Is Now the Time to Buy Oil Equipment and Services Stocks?

Investors in the oil sector can be excused if they are bemused by the current debate around the industry and oil services stocks in particular. The bears think energy demand is about to fall off a cliff due to a recession and expect the worst for oil services companies. Meanwhile, the bulls believe the industry will undergo a multi-year expansion in investment following an extended period of declining spending. So which side of the argument makes more sense?

The bearish case

There's no shortage of recessionary talk in the financial markets and for a good reason. There's ample evidence of a slowdown in consumer spending, with leading companies exposed to consumer discretionary spending warning of more challenging times ahead. Oil demand will decline if that blows over to a protracted economic downturn.

Indeed, oil equipment and services giant Baker Hughes' (BKR 3.08%) CEO Lorenzo Simonelli talked of a "deteriorating" demand outlook during the company's recent earnings call. Meanwhile, other economically sensitive commodities, copper being a prime example, have sold off after disappointing data on the economy from China.

Given its massive demand for resources to fuel growth, China is often seen as the swing factor in determining the trend in economically sensitive commodity prices. The bearish view would have received support from the commentary of companies exposed to China, such as Caterpillar, where management talked of a weakening market in the second quarter.

The bullish case

On the other side of the argument, Simonelli also stated that with "years of underinvestment globally and the potential need to replace Russian barrels, broader supply constraints can realistically keep commodity prices at elevated levels, even in a scenario of moderate demand destruction."

By "underinvestment," he means the slump in capital expenditures made by the major oil and exploration companies following the oil price slump that started in 2014.

Data by YCharts. TTM = trailing 12 months.

Of course, their spending is oil services companies' revenues. Given the long-cycle nature of the business, an extended period of investment will likely be needed now to bring supply back -- good news for oil services' top lines.

There's another subtle argument that supports more spending. If oil majors are worried about the long-term future of oil in the face of the threat from renewable energy, they are likely to be relatively constrained in investing. So, instead of the boom and bust cycles of heavy investment in capacity expansion leading to oversupply, a crash in the price of oil, and then a slump, there could be a long, sustained, gradual upcycle in investments. That's good news for oil services companies.

The final word

Despite the talk of recession, the price of oil is still around $90 a barrel. Moreover, oil services investors will probably get a better idea of market conditions by watching what the oil majors are doing (with capital spending) rather than what they say about market conditions.

Data source: Company presentations Chart by author.

Despite the recessionary talk, the oil majors haven't cut spending expectations yet. Given the current price of oil, the outlook is still positive for the oil services sector -- at least for the medium term. Unless you strongly believe that a recession will destroy demand, the bullish side of the argument seems to reflect the current conditions better.