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Investing in Oilfield Servicers 101

By Jason Hall – Sep 22, 2018 at 12:00AM

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Schlumberger and Halliburton have trailed the market in the last few years, but it would not be wise to ignore their long-term potential.

Oil is a cyclical industry, and we're coming out of a trough. Rig counts are increasing to their highest numbers since 2014. Great news for oilfield services companies! What exactly do servicers do?

In this week's episode of Industry Focus: Energy, host Nick Sciple and Motley Fool contributor Jason Hall explain. Find out how the industry works, the biggest threats and opportunities in the industry today, and what long-term investors should know before buying in. Also, the hosts take a deep dive on two of the biggest companies in the space, Schlumberger (SLB 4.94%) and Halliburton (HAL 3.31%). Learn what differentiates the two, which one has performed better lately, and, of course, which company looks like the better long-term buy.

A full transcript follows the video.

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This video was recorded on Sept. 20, 2018. 

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, September 20th, and we're discussing oilfield servicers. I'm your host Nick Sciple. I'm joined by contributor Jason Hall via Skype. How's it going, Jason?

Jason Hall: I'm trying to figure out how it's Thursday. I'm pretty sure yesterday was Monday. This week is flying by. 

Sciple: Yeah, tell me about. Yesterday at Fool HQ, we had a little bit of a power snafu. Had to work from home yesterday. That really threw off the whole week. Tomorrow's Friday, so I guess we'll get into the weekend. But it's been a very interesting week over here in Alexandria. 

Hall: Yeah, the whole eastern seaboard, from you guys and on down south, has been tough. I think I can speak for you and everybody else at Fool HQ to say that our thoughts are definitely with the people that have been affected by the hurricane. 

Sciple: Yes, completely. All of our listeners that might have been affected by the hurricane, we're with you. Anything we can do to help out, let us know.

Alright, Jason, let's go ahead and dive into the topic we're talking about today, oilfield servicers. I really like this topic because we're moving right down the supply chain from our episode last week on the frack sand industry. The frack sand providers will take that frack sand and provide it to servicers who in turn use that sand to drill and complete wells for their E&P customers.

One of our listeners actually sent us a picture of oilfield services integrating this frack sand process at an oilfield in Cheyenne, Wyoming. You can check that out on our Twitter account. It's @MFIndustryFocus. And remember, if you have any questions, comments, or pictures, please share those with us. You can reach us on Twitter @MFIndustryFocus, or you can email us at [email protected].

Jason, we're talking about oilfield servicers. First off the bat, what does it mean to be an oil field servicer? What are the services these companies provide, and who are their customers?

Hall: To set the stage with the way that most of the oil and gas industry works, a tremendous amount of the actual boots on the ground, they call it picks and shovels, kind of work is contracted out to third parties that actually do the work. Whether you're talking about things like seismic testing -- they're mapping out these reserves to figure out where the oil and the gas is, look at core testing, so, they drill these cores and it helps give them an idea of further information about where everything's located. The actual drilling itself, we talked about the sand suppliers last week. The pipeline companies that you connect in, these are all third parties that the actual oil and gas producers, generally, they contract a third party to do it. 

These companies can be incredibly profitable when demand is growing. Basic supply and demand, prices tend to go up for their services when there's higher demand. They're also the ones that can get absolutely beaten down when oil demand falls, prices fall, because they're the ones that get squeezed. As demand falls, they have to cut prices. Producers know that they can go to them to renegotiate contracts when demand is low. So, they basically do everything when it comes to actually getting the oil and gas out of the ground. These are the people who really do it. They're really the ones that get the oil and gas out of the ground.

Sciple: Right, Jason. You mentioned a second ago that they're very sensitive to supply and demand in the oil market. As we discussed last week, and I'm sure we'll keep discussing going forward, is that there was a huge collapse of oil prices in 2014 into this year, when it started ticking back up. As a result of that, you saw a lot of cutback from these E&P customers for the oil services companies. That's led, as you mentioned, to a huge oversupply of these oil servicers' equipment that has led prices down. As there's been a lot of this equipment that's had to have been idled, or there hasn't been a demand from their customers to keep drilling that's really hurt these companies.

We're starting to see some signs that there might be a little bit of a turnaround in the industry. Over the past year, the total number of oil and gas rigs in the United States averaged about 1,017. To put that in context, that's putting the total count of rigs in 2018 on track to be the highest since it was in 2014, which averaged 1,862 rigs. The rig count is up 19% so far in the United States this year, and it's up another 7% in the last quarter. We're really starting to see some demand coming back to put more rigs in the ground. 

