Service companies see revenue at the beginning of an E&P development cycle. The current cycle may be in different phases across the world, but oil above $80 per barrel assures strong E&P activity will continue.

Oil and Gas Investor asked service and supply analysts to detail the sector's main themes and companies benefiting the most in 2012.

According to a recent report from CLSA Asia-Pacific Markets, the upward E&P spending trend should continue globally, spurred by oil demand from key developing economies.

"China and India, with expected GDP growth rates above 7% in 2012, will continue to be the drivers of rising oil demand," CLSA analysts say. This in turn will drive worldwide capex spending, particularly outside of North America, where development will increasingly occur in more complex formations.

A large expansion of deepwater rigs is under way, yet the current newbuild program will not satiate demand with global crude over $90, says Scott Gruber, senior oil services and equipment analyst, Sanford C. Bernstein & Co.

Dahlman Rose & Co. LLC managing director and head of oilfield service research Jim Crandell believes the domestic E&P industry is entering its third year of recovery, while international activity is in an earlier phase in the recovery cycle. During the past two years, E&P spending increased by 30% in North America, and he expects this year's amount to rise 10%. Internationally, spending should grow 9% as the industry enters the second year of a recovery that began midway through 2011.

Scott Gruber, senior oil services and equipment analyst, Sanford C. Bernstein & Co. LLC U.S., is even more bullish. His team forecasts international spending growth of about 15% in 2012, based on recent customer spending announcements as well as offshore rig contracts.

Ultradeep

With E&Ps spending more to meet crude oil demand, picking winners would seem to be a relatively simple task. Not entirely, say Jefferies & Co. analysts, who see subtexts in some subsectors that investors should track. They expect more upside from offshore development for drillers and providers of subsea equipment, in particular. And they favor stocks involved in ultra-deepwater (UDW) plays.

Drillers will benefit from higher day rates, while equipment makers related to subsea completions and tiebacks should see more contracts and better margins in 2012, as it is still early in the deepwater capex cycle. Offshore drillers resonate with Crandell, who says ultradeep "is one of the few areas major oil companies can explore to add significant reserves."

"Brazil is a good growth area for industry, and there are eight or nine countries in the Asia-Pacific where activity is picking up. It's a global phenomenon." He calculates more than 70 UDW rigs under construction globally, which would increase the overall count by 40%.

Africa is also a hot spot, with 11% more offshore rigs expected to enter the region as activity expands, according to CLSA analysts.

Jim Crandell, Dahlman Rose & Co. managing director and head of oilfield service research, says the domestic E&P industry is entering the third year of a recovery, while international activity is earlier in the recovery cycle.

Bernstein's Gruber says deepwater rig rates have eclipsed previously reported figures in the low-$500,000s and are now heading into the high $500,000s. But that is not the only drilling segment that should see growth. Some 200- and 250-foot jackups in the Gulf of Mexico posted day rates in the high-$50,000s, exceeding expectations. Crandell expects a resurgent UDW Gulf of Mexico to add back a rig a month, potentially going from 24 to 36 rigs by year-end.

Both Crandell and Gruber like the contract drillers, especially those exposed to the international market. Customer budgets are coming in ahead of expectations, and Gruber foresees offshore spending hikes of almost 20% in 2012.

Of the drillers, Gruber favors Ensco Plc, and both analysts pick Noble Corp. Gruber likes the newbuild programs being executed by both Ensco and Noble, as well as their solid safety track records, earnings growth, and commitment to maintaining legacy rigs.

"In a tight market like today, they are capturing rising demand and rig rates versus peers that have not maintained legacy assets and cannot jump on the opportunity," says Gruber.

Offshore drillers have pricing power now and no exposure to gas. Last summer, Gruber and the Bernstein team completed a study on demand prospects for deepwater rigs, based on known deepwater projects.

"Surprisingly, the rig market shows a shortage of supply into 2014. Our conclusion is a large expansion of deepwater rigs is under way. Yet the current newbuild program will not satiate demand with global crude over $90."

Crandell notes the deepwater growth trend also plays to specialized segments leveraged to the deep water. He likes companies like Oceaneering International Inc. for its strength in the remotely operated vehicle market—ROVs reside on every deepwater rig. He also is partial to Tidewater Inc., the leading global supply vessel company, for its deepwater exposure. As well, Oceaneering is in better debt shape than it has been for most cycles, and is not overly levered.

