Follow the Leader
When billionaire investor Warren Buffet speaks, it pays to listen. I was struck by some unquestionably bullish comments Buffet made over the weekend. He commented that, although there further pain among individual mortgage holders was likely, the worst of the crisis is already over for Wall Street. He went on to say that the Federal Reserve’s bailout of Bear Stearns averted a wider credit contagion for the markets.
The seemingly ever-widening credit crunch that first struck the market last summer has affected the energy sector less than most industry groups. But that’s not to say there haven’t been some casualties, as well as several periods of extreme volatility such as we witnessed in the latter half of January 2008. If Buffet is correct, and it never pays to bet against him, the end of the credit crunch is certainly good news for energy stocks.
And Buffet isn’t the only one turning more bullish. By and large, earnings reports out of companies in The Energy Strategist coverage universe have been solid to date. And management teams have been making bullish comments and offering strong outlooks for the latter half of 2008 in their conference calls.
In its third and fourth quarter 2007 conference calls, Schlumberger noted that 2008 will be a transitional year as service companies wait for additional rigs to come online. But that forecast may change. See Changing Speeds.
Several factors increase the chance of growth in the services industry. These include demand for advanced technologies for complex well drilling and lessened weakness in North American drilling. See A Short-Lived Transition.
Two additional markets that will play a factor in supply are Russia and Mexico. Both are experiencing slowdowns but could see continued growth given the right projects. See Beyond North America.
Schlumberger and Weatherford International aren’t the only companies to benefit from a strengthening North American market. Here’s what I see happening for other stocks in the TES coverage universe. See Beyond Schlumberger.
Several smaller contract drillers may see some additional upside through deals with the services firms. Others, however, may have run their course. See Contract Drillers.
I added a new play earlier this week, and another reported earnings worth noting here. See Portfolio Update.
I’m recommending or reiterating my recommendation in the following stocks:
The reason for that is simple: Schlumberger is the largest oilfield services company and has its hand in just about every imaginable market all over the world. In addition, the company has traditionally offered long, detailed conference calls; CEO Andrew Gould often relates far more than the outlook for Schlumberger and offers considerable color and detail concerning trends for the industry in general.
This quarter’s conference call was no exception. Schlumberger’s outlook this quarter was far more upbeat than in its third and fourth quarter 2007 earnings calls. Gould backed away from comments he made in prior earnings calls that 2008 would be a “transition” year for the industry. Instead, he forecast a growth reacceleration in the second half of the year.
Schlumberger’s comments were so positive, in fact, that I’m adding the stock back to the growth-oriented Wildcatters Portfolio this issue as a buy under 115.
I highlighted Schlumberger’s third quarter conference call in the Nov. 7, 2007, issue, Coal and Services, and the fourth quarter call in both the Jan. 23 issue, Strengthening Headwinds, and the subsequent issue, Earnings on Tap. To review, Wall Street didn’t receive either quarter’s results well; Schlumberger’s stock dropped sharply in the wake of both reports. The main problem on both occasions is that the company called into question Wall Street’s outlook for growth in 2008 for the oil services industry.
Of course, for the entirety of 2007, the North American oil services market was weak, particularly in Canada. The only exception was the deepwater Gulf of Mexico. This weakness was well known and understood by both analysts and investors alike at the time of Schlumberger’s third and fourth quarter reports.
Because most North American drilling activity targets natural gas, not crude oil, depressed gas prices meant weak drilling activity. But Schlumberger’s comments regarding weakness in North America weren’t the reason for the stock’s slide in the wake of those quarterly reports.
The main problem was an issue known as the platform problem, which was a temporary slowdown in offshore operations and activity for the global oil services firms. As I’ve noted before, offshore drilling, particularly in deepwater fields, has been the source of considerable growth for oil services firms such as Schlumberger in recent years.
There are a couple reasons for that. First, as I noted in the March 5 issue, The Final Frontier, the deepwater is one of the only regions of the world where producers have been finding truly large oil and gas fields. It’s one of only a few potential plays where there will be meaningful oil and gas production growth over the next decade.
Therefore, there’s considerable interest in exploration and drilling activity in the deep. This plays right into the hands of the global oil services business because these firms provide the services and technology necessary to explore and develop offshore oilfields.
Another reason offshore operations are so important is complexity. The new deepwater fields discovered in Brazil offer a perfect example. Tupi is located in water two miles deep; production of the field requires drilling through a one-mile thick salt layer and into extremely high-pressure, high-temperature environments.
Drilling wells in this field requires the most advanced technology available today; in fact, some believe that drilling Brazil’s recently announced Carioca field may require some new technological developments before production is even possible.
Only a handful of firms, such as Schlumberger, own such technology and can actually drill those wells. Therefore, these high-tech service firms can charge a high price for the work they do.
This is precisely why offshore profit margins have been steadily rising for the big services firms over the past five years. Increasing reliance by producers on more-complex, land-based reservoirs and deepwater fields is extremely bullish for the services firms.
In its third and fourth quarter conference calls, Schlumberger was careful to point out that demand for offshore drilling services wasn’t declining. The problem wasn’t a lack of demand for their services related to the deepwater; the platform problem was a lack of rigs and equipment.
Demand for offshore exploration and development has been so strong that most of the world’s drilling rigs capable of handling such work are already being utilized. This problem is most acute in ultra-deepwater operations, where almost all the rigs in the world are contracted years in advance.
Even if an operator were to make a huge new find, there would be no rigs available for several years to drill wells. And constructing new deepwater rigs is an expensive, multi-year task; there’s no way to bring new capacity online quickly to meet demand. Services companies were constrained by the lack of rig platforms available to perform offshore work.
A significant number of new floating (offshore) rigs are scheduled for construction and service in 2008 and 2009. But it takes some time after a rig is first built and put into service for it to reach peak efficiency. There are typically small issues and snags with new rigs that must be fixed. And construction schedules can and do slip; rigs may not be available exactly when planned.
Schlumberger and other services firms felt that Wall Street was too optimistic in late 2007 about offshore growth. The Street seemed to assume that all the new rigs scheduled to be put into service globally would be delivered on time and be put into service with no delays, startup problems or operational issues. This perfect scenario rarely happens in the real world, particularly in the oil business.
The bottom line: Delays to offshore work caused by a lack of rigs were expected to cause a temporary slowdown in the offshore services business for 2008. This platform problem was expected to ease as new rigs were delivered and put into service into 2009; however, 2008 looked like a transitional year as the industry waited for new rigs to be delivered and reach full efficiency.
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Just as a subdued outlook was behind Schlumberger’s selloffs after its third and fourth quarter 2007 results, an upbeat forecast was the catalyst for the stock’s positive reaction to its first quarter 2008 release. In fact, the first question analysts posed to Schlumberger during the question-and-answer (Q&A) segment of the conference call was if the company was revising its forecast for a transitional year in 2008. CEO Andrew Gould replied:
It’s clear from this statement that Schlumberger’s CEO is softening his outlook for 2008 to be a transitional year. He now expects growth to reaccelerate in the second half of this year rather than in 2009. This is the most bullish statement we’ve heard from Schlumberger in several quarters.
Along the same lines, Gould was subsequently asked about Wall Street’s forecasts for 2008 earnings. Recall Gould said point-blank in the third and fourth quarter calls that he felt estimates may be too optimistic. He was fairly direct in warning Wall Street that its assumptions were too rosy.
But this quarter Gould stated that he was very comfortable with Wall Street assumptions for the full-year 2008. This suggests Wall Street may have taken estimates down far enough; if anything, it sounds as if Schlumberger believes it has room to beat current expectations.
Further, Gould was asked for an early take on 2009. He stated that his gut feeling was 2009 would be better than 2008.
Bottom line: Based on these comments, I see room for upside to estimates. It appears that Schlumberger’s growth is on pace to pick up steam in the second half of this year and accelerate into 2009. Gould isn’t one to make idle comments or put lipstick on the proverbial pig in an attempt to hype up Schlumberger’s prospects; it pays to put credence in his comments.
Of course, it’s useful to dig a bit deeper to try to determine why Schlumberger’s outlook appears to be turning more bullish. As the quote above suggests, the top reason is simple: Schlumberger was assuming continued weakness in its North American business, which has been a trend in the region for the past two years. Since late 2005, strong international operations have been more than making up for weakening trends in the US and Canada.
But this clearly is no longer the case. Although international operations continue to grow unabated, North America is no longer the anchor dragging down the rest of the business, or at the very least, it’s not as strong a headwind as it was last year. Schlumberger didn’t expect this when management called for a transitional year.
The most obvious reason for the uptick in North American activity is the improvement in natural gas prices since late 2007. I’ve highlighted this recovery on a few occasions, including in the March 19 issue, Gas over Oil. The chart of the 12-month NYMEX natural gas strip below is largely self-explanatory.
Source: Bloomberg
As gas prices picked up, so did interest in drilling activity. According to Schlumberger, Canada saw a robust winter drilling season, with a significant uptick in exploration activity. The company also noted a significant increase in growth in the Alaskan market, mainly related to exploration activity.