We're also seeing a rise in some of these large infrastructure projects. Firms are on track to approve about $300 billion in spending on mega project ventures in 2019 and 2020. That's more than the entire spending that we saw from 2015 to 2017. And that's across the world. It's liquefied natural gas in Mozambique, it's the oil in Guyana we're talking about, that Exxon is developing. All of this is taking place all over the world. It's really starting to see a comeback from where we were at in 2014. 

I think another thing that's significant -- and I'll ask you to talk about this, Jason -- is, over this time, when we've seen cutback in demand for oilfield servicing, and these E&P players have cut back their expenditures, they may not have been completing these wells, but they have been hiring these oilfield servicers to drill new wells that may not be completed. These are drilled but uncompleted wells. That's really been trending up. Currently, we're seeing almost 4,000 drilled but uncompleted wells in the Permian. 

Can you talk about the significance of these? For when that supply demand dynamic starts to shift, what are these drilled but uncompleted wells really going to mean for the oilfield servicers?

Hall: This is something that's been building for a couple of years, going back to during the downturn. As oil prices were falling toward the 20s, one of the things that was happening is that rigs were falling offline. The rig count in North America was dropping and dropping and dropping. But there was still this backlog of drilled uncompleted wells that had been fracked, they were ready to go. You just basically had to start throwing pump jacks on them and start pulling oil and gas out of them. As we've seen since oil prices have creeped back up over the past year and a half, rig counts have gone back up steadily, and more and more drilled uncompleted wells have come online. But, the count of drilled uncompleted wells has continued to grow. 

I think the biggest part of it, if you look at the Permian, we hear so much about that, we talked about it last week and I'm sure we're going to be talking about it constantly pretty regularly for the next few years, is infrastructure. That's the issue. There's no takeoff capacity to complete these wells and connect them to the pipeline grid and start getting the oil out of them and sending it somewhere. I think in the next year, 18 months, maybe two years, as more and more of this infrastructure comes online, we're going to hear more and more about these drilled, uncompleted wells that need to be connected. 

I think the bigger picture of that is, when you think about some of the oilfield service companies, is, really over the next year, especially if you think about shale, you think about North America, there could be some kind of a lull, depending on how things play out, simply because there are so many wells that are ready to start producing, but it's going to take time to get the capacity to get the oil out of those wells.

Sciple: Right, exactly. We're seeing maybe a little bit of an inflection point in demand for oilfield servicing. We're maybe seeing a little bit of this latent demand backed up with these drilled uncompleted wells. As that takeaway capacity comes on in the Permian, they're really going to be in a position to ramp up the services they're providing. I do want to point out one other issue. As this ramp up occurs, it may affect these oilfield servicers. During the pullback in the oil market, 2014 through the beginning of this year, there was a significant number of layoffs across the industry that's really shrunk the workforce. Particularly, this is affected the oilfield servicers. 195,000 employees in the oilfield services industry were laid off between 2014 and February of 2017. That sounds like a lot, it is. That's about 44% of the total layoffs across the energy industry. There's been a significant pullback in the headcount on these oilfield servicers. Going forward, as they try to ramp up, it's not only going to be that they need demand from their suppliers. They need to have the headcount to really make this take place. As we start ramping up, that's another thing to look out for. Is there going to be enough labor online to really ramp these as quickly as we'd like to see?

For some context about the amount of labor that you might need to run one of these operations, one frack fleet, in the Permian or elsewhere, other shale plays across the United States, typically can have as many as 40 pieces of large, heavy-duty equipment that have to be operated to just run the well. Each one of those needs a driver, you need a lot of labor to set up and take down these locations. So, this is something that could be an issue for these servicers, even as demand comes online. It's a thing to keep in mind as we're looking at these companies.

Anything else that investors should look out for, just from an industry perspective in the oilfield servicers, before we go into these individual companies we're going to talk about in the second half of the show?

Hall: Yeah, I think the labor shortage is really important. We're fortunate enough to have some industry workers who are also listeners. We've had a few that have reached out to us and share their individual perspective. One of the things that you mentioned, drivers. Looking bigger picture, there's been a driver shortage in the U.S. for years. It's been building and building and building. It's something that a lot of shipping and trucking companies talk about every quarter on their earnings calls, the struggles that they have finding enough qualified drivers. It's having a bigger impact on the oil and gas industry today than it has in the past because with hydraulic fracking and the changes in shale plays that have gotten a little more technical, being able to get equipment there, delivering sand, as we talked about last week, that's something that's only been around over the past decade or so. Those are things that are certainly going to affect it. I think those are things that could be good for some of these service companies, because the companies that have the best employees will probably be able to charge a bit of a premium. When push comes to shove and you're a producer and you need to bring production online, you may have to pay a premium to get access to it. 

