Tops in Service

Many analysts’ advice for service stocks in 2013 is fairly straightforward: Go deep. The sweet spots for the sector, many say, lie in exploring the fathoms of the Gulf of Mexico, African waters and even the icy seas of the Arctic.

Oil and Gas Investor talked to analysts about their expectations for the sector and their picks for the year’s success stories. In addition to ultra-deep and deepwater exploration, they see oil service consolidation in North America, increased drilling efficiencies and strength in internationally leveraged companies. Overall, service companies should find stability in 2013, although some analysts say services and equipment companies will be tightening their belts.

In 2012, services suffered from falling pricing power in pressure pumping and hobbled gas prices, says Scott Gruber, senior research analyst, U.S. oil services and equipment for San-ford C. Bernstein & Co. Because pumping is one of the most capital-intensive businesses in service companies’ portfolios, capital intensity should fall this year, expanding free cash flow.

Analysts also say the mad dash to fund fracing operations will take a sober step back in 2013. Capex should be down about 10% in aggregate for the service sector, Gruber says.

E&P budgets are an important indicator of what will follow for the services industry. A significant difference emerging for 2013 is the recognition that commodity prices are relatively range bound, barring outlier events such as an abnormally cold winter. From 2009 to 2011 E&P spending skyrocketed to $154 billion, then increased less dramatically, by 6.4%, or $164 billion, in 2012, according to Barclays.

In November, Tudor, Pickering, Holt & Co. forecast 2013 drilling capex in companies it covers to decline $4 billion, a 7% drop from 2012. While many E&P budgets were still in development at press time, some companies had given indications of where their money was—or was not—headed.

Talisman Energy Inc. said it would cut a quarter of capital expenditures. Devon Energy Corp. said capital spending would be significantly lower. EOG Resources’ 2013 investment in dry natural gas drilling went into an 85% freefall to $100 million from $700 million.

Other companies plan global E&P increases: 3% at Marathon Oil, 11% at Noble Energy and 16% at Chevron, Gruber says.

Capital investment in the domestic oilfield industry is somewhat less complicated. Margins over the course of 2012 were eviscerated due to severe frac-pricing contraction and poor cost management.

The days of “seemingly every private-equity enterprise under the sun wanting to fund a frac start-up” are done, says William A. Herbert, managing director and co-head of securities, Simmons & Co. International.

The days of “seemingly every private-equity enterprise under the sun wanting to fund a frac start-up” are done, says William A. Herbert, managing director and co-head of securities for Simmons & Co. International. Spending is giving way to enhanced capital discipline, diminished capital intensity and more balanced capital allocation, as well as greater return of cash to shareholders, he says.

In deep

While 2012 wasn’t terrible for offshore drillers, stocks remained mired at the lower end of historical valuations.

Still, the demand for deepwater drilling is tremendous, says Matthew D. Conlan, senior analyst, Wells Fargo Securities. Conlan likes Rowan Cos. and Halliburton for 2013. “HAL for U.S. land recovery, RDC as an undervalued offshore driller with well-above-average revenue/EBITDA/earnings per share/cash flow per share growth,” he says.

As a group, offshore drillers traded in 2012 at the lowest full-year valuations and the tightest stock price range in 20 years, Conlan says. An increase in volatility could mean an upside for valuations.

The demand for deepwater drilling is tremendous, says Matthew D. Conlan, senior analyst, Wells Fargo Securities.

Excluding small-cap stocks, offshore drillers covered by Wells Fargo appreciated an average 15% during 2012, slightly outpacing the 11% to 12% appreciation of the S&P 500. They were led by high-dividend payers Seadrill Ltd., Diamond Offshore Drilling and Ensco Plc.

The Gulf of Mexico, for one, has been recovering, and there’s “a lot of catch-up drilling that needs to occur there,” Conlan says.

Deepwater spot rates have inflated more than 30% from a low point two years ago, and supply and demand dynamics should elevate rates, Gruber says. Overall floater contract volumes remain healthy, lead times between contract signing and rig start-up are also expanding, and contracts are getting longer as the deepwater market tightens further.

