Energy Sector Losing Steam
Since 1994, the average S&P 1500 Index energy stock has earned an Overall score of 65 in our Quadrix® rating system, versus 58 for the entire index. During that 15-year period, energy stocks also topped the index average in all six Quadrix category scores. But at the end of February, the average energy stock in the index earned a 46 Overall, its lowest month-end score in nearly seven years and by far the lowest of any sector.
Energy stocks suffer from weak operating momentum. They average a Momentum score of 30, by far the lowest of any sector in the index, in the wake of several quarters of difficult profit comparisons. Record energy prices inflated the sector’s revenue and profits in 2008. Momentum scores should improve in coming quarters as year-to-year comparisons become easier.
Consensus estimates project a 111% increase in per-share profits for the S&P 1500 Energy Sector Index this year after a 67% decline in 2009. The gains look impressive on the surface, but it is difficult to discern how much those expectations hinge on further increases in oil and natural-gas prices. The projected profits for 2010 are still about 30% below 2008 earnings.
In last week’s issue, we dropped Chevron ($74; CVX) from the Long-Term Buy List and also dropped two other energy companies from the Focus List. Right now, we recommend only three oilfield-service companies, all of which are reviewed below.
National Oilwell Varco ($43; NOV) delivered annualized sales growth of 31% over the last 10 years, but that well came up dry in 2009. Sales slipped 5%, while per-share earnings fell 23%. Profits are likely to fall again this year, but the oilfield-services company is proving it can manage expectations despite the downturn. National Oilwell has exceeded the consensus profit estimate in each of the last four quarters, including a 25% surprise in the December quarter. Earnings estimates are also trending higher.
The $6.4 billion backlog for capital equipment, equal to about one-half of annual sales, is down 42% from last year’s level. But management says only 4% of the backlog is at risk. The recession hasn’t impaired National Oilwell’s balance sheet. The company carries enough cash to pay off long-term debt nearly three times over. In December, a special dividend returned $1.00 per share to investors, and National Oilwell committed to future payouts by initiating a quarterly distribution of $0.10. National Oilwell Varco is a Buy and a Long-Term Buy.
Oceaneering International ($62; OII) finds itself in choppy waters. The company reported 8% lower sales in 2009, following six years of double-digit growth. Profits also declined after five years of growth. The 2010 rebound appears more modest than many expected, driving analysts to prune profit estimates. These factors have contributed to a decline in the stock’s Quadrix Overall score, which has sunk to 73 after starting the year in the high 80s.
However, Oceaneering, with operations throughout the entire deepwater cycle, enjoys a solid long-term growth picture. The company supplies umbilical tubing that pumps out oil and offers inspection and repair services to keep rigs functioning. Its biggest business is also the most profitable — a fleet of remotely operated vehicles (ROVs) that can dive to depths of 10,000 feet. Oceaneering plans to increase its fleet by nine to 16 vehicles this year. Wall Street expects 10% annualized profit growth over the next five years. Oceaneering is a Long-Term Buy.
While the recession has hurt Transocean ($85; RIG), the contract driller managed to grow operating cash flow 13% last year. The company is looking to give some of that back to investors through a dividend and stock buybacks. Transocean authorized the repurchase of up to $3.2 billion in stock and plans to pay a dividend of about $3.11 per share in four installments starting in July.
At seven times trailing earnings, 62% below the five-year average P/E ratio, Transocean looks very cheap. True, profit estimates are falling. But even using the year-ahead estimate, Transocean’s P/E is just nine, well below the five-year average of 13.
While profits fell during the recession, Transocean’s most important business — deepwater drilling — is going strong, with demand fairly high and rates up slightly over the last year. The company announced a five-year contract for a newly completed rig and said it could snag up to nine new contracts for ultra-deepwater rigs in the next year. A sharp decline in shallow-water drilling hurt Transocean, but that segment has begun to show signs of recovery. In January and February, Transocean saw more interest in shallow-water rigs. Transocean is a Buy and a Long-Term Buy.
Don't count on higher energy prices
In February, West Texas Intermediate crude oil averaged a per-barrel price of $76.39, up 95% from the February 2009 low. Natural gas averaged a price of $4.89 per thousand cubic feet at the wellhead, up 67% from the September low.
Historically, such strong rises have been good for energy stocks. Over the last 25 years, the S&P 500 Energy Sector Index has tended to rise during periods when oil and natural-gas prices increased. The sector index has risen 39% over the last year but is up just 6% since the end of September.
Whether energy stocks as a group will continue to do well depends in part on whether energy prices will keep rising — or at least whether investors believe they will rise. Predicting energy prices is difficult, and the Forecasts does not attempt to do so. However, in the following paragraphs we present three reasons why investors should not be counting on a large increase in energy prices over the next year:
Low estimates: The U.S. Energy Information Administration expects per-barrel oil prices to average in the low $70s this year and next year. The EIA also estimates natural-gas prices will average about $4.00 per thousand cubic feet this year and just over $5.00 per thousand cubic feet in 2011. Those numbers suggest roughly flat oil prices and a pullback in natural-gas prices this year.
Supply and demand: Supplies of crude oil and natural gas are neither particularly low nor particularly high relative to five-year averages. The International Energy Agency expects global oil demand to rebound after two years of declines, rising 19% in 2010 to 86.5 million barrels per day — roughly equal to 2007 demand. Some uptick in demand is expected during an economic recovery, but a reversion to 2007 levels is not likely on its own to spark sharp price gains.
Recent highs no benchmark: While current oil and natural-gas prices remain well below the 2008 highs, the peaks may simply reflect the top of a bubble. The February average oil price was 6% above the five-year average, while natural-gas traded at a 23% discount. Relative to the 10-year average price, oil trades at a 47% premium and natural gas at an 8% discount.
Energy prices are certainly capable of rising despite the points presented above, and it is risky to play commodity prices in either direction. The Forecasts recommends investing not in the sector, but in companies capable of outperforming expectations, such as the Buys and Long-Term Buys listed in the table above.