Most energy-related stocks have pulled back since the beginning of April. The S&P 500 Energy Index has shed 3.7 percent, while the Philadelphia Oil Service Sector Index (OSX) is off 9.7 percent. This correction reflects profit-taking after a first quarter in which the S&P 500 Energy Index jumped 16.8 percent and the OSX soared almost 21 percent. Concerns about near-term weakness in oil prices have also hit investor sentiment.

But the group’s business prospects remain positive, with the Big Four service providers reporting that global spending on exploration and production should accelerate in 2011.

The recent decline is a box-standard correction, the likes of which occurred on multiple occasions when energy-related stocks rallied from 2005 to 2008. That doesn’t rule out further downside between now and early summer, but investors should regard any weakness as a buying opportunity for holdings in the Wildcatters, Proven Reserves and Gushers Portfolios.

In This Issue

The Stories

The oil services names in the model Portfolios have announced first-quarter earnings. Here’s a rundown on how Halliburton, Weatherford International, Schlumberger and Core Laboratories fared in the first three months of 2011 and the key trends to watch through the rest of the year.

Want to know which stocks to buy now? Check out the Fresh Money Buys list. See Fresh Money Buys.

The Stocks

Halliburton (NYSE: HAL)–Hold in Energy Watch List
Weatherford International (NYSE: WFT)–Buy < 28
Schlumberger (NYSE: SLB)–Buy < 100
Core Laboratories (NYSE: CLB)–Buy < 105
International Coal (NYSE: ICO)–Sold on 5/2/11 for 105 percent gain

Active Service

The four largest oil services companies–Halliburton (NYSE: HAL) and Wildcatters Portfolio Holdings Baker Hughes (NYSE: BHI), Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT)–are often referred to as the Big Four. Of the oil services giants, Halliburton and Baker Hughes have the most exposure to North America, a market that accounts for about half of their revenue.

Meanwhile, Schlumberger and Weatherford International have more earnings leverage to markets outside North America. Weatherford International still derives about 40 percent of its revenue from North America, but that proportion continues to decline. A significant chunk of the firm’s activity in the region takes place in Canadian oil plays. Schlumberger boasts the best geographic diverisity of any oil services name.

Halliburton

Key Takeaways:

• Strong growth in horizontal drilling activity continues to drive revenue growth and profit margins in North America. This trend should hold into 2012.
• Activity in the Gulf of Mexico appears to have bottomed a year after the Macondo spill. Look for a gradual recovery over the next 12 to 18 months.
• Intense price competition in the Eastern Hemisphere, coupled with disruptions in Libya, hit first-quarter profit margins. New projects should absorb excess capacity and push margins significantly higher by the end of 2011.

Halliburton (NYSE: HAL) reported strong first-quarter results, beating consensus earnings estimates by about $0.03–a result that caused the stock to rally slightly that day. More important are movements in Wall Street’s consensus earnings estimates, which provide insight into the extent to which the firm’s quarterly results and subsequent conference call changed analysts’ outlooks for the company. Ideally, the consensus earnings estimate should increase steadily over time.

Source: Bloomberg

As you can see, the consensus estimate of Halliburton’s 2011 earnings per share has increased since the beginning of the year, with the trend picking up pace since early April. Rising expectations for the company’s earnings have bolstered the stock price.

Halliburton’s once again revealed ongoing strength in North America and slow-but-steady improvement in international markets. The company’s first-quarter earnings and management’s commentary have changed our outlook in two ways:

• In the Feb. 2 issue, we warned that the introduction of additional pressure pumping capacity could cause Halliburton’s North American profit margins to slip in the second half of 2011. North American activity and margins should remain robust into at least early 2012, powered by continued strength in onshore drilling activity and a faster-than-expected return of activity in the US Gulf of Mexico.

• Outside the US, the Libyan civil war has disrupted the Big Four’s operations in the country. However, activity levels in Egypt and Algeria continue to recover, while growth prospects in Saudi Arabia have improved since the beginning of 2011. Our confidence in a late 2011 or early 2012 recovery in international margins and revenue has increased.

North America

This graph of Halliburton’s North American operating margins speaks volumes about how business conditions have evolved over the past few years.

Source: Halliburton

Pressure pumping is one of Halliburton’s key services in the North American market. Hydraulic fracturing involves pumping a liquid into the reservoir rock until the pressure cracks the rock, creating fissures through which the hydrocarbons can flow. Without hydraulic fracturing and horizontal drilling, extracting oil and gas from the Bakken Shale and the Eagle Ford Shale would be impossible. Readers who are unfamiliar with these fields or the processes of horizontal drilling and hydraulic fracturing should consult the Oct. 20, 2010, issue Rough Guide to Shale Oil.

Trends in Halliburton’s North American profit margins track drilling activity in US unconventional oil and gas fields.

Between 2005 and mid-2007, oil and natural gas prices rose steadily, increasing the profitability of the firm’s North American operations. But margins collapsed in late 2008 and early 2009, as producers slashed their capital spending budgets in response to the financial crisis and plummeting energy prices.

