Something I found while surfin,thought it might be of interest to the board. NOTE DATE!
Also referense to Simmon's
DECEMBER 1, 1998
Bullish On Oil
by Joel Ramin
What do oil and water have in common? These days, their value.
Few industries are as depressed as the oil industry. Even fewer have as much
upside potential. Within the industry, oil services companies are the best play on
current conditions and Schlumberger is the leader of the pack.
Cheap oil is killing the industry. With the benchmark Brent crude oil trading at
$10.48 a barrel as opposed to $19.07 one year ago, the volatile commodity is
barely up from its 10 year low. Collapsing oil prices have dragged oil stocks down
with them. The Philadelphia Stock Exchange Oil Services Index plunged 49% this
year through September. Oil service stocks in particular have spent the past six
months nose-diving from their 52-week highs and the three largest companies are
bruised and battered. Schlumberger is off by 44%, Halliburton is down by 43%
and Baker Hughes has tanked by 55%. But recently, oil prices have stabilized,
inching their way up from long-term lows reached in June. A few oil stocks
languishing near record lows have dusted off their running shoes and are
preparing to join the Dow in the race back up to all-time highs.
The oil industry has followed Murphy's Law to a tee. Everything that could go
wrong, has, pushing oil prices to painfully low levels and choking the industry's
profits. The Asian crisis reduced demand for oil in the world's
fastest growing region. As prices plummeted, OPEC increased
their oil supply by 10%, exerting even greater downward
pressure on already reeling prices. El Nino surprised the world
with bizarre weather patterns, bringing unusually warm
winters to the Americas and to Europe and pinching demand
for heating oil. As if that was not enough, politics have
joined in on the beating. Benjamin Netanyahu and Yasar
Arafat's struggle over land in Israel have made for very tense
times in the Middle East. Saddam Hussein is antagonizing the United Nations and
seems to be begging for US air strikes. The uncertainty underlying these leaders
and their decisions have elicited fears that the perennially warring region may
explode, chasing fearful investors away from the commodity that is so closely
linked to that region. Wall Street still remembers the 9.6% bite that Iraq's
invasion of Kuwait took out of the Dow Jones Industrials in one week and the
carnage it caused the oil stocks. In the three weeks after the day that Saddam
Hussein invaded Kuwait, Schlumberger fell 10%, Halliburton shed 12% and Baker
Hughes gave up 14%. In Nigeria, one of the world's largest crude oil suppliers,
political unrest following the sudden death of opposition leader Moshood Abiola
only added to the instability surrounding oil. However, these conditions are poised
to turn around, making now prime time to invest in the oil industry - especially
Schlumberger.
Oil prices are a function of supply and demand. When supply goes up and demand
goes down, prices dive. Decreases in oil supply stimulate oil prices similarly to the
way that interest rate cuts stimulate the financial markets. The beauty about
this industry though, is that instead of waiting for the Fed to change the rates,
the very countries that produce oil decide when to cut supply. Can you imagine if
Chase or Citibank could just cut interest rates at will? The problem is that many
of the OPEC nations agree to decrease supply and then each individual nation
actually increases its share behind everyone's back in order to squeeze out extra
profits. OPEC has been promising to lower supply for months but the market does
not believe them and prices continued to slide. But every country has its breaking
point. Crude oil selling at less than $14 a barrel is unbearable not only for U.S. oil
companies, but even more so for every country that produces oil. Vahan
Zanoyan, who has attended OPEC meetings for 15 years as president of
Petroleum Finance Co., a Washington, D.C. based consulting firm, says that Saudi
Arabia starts feeling severe pain when crude oil prices near $14, and Venezuela
when they hit $11.
OPEC shot itself in the foot last November when the cartel
gave each of its 11 members the go-ahead to boost
production by 10%, from 25 million barrels per day to 27.5
million. In addition, Iraq has been permitted to increase its oil
production in lieu of the UN sanctioned food-for-oil sale. The
risk of any more oil flooding the market and prices falling
even lower is mitigated by the fact that world
energy-production capacity utilization is firing on all cylinders
at 95%, leaving very little room to increase supply without
greatly increasing costs as well.
The current increase in supply drove prices below OPEC's
threshold and those nations have since met to alter their strategy. Cornered by
intense pricing pressures, many OPEC and non-OPEC countries formally signed the
Riyad agreement in March and the Amsterdam agreement in June as well as other
informal agreements. One round of promised cuts totaling 450,000 bpd boosted
crude oil prices up over 5% in seven days. The increase indicates the power that
supply has over price, but that level was not sustained because of the world's
lack of confidence in OPEC to stick to their word. The countries have agreed to
cut between 1 and 1.5 million barrels of oil a day, which should dramatically lift
prices. However, the price of oil has only slightly reacted, indicating that the
market will believe it when they see it.
