Each earnings season, we look forward to poring over quarterly results from the big four oil-field services companies - Schlumberger (NYSE: SLB), Halliburton (NYSE: HAL), Baker Hughes (NYSE: BHI) and Weatherford International (NYSE: WFT).
Part of this anticipation reflects our bullish outlook for the industry, which stands to benefit over the long term from the end of easy oil - an important secular trend that's one of the founding precepts of Energy & Income Advisor.
For the uninitiated, this thesis holds that declining production from the world's major oil fields has forced the industry to pursue deepwater developments and other complex, expensive-to-produce plays that require higher levels of service intensity. (See Going Long: The End of Easy Oil.)
The big four's conference calls to discuss quarterly earnings - particularly the wide-ranging calls hosted by Schlumberger, the world's largest oil-field services company - provide invaluable insights into other aspects of the energy patch.
In the past, closely listening to Schlumberger's quarterly conference calls has helped us to profit from rapidly improving margins in the marine-seismic services segment in 2010 and to avoid much of the fallout from the collapse in pressure-pumping prices that occurred in 2012. More recently, trends identified by the major oil-field services firms prompted our bullish stance on proppant producers, US Silica (NYSE: SLCA) and Hi-Crush Partners LP (NYSE: HCLP).
The read-through from Schlumberger and the other major oil-field services companies' earnings reports and subsequent conference calls are particularly useful because they occur before many other energy-related names announce quarterly results.
Schlumberger and Baker Hughes reported third-quarter results on Oct. 18, while Halliburton released earnings and hosted its conference call on Oct. 21. Weatherford International won't issue its results until Nov. 4.
We also delve into results and management comments from Core Laboratories (NYSE: CLB), which specializes in reservoir description and production enhancement. The company's quarterly conference calls have become must-listen events because of management's forthright commentary on exploration and production trends in US shale oil and gas plays.
Let's highlight the key takeaways from these results and management teams' commentaries and their investment implications.
1. North America
- Pressure-Pumping Prices under Pressure: Pressure-pumping prices continue to decline in North America, albeit at a slower pace. Improving drilling efficiency has ensured that excess capacity in this market should continue to hover around 20 percent. This supply overhang would be alleviated if drilling activity were to recover in basins that primarily produce natural gas, but investors shouldn't expect the price of this commodity to rally over the next two to three years.
- Focus on Costs: The three largest oil-field service companies continue to focus on reducing costs to drive profit margins. Baker Hughes has placed an emphasis on converting a higher percentage of its pressure-pumping fleet to 24-hour operations and improving its supply chain. Halliburton's Battle Red initiative seeks to standardize workflows across product lines and to better manage inventory levels and optimize deliveries to well sites. And the company's Frac of the Future program aims to reduce head count and maintenance expense through process automation and an overhaul of its pressure-pumping fleet. Schlumberger unveiled a similar plan to reduce unexpected downtime and the cost of maintaining its pressure-pumping fleet. But unlike Halliburton's rig replacement program, Schlumberger's initiative doesn't involve significant capital expendituresthe firm re-engineered the consumable part of its hydraulic fracturing pump and is upgrading its fleet on its regular maintenance schedule.
- Increasing Service Intensity Onshore: Despite the headwinds in the pressure-pumping market, the industry's heavyweights continue to benefit from the increasing service intensity of shale oil and gas plays, especially the trend toward longer laterals and tighter spacing of fracturing stages. Core Laboratories' management team estimates that although the number of horizontal wells drilled in North America declined in the third quarter, the average length drilled increased by 9 percent. The company expects the number of fracturing stages per well to increase by 10 percent to 15 percent this year. These developments, coupled with efforts to optimize rig efficiency, have helped to bolster profit margins and to offset some of the challenges in the pressure-pumping space.
- Push for Efficiency in Completions: Core Laboratories' CEO indicated that if drilling has become 20 percent more efficient, the completion process (hydraulic fracturing) has improved by about 7 percent to 9 percent. In coming quarters, expect oil-field services firms to focus on process and technological innovations that drive more effective completions and reduce the time and expense associated with this process. The diversionary pill that Schlumberger highlighted during its call would be one example of these efforts.
- Accelerating Activity in Gulf of Mexico: Management teams remain bullish in their outlook for the deepwater Gulf of Mexico, where the number of deployed rigs is expected to increase from about 30 at the beginning of 2013 to almost 50 by the end of 2014. This influx of new deepwater rigs represents a significant amount of high-margin work.
- Consensus Outlook for E&P Spending: Baker Hughes and Halliburton's management teams confirmed the consensus forecast that spending on exploration and production in international markets would increase by 10 percent in 2014 - a solid rate of expansion. Much of these capital expenditures will be related to deepwater projects.
