Interview From Briefing.
This week's topic: Oil Service Companies
Panelists
James K. Wicklund, Managing Director, Energy Research at Dain auscher, Inc.
Joseph Culp, CFA, Vice President, Energy Analyst at A.G. Edwards.
Mark Urness, Vice President, Equity Research at Salomon Smith Barney.
Q&A
Briefing: The major U.S. oil companies are expected to reflect lower oil and natural gas prices in their fourth quarter profits which will be about 10% below a year-ago, marking the first year-over-year decline in two years. Do you anticipate a reduction in exploration and
production in the first quarter?
James Wicklund: We expect a slowdown in E&P activity in the first quarter but not as a result of lower commodity prices but due to the seasonal slowdown in activity in the winter. Activity should be up year over year however, even though commodity prices are down. E&P companies disappointed investors in 1997 with lower than expected production volumes, oftentimes due to lack of equipment. They will spend dollars in excess of generated cash flow if needed to ensure production targets are hit.
Joseph Culp: When considering fourth quarter earnings, lower oil and natural gas prices, along with lower refining margins, will have a negative impact on the bottom line for these companies. However, predicting quarterly estimates for the major U.S. oil companies is a lesson in humility as these businesses sell lots of stuff in thousands of markets where prices change by the minute. I would agree that there will be some earnings disappointments, yet this would not be a new phenomenon as we have seen a dropoff before on a quarter-to-quarter basis between 1995 and 1996. Nevertheless, the key issue is that overtures of earnings shorfalls affect Wall Street, and Wall Street is now in a what-have-you-done-for-me-lately frame of mind. In contrast, oil companies are more farsighted than Wall Street and think in terms of a 5-7 year plan, not a quarter-to-quarter approach. In speaking with leaders of these businesses, I have learned that earnings projections were built around $15-$17 per barrel even though the norm was oil at $20 per barrel. What this means is that these companies, unlike Wall Street, are not unnerved with oil prices below $17 per barrel. Despite recent declines, and contrary to what popular thinking is, since oil had been above $20 for some time, these companies have a big cushion in terms of cash flow to get them over these little bumps in the road. In sum, the impact of lower oil and natural gas prices can be made up since these companies have ample borrowing power, a big cushion of cash, and they continue to benefit from methods of cost savings that allow them the same margins at lower prices.
With respect to investing in exploration and production projects, 4th quarter shortfalls won't make a bit of difference in their deep-water drilling plans. The only area that may see some curtailing of spending (though not major) is in short-cycle land-drilling where natural gas is the dominant element.
Mark Urness: No, we do not anticipate a reduction in upstream (exploration and production) spending because of lower fourth quarter profits among the big oil companies. In fact, the large oil companies have indicated to us that they plan to increase upstream spending by 10% in 1998, which will make it the third consecutive year of double
digit growth in spending. We do not expect them to change plans because oil hits $17 for a week.
Briefing: What impact will the Asian crisis have on the oil service companies in 1998?
James Wicklund: The Asian crisis will have no impact on oilfield service companies but will have some effect on E&P companies due to lower near-term prices. Oil companies do not predicate their capital budgets based on estimates of future oil prices or demand growth. They base them on the known decline rate of their current production base and the need to grow value by increasing net production volumes. If demand is high, the prices for their products are higher. If demand is low, pricing is lower. But this is not a controllable situation by the companies and the spending patterns of the E&P companies, especially internationally, are based on long-term cycles that near-term disruptions in demand do not effect. And if the oil/gas prices are lower near-term as a result of lower demand, oil companies will supplant that cash flow from debt/equity offerings so that spending levels, ie, revenues to the service companies, resemble a higher than noted price.
Joseph Culp: Oil service companies won't even get a sniffle from this Asian flu. People forget that Japan and Korea, two of the countries most affected by the Asian crisis, don't even have any oil to drill anyway. In addition, offshore rigs in the Far East account for only 10% of all rigs in operation. Also lost in the hoopla over Asia is the fact that the bill for most drilling projects is being footed by the major oil companies, not the countries themselves. While it is true that demand will slacken some, the impact on the oil market will be negligible. Even if demand in Korea and a few other countries dropped by 20%, we're still only talking 100,000-200,000 barrels per day while worlwide consumption clips along at a pace of 74-75 million barrels per day-- a drop in the bucket. The real impact with respect to Asia is more psychological than real and drilling activity won't be affected at all.
Mark Urness: We see very little impact form the financial crisis in Asia unless hydrocarbon demand drops drastically. Many are estimating that hydrocarbon demand in Asia which grew at 5-6% in 1997 will be cut in half in 1998. We don't see such a dramatic fall off in demand at this time. Nearly 90% of the companies we have spoken to said that they are not anticipating any cuts on demand out of Asia. We anticipate a rebound in oil prices before this year is over and by mid-year, we think that the Asian crisis will be stabilized. In the end, Asia will probably have little or no negative impacts on the oil sector, at least on upstream spending.
Briefing: Recently, many oil service stocks have taken a beating in spite of strong fundamentals. When do you anticipate investor sentiment will change and what will be the catalyst(s) for this change?
