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Is It Time To Look For Bargains In The Oil And Gas Sector?

In the space of six months or so since mid-2014 (when oil hit its annual peak), the price of oil has collapsed by more than half and the abruptness of the decline has taken most investors by surprise.

Many oil and gas related companies have also  seen their share prices being dragged along. For instance, shares of Ezra Holdings Limited (SGX: 5DN)Ezion Holdings Ltd (SGX: 5ME), and PACC Offshore Services Holdings Ltd (POSH) (SGX: U6C) have all declined by more than 35% in just three months. The trio provide support services to the oil and gas industry.

Given the current situation, it’s perhaps natural to question: What is the future for these companies and are they considered bargains at today’s prices?

The prospects

With the price of oil now less than half of its 2014-peak, as mentioned earlier, there is a real chance of upstream oil and gas companies (the explorers and producers of crude oil) cutting their capital expenditures. In fact, many U.S. oil and gas companies have already announced cuts to their capex plans in 2015. Nearer to home, Petroliam Nasional Bhd (PETRONAS), Malaysia’s national oil and gas major, has also indicated that it will cut its capex spending by 15% to 20% in the current year.

This means that the future earnings of companies providing support services to the industry – like the local trio of Ezra, Ezion, and PACC Offshore – might be less attractive. With capacity in support services having gone through an increase in the past few years and fewer jobs to go around now, there is a high possibility of support services providers having to compete on prices – and that can be a drag on their profit margins.

Over the past two years, Ezra has enjoyed gross margins of less than 20% while both Ezion and PACC Offshore have gross margins of more than 30%. If price competition between the support services providers does develop, leading to lower profit margins, it might affect Ezra more than PACC Offshore and Ezion.

The risks

Both Ezra and Ezion have expanded rapidly over the past few years but they’ve been financing that growth largely through debt. Therefore, the duo currently have a total debt to equity ratio of about 130%, which is an alarmingly high number.

PACC Offshore on the other hand, having just got itself listed last year, had raised the much needed cash to reduce its leverage – its total debt to equity ratio now stands at a way more palatable level of 39.7%. With the current slowdown in the oil and gas industry, having a strong balance sheet definitely helps. In this case, PACC Offshore is clearly in a much better shape financially as compared to Ezra and Ezion.

Foolish Summary

Charting Image Export Jan-05-2015 5_51 PM

Source: Capital IQ

The market is definitely aware of the dimmer prospects and financial risks faced by the three companies. We can see that in how the trio’s valuations – in terms of their price to book ratio – have dropped significantly since early 2014. The chart above (click for a larger image) plots the changes with the P/B ratios of PACC Offshore, Ezra, and Ezion shown in blue, green, and purple, respectively.

Interestingly, there is a huge gap between each of their valuations. Ezion is still trading at a P/B ratio of around 1.3, POSH is at 0.65, while Ezra seems to be the cheapest with a P/B ratio of only 0.39.

Given the uncertainty in the oil and gas sector now, a company with a stronger balance sheet would be better positioned to weather through the storm. In this case, PACC Offshore has a far stronger balance sheet compared to its peers and should be less affected by a decline in oil prices. Coupled with its relatively low P/B ratio now, the share might seem like a worthwhile target for further study by bargain hunters.

The emphasis on the words “further study” is important here as a strong balance sheet and low valuation does not necessarily make PACC Offshore a good investment going forward – a cheap share can go on to become even cheaper if its business deteriorates further. There are still other important factors at play here that can determine the outcome for investors, such as the future price of oil.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.