Since 2009, profit margins have recovered to their pre-crisis high of 24 to 25 percent. In the most recent quarter, margins again ticked higher, overcoming weather-related disruptions in January and February. With drilling activity in liquids-rich shale plays picking up, Halliburton has been able to raise the prices it charges for key services, boosting overall revenue and the profit earned from each sale.

Market observers continue to debate the sustainability of profit margins in the North American market. Two basic forces could erode this trend:

• Whereas drilling in oil- and natural gas liquids-rich plays remains robust and well-supported by commodity prices, natural gas-directed activity has slowed because an oversupplied market has depressed prices. Some worry that the decline in natural gas production could offset gains in liquids-rich fields.

• In response to rising North American profit margins and strong demand for pressure pumping equipment, many companies have added to their capacity. Should the industry expand its hydraulic fracturing capabilities too quickly, the supply-demand balance could slacken.

Halliburton’s first-quarter results and management’s commentary suggest that the North American market will dodge these risks in 2011–an outlook with which The Energy Strategist is inclined to agree.

Management indicated that at the end of last year, 3,100 onshore wells in North America had been drilled but still awaited fracturing services. These uncompleted wells represent a backlog for Halliburton and other service providers. If pressure pumping capacity were catching up with demand, this overhang of uncompleted wells would decline.

But pressure pumping firms have yet to make any headway into this backlog. In fact, Halliburton noted that the number of uncompleted horizontal wells had ballooned to 3,500 at the end of the first quarter. Inclement weather in the Bakken Shale of North Dakota–a key field for Halliburton–and other shale plays accounts for some of the uptick in uncompleted wells.

Despite these disruptions, Halliburton managed to increase its margins in the fourth quarter–an impressive feat. Much of this stems from an estimated 170 percent increase in oil-directed horizontal drilling. Although producers favor oil and natural gas liquids (NGL) over natural gas, the US onshore rig count has only climbed about 24 percent over the past year. However, drilling in these shale oil plays requires additional services, which translates into higher revenue and margins for Halliburton.

CEO David Lesar summed up this trend in his prepared remarks on the company’s first-quarter results:

The structural change toward oil and liquids-rich reservoirs has favorable implications to our overall business. Oil development requires longer laterals, a higher number of frac stages, much more complex fluid systems, and increased prop and volumes. These factors are driving the increased service intensity of the unconventional oil reservoirs compared to those in the dry gas areas.

Taking all of this into account, we currently estimate the average revenue per oil and liquids-rich well could be 1.4 to 1.8 times that of a dry gas well, depending on the basin that you’re in. The work in oil and liquids-rich plays is technically more complex. We believe the shift to these resources will persist and continue to benefit service providers that have reservoir knowledge, premium technology, and most importantly integrated service offerings.

Although hydraulic fracturing and horizontal drilling are used to produce oil, natural gas and NGLs from shale basins, flowing oil from the Bakken and other fields requires longer laterals–industry parlance for the horizontal segment of a well–to maximize efficiency.

Longer laterals, in turn, require more fracturing stages. Shale oil wells also tend to require greater volumes of fracturing fluid and additional proppant, a sand or ceramic material that props open the fissures created during the process of hydraulic fracturing.

All told, management estimates that Halliburton earns 40 to 80 percent more revenue from an oil or NGLs-rich well than a well that targets natural gas. With producers ramping up liquids production, the company’s leaders are confident that margins and the uptrend in North American activity will hold up throughout 2011.

However, management did point out one potential challenge: cost inflation. With hydraulic fracturing in high demand and companies struggling to add capacity, the cost of everything from proppant to labor continues to increase. Halliburton has succeeded in pushing through price increases thus far, but cost inflation can eat into profit margins.

The Q-and-A session that followed management’s prepared remarks offered additional color on Halliburton’s North American operations. Consider these comments from CFO Mark A. McCollum:

Analyst: How is sort of the rollout of equipment in North America proceeding? And along those lines, how should we think about North America pricing as we kind of go forward over the next several quarters?

Mark McCollum: I think that our general view, because that capacity is basically being fully absorbed, we saw in the quarter a continued increase in service intensity. We saw increases in the amount of horsepower required per job. And we saw an increase in the amount of 24-hour operations. That tells you that the environment is still ripe to continue to move pricing. And so we’re continuing to do that, particularly with regard to making sure that we’re more than covering cost inflation; that’s also pushing against us. And so we still believe that we can continue to move margins forward as the year progresses in North America.

According to McCollom, demand for fracturing services has outstripped capacity additions thus far. Producers require more horsepower to fracture the reservoir rock effectively. And with services firms pushing their equipment so hard, several have noted that pressure pumping units are wearing out far more quickly than in the past. This adds up to a market where services outfits with high-specification pressure pumping units can continue to push prices.

Management also indicated that some producers expressed interest in contracts that would guarantee access to fracturing capacity over periods of a year or longer. Producers continue to face long delays to obtain fracturing services, and higher prices eat into margins. Halliburton has been reluctant to sign such a contract because it would lose pricing power. These developments suggest that profitability in the pressure pumping market isn’t under imminent threat.