I think the big takeaway is, because we are approaching a bit of an inflection point, there's some uncertainty in the near-term about what's going to happen with demand. I think the key is, you can't just throw money at the sector and think you're going to do well. You have to be a little choosier in this sector to make sure that you invest in the companies that have the best prospects. And, scale is important. Position in the marketplace is really important. I think that's one of the reasons that we decided to talk about some of the big suppliers and the big oilfield servicer companies today. 

Sciple: Exactly. OK, Jason. In the first half of the show, we got a decent picture of the state of the oilfield services industry. Now, let's dive into a couple. We mentioned we were going to talk about Halliburton and we're going to talk about Schlumberger. These two companies that I mentioned are two of the largest oilfield services operators in the world. But over the past year or so, they've really trailed the market. Oil has been up about 41% over that past time. The oil services sector itself is up about 4%. We're looking at Halliburton down 8.5% or so, Schlumberger down 9.3%. What do you think about these businesses, how their performance has gone over the past year? Why are they trailing their sector average?

Hall: Let's go back a little bit farther before we talk about just the past year. If you look at these companies' financial performance, you look at gross margins, look at operating margins, both are still producing operating margins that are substantially lower today than they were when oil prices were higher. Which makes sense, because oil prices are an indicator of demand. Rolls back to their services, what we were talking about before. How much of a premium can they charge? Really, since the beginning of the year, we've started to see some improvement in their margins. But at the end of the day, because these are really big companies that do a lot of things -- especially Schlumberger, which is a little more geographically diverse and involved a little bit more in offshore -- a lot of the things that they do are areas that have still been relatively under-invested in. There hasn't been substantial investments in some of the other subsectors. Investors just haven't really seen any big catalysts that make these necessarily look like they're ready for a big run in the short-term. I think that's why they've trailed the greater industry.

Sciple: Yeah, that makes sense, Jason. We can pull the thread on that. Let's go ahead and swing into talking a little bit about Halliburton. Halliburton's a $34 billion market cap company, one of the largest operators in the oilfield services sector. What's significant about Halliburton is, they're the largest player in United States shale fracturing. About 62% of their revenue comes from North America. They have the biggest market share in fracking, and they're very substantially located, as we've mentioned when we speak about fracking, in the Permian.

Can you talk a little bit about that positioning, whether it's an advantage to Halliburton, a disadvantage? I know we talked last week about those takeaway constraints in the Permian. How do you think they really situate in the servicers market, based on that major concentration in U.S. fracking? 

Hall: I think it's one of those things that can be good or bad. Over the long-term, it's probably going to be a strength for the company. They're incredibly good at fracking. They're one of the companies that has led the significant reduction in cost and improved the turnaround time for fracked oil. We're talking, you go back a few years ago, and it would take a couple of months and millions and millions of dollars to get these wells online. Now, we're talking about production in a week in some cases, and half or less than half as much as it cost five or six years ago to bring one of these wells online. Their reputation is phenomenal because of that.

I think because of the Permian, you think about the Powder River Basin, which is another big shale play that's starting to get a lot of attention. I think it's going to be a strength. I think the key is, how much demand are we going to see over the next year? Something I talked about last week, is there going to be a slowdown in activity in the Permian because of the pipeline constraints or not? I think that's what's going to affect the near-term prospects for Halliburton.

Sciple: Right. And that's a thing that Halliburton really doesn't control. That's dependent on those other oil pipeline companies, to really bring that online. But as that takes place, Halliburton is probably, of the servicers, going to be best positioned to take advantage of that ramp up in shale.

As you mentioned, we've seen a little bit of constraints in these shale providers that have really been surprising to Halliburton. They mentioned on their second quarter earnings call that they had expected a little bit of a downturn in activity in recent months, but it's been more than they expected. Some of that's going to be the Permian constraints, some of that's going to be different suppliers, different fracking operators in different parts of the country maybe hitting their budget limitations for the year, those sorts of things. That's been something that been affecting Halliburton and has been a little bit of surprise, it appears, to their management.

Hall: Jeff Miller, their CEO, also talked a little bit about inflation in the second quarter earnings call, the fact that they're starting to see increased maintenance expenses, trucking -- there it is again, trucking costs are going up. They're starting to feel some of those costs going up. They can't necessarily pass all of those costs along to their customers. There's some challenges there.

