Top Energy Growth Trends and How to Play Them
Paying close attention to the trends that Schlumberger (NYSE: SLB) highlights in its quarterly earnings releases and conference calls–and investing accordingly–often pays off. Based on comments from Schlumberger’s CEO Paal Kibsgaard and the management teams at the other major oil-field services firms, energy investors should take several actions to position their portfolios.
Investors shouldn’t load up on shares of Halliburton (NYSE: HAL), which trade at less than 10 times the Bloomberg consensus estimate of 2012 earnings. Valuation metrics might suggest that the stock is a good value, but Schlumberger’s take on the supply-demand balance and pricing weakness in the pressure-pumping market suggests otherwise.
The consensus estimate of Halliburton’s 2012 earnings has already tumbled by $0.28 per share, while downward revisions have lowered the consensus forecast for the company’s 2013 earnings by about $0.44 per share. Analysts have consistently lowered their estimates of Halliburton’s earnings since mid-2011.
Until the US gas-directed rig count and/or pressure-pumping prices bottom, shares of Halliburton will trade sideways at best and underperform names with more exposure to the ongoing recovery in international markets. Halliburton is a value trap for new investors and rates a hold in the Energy Watch List.
Although a recent accounting restatement hurt management’s credibility, Weatherford International’s (NYSE: WFT) robust overseas operations and limited exposure to pressure pumping should enable the stock to outperform in the back half of the year.
Shares of Weatherford International rallied slightly after the firm reported weak first-quarter earnings and disappointing full-year guidance, suggesting that investors have low expectations for the stock. Weatherford International rates a buy under 20 and retains its position in my Best Buys List.
With supply-demand conditions tightening in the market for vessels that collect marine seismic data, Aggressive Portfolio holding Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY) should thrive. The Norway-based company owns a fleet of 14 offshore seismic vessels and 21 seismic data processing centers.
Petroleum Geo-Services reports first-quarter results on May 8, 2012. In the fourth quarter, the firm’s seismic backlog jumping to $678 million from less than $500 million in the third quarter. Management noted an uptick in demand for multi-client and contract seismic services. The market should tighten further in 2012, with demand expected to increase by at least 10 percent in 2012 and the global fleet expected to grow by only 6 percent.
Petroleum Geo-Services has encountered a few operational issues that have weighed on recent results. For example, a number of the firm’s vessels were forced to return to the shipyard for maintenance and repairs late last year, pushing down the fleet-utilization rate and saddling the company with additional costs. Management initiated a profit improvement program toward the end of 2011 to reduce costs and address these issues, but it’s unclear how soon these efforts will bear fruit.
Although Petroleum Geo-Services isn’t as profitable as Schlumberger’s WesternGeco subsidiary, improving market conditions will drag the Norway-based firm’s margins higher. We also believe expect management to get the company’s operations back on track as the year progresses.
Moreover, earnings estimates for the stock haven’t increased despite the significant improvement in the market for seismic services. With a low bar of expectations, the company could surprise to the upside.
A more aggressive play than Schlumberger, Petroleum Geo-Services’ American depositary receipt rates a buy under USD17.50 and appears in the Higher-Risk portion of my Best Buys List.
Schlumberger CEO Paal Kibsgaard’s bullish comments about deepwater drilling in general and the resurgence of activity in the US Gulf of Mexico bode well for the deepwater contract drilling business. The model Portfolios contain three contract drilling stocks: SeaDrill (NYSE: SDRL), Ensco (NYSE: ESV) and Pacific Drilling (NSDQ: PACD).
At the end of April, SeaDrill announced that it secured a three-year fixture for one of its deepwater semi-submersible rigs for a day-rate, including bonuses, of almost $650,000. The contract begins in the second quarter of 2010, and the rig will operate offshore West Africa.
Day-rates earned by deepwater rigs last eclipsed $600,000 at the height of the last boom in deepwater exploration. That producers are willing to pay such a high rate to secure a rig in 2013 suggests that the supply-demand balance remains ultra-tight and that the current fleet won’t be able to handle all the deepwater work producers are contemplating.
With one of the highest-quality fleets in the business and a dividend yield of more than 8 percent, SeaDrill rates a buy under 45.
