite the fact that worldwide drilling activity has been stepped up to levels unseen since the mid-’80s.
But even in this strong global environment, not all companies will benefit equally. For example, I’m already seeing signs of trouble ahead for oil drilling and services names that are over-leveraged to the North American marketplace. These stocks are the most vulnerable to any short-term pullbacks in crude and natural gas prices.
And in the past few issue of The Energy Strategist, I’ve identified a handful of companies that will grow dramatically in the current environment.
That includes my two favorite sub-sea equipment vendors, leveraged to rapid growth and massive investment in deepwater drilling projects. And while day rates are rising rapidly for all contract drillers, only a few have the scope to cheaply increase their capacity and take advantage of strong pricing. This includes Wildcatter Portfolio recommendations Noble Drilling (NYSE: NE) and GlobalSantaFe (NYSE: GSF).
In this issue, I’ll review a few of my favorite themes and companies. I’m also adding the world’s largest oil services company, Schlumberger (NYSE: SLB), to the Wildcatters Portfolio. Schlumberger has the strongest and most-diverse global presence of any oil services firm and is well positioned to grow in the most promising foreign markets.
Before delving into the details of the recommended stocks, let’s examine what makes this cycle so profitable for the energy companies.
The Buy Side
Consider the graph of global oil (and refined products) demand growth, based on figures provided by the International Energy Agency (IEA). The bars represent year-over-year growth in oil demand for the entire world. The IEA also provides a forecast for 2005 world demand.
Source: International Energy Agency
Throughout the ’90s, oil demand growth was low, averaging just 1.4 percent (see the blue bar on the graph). Certainly, there were one-off spikes in demand but nothing sustained in nature.
But look what’s happened during the past few years: Oil demand has been consistently higher than the ’90s average. And the 3.4 percent jump in oil demand last year was the highest since the early ’80s.
Some of the strongest demand growth of all has been coming from Asia and, more broadly, the emerging markets. Rapid economic growth in these markets is responsible for much of the jump in demand.
Just as important as economic growth is the oil intensity of these economies. Oil intensity is a measure of how much oil is required to produce one unit of Gross Domestic Product (GDP).
Oil intensity tends to drop as economies mature. The reason is that more mature economies, such as the US’, rely on service industries (e.g., insurance, banking and retail) for an outsized share of their GDP.
Manufacturing industries aren’t as crucial for these countries. And services require less energy than heavy industries, such as manufacturing.
But countries like China are growing on the back of a rapidly developing manufacturing base; these economies require a lot of oil. Check out the graph of oil intensity below.
Source: International Energy Agency
This graph shows global oil intensity of the developed OECD countries against that of developing countries, such as China and Brazil. The contrasts are striking. China’s economy, for example, is more than twice as intense as that of the OECD average.
China was a net exporter of oil as recently as 1994. Today, it’s the world’s second-largest consumer of oil and an increasingly important importer. India was never a big producer of oil, but imports have been growing at a near-parabolic pace since the late ’90s as demand has risen. India is also one of the most oil-intensive economies in the world, even more so than China.
The bottom line: There’s little chance for developing countries, such as China and India, to see oil demand drop, barring a sharp global recession.
The Supply Side
Burgeoning global demand is only half the story. Equally important is the fact that the world’s big oil companies are having a tough time keeping pace with demand. The chart below shows the reserve replacement ratios for a handful of the world’s largest oil producers.
Source: 2004 Annual Reports for Exxon Mobil, ChevronTexaco, BP, Royal Dutch Shell, ConocoPhillips, and Eni.
Every year, the big energy companies produce oil and natural gas out of existing reserves. Normally, these companies also explore for new reserves or perform tests to quantify the size of existing, yet unproven discoveries.
The reserve replacement ratio compares a company’s production of oil and gas to growth in proven reserves. If the ratio is 100 percent, that means that for every barrel of oil pumped out of the ground, the company is adding another barrel to its proven reserves.
Ratios above 100 mean that more oil is being discovered than produced. And ratios under 100 are indicative of a drawdown in reserves.