One of the things that he talked about, and actually something that one of our listeners that wrote in that worked in the industry talked about, is how they're seeing more use of containerized sand on some of the logistics services that the sand providers are offering to help offset some of that inflation. There are things that they're doing to help offset some of those cost overruns. But you're spot on, I think it's happening faster than they expected. 

Sciple: Exactly. I do want to mention, too, Halliburton presented at a Barclays oil conference earlier this month. They said they do expect, over the long-term, that they will reach returns that were as high as they were back in the 2014 cycle. But, important for investors to remember, with these constraints in the Permian, with these other factors affecting shale players in the United States, that's going to be a major contributor to Halliburton's performance going forward. Watch it over the next 18 to 20 months. See how this takeaway capacity plays out. If it starts to come online in a significant way, Halliburton is going to be in a position to take advantage of it.

Let's go ahead and swing into Schlumberger. It's got an $84 billion market cap. From a market cap perspective, it's about twice as big as Halliburton. You mentioned more geographically diverse. Why don't you give us a little bit of a rundown? Where does Schlumberger operate? What are their core competencies? Tell us a little bit about the company from that perspective.

Hall: First of all, it's definitely a bigger company. It's also more diverse in its services, as well. You think about, from a geographic perspective, less than 40% of Schlumberger's revenue comes from North America. Halliburton gets well over half of its revenue from North America. Schlumberger started to see some growth in its offshore work. This is a company that has invested in expanding its equipment side of its business, as well. It acquired Cameron International a couple of years ago now. A lot of what Cameron does is subsea, offshore, and underwater equipment. That's kind of where Schlumberger has been investing and building out its business. Halliburton has gone, I don't want to say all in on shale, but it's certainly hedging his bets more toward the shale side.

I think that's one of the things that makes Schlumberger really interesting right now. We've seen far less investments in offshore, seen far less investments in the more traditional, you think about a lot of the OPEC stuff. There just hasn't been a ton of investment in developing those resources over the past few years. I think we're getting to a point where, because of the decline in the output from those types of assets, and the need to invest, I just don't think shale can necessarily replace all of that lost capacity. I think that Schlumberger's in a really interesting position over the next few years, where we're already starting to see some of those investment dollars flowing back.

Sciple: Right. And that's, again, something we mentioned in the first half of the show. Another thing I just want to call out, too, you mentioned we're seeing some comeback in offshore investment. That's really a canary in the coal mine for the energy markets in general. Offshore tends to be the last thing to pop back. So, if we're really seeing some ramp up over there, that's a really bullish sign for the oil market.

I do want to call out a little bit that while Schlumberger is not primarily focused in the Permian, or in North American shale more broadly, Schlumberger still is making some significant investments there. They're up 43% year over year in their North American production. Earlier this year, beginning of this year, they purchased Weatherford International's pressure pumping and pumping down equipment for $430 million in cash. That's known as their OneStim service. It had originally been planned to be a joint venture with Weatherford to help compete with Halliburton in the Permian. They were going to bring together Weatherford's pressure pumping expertise with some of Schlumberger's services. It ended up turning out that Weatherford decided to sell that to Schlumberger. So, now, Schlumberger is really running a vertically integrated service with their OneStim offering. They're promising customers a 10% savings on barrel of oil equipment through this service. 

Another thing to call out -- this again ties back to what we talked about last year -- they're even investing in some sand mines to really vertically integrate their offering in the shale patch. They've got their hands in the oil market all over the place, from North American shale to offshore to North Africa. Anywhere the oil market pops back, Schlumberger's going to have a piece of that action.

Hall: Its scale is a real competitive advantage. You talk about, with the Weatherford deal, it's something that originally started out as a joint venture. If you go back to the Cameron acquisition, that was kind of a similar thing. There was OneSubsea, which was a 50/50 joint venture that Schlumberger had with Cameron. Acquiring Cameron as the manufacturer and rolling that joint venture, where Schlumberger was more the service provider, again, creating that vertical integration that you're talking about. Schlumberger is really strong. They're just really strong.

Sciple: Yeah. One other thing I do want to call out, too, and the management mentioned this in their recent earnings call, is as things start coming online, Schlumberger has expected to reach full capacity for all their fleets by Q4 of this year. That's just by following through on their existing contracts. What that means is, once all their capacity is under contract, there is no supply left in the market for their customers. That means the market's going to tighten a little bit. That's going to give Schlumberger and other operators in the oil services industry the opportunity to ratchet up their prices as the demand tightens. They said this explicitly on their earnings call, that they're in negotiations with customers where those customers can secure Schlumberger's capacity, but they're going to have to give Schlumberger some more favorable terms. So, we're really starting to see the market tighten, prices start to come up, and Schlumberger is one of those players that's really set up to benefit from that very, very soon.

