A Rare Opportunity to Buy Precision Drilling Trust

It’s no secret that we are staring down the barrel of a global economic recession.  As the world's financial markets go through the painful process of deleveraging, liquidity has become scarce causing difficulties in a broad array of industries.

Perhaps one of the industries most affected by this crisis is the energy sector.  After experiencing oil prices dropping from $150 down to the mid-60’s and natural gas tracing a similar pattern, energy producers are seeing margins crimped ad profitability drying up.  The situation is a far cry from last year when CEOs of major oil and gas producers were dragged before congress to testify about their “windfall profits.”  Even OPEC has become concerned, but an emergency production cut did nothing to slow the decline in oil prices.

Precision Drilling Trust (USA) (PDS) has not been immune to the declines and in the last 3 months alone the stock price has dropped from $28 down to a low of $8.41.  The company owns rigs that are employed by drillers to dig natural gas wells.  As the price of natural gas declines, drillers have less incentive to employ PDS to help with drilling projects.  The scenario has hit PDS especially hard as the company specializes in directional drilling or horizontal drilling.  These types of wells are more expensive to drill, but when the price of natural gas was higher it made sense to spend the capital to drill because the payoff more than made up for the additional cost.

At this point, however, the stock has gotten to a price that appears to fully discount the economic weakness and the potential slowdown for PDS.  With a current price of roughly $10.00 and expected earnings of $2.18 this year and $2.29 next year, the stock is trading for less than 5 times earnings.  At the same time, management has noted a change in trend as the company reported the first quarter since 2006 where earnings were above the year-ago quarter.  This earnings increase corresponds with an expansion from the company’s primarily Canadian operations into the United States.

There are some interesting competitive dynamics taking place for PDS right now that could significantly change the earnings potential for the next several years.  First, on August 31, there was a non-compete agreement which expired, allowing PDS to fully enter the US market.  This is part of what drove earnings for the third quarter as PDS moved several rigs into the US and began drilling.  At the same time, PDS is in a definitive agreement to acquire Grey Wolf Inc. (GW) for a cash and stock deal.  While the purchase will be slightly dillutive to PDS shareholders initially, the deal will allow PDS to immediately have a strong presence in the United States which is the strongest market for it to be growing in.

Funding for the transaction as well as for its expansion plans should be in place.  While today it is hard to believe anything is guaranteed, the company has received funding agreements from a consortium of banks.  The capital will not only fund the purchase of Grew Wolf, but will help with capital expenditures as the PDS refits some of its existing rigs and builds several new units.  Of the new units being built, all but two are already under contract with clients who will pay day rates for their use.  So in the near term, it looks like the company has a pretty strong handle on its revenue stream.

For those a bit uncomfortable owning the driller without some cushion, I might suggest buying the stock and then selling the December 10 calls.  One receives roughly $1.30 per share for the calls which has the benefit of basically adjusting the price paid down to $8.70 but caps the 2 month return at about 13%.  Still, this is a good internal rate of return if the stock is called away, and if the stock trades lower and the options are not assigned, investors are expecting a 12 cent dividend on a monthly basis.  So there may be several ways to approach an investment in PDS, but the value appears to be compelling no matter how you look at the stock.

PDS Notes

Disclosure: Author does not have a position in PDS.

Comments

[beabaggage:]

Cold weather will help nat gas recover, plus companies are cancelling or "postponing" which is just lingo for cancelling Green Projects left and right. Just like in the 80', green momemtum will diminish. With nat gas down, any green efforts would be feasible using nat gas. Just today see FPL cut way back on proposed wind energy expansion in 09.
Long PDS, paid to wait with the div, even if they cut it, which seems unlikely in winter heating season and with merger on the table.

2008 Oct 27 09:11 AM

[NOWHEREMAN:]

Nice, concise article with future promise and a safety valve.

Let me tell you though, any Greenie reading this will accuse you of "worshipping false Gods".

2008 Oct 27 10:27 PM

[Zachary Sch...:]

... worshiping false gods... haha - That's an interesting take...

I certainly think there is a place for green energy and with stock prices in this sector so low, there are some great buys. However, the transition is not going to happen overnight and there will be a gradual shifting from fossil fuels to renewables.

All the best and thanks for the comments!
Zach
zachstocks.com

2008 Oct 30 07:01 PM

[greensails:]

Six weeks has passed since you wrote this piece, and today's financing announcment has hit PDS pretty hard on a day other nat gas stocks are higher. What's your opinion on today's announcement, especially the possibility of a distribution cut or elimination?

2008 Dec 11 11:21 AM