With oil selling off significantly from its 2012 highs and natural gas prices depressed for most of the year, oil service stocks like Halliburton (HAL) have had a tough 2012. However, as is often the case in the marketplace, investors are ignoring the underlying earnings power of Halliburton.
Although I believe Halliburton to be an excellent long-term buy, I expect its share price to languish a bit longer, as I expect another leg down in the broader markets and in energy prices. Regardless, those who mitigate their individual equity risk with macro hedges shouldn't mind further weakness.
Halliburton operates in the oil services industry. HAL is employed to oversee the operational processes of drilling, monitor well construction and sealing, evaluate the drilling site, measure flow-rate, and so forth. The company supplies various technologies and equipment to those actually doing the drilling. Halliburton also maintains general consulting, IT infrastructure and software services that help clients perform their own operations.
A large part of Halliburton's business is the oversight of hydraulic fracturing, or "fracking." Though this operation has taken a lot of political heat, studies from the EPA have proven that the method poses no risk to drinking water supplies, given the various safety procedures that the operators employ.
There are definite "mega-trends" underway in the energy sector. The first is the transition from coal-based electricity generation to cleaner, more efficient, natural gas-based generation.
Just this past April, the EIA reported that coal and natural gas were each responsible for 32% of electricity production; compare this to 2007, when coal produced 100 million more megawatt hours than natural gas.
Halliburton benefits from this trend since natural gas producers utilize HAL's services to aid them in their fracking operations. Halliburton has strong operations in huge natural gas extraction sites like the Bakken, where they are the leading service provider. Obviously, with natural gas prices plunging below the $2 level earlier this year, production was rapidly cut to reduce market supply, temporarily hurting Halliburton's sales. Long-term however, natural gas production is in its infancy, and Halliburton's bottom line has already begun seeing the huge benefits from this trend.
As natural gas prices begin to rise and production picks up, Halliburton will return to the 50% operating income growth it enjoyed in 2010 and 2011. Since 2009, Halliburton's EPS has grown 152%, and yet investors are worrying about this year's weak growth, due to once in a lifetime natural gas price lows? It's terribly shortsighted, and has sent HAL to a no-growth valuation.
Another catalyst is offshore drilling, where Halliburton has large operations. The company's most recent 10-Q notes that its Gulf of Mexico operations have recovered significantly due to more drilling permits in the aftermath of the BP rig explosion. Offshore drilling is a particularly strong business for HAL as their technological expertise is a necessity for the complexities of the extraction process.
Valuation is only relevant to see whether or not a company is trading at fair value relative to its underlying cash flow generation and earnings power. In the case of Halliburton, trading at a mere 9 times trailing earnings, it is trading at a near 40% discount to the broader market multiple, despite a recent history of 50% EPS growth.
The market clearly believes that natural gas prices and overall energy demand will not recover anytime soon. Halliburton itself notes that natural gas prices of about $4 mmbtu are where producers achieve a reasonable rate of return on their investments.
I agree with the market's medium-term forecast; China, Brazil, India, and the U.S. are slowing markedly, and much of Europe may be entering a full-blown depression. This can't be ignored when analyzing any investment. The fact of the matter is an equity could be cheap and have an excellent business, but the overall economy can totally mess it up as a medium term investment.
That being said, Halliburton is trading at a huge discount to the broader market multiple, despite huge underlying growth. Five years from now, natural gas will be the clear leader in electricity generation, and will be responsible for far more vehicular energy. Firms will have worked out the supply glut, and Halliburton's leading services will be in high demand. HAL's EPS in 2017 could easily be double, if not more, than today's $3.20.
Halliburton's long-term prospects are exciting, and its business is so technological in nature that its existing competitors - Schlumberger (SLB), Baker Hughes (BHI), Weatherford (WFT) - are the only threats. Additionally, Halliburton's technology has been a clear leader, especially in the Bakken region, where drillers have been heavily utilizing their services.
There are some undeniable risks to the overall macroeconomy in the medium term, and they are going to affect all equities. Investors who implement their own macro hedging strategies don't have to worry, but vanilla investors may want to wait if they're not willing to experience any near-term pain.
I understand that some readers may be confused by my conclusion that Halliburton is cheap, but may not be a good investment at this very time. This is simply a result of my strong bearish feelings on the overall economy; if you feel differently, start accumulating Halliburton for the aforementioned reasons. Halliburton should outperform the market over the next decade by a wide margin.