When a major member of the oilfield service contingent, Halliburton (NYSE: HAL ) , announced recently that it would move its headquarters from Houston to Dubai, there was something of a collective gasp. How, wondered those unfamiliar with the company's intentions, could Halliburton renounce its U.S. base for an overheated sheikhdom halfway around the world?
To my way of thinking, the answer is relatively straightforward and probably has little to do with the ongoing investigations of malfeasance that have beset the company at home and abroad during the past few years. Indeed, Halliburton, like such other major companies such as Schlumberger (NYSE: SLB ) and Baker Hughes (NYSE: BHI ) , is first and foremost an oil services company. That means, quite simply, that it generates revenues by helping energy operators locate and produce crude oil and natural gas, either by providing its expertise or by lending the needed equipment.
The vacation spots
Unfortunately, some of us have only a vague sense that the epicenter of energy production is no longer the U.S., as it arguably was as recently as three decades ago. Today, the largest deposits of hydrocarbons are generally located in areas of the world that you and I wouldn't choose for a weekend home, but where the major producers and service companies must establish bases just to do their jobs.
I'm talking here about such garden spots as Nigeria's Niger River delta, Russia's frigid and remote Sakhalin Island, the Orinoco River Basin of Venezuela, Indonesia, and even the British and Norwegian North Sea. The truth is, for whatever reason, much of the world's oil and gas seems to have been buried in many of the world's most unattractive spots.
It didn't always appear to be thus. Nearly a century and a half ago, when Colonel Edwin Drake -- he wasn't really a colonel of anything -- discovered oil, it was in northwest Pennsylvania. And for about a century thereafter, most of the hydrocarbons being produced came from places like Texas, Oklahoma, Louisiana, and later offshore in the Gulf of Mexico. But as time has gone on, the U.S. has become relatively less significant to the world's total output, and the domestic future isn't particularly bright today. Indeed, U.S. production dipped by 5.5% in 2005 alone.
And yet, as The Wall Street Journal pointed out earlier this week, last year Halliburton generated about half of its energy services revenues in the U.S., while its contribution from the Middle East was only about 17%. In contrast, Schlumberger's North American revenues represented 31% of its total, while 24% came from the Middle East and Asia. And Halliburton's Houston neighbor Baker Hughes has initiated a "West to East" strategy, based upon its expectation of a softening of energy production in and around North America, contrasted with higher demand for its services in places like Brazil, Saudi Arabia, India, and Russia.
So look for more of the service companies -- particularly the larger ones -- to intensify their presence and their share of business outside the U.S. That's an approach that many of their producer customers adopted long ago. For instance, ExxonMobil (NYSE: XOM ) , the world's largest publicly owned oil company, last year found most of its new reserves in a variety of international locations, including Angola, Nigeria, Malaysia, Norway, the Netherlands, Australia, Canada, and Russia.
The company, through its Exxon Neftegas Limited subsidiary, is serving as operator of the Sakhalin-1 project, which recently reached its targeted peak production rate of 250,000 barrels of oil per day. The huge project's name comes from its location off Sakhalin Island, a sparsely inhabited parcel of land between northernmost Japan and the Sea of Okhotsk, off eastern Russia. But the Sakhalin area, which is estimated to contain about 45 billion barrels of oil -- or as much as is now left in the U.S. -- is a prime example of the forbidding areas where an abundance of hydrocarbons is trapped.
A changed picture
And if the companies' operating conditions aren't always difficult, the local governments with which they must work frequently are. In fact, through the years, the major oil companies have seen much of their handiwork taken from them in the form of abrupt nationalizations. The most recent such example is taking place in Venezuela, where President Hugo Chavez has decreed that operations in the Orinoco basin, which historically have been conducted by ExxonMobil and other major oil companies, will be handed over to Venezuela's national oil company by May 1.
But the companies -- both the producers and their trusted service helpers -- continue to slog it out to locate and produce oil and gas reserves in a variety of garden spots. The reason? As I've pointed out in the past, the world's demand for crude oil alone will likely increase by more than 40% in just the next couple of decades. Finding that much more oil, while dealing with declining production in numerous horizons, will be a daunting task for the producers and the service companies alike.
So what does this combination of increasingly internationalized energy production and the need for vast new reserves mean for Foolish investors? In my opinion, there are several interpretations to be drawn from these factors -- some geopolitical and some financial. But there's one overriding conclusion that I draw from them and that I'd like to pass on to my Foolish friends:
Because of their historic cyclicality, even the largest and best-known of the energy companies have traditionally traded at healthy discounts to the market. I believe that the traditional discounts are no longer defensible. As such, I also believe that there will be increasing value accorded to many -- perhaps most -- of the oil and gas production and service companies over time.
Let's look quickly at just a few examples. ExxonMobil, which we've talked about and which we know has tentacles around the world -- not to mention its status as the world's largest company -- earned nearly $40 billion last year. I would argue that its forward P/E of less than 12, or well below the broad averages, along with its enterprise value (the value of all the company's equity and borrowings) divided by EBITDA (earnings before interest, taxes, and depreciation and amortization) of less than 5.0, are not reflective of a company with its sort of size, stability, and probably reduced cyclicality.
Similarly, deepwater drillers Transocean (NYSE: RIG ) -- which is expected to increase its earnings from $2.99 last year to $7.32 this year, and on to $11.05 in 2008 -- and Diamond Offshore (NYSE: DO ) -- whose earnings are forecast to grow by about 60% this year and another 50% in 2008 -- both bear 2008 forward P/Es in the 6 to 7 range, or roughly less than half that of the S&P 500.
So, Fools, while I think it'd be absurd to contend that cycles have been completely wrung out of the energy sector, I would also contend that the changed picture in the sector has rendered the multiples currently being paid for these quality companies equally absurd.
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Because he has yet to declare a moratorium on writing about energy in deference to his own portfolio, of the companies mentioned, Fool contributor David Lee Smith owns only Schlumberger. He welcomes your comments. The Fool has a disclosure policy.