Wall Street noting E&P sector's recovery

Steven Poruban
Staff Writer

U.S. oil rig count [62,197 bytes]

The recent upswing in oil and gas prices in second quarter 1999, together with a wave of company cost-cutting and consolidation, has spawned a renewed optimism about the North American upstream sector in the financial community.

While exploration and production spending is projected to decline this year from last year's level, analysts can point to the seeds of a recovery for E&P firms in rebounding crude oil prices and continued robust natural gas prices.

That scenario, in turn, sets the stage for an improved outlook for upstream service companies-albeit after a lag, as operating companies shake off the effects of the recent devastating downturn.

The improved financial performance of certain E&P service firms, for example, is catching some financial analysts' attention. Several have voiced their optimism regarding what they see as the start of a significant and sustainable recovery period.

Considering earnings, many of the analysts' comments echo a familiar refrain: The second quarter of 1999 will serve as an earnings "trough," and the third and fourth quarters will be the time when true recovery begins and continues through 2000. Analysts focused on several driving forces behind the upswing, as well as the timing and nature of the recovery.

Bullish on natural gas

The recent rise in oil and gas prices and the subsequent climb in E&P company stocks mark only the beginning of a full-fledged recovery by yearend, says PaineWebber Inc. in a recent monthly update on E&P company performance.

"Although E&P stocks have risen more than 25% year-to-date commensurate with a rebound in crude oil and natural gas prices, we believe that further upside exists, as crude oil prices have regained solid footing and natural gas prices look to build momentum with a tightening supply-demand balance," the report said.

PaineWebber also expects cash flow per share for the group of companies it tracks to exhibit an increase for the second quarter of about 35% from the first quarter and to be up "slightly" from a year ago.

PaineWebber is particularly bullish on natural gas-leveraged firms, saying "natural gas prices appear to be poised to provide the encore for commodity price momentum in keeping the energy sector on an upward trend.

"Importantly, our sense along the natural gas front is that there is still 'pent up' demand for the more natural gas-leveraged stocks in light of the tightening supply-demand balance.

"Our viewellipseis that the market will once again be receptive to a wave of equity-related offerings as the year progresses. This will allow many E&P companies to 'reload' their balance sheets and step up spending plans during the latter part of this year and into 2000," said the firm.

Still bearish on spending

Even with the brightening overall outlook for the E&P sector, however, the damage done to bottom lines early in the year is keeping many operators somewhat wary about the near-term outlook, in one analyst's view.

In its forecast for the second half, Moody's Investors Service predicts that oil and gas producers worldwide will spend about $70-75 billion in 1999 for oil field services related to exploration, drilling, and well servicing. This figure is down about 20% from the $90 billion spent in 1998.

"This decline (in spending) reflects financial stress at many producing companies because of low oil prices, and continuing price uncertainty, which has led producers to be cautious in reacting to the recovery of oil prices," said Moody's.

"Demand for oil field services will also be negatively affected by the dramatic surge in upstream consolidation and by the upstream sector's efforts to improve earnings by reducing operating costs," said Daniel Gates, Moody's vice-president and senior analyst.

Despite the significant firming of oil prices following the Organization of Petroleum Exporting Countries accord to reduce production starting Apr. 1, there will be a 2 or 3 quarter lag time for recovery to kick in, said Moody's.

"The current downturn will be much less severe than the late 1980s collapse, because consolidation has substantially reduced the number of competitors, and companies in the industry have taken a conservative approach to financing growth," Gates added.

Moody's also found that the more diversified service companies will have an easier time recovering from the latest downturn than the smaller, "niche" firms.

Having long-term drilling contracts and financially stable companies as customers also will aid service companies in their recovery, noted Gates.

Macro-energy environment

While focusing primarily on the large and mid-capitalization E&P firms, Simmons & Co. International, Houston, recently released a study outlining the consulting firm's outlook for seven service companies. Included in the report were: Schlumberger, Halliburton, Baker Hughes Inc., Weatherford, Smith International, Cooper Cameron Corp., and BJ Services Co.

"As I look at the group, I think it's impossible to invest here, if you don't have an opinion on the macro-energy environment," said Daniel R. Pickering, managing director, research, for Simmons & Co. "The stocks as we look at them are expensive on almost any measure of 2000 earnings that you can dream up. That tells me the market's already discounted a pretty hefty recovery in earnings in 2000 and into 2001.

"We do think that earnings can grow through 2000 into 2001. Based on what we see happening with the macro, we think that E&P companies are going to regain their confidence, and they are going to have to start spending by late this year or early next year."

Simmons & Co. bolstered its expectations for E&P spending in 2000 from its old estimate of a 6-8% increase frodm 1999 outlays to a hike of 15%, essentially doubling its expected oil service revenue growth in 2000.

The firm views 2001 as the "midpoint" of this emerging up-cycle, and the firm assumes 15%/year E&P spending growth in 2001 as well. "In our opinion," Pickering said, "there's a lot of catch-up spending that has to happen, and we think that 15%/year over the next couple of years is a reasonable number (that) gets us back to roughly 1997 levels for non-OPEC E&P spending."

Simmons & Co.'s analysis foresees E&P firms' earnings to be up for 2001 as well, citing an average increase of almost 60% vs. 2000 numbers. "I think (Wall) Street has probably dramatically underestimated the growth potential for the service earnings," said Pickering. "And I think, as people start to figure out the strength of the upturn, the stocks are going to get the 25 or 30- times multiple that they have historically enjoyed."

Improving rig counts

Donaldson, Lufkin & Jenrette Securities Corp. (DLJ), New York, in a newly released report, notes that the past 2 months have yielded a "powerful recovery" of oil field service stocks as the result of the rebound in oil and gas prices.

In March, oil field service stocks logged a rise in value of 51%. And although the sustainability of the recent resurgence may not be immediately apparent, the industry does show signs of vitality returning.

The report suggests that this upturn in commodity prices is just the first in a series of catalysts that will rekindle industry's eventual recovery.

Following the increase in commodity prices that has already taken place, the next stage of recovery, says DLJ, is the newly reviving U.S. oil rig count (see chart).

"Further sustained improvement in commodity price is unlikely until second half (1999), when other factors may also show up," the report said.

The firm points out that the count of U.S. rigs drilling for oil "bottomed out" earlier this year. The Baker Hughes-tracked count reached its lowest point, 108, the week ended Feb. 26. Since reaching 142 the week ended May 14, the count has declined again, to 117 the week ended June 18.

"The primary reason for this pick-up in activity," the DLJ report said, "is the improvement in oil and gas prices, which are benefiting from increasing evidence of supply declines and a demand recovery. We expect (the overall U.S. rig count) to be the first one to recover, to a level of 575-600 by the end of second quarter and close to 700 by yearend," the report said.

According to the firm, the bolstered rig counts will lead to Stages 3 and 4 of the recovery, comprising respective recoveries in earnings and in deepwater, non-U.S. drilling, and worldwide seismic activity. Stage 3 is expected to occur by third quarter 1999, and Stage 4 should take place in early 2000, DLJ said.