Matt Badiali: Time to Buy Oil Service Companies

Apr. 24, 2009 4:29 PM ETRDC, BJS, PKDC
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The Energy Report features leading investment coverage of fossil, nuclear, renewable and alternative energies. A Streetwise Reports publication.

Matt Badiali: Time to Buy Oil Service Companies
Source: The Energy Report 4/23/2009


Who doesn't want the opportunity to make 300%, 400%—even 500%—on stocks? "As an investor right now," says Matt Badiali, editor of the S&A Oil Report, "I think this is the best time you could possibly be buying your oil stocks." In this exclusive interview with The Energy Report, Matt reviews the last two decades of this highly cyclical commodity, explaining how you can capitalize on 20-year lows in oil service companies before the world economies stabilize.

The Energy Report: Matt, could you give us a general outlook for where you see green, renewable and fossil fuels going? How about both short-term (one to two years) and longer-term (two to five years)?

Matt Badiali: Right now, I am really excited about oil. People seem to forget that oil is a highly cyclical commodity. It's been as low as $10 a barrel in the last 10 years. It shot all the way up to $147 a barrel last year, and it's back down to really cheap right now. What happened in concert with this economic collapse is that people have abandoned oil companies.

So, the index of oil service companies is trading at just over book value. You can find fantastic companies that own all the tools and equipment needed to drill oil and gas wells, and they're trading at less than the scrap value of their equipment because the market is afraid. They look at the yards full of drill rigs and say, "what economic value does a drill rig have right now?" If it's parked in the yard, it has none; so, they assign 30% or 40% or 50% discount to the value. That can change dramatically, and it has.

If you look at the last 20 years, there have been about 10 big cycles wherein these oil service companies have gone from less than book value to three, four, or even five times book value. So as an investor right now, I think this is the best time you could possibly be buying your stocks.

In terms of forecasting, I am not a big fan of trying to put numbers on things. But let's look at gasoline demand. Gasoline makes up about 45% of oil use. So out of one barrel of oil, 45% of its useful stuff is gasoline. Gasoline demand is down less than 1% over last year (the 30-Day Report just came out, and it was .82%). So, the demand hasn't really fallen off; people had stopped driving when gasoline hit $4, but when it fell all the way down to $1.60 or so a gallon, they started right back up again. And when you talk to people about their gasoline conservation, and they say, "Well, I started to conserve, but the prices fell. . ." So, consumption doesn't seem to have gone anywhere, and that tells me that the outlook for oil is very, very good.

TER: But Matt, if the oil price goes up, and as a result the gasoline price goes up—and we did see a drop in driving when gasoline prices were $4—if we project forward a year or two, aren't we expecting gasoline prices to go back up there, and won't demand go down by more than 1%?

MB: Well, when oil hit $90 a barrel, I thought how could it go any higher than this? I was very, very wrong about where it would go. Yes, I think if gasoline hits $4 a gallon, it really has a big effect on the entire economy. But things didn't seem to slow down when oil was at a $100/barrel. I wonder if this hadn't been concurrent with the banking and the mortgage crisis, what would have happened. Would we just have adjusted? Oil goes from $10 to $20 a barrel; people moan and weep and pull their hair out, and then they adjust.

It goes from $40 to $80, and the same thing seems to happen. But it just got so that speculation was really rampant, and the prices just really, really soared. It didn't seem to find an operating level, and I think that's what will happen. That's OPEC's business plan right now. They want to see oil hit an operating level of around $70 a barrel.

TER: So, if oil hits an operating level of $70 a barrel, is that high enough for the oil trade to start pulling these drill rigs out of the yards and putting them back out?

MB: Oh, absolutely. I think if oil hits $60 a barrel and stays there for a while, you will see a dramatic uptick in utilities—in terms of these drill rigs coming back out. Really, the other thing that I am most concerned about is natural gas prices. I have seen natural gas—if it hits $6/MCF again. $7/MCF again, you will see massive mobilization of drill rigs. That’s because the unconventional natural gas shales become economic to produce. Are you familiar with these natural gas shales, these unconventional shales? I'll give you some context.

You can think of natural gas in a traditional or conventional system as the carbon dioxide on top of a soda bottle. Soda would be the oil and topping it would be the natural gas. You put a well in there and you siphon off the gas from the top. But in these unconventional shales you have this very fine-grained rock that is really rich in organics and is usually deposited at the bottom of a giant lake or an ocean basin. And the organic is converted into natural gas, but there is no way for it to get out; there isn't enough room for it to move and collect in one big place like in a traditional system. So, what happens is it collects in the cracks in the rocks.

