Between weak rig counts and rampant competition in some parts of the well servicing business, 2013 has been a big disappointment. Things have been turning up recently, though, as E&P spending budgets for 2014 are looking promising and investors are counting on pent-up demand leading to better results. Given the demands of horizontal wells, Key Energy Services (NYSE:KEG) has reason to expect better days.
I was bullish on Basic Energy Services (NYSE:BAS) back in October, and the stock is up more than 20% since then. At this point, I feel like BAS versus KEG is more of a "pick 'em". I think Key Energy is a better company, but it seems that the Street thinks so too and the valuation is a little higher on these shares. Although Key Energy shares appear to be priced to generate a decent return on moderate expectations for 2014, investors have to be willing to accept the risk that 2014 is another disappointing year in the oilfields of the U.S. and Mexico.
A Quick Overview
Key Energy is one of the largest well servicing companies in the U.S. Key operates a fleet of approximately 800 rigs in its Rig Services unit that provide a range of maintenance, workover, and recompletion services to E&P companies. Key Energy designs and builds its own rigs, and has a range of rigs across various horsepower and specification categories.
Key is the largest provider of these services, with approximately 20% share - ahead of Nabors (NYSE:NBR) at 14%, Superior (NYSE:SPN) at 6%, and Basic Energy at 6%. The primary markets for Key's Rig Services unit are the oil-rich Permian and California markets, the former being a highly competitive market for service companies.
More than 40% of Key Energy's revenue comes from Rig Services, and another 20% comes from Fluid Management - a business that involves hauling, storing, and managing water, drilling fluids, and waste products. Key, Basic Energy, Nabors, and Superior all have sizable truck and tank fleets, but there are minimal barriers to entry in this business for now. Looking ahead, there may be more of a premium on value-added services like recycling, particularly as pollution from drilling sites has generated a lot of negative attention.
Coiled tubing is the next-largest business for Key, and it operates nearly 50 units. Key is a small player in this market (about 4% share), particularly as the Big Three (Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL), and Baker Hughes (BHI)) account for nearly 50% of the market. This is also a focused business for Key Energy, as about half of its segment sales come from the Eagle Ford region.
Fishing and tool rental makes up the remainder of the company's U.S. operations, where it is a small player (3% share) focused on the Eagle Ford and Permian regions.
Horizontal Wells Will Need More Work
Horizontal wells, which have become the norm in areas like the Permian, Eagle Ford, and Bakken, offer considerably more revenue potential to Key Energy than vertical wells. Many of the horizontal wells drilled in unconventional shales have seen steep decline rates and that should mean more workover work.
According to Barclays, the number of wells that are in the "2 to 4 years old" category will increase by 30% in 2014 and that is typically the point where workovers come into play. It's also important to note that many oil wells drilled in recent years have needed artificial lift relatively early on in life and the use of rod-lift systems is hard on the well, leading to maintenance requirements every six to 18 months (as opposed to less than once a year for gas wells using pump systems).
Mexico Has To Get Better, Right?
Key Energy spent a fair bit of time, energy, and money scaling up its operations in Mexico in 2011 and 2012 only to run head-first into a wall. Pemex badly needs to run a sizable number of well interventions, but activity in Mexico was held up for most of 2013 by uncertainties around new energy legislation. In particular, Key Energy saw significant curtailments in northern Mexico through the year.
Management reallocated some resources and crews, but has kept a presence in northern Mexico on the expectation of a turnaround. Conditions for 2014 are still pretty murky, but the regulatory / legislative uncertainty has decreased and those badly-needed interventions should get underway. With that, Key Energy should see significantly better demand for its 40 rigs and better margins.
Keep An Eye On Pricing
Maybe it goes without saying, but the prevailing price of oil and natural gas has a definite impact on Key Energy's business. As gas prices plunged, Key reoriented its fleet towards more oil-rich services and plays and oil is more than 80% of the business today.
It would take a significant fall in oil to really curtail drilling in key areas like the Permian and Eagle Ford, but the impact on the workover business may be more sensitive. If a well is already marginal and the operator is not confident about the direction of oil prices, I can see them delaying the intervention work. That will likely only increase the eventual amount of work Key will need to do for them, but it would still be damaging to the share price in the short term.
The Bottom Line
If I gave Key Energy the same 5x multiple to forward EBTIDA that I give Basic Energy, the shares would not look like any particular bargain today. Given the company's larger market share in higher-value services like workovers, though, I'm inclined to goose that multiple a bit to 5.5x. Keep in mind, though, that these stocks can trade at high single-digit and sometimes low-teens multiples when activity levels are really running. If 2014 turns out to be a good year, both the multiple and EBTIDA estimate could prove conservative.
At 5.5x next year's current sell-side 2014 EBTIDA estimate, Key Energy is worth about $8.50 a share. That's okay, particularly for investors who have a bullish leaning toward oilfield activity in North America in the coming year. While I would like to see a little less enthusiasm on these shares from the sell-side (this is a popular rebound pick for 2014), Key still looks like a name with upside leverage to a better year for the energy sector.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.