Land-Based Drillers Extremely Mispriced

Though I am a native Texan and current resident, I am quick to point out that my interests and knowledge base are pretty far from the energy industry. With that in mind, though, I bring a generalist’s perspective, a vantage point that can often allow one to be completely objective and not get mired in the group-think that often affects the views of the experts. I believe that the market is significantly discounting the value of the land-based drillers and have recently purchased the one that I believe is most attractive, Pioneer Drilling (PDC).

The universe of land-based drillers, whose price as a group (equally weighted) is depicted in the chart below, includes Bronco Drilling (BRNC), Grey Wolf (GW), Helmerich & Payne (HP), Nabors (NBR), Pioneer Drilling (PDC), Parker Drilling (PKD), Patterson-UTI (PTEN) and Union Drilling (UDRL). While some of these are pure-plays, a few have ancillary businesses as well.

As one can see in the chart, the group has rallied tremendously since $10 oil in 1998. It trades at 9X 2008 EPS, but, as the green line shows, earnings are very cyclical. The projections would seem to defy the historical pattern by showing only a shallow retrenchment in earnings relative to the typical post-boom plunges. Indeed, though, expectations have become somewhat tempered, as the group’s estimates have declined over the past year:

The short-term price action, though, shows that the market is starting to look ahead. The group is up strongly year-to-date as it recovers from the sharp contraction at the post-Katrina peak 18 months ago:

Why am I so excited? I believe that similar to the home builders several years ago, the group is mispriced due to a misunderstanding regarding the fundamentals of the industry. Like the aforementioned home builders (not a great analogy anymore!), the dynamics of the industry have changed such that what is typically cyclical can be much less so now. For the housing market, the catalysts were many: A tax law change that encouraged turnover, favorable demographics, an extremely favorable interest rate environment and trends that favored the larger public companies. For the drillers, the key difference is the significantly lower chance of a plunge in commodity prices that would make drilling uneconomic. Surely, there will continue to be shifts in supply and demand. After natural gas prices spiked, mothballed rigs were unstacked and new ones were built. Typically, one might then laugh at the industry expansion just prior to the plunge in the commodity price. In this case, as seen in the charts above, earnings estimates came down and the prices of the stock came down as investors tempered their enthusiasm, but there is no laughing now. The demand has grown into the supply. Another interesting point: Supply hit the market not only in rigs but also in the stocks, as BRNC and UDRL both went public near the peak post-Katrina. How was that for a sign?

In the chart below, one can see the growth in the rig count. In contrast to the extremely sharp commodity price moves over the past decade, though, we are in a period of relative stability. The bottom panel, though, depicts the valuation of the group. This is the key point: we are priced as though we are at a cyclical top! I believe that when the market figures out, in fact, that the downside priced in will not happen, the stocks could soar.

Why do I like PDC? I think that the group will probably trade as a group, but I recently purchased PDC because it is among the cheapest despite having a better balance sheet and the potential to be acquired. I am aware that their rigs don’t drill as deep and that they aren’t strong enough to support top drives, but I think that these attributes aren’t as significant as some might suggest. I believe that the real issue in terms of the company’s valuation is that it is of a different market cap group than its peers, which tend to be Mid-Cap. Its closest peer is GW, valued at over 2X. Mid-Cap investors are well aware of the group’s presence in the benchmarks, while Small-Cap investors are much less so. I think that the support is at 14.50 on PDC, with a year-end potential price of 20 or so (multiple expansion to 1.5, slightly improved earnings estimates). In the chart below, one can see various attributes for the group. While I like PDC, as I said before, I would expect the whole group to work.

click to enlarge

Disclosure: Long PDC

Comments

[Jeffrey Lin_:]

Great analysis Alan. I'd like to point out, however, that just as the trend is for deep water drilling in the ocean, land drilling must go much deeper as well. This might separate the haves and the have-nots where the ones with the best equipment & crew can drill deepest and those who have out-dated equipment are out of luck. Also, the turnaround in land drilling might not be as strong as your historical data shows. There might be less rigs put up because less places to drill. Unlike in the past, geological imaging has greatly improved such that drilling companies can identify wells instead of having to put up rigs to drill holes and check for oil.

Still, I'm not familiar with some of the names you suggested, so I'll definitely check them out. Thanks for this article.

2007 Jun 27 04:18 PM

[Alan Brochs...:]

Thanks for your comments, Jeffrey. I look forward to your follow-up. I believe that Pioneer has done a good job of keeping their equipment in top shape, but perhaps their shallower focus could prove problematic. With that said, though, just because there is a trend for deeper doesn't mean that that there won't be a continuing strong market for the depths that Pioneer drills. Management's explanation of the capital costs relative to day-rates suggest to me that the economics remain very favorable despite not being at the "bleeding" edge.

2007 Jun 27 05:03 PM

[Mmarrkk:]

I might take exception on the deep hypothesis. More and more rigs are being focused on unconventional plays like shale gas. In these plays, its not necessarily a depth issue as it is a reach issue...going horizontal. Wells aren't super deep (5000' to 10,000') but there are 1500' to 3000' horizontal sections being drilled. The big focus in unconventional gas drilling and development is turning the drilling program into a manufacturing process. Drilling hundreds of wells at rapid pace, using economies of scale to drag costs out, minimizing non-drilling time such as moving from well to well, etc. Efficiency is the word. The new-build rigs that are currently still on back order are driving efficiency to new levels. The old rigs can't compete.

2007 Jun 28 08:43 AM

[James Cullen:]

Very nice article - it really caught my eye, although that might be a bit of confirmation bias on my part.

The quantitative model I run monthly has selected GW and PTEN as "top 25" picks for the past several months; PDC dropped out of the top after running up about 20% since March... I don't quite do the in-depth analysis you did here, but fundamentally they are one of the top industry groups in the market.

2007 Jun 29 12:15 AM

[seterk:]

where can I find your top 25 picks? Thanks

2007 Sep 02 11:09 PM