Although the Asian crisis has slowed demand for everything under the sun, the
market has overreacted to its impact on oil companies. Cambridge Energy
Research Associates reported that, "Even if the current economic crisis reduces
growth in Asia's oil demand to just 1% in each of the next 3 years, compared
with an average 5.2% from 1990 to 1995, demand would still be 9 million barrels
of oil per day higher in 2010 than in 1996 - an increase greater than the entire
current output of Saudi Arabia." The international oil services companies have
been making plans for China and India, identifying them as major potential growth
areas. Because of the Asian crisis, their stocks have taken it on the chin. Crisis
or no crisis though, eventually China and India will be flooded with cars and the
demand for gasoline will create profits.
Perhaps the greatest variable effecting the oil industry is good old mother earth.
Abnormally warm weather like this past year and we could see oil stocks trading
at half of today's prices. El Nino peaked in December, yielding cooler weather
ever since and giving hope that this Christmas may well be a white one. Colder
weather brings greater demand for heating oil and greater profits to the
companies associated with it. El Nino also sent storms ripping through the Gulf of
Mexico earlier this year, erasing 10-15 business days during the quarter. Although
the market seems to have discounted such events as annual occurrences, the
weather experts do not expect the return of such conditions any time soon.
Having determined that the oil industry is primed for serious
growth, let's continue with this top down analysis to find the
best way to invest your money. Within the industry there are
two major areas. There are the oil producers like Mobil, Exxon
and British Petroleum and there are the oil services
companies like Schlumberger, Halliburton and Baker Hughes
that find oil and get it out of the ground. The oil services are
better investments right now for a few reasons. The services
will react faster and more emphatically to the current
situation. Producers' value will only start to climb after the
price of oil actually begins an upward trend. Since the oil
producers tend to have large cash flows, they trust their analysts to anticipate
rises in oil prices and then act on those forecasts by signing contracts to spend
more on exploration and development. The service companies are in charge of
exploring and developing oil and as a result reap profits from digging contracts
before the producers make money from selling the oil. Not only that, but if the
producers are wrong and oil prices drop, the service companies involved in
offshore and deep sea drilling, which require much longer-term contracts, will lock
in profits while the producers absorb the losses.
The integrated oil companies like Mobil and Exxon are not only sellers of crude oil,
but they are buyers as well. When oil prices fall, their largest input cost for
refineries falls too, allowing for greater margins in the sale of refined oil products.
Because the producers have ways of making money off cheap oil too, they are
not as sensitive to changes in oil prices as the services companies are.
Oil services companies were the place to be during the oil booms of the 1980's
and 1990's. The Simmon's Large-Cap Oil Service Index developed by the
investment bank, Simmons & Co. International, soared 67% in the 12 months
following oil prices bottoming out at $10.40 in March, 1986, as compared to 34%
for the S&P 500. The same index returned 54% as opposed to the S&P's 28% in
the year following the October 1988 depths of $12.60 a barrel. Once again, in the
12 months after December 1993 supported $13.91 a barrel, the Simmons index
popped up 17%, outperforming the S&P's 14% return for the same period.
If you are still not convinced that now is the time to invest in oil services, believe
those who know best; the insiders. Upper level management throughout the
industry is snapping up undervalued stocks with a sense of urgency. Insiders at
Enron, Ensco, Apache, Offshore Logistics, Nabors Industries, Triton Energy, Global
Marine, and Schlumberger are all accumulating their own company's depressed
shares. Oil service insiders were reliable judges of oil prices in the fall of 1997
when their heavy selling precipitated sharp oil price declines.
The oil services industry is replete with many small players who pick up the
scraps of the bellwethers. Schlumberger and Halliburton are the biggest with
Baker Hughes rounding out the three main competitors. Their operating revenues
are $10.65 billion, $8.82 billion and $3.69 billion respectively. These companies
provide the equipment and tools necessary for drilling. They find the oil and get it
out of the ground. The recent swoon in oil prices has forced these stars to
reduce costs. They have all responded by laying off workers and by consolidating
to capture synergies and reduce overhead. Baker Hughes merged with geological
data specialist Western Atlas in a $4.8 billion stock deal, Halliburton acquired
Dresser Industries for $5.4 billion in the biggest deal the industry has ever seen,
and Schlumberger gobbled up Camco, a drilling-products manufacturer, for $2.2
billion.