Expansion of the geographic footprint of ultra-deepwater drilling will continue as new discoveries are made in virgin territories, Conlan says. “We’re expanding deepwater development further around the west coast of Africa, east coast of Africa, north coast of Africa, the Mediterranean and in Asia as well,” he says.

And since Macondo, major oil companies appear to be putting a higher premium on the most capable and safely operable equipment, Conlan says. Newbuilds have dual blowout preventers (BOPs).

“As BOP maintenance becomes more important and the allowances for imperfections become narrower, having a standby BOP is something they believe will save time and money in their drilling programs,” Conlan says.

Offshore drillers covered by Conlan, with a combined enterprise value (EV) of $105 billion, are expected to deliver and begin operating 43 new ultra-deepwater (UDW) floaters and 24 jackups from 2012 to 2015, representing about $35 billion in new equipment. The fastest revenue and profit growers from 2012 to 2015 include Rowan, Atwood Oceanics, Vantage Drilling Co. and Noble Corp.

2013 may reveal whether investors will again acknowledge drillers are worth more than their rig value.

Overall, the UDW drilling market is positive. Offshore drillers are highlighting robust contract terms. A standard three-year term contract in the Gulf of Mexico currently runs between $560,000 and $585,000 per day. Adding a second BOP on the rig could add about $25,000 to $30,000 per day.

Dual-activity capabilities can add roughly $10,000 per day, but contracts longer than three years can see rates discounted by $10,000 to $15,000 per day for each additional year, Conlan says. Additionally, some contract announcements have rolled the mobilization fee into the dayrate, which could add another $30,000 per day for a three-year term.

Deployment in higher-cost areas such as West Africa could add about $30,000 to $40,000 per day. 2013 UDW capacity is “essentially all spoken” for and contracting discussions are now centered on rigs delivering in 2014 to 2015, Conlan says.

Services, equipment or drilling?

Some analysts see onshore services outperforming drillers and equipment. But mostly that depends on what shore they’re talking about.

The primary driver for creating value for onshore North American oil services should be a move toward techniques and technology to increase efficiency and performance. International flavors, however, are preferred.

An emerging bifurcation in share and profitability between commodity providers and large-cap services is on the rise, Gruber says.

Notably, services have underperformed the S&P, and are trading further below normal than other subgroups, except land drillers. The services group offers the best risk-reward. Gruber expects U.S. oil services to “reign supreme in 2013,” with Schlumberger and Halliburton his top picks.

“We forecast North American service margins to find stability in 2013,” he says. “In 2013, we believe the services will outperform the peer group.” He notes offshore is leading the industry and spending will grow 13%.

However, material revenue generation is another couple of years off in international shale, he says.

Edward C. Muztafago, vice president of equity research for Société Générale (SG), says slow growth is likely, given a bifurcated market in which some of the sector performs well and some doesn’t.

“North America continues to be pretty soft, and you’re probably going to see at least through the first half of 2013 a pretty muted North American environment,” he says.

The long-term take on onshore drilling rests on technology.

Edward C. Muztafago, vice president of equity research for Société Générale, says slow growth is likely for services, given a bifurcated market

“What you really have seen, particularly in oil plays and high-liquids-content plays, is a lot of focus on reservoir optimization, usage of microseismic technology to enhance productivity,” Muztafago says. “As we start to cycle back into some of the gas plays, maybe in the tail half of 2013 to 2014, I think it’s likely you start to see some of the optimization technologies creep in there.”

Ultimately that will shift more and more of the services demand to optimization through the use of data, which favors larger service companies. The one-off frac contractors don’t have the same data capabilities.

“There’s always been a place for smaller players, but I think it’s becoming a smaller piece of the pie going forward,” he says.

International markets will provide insulation for companies investing overseas, Muztafago says. The global market will slowly grind higher, though at a more tempered pace than most would have expected 12 months ago.

