Oil and Gas Sell-off Creates a Great Entry — For the Right Companies

After plunging steadily in recent weeks, share prices in the oil and gas exploration appear to have finally found a floor. Some stocks such as Halliburton (NYSE: HAL) and Schlumberger (NYSE: SLB) sharply rose on Wednesday after falling close to their 52-week lows, while other stocks such as Diamond Offshore (NYSE: DO) and Pride International (NYSE: PDE) are still in the doldrums. Their relative levels of exposure to the Gulf Coast explains why the stock charts are diverging.

A Quick Primer

To get a sense of the future direction of these stocks, you need to step back and assess both geographic and technical considerations. To be sure, the massive sell-off, which has eroded -30% to -40% of the value of some of these companies, is far out of proportion to their exposure to the Gulf Coast. Companies that provide equipment and services for oil and gas drillers in the Gulf include Diamond Offshore, ENSCO International (NYSE: ESV), Noble Corporation (NYSE: NE), Pride International, Rowan Companies (NYSE: RDC), Seahawk Drilling (Nasdaq: HAWK) and Transocean (NYSE: RIG).

Most of these firms derive the majority of sales through the lease of drilling rigs. Some have greater exposure to shallow water rigs (which are likely to be less impacted by further government action) while others have greater exposure to deep-water rigs. This is the area receiving a great deal of scrutiny, as deep-water drilling takes place under extremely high pressures (which can reach 30,000 pounds per square inch).

Even though Transocean is closely associated with the current massive oil and gas leak, it actually derives only a small portion of revenue in the Gulf Coast. Most of its equipment and services are used in other international markets. That’s also the case with Pride International. In contrast, firms such as Noble and Diamond Offshore have a much higher degree of exposure to Gulf Coast drilling. That helps explain why shares of Pride International are off -20% during the past three months while Diamond and Noble are off closer to -35% or -40%.

Action to Take –> It might be tempting to buy up shares of Diamond and Noble, as they are undeniably cheap based on historical cash flow rates, but we simply don’t know how any regulatory changes regarding drilling will play out. A moratorium on new drilling activity in the Gulf could last as little as three months or as long as two years. The longer the spill continues, the longer the moratorium will likely last.

Instead, investors should look at shares of Pride International, which are back down at 52-week lows and trade at half the price they fetched in 2008, when the industry was in a growth phase. Analysts expect Pride to sharply boost per-share profits above the $3 mark next year, as expiring contracts are renewed on better terms. Shares trade for around eight times projected 2011 profits and six times projected 2011 earnings before interest, tax, depreciation and amortization (EBITDA). As investors come to see that Pride has much greater exposure to drilling markets such as Latin America, Africa and the North Sea, those multiples should rebound, and shares have some +50% upside back to their 52-week high.

Staying on Dry Land

Companies that offer drilling equipment and services to land-based energy exploration firms have also been hit recently — though to a more moderate extent. Shares of Helmerich & Payne (NYSE: HP), Nabors Industries (NYSE: NBR) and Patterson-UTI Energy (Nasdaq: PTEN) have shed roughly -10% to -15% of their value during the past month, though they will not be affected by any industry regulatory changes.

Analysts have been lukewarm to this group, largely because low natural gas prices have crimped drilling activity. But if the output from the Gulf drops in coming quarters, supply will shrink and gas prices will rise, which should spur an increase in land-based drilling. As drilling activity increases, these firms can charge more for their equipment, known in the industry as “day-rates.”

Action to Take –> Nabors, the industry’s largest player, looks particularly appealing, trading just above book value of $18 a share, and less than four times EBITDA, on an enterprise value basis.

Year-over-year revenue comparisons have been negative for a number of quarters as the number of land-based rigs in action steadily declined over the last few years. But the number of rigs in service has begun climbing again, according to Baker Hughes (NYSE: BHI), and analysts expect Nabors Industries to start posting positive revenue comparisons beginning in the current quarter. Per-share profits should bottom out at around $1 this year, and thanks to the high degree of leverage in this earnings model, profits could rise more than +50% next year on a +15% jump in revenue. Cash flow per share could approach $4 next year.

The International Giants

Shares of the largest international oil services companies have also been hit hard in recent weeks, though as noted earlier, showed big gains on Wednesday. The sell-off seemed unwarranted. These firms derive most of their revenue in other regions of the world, and should see minimal impact from any slowdown in the Gulf coast. Governments in Latin America, Asia and the Middle East will want to know what caused BP’s (NYSE: BP) equipment to fail, but they are unlikely to slow the pace of drilling activity. In fact, with their deep technical expertise, these firms may actually benefit from an increased demand for engineering services and safety equipment.

