Seeking Alpha
Deep value, special situations
Profile| Send Message|
( followers)  

Oil Service Sector Overpriced, Shale Boom Changed

Oil service sector valuations, such as Halliburton (NYSE:HAL), Schlumberger (NYSE:SLB), and Baker Hughes (NYSE:BHI) are looking similar to 2010, when earnings rose dramatically. Earnings came from North America's newly realized oil shale boom. Starting in 2009 and heading into early 2011, markets appreciated from a steep decline, and oil equities were in better fashion due to U.S. shale prospects. 2009 through the first half of 2011 also saw Fed QE2 create a balance sheet of nearly $3T.

Now, many similarities exist with a Fed balance sheet approaching $4T and markets in considerable appreciation. Oil service companies are certainly witnessing 2010-type value increases. What isn't similar, however, is a changed and more defined oil shale industry in North America, leading to market concentration risk. Currently, revenue growth doesn't outpace costs and earnings are in decline due to such dynamics. Still, the sector's valuation multiples increase, which creates an irrational situation. Good cause existed for value increases in the 2010 to 2011 period. Now, transition and transformation is needed to correct sector imbalances.

Nature of 2009 to 2010 Value Increase

2009 U.S. crude oil production increased 7% vs. flat 2008 and 2007 numbers. By 2012, U.S. oil production reached its highest rate in 15 years, increasing 16%, or 779,000 barrels per day (bpd), totaling 6.5M bpd. Rig count in 2010 increased over 600. The big three oil service companies SLB, HAL, and BHI sold tools, pressure pumping, completion services, and fluid products into market expansion.

Share performance of these companies reflect market expansion from 2009 to 2010. HAL's stock increased 67% in 2009 and 37% in 2010. SLB grew 55% and 30% and BHI stock advanced 28% and 43%, respectively, over the same period. P/E ratios went from 8.4 for HAL in 2008 to 23.5 in 2009 and 20.7 for 2010. SLB was essentially similar, but BHI had higher P/E multiples at 30 in 2009 and 28 in 2010. S&P 500 had a P/E of 15.5 in 2009 and 15 in 2010.

2010 to 2011: Value Came From Revenue and Earnings

The driving performance of these companies was increasing revenues. HAL saw revenue go from $14.7B in 2009 to $17.9B in 2010, an increase of 23%, against cost of revenue (COR) increasing only 18%. Net income rose 60% against 2009 declines. SLB saw a 26% increase in revenue, a 23% increase in COR, and a 36% increase in income. BHI came off a lousy 2009 to increase revenue 49%, COR 51%, and income 93%.

HAL acquired Boots & Coots in 2010 for $240M, expanding the company's intervention and pressure control lines. Assets for HAL increased only 11% in 2010. BHI entered the pressure pumping market by purchasing BJ Services Company for $5.5B, which accounts for its numerical jump. BHI assets increased 100%. SLB acquired competitor Smith International, Inc. in an $11B all-stock transaction and assets grew 57%.

Shale plays in North America and market consolidation account for high multiples and earnings. HAL's North American revenue increased 46% in 2010 and made up 48% of its total revenue. SLB demonstrated more diverse results, with North America growing 20%, but made up only 18% of total revenue. Deepest reliance on North America was BHI with its North American revenue increasing 117%, while accounting for 44% of total revenue.

2012 Carry Over of Pricing Weakness and Weak Company Performance

Slowing U.S. rig servicing became obvious in 2012. The gas rig count opened 2012 at 811, and by December closed the year at 431. 2012's total rig count stood at 1,806, falling from 2,000 in 2011. Now, the total rig count is down 52 rigs in U.S. at 1,754. For North America (including Canada), rigs are down 44 at 2132. Gas rigs are down 48 at 365.

In 2012, HAL's income decreased 7% and BHI's income fell 25%. Both companies had North American revenue exposure of nearly half, or exceeding half, of their total revenue. Though income declined for these companies, revenue increased but COR grew faster. For HAL in 2012, revenue grew 15% and COR increased 22%. BHI's revenue, in the same period, increased 8%, but COR rose at 14%.

SLB, however, saw 2012 net income grow 10%, when revenue grew 7% against a slower 5% increase in COR. SLB had a North American revenue exposure of only 33%. Stock prices for these companies in 2012 faltered. SLB increased most at 3.6%, HAL was up 1.5%, and BHI fell 15% after a 2011 decline of 14%.

2013 Company Underperformance and Concentration Risk in North America

Currently, HAL's stock is up 53% and is trading at 15 times EBITDA. Revenue for HAL, on a trailing 12 months (TTM) basis is up only 1.9% vs. a rise in COR of 4.14%, explaining a decline in net income of 24%. BHI's stock is up 43% and income down 19%, with the same dynamic of revenue growing slower than COR.

Contrasting HAL and BHI with SLB this year, SLB's stock is up 37%. But, unlike the others, SLB's income is up 17% TTM, with revenue up 9% and COR up only 6%. Reason for SLB's earnings performance is what it doesn't have in common with the others: diverse sources of revenue and better control of COR. In the nine months ending Sept. 30, HAL's North American revenue exposure was 52% at $11B and down 7% year over year. BHI's exposure is 49% at $8B and down 2%. SLB's North American exposure is 31% and up 1.4%.

HAL's last conference call reported 20% overcapacity in the North American pressure pumping market, with continued pricing pressure extending from 2012. BHI's investor presentation noted that the North American rig count was down 11%, and well count was down 4%. Also generally mentioned has been a move in North America to multi-well pads and increasing frac stages. Still, revenue and earnings numbers for those most heavily concentrated in North America have shown a downtrend for some time.

View on 2014 Sector Prospects

Increases in Gulf of Mexico (GOM) production shows potential, but as a piece of the pie for North America it's very small, though it does have wider margins. Currently, GOM rigs are at 56 vs. last year's 47. International rig counts pale in comparison with North American counts. For instance, Latin America's count is 420, Europe/Africa is 267, Middle East/Asia-Pacific is 628. The U.S./Canada compose bulk of rig count at 2,132.

Essentially, for a dramatic increase in sector earnings to reoccur, something unique needs to develop -- something similar to North America's technological boom that created a shale boom. The transformation of Mexico's oil industry faces significant opposition. Europe generally expresses opposition to fracking, and the Middle East has water supply issues.

Source: Oil Service Sector In Decline: Halliburton, Baker Hughes, Schlumberger, And Concentration Risk