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Two Ways to Drill into Oil Services

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Demand for oil has grown fairly steadily. Supply, though, has vacillated because of geopolitical events – Libya, Venezuela — and especially the take-off of fracking in 2011-2012, explains Stephen Leeb, commodity-sector expert and editor of The Complete Investor.

We expect oil demand to continue to rise fairly steadily for at least the next generation. Even if gasoline usage falls, demand for petrochemicals will be growing.

As for supply, fracking’s extent and duration has surprised us. But signs have begun to emerge that its best days are behind it. Over the shorter term, geopolitically induced changes in supply will likely keep oil prices volatile. Within the next two years, though, as pressures on supply grow, the uptrend in oil prices that began near the century’s start will likely resume.

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That’s good news for stocks with the greatest degree of cyclicality: oil service companies. Since its 2016 high point, the oil services group is down more than 70%.

Two small oil service companies, Frank’s International (FI) and Dril-Quip (DRQ), both will have tremendous leverage to the upside when the oil market turns. Meanwhile, they’re protected by their strong cash positions.

That both Frank’s and Dril-Quip emerged from the severe downtown in the oil service patch with positive cash is a feat in itself. Moreover, Dril-Quip has had consistently positive free cash flow since 2013.

Frank’s has been more volatile but has been solidly free cash flow-positive since 2013. Currently Dril-Quip has $2 million in debt and $425 million in cash. Frank’s has no debt and around $250 million in cash.

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Dril-Quip focuses largely on offshore drilling, offering products like subsea control systems and subsea wellheads and servicing all its equipment. Around 62% of its activities are in the Western Hemisphere.

Offshore drilling has been hit particularly hard by volatile oil prices, reflected in Dril-Quip’s results. Revenues have fallen from more than $900 million in 2014 to below $400 million over the most recent 12 months; profits dropped from more than $5 a share to negative 66 cents. In line with other oil service companies, the share price is down sharply — below 40 today compared to near 120 in 2014.

The 2014 high-water mark serves as a long-term target. As many competitors failed, Dril-Quip cut costs sharply while maintaining state-of-the-art products, leaving it exceptionally well situated for when oil exploration returns to better days.

Offshore exploration, because it’s so expensive, requires the greatest amount of confidence in future oil prices. The turn in the potentially massive offshore market may already have begun. Dril-Quip recently reported revenues that beat Wall Street estimates and has noted signs of increased bidding and service activity.

Still, despite the company’s cash-heavy balance sheet, it should be regarded as speculative until the upturn becomes more visible. But if it hangs in, its industry position will be stronger than ever when the upturn starts. This is a stock whose potential upside is several times the current price.

Frank’s is a leading global provider of tubular services and products that maintain the integrity of drill pipes. More than 50% of revenues come from offshore wells.

Its fundamentals — revenue, growth, current income — have followed a trajectory in line with other oil servicers. Revenues for the most recent 12-month period are less than half of peak 2014 levels. Its share price today is more than 75% below the peak near 27 in 2014.

But as with Dril-Quip, Frank’s’s balance sheet proves the company is a survivor. And also like Dril-Quip, it has increased its competitive mettle within a toxic group whose turnaround could be dramatic. Frank’s’s high-water profit level was in 2012, at $2 a share. At its peak in 2014, the stock sold at roughly 20 times earnings.

For both these oil service companies, the upside is many times the current share price. Patience will certainly be required, and they could drop further, but in the end the rewards should be substantial.

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