Dissecting the Oil Service HOLDRs ETF

Feb.27.07 | About: VanEck Vectors (OIH)

The Oil Service HOLDRs ETF (NYSEARCA:OIH) is comprised of 18 large oil service and drilling companies.

The ETF includes a who’s who of service companies, from Transocean Inc. (NYSE:RIG), the ETF’s largest position making up 10% of its holdings, down to Hanover Compressor Company (HC) at 1%. As oil and gas have had stellar rides this decade, so too have oil service company revenues and earnings. My question is whether or not continued out-performance is sustainable.

OIH 27 02 2007

Oil Service analysts point to charts like the following to show that the oil service stocks are cheap: (this chart shows the range between high and low P/E multiples for the OIH for a given year)

OIH PE 27 02 2007

... if current estimates hold up for 2007, these stocks are even cheaper:

OIH PE Forward 27 02 2007

... but it took rising oil & natural gas prices:

Rising oil and NG prices 27 02 2007

...for the majors and E&P [exploration and production] companies to support service cost inflation like this:

CERA Upstream Capital Cost 27 02 2007

Something’s got to give here!

Service cost inflation has wildly outpaced production growth, yielding large increases in per unit operating costs. Either:

1. commodity prices must continue resume their long-interrupted upward course, or
2. service cost prices must stagnate/fall, or
3. oil and gas companies must live with smaller margins.

Maybe it’s a combination of #2 and #3 that ultimately occurs. Without further increases in oil and gas prices, producer margins will be squeezed to the point that they rein in their capital budgets. And if that happens, then everybody (service and producer alike) suffers.

One Last look at Oil Service HOLDRs ETF, from a component standpoint

While the forward multiple averages 12x, you can see several outliers. Note also that the Street expects earnings growth to slow:

OIH Component PE 27 02 2007

(This post will be permanently archived with all my “Big Picture” posts here.)