Surveying Earnings in the Oil Patch

Christopher Edmonds

With crude oil hanging well above $50 per barrel and natural gas holding strong above $7 per thousand cubic feet (mcf), investors are expecting a lot when second-quarter earnings are reported from the oil patch. So much so that many analysts have recently "freshened up" their estimates for oil and gas companies to reflect stubbornly higher commodity prices during the quarter. 
While those earnings revisions have helped add a spark to many energy stocks over the last several weeks, such revisions also raise investor expectations, making "surprises" from earnings reports harder to accomplish. In fact, savvy market pundits such as Jim Cramer recently argued that investors should consider using recent upgrades of some of the major integrated oil companies -- such as Exxon Mobil (XOM:NYSE - commentary - research), BP (BP:NYSE - commentary - research) and ConocoPhillips (COP:NYSE - commentary - research) -- as an opportunity to lock in some profits. 
While I remain sanguine on the outlook for energy equities over the balance of the year, it is important to acknowledge the very important psychological aspects of investing in energy. When expectations hit bottom, it's time to buy; when expectations are frothy, history suggests it's prudent to take some gains. 
Today's froth isn't extreme, but it is certainly worth a watchful eye. As estimates move higher, investor expectations follow. That said, many estimates remain conservative, providing companies opportunities to jump the higher hurdles. Yet at this point in the cycle, companies that don't clear the bar are likely to face greater punishment than they have in past quarters. Very simply, investors expect energy companies to beat estimates. Those that don't will pay the price. 
So as we approach energy earnings season, here is a checklist of items to watch for as companies report.
Watch for margin expansion among the energy service companies, especially the drillers. As rig utilization continues to climb closer to full capacity, price becomes the rationing mechanism to help supply meet demand. And that happens largely without significant cost creep for the drillers. As a result, the margin expansion experienced in the first quarter for land drillers is likely to continue. 
That should benefit the entire group, from large players such as Nabors (NBR:Amex - commentary - research) and Patterson-UTI (PTEN:Nasdaq - commentary - research) to the midtier and smaller players such as Pioneer Drilling (PDC:NYSE - commentary - research) and Grey Wolf (GW:NYSE - commentary - research). 
In addition, day rates on offshore rigs have been accelerating, both for shallower-water jack-up rigs owned by companies such as Todco (THE:NYSE - commentary - research), Ensco (ESV:NYSE - commentary - research) and Rowan (RDC:NYSE - commentary - research) to deepwater players such as Diamond Offshore (DO:NYSE - commentary - research), Transocean (RIG:NYSE - commentary - research) and the mixed fleets like GlobalSantaFe (GSF:NYSE - commentary - research). One name that has lagged the group and seems like it might be ready for some good news and catch-up is Pride (PDE:NYSE - commentary - research), especially if it reports another positive quarter. 
Margin expansion should also be present in many of the other service companies. The pressure-pumping and stimulation businesses continue to experience strong demand both in the U.S. and Canada. Prices continue to push higher, and that benefits companies like BJ Services (BJS:NYSE - commentary - research) as well as the bundled service providers such as Halliburton (HAL:NYSE - commentary - research), Schlumberger (SLB:NYSE - commentary - research) and Weatherford (WFT:NYSE - commentary - research). 
Finally, margins should also show signs of additional improvement in the tubular and drill pipe businesses. With steel prices moderating a bit but demand for production tubing and drill pipe continuing to be strong, companies such as Lone Star Technologies (LSS:NYSE - commentary - research) and Grant Prideco (GRP:NYSE - commentary - research) should post strong quarters. 
And here is a sector where there doesn't seem to be euphoric consensus. In fact, because of an earnings warning from Maverick Tube (MVK:NYSE - commentary - research) -- related to its industrial business, not its oil field business -- and some concern over carbon tubing, Lone Star has felt some pressure. That may well provide an opportunity for investors looking for "value" opportunities in the service names. 
Follow the Cash
On the exploration and production front, it will be critical for investors to pay particular attention to cash flows and not to focus solely on reported GAAP earnings per share. Remember, as a result of recent accounting-reporting adjustments, many E&P companies are likely to report mark-to-market adjustments from their price-hedging activity that may dampen an otherwise stellar quarter. 
Even the smartest hedging companies such as Chesapeake Energy (CHK:NYSE - commentary - research) will likely be affected from the strength in commodity prices that make past hedging decisions look too conservative. That said, hedging provides companies an opportunity to "lock in" economic returns, especially when making acquisitions. In many cases, hedging out portions of the portfolio is very prudent. 
In most cases, production hedges simply create opportunity costs for E&P companies. For example, let's say a company has hedged a portion of its oil production at $50 per barrel. That means, in effect, that the company has committed to sell its oil to the person holding the other side of the hedge for $50 a barrel over a certain time period. With oil at $60, the company still will sell its oil at $50 a barrel, creating $10 worth of opportunity cost but no direct cash impact. 
Think about it the other way: Oil goes to $40 a barrel. The company still sells its oil for $50 a barrel and gets $10 of "opportunity benefit" as a result. Still, there is no direct cash impact. However, accounting rules require companies to make "mark to market" adjustments that can have meaningful noncash impact on earnings. 
Nearly all exploration and production companies will also report cash flow per share as another way to measure health and performance. With today's commodity prices, a look at those numbers is important in benchmarking E&P companies. 
That's not to say a critical look at a company's hedging profile isn't important. A company that has a portfolio of meaningfully below-market hedges may well say something both about management's adroitness at hedging and also about its future earnings and cash-flow prospects. 
Analyzing the structure of a hedge portfolio is important; penalizing a company solely as a result of mark-to-market losses may be incorrect and could cost you money. 
The third item to pay close attention to as second-quarter earnings roll in is a company's outlook for the balance of the year. Most companies have a good feeling for the current quarter as they report the previous quarter's results, and earnings releases and conference calls -- especially the Q&A -- are good places to glean important information. 
Moreover, get behind the outlook by determining the assumption used in the outlook. If a company says it will post X% growth in the second half of the year but is basing that outlook on $40 oil and $5 natural gas, those numbers are probably too conservative. Conversely, there will be companies that try to stretch their growth expectations by using $60 oil and $7 gas, and that creates unnecessary price risk. 
The earnings outlook game is really quite simple: When it comes to anticipation, guidance and estimates, it's all about the assumptions. 
There you have it: three items to key on during upcoming earnings reports. If you focus on these issues, it should be very difficult for any energy company to throw you off course and may well provide opportunities that can add juice to your portfolio.