“As long as crude prices stay at the $85, $90 mark, I think growth in international activity remains reasonably well intact,” he says.

In the near term, international markets are likely to hit minor headwinds. Schlumberger illustrates that trend.

In late December, the Houston company warned its earnings per share could fall 5 to 7 cents because of contractual delays in the Europe/CIS/Africa area and “higher-than-usual” seasonal slowdowns in activity. Weak North American activity in the U.S. and Western Canada was also a factor.

Baker Hughes made a similar profit-warning announcement, citing similar concerns.

“Part of what we’re seeing internationally is that you just have a lot more involvement by national oil companies, who just tend to be slower at the project-tendering process and sanctioning and things of that nature,” Muztafago says.

While such changes are more transitory than long term, “We’ve been pretty clear to clients that these one-offs are going to be a bit more the norm going forward than the exception.”

However, larger companies have goals with a five- to 10-year horizon, so sensitivity to the minor ebb and flow in oil prices is less acute. That means a mixed environment for companies leveraged in North America vs. overseas.

The first three months of 2013 will see the finalization of E&P budgets. Spending looks to be flat to slightly higher, but generally “lower in North America, higher internationally,” Muztafago says.

Underscoring that position, Schlumberger is the only multiservice company that SG rates as “buy,” because “they’re more internationally levered than the others,” Muztafago says.

Schlumberger is also poised to take advantage of deepwater exploration due to its reservoir-monitoring management and reservoir-delineation technologies.

Muztafago predicts a step-up in offshore exploration activity, particularly for the integrated oil companies. IOCs have underinvested during the past 10 years and have to step their exploration, he says.

“We finally look like we’re on the cusp of a real re-acceleration in exploration activity offshore and of course that’s going to be deepwater areas and what you would call deep-formation environments, high-pressure, high-temperature, shallow-water development areas,” he says.

The subsea market in particular has gone through a structural step change with the joint venture linking Schlumberger with Cameron International Corp.

The JV will manufacture and develop products, systems and services for the subsea oil and gas market. The new company will offer a step change in reservoir recovery for the subsea oil and gas industry through integration and optimization of production systems over the life of the field. Cameron and Schlumberger have 60/40 ownership of the venture, which is subject to regulatory approvals and other closing conditions.

Cameron International is SG’s top pick for 2013.

“The company is continuing to gain market share in North America,” Muztafago says. “They’ve got the largest exposure to the pressure control market offshore and, post-Ma-condo, we’ve obviously seen a very massive revamping of the rig fleet, BOPs and related components. That’s going to continue on through 2013.”

Internationally, CAM is well levered to onshore and offshore drilling activity.

“As we kind of look at equipment coverage, we think they’re probably the only company that’s got a really solid shot at putting up order levels in 2013 that are above what we saw in 2012,” he says.

Muztafago tends to be more heavily buy rated in equipment names and international levered oil projects, including Cameron, National-Oilwell Varco Inc. and FMC Technologies.

However, he thinks Schlumberger should do well.

“For us, it’s structurally a short-term call on North America, how the budgetary process may act as a little bit of headwind on the Halliburtons and Baker Hughes of the world relative to Schlumberger, which is just less North American-centric,” he says.

National-Oilwell will continue to perform well from an order standpoint, with its allure tied to cash flow of $5- to $6 billion from operations over next two years.

FMC also has potential.

“We think there’s a real margin recovery story embedded in there,” he says. “The company’s had pretty messy quarters and has had a few one-off projects that were run over budget.” But by next year, the company should start to improve its margins from its core subsea business, Muztafago says.

Analysts believe these service stocks have upside in 2013 and beyond.

Consolidation

Sizing up the challenges for oil service and capital equipment companies in 2012 with pro- nounced North American leverage, Simmons analyst Herbert turns to a Latin phrase: annus horribilis—a “year of horrors.”

While deep water, such as subsea cap equipment, DW drillers and high-end seismic and offshore construction, experienced relative tranquility, the up-and-to-the-right expectation for domestic E&P cash-flow and capital-spending growth “has given way to a new realism.”

