This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
Oil Whipsaws Investors… Again
On Thursday, oil prices jumped 5% in yet another head-spinning day of trading. Oil price estimates now range from Citigroup’s bearish $65 target to JPMorgan’s “high-on-life” $380.
So much for “expert” predictions… I could sail an oil tanker through those goalposts.
That’s a great encapsulation of the precise reason zero traditional oil and gas firms make it onto the core Profit & Protection “buy” list. When 89% of Exxon’s (NYSE:XOM) price movement is explained by moves in rival Chevron (NYSE:CVX), there’s very little “alpha” that investors can generate from stock-picking.
But there are plenty of non-traditional energy firms with strong potential. Last month, the quantitative Profit & Protection system flagged solar firm Shoals Technologies (NASDAQ:SHLS) as a top five pick. Its shares are up almost 20% over the past week. And no conversation about energy investing would be complete without Enphase Energy (NASDAQ:ENPH), the top-performing company in the S&P 500. Shares of the solar inverter company are up 26,000% in the past 5 years.
These non-traditional companies succeed because they avoid competing in the commoditized world of oil, where the only factor that matters is price.
And today, I’m revealing my No. 1 oil and gas pick from within the traditional world that finally deserves a place on the core Profit & Protection list:
The No. 1 Stock of the Oil and Gas Industry
In 1859, former train conductor Edwin Drake was hired by the Seneca Oil Company to investigate oil deposits in a remote corner of northwest Pennsylvania. After several months of failures, Mr. Drake and his team eventually struck oil in a lucky break. They allegedly brought the oil to the surface with a hand pitcher pump and collected it in a bathtub.
Fast forward 150 years and surprisingly little has changed. Energy companies still extract fossil fuels by boring pipes into the ground — an innovation Mr. Drake himself pioneered. And modern firms continue the time-honored tradition of almost going bankrupt every time an energy crisis happens; Mr. Drake died an impoverished man after losing his life savings in the 1863 oil speculation craze.
The problem is that upstream drilling is a cyclical, commoditized business (Yuck!). No matter how productive and low-cost a company’s oil fields may be, they inevitably deplete, leaving their owners scrambling for new assets. These are generally sold to the highest bidder, removing the vast majority of potential profits. With the exception of Saudi Aramco and other nationalized producers, no oil driller has a monopoly on low-cost fields.
This “race to the bottom” shows in the financial returns. Exxon’s return on capital invested (ROIC) has averaged 7% over the past decade, barely higher than its cost of capital. And shares in Exxon and the wider industry tend to go … nowhere. The iShares US Oil & Gas Exploration & Production ETF (BATS:IEO) trades at the same price it reached in 2008. The average energy firm scores a “B-” in the Profit & Protection ranking system.
Escaping Rock-Bottom Returns
Yet there have been companies that manage to turn small investments into stunningly large wins.
On the speculation side, highly leveraged firms can often ride energy prices to the moon — even if only temporarily. $10,000 invested in Enservco (NYSEAMERICAN:ENSV) when I recommended it in November 2021 would have turned into $65,800 four months later.
And longer-term investors often find mid-sized firms with sustainable competitive advantages. Warren Buffett’s purchase of Occidental Petroleum (NYSE:OXY) coincided with the energy firm’s sale of many of its traditional oil assets.
But to truly profit from oil and gas investing over the long-run, we need to find companies doing things no one else can.
And that’s where Schlumberger comes in.
The $50 Billion Wunderkid
Schlumberger is arguably the top oilfield service company in the world. The firm pioneered directional drilling in the mid-1980s and opened the door for modern shale drilling. Even now, new products still generate around 20% of company revenues.
Among its current-generation products are advanced artificial lift pumps that bring oil to the surface. Schlumberger and Baker Hughes together hold 50% of the world’s electrical submersible pump market. And its Optiq product launched in 2021, which uses fiber-optic strands rather than traditional sensors, has already won the World Oil’s New Horizons Idea Award.
Advances in software and digital solutions are also driving revenue. In a world where new fields can cost billions to drill, exploration firms need all the help they can get. In June, French-based TotalEnergies revealed it would cost almost $29 billion to develop Qatar’s North Field East gas reserves.
Meanwhile, America’s oil bonanza has benefited Schlumberger’s core businesses of well construction and production systems. Analysts expect the firm’s revenues to grow 14% this year, earning the firm a comfortable “A” grade for growth from the Profit & Protection system.
These tailwinds are translating into double-digit ROICs — an essential element of my Perpetual Money Machine strategy, which involves buying high-returning businesses that reinvest earnings at high rates. The company’s fair value sits at $50, a comfortable 50% upside from current levels.
What’s Schlumberger Worth?
Schlumberger benefits from a lack of direct exposure to oil prices. Its business is instead tied to the volume of new wells and existing production — elements that are far more predictable.
That makes valuations somewhat easier to estimate. A 2-stage discounted cash flow (DCF) model now places the firm’s fair value at $50.
Many analysts are taking things a step further. David Anderson at Barclays puts fair value at almost $60, a 73% upside from current levels. These are achievable figures — Schlumberger’s shares traded at $75 as recently as 2018.
There are, however, some issues with SLB’s stock.
First, the firm has a weak presence in renewable energy, a fact that its future top brass absolutely must address. The U.S. Energy Information Administration (EIA) projects U.S. oil production to taper off sometime in 2035.
Second, Schlumberger is still a second-order beneficiary of oil prices. Shares rose nearly 200% in the years leading up to 2014 before collapsing 85% after new drilling dried up.
And finally, the firm’s high earnings quality cuts both ways. Though SLB shares won’t fall to zero in the next oil crash, its upside is more limited than more speculative plays.
Still, building a well-diversified portfolio means buying companies that “zig” while the market “zags.” And if you were going to pick one survivor of the oil and gas world, then Schlumberger is Profit & Protection’s first place to start.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.