Turn fears in the energy sector into pay dirt!

One of the biggest stories of 2012 has been the absolute collapse of natural gas prices. The fall has been truly breathtaking, with natural gas falling from $2.97 at the start of the year, to a sub $2.00 as of the end of last week.

This collapse has had numerous peripheral effects on the energy markets, and on energy stocks. But one of the areas where we’ve seen particular weakness because of this decline in natural gas has been the oil service sector …

Despite higher oil prices for the vast majority of 2012, energy service shares have underperformed the market. While the overall stock market is up nearly 10 percent year-to-date, the oil service sector is up less than 1 percent.

The reason for the underperformance comes from concern that low natural gas prices will cause exploration and production companies to “shut in” production, or simply quit drilling for natural gas. Obviously that is a negative for companies that lease drilling rigs, like many oil service companies.

Data has shown these concerns to be well founded …

According to the Baker Hughes rig count, the number of active natural gas drilling rigs operating in the U.S. has fallen from 878 one year ago to 631 this week, a decline of 247 rigs, or almost 30 percent. Certainly this is a big negative for companies that are solely reliant on drilling for natural gas, such as land-based gas drillers.

And Here Lurks the Opportunity!

What I think is being missed in all this concern regarding the decline in natural gas drilling rigs is the fact that the number of oil drilling rigs has increased by 45 percent from last year, from 913 to 1,322 as of this week.

So we have a divided market:

The decline in natural gas has caused a severe reduction in the number of natural-gas-focused drilling rigs here in North America. On the other hand, higher oil prices have led to an even greater increase in oil rigs.

While the number of natural gas rigs has been dwindling, oil rigs are sprouting up like weeds.

Despite this divide, the entire oil service sector has been punished. And I think that may present an opportunity for savvy contrarian investors.

The sub sector of oil service companies that is most exposed to low natural gas prices are land-based, natural-gas-focused drillers. Outside of that subset, things in the oil service sector remain healthy. And we got specific evidence of that last week when two of the largest, most diversified oil service companies, Schlumberger (SLB) and Million-Dollar Contrarian Portfolio holding Halliburton (HAL), reported earnings that easily beat the market’s expectations. Both stocks rallied over 4 percent on the earnings releases.

What their releases showed is that outside of natural gas drilling, conditions in the energy service sector aren’t as bad as feared. And strong companies with sound operation capacity are weathering the storm just fine. The takeaway from this situation in the oil service sector is it appears that the proverbial “Baby has been thrown out with the bathwater.”

And that is exactly the type of situation contrarian investors look for.

The Perceived Weakness

As I see it, there is deserved weakness in the land-based, natural gas drilling companies. But that is only a small subset of the oil service sector. And perceived weakness in that sector has led investors to paint the whole sector with the same brush.

Well diversified service companies like Schlumberger and Halliburton are still enjoying strong businesses from oil and natural gas liquids drilling. And shallow and deep water oil drilling companies have virtually no exposure to land-based natural gas drilling. Yet they have been sold off in sympathy with the rest of the sector!

I think this presents an opportunity in the Market Vectors Oil Service ETF (OIH). It is one of the best oil service sector ETFs on the market. And land-based, natural-gas-focused companies only make up a small portion of the ETF’s holdings. Most of its major holdings are in well diversified energy service companies and offshore drillers, companies whose performance is insulated from the weakness in natural gas.

Every crisis presents an opportunity for contrarian investors. The shocking decline in the price of natural gas has undoubtedly caused a crisis for certain groups in the energy industry, and in particular very focused, land-based natural gas drilling companies. But this jittery market has sold the entire sector off based on this concern, which may present an attractive opportunity for contrarian investors.

Best,

Tom

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