Why Oil Carnage Doesn't Equal Poor Oil Service Earnings

The earnings reports are still filing in and the energy sector is one that's been on the forefront of most investors' minds.

Three of the four major companies all showed promise with growth in an otherwise desperate energy sector. As Baker Hughes (BHI) talks merger, Core Labs (CLB) is pumping black gold from the newest country on the market and taking part in the oil enhancement recovery to fill its bottom line. Who else should you keep your eye on in this finicky, unfriendly space? Find out on today's energy edition of Industry Focus. 

A full transcript follows the video.

Sean O'Reilly: We're talking oil services on this energy edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly joining you here from Fool headquarters in beautiful Alexandria, Virginia. To my left is Tyler Crowe, and to my right is the one and only Taylor Muckerman. How are you today?

Taylor Muckerman: I'm not bad, how are you?

Tyler Crowe: Doing pretty good, man.

O'Reilly: Not too shabby. We're talking about oil services earnings and you might expect that they're obviously getting crushed, but that's not the case.

Crowe: No. So far we've had about four of the larger companies in the oil services space that have reported so far. We've got Core Labs, Schlumberger (SLB 0.38%), Halliburton (HAL 0.47%), Baker Hughes; three out of the four -- Core Labs, Schlumberger, and Halliburton -- all beat earning expectations this quarter. Baker Hughes, not so much. I guess that ...

Muckerman: Somebody has to be the outlier.

O'Reilly: Right.

Crowe: Somebody has to be the loser some days.

O'Reilly: Now, do you think they beat because the expectations were just so abysmal?

Muckerman: They could be. You're looking at really tough year-over-year comps, but it's industrywide. You look at service companies, especially Halliburton and Baker Hughes, which have been focused on North America for more than 50% of their revenues. That's where you see most of the downturn in production. I could understand why analysts would think the worst of times is about to hit these companies. It shows you the advantage that size has and their ability to cut costs and still maintain a profitable business.

At least for Halliburton, Schlumberger, and Core Labs. Baker Hughes turned a loss, but you look at some of their smaller peers, they're probably not able to cut costs and still keep the lights on as well because they have stable balance sheets and they've been able to withstand a little bit of this. I think that shows the advantage that these companies have. Halliburton is getting even bigger if they can close this deal with Baker Hughes.

They said they're on track for it. They're selling three drilling units and they've seen prices and levels of interest that they're pleased with. Things look "all systems go" for Schlumberger, Core Labs, and Halliburton, at least.

Crowe: One of the other things -- and maybe I'm speculating a little bit too much -- but one of the things I always get the feeling of is, being American investors we have a tendency to be a bit more American-centric with our investments and how we look at the global markets and things.

When we see that drilling activity in the United States has declined by 40% based on rig counts we would assume that with oil services stocks we're going to get a bigger hit than what we actually saw with some of these guys like Schlumberger and Halliburton.

Declining revenues of 24%, not as much. But if you look at Core Labs and Schlumberger, they're tied much more to the international markets. Core Labs has a very strong presence in the Middle East, which has had relatively steady drilling activity since this decline has started.

Muckerman: Right. You saw OPEC say, "We're keeping the pumps going." That pretty much tells you that Core Labs is going to have some business.

Crowe: Especially with so much of their stuff being associated with enhanced oil recovery and many of the older fields in the Middle East. At that point where they're looking at those solutions for them you're getting these companies that are more internationally exposed, holding up much better in the oil industry than the Halliburton and Baker Hughes, who have closer to 1/3 and 1/2 of their revenue generated within the North American market.

O'Reilly: Which of these names and their respective performances really stands out to you guys? Who are you actually applauding how they've handled things?

Muckerman: Halliburton, for one, because 50% of their business comes from North America, and they've also been going through this potential merger and acquisition with Baker Hughes. They've got a lot on their plates and they're still performing. Then, Core Labs. I thought this company was beaten up way too much to begin with in the markets. They're showing the results you would expected from a company like this.

They're generating significant cash flows still in a time where companies are pulling back on the dividends, as we'll talk about in a little bit, but Core Labs is still churning out cash flow for their investors.

O'Reilly: On that note, Core Labs is known for spectacular free cash flow generation. They literally just buy back stock without abandon. Have they increased that given what their share price has done in the last year at all?

Muckerman: I know they instituted a share buyback plan. I'm not sure of the exact count on that, but I know when the market first initiated its downturn in oil and gas they went out and proclaimed they were going to buy back. This is a company that's known for buying back shares, but I think it's a good time for sure.

