The oil sector's real winners - Jubak's Journal

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Posted 5/25/2005

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Jubak's Journal
The oil sector's real winners

Oil service and drilling companies are seeing strong demand as big oil companies buy equipment to get more crude out of the ground.

By Jim Jubak

The price of a barrel of oil doesn't look like it's headed down to $40 or even $45 any time soon. After slipping below $50 a barrel, it seems to have stabilized somewhere north of $47 to $48.

That's good for oil stocks, of course. On Monday, when oil futures for benchmark light sweet crude for July delivery gained 51 cents to end the day at $49.16, Exxon Mobil (XOM, news, msgs) climbed 1.4%, ChevronTexaco (CVX, news, msgs) gained 1.6% and Shell Transport & Trading (SC, news, msgs) rose 1.2%.

But the biggest winners over the next six months from stable or modestly rising oil prices aren't going to be the big integrated oil producers. Instead, they'll be the oil service and drilling companies.
Why pick oil drillers and service stocks over oil producers if prices are stuck near $50 for the next few months? I can think of three reasons.

Catching up
First, the conservatism of the oil industry, especially of the big integrated producers such as Exxon Mobil, means that oil service and drilling stocks have lagged behind oil price increases. Now they're set to catch up.

Oil exploration and production companies are notoriously reluctant to raise their exploration and production budgets until they can be sure that the price of oil isn't going to fall. At the start of the recent big price jump, exploration and production companies were using a figure of $18 a barrel or less to calculate whether it was worth exploring in an unproven but promising formation or drilling new wells to tap promising new deposits. Then with prices above $30, they inched their planning targets up to $20 and then to $25. If oil prices stabilize near $50 for a while, I'd expect the target to move up to $30 or, for the daring, maybe $35. This means that even if the price of oil merely stays in the current grove the drilling and service companies will see big increases in their businesses.

Second, most of the costs at the oil drilling and service companies are fixed, so their earnings are highly leveraged to utilization and day rates. Take a relatively small drilling contractor like Helmerich & Payne (HP, news, msgs) for example. The company owns 131 rigs that it rents out to oil producers drilling for new oil and gas. In the March quarter the day rates the company gets for its rigs soared ahead 12% from the previous quarter, but earnings per share jumped 23% as cash margins per rig jumped 25%.

Increasing visibility
Third, as day rates climb and oil drilling companies sign contracts that stretch out in 2006 and beyond, Wall Street becomes more confident that the profit cycle for these companies hasn't peaked. And analysts become more confident about projecting earnings growth. Wall Street calls that "visibility" and as it increases the price-to-earnings multiples for these stocks will inch ahead.

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For example, the market now values Transocean (RIG, news, msgs) at just 14 times projected 2006 earnings per share despite Wall Street projections of better than 100% earnings growth that year. As investors get more confident that growth will continue into 2007 and 2008, that multiple on 2006 earnings will rise, and so will the stock.

Here are the three picks in the drilling and oil service sector that I made Wednesday on CNBC's "Morning Call."

Outpacing the industry

Helmerich & Payne specializes in deep drilling for natural gas in the United States and drilling for oil and gas in remote areas in South America. Profit margins are growing quite nicely, thank you, along with the industry. But they have the potential to outstrip competitors because of the company's investment in next generation FlexiRigs, which command a premium day rate because they're highly mobile and allow drilling at flexible depths from 8,000 to 15,000 feet. The company began deploying these rigs in 1998 and they now make up 50 of the company's fleet of 131 drilling rigs.

Wall Street projects earnings growth of 152% in the fiscal year that ends in September, to be followed by 45% growth in fiscal 2006. The stock trades at 21.2 times projected fiscal 2005 earnings per share and 14.6 times projected fiscal 2006 earnings. Our StockScouter rated the stock a 5 out of a possible 10 on May 25.

A rising rig count

Nabors Industries (NBR, news, msgs) is a margin story like Helmerich & Payne but with an increased rig-count kicker providing an extra boost to the stock. Like Helmerich & Payne, Nabors saw day rates and margins for its drilling rigs soar in the first quarter. Daily rig margins increased by 45% from the fourth quarter. The company has projected another 10% increase in rig margins this quarter.

That's solid growth but at a slower rate, so why buy the stock now? Because growth in rig counts is about to kick in to more than pick up the slack. Nabors expects to reactivate 20 to 30 rigs this year and says that most already have been signed to contracts. Nabors has decided to not just refurbish these rigs but also to upgrade them to the leading edge of current technology. This raises the cost per rig to $7.5 million to $8 million from the $4 million to $5 million refurbishment cost, but the company can then sign the rig to a contract at the highest end of today's prices.

Nabors also is seeing rig count growth internationally where the company has just added 10 new rigs in Saudi Arabia, a huge jump over the 14 that were in operation in that country. The company told Wall Street that international operating income will jump 40% to 50% in 2005 and in 2006. The stock trades at 16.5 times projected 2005 earnings per share. Our StockScouter rated the stock a 10 on May 25.

Plenty of capacity

Patterson-UTI (PTEN, news, msgs) (PTEN) will activate 30 rigs in 2005, which is 50% above the company's previous guidance to Wall Street. But Patterson-UTI still has plenty of capacity to put to use thanks to its January 2005 and February 2004 acquisitions of 35 and 18 rigs, respectively.

Patterson-UTI finished 2004 with just under 60% of its rigs under contract. This isn't to say that the company hasn't been getting the full advantage of rising rig day rates. Rig margin increased by $1,180, or 30% in the first quarter from the fourth quarter. The company projects an increase in rig margin of $830, or 16%, this quarter.

Wall Street projects a 163% increase in earnings per share this year and a 31% increase in 2006. The stock trades at 14.6 times projected 2005 earnings per share. Our StockScouter rated the stock a 7 on May 25.

Exclusive picks
As always, I have two exclusive picks for CNBC.com on MSN readers.

Transocean is a specialist in deepwater drilling. With supply of deepwater drill ships extremely tight -- and extreme deepwater drilling in the Gulf of Mexico about to show a big pick up -- Transocean is seeing huge increases in day rates for its fleet of 32 deepwater rigs. The company has told Wall Street that current discussions are for rates in the range of $260,000 to $350,000 a day for contracts of two to three years. Contracts of that duration, if actually signed, would give Wall Street confidence in the company's revenue and earnings numbers into 2008. This fleet is 84% booked for this year and 46% booked for 2006.

The stock trades at 14.1 times projected 2006 earnings per share. Our StockScouter rated the stock a 7 on May 25. (Transocean is one of my Jubak's Picks as well. I added it to that portfolio on April 26.)

Grant Prideco (GRP, news, msgs) (GRP) makes its money by selling things like pipe and drill bits to the companies that do the actual drilling. So every new rig they put to work -- and every extra day that rig works -- lights up the cash register at Grant Prideco.

Order backlog rose to $411 million at the end of March from $292 in December: That's a huge backlog for a company with first quarter revenue of $292 million. As you'd expect, that kind of backlog has given the company the power to raise prices -- a 7% increase is scheduled to take effect this month.

Wall Street projects earnings growth of 140% this year, dropping to 20% in 2006. The stock sells for 18 times projected 2005 earnings per share. Our StockScouter rated the stock a 7 on May 25.

Editor's Note: A new Jubaks 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 in 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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