This graph shows that among these six major oil producers, only two have reserve replacement ratios of more than 100. Half of the stocks in this chart replaced less than 70 percent of the oil and gas produced last year–a dramatic dropoff in reserves.
The big oils are having trouble replacing their reserves, but it’s not due to a lack of capital. The strong pricing environment for both oil and gas during the past two years has led to an explosion in profits and cash flow for the industry.
In fact, the combined operating profit of four of the largest integrated oil companies (Shell, BP, Exxon Mobil and ChevronTexaco) swelled to more than $170 billion last year from around $130 billion in 2002. To date, much of that cash has been deployed in paying down debt and, to some extent, buying back stock.
Increasingly, however, this cash is being redeployed to explore for and develop new reserves. And with debt levels already near historically low levels, it’s likely the big oils will use more cash in exploration activities to boost anemic reserve replacement ratios.
But, it takes years to bring major new projects into production. That means it will take a considerable period of time and major investment to reverse the downward trend in reserve replacement ratios and meet increasing global demand. Bottom line: A new multi-year spending cycle is underway in the energy markets.
The most obvious manifestation of that spending cycle is the dramatic jump in drilling activity during the past year and a half. As I detailed in the April 27 issue of The Energy Strategist, global drilling activity is at levels unseen since the mid-’80s.
The Short Term
Of course, every bull market has its pullbacks, and markets never move higher in a straight line, at least not for long. Even in the booming ’70s oil market, stocks experienced several corrections. Some of those short-term selloffs certainly seemed vicious at the time, but they all marked excellent buying opportunities for investors.
The long-term fundamentals outlined above are unquestionably bullish for energy. However, it’s likely that oil and natural gas prices will pull back near term. As the chart of crude oil inventories (below) illustrates, US inventories are seasonal, but current inventories are running above average for this time of year. The world’s biggest oil consumer is well supplied with crude, at least for now.
Source: US Dept of Energy
There’s also a simple seasonal pattern for energy stocks. The second quarter is traditionally the weakest for the group; energy stocks don’t tend to perform well going into early summer.
There are many reasons for this. Natural gas inventories, for example, start to build in April when the winter heating season ends in the Northeast. The second quarter, therefore, is a time of rapidly building supply of gas and weakening demand.
For oil, the second quarter represents an in-between period. Demand for heating oil products starts to drop off in the second quarter and gasoline demand ahead of the summer driving season picks up in earnest late in the quarter. Perhaps the seasonality is related to the uncertainty surrounding summer demand.
Regardless of the reasons, if there’s to be a pullback in energy prices and related stocks, it’s likely to come before mid-summer. Given the high inventories currently in the US, energy markets are particularly vulnerable to that sort of seasonal effect. These markets are already pricing in strong demand short term and are vulnerable to disappointment.
This isn’t a long-term call on energy fundamentals. In fact, any pullback is a chance to pick up attractive industry leaders at good prices. Subscribers should be prepared to weather some volatility short-term.
Be Selective
To play the energy market successfully in this environment, selectivity is key. Fundamentals are strong industry wide, but some stocks have a shot at growing faster than the industry at large. Such companies are uniquely levered to the current, strong pricing environment.
For the drillers, focus on companies that have exposure to the deepwater drilling market and can bring additional rig capacity online to take advantage of higher rates. Noble Drilling (NYSE: NE) is a perfect example.
But as explained in the last issue of The Energy Strategist, “Offshore and Overseas,” Noble has a large fleet of semisubmersible rigs capable of drilling in deepwater.
Even more important, the company has three deepwater semi-submersible rigs that aren’t quite ready to drill but could be outfitted as deepwater rigs at a cost of approximately $275 million.
Since it costs more than $500 million to build such a rig from scratch, Noble has an advantage. The company could meaningfully expand its fleet to take advantage of sky-high deepwater day rates for a comparatively small investment. Only one deepwater semi is scheduled for construction in the next few years, so Noble’s three unfinished rigs are particularly valuable.
