Earnings Not That Bad

Jim Brown
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Energy earnings and earnings in general have not been as bad as expected if you believe what the market is telling us. Markets rise for many reasons and in this case it is not fundamental.

Energy earnings have been relatively low since the price received for oil declined -$9 from the same quarter in 2012. Apparently investors are giving the produces a pass on the lower revenue and there have not been many blowups in stock prices as a result.

Service companies were not so lucky. Cameron International (CAM) reported earnings of 79 cents that beat by a penny and revenue was up +18% to $2.053 billion and also a beat. However, the stock was crushed because of the internal components. Revenue in Process and Compression systems fell -7.3%. Revenue in Valves and Measurement fell -4.3%. Revenue in Drilling and Production systems supported the entire company with a +24.5% increase to $1.438 billion. The gain was due mostly to subsea activity.

Order backlog rose to a new high but order growth declined -9.4% to $2.33 billion. Total backlogs totaled $10.497 billion.

The company lowered 2013 full year guidance to $3.40-$3.55 from $3.50-$3.70 with analyst estimates at $3.65. Q3 guidance was cut to 82.5 cents compared to estimates of $1.00.

Cameron is a great company but the weakness in land drilling is slowing their growth. Companies are drilling more wells in total but that includes more wells from the same pad and that reduces expenses and lowers the rig count significantly. I believe Cameron shares have risk to $50 but I doubt they will retrace to $40 where it dipped last June.

Cameron Chart

Drilling contractor Nabors Industries (NBR) warned that most of their clients were planning rig reductions in the second half of the year. Greater efficiency in drilling operations and the high price of oil led companies to drill more and spend more than expected in the first half. That means capex budgets are depleted and money needs to be spent on completions and infrastructure. Nabors posted lower than expected earnings on Tuesday.

However, Halliburton said the high price of oil would make budget increases more likely as long as prices remain at the current levels.

Halliburton also settled part of its liability in the Deepwater Horizon disaster after pleading guilty to destroying evidence. The test results pertaining to the number of casing centralizers was destroyed. Halliburton put six centralizers in the well to save time and money instead of the 21 that were called for in the design. These help stabilize the well bore during cementing. Since it is apparent the cement job did not hold the court wanted to know the results of the post disaster tests. The guilty plea incurred a maximum fine of $200,000. Halliburton claimed BP forced them to go with fewer centralizers to avoid a delay in completing the well.

As part of the plea Halliburton dropped the claim that BP had forced them to use fewer than necessary. That would appear to open the company up to greater liability in the case between BP and Halliburton. Claiming it was BP's fault was the main point in the case. Also, by destroying the cementing evidence it would appear Halliburton was covering up their mistakes in the cement process. In theory they would want to preserve the evidence if it supported their claim that the cement job was done correctly. When the trial resumes on Sept 30th the judge could take action against Halliburton including sanctions and could strike all their pleadings in the case.

Shares of Halliburton rose 4% because they announced a $3.3 billion share buyback at the same time.

On Thursday Halliburton said it received an information request from the Dept of Justice regarding potential antitrust issues surrounding fracking. Halliburton has the largest share of the pressure pumping market. The DOJ spokeswoman said they were investigating "anticompetitive practices" in pressure pumping. Capacity in the market increased by as much as 50% in 2011 about the time gas-directed drilling began to decline. Active gas rigs fell to an 18 year low of 349 in June.

George Mitchell died last week at 94. He was the petroleum engineer that transformed the natural gas industry by using hydraulic fracturing to extract gas from shale formations. He was born to a modest family of Greek immigrants with very little money and rose to be the Chairman of Mitchell Energy, which was sold to Devon Energy for $3.5 billion in 2002. Mitchell had his first commercially successful test of his fracking process in the Barnett Shale after working for 17 years to develop the technology. Once he discovered the right combination of sand, water, pressure and delivery method he unlocked the door to the current natural gas bonanza. That happened when he was 80 and Devon was quick to jump on the new technology. Mitchell had a personal fortune of more than $2 billion at his death and 95% of it the final result of that 17 year quest for the fracking technology.

Tropical storm Dorian broke up just east of Puerto Rico and collapsed into a wall of disorganized storms and high wind. The weather patterns are not conducive to Dorian returning to tropical storm status over the next two days.

Tropical Storm Outlook Map

Charlie Munger of Berkshire Hathaway fame said some amazing things in an interview on Thursday. They were amazing because they contradicted the prevailing trend in the media to press for U.S. energy independence. They just happen to correspond to my thoughts exactly.

Munger believes accelerating development of U.S. oil and gas resources is a "dumb idea." I agree. While Peak Oil was pushed back several years by the great recession, the recession in Europe and the three year decline of China's economy, it will eventually return. When it does and supplies become tight we will wish we had some of our own oil. Not for price considerations but for availability. Oil will reach a point where there will be shortages. Prices will rocket higher and those countries without internal production will suffer the most.

