On the one hand, it was a quiet week in the oil market. Crude didn't do all that much, ending the week roughly flat at around $51.50 for WTI and $57.50 for Brent. That's despite some bullish commentary from OPEC's secretary general, Mohammad Barkindo, who noted that rebalancing in the market was happening at an "accelerated pace."
One of the reasons for this improvement is that shale drillers in the U.S. continue cutting rigs from their fleet, which is slowing production growth. According to the latest count from Baker Hughes (BKR 0.76%), drillers in the U.S. dropped 15 rigs this week. That's on top of the eight they cut last week and marked the sixth decline in the past seven weeks. That reduction in the rig count, as well as cautious third-quarter earnings reports from oil service giants Baker Hughes and Schlumberger (SLB -0.31%), weighed most heavily on oil service stocks this week according to data from S&P Global Market Intelligence.
A trio of service companies slumped double-digits this week, including Fairmount Santrol (NYSE: FMSA), Superior Energy Services (SPN), and Key Energy Services (KEG 0.00%). One of the drivers of the sell-off is that an analyst downgraded Superior Energy Services and Fairmount Santrol earlier in the week, cutting both from outperform to market perform. Driving the downgrade is a view that drilling activities in the U.S. will grow at a slower pace, which would cause operating conditions to become more challenging and weigh on margins for smaller service companies.
That slowdown seems to be materializing given what Schlumberger and Baker Hughes said in their third-quarter earnings calls this week. While Schlumberger reported an in-line quarter, CEO Paal Kibsgaard warned that "the investment appetite in North America land now seems to be moderating, driven by a growing focus from E&P companies on financial return and the need to operate within cash flow rather than the pursuit of production growth." Because of that, Kibsgaard said that the company might not earn as much as analysts expect in the fourth quarter.
Meanwhile, Baker Hughes believes that the oil and gas environment will remain challenging this year. CEO Lorenzo Simonelli said that "we have seen some improvement in activity but we have not seen meaningful increases in customer capital commitments."
The view that activity in North America will grow at a much slower pace doesn't bode well for smaller service companies like Key Energy Services and Superior Energy Services, which both need activity-driven price increases to boost profitability. Likewise, Fairmount Santrol had hoped that drillers would keep ramping up, which would improve volumes and prices for the frack sand it sells.
Shale drillers in the U.S. are clearly holding back spending, which will make it more challenging for service companies in the near term. That said, by slowing their pace now, it prevents them from flooding the market with more oil, which would keep a lid on prices. Instead, it's potentially setting the stage for a stronger environment next year. Yet even if that were the case, investors should still avoid weaker service companies like Fairmount, Superior, and Key because they don't have the scale to compete against Schlumberger and Baker Hughes in what could remain a challenging market in the near term.