Saturday, July 13, 2013

How a Drop in This Commodity's Price Will Improve Halliburton's Margins

The price of guar gum, one of the primary ingredients used by the oil and gas service industry giants, such as Halliburton (NYSE: HAL) and Schlumberger (NYSE: SLB) in hydraulic fracturing (or fracking) for shale gas, has fallen considerably this year. This is going to improve the margins of these companies and could even cause an increase in earnings, particularly for Halliburton, which dominates the North American market. 

Guar drops
Guar seed and gum has a variety of applications and is used by the food, textile, paper, explosives as well as the oil and gas industry. Nearly 80% to 85% of the global supply comes from India where it is the top agricultural export. This year, prices have plummeted. Futures trading in guar gum and guar seed began on May 14 and since then have dropped by more than 20%. The spot prices have dropped by more than 30% this year alone. Guar touched its peak in the first quarter of 2012 and since then, it has fallen by 75% to $3/lb, which, according to UBS, is significantly below estimates of $4/lb to $4.50/lb.
The good news for oilfield-services companies is that the bears have taken a strong hold of this market and prices are expected to drop even further to as low as $1.50/lb. Investors remember last year when the oilfield-services industry firms complained about the high guar prices, which were making things difficult for them (such as here). They certainly won’t be complaining this year. Two factors are driving the prices lower; the increase in acreage in India – which could go up by 25% this year – and pressure coming from buyers due to high prices.
How is this going to reflect in the shares of oilfield-services companies?
The markets are expecting 5% upside as a direct result of the price dynamic as well as an earnings boost of 4.5% to Halliburton, 2.5% to Baker Hughes (NYSE: BHI) and 1.5% to Schlumberger. While I have no doubt that the significant drop in guar-gum prices is going to translate into higher margins, Halliburton would emerge as the biggest winner simply because: 
       a.) It dominates as a North American shale-gas play, which makes it the single-biggest user of guar gum; and
       b.) It purchased large quantities of guar gum last year at higher prices and in its fourth-quarter conference call, the management revealed that it would consume all of its old stock in the first month of the current fiscal year – which means this year, it will only use the lower-priced guar gum.
The current year started with a slowdown in rig-count growth, which caused investors to wonder whether the demand would actually increase for the three oilfield-service firms in the coming quarters. But in June, according to Barclays, a significantly higher number of land-drilling permits were processed, which would eventually lead to an uptake in onshore drilling in the coming months, This will then translate into more business for Halliburton, Schlumberger and Baker Hughes.
Halliburton - a bullish view
Although I am long-term bullish on the US oilfield services firms, I believe that Halliburton will be the biggest beneficiary from the drop in guar-gum prices. Add the U.S. oil boom caused by record levels of domestic production to the equation and we have an oilfield-services giant that is well positioned to capitalize on the improving business environment. 
Moreover, Halliburton is trading at 13 times its current full-year’s profit estimates as opposed to Schlumberger and Baker Hughes, which are both trading at 16 times, which makes them relatively more expensive. Therefore, I would recommend Halliburton. 
So far this year, Halliburton's stock has been up 25%, easily outperforming the S&P 500 ETF (NYSEARCA:SPY), which is up 15.2% in the corresponding period.
Baker Hughes is unattractive
Baker Hughes has also beaten the S&P 500 by posting an increase of 19.3% but it is trading at $47.60, close to its one-year high of $50.97. Its weakness lies in its disappointing operating margin, of just 9.8% and a poor return of equity of 7.1%, which is considerably below Schlumberger and Halliburton’s numbers. Its strength lies in its better performance at the U.S Gulf of Mexico but at current price levels, Baker Hughes is not attractive.
Schlumberger - an attractive long-term play
On the other hand, Schlumberger has significant exposure outside of North America, which has its own unique set of advantages, but it also means that it doesn’t play as big a role in U.S shale-gas plays as Halliburton; therefore analysts have predicted a smaller increase in Schlumberger’s income from the drop in guar-gum prices.
Although Schlumberger missed its revenue estimates in its most recent quarterly results by $800 million, it continues to display better-than-expected performance in international operations. The company is aiming to grow its international business in the current year by 10%, mainly in Africa, Russia, China and Australia. Its stock has under-performed this year but I believe that it is still a very attractive long-term play that generates higher margins of 17.8% and better return on equity of 16% than Halliburton or Baker Hughes. Moreover, unlike its two rivals, Schlumberger generates positive free cash flow. 
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I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours of this publication. I wrote this article myself, and it expresses my own personal opinion. I have no business relationship with any company whose stock is mentioned in this article