Oil and Gas Servicer Warnings Present Good Opportunity

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The world’s leading oil and gas service company, Schlumberger (NYSE: SLB), released an earnings warning due to project delays in Europe, Commonwealth of Independent States and Africa, as well as a slowdown in drilling activity in North America. Earnings therefore are expected to be up to $0.07 lower than expected.

Its rival, Baker Hughes (NYSE: BHI), in a report released earlier in December, has also said that the international rig count (excluding North America) for November stood at 1,267, which is 0.64% more than the prior month and 6.92% more than November 2011. However, within North America, the U.S rig count has fallen by 1.36% from October and by 10.04% from November of last year to 1,809 rigs. There are 305 less rigs operating in North America now than there were in November 2011.   

Lower North American rig counts should not surprise anyone with the collapse in U.S. natural gas prices over the last 18 months.  Moreover, the North American oil companies are scaling back on their spending with many opting to focus on more lucrative and less risky assets. More activity in the U.S. is expected to come in the next quarter after some of the leading energy firms, such as ConocoPhillips, announced their annual capital budgets for 2013.   

We’ll see a period of lower production growth and greater exploration confirming new reserves while prices return back to the $4 per million BTU level that the industry would love to get back to.  Increasing U.S. production and lack of domestic demand and transport infrastructure has created an odd disconnect with the rest of the world that should begin working itself out in 2013. 

<table> <tbody> <tr> <td> <p><strong>Year End Price</strong></p> </td> <td> <p><strong>U.S. Natural Gas</strong></p> </td> <td> <p><strong>Brent Crude</strong></p> </td> <td> <p><strong>WTI Crude</strong></p> </td> </tr> <tr> <td> <p><strong>2010</strong></p> </td> <td> <p>$5.297</p> </td> <td> <p>$71.36</p> </td> <td> <p>$72.80</p> </td> </tr> <tr> <td> <p><strong>2011</strong></p> </td> <td> <p>$4.396</p> </td> <td> <p>$111.11</p> </td> <td> <p>$98.45</p> </td> </tr> <tr> <td> <p><strong>2012 (12/21/2010 close)</strong></p> </td> <td> <p>$3.445</p> </td> <td> <p>$109.10</p> </td> <td> <p>$88.90</p> </td> </tr> </tbody> </table>

After releasing the report, Baker Hughes also said that it is expecting a drop in earnings for the fourth quarter but since the report was already out, this comes as no surprise. The company’s operating profit margin in North America is going to drop from 11.7% in the previous quarter to 8.5%-9.5% in the current. Baker Hughes’s rig count from international operations fell by 17% sequentially in the previous quarter due to drop in demand in Brazil and Columbia and project delays in the North Sea and Iraq.  However, the company has reiterated that its operating margin from international operations will remain around 12%. Analysts are now expecting the company to report quarterly EPS of around $0.62. The business reported a diluted EPS (excluding extraordinary items) of $0.60 in the previous quarter and $0.72 for the quarter ending December 2011.

The decline in rigs in North America will hit both Baker Hughes and Halliburton (NYSE: HAL) harder than Schlumberger as the latter has an impressive international presence and earns just 30% of its revenues from North America. Last month, Halliburton’s chief had warned shareholders that the coming quarters are going to be difficult due to the North American slowdown and the volatility in prices of guar gum. Halliburton has been trying to diversify its North America focused portfolio. About a month ago, it signed a $1.2 billion agreement with Malaysia-based Dialog Group. The company already has a good working relationship with the Malaysian oil giant Petronas and the two have worked together on Bayan oil fields in the past.  

The slump in natural gas prices has impacted the margins across the industry. Natural gas drilling is a high-margin operation but the glut has spurred oil production, a lower-margin operation for oil and gas service firms, especially with WTI Crude trading below $90 per barrel.  However, the question is what is the near term future for oil prices? 

Oil is trapped between its rising extraction costs from unconventional sources, like shale, tar sands and offshore drilling, and stagnant demand at present, which is as much a product of the Fed’s volatile monetary policy for the past 18 months as anything else – ultimately long-term neutral with sterilized QE measures and falling total Fed credit.  The Fed is now on the side of rising commodity prices with unsterilized QE.  The last time the Fed turned to expansionist the price of Brent Crude (NYSEMKT: BNO) rose from $103 to $125 per barrel in less than 3 months.

<table> <tbody> <tr> <td> <p><strong> </strong></p> </td> <td> <p><strong>Schlumberger</strong></p> </td> <td> <p><strong>Baker Hughes</strong></p> </td> <td> <p><strong>Halliburton</strong></p> </td> </tr> <tr> <td> <p><strong>Stock YTD</strong></p> </td> <td> <p><strong>4.45%</strong></p> </td> <td> <p><strong>-13.80%</strong></p> </td> <td> <p><strong>0.84%</strong></p> </td> </tr> <tr> <td> <p><strong>P/E</strong></p> </td> <td> <p>17.28</p> </td> <td> <p>13.08</p> </td> <td> <p>11.24</p> </td> </tr> <tr> <td> <p><strong>EPS</strong></p> </td> <td> <p>4.13</p> </td> <td> <p>3.21</p> </td> <td> <p>3.1</p> </td> </tr> <tr> <td> <p><strong>Yield</strong></p> </td> <td> <p>1.60%</p> </td> <td> <p>1.50%</p> </td> <td> <p>1.10%</p> </td> </tr> <tr> <td> <p><strong>ROA</strong></p> </td> <td> <p>8.32%</p> </td> <td> <p>6.31%</p> </td> <td> <p>12.91%</p> </td> </tr> <tr> <td> <p><strong>ROE</strong></p> </td> <td> <p>16.87%</p> </td> <td> <p>8.61%</p> </td> <td> <p>21.05%</p> </td> </tr> </tbody> </table>

While the near term for the oil servicers looks mixed to negative at best, the long-term fundamentals for oil and gas demand are still very bullish both from the perspective of numerical demand – Southeast Asia’s growth alone will drive this – and a monetary perspective as the West’s central banks will have to continue providing liquidity to offset mountains of debt that is deflating.  I like Schlumberger in the short term due to its international portfolio and Baker Hughes and Halliburton in the longer term as their U.S. business will be the backbone of a U.S. renaissance in oil and gas production.

A possible natural gas long side play would be to sell long-dated out of the money puts in the United States Natural Gas ETF (NYSEMKT: UNG). $15 January 2014 Puts are trading around $1.00 and provide good value there.  This leaves you plenty of room to account for any disruptions due to the fiscal cliff and a collapse of the U.S. economy. If prices crash again, then you are picking up a valuable commodity at a price that is far lower than its international price and time works to your advantage as the U.S. builds out its LNG infrastructure.



PeterPham8 has no positions in the stocks mentioned above. The Motley Fool owns shares of Halliburton Company. Motley Fool newsletter services recommend Halliburton Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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