Crowe: I believe it was somewhere around $45 million worth of stock that they bought back this past quarter alone. For a company that only generated $200 million in earnings, cranking out somewhere $45-$50 million free cash flow range and then being able to buy back that much stock on top of paying a dividend, that's pretty spectacular.

Muckerman: They're not drilling so their capex isn't that high. They're investing in R&D for the most part.

O'Reilly: I think I checked out their capex for last year and it was $30 million.

Muckerman: It's peanuts compared to the amount of money that they are making, which is why they're able to pay a dividend, buy back shares, and keep the cash count high.

O'Reilly: Is their competitive position going to withstand the next five or 10 years?

Muckerman: I would imagine so. We visited them two years ago. We got a tour of their facilities and they're talking about companies that are employing Halliburton and Schlumberger and others to do their drilling, and those companies do some of the same things that Core Labs does, but the producers say, "Can you check this work for us to double check? We trust your opinion so highly."

They'll outsource some of the work that they're already contracting an equipment and services provider to do just as a double check to make sure Core Labs jives with what the other parties are saying.

O'Reilly: Got it.

Crowe: Yeah. Their market opportunity is certainly there. If you look at the oil and gas space over the next five to 10 years, a larger percentage of our oil production is going to be coming from the higher service intensity areas -- deep, offshore drilling areas where you have high pressure, high temperature wells. It's really hard to parse data out of these things and Core has developed a niche in that specific kind of data analysis.

At the same time, like we were just talking about with the Middle East stuff, you're moving to enhanced oil recovery where Core is going to be a specialist in reservoir descriptions and they're saying, "This is how you can best manage the decline, or the enhanced recovery of these things." The market opportunity is certainly there.

As long as they can maintain that technological advantage over the traditional oil service guys I don't see how they could really not go up from here.

Muckerman: Yeah. With the reductive modeling I think they can describe exactly how oil is likely to come out of your well and the best case scenario and how you need to go about it before you even start to drill. It can save companies a lot of money, increase the revenues further down the road.

The science behind these individual wells is incredibly complex and each individual well is different. If they can tell you exactly how you need to do it before you try and mess up a few times, I think that's a no-brainer for companies to get in there and spend a few extra million bucks on that early on.

O'Reilly: Got it. Before we move on here, what's not working with these names?

Crowe: What's not working?

O'Reilly: Yeah. We've been talking a lot about their success and all that.

Crowe: More than anything it's the natural commodity cycle of things. We've seen rig activity down, we've seen oil prices go down, and you were talking earlier about perceptions. Everyone is looking at things like Iranian oil getting back online, talking about OPEC not wanting to budge, and how the quick turnaround cycle with American oil is going to keep prices low for a really long time. From a company standpoint, I don't really worry about these guys in many ways because they've shown the ability to adapt to the market.

O'Reilly: This isn't their first rodeo.

Crowe: Exactly. Even Schlumberger's CEO said, "We have probably handled this downturn better than any downturn we have ever done in our history." I'm not worried about that. The only thing I can see is people's perception of these companies in these down market cycles.

Muckerman: Yeah. If you're worried about downturn you have to worry about it industrywide. These are the companies where, if you're willing to invest in oil and gas, these are probably the bets that you can forget, comparatively speaking, to the rest of the pack.

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Moving on to our next topic, we've got Chesapeake Energy (CHKA.Q) cutting its dividend after being mum about it for six weeks.

Muckerman: Not just cutting, but eliminating.

O'Reilly: Yeah. Completely cutting it. Gone. This will obviously save them money. As I recall, I think the stock actually popped up and then it pulled back on the news. Anyone surprised by this at all?

Muckerman: I'm not knowledgeable enough about the company at the moment to have predicted it, but hearing it and then going back and looking at the numbers, yeah. It was totally reasonable to have predicted this if this is a company that you follow pretty regularly.

Crowe: This is one of those tough companies. It's emerging as one of the largest oil and gas producers in the United States.

O'Reilly: Yeah. At last check I think they're the second largest natural gas producer in the United States, 11th largest of crude oil. They're not small.

Crowe: They've been growing really fast. If you look at crude oil itself they were almost nonexistent in crude oil back in 2011, 2012, when natural gas prices collapsed. All of a sudden the company said, "We'd better go get some oil production to hedge our bets a bit here." To see the amount of growth that they have done over the years is quite spectacular. I think when a company gets that large there's a certain expectation that ...

Muckerman: Especially that quickly.

Crowe: Yeah. There's an expectation of a company that large. "Oh, they must be doing quite well. They can probably afford a dividend, financially." When in reality, the company has been spending so much money to get to where it is today that budgetary cash obligations for them aren't matching what they're doing out in the field.

