It's no secret that things are bad for oil drilling companies.
U.S. crude oil prices have experienced a tremendous 58% decline from the high of $107.22 last May to the recent low of $45.42. While oil prices have rebounded moderately in recent weeks, the current price of a barrel of oil is still just $57.25 (down 47% from the high).
Low oil prices are bad news for drilling companies… Really bad news.
Energy companies which own the rights to oil reserve typically hire drilling companies to tap into underground reserves. Drilling an oil well is expensive and requires significant expertise.
In the U.S. especially, a drilling process known as "fracking" has been used to tap into shale rock formations. In the past, it has been difficult to reach oil and gas reserves trapped in shale rock. But the fracking technique uses high pressure water to fracture the rock and then sand and other chemicals to prop open the fractures, releasing the gas and oil.
When oil prices were high, fracking companies were in high demand. Oil companies could could afford to pay drillers to bring their rigs in and tap into resources. Selling oil at a high price more than made up for the expense of this specialized drilling process.
But now that oil prices have plummeted, oil drilling companies are facing some serious risks. Oil companies are cutting projects in an effort to cut costs. They simply can't afford to keep drilling when they can no longer sell the oil produced at a premium price.
As projects are cut, revenues for drilling companies plummet. This week Bloomberg ran an article speculating that half of the companies which currently provide fracking services will either be out of business or sold this year. This, after the industry has already consolidated by 30% over the past year.
On Tuesday, drilling company Baker Hughes (BHI) announced that it will cut 17% of its employees in an effort to cut costs as projects are shuttered. This echoes similar plans which have been announced by rivals Halliburton (HAL) and Schlumberger (SLB). On Wednesday, Weatherford International (WFT) announced that it will expand its layoffs to cover 10,000 workers.
As oil prices have dropped, stock prices for all four of these drilling companies have fallen, with market values declining anywhere from 30% to more than 50%. It's been a truly bloody season for energy companies, with drilling stocks bearing the brunt of the carnage.
To top off the dismal environment, Weatherford International reported a loss of 4 cents per share after the market closed on Wednesday. This, compared to Wall Street's expectations of a profit of 1 cent per share. One would think the news would send the stock lower - right?
So Why Did Drilling Stocks Rebound?
Somewhat surprisingly, shares of WFT gapped higher when the market opened on Thursday morning. By the end of the day, the stock closed at $14.21, more than 6% higher than Wednesday's closing price of $13.37. So while WFT's announcement was even worse than analysts had projected, investors still found a reason to be optimistic.
There are basically three reasons shares of WFT traded higher following Wednesday's disappointing announcement:
- Investors are encouraged by cost cutting. As part of its quarterly announcement, WFT announced that it is increasing its layoff program from 8,000 to 10,000 positions. These layoffs should save the company $640 million. The company is also shutting down seven manufacturing facilities and 60 operating facilities in North America. If WFT is effective in cutting costs, future profits could be stronger than investors are currently expecting.
- Oil prices appear to be stabilizing. Since April 6, oil prices have pushed above the key $50 per barrel level and have not retraced back below this point. While no one has a crystal ball, the longer oil stays above this level, the more confident investors can be that the worst is behind us.
- Drilling stocks now represent a deep value. Analysts expect WFT to post a modest loss in 2015 (just 4 cents per share), followed by a profit of 29 cents per share next year. Meanwhile, HAL, SLB and BHI are all expected to post profits this year and to grow those profits next year. Bargain hunters now appear to be nibbling on shares of drillers to take advantage of the low stock prices.
Over the last two decades of investing, one of the things that we have learned is that it's not usually the actual news that matters. Instead, it is the market's reaction to the news.
The fact that shares of these driller companies have been able to rally despite the bearish fundamental overtones tells us that the selloff for drilling stocks may be near its end.
Logistically speaking, most of the investors who are worried about lower oil prices have already sold their drilling stocks, leaving long-term investors with plenty of intestinal fortitude holding the remaining shares. As value investors step in to take advantage of the low stock prices, demand for these shares may continue to send the stocks higher.
In March, we explained why ConocoPhillips (COP) could be one of the strongest survivors of the oil downturn. Later, we noted that disappointing employment reports could actually be bullish for oil prices. And today, we're taking a bullish stand on oil drillers as these shares appear to have found a bottom.
Our tactical strategy for creating investment income typically revolves around selling put options on stocks that we would like to own. This strategy works especially well for drilling companies because uncertainty surrounding these stocks has led to higher option premiums.
By selling put contracts on these drillers, we are agreeing to buy shares of stock at a specific price, and we are getting paid extra income for taking on this obligation. If shares of WFT or the other drillers trade higher from this point, our obligation to buy shares will go away (and we will get to keep the income from selling the puts). And if the stocks pull back, we will get to buy shares at a discount to today's market price (while still keeping our income from selling the puts).
Over the next few trading days, we will likely set up one or more put positions in these drilling stocks.
