Pair Trade: Oil & Gas Exploration and Drillers

For my explanation on pair trading, please see here.

Industry: Oil & Gas Exploration and Drillers

With oil finding support and unlikely to trade much lower than $60, and hurricane season fading, the oil and gas drillers may be ready to make a move higher from terribly oversold conditions. With oil no longer at $150, the strongest companies will survive and the ones with strategic contracts will thrive as competition heats up. Although there has been demand destruction, the outlook abroad continues to be brighter and raw material costs such as steel are declining which should lead to some margin expansion. Valuation is at a record low for the group and without worrying about where oil is heading next we can execute a pair trading strategy to reap gains on relative strength in the industry.

Long: Rowan Companies (RDC), $18.66: Rowan Companies is down 51. 63% this year, with most of the losses in recent months as oil prices have slid. Rowan and Co. provides a range of onshore and offshore drilling services in the US and abroad and also manufactures and markets drilling products and systems, which can be seen as a lower margin segment due to rising input prices, but provides a nice diversity shield in times of volatile oil prices. Rowan operates at efficient day rates and is expanding production while oil prices continue to rise, and the company will continue to reap the profits. Current day rates have increased 300% in the last 3 years from $48,000 to $150,000 on average.

Rowan trades at the second cheapest Price/Book in the industry at 0.82, the third cheapest Price/Sales at 0.96, and the fourth lowest PEG at 0.34 in a group that consists of 24 companies after filters were applied. There are also no debt concerns with this company with a current ratio greater than 2.7 and a Debt/Equity ratio of 0.18. Rowan’s EV/EBITDA is 2.78 which is lower than peers such as Bill Barrett which is at 3.48. Growth prospects are outstanding for Rowan as it recently signed contracts with Royal Dutch Shell (RDS.A), McMoran Exploration (MMR), and Devon Energy (DVN). These two year contracts provide earnings stability and show that Rowan is one of the true big time players in the jack-up world.

Short: Bill Barrett Corp. (BBG), $20.06: Bill Barrett is down a comparable 57.14% this year. However, the company’s outlook looks much worse considering the lack of liquidity with a current ratio of just 0.76 even though it received a recent expanded credit facility. Shares are trading at a price/book of 1.28 while management efficiency ratios such as ROA (4.93%) are much less than competitors. 

Also, Bill Barrett has the highest short interest in the industry, and shorts are often thought to be the smartest of the traders. Bill Barrett operates in the rocky mountain region where the prospects for growth are much less than areas such as the shelf in the Gulf of Mexico where Rowan operates. The below table will more clearly show the valuation disconnect between these two highly correlated firms.

Correlation: 89.08% correlated over the past 3 months.

Fight Card”

 

 

The Trade

RDC: Long 1 April ’09 $17.50/$25 vertical call spread for $270

BBG: Short 1 March ’09 $20/$30 vertical call spread for $270

Disclosure: none

Comments

[Alan von Al...:]

Good research. Adding you to my author Watchlist.

2008 Nov 03 05:37 AM

[Augustus:]

BBG is not a drilling operation but a production company. It seems to be pretty sound financially and has substantial production volumes. I don't see it as a comparable company to RDC.

Thanks for the idea of the JPM / WFC trade.

2008 Nov 06 02:58 PM

[Tig:]

Rowan will soon change even more as current CEO, Danny McNease retires under pressure of Steel Partners, who will continue their hostile takeover after the unsuccessful attempt to sell off the LTI (LeTourneau) manufacturing division. Rowan has been quietly laying off employees starting April '08, selling off aircraft, and slashing budgets in attempt to increase profits and head off the takeover, but recent market and oil price slides have sealed their fate.

2008 Dec 01 04:01 PM