Core Labs Gives Gushing Numbers

Core Labs Earnings Review

The best way to play a rising oil price is to buy an oil service company, and Core Labs is one of the best ways to get exposure. Oil services stocks tend to be highly correlated with spot oil prices, because their end demand is guided by it. By way of comparison, exploration and production companies tend to be less correlated because their value tends to lie in their reserves, which are only released over time.

What makes Core Labs an attractive stock to buy is that they are focused on using technology to help oil producers define and maximize production from existing oil fields. Therefore, as oil prices go higher, Core Labs will see its services in greater demand. In addition, oil exploration is taking place in increasingly difficult environments (deep water, off shore etc) which encourages utilization of technology in order to be able to better define reserves.

Core Labs Results

Turning to Core Labs results and guidance

• Q4 Adjusted EPS of 84c vs. 81c estimates
• Q4 Revenues of $208.2m vs. $206.3m estimates

Guidance

• Q1 EPS of 82-84c vs. 82c estimates
• Q1 Revenues of $205-210m vs. $211.1m estimates
• Full Year EPS of $3.55-3.60 vs. $3.58 estimates
• Full Year Revenues of $890-910m vs. $893.2m estimates

So, Core Labs beat estimates and revenues for the quarter and, the mid point of full year revenue guidance is above estimates. Full year EPS guidance is within the range of analyst forecasts but Core Labs does tend to be conservative with guidance

Core Labs Growth Drivers

The really good news in this statement is that the biggest single division, Reservoir Description with 53.5% of revenues, is likely to see a strong return to growth. With high oil prices new large scale international deepwater projects are being developed alongside the worldwide shale reservoir projects. In addition, I believe that Core Labs is very active in Iraq and with the formulation of a new Government and the Kurdistan Regional Government planning to recommence exports, there is upside potential here.

Production Enhancement contributes 39.5% of revenues. The division has reported very strong revenue growth (41%) and margin expansion (300bp) which is quite impressive considering that it is strongly focused on North America. Core Labs are assuming a flat rig count for North America, although this is not necessarily a bad thing. Many rigs look likely to shift towards oil from gas as there is a wide historical discrepancy between oil/gas prices. Furthermore, Core Labs activity is in production enhancement so the company can generate strong growth even without a major pick up in exploration activity. The price of oil is more of a driver here.

Reservoir Management is the smallest of the division with only 7% of revenues and 8.7% of operating incomes. It is small, but has the potential for strong growth due to the growth of shale oil and gas projects. Unconventional types of oil and gas projects require greater understanding of reservoir optimization because of the unusual nature of their structural formulation.

Core Labs Stock Evaluation

Core Labs is a likeable stock but its hard to argue that it is anything other than fairly priced at the moment. This is not to say that it won’t go higher. If oil prices go north of $100 than Core Labs stock price will be easily north of a $100 too. However, investing is about risk and reward. Investors should buy stock when the odds are in their favor (value investing) and/or to manifest a strong viewpoint (growth investing) about the stocks growth drivers. Taking a view and assuming that oil prices will go higher this year is fine, but it doesn’t obviate the need to manage the risk of a slowdown in emerging markets.

In the statement Core Labs thinks that it will spend around the same amount in 2011 on capital expenditures. Interpolating the estimates for net income, and historical operating cash flow conversion will get to free cash flow generation of around$175m for 2011. This puts Core Labs on a forward FCF/EV of 4.2% and a forward PE of 25.5x assuming the current share price of $91.3 and that the company hits estimates. Core Labs looks to be fairly valued, although if oil prices rise, it is a great oil services stock to buy.

DNO International and Oil in Kurdistan

Oil explorer DNO International will have been glad to hear that Oil exports are expected to resume soon. The company was featured in an earlier article on stocks focused on oil in Kurdistan linked here

According to the Kurdistan Regional Government (KRG), oil exports are due to resume by February. From the press release from the KRG website

'At a joint press conference following the meeting, Prime Minister Maliki described their discussion as positive and said, “One of the meeting’s key achievements was agreeing on the resumption of oil exports from the Kurdistan Region.”

