June 28, 2006 Global Gambits The Right Moves for Right Now Oil and Gas Oil Services chapter The following is a chapter from, dated June 28, 2006. This chapter is presented for convenience, and should be read in conjunction with the full report and its analyst certifications and important disclosures. The full report is available on MorganMarkets.
Oil and Gas - Oil Services & Equipment Eastern Hemisphere Growth Continues to Deliever Upside Surprise Global Sector Coordinator Michael K.LaMotte (1-214) 965-3623 michael.lamotte@jpmorgan.com J.P. Morgan Securities Inc. Full sector coverage details on page 7 Key Drivers The Middle East should continue to be the main engine of global upstream spending growth through 07. We expect drilling and completion expenditures in the Middle East to grow almost 50% this year and another 33% in 07, led by Saudi Arabia. Next year, Abu Dhabi and Kuwait are expected to contribute more to the region s growth as well. In Saudi, few investors realize the importance of natural gas, which now accounts for roughly 30% of all drilling activity. From a services standpoint, these wells being deeper and hotter generate 3-4 times more revenue than an oil well. Exploration is accelerating, and deepwater is benefiting disproportionately. The combination of record cash flow (which tends to loosen discretionary budgets) and limited access to new reserves is forcing the major oil companies to look for reserves in known basins. Of all these, deepwater as the least mature still holds the most promise for discoveries of meaningful size. Globalization of natural gas helps with earnings visibility. The current international cycle has two drivers the need for growth in oil capacity and the globalization of natural gas. Because of the long lead times and size of the ultimate capital commitment, LNG and GTL developments (primarily in Africa and the Middle East) are contributing to the industry s unprecedented earnings visibility. Labor is the governor of growth this time, not capital or equipment. Though some investors are worried about the pace of investment in new rigs and equipment, growth in services is being tempered by the ability to train new crews. In our view, this is one of the best arguments for a more protracted cycle. Our Non-Consensus Views The premium jackup market has the most day rate upside of any offshore rig class. The consensus view of the premium jackup market is that it is on the verge of being oversupplied by the 61 rigs now under construction or on order. However, our proprietary day rate forecasting model, TABS, is the only forward-looking model that looks at the market the way operators and contractors do: incremental demand is measured by outstanding tenders, and supply is measured by availability. Within this context, the international jackup market despite the 26 newbuilds coming into service by end- 07 remains undersupplied by 28 rigs. The balancing mechanisms for the market are bullish for day rates: (1) more rigs need to move from the US Gulf of Mexico (at higher rates that cover both the mobilization and opportunity costs), and/or (2) some tenders get priced out of the market. The US natural gas problem is not just an inventory overhang. The consensus view on the US natural gas market is that: (1) a storage surplus exists only because of the warm 05-06 winter, and (2) storage resets every year on October 31 when the injection season ends. However, we believe that the supply/demand imbalance is more pronounced than the storage numbers suggest, as domestic production appears to be growing (hurricane adjusted) by 1.7% Y/Y, and industrial demand remains very weak. Consequently, it is looking increasingly likely that the rig count will dip in 2H06 and into 07. 2
Oil & Gas - Oil Services & Equipment: Top Picks Company Key Financials Rationale and Catalysts Schlumberger Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: SLB US / SLB 2005 2006E 2007E 1.67 2.70 3.55 Exchange: NYSE P/E (Calendar) Price (Local): US$59.03 2006E 2007E Mkt Cap (US$): 69.7 bn 21.9 16.6 Analyst: Michael K.LaMotte EV/EBITDA (Calendar) Phone: (1-214) 965-3623 2006E 2007E Email: michael.lamotte@jpmorgan.com 12.6 10.1 ENSCO International Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: ESV US / ESV 2005 2006E 2007E 1.85 4.70 6.55 Exchange: NYSE P/E (Calendar) Price (Local): US$44.40 2006E 2007E Mkt Cap (US$): 6.8 bn 9.5 6.8 Analyst: Michael K.LaMotte EV/EBITDA (Calendar) Phone: (1-214) 965-3623 2006E 2007E Email: michael.lamotte@jpmorgan.com 6.0 4.4 Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, 2006. Although SLB is the largest company in the sector, it should be one of the fastest top-line growers in 06 due to the combination of: (1) growth in its rigless businesses (e.g., seismic, wireline, DCS, and SIS); (2) market share and pricing gains from new technologies (e.g. SCANNER and SCOPE); and (3) continued flow-through of higher-priced contracts in the eastern hemisphere particularly the Middle East, Africa, and parts of Asia. Incremental margins should continue to be greater than expected due to: (1) strength in pricing; (2) improved asset turnover (especially in high-growth markets); (3) more complete deployment of