I have been bearish on the global economy for several years now. I fancy myself as an expert on cyclical businesses, including oil and gas. Over the past few years, prices have been buoyed by OPEC supply cuts. At some point, oil prices and the prospects of oil services names like Schlumberger (SLB) may coincide with the economy. That moment may now have arrived.
North America May Have Peaked
North America land drilling has been white-hot over past few years. The sector had been dominated by Halliburton (HAL), Baker Hughes, a GE company (BHGE) and Weatherford International (OTCPK:WFTIF). In an apparent chess move, Schlumberger acquired Weatherford's (WFT) U.S. pressure pumping assets in early 2018. Weatherford had been struggling financially and needed capital. Schlumberger coveted more market share in North America. The company now receives about 35% of total revenue from the region, up from 27% two years earlier.
I assumed Schlumberger was late to the party. In December, the company rang the alarm on North America; management warned a decline in fracking activity could cause customers to retrench. Schlumberger's Q1 2019 revenue in the region fell 3% Q/Q. This followed a double-digit decline in Q4. A decline in activity and fall-off in pricing power for hydraulic fracking and drilling-related activities created headwinds.
These headwinds could persist given the sharp drop in oil prices. Brent oil is in the low $60 range. It was over $70 just last month. Fears over global growth have hurt oil prices. I believe these fears are warranted. Despite trillions in government stimulus, growth in personal consumption expenditures ("PCE") have undershot the Fed's 2% target for the past few months. The Fed is now considering cutting interest rates to offset headwinds from a trade war with China (and potentially Mexico).
The retrenchment in the oil patch could persist if demand from the industrial sector wanes. Schlumberger, Baker Hughes and Halliburton are large enough to weather the storm; smaller players like Core Laboratories (CLB) or Oil States International (OIS) could be vulnerable.
Schlumberger's revenue in Latin America rose 1% Q/Q on strong growth in the GeoMarket in Mexico and Central America. Seasonal slowdowns hurt E&P in Europe, CIS and Africa, while slowing activity stymied revenue growth in the Middle East. That said, North America will likely drive the narrative for Schlumberger, and that may not be a good thing.
Offshore Is In Decline
Schlumberger is one of the most-diversified oil services companies. It has scale in North America and a sizeable international presence. The company gained offshore scale with its 2016 acquisition of Cameron International. Halliburton lags Schlumberger and Baker Hughes in the offshore space. Offshore has been barren over the past few years. The general consensus was that oil prices had to remain at or above $70 for E&P to pick up in deepwater. During the quarter, Cameron generated revenue of $1.2 billion, down 7% sequentially. This represented a proxy for Schlumberger's offshore activities.
The segment realized strong OneSubsea bookings, yet revenue was down. Breakeven costs for subsea have also come down, which is encouraging. However, with Brent oil in the low $60's range, it could stymie deepwater E&P. If the global economy continues to falter, then oil prices could fall further, leading to a vicious cycle. In the next oil market downturn, I look for Halliburton to make an acquisition of an offshore equipment provider in an attempt to close the gap with Schlumberger. That could create more competition in the subsea equipment space.
SLB Appears Fairly Valued
Schlumberger's management team is one of the best in the business. Management is excellent at cost containment and maintaining acceptable EBITDA margins, even in a downturn. Q1 2019 EBITDA margin was 20%, down from 23% in Q4 2018. Among the large oil service firms, Schlumberger's margins are still best-in-class.
With an enterprise value of $63 billion, SLB trades at 9x last twelve months' EBITDA. This is much less than the 16x it traded at last year this time, and reflects the fall-off in oil prices. It also likely reflects the expectation that demand, and not OPEC supply cuts, could drive future oil prices. Nonetheless, 8x-9x for a cyclical company appears fairly valued for now.
SLB is off by over 45% Y/Y. I believe the decline in the oil patch could become more protracted. Sell SLB.
I also run the Shocking The Street investment service as part of the Seeking Alpha Marketplace. You will get access to exclusive ideas from Shocking The Street, and stay abreast of opportunities months before the market becomes aware of them. I am currently offering a two-week free trial period for subscribers to enjoy. Check out the service and find out first-hand why other subscribers appear to be two steps ahead of the market.
Pricing for Shocking The Street is $35 per month. Those who sign up for the yearly plan will enjoy a price of $280 per year - a 33% discount.
Disclosure: I/we 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.