As well as deciding to resume Kurdistan’s oil exports, Prime Minister Salih and Prime Minister Maliki agreed that the Kurdistan Region will keep a share of its crude oil to supply its local refineries and power plants.'

This bodes well for the listed plays. As discussed previously, my favoured play is DNO International. DNO gave a guarded welcome to the news. According to a Reuters article

'There is definitely information that is still lacking here," said DNO spokesman Tom Bratlie. "It's not like we can just push a button. At the moment there are several issues that have to be agreed upon before we can start exports.'

which could be construed as negative news. However, I don't think it is unduly worrying.


Kurdistan Oil and Iraq

The process of horse-trading over the Iraqi 2011 budget is on-going and oil revenues are the critical issue. In the previous article, I highlighted some of the differences between the Iraqi Technical Service Contracts (TSC) and KRG Production Sharing Contracts (PSC). They appear to be similar and, I suspect that the will to adjust the PSCs from Baghdad, will not prove to be the issue at hand. I suspect the key issues between the KRG and Baghdad will relate to the relative percentages that each pay for the costs of development in Kurdistan. Naturally, the KRG will want them to be paid nationally, as their share of oil production is currently than their share of the Iraqi population.

If I am right, than the issue could be more about from who DNO get paid rather than how much etc. Moreover, Kurdistan is a land locked country, whose neighbours are hardly friendly and, view any aspirations to a Kurdistan state as being a  potential threat. I don't think Kurdistan is in any position to discourage foreign oil explorers, especially if they are allied to the countries they need to transport their oil.


DNO International and RAK Petroleum

One of the key attractions of DNO is that RAK Petroleum holds a strategic stake. They are seen as potential bidders and when/if  the issue of the Kurdistan agreements is finalised, I would expect speculation to increase. RAK Petroleum holds near 30% of DNO and has managed to get the Co's Group Commercial Director, Shelley Watson, onto the board of DNO International. 

Watson was nominated to the DNO board at the AGM in June alongside another RAK Petroleum Director, Zalmay Khalilzad. Given that the latter (he did not take up the position due to heavy workload) is a former US ambassador to the UN and Iraq, I think it fair to conclude that RAK Petroleum has a good angle on what is going on in Iraq and Kurdistan.

I top sliced a few DNO recently on the move up.


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Source:

Earnings View 'Oil Stocks Exposed to Kurdistan'

Reuters article 'DNO says no exports until Iraqi deal clarified'

Oil Stocks Exposed to Kurdistan

I thought it would be useful to look at some of the Western oil companies that are focused on Kurdistan. I think these could be good oil stocks to buy. They are interesting for a number of reasons, most of which are predicated on a successful resolution of disagreements between the central Government and the Kurdistan Regional Government (KRG)

1. They tend to be characterised by being smaller companies who moved in on the market when the central Government said they wouldn’t allow any of the companies with KRG licences to take on development projects in the rest of the country.  This means that these companies are potential takeover targets once the political issues are resolved.
2. There is likely to be significant upside potential due to de-risking once/if this process takes place.
3. Iraq is oil rich and Kurdistan is under explored. The early movers have advantages.

 Oil Companies Involved in Kurdistan

The four companies identified are DNO (Norwegian), Gulf Keystone Petroleum, Heritage Oil and Sterling Energy. I have added a link below to some Goldman Sachs research whereby you can source forecasts and outlook or these stocks.

Before going any further, it should be understood that this idea is a speculative one, based on a successful resolution of the problem between the KRG and central Government. The standoff centres on licences issued by the KRG with these oil companies. The licences are based on Product Share Contracts (PSC) which central Government has consistently said it would not ratify. Naturally, as they are not ratified, export licences have not been issued. Furthermore, the PSCs may be torn up or be made subject to significant revisions in the political horse trading process with the central Government.

