Shares of Schlumberger (SLB) and other oil-services stocks have endured gut-wrenching volatility over the past year. The Philadelphia Stock Exchange Oil Service Sector Index almost doubled from its summer 2010 low to its April 2011 high, before pulling back as much as 40 percent in early October.
Management teams rarely comment on the company’s stock price during quarterly conference calls, but Schlumberger’s management discussed this unsettling volatility at length during its Oct. 21, 2011, call. That wasn’t the only surprise. Former CEO Andrew Gould also participated in the conference call after indicating that the second-quarter call would be his last. Here’s Gould’s take on the recent volatility in Schlumberger’s share price:
Well, I think it’s not just our stock. I think there are a lot of quality stocks there’s a dislocation between market sentiment and the underlying realities. And that dislocation, as I said earlier, I think is largely due to uncertainty which everybody hates which is why some form of resolution to the European sovereign debt crisis, which is going to come, is likely to be an event that will settle people’s nerves. But a lot of industries, not just ours, the fundamentals are not nearly as bad as people seem to imagine. They’re anticipating the worst.
Gould articulates the same point I’ve made in recent issues of my advisory service, The Energy Strategist: The volatility in shares of Schlumberger and other services stocks might make sense if business conditions had shown signs of deterioration. But as I discussed at length in Crude Realities, Brent crude oil has consistently commanded more than $100 per barrel in recent months, reflecting tight supply-demand conditions in the global oil market. All of this adds up to robust drilling activity around the globe.
Fears about the macroeconomic outlook continue to drive the binary risk-on/risk-off trade. A weak economic data point or a discouraging development in efforts to address the EU sovereign-debt crisis is enough to send traders en masse to the safety of US Treasury securities. On the other hand, any encouraging macroeconomic news sends investors rushing into fast-moving names that stand to benefit the most from an improvement in the global economy.
Schlumberger’s shares have been caught in this vicious cycle. Check out this graph comparing the stock’s historical price-to-sales ratio to the mean price-to-sales ratio for this period and the standard deviation 1.5 percent above and 1.5 percent below this average. These standard deviations roughly delineate when the stock is undervalued or overvalued.
In 2007 and 2008, the stock’s valuation tended to hug the upper bound of this range. This elevated valuation reflected rising oil and natural-gas prices and a shortage of capacity to perform basic services related to exploration and development.
When the stock’s valuation collapsed in the back half of 2008, the move reflected the collapse in commodity prices amid the global credit crunch and recession.
But the most recent trading action is more difficult to explain. In early 2011, shares of Schlumberger hovered around the five-year average for price to sales, before plummeting to levels last seen in 2008-09. Although the stock has traded higher in absolute terms, its price-to-sales multiple remains at levels that prevailed during the Great Recession.
The current business environment doesn’t mesh with the stock’s depressed valuation. In fact, the price of Brent crude oil is almost three times its 2008-09 low. Moreover, the supply-demand balance in the global oil market suggests that oil prices will remain elevated for some time. Former Schlumberger CEO Andrew Gould drove this point home during the company’s Oct. 21, 2011 conference call:
I think we’ve said before and I’ll say again that the thing our customers dislike most, just like financial markets, is uncertainty. And I think that you have to assume before 2012 starts, the European Union will come to some sort of resolution on their sovereign debt crisis. And if you couple that to the fact that actually the supply situation is probably the tightest it has been since 2006, it’s certainly tighter now than it was in 2008. And if you look at the US inventories yesterday, they went below the five year average both for products and crude for the first time since 2008. So absent a really deep cut in demand, which would basically mean the developing countries going into recession, there’s no reason at this point in time to suppose that international activity is not going to remain pretty robust in the year to come.
Earlier on, I advanced a similar argument in The Energy Strategist when I said: Although estimates for oil demand have declined of late, expectations for supply growth have diminished to an even greater extent. In fact, the world has less spare productive capacity today than it did when oil prices surged in 2008.
Gould’s observation that the decline in US oil and refined-product inventories has buoyed the price of West Texas Intermediate (WTI) crude oil also bodes well for North American producers. The spread between the price of Brent crude oil and WTI had widened to as much as $30 per barrel in recent months. Although this anomalous discount should narrow in coming months, WTI will likely trade at prices that are roughly $10 per barrel lower than the price of Brent crude oil. My updated forecast calls for WTI to eclipse $100 per barrel by the end of 2011.
Check out this graph comparing US oil and refined-products inventories in 2011 to the five-year average, as well as the maximum and minimum storage levels over this period.
US inventories of oil and refined products in recent weeks dropped to slightly less than the five-year average for the first time since 2008. This development is hardly consistent with weak demand growth, especially when the decline occurred despite the release of large volumes of crude oil from the US Strategic Petroleum Reserve this summer. Storage utilization in Cushing, Okla., the delivery point for WTI, has also declined in recent weeks--another indication that inventories are being drawn down.
The current multiple on Schlumberger’s stock reflects investors’ emotions rather than the company’s business prospects. Investors began to embrace the firm’s bullish outlook in the spring, but a late-summer growth scare prompted sentiment to reverse in September.
I stand by my bullish outlook for oil services stocks and note that it’s difficult to find data to support the bearish case against Schlumberger. Although pricing power in the North American market could moderate as additional capacity enters the market, this softness is more of a concern for Halliburton (NYSE: HAL) and shouldn’t lead to a total collapse in profitability.
Meanwhile, elevated oil prices continue to support the exploration and development cycle, a key growth driver for Schlumberger. Management also noted that profit margins have started to firm up in some geographic segments.
Disclosure: I am long SLB.