As longtime readers are aware, one of the first service markets to turn down in North America back in 2006 was well stimulation—basically, fracturing or pressure pumping operations. For those unfamiliar with this product line, see the Feb. 20 issue, Growing Unconventionally.
To summarize, pressure pumping involves injecting a liquid into a reservoir rock under high pressure to crack the rock itself. Cracking the reservoir rock makes it easier for oil and natural gas to flow through the rock into the well. Suffice it to say that this is a crucial service function for producing many of the most promising unconventional gas and oil reserves in the US.
The problem with pressure pumping was twofold. First, a decline in gas prices in 2006 and 2007 meant that producers scaled back their drilling activity and, therefore, their demand for pressure pumping services.
Second, in the big gas price run-up of 2004 and 2005, many service companies built up their capacity to perform pressure pumping services. This involved building more compressors and pressure pumping trucks.
What ended up happening is that a lot of this new capacity came online just as gas prices fell. Falling demand and surging supply is a noxious combination that invariably leads to weakened pricing.
But even in pressure pumping, there are signs of a bottom. Schlumberger stated that pricing in well stimulation services is still weak but is in the process of bottoming. The company noted that, if the North American rig count improves quickly enough, pricing could improve as soon as this year.
And remember this is the weakest of all services functions in North America. Schlumberger stated there’s already some pricing leverage in certain North American services.
For example, services involved in drilling directional wells are already seeing improvement. As I’ve noted before, North American producers are increasingly targeting more-complex fields that require nonvertical wells to produce efficiently. Check out the chart below.
Source: Bloomberg, Baker Hughes
This chart shows the percentage of total wells drilled in the US that are simple vertical wells. What’s clear is that this percentage has been steadily declining for more than a decade. Obviously, this is bullish for firms offering services related to drilling directional wells.
Other areas of strength include so-called wireline services, and drilling and measurements. Wireline services involve placing devices into a well to measure the characteristics of the reservoir. Drilling and measurements include tools and sensors that allow data about a well to be transmitted to operators as the well is drilled. This allows for more precise well placement.
The basic platform problem still exists with respect to offshore services. Certainly, there still aren’t enough rigs internationally to meet demand for all the new, planned drilling projects. And now, as before, there are sure to be issues ramping up newly constructed drilling rigs to full efficiency.
However, a recovery in North American land-based operations means that the region will no longer be the headwind for Schlumberger and other services firms that it was over the past two years. Because there’s no real shortage of land rigs in North America, this region isn’t exposed to the platform issue.
Therefore, an uptick in North America will help offset the platform issue near term. As we enter 2009, new rigs will come into service, and producers will begin ramping up their offshore activity. This will bring the industry its next wave of offshore and international growth.
But of the service majors, Schlumberger is among the least exposed to North American land operations. An uptick in growth here isn’t the sole reason for the improved outlook.
In addition, Schlumberger notes a few additional points: accelerating decline rates in some countries, integrated project management (IPM) and higher-than-expected land-based drilling activity internationally.
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The International Energy Agency (IEA) recently announced that Russia saw a 1 percent drop in oil production in the first three months of this year compared to the same quarter one year ago. This is the first time Russian oil production has dropped in roughly a decade. Russian production appears to continue to wane: Monthly production hit 9.72 million barrels per day in April, the lowest monthly total in a year and a half.
And we’re starting to hear rhetoric from Russia that production has either peaked or flattened. Energy and Industry Minister Viktor Khristenko described Russian output as a plateau back in April. And Leonid Fedun, a vice president of Russian oil giant Lukoil, stated in an interview to Britain’s Financial Times that Russia’s oil production of 10 million barrels per day was the most he’d see in his lifetime. He went so far as to compare Russia’s current situation to the North Sea and Mexico, both producing regions where production has already peaked.
Other analysts believe that Russian oil production hasn’t necessarily hit its ceiling but will simply require large additional investment in exploration and development to grow. As I highlighted in the Dec. 19, 2007, issue, Focus on Russia, the nation does have some promising new regions for exploration and several large-scale projects due to come online over the next few years.
Whether Russian oil production has actually peaked or not is still a matter of some debate. What is crystal clear is that maintaining current production and preventing a significant decline in output means massive investment in both new exploration and in projects within existing, mature fields designed to boost production.
Russia imposes an export tax on oil. But the government has been talking about reducing this tax burden in an effort to encourage more investment in the oilfield and stabilize production. Gould commented that he thought the Russian government would make some positive changes but they may not have an impact for Schlumberger until 2009.
One way or the other, the step-up in Russian activity levels—with or without an additional tax concession—is good for Schlumberger and other services firms with the right technologies. The big growth area in this market will be integrated project management (IPM). IPM is an interesting market; in fact, Gould stated that he remains astonished at the demand for this service.
In an IPM deal, a producer actually contracts with a service firm to handle a project. Depending upon how the deal is structured, the services firm may provide the rigs, contract with engineering companies or provide some of its own in-house service functions, as well as contract with third-party providers for other services.
In many ways, IPM deals are replacing production-sharing deals with major international integrated oil companies. Many state-owned national oil companies (NOC) prefer not to give up rights to some of the production from their fields; this was the norm under production-sharing deals. In an IPM, the NOCs can simply pay the services companies to handle the work.
IPM is also good for the services firms because these deals typically represent major contracts and can carry healthy profit margins. The growth in this market is exploding as producers switch from partnership deals to IPMs. Russia is one of the fastest-growing IPM markets in the world, with arguably the best prospects for growth. A good deal of spending in this market will flow through IPM deals to services companies.
I won’t belabor the point, but suffice it to say that Mexico is in a similar boat to Russia. But the situation is even more severe: The giant Cantarell field is declining at a far faster pace than most analysts had projected, and Mexican oil production could drop significantly in coming years—to the point that, within a decade, the nation will no longer be an oil exporter.
To arrest or slow that decline will require a massive new wave of spending on drilling and development. Unfortunately, the Mexican constitution essentially prohibits the NOC, PEMEX, from partnering with foreign oil majors on deals. The result: Mexico can’t exploit its potentially vast deepwater resources because PEMEX doesn’t have the technology or in-house know-how to drill those wells.
But one thing PEMEX can do is step up drilling activity on some smaller onshore fields and try to stem production declines at Cantarell. That’s exactly what’s going on right now.
A great deal of that investment is also flowing to services firms under IPM deals. Because IPMs don’t involve production or reserves sharing, the constitution doesn’t bar such deals.
The beauty of these IPM deals is that many, including those in Russia and Mexico, are actually land-based deals rather than deepwater/offshore work. Because there’s no real shortage of land drilling rigs or, at least, less-acute shortage, there’s less of a limitation on growth near term.
In short: IPM isn’t exposed to the platform issue. The ramp-up of such deals ramp up into 2009 spells a reacceleration of growth for services firms.
In Schlumberger’s case, IPM will begin ramping up this year. In the first quarter, the company started several new IPM projects, primarily in Mexico, and experienced substantial startup costs as a result. There are always startup costs associated with beginning new projects. Those may include costs associated with moving crews and rigs into position.
In addition, if a services firm isn’t familiar with a particular field or there’s limited drilling history, it may take time and experience to ramp up to full efficiency in terms of drilling wells. This is a sort of learning curve. Schlumberger stated that it believes these startup costs will continue to decline as the year progresses.
A few additional points highlighted in Schlumberger’s call are worthy of note:
Seismic Operations—Producers use seismic maps of underground rock formations to locate potential new reserves and determine ideal well placement. This is particularly crucial in the deepwater, where wells routinely cost upward of $1 million per day to drill.
In recent years, services companies have developed seismic technology that can provide great detail. Schlumberger’s Q seismic technology is among the most advanced in the world and is in high demand.
In the first quarter, however, seismic revenues were below expectations; in fact, this was the main reason for Schlumberger’s earnings miss. However, this isn’t an issue.
Seismic revenues are “lumpy” and can vary widely by quarter. For example, in the first quarter, the US government sold off drilling rights for deepwater plots in the Gulf of Mexico as part of a lease sale scheduled late in the quarter. Therefore, many producers held off seismic contracting until after that sale was complete.
In addition, Schlumberger has plans to release a huge seismic database of high-quality deepwater information later this year. These data are going to be released on a multiclient sales basis. That means any operator can gain access to the information for a fee. When those data are released, seismic demand should pick up.
More Exploration Spending—One analyst noted that his firm estimates exploration and production (E&P) companies globally had committed to an additional $10 billion in spending since the end of 2007. Much of this spending would ultimately end up in the hands of services companies such as Schlumberger. Management suggested that the $10 billion figure, a large increase by any measure, wasn’t far off Schlumberger’s own internal estimates.
Brazil—Schlumberger stated that 2009 would be an excellent year for Brazil. Management seemed truly excited about the prospects for this country; I highlighted myriad Brazilian deepwater projects on tap over the next few years in the March 5 issue. This is yet another data point that suggests Brazil is a key market to watch.