Expectations of growth in international E&P spending over the long term leads Crandell to favor Schlumberger Ltd. Gruber also thinks Schlumberger is interesting for the full year, because margins in offshore and completions services look good through 2013. Weatherford International and Tenaris SA, the world's largest manufacturer of tubular goods—particularly higher-end seamless pipe—also make Crandell's buy list.

There will also be opportunity for makers of subsea equipment, which has an outstanding long-term outlook. But low capacity utilization is holding the segment back. "My only caution is near term, we could see some jobs with significant price competition in segments like trees and completion systems," says Crandell.

Onshore outlook

North American onshore development will continue apace, but will not likely support margins as robust as in 2011. Pricing for services associated with unconventional-resource development may fall rather than rise. Crandell thinks the North American market is transforming, because of weak natural gas prices.

Doug Garber, vice president of oil service research, Dahlman Rose & Co., likes Carbo Ceramics Inc., despite the company’s most recent earnings miss.

"There is a tremendous change in the nature of drilling activity in the U.S. because of horizontal drilling in shales," he says. "It's gone from short-term boom and bust to a longer, international-style business cycle." The entrance and expansion of the majors and international oil and gas companies into the U.S. onshore market bring a longer-term perspective.

Rates for pressure pumping had been strong on supply-and-demand imbalances, but some analysts think frac fundamentals are reaching equilibrium. The forecasted lower gas-price environment will hasten this rebalancing.

There is opportunity in selected pressure-pumping names, according to Crandell. Demand has been vigorous, but barriers to entry are not high, and capacity is still being built. Crandell looks to financially strong companies in the space with diverse product lines, such as Halliburton Co. and Baker Hughes Inc.

Proppant used in fracing is a longer-term growth area, according to Crandell. His colleague, vice president of oil services research Doug Garber, still likes Carbo Ceramics Inc., despite the company's most recent earnings miss. Its underperformance was attributed to reduced demand for ceramic proppants, particularly in the Haynesville shale, which underwent a 70% reduction in proppant sales in the fourth quarter, according to Reuters.

Similar drilling pullbacks in the Haynesville and Barnett shales have caused spot equipment and service prices to come down, while primarily oil-producing basins like the Eagle Ford, Permian, and Bakken remain strong and could absorb excess equipment from gas plays. Crandell believes equipment supply and demand is balanced. Commodity price remains a consideration.

"Historically, gas bottoms when E&Ps can't cover cash operating costs and shut-ins occur," says Bernstein's Gruber. However, when excess inventories exist, prices are typically the weakest during the fall season.

Gruber's chief concern is an inventory surplus heading into the fall gas-storage build season. "For investors, there's not a lot to get excited about within the U.S. onshore market until the fall build season has passed."

Gruber notes that the pace of drilling is driven by E&Ps' cash flow, plus the amount of cash they can raise in capital markets. They constantly outspend cash flow, and must raise money consistently. "The pace of drilling is determined not by absolute commodity prices, but by cash generation and capital raises. Cash generation is taking a big hit, so it's difficult to grow activity."

Gruber offers simple math to understand the relationship between gas prices and drilling ability: For every 50-cent drop in gas, the North American E&P industry loses $12 billion in cash flow. He maintains that gas prices will likely come in about $1.50 below where expectations were six months ago for 2012 pricing. This would equate to a $36-billion negative swing in E&P cash flow.

"The bulls say oil shale is economic and therefore growth will continue unabated, but the market doesn't work that way. It's the change in cash flow and capital raises."

Nevertheless, larger diversified service companies might be spared from pressure-pumping overcapacity and some of the effects of lower gas prices by shuffling equipment, particularly moving it overseas. Margins have peaked, but a case could be made for a soft landing for service companies, as opposed to the last cycle, when oil prices collapsed, says Crandell. He attributes this more positive outlook to continued drilling activity.

"Margin deterioration could be relatively moderate, particularly for Halliburton and Baker Hughes," Crandell says.

Some analysts believe large-cap service stocks are undervalued relative to their earnings outlook for 2012, but the equities will have trouble seeing much appreciation in 2012. International competition is high, and margins will be tested. This might not improve for several quarters, according to Jefferies & Co.

John Lawrence, Tudor, Pickering Holt & Co. vice president of oil service research, thinks offshore newbuild orders will drive National Oilwell Varco’s stock price, which had cooled.

CLSA projects both Canadian and U.S. rig counts and production will increase, leading to some winners. The firm expects a 28% jump in the U.S. oil-rig count to more than offset gas-rig declines.

