It’s no secret that we are staring down the barrel of a global economic recession.  As the worlds financial markets go through the painful process of deleveraging, liquidity has become scarce causing difficulties in a broad array of industries.Perhaps one of the industries most affected by this crisis is the energy sector.  After experiencing oil prices dropping from $150 down to the mid-60’s and natural gas tracing a similar pattern, energy producers are seeing margins crimped ad profitability drying up.  The situation is a far cry from last year when CEO’s of major oil and gas producers were dragged before congress to testify about their “windfall profits.”  Even OPEC has become concerned, but an emergency production cut did nothing to slow the decline in oil prices.

Precision Drilling Trust (USA) (PDS) has not been immune to the declines and in the last 3 months alone the stock price has dropped from $28 down to a low of $8.41.  The company owns rigs that are employed by drillers to dig natural gas wells.  As the price of natural gas declines, drillers have less incentive to employ PDS to help with drilling projects.  The scenario has hit PDS especially hard as the company specializes in directional drilling or horizontal drilling.  These types of wells are more expensive to drill, but when the price of natural gas was higher it made sense to spend the capital to drill because the payoff more than made up for the additional cost.

At this point, however, the stock has gotten to a price that appears to fully discount the economic weakness and the potential slowdown for PDS.  With a current price of roughly $10.00 and expected earnings of $2.18 this year and $2.29 next year, the stock is trading for less than 5 times earnings.  At the same time, management has noted a change in trend as the company reported the first quarter since 2006 where earnings were above the year-ago quarter.  This earnings increase corresponds with an expansion from the company’s primarily Canadian operations into the United States.

There are some interesting competitive dynamics taking place for PDS right now that could significantly change the earnings potential for the next several years.  First, on August 31, there was a non-compete agreement which expired, allowing PDS to fully enter the US market.  This is part of what drove earnings for the third quarter as PDS moved several rigs into the US and began drilling.  At the same time, PDS is in a definitive agreement to acquire Grey Wolf Inc. (GW) for a cash and stock deal.  While the purchase will be slightly dillutive to PDS shareholders initially, the deal will allow PDS to immediately have a strong presence in the United States which is the strongest market for it to be growing in.

Funding for the transaction as well as for its expansion plans should be in place.  While today it is hard to believe anything is guaranteed, the company has received funding agreements from a consortium of banks.  The capital will not only fund the purchase of Grew Wolf, but will help with capital expenditures as the PDS refits some of its existing rigs, and builds several new units.  Of the new units being built, all but two are already under contract with clients who will pay day rates for their use.  So in the near term, it looks like the company has a pretty strong handle on its revenue stream.

For those a bit uncomfortable owning the driller without some cushion, I might suggest buying the stock and then selling the December 10 calls.  One receives roughly $1.30 per share for the calls which has the benefit of basically adjusting the price paid down to $8.70 but caps the 2 month return at about 13%.  Still, this is a good internal rate of return if the stock is called away, and if the stock trades lower and the options are not assigned, investors are expecting a 12 cent dividend on a monthly basis.  So there may be several ways to approach an investment in PDS, but the value appears to be compelling no matter how you look at the stock.

PDS Notes

FD: Author does not have a position in PDS

Additional Reading:

• FP Trading Desk with 10 ways to play Energy Services
• NYT: Alternative Energy Faces Headwinds