Cycle Sustainability—Schlumberger reiterated that it sees the current upcycle in the energy business as different from the market of the 1970s. Back then, oil supplies were restricted primarily by political considerations.
Now, however, supplies are limited by producers’ ability to overcome high decline rates and bring new fields online. The current supply problem is more intractable than the issues of the ’70s.
Schlumberger also noted one factor that killed the oil bull market back in the ’70s was the addition of volumes from new fields brought online in Alaska, Mexico and the North Sea. Those fields were discovered in the ’60s and early ’70s; when the fields started ramping up production in the late ’70s, global oil supplies rose. This time around, however, Schlumberger doesn’t see any fields of that size in the offing.
This suggests that, barring a truly nasty global recession, the current cycle will stay stronger for longer than that of the ’70s.
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To review, I recommended Schlumberger for much of 2007. I decided to take some profits in July 2007 and sold completely out of the stock in the fall for an overall gain of around 70 percent. On those occasions, I recommended focusing new investment monies on Weatherford instead.
My rationale for favoring Weatherford since last summer was the company is less exposed to the transitional platform problems. Weatherford is a much smaller firm and doesn’t sell its services in all of the most promising regions of the world. The company has scope to enter new countries and use its sales force to rapidly build market share in key service functions.
In contrast, Schlumberger is already a market leader in many of the service functions and regions where it operates. Growth is more dependent on overall growth in the services industry and exploration spending rather than market share gains.
With the platform problem and transitional year looming, I saw Weatherford as the safer growth play. This view has proved largely correct. Check out the chart below.
Source: Bloomberg
This chart shows the relative performance of Schlumberger, Weatherford and the Philadelphia Oil Services Index since I first recommended taking profits in Schlumberger last summer. Since that time, Schlumberger returned only 4.7 percent, including dividends, compared to a 13 percent gain for the Oil Services Index and a 41 percent gain for Weatherford.
With the transitional problems now passing, I’m once again recommending Schlumberger. After an unusual period of underperformance, the firm is poised to catch up to the rest of the services index.
However, this doesn’t mean you should ignore Weatherford. This company continues to fire on all cylinders, and growth prospects are undimmed.
In its first quarter call April 21, Weatherford echoed many of Schlumberger’s comments. The company is more heavily exposed to the US and Canadian markets than Schlumberger, so its comments are important.
Weatherford reiterated that this is the first time in seven quarters that it has anything positive to relate about the North American and, in particular, Canadian drilling markets. Not only did revenues rise by 8 percent year-over-year in North America, but the company also saw an increase in profit margins.
Weatherford went on to say that the Canadian market has bottomed and will see a strong recovery starting at the end of this year. The first market to recover will be oil sands; a number of new projects are scheduled to start up. But Weatherford also sees interest in the new gas shale plays, such as the play in British Columbia that EOG Resources announced earlier this year. Weatherford expects 2009 to be a lot better year in North America than analysts currently estimate.
And while the North American market improves, international markets are accelerating. Like Schlumberger, Weatherford spent considerable time highlighting its growth prospects in IPM. By the end of 2008, Weatherford expects to be working on six IPM projects; annualized revenues from those six deals will be around $750 million to $800 million by year-end.
Weatherford, like most services firms, only offers limited details about exactly what its contracts are and where it’s bidding because it’s sensitive, competitive information. However, the one deal we do know about is in Russia.
Late in 2007, TNK-BP awarded a $3 billion three- to five-year IPM contract. Weatherford was the big winner in the deal; the IPM contract there is worth around $1 billion to Weatherford over the term of the contract. This also marks Weatherford’s entrance into the West Siberian services market, perhaps one of the most promising markets for services firms in the world.
In fact, Weatherford noted in its call that Russia is growing at the fastest possible pace. It seems the country’s growth is already so strong it’s pushing Weatherford’s limits from an operational standpoint.
Another market where Weatherford was bullish is Algeria; CEO Bernard Duroc-Danner described this market as a “coiled spring” that could really explode as new projects start up later in the year.
To make a long story short, I see Weatherford on track to generate one of the strongest growth rates of any oil service firm in the world. I’m raising my buy target on Weatherford International to 87 and my stop to 71.
Also note Weatherford has scheduled a 2-for-1 stock split effective May 27. My buy target and stop price are based on pre-split numbers; I’ll change the information listed in the portfolio table May 27 to reflect the split.
Given positive comments about deepwater growth from both Schlumberger and Weatherford, it’s also worth reiterating my buy recommendation on subsea construction specialist Acergy. I highlighted the stock at some length in the March 5 issue, and it remains my top focused play on deepwater growth for now. Acergy rates a buy under 27.50.
Outside the model portfolios, I would also highlight a few additional services names as possible beneficiaries of the trends highlighted by Schlumberger and Weatherford:
BJ Services is the services company in my coverage universe with the most leverage to pressure pumping. I’ve recommended avoiding the stock for some time now; as noted above, this has been the weakest market in the entire oilfield services industry. BJ recently missed its quarterly consensus estimates, and the stock was slammed in the wake of its report and conference call.
I suspect pressure pumping will remain weak for some time because of excess capacity. But it appears the North American drilling markets are recovering, and according to Schlumberger, pressure pumping should begin the see pricing improvement toward the end of 2008 or into early 2009.
For now, I’m upgrading BJ Services from a sell to a hold in the How They Rate Table. I’m watching this stock as a potential addition to the model portfolios toward the end of 2008, ahead of a recovery in its main business.
Halliburton is probably the most often recommended oil services firms of all. I’ve broadly avoided the stock over the past two years because it has heavy exposure to North America and to pressure pumping.
In fact, I’ve successfully recommended shorting the stock on a few occasions. For the record, Halliburton is up 53 percent since the end of 2005, compared to 118 percent for Schlumberger and 136 percent for Weatherford.
But I think this period of underperformance is over. Halliburton’s North American sector is recovering, and its natural gas-levered service functions are likely to see a strong recovery over the next 12 months.
Meanwhile, Halliburton has been expanding aggressively into international markets and IPM, so it’s beginning to benefit more meaningfully from the same growth dynamics as Weatherford and Schlumberger. I’m upgrading Halliburton to a buy in the How They Rate Table, and I’ll consider for a possible addition to the model portfolios.
Smith International’s most interesting business is drilling fluids. I explained the concept of drilling fluids and mud in the Feb. 20 issue. Suffice it to say, deepwater drilling requires the use of specialized fluids, and Smith has a solid market share in that area.
Smith has been dragged down by two issues. First, because most of its growth is deepwater-related, the stock is ultra-exposed to the platform problem highlighted above. And second, it has fairly heavy exposure to North American gas drilling, in particular with its drill bits and distribution businesses.
With North America recovering, the platform problem easing and deepwater spending exploding, Smith looks promising again. Smith International is rated a buy in the How They Rate Table, and I’m also considering it for addition to the model portfolios.
Baker Hughes is one of the world’s largest oil services firms and has an excellent position in terms of product lines and international leverage. However, the company has consistently posted sub-par growth compared to Schlumberger and Weatherford.
Some of this sub-par growth has been due to operational missteps. In addition, some feel that Baker just didn’t build out its capacity fast enough as the cycle turned higher for services earlier this decade. For whatever reason, the stock has lagged and is underperforming the Philadelphia Oil Services Index by nearly 100 percentage points over the past five years.
Baker will eventually benefit from strong growth in the services business. Alternatively, one of the other big services providers may simply take it over, taking advantage of the stock’s cheap valuation.
Either way, Baker’s shareholders are likely to see some improvement over the next year. I’m raising Baker Hughes from a hold to a buy in the How They Rate Table.
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Both firms are contract drillers. Typically, oil and gas producing companies don’t own their own drilling rigs. Instead, the contract drillers own rigs and lease them to producers for a daily fee known as a day-rate.
Rigs can be contracted on a short-term or spot basis; day-rates under spot deals are based on short-term supply and demand conditions. Alternatively, some drillers, particularly deepwater drillers, sign long-term contracts with a fixed day-rate.
Hercules Offshore is primarily a shallow-water jackup driller with a focus on the Gulf of Mexico (GOM). A jackup is a type of rig that has legs that rest on the seafloor; jackups are typically used in waters up to a few hundred feet deep. Here’s a picture of a typical jackup rig.
Source: Google
Jackups are not all the same. Some rigs are capable of handling deeper wells, while others are designed to handle rougher water conditions. For the most part, Hercules’ jackups are on the less-capable end of that spectrum. Such rigs are most suitable for the shallow-water GOM.
But just as the market for services in North America has been weak, so has the drilling environment in the shallow-water GOM. Most drilling activity there targets natural gas rather than oil.
Unlike deepwater projects in the GOM, shallow-water drilling is the province of smaller producers. When gas prices collapsed in 2006 and remained weak through 2007, these producers stopped drilling. That left a glut of unused rigs in the shallow-water GOM, and day-rates plummeted.