My second drilling play, GlobalSantaFe (NYSE: GSF), is a cheap play on the drilling market. The stock trades at approximately a 30 percent discount to similar drillers. As explained in the last issue, this is due to a transaction the company undertook to reduce Kuwait Petroleum‘s stake in the company; the pressure on the shares is temporary.
The second major group where there’s a near-term growth catalyst is the subsea equipment companies. The big integrated oils are developing extreme deepwater projects offshore of West Africa, in the North Sea and in the Gulf of Mexico. The largest oil and gas reserves discovered during the past 10 years are located in these deepwater reservoirs.
Producing these wells normally involves the construction of a floating production platform. The platform isn’t used for drilling; rather it serves as a point for gathering oil and gas produced by several deepwater wells. These hydrocarbons can then be sent either by pipeline or tanker ship to shore for further processing.
These floating platforms are extremely expensive to build. To make that cost worthwhile, floating platforms are tied by undersea pipelines to many different wells, including some that are many miles away.
The actual valves and pipes used to control the flow of oil from all these wells are installed directly on the seafloor. Other equipment used to process and separate oil, water and gas is also located on the seafloor.
The big oil companies have been investing in many such major deepwater projects and platforms. Several of these projects are scheduled for completion during the next three years; most of these kind of projects are multi-year affairs.
Subsea equipment firms that make the highly sophisticated pipes, valves and production equipment used to produce these deepwater wells are seeing an earnings explosion. Two favorites out of this group are Cooper Cameron (NYSE: CAM) and FMC Technologies (NYSE: FTI).
Also leveraged to the strong offshore drilling market is oil-services firm Weatherford International (NYSE: WFT). For details on this company, check out the last issue of The Energy Strategist.
In this issue, I’m adding Schlumberger (NYSE: SLB) to the Wildcatters Portfolio. Schlumberger is the world’s largest and most technically advanced oil-services firm.
The company offers so-called seismic services. Seismic services are basically a way of locating and assessing the size of oil and gas reservoirs. The technology involves sending sound waves into the ground and using a computer to interpret the returning sound waves as they bounce off underground rock formations.
Offshore, deepwater drilling activities are extraordinarily expensive. Drilling dry holes that can’t produce economic quantities of oil isn’t an option when each hole is so expensive to drill.
Schlumberger’s advanced seismic technologies can provide an extremely accurate picture of underwater reserves. This allows the majors to reduce the incidence of dry holes to an absolute minimum.
In addition to seismic services, Schlumberger is involved in nearly every other segment of the services business. That includes stimulation services used to enhance the productivity of older wells. Schlumberger also performs wire logging, a way of evaluating the potential of wells as they’re drilled.
The stock also wins points for its international exposure. The company operates in almost every country and isn’t overly leveraged to the most volatile North American market. Buy Schlumberger below 73 with a stop at 59.
Finally, one way to protect your downside when energy prices pull back is to short a few weak energy stocks to balance your exposure in my favorite names.
By far the most vulnerable market is North America. North American drilling activity is generally focused on mature wells in mature reservoirs. These reservoirs have been largely produced and coaxing additional oil and gas from such wells is more expensive.
Therefore, North American drilling activity is extremely sensitive to prices of oil and gas, particularly natural gas. If energy prices pull back short term, as I expect, some companies will most likely delay or push back planned drilling operations. This is bad news for oil and oil services names overleveraged to the market.
International projects, especially major deepwater projects, aren’t as sensitive. These projects take years to plan and organize and are far less likely to be canceled or pushed back.
Patterson-UTI (NSDQ: PTEN) is a North America-focused land drilling company. The company has seen strong growth in day rates in recent quarters, but the best of that growth is over. Land-drilling rigs are unlikely to see much additional day rate upside from current elevated levels; there’s a bigger supply of land rigs compared to deepwater semis, so these rigs have no where near the day-rate upside potential. Any pullback in energy prices will be detrimental to Patterson.
And, BJ Services (NYSE: BJS) faces a similar problem. This company is an oil services firm focused on pressure pumping in North America. Pressure pumping involves pumping a gel-like substance into a well under high pressure. Doing so cracks the formation of rocks around the well. By cracking the rocks, oil can more easily flow into the well.
