RALLY TIME?
The entire oil service sector is rocking today after the weekly API
crude oil storage report surprised traders with a drawdown of almost
six million barrels. It appears the trend is moving in favor of a
diminishing oil supply.
Watch For >>>> Downward revisions of reserves, worldwide. Mexico was
first, reporting yesterday that it's reserves, at current prices, were
only half of previous estimates. At lower prices, not as much oil is
recoverable, therefore decreasing the reserve estimate and making the
supply/demand picture more inclined to higher oil prices.
Watch For >>>> Slow down in oil production due to decreases in
Exploration & Production spending by oil companies worldwide. Simple
fact -- less drilling, less oil. It's impossible to keep up with
depletion without finding and developing new reserves. And without
spending the bucks to do the work, the news reserves won't be found.
These reduced production numbers have not begun to show up yet. But
they will.
Watch For >>>> OPEC to succeed in increasing its market share by
"washing out" a considerable amount of oil production as a result of
low prices. Maybe OPEC will decide to endure even more pain in order
to cripple the rest of the world's capacity for production for years
to come. Don't bet the farm that OPEC will make moves to increase oil
prices during their meeting later this month. Don't forget the old
saying, "Buy on the rumor, sell on the news." It may apply here
leading up to the meeting.
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Since ODB coverage of the oil service stocks is limited, I thought I
would include an article published today by
investorsalley.com that is a good summary of the current
affairs of oil service stocks. Industry readers may see the article
is written by a stock trader and not an industry participant. But
it's the stock traders that make the stocks move up and down, and we
all need to know how they may be thinking.
Industry Focus: Time to drill for oil services stocks
Background
This once high-flying group has been falling back to earth fast for
over 12 months. As measured by the Philadelphia Stock Exchange Oil
Services Index (OSX), the group is off almost 70% from an index high
near 140 at the end of 1997. For those who may not remember, at one
point just a few years ago this group was racking up major gains,
allowing energy sector mutual funds like the State Street Research
Global Resources Fund (SSGRX) to deliver killer performance to their
shareholders. SSGRX led all funds in 1996 with returns near 70% for
the year. Since, then, well.........we'll address that issue soon
enough.
Plummeting crude oil prices are to blame for recent dismal
performance. The March '99 NYMEX crude oil contract is currently
trading below $12/bbl, in the neighborhood of contract lows. The crude
contract has been consistently downtrending since the end of '97, but
appears maybe to have found some kind of support under $12/bbl. OPEC
hasn't been able to do a damned thing about any of this price
weakness, and the weather certainly hasn't been a plus. In fact,
almost nothing seems to be able to light a fire under crude prices,
even intermittent military tensions in the Middle East.
The good news is that both crude oil and the OSX seem to have found
some sort of bottom in this range they are now re-entering. Crude
hasn't stayed much below $12 for very long, and the OSX has found
support below 50 more than once during the recent downtrend it has
been in. The sector is not a screaming buy, but with each day that
passes and each low that holds, it becomes more interesting and
deserves a little more attention from contrarians and value players
who recognize that the energy group cannot stay down forever.
Fundamentals
Big Cars - the trend toward big autos remains on. SUV's, sports sedan
hybrids that offer comfort and performance, trucks. These are the cars
that seem to be zooming out of dealerships. There has clearly not been
a premium on fuel efficiency for some time. Gasoline prices that are
at all-time lows on an inflation-adjusted basis contribute to that,
but income expansion and a wealth-effect relating to strong investment
markets also deserve some credit. At some point, after capacity is
reduced enough and the supply-demand balance is found, the
proliferation of gas-guzzlers that has occurred in this decade will
become a catalyst for strong fossil fuel prices and improved stock
performance. The auto production cycle will not switch from focus on
size to focus on fuel efficiency overnight, and in the interim cars
that guzzle gas will be all over our highways and byways, representing
demand.
Weak Economies - Asia hasn't recovered, Latin America is not looking
good, the US can only expand for so long..........Economic weakness
has contributed to low crude oil prices. Bond prices seem to imply
that our economy may not be slowing enough, that inflation is looming.
