Energy Investing 101: Seeking Out the Best Oil Services Stocks

Image Source: National Institute for Occupational Safety and Health.

When people from all over the world moved to California in the 1840s and '50s in search of fortune and gold, there was one man who stood out as the richest man of them all. His name was Sam Brennan, and he was able to do it without ever panning for a single ounce of gold. Instead, Brennan sold those starry-eyed prospectors all the equipment they needed to get the job done, and made the one true California gold rush fortune in the process.

Today, there are a select group of companies that are following in Sam Brennan's footsteps. These ones aren't looking to help those looking for yellow gold, though, they are in the business of supplying overly optimistic wildcatters looking for black gold: Oil and gas equipment and services providers.

Investing in oil services companies can be one of the best ways to invest in the oil and gas space without too much exposure to the risk of selling a commodity, but getting to know the ins-and-outs of the industry can seem intimidating. So, to help you better understand how the oil services sector ticks, here is a primer on what these companies do and what you should look for when analyzing the business of an oil services stock. 

Who are we talking about?
When you think of drilling for oil and gas, we normally think of oil and gas producers. While these companies may have the geologists and the project managers and the petroleum engineers on staff to design a project, very rarely do they have the boots on the ground to do the actual drilling. In fact there are a lot of different activities that oil and gas producers don't do that are necessary for the development of a new hydrocarbon source.

The companies that do the actual work in the oilfields are the oil and gas equipment and services providers, and they do a wide range of work, from seismic surveys to assessing new sources, to well drilling and completion, as well as supplying the equipment, the parts to keep that equipment running, and the people to repair and maintain it. Think of them as the hardware stores, contractors, and maintenance men of the oil and gas industry. 

There are dozens of these companies out there. Some are small mom and pop type of niche service providers, and some are $100 billion-plus behemoths. Offshore rig providers are a kind of oil services company, but they are a unique beast all their own.

Here is a list of the 10 largest publicly traded oil service companies on the U.S. exchanges, with their market cap, as well as earnings and revenue for the past 12 months:

*Halliburton has announced that it plans to buy Baker Hughes; the acquisition was not yet complete as of this writing.
Source: S&P Capital IQ.

A major misconception about oil services
One thing that many investors don't always get right off the bat is that oil services companies are not as tied to the price of oil as you might think. Instead, their prospects are much more tied to drilling activity and service intensity. Drilling activity is a pretty cut and dried thing: It's a measure of how much oil companies are actually exploring for and developing new oil sources. While drilling activity does have a tendency to rise and fall with the price of oil, that may not always be the case because some development projects take months or even years to bring online, and very few oil and gas producers are willing to scrap a project that they have already poured billions of dollars into... even ones where profits may be hard to come by. 

Service intensity is a fancy way of saying how much effort it takes to coax a barrel of oil out of the ground. Simpler jobs such as drilling vertical wells into conventional oil and gas reservoirs don't need as much work and are therefore less service intense. As the jobs get more complicated, though, that's when service intensity takes off.

For example, deepwater exploration needs high tech floating rigs, underwater vehicles to install equipment on the ocean floor, and massive blowout preventers and underwater monitoring equipment. Hydraulic fracturing needs high pressure well casing and cementing, thousands of horsepower for pumping fracking fluid into the ground, and all that water then needs to be treated or disposed of in some way or another. This high level of service intensity means more money per barrel of oil is going toward service companies.

Overall, service intensity is a trend that looks to be headed in the favor of the services industry in a big way. Between now and 2020, we will need to find 23 million barrels of oil equivalent per day of new oil reserves, to replace the decline of existing production and meet the steady increase of demand. Of those 23 million barrels per day, a growing percentage will come from more service-intensive areas such as shale and offshore drilling. This means that demand for oil services will continue to grow, and with that service providers can charge more for their services and expand margins.

Image Source: FMC Technologies Investor Presentation; data from U.S. Energy Information Administration.

4 key points for your research
One thing that makes investing in oil services more challenging than other sectors is that so many of them are completely unique. It's very hard to compare and contrast these companies because each of them have completely different drivers. So it is much more important to understand what drives the company and whether the future of oil and gas will be favorable to it. These drivers can be broken up into four different categories: whether it's an equipment manufacturer or service provider, its geographical breakdown, its role in the oil and gas value chain, and its cut of market share.