Schlumberger has said that there is excess pressure-pumping capacity in North America. This won’t become a fundamental problem until drilling activity moderates. When energy prices moderate, BJ Services will likely reduce prices or at least moderate the pace of increases.
Pairing the Tankers
I would like to remind all subscribers to read the March 30, 2005, issue of The Energy Strategist carefully. This issue is posted in the archives here.
Consider that every day the world consumes more than 80 million barrels of oil; that’s 3.36 billion gallons. Much of that oil is produced in the Middle East and Africa, but consumed in North America, Japan and Europe. The vast majority of oil moved around the world spends at least some time aboard a tanker ship.
The large tanker companies are benefiting from booming trade in oil. Better yet, the best in the business have been using their huge cash flows to pay out enormous dividends for shareholders–yields as high as 30 percent.
But tanker stocks aren’t immune from risk–when oil prices fall, the stocks tend to get hit. One of the pillars of the Proven Reserves portfolio is to preserve capital and minimize volatility. To grab these attractive yields and reduce risk, we’ve added a pair trade to the portfolio.
We recommend buying General Maritime (NYSE: GMR) and shorting OMI Corporation (NYSE: OMM) in equal dollar amounts. In other words, if you buy $5,000 worth of Maritime, short $5,000 worth of OMI.
OMI pays a 1.7 percent yield and General Maritime could pay a yield between 15 and 20 percent this year (click here for more on the company’s unique dividend policy). By purchasing General Maritime you’ll get the big dividends. And if oil pulls back, the short in OMI will hedge your risk of capital losses.
That’s great news for investors. Oil companies were among the market’s strongest performers in the ’70s; the group’s bull market lasted more than a decade.
Expect the current up cycle to last at least as long and offer well-placed investors the strongest long-term opportunities of any major industry group.
In the ’80s and ’90s, there were several short cycles in energy. The up cycles were invariably caused by some disruption in supply or short-term demand spike.
A perfect example is the California power crisis at the beginning of this decade; a gas shortage in that market led to some extreme price spikes. Those price spikes, in turn, prompted energy companies to step up drilling activity, particularly in the Gulf of Mexico.
This isn’t the cycle at work in the energy markets today. The current rally in energy prices isn’t just another one-off, localized demand spike. This time, the rise in demand is persistent and global.
Meanwhile, current reserves and supplies are insufficient to meet that demand, despite the fact that worldwide drilling activity has been stepped up to levels unseen since the mid-’80s.
But even in this strong global environment, not all companies will benefit equally. For example, I’m already seeing signs of trouble ahead for oil drilling and services names that are over-leveraged to the North American marketplace. These stocks are the most vulnerable to any short-term pullbacks in crude and natural gas prices.
And in the past few issue of The Energy Strategist, I’ve identified a handful of companies that will grow dramatically in the current environment.
That includes my two favorite sub-sea equipment vendors, leveraged to rapid growth and massive investment in deepwater drilling projects. And while day rates are rising rapidly for all contract drillers, only a few have the scope to cheaply increase their capacity and take advantage of strong pricing. This includes Wildcatter Portfolio recommendations Noble Drilling (NYSE: NE) and GlobalSantaFe (NYSE: GSF).
In this issue, I’ll review a few of my favorite themes and companies. I’m also adding the world’s largest oil services company, Schlumberger (NYSE: SLB), to the Wildcatters Portfolio. Schlumberger has the strongest and most-diverse global presence of any oil services firm and is well positioned to grow in the most promising foreign markets.
Before delving into the details of the recommended stocks, let’s examine what makes this cycle so profitable for the energy companies.
The Buy Side
Consider the graph of global oil (and refined products) demand growth, based on figures provided by the International Energy Agency (IEA). The bars represent year-over-year growth in oil demand for the entire world. The IEA also provides a forecast for 2005 world demand.
Source: International Energy Agency
Throughout the ’90s, oil demand growth was low, averaging just 1.4 percent (see the blue bar on the graph). Certainly, there were one-off spikes in demand but nothing sustained in nature.
