7 blue ribbons from the energy patch

Energy is always a hard sector to sort out since there are so many specialties, and when one is hitting, others may be hurting. Here's the current view.

By MoneyShow.com Mar 28, 2012 4:45PM

Image: Natural gas plant (© Kevin Burke/Corbis)The worst-performing stock in the entire S&P 500 index on March 21 was Baker Hughes (BHI), an energy service company. The stock fell 5.8% after the company issued a press release warning that first-quarter operating income would be lower than expected.

 

Baker Hughes' upcoming earnings shortfall is directly related to the sharp decline in natural gas prices to the lowest levels of the past decade, and the resulting reduction in natural gas drilling by exploration and production (E&P) firms.

 

For example, natural gas E&P company Chesapeake Energy (CHK) announced in January that it was cutting its North American "dry" gas (i.e., mostly methane) rig count by 67% (to 24 rigs from 75 rigs in 2011) in reaction to low gas prices.

 

According to Chesapeake CEO Aubrey McClendon, "an exceptionally mild winter to date has pressured U.S. natural gas prices to levels below our prior expectations, and below levels that are economically attractive for developing dry gas plays in the U.S., shale or otherwise."

 

Fewer natural gas rigs and lower production means less demand for energy services, especially "pressure pumping" services that crack open the shale rock to release natural gas. Pressure pumping has leapfrogged past land drilling, offshore construction, and offshore drilling in the last ten years to become the largest segment of the energy services industry.

 

This is particularly bad news for energy service firms that focus on North American natural gas fracking, like Baker Hughes and Halliburton (HAL). In 2010, Baker Hughes bet big on North American natural gas fracking when it acquired pressure-pumping specialist BJ Services for $5.5 billion, the largest oilfield-services company takeover since 1998. Oops.

 

In its March 21 press release, Baker Hughes warned: "As a result of the continued shift in U.S. rig activity from natural gas to oil and liquids-rich basins and other market forces, the company's pressure pumping product line is currently experiencing: decreased fleet utilization, lower pricing, higher than expected personnel and logistics costs, and shortages of and higher costs for critical raw materials, such as gel."

 

The company expects North American operating profit before tax margin for the first quarter of 2012 to be between 13.2% and 14.2%, compared with 18.7% in the fourth quarter of 2011.

Although part of this earnings warning is probably company-specific, Baker Hughes says that the problem is industry-wide due to "rapidly changing market conditions." Investors seem to agree, selling off virtually all energy-service stocks.

 

To its credit, the Raymond James brokerage downgraded several energy service firms in late February, stating that the market for drilling services "may be unraveling faster than we thought."

 

But Schlumberger looks good
One energy service stock the brokerage didn't downgrade in February was industry bellwether Schlumberger (SLB). Yet it fell nearly 3% on March 22, despite the fact that it is well-diversified internationally and much less exposed to North American natural gas fracking than Baker Hughes or Halliburton.

 

I love to buy healthy stocks that fall in sympathy with other more-troubled stocks. The healthy stock's price drop is temporary and emotion-driven, and quickly reverses once investors realize that the company-specific bad news doesn’t apply to the healthy stock.

 

Schlumberger is a perfect example of a healthy company and its sympathy-driven price drop looks like a gift to investors.

 

And other energy stocks remain attractive
Before you follow the lemmings and sell all energy-service-related stocks, keep three things in mind.

 

First, only "dry" natural gas drilling is in trouble. Prices of crude oil and natural gas liquids (e.g., ethane, butane, propane) remain high, and horizontal drilling in North American oil-shale regions like North Dakota's Bakken, Colorado's Niobrara, and Texas' Eagle Ford and Permian is strong and getting stronger.

 

Energy-service companies can help E&P firms develop oil-shale wells using the same fracking techniques found to be effective in the gas-shale context. This is important given the recent Wall Street Journal report that water contamination is caused by poorly sealed wells and not fracking. Fracking is here to stay.

 

Oil-focused energy service firms include Lufkin Industries (LUFK) and Weatherford International (WFT).

 

Elliott Gue of The Energy Strategist newsletter is a big fan of Weatherford, saying it has "less exposure to natural gas-focused services in North America than any of its peers and has strong leverage to international markets and oil-related services.

 

"The investment case for Weatherford International continues to rest on its leading market position in rapidly growing markets such as artificial lift, a service line that enhances production from mature oil fields," Gue adds.

 

Second, Baker Hughes’ press release speaks of "shortages of and higher costs for critical raw materials, such as gel." It seems to me that producers of such "critical raw materials" used in fracking fluid and proppants are in the sweet spot right now, and can benefit from the pain felt from buyers such as Baker Hughes. Example: Carbo Ceramics (CRR).

 

Third, offshore deepwater oil drilling continues to be robust, and energy-service companies that focus on offshore continue to do well. Names here include Ensco (ESV), Transocean (RIG), and SeaDrill (SDRL).

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