“Two Stocks You Must Buy Before Gas Blows Past $4 Per Gallon…”

By Travis Johnson, Stock Gumshoe, March 8, 2011

The Motley Fool copywriters seem to love this general type of pitch — “Must buy X before Y happens!” — they used it heavily for their multiple teases of American Tower, among others (buy before the iPhone 4, then buy before Verizon gets the iPhone … I assume we’ll also see it again when the speculation about iPhone 5 heats up).

So now that oil prices are rising, we get the “must buy before gas blows past $4” stocks — and several intrepid Gumshoe readers are asking for answers … so let’s dig in, shall we?

The tease is for the “flagship” newsletter over in Fooldom, the Motley Fool Stock Advisor from Dave and Tom Gardner, and it’s all about oil services companies.

Actually, that’s not true, it’s mostly about oil prices and Saudi Arabia — the speculation that if the unrest that has moved through Algeria and Egypt to Libya, Yemen and elsewhere really takes hold in Saudi Arabia and starts to threaten production from the only OPEC country that most people think can really crank open the taps if needed (though there’s some debate about their spare capacity and reserves in the Kingdom, too, with lots of folks thinking — even before the WikiLeaks revelations — that their reserves are significantly overstated).

So the trend behind this ad, and these stock ideas, is that oil and gas are going to go up in price, and that the climb in prices might be even more dramatic than the recent spike to over $100 a barrel. And this is certainly an attention-getting idea among both drivers and investors these days, since even though our economy is far more efficient with oil now than it was twenty or thirty years ago, and even though domestic production is actually rising for the first time since the late 1980s … we are still a nation that depends heavily on imported oil — and gas prices seem to continue to have an outsize impact on consumer sentiment.

Many of us have already seen $4 gas prices, depending on where you live and how opportunistic your local retailers are, but the average national price is closing in on that number pretty quickly — it’s over $3.50 now and rising, so the idea that it will surpass the old record of $4.11 or so (set when oil was nearing $1.50 in the Summer of 2008) is certainly not an “out there” prediction. Of course, if the expected “day of rage” in Saudi Arabia on Friday actually turns into a circle of smiling people singing Kumbaya (or the arabic equivalent), one can probably assume that the price will lose a lot of this recent steam at least in the short term — despite the fact that a growing (if it continues) global economy, with more drivers in China and elsewhere, will continue to gradually increase demand.

But you’ve probably heard most of that, so I’ll spare you the long spiel from the Fool about what might cause oil prices to rise even further — let’s get straight to the companies they tease as hot investments in this rising price environment …

“You see, only a handful of highly specialized companies — like the two I’m going to introduce you to today — have the state-of-the-art technology, the specialized skills, and the artful know-how needed to tap the world’s next great oil fields.

“That’s because these fields are located in some of the hardest-to-reach places on Earth — hundreds of miles offshore and thousands of feet below the ocean’s surface.

“In other words, these two little-known companies are absolutely essential to the success of any big name oil company that wants to extract oil from these vast, ultra-profitable deposits.”

So it sounds like we’re about to get some hints about offshore drillers, eh? Well, that’s at least one of the stocks — let’s get the details.

First we’re told that one advantage they have over the oil majors is that they’re smaller, so therefore perhaps easier for them to see significant growth …

“the relatively small size of these two highly specialized companies is actually a huge advantage.

“Especially considering they’re both growing like wild fire… are trusted leaders in their respective fields… and have highly experienced, shareholder-friendly management teams.”

Then we get a few specifics for the first company teased:

“… the first company I’m going to tell you about today is in such high demand right now….

“Charging big-name oil companies like Noble as much as $545,000 per day to drill wells in 5,000 feet of water off the coast of remote African nations like Ghana and Equatorial Guinea…

“While also drilling in more easily-accessible places like the waters off Australia and Malaysia for clients like Chevron and Shell (jobs which each bring in more than $400,000 per day)…

“And rapidly expanding its fleet — including adding three more ultra-deepwater rigs (one of which will come online within months and is already under contract) — giving it a major leg up on its competitor’s aging and outdated fleets….

“… its PE ratio currently sits at less than half that of its more well-known competitors like Transocean (meaning you can buy it much cheaper).

“Combine that with the fact that this company is sitting on over $200 million in cash (which will allow it to continue to expand its fleet)… has an extremely healthy balance sheet… and has grown profits at an average compound rate of 50% per year over the past five years…”

So we toss all those goodies into the Thinkolator and find that … yep, this is a stock that Dave Gardner recommended not only last year, but also the year before, Atwood Oceanics (ATW), probably the smallest of the publicly-traded, deepwater-focused oil drillers.

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Atwood is a tempting target now, as it was back in 2009 when David Gardner was teasing it for this same newsletter — with, now that my memory has been rekindled, almost the same pitch (“buy before gas prices soar“).

In the spectrum of deepwater drillers the tendency has been, for whatever reason, for the US companies to be relatively conservative, keep a reign on debt, and refurbish rigs rather than build hugely expensive new ones, while the Norwegians have been the aggressors in using heavy leverage and aggressively filling up the order books of the few global shipyards who can build the most capable fifth and sixth generation deepwater rigs and drillships. When looking at larger drillers, the difference is most easily understood by comparing Diamond Offshore to Seadrill — both have great businesses and spin off much of their cash flow to investors in the form of high dividends, but DO has an older fleet of rigs and doesn’t have much debt or revenue growth, and SDRL has the most modern big-company fleet and is highly levered and is growing quickly thanks to new rigs and turnover.