However, there was still a shortage for more capable jackup rigs outside the US, and foreign producers were willing to pay large day-rates under long-term contracts. The result was a mass exodus of rigs from the area. Consider that earlier this decade around 150 jackups were in the shallow-water GOM; now there are just 65, and that supply will drop to the low 60s by year end as rigs depart on international deals.
But with gas prices rising again, drilling activity has also started to pick up. And with just 65 rigs in the US GOM, demand looks quick to outstrip supply. This would send day-rates sharply higher.
Hercules reported its first quarter results May 1. The driller said that day-rates continued to fall earlier in the quarter and were weak. However, rates started to improve in the final weeks of the quarter and into the second quarter; these numbers will be reflected in second quarter results.
To give an idea of the scope of improvement, average daily revenue per rig in the first quarter fell $6,000 to $56,900. As of May 1, rigs are earning day-rates in the $60,000 to $70,000 range. As the gas drilling market tightens, that could easily jump to $80,000 over the next few quarters.
According to Hercules, every $10,000 improvement in day-rates equals 50 cents in earnings per share. Hercules’ earnings of just $2.29 per share on a trailing 12-month basis give an idea just how levered the stock is to rising GOM jackup rates and the improving gas drilling market.
Bottom line: Hercules has upside as jackup day-rates continue to strengthen. I’m raising my buy target, given the now more conclusive evidence of a GOM turn; Hercules Offshore rates a buy under 33.
Nabors is primarily a land drilling contractor. I’ve outlined my rationale for owning the stock on a few occasions, most recently in the March 5 issue. Basically, Nabors’ North American business stands to improve markedly, given the recent uptick in drilling activity. And Nabors’ international business continues to grow at close to 50 percent annualized.
In fact, Nabors is a major part of Weatherford’s IPM deal with TNK-BP in Russia. Nabors will be supplying land rigs to handle much of this work; the company is one of only a handful of land drillers with the size and international experience to handle such work.
What’s interesting is that IPM deals often involve land rigs, and some of the big services firms—including both Schlumberger and Weatherford—have actually bought up land rigs or small contract drilling firms to secure access. This just highlights the value of capable land rigs, such as those owned by Nabors. With its large international presence, Nabors is well placed to bid as a contractor on IPM deals.
In its first quarter call April 22, Nabors also sounded an encouraging note and reported operating earnings of 79 cents, well above consensus estimates for 76 cents per share. The company noted that it had a number of rigs come off longer-term contracts in North America; the day-rates Nabors was able to negotiate for these rigs under new contracts were higher than it had expected. Nabors sees day-rates for these so-called “legacy” rigs ticking higher in the second half of the year.
In addition, Nabors also builds new state-of-the-art rigs that are designed to handle the toughest drilling needs. These rigs are typically built for a specific producer; that producer signs a long-term contract for the rig at attractive day-rates. Not only are rates on such rigs firming, but Nabors has been successful cutting its operational costs. This has the effect of boosting margins, and the company feels that will continue throughout 2008.
In addition, Nabors builds and owns some of the most advanced rigs in the contract drilling business. These are the rigs that producers use to drill unconventional oil and gas plays, such as the Bakken Shale of North Dakota and the Marcellus gas shale play in Appalachia. I explained my bullish outlook for drilling activity in these areas in the Feb. 20 issue.
I’m raising my buy target for Nabors Industries to 40. I see upside to 50 or higher this year as the North American drilling recovery takes hold and the firm announces new international deals.
It’s also worth noting my two final contract drilling plays in TES: Seadrill and Rowan Companies. I highlighted Seadrill in the Jan. 2 issue. Seadrill is a contract driller that focuses on deepwater rigs; day-rates on such rigs have been very strong in recent years as interest in deepwater drilling activity picked up.
Many deepwater contractors booked their rigs under long-term contracts years ago at much lower day-rates than would be available today. But Seadrill has signed several deals at or near current strong rates; the company even has a few rigs uncommitted and available over the next few years. These rigs represent most of the industry’s spare, uncommitted capacity of deepwater rigs, meaning Seadrill will be able to charge sky-high rates.
Seadrill has nearly doubled in price since my recommendation in January 2007. Many of the company’s rigs aren’t even built yet; the next catalyst for the stock will be when its new rigs are completed and start earning day-rates under contracts Seadrill has already signed. This should start happening in the second half of the year and continue through 2009. When that happens, Seadrill will see a veritable flood of guaranteed cash flow under long-term deals.
I suspect that the firm may look to pay out some of that cash in the form of a dividend eventually. This will be the next big catalyst for the shares. Although the fundamentals are still solid, Seadrill looks extended near-term; I’m cutting my recommendation to a hold from a buy.
Rowan owns primarily high-specification jackup rigs, used mainly on international contracts. It isn’t particularly leveraged to the recovery in the shallow-water GOM, and as I explained in the Feb. 6 issue, I see limited upside for day-rates in high-spec jackups.
The only reason I didn’t recommend selling Rowan back in February was because I felt the company was likely to dispose of its Le Tourneau rig construction unit. Subsequently, Rowan did just that, and the stock popped higher. But with this catalyst removed, I see Rowan at best performing in-line with the broader oil services group.
Although Rowan is as well-run firm, I don’t see as much upside for this stock as I see in the other recommendations in the TES portfolios. Sell Rowan Companies for a gain of about 18 percent from my original recommendation.
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The iShares are an exchange traded fund (ETF). All ETFs are just portfolios of stocks. This table highlights the holdings that make up the iShares Transport Average, sorted by weight.
Source: Bloomberg
As the table indicates, the iShares are broadly diversified but have a healthy 34 percent weighting in the rails, the strongest group within the transports right now. Buy the iShares Dow Jones Transportation Average under 97.
E&P firm XTO Energy reported earnings April 23, and the stock sold off slightly in the wake of that report. But that selling appears to be more a case of profit-taking after a strong run-up this year, rather than anything fundamentally wrong with the report. In fact, XTO has begun to tick higher yet again.
In its report, XTO demonstrated once again the impressive breadth of its unconventional gas plays and its operational excellence. In the first quarter, overall production grew 32 percent year-over-year; 17 percent of that increase came from new acquisitions, and the remaining 15 percent came from organic growth via drilling new wells or trying new extraction techniques.
Management believes the acquisition market is healthy because the credit crunch of the past year has made it harder for smaller firms to bid on properties. There’s less competition on deals. XTO did $4 billion in acquisitions last year and could do even more in 2008.
In its existing operations, the Barnett Shale saw production flat against the fourth quarter, but this was mainly a matter of third-party issues with pipeline capacity, not a lack of productive wells. Meanwhile, as XTO gains experience drilling, it’s lowering the costs and enhancing the productivity of wells in the Woodford and Fayetteville shale plays.
The Marcellus Shale is an early cycle play. However, XTO believes it holds promise, and it’s using the experience of other producers in the region to help it choose the most viable techniques for producing in the region. Buy XTO Energy under 68.
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The seemingly ever-widening credit crunch that first struck the market last summer has affected the energy sector less than most industry groups. But that’s not to say there haven’t been some casualties, as well as several periods of extreme volatility such as we witnessed in the latter half of January 2008. If Buffet is correct, and it never pays to bet against him, the end of the credit crunch is certainly good news for energy stocks.
And Buffet isn’t the only one turning more bullish. By and large, earnings reports out of companies in The Energy Strategist coverage universe have been solid to date. And management teams have been making bullish comments and offering strong outlooks for the latter half of 2008 in their conference calls.
In This Issue
One of my favorite indicators for the energy markets is Schlumberger’s quarterly conference calls and earnings releases. In this quarter’s call, Schlumberger’s management team was notably upbeat, the most positive on industry growth expectations in more than a year. This is a key shift in sentiment that has broader implications for the energy patch at large.In its third and fourth quarter 2007 conference calls, Schlumberger noted that 2008 will be a transitional year as service companies wait for additional rigs to come online. But that forecast may change. See Changing Speeds.
Several factors increase the chance of growth in the services industry. These include demand for advanced technologies for complex well drilling and lessened weakness in North American drilling. See A Short-Lived Transition.
Two additional markets that will play a factor in supply are Russia and Mexico. Both are experiencing slowdowns but could see continued growth given the right projects. See Beyond North America.
Schlumberger and Weatherford International aren’t the only companies to benefit from a strengthening North American market. Here’s what I see happening for other stocks in the TES coverage universe. See Beyond Schlumberger.
Several smaller contract drillers may see some additional upside through deals with the services firms. Others, however, may have run their course. See Contract Drillers.
I added a new play earlier this week, and another reported earnings worth noting here. See Portfolio Update.