“I think people are largely in agreement we’ve seen the worst in natural gas prices,” he says. “As we contemplate 2013, the range-bound purgatory for commodity prices appears likely to persist.”

Domestic activity gains over the course of 2013 will be labored early on, although the compressing spread between WTI and Brent will likely lead to accelerating momentum as the year unfolds, particularly in the second half.

Herbert says the oil service industry is now “in penance mode,” slashing capital spending for oil services, cutting costs and right sizing budgets to “life-support” maintenance levels.

That will give momentum to North American oil service consolidation. “The law of economics dictates that an overcapitalized domestic oil service industry begins the process of reconsolidation following a prolonged period of deconsolidation,” Herbert says.

Conlan, the Wells Fargo analyst, says U.S. onshore service providers are likely to slow organic growth investments in 2013, which would likely lead to considerable free cash-flow generation. Initial free cash would likely be used to repay some debt, but most companies are already strongly capitalized. Purchase prices for smaller and/or struggling operators have remained too high, so managements have highlighted the ability to return cash to shareholders, seeming to favor repurchases at current stock prices.

Over time, the industry should and likely will consolidate as large companies buy smaller ones and private companies merge. The gradual institutionalization of the domestic upstream business will be a driving force as well, as scale, balance-sheet strength and breadth become increasingly necessary, Herbert says. He sees potential in several stocks: Schlumberger, Cameron, FMC Technologies and Halliburton.

Schlumberger’s competitive positioning, cash-flow generation, balanced capital allocation and valuation are solid. The company’s well-above-average, high-end international, Gulf of Mexico, deepwater and exploration exposure “makes this one of the easier longs within oil service,” he says.

Cameron is a consensus long and one of the better stories in oil service. FMC’s combination of return on capital employed and earnings growth should result in satisfying stock price performance over the next 12 to 24 months, Herbert says. Halliburton’s fourth quarter should be the bottom for North American margins and should recover and normalize over the course of 2013.

Herbert also likes National-Oilwell mainly because of its valuation and strong free-cash-flow generation. Plus, “it’s so darn cheap.”

In the small-cap arena, Herbert favors Carbo Ceramics Inc. as ceramic supply and demand imbalances improve because of a decline in foreign imports and possible delays in domestic start-ups.

“Lower industry supply, combined with rising well counts, lead us to believe that Carbo Ceramics will be able to return to selling its stated productive capacity by this summer, which all else being equal, should allow for some margin gains due to its ability to leverage its fixed-cost structure,” Herbert says.

The company is building new distribution plants in the Eagle Ford and the Bakken shales. Pricing for ceramic will likely stay at depressed levels as the company focuses on volume over price. Factoring in new production lines in 2014 as well as Herbert’s view that ceramic pricing should nudge higher in late 2013, earnings per share in 2014 will rise. Carbo Ceramics is debt free and has some $50 million in cash.

The drill

As for drilling, efficiencies will make the difference in 2013 for top-line performance in the oil service subsector.

In 2012, the number of wells drilled per rig increased by about 15%, according to Baker Hughes Inc. In 2013, a further increase of 10% is likely.

Muztafago says expectations for rig counts in 2013 are somewhat muted in Canada and the Lower 48. “Clearly, what we have to see to get rig counts to move materially higher in North America is a real right-sizing of the gas market,” he says.

Until a rollover in natural gas production in North America sets in, there’s little optimism that the gas market will make a turn. But Muztafago says around the second half of the year the turn will occur, and the gas market will be on better footing price-wise. The question is how long it will take for E&Ps to gain real comfort in the pricing situation and start to cycle back into some of the gas plays.

Bernstein’s Gruber says that because the oil-field service market remains cyclical, services must be viewed in relation to the current level of profitability. “Our preference is to buy high-quality franchises trading at a discount, and thus our top stock picks within our top sub-segment are Schlumberger and Halliburton, both rated outperform.”

This article is part of our occasional series on analysts’ stock picks.