technology; and (4) increased contribution from pay for performance" contracts. Although the stock looks relatively expensive on 07 consensus estimates, we believe these forecasts are still too low. In addition, SLB s current premium is less than half of that of the 1990s, even though we believe its leadership is more distinctive today. Lastly, the stock trades well below its cash flow-driven valuation. Consequently, as long as the company can continue to beat consensus expectations, we believe the stock can continue to outperform. We continue to believe that the premium jackup market has the most day rate upside of any of the offshore rig classes. This view is supported by our proprietary day rate forecasting model, TABS, which shows a 28 rig deficit in international markets over the next 12 months despite the addition of 26 newbuilds between now and year-end 07. The market can clear only two ways both of which are supportive of day rates: rigs will continue to leave the Gulf of Mexico, and/or some tenders will be priced out of the market. ESV International, we believe, is the best way to invest in this market, as it has the greatest backlog-adjusted earnings sensitivity to higher international jack-up day rates. In addition, with 17 jack-ups in the US Gulf of Mexico all of which are capable of working in international waters it stands to benefit from rig mobilizations out of that market either directly (as is the case with ESV Rig 105) or indirectly (as the supply/demand balance tightens domestically). Lastly, ESV has one of the best organic growth profiles in the sector, largely as a result of its deepwater newbuilds. In aggregate, the ESV 8500 and 8501 are adding over US$1.50 (almost 20%) to ESV s mark to market earnings, giving the company one of the most accretive capital programs in the industry. This growth should continue: during the next 12 months, we believe the company will receive contracts to build the 8502 and 8503 as well. 3
Oil and Gas - Oil Services & Equipment: Top Picks (cont d) Company Key Financials Rationale and Catalysts Technip Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: TEC FP / TECF.PA 2005 2006E 2007E 1.25 1.52 2.48 Exchange: Paris Stock Exchange P/E (Calendar) Price (Local): 39.98 2006E 2007E Mkt Cap (US$): 5.6 bn 26.3 16.1 Analyst: Gordon Gray EV/EBITDA (Calendar) Phone: (44-20) 7325-1570 2006E 2007E Email: gordon.m.gray@jpmorgan.com 7.5 5.3 Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, 2006. Technip s shares have been badly hit in recent months by management s disclosure of pressures on near-term profitability. Current results are being strongly affected by: (1) substantial cost pressure on older contracts which are currently approaching the end of their lives; and (2) Technip s profit-booking policy whereby the first 25% of a contract s revenue is booked at zero profit (71% of 1Q onshore revenue was booked at zero/very low profit). We expect cost pressures to continue to affect near-term figures but believe the more recent (2004-05) contract awards are far more resilient to the current environment, and carry far higher contingencies. As a result, we are still reasonably confident of seeing a significant margin improvement from 2H06 onwards. We recently lowered our forecasts for 2006 substantially but felt the need for only limited reductions (6-7%) to our longer-term estimates. We have only lowered our 2007-08 EPS estimates by around 6-7%. We still see compound earnings growth of more than 20% p.a. for 2005-08E. Technip trades at a 2007E-08E discount to Saipem of around 15% on P/E and P/CF, which we believe more than discounts the increased uncertainty over the company s growth outlook. While confidence may take some time to rebuild, we expect the new share buyback program to lend good support to the stock. 4
Oil and Gas - Oil Services & Equipment: Stocks to Underweight Company Key Financials Rationale and Catalysts Pride International Rating: Underweight Fiscal EPS (Local): Year-end Dec. Ticker: PDE US / PDE 2005 2006E 2007E 0.74 1.85 4.11 Exchange: NYSE P/E (Calendar) Price (Local): US$29.94 2006E 2007E Mkt Cap (US$): 4.8 bn 16.2 7.3 Analyst: Michael K.LaMotte EV/EBITDA (Calendar) Phone: (1-214) 965-3623 2006E 2007E Email: michael.lamotte@jpmorgan.com 7.0 4.0 China Oilfield Services Limited Rating: Underweight Fiscal EPS (Local): Year-end Dec. Ticker: 2883 HK / 2883.HK 2005 2006E 2007E 0.19 0.26 0.30 Exchange: Hong Kong Stock Exchange P/E (Calendar) Price (Local): HK$3.40 2006E 2007E Mkt Cap (US$): 1.9 bn 13.2 11.3 Analyst: Graham EV/EBITDA (Calendar) Phone: (852) 2800-8505 2006E 2007E Email: graham.d.cunningham@jpmorgan.com 5.5 4.7 Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, 2006. Because of PDE s previous balance sheet constraints, its premium rig fleet was committed to long-term contracts very early in the cycle at prices that are now 60% below the market. Because of the duration of these contracts, the company has very little in the way of repricing opportunities before 08. We estimate that marking these contracts to market would add US$1.80/shr in earnings between now and the end of 07 (off of a base of US$1.85 for this year and US$4.10 for next). The majority of the