In The Age of Too Much Information, more and more investors are falling behind the actual benchmark returns. We see this in the returns as measured by extremely large representative samplings. The reason for this under-performance is emotion. And the triggers that make us more emotional are the access to minute-to-minute data that make us either (1) fear we will lose money just because the market is down 250 points on one unusual day or (2) greed, when we see that it is up 250 points on one outlier day.
Thousands of Internet sites scream “Buy! Sell! Don’t just sit there and get passed by — DO SOMETHING RIGHT NOW!” And therein lies the problem: Any buy/sell/hold discipline has gone out the window.
We will not “beat the market” every year. But we will hew to a discipline that is both rational and repeatable. This trend is eternal.
Semper Paratus
“Always Ready.” This is the motto of the Coast Guard. I’ve had the privilege of working with the “Coasties” over many years of counter-drug / counter-
terrorism work. I have great respect for this fine group of men and women. In fact, I think they do more with less than just about any other national organization.
We strive to remain “always ready” in our investing too. We aren’t initiating any new long positions right now, but you may be certain that when we do it will be in the sectors we find most attractive at the time, the selections will be tops in their field, and the prices will be right. This typically means that we buy during market corrections (though sometimes there can be declines in one sector that get overdone, even as the market they are in is itself continuing to climb.)
The next thing we do is try to identify the sectors most likely to benefit. This usually means finding a sector that is cheap relative to its historic P/E, Price/Sales, Price/Book, etc. and has a catalyst working in its favor to change investor perception. And finally, we want to own the most highly-regarded firms within that sector or specific industry. By “highly regarded” I do not mean the shills for hire at Wall Street brokerage firms; I mean most highly regarded by their peers, by their customers, and by potential new customers.
First comes the most important decision: whether to invest in emerging markets or US equities or US bonds or some other asset. Then comes the analysis of which sector makes the most sense. And then—and only then—comes the decision of which closed-end fund, ETF or individual company to buy. In each case, but especially for individual stocks, we seek to buy one of the top quality outfits that are most respected by peers and customers.
This analysis leads me right now to prepare for a market decline and subsequent opportunity in energy firms, most of which are now down on the false belief that, since America is quickly becoming, once again, energy self-sufficient, oil and gas prices must fall and therefore energy exploration and production will prove less profitable.
Will Lightning Strike Twice for the Energy Sector?
Yes. Twice. Three times. Ten times. While we of course need food to survive, we need energy to irrigate fields, to power tractors, to truck the food to us. Energy is essential for any post-stone-age society. The price of various energy sources is supply/demand dependent. When prices retreat, energy companies’ stocks retreat. Semper Paratus. We stand ready to buy when this happens.
I noted last month that the stocks that allowed us to so out-pace the markets from 2000-2002 was buying integrated energy firms, pipeline companies, oilfield service firms and so on, with the drillers that supply the rigs to the energy industry providing the very best returns.
Right now, sufficient energy supplies exist so the price of oil has dropped below $90 a barrel (West Texas Intermediate price). Sounds about right — the driving, construction, air conditioning and growing/harvesting seasons are drawing to a close and the winter need for energy to heat our homes and workplaces hasn’t yet begun. Buy your straw hats in the fall. We want to be ready to buy quality energy firms in the coming couple months, even if we only nibble now.
Last month I mentioned that among our top choices would be Schlumberger (NYSE:SLB), Oceaneering International (NYSE:OII), Seadrill (NYSE:SDRL), Atwood Oceanics (NYSE:ATW) and Transocean Ltd. (NYSE:RIG). Our emphasis is on US companies and those international firms with at least 50% of their operations in the US or US waters. After all, the US is now the largest producer of natural gas in the world and our oil and gas exports hit a new high last month.
For me the Energy Services sub-sector is the best way to profit going forward. I then break this sub-sector into four key industries for our consideration:
Machinery providers. This would include great companies like National Oilwell (NYSE:NOV), Dresser-Rand (NYSE:DRC) currently subject to a possible takeover by German giant Siemens (OTC:SIEGY) and BOLT Technology (NASDAQ:BOLT).
Field (and Marine) Services. Schlumberger Ltd (NYSE:SLB), Halliburton (NYSE:HAL), Spectra Energy (NYSE:SE) and Oceaneering International (NYSE:OII) are companies in this side of the business.
Transport and Storage. This includes companies that provide pipelines, MLPs and storage facilities, companies like Kinder Morgan (NYSE:KMI), Enbridge Energy Partners LP (NYSE:EEP) and Williams Companies (NYSE:WMB).
Drillers. The aforementioned Seadrill (NYSE:SDRL), Atwood Oceanics (NYSE:ATW) and Transocean Ltd. (NYSE:RIG) are among the most interesting in this group.
Whether oil prices are up or down there are many new opportunities around the world, especially in the offshore and offshore-deep arenas. Brazil is com-
mitted to spending billions to prove its oil reserves offshore and Mexico is moving much faster than most observers predicted in opening up their exploration prospects to foreign firms.