But look what’s happened during the past few years: Oil demand has been consistently higher than the ’90s average. And the 3.4 percent jump in oil demand last year was the highest since the early ’80s.
Some of the strongest demand growth of all has been coming from Asia and, more broadly, the emerging markets. Rapid economic growth in these markets is responsible for much of the jump in demand.
Just as important as economic growth is the oil intensity of these economies. Oil intensity is a measure of how much oil is required to produce one unit of Gross Domestic Product (GDP).
Oil intensity tends to drop as economies mature. The reason is that more mature economies, such as the US’, rely on service industries (e.g., insurance, banking and retail) for an outsized share of their GDP.
Manufacturing industries aren’t as crucial for these countries. And services require less energy than heavy industries, such as manufacturing.
But countries like China are growing on the back of a rapidly developing manufacturing base; these economies require a lot of oil. Check out the graph of oil intensity below.
Source: International Energy Agency
This graph shows global oil intensity of the developed OECD countries against that of developing countries, such as China and Brazil. The contrasts are striking. China’s economy, for example, is more than twice as intense as that of the OECD average.
China was a net exporter of oil as recently as 1994. Today, it’s the world’s second-largest consumer of oil and an increasingly important importer. India was never a big producer of oil, but imports have been growing at a near-parabolic pace since the late ’90s as demand has risen. India is also one of the most oil-intensive economies in the world, even more so than China.
The bottom line: There’s little chance for developing countries, such as China and India, to see oil demand drop, barring a sharp global recession.
The Supply Side
Burgeoning global demand is only half the story. Equally important is the fact that the world’s big oil companies are having a tough time keeping pace with demand. The chart below shows the reserve replacement ratios for a handful of the world’s largest oil producers.
Source: 2004 Annual Reports for Exxon Mobil, ChevronTexaco, BP, Royal Dutch Shell, ConocoPhillips, and Eni.
Every year, the big energy companies produce oil and natural gas out of existing reserves. Normally, these companies also explore for new reserves or perform tests to quantify the size of existing, yet unproven discoveries.
The reserve replacement ratio compares a company’s production of oil and gas to growth in proven reserves. If the ratio is 100 percent, that means that for every barrel of oil pumped out of the ground, the company is adding another barrel to its proven reserves.
Ratios above 100 mean that more oil is being discovered than produced. And ratios under 100 are indicative of a drawdown in reserves.
This graph shows that among these six major oil producers, only two have reserve replacement ratios of more than 100. Half of the stocks in this chart replaced less than 70 percent of the oil and gas produced last year–a dramatic dropoff in reserves.
The big oils are having trouble replacing their reserves, but it’s not due to a lack of capital. The strong pricing environment for both oil and gas during the past two years has led to an explosion in profits and cash flow for the industry.
In fact, the combined operating profit of four of the largest integrated oil companies (Shell, BP, Exxon Mobil and ChevronTexaco) swelled to more than $170 billion last year from around $130 billion in 2002. To date, much of that cash has been deployed in paying down debt and, to some extent, buying back stock.
Increasingly, however, this cash is being redeployed to explore for and develop new reserves. And with debt levels already near historically low levels, it’s likely the big oils will use more cash in exploration activities to boost anemic reserve replacement ratios.
But, it takes years to bring major new projects into production. That means it will take a considerable period of time and major investment to reverse the downward trend in reserve replacement ratios and meet increasing global demand. Bottom line: A new multi-year spending cycle is underway in the energy markets.
The most obvious manifestation of that spending cycle is the dramatic jump in drilling activity during the past year and a half. As I detailed in the April 27 issue of The Energy Strategist, global drilling activity is at levels unseen since the mid-’80s.
The Short Term
Of course, every bull market has its pullbacks, and markets never move higher in a straight line, at least not for long. Even in the booming ’70s oil market, stocks experienced several corrections. Some of those short-term selloffs certainly seemed vicious at the time, but they all marked excellent buying opportunities for investors.
