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Don't try to catch a falling knife. It is good advice to avoid buying an apparently undervalued stock that is declining in price. I also like the comment by Bernard Baruch: "You take the 10% at the top and bottom, and I will take the 80% in the middle." That wisdom explains that being right on the big moves is good enough to make a fortune in the market, so why risk capital trying to time the turns?

All that good advice aside, it is awfully hard to sit on funds when interest returns are essentially nothing, after factoring in inflation. When you are managing a "diversified" portfolio, you need to review the mix of sectors occasionally. When the market appears oversold, it may be time to add a little toward sectors not represented adequately in the portfolio. Be careful not to use that logic as an excuse for compulsive buying, and only look at stocks that you want for a long-term investment. If you are a trader, you should go back to the first sentence of this article.

Oil Services Sector

An under-represented sector in our Roth IRAs is the oil service group. We had been suspicious of this group due to the natural gas glut. The short-term market action can be influenced primarily by the price of oil, and the recent drop to $83/barrel (see chart below) has brought many in this group back into the value range.

Click to enlarge image.

It is true that some drillers are highly leveraged, and they are left with large expensive rigs in the yard when producers are cutting back exploration due to low prices. On the other hand, some oil service companies have the flexibility to move their operations to the hot spots. When the producers decide to postpone drilling new wells, they may feel the need to do something to advance their exploration program. That may translate to more seismic studies or reworking some existing wells to increase production. None of the small explorers that we follow have indicated that they plan to reduce exploration budgets due to the recent drop in oil prices. That may occur, and it looks like the market has priced the eventuality into the oil service stock prices, which have dropped as much as 50% of their value in the past few months.

The real question before investing in this group is: Will the drop continue, or will prices stabilize and return to the $100 per barrel range? We are inclined to believe that the likelihood is that there will be events, both natural and political, that will eventually assure that oil will be above $100 for years to come. Apparently we are not alone in this assessment as the oil service companies listed in this article have analyst's estimates of double-digit growth into the foreseeable future. Even without high prices, the oil service companies will not be without work. We are not going to try to guess the bottom, but we are confident that, by the time we need the funds for retirement, these stocks will be much higher than they are today. This article describes the oil service companies that we think are worth a nibble.

Precision Drilling Corporation (PDS) is the largest oil and gas driller in Canada, and also offers well workover services. As of Dec. 31, 2011, PDS operated 188 land drilling rigs in Canada, 143 land drilling rigs in the United States, three land drilling rigs in Saudi Arabia, two land drilling rigs in Mexico, and one land drilling rig in Colombia. PDS also operated 189 well completion and workover service rigs and 17 snubbing units in Canada; one snubbing unit in the United States; 232 wellsite accommodation units in Canada; 28 wellsite accommodation units in the United States; 86 small-flow wastewater treatment units, four large-flow wastewater treatment units, and three potable water production units in Canada, among other services. Below is a table comparing PDS with the petroleum industry, service sector and S&P 500:

Growth EstPDSIndustrySectorS&P 500
Current Qtr.66.70%25.10%13.60%12.80%
Next Qtr.24.10%21.00%24.90%17.30%
This Year25.70%14.30%-4.60%11.40%
Next Year17.30%15.20%9.60%14.20%
Past 5 Years (per annum)-19.07%N/AN/AN/A
Next 5 Years (per annum)23.40%16.23%14.84%10.31%
Price/Earnings (avg. for comparison categories)6.2916.1517.1813.73
PEG Ratio (avg. for comparison categories)0.271.152.581.29

It is clear from the above that PDS is expected to have superior growth prospects for the next five years, and the P/E of 6.29 indicates that the current price is deeply discounted, due to the recent drop. The current price is about the book value of PDS, although the debt level is high from investment in new rigs, and maturities begin in 2019.

Precision Drilling has expertise in horizontal drilling and can move and redeploy their high-performance rigs quickly, taking advantage of the booming new North American shale plays. The rework segment may provide a less expensive way for producers to improve production, even if they decide to cut back on drilling.

Mitchum Industries (MIND) is an oil service stock that we liked at $13, but hesitated in adding the sector. We have had to watch the stock double, and now it is coming back to us. Its current price of $17.54 is a bargain as the forward P/E is less than 7, with 22% revenue growth. MIND engages in the leasing, sale, and service of geophysical and other equipment to the seismic industry worldwide.

