Jubak's Journal
Oil backlash? These 5 drillers will still find profits
After Katrina, politicians are targeting oil companies and demand is softening. But exploration will go on. These drilling and service companies should thrive.
By Jim Jubak
The post-Katrina backlash against high oil and gasoline prices is in full swing.
And no wonder, with the price of gasoline at U.S. stations peaking above $3 a gallon and oil prices breaking above $70 a barrel.
The backlash comes in many varieties -- all flavored with more than a dash of political posturing, of course. Politicians have promised to investigate -- and punish -- price gouging by gas station owners. The U.S. and European Union governments have released more than a million barrels a day of crude from emergency reserves. And France's finance minister has threatened to impose a windfall-profits tax on oil.
This backlash will just speed the ongoing correction in the market for oil and the stocks of oil producers. Oddly enough, though, it's good news for the stocks of oil drilling and service companies. They stand to see increased revenue -- and profits -- as their oil company customers have to increase spending to placate grandstanding politicians.See the news
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Conspicuous profits become targets
Already high oil prices have caused a drop, if not in actual demand, at least in forecast demand. The International Energy Agency has cut its oil demand forecast for 2005 by 250,000 barrels a day. And there's some evidence that current demand for real oil has fallen as well. Oil companies have canceled several tankers due to sail from Latin America to the United States. Mexico has cut exports and Venezuela is now sending some of its oil into storage tanks in the Caribbean.
With demand at least temporarily softening, oil prices have tumbled from north of $70 a barrel to south of $64. Even with the drop, oil companies are going to report huge earnings gains for the quarter that closes on Sept 30. Wall Street expects a major company such as Exxon Mobil (XOM, news, msgs) to show a 34% jump in earnings in the third quarter of 2005 from the third quarter of 2004, and XTO Energy (XTO, news, msgs), a smaller independent producer, to grow earnings by 54% in the quarter.
But those kinds of earnings numbers are largely reflected in oil-stock prices, so the oil producer stocks have come down with the price of oil, because investors have concluded, for the near term at least, that oil earnings-growth rates have peaked.
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The political backlash against oil profits is a reason to sell, too. No matter how you cut it, this backlash -- led by politicians who have done almost nothing to prepare for an energy supply crisis -- will cost oil producers money.
Look at what's going on in France. Total (TOT, news, msgs), the leading French oil company (with 50% of French refining capacity) but one that does business in 130 countries, has been lambasted by French politicians for high profits -- first-half profits climbed by 44%. The company, the politicians have said, should 1) lower the price it charges for oil and gas, 2) increase its investments in renewable and alternative energy, and 3) increase its investment in finding new oil and in refining it. One of the politicians leading the charge, finance minister Thierry Breton, has proposed a windfall tax on oil profits. Total knows it has to take that possibility especially seriously since the finance minister has noted that such a tax would be the easiest way to close the French government's budget deficit.
Spend it or lose it
So how has Total fought back? By spending more on oil exploration, drilling and refining. The company will boost capital spending by $1 billion next year, according to Total CEO Thierry Desmarest. See, the company is saying, we're plowing those profits back into finding and refining more oil. Tax those profits and there will be less oil in the future.
Investors don't have to take sides here or chose between self-interested politicians and equally self-interested oil company executives. It's the end effect that counts: This oil company and others around the world will be increasing spending on oil exploration and production, even above already elevated forecasts.
Spending on exploration and development was already headed upward thanks to higher oil prices -- hence the rally in oil drilling and service stocks this year. For example, OPEC (the Organization of Petroleum Exporting Countries) just reported that its members had drilled 7.5% more wells in 2004 than in 2003 in response to higher oil prices. The number of oil rigs in operation by the 11-member oil cartel climbed 19% in 2004 after dropping by 6% in 2003. The boost in spending on oil exploration and development is the first for OPEC in almost 20 years.
Note that these figures, though just released by OPEC, cover 2004. There's good reason to believe that spending on exploration, drilling, and development has grown at an even faster rate in 2005. On Aug. 2, Wachovia Securities estimated that the 71% of oil exploration and production companies that had reported for the second quarter had increased their capital spending budgets for 2005 by an average 13%.
And that was before Katrina. I think capital spending budgets will rise again in Katrina's wake because of dual pressure from higher prices and the need to head off political criticism. That means more spending for exploration and development at a time when supplies of everything from steel tube to deep-water drilling platforms are extremely tight. Prices have already soared in response to tight supply and heavy demand, but it looks like they'll be spiking some more as 2005 continues.