I’m recommending or reiterating my recommendation in the following stocks:
- Acergy (NSDQ: ACGY, Norway: ACY)
- Baker Hughes (NYSE: BHI)
- Halliburton (NYSE: HAL)
- Hercules Offshore (NSDQ: HERO)
- iShares Dow Jones Transportation Average (NYSE: IYT)
- Nabors Industries (NYSE: NBR)
- Schlumberger (NYSE: SLB)
- Weatherford International (NYSE: WFT)
- XTO Energy (NYSE: XTO)
- BJ Services (NYSE: BJS)
- Rowan Companies (NYSE: RDC)
- Seadrill (Norway: SDRL, OTC: SDRLF)
Changing Speeds
Longtime TES readers know that I regard oil services giant Schlumberger as a key indicator of health for the oil services industry as well as for the oil and gas business in general. Schlumberger’s quarterly reports and conference calls have proved extraordinarily useful in the past for determining the most profitable trends and investment themes.The reason for that is simple: Schlumberger is the largest oilfield services company and has its hand in just about every imaginable market all over the world. In addition, the company has traditionally offered long, detailed conference calls; CEO Andrew Gould often relates far more than the outlook for Schlumberger and offers considerable color and detail concerning trends for the industry in general.
This quarter’s conference call was no exception. Schlumberger’s outlook this quarter was far more upbeat than in its third and fourth quarter 2007 earnings calls. Gould backed away from comments he made in prior earnings calls that 2008 would be a “transition” year for the industry. Instead, he forecast a growth reacceleration in the second half of the year.
Schlumberger’s comments were so positive, in fact, that I’m adding the stock back to the growth-oriented Wildcatters Portfolio this issue as a buy under 115.
I highlighted Schlumberger’s third quarter conference call in the Nov. 7, 2007, issue, Coal and Services, and the fourth quarter call in both the Jan. 23 issue, Strengthening Headwinds, and the subsequent issue, Earnings on Tap. To review, Wall Street didn’t receive either quarter’s results well; Schlumberger’s stock dropped sharply in the wake of both reports. The main problem on both occasions is that the company called into question Wall Street’s outlook for growth in 2008 for the oil services industry.
Of course, for the entirety of 2007, the North American oil services market was weak, particularly in Canada. The only exception was the deepwater Gulf of Mexico. This weakness was well known and understood by both analysts and investors alike at the time of Schlumberger’s third and fourth quarter reports.
Because most North American drilling activity targets natural gas, not crude oil, depressed gas prices meant weak drilling activity. But Schlumberger’s comments regarding weakness in North America weren’t the reason for the stock’s slide in the wake of those quarterly reports.
The main problem was an issue known as the platform problem, which was a temporary slowdown in offshore operations and activity for the global oil services firms. As I’ve noted before, offshore drilling, particularly in deepwater fields, has been the source of considerable growth for oil services firms such as Schlumberger in recent years.
There are a couple reasons for that. First, as I noted in the March 5 issue, The Final Frontier, the deepwater is one of the only regions of the world where producers have been finding truly large oil and gas fields. It’s one of only a few potential plays where there will be meaningful oil and gas production growth over the next decade.
Therefore, there’s considerable interest in exploration and drilling activity in the deep. This plays right into the hands of the global oil services business because these firms provide the services and technology necessary to explore and develop offshore oilfields.
Another reason offshore operations are so important is complexity. The new deepwater fields discovered in Brazil offer a perfect example. Tupi is located in water two miles deep; production of the field requires drilling through a one-mile thick salt layer and into extremely high-pressure, high-temperature environments.
Drilling wells in this field requires the most advanced technology available today; in fact, some believe that drilling Brazil’s recently announced Carioca field may require some new technological developments before production is even possible.
Only a handful of firms, such as Schlumberger, own such technology and can actually drill those wells. Therefore, these high-tech service firms can charge a high price for the work they do.
This is precisely why offshore profit margins have been steadily rising for the big services firms over the past five years. Increasing reliance by producers on more-complex, land-based reservoirs and deepwater fields is extremely bullish for the services firms.
In its third and fourth quarter conference calls, Schlumberger was careful to point out that demand for offshore drilling services wasn’t declining. The problem wasn’t a lack of demand for their services related to the deepwater; the platform problem was a lack of rigs and equipment.
Demand for offshore exploration and development has been so strong that most of the world’s drilling rigs capable of handling such work are already being utilized. This problem is most acute in ultra-deepwater operations, where almost all the rigs in the world are contracted years in advance.
Even if an operator were to make a huge new find, there would be no rigs available for several years to drill wells. And constructing new deepwater rigs is an expensive, multi-year task; there’s no way to bring new capacity online quickly to meet demand. Services companies were constrained by the lack of rig platforms available to perform offshore work.
A significant number of new floating (offshore) rigs are scheduled for construction and service in 2008 and 2009. But it takes some time after a rig is first built and put into service for it to reach peak efficiency. There are typically small issues and snags with new rigs that must be fixed. And construction schedules can and do slip; rigs may not be available exactly when planned.
Schlumberger and other services firms felt that Wall Street was too optimistic in late 2007 about offshore growth. The Street seemed to assume that all the new rigs scheduled to be put into service globally would be delivered on time and be put into service with no delays, startup problems or operational issues. This perfect scenario rarely happens in the real world, particularly in the oil business.
The bottom line: Delays to offshore work caused by a lack of rigs were expected to cause a temporary slowdown in the offshore services business for 2008. This platform problem was expected to ease as new rigs were delivered and put into service into 2009; however, 2008 looked like a transitional year as the industry waited for new rigs to be delivered and reach full efficiency.
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A Short-Lived Transition
Schlumberger’s first quarter 2008 conference call April 18 couldn’t have been more different. The company actually missed analysts’ consensus by a sizeable margin, but the stock rallied on heavy volume the day earnings were released; Schlumberger reported earnings of $1.06 per share, while analysts had been looking for $1.11 to $1.12 per share, but the stock still managed to rally close to 7 percent on the day on heavy trading volume.Just as a subdued outlook was behind Schlumberger’s selloffs after its third and fourth quarter 2007 results, an upbeat forecast was the catalyst for the stock’s positive reaction to its first quarter 2008 release. In fact, the first question analysts posed to Schlumberger during the question-and-answer (Q&A) segment of the conference call was if the company was revising its forecast for a transitional year in 2008. CEO Andrew Gould replied:
…I think that when I made that comment in December, Michael, I was thinking it [2008] was a transition year. I would say that what has happened in North America, coupled with–as I am sure you’ve noticed–some fairly dramatic declines in oil production in a number of places around the world, leads me to believe that absent [a] global recession, it’s more and more a year in which growth is going to strengthen significantly in H2 [the second half of the year].
It’s clear from this statement that Schlumberger’s CEO is softening his outlook for 2008 to be a transitional year. He now expects growth to reaccelerate in the second half of this year rather than in 2009. This is the most bullish statement we’ve heard from Schlumberger in several quarters.
Along the same lines, Gould was subsequently asked about Wall Street’s forecasts for 2008 earnings. Recall Gould said point-blank in the third and fourth quarter calls that he felt estimates may be too optimistic. He was fairly direct in warning Wall Street that its assumptions were too rosy.
But this quarter Gould stated that he was very comfortable with Wall Street assumptions for the full-year 2008. This suggests Wall Street may have taken estimates down far enough; if anything, it sounds as if Schlumberger believes it has room to beat current expectations.
Further, Gould was asked for an early take on 2009. He stated that his gut feeling was 2009 would be better than 2008.
Bottom line: Based on these comments, I see room for upside to estimates. It appears that Schlumberger’s growth is on pace to pick up steam in the second half of this year and accelerate into 2009. Gould isn’t one to make idle comments or put lipstick on the proverbial pig in an attempt to hype up Schlumberger’s prospects; it pays to put credence in his comments.
Of course, it’s useful to dig a bit deeper to try to determine why Schlumberger’s outlook appears to be turning more bullish. As the quote above suggests, the top reason is simple: Schlumberger was assuming continued weakness in its North American business, which has been a trend in the region for the past two years. Since late 2005, strong international operations have been more than making up for weakening trends in the US and Canada.
But this clearly is no longer the case. Although international operations continue to grow unabated, North America is no longer the anchor dragging down the rest of the business, or at the very least, it’s not as strong a headwind as it was last year. Schlumberger didn’t expect this when management called for a transitional year.
The most obvious reason for the uptick in North American activity is the improvement in natural gas prices since late 2007. I’ve highlighted this recovery on a few occasions, including in the March 19 issue, Gas over Oil. The chart of the 12-month NYMEX natural gas strip below is largely self-explanatory.
Source: Bloomberg
As gas prices picked up, so did interest in drilling activity. According to Schlumberger, Canada saw a robust winter drilling season, with a significant uptick in exploration activity. The company also noted a significant increase in growth in the Alaskan market, mainly related to exploration activity.
As longtime readers are aware, one of the first service markets to turn down in North America back in 2006 was well stimulation—basically, fracturing or pressure pumping operations. For those unfamiliar with this product line, see the Feb. 20 issue, Growing Unconventionally.
To summarize, pressure pumping involves injecting a liquid into a reservoir rock under high pressure to crack the rock itself. Cracking the reservoir rock makes it easier for oil and natural gas to flow through the rock into the well. Suffice it to say that this is a crucial service function for producing many of the most promising unconventional gas and oil reserves in the US.
