With natural gas prices still trading at depressed levels, firms operating in the energy service sector have taken substantial hits to their valuations over the past year. The two Canadian firms featured here, Calfrac Well Services Ltd. (CFWFF.PK) and Trican Well Service Ltd. (TOLWF.PK) have seen 30% and 40% of their market value eroded over the past year respectively.
Whether it is due to inefficiencies in the Canadian market, the smaller relative size of the firms or the discount related to fracturing operations, these firms trade at substantial discounts to their American and international peers. While at this point it is unclear whether or not this sector as a whole will have a strong recovery, if an investor is looking for exposure to a potential return in strength for the drilling and service industry, Canadian firms are a clear choice. Canadian operating margins for both firms are substantial higher than the margins they experience in their United States operations.
While many investors focus on the negative implications of low natural gas prices in North America, it is important to remember that many of these companies have overseas operations as well as operations in crude oil recovery as well. Liquids rich natural gas plays are also a popular area for exploitation especially in Canada as well as in the United States. Regardless of the state of the natural gas industry, the focus here is on the value of these two firms relative to their US peers, and whether there is a relative value opportunity.
In consideration of the current state of natural gas prices, however, four major factors are driving North American activity, as described by Calfrac in their 2011 annual report. These include:
- Horizontal Activity: More horizontal wells are being drilled and the average size and number of fractures per well have increased.
- Oil and Liquids Rich Plays: Fracturing is being applied increasing to oil and liquids rich natural gas plays. These are much more economical projects today than pure natural gas plays.
- Technology: Mainstreaming of technology has encouraged producers to test wells in more unconventional plays than in the past.
- Efficiency Gains: Producers and service providers are cooperating to reduce per-well costs.
Clearly, regulatory decisions regarding fracturing are a potential risk to this industry and it's important that investors have a firm understanding of this risk. However, with America looking at increasing its energy independence, fracturing and natural gas are going to have to be a key part of the solution.
Some of the key metrics are presented in the following table:
except per share amounts)
|Cash Flow Per Share||$6.69||$3.24|
|Adj. Earnings Per Share||$4.72||$2.34|
|Debt to Total Cap||36.51%||22.85%|
|Return on Assets||15.63%||17.37%|
|Return on Equity||31.32%||27.12%|
|Price to Book||1.3x||1.3x|
Now on its own, it looks as if these firms are definitely value stocks, with low price to earnings multiples and price to book values. The value in these firms becomes even more apparent when examined in comparison to American traded peers:
P/E Multiples, Energy Service Firms:
|FIRM||CFW||TCW||HAL||PDS||Baker Hughes BHI||NBR||Tesco TESO|
These differences are apparent despite both Calfrac and Trican reporting higher margins on their Canadian operations than they reported in their American operations. With greater exposure to a higher margin business, they trade at a significant discount to their American traded peers. While firms such as Halliburton (HAL) and Baker Hughes (BHI) are global diversified service companies, and are not direct comparisons, it is interesting to see the pricing differential between firms such as Nabors (NBR) and the two Canadian firms. What this would suggested is either the comparable American firm is overvalued, the Canadian firm is undervalued, or finally, that the discount related to fracturing activities is that substantial.
What is even more telling in terms of relative valuation between the two markets is the pricing of Precision Drilling (PDS) in comparison to its Canadian peers. Precision is a Canadian firm of approximately equal size to Calfrac and Trican, yet trades at nearly two times the price. Precision is also involved substantially in hydraulic fracturing operations, yet does not seem to be discounted to the extent of the two Toronto exchange traded firms. This again suggests an opportunity to take advantage of some potential cross border inefficiency.
It's important to note that both Trican and Calfrac are companies that do focus on hydraulic fracturing and would be disproportionately harmed by regulatory or legislative decisions that would restrict the technology. However, horizontal oil and gas must be a reality for American energy independence, something that I believe politicians in Washington do take seriously. As part of the discount in Trican and Calfrac is driven by this uncertainty around the regulatory future, your outlook on this technology and potential legislation should be factored into your evaluation. However, some of the American firms also rely on fracturing for a large portion of revenue (though perhaps not to the extent of Calfrac and Trican), so this needs to be viewed consistently across firms.
How to trade
While it is probably wise to remain cautious on any bullish outlook in the near term on natural gas prices, there are plenty of other opportunities for these firms to explore in the interim in natural gas liquids and horizontal oil plays. However, the argument behind these two stocks is not necessarily bullish trends in the market but their value relative to their peers. Earnings are not available this cheap in US traded oil service firms, and if investors are looking for exposure to this sector, it seems that value can be had across the border.
Investing in these two companies is also a great play if an investor is optimistic on the future of hydraulic fracturing in continental North America. However, it should be cautioned that much risk still exists in the regulatory outlook surrounding this technology.