On Monday, oil prices stabilized after dropping 10% on Friday. However, it is still unclear whether oil prices have bottomed or if this was merely a "dead cat bounce." Anyone who claims to know for certain where this commodity will trade in a few months is either fooling you or fooling themselves. There are too many variables that make predicting oil with consistent precision possible. OPEC could decide to cut production in a few months, how US shale plays respond remains unclear, global growth could speed up (or slow down), or an increase in geopolitical tensions could strain supply. Put simply, one could construct an argument for oil going to $45 or bottoming around $65. The near term is very uncertain.
In the longer term, I do believe oil has a place in your portfolio because demand for the fuel isn't going away. The transition to renewable energy is very slow, and emerging economies continue to demand more energy today. Every day, there is less oil in the world than on the previous day with remaining reserves becoming more costly, which keeps supply controlled over the longer term. Given these factors, I believe long term investors should be looking to the energy space at this moment. However with the near term uncertainty, it is imperative to invest in a name that offers an adequate margin of safety to avoid severe near term losses. That is why I recommend investors buy Baker Hughes (BHI).
On November 17, Baker Hughes agreed to sell itself for $19 and 1.12 shares of Halliburton (NYSE:HAL) with closing targeted for mid-2015 (details available here). On Monday, Halliburton closed at $41.19, which implies a deal value of $65.13; however, Baker Hughes is only trading at $56.52. Baker Hughes can rally 15% before hitting the deal price. At BHI's current share price, Halliburton stock would have to fall to $33.49 (a drop of 18.7%) for BHI shareholders to start losing money.
As oil service firms, Baker Hughes and Halliburton are levered to the cap-ex cycle, which is in part determined by the price of oil. Traditionally, oil service revenue is more volatile than the price of oil as small movements in oil can have larger impacts on cap-ex spending as E&P companies try to retain cash. However, these companies also provide a lot of services aimed at increasing the efficiencies of existing wells, which is even more important when oil prices are falling. In an environment where oil hovers between $50 and $70, I believe the new Halliburton (the one that includes Baker Hughes) can still earn at least $3.80 in 2015. By purchasing Baker Hughes now, investors are essentially purchasing the new Halliburton at 8.8x earnings. That is a very attractive valuation, considering that 2015 may represent a cyclical low in oil prices.
Given the steep discount BHI is trading to HAL, it is a wonder to me that investors would buy HAL instead of BHI, and it is important to explain why the discount is so large. No merger has a 100% certainty of being completed as the buyer may try to back out or the government may try to block it. As such, the acquired company tends to trade at a discount to the implied merger price to reflect the risk that the deal falls through. As shares can rally 15% before hitting the deal price, investors are saying there is a sizable chance the deal is not approved. I believe this is a mistake.
Yes, the new Halliburton will be the biggest oil service company; in fact, this is one reason I like the deal. The new entity should have more pricing power, which should boost margins. BHI and HAL have product overlap and should be able to generate $2 billion in savings once combined. While Halliburton will be the biggest service name, it will only be 5-10% bigger than Schlumberger (NYSE:SLB), and SLB will still be generating more profits. Between these two players, there will still be plenty of competition. Governments also tend to be slightly more lenient in mergers when corporations rather than consumers (who get to vote) are your customer.
While Halliburton and Schlumberger will likely be roughly the same size, HAL may end up being a bit bigger in select product categories. However, HAL has pledged its willingness to divest businesses that generate $7.5 billion in sales. If this full amount is reached, Halliburton would likely end up being slightly smaller than Schlumberger. There has been no suggestion that Schlumberger is too big, so Halliburton should not face anti-trust issues after these divestitures. It is also worth noting that Halliburton has a history of influence in Washington, which will prove invaluable through this process.
Finally, Halliburton has agreed to pay Baker Hughes $3.5 billion if regulators block the deal. This is a significant insurance policy and ensures Halliburton will do everything possible to close the merger as writing a $3.5 billion check is not anyone's idea of fun. This payout would amount to $8 per share. As a stand-alone entity, I believe Baker Hughes would be able to earn $4.20 assuming oil stays above $50. At 10x earnings and with the cash receipt from Halliburton, Baker Hughes would be worth $50. This implies that Baker Hughes has an 11% downside but 15% upside if the merger is completed. I believe there is at least an 80% probability the deal goes through, making this an attractive wager.
If I am right about the merger being completed, investors basically can buy Halliburton at an 18% discount by purchasing Baker Hughes. This provides investors with a very sizable margin of safety in case oil stocks continue to fall. Upon completion of the deal, Halliburton will be the leading oil services firm, with room for margin expansion, and a single-A credit rating to ride out any volatility. With its discount to the deal, Baker Hughes is a good way to add exposure to oil while maintaining a robust margin of safety.
Disclosure: The author is long BHI.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.