Marshall Adkins: Natural Gas: Weakness Borne of Strength
Source: The Energy Report (3/18/09)
Ironically, terrific strides in productivity are making life miserable and the outlook bleak for the U.S. natural gas industry. Dazzling technological advances coupled with exponential production increases in shale wells have flooded the U.S. with an over-supply of natural gas at the same time that economic woes are driving consumer and industrial demand into the ground. Too much of a good thing does not make a pretty picture. In fact, J. Marshall Adkins, who leads the energy research team at Raymond James, thinks it's pretty ugly. On a more positive note, he tells The Energy Report readers that oil fundamentals remain strong and his firm is as bullish as it can be on oil's long-term future.
The Energy Report: How about getting us started with an overview of where you see oil and natural gas this year and next?
Marshall Adkins: Against any backdrop of investing in energy companies and specifically the oil service group that I follow, one must understand the direction of oil and gas commodities. We have some pretty strong opinions, particularly about natural gas. Natural gas used to be 90% of the rig count, now it’s 80%, so it is still a huge driver of any service company with significant North American operations.
Frankly, the industry has gotten too good at getting gas out of the ground. Advanced oilfield technologies have developed over the last 20 years to the point where we’ve opened up reservoirs that were previously inaccessible, uneconomic, and made them very economic and very prolific. That’s created a gas supply problem. In 2008, the industry created a pretty substantial increase in gas supply—on the order of 8% to 10% growth in U.S. gas supply. That is just a mind-bogglingly big number.
Keep in mind that in the prior decade, U.S. gas supply drifted consistently lower despite higher drilling activity, higher rig count. More recently, however, the application of technology—particularly in the shale plays—has created a surge in supply. That is why we became concerned roughly about a year ago about a potential gas oversupply situation in the U.S. Today, that gas supply problem has become a reality.
In addition to the supply problem, we now also have a demand problem for U.S. natural gas. Specifically U.S., economic problems are shutting down a lot of industrial consumption, slowing residential consumption, and slowing gas-fired electric consumption. The combination of surging gas supply and falling gas demand means we are facing a train wreck for U.S. natural gas prices this summer.
TER: How would you describe that train wreck?
MA: I think gas prices will move meaningfully lower (maybe even below $2.00/mcf) and the rig count will get cut by more than 50% (maybe as much as 70%). This is obviously very bad for any service company in North America. Ironically, the solution to this problem is just that—a reduction in rig count. I think you’re going to see the rig count fall to the point to where we will see the U.S. gas supply growth trend lower by the end of 2009. In 2010, perhaps, if you have any recovery in demand from the economy, and LNG doesn’t flood into the U.S., natural gas prices could improve.
Unfortunately, even if you get an improvement in natural gas prices in 2010, earnings, average rig activity, and pricing for services are going to be so much lower than 2009. So the gas side looks pretty ugly in 2009 and negative earnings factors are at play here for drilling and oilfield service companies at least into 2010. That’s the bad news.
TER: And the good news?
MA: The good news is that global oil fundamentals remain very strong. Yes, we’ve had a massive destruction of global oil demand with this economic meltdown and, yes, it’s very difficult to pinpoint when the global economy is going to turn to drive demand higher. That being said, I see several positive things on the horizon for crude. To begin with, OPEC is cutting production and they’re taking a substantial amount of oil supply off the market. These oil production cuts should begin to show up in oil inventories over the next few months, so there’s a good chance that we’ll start to see oil prices improve as we move into the second half of the year. Of course, the timing and magnitude of that improvement still depends largely on global demand.
TER: And looking farther out?
MA: Longer term, oil looks phenomenally bullish. The reasons are: (1) I think we saw global oil production peak in 2008 and (2) I think you’re going to see production, particularly on the non-OPEC side, fall dramatically as drilling activity begins to decline and as the credit crunch puts pressure on some of the marginal areas of global oil production. This suggests a meaningful reduction in non-OPEC oil supply, particularly moving into ’10 and ’11, due to the today’s reduced spending. While we’re certainly in an oil downturn that could last well into ’09, I guess the good news on the energy front and the oil service front is those with exposure to international, oil-related activity will see some meaningful improvements longer term (over the next two to five years).
TER: With the natural gas supply-demand imbalance in the U.S., what’s the opportunity to export it?
MA: Very low for several reasons. First, it becomes a very sticky political issue sending U.S. energy elsewhere. With the U.S. trying to become energy-independent and spending $50 billion on various energy redistribution plans that Obama has just announced, it’s kind of hard to visualize the U.S. willingly sending “clean gas” elsewhere. Assuming you get past that, which I’m not sure you could, it would still take at least five years to site, permit and build a liquefaction facility in the U.S. Therefore, I think the odds are very low for any U.S. natural gas exports to happen in a timeframe that’s investable.
Of course, there are some other ways to export gas. Besides pipelines to Mexico (which are already exporting gas to Mexico), there are some floating gas liquefaction ships are being built. Technically, they could pull up to an offshore U.S. gas platform, liquefy the gas and export it elsewhere. Unfortunately, those ships are generally fairly small in volume. A higher-odds solution for increasing U.S. natural gas demand would be increased use of CNG (compressed natural gas) vehicles and more gas-fired electric generation plants.
TER: It just seemed that with such an oversupply, exports might make sense.
MA: The problem is timing and government willingness to allow it. I highly doubt that, with the Obama administration, you will see any meaningful U.S. LNG exports in the next five years.
TER: How long is this U.S. gas problem going to persist?
