Service Companies Face Competitive 2014, But E&P Spending May Help

The service and supply sector has been bruised and buffeted in the past couple of years. In 2012, service companies suffered sinking natural gas prices and faltering pressure-pumping rates.

In 2013, E&P spending was so-so, with widely varying surveys indicating spending was up 4% or plummeting by as much as 3.2% from the previous year.

Regardless of these negatives, in 2014, more money will be spent. How much? A Barclays Capital (NYSE: BCS) survey estimates U.S. E&P spending could spike 8.5%. A Cowen and Co. survey reported a 5.3% increase possible.

Oil and Gas Investor talked to analysts about their expectations for the sector in 2014 and where activity is most likely to pick up or is fated to slacken.

Good bets are to be found. Frac sand, one analyst said, is poised to bring solid returns. More demanding work cycles will increase the efficiency of frac time as E&Ps look to supercharge their productivity.

Service sector giants — Halliburton Co. (NYSE: HAL) and Schlumberger Ltd. (NYSE: SLB) in particular — are expected to dominate activity in 2014. Other large-cap companies, Baker Hughes Inc. (NYSE: BHI) and Weatherford International Ltd. (NYSE: WFT), are formidable but in states of flux, some analysts said.

One clear trend: Many E&Ps will have the throttle wide open on full-scale development drilling as they turn to a growing backlog of untapped wells.

The atmosphere for the service sector promises to be competitive and challenging, especially for those companies that lack differentiated technology or product service line portfolios.

“I think where the industry is going, it’s basically a game of increasing velocity in terms of converting an E&P’s assets into production faster,” said William A. Herbert, managing director and co-head of securities for Simmons & Co. International.

James C. West, lead oil service and drilling analyst for Barclays Capital, is bullish on oilfield services, especially given Barclays’ expectation for an uptick in E&P spending in North America.

“We expect market fundamentals to favor service companies for the next several years,” West said.

However, that won’t initially benefit most service companies, which will operate at maintenance capital levels.

“The first splash of this capex is going to absorb the equipment that’s already in the field,” West said. “I really don’t expect the oil service industry to throw a lot of additional capital at the shales until we get to the back half of the year or into 2015. Right now a lot of product lines are underutilized.”

Making The Play

The Permian Basin is a microcosm of what faces service companies in 2014.

It is the leading engine of growth for the service industry. Over the course of 2013, the Permian horizontal rig count expanded by 65%, while the like rig counts in the Eagle Ford and Williston Basin treaded water and the Marcellus declined by 13%, Herbert said.

The money being thrown at the Permian will spark activity. But service companies weathering the Texas heat in 2014 won’t be that much better off than those in other plays. All are dealing with a glut of service equipment across multiple products tied to new well completions, West said.

As many as 10,000 companies provide oil and natural gas services and supplies to the industry, according to the American Petroleum Institute.

Simmons & Co. projects horizontal well count growth from 2013 to 2015 at 8% per annum. Given the price of natural gas, horizontal oil wells in particular are anticipated to grow at a 13%-per-annum rate over the period.

The most worked basins, currently representing close to 60% of the domestic horizontal rig count, will continue to drive the lion’s share of activity. Of the roughly 1,200 horizontal onshore rigs in the U.S., 237 are in the Permian, 194 in the Eagle Ford, 178 in the Williston and 83 in the Marcellus, Herbert said.

Growth is in the offing in the Bakken, Niobrara and the Marcellus, West agrees.

Despite the level of competition, investors should be positioning in small- to mid-cap service company names likely to benefit from incremental improvements in equipment or crew utilization, according to analysts. They should also look to well count-driven stocks, rather than those levered to rig count.

Small- to mid-caps will eventually “do just fine in a rising tide,” West said.

Across the spectrum, none appear to have distressed balance sheets. While they might be more leveraged than large-cap companies, they’re not cash-flow negative.

Cowen Earnings Estimates, Oilfield Services

Source: Cowen and Co.

Companies that West views as having upside include C&J Energy Services Inc. (NYSE: CJES), Calfrac Well Services Ltd. (OTC: CFWFF), Key Energy Services Inc. (NYSE: KEG), Patterson-UTI Energy Inc. (NasdaqGS: PTEN), Superior Energy Services Inc. (NYSE: SPN) and Trican Well Service Ltd. (OTC: TOLWF) He also likes National Oilwell Varco Inc. (NYSE: NOV), but said his top stock pick is capital equipment company Cameron International Corp. (NYSE: CAM).

“While Cameron’s execution problems and persistent guide-downs have been an issue, we believe execution is poised to improve and think estimates are now at achievable levels,” he wrote in a report.

Herbert, too, likes Patterson-UTI Energy Inc. In an analyst note, he wrote that the company remains “our favorite land driller based on a combination of valuation (cheap on EBITDA, not so cheap on earnings after tax net income), balance sheet quality and management’s continued willingness to return capital to shareholders.”

With enough money put to work by operators, the outlook could be rosy for service companies in certain plays. The Permian, for instance, could experience net additions for horizontal rigs in the range of 50 to 70 units, about 35% more than current levels. “We think the demand tied to these units would help fully rebalance the market for pressure pumpers and provide better utilization for coiled tubing units, wireline equipment and land rigs,” West said.

