Services Stocks Lag Within Energy

During the most recent economic and market downturn the most unlikely of sub-sectors has been the worst under-performer within the Energy Sector.  Services stocks, often time viewed as stalwarts within the industry, have been absolutely destroyed this year with some of the mega-caps like Schlumberger Ltd. (SLB) leading the way.  This is extremely atypical of the energy sector, and many investors are still left wondering why exactly this happened.  Obviously the horses are out of the barn, but I think it is important to try to understand the risks that, prior to the equity prices falling dramatically, were not very transparent.

I believe the key to this perplexing puzzle is within the question of “exactly how necessary are the services that these companies provide?”  As investors we are taught to look for corporations that produce goods that the world can’t live without, especially if those goods need to be replaced over time.  This type of business model has proven very successful for both corporations and their shareholders.  The difference in this scenario was many investors were fooled as to the somewhat discretionary nature of energy services.  Most investors believed that just because an equity had an “energy tag” slapped on it that it was a life or death necessity for the world’s growing economy.  In some cases this is true.  The world cannot function without crude oil and many other commodities; the problem is these companies are not the ones directly producing the commodities.

Often times in the past investors believed that small and mid capitalization exploration and production companies were the ones that held the risk as their profits were directly linked to the underlying value of their production and reserves.  As we have recently found out, this formula is no longer accurate.  While it is entirely true that exploration and production companies’ stock prices took a large tumble from the top in July of 2008, they still maintained their production levels while operating at lower profit margins.  The same can not be said for the services companies.  When the price of crude oil fell from a historic high of $147 back down toward the current $55 dollar range, the exploration and production companies either put on hold or stopped projects that had to have a higher commodity price to be profitable.  In return, the services contracts on these particular projects were not renewed.  These assumptions of service project renewals were priced into the equity prices at the top in July 2008, and have since been removed from the market’s discounting formula.

The reason this is a larger problem for the service companies versus the exploration and production companies is because these are revenues that will not return.  The lost time in 2008 can’t be used up by service companies going into the future, but the exploration and production companies can still produce their reserves that they left idle in the ground during 2008.  The opportunity cost that the service companies lost was the main reason for the fall in equity prices.

Some equities have shown extremely glaring examples of this, but almost all investors are still clueless on how this puzzle pieces together.  Take for example Helix Energy Solutions (HLX) and Acergy S.A. (ACGY).  These are two companies that specialize in deep water services.  While it is true that the companies currently have work, it is also true that they won’t have work if oil stays in this depressed range for a long period of time.  If oil is at $55 dollars a barrel, will an exploration and production company choose to produce from a land well that may output at a cost of $15 a barrel, or a shallow water shelf well that may cost somewhere between $35 to $80 a barrel to produce?  The answer is obvious, but most investors have ignored this fact when scratching their heads and wondering why these equity prices are down in some cases close to 90%.

Even though services are down, they are definitely not out.  Crude oil coming down to these levels actually presents extremely interesting investing opportunities for savvy investors.  If you were to hypothesize that crude oil would begin to appreciate back towards the $100 a barrel mark, then these small and mid size services companies could have huge upside as there would be increased demand for their highly specialized services.  If crude oil stays in the $55 dollar range for a long period of time, the free cash flow of these companies could be choked off and their currently in-check debt levels could become a burden too big to absorb.  In this scenario, the answer lies in the long term trend of crude oil pricing, something no one in the history of the world has been able to accurately predict.

My advice to investors is to be extremely cautious when looking into going long or short a service company as the movements in the equity prices may prove too difficult for individual investors to understand.

Disclosure: The mutual fund the author manages is long SLB and the author’s family is long HLX.

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