Why oil service stocks have great long-term potential

That group of stocks has fallen far more than the price of oil has, setting up what appears to be an opportunity for investors who can look beyond the next few months and stay committed for several years.

Charles Lemonides, chief investment officer of ValueWorks, which manages about $220 million for private and institutional clients in New York, named two oil-services companies he has invested in for the long term. Those and related exchange traded funds are listed below.

Long-term potential

A list of S&P 500 companies that had fallen at least 50% from 52-week highs included two oil-field-services companies: Halliburton HAL, +0.09%  and National Oilwell Varco NOV, -1.10%

Here are total returns (and the price change for crude oil) for five oil-related energy subsectors for one year through May 28:

Phil Flynn, a senior market analyst at Price Futures Group who writes a daily energy report, said in an interview May 28 that oil-services companies have suffered “partly because their customers cannot afford to pay them.” Cuts in capital spending by oil-exploration-and-production companies have hurt services companies’ profitability.

Flynn said that when the price of oil was rising in late 2017 and early 2018, oil-services companies were “ramping up,” but then “got caught leaning the wrong way” as a reversal in price action led to a significant decline in the U.S. shale rig count.

Meanwhile, services companies that need to expand their labor forces face a seller’s market, which means more pressure on profits.

With a lot of oil producers “in debt up to their eyeballs,” Flynn doesn’t expect a quick turnaround for the services companies. Yes, the U.S. oil industry is expected to set a production record this year, but spending on exploration and production is set to decline significantly.

So the short-term problem for oil-services companies is clear. But “you will not continue to see increases in production without drilling,” Flynn said.

“We know the cycle will change, especially with growth of demand, which people are underestimating. A couple of years from now, producers may have difficulty meeting demand, and then the services companies will be in the drivers seat,” he added.

So there’s the long-term case for beaten-down oil-services stocks, with an emphasis on “long term.” It’s easy to say that you shouldn’t be buying stocks unless you can commit for three to five years. That flies in the face of sell-side analysts’ one-year price targets. But for oil-services companies, it might be more reasonable to make a firm five-year commitment before jumping in. Otherwise you could easily get burned. Badly.

Two favorite stocks and four ETFs

Lemonides of ValueWorks said a slowdown in drilling activity would likely be “a pretty quick self-correcting phenomenon.”

“If activity slows, production slows, and then prices head higher, and we start the whole thing again,” he said in an interview May 28.

“Up to now we have been mostly keeping our powder dry” in the energy space, he said, but ValueWorks has positions in two oil-services companies:

Transocean

Lemonides called Transocean RIG, +0.90%  “very compelling” because the shares are “trading arguably” at a quarter or a third of the replacement cost of the company’s vessels, in his estimation. “At some point it will come back to replacement value. So the upside on the shares is three to eight times your money,” he said.

That is a big potential, which is why it isn’t surprising that Lemonides said: “We don’t get too sensitive on time periods.” He expects the shares eventually to rise to $30 to $40 from the current levels of below $7, “two to five years down the road.” Maybe you should focus on the second of those year-range numbers.

Tidewater

Tidewater TDW, -2.27%  is “even more of a niche play,” Lemonides said, as it runs a fleet of offshore supply vessels. “Its share price has held up much better than the rest, probably because it was just too cheap, and secondarily you are seeing signs of an inflection in their business,” he added.

That inflection point represents the endpoint of Tidewater’s efforts to absorb its excess inventory of unused vessels, brought about by the collapse of oil prices in 2014 and 2015 and the consequent reduction in demand for ocean drilling. Once the inventory problem is solved, “profitability can explode to the upside,” Lemonides said.

“And you are starting to have credible arguments made that the supply/demand imbalance is starting to close. It is still early, but the share price is compelling,” he said, while calling Tidewater “the premier company in that space.”

Lemonides emphasized the importance of long-term discipline for this type of investment. “The willingness to be invested even though there is near-term volatility and compression is a huge advantage. If you are willing to look past the storms and are willing to be invested for the next two to five years, you can position yourself for two- to five-fold increases,” he said.

A broad investment in the oil-services space might be appropriate if you are confident that the industry cycle will eventually favor the subsector and if you don’t want to select individual stocks. Here are four ETFs that track the oil and gas services subsector in various ways:

The ETFs follow various methodologies. Before considering any of them, you need to do your own research and assess an ETF’s strategy for yourself.

The VanEck Vectors Oil Services ETF (OIH) . Year-to-date, OIH has declined -47.41%, versus a 4.64% rise in the benchmark S&P 500 index during the same period.

OIH currently has an ETF Daily News SMART Grade of C (Neutral), and is ranked #26 of 36 ETFs in the Energy Equities ETFs category.

This article is brought to you courtesy of MarketWatch .