Management’s outlook for activity in the US Gulf of Mexico also raised eyebrows. Although the Obama administration officially lifted the moratorium on drilling in the deepwater Gulf, regulators’ sat on new drilling permits. The Energy Strategist has held that this de facto moratorium would limit drilling activity well into 2012.  

Halliburton’s take on the situation is a bit more optimistic. Management asserted that activity in the Gulf has bottomed, noting that customers have expressed interest in new projects in the region. Halliburton’s Gulf operations historically have generated healthy profit margins–another potential tailwind for the firm.

Eastern Hemisphere

Although Halliburton boasts more exposure to North America than its peers, investors shouldn’t ignore its operations in Africa, Asia, Europe and the Middle East; the firm stands to benefit when spending picks up in international market. Here’s a look at Halliburton’s operating margins in key markets outside North America over the past few years.  

Source: Halliburton

Oil services firms tend to refer to most markets outside the Americas as the Eastern Hemisphere. Halliburton breaks out results for the Middle East/Asia and Europe/Africa/Commonwealth of Independent States (CIS). As a rule of thumb, activity in the major Eastern Hemisphere markets hinges on oil prices and multiyear projects spearheaded by national oil companies (NOC) and large-cap integrated energy firms.

As in North America, Halliburton enjoyed strong margins in its two Eastern Hemisphere markets from 2005 to 2008, a period of rising oil prices. Likewise, margins deteriorated between early 2009 and 2010.

The NOCs and behemoth oil companies such as ExxonMobile Corp (NYSE: XOM) that drive activity in these regions have the financial wherewithal to maintain their spending when oil and natural gas prices dip. A temporary decline in energy prices won’t stop one of their multibillion-dollar deepwater drilling programs.

In contrast, many North American operators rely on incoming cash flow to fund their drilling programs, along with bank loans or the issuance of additional shares. When credit and equity markets dried up in late 2008, financial constraints forced these producers reduce activity levels sharply.

Think of the Eastern Hemisphere a giant tanker and the North American market as a speedboat; the former takes more time to reverse course. This distinction accounts for continued strength in Eastern Hemisphere profit margins into early 2009. Inevitably, however, an extended period of weak oil prices prompted even the larger companies to reduce activity, increasing the competition between services firms.

In the current uptrend, profit margins in the Eastern Hemisphere have lagged North America by a few quarters. The Energy Strategist has followed this issue closely in our reviews of the oil services industry’s quarterly earnings.

As you can see, Halliburton’s profitability in international markets began to tick up toward the end of 2010, but the Libyan civil war and unrest in parts of the Middle East weighed on margins in the first quarter of 2011. In fact, the complete disruption of the company’s Libyan operations pushed margins in Europe/Africa/CIS nto negative territory.

Despite this bad news, the stock didn’t sell off; the market already had priced in this shortfall and had shifted its focus to future earnings growth and profit margins. On that score, the news is far better.

With the exception of Libya, Eastern Hemisphere markets have shown signs of recovery. For example, management noted that its operations in Egypt should return to normal over the next several months. Meanwhile, activity in Algeria and Iraq continues to improve, despite delays to certain projects.

Management estimates that normal seasonality and weather disruptions in the first quarter accounted for about $110 million in lost margin. The turmoil in North Africa subtracted another $105 million, while some delays in Iraq pushed margins down another $20 million or so from the fourth quarter.

Meanwhile, activity in the crucial Saudi Arabian market has picked up. Given the effect of recent geopolitical events on oil prices, the Saudis are eager to increase their excess production capacity. Moreover, with the government pledging to spend about 25 percent of the nation’s gross domestic product on social programs over the next few years, the Saudis must flow more crude and collect higher prices. These trends didn’t show up in first-quarter margins but should provide a tailwind in 2011.

The Saudis plan to boost their drilling activity by 30 percent over the coming year. About 60 percent of the planned increase will occur in Manifa, a field that eventually could add as much as 900,000 barrels per day of production capacity. Check out the circled area on this map of Saudi Arabia’s major oil and gas fields.

Source: Energy Information Administration

Located in the shallows, Manifa was discovered in the late 1950s. Scant development work has occurred over the years because the field contains heavy oil and presents some daunting technical challenges. For example, in February 2011 Saudi Aramco announced it had set a record for the longest well ever drilled in the Kingdom, a 32,136-foot well in the Manifa.

To develop the field, Saudi Arabia will build 27 artificial islands in the Persian Gulf that will be connected by a 47-mile causeway. The Saudis also plan to drill aggressively in an onshore portion of the field.

The challenges of producing Manifa make the field a much higher-cost proposition than a well-behaved onshore field such as Ghawar–outstanding news for Halliburton, which won the lucrative contract to handle most of the services related to the field’s offshore.

During the Q-and-A portion of Halliburton’s conference call to discuss first-quarter earnings, one analyst asked if margins might be slow to improve in the Eastern Hemisphere. Here’s how Tim Probert, president of Halliburton’s global business lines, responded:

I think things are more competitive today than we’ve seen them in the last couple of years, certainly. I mean, typically when we think about pricing and you think about tightening pricing, you really think about changing the trajectory of the market. And I think you would agree that we haven’t seen a significant trajectory change in the market. I think what we’re starting to see now are some significant signs of trajectory change.