company s spot day rate exposure is in the US Gulf commodity jack-up market, which in our view is one of the least attractive asset classes. Although some investors are bullish on commodity jackups in the Gulf because of the expected exodus of premium jackups, we believe the demand for commodity jackups is being threatened by weak natural gas prices. This has already started to materialize: PDE s major competitor in the Gulf commodity market, THE, recently stated that rates for some rigs are beginning to fall. Many investors have ascribed a value of about US$1.5 billion to PDE s Latin American land drilling and services businesses, which we believe is too high. Our sum-of-the parts valuation puts the value of these businesses at US$1.0-1.2 billion, which means that the eventual sale could be viewed as a disappointment. Premium valuation with less exposure to offshore drilling. COSL is trading at a 15.1% premium in terms of FY07E P/E to its offshore drilling peers in the US. However, COSL, with about 40% revenues from the non-drilling business and the achieved drilling rate, has historically been in a structural discount to global rates; the company has less exposure to the strong outlook of offshore drilling market. The gap between global drilling rates and offshore Chinese drilling rates has been constant or widening since 2002, and we expect it will continue to widen in FY06. The increase in overseas drilling activities outside offshore China should not be able to increase COSL s margins at least in FY06. It is mainly because COSL has to go through a learning curve to operate outside offshore China. The recent deployment of its new rig COSL 941 (400 feet jack up) in offshore China should lead to disappointment in the market, as offshore drilling rates in offshore China are far lower than those in the international market. In next 12 months, we are also worried about the news flow on COSL s deep-water exploration drill ship investment and the sustainability of the low corporate tax (currently it is at 15% versus the normal 33%). Our Dec-06 price target of HK$ 3.3 is based on DCF, global comparables, and sum-of-the-parts valuation. Key risks are higher realized drilling rates and strong liquidity in the Chinese equities market. 5
Oil and Gas - Oil Services & Equipment: Stocks to Underweight (cont d) Company Key Financials Rationale and Catalysts BJ Services Rating: Underweight Fiscal EPS (Local): Year-end Sept. Ticker: BJS US / BJS 2005 2006E 2007E 1.59 2.55 3.28 Exchange: NYSE P/E (Calendar) Price (Local): US$36.23 2006E 2007E Mkt Cap (US$): 11.6 bn 15.4 11.7 Analyst: Michael K.LaMotte EV/EBITDA (Calendar) Phone: (1-214) 965-3623 2006E 2007E Email: michael.lamotte@jpmorgan.com 9.0 6.9 Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, 2006. With roughly 80% of its earnings coming from the North American pressure pumping business, BJS is one of the most US natural gas-exposed companies in our coverage group. Consequently, should drilling activity in North America slow down in the later half of this year and into 07 as we now expect BJS earnings would be among the most at risk of negative revision. Though concerns about capacity growth in the North American pressure pumping market have been long-standing (and thus far unwarranted), the market could quickly become oversupplied (having a negative impact on the pricing structure) should the rig count dip over the next six months. This is purely a function of the inability to match, from a timing perspective, demand and supply. Whereas demand is effectively a call-out (forward visibility is measured in days), lead times on pumping equipment mean supply-side changes are delayed by up to a year. 6
JPMorgan Global Oil and Gas Team Research Equity Research Credit Research Exploration and Production Integrated Oils Downstream Gas Oil Services Gordon Gray Gordon Gray, Coordinator Michael LaMotte, Coordinator Global Sector Americas Americas Americas Americas Americas Coordinator United States Philips Johnston, CFA Latin America Bidzina Bejuashvili Katya Shiro United States Jennifer C. Rowland Daniel Vetter Katherine Lucas United States Brooke Glenn Mullin United States Michael LaMotte Kevin Pollard David Smith United States Latin America Bidzina Latin America Bejuashvili Katya Shiro EMEA EMEA EMEA Pan Europe Gordon Gray Pan Europe Gordon Gray CEEMEA Tao Ly Tao Ly Ross McCormick Ross McCormick James C. Gibbons (/HY- Energy, Natural Gas Pipelines) Robin Levine (HG-Energy, Natural Gas Pipelines) Xin Liu (HY-Energy) William W Perry Douglas Krehbiel CEEMEA Bidzina Bejuashvili Katya Shiro CEEMEA Bidzina Bejuashvili Katya Shiro Asia Pacific Asia Pacific Asia Pacific Asia Pacific Asia Pacific Pan Asia Pacific Graham Pan Asia Pacific Graham Cunningham Pan Asia Pacific Graham China Frank Li Australia, New Zealand Allison Bellows Tiernan Australia China Mark Greenwood Ryan Martyn Graham Australia Jessica Smith China Graham Singapore Winnfred Heap Ex-Japan Asia Allison Bellows Tiernan China Graham Thailand Sukit Chawalitakul Japan Rie Kajiyama Indonesia Ami Tantri HongKong Graham Thailand Sukit Chawalitakul Thailand Sukit Chawalitakul 7
