EIS Idea — June 7, 2007: Drillers and Service Companies

I think the drillers and service companies are significantly undervalued by the market, despite having achieved substantial gains over the past several years. They make up the largest segment of the EIS portfolio.

The oilfield service business reminds me of cable television in several respects.

• First, it is a capital intensive, high cash flow business where book depreciation is greater than true depreciation and therefore tends to reduce reported earnings so much that the true value of the operations is hidden from the view of many investors.

• Secondly, analysts and the investing public under-estimated the highly predictable and rapid long term growth rate of cable earnings, just as they are now doing in regard to oilfield service companies. Cable earnings (or cash flow) was in a very long term up-trend, driven by the fundamental technological change that allowed the public to view a multitude of channels with excellent quality instead of being limited to the half dozen or so capable of being transmitted with inconsistent quality by over the air technology. This unleashed an unquenchable demand that took decades to for cable to satisfy.

 

By the same token, oil service companies growth is now in a secular up trend, not the cyclical pattern that analysts have always assumed in prior periods. The secular uptrend is being driven by the increased drilling requiring increasingly complex equipment (and therefore higher cost) required to maintain the existing rate of global oil and gas production. For example, Saudi Arabia has increased its number of rigs by a factor of four over the past year while actually producing less oil. A similar phenomenon can be seen in U. S. natural gas production. For geological reasons, this trend will only become more pronounced every year. The cost of extracting oil and gas in the future can only increase, and much of that money is paid to the drillers and service companies.

• Third, when cable’s true earnings growth and predictability were finally appreciated by large corporate acquirers like AT&T, that was the signal that it was finally time for the small players and the private investors to sell. My sense is that we will see a similar sell signal in the oilfield service business eventually, and at significantly higher prices than today’s. It will come when the industry begins to consolidate and when private equity players begin to buy into it.

But I could be wrong. The main thing that could make me wrong would be a sustained period of lower oil and/or natural gas prices. That is why I devote considerable attention to trying to understand the fundamental factors that are likely to impact oil and natural gas prices in the next year. I don’t worry about what may happen to them next week or next month. Nor do I depend on the certainty that eventually the prices of both commodities will be vastly higher than they are today. I try to focus on potential developments that could fundamentally change the nature of the markets for these commodities.

 

My analysis of these matters is presented in the section called Price Vectors. It’s the best I can do to peek into the future, like those seismic meters that monitor the subsurface of the earth to detect advance warnings of earthquakes and tsunamis. The future direction of the prices of oil and gas is the area we need to get right in order to continue to prosper in making energy investments.