Why I'm Still Drawn to BJS Services

Oil service company BJS Services (BJS) is heavily dependent on North American natural gas drilling activity. Recently, natural gas has been trading at historically low prices, especially when viewed in terms of a ratio of natural gas to oil prices. New supply from shale plays has created a situation where natural gas storage is much higher than for the same month in previous years, depressing prices. US active rig count, as reported by Baker Hughes (BHI), a direct driver of BJS's results, has declined from around 2,000 to 899 as of last report.

Now would be a good time to update my opinion on BJS, with special attention to the context of industry conditions and probable future scenarios.

I wrote the company up favorably back in December at 9.73. With shares closing at 13.68 Wednesday, I have a gain from that point but it is still well below my target price, 28 to as high as 76 at the time.

Original (hypo)thesis – here is the line of thinking from December:

BJ Services' business is cyclical, and there have been two trough years during the past ten: 1999 and 2002. Revenues for the trough year were substantially less than the preceding year: 26% less in 1999; 12% less in 2002. Price to Sales ratios have varied from .6 to 4.2, with the low point occurring in the year before a trough, presumably because the market was predicting the downturn.

At its low price this year – 8.67, BJS had a P/S ratio of .47, well below anything seen during the past ten years. If Mr. Market is correct, revenues for 2009 are going to be 26% less than 2008, if not worse. If history repeats itself, revenues in 2010, the recovery year, will be approximately the same as 2008.

Here's the interesting part – in the recovery years of 2000 and 2003, P/S ratios ranged from a low of 2.1 to a high of 4.2. History does not always repeat itself, but if it does, BJS could trade from a low of 28 to a high of 76 during 2010, assuming the natural gas business is in recovery by then.

Active rig count – The data presented is from Baker Hughes, US Active Rig Counts. There are a number of sources of rig counts, and various flavors, but the Baker Hughes US Active Rig Count is frequently cited and is used here. A regression suggests that the current need of active rigs would be 1,500 on an annual basis, increasing by approximately 50 rigs per year.

There is a definite pattern of sharp drops followed by longer build-ups. Bottoms occurred in 1999 and 2002, and in 2009 we are perhaps at the next bottom. If the rig counts recover along the lines of what happened after previous low points, BJS will recover in sync. However, there is an over-supply of producing wells, and it may take a long time to work off the excess capacity.

Producing well count – The data presented is from the EIA, and extends through 2007. The interesting point is that well counts decreased in 1999, presumably as older and less productive wells were closed down due to low prices. Of course this marginal production was missed when prices recovered, and perhaps some of the wells involved were re-opened.

Projecting the data forward, my impression would be that the level of producing wells will go further above the long term trend in 2008, based on the large number of rigs that were active that year. New data (to include 2008) is due 6/30/09.

Working gas storage – Natural gas is mostly stored underground, in previously emptied reservoirs. A large amount of gas is required to maintain pressure, and only part of what is injected can be withdrawn to accommodate seasonal changes in demand. That part is referred to as working gas storage.

As shown, working storage fluctuates quite regularly on an annual basis. Looking at the years 1999 and 2002, early in the year the amount in storage was higher than in previous years at the same time, demonstrating a correlation between prices, rig counts, and working storage. Not visible in the graph, for 2009 working storage is increasing more rapidly than in the previous year: as of 6/19 storage was 618 billion cubic feet ahead of the same point last year.

Price history – Natural gas futures have been on a roller coaster ride. At the 1999 and 2002 lows the prices correspond nicely with what you would expect based on working storage and rig counts. For 2006 and onward, and especially in 2008, natural gas prices were not driven strictly by supply and demand for that commodity, but were apparently influenced by developments in the pricing of crude oil.

2008 in review – Here is a link to an EIA report that provides good perspective on recent developments in the natural gas industry. A number of key points:

• Prices declined after hurricanes Gustave and Ike, even though production was disrupted
• Cumulative hurricane related shut-ins were 400 billion cubic feet from September through the end of the year
• Working gas storage exceeded the five year average toward the end of 2008
• 4,000 miles of natural gas pipeline were added
• Consumption was the second highest on record, imports were the lowest since 1997
• Prices exhibited a counter-seasonal trend

Long term view – The invisible hand has attracted huge resources to natural gas, as demonstrated by the upsurge in pipeline construction and the rapid refinement of horizontal drilling techniques. Natural gas is clean: coal is dirty. Natural gas is here in the US: oil is over there in Iran, Iraq, Nigeria, etc. Solar and wind power are intermittent and difficult to store: natural gas is continuous and the infrastructure for storage and transportation is in place and expanding.

Natural gas is going to be big: downturns should be regarded as opportunities to sign up for the long term.

Revised hypothesis for BJS – During 2008, natural gas pricing was distorted by the influence of speculation in crude oil, energy and commodities. This led to the development of production capabilities (producing wells) well in excess of underlying demand. Predictably, prices and rig counts crashed and are unlikely to increase until sufficient depletion occurs to align supply more closely with demand.

The timing is impossible to predict. The longer rig counts stay low, the greater the accumulated deficit in producing wells and the greater the rebound effect. Working gas storage is ahead of its normal seasonal patterns, suggesting supply still exceeds demand, in spite of the severely reduced drilling activity. Long term the prospects are good because shale wells suffer rapid depletion, so that it is necessary to drill more wells in order to produce the same amount of gas.

BJS revenue, EPS and share price will not fully recover until the excess supply in natural gas is worked off. The trajectory of the recovery will become clearer when the duration of the downturn and the size of the resulting production deficit are known. When recovery develops, a period of very strong performance is likely.

