Mexican Reforms: Time To Buy These Oilfield Services Titans

Aug.29.13 | About: Schlumberger Limited (SLB)

Mexico is gearing up for some significant oil reforms in an effort to revive its economy in general and its oil and gas sector in particular. The country's energy sector has been dominated by Petróleos Mexicanos, also known as Pemex. With the new reforms, one of the world's most restrictive energy markets could open its doors to international energy firms. The oilfield services firms Schlumberger (NYSE:SLB) and Halliburton (NYSE:HAL) could be the first to capitalize on this development. The two were already eyeing more than $8 billion worth of large integrated projects in Mexico. Analysts believe that now is the time to buy Schlumberger and Halliburton on these new developments. The new price targets on these firms represent a 30% upside.

Declining Output

The state-owned energy behemoth Pemex has been operating as a monopoly for seven decades. The business has worked under service contracts with foreign firms, as opposed to profit-sharing contracts. The absence of profit or production sharing contracts has kept most foreign energy firms at bay. The country's energy sector has suffered with falling levels of output due to a lack of investment. In the last ten years, Pemex increased its annual investment by five-fold to $20 billion, but its production fell from 3.59 million barrels per day in 2002 to 2.93 million barrels per day in 2012.

The oil reforms could bring an energy revival to the country which holds 15 billion barrels of oil (as much as Kuwait) and could be home to 27 billion barrels of deep-sea crude reserves. Besides conventional crude, Mexico also has the eighth largest reserve of shale oil and sixth largest shale gas resources. However, Pemex doesn't have the necessary skills to develop the technically challenging deep-water and unconventional reserves. The country needs U.S. oil and oilfield services firms to develop its resources.

Unlike Iraq and Malaysia, Mexico will not offer production sharing contracts, but I believe that even the profit sharing contracts would be a crucial step in the right direction.

Mexican ETF

Mexico's capital markets, which are represented in the iShares MSCI Mexico ETF (NYSEARCA:EWW), reacted negatively to the news. The $2.3 billion ETF has fallen by 5.4% in August. However, the ETF is not a fair indicator of one of the largest non-OPEC oil producing countries. This is because firstly Pemex is not represented in the fund and secondly the ETF is dominated by Consumer Staples and Telecommunication sectors.

So far this year, the ETF has recorded net inflows of $647.8 million, including inflows of $108.23 million in last four weeks. The iShares MSCI Mexico ETF is one of the few emerging market funds out there that could see an adverse impact due to the Federal Reserve's tapering expected to begin in September.

Opportunity for Oilfield Service Industry

Analysts believe that Mexico might only open its doors to the big boys of the industry. While deep-sea experts such as Chevron (NYSE:CVX) and Statoil (NYSE:STO) would be looking for business opportunities in Mexico, the oilfield services firms Schlumberger and Halliburton could be some of the biggest and earliest beneficiaries of the oil reforms. These companies would lay out the groundwork for E&P firms and will not be concerned about the absence of production sharing contracts. Merrill Lynch believes that investors should consider buying the oilfield services stocks that could capitalize on the Mexican oil reforms.

Moreover, the heads of both of these companies (Schlumberger and Halliburton) were already eyeing other opportunities in Mexico. The country has a pipeline of large integrated projects worth $8 billion to $10 billion. Mexico could start awarding these projects in the current year through a series of production incentive bids.

Merrill Lynch has a $106 price target on Schlumberger which shows nearly a 30% upside from its current price levels. Schlumberger was already targeting "double digit" growth due to expected increase in E&P expenditures, particularly in Saudi Arabia, Iraq, China and Australia. With the developments in Mexico, Schlumberger could get more opportunities.

Meanwhile, Halliburton has received a 'conviction buy' from Goldman Sachs with a price target of $63. This also indicates a 30% upside from the current price levels. While Halliburton's previous results were above expectations, its performance in Latin America was not impressive due to shrinking margins. Halliburton's operating income in the region dropped by 7.3% sequentially and 26.8% year-over-year to $101 million in 2Q-2013. This was due to a drop in drilling and lower vessel activity. However, Halliburton is expecting improvements in Latin America the second half of the year which will be driven by its operations in Mexico (with the exception of North Mexico).

Performance Summary

In the last three months, the shares of both of these companies have risen by 8.7% (Schlumberger) and 11.8% (Halliburton), easily outperforming the S&P 500-ETF (NYSEARCA:SPY) which is down 1.2% in the same period. Schlumberger is trading 17.38 times its trailing earnings, which is above the industry's average of 16.22 times. However, Schlumberger is the market leader and generates a healthy return on equity of 17.9%, more than the industry's average of 15%. On the other hand, Halliburton is relatively expensive since it is trading 24.5 times its trailing earnings and generates a lower return on equity of 12.2%.

Conclusion

With regard to oil reforms, investors should note that this is not a short-term process. The oil field services firms might not get anything from Mexico in the next few months. The E&P companies are awaiting further details on the reforms. The secondary laws related to the structure of contracts and taxation policies are expected to be released in late 2013, at best. Schlumberger itself was not looking at a lot of growth from Mexico in the coming months. However, the oilfield services companies have bright long-term prospects in Mexico due to the oil reforms and the pipeline of large integrated projects.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.