Shares of Pacific Drilling have lagged over the past two months, likely because the stock went public at the end of 2011 and investors may not fully recognize the company’s earnings and growth potential.
The small-cap contract driller has four deepwater drillship rigs currently under contract at solid day-rates, while the two new rigs slated for delivery in 2013 should secure favorable fixtures. Pacific Drilling Rates a buy under 11 and appears on my Best Buys List.
During an analyst day on April 11, Ensco’s management team shared its bullish outlook for day-rates through at least 2013. Ensco also has the financial capacity to build more deepwater and ultra-deepwater rigs to its standardized design over the next few years to take advantage of rising rates. Ensco rates a buy under 60 in the Growth Portfolio.
Finally, investors must understand that Schlumberger’s comments about pressure pumping don’t indicate the industry’s waning interest in developing unconventional oil and gas fields. Rather, declining profit margins in pressure pumping are a symptom over overcapacity in the hydraulic fracturing services industry.
With development in liquids-rich shale plays expected to continue apace, the market for proppant–sand or ceramic material that props open the fracture reservoir rock–will tighten even further. US Silica (NYSE: SLCA) is the second-largest producer of commercial-grade silica (quartz sand) in the US. The company produces its silica by extracting quartz from open-pit mines and crushing and processing the mineral into sand.
The primary end markets for commercial silica include the oil and gas production industry, glassmaking, building products and the metal foundry industry. In many of these end markets, there are few, if any, substitutes for commercial-grade silica because of its resistance to crushing and other difficult-to-replicate qualities.
The dynamics of silica demand have changed dramatically in recent years. As recently as 2004, industrial processes such as the manufacture of glass, building materials and metal castings accounted for almost 88 percent of silica demand. Today, the energy industry is the largest single end market for silica, and this growth trend should continue in coming years.
This paradigm shift in silica demand stems from the rapid development of shale oil and gas plays.
Producers mix either silica sand, resin-coated sand or ceramic material into the fracturing fluid to act serve as a proppant. The material enters the fissures created during the hydraulic fracturing process and literally props them open so that these cracks don’t close up once the pressure is removed.
Producers must use sand that meets certain standards set by the American Petroleum Institute (API) for shape, size and resistance to crushing. The most common proppant used in the oil and gas industry is API-grade silica sand, which accounts for about 80 percent of the market. Meanwhile, resin-coated sand–silica sand coated with a resin to makes it smoother and more crush-resistant–accounts for another 10 percent of the market. Ceramic proppant manufactured by firms such as CARBO Ceramics (NYSE: CRR) is more expensive and accounts for the remaining 10 percent of the market.
The US horizontal rig count serves as a good gauge of demand for commercial-grade silica. Horizontal drilling is one of the key innovations that enable producers to unlock the hydrocarbons trapped in low-permeability formations. By drilling laterally off a vertical shaft, producers expose the well to more of the productive layers.
Over the past three years, the US horizontal rig count has soared to more than 1,150 units in early 2012 from a low of 372 rigs, a trend that reflects the frenzied development of shale oil and gas plays.
Shares of US Silica have slumped from a high of almost $22 to less than their initial public offering price because of concerns that drilling activity will diminish this year. We expect the US rig count to hold steady or increase by 5 percent in 2012 as producers shift their emphasis from dry-gas fields to liquids-rich plays.
But the rig count alone isn’t the only driver of proppant demand.
As operators gain experience in the major shale plays and better understand the geology, they grow more efficient and can drill more wells with the same or fewer rigs. Even with a flat rig count, producers may drill more wells.
Producers now drill longer horizontal segments for their wells. A few years ago, a producer might have drilled a 5,000-foot horizontal well; today, lateral segments often exceed 10,000 feet. Longer wells involve more fracturing stages, which translates into more proppant per well. The industry has also found that increasing the amount of proppant used to complete each fracturing stage yields superior initial production rates and overall productivity.
In addition to rising demand, US Silica benefits from certain company-specific advantages.
