2 Energy Service Companies Likely to Outperform

Third-quarter-earnings season is beginning to pick up the pace. With mixed reviews on corporate strength in the quarter thus far, analysts and investors are still waiting to decipher the overall direction that full-year earnings are headed. For the most part, we have been hearing from major consumer goods, finance, and tech companies, but that all changed this morning. As the markets opened, Halliburton (NYSE: HAL  ) executives were on the horn, leading the first major quarterly earnings call of the energy industry. Yes, Chevron (NYSE: CVX  ) publicly announced last week that they were reducing their 3Q estimates, but no industry heavyweight had officially released hard data until the sun began to shine on Wall Street this morning.

As the announcement date came closer, analysts and industry pundits had been taming expectations for the energy services sector, largely based on reduced activity in the North American drilling market. Since Oct. 12, 2011, the land rig count in North America has dropped 10%, and the number of land rigs associated with natural gas has dropped much more dramatically, down 54%. While some portion of this drop is due to explorer and producer companies migrating rigs from gas to liquid wells, liquids-based land rigs have only increased 18% over the same time frame.

All rig count calculations used data from the 10/12/2012 Baker Hughes Rig Count Summary.

This point was certainly hammered home during Halliburton's 3Q2012 earnings call, which shed light on the 11.9% drop in profits from a year ago. And while top-line revenue increased by 8.6%, the company still managed to miss estimates by $30 million. Analysts' expectations for EPS were also slightly overambitious; Halliburton only delivered $0.65 per share versus estimates of $0.67 per share. Aside from the obvious reduction in North American activity, a few other factors had a hand in this down quarter; most notably, pricing pressures from guar and, to a certain extent, Hurricane Isaac's disruption in the Gulf of Mexico.

As we look forward to Halliburton's main competitors, Schlumberger (NYSE: SLB  ) and Baker Hughes (NYSE: BHI  ) releasing on Friday, there are a few points to make regarding how their performance is likely to stack up against what we saw this morning. Right off the top, Halliburton has shown that it is more dependent than its peers on upstream spending in North America. In 2011, 58% of its revenues came from the U.S. and Canada, while Schlumberger and Baker Hughes were better hedged at only 33% and 55%, respectively. This filtered down the income statement to a much greater degree, as operating income before taxes from North America for Halliburton reached 76% of its total. Compare this to an average of 50.8% for SLB, BHI, and Weatherford International (NYSE: WFT  ) , which also includes Halliburton's inflated share. Given this data, it would be reasonable to expect the lack of North American spending to affect these other service companies to a lesser degree than it did Halliburton.

Prior to discussing the margin pressures created by increased guar gum prices, let me first provide a basic description of what exactly guar gum is: It is a by-product of guar beans, which are typically grown in India and Pakistan, with almost 80% of total production coming from India. After de-husking and grinding the beans, the gum can be used for a variety of purposes. Where it applies here is in its application to hydraulic fracturing, also known as "fracking." During this process, gas and oil are extracted from far below the earth using water and chemicals to force the commodities out of the ground. Guar binds to the liquids and helps separate the chemicals used from the water.

Due to the recent dependence on this crop and the fact that its production is largely dependent on one geographic region, prices have soared. From January 2011 to July 2012, farmers saw the price per kilogram skyrocket 650%, from $4 to $30. This dynamic leap created cause for concern within the drilling industry as margins were being squeezed across the board. In a strategic move, Halliburton decided to lock in a tremendously large quantity through contracts in anticipation of prices continuing to rise. Unfortunately for it, guar gum has seen its price drop almost as quickly as it rose. Since its peak in March 2012, it has dropped close to 80%, as of Oct. 5. Overall, company brass has attributed 600 bps (or 6%) of margin contraction to the price increase in guar and the existing contracts. While guar has most certainly affected the entire industry's cost structure during the past year or so, the fact that Halliburton locked these prices in and still holds some of the overpriced inventory is likely to have hurt them a bit more than Schlumberger and Baker Hughes. Halliburton expects this overpriced guar gum inventory to be used up by the first half of 2013.

Because of these two major reasons, I am expecting Schlumberger and Baker Hughes to deliver slightly better year-over-year performance for the third quarter of 2012. Of course, this prediction is barring any unknown circumstances that are more company-specific to each of them. Stay tuned for Friday's releases to see if this holds true.

While energy service companies have seen a reduction in North American land rig use, offshore drilling is set to pick up tremendous steam. Seadrill is a contracted driller that is poised to take advantage of this. To learn more about the strengths and weaknesses of the company, as well as what to expect from Seadrill going forward, be sure to check out this brand-new premium report one of our top Stock Advisor analysts has put together. Click here to get started.

Taylor Muckerman has no positions in the stocks mentioned above. The Motley Fool owns shares of Halliburton Company. Motley Fool newsletter services recommend Chevron and Halliburton Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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