Last year, National Oilwell Varco Inc. was a hot name. This year, that is not the case—and it is one of the reasons John Lawrence, Tudor, Pickering Holt & Co.'s vice president of oil service research, is intrigued. Investors are less interested, and the stock may have cooled excessively. Though NOV's orders are likely declining, beginning with fourth-quarter 2011 results, Lawrence thinks that trend will reverse.

"The buzz isn't there now, but our thesis is offshore newbuild orders will drive the stock," says Lawrence. This stock fits both the offshore-exposure and the land-drilling-expansion themes, but analysts have keyed on the offshore theme. It offers the most upside due to margins.

Lawrence says NOV's margins are roughly 20% now, but will steadily ramp up to exit 2012 at 21.5%—atypical for large integrated service companies this year, in his view.

Bernstein's Gruber agrees, suggesting that NOV's rig-tech margins are bottoming out, and should positively inflect in 2012 and 2013. Petroleum services and supplies (PS&S) margins, on the other hand, are already strong, because they involve short-cycle items like drill pipe and bits. NOV's PS&S margins should edge higher, but the growth rate in margins for this business should slow in 2012. Orders are expected to pick up in the second half of the year as the market tightens.

"Contracts for key equipment like drill-ships are being signed well ahead of delivery, and capacity will be absorbed over the next six months or so," says TPH's Lawrence. That bodes well for future 2012 orders, and the company's floating production, storage and offloading (FPSO) business could lift its stock. Dahlman Rose's Crandell says there are over 100 FPSO contract prospects.

"We expected FPSO orders to come a bit quicker, but it still looks attractive," Crandell says, noting NOV is trading at less than 10 times estimated 2013 earnings.

The company holds around $9 per share in cash and is unlevered. NOV will likely use the cash for acquisitions.

"Short-term, they could double the dividend, but I don't think they will be very aggressive. They will take their time," he says.

Onshore

Onshore, the North American land-rig business is robust, as is coil tubing. NOV should see about 50 rig orders, according to Lawrence, along with more sales of drill pipe, both of which margins will creep upward. Gruber agrees. Crandell forecasts about 150 new rig deliveries in the U.S. market in 2012.

"Less than half of land rigs drilling in the U.S. are top tier. That creates ample running room to high-grade the fleet," says Gruber.

The theme holds true for land driller Precision Drilling Corp. as well. TPH has a $16 target on the stock, based on a 12-times-forwardearnings-per-share (EPS) estimate for 2012. The company strongly relies on U.S. and Canadian markets, but in Precision's case, that is not a bad thing.

"Canada is better than people first anticipated," Lawrence says. "Combined with the U.S. shift to oil and liquids, there is opportunity for the right company."

Roughly half of Precision's 350 rigs are in the U.S., and the other half are in Canada. Upwards of 30 new rigs are set for delivery, and most will exit the yard on three- to five-year contracts. The company has exposure to the hot Eagle Ford, Bakken and Cardium plays.

Precision's return on capital is in the high teens to low twenties, according to Lawrence. At eight times expected 2012 EPS, versus a 10-year median valuation of 12 times, the valuation looks reasonable.

"Mechanical rigs out there aren't necessarily capable of drilling these shales. There are between 200 to 250 replacement opportunities, and Precision will get its share," he says.

"When you think of beneficiaries of the shale-drilling trend, you can think of fit-for-purpose rig owners. Those rigs are ideal for drilling there, as they are fully automated, and they rig up and rig down quickly," says Crandell. He believes the leader in the space is Helmerich & Payne, but he also likes Precision.

Service analysts see opportunity in these service stocks in the coming year.

Oil States International Inc. is another company with North American exposure that Lawrence expects to prosper. Oil States has outperformed the OSX index eight of 11 years since its initial public offering. Lawrence thinks the accommodations business is a key component to performance again this year.

"Half of OIS' EBITDA, which we estimate at $836 million for 2012, comes from accommodations," says Lawrence.

The business line experienced strong growth in 2011 and is expected to add capacity in Canada and Australia. Nearly 85% of 2012 capacity is already booked, says Lawrence. He forecasts strong demand for rentals as well, which will benefit equipment lines like Oil States' proprietary wellhead isolation solution and offshore products.

"They've had good orders over the last four quarters, and book-to-bill is 1.5 times. There is big order potential in Australia, Brazil and the Gulf of Mexico," he says.

At a valuation of 11 times 2012 EPS, TPH's price target for the stock is $100.

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