Equipment manufacturer or service provider: The best way to explain this is to look at two companies, so let's use Halliburton and National Oilwell Varco. While they are both giants in the oil services business, they do completely different things and don't really compete with each other. Halliburton is more of a services provider that performs a variety of tasks for producers such as seismic surveys and well drilling and completion, whereas National Oilwell Varco is an equipment manufacturer that supplies the industry with drilling equipment ranging from replacement bits to entire drilling rig packages for an offshore rig. 

One thing you should look at especially when researching an equipment manufacturer: Its backlog. This is the amount of orders the company has taken in from customers that have not yet been completed. The size of the backlog and how much it is growing on a yearly basis is generally a sign of health. Also, having a robust backlog can help an equipment manufacturer maintain revenue and earnings during the inevitable down cycles in the industry.

Geography -- Location, location, location: Most of the time we talk about the oil market as a fluid, global market where some minor price discrepancies exist. In reality, though, drilling activity and the dynamics of the market can be quite different from one part of the world to another. For example, oil and gas from the Middle East is almost all controlled by the state, and the activity in the region will depend greatly on what OPEC says and does. This means that services companies that operate in the region will normally work under large, long-term contracts that are rather steady and predictable.

On the other hand, we have the North American market. This is a highly fragmented market with hundreds of different producers simultaneously trying to grow their respective businesses. Thanks to advancements in accessing shale, the time to drill a new well can be a matter of days. So service companies that operate in this market are much more likely to experience wild swings in drilling activity as domestic producers can quickly slow their quest for oil and gas when prices aren't great. 

When you invest in an oil services company, you should get to know where -- geographically speaking -- its revenue and earnings come from. A company that is tied heavily to a region like the Middle East will perform very differently than one with deep ties to the American market.

Know your role: Like the geographical differences, the role that an oil services company plays within the oil market is extremely valuable to know as well. This can relate to whether the company's operations are more suited for onshore or offshore development, or which phase of the exploration and development process the company targets. Here's a table to show what each phase of the exploration and production business looks like, and a couple examples of the services involved in that stage.

Then there is the big question that can be extremely difficult to answer: Is the type of service this company provides tied to more expensive sources of oil?

When the price of oil declines, certain types of oil will more likely be taken off the market than others, because the cost to produce them is higher. The cost to bring on that last barrel of oil the world needs to meet demand is known as the marginal cost barrel, and several types of production have various marginal cost barrels as seen in this diagram.

Source: Chevron Investor Presentation.

If you can identify the geographic breakdown of the company, its operations, and the role it plays in the broader market, you're 90% there.

Getting a piece of the pie (and knowing how big the pie is): Actually identifying which part of the market an individual company services, and what drives that market segment is the hard part. Once you have nailed that part down there is one last question to ask. Does this company dominate that respective market like Michael Jordan did on the basketball court?

Having a dominant market share has lots of perks. It helps to protect against producers trying to squeeze prices for those services, and it helps to prevent competitors from gaining a foothold. Getting that market share can happen in several different ways: A company can be a technology leader, a low-cost supplier, or do some of the unsexy work that no one cares to engage in. 

Dominant market share doesn't necessarily mean a company has to own the entire oil and gas services space -- although if you ask Schlumberger, it will probably say it is a good place to be. Instead, some of the companies in the space simply engage in a niche market and gain a massive market share there. A couple examples of this are FMC Technologies and Oceaneering International. Neither of them are by any means large companies compared to some of the other players in the space.

But FMC supplies more than 40% of the global subsea equipment for offshore production...

Source: FMC Technologies Investor Presentation.

... and Oceaneering controls close to 60% of the market for contracted remotely operated vehicles used for underwater surveying, installation, and maintenance. 

Source: Oceaneering International Investor Presentation.

Any company that can sustainably maintain dominant market share numbers like this in their respective area of focus will have a much better chance of being successful over the long term.

What a Fool believes
Yes, the oil services industry is a cyclical one just like every other industry that deals with commodities, and the prospects of any company in this space will depend not only on the big trends like drilling activity and service intensity, but will also vary based on the conditions impacting particular services that a company may provide. Companies that have a dominant market share will typically fare better in the down times, provided they are in reasonable financial health, and typically do very well at generating returns for investors.

If you follow these guidelines to identify what makes the engine at a particular oil services company run -- and do your due diligence with the financials -- you should be well on your way to finding some great oil services investments for your portfolio.

Other subjects in the Energy Investing 101 series:

• Integrated oil and gas, aka Big Oil
• Offshore rigs
• Oil and gas royalty trusts
• Master limited partnerships 
• Independent oil and gas producers
• Refining