Where are oil services stock prices headed?

Momentum investors giving way to growth, value investors

William Furlow
Technology Editor

With the recent volatility in the US stock market and a rash of quickly accelerating initial public offerings (IPOs) in the oil service sector, many investors are wondering how long the current boom will last and if there is still money to be made in oil service stocks.

Michael W. Rabalais, vice-president and oil services analyst with Robinson-Humpherey Companies said the 25 service stocks he follows have logged unprecedented growth over the last year, peaking at 70% growth. This growth has not gone unnoticed on Wall Street. Where US East Coast analysts traditionally tied oil-service company earnings estimates to the price of gas and crude, analysts have quickly come up to speed on the forces which actually drive this market, such as rig supply.

As predictions of growth began to better reflect the potential of these sleeping giants, the sector exploded. Along with high technology, Rabalais said the oil service sector has become the hottest in the market. A recent surge in successful IPOs just added fuel to this fire and drew in momentum investors, lured by the potential of tripling and quadrupling their investment in a matter of weeks.

Stock price liftoff

This investor herd mentality is behind the skyrocketing stock prices for companies such as Friede Goldman and Gulf Island Fabrication. They also explain why IPOs priced at $14-$18 are opening on the secondary market at $32. Rabalais said as this growth slows to a more sustainable level, the momentum investors will lose interest and move on, leaving prices to find their own level.

While no one can predict where this will be, it's a safe bet it will be at or below where they stand now. In fact, Rabalais said a drop in sector prices will be required to attract the next wave of investors. He said this type of rabid expansion cannot continue indefinitely and he does not expect it to last into next year.

The good news is that once prices stabilize, then these highly efficient and profitable companies will begin to attract value investors. The value investor takes a longer view and researches an individual company before committing funds. This type of investor is in for the long haul in most cases and is much more attractive to shareholders than the hit and run sector bandits that have driven prices during the current recovery.

Rabalais said the value investors will be able to save the stock prices of the oil service sector, and take companies beyond the current "recovery" phase into a period of growth in which newbuilds will be justified by higher day rates. It is during this period that the companies currently enjoying such rapid growth will come into their own, realizing the potential so many are currently banking on.

Value investors there

William Walker, President of Howard, Weil, Labouisse, Friedrichs, said he disagrees with this analysis. Walker said he believes the value investors are already represented in the oil service market.

They got there early, when no one was interested, and most have already sold their position and are waiting to get back in when prices drop back to a reasonable level. "Even at the current price, the fundamentals are there," Walker said.

He credits the momentum investors with driving prices to a level unsustainable in the short term. He said these major fund managers are simply jumping on the band wagon, buying where others have bought in a sector that is clearly outperforming the market. This group of investors is notorious for being disinterested in the companies they buy shares in, preferring to focus on the movement of the market sector.

Walker said he has heard the story of one fund manager calling to purchase 100,000 shares of "Global." Walker said when the broker asked if the client was referring to Global Marine or Global Industries, the response was, "What's the difference?" After explaining the distinction to the client, the manager was told to buy 100,000 shares in both companies.

Walker also said a Varco executive told him about a call he received at the office from another fund manager who informed the executive that he was a large stockholder.

"He said, 'I'm a large stockholder in your company, what do you do?'," Walker said.

It is this type of trend investors that are soon to leave the oil service sector for the next flavor of the month, but Walker said the stock will be saved by growth investors. Growth investors as well as the re-entry of value investors.

Growth investors find the sector attractive even as the stock market begins to slow. Growth investors see the sector as sustaining a reasonable level of growth, that outpaces the market as a whole. The problem with this group is that it has not looked at this sector in a long time, and are thus not familiar with the cyclical nature of the energy business.

So what is the bottom line?

Walker said he does not think the industry has reached a boom status yet, but is still in a recovery mode. He said oil service companies will struggle to keep up with demand. There will be resistance to commodity pricing pressures as production slows. US oil and gas production will remain flat, Caspian Sea production will not be a factor, until at least 2000, and supplies from Russia will be flat.

Consolidation in the industry will continue, according to Walker, with the stronger companies gaining market share while the weaker players will dry up or be bought out.

Walker said recent sell-offs were technically, not fundamentally based. He characterizes the market as complacent, meaning there will be very little growth in the wake of good news and large sell-offs on the reporting of bad news. This means successful investors will have to do their homework, focusing carefully on value and specific sectors.

"Whether the market rises to 12,000, or drops down to 4,000, there is more fundamental value in the oil industry stocks now than any other sector," he said.

Even at current prices, this values should remain strong for the foreseeable future. Walker said his only caveat is that all stocks float on the sea of the market. If the tide goes out all stocks will be effected, but the energy sector will suffer less than any other group because the fundamentals are so strong.