And in the last decade or so two techniques have really revolutionized the natural gas industry. One is what they call "horizontal drilling," which is the ability to take what would be a vertical drill pipe and send it any direction you want it to go. And so if they map the natural cracks in the rock, you can actually direct the drill rig across those cracks to maximize the amount of natural gas you can produce. That way, you hit the natural avenues and alleys in these rocks.

The second thing they've done is they've really come a long way in their ability to come to explode the rock in the well. So, they put in a high-pressure fluid, water or gel that actually expands the natural cracks, and in that fluid they pump sand to hold the cracks open.

Those two technologies have just revolutionized the natural gas industry. The most natural gas we've ever produced is what we produced last year, and it was just a phenomenal amount. And so, it needs about $6 or $7 per thousand cubic feet (MCF) for these unconventional shales to be cost effective, but there's so much natural gas there now.

TER: So, we're talking about natural gas in the U.S. going up a lot and we've had more production of it in the last year than previously. Yet, in order to bring these oil drill rigs back out of the yard, we're expecting natural gas to go up to $6 Per MCF. I'm missing the connection. It looks like oil won't go up because we have so much natural gas.

MB: I think they're going to be independent of each other. First oil will move. The price of oil will continue to be set internationally. But natural gas, I think will be set regionally.

That's the hard thing about predicting what's going to happen. Natural gas is a volatile commodity. The demand for it really relies on climate; and, in terms of natural gas consumption, what's going to affect prices is this new energy plan. If they pass the cap-and-trade program, essentially a carbon tax, they're going to make coal incredibly expensive for electrical plants.

Natural gas is the second-cheapest source of generating electrical power in the U.S.; coal is the first. Coal is half as expensive per kilowatt or per BTU as natural gas. But if they pass this cap-and-trade system, it's going to make coal much, much more expensive. So then you're left with how do you make up that deficit of electrical generation? Where do you come up with a source of cheap electrical power? And that source is going to be natural gas.

And in that case, demand will rise and you're going to need these unconventional shales. And I just think you're going to see natural gas consumption increase. In fact, when you think about how everyone's pushing green energy, and you look at solar power, it's only 50% reliable because it's got one big flaw and that's nighttime.

I know the green people are going to burn me over the coals for saying that, but it's true, and there really aren't any massive battery storage systems that are economically feasible right now. So, how do you make up that lack? Well, you have to have an alternative power source, and right now the best and cheapest alternative power source for nighttime is natural gas. The same thing goes for wind; wind is great, but sometimes the wind doesn't blow so you have to have a back-up system—and that's natural gas. Now, the one other green electrical generation source that I like is geothermal power.

TER: Yes, I was about to ask you about that.

MB: There's a ton of geothermal potential but, outside of the Navy, geothermal isn't exactly economic yet. I think with the amount of help that the government is planning and if—again, all this rests on the cap-and-trade—if they really make coal expensive, geothermal is going to be the best, viable, green electrical power. But when you look at the economics of this stuff, these alternative energy sources that everybody puts forward are in order of magnitude more expensive than hydrocarbons.

TER: But isn't there a natural tension that will develop here as we continue in our recession? People, especially those on the East Coast, use coal-driven electricity quite a bit. Who can afford it? There's going to be a public outcry that energy is getting too expensive. Do you think politicians will stick to this whole cap-and-trade legislation?

MB: I think it's going to be tough. I was talking to another author who works for InvestmentU recently at a conference and, when I did the estimates, I figured our electrical bills are going to double. So, if you're Joe Homeowner like me; it's going to cost twice as much once cap-and-trade gets passed. He came up with triple. This is all public information.

TER: If the plan doesn't go through the way it's laid out, what's the prognosis for natural gas and oil? Is it still the same or will it go down?

MB: No. Here's the other part of the oil price that I didn't talk about. Mexico, Nigeria, Venezuela, and Iran have been taking the money they've made from their oil industry and they've been diverting it to social programs.

Well, an oilfield is like a loaf of bread and the oil company is like a sandwich shop. You have to set enough of your sandwich shop profits aside to buy another loaf of bread; otherwise, you're out of business. And that's pretty much what Venezuela, Mexico, Nigeria and Iran are not doing. So, they had a great big loaf of bread, and they just figured they didn't need to do anything else. And then the government became more and more reliant on that income and less and less willing to invest any money in the maintenance costs of the oilfields.