Schlumberger is the industry’s largest player, offering a wide array of services and equipment, and with shares not far from the 52-week low, they represent real value. Halliburton, the industry’s second leading player, also represents a solid play on the rapid engineering advances taking place in energy exploration. But investors may want to focus on Weatherford International (NYSE: WFT), which is arguably the least-understood and most compellingly valued name in the group. Shares hit a 52-week low before rebounding on Wednesday.

Earlier in the decade, Weatherford wouldn’t have been mentioned in the same breath as the biggest industry players, as it had a limited set of products and services to offer customers. But a 2005 acquisition of Precision Drilling and a 2009 purchase of BP’s TNK division has turned Weatherford into a full-service shop. And that has fueled an impressive string of new contract signings.

Trouble is, those new deals are still in various stages of development, so the company’s recent earnings reports have been a grab bag of slipped deadlines. The company has sought to clear the decks by taking a series of one-time charges that led Weatherford to miss estimates in each of the last two quarters.

As this year progresses, Weatherford expects to report cleaner results and post rising revenue and profits. Why the brightening outlook? As noted earlier, Weatherford acquired BP’s stake in TNK to gain greater access to the Russian energy market. Management concedes that it has been a challenge to integrate TNK into its operations, but expects to post strong results from that unit in 2011. In addition, the company is ramping up in Iraq, and has already secured more than $400 million in contracts to help that country rebuild its energy infrastructure. Lastly, energy exploration efforts in a range of other countries are expected to rebound in coming quarters, unless we see another precipitous plunge in global energy prices.

Action to Take –> Most investors are squarely focused on the present, so Weatherford’s stock price remains stuck in the mid-teens. As investors start to look beyond the near-term noise, shares should again start to merit a price-to-earnings ratio (P/E) closer to 20, which is a typical P/E ratio in the early stage of the cycle for these companies. Weatherford looks set to earn more than $1 a share in 2011, and closer to $1.50 in 2012, which means shares could hit $25 to $30 as the industry truly enters an upturn.

Exploration & Production Stocks Dragged Down by BP

The exploration & production (E&P) stocks have been particularly hard hit as of late, especially those with a high degree of exposure to Gulf Coast drilling. Anadarko Petroleum (NYSE: APC) for example, has fallen from $75 to $44 in just five weeks. More than $10 billion has been erased from its market value. Anadarko was involved in the current damaged well, and could be on the hook for big lawsuits, but they are unlikely to reach even half the amount of that lost market value.

That makes the stock a real value to those willing to shoulder the risk that lawsuits could weigh on the stock for some time to come. Analysts believe the value, of Anadarko’s remaining oil fields, is worth around $68 a share, roughly +50% above the current share price.

Small-cap driller McMoran Exploration (NYSE: MMR) has seen its shares fall more than -40% in the last three months. McMoran is focused exclusively on the Gulf, and will surely see a hit to sales and profits from the drilling moratorium. But once the moratorium is lifted, shares, which saw a solid pop on Wednesday, could rise another +50% or more, back to their 52-week high. Value investors will want to get in on this name before the moratorium is lifted.

Other E&P firms have been hit to a smaller degree, as they don’t have the same liability but will be similarly impacted by the current drilling moratorium. Devon Energy (NYSE: DVN), for example, is off its highs set in January, but is always a favorite of institutional investors thanks to the high quality of its various oil and gas fields (almost all of which are land-based) and management’s very strong track record.

But value investors should take a closer look at Southwest Energy (NYSE: SWN), which has fallen nearly -15% in the past three months even though it has no exposure to Gulf-based drilling.

Shares have been trading poorly due to weak natural gas prices. If and when gas prices finally firm up, Southwestern Energy looks set to generate considerable cash flow in 2011 and 2012. The company has been digging hundreds of new wells in the Fayetteville, Ark., region, known as the Fayetteville Shale. That should lead to a +30% jump in production this year, and another +30% spike in output next year.

Action to Take –> Analysts tend to multiply projected gas prices by projected output, and then subtract projected expenses to arrive at a forecast for cash flow. Based on the current price curve and Southwestern’s stated output plans, the company is expected to generate around $1.5 billion in cash flow this year, $2.2 billion in 2011 and $2.8 billion in 2012. Against that backdrop, shares trade at a sharp discount to their historical average. During the past ten years, which have seen all phases of the boom and bust cycle, shares have typically traded for 8.6 times next year’s cash flow. Now, they trade for just five times projected 2011 cash flow. If shares can climb back to that average multiple, then they possess more than +50% upside from current levels.