Pemex, Mexico's oil company, is keeping about 90% of the nation’s proved and probable reserves. In my opinion, that’s not where the value lies. They “should” be seeking to joint venture with better-positioned, deeper-pocketed, more hi-tech firms in the vast areas as yet unexplored. It looks as if “Round One” of the bidding will include 109 exploration tracts (and 60 producing tracts) in mid-2015.
The drillers, currently suffering from the lowest day rates for their rigs in recent memory, stand to see a serious uptick in utilization as Mexico and Brazil add to their demand for rigs. While the demand is likely to remain weak for the rest of 2014 and possibly into the first quarter of 2015, I consider this an opportunity buy cheaply into what I believe will be a boom by summertime.
Which drillers will benefit most? I believe the biggest, with the deepest pockets, and the best reputations will weather the under-utilization storm and emerge stronger than ever when day rates once again accelerate. Don’t be fooled by charts like this one:
The chart above comes from Pacific Drilling (NYSE:PACD), a great little company we have owned in our Aggressive Growth portfolio in the past. They can be forgiven for being a bit self-serving. The chart purports to show that the “old fleet” of rigs held by the likes of Transocean, Noble (NYSE:NE), Rowan (NYSE:RDC), Diamond Offshore Drilling(NYSE:DO) and ENSCO (NYSE:ESV) make them uncompetitive against those with the newest high specification drillers.
What the company doesn’t mention is that they own just 7 rigs, and their peer competitor, Ocean Rig, has just 10! For comparison, Diamond Offshore has 49 and Transocean has 79. Who do you think Pemex and Petrobras (Brazil’s national oil company) are going to be most comfortable partnering with – huge firms with decades of experience and reputation or the younger firms hoping to expand their fleet by 14% next year – with the addition of *1* more rig.
That’s not to disparage PACD. I uncovered it a couple of years back and still see it as the #1 takeover choice for a firm like RIG or DO. Both need to increase their share of newer rigs and it’s a heck of a lot easier to buy a company, even at a premium, and gain shiny new rigs immediately than to place orders with shipyards at unknown-today costs for something that will take another two years to build and deliver. (Speaking of self-serving, Carl Icahn’s attempt to bleed RIG dry by insisting on huge cash dividend payouts could hurt RIG’s ability to acquire another firm. Investors interested only in dividends may applaud his latest raid; It does nothing for the future of the company.)
Of all the companies in this space, I like Transocean best. RIG has the most potential based on its available equipment, its worldwide presence, and its new build schedule into 2017. Their management has been hampered by the Icahn raid but, given his board representation, is doing a good job of running their business. 79 rigs, many stacked right now, still counts for a lot when an oil major wants to drill tomorrow, not 6 months from now.
I said last month I liked Seadrill a lot, as well. Part of that is because they gave us a whopping capital gain during the last exploration explosion, part of it is their 16% (yes, 16%) yield, which is only a 45% dividend payout ratio. However! SDRL is highly-leveraged, and in this business trailing earnings are not a valid harbinger of current earnings. That dividend may not be sustainable, especially since the company predicts no uptick in rig usage until the summer of 2015.
Of course, they could slash the dividend by 50% and still be paying an 8% yield! They have a lot of floating-rate debt which, if interest rates rise rapidly, would force them to retrench. Among the positives, however, are a large high specification fleet and high insider ownership. We might nibble a little now. On a dividend cut that drives the stock down to the high teens and low 20s, our last entry point, and assuming stable interest rate projections, we’d buy with both hands!
The other driller I mentioned last month, Atwood Oceanics (NYSE:ATW), I’ll discuss in another post. To complete our discussion of the Bigs here, however, let me at least briefly touch upon Noble, Rowan, Ensco and Diamond Offshore.
Noble has a well-diversified fleet, but has to-date only been able to obtain below-average day rates and has multiple stacked rigs. It is likely a fine long-
term holding, but I think we’ll do better with others.
Rowan is one of the best of the mid cap drillers and has handled this downturn very well – better than most of its peers. It has a preponderance of jackup rigs, which is seen as a negative by many analysts. I don’t agree with them. When a client needs rigs, they don’t always need the latest and greatest for the mundane effort of dealing with not-as-deep drilling as the new rigs are designed for. Rowan has done a fine job of staggering contracts. Management is on the ball.
Ensco is a solid company, but I need to see better asset (rig) utilization before I buy them. I think they over-stacked too early in the game and lost opportunity to other firms. We’ll see if they play it a little smarter going forward.
Diamond Offshore, maligned by most analysts, was the surprise of my research this past month. Its fleet is relatively old and the company doesn’t seem that aggressive. But under the current depressed conditions for the industry, DO has a higher credit rating, better interest coverage, and more assets than any of those I surveyed except, by some parameters, RIG.
The rigs they have stacked are nearly fully depreciated, so there is negligible revenue impact. They are a proven entity which has been through similar downturns many times in the past and know how to weather these downturns. And they have a history of using such downturns as an opportunity to buy more-highly-leveraged firms in their space. Finally, they are well-regarded internationally so it’s likely they will be at or near the top of the shopping list for firms and governments around the globe.
Next month I’ll move on to the other industries that comprise the energy services sub-sector.