MA: If we see robust improvement in demand in ’10, then gas prices will go higher. Unfortunately, with higher gas prices comes more rigs drilling and more shale gas supply. Without strong growth in demand for the next five years, a potential over-supply situation in the U.S. natural gas markets may last for years. Longer term, the most visible recovery in gas prices will occur once you start depleting some of these very large shale reservoirs—the Barnett, the Fayetteville, the Haynesville and, eventually, the Marcellus shale.
TER: Okay. Let’s get back to the commodity backdrop you were describing. Where do investors want to be, given that backdrop?
MA: Short term, I think all natural gas driven stocks are at risk if natural gas prices do what we think they’re going to do. Again, we think U.S. natural gas prices could get cut to half from today’s levels near $4/mcf. A lot of our competitors have been recently upgrading their gas price forecasts, gas outlooks, and gas stocks in anticipation of a recovery. Unfortunately, I still think the 2009 supply-demand situation is so bad that the possibility of additional gas price cuts is very real. If that happens, all of the names we cover on the oilfield service side will be under some degree of downward pressure.
TER: Is the more distant horizon brighter?
MA: Yes, again, we love the crude story longer term. You have some tremendous values on some of these crude-driven names, tremendous values on some of these deep-water-driven oil service names. So for investors with a little longer-term perspective, we love the oily, deep-water side of the business.
Two names that jump off the table are Transocean Ltd. (NYSE: RIG) and Noble Corporation (NYSE: NE). Transocean has a dominant position in the deep-water drilling business, and the deep-water rigs typically have long-term contracts. You just don’t cancel these long-cycle projects if gas prices are down for six months or a year. You don’t cancel if oil goes down for six months or a year. So, I think we have pretty good visibility on that business for the next three to five years.
Noble Drilling is similar to Transocean. Again, both names have a very large, significant exposure to the oilier deep-water side of the business. In terms of valuation, they’re both trading at extremely low multiples when we look at 2010 numbers. I emphasize 2010 because so many people just look at current-year estimates when they value service companies. You really need to go out to ’10 because ’10 earnings are going to be 30% to 50% lower than ’09 for most North American driven drilling and service names. What you see is that Transocean and Noble are trading at kind of low single-digit price to earnings estimates—or P/E ratios. Given that we’re in the midst of a massive down cycle, that’s a pretty attractive valuation.
Other names we like longer term would be those that either service or manufacture components that go into the deep water and/or are exposed to the international side of the business. Again, I emphasize earnings estimates are going to drift lower for these companies over the next year, but I think those exposed to the oily side will have the best rebound off the bottom.
Companies in this category out include two that manufacture subsea trees, Cameron (NYSE: CAM) and FMC Technologies (NYSE: FTI). Another one is National Oilwell Varco (NYSE: NOV). A big chunk of its business is in North America, but it’s one of the best franchises on the planet in terms of manufacturing oilfield equipment. On a valuation basis, it’s trading at below 10 times our 2010 earnings estimate. So you get a world-class franchise at less than 10 times forward estimates. In summary, the most attractive longer-term names in the drilling/oilfield service space are names with deep-water exposure and high visibility on earnings and growth.
TER: Any others?
MA: Yes. I’d throw into that mix a couple of diversified international service companies, so value-added, technology-driven companies such as Baker Hughes Inc. (NYSE: BHI) and Schlumberger (NYSE: SLB) would be on our relatively limited buy list as well. As an example, Schlumberger’s business is 75% driven by international drilling activity. That will be primarily oil-driven, and true, international activity is falling right now, but if we see any stabilization in crude later this year and improvement in ’10 - ’11, those names should see good acceleration in earnings in 2011 and beyond.
So that’s it—only 25% of our universe right now is buy rated due to our concerns over 2009 natural gas prices. Again, for the next three to six months, I think that will have a negative impact on most of these service stocks. If you are a longer-term holder, you can probably starting buying some of these “oily” names in the summer, then you should see some solid returns as you go into ’10 - ’11.
TER: Isn’t the question here really more when is it bottoming? When can you determine the bottom?
MA: That’s a great question. My group of six analysts in oil service research spend thousands of man-hours on company specific research. We have very detailed earnings models on nearly 50 companies and we regularly interview all these management teams and many others that we don’t cover. That said, both service stocks and E&P stocks tend to bottom when natural gas prices bottom, not when earnings estimates bottom.
If you go back to the downturns in ’99 and’01 - ’02, what you see is the oilfield service stocks bottomed either right when gas bottomed or within months of natural gas prices bottoming. That’s what we’re watching. If we had to pick an optimal buying time, we’d pick August plus or minus a few months. Of course, we aren’t going to get the bottom exactly right, but it should be close. As I mentioned earlier, if you have staying power, you can buy a little bit early.
TER: We really appreciate this. Marshall. Your comments are very insightful, very to the point and straight up—which is exactly what people are looking for right now.
J. Marshall Adkins focuses on oilfield services and products, in addition to leading the energy research team at Raymond James & Associates, Inc. Among his credits are three appearances each on The Wall Street Journal’s Best on the Street Analyst list and in Reuters’ top 10 rankings; he’s also won StarMine Top Analyst honors twice; plus earning a number-one ranking in TheStreet.com. Marshall, who holds a bachelor’s degree in petroleum engineering and an MBA from the University of Texas at Austin, joined Raymond James in 1995. His prior experience included 10 years in the oilfield services industry as a services analyst, project manager, corporate financial analyst, sales manager and engineer.
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