Our Independent Oil Company (IOC) customers and independent customers are getting more confident about their spend, and in particular the national oil company (NOC) customers–and you see that–obviously Saudi Aramco would be a good example, KOC [Kuwait Oil Company] is another example of–and also in the United Arab Emirates (UAE), we’re starting to see some significant changes in terms of NOC spending patterns. They don’t always typically follow the natural progression of commodity prices. But as they kick in, you’re going to see a change in trajectory of the market, you’re going to therefore see a tightening of supply, and I think that to Dave’s point, as we get towards the end of this year and into 2012, we will see more stability in the pricing market.

In his comments, Probert indicates that weak activity isn’t the problem in the Eastern Hemisphere; rather, intense competition among the major services company has limited the industry’s ability to raise prices and boost profit margins. Only capacity absorption will alleviate this problem. That is, as more projects start up, excess capacity declines and firms are less willing to win business through price discounts.

With the exception of the short-term challenges in Libya and elsewhere, management expects profit margins to climb toward the end of 2011 and into early 2012. Such a move would be a major catalyst for oil services stocks. Rising margins in international markets were a powerful driver during the group’s 2005-08 rally.

With its North American business on fire and exposure to Saudi Arabia and other promising markets, Halliburton is well-positioned to grow earnings. But selecting stocks involves understanding which catalysts the market has already priced in and which fundamentals could surprise to the upside. Investors are well-aware of the strength in the North American services market–so aware, in fact, that there’s concern that capacity increases in pressure pumping could eventually weigh on margins.

Halliburton rates a hold in the Energy Watch List.

Weatherford International

• Weatherford International has disappointed investors on a number of occasions over the past few years, so the stock’s is undervalued relative to its peers. With sentiment this negative, the stock has priced in a good deal of bad news.
• The artificial lift business in North America is booming. As the dominant player in this service line, Weatherford International has pushed through price increases.
• Geopolitical events in North Africa have weighed on the company’s international revenue and margins, but activity and pricing should begin to recover by year-end.
• The company’s second-quarter guidance appears conservative; Weatherford International should be able to exceed expectations.

Let’s start with the bad news. Over the past few quarters, Weatherford International (NYSE: WFT) has reminded me of Joe Btsfplk, the comic-strip character with a perpetual storm cloud looming over his head. From an operational perspective, few companies are in a better strategic position or boast better growth prospects. Nevertheless, several missteps have frustrated investors.

Some of the company’s problems, such as a recent accounting restatement, have been self-inflicted. Others, such as Mexico’s about-face on developing the Chicontepec oilfield in 2009, were simply bad luck.

Weatherford International’s first-quarter results disappointed, especially after its peers delivered solid earnings. The quarter featured a lot of noise, but on an adjusted basis, the company’s earnings per share (EPS) of $0.10 fell well short of the consensus estimate of between $0.17 and $0.18. Worse still, this consensus estimate reflected guidance that management had delivered only a few weeks prior to the first-quarter earnings announcement.

Management’s forecast for second-quarter EPS of $0.15 to $0.17 was also below analysts’ consensus expectations, which called for EPS of $0.20. Of the Big Four, Weatherford International has the most exposure to Canada, a market that suffers a seasonal decline in the second quarter. This “spring break-up” is expected to chip $0.05 from second-quarter earnings, though this shortfall should be offset by gains in international markets.

The stock pulled back after the company announced earnings, trading in a fairly narrow range of $20 to $23 since the firm announced an accounting restatement on March 2, 2011.

Although the company’s recent bungles have prompted some to question CEO Bernard Duroc-Danner credibility, the risk-reward outlook for the stock remains skewed to the upside. The bullish case for Weatherford International rests on four pillars:

• Investor sentiment toward the stock is overly negative. Trading at a considerable discount to its peer group, the shares price in a lot of bad news.
• Management’s comments during Weatherford International’s conference call to discuss first-quarter earnings suggest that the first three months of 2011 were a “kitchen-sink quarter.” That is, management lowered expectations to levels that are easy to exceed.
• Despite the stock’s low valuation, Weatherford International enjoys a number of potential upside catalysts. Like its peers, the firm stands to benefit from an uptick in spending in international markets.
• Concerns about management’s credibility are overdone. Duroc-Danner has helmed the company for two decades, and during the last major bull market for energy stocks, Weatherford International’s stock handily outperformed its peers.

One of my cardinal rules of investing is that valuation alone is never a good reason to buy or sell a stock. Countless analyst reports and stock write-ups in the financial media base their arguments on the premise that a particular stock is “cheap” or a “good value.” Some of these calls work out, but more often than not they end up in tears. Shares of WorldCom and Enron, for example, appeared cheap and were considered solid companies until they declared bankruptcy. Meanwhile, Google (NSDQ: GOOG) and Apple’s (NSDQ: AAPL) stocks looked expensive a few years ago, but both treated investors to huge, multiyear rallies.