The problem with pressure pumping was twofold. First, a decline in gas prices in 2006 and 2007 meant that producers scaled back their drilling activity and, therefore, their demand for pressure pumping services.
Second, in the big gas price run-up of 2004 and 2005, many service companies built up their capacity to perform pressure pumping services. This involved building more compressors and pressure pumping trucks.
What ended up happening is that a lot of this new capacity came online just as gas prices fell. Falling demand and surging supply is a noxious combination that invariably leads to weakened pricing.
But even in pressure pumping, there are signs of a bottom. Schlumberger stated that pricing in well stimulation services is still weak but is in the process of bottoming. The company noted that, if the North American rig count improves quickly enough, pricing could improve as soon as this year.
And remember this is the weakest of all services functions in North America. Schlumberger stated there’s already some pricing leverage in certain North American services.
For example, services involved in drilling directional wells are already seeing improvement. As I’ve noted before, North American producers are increasingly targeting more-complex fields that require nonvertical wells to produce efficiently. Check out the chart below.
Source: Bloomberg, Baker Hughes
This chart shows the percentage of total wells drilled in the US that are simple vertical wells. What’s clear is that this percentage has been steadily declining for more than a decade. Obviously, this is bullish for firms offering services related to drilling directional wells.
Other areas of strength include so-called wireline services, and drilling and measurements. Wireline services involve placing devices into a well to measure the characteristics of the reservoir. Drilling and measurements include tools and sensors that allow data about a well to be transmitted to operators as the well is drilled. This allows for more precise well placement.
The basic platform problem still exists with respect to offshore services. Certainly, there still aren’t enough rigs internationally to meet demand for all the new, planned drilling projects. And now, as before, there are sure to be issues ramping up newly constructed drilling rigs to full efficiency.
However, a recovery in North American land-based operations means that the region will no longer be the headwind for Schlumberger and other services firms that it was over the past two years. Because there’s no real shortage of land rigs in North America, this region isn’t exposed to the platform issue.
Therefore, an uptick in North America will help offset the platform issue near term. As we enter 2009, new rigs will come into service, and producers will begin ramping up their offshore activity. This will bring the industry its next wave of offshore and international growth.
But of the service majors, Schlumberger is among the least exposed to North American land operations. An uptick in growth here isn’t the sole reason for the improved outlook.
In addition, Schlumberger notes a few additional points: accelerating decline rates in some countries, integrated project management (IPM) and higher-than-expected land-based drilling activity internationally.
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Beyond North America
All of these three factors are somewhat related. The accelerated decline issue is something I’ve covered in TES on several occasions, most recently in the Jan. 2 issue, Taking Stock of 2007. The basic idea is that production from many large onshore oilfields around the world is declining at a faster pace than most analysts had expected. Two of the countries frequently alluded to in the Schlumberger call were Russia and Mexico.The International Energy Agency (IEA) recently announced that Russia saw a 1 percent drop in oil production in the first three months of this year compared to the same quarter one year ago. This is the first time Russian oil production has dropped in roughly a decade. Russian production appears to continue to wane: Monthly production hit 9.72 million barrels per day in April, the lowest monthly total in a year and a half.
And we’re starting to hear rhetoric from Russia that production has either peaked or flattened. Energy and Industry Minister Viktor Khristenko described Russian output as a plateau back in April. And Leonid Fedun, a vice president of Russian oil giant Lukoil, stated in an interview to Britain’s Financial Times that Russia’s oil production of 10 million barrels per day was the most he’d see in his lifetime. He went so far as to compare Russia’s current situation to the North Sea and Mexico, both producing regions where production has already peaked.
Other analysts believe that Russian oil production hasn’t necessarily hit its ceiling but will simply require large additional investment in exploration and development to grow. As I highlighted in the Dec. 19, 2007, issue, Focus on Russia, the nation does have some promising new regions for exploration and several large-scale projects due to come online over the next few years.
Whether Russian oil production has actually peaked or not is still a matter of some debate. What is crystal clear is that maintaining current production and preventing a significant decline in output means massive investment in both new exploration and in projects within existing, mature fields designed to boost production.
Russia imposes an export tax on oil. But the government has been talking about reducing this tax burden in an effort to encourage more investment in the oilfield and stabilize production. Gould commented that he thought the Russian government would make some positive changes but they may not have an impact for Schlumberger until 2009.
One way or the other, the step-up in Russian activity levels—with or without an additional tax concession—is good for Schlumberger and other services firms with the right technologies. The big growth area in this market will be integrated project management (IPM). IPM is an interesting market; in fact, Gould stated that he remains astonished at the demand for this service.
In an IPM deal, a producer actually contracts with a service firm to handle a project. Depending upon how the deal is structured, the services firm may provide the rigs, contract with engineering companies or provide some of its own in-house service functions, as well as contract with third-party providers for other services.
In many ways, IPM deals are replacing production-sharing deals with major international integrated oil companies. Many state-owned national oil companies (NOC) prefer not to give up rights to some of the production from their fields; this was the norm under production-sharing deals. In an IPM, the NOCs can simply pay the services companies to handle the work.
IPM is also good for the services firms because these deals typically represent major contracts and can carry healthy profit margins. The growth in this market is exploding as producers switch from partnership deals to IPMs. Russia is one of the fastest-growing IPM markets in the world, with arguably the best prospects for growth. A good deal of spending in this market will flow through IPM deals to services companies.
I won’t belabor the point, but suffice it to say that Mexico is in a similar boat to Russia. But the situation is even more severe: The giant Cantarell field is declining at a far faster pace than most analysts had projected, and Mexican oil production could drop significantly in coming years—to the point that, within a decade, the nation will no longer be an oil exporter.
To arrest or slow that decline will require a massive new wave of spending on drilling and development. Unfortunately, the Mexican constitution essentially prohibits the NOC, PEMEX, from partnering with foreign oil majors on deals. The result: Mexico can’t exploit its potentially vast deepwater resources because PEMEX doesn’t have the technology or in-house know-how to drill those wells.
But one thing PEMEX can do is step up drilling activity on some smaller onshore fields and try to stem production declines at Cantarell. That’s exactly what’s going on right now.
A great deal of that investment is also flowing to services firms under IPM deals. Because IPMs don’t involve production or reserves sharing, the constitution doesn’t bar such deals.
The beauty of these IPM deals is that many, including those in Russia and Mexico, are actually land-based deals rather than deepwater/offshore work. Because there’s no real shortage of land drilling rigs or, at least, less-acute shortage, there’s less of a limitation on growth near term.
In short: IPM isn’t exposed to the platform issue. The ramp-up of such deals ramp up into 2009 spells a reacceleration of growth for services firms.
In Schlumberger’s case, IPM will begin ramping up this year. In the first quarter, the company started several new IPM projects, primarily in Mexico, and experienced substantial startup costs as a result. There are always startup costs associated with beginning new projects. Those may include costs associated with moving crews and rigs into position.
In addition, if a services firm isn’t familiar with a particular field or there’s limited drilling history, it may take time and experience to ramp up to full efficiency in terms of drilling wells. This is a sort of learning curve. Schlumberger stated that it believes these startup costs will continue to decline as the year progresses.
A few additional points highlighted in Schlumberger’s call are worthy of note:
Seismic Operations—Producers use seismic maps of underground rock formations to locate potential new reserves and determine ideal well placement. This is particularly crucial in the deepwater, where wells routinely cost upward of $1 million per day to drill.
In recent years, services companies have developed seismic technology that can provide great detail. Schlumberger’s Q seismic technology is among the most advanced in the world and is in high demand.
In the first quarter, however, seismic revenues were below expectations; in fact, this was the main reason for Schlumberger’s earnings miss. However, this isn’t an issue.
Seismic revenues are “lumpy” and can vary widely by quarter. For example, in the first quarter, the US government sold off drilling rights for deepwater plots in the Gulf of Mexico as part of a lease sale scheduled late in the quarter. Therefore, many producers held off seismic contracting until after that sale was complete.
In addition, Schlumberger has plans to release a huge seismic database of high-quality deepwater information later this year. These data are going to be released on a multiclient sales basis. That means any operator can gain access to the information for a fee. When those data are released, seismic demand should pick up.
More Exploration Spending—One analyst noted that his firm estimates exploration and production (E&P) companies globally had committed to an additional $10 billion in spending since the end of 2007. Much of this spending would ultimately end up in the hands of services companies such as Schlumberger. Management suggested that the $10 billion figure, a large increase by any measure, wasn’t far off Schlumberger’s own internal estimates.
Brazil—Schlumberger stated that 2009 would be an excellent year for Brazil. Management seemed truly excited about the prospects for this country; I highlighted myriad Brazilian deepwater projects on tap over the next few years in the March 5 issue. This is yet another data point that suggests Brazil is a key market to watch.
Cycle Sustainability—Schlumberger reiterated that it sees the current upcycle in the energy business as different from the market of the 1970s. Back then, oil supplies were restricted primarily by political considerations.
Now, however, supplies are limited by producers’ ability to overcome high decline rates and bring new fields online. The current supply problem is more intractable than the issues of the ’70s.
