A OS sector report issued by SSB on Friday. I highlighted a few key points........
A Slick Opportunity in Oil
Salomon Smith Barney
Friday, May 14, 1999
--SUMMARY:----Equity Strategy
*While stocks with exposure to oil have appreciated significantly from their recent lows, we believe they have further upside. Additional capital spending in 2000 should result in increased drilling activity and stronger profits for oilfield services and contract drilling *We recommend purchase of Schlumberger and Halliburton as the largest, most diversified players in the oilfield services sector. The contract drillers Noble Drilling and Transocean Offshore also appear attractive, as the deepwater segment remains the most attractive in the offshore drilling market.
The peak earnings power at Schlumberger and Halliburton could double from 1997 levels and Noble Drilling and Transocean Offshore could earn $4.95 and $7.40, respectively, at their peak.
--OPINION-------------------------------------------------------------------
For a number of years, oilfield services and contract drilling companies benefited from pricing power. New technology greatly improved exploration and drilling techniques, thereby allowing oil producers to lift more oil from each well and reduce the risk of drilling dry wells.
Because of the lower costs, the oil producers have been able to generate significant cash flow, which they have reinvested in replacement reserves, raising the demand for oilfield services companies' expertise. In 1998, this virtuous cycle came to an end with the collapse of oil prices. Regardless of how inexpensively companies could lift oil, the lowest oil prices seen in decades reduced the returns to oil producers and curtailed drilling activity. However, we believe overcapacity in the global oil market is beginning to correct and that rising oil prices will again fuel demand for oilfield services and contract drilling. Despite efforts to boost oil prices since early 1997, production cuts by OPEC and non-OPEC nations have largely resulted in a big yawn. Before their recent rebound, oil commodity prices have trended down since the beginning of 1997 (Figure 1), and until recently, market skepticism regarding the ability of these nations to stick to their pledged production cuts have contributed to the slide. Moreover, despite previous attempts at production cuts, global petroleum inventories have continued to rise. Sluggish demand from troubled emerging economies and two sequential winters of unseasonably mild weather further exacerbated the situation.
The latest round of production cuts, however, finally achieved the desired result. WTI oil prices have risen 68% from their closing price low of $10.73 per barrel last December. Oil producing nations met on March 26 and agreed to further production cuts, which brings the cumulative total pledged cuts to 4.3 million barrels per day. This time producers appear likely to stick to these cuts, and in fact, a May 10 report from the International Energy Agency (IEA) indicates that OPEC has achieved 85% compliance with its pledged cuts so far. Moreover, OECD inventory levels declined by 1.4 million barrels per day in February and March (vs. an historical decline of 1.0 million barrels per day) Analyst Paul Ting believes that Saudi Arabia will cut an additional 150 to 200 thousand barrels per day in May to raise its compliance to approximately 95%.
While we would not be surprised to see many of the oil producing nations exceed these new production levels eventually, we believe that oil prices will remain in a range substantially higher than they have been over the past two years. We note that even if oil prices do not rise from here, a relatively stable pricing environment should result in increased capital spending by the major oil companies, which, in turn, would result in increased drilling activity.
The reduction in drilling activity over the past two years has caused worldwide offshore rig utilization rates to decline to 75.6%, a 10 year low. Offshore utilization rates in the Gulf of Mexico have plummeted even further, to 61.7% from 96.6% a year ago. As a result, day rates have declined by as much as 70%, reducing revenues at the drilling and oilfield services companies. In response, companies have been cutting costs and reducing headcount in an effort to bolster balance sheets against the downturn in the industry. With the rebound in drilling activity that we anticipate, these leaner operators should enjoy margin improvement along with revenue growth.
Paul Ting believes that WTI oil prices should average $16.25 per barrel for 1999 and $18.00 per barrel in 2000. Under this assumption, we believe that capital spending will accelerate somewhat by year end and more markedly in 2000 as expanding refining margins entice producers back into the market. Moreover, with rig rates as depressed as they currently are, producers have an increased incentive to begin working down their capital spending budgets that have been underspent year to date.
Analyst Geoff Kieburtz notes that capital spending is anticipated to decline roughly 25% in 1999. He expects a moderate rebound in 2000, with capital spending growth of around 8%-10%. Potential upside exists if recent merger activity settles more quickly than anticipated and spending plans are finalized ahead of schedule. Moreover, Kieburtz points out that independent oil producers are once again able to access the equity markets and that balance sheet stress should become less of a constraint to capital spending.
The deepwater segment of the offshore drilling market remains the most attractive, in our opinion, owing to the long-term nature of its contracts and a large contracted backlog. This segment of the drilling market has seen rig utilization and day rates decline at a slower rate than the rest of the market and we expect that it will be the first and fastest segment to recover when E&P spending accelerates. The recent rise in natural gas prices could also add incremental demand for drilling services as gas producers return to the market as well. Moreover, improved technology has reduced the cost of drilling in these harsh environments. Recent deepwater discoveries near West Africa and Brazil bode particularly well for internationally diversified drillers, such as Noble Drilling Corporation and Transocean Offshore. Analyst Mark Urness notes that additional capacity is slated to come on line in this segment over the next couple of years, but we believe that demand in new markets such as West Africa and Brazil should help absorb the new drillships.
In the oilfield services market, we recommend Schlumberger and Halliburton. As the largest and most diversified players in the industry, they have the staying power necessary to weather industry downturns. Both companies are well recognized as industry leaders, owing to the array of services they are able to offer. Moreover, Halliburton's acquisition of Dresser Equipment last year added depth to its product portfolio, especially in the fluids, drilling services, subsea engineering, and engineering and construction segments. Significant upside earnings potential still exists for all these names, as Mark Urness believes that Noble Drilling could earn $4.95 and Transocean Offshore could earn $7.40 at their peaks. At these levels, dayrates would approximate replacement cost and additional capacity would become a threat. Geoff Kieburtz believes peak earnings power at Schlumberger and Halliburton could double the earnings they achieved in 1997. Both the oilfield services and the contract drilling markets are highly leveraged to oil prices and earnings should benefit now that prices are more favorable.
We believe that higher average oil prices will drive capital spending increases in 2000, and that drilling activity will pick up significantly. While there remains the risk that oil producing nations will become less disciplined as prices rise, we believe that another round of sustained oil price weakness is unlikely. Even if prices retreat somewhat from here, we believe capital spending budgets will return to more "normal" levels next year. While many of the stocks with oil exposure have already appreciated significantly, the magnitude of the declines since 1997 was much greater. We believe further upside exists in this group and recommend purchase of Schlumberger and Halliburton in the oilfield services sector, and Noble Drilling and Transocean Offshore in the contract drilling sector.
|