Hall: Because it controls so much of the market, and so many of these things in so many geographies and so many different parts of the value chain. It's just really well-positioned.

Sciple: Exactly. We've talked about these two companies. We've talked about how they're positioned geographically. If you look at Halliburton relative to Schlumberger, on an EB to EBITDA multiple, Halliburton is trading at about a 30% discount. Just from your perspective, Jason, if you had to pick one of these companies today to invest in, which one would it be and why? 

Hall: I think it would be Schlumberger, even though it's technically the more expensive stock. I like the fact that, in terms of where it is right now, I think it's exposed to where there's probably going to be more investment growth. Think about the offshore investment, I think that's great. But I think it's also started to position itself in shale so that it can benefit from some of the things that are happening onshore. You're paying for it in the premium multiple that's already there, but I think there's also a little bit better downside protection. If you look at its existing backlog and how much of its capacity is already under contract, there's some value to that. If prices fall, if the oil market goes into a little bit of a downturn, its business is a little more protected. Its cash flows are already locked in for the for the near-term. There's some benefits of that. I really think so. I like that it's a more diverse business. I like that it's become more vertically integrated. I'm just not convinced that Halliburton's heavier exposure just to shale is going to be a dead cinch way to get the best returns. I just like the diversity.

Sciple: Yeah. It's just like we tell investors with their own personal portfolios -- you're better prepared for uncertainty when you have a diverse portfolio. When it comes to Schlumberger's geographical locations, where they operate, their portfolio of offerings is much more geographically diverse than Halliburton's. If shale really explodes, Halliburton may be in a position to make outsized returns. But if shale doesn't quite live up to what Halliburton is expecting, and maybe what the market is expecting, Halliburton is going to suffer in a disproportionate way that Schlumberger really is not going to because of their geographic diversity. 

Hall: I have to admit, too, I'm also really bullish on offshore from here going forward. There's a little built-in bias right there. Maybe one of these days, we can talk about this, some of the offshore drilling contractors, on one of these shows. I just think, if you look at where we are now, the investment in offshore, we're on track this year to see about 50% more dollars invested in offshore than we did a year ago. That's pretty substantial. We're still below 2014 levels by far. There's a lot of room to run in offshore. It's one of the things I like for Schlumberger.

Sciple: Jason, I think that's a really good thesis, really makes a lot of sense. Last thing going away for listeners, if they're thinking about getting involved in the oilfield servicers industry broadly -- we may have touched on some of these points, but just to really draw them out for investors -- what are the things they should be watching? If you're already in the space, what should you be watching that will point out your thesis may be changing? What are the important two or three things investors should really pay attention to if they're interested in this space?

Hall: I think the first thing you have to look out with any individual company, especially if it's a specialist company that does only one or two things, or only works in a specific geography, you really want to look closely at the balance sheet. Companies that are more leveraged are the ones that are going to get absolutely beaten down. You have to protect on the downside in this space. You don't want companies that have taken on too much risk with a ton of debt, don't necessarily generate the cash flows that are going to be secure when there's a downturn. I think that's one place that you have to start with any of these companies, is understanding their balance sheet.

I think you also need to spend some time, if you are looking at any of the smaller guys that are doing certain things in certain areas, really understand that play. Understand who they're competing with, who are their potential customers, just piecing together those little pieces of the relationships. If you're not comfortable or willing to put in the time to really get into the weeds on those sorts of things, I think you really just need to look at some of the bigger companies that have the geographical diversity, that offer multiple services. Then, just look for good value opportunities. Look for opportunities to invest at better prices over time. Instead of trying to sell at the top, invest when the prices are down and play them out over the long-term. I think that's how you can do well. 

Sciple: Exactly. That probably ties into your thesis there on the offshore players. Well, Jason, thanks for coming on again! Looking forward to having you on in the future. Maybe we'll get a chance to talk about those offshore players a little bit more in detail. 

Hall: Sounds great!

Sciple: Alright! As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Today's show was produced by Austin Morgan. For Jason Hall, I'm Nick Sciple. Thanks for listening and Fool on!

Jason Hall has no position in any of the stocks mentioned. Nick Sciple has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Twitter. The Motley Fool has a disclosure policy.

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