At this point, it’s no secret that I’m gaga for the oil services sector. As we continue to drill deeper and explore more unconventional assets, these firms will keep pulling in the cash. So, when an industry stalwart reports a problem, I start to get a little concerned.
The kingpin of hydraulic fracturing, or “fracking,” and world’s second-largest oilfield services company is Halliburton (NYSE:HAL), and last week it announced that North American profit margins this quarter would drop by twice as much as it had been expecting. The surprising culprit: a common ingredient found in cupcakes, paper products, cosmetics and pharmaceuticals. Needless to say, the news sent the company’s shares down by 5% to an eight-month low.
The questions for investors are: Just how big of a problem are rising material costs for the venerable fracker, and is it time to avoid Halliburton stock?
Blame It on a Bean
Aside from finding itself in ice cream — among scads of other everyday products — guar beans are also a key ingredient in fracking fluid. The beans are turned into a thickening gel — called guar gum — which is used to carry sand or ceramic “proppants” down a well during the hydraulic fracturing process. The proppants are able migrate further into the cracked shale by using guar gum rather than other, thinner fluids. That allows more oil and natural gas to flow out as the fractures are propped open wider.
Grown mostly in India, which produces around 70% of the world’s output, guar beans are in short supply. As the fracking and shale boom has swept across the globe, farmers in India have struggled to meet rising demand. That’s caused prices for the additive to surge, with some analysts pointing to a severe shortage occurring by the end of 2012.
Halliburton has said guar can now account for as much as 30% of the overall price to frack a well. Analysts had previously thought that the company’s leadership and dominance in fracking would allow it absorb such cost increases better than others. After all, Halliburton basically invented the technique after being granted an exclusive patent back in the 1940s. Rival Nabors (NYSE:NBR) has also felt the pressure, and Baker Hughes (NYSE:BHI) called current guar costs “horrific.”
Speaking to an investor conference in May, Halliburton CFO Mark McCollum said, “Everybody’s struggling for guar. We’re aware that there are some of our primary competitors missing jobs because of the unavailability of guar.”
HAL had previously forecast a 2% to 2.5% reduction in its second-quarter North American margins due to rising material costs. Now, exploding guar costs have it estimating those margins will be 5 to 5.5 percentage points lower.
Time to Load Up
So far, it’s been all downhill for HAL since hitting all-time highs of around $57 last July. Year-to-date, shares have fallen more than 18% as historically low natural gas prices have many exploration and production firms cutting production (see Chesapeake Energy (NYSE:CHK)). Add in this guar fiasco, and it’s easy to see why investors are abandoning the stock. However, now could be the best time to load up on this oil services leader.
First, Halliburton believes the increased costs are strictly transitory and that new supplies will available in early 2013. Record prices for guar gum are expected to prompt farmers to increase crops by as much as 50% next year. Already, key Indian producers such as Vikas plan to double output next year based on the surging demand. That will help drop prices and boost margins for the drillers.
Meantime, Halliburton is looking to lessen the impact in the second half by increasing the use of guar alternatives. The company is already trying out non-chemical additives as way to get around future fracking legislation. Additionally, Halliburton’s leadership position should help it pass along more of the costs to customers versus some of its rivals.
Halliburton, the oil-service industry’s No. 2 behind Schlumberger (NYSE:SLB), is set to release quarterly results on Monday, July 23 before the start of trading. While it’s always risky to buy a firm’s shares shortly before earnings, Halliburton has already telegraphed that profit will be lower this quarter than the last. Consensus earnings estimates for the firm’s second quarter is 76 cents per share. Since the “guar gum issues” are roughly baked into the stock, any sort of good news could send shares higher in the short term.
Over the longer term, HAL is a bargain. As we continue to crave more energy and drill in more unconventional fields, the services Halliburton provides will be in ever-greater demand. Analysts at Goldman Sachs (NYSE:GS) echo that bullish sentiment and recently initiated coverage on the firm with a conviction buy rating. The investment bank believes Halliburton has “positioned itself extremely well to benefit from the major trends in the oil and gas upstream business.” Goldman’s $55 price target provides nearly 65% upside from current prices.
Shares of Halliburton currently can be had for P/E of 8.87, and they carry a 1.3% dividend yield. That’s valuation is pretty inexpensive considering HAL’s long-term potential. The recent guar problems offer investors the perfect chance to buy HAL or a broad oil-services sector fund, like my favorite, the SPDR S&P Oil & Gas Equipment & Services ETF (NYSE:XES).
As of this writing, Aaron Levitt was long XES.