That’s not to suggest that investors should wholly disregard valuations. Relative valuations can indicate how much good or bad news is already priced into a particular stock. For example, a stock that’s extremely cheap relative to its peers may have less-attractive growth prospects. At the same time, cheap valuations can be transitory, caused by poor investor sentiment toward a particular name. Weatherford International falls into the latter camp.

Shares of Weatherford International trade at 13 times analysts’ consensus earnings estimate for 2012; its peers’ stocks trade at an average of 15 times the 2012 consensus estimate. On a trailing price-to-sales basis, Weatherford International’s stock fetches 1.4 times sales, half the average of the other three service majors. 

And Duroc-Danner made some illuminating comments about the firm’s earnings and revenue guidance during the Q-and-A portion of the company’s April 21 conference call:

Analyst: I wanted to talk a little bit about the visibility that you have into your business and completely recognizing that this is just an extraordinary quarter in a number of ways, and most of them not good. But you adjusted your guidance not too long ago, within just the last few weeks, and it seems like a few things snuck up on you here. And we’ve seen that a little bit in the past. Is there anything that you can or are doing organizationally to try to improve that visibility internally into your business and help you think about planning in a more efficient way?

Bernard Duroc-Danner: That’s a very long–that’s a question that deserves a very long answer. The short answer would be yes. We are taking measure in order to provide, let’s just say guidance which is more reliable as opposed having guidance for sometimes is too optimistic or perhaps to be construed as being well intentioned but at the end of the day it doesn’t help. Now, the organizational detail, I’d rather not describe them on a conference call. But the answer is definitely yes, we’re taking measures. So time will tell.

This excerpt marks one of several instances where Duroc-Danner admits that management was overly optimistic about the firm’s growth prospects in the recent past. These and other comments suggest that management is aware of its past missteps and that it will work to provide more realistic earnings guidance. Management’s decision to lower its guidance for the second quarter suggests that it will take a more conservative tack from here on.

Only time will tell whether that’s rhetoric or reality, but the stock’s low valuation suggests investors have adopted a show-me attitude. At this point, the stock already has priced in the potential for downside revisions to earnings.

Those who question management’s credibility in the wake of Weatherford International’s recent snafus should consider the stock’s performance from 2005 to 2008, the last bull market for oil prices and oil services stocks.

Source: Bloomberg

As you can see, shares of Weatherford International outperformed over this period, returning more than 240 percent. Schlumberger’s stock posted a 215 percent return, while the OSX advanced 170 percent. A degree of skepticism is justified after Weatherford International’s recent missteps, but investors should remember that the CEO and management team don’t lack experience. It’s not easy feat to outperform Schlumberger at anything. The bearish sentiment toward senior management is overdone.

More important, the company’s operational outlook offers plenty of upside catalysts.

During a conference call to discuss first-quarter earnings, management highlighted the potential for the company’s North American operations to grow revenue. Whereas Halliburton and Baker Hughes focus on hydraulic fracturing, Weatherford International relies on its artificial-lift business and its sizable exposure to the Canadian market.

Artificial lift refers to any technique that enhances the flow of hydrocarbons from a well. Oil producers are the primary users of Weatherford International’s artificial-lift technologies, which include reciprocating rod lifts, electric submersible pumps (ESP) and gas lift systems.

Anyone who has ever glanced out the window while landing at Los Angeles International Airport should be familiar with the reciprocating rod lift. The picture below should jog your memory.

Source: Wikimedia Commons

When the underground pressure in an oil field dissipates to the point that hydrocarbons no longer flow into the well, producers sometimes add a reciprocating rod lift to the wellhead. The pump acts like a plunger that pumps oil out of the field and to the surface. Alternatively, producers can place an electric-powered pump at the bottom of a well to achieve a similar effect. In some instances, the services firm pumps gas into the well. The injected gas bubbles up through the oil column, reduces the oil column’s density and makes it easier for hydrocarbons in the field to flow into the well.

Weatherford International’s artificial-lift technologies also figure prominently in producing Canadian oil sands. Rather than mining the oil sands, operators heat the underground deposits and pump the hydrocarbons to the surface. The company is also a leader in drilling and producing mature oil fields whose geologic pressures have dissipated over time.

During Weatherford International’s conference call to discuss first-quarter earnings, Duroc-Danner highlighted his sanguine outlook for the artificial-lift business:

Analyst: [C]oming back to [artificial] lift for a moment, where would you characterize pricing today versus say six months ago? And how much further do you think pricing can go?

Bernard Duroc-Danner: Pricing just moved, as I tried to–pricing just moved a few weeks ago, actually two weeks ago in North America, at least for us. Our competitors will do what they feel is right; move for us across the board. And best I can recall, this is really the first time we do this. I’d have to go back to the times prior to 2008 to remember events like this. I’m just categorizing [inaudible]. So that particular pricing will–should–will take effect in our business and that’s why our P&L I would say in Q4, if I was to guess, about six months, but we have to roll through the business because we do have a backlog. So where is pricing now versus after that pricing increase? I don’t think it’s at the peak; we still have some room to go.

