With energy stocks struggling to catch a bid, many investors are wondering if this is the end of the oilfield cycle. Combined with the decline in both crude and especially natural gas, there appear to be some worrisome signs on the horizon for energy equities.
To say the stocks have not had a good week may be an understatement. Through early Friday morning, the energy complex -- as measured by the Philadelphia Oilfield Service Index (OSX) -- was down nearly 8% for the week and about 14% off the highs set in mid-May. Nobody can argue that such a sharp correction isn't painful.
However, recent history suggests such corrections in the oil patch are followed by meaningful rallies. In 2005, for example, the OSX saw two 15%-plus corrections that were followed by rallies to new highs. While past performance is no guarantee of the future, the recent volatility in the energy complex shouldn't be considered out of context with activity of the past several months.
However, there are some differences that deserve mention and some strategies that should make sense as investors position themselves in energy in the coming weeks.
First, technology and innovation will continue to be important in the oil patch. As exploration becomes more complex and new horizons are considered, companies with new technologies will continue to be at the forefront.
One name discussed in these pages before is
. The company posted solid results for the quarter and increased guidance. At the recent offshore-technologies conference in Houston, the company was awarded a "best in show" award for its new subsea processing technology. It will go commercial next year, and the technology has the potential to reduce costs of subsea production and ultimately increase recovery from offshore fields. Once proven, oilfield experts put the potential market in the billions of dollars of the next decade, with little current competition.
Also on the technology front is
National Oilwell Varco
, the leading manufacturer of rigs and rig components. Earlier this month, the company launched a new rig prototype, the Rapid Rig, that is a quick-mobilization rig that can be operated by a crew of three. Not only does the rig reduce the labor needed to drill mid-depth wells (up to 11,000 feet), but it also automates several rig operations. Combined with its other rig-construction and services business, the company's backlog should continue to support performance well into 2007.
Other companies that have a technological edge include
Another theme of interest is the need for new infrastructure.
From refineries to pipelines, the need for additional infrastructure to support continued expansion into new basins will keep many companies busy. Companies like Halliburton's Kellogg, Brown & Root division,
all should continue to see solid business opportunities.
The Gas Challenge
One difference between today and 2005 is the price and short-term fundamental outlook for natural gas. While very little has changed in the long-term natural gas picture -- production is still challenged, the average well-production decline rate remains north of 30% and the cost of production continues to inch higher -- the short-term supply picture is not bullish.
The much-warmer-than-normal winter left natural gas storage at levels not seen in recent memory. In fact, the worry now, with more than 2 trillion cubic feet of natural gas in storage, is that underground storage will fill by August and newly produced natural gas will have no place to go.
The problem is real.
Natural gas storage levels are 31% above last year's levels and 53% above the five-year storage average. Absent a hot summer and increased demand for natural gas to fuel power generation or another significant hurricane season to limit production, storage will remain an issue, and natural gas prices will likely drift close to the current $6 per mmbtu price.
However, you are beginning to see a modest increase in industrial demand, and lower prices will lead to a decision to run more natural gas generation vs. coal-fired plants. In addition, while I don't expect significant reduction in drilling activity, prices well below $6 could lead to a decision to slow exploration. If that happens, the decline rate suggests a quick response in overall natural gas production and, as a result, higher prices.
In short, summer could bring sloppiness in the natural gas markets, but any significant decline in prices that leads to a response in drilling activity would quickly show up in production data, leading to higher prices and more activity.
Simply, any natural gas price correction is likely to be short-lived.
The energy cycle remains intact, but understand that markets never travel in straight lines. Stick to your discipline, know your risk tolerance and do your homework. As always, patience and strategy are rewarded in difficult markets.
This time should be no different.
Christopher S. Edmonds is vice president and director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he appreciates your feedback;
to send him an email.