HOLD on to Oil Service Profits

07/31/2008 12:00 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns (and Paul Justice) of Morningstar ETFInvestor like an oil services ETF tied to higher oil prices.

Prior to the last five years, oil- and gas-services firms were thought of as only marginal contributors in the global energy investment landscape. Today's energy prices and the lack of easy-to-reach hydrocarbons have changed that picture dramatically. Although we wouldn't call the sector extremely cheap today, several fundamental factors are working in favor of services firms that could keep cash flowing into their coffers.

Oil Services HOLDRs (Amex: OIH) passively invests in a small group of oil services stocks. The fund holds 16 services firms and is highly concentrated in some of the highest-quality companies in the industry. At 16% of assets, Transocean (NYSE: RIG) boasts the largest position, and the top ten names garner 85% of assets collectively.

Investors buying this fund likely believe that high oil and natural-gas prices are here to stay or are perhaps going even higher. We would expect the underlying firms to exhibit returns highly correlated to hydrocarbon prices, but we would also expect the returns to exhibit more leverage than integrated oil majors, or traditional exploration and production firms. Thus, the highs are higher, the lows are lower, and the movements are faster.

While highly correlated to oil and gas prices, the fortunes of these companies are more directly tied to the capital expenditures of those firms and national oil companies seeking services. Thus, the services firms may experience revenue volatility even if commodity prices stabilize. Owning this basket instead of individual stocks outright gives investors a piece of the pie, regardless of how it's sliced.

Currently, oil and gas customers have little buying power over offshore drillers. This is due to the huge shortage of rigs needed to develop newly economical offshore discoveries. We think this shortage could persist for some time for deep-water drillers.

The tail wind for services demand currently does not come from major oil and gas companies like Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX). They keep many of their own services in house, and the majors are reluctant to share their selected high-value services, such as seismic technology.

However, services firms exploit the nationalist tendencies of major oil-[producing] nations by offering integrated project-management agreements (all-in-one service agreements) and pay-for-performance contracts. Thus, for the foreseeable future, we do not see a major substitute for the services the firms provide.

Rather than an annual expense ratio, the fund charges eight cents per share in annual custody fees, which are waived if the underlying securities fail to generate enough income to cover them. This structure makes the ETF very cheap. (It closed just below $200 Wednesday-Editor.)

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