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This article is part of our Rising Star Portfolios series.
Like it or not, the world needs oil, and oil companies need to add reserves if long-term demand from emerging markets like China and India are to be met. Since the financial crisis in 2008, spending on exploration has dried up, but now after two years of lackluster capital spending, oil is firmly above $80 a barrel, and I expect oil companies to aggressively begin spending on exploration. In my portfolio, I am taking a 6% position in the largest oilfield services company, Schlumberger (NYSE: SLB ) , which provides the picks and shovels for oil and gas companies.
An oncoming surge in oil exploration spending is what led me to my first pick, seismic company ION Geophysical (NYSE: IO ) , which has worked out quite well thus far. In the past month as I patiently perused the market, I kept coming back to Schlumberger, despite its recent rally, as a stock that everyone should own as another wave of exploration spending is set to begin.
Schlumberger is the clear leader in oilfield services in terms of size, scope, and technology, and it's in a superior position to its competition to benefit from a ramp up in oil exploration spending. The company's size -- which dwarfs its nearest competitors: Halliburton (NYSE: HAL ) , Baker Hughes (NYSE: BHI ) , and Weatherford (NYSE: WFT ) -- makes it a key companion for some of the largest oil companies in the world and helps produce the most attractive profit margins when business booms.
National and major public integrated oil companies will likely be aggressive investors in the next spending cycle, which I expect to occur in international oilfields and deepwater drilling. This scenario puts Schlumberger in the sweet spot with its one-stop shop convenience and close ties to national oil companies. Schlumberger is one of the few companies with the ability to integrate technology from seismic all the way to well completion in one integrated package, which attracts large oil companies.
Further, the company's focus on international operations will be a catalyst as customers ramp up spending; international rig counts recently reached an all-time high. Schlumberger's geographical reach, which put it at a disadvantage to competitor Halliburton over the past year as spending heated up in North America, should reverse as the exploration focus shifts overseas. With more than 40% of sales coming from exploration stage and 75% from international markets, Schlumberger is poised to grow its share of oil services revenue.
Schlumberger's size has also let it differentiate itself from its peers because of its clear technological lead -- thanks to a research and development budget that's larger than its three closest competitors combined.
The bulk of service and equipment spending over the past year came from gas shale plays in North America, where independent exploration and production companies spent primarily based on equipment price versus quality. This will likely reverse as Schlumberger's major customers -- the largest players -- beef up spending in harder to reach places like the deep waters off the coasts of West Africa and Brazil. Oil is not getting any easier to find, and Schlumberger's strong technological lead will be key in the next spending cycle.
3 critical elements to the thesis
- The price of oil does not need to reach $140 a barrel again for this investment to work out. All we need is stability above $75 a barrel for oil companies to bring exploration spending back online.
- Schlumberger brings in three-fourths of its revenue from international markets, which are at an all-time high in terms of rig counts. International exploration spending typically lags that in North America at the beginning of a cycle. Brazil, the Middle East, and Africa are key regions where activity is expected to be robust and growing.
- Margin expansion: Schlumberger's strongest margins come from its international business, which I expect will expand in the coming years. As an added kicker, margins in North America should rebound after the company has reorganized its fragmented operations domestically, and the wave of mergers and acquisitions recently will bring larger players to North America – Schlumberger's primary customer base.
What could go wrong?
It's highly likely that Schlumberger will gain market share and expand its profit margins as exploration spending heats up. Economic growth from emerging markets like China and India should also support oil demand, but a major economic meltdown would curb the spending cycle or at least shorten the duration. The broader economy will need to play nice to get the biggest bang for our buck as spending grows over the next five years.
Political and operational risk is always high as we all witnessed with the Maconda oil spill. Also, Iraq is a key region in the Middle East as it boosts production and is expected to absorb a good deal of capacity. This will be a key component of margin expansion internationally. Growth overseas may also be held up as projects that were put on hold in 2008 take longer than expected to restart.
The Foolish bottom line
Schlumberger is up 50% since September, which would usually keep me from jumping on board, but I expect earnings per share to surpass its prior peak in 2008 and break above $5 a share by 2012. Schlumberger is the most leveraged major services company to exploration, international growth, and the difficult deepwater and unconventional plays. All these areas of expertise make it a solid pick as we head into 2011 and beyond.
For earnings updates and buy, sell, hold advice on all of my stock picks, follow my discussion board here.