Description

National Oilwell Varco (NOV) is a leading worldwide provider of products used in the onshore and offshore oil and gas industry. The company has admirably survived the recent oil price downturn due to a strong balance sheet and experienced management team. Because of the long-cycle nature of its business and leverage to offshore exploration, NOV has less cyclical oil upside priced into its share price relative to more popular oil service stocks. Biffins has done a good job laying out the case for long-cycle projects coming back in the next year or two and I believe this will benefit both the earnings and multiple for NOV.

A quick and dirty alternative way of valuing NOV is to estimate mid-cycle earnings based on the current amount of capital deployed. Over time, NOV should be able to earn a reasonable average return on its capital assuming a reasonable oil price. Indeed, over the prior cycle (2005-2014), NOV earned an average ROIC of 14%. If we assume that NOV earns a 12.5% ROIC going forward (historically the average ROIC was 12.5% when WTI was around $60-65), and that they currently have ~$16.8 billion of capital deployed, NOV should have mid-cycle earnings somewhere in the $5-6 range. Over the previous cycle, NOV traded at an average P/E multiple of ~14x. Assuming a 12x multiple on our mid-cycle earnings estimate results in a stock price of ~$65, or ~60% upside over the next 2-3 years. At 1.1x BV, it is trading well below its historical average.

1.       We are exiting the seasonally weakest period for oil inventories and oil price due to refinery maintenance. During the January-April period, US refineries enter maintenance season, temporarily removing a significant amount of demand for crude oil. This also coincides with the seasonally weak period for oil prices, as inventories build during this period. The pre-2015 10-year average inventory build during the first four months of the year was almost 34 million barrels. However, this year US inventories only built by 11.5 million barrels. I expect US inventory changes to continue to come in materially below expectations, which should be supportive of the oil price in the near term. Regardless, we should continue seeing seasonal strength in oil prices over the next several months.

2.       The supply demand picture for 2018 is still bullish, with physical spreads still tight, meaning that the curve should stay in backwardation, inventories will continue to draw, and prices should continue to rise. The world was undersupplied with oil in 2017 to the tune of ~500k bopd. Global oil demand is expected to grow by ~1.7m bopd while US production is expected to grow by ~1.4m bopd and the rest of non-OPEC will likely grow by ~200k bopd. This would leave the global crude market in deficit by ~600k bopd for 2018. Global inventories would drop by another 220 million barrels, which would not only be the largest inventory decline since at least 2005 by a factor of 3.0-4.4x, but would leave inventories at a dangerously low level of ~9 days of demand cover. Historically, this kind of inventory position has translated into triple digit oil prices.

The IEA is currently anticipating 2018 demand growth of 1.4 million bopd, which is well below what both the EIA and OPEC are forecasting. The IEA is absolutely awful when it comes to forecasting global oil demand. Seriously, they could throw darts at a dart board and probably do a better job. Since 2010, the IEA has revised global demand higher by an average of 1.2 million bopd and has revised demand growth higher by an average of 100k bopd. These revisions are driven almost exclusively by revisions to non-OECD demand, which I expect the IEA to continue to underestimate. It is likely that both the 2018 demand starting point, as well as 2018 demand growth, will be revised higher, further exacerbating the supply deficit.

Meanwhile, physical spreads in the rest of the world, particularly Dubai, are tightening, meaning there is a shortage of actual barrels in the marketplace.

3.       Since oil bottomed in 2016, NOV has severely lagged the performance of the oil price.  It’s not just NOV, though, almost all oil service and E&P stocks have lagged the oil price during this recovery.

4.        If the February correction was not the end of the bull cycle, then commodities offer the best historical value relative to equities. Commodities are as cheap today as they have ever been relative to equities. At these relative valuation levels, the returns accruing to commodity investors have been spectacular.

5.       If the February correction WAS the end of the bull cycle, and inflation is picking up, then commodities should outperform as rates rise and equity valuations decline. The US 10-year yield seems to be signalling that inflation is coming, recently breaking out of a multi-decade downtrend. Meanwhile, both food and agriculture prices are on the rise, not to mention oil prices.  Despite the fact that food and energy are excluded from the official inflation measure, in 2002, the Fed published a paper showing that food is actually the best predictor of future inflation. Commodity producers and anything that has a business model hedged for rising inflation will benefit. Meanwhile, growth stock multiples are likely to compress in an inflationary environment as investors increasingly focus on what they are getting paid today rather than what they will get paid tomorrow. This should benefit the multiples of cyclicals, financials, etc. relative to technology companies.

Meanwhile, if the top of the market is behind us, we can expect the oil price and oil stocks to outperform the general market, provided we don’t get another “Lehman event.”

Catalyst

1. Continued increase in the oil price.

2. Long-cycle projects FID.

3. Higher for longer oil prices.