Editor's Note: With this column, we introduce Henry Scholder, an independent investor who manages his own account and describes his investment philosophy as "value-oriented with an edge." Previously, he was a trader and portfolio manager at Steinhardt Partners and a general partner and portfolio manager at Chen Capital. As always, let us know what you think.
Eugene M. Isenberg and I have been friendly ever since we met at an energy conference four or five years ago. I was struck at the time by an energy sector CEO who spoke with a distinct Boston accent; other capable leaders in the sector speak Texan or Oklahoman. Gene Isenberg is, by any standard, an extremely successful CEO: On his watch,
has been transformed from an ailing, insignificant business to the world's largest land driller.
I recently sought Gene's observations about the huge decline Nabors' stock has suffered, along with massive declines in the sector as a whole.
The OSX oil service index has plummeted from above 130 in May to 80 in recent days, with Nabors' shares dropping from 60 to 25. What happened?
: Everybody underestimated the elasticity of supply and demand. On the demand side, industrial users, makers of polyethylene, etc., turned to cheaper sources when prices
of natural gas, the material used by petrochemicals makers soared. Electricity producers turned to petroleum.
For people who had electricity contracts or who had contracts for gas, it became more economical to sell the contract
because the market price was substantially higher than the price they had locked in. The market is humiliating people who said that 90% of the incremental electricity would be generated from natural gas. Those people should have said:
In the context of prices between blank and blank,
90% of incremental electricity is going to be generated from natural gas.
If the price
of gas gets to $9 or $10, a couple of things happen: Coal utilization goes from a lower number to a materially higher number. Nuclear energy goes from historic lows to unbelievably high numbers. And a whole bunch of
electricity-producing plants don't get built. The missing link in a simplified supply/demand-based analysis is the question of price.
Okay, you've broken down the demand side of this issue. What about supply?
: I also think
that the elasticity of supply is a lot more substantial than people give it credit for being. Not so long ago, people were saying that, despite all the holes we were punching in the ground, the drillers were failing to come up with sufficient gas supplies.
So then how did a high level of incremental production suddenly appear?
: Imagine what would have happened had we not had these rigs
working at all. We were up in the first quarter (supplywise) 2% to 2.5%. What really should be considered is that supply would have been down 22% to 23%, in the absence of
incremental drilling because of the rapid decline curve. So the incremental drilling activity has increased supply by about 25%, which is pretty dramatic.
Why the rapid decline curve?
: For one, we know how to economically exploit a discovery now. The numbers suggest that the more recent the discovery, the sharper the decline rate.
In my investment experience, energy is a self-correcting sector. How do you see things unfolding in the future?
: If the price
of natural gas stays low or modestly lower, there is going to be a consequence in terms of less drilling and less supply. There will be a supply response that will be negative because we will no longer have the firepower (that is, the number of rigs working) to offset the declining rigs.
That suggests that a self-correcting mechanism will indeed kick in: Lower gas prices will prompt industrial and other users to switch back to gas, thus causing prices to firm up, thus bringing about increased drilling activity, and so on.So you are saying that declines in the price of the commodity also drives down share prices of the drillers?
: I think that is right.
How has capacity in your sector been affected? Are there fewer rigs in service because demand is low?
: Three months ago, there were 12 stacked rigs
those that have taken out of service; at the end of quarter, there were five times that number.
And prices -- that is, day rates for rigs?
: They are clearly trending downward. But it is a question of what kind of friction there is in the market: Is it a relatively consolidated market or is it a totally unconsolidated, fragmented market? The virtually unconsolidated jack-up market
in which Nabors is not a major player is really getting creamed. We have not had that kind of drop. On land, there are maybe three companies -- Nabors,
( GW) -- with 50% to 60% of the rigs. In the offshore market, three companies have 20% of the market.
What about customer visibility?
: Six months ago there was a feeding frenzy. In July, Nabors announced a curtailment of our refurbishing program.
What about consolidation? Prices of potential target companies are way down.
: Not yet. I haven't been offered anything at a price as attractive as things were in the last downturn. There is a limited universe of possible acquisitions. We generally know these people; we approach them. I don't need exposure to anything, except to make investments that are as far above my cost of capital as I can get.
How do you see things unfolding from here?
: From a personal point of view, I have lost a reasonable amount of money from this
decline in the price of Nabors' shares, but I am fully confident that the long-term energy cycle is essentially intact. There is a long-term energy shortage; in two years or less the trend will become apparent again. I believe that we will return to a good cycle for gas in North America, and thus I also think that there is a good shot that, within a year or two, we will break our all-time record for the stock price.
Editor's note: Because, this interview was conducted before the terrorist attacks at the World Trade Center and the Pentagon, Scholder checked in with Gene Isenberg this week to see how his outlook for the energy sector may have changed in recent days.
A lot has happened since we spoke, Gene. What is your take on the potential impact of Sept. 11's terrible events on your sector and on Nabors?
: There are going to be relatively short-term dislocations and incremental risks for a downward economic period. Demand for electricity will fall off. We can expect a slowdown and its attendant implications for overall commodity prices.
In terms of Nabors, the events enhance the probability that we
the U.S. will move in the direction of more self-sufficiency,
of less reliance on higher-risk OPEC energy sources. That means that the probabilities of ANWR
Arctic National Wildlife Refuge going through have increased two or threefold. More importantly, for us
at Nabors the debate between the Greens
environmentalists and the self-sufficiency
advocates has moved in the direction of more drilling. A No. 1 priority for us is the Rockies, where there is a tremendous amount of drilling permitted, but much of it is delayed. I think that boundary is going to move in the direction of drilling.
I think, generally, there will be more demand for drilling in North America, particularly for gas. On the other hand, demand for coal will rise too, which isn't super great for us. Nuclear power, given our current concerns about terrorism, is not the best thing.
What about the political risks? You have a large presence in the Middle East. How will political uncertainties there affect Nabors?
: We are the biggest in Saudi Arabia, Yemen, pretty big in Algeria and big in the Gulf. We worry about it from a security viewpoint, and so far, we and the operators for whom we work don't see an imminent problem. All the energy companies work in the Middle East, and if we thought we were putting people at risk we would not work there. This is such a monster geopolitical issue that I don't think anybody really knows. But it's safe to say that the relative security of energy supply from North America is an order of magnitude more secure
than it is from OPEC right now.
Henry Scholder is an independent investor who manages his own account and describes his investment philosophy as "value-oriented with an edge." Previously, he was a trader and portfolio manager at Steinhardt Partners and a general partner and portfolio manager at Chen Capital. At the time of publication, he held no positions in any of the stocks mentioned in this article.