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Don't get scared off by oil companies

Tuesday, October 27th, 2015

Investors have been scared out of energy and oil companies because of the drop in oil prices, which has caused many companies to decline 40-50% in value. While I understand their fear and that the earnings of these companies have dropped, there are other factors that make some of these oil companies great buys.

 It is important to understand that these companies are tied to the price of oil (which is a usable commodity,) and just like any usable commodity when inventory increases, prices decline.

 Two things also happen that change the future of the inventory. First prices decline, which will increase consumption because no one cares about how much they consume due to the price being so cheap.

The second thing that happens is companies will cut their production because it is no longer profitable to crank out large amounts of oil for low profit margins; also some companies will go out of business because they are too far in debt, can’t pay their bills and are forced into bankruptcy never to return.

 So once the inventory declines from the above forces, prices will increase and profits will return. Investors need to invest in companies that are on sale now, but must be careful not to invest in companies that will go under.

 A few examples of these companies would include Atwood Oceanics Inc. (symbol ATW.) This company has a price-to-tangible book value of 0.39, compared with the industry average of not material. What this means is that investors are paying 39 cents on the dollar for the tangible assets of the company, like buildings and equipment.

 With the industry at not material means the liabilities exceed the assets and there is no value to the company. So a 0.39 PTB is a very good value.

 Also important is something called a current ratio, which companies the short term assets to the short term liabilities and is a measure of liquidity for the company. Atwood has a current ratio of 3.27, compared to the industry at 1.85. Atwood could pay over three times their current liabilities with their current assets, which makes their creditors very happy, and there is no concern of defaulting on any bills.

 Make sure one checks the debt-to-equity of the oil company, because high debt could also cause the company to file bankruptcy if they can’t pay back the loan or interest on the debt.  Atwood has a comfortable debt-to-equity of 0.61.

 Cash flow would be another important thing to look at because while earnings could be negative from depreciation and amortization, the business may bring in more cash than they are using to pay their bills. For the past nine months Atwood brought in $484 million of cash from operations, another positive sign that this company can stay in business and last through the “tough” time.

 Another oil company that we hold in our portfolio is Parker Drilling (symbol PKD,) which has a current price-to-tangible book value of 0.60. From their positive cash flow of $103 million, they managed to reduce their debt by $35 million over the last 12 months to $535 million.

 They also took advantage of the fire sale of energy companies and acquired a business for $10 million. And while earnings per share are currently negative, their equity (which is like your net worth) increased from $641 million last year to $654 million this year.

 My last example would include a company called Patterson-UTI Energy Inc. (PTEN.) Price-to-tangible book currently stands at 0.80. The company actual has a small net profit margin of 2.2%. 

Cash flow for the company year over year nearly doubled from $360 million to $641 million, a huge positive. However the stock price was around $40 in the summer of 2014, and now trades around $14/share.

 Be sure to understand what you’re investing in, and if you do some research and understand what you’re buying you could have some very good returns on your energy investments down the road.

 I leave you with a quote from Warren Buffett: “The best thing that happens to us is when a great company gets in temporary trouble... We want to buy them when they’re on the operating table.”

Do you have a question or a company you would like us to take a look at?
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