Oilfield services

Oil in troubled waters

Using fancy charts and slides, potted histories and personal anecdotes, drillers for oil and natural gas claim that astonishing breakthroughs are transforming their business, particularly where it concerns the oil industry’s final frontier – deep water exploration. Until recently, however, many geologists were convinced that offshore oil would be found only in shallow waters. The sorts of rock conducive to petroleum accumulation, they argued, would be found only in ancient river deltas and other formations close to shore. That view has been debunked – oil majors are now betting that enormous amounts of oil are trapped under the ocean off Brazil, West Africa and the Gulf of Mexico.

That’s good for oilfield services companies. During a gold rush, it’s often the people selling shovels rather than the prospectors themselves who wind up making the most money. The oilfield services companies that are integral to energy production did extremely well during the black gold rush of the past few years, but now the demand for their implements – and more importantly the amount they can charge for them – are set to drop. While that will hurt profits, investors seem to have fled from the sector indiscriminately, confusing the rotten fundamentals of oil and gas producers with the more mixed picture at service companies that have lost two-thirds of their value.

Take industry leader Schlumberger (Ticker: SLB). Earnings per share increased nearly sevenfold over the past five years, yet earnings should not decline to 2003 levels even if oil prices might. The big oil fields needed to keep global output steady are in increasingly challenging and inhospitable spots that require Schlumberger’s technology and expertise.

Even in less dramatic settings, such as onshore natural gas production, the need for services like pressure pumping has increased as unconventional wells take up the slack of fading traditional reservoirs. The pace at which new wells must be drilled has increased too, particularly for gas, even if oil prices continue to fall. Analysts at Tudor, Pickering & Holt calculate that marginal gas wells are no longer profitable in many key areas, meaning gas prices – and hence drilling activity – could rebound soon.

Even if hydrocarbon prices continue to slump, four leading U.S. service companies – Schlumberger, Halliburton (Ticker: HAL), Baker Hughes (Ticker: BHI) and Weatherford International (Ticker: WFT), along with our portfolio holding Oceaneering International (Ticker: OII) – trade at under 7 times next year’s net earnings on average and sport a free cash flow yield of 9%. Some weaker players will struggle with a drop in prices and demand, but the larger companies appear well placed to emerge stronger the next time picks and shovels are sold at a premium.