By Stephen Ellis
We remain concerned about the health of the oil services industry. While guar prices have declined to around $10-$12 per kilogram from peak prices of around $25 per kilogram, the industry still needs to overcome weak natural gas and natural gas liquids pricing. This situation is driving continued gas-to-oil rig switching (previously dry gas-to-oil, now wet gas-to-oil) and pressure-pumping oversupply, as well as the associated cost inefficiencies. On the international side of the coin, we expect slowing demand for oil from China and Europe to boost the overall global oil supply cushion, putting further pressure on oil prices and limiting appetites for initiating new drilling projects.
However, we still like the long-term prospects for the industry, as the incremental barrel is increasingly coming from the services-intensive offshore reservoirs. Oil and gas producers also are sanctioning new efforts to boost recovery rates at old and mature fields. We believe the market is currently pricing in a weak 2013. However, as market expectations shift toward 2014 in the next six to nine months, taking into account the temporary nature of many of the industry's headwinds, we think both fundamentals and market sentiment will shift to the positive.
As the largest pressure-pumper in North America, Halliburton's (HAL) outlook is challenging. Not only is the company the most exposed to region-specific issues, but it will be challenged by stagnant growth in the overseas rig count. But at around $30 per share, we believe Halliburton stands as an opportunity to purchase the best-in-class North American oil services franchise at a discount because pessimistic near-term concerns are outweighing the more attractive fundamental long-term outlook. We don't deny that there could be more downside, but North American players such as Halliburton offer the greatest amount of upside over the next 12-18 months as North American trends turn positive from negative. Any sign of stabilization or improvement in the oil services end markets likely will lead to substantial revaluation toward our $50 fair value estimate.
Guar: A Sticky Issue
The list of the challenges the industry faces in the next two years is long, but at least the guar issue should be short term as we believe its pricing inflation is unsustainable. What is guar you ask? That's a fair question. Oil services firms use it to help carry proppant downhole and place it in fractures. Guar prices soared during the last 18 months to $25.00 per kilogram from $1.50. In fact, current official pricing for guar is unavailable as regulators in India (the source of 80% of the world's guar) have halted trading in guar gum on its futures exchanges from March until September while they investigate possible illegal manipulation of the commodity. Earlier, regulators had raised margin limits, lowered position limits, and suspended traders to no avail as guar prices continued to increase. The Forward Market Commission has submitted a report to the Ministry of Consumer Affairs, indicating that nearly 5,000 entities were found involved in price manipulation, apparently acquiring guar gum under various fake names and effectively cornering the market.
However, a substantially larger guar crop harvest in October and November should put downward pressure on prices, and the potential margin uplift for the oil services industry could be significant. For example, we calculate that guar costs went from around 1% of an Eagle Ford fracturing cost in 2011 to around 28% in 2012, or from about $36,000 per well to around $730,000 per well. Pressure pumpers were caught off guard by the rapid rise in guar prices and they were unable to immediately pass along any cost increases to customers. Guar substitutes were not available, although the industry is now rapidly sourcing alternatives. Halliburton, in an effort to avoid shortages, recently increased its guar inventory to around three to four months from one month at around peak pricing of $25 per kilogram, by our estimates. It may take a quarter or two for this high-cost inventory to flow through the income statement, thus pressuring margins.
And Some More Bad News ...
The very positive effects of a guar price collapse may be largely offset by continued weakness in the pressure-pumping market and gas rig count, and Halliburton will be negatively affected by these North American dynamics in 2012-13. Natural gas liquids pricing, particularly ethane pricing, has dropped to under $0.30 a gallon recently from around $0.60 a gallon in early 2011. This could drive more gas rigs to be laid down with additional capacity shifted to oil-rich plays, exacerbating the current oversupply issues. The ethane weakness also hurts the cash flows of certain gas-focused exploration and production firms, which could lead to capital spending reductions and a lower demand for services.
And given the well-known challenges in Europe and slowing growth in China, oil demand and prices could decline substantially. Now, international and national oil companies will continue to invest with a long-term mindset, meaning projects currently underway are unlikely to be effected, but those yet to be sanctioned likely will be delayed as the companies seek to take advantage of lower costs, like we saw in 2009. In this situation, the oil services industry, which is currently still seeing competitive pricing on standard tenders even as the market has improved during the last year, likely would lose considerable bargaining leverage.