The long-term fundamentals outlined above are unquestionably bullish for energy. However, it’s likely that oil and natural gas prices will pull back near term. As the chart of crude oil inventories (below) illustrates, US inventories are seasonal, but current inventories are running above average for this time of year. The world’s biggest oil consumer is well supplied with crude, at least for now.
Source: US Dept of Energy
There’s also a simple seasonal pattern for energy stocks. The second quarter is traditionally the weakest for the group; energy stocks don’t tend to perform well going into early summer.
There are many reasons for this. Natural gas inventories, for example, start to build in April when the winter heating season ends in the Northeast. The second quarter, therefore, is a time of rapidly building supply of gas and weakening demand.
For oil, the second quarter represents an in-between period. Demand for heating oil products starts to drop off in the second quarter and gasoline demand ahead of the summer driving season picks up in earnest late in the quarter. Perhaps the seasonality is related to the uncertainty surrounding summer demand.
Regardless of the reasons, if there’s to be a pullback in energy prices and related stocks, it’s likely to come before mid-summer. Given the high inventories currently in the US, energy markets are particularly vulnerable to that sort of seasonal effect. These markets are already pricing in strong demand short term and are vulnerable to disappointment.
This isn’t a long-term call on energy fundamentals. In fact, any pullback is a chance to pick up attractive industry leaders at good prices. Subscribers should be prepared to weather some volatility short-term.
Be Selective
To play the energy market successfully in this environment, selectivity is key. Fundamentals are strong industry wide, but some stocks have a shot at growing faster than the industry at large. Such companies are uniquely levered to the current, strong pricing environment.
For the drillers, focus on companies that have exposure to the deepwater drilling market and can bring additional rig capacity online to take advantage of higher rates. Noble Drilling (NYSE: NE) is a perfect example.
But as explained in the last issue of The Energy Strategist, “Offshore and Overseas,” Noble has a large fleet of semisubmersible rigs capable of drilling in deepwater.
Even more important, the company has three deepwater semi-submersible rigs that aren’t quite ready to drill but could be outfitted as deepwater rigs at a cost of approximately $275 million.
Since it costs more than $500 million to build such a rig from scratch, Noble has an advantage. The company could meaningfully expand its fleet to take advantage of sky-high deepwater day rates for a comparatively small investment. Only one deepwater semi is scheduled for construction in the next few years, so Noble’s three unfinished rigs are particularly valuable.
My second drilling play, GlobalSantaFe (NYSE: GSF), is a cheap play on the drilling market. The stock trades at approximately a 30 percent discount to similar drillers. As explained in the last issue, this is due to a transaction the company undertook to reduce Kuwait Petroleum‘s stake in the company; the pressure on the shares is temporary.
The second major group where there’s a near-term growth catalyst is the subsea equipment companies. The big integrated oils are developing extreme deepwater projects offshore of West Africa, in the North Sea and in the Gulf of Mexico. The largest oil and gas reserves discovered during the past 10 years are located in these deepwater reservoirs.
Producing these wells normally involves the construction of a floating production platform. The platform isn’t used for drilling; rather it serves as a point for gathering oil and gas produced by several deepwater wells. These hydrocarbons can then be sent either by pipeline or tanker ship to shore for further processing.
These floating platforms are extremely expensive to build. To make that cost worthwhile, floating platforms are tied by undersea pipelines to many different wells, including some that are many miles away.
The actual valves and pipes used to control the flow of oil from all these wells are installed directly on the seafloor. Other equipment used to process and separate oil, water and gas is also located on the seafloor.
The big oil companies have been investing in many such major deepwater projects and platforms. Several of these projects are scheduled for completion during the next three years; most of these kind of projects are multi-year affairs.
Subsea equipment firms that make the highly sophisticated pipes, valves and production equipment used to produce these deepwater wells are seeing an earnings explosion. Two favorites out of this group are Cooper Cameron (NYSE: CAM) and FMC Technologies (NYSE: FTI).
Also leveraged to the strong offshore drilling market is oil-services firm Weatherford International (NYSE: WFT). For details on this company, check out the last issue of The Energy Strategist.