TER: So, the supply seems to be depleting, the double peak oil concept.

MB: Massive, massive depletion. Don't get me started on peak oil. The peak oil theory is based on engineering data. What the engineers never figured on is that we'd find oil and gas in places we never thought we'd find them, like off of South America right now. Nobody anticipated finding the oil that we're going to find in the sub-salt areas there.

Tupi blew everyone away; Tupi is Petrobras' massive light oilfield. It's rewriting the geology books as we speak. It is just an unbelievable discovery. Now, I've heard it compared to Ghawar, which is Saudi Arabia's giant flagship field, but I don't think that's quite accurate because in Saudi Arabia and oil came out of the ground. So, you had this wonderful light oil you could almost put in your gas tank and drive away with. It was right there at the surface, so you really didn't have to do anything difficult to get the oil out. The operating costs there are single dollars per barrel of oil.

Tupi and these fields off of South America are going to be a whole different story. They're going to require technology that we haven't developed yet to get at that oil. You're talking tens of dollars per barrel to get that oil out. But it's going to be economic because we're going to need it.

People say they want wean our society off of oil, but when you stop and think of what that implies, how do we untangle our use of oil and maintain the quality of life that we have? It's such an enormous proposition that it's a multi-decade problem. In the meantime, you have the demand that's going on right now and through the years. So, I think oil investing is going to be a great place to be. It's going to be a necessary place to be for investors who want to make money over the next decade. There's no way around it.

TER: Let's talk about some of those opportunities from an investor's point of view. What are some of the investment plays that our readers should be looking at?

MB: Well, as you know, oil is a very cyclical industry, and folks who capitalize when it's down do very well. I think that you have an opportunity to make 300%, 400% and 500% in those oil service stocks. They're so volatile that when you look at the 20-year history of these things, when oil has moved 50% to 60%, they'd move 150%. So, that's where I look.

I've found the companies that have been around for 20 years, where you can actually chart their moves, and I told my readers there are some keys to buying these companies. You could buy the index, which doesn't move quite as well as some of these companies, but you have a safety margin there that I like. But if you're looking at individual companies, my criteria are longevity—they have had to be around through several of these cycles, which proves that their management team understands the nature of the oil business. And they also have to have low debt.

So, I like a company that doesn't have a whole lot of debt, and I also like to look at their 10-year average operating income; that's an old Ben Graham and David Dodd technique. You look at three, four, or five years of average earnings, and then you look at the price of the company based on that rather than looking at last year's earnings. A lot of people are falling into this trap using that price-to-earnings ratio. They were using last year's earnings when the price of oil was over $100/barrel and this year's share price, thinking, "Oh man, these companies are really cheap." And the trap is that this year's earnings could very well be negative, as the price of oil drops to $30, $40, $50 a barrel. Some of these guys are closing up shop.

The mining industry went through that, as well. And the base metal companies, if you used last year's copper company's earnings and today's prices, they look really cheap. Then you look at how much it costs to operate some of these mines and these wells, and they're going to be shutting some of this stuff down. So you just can't do that.

So I use 10 years of average earnings, and I bought companies that were cheap compared to 10 years average earnings. There are probably 10—15 companies with over $400 million market caps today that meet my criteria. And I think they're going to pay off big for investors. I think the three that I recommended recently will probably make 150% on an average over the next 18 months.

TER: Can you share some of those names with us?

MB: Sure, I recommended three. The first one I recommended was Rowan Companies Inc. (NYSE:RDC), which is a driller with some offshore rigs. They're the classic example of a company that has been around for many years. They were founded in 1954, they own services that they would call "drilling service in stream" and they also have some mining and forestry equipment.

They're a big company; their average market cap over the last four years was nearly $4 billion ($3.7 billion). Today, they're about $1.4 billion; so, they've come way down. They're selling right now at just half of their book value; so, basically, you're buying all of their offshore rigs and all of their drilling equipment at half the price.

It's a great opportunity for an investor. All we have to do is have the market value for that equipment—what it's actually worth—and we've doubled our money. That, to me, is an incredibly powerful statement. We haven't had these opportunities in 20 years.