…I wish it [artificial lift] was the only product line we had, which is a silly wish if you think about it because that sort of summarizes our [inaudible]. The product line in which was typically viewed as one where we’re dominate, but you know, in an application which has secular growth based on accelerating decline rates, but other than that, a product that’s very well established and mature, it’s now become a very young product line in many respects in terms of growth prospects. So it will become our largest, probably our largest product line of all.

Artificial lift is a stellar opportunity for Weatherford International. With a near monopoly in some aspects of this business and surging demand, the company has pushed through price increases.

On the international front, the company’s business suffered from the same events that plagued their peers–namely, the civil war in Libya and operational disruptions in other parts of the Middle East and North Africa.

In a stroke of bad luck, the company is more exposed to some of these markets than its competition. That being said, management noted that revenue from regions affected by recent geopolitical events represents only around 10 to 12 percent of total sales.

Duroc-Danner’s commentary on the firm’s international markets also highlighted a few bright spots, including an integrated project management deal for Algeria’s Berkine field:                                   

Actually, the news there is positive, which is in–as of right now we have two strings of our drilling and drilling well. There’s a third string, we’ll be starting to drill sometime let’s say in the month of June and the other two are pending. We’re waiting on well price preparation and the like. So what it means is that by the end of the second quarter, this quarter, we’ll have three out of five. After all this time we’ll be drilling and if the third is performed like the first two, drilling well. So that is constructive.

My comment has to do really with the normal course of business where what we have experienced is an unusual level of delay or slowness if the word existed on behalf of our clients, to go through routine procedures. And as a result, at times projects go not funded and are interrupted. And this is not a Weatherford issue, this is a general issue, which one, I think you can explain by a great deal of understandable distraction given the viewed political environments that surrounds that country, which has remained reasonably quiet for the time being. In other words, our time’s been distracted and as a result things are not getting done, it slows everything down.

The Berkine Field, and the project you identified, actually after all this time is progressing well, understanding that the funding–the funds for this project were preapproved a year ago so there is no administrative steps to be taken, just well-side preparations. So it is really market which is doing well from the new project standpoint since it finally got started, not operating normally when it comes to the routine business, which is a variety of product lines in all sorts of different contractual applications.

In this excerpt, Weatherford International’s CEO notes that the energy business in Algeria has yet to return to normal and emphasize that this isn’t a company-specific issue. Nevertheless, the company has made progress on Berkine, one of its largest projects to date.

Other highlights include the firm’s promising operations in Asia, which management expects to drive international revenue growth over the next few quarters. Duroc-Danner is also optimistic about conditions in the Russia, a key growth market for the company after it acquired TNK-BP’s services business. Sky-high oil prices and rising demand for natural gas in Europe should drive activity in Russia.

That being said, an investment in Weatherford International isn’t devoid of downside risks, including the potential for ongoing disruptions in the Middle East and North Africa.

Some readers have expressed concern about the still-unresolved investigation of potential violations under the Foreign Corrupt Practices Act (FCPA). Such inquiries aren’t uncommon in the energy industry. For example, Baker Hughes settled with the government about four years ago to resolve an-FCPA related issue. In all likelihood, the company eventually will pay a fine and perhaps be subjected to closer monitoring for compliance. In the case of Baker Hughes, settlement was good for the stock, as it resolved a lingering uncertainty.

In a worst-case scenario, the stock could retreat to between $15 and $17.50–its trading range before oil services names began to rally in late 2010. With the stock already trading at an undemanding valuation, such a pullback is unlikely.

Meanwhile, in its peak earnings year. Weatherford International generated over $2 in earnings per share–the firm’s geographic footprint and product lines have expanded since then, but this number serves as a conservative estimate. Based on a typical multiple for an oil services stock in a bull market, Weatherford International would fetch 17 to 19 times earnings, or $35 to $40 per share.

Assuming oil prices remain elevated, the stock’s upside potential ($15 to $20) outweighs its downside risk ($3 to $5). Buy Weatherford International up to 28.

Schlumberger

• Customers have embraced Schlumberger’s new HiWAY fracturing process.
• Management has grown more optimistic about activity levels in the Gulf of Mexico, a development that could have pricing ramifications in other markets.

In-depth discussions of Schlumberger’s quarterly earnings reports and subsequent conference calls have long been a feature of The Energy Strategist. The company rarely disappoints–I can recall only one truly bad quarter over the past seven years. More important, management usually provides invaluable color on trends within the industry and in specific regions.

Schlumberger has been more bearish on the North American market than its major competitors. This reflects the company’s smaller presence in the US and management’s worries that new pressure pumping capacity will weaken pricing.

But management was far more upbeat about the North American market and the company’s HiWAY fracturing technology that’s used extensively in the Eagle Ford Shale. The company has enjoyed strong pricing for this technology, and producers have embraced this new system. Schlumberger completed 528 fracturing stages in the first quarter of 2011, compared to just 102 stages in the fourth quarter of last year.

Although Schlumberger has yet to reveal the technical details about what differentiates the product from its peers’ offerings, the company and its customers have indicated that the HiWAY system improves the flow of hydrocarbons through a field.