O'Reilly: Do you think they were trying to reach and be an ExxonMobil (XOM 0.27%), or something by paying a dividend?

Crowe: Perhaps. I don't have enough insider knowledge. Maybe back when Aubrey McClendon said, "We are going to be the next ExxonMobil." I highly doubt that considering they're a pure producer versus the integrated model that somebody like ExxonMobil has taken on. If you look over this past year they have a $2.4 billion cash shortfall in their operations.

Considering the lack of financing that wouldn't lack today, but the uneasiness that the credit markets are seeing with oil and gas producers in the United States -- it's going to be much harder for them to secure financing than they did two or three years ago when everyone thought everything shale was wonderful.

Any little bit helps. It's only about $250 million annually that Chesapeake is going to save with this deal, but it sounds like a drop in a hat when you have a $2.5 billion cash shortfall. At the same time, it's better than nothing.

O'Reilly: Right. This isn't to say that Chesapeake is looking at a credit crunch because they did just have that deal where they sold a bunch of their shale assets last October for upward of $5 billion. That's a big check.

Crowe: Yeah. They certainly have plenty of cash left on the books.

O'Reilly: But their capex commitments for the year ahead ...

Crowe: Yeah. Between capex commitments this year, and obviously you're going to have capex commitments next year, they don't have the ability where they say, "We've got $5 billion. We can give it back to shareholders." It has to go back into the budget in some way or another. Provided there isn't some upturn anytime soon it's really hard for anyone to see that cash shortfall closing.

They can't cut fast enough when they're talking about -- spread across as many fields in the United States that they are. They're very focused on Eagle Ford, they're focused in Utica. If you go across all their investors' presentations they're giving you data on eight different formations in the United States.

Eventually somewhere, if we stay in the market conditions we're in today, they're going to have to look really hard at a couple of these positions and say, "We have to focus. Which ones are we going to focus on?"

O'Reilly: Got it. One of the tenants of the shale revolution we've had over the last five or six years has been how it's been financed by Wall Street and high-yield bonds and all this stuff. As near as I can tell, I don't think any of these companies have any huge $5-$10 billion bond issues coming due next year, but toward the end of the decade bond issues start to happen. My question is: How big are the issues that these producers will have in the immediate to medium term?

Muckerman: I don't think it's anything too detrimental in the short term, unless this pricing environment stays as it is for another year or so. One thing about Chesapeake: a year ago everyone was singing their praises about selling assets and becoming cash flow positive sooner than people thought they could have. Then the prices take a downturn and now we see them cutting the dividend and stock at a multiyear low.

Crowe: It's below $10 today, which is something we haven't seen since prior to the financial collapse, or several year lows.

Muckerman: They're preparing for the worst by cutting this dividend because, while I don't think any dividends are guaranteed, that's one of the last things that a company wants to do because investors' ears go up. Even though it might be the best thing for the company, they still get a little nervous. Looking at this, the banks that are assigning these bonds don't seem to be too worried about it. J.P. Morgan (JPM 1.26%) has only set aside $140 million for potential losses in oil and gas loans.

O'Reilly: That's not large.

Crowe: Pennies.

Muckerman: Wells Fargo (WFC 0.16%) said the past-due loans that increased in the last quarter were relatively immaterial. They're not too worried about it. Whether or not they're not worried enough, I don't know, because I don't follow these banks closely enough to really look at their books. If the banks are loaning these companies money and say it's relatively immaterial, we'll play the "wait and see" game.

Crowe: I also think it depends a lot on the company you're talking about specifically. Chesapeake Energy has a lot of cash on the books; it also has a lot of assets that it could sell in the event that something goes wrong. However, if you're looking at some of the smaller companies -- a great example was one we saw in a Bloomberg article a couple days ago, Alcyone Resources.

These are companies that are much smaller. They're facing much tighter cash obligations. Not to say they're going to default on the loans that they have today, but they're much less likely to secure good rates on new financing.

Muckerman: Yeah, be able to roll over current data.

O'Reilly: Credit facilities get cut, all kinds of fun stuff.

Crowe: Exactly. We've seen that a lot with some of the master limited partnerships as of late. They've run up to the top of their revolving credit facilities -- basically the credit card that these companies can use to do their operations -- so they've had to turn it into a long-term loan because that credit line they had has been dropped. We've seen some significant drops at those companies because of those things.

O'Reilly: Got it. Very good. Well thanks, guys, for your thoughts. If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks that they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. For Tyler Crowe and Taylor Muckerman, I'm Sean O'Reilly. Thanks for listening, and Fool on!