The second company I recommended was BJ Services Company (NYSE:BJS); they're just under $3 billion market value. The company was founded in 1872; so they've been around a long time and they are the premier fracturing company. Remember what I said about the natural gas—the unconventional gas shale? I said one of the two technologies was horizontal drilling and then there was the ability to fracture these rocks with high-pressure fluid. Well, B. J. Services is one of the best companies in that field and the technology is now a main staple of the oil and gas industry. It allows us to drill for oil and gas where we've never drilled before. It's necessary, and so that to me is an incredibly huge moat around B. J. Services; these guys are not going away.

They have low debt, they're very cheap and right now they're trading at less than book value. If you look at their 10-year average prices, we stand to make between 175% and 260% gains if they just hit their averages, if they just return to the mean.

These are the opportunities that are just mind boggling; I've been jumping up and down about this for weeks now. I just can't get over it. This isn't one of those things when I say, "If they just returned their average," and you reply, "Well, Matt, it could take years; it could take decades for them to return to the average." Right? That's the problem with some of these deep-value investments. "Wow, we'll make a lot of money if we're patient."

Trading oil is not quite day trading, but it's like attention deficit disorder value investing. You have this fantastic opportunity, and we don't have to wait that long—18 months, two years.

The third company I recommended was Parker Drilling Company (NYSE:PKD). You know Parker has always been one of my favorite drilling companies. They were founded 70 years ago, and they were one of the first companies to switch from steam to diesel back in 1935. They're great; they went international in 1945. And drilling is really all they do; they rent drilling tools and they do some construction. The company's been through these cycles before, and it's so incredibly cheap.

And the book value is less than .4; so again, it's one of those companies that, if the market just valued their tools and equipment for what they're worth, we'll more than double our money. And the gains look to be between 300% and 400% if Parker just comes back to average.

So, I'm not shooting for the moon with these. I'm not telling you if oil gets back to $150/barrel, you're going to make 200%. I'm telling you that if this industry just comes back to its long-term average —half way up to the peak—you're going to make 200%. So, it only has to come up half way and you're going to make three or four times your money. This is the kind of opportunity that we have right now because of what happened. Because the oil price fell in conjunction with this massive market decline caused by the financial industry, you have 20-year lows. You know, people have forgotten about the oil industry and are looking for the next bubble somewhere else. But oil is energy; we can't do without it. It is the fundament of our way of life today.

TER: Matt, earlier you said that a lot of these are looking at 18 months to two years to see what you're calling the 'triple-digit gain.' What's the key leverage point that you're looking for to say, "Okay, here we go; now, these things are going to turn and take off?" What are you looking for?

MB: I think I'm looking for a lot of small things, and I'm starting to see the first signs happening. First, the 30-day report came out yesterday and the amount of oil in storage was less than what analysts predicted. So that tells me there was more demand than analysts expected. Now with this recent price spike from $35 to $50, the rumors were swirling all around that China was stockpiling, putting together a strategic oil reserve. I think we're going to see some more of that, where countries are a little worried about getting their fair share.

But I also want to see some economic recovery. As we said, oil is an international commodity, and the real consumption happens when the economies are working. Right now, the economies are not working—that's what is giving us the opportunity. I think if you wait until you see those signs, you're going to miss the big gains. You'll be buying the companies we just talked about at over one times book instead of at half book value. So, if you think about that, if you bought it at half and it goes to two, you made 300% or 400%.

TER: Right.

MB: If you buy at one and it goes to two, you've doubled your money. So I think that in 18 months we'll be firing on all cylinders; I think it's probably a much shorter term before we start seeing oil price recovery. I don't subscribe to this real "doom and gloom" outlook that oil's going to stay at $35/barrel indefinitely. These are the same folks that stood at the top of $140/barrel and pointed to $250/barrel.

If you do the math and oil or gasoline prices are at $10/gallon, ladies and gentleman, I'm officially a bicycle owner at that point. Economically, it's still a market and markets work. The best cure for high prices is high prices, and the best cure for low prices is low prices. So in the oil business, you can look at the last 20 years and you see a market that works.

Matt Badiali is the editor of the S&A Oil Report, a monthly investment advisory that focuses on natural resources—from small exploration outfits, to equipment companies, to the biggest commodity companies in the world. In Matt's own words, "as a geologist, I focus on all natural resources including silver, uranium, copper, natural gas, oil, water, and gold, just to name a few." He's also a regular contributor to Growth Stock Wire, a free pre-market briefing on the day's most profitable trading opportunities. Matt has real-world experience as a hydrologist, geologist, and a consultant to the oil industry and he holds a master's in geology from Florida Atlantic University.

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