Munger believes oil prices are going higher, a lot higher as shortages appear. Every local barrel we leave in the ground today is a national treasure. Every barrel we buy today from somebody else is a barrel they will not have tomorrow. Buying foreign oil today depletes their resources and keeps ours in storage for the future.

There is no substitute for hydrocarbons. Besides transportation fuel they are used for fertilizer, fungicides, drugs, plastics, lubrication, etc. Eventually America will have to depend on its own resources for those items. If a new global conflict arose the first thing to be cut off would be oil. Shipping millions of barrels of oil from halfway around the world is an extreme security risk. It would be very easy for anyone with a minimal amount of military effort to cut off foreign exports from reaching the USA. In a matter of weeks it would be utter chaos in America. Cutting supply lines of strategic products has been an early conflict strategy since Roman times. Cut supply and the enemy will starve. In our case cut oil supplies and transportation stops.

Munger's view just happens to also coincide with Rex Tillerson, CEO of Exxon, who also thinks consuming our own reserves is a bad idea.

Munger believes the U.S. should issue long term bonds and buy as much foreign oil as we can store. Foreign oil also works to keep our interest rates low. We buy oil from overseas nations. They get our dollars. They recycle those dollars by purchasing our debt, which keeps our rates low.

While on the subject of oil and dollars everyone should understand that the U.S. dollar is the world's reserve currency. As long as this situation exists the U.S. can continue running up debts and issuing more debt to pay for the old debt. This will eventually end. China and Russia are working on a plan to create a new reserve currency that is not country based. That means it will remain stable while country currencies tend to fluctuate. This will eventually happen. The U.S. dollar causes too much grief to countries like Russia, China and others. Most commodities are traded in dollars. When our dollar goes down it takes more dollars to buy the same amount of a commodity. When the U.S. dollar eventually loses its reserve currency status the economy as we know it will cease to exist. With our national debt on track to hit $25 trillion by 2025 we are becoming less bankable to foreign investors as each day passes. Keep this in mind because it will eventually happen. When it does you will want to own some hard asset like silver, gold or oil.

The energy independence idea is a myth. In the chart below it shows the amount of gas production in the USA for the last 20 years. Every type of gas production except shale has been declining. Shale has exploded to roughly 5 Tcf today or 20% of U.S. production. However, that is not expected to increase significantly because of the high decline rates of shale wells. Plus all the other gas reserves are accelerating their declines each year. We will have gas for the next decade but to claim we are going to be energy dependent because of our gas reserves is just stupid.

Gas Production Chart

The domestic production of oil is a similar problem. Shale oil has increased from about 600,000 bpd in 2010 to 2.5 mbpd today. Even with all the active drilling in the various shale reserves that is only expected to increase to 3.8 mbpd by 2022. That means only a 1.3 mbpd gain over the next ten years and most of that is in the 2014-2016 period. That pesky decline rate of new wells is the problem. We are punching roughly 2,000 new oil wells a month and initial production is fantastic because of new completion technology. However, the faster we get the oil out of the ground the faster the well goes dry.

If a well is going to produce 1.0 million barrels of oil in its lifetime and it starts at 5,000 bpd because of a $2-$3 million frack job then we are front loading the lifetime production cycle. Within six months that well would be down to 3,000 bpd and within a year 1,500 bpd. After 18 months it would be producing several hundred barrels per day and continue to decline until it becomes noncommercial. There is nothing wrong in accelerating production except that you can't project the rapidly rising production rates today for a decade into the future. You have to allow for the rapid decline rate of existing wells.

Production companies are finding much of the acreage in the various shale plays to be non commercial after the first six months. If they are not in the "fairway" they tend to deplete very rapidly.

Tinker Production Chart - EIA Estimates


The equity markets barely eked out a gain for the week. Sentiment appears to be fading and next week has a very busy economic calendar. We have the GDP, which is expected to decline. The payroll reports on Wednesday and Friday are also expected to decline. The ISM Manufacturing is a tossup on whether it shows improvement or falls back into contraction territory. Lastly, the FOMC announcement on Wednesday could be a serious challenge for the market. I personally believe the Fed will not want to taper QE with GDP growth under 1% but there may be political issues in play that forces a change.

We are reaching the point where investors are losing their excitement over Q2 earnings and thinking more about vacations before school starts. The next 9 weeks are typically a rough period for the market with August and September the worst months of the year.

Nobody knows if this year will follow the seasonal patterns but I would want to err on the side of caution rather than load up with long positions on the first dip.

Crude prices typically decline in August-September and then rebound in the fall as winter heating oil demand increases. Investors should wait for the normal end of summer weakness to add long positions.

Jim Brown

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