In this issue, I’m adding Schlumberger (NYSE: SLB) to the Wildcatters Portfolio. Schlumberger is the world’s largest and most technically advanced oil-services firm.
The company offers so-called seismic services. Seismic services are basically a way of locating and assessing the size of oil and gas reservoirs. The technology involves sending sound waves into the ground and using a computer to interpret the returning sound waves as they bounce off underground rock formations.
Offshore, deepwater drilling activities are extraordinarily expensive. Drilling dry holes that can’t produce economic quantities of oil isn’t an option when each hole is so expensive to drill.
Schlumberger’s advanced seismic technologies can provide an extremely accurate picture of underwater reserves. This allows the majors to reduce the incidence of dry holes to an absolute minimum.
In addition to seismic services, Schlumberger is involved in nearly every other segment of the services business. That includes stimulation services used to enhance the productivity of older wells. Schlumberger also performs wire logging, a way of evaluating the potential of wells as they’re drilled.
The stock also wins points for its international exposure. The company operates in almost every country and isn’t overly leveraged to the most volatile North American market. Buy Schlumberger below 73 with a stop at 59.
Finally, one way to protect your downside when energy prices pull back is to short a few weak energy stocks to balance your exposure in my favorite names.
By far the most vulnerable market is North America. North American drilling activity is generally focused on mature wells in mature reservoirs. These reservoirs have been largely produced and coaxing additional oil and gas from such wells is more expensive.
Therefore, North American drilling activity is extremely sensitive to prices of oil and gas, particularly natural gas. If energy prices pull back short term, as I expect, some companies will most likely delay or push back planned drilling operations. This is bad news for oil and oil services names overleveraged to the market.
International projects, especially major deepwater projects, aren’t as sensitive. These projects take years to plan and organize and are far less likely to be canceled or pushed back.
Patterson-UTI (NSDQ: PTEN) is a North America-focused land drilling company. The company has seen strong growth in day rates in recent quarters, but the best of that growth is over. Land-drilling rigs are unlikely to see much additional day rate upside from current elevated levels; there’s a bigger supply of land rigs compared to deepwater semis, so these rigs have no where near the day-rate upside potential. Any pullback in energy prices will be detrimental to Patterson.
And, BJ Services (NYSE: BJS) faces a similar problem. This company is an oil services firm focused on pressure pumping in North America. Pressure pumping involves pumping a gel-like substance into a well under high pressure. Doing so cracks the formation of rocks around the well. By cracking the rocks, oil can more easily flow into the well.
Schlumberger has said that there is excess pressure-pumping capacity in North America. This won’t become a fundamental problem until drilling activity moderates. When energy prices moderate, BJ Services will likely reduce prices or at least moderate the pace of increases.
Pairing the Tankers
I would like to remind all subscribers to read the March 30, 2005, issue of The Energy Strategist carefully. This issue is posted in the archives here.
Consider that every day the world consumes more than 80 million barrels of oil; that’s 3.36 billion gallons. Much of that oil is produced in the Middle East and Africa, but consumed in North America, Japan and Europe. The vast majority of oil moved around the world spends at least some time aboard a tanker ship.
The large tanker companies are benefiting from booming trade in oil. Better yet, the best in the business have been using their huge cash flows to pay out enormous dividends for shareholders–yields as high as 30 percent.
But tanker stocks aren’t immune from risk–when oil prices fall, the stocks tend to get hit. One of the pillars of the Proven Reserves portfolio is to preserve capital and minimize volatility. To grab these attractive yields and reduce risk, we’ve added a pair trade to the portfolio.
We recommend buying General Maritime (NYSE: GMR) and shorting OMI Corporation (NYSE: OMM) in equal dollar amounts. In other words, if you buy $5,000 worth of Maritime, short $5,000 worth of OMI.
OMI pays a 1.7 percent yield and General Maritime could pay a yield between 15 and 20 percent this year (click here for more on the company’s unique dividend policy). By purchasing General Maritime you’ll get the big dividends. And if oil pulls back, the short in OMI will hedge your risk of capital losses.
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