Management is also evaluating the potential to test this fracturing service in a handful of international markets, including potential projects in Argentina, Oman, Algeria, India and Saudi Arabia. Although international shale plays remain in their infancy, Schlumberger’s unparalleled geographic footprint positions the firm to push its technologies into new, potentially high growth markets.

In North America, Schlumberger has historically focused on the Gulf of Mexico. Last year’s acquisition of former competitor Smith International, a leading producer of drilling fluids, further enhanced the firm’s competitive position in the deepwater Gulf. A slurry of oil, water and other substances, drilling fluid is pumped down a well during drilling. The idea is that the pressure of the drilling fluid (or drilling mud) will offset the pressure of the oil or gas in the field and prevent a blowout.

As Schlumberger traditionally has enjoyed high profit margins in the Gulf of Mexico, last year’s Macondo oil spill and subsequent moratorium on drilling have weighed on results. Now that the pace of permitting has picked up, management is “relatively optimistic” that activity in the region will pick up by the end of 2012.

CEO Andrew Gould stated has even stated that the Gulf is the No. 1 upside surprise that could tighten the global oil services markets and boost margins. Production in the Gulf of Mexico requires the same basic service functions as production offshore West Africa; if activity in the Gulf ramps up by the end of 2011, this new demand could absorb some of the excess capacity in international markets. That, in turn, would allow services firms to raise prices.

Like all of the other services companies, Schlumberger’s operations were interrupted by civil unrest in Libya and elsewhere in North Africa and the Middle East. However, the breadth of the firm’s geographic footprint limited the damage.

More important, Gould was incrementally more optimistic about stronger international pricing than his counterparts at Halliburton and Weatherford International. As Gould is arguably the most conservative of the bunch, this distinction is meaningful. Consider the following exchange during Schlumberger’s conference call to discuss first-quarter earnings:

Analyst: Andrew, in your comments you mentioned that you believe some resources will be constrained as activity increases. Which product lines would you expect would be constrained first? And I would assume it would likely be in some international markets over others, could you give us a little color?

Andrew Gould: I think that if the Gulf of Mexico plays out, Saudi plays out. The new projects seem to be coming on a pretty much as we planned them, then the first place that equipment control that will show up will be Drilling and Measurements. In fact, in some places, they’re showing up already which makes complete nonsense of the industry’s pricing policy at this point in time.

Analyst: And on international margins, for the third quarter of 2007, we were at 18.7 percent. Obviously, increased in Q4 to 19.3 percent on seasonality and as expected declined here in Q1 to 16.5 percent for international margins. When you think about the second quarter, could we go back to the third-quarter level for international margins at 18.7 percent, or do you see that as a second half of 2011 event?

Andrew Gould: No, I will be disappointed if we don’t do that in the second quarter.

In this excerpt, Gould suggests that the major services firms haven’t pursued a logical pricing policy; they’ve priced projects too aggressively, even in areas where capacity is tightening. Gould and the rest of the management team expect this to change as excess capacity is absorbed. This shift is already underway in Drilling and Measurements (D&M) and other business lines.

D&M includes services such as directional drilling, drilling fluids and measurements while drilling (MWD), which involves equipment that evaluates the quality and productivity of a well throughout the drilling process.

Management clearly believes that international pricing will turn before year-end. In fact, Gould indicated that he expects international margins to bounce back quickly from the first-quarter. At one point in the call, he asserted that prices should pick up by the second half of 2011.

Finally, Gould and his team noted signs tightening in the seismic services market–the use of sound and pressure waves to map a reservoir. Investors interested in a more detailed treatment of this industry should check out the Dec. 22, 2010, issue Here Comes the Spending. Spending on seismic services is highly leveraged to investment in deepwater exploration, a market that appears to be recovering. An uptick in drilling activity in the Gulf of Mexico would accelerate this turnaround.

This is positive for Schlumberger’s WesternGeco seismic subsidiary and for Gushers Portfolio holding Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY), a pure play on seismic services.

Schlumberger is a buy up to 100.

Core Laboratories

Key Takeaways:

• Management issued conservative guidance for the second quarter because it doesn’t expect international oil service markets to rebound until second half.
• Demand for the company’s HTD Blast perforation system–a technology that increases effectiveness of hydraulic fracturing in oil shale–remains strong.

Netherlands-based Core Laboratories (NYSE: CLB) provides a range of services and solutions that enable oil and natural gas producers to maximize a energy output throughout a field’s life cycle. The company operates three business segments:

• Reservoir Description (about 52 percent of first-quarter revenue) conducts complex analyses of the porosity and permeability reservoir rocks, as well as the quantity and quality of fluids therein. This information is essential to allocating capital and calculating returns, and enables producers to develop an informed, efficient and cost-effective plan for extracting hydrocarbons from a recently discovered field.  
• Production Enhancement (almost 40 percent of first-quarter revenue) analyzes producing fields to determine the best way to enhance production, either through hydraulic fracturing–as in the Bakken and other onshore US oil plays–or flooding with water, miscible gas or carbon dioxide. This division also produces popular perforating technologies that increase the effectiveness of hydraulic fracturing.
• Reservoir Management (about 8 percent of first-quarter revenue) involves reservoir management and monitoring throughout the course of an oil field’s life. These multi-client surveys and studies take place in both shale oil plays and in deepwater fields.

