Worries of an Aging Cycle as Investors Exit Oil Serv. Stocks
by Richard Mason
|Tuesday, September 23, 2003
Abstract: Rightly or wrongly, the equities market has a reputation for anticipating direction in energy. Investors are beginning to move towards the exit on oil service stocks, signaling change may be at hand.
Analysis: The wrinkles are beginning to show. In the cool clear light of autumn, the oil service sector is starting to exhibit the effects of aging.
As a result, the ardor for oil services is beginning to wane for folks in the financial industry.
Analysts have spent a busy month condemning the oil service sector with faint praise. Thus, changes in recommendations have evolved from "overweight" to "market weight." Or "market outperform" to "market perform."
In the binary world of financial services, there are few shades of gray or nuance despite the intricate valuation scenarios each firm promotes. While these scenarios may involve terms such as "accumulate," "market outperform," "hold," or "market weight," the reality is that it all boils down to an either/or choice.
That choice is "to buy" or "to sell."
Terms such as "market perform" or "market weight" or "hold" often really mean "sell." And that is exactly what is happening in oil services at the moment. Some investors are moving purposefully towards the exit doors.
Whether industry analysts are rushing to get ahead of the parade or have some influence on the market is a subject of unending debate. But downgrades for the oil service sector continue to roll out from the various financial houses, including Banc of America Securities, Raymond James & Associates, Sanders Morris Harris, and Lehman Brothers, to name a few in the last 10 days.
While general equities, as represented by the Dow Jones Industrial index, reached 15-month highs in September, the OSX, a widely watched index of 15 oil service firms on the Philadelphia stock exchange, has declined from its June peak.
Indeed the initial drop in the OSX was 18 percent during the third quarter. The index managed a 10 percent rally in August, but has since given half of that back so far this month.
For that, one can blame commodity prices. Natural gas prices peaked in late second quarter about the time Federal Reserve Board chairman Alan Greenspan was addressing Congressional committees. His testimony was widely quoted in popular media as predicting crisis in the natural gas sector, which was a misinterpretation of his actual remarks.
Since then, talk of crisis has faded weekly as natural gas storage injection moved forward at rates more than one-third higher than average. Natural gas prices are now down one-third from their summertime highs.
That price erosion serves as the basis for the downturn in recommendations on oil service and energy stocks. As research houses announce revisions to their price deck for the remainder of 2003 and 2004, there are repercussions for publicly held energy companies. All of those price revisions have been down.
There is a general belief that a certain threshold range exists for natural gas prices and field work. If prices drift below that threshold, operators cut back significantly on field work.
The price threshold reportedly lies somewhere between $3.50 and $3.75. But the assumption is that rig count turns south even before prices hit the magic threshold. In other words, as natural gas prices fall below the $4 barrier, the number of active rigs will begin to drop at an accelerated rate.
Usually high commodity prices encourage members of the E&P community to spend all their free cash flow--and then some. That has not happened in this cycle. Indeed, significant portions of free cash flow have been allocated towards debt and balance sheet issues, or funneled to reserves in anticipation of attractive acquisition targets. As a result, falling commodity prices now signal that capital spending will not rise much next year, if it rises at all.
Hence the downgrades.
Meanwhile, the industry sees every indication that gas storage levels will reach normal volumes heading into winter, a prospect that seemed dim, if not impossible, just five months ago.
Rig count has also lost momentum after peaking in early August. Generally, the count has been sideways over the last eight weeks. A funny thing is happening in the field. Larger independents who led rig count up earlier this year are now pulling back. They have been replaced with smaller, privately held E&P firms who seem to be adding rigs at about the same rate that the larger players are stepping back.
The last time this pattern occurred was the summer of 2001, shortly before the rig count followed natural gas prices down, ending the 2000 to 2001 cycle.
Indications are that end-of-year tax considerations could boost rig count some in the fourth quarter, particularly for the smaller E&P firms. However, permitting levels peaked in June and have since fallen incrementally lower in the nation's major drilling regions. Commodity prices, though lower, remain high enough not to portend a collapse in activity, at least for the moment. But it now appears this cycle will fall short of previous activity peaks as it evolves along a flatter and longer arc.
The rig count is proof of the former, though it may be premature to address longevity at this point.
This is why one can question whether the present drop in expectations for oil services is real, or an historical artifact. There are theories of seasonal cyclicality that come into play. The oil services research department at Banc of America Securities has done studies on seasonality in oil service stocks as part of a broader Timing Model Index. Those studies indicate that the fourth quarter is a time of falling values in energy equities anyway. Generally oil service stocks are sold as the fourth quarter gets underway in anticipation that activity will be seasonally lower about six months out. In other words, the equities market discounts activity in the energy sector about six months in advance. Similarly, equity values in oil services tend to peak in May with another peak late in the third quarter.
This year was no different. An index of investor-owned land drillers peaked in mid-May with a slightly lower peak in August. It has fallen since.
But there are some unofficial indications that this cycle may be beginning to age. For one, whenever the term "crisis" is paired with the word "energy," it usually occurs near cyclical peaks. Thus the Alan Greenspan Congressional testimony in the second quarter--though widely misinterpreted--was the first unofficial warning that an inflection point was close at hand.
A second unofficial indicator has to do with political response to high energy prices, typically in the motor fuels area. As gasoline prices spike, governmental investigations search for evidence of collusion, price gouging, or market manipulation. Generally this will include the Attorney General offices in various states, but it also applies to the national level as members of Congress conduct hearings into the price spike scenario. While that has not happened yet, the U.S. Department of Energy has been instructed to investigate the rise in gasoline prices that occurred before Labor Day.
Such investigations usually start with a great deal of publicity just as the peak occurs, but wind up six months or so later with no reliable evidence of price fixing, gouging, or collusion. Unfortunately, the articles detailing the investigatory conclusions are often buried in the back pages of newspapers.
Unofficial trends say the cycle has aged. Broader trends are uncertain. And that gets back to what the financial folks are doing. Investors can be the canary in the coalmine, or lemmings rushing for the cliffs. Either way, investor behavior often signals change is at hand in energy even before real evidence arrives. At the moment, investors--and their advisors--are anticipating a change for the negative.