Importance of Energy Sector Stocks Selection

By: Elliot_H_Gue

Perhaps one of the most-frustrating myths about investing in the energy patch is that it's all about predicting the direction of oil and natural gas prices.

One commonly held belief is that oil and gas-related stocks all move as a group--basically, in the same direction as the underlying commodities. For that matter, I've heard plenty of times from investors who believe that nuclear power, alternative energy and other non-hydrocarbon energy plays also follow oil and natural gas prices.

If that were the case, there would be little value in stock-picking or sector selection. The evidence, though, suggests otherwise. In fact, selectivity is the key to playing the group. A big picture outlook on commodity prices is important, but it's only one piece of the puzzle.

For example, consider the 15 oil and gas services stocks that make up the Philadelphia Oil Services Index (OSX). This is the most widely followed index of large capitalization oil services names; the index includes a mixture of contract drillers, pure services stocks and some oil and gas equipment firms. The chart below compares the performance of the top three and bottom three OSX components from January 2004 through December 2007.

Source: Bloomberg , The Energy Strategist

I created these two indexes using an equal weighting. The indexes aren't sorted by market capitalization. It's clear that if you had invested in the three top oil services stocks in early 2004, you'd be up more than 465 percent or 54 percent annualized, an impressive performance by any measure.

If, however, you'd been buying the worst three stocks in the OSX, that investment would be up less than 50 percent, or just more than 10 percent per year. That's a gigantic disparity between the best- and worst-performing OSX stocks.

And keep in mind that the OSX is a relatively specific index that focuses on just one relatively small part of the energy business--services and contract drillers. If the difference between the best and worst performers in a relatively homogenous group can be that large, you can imagine how large the differences are between stocks in different energy subsectors.

Of course, this wide disparity in performance begs the question as to how to differentiate between the winners and the losers in a sub-sector like the OSX. The key is to understand the basic fundamental driver for the oil services group: the end of easy oil.

Yesterday on At These Levels ( www.attheselevels.com ), a free blog I contribute to frequently, I highlighted an article that appeared in the Financial Times this week. The gist of the article was that the International Energy Agency (IEA) had recently admitted that it has been paying too little attention to oil supply; the IEA has focused most of its attention on oil demand.

The result is that the IEA has wildly underestimated the decline rates for existing mature oilfields. These fields are declining far faster than originally thought. In addition, the IEA has overestimated producing firms' abilities to locate new reserves and make discoveries. The truth is that this isn't really a revelation; the IEA has simply admitted a well-known fact.

One stock that I always pay extremely close attention to is oilfield services giant Schlumberger. This company operates in every oil and gas-producing corner of the world and is involved in most of the world's high-profile development projects to at least some extent.

This gives Schlumberger a unique perspective on what types of reserves oil companies are targeting, technical difficulties they're facing and the most promising new avenues of exploration. It shouldn't come as a huge surprise that Schlumberger has revealed important new trends on multiple occasions that we've been able to play profitably in The Energy Strategist .

One exchange between a prominent Wall Street analyst and Schlumberger's CEO during the company's third quarter conference call back in October caught my attention:

Question: "...So, you mentioned production declines in mature areas. Could you be a little more specific in terms of what level you think non-OPEC [Organization of Petroleum Exporting Countries] production declines?...You highlighted a year ago that non-OPEC [production forecasts] were way too optimistic.”

Answer: “I have never given a public answer to this question, and I'm not going to. I use a figure that was used by one of my major customers a few years ago, which was 8 percent. Now whether that's accelerating or not, overall I think it's an open question. What I do think is that a lot of the forecasting agencies are still using decline rates that are inferior to that...”

The above exchange was excerpted from Schlumberger third quarter conference call, Oct. 19, 2007.

Basically, Schlumberger is saying that mature fields in non-OPEC countries are declining at a far faster pace than international forecasting agencies suspect. Schlumberger certainly has access to data of unparalleled quality in the form of actual experience in the field. Arguably, the company's access to data is superior to that of the forecasting agencies; certainly Schlumberger's statement has been borne out in recent years as non-OPEC production has consistently disappointed expectations.

My point in all of this is that declining non-OPEC output and accelerating decline rates is forcing producers to look further afield to find significant new reserves. That means targeting reserves in deepwater environments, in the Arctic or in regions of the world that lack political and economic stability. The easy and cheap-to-produce fields located on land in the developed world are largely depleted; the world is now relying on increased output of difficult-to-produce fields.

This trend plays right into the hands of some global oil services names, particularly those with access to the technology and expertise needed to produce these complex fields. This is the key to understanding the disparity in performance among OSX stocks in the chart above.

The underperformers in the chart are stocks levered to primarily low-tech service business lines. In many cases, the worst-performers are companies with heavy exposure to mature oil- and gas-producing markets, particularly North America.

It's not that these companies never perform well. Rather, drilling activity in North America is heavily dependent on commodity prices. The drop-off in gas prices since late 2005 has resulted in a severe retrenchment in activity levels in Canada and a moderation in growth for the US. This has severely punished the stocks levered to these markets.

The real growth is to be found in major large-scale projects outside of North America. These would be projects targeting the “hard” oil reserves I outlined earlier. As producers increasingly turn to such international projects to make up for declining production in mature basins, services firms with the ability to produce these reserves are in the catbird's seat.

Even better, such projects really aren't commodity sensitive. No company is going to delay or cancel a multi-billion dollar deepwater oil development project because oil prices fall from $95 to $80 per barrel.

In fact, several producers have said that you would need to see oil prices fall back into the $40s for a prolonged period before there would be a major impact on activity in international projects. Many big oil companies are using crude prices well under $50 to evaluate the long-term economic returns expected from new projects.

It should come as little surprise that the big winners in the OSX chart are those levered to big international projects.

By Elliott H. Gue
The Energy Letter

© 2007 Elliott H. Gue
Elliott H. Gue is editor of The Energy Letter , a bi-weekly e-letter as well as editor of The Energy Strategist , a premium bi-weekly newsletter on the energy markets. Mr. Gue is also associate editor for Personal Finance , where he contributes his knowledge of the energy markets.

Mr. Gue has a Master's of Finance degree from the University of London and a Bachelor of Science degree in Economics and Management from the University of London , graduating in the top 3 percent of his class. Mr. Gue was the first American student to ever complete a full degree at that university.

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