Oil Majors versus Drillers: The Battle for Profits

If you’re bullish on mining, don’t buy the companies. Instead, buy the companies that manufacture the shovels and picks…

That was conventional advice years ago before gold-mining developed into a legitimate investment sector. But that old adage still stands true today – especially as it pertains to the oil business.

There’s a major anomaly occurring in the energy sector over the last two years as the oil majors struggle to boost refining margins while the oil drillers post record-breaking earnings from an order back-log as far as the eye can see.

The Big Oil Squeeze

Increasingly, the majority of oil companies are shedding profit margins as refining margins are squeezed.

Earnings have largely been a disappointment for the large-cap oil producers since mid-2006, as refining margins shrink. Oil companies are still earning billions of dollars, but margins are definitely compressing largely because of soaring refining costs.

Despite skyrocketing oil prices this decade, the oil companies can’t contain surging input costs. Lighter distillate fuels, including diesel and heating oil, have become expensive to refine resulting in lower profit margins for this segment of the energy business.

Despite lower margins for the majority of oil companies worldwide, investors continue to lunge after stocks in this sector. Crude oil prices have leapt 33% this year but the iShares Energy Select Spiders ETF (XLE) has declined 2.5%, including dividends. That’s hardly an inspiring performance in a bull market. Overseas, the oil majors have generated similar disappointing results.

The Drillers do the Dirty Work

The big money in energy stocks lies in the companies that extract crude oil and natural gas or service companies contracted by the oil majors to pump Black Gold.

When Exxon-Mobil (XOM) or BP Petroleum (BP) seeks to boost exploration and development, they contract the oil equipment and service companies to lease onshore or offshore rigs. Exxon-Mobil and BP don’t drill; oil majors need to outsource that role to the drillers. And that’s where the big bucks have been earned since 2002.

Still Plenty of Fuel Left to Ride this Bull!

From January 1, 2002 to July 22, 2008, the oil services sector as measured by the Philadelphia Oil Services Index (OSX) has skyrocketed a cumulative 275% -- and it’s still climbing this year. As the oil majors are flat or barely in the plus column in 2008, the oil drillers are up another 8% while the S&P 500 Index has tanked 12%.

Second quarter earnings for the drillers have largely been quite strong, exceeding consensus estimates. Many companies that specialize in offshore drilling have been especially strong performers as daily lease rates for rigs continues to hit all-time highs in excess of $500,000 per day.

If you missed buying the oil services and equipment stocks in this bull market then you’ve got another chance coming this summer as crude oil prices continue to correct.

The correlation of crude oil to the drillers is pretty strong. From its all-time high of $147 a barrel earlier this month, West Texas intermediate crude oil has declined to $127 recently. And the oil drillers, as expected, have also pulled back and now sit about 12% off their best levels.

Deficit of Offshore Rigs

The oil drillers are the specialists required to extract Black Gold once the oil majors discover a new find or develop an existing field. It’s the oil companies that hire the drillers to explore and drill thousands of feet into the ocean floor. It can take years to construct a new offshore rig, including skyrocketing input costs for piping, metals, deep-sea drilling and labor. You can’t just flip a switch and turn on a new rig. It takes time.

Until recently, barely any new rigs were constructed to meet bulging demand. A bear market in the energy complex in the post-1980 period resulted in a glut, especially in the Gulf of Mexico and Texas. But now, according to Barclays, the active natural gas rig count has risen to 1,530 in the United States as of last week – the highest number of rigs in operation since 1987. But offshore rigs – where the daily lease rates are still soaring – remain in a net supply deficit.

The real money to be made in oil drilling is overseas offshore – specifically in the Middle East, Africa and off the coast of Brazil. Since 2006, more oil drillers have fled the United States for greener pastures in the Middle East and elsewhere.

Rogue States Need the Drillers

The oil services companies poised for the biggest profits are those with an international presence as national oil companies that control more than 80% of the world’s oil reserves are now shutting out the middleman – the oil majors. But they still need the expertise of the oil services and equipment companies. Russia, Venezuela, Bolivia and other pariah states that have thrown out the major oil companies still need the oil equipment and services firms.

But the bull market in oil services is not entirely contingent on Russian or Venezuelan exploration. In fact, the drillers are earning the bulk of their profits elsewhere – mainly in the Middle East, Africa and offshore in the North Sea, Gulf of Mexico and now, Brazil.

Brazil’s Offshore Find is a Drillers’ Gold!

Large oil discoveries in deep-water off the coast of Brazil has triggered another major long-term round of contracts for the leading international drillers.

The Brazilian find sits thousands of feet below the surface and only the major drillers can get to that oil. Other fields in Russia, the North Sea and off the coast of Indonesia require the drillers. The order backlog has become enormous and following the Brazilian offshore find, will create an even deeper backlog.

There’s also another offshore drilling region that might open to the oil services companies – California and Florida.

I’m not sure the United States will allow offshore drilling off both coasts. Senator Obama, if elected President, would probably slam that idea. But even if drilling is allowed on either shore, even on a limited scale, it would boost earnings for the deep-water operators.

Summer is typically a bad time to invest in commodities. This seasonal aberration is occurring again as commodity prices have tumbled 11% from their highs. I expect this correction will also take the oil equipment stocks lower, too. This will eventually present another great buying opportunity for long-term investors as the hunt for oil and gas continues in a world marred by declining production and rising demand, especially in Asia.

Amid Peak Oil, focus new investment capital to the oil equipment and services companies. That’s where earnings, cash-flows and momentum are most favorable over the next several years and beyond.

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