Looking Up in the Long Run
Despite our more pessimistic outlook on the industry for the next few years, we still view it as attractive in the long term. The North American market will remain cyclical, but it has structurally improved over time. We still think long-term operating margins for the industry in the attractive 20%-range are very achievable. For example, a few years ago, the industry typically moved services pricing in lock step across all basins, ignoring the underlying economics of the reservoirs for E&Ps, which caused rigs to be laid down to the industry’s detriment. Contracts were on a well-to-well basis, and E&Ps typically cut the services firm loose at the first sign of trouble. Today, the step-up in services intensity and expertise required to properly exploit the new tight oil reservoirs requires a closer working relationship and a fully integrated services offering to maximize any cost-efficiencies and well productivity. Contracts tend to be longer term in nature, to the point where most capacity for the Big 4-- Schlumberger (SLB), Baker-Hughes (BHI), Weatherford (WFT), and Halliburton--is under contract for 2012. Services pricing is now typically adjusted on a reservoir-specific basis to keep services profitability at a reasonable level.
A shift toward a more technology-driven solution in North America still benefits the largest services companies that can spend the most on research and development and continuously bring new technologies to the field, such as Schlumberger's HiWAY technology. The brute-force approach, which required more equipment, fracs, and people in demanding tight oil plays, has been very beneficial for the oil services industry--but that reservoir has largely been tapped. Efforts now are being directed toward more intelligent well design, and Halliburton already has a leadership role here with its "frac of the future" initiative that envisions substantial well-site efficiency improvements by 2013 to further strengthen its low-cost position in North America. Halliburton is attempting to lower costs by cutting the level of capital expenditures per well site by 20% and by reducing both the onsite crews and the time required to complete a well by 25%. Alternatively, Schlumberger is simply letting a third party furnish the pressure-pumping equipment while it provides the technology, such as its HiWAY efforts. The increased wear and tear on today's fracturing equipment means that up to 20%-30% of the equipment fails and needs to be replaced annually, which leads us to believe that any halt in capacity additions will quickly tighten the market, and North America will rebound again.
Outside of North America, the oil services sector still benefits from a number of attractive secular trends in terms of oil and gas companies exploiting more services-intensive offshore reservoirs and increasing their efforts to boost recovery rates at old and mature fields. National oil companies may control the majority of the world's reserves, but they still need considerable services expertise to extract the oil and gas in the most productive and cost-efficient manner possible while not damaging the reservoirs' long-term ability to produce. International shale opportunities in Europe, China, and South America are substantial. While ExxonMobil's (XOM) decision to scale back on its ambitions in Poland is a short-term negative, the vast amount of reserves ensures that the services industry will benefit once the infrastructure, regulatory, and technology-related challenges are resolved. In addition, plans by Mexico, Iraq, Brazil, and Venezuela to substantially increase production in the next decade are all healthy demand indicators for the services industry.
Tap Into Halliburton
Halliburton is the industry's best operator in North America, and we consider its low-cost and highly efficient model as differentiated and hard to duplicate. The firm has typically delivered the industry's best margins in the region and its integrated solution has helped the firm steal significant share from both large and small peers. For example, Halliburton's production testing and specialty chemicals businesses have outgrown the respective markets by a 13% and 17% compound annual growth rate during the last five years. In addition, the company's integrated model creates real switching costs for customers that will lose out on productivity gains if they try to use more third-party oil services providers. Unsurprisingly, we estimate around 60% of the wells Halliburton drilled at the end of 2011 use its fully integrated drilling solution. We believe some investors continue to prefer Schlumberger for its wide-moat attributes while not fully appreciating the strength in Halliburton's more narrowly focused business model.
While we expect a difficult 2012 and 2013, we consider the overall oil services industry an attractive one with secular growth prospects, whereas investors seem to be assuming current headwinds will persist into perpetuity. We do not think that is the case and consider Halliburton to be the most attractive oil services idea. We expect North American margins to compress into 2013 but that Halliburton will generate $6.0 billion in EBITDA (earnings before interest, taxes, depreciation, and amortization) next year. Our $50 per share fair value estimate implies an 8 times forward EBITDA multiple. For comparison purposes, Halliburton generated EBITDA of $4.7 billion in 2008, $2.9 billion in 2009, $4.1 billion in 2010, and $6.1 billion in 2011. We estimate about $6.3 billion for 2012.
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