Schlumberger also noted one factor that killed the oil bull market back in the ’70s was the addition of volumes from new fields brought online in Alaska, Mexico and the North Sea. Those fields were discovered in the ’60s and early ’70s; when the fields started ramping up production in the late ’70s, global oil supplies rose. This time around, however, Schlumberger doesn’t see any fields of that size in the offing.
This suggests that, barring a truly nasty global recession, the current cycle will stay stronger for longer than that of the ’70s.
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Beyond Schlumberger
Of course, Schlumberger’s positive comments have more broad application to other companies in the services business, including Wildcatters Portfolio holding Weatherford International.To review, I recommended Schlumberger for much of 2007. I decided to take some profits in July 2007 and sold completely out of the stock in the fall for an overall gain of around 70 percent. On those occasions, I recommended focusing new investment monies on Weatherford instead.
My rationale for favoring Weatherford since last summer was the company is less exposed to the transitional platform problems. Weatherford is a much smaller firm and doesn’t sell its services in all of the most promising regions of the world. The company has scope to enter new countries and use its sales force to rapidly build market share in key service functions.
In contrast, Schlumberger is already a market leader in many of the service functions and regions where it operates. Growth is more dependent on overall growth in the services industry and exploration spending rather than market share gains.
With the platform problem and transitional year looming, I saw Weatherford as the safer growth play. This view has proved largely correct. Check out the chart below.
Source: Bloomberg
This chart shows the relative performance of Schlumberger, Weatherford and the Philadelphia Oil Services Index since I first recommended taking profits in Schlumberger last summer. Since that time, Schlumberger returned only 4.7 percent, including dividends, compared to a 13 percent gain for the Oil Services Index and a 41 percent gain for Weatherford.
With the transitional problems now passing, I’m once again recommending Schlumberger. After an unusual period of underperformance, the firm is poised to catch up to the rest of the services index.
However, this doesn’t mean you should ignore Weatherford. This company continues to fire on all cylinders, and growth prospects are undimmed.
In its first quarter call April 21, Weatherford echoed many of Schlumberger’s comments. The company is more heavily exposed to the US and Canadian markets than Schlumberger, so its comments are important.
Weatherford reiterated that this is the first time in seven quarters that it has anything positive to relate about the North American and, in particular, Canadian drilling markets. Not only did revenues rise by 8 percent year-over-year in North America, but the company also saw an increase in profit margins.
Weatherford went on to say that the Canadian market has bottomed and will see a strong recovery starting at the end of this year. The first market to recover will be oil sands; a number of new projects are scheduled to start up. But Weatherford also sees interest in the new gas shale plays, such as the play in British Columbia that EOG Resources announced earlier this year. Weatherford expects 2009 to be a lot better year in North America than analysts currently estimate.
And while the North American market improves, international markets are accelerating. Like Schlumberger, Weatherford spent considerable time highlighting its growth prospects in IPM. By the end of 2008, Weatherford expects to be working on six IPM projects; annualized revenues from those six deals will be around $750 million to $800 million by year-end.
Weatherford, like most services firms, only offers limited details about exactly what its contracts are and where it’s bidding because it’s sensitive, competitive information. However, the one deal we do know about is in Russia.
Late in 2007, TNK-BP awarded a $3 billion three- to five-year IPM contract. Weatherford was the big winner in the deal; the IPM contract there is worth around $1 billion to Weatherford over the term of the contract. This also marks Weatherford’s entrance into the West Siberian services market, perhaps one of the most promising markets for services firms in the world.
In fact, Weatherford noted in its call that Russia is growing at the fastest possible pace. It seems the country’s growth is already so strong it’s pushing Weatherford’s limits from an operational standpoint.
Another market where Weatherford was bullish is Algeria; CEO Bernard Duroc-Danner described this market as a “coiled spring” that could really explode as new projects start up later in the year.
To make a long story short, I see Weatherford on track to generate one of the strongest growth rates of any oil service firm in the world. I’m raising my buy target on Weatherford International to 87 and my stop to 71.
Also note Weatherford has scheduled a 2-for-1 stock split effective May 27. My buy target and stop price are based on pre-split numbers; I’ll change the information listed in the portfolio table May 27 to reflect the split.
Given positive comments about deepwater growth from both Schlumberger and Weatherford, it’s also worth reiterating my buy recommendation on subsea construction specialist Acergy. I highlighted the stock at some length in the March 5 issue, and it remains my top focused play on deepwater growth for now. Acergy rates a buy under 27.50.
Outside the model portfolios, I would also highlight a few additional services names as possible beneficiaries of the trends highlighted by Schlumberger and Weatherford:
BJ Services is the services company in my coverage universe with the most leverage to pressure pumping. I’ve recommended avoiding the stock for some time now; as noted above, this has been the weakest market in the entire oilfield services industry. BJ recently missed its quarterly consensus estimates, and the stock was slammed in the wake of its report and conference call.
I suspect pressure pumping will remain weak for some time because of excess capacity. But it appears the North American drilling markets are recovering, and according to Schlumberger, pressure pumping should begin the see pricing improvement toward the end of 2008 or into early 2009.
For now, I’m upgrading BJ Services from a sell to a hold in the How They Rate Table. I’m watching this stock as a potential addition to the model portfolios toward the end of 2008, ahead of a recovery in its main business.
Halliburton is probably the most often recommended oil services firms of all. I’ve broadly avoided the stock over the past two years because it has heavy exposure to North America and to pressure pumping.
In fact, I’ve successfully recommended shorting the stock on a few occasions. For the record, Halliburton is up 53 percent since the end of 2005, compared to 118 percent for Schlumberger and 136 percent for Weatherford.
But I think this period of underperformance is over. Halliburton’s North American sector is recovering, and its natural gas-levered service functions are likely to see a strong recovery over the next 12 months.
Meanwhile, Halliburton has been expanding aggressively into international markets and IPM, so it’s beginning to benefit more meaningfully from the same growth dynamics as Weatherford and Schlumberger. I’m upgrading Halliburton to a buy in the How They Rate Table, and I’ll consider for a possible addition to the model portfolios.
Smith International’s most interesting business is drilling fluids. I explained the concept of drilling fluids and mud in the Feb. 20 issue. Suffice it to say, deepwater drilling requires the use of specialized fluids, and Smith has a solid market share in that area.
Smith has been dragged down by two issues. First, because most of its growth is deepwater-related, the stock is ultra-exposed to the platform problem highlighted above. And second, it has fairly heavy exposure to North American gas drilling, in particular with its drill bits and distribution businesses.
With North America recovering, the platform problem easing and deepwater spending exploding, Smith looks promising again. Smith International is rated a buy in the How They Rate Table, and I’m also considering it for addition to the model portfolios.
Baker Hughes is one of the world’s largest oil services firms and has an excellent position in terms of product lines and international leverage. However, the company has consistently posted sub-par growth compared to Schlumberger and Weatherford.
Some of this sub-par growth has been due to operational missteps. In addition, some feel that Baker just didn’t build out its capacity fast enough as the cycle turned higher for services earlier this decade. For whatever reason, the stock has lagged and is underperforming the Philadelphia Oil Services Index by nearly 100 percentage points over the past five years.
Baker will eventually benefit from strong growth in the services business. Alternatively, one of the other big services providers may simply take it over, taking advantage of the stock’s cheap valuation.
Either way, Baker’s shareholders are likely to see some improvement over the next year. I’m raising Baker Hughes from a hold to a buy in the How They Rate Table.
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Contract Drillers
The implication of earnings releases from Schlumberger and Weatherford also stretched far beyond the services business. Gushers Portfolio recommendations Hercules Offshore and Nabors Industries are also prime beneficiaries of the strengthening North American drilling market.Both firms are contract drillers. Typically, oil and gas producing companies don’t own their own drilling rigs. Instead, the contract drillers own rigs and lease them to producers for a daily fee known as a day-rate.
Rigs can be contracted on a short-term or spot basis; day-rates under spot deals are based on short-term supply and demand conditions. Alternatively, some drillers, particularly deepwater drillers, sign long-term contracts with a fixed day-rate.
Hercules Offshore is primarily a shallow-water jackup driller with a focus on the Gulf of Mexico (GOM). A jackup is a type of rig that has legs that rest on the seafloor; jackups are typically used in waters up to a few hundred feet deep. Here’s a picture of a typical jackup rig.
Source: Google
Jackups are not all the same. Some rigs are capable of handling deeper wells, while others are designed to handle rougher water conditions. For the most part, Hercules’ jackups are on the less-capable end of that spectrum. Such rigs are most suitable for the shallow-water GOM.
But just as the market for services in North America has been weak, so has the drilling environment in the shallow-water GOM. Most drilling activity there targets natural gas rather than oil.
Unlike deepwater projects in the GOM, shallow-water drilling is the province of smaller producers. When gas prices collapsed in 2006 and remained weak through 2007, these producers stopped drilling. That left a glut of unused rigs in the shallow-water GOM, and day-rates plummeted.
