3 Outstanding Energy Sector Investments

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 |  Includes: NOV, OII, SLB
by: Dr. Stephen Leeb

Our goal in these past couple of months has been to find stocks with measurable downside protection that have the potential for large upside surprises.

Clearly not every one of them is going to deliver. And even if we're right and these companies deliver in terms of free cash flow, dividends, etc., they could still go down further. But at least investors will have the solace of knowing that their investments are performing well, as companies… and from there the stock prices will take care of themselves.

On the other hand, certainly not every stock is going to deliver an upside surprise just by the definition of surprise. But if we're able to recommend, let's say 10 stocks, and three or four do have surprises to the upside, and the vast majority of the others hang in there, you're going to have a strong portfolio.

Our latest additions to this project are three in the most unloved part of the market right now: energy. In particular, we are going with three energy service companies: Schlumberger Ltd. (NYSE:SLB), Oceaneering International Inc. (NYSE:OII) and National Oilwell Varco (NYSE:NOV). Each dominates a particular segment (or in the case of Schlumberger, make that segments, plural) of the energy service market.

Schlumberger's forte is really the entire oil service sector. It has been the acknowledged technology leader in this space for almost as long as I've been in this business (and trust me, that's a long time). Its special strength is in exploration, which includes seismic, reservoir analysis and information, and all those technologies that tell oil companies how much oil they have, how and where to drill, etc. They've also become experts in offshore technologies.

What's changed about Schlumberger in the past decade or so is that previously, when times were good, they would invariably make some acquisition totally unrelated to their core focus on oil. If memory serves me right, one such acquisition was in the credit card industry. But for the last decade or more, the company has been wholly focused on energy services.

Back in the mid 80's and late 90's, a less well-run Schlumberger would leave the company holding the bag when oil prices fell: for example, it saw a 70 percent decline in earnings in 1999 and deficit earnings in 1985 and 1986. But during the worst of the recent decline in energy prices, Schlumberger's earnings have held up very well. And indeed, unless oil prices continue to fall sharply (something we don't expect, as we'll explain in a moment) Schlumberger's earnings in 2012 should reach record levels. Balance sheet metrics are also exceptional.

This is occurring only three years since their recent trough, whereas in the past the company was lucky to get back to record levels in six to twelve years from similar declines. The stock also currently sells at or close to its lowest valuation in memory, in both nominal and relative terms.

Turning to Oceaneering International, we're looking at the leading servicer of deep water drillers. And that's a darn good area to be in, as it's one of the few remaining sources of substantial hydrocarbons in this world of ours. The need for Oceaneering International's services shows up most clearly in its profits. Even at the worst of the recent recession in 2009, Oceaneering's earnings were essentially flat. Over the past five and ten years profit growth has been consistently above 20 percent a year. Although the company is no longer tiny, it still isn't so large that it's unreasonable to project profit growth of more than 15 percent a year well into the future. Again, we are assuming that oil prices don't have much further to fall.

We can't resist making one more comment about Oceaneering International, specifically about its balance sheet, which has nominal long-term debt and very substantial free cash flow.

Our third pick is National Oilwell Varco. This is a franchise that's been created out of several mergers. And as a large company (though not as large as Schlumberger) its earnings, too, are likely to blast through previous records in 2012.

That's not surprising, because the company is the largest provider of offshore drilling equipment - a wonderful area in which to have a franchise. True, the Deepwater Horizon catastrophe in the Gulf of Mexico may have slowed down offshore drilling; but the demand for additional hydrocarbons made the slowdown a very short-term one. And at the same time, the catastrophe itself has dramatically increased demand for blowout protection - an additional multi-billion dollar opportunity for this company already hitting on nearly all cylinders.

Like our other two picks, this one has an exceptional balance sheet. Indeed by one measure, free cash flow yield, it is the clear winner at over 10 percent.

Clearly we think we've made the case that these three stocks have plenty of downside protection at current prices. Indeed even if oil were to drop another 10 percent or so each would easily hold its own.

The upside catalyst for each would be at a minimum a leveling off of oil prices, but better yet, higher oil prices.

While space doesn't permit a detailed analysis here, we have to make a comment about Peak Oil. We've never actually been a believer in Peak Oil per se, on the simple grounds that, using an analogy we've used in the past, there is plenty of oil out there - more than we could ever dream of using - but it's a question of how much you're going to pay to get it. (For example, there's a moon that travels around the planet Saturn that's made of nothing but methane; but imagine the costs of bringing it back to earth.)

What we've seen in the recent past is that conventional oil, the kind you get by just drilling a hole in the ground and watching the oil erupt from it, has indeed peaked. So the cheap oil is largely a thing of the past.

Thus, we're now in a situation now where the marginal costs of oil are jumping, not only climbing at rates well into double digit rates. As a result marginal costs of oil are approaching triple digits. This means that if the world is going to grow, the demand for oil is going to grow, too - and by mid-decade these additional barrels of oil are going to cost more than $100 a barrel. This could be true even in places like Saudi Arabia, where clearly the economic marginal costs are low, but when you factor in costs for protection, which have become ever more essential for the Sunni kingdom, you can argue total marginal costs there will also approach triple digits.

Again, the very simple bottom line is that if the world is going to grow, oil prices are probably going to go much higher. And oil service companies, especially the three franchises we've mentioned here, will in this world we envision be sitting in the catbird's seat.

Please note that these are not recommendations that should be treated like trades. In the short term, obviously oil prices could drop further, and so could these stocks. But as we said above regarding every one of them, you have balance sheet protection, cash flow protection, and another form of protection we didn't mention earlier but should have, as it applies to all three - superior management. And over the next couple of years they could yield outsized gains in an otherwise turbulent market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.