Strategy – I have been playing BJS by means of distant expiration options, currently the Jan10 7.5 calls. The decay of time value creates cost: to offset it I have been selling near-term OTM calls, currently the Oct09 15 strike. The thinking is, the calls I sold create an opportunity to exit the position if the stock gets ahead of itself, otherwise the premium received is a source of income while waiting for recovery. Implied volatility on BJS is relatively high, making the diagonal spread strategy attractive: it generates a 61% static return, annualized.

There are a multitude of companies active in various parts of the natural gas industry. Given the volatility of pricing, those that use excessive leverage are speculative plays. I am planning to review the industry and diversify my position to include a selection of natural gas related stocks, based on a long term positive view.

Disclosure: Long BJS as described in the article

Comments

[Respirate:]

Tom, fine comprehensive article. I appreciate that you don't speculate to give answers that you don't have.

Like you, I look to invest in areas that are currently depressed but have a very strong future. If you don't mind, a couple of questions:

Are you also positive regarding competitors like Weatherford (or others)? WFT seems to maintain better margins and efficiency during the industry's up cycle.

In anticipation of an eventual NG recovery, what's your opinion of suppliers such as Baker Hughes, or well consumables makers like Carbo?

Many thanks. --R

Jun 30 10:20 AM

[Larry House:]

Since timing is impossible, as you say, BJS makes sense as a long-term holding for better days ahead in the gas field.

Jun 30 10:53 AM

[Tom Armistead:]

Suppliers should be attractive, the thinking would be along the lines in the California gold rush a lot of miners came up empty handed but those who sold them shovels etc made money. Both CRR and BHI look good to me based on a quick look at their financials, and CRR appeared on a value screen I was looking at this morning.

I didn't make a systematic review of BJS's competitors - I looked at HAL and SLB but they seemed pricey at the time (a while ago) so I settled on BJS primarily for low multiples. At this point I am making a serious effort to understand the industry...WFT is one of the stocks I will look into as I get further along on the project.

Tom

On Jun 30 10:20 AM Respirate wrote:

> Tom, fine comprehensive article. I appreciate that you don't speculate
> to give answers that you don't have.
>
> Like you, I look to invest in areas that are currently depressed
> but have a very strong future. If you don't mind, a couple of questions:
>
>
> Are you also positive regarding competitors like Weatherford (or
> others)? WFT seems to maintain better margins and efficiency during
> the industry's up cycle.
>
> In anticipation of an eventual NG recovery, what's your opinion of
> suppliers such as Baker Hughes, or well consumables makers like Carbo?
>
>
> Many thanks. --R

Jun 30 02:32 PM

[ripskii:]

Another good company in this area is Dawson Geophysical (DWSN). They are the largest U.S. land based seismic company and their services are critical for both gas and oil drilling projects. The present high success rate in well drilling is largely a result of good 3-D seismic surveys and analysis. They are conservatively run and profitable with no debt and solid value.

Jun 30 08:57 PM

[Shale Gas:]

One other things to consider. The rig count has gone down but the overall percentage mix is shifting inexorably toward horizontal wells. Horizontal wells are more service intensive and that should help pressure pumpers.

Jul 01 08:30 AM

[Tom Armistead:]

There was an interview yesterday on Bloomberg, Jason Gammel of MaQuarie Securities, an energy analyst, with Pimm Fox.

Gammel says that new wells account for 25-30% of production and if we stop drilling production will be inadequate. He sees a V shaped recovery in natural gas prices.

He was willing to provide a time line, second quarter of 2010, and thinks prices could go from 2 to 8 or 9. I thought I would pass this along because the 25-30% figure quantifies how important new drilling is. After the smoke cleared in 1999 the wisdom of hindsight revealed that this number was 15% at the time.

Jul 11 06:47 AM

[Respirate:]

Thanks for the relevant update, Tom. I'm surprised that new wells account for that large a fraction of production. That fact taken alone may support the conclusion that the current drop in drilling activity could lead to an inordinate decline in 2009-10 production.

Taking another look at the chart data shows that the 2001 NG price spike correlates well with the marked decrease in the number of producing wells, and was preceded by a drastic cut in rig count. The current drop in rig count is even more significant than 2001 on a percentage basis, but it also looks like we have a higher base to work off before the slack is taken up.

However, there's one more item that may or not be a factor: capped "new" wells. The huge drilling activity from 2006-08 created a corresponding increase in new high productivity wells, but many of those were taken out of production, where they presumably wouldn't show up in the "producing" well numbers. If that's the case, there will be an additional lag of a least a year between work-off of surplus supply and a pickup in drilling activity, with a softer rise when it does ramp up. My thought is that the current slowdown for land drillers, field service providers, and well equipment & supply manufacturers could lag much longer than we (investors) would like -- well into mid-2011.

If you can snag a chart for the 2008 "producing wells" data, thanks in advance. I was unable to find the 30 June 09 data, and would like to compare the extent of increase in producing wells.

Regards -- R

Jul 11 09:37 AM

[ValueTiming...:]

What about HAL. They came on my value screen as well?

Aug 07 10:15 PM

[Tom Armistead:]

Today the news came out that BHI will acquire BJS in a deal valued at 16.3% above Friday's close, 15.43 x 1.163 = 17.94. So much for my target.

Apparently management is not optimistic about the chances of recovery in natural gas anytime soon, otherwise they would have held out for a better price.

Depending on the time value of the Oct 15 calls I sold I will probably close the position and put the funds to work elsewhere.

Aug 31 07:40 AM