After Disaster, Oil Service Bargains for Long-Term InvestorsDavid Bogoslaw
Less than a year ago, when low oil prices and uncertainty about the timing of an economic recovery made investors nervous about energy bets, the oilfield services industry was the place to be, since oil producers couldn't afford not to continue drilling. Now, in the wake of what's said to be the biggest environmental disaster in U.S. history, the near-term outlook for oilfield services companies doesn't look nearly as bright. But for investors willing to stick with battered stocks such as Cameron International (CAM) or Halliburton (HAL)—for a year or two—stiffer regulations on drilling in the Gulf of Mexico could mean enhanced opportunities. And while the sector remains risky, there could be some bargains.
The near-term impact of the blowout of BP's (BP) Deepwater Horizon rig has been rough on companies working in the Gulf. On May 27, President Obama declared a six-month moratorium on all deepwater drilling in the Gulf of Mexico, which affects all wells drilled in waters deeper than 500 feet. The following day, Interior Secretary Ken Salazar announced tough safety and control regulations on rigs working in the Gulf. And on June 1, the Obama Administration said it was investigating whether any criminal or civil laws were violated in the rig disaster.
But since about 30 percent of the oil the U.S. consumes comes from the Gulf, it's unlikely the Obama Administration would choose to permanently ban drilling there, say some analysts. The fact that minerals royalties are a major source of federal revenue makes that option even more unlikely, according to Tim Parker, an energy analyst at T. Rowe Price (TROW).
The ban on deepwater drilling is sure to hurt oil services companies' earnings for the second half of 2010 and for the full year. Parker expects earnings to be reduced by 5 percent to 10 percent on the low end and 10 percent to 15 percent on the upper end. The impact might be worse if companies don't trim their cost structures, says Parker, who expects them to move personnel around to manage expenses.
Still, Parker sees this as a short-term money issue. "If you have a one-year time horizon, you'll be very happy owning these stocks," he says. "You could own these things for the next two years and get them cheap for the next six months."
In a research note for FBR Capital Markets (FBCM) on May 27, Rob MacKenzie estimated that Transocean's (RIG) earnings before interest, taxes, depreciation, and amortization (EBITDA) for 2010 would drop by up to 14 percent if the deepwater permit moratorium were extended by six months and all its deepwater rigs working in the Gulf of Mexico went idle after its current wells for roughly another five months of downtime. Diamond Offshore's (DO) 2010 EBITDA would decrease by up to 28 percent under the same scenario. The financial impact of the drilling ban could be reduced if the rigs were hired to drill sidetrack wells, or secondary wellbores drilled away from the original hole, which are exempted from the drilling permit moratorium, or if rigs were moved to projects in other geographic regions, he wrote. MacKenzie reaffirmed his outperform rating on Transocean and market perform rating for Diamond Offshore.
Moving a rig to Brazil, the drilling region closest to the Gulf, would result in the loss of a month's worth of revenue for an operator, while a move to West Africa would cause an even longer disruption in revenue, says Geoff Kieburtz, an analyst at Weedon & Co. in Greenwich, Conn.
There's additional uncertainty for contractors if other operators take a cue from Cobalt International Energy (CIE), which on June 1 invoked the force majeure provision under its drilling contract with Diamond Offshore for a rig that was ready to start drilling an exploratory well in the Gulf. That means that revenues which contractors believed were locked in may not be if the operators refuse to pay, citing events beyond their control.
Of the big four multi-service companies, Baker Hughes (BHI) is most exposed to the Gulf of Mexico, where it generates a bigger portion of its total revenues relative to other regions, says Will Riley, co-manager of the Guinness Atkinson Global Energy Fund (GAGEX). "If you can get over the fact that earnings will be weak this year, the outlook for next year looks good," he says.
These companies' balance sheets are generally strong, so they can withstand short-term earnings pressure, Riley says. His fund, which manages $95 million in assets, has maintained both its direct and indirect exposure to the Gulf. While he doesn't own shares of Noble Group (NE) or Ensco International (ESV), two other companies that are active in the Gulf, he believes both would be good bargains fairly soon.
More risk-averse investors might want to avoid companies directly exposed to the Gulf of Mexico, but most stocks in the multi-services group have potentially fallen too far and will "require serious attention" fairly soon, says Riley.
Ironically, the stricter safety regulations the Interior Dept. is calling for will likely increase oil services companies' revenues in the long term as some of the services they aren't currently required to provide will be mandated in the future, says Parker of T. Rowe Price. Enhanced safety procedures could include stronger control systems such as a cement bond log, which gauges the quality of a cement bond on a well's exterior casing by measuring variations in the acoustic signal traveling down the casing wall between a transmitter and receiver. "[Currently], you don't have to do that for every job." Halliburton is one of the leading providers of this service.
Another gainer from new rules might be Cameron International, which made the blowout preventer, or BOP, installed on the Deepwater Horizon rig. The company probably won't be held liable for the Apr. 20 explosion, since the various problems with the blowout preventer that may have caused its malfunction aren't the result of a product defect or design flaw, Gabelli & Co. said in a May 25 research note. Cameron, with about a 40 percent share of the BOP market, "will be a beneficiary of a new equipment cycle to increase safety standards" for offshore drilling. Blowout preventers represent an estimated 10 percent to 15 percent of Cameron's annual revenue, the note said.
One recommendation from the Interior Dept. is that every floating rig in the Gulf would have to have redundant shear rams—the part of the blowout preventer that cuts through drill pipe and forms a seal against well pressure—as a backup safety measure. Although the Deepwater Horizon rig did have two shear rams, that isn't a typical configuration, says Weedon's Kieburtz. Multiple shear rams would boost equipment sales for Cameron and the other leading BOP manufacturer, National Oilwell Varco (NOV), he adds.
Cameron and National Oilwell would also benefit from increased aftermarket activity if new regulations require the original blowout preventer manufacturers to have a hand in maintenance after sales to contractors. Transocean had done all the maintenance on the blowout preventer involved in the Deepwater Horizon incident since buying it from Cameron in 2001.
Shares of other drilling equipment manufacturers, such as FMC Technologies (FTI) and Dril-Quip (DRQ), have dropped considerably since the oil spill, making them more attractive to investors willing to take a risk. Riley says he's always believed they were relatively expensive stocks to own, but for investors who can get comfortable with valuations, the new regulatory environment should boost these companies' sales.
Two other names in the industry, Oceaneering International (OII) and Subsea 7 (S8J:GR), which manufacture underwater remotely operated vehicles, or ROVs—the tethered robots that function as oil producers' eyes and hands on the ocean floor—stand to gain from improved operating capabilities in ROVs that may be required as a result of the BP disaster, says Parker at T. Rowe Price.