First, the company has a total of 316 million tons of silica sand reserves, about 148 million tons of which should qualify as API grade. In addition, the firm benefits from some of the lowest production costs in the US. The company’s reserves are located near key rail links, which reduces transportation time and costs–a distinct advantage and a major cost center for some competitors. US Silica believes it’s the only proppant producer capable of delivering its product to all the major shale fields in the US.
Moreover, investors must consider the type of proppant the company can produce. As a rule of thumb, dry natural gas fields are located further underground, where temperatures and geologic pressures are intense. (That’s why exploration and production companies sometimes refer to a field being “too cooked” to produce oil). Oil- and liquids-rich plays, on the other hand, are often located at shallower depths and under less extreme pressures and temperatures.
Ceramic proppant resists crushing better than sand, but it’s also more expensive. Historically, producers have opted for ceramic proppant in deep-lying gas formations that contain little or no natural gas liquids (NGL).
However, with natural gas prices at depressed levels, many producers have decided not to pay up for ceramic proppant even if it leads to better production rates. These trends, coupled with a shift in drilling activity from dry-gas fields to liquids-rich plays, explains why shares of CARBO Ceramics have lagged over the past year. Since US Silica produces silica sand proppant and will launch a resin-coated variety, the company stands to benefits from the shift away from dry-gas fields and ceramic proppant.
In addition, not all sand is identical. US Silica’s coarse, white Ottawa sand is best-suited for formations that contain oil and NGLs, while finer, brown sands are the proppant of choice for budget-minded producers targeting natural gas. As drilling activity in liquids-rich plays continues to accelerate, demand for US Silica’s wares should grow significantly.
The supply side of the equation should also support higher prices for US Silica’s output. During the financial crisis and Great Recession, traditional industrial demand for silica sand contracted to 19.1 million tons in 2009 from 28.8 million tons in 2006. Although the oil and gas industry’s demand for silica sand increased over this period, the market remained oversupplied. As a result of the decline in overall demand, producers curtailed investments in new supply.
It’s not a simple matter to increase silica sand production. It can take 12 months or longer to find an appropriate deposit, one to three years to obtain the necessary permitting from the government, and two to three years to site and build mining, processing and transportation infrastructure. Two to three years would be the minimum time frame to bring a greenfield silica project online. As demand surged in 2011 and into early 2012, supply growth has remained sluggish because of a lack of investment.
However, US Silica has expanded its capacity to produce silica sand significantly. In 2011 the firm completed a project that increased the annual production capacity of its Ottawa, Ill., operation by 1.2 million tons and expanded a plant in Michigan.
To fund these endeavors, the company signed take-or-pay contracts with customers that guarantee minimum cash payments regardless of whether the silica sand is used. As both facilities produce the coarse, white sand used in liquids-rich fields, this material will likely be in high demand.
US Silica will launch a line of resin-coated sand once the firm completes a plant in Illinois that’s capable of producing about 200,000 tons of the proppant. Management expects this facility to be up and running in 2013.
The company has also identified additional brownfield expansion projects at its existing facilities that could add incremental capacity. Longer-term production growth could come from reserves acquired in Wisconsin. The company expects to complete construction on a production plant by the end of 2013 and to start churning out silica sand in 2014. Management expects this facility to produce about 500,000 tons of proppant per annum.
In 2009 the oil and gas industry accounted for only 19 percent of the company’s sales, compared to about 36 percent in 2011. Management estimates that energy companies will generate two-thirds of the firm’s sales by the end of 2013. Spot silica sand prices have surged over the past two years, and with demand expected to increase at an annualized rate of 15 percent through 2014, prices have room to grow.
And even if spot prices remain flat, US Silica will reap the rewards as supply contracts signed in 2008-09 roll off and are replaced with deals that feature more lucrative terms.
Shares of US Silica trade at roughly 11 times projected 2012 earnings, while CARBO Ceramics’ stock fetches more than 13 times forward earnings–a huge disparity when you consider US Silica’s superior growth prospects and that the company has the potential to grow its earnings at an average annualized rate of 30 percent to 40 percent.
With North America-focused services firms struggling to secure sufficient proppant to meet demand and drilling in liquids-rich shale plays accelerating, US Silica’s growing production makes the stock a buy up to 19.50 in the Aggressive Portfolio and in my Best Buys List.