- Near-Term Headwinds in Latin America: The near-term outlook for oil-field services in Mexico remains challenging, with some companies still suffering pinched margins after funding issues prompted Petroleos Mexicanos (Pemex) to halt activity in the Chicontepec field. That being said, the three largest oil-field service companies expect Mexico to become an important growth market in the back half of 2014, when several so-called mega tenders will start up. Efforts to reform Mexico's energy industry and make the country more welcoming to international operators could also help to stimulate exploration and development activity. Meanwhile, the consensus outlook for drilling activity in Brazil - the world's largest deepwater market - remains muted, as Petroleo Brasileiro (Sao Paulo: PETR4, NYSE: PBR) shifts its focus to well completions.
- Top Growth Markets for 2014: Management teams highlighted Africa's east coast as a highly active market in 2014, along with Russia, China and the Middle East.
- Deepwater Remains Key Driver: With about 98 new deepwater and ultra-deepwater floaters and drillships slated for delivery in coming years, the outlook for these service-intensive plays appears sanguine and should support additional upside for the space.
- No Inflection Point on Pricing: Management teams reiterated that although the international market has strengthened, the tendering process remains competitive and the supply-demand balance hasn't yet reached levels where the industry enjoys significant pricing power. Baker Hughes, Halliburton and Schlumberger's management teams reiterated that execution and technological innovation will be critical to pushing prices in this environment.
3. Investment Implications
Within the oil-field services patch, Schlumberger and Weatherford International remain the stocks to own heading into 2014:
- Schlumberger's limited exposure to the North American pressure-pumping market and industry-leading presence in the Gulf of Mexico bode well for the coming quarters. Meanwhile, the firm's superior exposure to accelerating activity in international markets sets it apart from its peers. Schlumberger was also the first of the diversified oil-field services firms to establish a foothold in China via its stake in Anton Oilfield Services and recently inked a promising joint venture with equipment manufacturer Cameron International Corp (NYSE: CAM). The stock could also receive a boost once Forest Oil Corp (NYSE: FST) reports results related to its production-sharing agreement with Schlumberger.
- Weatherford International has built a strong franchise in artificial lift and other products and services that enhance production from mature oil plays - a market that's expected to boom as output from the world's major oil plays continues to decline. These production enhancers are used almost exclusively in oil-bearing fields, providing a degree of protection against weakness in the domestic market for natural gas. We also like Weatherford International's limited exposure to the US pressure-pumping market, which has rapidly shifted from an undersupply to an oversupply. The company's third-quarter results should also benefit from strong activity in Canada.
We maintain our hold ratings on Baker Hughes and Halliburton:
- Baker Hughes posted a surprisingly strong second quarter, delivering impressive margin growth in North America. Of the four major oil-field service firms, Baker Hughes has the most opportunity to eke additional efficiencies out of its US operations. For example, only 50 percent of the company's pressure-pumping fleets are capable of operating on a 24-hour cycle. Whether Baker Hughes can take advantage of these opportunities remains to be seen - execution has become an issue in recent quarters.
- Halliburton posted somewhat disappointing third-quarter results, with its North American operations suffering from flood-related disruptions in Colorado, where the company is the leading service provider in the Niobrara Shale. Management indicated that these disruptions have continued into the fourth quarter and guided for further weakness in its Latin American operations. Halliburton could see additional downside in the US, as a number of its pressure-pumping contracts expire in the final three months of the year. If the firm is able to renew these service agreements - competition in this space is cutthroat - the prices will likely be lower. On the other side of the coin, we're impressed by Halliburton's Frac of the Future and Battle Red initiatives, which aim to deliver significant cost reductions in coming quarters. Management indicated that the firm's Nov. 5 Analyst Day would include updated guidance for these cost-saving programs and the introduction of exciting new technologies. We prefer names with more exposure to international markets.
Exploration and production companies continue to benefit from efficiency gains and lower costs:
- Oasis Petroleum (NYSE: OAS) has delivered impressive output growth and reduced its costs significantly over the past several quarters. The stock has rallied beyond our buy target and could be at risk of a pullback after the firm reports third quarter earnings.
- Noble Energy (NYSE: NBL), a leading operator in the Niobrara Shale (see Niobrara Shale Comes into Its Own), stands to benefit from the same trends and perhaps offers more upside over the long term, as that play is in the earlier stages of development. Roger Conrad and I will highlight our favorite North American oil and gas producers in a free webinar on Nov. 21.
Demand for silica sand to strengthen:
- The inroads made by horizontal drilling in conventional plays and trend toward longer laterals and tighter spacing between fracturing stages add up to rising consumption of the silica sand produced by US Silica and Aggressive Portfolio holding Hi-Crush Partners. That being said, the share prices of these stocks have run up considerably over the past several weeks. Investors should consider taking some profits off the table before these names report third-quarter results.