Buying Flowserve in Jubak's Picks as play on U.S.--and Mexican--energy boom

12/10/2013 3:36 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Certainly it’s too early to say that a historic energy bill—and constitutional amendment—will pass Mexico’s legislature. Mexican senators have just begun to debate a bill that would amend the constitution and create a system that permits foreign oil companies to invest in Mexico’s oil industry for the first time since the sector was nationalized in 1938. The current bill would allow private companies to own part of the production—or part of the profit--from Mexican oil wells while keeping ownership of Mexican oil reserves in the hands of the government owned national oil company Petroleos Mexicanos or Pemex. Foreign oil companies would not be allowed to book state-owned reserves for accounting purposes—but would be able to put cash flow from production on their balance sheets. A system like this would give Mexico, which has seen production fall by 25% since 2004, the capital it needs to drill in deeper parts of the Gulf of Mexico, to modernize oil recovery methods used in its existing fields, and to begin to exploit the country’s own oil and gas shale geologies. (The effort is crucial to Mexico’s economy, which has seen a manufacturing recovery hobbled by energy costs far higher than those just across the border and by electricity rates 25% higher than in the United States.)

The bill is contentious. Mexico’s ownership of its own oil is, for many Mexicans a foundation of the country’s economic independence from the United States.  Street protests are likely to be a continuing fact of life in Mexico City while the legislature debates the bill. The government of President Enrique Pena Nieto has set the goal of passing a bill before Christmas

Despite the protests and the deep ambivalence many Mexicans feel about letting the big international oil companies that dominated the country’s oil industry back in the door, I think the current legislation has a very good chance of passing. It has been crafted to avoid those points most likely to invoke that history—and the need is very pressing. Mexico gets a third of its budget from Pemex and therefore the downward trend in oil production isn’t just an issue for the economy as a whole but also goes right to the ability of the government to fund its operations.

If the bill does pass as I expect, what might an investor want to own? All the big international oil producers will move to invest in Mexico’s fields. For most of these, though, even big increases in Mexican production isn’t going to make a huge impact on their balance sheets. Exxon Mobil (XOM), for example, is just too big to get much leverage out of Mexico. (The two international oil producers that are likely to get the biggest leverage out of investing in Mexico are Chevron (CVX) and Anadarko (APC)—because their current finds in the Gulf of Mexico fit together, in my opinion, so well with reserves and potential reserves owned by Pemex

But I think the biggest beneficiaries of a change in Mexico’s constitution that allows foreign investment in Mexico’s oil industry will be companies that sell equipment to the oil industry.

The safest play here is National Oilwell Varco (NOV) because the company makes almost everything that goes onto oilrigs, drilling platforms, and service pipelines. From mud pumps and draw works to drilling motors and drill bits, National Oilwell sells it.

But the ubiquity of National Oilwell equipment is also, currently, a bit of a handicap. Because the company is exposed to all the sectors of the oil drilling and production industry, it faces a current drag from a drop off in U.S. land-based rigs as some companies curtail exploration and production in the face of persistently low U.S. natural gas prices. Thanks to a declining U.S. land-based rig count, revenue at the company’s Petroleum Services and Supplies segment—about 40% of company revenue in 2012—is projected by Standard & Poor’s to grow by just 2.5% in 2013

I think Flowserve (FLS) is a slightly better choice. The maker of pumps and integrated pumping solutions (49% of sales) and valves and other control products (32% of sales) gets about 40% of total revenue from the oil and gas industry. The company currently gets about 10% of sales from Latin America and already does business with Pemex.

Flowserve isn’t the pure play on the oil and gas sector that National Oilwell is, but in the current U.S. energy boom that’s actually an advantage. Rather than feeling the negative impact of low natural gas prices through the medium of lower rig counts as National Oilwell is, Flowserve is getting a boost as those low prices drive the construction of new chemical plants (or the expansion of existing plants) as chemical producers expand capacity in the United States. Other growing markets that Flowserve addresses include water desalination—for example, in November Flowserve signed a contract for 13 pumps at a 50 million gallon a day desalination plant in Carlsbad, California—and centralized, concentrated solar power plants—Flowserve will, for instance, provide the pumps and control systems for the Kaxu project in Pofadder, South Africa that will be the world’s largest solar power plant.

As of today, December 10, I’m adding Flowserve to my Jubak’s Picks portfolio http://jubakpicks.com/ . I think a reasonable target price for Flowserve is $84—about 17% above the December 9 close –by July 2014. The shares pay a 0.78% yield.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Flowserve or National Oilwell Varco as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/.

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