The Eagle Ford should turn in a good year, too, and contribute to growth in 2014 despite it “fading as a play” in some people’s minds, said Brad Handler, managing director and senior oilfield services analyst with Jefferies & Co.

Activity could also increase in the Utica, though the prevalence of dry gas there may dampen enthusiasm.

“There is talk about the Bakken kicking up a little bit,” Handler adds. “It’s been relatively disappointing. There had been more expectations for more activity than we’ve seen.”

Handler said the Permian may be interesting to watch for different reasons. Inconsistent production from Permian horizontal wells could be worrisome.

“The shale is not very thick. Sometimes you’re dealing with 10 feet or 20 feet of pay,” he said. “If you attack that, especially if you don’t use rotary steerable systems, it’s easy to fall out of the zone. So your production may disappoint, which may take some of the wind out of the sails of the Permian.”

Big Four

In the realm of large-cap, well-managed service companies, odds are that investors are focused on the balance sheets of either Schlumberger or Halliburton.

The two companies are poised to do well, analysts said.

Along with Baker Hughes and Weatherford, they make up the Big Four, the powerhouses of the sector.

Large-cap service and capital-equipment stocks have, on average, the potential to appreciate by 15% to 20% over the next six to 12 months. In the coming year, for instance, Herbert sees a potential 25% upside for Halliburton.

Whether it’s more horizontal drilling, U.S. shale development or deepwater and offshore activity, the technical requirements tend to favor the sophisticated capabilities of the Big Four.

Weatherford is in the midst of considerable change, Handler said.

“Weatherford has indicated that roughly a quarter of its revenue comes from activities that have not been as profitable as management would like,” he said. “So it will attempt in various ways to step away from those or at least to fix them.”

The company will likely put some small businesses up for sale and exit certain activities in Iraq. “You’ll also see a spin-off into a separately traded entity of its international land drilling business,” Handler said.

West said Weatherford will stick to four high-quality businesses: well integrity, artificial lift, formation evaluation and stimulation.

Meanwhile, Baker Hughes had a rough patch or two in 2013. The company will be a little more of a “self-help story” in 2014, West said.

The company underperformed significantly in North America, with trouble in the pressure pumping business. However, market dynamics will play to its favor in 2014.

“It’s much easier to fix the business in a market that is improving rather than a market that is deteriorating, which is what it had been doing,” West said.

Good, On Sandpaper

In the coming year, E&Ps will focus on delivering the lowest-cost barrel possible. Service companies that can help them achieve that will be the winners. Therefore, the gap between best-in-class companies and the rest will continue to widen, Herbert said.

In 2014, that means more frac stages, more wells drilled per rig and around-the-clock operations.

And for some supply companies, that lines up nicely as a potential money maker, Handler said.

“There are a lot of initiatives underway to use even more sand per well or per stage, and that can keep that market tight and drive a lot more revenue growth.”

Handler is enthusiastic about supply companies, particularly frac-sand suppliers such as U.S. Silica Holdings Inc. (NYSE: SLCA) The company is adding capacity, “and we’re glad they’re adding capacity,” he said. “I like how they run their business, and more fundamentally, in terms of demand for their product, more 24-hour work, more completion stages per well and rising quantity of sand used per stage, all imply a lot higher demand for sand. So there’s a revenue opportunity there.”

Jefferies’ outlook points to 18% growth in year-over-year demand for frac sand by the fourth quarter of 2014. Some of that is due to companies performing more 24-hour fracturing work than in 2013.

Companies are attempting to work two 12-hour shifts per day, and thus perform six or more completion stages per day instead of three or four, effectively cutting their frac times in half.

While 24-hour work has been done for years, more companies are now trying to make it work.

“This shale-development process is encouraging efficiencies across the chain,” Handler said. “This is oil companies bringing a manufacturing mindset, trying to make it all sort of very predetermined,” and, as a result, faster and more efficient.

Service And Survival

Herbert describes the plight of the U.S. onshore service market as a “Darwinian struggle.”

The companies’ fates are tied to the stupendous production growth prospects offered by domestic resource development. But the sector remains overcapitalized and fragmented. Consolidation should be in the works, but no signs have emerged for what Herbert calls a more rational, competitive industry.

Instead, the domestic oil service market will remain “challenging for essentially all participants, but especially for those companies that either don’t have differentiated technology or differentiated breadth with regard to their product service line portfolio.”

Growth, rather than capital spending discipline, remains the singular aspiration of the domestic E&P industry, which augurs reasonably well for oil service revenue growth this year, Herbert said.

The prospects for increased spending should boost revenue growth. That’s partly due to the surge in commodity prices late last year and a favorable hedging opportunity that allowed E&Ps to secure cash flow.

But service companies are seeing their prices bottom, Herbert said, even as activity increases. Stagnation may follow barring a revival in natural gas drilling and increased basin breadth driving growth.

Adding to competitive pressures, the production onslaught in the U.S. will cause oil prices to shrink from unsustainably higher levels.

For now, the importance of improving efficiencies and lowering costs will become more acute. For the most part, service companies are tightening their belts. In 2013, the service industry began to embrace “the doctrine of realism and the virtues of capital” restraint, Herbert said.

Companies have lowered capital spending, improved free cash flow and returned cash to shareholders.