During corporate presentations, management often emphasizes what it refers to as the “70-percent rule.” Core Labs generates about 70 percent of its business comes from large, international oil companies. Management also estimates that 70 percent of its business relates to oil fields and that 70 percent of its revenue comes from international markets.

Since the end of the first quarter, shares of Core Labs have slipped almost 10 percent, reflecting renewed concern about the recovery in international oil services markets. Although the company’s first-quarter earnings per share topped both its own forecast and analysts’ consensus estimate by a small margin, the stock has continued to slide. Management even reaffirmed its full-year revenue and earnings forecasts.

What spooked investors? Spending in international markets failed to pick up measurably, limiting year-over-year revenue growth in the company’s reservoir description business to 3 percent. Nevertheless, management affirmed that it expects spending on exploration and production to increase at least 10 percent in international markets.

During Core Labs’ conference call to discuss first-quarter earnings, CEO David Demshur cited this slow turnaround and unrest in the Middle East and North Africa as the reasons for the company’s conservative guidance for the second quarter:

We are surprised, as you are,…that we haven’t seen an expansion in international operations, especially when we are looking at $120 Brent crude oil prices….We can see by the number of inquiries that we are getting that we are confident that in the second half we will see a ramp on that, and hopefully we exit the year with a 10 percent increase [in international spending].

And that’s why we put some of the conservative nature into our guidance. Because we would have thought we would have already seen that by now, but certainly it has to be in the pipeline with $120 crude. We are getting indications out of Saudi Aramco that they are looking at expanding capacity with recent announcements in Manifa. We were unusually active in South America related to a number of oil plays there. So, the Middle East, South America and Asia-Pacific, all oil-related plays, the indications are that we are looking for a strong second half.

Meanwhile, the company’s production enhancement division grew revenue by 19 percent from a year ago, despite inclement winter weather that shut down drilling activity in certain US shale oil plays. However, these delays did weigh on margins, which declined by 200 basis points to 28 percent.

The unit’s results were bolstered by a project to monitor the water and gas flooding of a field offshore West Africa. Strong North American demand for the company’s HTD Blast firing system, which increased its market share to 19 percent from 17 percent in the fourth quarter, also boosted revenue. This technology, which increases the effectiveness of hydraulic fracturing, has proved popular in the Bakken and other shale oil fields.

Finally, the firm’s reservoir management division generated 10 percent more revenue in the first quarter than it did a year ago, with margins improving 300 basis points to 39 percent. In the first three months of the year, the firm kicked off a consortium study of the Avalon oil play, which encompasses parts of New Mexico and West Texas. Thirty-seven companies have now signed on to participate in the company’s Eagle Ford study, data from which will enable producers to maximize ultimate recovery rates.

Although a broader pullback in oil services stocks and Core Labs’ conservative guidance for the second quarter have weighed on the stock, our investment thesis remains intact.

The end of easy oil has forced producers into the deepwater and other expensive-to-produce plays, increasing demand for Core Labs’ reservoir description services. Meanwhile, the service intensity of deepwater fields should be a boon to Core Labs. Consider Demshur’s comment during the company’s April 20, 2011, conference call:

[I]f we look at Core Lab worldwide, about 30 percent of crude oil was produced off shore, it generates about 40 percent of our revenue. Deepwater is somewhere north of 10 percent of all crude oil produced, so about 20 percent of our revenue. So you can see the service intensity is much higher on these deepwater wells. When you…spend $150 million to drill a well, you’re going to use a lot of science, and when we use a lot of science that’s good for our company.

At the same time, the company’s production enhancement business should benefit from efforts to maximize output from producing wells.

These upside drivers could make Core Labs an attractive takeover target for a larger services firm. Buy Core Laboratories up to 105.

Fresh Money Buys

The stocks recommended in the three model Portfolios represent my favorite picks. The three Portfolios are designed to target different levels of risk: Proven Reserves is the most conservative the Wildcatters names entail a bit more volatility; and Gushers are the riskier plays but have the most potential upside.

I realize that this long list of stocks can be confusing; subscribers often ask what they should buy now or where they should start. To answer that question, I’ve compiled a list of 18 Fresh Money Buys that includes 16 stocks and two hedges.

I’ve classified each recommendation by risk level–high, low or moderate–and included a brief rationale for buying each stock. Conservative investors should focus the majority of their assets in low- and moderate-risk plays, while aggressive investors should layer in exposure to my riskier and higher-potential plays. Hedges are appropriate for investors looking to offset exposure to energy stocks.

Also note that stocks that exceed my buy target for more than two consecutive issues will either be removed from the list or the buy target will be increased.

Source: The Energy Strategist

As explained in a May 2 Flash Alert, US coal mining giant Arch Coal (NYSE: ACI) bid to acquire Gushers Portfolio holding International Coal (NYSE: ICO) for $14.60 per share. Sell International Coal and book a 105 percent gain. In light of this deal, International Coal has dropped from the Fresh Money Buys list.