While undoubtedly Mitchum will be affected by slower drilling activity and higher oil prices in the short term, the long-term prospects for MIND are promising. Its Seamap segment designs, manufactures, and sells a range of products for the marine seismic industry, and the precise mapping of the ocean is a prerequisite for oil exploration. Even during slowdowns, the geophysical surveys are likely to continue so that precise drilling locations will be identified once the producer is ready to invest in new wells. MIND turned in blowout earnings in the most recent quarter.

A quick comparison indicates the MIND value and growth measures are similar to Precision Drilling:

Growth EstMINDPDS
Current Qtr.43.10%66.70%
Next Qtr.209.10%24.10%
This Year29.20%25.70%
Next Year23.40%17.30%
Past 5 Years (per annum)6.66%-19.07%
Next 5 Years (per annum)15.00%23.40%
Price/Earnings (avg. for comparison categories)7.246.29
PEG Ratio (avg. for comparison categories)0.480.27

Key Energy Services (KEG) operates as an onshore rig-based well servicing contractor in the United States and internationally. The company offers rig-based services, including the maintenance, workover, and re-completion of existing oil and gas wells; completion of newly drilled wells; and plugging and abandonment of wells at the end of their lives, as well as specialty drilling services to oil and natural gas producers.

Like PDS, KEG missed overly optimistic analysts' earnings estimates in the last quarter, despite 30% growth. As a result the stock has dropped from a price of $18 in March to its current price of $9.56, with a forward P/E of 7. The following is a table comparing KEG to PDS:

Growth EstKEGPDS
Current Qtr.39.10%66.70%
Next Qtr.35.50%24.10%
This Year54.90%25.70%
Next Year33.30%17.30%
Past 5 Years (per annum)-12.18%-19.07%
Next 5 Years (per annum)12.00%23.40%
Price/Earnings (avg. for comparison categories)7.036.29
PEG Ratio (avg. for comparison categories)0.590.27

Key Energy provides maintenance for existing wells, fluid management and removal from producing wells and fishing services to recover lost equipment. The lower oil prices will temporarily cut back on growth in its business, but existing wells will continue to need maintenance. When oil prices inevitably rise, its business growth will resume.

Conclusion

By just about any measure, the above three stocks can be considered oversold, but specific characteristics of their business make them appropriate for different portfolios and investor appetites.

We use Precision Drilling as the baseline to compare the other two because it owns both the lowest Price-Earnings Ratio and highest five-year growth projection, as per Yahoo. However, PDS is predominantly a driller, and the drillers may be more susceptible to continued lower oil prices than others in the oil service sector. For our low-maintenance Roth IRA, with a five-year perspective, we are confident that both the oil price and the PDS stock price will be substantially higher when we decide to sell. An alternate in the driller group is Seadrill (SDRL), which pays a 7.6% dividend and has good growth prospects. The dividend has helped support the stock some in the down market, so it is not quite as undervalued as PDS. Because of the yield, SDRL may be easier to hold if you think the price of oil is going to stay low for a long time.

On the other hand, Mitchum Industries has the strongest momentum among the three in this article. It announced surprisingly good earnings, whereas the other two missed estimates in the last quarter. In the event of a jump in oil prices or a general market turnaround, MIND will probably make the biggest short-term upward move. We like that MIND is partly a technology company, but as such, it is susceptible to being made less relevant by changes in technology by competitors. Because of that, the long-term prospects are less clear for MIND than a driller like PDS, but short-term investors would probably have more success with MIND when things turn around. For those interested in the seismic business, without as much exposure to the technology change factor, TGC Industries (TGE) is basically a seismic contractor with growth, momentum and value measures that are exceptional.

The workover and fluid control business of Key Energy will not slow substantially because of lower oil prices. The effect of slower natural gas well activity is seen in the recent earnings announcement, which was slightly below analysts estimates. We think that of the three KEG is the more conservative selection, given that its business will be necessary to maintain producing wells. The growth rate is projected as slower than both PDS and MIND, so that is the trade off. Another undervalued stock in the same business is Basic Energy Service (BAS). We prefer KEG as its EPS growth is expected to be about 30% in 2013, while the BAS 2013 EPS is about flat.

It is a dangerous game trying to pick the bottom of the current market drop, but long-term investors should start looking for buying opportunities in these solid oil service companies.

Source: Cherry Picking 3 Cheap Oil Service Stocks