Prices down, earnings up: time to buy
Which is why the recent dip, small though it is, in the price of oil drilling and service stocks -- in sympathy with the drop in the price of oil -- is a good opportunity to buy. Earnings, which are likely to explode for the oil service and drilling companies in the third quarter, haven't peaked by any means, and the dual pressures of higher prices and noisy politicians have just pushed the peak of the revenue cycle for these companies further into the future.
In my Wednesday morning appearance on CNBC's Morning Call, I recommended these three drilling and service stocks:
Weatherford International (WFT, news, msgs) is making the transition from a drilling services company focused almost exclusively on North America to one with a major presence in Europe, the Middle East, and Asia thanks to its acquisition of Precision Drilling. That deal, which closed on Aug. 31, also brought Weatherford 48 land rigs: 33 in the Middle East, 10 in Mexico and 5 in Venezuela. Revenue from these rigs should double by this time in 2006 as utilization and day rates rise. But the advantages of the deal don't end there: Precision had developed new directional drilling technology that promised to give the company a foothold in markets now dominated by the big three service companies of Schlumberger (SLB, news, msgs), Halliburton (HAL, news, msgs), and Baker Hughes (BHI, news, msgs). That technology should gradually enable Weatherford to expand into new markets. The stock now trades at 23.9 times projected 2005 earnings per share and at 17.6 times projected 2006 earnings. Our StockScouter rates the shares an 8 out of a possible 10.
Dril-Quip (DRQ, news, msgs) gets its biggest surge in revenue relatively late in the oil drilling cycle, which makes this a good time for this stock. As drillers and service companies work through inventory and see their order books fill up, they place more orders for Dril-Quip products such as specialty casing connectors, mud line suspension systems and sub sea wellhead connectors, where Dril-Quip owns about 30% of the market. The company has doubled its manufacturing capacity since 1998, the last peak in the oil drilling cycle, and now has the capacity to deliver about three times as much revenue as it did that year. Dril-Quip has just sold its first integrated undersea system, breaking into a $1.2 billion market that further increases the company's revenue opportunities over the new two to three years. The stock now trades at 32.3 times projected 2005 earnings per share and 21.9 times projected 2006 earnings. Our StockScouter rates these shares a 7 out of a possible 10.Jim Jubak's newsletter
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Ensco International (ESV, news, msgs) is a buy on the timing of the contracts for its fleet of 43 jack-up rigs. Only 39% of its fleet is under contract through 2006. In times of weak demand, that would be a problem because investors would be rightly worried about how many of those new rigs would wind up hired and at what rates. But with ocean drilling rigs in very short supply, the lack of contracts becomes a plus because it will allow Ensco International to sign 61% of its rigs to contracts at higher day rates. For example, the company recently signed a new contract with Saudi Arabia's Aramco at a day rate of $81,000, up from the mid-$50,000 range for the old contract. The shares now trade at 23 times estimated 2005 earnings per share but at just 12.6 times estimated 2006 earnings. And there's a good chance, in my opinion, that the Wall Street consensus on 2006 earnings is low. (My own estimate is 25 cents a share higher than the current consensus, for a 2006 forward PE of 11.6). Our Stock Scouter rates these shares a 9 out of a possible 10.
And, as always, I have two more exclusive picks for readers of CNBC.com on MSN Money.
Transocean (RIG, news, msgs), as a deep-sea drilling specialist, should reap the benefits as the oil industry goes ever deeper in its search for new oil. For example, in a recent sale of Gulf of Mexico leases, rights to the deepwater blocks sold for a record of $202 million, with the ultra-deep block accounting for 48% of total deepwater bids. The backlog for deepwater rigs has continued to climb, rising to 6,134 rig months on Sept. 9, according to Friedman Billings Ramsey, up 10% from the Aug. 5 level. Right now, 2006 is sold out. The Wall Street consensus projects earnings growth at Transocean at 438% in 2005 and at 143% in 2006. I think the 2006 projection, especially, is probably low. The P/E of 34.8 on projected 2005 earnings drops to 13.8 on projected 2006 earnings per share. Our Stock Scouter rates the shares a 7 out of a possible 10. (Transocean is a current member of my Jubak's Picks portfolio.)
Cooper Cameron (CAM, news, msgs) acquired Dresser's valve business for just $224 million (or about 0.5 times projected 2005 sales) at the beginning of September. That deal will just about double the size of Cooper Cameron's value business, just in time for orders for post-Katrina rebuilding and to catch the same late-cycle wave as Dril-Quip. The stock now trades at 24.8 times projected 2005 earnings per share of $2.89 and 19.2 times projected 2006 earnings of $3.68. Our StockScouter rates these shares an 8 out of a possible 10.
Editor's Note: A new Jubak’s Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: Transocean. He does not own short positions in any stock mentioned in this column.
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