Both models, and any mix inbetween, can probably be quite successful during a time like this, when the demand is very high for all kinds of floating rigs — not just the absolutely most capable ones that can drill in water two miles deep, but even those that can drill in a few thousand feet of water. Atwood is a very small company in terms of fleet size, they have three ultra-deepwater rigs (well over 5,000 feet water depth capable) that are on order, with one delivering this year and one each in the next two years, but their other deepwater semisubmersibles, all three of which are under contract at rates ranging from $430-545,000/day, are all in pretty strong demand. Those three operating rigs are all old, build in the early 1980s, but they were all upgraded and refurbished in the early 2000s so they do get close to the rates that the newest rigs earn (the best deals for the drillers have been up to about $650,000/day for the newest 6th generation ultra-deepwater rigs).

Atwood trades at what looks like a pretty reasonable price relative to their competitors in the deepwater drilling space (they own several jack-up rigs too, including one that was briefly sidelined in Egypt last month — those are the rigs that sit on the ocean floor and usually max out at depths of about 400 feet), but they also have a tiny fleet compared to most of the comparable companies, and investors generally will pay more for larger and more advanced fleets (with the assumption that tighter safety regulations will favor newer rigs, and that having more rigs means a problem with one of them doesn’t hit the bottom line as hard). So yes, ATW has a lower PE ratio than many of the other drillers, and is also smaller than most of the ones you’ll have heard of (market cap around $2 billion) — and all else being equal a low valuation is the best indicator for long-term stock performance … but, of course, “all else” is never equal.

I personally own Seadrill because of its leverage to Brazil and the toughest drilling challenges, and because of their aggressive dividend policy, but I expect that if oil prices remain this high — and, importantly, if the middle east remains on heightened alert — then pretty much all of the deepwater rig owners will be shopping for new Cadillacs. If you’ve got a favorite stock in this space, from industry leaders Seadrill (SDRL) or Transocean (RIG) to Pride (PDE) or Ensco (ESV), which are trying to merge, or others like Noble (NE), Diamond Offshore (DO) or even DryShips (DRYS), which has added a handful of deepwater drillers to its fleet of dry bulk tankers, feel free to let us know with a comment below.

And yes, they did say two stocks — so what’s the second one?

Here are the clues we get in the ad:

“Without this company, drilling for oil would be virtually impossible to begin with…

“As I mentioned, for the past 149 years, this company has been a worldwide leader in the design, manufacture, and sale of equipment used in oil and gas drilling.

“Today, it operates over 700 locations across six continents, and according to Morningstar, it currently controls some 60% of the oil rig equipment market.

“Morningstar further estimates than 90% of all rigs worldwide use this company’s products and services. Yet, as I mentioned earlier, there’s a good chance you’ve never even heard this company’s name.”

So that sounds good — a long history, very big footprint. Anything else?

” … Forbes recently named it one of the “World’s Most Admired Companies”…

“And you can bet its safety-enhancing services are going to be in high demand going forward now that oil companies are being forced to operate in an extremely liability-conscious environment.

“Combine that with the fact that this company has an absolute stranglehold on one of the most important industries in the world… is run by a management team that speaks in terms of decades, not quarters… pays a decent dividend… and has a stellar balance sheet with over $3.3 BILLION in cash…

“And I think you’ll see why this is exactly the kind of stock you want to load up on before oil and gas prices shoot any higher.”

Well, given the number of times a designation like this comes up and the crazy number of different rankings there are, I’m starting to feel a little disappointed that Stock Gumshoe has not made it onto any of these Forbes lists … but yes, this is a “most admired company” and the Thinkolator sez it’s …

National Oilwell Varco (NOV), which is one of the major oil services companies in the world — it’s nowhere near as big as giant Schlumberger (SLB) if we’re measuring by market capitalization, but is nearly as big as Halliburton (HAL) and larger than competitors like Weatherford (WFI) or Baker Hughes (BHI). They are best known for selling equipment and components for oil wells around the world, but also provide a broader range of services.

Compared to most of the other names noted in that paragraph above, NOV has proven to be more levered to oil prices, perhaps because their business mix or product positioning has them earning substantially higher margins than most of those companies — the share price has tripled over the last three years, far stronger performance than SLB or HAL, and it also fell a little more sharply than most of the other big players during the 2008-2009 oil selloff.

From what I can tell, of the relatively big name companies in this space who provide services to a broad swath of the industry, NOV is the only one that’s approaching the valuation of global giant Schlumberger — NOV trades for about 15X next year’s earnings, SLB for 18X, both of those numbers higher than the PEs of 11-13 boasted by most of the players.

And as you can imagine, all of those forward PE estimates by analysts rely on those analysts’ estimates for oil prices … and before two months ago there probably weren’t any oil services sector analysts forecasting $150 oil for this year, but I bet some of them are upping their numbers now. I don’t know much about NOV and have never owned any of these major oil services names, so I don’t know whether we should expect NOV to continue to outperform their competitors — but it’s true that when oil prices are climbing, it’s hard to lose money buying oil services stocks (and yes, the reverse is also true — it’s hard to find an oil services stock that didn’t lose at least half of its value between June 2008 and March 2009).

So what do you think? Is oil topping out here, or will we see it climb to new highs this year? Have a favorite pick for a new high-price era in either the deepwater drillers or the big oil services names? Let us know with a comment below.

And as always, the vast sea of Gumshoe readers craves your opinion about the newsletters you’ve subscribed to — if you’ve ever subscribed to the Motley Fool Stock Advisor, please click here to share your thoughts with your fellow investors. Thank you!

Author’s disclosure: as noted above, I do own shares of Seadrill. I do not own any other stock mentioned in this article, and I will not trade in any stock written about for at least three days.



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March 8, 2011 2:59 pm

Drilling and Extraction… the drugs and prostitution of the investment world…

March 8, 2011 3:38 pm

Which newsletter performs the best analysis of the drillers and the service companies? Not interested in the producers and explorers.