Energy Remains a Bold Contrarian Play
Wednesday October 15, 12:32 pm ET
By Christopher Edmonds, Special to RealMoney.com
As the energy earnings reporting season begins this week, it's time to look ahead at what to expect and what it could mean for oil and gas stocks.
The third quarter has been disappointing. With natural gas prices above $5 and crude oil prices holding near $30, there should've been plenty of activity in the oil patch. Yet, with companies like Anadarko (NYSE:APC - News) and El Paso (NYSE:EP - News) laying off rigs, the drilling and energy service companies saw little improvement. In fact, Lone Star Technologies (NYSE:LSS - News) summed it up best when it warned that it would severely miss third-quarter estimates: "Activity just didn't pick up as we thought it would earlier in the year," said Chairman and CEO Rhys Best at a recent San Francisco investor meeting.
Because of anemic exploration and drilling in the face of higher commodity prices, many investors have lost patience with the sector. You only need to look at this week's shellacking of a quality name like BJ Services (NYSE:BJS - News) to see just how out of favor the group has become.
Just this morning, Rowan (NYSE:RDC - News) reported a weaker-than-expected quarter, with earnings coming in at 12 cents a share, vs. the consensus estimate of 16 cents. In short, an early look at the third quarter suggests there won't be a lot of celebrating in the oil patch.
Ironically, therein lies the opportunity.
Reverse Psychology
My colleague, Tom Escott, who's made a career out of oilfield punditry, is fond of saying that you usually make the most money in the energy sector if you buy when the stocks stink the most. In other words, oilfield names are typically a bold contrarian play.
Now is one of those times. The bearish crowd -- now approaching a majority -- is suggesting that commodity prices will tumble, natural gas storage will be full, and Russia and other non-OPEC nations are going to flood the world with crude oil. That, in turn, will lead to a precipitous decline in energy-company earnings and stock prices.
In the short term, that means that many companies will seriously miss their third-quarter earnings projections and lower their fourth-quarter estimates, putting even more pressure on the stocks.
I'm willing to take the other side of that bet. While energy equities may dip into the earnings season, the risk-reward calculus is quickly beginning to favor the reward side of the equation. One fund manager who has made a lot of money trading oil-service names for more than a decade noted today, "The psychology is so negative that things only have to be 'less bad' for perception to shift and investors to step up and buy these names again."
The quarter will most likely be light for a number of energy-service companies. Yet, most investors expect that, and they also expect fourth-quarter guidance to be poor as well. So, if the quarter is just "not as bad" and trends look even modestly positive, the perception may well be one of a positive surprise.
Back at the Table
One positive surprise may be the fourth-quarter level of U.S. and Canadian activity for two downtrodden explorers: Anadarko and El Paso.
Now that Anadarko doesn't appear to be for sale -- at least not at the price anyone was willing to ante up -- Anadarko looks set to drill aggressively in the fourth quarter, putting a handful of additional rigs to work in the U.S. and probably at least five new rigs to work in its Canadian winter drilling program.
El Paso signed a major drilling partnership with Nabors (AMEX:NBR - News), bringing the financially challenged El Paso back into the exploration business in a big way. It wouldn't surprise me to see El Paso announce another deal with Rowan for a couple of offshore rigs in the coming weeks.
Add to that continued robust exploration programs from land-based E&P companies like Chesapeake (NYSE:CHK - News) and accelerated offshore drilling from companies like Energy Partners (NYSE:EPL - News), Magnum Hunter (NYSE:MHR - News) and Remington (NYSE:REM - News), and you'll probably see the rig count creep steadily higher in the coming weeks.
Other E&P companies may be putting rigs to work in the fourth quarter on short-term projects to capture intangible drilling costs to offset strong profits as a result of high commodity prices. While that activity may not last into the first quarter, it could temporarily boost rig counts and, more importantly, investor optimism.
Oh, Canada!
Another positive development is happening north of the border. As discussed in a recent column, the winter drilling season is shaping up to be strong. Some predict that rig usage could peak above 625, the record set in the winter of 2001-02. There are already signs that rig dayrates -- the amount a rig owner charges for use of a rig -- could rise by C$1,000 to C$2,000 this winter.
That would benefit companies with leverage to the Great White North, including Nabors, BJ Services and Maverick Tube (NYSE:MVK - News), all with significant exposure to Canadian markets. Canadian-based drillers like Precision (NYSE:PDS - News) will also benefit.
The possible kink in the Canadian story is weather. Last year's late freeze kept crews out of the fields until December. If that happens, the season could be slow to start, causing some slippage in both utilization and rate. However, early signs suggest a more normal winter, meaning a lot of frozen drillbits into Canadian soil.
Sink or Swim
The most important sign still needed for investors to return to oil and gas stocks is a renaissance in Gulf of Mexico activity. While the number of rigs working in the U.S. has risen steadily this year, nearly all of the gains have come from land-based drilling. The Gulf of Mexico remains very weak.
That could change as both the major integrateds and large independents scurry to book reserves and find prospects to drill before year-end. However, for a sustainable rally in most of the service names, we'd need to see both a pickup in the Gulf of Mexico and an increase in deep drilling activity, which leads to the need for more drill pipe, better technology and more expensive equipment.
For now, however, I'd watch for "not-so-bad" third-quarter results to change into "pretty good" performance for many of the service names as we roll into the fourth quarter.
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This article caused me to look at buying some PTEN, but after looking at it again I would not touch it and possibly would consider it as a short.
They will probably get within a few pennies of 3Q estimates, but IMO there is a big likelihood that they will have to put out very negative comments re: how 4Q is looking vis a vis the consensus earnings estimates. Analysts expect their revenues to skyrocket 15% over 3Q, but the rig counts so far are not supporting that kinda increase.
And then the question becomes, when do analysts start taking down the massive ramp up in '04 revenues. |
