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Monday, November 30, 1998

FOOL ON THE HILL
An Investment Opinion
by Alex Schay

Not "If," but "When"

Petroleum, also known as crude oil, is a naturally occurring bituminous (what is bitumen?) liquid composed of various organic chemicals, and as we have all heard, contemporary industrial civilization depends on it. The "addict" simile, where society is dependent upon its continued "fix" of abundant, inexpensive petroleum, seems all the more appropriate today. Developing countries, rife with visions of improved living standards, are eager to exploit their natural resources and fulfill the promise that industrialized society offers.

For virtually the last decade, oil service industry stocks have been doing what is appropriate during a bear market -- hibernating. When the price of crude hit $32 a barrel back in 1981, it sparked a competition among the oilfield service companies to determine who could amass the most debt preparing for the coming drilling boom. By the end of 1981, an all-time high of 4,530 rigs were at work in the U.S. When the price of oil went south during the mid-eighties, many oilfield service companies were woefully unprepared. By June of 1992, the U.S. rig count sank to a modern day low of 596. Many companies did not survive.

The major forces in place at the beginning of 1997 that led to some optimism about the segment included major restructuring at many of the larger oilfield services firms, continued consolidation within the industry, increasing levels of outsourcing by the integrated oil companies, continued world industrialization (1%-2% annual growth), strong cash flow at the major oil companies leading to increased capital spending, significant technological improvements, and the sale of smaller oil and gas properties by the majors to independent outfits. These factors, outlined by our own industry analyst at the time, have all seen substantial developments over the last two years.

With oil at below twelve dollars per barrel (January crude fell to $11.22 on the New York Mercantile Exchange today -- a 12-year low), cash flow is drying up at the companies that employ oilfield equipment and services, drilling, and offshore support. This and events in Asia have resulted in poor visibility heading into 1999. As a result, companies in the oil services segment have been dismantled over the last six months. Plumbing the murky depths of the oil industry has been aided recently by the Drip Portfolio, which has chosen to take a look at the segment as its next potential investment opportunity. Interested investors should follow along as they drill for information about the business.

Exploration and production efforts in these lean times are centered around building reserves and cutting costs to scale with declines in output. Since most analysis of reserves entails the discounting of expected future net cash inflows from proved reserves (based on year-end prices and costs) -- the "value" placed on proved reserves becomes of the utmost importance. In the present climate, investors are having little difficulty finding value, with commodity price gains the chief catalyst.

The driving force behind any and all gains in this sector will be continued worldwide petroleum demand growth. With excess production capacity pegged at only 3% of total production, the system is pretty tight. In addition, most of the excess capacity is in the Middle East, which is prone to supply disruption.

This is the primary reason why the fate of oil demand is beholden to so many "what if" scenarios, many of which have been outlined in recent Drip Portfolio columns. Even though Iraq gets by U.N. restrictions by transporting oil on ships with Iranian flags departing from Basra (thanks 60 Minutes), and the effects of production cuts take a long while to work themselves out, all these seemingly intangible elements (and hundreds more) come together to determine commodity prices. The point of all this being -- now is the time to take a look at buying some great oil services companies that have been beaten down by the cyclical flows of the economy. And the Motley Fool can help.

-- Oil & Gas Discussion Board
-- Drip Portfolio archive


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