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Oil-Field Services: An Uncertain Investor Outlook

The apparent stability of oil prices above $70 a barrel and forecasts of higher natural gas prices are making energy companies more confident about increasing spending. That's good news for oil-field service providers, but analysts don't think they will be able to raise their prices for services and equipment rentals until the second half of 2010. And companies' year-over-year earnings comparisons aren't expected to improve until the second quarter of this year.

Shares in the sector have had a good run from the beginning of the fourth quarter into late January. The Philadelphia Oil Service Sector (OSX) is up 7.7% from its Oct. 1, 2009, close at 185.71, finishing at 199.92 on Jan. 25. But it has closed as high as 216.61 on Jan. 8.

But the two largest companies in the sector kicked off fourth-quarter reporting season with disappointing results. Schlumberger (SLB) on Jan. 22 posted 67¢ in income from continuing operations, down from $1.03 a share a year ago, on a 16.4% drop in revenue to $5.74 billion. Schlumberger's results did beat a consensus forecast of 64¢ a share among analysts.

North American Rebound

Halliburton Co.'s (HAL) earnings, reported on Jan. 25, were nearly halved to 27¢ from 52¢ a share a year earlier, but they beat analysts' consensus estimate by one cent after excluding a tax-related charge. Halliburton said on its post-earnings conference call that it expects the devaluation of Venezuela's currency to cost the company $30 million in exchange losses in the first quarter, with an additional $10 million in dollar-denominated income tax in the country.

Other big industry players are on deck. Baker Hughes International (BHI) and Weatherford International (WFT) are scheduled to report earnings on Jan. 26, with Smith International (SII) scheduled for Jan. 27.

Drilling activity in North America seems to be outpacing a rebound in other parts of the world, thanks to the growth prospects of U.S.-located unconventional natural gas deposits—those found in tight rock formations, which require more advanced production techniques than conventional gas assets. The number of rigs drilling in the U.S. rose 14% in the fourth quarter from the third but was down 41% from a year ago, while Canadian rig count jumped 46% from the third quarter but fell 29% from a year ago, Credit Suisse Equity Research said in a Jan. 19 report. The increase in the rig count isn't reflected in consensus estimates and should drive potential upside for earnings for most of the service companies that Credit Suisse covers, the note said.

Outside North America, there wasn't the typical yearend spending rush, and that may mean more modest revenue growth in the fourth quarter than analysts anticipate. But the rig count rose 4% from the third quarter, led by a 16% increase in Africa, Credit Suisse said.

Warming to Natural Gas

Improving returns from U.S. shale gas plays will continue to drive gas production growth with improved efficiency, Friedman Billings Ramsey said in a Jan. 12 research note. But unused capacity in the land rig fleet will prevent significant hikes in daily rental rates for rigs this year. Some investors are warming to natural gas-focused service and drilling companies, but they won't be encouraged by a lack of pricing improvement in the sector, the note said. FBR (FBCM) believes investment in U.S. oil properties will provide the "strongest and most surprising" growth in the industry this year and predicted well services contractor Key Energy Services (KEG) should be one of the largest beneficiaries.

There is talk of pricing strength in specific markets, primarily for the larger hydraulic fracturing jobs, where pressure pumping is used to loosen tight rock formations in which shale gas is trapped, says Geoff Kieburtz, an oil service analyst at Weeden & Co. in Greenwich, Conn.

BMO Capital Markets said in a Jan. 20 research note that it now expects quarterly earnings of large-cap oil-field service companies to bottom earlier than expected, in the fourth quarter, given recovering profits in North America and signs of improving international activity. BMO raised its sector rating to outperform and boosted its producer capital spending growth assumptions from 5% to 12% in 2010 and from 15% to 20% in 2011.

While onshore capital spending won't return to 2008 levels for a a few years, FBR expects offshore expenditures to bounce back to 2008 levels by 2011. Deepwater growth will mostly compensate for the decline in spending on continental shelf gas. An increase in deepwater spending that is almost triple expected growth in onshore spending will drive offshore spending overall at a rate of around 15% for the next few years, according to FBR. The firm said it prefers offshore drillers with exposure to jackup rigs, which generally operate in shallow waters less than 400 feet deep, to those with a deepwater focus, since a clear bottom in the jackup market means that many idle rigs will be able to be put to work, increasing rig owners' cash flows.

Day rates for floaters, which are rated to drill in water depths of 10,000 feet or more, have fallen from up to $550,000 to $350,000 in the Gulf of Mexico, with comparable declines in the North Sea and offshore Africa, says Tim Guinness, chairman and chief investment officer of London-based Guinness Atkinson Asset Management. He notes, though, that rates remain much stronger than they were from 1998 to 2002.

Projects Are Restarting

"The next two years are going to be a grinding period for service companies. They will find contracts coming to an end, and having to roll them over at lower rates than they had been getting," he says. "At the moment, rates may have bottomed, but they aren't going to recover rapidly because you have oversupply that needs to be worked off."

The return of relative stability in oil prices has spurred oil producers working in North America and overseas to restart projects they slowed down or completely deferred a year ago, says Kieburtz at Weeden & Co. While prices are no longer falling, the renewal of existing contracts at lower prices will continue to have an adverse impact on international companies' profitability for at least a couple more quarters, he predicts.

"The rig count bottomed at a higher level and started rising at a faster pace than we had anticipated." he says, based largely on reduced service costs. "If we start to see pricing increase for oil-field services, how far can it move up before it can halt increases in production?"

Brad Handler, an analyst at Credit Suisse and author of the Jan. 19 report, also expects to see oil production grow this year, but he believes national oil companies overseas will spend more money than the major integrated companies will.

The improving economics of natural gas are making producers in the U.S. more willing to spend to expand production, he says. Many exploration and production (E&P) companies have indicated plans to spend 15% to 20% more this year because they believe they'll be paid for the growth. Their willingness to increase spending is based not only on higher productivity of shale reservoirs in Arkansas, Texas, Pennsylvania and elsewhere but also on their ongoing access to capital markets, where they raised a total of $25 billion last year by issuing debt and equity, says Handler.

Fully Valued Giants

Optimism among E&P companies could change very quickly, however, if economic data turn negative and raise concerns about the strength of industrial demand, says Handler. Credit Suisse (CS) analyst Jon Wolff expects onshore production to rise 200 million cubic feet per day and liquefied natural gas (LNG) imports to average 600 million cubic feet per day more than they did in 2009. "If we're right, that's a little bearish for gas prices," says Handler.

Guinness is very bullish about natural gas, expecting the price to climb to between $6 million and $7 per million cubic feet this year. But he's wary of oil-field service stocks, based mostly on what he sees as rich valuations. Large-cap names such as Schlumberger, Halliburton, and Weatherford all appear fully valued at this point in the cycle, he says, priced more for a recovery in 2011.

He owns a position in Transocean (RIG) but doesn't like the fact that the price-to-earnings multiple has risen from 7.3 times 2009 earnings to 8.2 times 2010 earnings because of a lower earnings estimate. Guinness worries that the multiple may be much higher if earnings deteriorate further in 2011.

"If we're right, we'll see these stocks trade sideways for a bit until [earnings improve substantially]. There's a lack of visibility as to what 2011 is going to look like," he says.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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