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Oil Service Stocks Scraping the Barrel
Oil Service Stocks Still Scraping the Barrel
Analyst: Will Frankenhoff (2/24/99)
Valuations in the oil service sector are hard to ignore.
R&B Falcon (NYSE: FLC), Global Marine (NYSE: GLM) and Transocean Offshore (NYSE: RIG) are trading at an average 1.2 times book value, 1.5 times trailing 12-month sales and a mere 8.9 times estimated 1999 earnings.
In fact, the 15 stocks that make up the Philadelphia Oil Service Sector Index currently trade at an average trailing P/E of 13.2, a 81% discount to the 70.9 multiple of the Nasdaq and a 59% discount to the S&P 500.
Held Hostage
Given these valuations and the fact that most of these companies, ranging from the above-mentioned Transocean Offshore to industry powerhouse Schlumberger (NYSE: SLB), have excellent management, it's hard to recommend that investors ignore the sector but that's exactly what we're doing. The reason: No matter how well-run these companies are or how attractively valued, the price of a barrel of oil is what they live and die by and that price doesn't look to be rising anytime soon.
Now before I flesh out my thesis I'd like to explain my bullishness on Falcon back in October when I recommended it at $11.06 (the stock is now $5.63). When the original piece was written, circumstances were very different. OPEC compliance was far higher, Iraqi oil exports were one half of today's levels and talk of additional OPEC cuts were commonplace. Long term, the patient investor should do fine with Falcon but near-term, there is no catalyst for upside in sight.
According to Mohammed bin Hamed Al-Rumhy, Oman's Oil Minister, OPEC has to 'remove the 2 million barrels (of oil a day) surplus still in the market'. The problem is that it is very unlikely that it can do so at current levels of production.Why? Remember the much ballyhooed meeting last June when OPEC (excluding Iraq) pledged to cut production by some 4% or 2.6 million barrels a day? Well, compliance with these proposed cuts was a mere 1.87 million barrels.
On the surface, this looks like it comes close to erasing the surplus but that number doesn't take into account the fact that over the past year Iraq has doubled its oil exports to 2.07 million barrels, effectively diluting the cuts to a mere 870,000 barrels, 56% below what is minimally needed.
Forging a consensus for further cuts, or 100% compliance, among OPEC countries is not likely to succeed. As OPEC's Secretary General Rilwanu Lukman said last week 'there are problems (among OPEC members) with 'one or two countries' way behind others in terms of compliance.
Further aggravating the situation is the fact that countries outside of OPEC (notably Venezuela) flout compliance levels even more flagrantly. As Oman's Al-Rumhy recently stated 'The fear is that if the Gulf states cut production to stabilize the market, someone else will pick up that cut and increase their output.'
A Crude Plunge
The upshot of all this is that crude oil prices plunged 38% to a Benchmark Brent crude average price of $11.75 a barrel in the fourth quarter of 1998, down from $19.02 per barrel the previous year. This precipitous decline has put the squeeze on the major oils, fueling the merger-mania which has gripped the sector as giants like Mobil (NYSE: MOB) and Exxon (NYSE: XON) combine to generate economies of scale and boost profitability through cost-cuts.
The combination of these mergers and the depressed price of oil are a double-whammy to oil service companies. First of all is the fact that it is generally known that the major oils increase their exploration and production budgets (and hence the revenue of oil service companies) when the price of oil is over $16 per barrel. With oil at current levels, this isn't going to happen anytime soon.
In fact, BP Amoco (NYSE: BPA) has said it is expecting crude oil to average $11 per barrel in 1999. Indeed, according to Chief Executive John Browne, 'We don't believe that anything much below $11 is sustainable for very long because the fundamentals of supply and demand would be disrupted by a lack of investment. But it's equally hard to see a rapid rebound of prices from current levels because of the extent of (stockpiles).'
Bottom Line:
As long as oil prices stay at low levels, the majors won't spend much on exploration and production and that fact will continue to hurt the oil service sector. Our advice is to stay away until there's better forward visibility because as Joseph Ancona, an oil analyst at Burns, Gusts & Co., so eloquently pointed out 'Gloom, doom and despair is no longer an exaggeration.'
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