James Wicklund: After the seasonal drop in oilfield service stocks at the end of November, a number of factors including over-production by OPEC, reduced demand due to US weather patterns and the slowdown of Asian demand, dropped commodity prices and forced oilfield service stocks to continue their decline. At this point, all of the drop has been psychological since earnings estimates and activity forecasts remain unchanged. The psychology identifies crude oil prices as the barometer. While the level of oilfield service activity and commodity prices experienced a de-coupling of correlation several years ago, prices are still the sentiment indicator many are using today. Since 1987, the oil price on average has bottomed in February. Once the commodity price quits going down and/or winter ends, the stocks will bottom and move up.
Joseph Culp: These stocks went into a free-fall because momentum investors panicked. The catalyst for sentiment change will be to weed out those who are faint of heart. Right now, value investors are looking at these momentum players as if they are madmen running down the street with a bag of gold and a gun. Are they going to try and
apprehend them when they are in full stride? No. They are going to let these madmen tire themselves out, and when they sense that they have, then they will pounce. As mentioned earlier, these stocks have fallen victim more to psychological problems than real ones. Keep in mind that earnings at these companies are still growing at double-digit rates, and they are not going to slow down by any appreciable degree. Yet, naysayers have a hard time believing that these stocks can continue to go up after registering phenomenal gains the past three years. Well, that's nonsense as these companies have growth projections of 20% per annum for almost as far as they can see.
Moreover, they have long-term contracts with the cream of the financial world; and major oil companies don't renege on contracts. They remain good values despite higher valuations, and have been unfairly victimized by the psychological whimsies of the Asian flu, increased OPEC production quotas, and El Nino. When considering
fundamentals, the lower oil and natural gas prices at this time are like a match flickering in a crowded opera house. Someone yells fire, everybody runs, but eventually they come back when they realize it was just a match and not a blazing inferno.
Mark Urness: Yes, stocks are off their 52 week highs by about 35% since November. This is mainly due to four factors: 1) increase in OPEC supply, 2) resumption of Iraq sales, 3) El Nino and the warmer than usual winter, and 4) perceived implications of the Asian crisis . We think that investors are accustomed with evaluating the first three, but the Asian crisis is new to investors and we have seen them retreating in anticipation of the worst case scenario.
It is difficult to identify a catalyst that will trigger a turn investor sentiment. Passage of time combined with a couple quarters of strong earnings releases from the oil service companies will no doubt be encouraging to investors. Other positive events ofr the group include OPEC deciding to take emergency action to support prices (unlikely), a major freeze, and/or a speedy resolution to the Asian crisis
Briefing: Which stocks are you recommending and/or avoiding?
James Wicklund: We are recommending the deepwater drilling contractors since the break-even economics of most offshore projects require an oil price no higher than $10/barrel and the deepwater sector is still in its very early stages, giving significant stability to the earnings estimates. R&B Falcon (FLC), Noble Drilling (NE), Transocean (RIG) and Rowan (RDC) are our top picks. The onshore sector has been oversold based on expectations of lower dayrates. We look for minimal exposure to marginally economic oil drilling, a higher percentage of the fleet being diesel electric rigs, strong operating region and capable management. Bayard Drilling (BDI), UTI Energy (UTI)and Nabors Industries (NBR) fit that bill. Technology companies are becoming more critical to economic success and our top picks include Veritas DGC (VTS), a large independent land and marine contractors, Mitcham
Industries (MIND) who leases seismic equipment to contractors, OYO Geospace (OYOG) who is manufacturing and developing certain seismic equipment, and Input/Output (IO), the worlds largest seismic equipment provider whose stock as been beaten down by misunderstandings. Lastly, we like the high capital cost equipment companies where incremental utilization pushes dayrates higher yet returns are not high enough to foster increased capacity. These stocks would include BJ Services (BJS), Weatherford (WII) and Tuboscope (TBI).
Joseph Culp: Because the deep-water drillers have been killed in this psychologically-driven market, we are focusing are recommendations in this area as they have the best value visibility. Our top recommendations include R&B Falcon (FLC), TransOcean Offshore (RIG), and Diamond Offshore (DO). We have BUY ratings on each of these stocks. For the investor looking for high-quality, broad-based exposure in an undervalued group, we are recommending Schlumberger (SLB) with a BUY rating.
Mark Urness: We generally like companies with international exposure given that international spending growth is at about 14% versus U.S. spending growth which is at about 6%. We also like deep water drilling companies. Schlumberger (SLB) and Halliburton (HAL) are well diversified internationally and strong companies generally. Other stocks we like include Cooper Cameron (RON) - heavy exposure in deep water; Smith International (SII) - not previously recommended because of lofty valuations, but it is a solid company with a number of oilfield service products and it is now trading at about 14 1/2 times 1998 earnings; and Global Industries (GLBL) - in the marine construction business which lags drilling by a couple of years ( it is a "late cycle play"). In the drilling arena, we like Noble Drilling (NE) and R&B Falcon (FLC). According to our estimates, both of these drillers should double their earnings in 1998. They are currently trading at about 12 times 1998 earnings. |
