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The Dow Jones Industrial Average is up by more than 20% over the past 12 months, and despite the recent retreat the index is still close to its all-time high. At the same time, investors seem to be getting more worried that the Fed might reduce its stimulus measures. In the current investing environment, it is becoming more difficult for analysts to identify attractive investment opportunities. Having said that, we have taken a liking to the U.S. oil equipment and services sector.

Below, we outline the performance of the Dow Jones U.S. Oil and Gas Index against the performance of the broad Dow Jones Industrial Average for the past five years. As you can see in the chart, the oil equipment and services sector has significantly underperformed the market. What's more is that the sector has even failed to recover to pre-crisis levels.

^DJUSEN Chart

Going forward, we expect the oil equipment and services sector to perform stronger. We base our analysis on valuation multiples and economic fundamentals. Within the sector, we like certain stocks more than others. We start our discussion with several important points.

Oilfield Services Market to Jump in Value by 2017

In its report Oilfield Service Industry to 2017, the business intelligence company GBI Research forecasts that the global value of the oilfield services industry will rise to $213 billion by 2017 from $152 billion in 2012 due to booming exploration and production. This is an increase of 40.1%. Although we are optimistic about the long-term prospects of the sector, we remain somewhat cautious of its short-term outlook. The latest industry reports predict a slowdown of drilling activity in the U.S. in 2013.

Energy Prices and Industry Transformation

To some extent the weaker performance of the oil equipment and services sector is due to the falling oil prices, which tend to discourage drilling activity. The outlook for the price of oil is not promising over the next 12 months. Natural gas prices, however, are expected to rise by 11.3% in 2014, according to the U.S. Energy Information Administration.

Source: U.S. Energy Information Administration

Another important driver for the sector that must be considered is shale oil. Morgan Stanley expects shale oil production to increase about five times by 2016, which should boost the number of rigs supplied by the oil-services firms. In general, the companies in the sector will profit from the growing exploration of non-traditional oil deposits. Moreover, the exhaustion of the so-called "easy oil" reserves will increase expenditures on services and on better extraction technology to capture less accessible reserves.

Valuations

The Dow Jones U.S. Select Oil Equipment & Services Index was formed in 2006 to track the performance of the U.S. companies from the oil equipment & services sector. According to the latest data from S&P Dow Jones Indices, the index is trading at a forward P/E of 14.12x and a P/B of 1.68x. Oilfield services stocks are considered cyclical with high margins during boom times and suppressed margins during times of economic slowdown. At the end of May 2013, the largest constituents of the DJSOEST Index were:

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Source: S&P, Bloomberg.com

In the table, we showed both the P/E ratio and the price-to-cash flow ratio. The latter is quite important, as oil companies tend to report significant non-cash items on their income statements. Among the big names, we recommend Halliburton (HAL) and National Oilwell Varco (NOV). Although Halliburton has risen 53% in the past 12 months, it still looks attractive on valuations. We would avoid Schlumberger (SLB) at the moment, as it is trading at higher-than-average valuation ratios. Schlumberger has an estimated PEG ratio of 1.04x, compared to 0.80x for Halliburton. We like that Schlumberger reported solid results for Q1 2013 but we think this is already reflected in the share price.

Among the smaller players, we favor Ensco (ESV) and Noble Corp (NE). On valuations, Transocean (RIG) also looks cheap but we do not like the higher leverage of the company (see the table below). We recommend staying away from FMC Technologies (FTI), as it looks unreasonably expensive and its debt-to-equity ratio is 89.9%, which is among the highest in the peer group.

In general, we prefer companies with lower levels of debt and a good cash position. This is especially relevant for the companies in this sector, as they need to fund their capital expenditures going forward. The larger players tend to be less leveraged than the smaller ones. In the group, National Oilwell Varco has the lowest debt-to-equity ratio and a strong liquidity position. An interesting fact about this company is that Warren Buffett increased his stake in it in the first quarter of this year.

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Source: Company reports

Conclusion

We think the oil equipment and services sector is a good long-term bet. In the short term, we expect some downward pressure from falling oil prices and weaker drilling activity on some of the smaller and more leveraged players. However, National Oilwell appears to be well positioned for the future, with Halliburton another solid bet on the industry.

Source: A Bet On The U.S. Oil Equipment And Services Sector