The Tycoon Report

Oil Service Sector: A Short Play ... For Now!

Last week a reader asked what I thought of the Oil Service sector in response to my article “OIL: The Beginning of a Long Term Down Trend?”

Although oil service stocks have experienced gains over the past couple of years, as oil prices have ballooned, the oil service sector has been adversely affected.

Maybe it’s just me, but didn’t we just get started down a road to energy independence? How is the industry already retreating?

Bargains are being created on the long side that we should keep an eye on (2 of my top picks below). Nevertheless, institutions are unloading shares of oil service stocks. So how am I going to make money off it?

Here’s how! Let's start by taking a look at the internal breakdown of the oil service sector.

Below is the Oil Service Sector Bullish Percent Index (BPI) chart: The chart represents a bearish pattern and a BPI at 23.15%. Generally, a sector is considered oversold when the BPI is below 30%. Nevertheless, it is important to look at the BPI history of each sector separately. Just this past January (Green Circle), the BPI went as low as 10.60%.

So the industry does show some heavy volatility compared to other sectors. What this tells me is, since the oil service sector is generally oversold, I need to watch closely for a reversing trend. Although, historical performance says there is room for further gains on the short side. (Below)

Below is the 1-year chart of the Oil Service Index (SYM: $OSX). I want to point out two aspects of this chart specifically. First, the “hand” is pointing to the recent crossover by the 20-day EMA over the 50-day. Not exactly signifying an impending bullish trend reversal.

Second, notice the large red arrow. OSX has tested its lows four times this year. Is it possible it will be tested again? I believe so. Will it go lower? As early as 2007, the index teetered around $175.

Note: The RSI and MACD are in heavily bearish trends as well (Below). 

Now let's look at the 6-month chart of OSX. We see that the next level of support is around $255 (The big red line). You will notice four red arrows above bounces in the downward momentum.

The fourth is where I believe the next bounce is forming before a spiral down. I will act once the index bounces above 300.

The oil service sector historically trades in relation to oil. If we believe oil is in a downward trend, as I do, then it should also help bring oil service stocks down with some negative momentum.

Based on what I displayed as well as other indicators, I am purchasing the (SYM: OSXOJ) OSX March 09, 350 Put Options trading at roughly $65.

I WILL HOLD MY POSTURE UNLESS MY INDICATORS TELL ME DIFFERENTLY. NOTE: NO FEELINGS OR PERCEPTIONS INVOLVED; ONLY INDICATORS!

For the longer term of 9 months - 2 years, my second strategy is to keep some money on the side and watch closely for signs that oil service stocks are beginning a bullish trend.

Here are two companies I am watching closely ...

Apache Corporation (SYM: APA) explores, develops, and produces natural gas, crude oil and other energy related products.

First of all, look at the growth in this company over the past five years. Despite this robust growth, APA trades at a P/E of less than 9, and less than 6 times next year's expected earnings. When you look at this chart, doesn’t it look like a chart trading at least 20 times this year's earnings, if not next year's? (Below)

What stands out about APA to me?

• For its most recent quarter, APA reported net income of $1.4 billion or $4.28 per common share, a 128-percent increase from $632 million or $1.89 per share in the prior-year period.

• Second-quarter cash from operations totaled $2.3 billion, compared with $1.5 billion in the prior-year period, and surpassed the record of $1.9 billion set in the fourth quarter of 2007.

• With record growth, the company still saw second-quarter production declines of 3.6 percent from the prior-year period and 1 percent from the first quarter. Yet the declines were related to an explosion that disrupted operations at the gas processing and transportation hub at Varanus Island. And, in Australia, a strike at a refinery shut down production.

Noble Corporation (SYM: NE) is an offshore drilling contractor for the oil and gas industry. The company performs drilling services with a fleet of 62 offshore drilling units worldwide. NE is trading at a P/E of 9.40 in spite of considerable growth over the past few years.

What stands out about NE to me?

• 89 percent of the company's total rigs are committed for the remainder of 2008.

• 68 percent are committed for 2009, showing strong demand for the Noble Corporation’s products.

• NE reported second quarter 2008 earnings of $376 million, or $1.40 per share, versus $290 million, or $1.08 per share, for the second quarter of 2007.

• Per-share earnings were up 30 percent from the second quarter of 2007.

• Earnings for the first 6 months of 2008 totaled $2.83 per share compared with $2.01 last year.

• Its core business, contract-drilling services, saw earnings rise to $760 million in the first half of 2008, up 41 percent from the year-earlier period.

• It recently declared a quarterly cash dividend of $0.04 share.

You will notice that both stocks have been hit hard lately, both show strong financial strength, low P/E, and are situated correctly in the oil service industry.

INDUSTRY TIP: While looking through NE operating cash flow, I noticed the company was openly honest about one-time sales or expenditures showing unsustainable earnings for the quarter.

During the tech bomb and still today, companies try to hide one time gains in operating income in order to make investors believe they are generating earnings which will be sustainable quarter to quarter. I am sorry, but the one-time sale of a failing unit does not equal sustainable earnings.

One-time sales do from time to time inflate, or for that matter deflate, earnings. If a company is honest about these items, it is a good sign they are not trying to manufacture earnings.

In closing, my posture is bearish on the oil service sector as well as oil for the short term, while I look out for future bullish positions. I believe long term there is going to be an influx of money into the sector, and the companies that work in the industry will benefit.