OPEC and Russia are in the middle of an oil fight, with the end target really U.S. onshore oil production. The early days of this "little" spat haven't been pretty, dragging shares of Baker Hughes (NYSE:BKR) down along with the broader market -- so far this year the oil services company's stock has fallen a painful 46%. What's going on with Baker Hughes, and is it worth a closer look?
A frightening time
First things first: Oil is a commodity known for frequent and often dramatic price swings. Supply and demand are the long-term drivers in the energy industry, but over shorter periods of time emotions can get quite heated because of geopolitical events, economic conditions, and near-term supply/demand changes that are unlikely to have a lasting impact. Right now the big news is a price war between Russia and OPEC, which has tanked the price of oil. In a few months it could be something else that pushes prices up or down in dramatic fashion.
Virtually every stock tied to the commodity has gone along for the ride in some way. That obviously includes Baker Hughes. That said, as an energy services company, it has taken an ever greater hit than some of its prime customers, which span from the upstream (drillers) all the way to the downstream (chemical makers and refiners). Although that level of reach is fairly unique in the services space, and includes midstream (pipelines) companies, the tap-on effect for a company like Baker Hughes is material. If oil drillers decrease their spending, then services companies could see a notable decline in their revenue. And if the pull back is severe enough, the pain could linger for years.
Simply put, it's going to be ugly out there for a little while until this little spat works itself out. For now, conservative investors should probably avoid most energy stocks and energy services names like Baker Hughes. In fact, even in good times, conservative investors should think carefully before jumping into the energy sector.
Some things to like and dislike
That said, Baker Hughes is highly likely to survive this rough patch. For starters, its financial debt to equity ratio is 0.17 times, which is low for any industry. Financial debt to EBITDA, meanwhile, is 2.3 times, which isn't a particularly worrying number either. And it covered its interest expenses by roughly 6.7 times over the last 12 months, a solid figure. The last two numbers are highly dependent on financial performance, so they might weaken from these levels, which are based on historical performance. However, they are starting from reasonable levels, and aren't indicative of a severely troubled company.
That's notable because it is the weakest players that are being taken out by the current energy industry upheaval. At this point, it's hard to suggest that Baker Hughes falls into that category.
In fact, after a complex deal in which Baker Hughes merged with General Electric's (NYSE:GE) energy business, Baker Hughes has actually been doing a good job of improving its operations and performance. That's notably included steadily increasing operating margins over the last three years. Its business has been a bit of a mixed story, though. For example, orders were up 1% year-over-year in 2019, but the final quarter of that year saw a sequential quarter decline. Weakness in North America was a key part of that.
Since the main target of the oil battle between Russia and OPEC is really U.S. onshore production, North America could remain a trouble spot for Baker Hughes. And other areas around the world will likely be added to that problem, as oil prices in the $30 range make it hard to justify capital spending plans for oil companies everywhere. Existing contracts will help smooth things out, but that won't be enough to save Baker Hughes' top line if oil prices remain low for a long time.
Adding a bit of a complication to this picture is that GE still owns around a third of Baker Hughes' shares. It wants to sell this position to raise cash for its own turnaround efforts. The steep price drop at Baker Hughes will frustrate that effort. GE could cut and run, pushing a large block of shares onto the market that will further depress the stock. Or it could hold tight, noting that GE's finances are in better shape today than they were not too long ago following a series of asset sales (including some of its Baker Hughes stake). But holding tight just means that GE will look to sell at a later date, which could restrain the upside of Baker Hughes' stock in the future. There's no way to know what GE will do.
The big takeaway
It is hard to suggest that even aggressive investors step in and buy Baker Hughes today. Yes, it has made great progress as it integrates the old Baker Hughes with GE's energy business. But there were already signs of headwinds showing up in the fourth quarter of 2019. Now, with the tussle between OPEC and Russia, the headwinds are likely to grow even stronger (and more widespread) over the near term, with no way to tell when the infighting will end. Overhanging all of that is GE's large ownership stake, which it has stated it wants to divest. GE selling could make things worse today or constrain the upside later. Once again, there's no way to tell.
Although it is unlikely that this confusing period will lead Baker Hughes to go out of business, it will be hard for most investors to sleep at night owning the stock. And the situation is likely to get worse before it gets better, as onshore U.S. oil drillers, which include Baker Hughes customers, struggle to survive through a period of deeply depressed oil prices. There's likely turnaround potential at Baker Hughes when oil prices finally start to recover, but only if you are willing to hold on through what is probably going to be a very bumpy ride. Most investors should look elsewhere.