If you like the upside potential that the undervalued industry has to offer and
want to hedge out most of the downside risk that unstable oil prices have on the
companies, buy Schlumberger. Darwinism is taking control here. The giants are
taking hits, but the shakeout will force consolidation and elimination of the smaller
competitors, resulting in greater rewards for any survivors.
For decades, Schlumberger has been the leader of big oil. It sets the pace for
technological advances. These days, improved technology is permeating the
industry. Directional drilling, coiled tubing applications, jack-up rigs and
three-dimensional seismic imaging have made oil services faster, cheaper, and
more efficient. Every reservoir of oil that is discovered makes the next one harder
to find. This increases demand for Schlumberger's state of the art exploration
equipment and efficiency techniques, which extract as much
oil as possible from existing wells. If oil prices remain
depressed and the days of $18 barrels are over, then
cheaper exploration will be essential and only those
companies with the money to keep up with the technological
advances will remain in business. In 1997 Schlumberger
pumped $486.2 million into research and development,
leaving it with net income of $1.30 billion. Halliburton, on the
other hand, invested $164.7 million in R&D, finishing 1997
with a net income of $454.4 million - one- third of
Schlumberger's. Baker Hughes spent $118 million on R&D,
resulting in a net income of $97 million.
Schlumberger is the most diversified of the big oil companies. Its business
comprises three industry segments. Oilfield services is dominant and supports the
smaller Measurement and Systems segment, which supplies technology, services
and products to the semiconductor, banking, telecommunication, healthcare and
oil industries. Measurement and Systems is also a global solutions provider to
energy resource industry clients. Schlumberger's smallest segment is a joint
venture with Britain's Cable & Wireless to sell computer technology to energy
companies in remote regions. In addition to product diversification,
Schlumberger's international presence gives it advantageous global exposure. Oil
exploration costs in the U.S. are approximately twice as much as they are
over-seas, due to larger sites and less competition. Schlumberger concentrates
on Europe, generating 1997 operating income in Europe of $349 million as
compared to Halliburton's $101.2 million, and $374 million in the U.S. as opposed
to Halliburton's $617.1.
Schlumberger is sitting on an inordinate amount of cash right now. As of the end
of the third quarter of 1998, Schlumberger has $3.87 billion in cash. Compare this
to Halliburton's $145.4 million and Baker Hughes' $8.4 million and you get an idea
of just how abnormal that cash pool is. It seems that some kind of move is
imminent. Another stock repurchase is out of the question because of a
stipulation in the Camco deal. Having just acquired Camco, purchasing yet
another company would be a bit irregular, making it extremely difficult to
integrate so many different operations and management. Despite the apparent
irregularity, Schlumberger's abundance of cash and the cheap valuation of oil
companies these days, makes another acquisition likely. Barron's is speculating
that perhaps Smith International, a drill bit and drilling fluid manufacturer, with
whom Schlumberger already has a joint venture, is the target. R&B Falcon, Global
Marine, Ocean Energy, Noble Drilling, and Transocean Offshore are other
possibilities. Schlumberger could forgo any company purchases and buy heavy
equipment instead. However, $3.87 billion is an awful lot to spend on equipment.
One possibility is that Schlumberger will make a purchase in line with its Resource
Management Services segment. Another bold scenario would entail
Schlumberger's acquisition of an oil producing company in order to be the first of
the big oil companies to attempt vertical integration.
In times of turmoil, confident leadership and experienced management is key.
Euan Baird, CEO of Schlumberger, has been at the helm since 1985 and has an
intimate knowledge of the business. He has been with the company and much of
the same management team through the ups and the downs. Baird has pulled
Schlumberger through adverse industry conditions in the past and is taking
proactive measures to lead the oil giant into prosperity again.
Given the current situation there are many different plays you can make. If you're
a gambler, grab some oil futures and hold on for dear life. You can also bet on a
specific niche within the oil services industry such as offshore drilling (Diamond
Offshore is the fastest growing of these), deep water rigging (Gulf Marine is the
leader here), or land drilling (Nabors Industries is the world's largest). So go
ahead and buy your futures. Make your niche bets. They may make you a very
rich person not too long from now. I, on the other hand, would rather have
ownership in a company that has been around for more than half a century, sit
on the 1.46% dividend yield, wait six months or one year or five years, whatever
it takes for this blue-chip, bellwether, oil giant to climb back up to $100 a share.
And I'll sleep like a baby every single night until then. Sweet dreams.
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