Oil Services Group May Stage Robust Rally

by: webscribe

Investors who still believe in the global growth story are finding some compelling opportunities in risk assets in the winter months. Among the glittering gems in the market's discount bin, the oil services group (NYSEARCA:OIH), down 25% since last March, may have the potential to stage a robust rally from the cyclicals fire sale of 2011. Due to the success of hydraulic fracturing and horizontal drilling in the Marcellus Basin, the Bakken and many other shale formations, discourse on the drillers has focused somewhat myopically on the movement from the vertical to the horizontal plane. The introduction of multistage fracking rigs to exploit previously unprofitable shale may be the 'product replacement cycle' of the decade, but other cycles are still at work among exploration and production firms, in energy markets, and deep in the ocean where rust never sleeps. While oil services firms will profit from these cycles over time - and from persistently high crude oil prices - near-term regulatory threats and fierce competition for contracts present risks for some players in this space.

Readers who need a refresher on fracking and horizontal drilling and how these approaches unlock the potential of shale will find comprehensible explanations here.

Tailwinds for the Oil Services Group

In the current environment, a number of strong tailwinds should benefit the oil services industry:

  1. The ongoing, widespread adoption of horizontal drilling and hydraulic fracturing continues to drive demand for newer systems and instrumentation, as well as demand for the horsepower, pipes and fluids consumed in the drilling and completions processes.
  2. Fracking has made extraction from shale reservoirs viable in hundreds of rich fields around the world, and while Canadian and US producers have wasted no time in monetizing these assets, international basins remain largely undeveloped.
  3. For international energy producers looking to tap into shale, the oil services majors are often the only game in town. Companies like Weatherford (NYSE:WFT) and Halliburton (NYSE:HAL) have the technology and expertise to bring well stimulation to parts of the world where the crucial knowledge base and personnel are lacking. The majors' manufacturing scales and facilities in Asia and Africa also enable them to place competitive bids for contracts in China, Argentina, Brazil, New Zealand, and many other countries blessed with productive shale.
  4. Although fracking's principal application is in unconventional oil and gas reservoirs, more producers have begun to use multistage methods for specific purposes in conventional fields.
  5. The accessibility of fracturing rigs in tandem with low natural gas prices has prompted many E&P companies to switch from natural gas to oil. This shift opens up another revenue stream for oilfield equipment and service providers.
  6. Although the reserves realized from unconventional deposits more than offset the much higher cost of horizontal drilling and high pressure injection, these brute force methods consume hardware and pumps more efficiently than vertical extraction. In their Q1 2010 conference call, National Oilwell Varco (NOV) execs. described the working of unconventional shale as "highly drilling and completions intensive." This means that the development of unconventional plays improves the bottom line for both the drillers and the producers.
  7. The average age of a drilling rig in any part of the world is 25 years or right on the cusp of its expected lifespan. As oilfield technology has advanced dramatically since the advent of the Sony Walkman - and as more accessible surface sources are exhausted - E&P firms need to invest in hardware that drills deeper and longer and, increasingly, more complex or highly deviated wells. With respect to the offshore fleet, the Gulf of Mexico spill has drawn attention to aging infrastructure and obsolete systems that stakeholders will eventually be compelled to replace. Finally, crude prices above $90/barrel and recent discoveries at depths of greater than 4,500 ft. mean that deeper and longer also applies to offshore projects in more treacherous environments.
  8. While energy consumption in the US remains depressed by fatigued consumers, international demand continues to support crude futures. And if you believe Jeff Rubin, author of Why Your World Is About to Get a Whole Lot Smaller, North American per capita demand has already become less relevant than the needs of billions of would-be motorists in emerging nations.

Headwinds for the Drillers

  1. High pressure fracturing - also known as hydrofracturing - consumes and produces large quantities of water. Those good folk who care about the earth and the water supply are concerned with both sides of this equation. Given the recent record of the industry vis-à-vis the environment (think BP (BP, Enbridge (NYSE:ENB) in Michigan, and even Japan's nuclear disaster), legislators have proven receptive to objections to fracking, which has never seen such widespread use on US soil. The Frac Act, which empowers the Environmental Protection Agency to regulate fracturing practices, currently awaits a decision from Congress. Meanwhile, New York State has imposed a ban on hydraulic fracturing to enable the Assembly to study the effect of stimulation fluids on the environment and public water sources. Although the drillers may profit from a need for rigs and consumables that meet more stringent environmental controls, state-wide moratoriums pose an immediate threat to companies that sell and lease fracking equipment.
  2. Drillers like Schlumberger (NYSE:SLB) and Baker Hughes (NYSE:BHI) have a long history of responding quickly to technological advances and changes in market conditions. That investors have many options for fracking-related plays at the small and mid-cap level (Complete Production Services (NYSE:CPX), Canyon Services Group (OTC:CYSVF), Precision Drilling (NYSE:PDS)) in addition to the services giants, says something about the competitiveness of this space. Although the fleet of fracturing rigs currently operates near capacity, some oilfield service providers fear that robust manufacturing will lead to an oversupply of rigs. Idle rigs mean lower day-rates and pricing pressure for firms competing for a fraction of the fracturing pie.
  3. Investors can underestimate the impact of economic constraints, and even cultural differences, when technologies and products that succeed on our shores receive a trial in international markets. In a 2010 conference call, Schlumberger CEO Andrew Gould minced no words about the future of fracking in international shale. According to Gould, the lack of infrastructure and environmental controls in many nations with probable shale reserves precludes the adoption of fracking in international basins on the same scale as witnessed in the US.
  4. Duct tape works wonders for aging rigs - particularly in countries with 'generous' environmental policies and even more generous safety regulations. Elsewhere, it's easier to convince a board of directors to pay for Tylenol to manage operators' migraines than to get the green light for a new drilling rig. Remember when we were all so excited about our crumbling domestic infrastructure that we all knew just had to be replaced? Since then, a dozen bridges have collapsed under our feet, and governments still have other priorities.
  5. Like most newly adopted technologies, the practice of hydraulic fracturing carries within it the seeds of its own demise. The more shale we exploit, the more natural gas we produce, which leads to lower realized prices and netbacks for producers. Oil services companies could feel the squeeze if E & P players scale back on planned projects to expand production in international shale.

With the domestic rig count now approaching the heady levels of 2008, oil services firms will benefit from demand for blow-out preventers, larger diameter pipe, and inspection and maintenance services. However, at this point in the cycle, renewed activity in international markets - where companies are slower to revise their forecasts for energy prices - typically begins to outpace the domestic recovery. Diversified players in the services group with exposure to international shale, as well as conventional deposits, offer investors a way to participate in the current drilling boom.

Disclosure: I am long NOV.