Kurdistan Production Share Contracts

Essentially, the PSCs are seen by some as being on more favourable terms to the Oil companies than would be the case under typical Iraqi service agreements. Furthermore, the KRG are effectively getting a subsidy from the rest of Iraq in order to pay the contractors exploration and developmental costs, because these costs are paid centrally from revenues emanating from total Iraqi production. Currently, Kurdistan’s oil production is proportionally lower than the rest of Iraq per head.

My hunch is that these licences will be ratified but there could be pressure to renegotiate contracts downwards for the contractors. With a new Government formed and the necessity of Baghdad to garner Oil revenues, I consider it unlikely that they will seek instability by not ratifying. Furthermore, Kurdistan remains a pet project of US foreign policy, even though the politically powerful Oil majors are not there yet. The pressure to get their oil industry developed will be significant. However, quantifying this viewpoint is not easy, although I note that Goldman Sachs ascribe a 50% political risking to the NPV calculations. I suspect the outcome could be more benign than the risks implied by Goldman Sachs.

Iraq/Kurdistan Oil Contract Dispute

The reason I suspect that they will be benign is that, the PSC agreements appear to be generous, but not overly so. According to Peter Wells when comparing Iraq’s Technical Service Contracts (TSC) with Kurdistan’s PSC agreements

“The contrast with the KRG is considerable. The KRG’s PSCs have been awarded by opaque, secret negotiations to companies with, in the main, very limited major international field operating experience. The profit sharing terms of the KRG PSC are simplistic by the standards of modern PSCs and yield lower revenues and value to the state than PSCs in

comparable countries.”

Furthermore, if we look at figures 4 & 5 you will see that his modelling produces 97% of state take under the PSC but around 99% under the TSC. This isn’t a huge percentage difference to the State, but it is to the contractors share. In other words, assuming $60 a barrel of oil, he might get $5bn instead of $8bn under this model.

However, in his response to this paper, Muhammed Mazeel al-Aboudi articulates the KRG position on Iraq’s TSC agreements

“The contracts are, therefore, not in the best interest of Iraq – even with the important budget needs. These will be long-term contracts and need to be properly offered, reviewed, and approved in accordance with the Constitution and an oil and gas law that is in accord with the Constitution.

In the Kurdistan Region, by contrast, IOCs will, on average, receive a “gross undiscounted profit” figure of just $1.58 (at NPV of 10%) for each barrel of oil discovered and produced from any large field discoveries – almost 40% less than $2.20/B in the case of Ministry of Oil proposed contracts. “

So, by way of contrast, the KRG argue that the Iraq TSC agreements are too generous! I’ve included a link to the KRG’s views below.

Stocks to Buy and Benefit from Oil in Kurdistan

I think the important point is that the KRG thinks –or at least they say-that their contracts are not unfavourable relative to Iraq TSC. With the political wind moving behind the KRG it could mean that they get what they have already signed up for.

Of the four companies noted, Sterling Energy appears to be an also ran. They have had disappointing results in Kurdistan and the potential uplift is minimal. Gulf Keystone Petroleum appears to have the largest upside potential from a successful resolution. Heritage Oil is very interesting but contains the added risk of a tax dispute with the Ugandan Government over the sale of some of its assets. Since the idea here is to gain exposure to Kurdistan specifically, this might preclude an aggressive position with Heritage Oil. DNO is very interesting. Although the evaluation discount does not appear to be large, they have assets in production and would give good upside potential given successful political resolution.

Source:

Al-Aboudi, Muhammed Mazeel ‘Iraq’s TSC And PSC Agreements – A Good Deal For Iraq?’ http://mepep.com/postedarticles/oped/v53n03-5OD01.htm

Goldman Sachs Research http://www.oilbarrel.com/fileadmin/content/pdfs/Brokers_Notes_Oct_10/50%20E%20and%20Ps%20to%20change%20your%20portfolio.pdf

Kurdistan Regional Government Website

http://www.krg.org/articles/detail.asp?smap=02010100&lngnr=12&anr=30161&rnr=223

Wells, Peter ‘Iraq’s Technical Service Contracts-A Good Deal for Iraq?’ http://www.iraqoilforum.com/wp-content/uploads/2009/12/Iraqs-Technical-Service-Contracts.pdf