But worldwide economic growth has not confirmed any such notion since
emerging markets started getting thrashed two years ago, and a
slowdown in PC sales implies that maybe the economy is in fact slowing
in this country. If the world economy slows any more, one cannot
assume that higher oil prices will come. The oil services group relies
on strong oil prices which in turn depend on a strong world economy.
Right now, at best the world economy is bottoming, but if it is not,
the group has plenty of downside.
Valuations - the group isn't expensive, period. The recent salad days
of very high rig lease rates and declining supplies of drilling
platforms created huge inflows of cash for oil services firms and the
group has assets on its books that do have a value. Much of oil
services is very capital intensive, and a multi-year trend toward less
drilling rigs has created ripe conditions for a supply squeeze should
major oils decide to pick up on exploration efforts. Another issue
here is that by many private marketplace measures it is becoming very
cost effective to buy assets via an open market takeover rather than
having them produced. There is a floor here someplace below which it
becomes awful difficult to forecast significantly lower prices, as
asset values are fairly stable and capital intensive firms can
logically trade on multiples of assets as well as multiples of
earnings or cash flows if things are stagnant long enough.
American Presence - there are plenty of domestic plays for an
interested oil services investor. One need not play the group via
ADR's or overseas issues, but making a play on an American company can
still lead to an international exposure. Many nations rely on services
of American firms in this area, so a backdoor way to play an emerging
markets recovery is to have a position here, not only because those
countries are incremental consumers of crude oil, but because there
are many that would enlist the services of oil service firms if their
economies were to turn up.
Technicals
We look to be basing. The OSX has not significantly taken out a number
much below 50 during this entire rout. There is apparently support
around 45 on the OSX. Should that level get taken out, you can expect
a big gap down, but unless the broad market caves in this event is
unlikely. There is not much incremental bad news out there that would
drive the group down through this support level short of a major
equity-revaluing scenario.
The group seems range bound, with an OSX below 50 level as the bottom
end of the range. Decent trading gains can be had catching this low
end of the range and selling the 55 or so resistance that has held
pretty well in the past. This is a good, wide range and offers trading
opportunities at valuation levels that are pretty low and offer an
understandable support.
Keying on crude oil and keeping in mind that the stocks seem to get
pulled between being affected by crude conditions and being affected
by stock market conditions is wise. There have been numerous
opportunities to get out of OSX longs after having been warned by
crude declines that the sector may drop. The market has tended to drag
this group up higher, perhaps, than crude conditions would dictate on
their own. Don't ignore crude, but at the same time take note of the
relative discount OSX stocks trade at and be aware that institutional
portfolios often look to buy sectors trading at a discount valuation,
even if fundamentals specific to that sector might not justify that.
Wrap-Up
The SSGRX, mentioned above, once led all funds in performance. Then it
got thrashed along with the sector it focuses on. These are the
hazards of sector funds. It may be time to look at this group, either
via individual issues, or a sector fund like SSGRX. When the stocks
move, letting a fund manager put you into the group may be worthwhile.
These stocks move fast, and they tend to move far. They benefit from
secular dynamics that go to the heart of the world economy, and they
are leveraged to that pretty heavily. You can play the group, instead
of just a few stocks, and make web-stock type returns when things go
well.
One thing to keep in mind is that you want to play this group as a
sector play on energy, on fossil fuels, on the market for drilling rig
leasing, seismic exploration, and parts and services relating to them.
These are at the mercy of major oil firm exploration and drilling
budgets, which are determined by expectations about oil prices. Do not
think one company in the group will buck a sector trend, because it
won't. As the group goes, so will the companies in it.
One caveat: If you go the sector fund route trying to play oil
services, make sure you get a pure play fund. Some fund groups lump
"Natural Resources" into one fund that in large part may hold oil
services stocks, but will also dabble in gold, etc. Golds can go
exactly the wrong way because they trade for different reasons, so if
you pick a fund to make a long oil services bet, make sure it pays off
for you if you're right by avoiding funds that hold significant no oil
service positions which might only serve to cripple your returns.
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