Don't Invest Like the President
By Tim Hanson (TMF Mmbop)
May 10, 2006
Oil and gas prices affect every American, and as prices rise and rise, we all feel the pinch. But what's the solution?
President Bush recently reaffirmed his position that "the American people expect [oil companies] to reinvest their cash flows in such a way that it enhances our energy security. That means pipeline construction for natural gas deliveries. That means expansion of refineries. That means exploration in environmentally-friendly ways. It also means investment in renewable sources of energy."
That sounds good on the surface, but I'm not sure it holds water. Unfortunately, that's not stopping all of Washington from offering up its "help."
Bubble economics
Like anyone who drives a car, I'd appreciate lower prices at the pump. But as an investor in several energy firms, I don't want the businesses that I own to start throwing money around willy-nilly.
Yes, energy companies are earning record profits. And yes, many of these companies now have cash reserves that far exceed their needs. Yet many of these companies are expanding operations; they're just doing so judiciously.
That's smart. Too much spending means that if and when oil prices fall, the same oil companies that are earning record profits now will be earning lousy returns in the future. When that happens, there won't be nearly the enthusiasm to give them money as there is to take it away from them.
High prices all around
The problem that I'm hearing over and over from energy companies -- particularly smaller energy companies -- is that this is an expensive time to undertake rapid expansion or acquisitions. At the recent Burkenroad Reports conference at Tulane University, it was a question and answer drumbeat.
Q: What do you intend to do with all your cash?
A: Well, we're looking at acquisitions. But the environment is a little expensive right now.
Q: What kind of ballpark EBITDA multiple would you like to price an acquisition?
A: Anywhere from five to eight, but we're just not seeing that on the market.
Broadly speaking, paying five to eight times EBITDA (earnings before interest, taxes, depreciation, and amortization) is a rational price to pay when acquiring a company in a cash deal. And there are only about 100 energy companies small enough to be considered for a cash transaction that are trading in this range. Throw in the fact that not all energy businesses are synergistic, and it's easy to see why companies are having a difficult time increasing efficiency via acquisition.
Pay now, produce later
Acquisitions are certainly not the only way to expand operations. Energy companies can also drill more holes, build more wells, and invest in more infrastructure. Unfortunately, it can take a long time to get a rig up and running. A company that wants to drill offshore, for example, must get permits, hire workers, explore, build equipment, move mud, filter product, send the product to refineries, and so on.
There are plenty of pinch points along this production model. Parts manufacturers such as Hydril (Nasdaq: HYDL) are charging more, as are service companies such as offshore service vessel (OSV) provider Hornbeck Offshore Services (NYSE: HOS) and seismic data firm TGC Industries (AMEX: TGE). Indeed, rising rates are one of the reasons why these smaller service companies have offered better returns over the past 12 months than titans such as ExxonMobil (NYSE: XOM) or Chevron (NYSE: CVX).
Company
TTM Return
Chevron
21.2%
ExxonMobil
12.9%
Hydril
52.4%
Hornbeck Offshore
56.1%
TGC Industries
262.7%
Indeed, for oil companies to reinvest cash flows in a way that will meaningfully reduce gas prices, there must be expansion across the economy. And then what happens when prices drop? Assets and capacity that were once purchased expensively will be left nearly worthless.
The rich get poorer
Boo hoo, right? The folks that run these companies are millionaires and billionaires many times over. Consider, however, that many of these companies are majority-owned -- whether directly or via mutual funds -- by individual investors like you and me.
And while consumers may benefit in the near term from lots of expansion, shareholders won't benefit in the long run. For a refresher on what happens following a period of overinvestment, take a look at the stock chart for Lucent Technologies (NYSE: LU). Both Lucent and Global Crossing (Nasdaq: GLBC), which has been resurrected from bankruptcy, paid too much to provide too much fiber-optic cable. While the Internet benefits today, investors got crushed.
The Foolish bottom line
The key to feeling less pain at the pump is conservation, and the key to investing successfully is never overpaying. As investors, we shouldn't overpay when we buy stocks, and we shouldn't want the companies we own shares of to do so, either.
Instead of joining the cry for oil companies to pay too much for a short-term fix, consider investing in some of the small service companies that are seeing their dayrates rise. While we haven't yet recommended any of the three energy service companies mentioned above at our Motley Fool Hidden Gems small-cap service, analyst Bill Mann has recommended two that are doing pretty well. You may even use the profits to help fill up your car. Click here to learn more.
Tim Hanson does not own shares of any company mentioned. No Fool is too cool for disclosure, and Tim is pretty darn cool.
