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5 stocks playing catch-up with oil
Analysts and oil companies still are pushing up their estimates for the price of oil. Oil drilling stocks offer the biggest leverage on the difference between actual oil prices and projected oil prices.
By Jim Jubak
Is it too late to buy, or to add to your, shares of oil producers, oil service companies or oil drillers? Maybe you didn't buy at $40 or at $50. Should you buy now that oil has finally closed above $60 a barrel?
The answer is yes, even after Tuesday's big 4% decline to $58.20 a barrel -- if you buy carefully with an eye on getting the most bang for your investment buck. (It's an even more emphatic yes if Tuesday's decline turns into a dip on profit-taking before the long holiday weekend.)
I know it can be scary buying into a trend that has run as long and hard as this one has. The price of oil is 60% higher than it was a year ago. And stocks in the sector have soared in that time. Apache (APA, news, msgs) has jumped 50%, Chesapeake Energy (CHK, news, msgs) has climbed 60% and Talisman Energy (TLM, news, msgs) has leapt 80%. The SPDR Energy (XLE, news, msgs) exchange-traded fund (ETF) for the sector is up 50%.
Mighty oaks from little acorns may grow, but Wall Street experience warns us that trees don't grow to the sky. All trends end some time. Bubbles burst. Stock rockets flame out. Today's $200 stock is tomorrow's $2 stock.
All too true.
Longer than expected
But stock market history also shows over and over again that trends go on longer than investors think. For example, we all know that the housing boom isn't sustainable at its current growth rate, but when will the trend of ever-rising prices end? Business Week wondered just that in an article headlined "Is a housing bubble about to burst?" on July 19, 2004.
About all that's safe to say now is that we're closer to the end of the current trend now than we were when Business Week asked its question a year ago. And that in the period since the Business Week article ran to the close on June 27 the shares of home builders Hovnanian Enterprises (HOV, news, msgs) have jumped 104%, Ryland Group (RYL, news, msgs) have risen 106% and Toll Brothers (TOL, news, msgs) have climbed 151%.
But notice the difference in the gains posted by home builders and oil companies. The appreciation in oil stocks lags the gain in the price of oil. That's evidence oil stocks still are grounded in reality. In fact, for the last year, oil shares have climbed the famous Wall Street wall of worry as investors, analysts and oil company executives have stubbornly waited for oil to pull back to more "reasonable" price levels. The truth is that the most aggressive major oil companies like Shell Transport & Trading (SC, news, msgs) have just recently started to plan on $40 oil. Analysts are still playing catch up: In the last week I've seen two major analysts raise their projections for the 2005 price of oil to $48 a barrel and $53 a barrel, still well below the current price.
A preference
It's that catch-up factor that'll take oil stocks higher, and it's the reason that I prefer oil drilling and service stocks to oil producing stocks now. Oil drilling stocks offer the biggest leverage on the difference between actual oil prices and projected oil prices.
Here's how it works. In December, when Smith Barney surveyed oil producers on their planned exploration and production spending, the survey showed that spending outside North America would climb 3.9% in 2005 from 2004. Smith Barney's just completed mid-year survey, however, shows a 13.1% increase. That huge acceleration is a reaction to the companies' growing belief that oil prices will certainly stay above $40 and maybe above $50 and possibly above $60 for the foreseeable future.
To see the leverage at work, apply that higher spending to an oil services industry leader such as Schlumberger (SLB, news, msgs).
In the first quarter, Schlumberger's results finally broke with the lackluster performance of 2004. Revenue grew 18% from a year earlier and eked out a 2% gain from the fourth quarter. But since, like most oil drilling and service companies, a high percentage of Schlumberger's costs are fixed, the increase in revenue resulted in those fixed costs being spread over a larger revenue base. The result was a big pickup in the profit margin based on earning before interest and taxes. It reached 20.1% in the first quarter from 17.7% in the fourth quarter.
Wall Street now expects Schlumberger's earnings to climb 39% in the June quarter (to be reported on July 22 before the market opens) and 37% in the September quarter. Given what Smith Barney found in its latest spending survey, those numbers could well be low.
The purer the better
But as well as shares of Schlumberger should do for investors, the shares of pure drilling companies will do even better because these companies will see higher margins from two sources. First, like Schlumberger, they'll get cost margin improvement from spreading their fixed costs over a larger revenue base. Second, they get price margin improvement as the relative scarcity of drilling equipment earns them higher day rates.
And now, not only are those companies seeing higher prices for their rigs but also prices are climbing at a faster rate than they were at the beginning of the year.
For example, here are increases in the day rates for offshore drilling rigs, according to Sanford Bernstein. Day rates for the average jack-up rig jumped 18% in May from the same month last year. That's up from a 13% climb in day rates for this kind of drilling rig in the first quarter. Shallow floating rigs showed a 13% increase in May after rising 2% in the first quarter. And in the segment where supply is tightest, deepwater rigs, day rates climbed 25% in May after increasing 9% in the first quarter.
Why the acceleration in day rates? The world has temporarily run out of offshore drilling rigs just as oil exploration and production companies want more. In all categories, Sanford Bernstein calculates, effective rig utilization is at 100%. Since the year's beginning worldwide demand for rigs is up by 16 but only five are scheduled for delivery through the end of the year.
Here are the three picks I made during my 11:20 a.m. Wednesday appearance on CNBC's "Morning Call."
Big boosts
GlobalSantaFe (GSF, news, msgs). Cash flow projections drive oil service stocks, and GlobalSantaFe looks to have the sector's best cash flow prospects. With two new deepwater rigs and the reactivation of a third, the company will add about $500,000 a day to revenue. Six other rigs -- out of the company's 59 -- are set to finish contracts at what are now below-market rates and the company already has signed new contracts for these rigs that'll add another $500,000 a day to revenue. That would just about double the company's revenue from its floating rigs.
