The Coming Boom in Oil Service

by: Bruce Vanderveen

SpindletopWith a deafening roar the greenish black gunk spewed 150 feet into the air, drenching men and machinery alike. Welcome to east Texas in 1901. The Spindletop oil discovery produced some 100,000 barrels/day (they expected 5), more oil than anyone knew what to do with at that time. The gusher heralded the start of the great east Texas oil boom. By 1903 the price of a barrel of oil was 3 cents.

But 1901 is so very long ago. Oil is now $80/barrel, gasoline $2.80/gallon, and both are heading up. A voracious, continually growing, worldwide fleet of 600 million plus vehicles, each suck up their quota every day with no end in sight. Oil companies drill through miles of rock and salt, often under thousands of feet of sea water, all doing so in a desperate attempt to find more of the elusive black stuff.

Now, in 2009, the easy pickings are mostly gone. Salt domes like Spindletop are tapped dry (Spindletop itself quit producing in the 1930's). Lots of hydrocarbons remain in the earth, but they are increasingly difficult to extract. Consider:

The U.S. (lower 48):
Texas produces more oil than any other U.S. state but production peaked at 3.5 million barrels/day in the early 1970's. Now, Texas production is below 1 million barrels/day and steadily dropping. With the exception of North Dakota and the Gulf of Mexico, the same is true for the rest of the U.S.

Alaska: Prudhoe Bay, the largest oil field in North America, has produced some 13 billion barrels since 1977. BP plc estimated that as of August 2006 only some 2 billion barrels of recoverable oil was left in Prudhoe Bay.

Canada: Canada is the U.S.'s largest oil supplier. I covered Canadian oil production in a previous SA article. It covered the same scenario: conventional oil production is in decline. Potential exists in oil sands and shale, but environmental issues cloud the promise.

Mexico: The woes of Cantarell, one time the second fastest producing oil field in the world (behind Saudi Arabia's Ghawar), are legendary. Production peaked at 2.1 million barrels/day in 2003, and by 2009 it was at 774 thousand barrels/day and falling rapidly. Schlumberger (NYSE:SLB) is now working with Pemex to slow the decline in Mexican production.

An interesting aside: It is thought that Cantarell exists only because of an asteroid strike some 65 million years ago (the same one that wiped out the dinosaurs). The strike created a large rubble field deep in the earth with good porosity in which oil collected.

The North Sea: North Sea oil production peaked in 1999 and A Wall Street Journal article on January 13, 2010, said about North Sea fields:

... oil and gas fields are in steep decline and nearing the end of their production lives.

The Middle East: The Middle East, especially Saudi Arabia, is somewhat of an unknown. The Saudis, currently pumping 8 million barrels per day, claim to have 4 million barrels per day of spare capacity. But, can you believe the notoriously secretive kingdom? Even assuming the Saudis are right, a worldwide economic resurgence could easily absorb this extra capacity. Ghawar, Saudi Arabia's, and the world's, largest oil field, needs increasingly large water injections to keep the oil flowing. Among other Middle Eastern states only Iraq may be able to ramp up production (and then only if it is able to keep the violence under control).

There is always the risk of geopolitical issues flaring up in the Middle East. Currently, things are relatively calm, and we have $80/barrel oil. Iranian Shiites have aspirations on Sunni oil, Al Qaeda is still around, and Israeli/Arab issues go unresolved. If any of the above flare up you can say goodbye to $80 oil - I don't need to tell you which direction it will go.

Elsewhere: Brazil, Russia, Africa, Indonesia, Venezuela are all large oil producers. All, except Brazil, have plateauing or declining production and/or exports. Several large off shore fields have been discovered in Brazil recently, but they are miles deep in the ocean, under salt and rock.

Throw a worldwide money printing binge into the mix, as governments try to inflate away their debts, and it seems certain the dollar denominated assets such as oil must rise.

This article is not meant to prove or even argue peak oil. Rather, the point is no matter what or who is right about peak oil, it will take more and more effort (read oil service) to keep oil flowing.

The oil services sector supplies the expertise that supports the massive worldwide infrastructure continually turning raw petroleum into useful products, such as the gasoline you put into your car. Whether it be horizontal shale, deep sea basins, getting more out of older fields, transportation or refining, none of it would happen without the oil services sector.

Oil Service Companies

Schlumberger (SLB) is a dominant player, and with a market capitalization of over $75 billion, it dwarfs competitors such as Haliburton (NYSE:HAL) and Baker Hughes (NYSE:BHI). Schlumberger is a quality leader in almost all aspects of the oil service industry. Recent acquisitions of Smith International (SII) and Nexus Geosciences enhance expertise in drilling and seismic services. If you were to pick just one, Schlumberger would probably be the best choice.

Transocean (NYSE:RIG) and Diamond Offshore (NYSE:DO) specialize in offshore contract drilling, while National Oilwell Varco (NYSE:NOV) is more a "nuts and bolts" type company, designing, manufacturing and selling products used for the production and transportation of petrochemicals.

Exchange Traded Funds (ETFs)

If you wish to avoid corporate risk consider oil service ETFs. Three of the larger ones are: iShares Dow Jones US Oil Equipment Index ETF (NYSEARCA:IEZ), Oil Services HOLDRs (NYSEARCA:OIH), SPDR S&P Oil and Gas Equipment Services ETF (NYSEARCA:XES).

iShares Dow Jones US Oil Equipment Index ETF

IEZ has holdings in over 40 companies and is market-cap weighted. The three largest holdings: Schlumberger, Haliburton, and National Oilwell Varco comprise almost 40% of capitalization.

Since holdings are weighed by market capitalization, IEZ keeps most of your investment in the the larger, high quality companies, yet still gives some exposure to the smaller ones.

IEZ has a market cap. of $407 million and an expense ratio of .47%.

Oil Services HOLDRs

Like IEZ, OIH is concentrated in the larger oil service area. Transocean is the top holding at 15%. There are only 16 securities in this ETF. The three largest: Transocean, Schlumberger and Haliburton total around 35% of holdings.

If you are considering investing in OIH you should be aware of the unusual features of the HOLDR Merrill Lynch products. Here is a good article on how they differ from most ETFs. Since you can only invest in round lots of OIH, you will need a minimum of $12,100 more or less at current prices to invest.

OIH has a market cap. of $2.28 billion and an expense ratio of .06%. The expense ratio is low because of the unique way that it is calculated (see the above article link for an explanation).

SPDR S&P Oil and Gas Equipment Services ETF

This oil and gas equipment and services ETF holds 24 securities, but no one security comprises more than 5-6% of holdings. Smith International is currently the largest holding. Although XES has many of the same companies as IEZ and OIH, there is a greater weighting of smaller to midsize companies in XES.

XES has a market cap. of $342 million and an expense ratio of .35%.

A Cautionary Note:

If you believe a double dip recession, crash, or even signifigant market decline are on the horizon, you may wish to stay away from this volatile sector. The sector shows even more volatility than oil prices do.

Disclosure: Author long XES