Many value-oriented investors are trying to stick to their approach of buying good companies at cheap prices, but these days macroeconomic developments seem to be affecting what constitutes a good or bad company more than they have in decades. One of the macro variables that has a big impact on which companies will prosper is the price of oil. As we all know, oil prices have fallen from $147/bbl to $30s/bbl in the last couple of months. Such sharp volatility in oil prices is consistent with the theory of Peak Oil.
I will assume that most readers of VIC are familiar with Peak Oil. Prices may whipsaw around, but Peak Oil proponents expect that the trend will average out higher and higher. If you are a believer in Peak Oil (or even if you are on the fence regarding the theory) and are looking for a company that will do well (at least on a relative basis) under such circumstances, where are you to turn? Perhaps the best option is the oil services companies. And the world’s leading oilfield services company is Schlumberger.
Schlumberger supplies technology, information solutions and integrated project management that optimize reservoir performance for customers working in the oil and gas industry. The company supplies a wide range of products and services from seismic acquisition and processing; formation evaluation; well testing and directional drilling to well cementing and stimulation; artificial lift and well completions; and consulting, software and information management. Schlumberger employs more than 80,000 people of over 140 nationalities working in approximately 80 countries. Over 3/4ths of revenue comes from outside the U.S.
Schlumberger’s core skill set since 1926 has been subsurface measurement. Over time this has expanded to include the metrology of surface flows of hydrocarbons and associated fluids. The company’s core businesses all have to do with improving the processes of accessing, characterizing, developing and recovering hydrocarbons from the reservoir.
Maintaining the production base for both oil and natural gas continues to face challenges. Indeed, as Schlumberger’s financial documents point out, the aging of reservoirs that have been in production for many decades gives rise to increasing production decline rates that require constant stemming, while weak reserves replacement ratios and heightened resource nationalism dictate that exploration of new hydrocarbon deposits--in increasingly more remote areas and complex geologies--must increase. In the longer-term, current levels of drilling are insufficient to meaningfully slow decline rates, improve reservoir recovery or add sufficient new production capacity.
Schlumberger has achieved margins and ROCE that are high on both an absolute basis and relative to competitors. Schlumberger has accomplished this result due to differentiation and scale. The company has a unique ability to assist customers with exploration and production objectives. Geophysical, Drilling & Measurements, Wireline and Well Testing product lines are all ranked first by the Spears Oilfield Market Report. Schlumberger is the best of its peers at integrating different data sets with fresh information in short timeframes.
Schlumberger will generate total revenue in 2008 of over $27 billion and earn operating income of roughly $7 billion, for a margin of about 26%. Returns on equity are in the mid-thirties percentage range. For a company of this size and diversity, these numbers are extraordinary.
The balance sheet is strong as well. At September 30, Schlumberger had cash of $3.5 billion and debt of $5.7 billion. The aggregate value of the enterprise is $54 billion at today’s closing price of $42 per share. Schlumberger can withstand periods of extended weakness.
This year, EPS should come in around $4.60. On December 3rd, Schlumberger announced that it was unlikely to meet consensus expectations for Q4 due to deteriorating global financial conditions affecting world oil demand. Current areas of particular weakness include Russia and the North Sea. Despite slowing trends, consensus numbers for 2009 are $3.87 and for 2010 are $3.91. Paying roughly 10x earnings for the leading oilfield services company at a time when oil prices are low seems like an opportunity.
If oil prices rise meaningfully from here, the company ought to enjoy operating leverage and EPS could rocket higher. Just look at where consensus numbers were a few months ago with higher oil price expectations. The explosion of exploration licenses awarded in the last three years, the continual expansion of the number of new offshore rigs being ordered for delivery through and beyond the end of the decade, and the industry-wide, as well as Schlumberger's own plans to increase capital expenditures and R&D spending, are clear indicators of future growth.
What are the risks?
I am most concerned about the potential for margin and ROCE compression. A review of many years of historical data reveals that current margins and returns on capital exceed historical norms. The company asserts that much of this gain is due to technology improvements and service mix changes, but it is difficult to know how enduring these benefits will prove to be. As recently as the early part of this decade, Schlumberger had operating margins of 8-9% and single-digit ROEs. The demand for oilfield services is dependent on the level of expenditures by the oil and gas industry. Substantial or extended declines in oil and gas prices could result in lower expenditures by the oil and gas industry and thus reduce Schlumberger’s revenues. However, under a Peak Oil scenario, oil and gas companies will have to continue searching for harder to get prospects. Even if the company earns less than expected, investors should be protected by the low entry price of $42. If you wind up actually paying low to mid teens for a company of this caliber that is this well positioned from a macro standpoint rather than the 10x you think you are paying, you are still likely to do fine over time.
The other key risk is increased competition. Competitors such as HAL, BHI, WFT and SII are now more diverse and better positioned geographically than they used to be in the past. I suspect that all of these companies will do well in the years to come.
Higher oil prices
Weakening US dollar longer-term
Realization that we are in or near Peak Oil on a global basis