Saturday, January 28, 2006

Tea time in oil service or tee up time in oil service?

There are lots of recommendations on oil service these days. I would normally take that as somewhat of a bad sign, except:

- The loudest on oil service are the analysts, who have been long suffering and mostly ignored for their tech brethren.
- The second loudest are some fairly savvy investors.
- The earnings in oil service have been very good.
- I suspect that oil service is underweighted in the average investor's portfolio.

FoxNews: Cashin' In, January 21.


Wayne's Slick Pick: Oil Service HOLDRS (OIH)
Friday's close: $151.75
52-wk High: $151.75
52-wk Low: $84.16

Wayne Rogers: HOLDRS has about 18 different companies in it, most of which are in the oil service business, like Halliburton (HAL), Baker Hughes (BHI), and those kinds of companies. They constitute between 5-10 percent of the total fund and it's a bet on the whole thing. I've owned that for over a year. It's doubled in the last 15 months. I'm still holding it, and like Jonathan and I always talk, I've got a stop-loss in there and if it hits it, it hits it. In the meantime, it's running.

Barrons: Bold Views, Heavy Mettle.

Quotes from Barron's Roundtable member Felix Zulauf:

Thank you, Abby. Felix, you're next.

Zulauf: Every decade has its winner. In the 1960s it was the rise of multinational companies. In the 'Seventies it was gold. In the 'Eighties it was Japan. In the 'Nineties it was technology and in the current decade it is everything geared to the rise of China, India, the emerging economies and the industrialization process. Natural resources is the candidate for the mania, particularly oil and probably precious metals. Emerging markets should do well, along with capital-goods companies around the world. The loser is the middle- and lower-class consumer in the old industrial countries. That's the long-term structural set-up.

This is the second year in the U.S. presidential-election cycle, which historically has been a bear-market year. There is a reason for that phenomenon. The government stimulates the economy in the two years prior to the election, and withdraws the stimulus in the two years after. This time it will probably work a little differently.

Why is that?

Zulauf: The economic cycle globally is de-synchronized. A slowdown is beginning in the U.S. that will accelerate during the year. We have an acceleration in Asia and Europe -- Japan and Europe, in particular. Consumer inflation is held in check due to the forces of intense globalization, so there is no reason for central banks around the world to get harsh on monetary policy. U.S. monetary policy, which has been the most restrained globally, will change this year, becoming accommodative. If Bernanke [incoming Federal Reserve Chairman Ben Bernanke] wants to improve his image, there is a risk he goes further than expected in raising rates, provoking a correction between spring and fall. After, the market should do well. I'm pretty constructive on equity markets around the world.

With the underlying trend bullish, I'll stick to natural resources. Last year I recommended crude oil, as I did the year before, and Transocean [RIG]. This year crude could pause in the range of $50 to $70 a barrel. After the pause, it will run up more, hitting $100 before the decade is over. I'm recommending an ETF, the Oil Service HOLDRS Trust, which is traded on the American Stock Exchange.

What does it consist of?

Zulauf: It's a basket of 18 drillers, service and equipment companies. It's an easy way for investors to participate in an ongoing bonanza in this industry. Investments in oil infrastructure declined from their 1981 peak for 20 years. Supply does not respond quickly to rising demand, as investments are capital intense. Rising replacement costs have slowed the process of bringing new supply on stream. In 2004 -- the '05 numbers are not out yet -- oil companies could replace only 66% of the reserves they had lifted. They're continuing to deplete their reserves rapidly. As companies find new oil and gas, they are enjoying excellent cash flow. In recent months, the industry has increased its exploration budget dramatically.

Schafer: Felix, isn't it amazing how the major oil companies look in the rear-view mirror as far as what they expect oil prices to be?

Zulauf: They can't believe in a higher oil price because to some extent it hurts them. There are a lot of production-sharing agreements with governments in Africa, the Caucuses and such. If oil goes higher, a rising share of future production goes to these governments, and the portion of reserves booked for the companies isn't theirs any more. That is going to be a problem next year. Some large, integrated companies could run into shocking problems when they disclose they have to reduce reserves.

Neff: À la Royal Dutch?

Zulauf: Yes. The bullish thing about the oil-drilling, service and equipment industries is that all the money spent by the oil producers flows through the service providers. A few years ago it was a buyer's market, and drillers accepted multiyear contracts at low prices. Today the drilling industry still has about 70% of its fleet contracted at rock-bottom rates. Most of these contracts are ending this year, and '07 will see a dramatic jump in earnings and cash flows when capacity is contracted at spot rates. Transocean, for example, earned 27 cents per share in '04. It probably earned $1.70 a share in '05. Consensus estimates for '06 are $5 and for '07, $8. This is based on contracts ending and new ones signed at current spot rates. Based on '07 earnings, the stock trades for nine times earnings, which is really cheap. It closed Friday at 75. Book value is $36 a share, but replacement book is probably $60. The company is buying back 10% of its shares. I recommend buying the industry through an ETF, but Transocean is a great investment.