However, there was still a shortage for more capable jackup rigs outside the US, and foreign producers were willing to pay large day-rates under long-term contracts. The result was a mass exodus of rigs from the area. Consider that earlier this decade around 150 jackups were in the shallow-water GOM; now there are just 65, and that supply will drop to the low 60s by year end as rigs depart on international deals.
But with gas prices rising again, drilling activity has also started to pick up. And with just 65 rigs in the US GOM, demand looks quick to outstrip supply. This would send day-rates sharply higher.
Hercules reported its first quarter results May 1. The driller said that day-rates continued to fall earlier in the quarter and were weak. However, rates started to improve in the final weeks of the quarter and into the second quarter; these numbers will be reflected in second quarter results.
To give an idea of the scope of improvement, average daily revenue per rig in the first quarter fell $6,000 to $56,900. As of May 1, rigs are earning day-rates in the $60,000 to $70,000 range. As the gas drilling market tightens, that could easily jump to $80,000 over the next few quarters.
According to Hercules, every $10,000 improvement in day-rates equals 50 cents in earnings per share. Hercules’ earnings of just $2.29 per share on a trailing 12-month basis give an idea just how levered the stock is to rising GOM jackup rates and the improving gas drilling market.
Bottom line: Hercules has upside as jackup day-rates continue to strengthen. I’m raising my buy target, given the now more conclusive evidence of a GOM turn; Hercules Offshore rates a buy under 33.
Nabors is primarily a land drilling contractor. I’ve outlined my rationale for owning the stock on a few occasions, most recently in the March 5 issue. Basically, Nabors’ North American business stands to improve markedly, given the recent uptick in drilling activity. And Nabors’ international business continues to grow at close to 50 percent annualized.
In fact, Nabors is a major part of Weatherford’s IPM deal with TNK-BP in Russia. Nabors will be supplying land rigs to handle much of this work; the company is one of only a handful of land drillers with the size and international experience to handle such work.
What’s interesting is that IPM deals often involve land rigs, and some of the big services firms—including both Schlumberger and Weatherford—have actually bought up land rigs or small contract drilling firms to secure access. This just highlights the value of capable land rigs, such as those owned by Nabors. With its large international presence, Nabors is well placed to bid as a contractor on IPM deals.
In its first quarter call April 22, Nabors also sounded an encouraging note and reported operating earnings of 79 cents, well above consensus estimates for 76 cents per share. The company noted that it had a number of rigs come off longer-term contracts in North America; the day-rates Nabors was able to negotiate for these rigs under new contracts were higher than it had expected. Nabors sees day-rates for these so-called “legacy” rigs ticking higher in the second half of the year.
In addition, Nabors also builds new state-of-the-art rigs that are designed to handle the toughest drilling needs. These rigs are typically built for a specific producer; that producer signs a long-term contract for the rig at attractive day-rates. Not only are rates on such rigs firming, but Nabors has been successful cutting its operational costs. This has the effect of boosting margins, and the company feels that will continue throughout 2008.
In addition, Nabors builds and owns some of the most advanced rigs in the contract drilling business. These are the rigs that producers use to drill unconventional oil and gas plays, such as the Bakken Shale of North Dakota and the Marcellus gas shale play in Appalachia. I explained my bullish outlook for drilling activity in these areas in the Feb. 20 issue.
I’m raising my buy target for Nabors Industries to 40. I see upside to 50 or higher this year as the North American drilling recovery takes hold and the firm announces new international deals.
It’s also worth noting my two final contract drilling plays in TES: Seadrill and Rowan Companies. I highlighted Seadrill in the Jan. 2 issue. Seadrill is a contract driller that focuses on deepwater rigs; day-rates on such rigs have been very strong in recent years as interest in deepwater drilling activity picked up.
Many deepwater contractors booked their rigs under long-term contracts years ago at much lower day-rates than would be available today. But Seadrill has signed several deals at or near current strong rates; the company even has a few rigs uncommitted and available over the next few years. These rigs represent most of the industry’s spare, uncommitted capacity of deepwater rigs, meaning Seadrill will be able to charge sky-high rates.
Seadrill has nearly doubled in price since my recommendation in January 2007. Many of the company’s rigs aren’t even built yet; the next catalyst for the stock will be when its new rigs are completed and start earning day-rates under contracts Seadrill has already signed. This should start happening in the second half of the year and continue through 2009. When that happens, Seadrill will see a veritable flood of guaranteed cash flow under long-term deals.
I suspect that the firm may look to pay out some of that cash in the form of a dividend eventually. This will be the next big catalyst for the shares. Although the fundamentals are still solid, Seadrill looks extended near-term; I’m cutting my recommendation to a hold from a buy.
Rowan owns primarily high-specification jackup rigs, used mainly on international contracts. It isn’t particularly leveraged to the recovery in the shallow-water GOM, and as I explained in the Feb. 6 issue, I see limited upside for day-rates in high-spec jackups.
The only reason I didn’t recommend selling Rowan back in February was because I felt the company was likely to dispose of its Le Tourneau rig construction unit. Subsequently, Rowan did just that, and the stock popped higher. But with this catalyst removed, I see Rowan at best performing in-line with the broader oil services group.
Although Rowan is as well-run firm, I don’t see as much upside for this stock as I see in the other recommendations in the TES portfolios. Sell Rowan Companies for a gain of about 18 percent from my original recommendation.
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Portfolio Update
Monday I sent out Flash Alert: Buying Transports, in which I recommended the iShares Dow Jones Transportation Average as a play both on the strength of the railroad industry and on a possible recovery in other transport industries. (See that flash alert for full details on that call and how the transportation and energy industries are inextricably related.)The iShares are an exchange traded fund (ETF). All ETFs are just portfolios of stocks. This table highlights the holdings that make up the iShares Transport Average, sorted by weight.
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iShares Dow Jones Transportation Average Holdings
|
||
|
Company (Exchange: Symbol)
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Sector
|
Weight in the ETF (%)
|
| Alexander & Baldwin (NSDQ: ALEX) | Marine Transports | 4.4 |
| AMR Corp (NYSE: AMR) | Airlines | 0.8 |
| Burlington Northern Santa Fe (NYSE: BNI) | Railroads | 9.4 |
| CH Robinson Worldwide (NSDQ: CHRW) | Logistics | 5.9 |
| Con-way (NYSE: CNW) | Truckers | 4.5 |
| Continental Airlines (NYSE: CAL) | Airlines | 1.6 |
| CSX Corp (NYSE: CSX) | Railroads | 5.8 |
| Expeditors International of Washington (NSDQ: EXPD) | Logistics | 4.3 |
| FedEx (NYSE: FDX) | Package Freight | 8.7 |
| GATX Corp (NYSE: GMT) | Equipment Leasing | 4.1 |
| JB Hunt Transport Services (NSDQ: JBHT) | Truckers | 3.1 |
| JetBlue Airlines (NSDQ: JBLU) | Airlines | 0.4 |
| Landstar System (NSDQ: LSTR) | Truckers | 4.8 |
| Norfolk Southern Corp (NYSE: NSC) | Railroads | 5.6 |
| Overseas Shipholding Group (NYSE: OSG) | Marine Transports | 7.4 |
| Ryder System (NYSE: R) | Logistics | 6.4 |
| Southwest Airlines (NYSE: LUV) | Airlines | 1.2 |
| Union Pacific Corp (NYSE: UNP) | Railroads | 13.3 |
| United Parcel Services (NYSE: UPS) | Package Freight | 6.5 |
| YRC World (NSDQ: YRCW) | Truckers | 1.7 |
Source: Bloomberg
As the table indicates, the iShares are broadly diversified but have a healthy 34 percent weighting in the rails, the strongest group within the transports right now. Buy the iShares Dow Jones Transportation Average under 97.
E&P firm XTO Energy reported earnings April 23, and the stock sold off slightly in the wake of that report. But that selling appears to be more a case of profit-taking after a strong run-up this year, rather than anything fundamentally wrong with the report. In fact, XTO has begun to tick higher yet again.
In its report, XTO demonstrated once again the impressive breadth of its unconventional gas plays and its operational excellence. In the first quarter, overall production grew 32 percent year-over-year; 17 percent of that increase came from new acquisitions, and the remaining 15 percent came from organic growth via drilling new wells or trying new extraction techniques.
Management believes the acquisition market is healthy because the credit crunch of the past year has made it harder for smaller firms to bid on properties. There’s less competition on deals. XTO did $4 billion in acquisitions last year and could do even more in 2008.
In its existing operations, the Barnett Shale saw production flat against the fourth quarter, but this was mainly a matter of third-party issues with pipeline capacity, not a lack of productive wells. Meanwhile, as XTO gains experience drilling, it’s lowering the costs and enhancing the productivity of wells in the Woodford and Fayetteville shale plays.
The Marcellus Shale is an early cycle play. However, XTO believes it holds promise, and it’s using the experience of other producers in the region to help it choose the most viable techniques for producing in the region. Buy XTO Energy under 68.
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