In the past, oilfield-services companies have outperformed the broader market significantly, provided the holding period for their stocks didn't dip below a decade. The factors that've helped them drive value in the past, however, are still relavant today. And that's simply because increasing global demand for energy is expected to drive global oil and gas development for a long time to come.
Looking strictly from a business perspective, there've been two core value drivers that drove growth for these companies, and are still as relavant today. But before we dive into them, let's see why this industry is poised to thrive as a whole.
What they do and why they'd continue to thrive
Oilfield-services companies form the backbone of the oil and gas industry. Without their expertise, it would be impossible to drill or complete wells, or develop cutting-edge technologies that enable extraction of oil and gas from reserves once considered commercially nonviable. The credit effectively goes to these companies for increasing oil and gas production volumes to current levels.
The world's long-term energy needs are far from being satiated. On the contrary, energy requirements are only expected to grow exponentially for the next couple of decades, which is why the importance of these companies can't be emphasized enough. If your investment horizon is greater than five years, the oilfield-services industry presents ample opportunities to outperform any broad-market index.
How to identify the best from the rest
But not all oilfield-services companies are created equal. Only companies with solid business fundamentals and diverse revenue-building opportunities can generate solid returns on investments. As always, investors must do their due diligence before making any concrete decisions.
A mentioned earlier, from a business standpoint there are two core value drivers that have helped oilfield-services companies outperform the broader market in the past. Let's take a look at them:
Invest in service companies with well-diversified international operations
Companies that generate revenue and earnings from geographically diverse operations are more likely to perform better. The reason is twofold. First, a healthy operational exposure to all oil-producing regions helps such companies build proprietary knowledge and expertise with regard to the most cost-effective and optimal practices for exploration and development.
Second, the cost of oil production varies from region to region. Most of the world's cheaper barrels are produced by state-run companies in the Middle East, Latin America, and Africa using conventional drilling techniques. Production from these regions falls on the lower end of the cost curve. A higher operational exposure to these regions helps generate higher profit margins. Middle East and Asia operations generate the highest before-tax profit margins for the biggest three services companies -- Schlumberger (SLB -0.71%), Halliburton (HAL -1.80%), and Baker Hughes (BHI):
Sources: Company filings. LTM Q2 2015 data used for all companies. Graphics by author.
In addition, greater diversification means greater immunity to region-specific disruptions, even though geopolitical tensions don't necessarily disrupt oil production. For example, Iraq managed to maintain and even increase its crude-oil output despite violent sectarian clashes this year. However, that hasn't always been the case.
Currently, the best example fulfilling the criteria would be Schlumberger. The Curacao-registered, Houston-based services giant has a solid, diversified exposure to international operations in addition to holding a competitive position in the North American market. The company's geographical revenue mix is the most attractive among all oilfield-services companies. No single region commands more than 32% of Schlumberger's total revenue. Here's a visual breakdown of Schlumberger's revenue mix over the past four quarters:
Source: Company filings. Graphics by author.
In comparison, 52% of Haliburton's revenue are tied to North American operations while the rest of the revenue came from international operations. Similarly, for Baker Hughes, 47% of its revenue comes from North America. In addition, the chart above depicting region-wise profit margins shows that Schlumberger's margins are superior to those of Halliburton and Baker Hughes.
Invest in market leaders specializing in a niche within the services space
Companies that have specialized in a particular sub-segment in the oilfield-services space -- and eventually went on to become market leaders in that space -- have performed extremely well.
Core Laboratories (NYSE: CLB) and Oceaneering International (NYSE: OII) are prime examples of companies who have made a name for themselves in their chosen field and have beaten the broader market comprehensively. Averaged over a whole business or industry cycle, there's no reason why these two companies wouldn't continue their brilliant track record well into the future.
Core Laboratories' services should continue to be in demand. Its forte lies in maximizing production from existing oilfields -- conventional, unconventional, and offshore -- and increasing returns for oil-producing companies. Very few companies offer such specialized services with regard to reservoir description and management, with the objective to enhance ultimate recovery volumes. Over the past few years, operating margins have been steadily going up, except for a slight dip in the past 12 months. Additionally, the company has been buying back its own stock, thanks to solid free cash flow generated from its business.
Oceaneering International, on the other hand, has been a market leader for contracted remotely operated vehicles, or ROVs, used in offshore drilling. The company owns 36% of the entire worldwide fleet of 937 ROV systems, and it offers drill support for 58% of global offshore drilling. Another area of expertise for the company is its asset integrity segment. Customers seek Oceaneering's services for maintenance of their offshore assets including sub-sea assets such as flow lines, pipelines, risers, etc. This segment holds a lot of promise for the long run as more offshore development of hydrocarbon reserves take place.
Foolish takeaway
Investing money in oilfield services isn't too difficult if one knows what drives these companies. The two drivers I mentioned should hold true for years to come, because they're more fundamental in nature than event-driven. It's also therefore important to note that in the long run, oil prices will have little to no correlation with oilfield-services stocks. Business fundamentals should instead drive value for these companies.