Despite this cash-flow surge, the shares are trading at the average price-to-earnings ratio for the sector on 2005 earnings projections and below the average on 2006 projections. Our StockScouter rated the stock a 9 out of a potential 10 on June 29.
Using leverage
Noble (NE, news, msgs). According to J.P. Morgan, Noble has the highest leverage to the international jack-up rig market. Remember that day rates in that sector jumped 18% in May? Well, every $5,000 increase in international jack-up day rates adds 44 cents a share in annual earnings to Noble, J.P. Morgan calculates.
In the Gulf of Mexico, a hot area for new drilling now, Noble's leverage adds 16 cents a share to annual earnings for each $10,000 increase in day-rates for jack-up rigs. Noble's fleet of 60 offshore rigs includes three drill ships, 13 semi-submersibles, three submersibles and 41 jack-up rigs. Our StockScouter rated the stock a 9 June 29.
In the deepwater
At Transocean (RIG, news, msgs), 34 of the company's 95 rigs are ultra-deepwater or deepwater floaters, giving it more exposure to the deepwater sector than any other drilling company. This is important because all of the world's ultra-deepwater drilling fleet is under contract for 2005 and 76% of capacity is already booked for 2006.
That tight supply has sent day rates soaring so that each new contract brings in significantly more than the last one. So, for instance, the contract that starts in June 2006 for the company's Deepwater Millennium rig sets a day rate of $288,000, up from $200,000 in the last contract. The day rate for the Deepwater Horizon, in a contact that starts in November 2006, is $240,000, up from $135,000.
Our StockScouter rated the stock a 10 on June 29.
Exclusive picks
My two exclusive picks for CNBC.com on MSN readers are two stocks outside the drilling sector that also are likely to profit from the continued boom in oil.
OMI (OMM, news, msgs). Oil tanker rates have collapsed as big inventories in the U.S. have left long-haul tankers idling in the Middle East. Rates have fallen more than 90% in the last eight months. But that looks likely to shift in the next few months as we move from driving (gasoline) season to heating oil season. In fact, you can already see signs of the shift: Recently OMI signed three- to five-year contracts on five tankers for rates above the previous contract.
Our StockScouter rated the stock a 10 on June 29.
Chicago Bridge & Iron (CBI, news, msgs). The story here isn't bridges but LNG terminals. There's a huge global mismatch between where natural gas comes out of the ground and where natural gas consumers live. In the U.S. we solve that by shipping gas by pipe from Canada. But pipelines won't do the job to get gas from places such as Indonesia and the Persian Gulf to places such as China, at least not enough of it.
The solution is to turn natural gas into a liquid (hence LNG for liquid natural gas) by super-cooling it, pumping it into special tankers and then, after a long ocean voyage, turning it back into gas that can be sent through pipelines to consumers. Chicago Bridge is in the business of designing and building these storage and processing plants. That work has been the driver in doubling backlog from a year ago. The first quarter also saw a record level of new orders.
Our StockScouter rated the stock a 5 on June 29.
Changes to Jubak's Picks
Buy Noble
Owning Noble (NE, news, msgs) gives you exposure to two of the hottest areas of the offshore drilling market. In May, day rates for jack-up rigs climbed by 18%, a big pickup from the 13% increase in day rates in the first quarter. According to J.P. Morgan, Noble has the highest leverage to the international jack-up rig market. Every $5,000 increase in international jack-up day rates adds 44 cents a share in annual earnings at Noble, J.P. Morgan calculates. In the Gulf of Mexico, a hot area for new drilling now, Noble's leverage adds 16 cents a share to annual earnings for each $10,000 increase in day-rates for jack-up rigs. Ninety-three percent of Noble's Gulf of Mexico rigs are under contract but most of those contracts end by early 2006 and Noble should be able to sign new deals at higher rates.
Earnings took a beating in 2004 as the company pushed new rig construction scheduled for completion in 2005 into the end of 2004 in order to take advantage of rising demand for rigs and rising day rates. This added capacity, especially the added deepwater capacity, should let Noble break into the very lucrative Southeast Asia market. The consensus among analysts is that earnings will climb 113% to $2.40 a share this year. Even that huge jump gives the company plenty of earnings overhead, though. Lehman Brothers calculates peak earnings per share for this cycle at $8.83 a share. I'm adding Noble to Jubak's Picks with a June 2006 target price of $76 a share. I'd set a stop loss at $54. (Full disclosure: I will buy shares of Noble three days after this column is posted.)
New developments on past columns
Get ready for a nice growth surprise
Well, so much for that slowdown in the U.S. economy that so worried the stock market in late April and early May. Remember it? It all started on April 28, when the Commerce Department issued its advance first-quarter report. That showed economic growth in the first quarter dropping to 3.1% from 3.8% in the fourth quarter and dropping from 4% in the third quarter.
Since then, we've had two revisions to that initial reading. The first revision raised the first-quarter growth rate to 3.5%. The second, released on June 29, put growth for the first quarter at 3.8%. That's the same 3.8% growth rate the economy showed in the fourth quarter, and that pretty much puts the kibosh on the belief that the economy is slowing dangerously under the impact of higher short-term interest rates from the Federal Reserve and steeper oil prices. Not that everything in the final GDP report was rosy: The housing sector remains the economy's key growth engine. Investment in the residential sector -- otherwise known as "housing" -- climbed 11.5% in the first quarter, almost triple the 3.4% growth in the fourth quarter. The current pace is certainly unsustainable in the long term.
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: Schlumberger and Transocean. He doesn't own short positions in any stock mentioned in this column.
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