Companies Recommended in This Report (prices as of COB 19 June 2006) China Oilfield Services Limited (2883.HK/HK$3.40/Underweight) Analyst Certification: The research analyst who is primarily responsible for this research and whose name is listed first on the front cover certifies (or in a case where multiple research analysts are primarily responsible for this research, the research analyst named first in each group on the front cover or named within the document individually certifies, with respect to each security or issuer that the research analyst covered in this research) that: (1) all of the views expressed in this research accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research. Important Disclosures Client of the Firm: China Oilfield Services Limited is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company noninvestment banking securities-related service. Non-Investment Banking Compensation: JPMSI has received compensation in the past 12 months for products or services other than investment banking from China Oilfield Services Limited. China Oilfield Services Limited (2883.HK) Price Chart 9 8 7 6 5 Price(HK$) 4 3 2 1 UW HK$3.3 HK$3.3 Date Rating Share Price (HK$) 25-Apr-06 UW 4.58 3.30 Price Target (HK$) 0 Jun 03 Sep 03 Dec 03 Mar 04 Jun 04 Sep 04 Dec 04 Mar 05 Jun 05 Sep 05 Dec 05 Mar 06 Jun 06 Source: Reuters and JPMorgan; price data adjusted for stock splits and dividends. Initiated coverage Apr 25, 2006. This chart shows JPMorgan's continuing coverage of this stock; the current analyst may or may not have covered it over the entire period. As of Aug. 30, 2002, the firm discontinued price targets in all markets where they were used. They were reinstated at JPMSI as of May 19th, 2003, for Focus List (FL) and selected Latin stocks. For non-jpmsi covered stocks, price targets are required for regional FL stocks and may be set for other stocks at analysts' discretion. JPMorgan ratings: OW = Overweight, N = Neutral, UW = Underweight. Important Disclosures for Equity Research Compendium Reports: Important disclosures, including price charts for all companies under coverage for at least one year, are available through the search function on JP Morgan s website https://mm.jpmorgan.com/disclosures/company or by calling this U.S. toll-free number (1-800-477-0406) 8
Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: JPMorgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] The analyst or analyst s team s coverage universe is the sector and/or country shown on the cover of each publication. See below for the specific stocks in the certifying analyst(s) coverage universe. JPMorgan Equity Research Ratings Distribution, as of April 3, 2006 Overweight (buy) Neutral (hold) Underweight (sell) JPM Coverage 40% 42% 18% IB clients* 45% 47% 39% JPMSI Equity Research Coverage 35% 50% 15% IB clients* 63% 57% 46% *Percentage of investment banking clients in each rating category. For purposes only of NASD/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category. Valuation and Risks: Equity Research company notes and reports include a discussion of valuation methods used, including methods used to determine a price target (if any), and a discussion of risks to the price target. Analysts Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking. Other Disclosures Options related research: If the information contained herein regards options related research, such information is available only to persons who have received the proper option risk disclosure documents. For a copy of the Option Clearing Corporation s Characteristics and Risks of Standardized Options, please contact your JPMorgan Representative or visit the OCC s website at http://www.optionsclearing.com/publications/risks/riskstoc.pdf. Legal Entities Disclosures U.S.: JPMSI is a member of NYSE, NASD and SIPC. J.P. Morgan Futures Inc. is a member of the NFA. J.P. Morgan Chase Bank, N.A. is a member of FDIC and is authorized and regulated in the UK by the Financial Services Authority. U.K.: J.P. Morgan Securities Ltd. (JPMSL) is a member of the London Stock Exchange and is authorised and regulated by the Financial Services Authority. South Africa: J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. Hong Kong: J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission in Hong Kong. Korea: J.P. Morgan Securities (Far East) Ltd, Seoul branch, is regulated by the Korea Financial Supervisory Service. Australia: J.P. Morgan Australia Limited (ABN 52 002 888 011/AFS Licence No: 238188, regulated by ASIC) and J.P. Morgan Securities Australia Limited (ABN 61 003 245 234/AFS Licence No: 238066, a Market Participant with the ASX) (JPMSAL) are licensed securities dealers. New Zealand: J.P. Morgan Securities New Zealand Limited is a New Zealand Exchange Limited Market Participant. Taiwan: J.P.Morgan Securities (Taiwan) Limited is a participant of the Taiwan Stock Exchange (company-type) and regulated by the Taiwan Securities and Futures Commission. India: J.P. Morgan India Private Limited is a member of the National Stock Exchange of India Limited and The Stock Exchange, Mumbai and is regulated by the Securities and Exchange Board of India. Thailand: JPMorgan Securities (Thailand) Limited is a 9
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