Boosted by a resurgent North American shale drilling, oilfield services behemoth Schlumberger Limited (SLB 0.71%) appears well set to cash in, even as innovative technology and the integrated oil services model rapidly become key industry benchmarks. On a deeper analysis, the Curacao-registered company looks better set to dominate the ultracompetitive oil services space, ahead of Halliburton (HAL 2.08%) and Baker Hughes (BHI).
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A turnaround under immense pressure
Oilfield services companies have come under intense pressure over the last 18 months to develop solutions that are comprehensive and cutting edge but at the same time cost effective. The reason is pretty simple: Over the last decade, the billions of dollars that were spent on oil exploration and production could not justify the meager growth in global oil production.
In an investor presentation in March, Schlumberger CEO categorically states that while the upstream E&P capital spending grew 400% in the last decade, global oil production grew only 15%. The new frontiers of oil and gas exploration that attracted much attention from investors proved to be more challenging than anticipated initially. With project delays and escalating costs seemingly the norm rather than the exception, the meager returns haven't really justified the billions spent on massive projects. As a result, investors are pushing E&P companies to cut spending. Add to that, the terribly weak North American natural gas market in 2012 and 2013 meant that shale gas drilling had to be scaled back and natural gas assets worth billions impaired.
Back to the drawing board
For oil services companies, it is a rethink of the entire service model from a cost perspective while facing up to the realities of developing the most challenging oilfields on the planet. Additionally, the legacy oilfields that have been pumping out oil for decades are now struggling to maintain output at historical levels. Yet the long term global demand for oil and gas is forecast to increase in the next couple of decades.
It is this challenging environment that Schlumberger has been quietly converting into solid growth opportunities. What sets this company apart is its visionary management, which focuses on long-term growth prospects rather than quick-fix solutions, and Schlumberger has a head start. One of the key transformation programs -- technology innovation -- started in 2008 and has significantly affected the company's research and engineering.
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2 reasons that sets Schlumberger apart
Some of the most ground-breaking technological innovation followed a comprehensive study of best practices in other technology-heavy industries, such as automotive and aerospace. What followed was an integration of Schlumberger's engineering and manufacturing divisions. By doing this, Schlumberger created a natural environment to increase innovation, and there were two main consequences.
First, the company achieved higher internal efficiency. By using the latest advances of IT infrastructure and transportation, Schlumberger could better control its vast scale of operations. For a capital-intensive company with a market capitalization of $130 billion, it's extremely important that operations remain nimble and flexible.
Second, Schlumberger could offer a higher level of project management and integrated solutions for oil companies. Too many individual suppliers involved with E&Ps add unnecessary costs as well as increase complexities. Instead, Schlumberger decided to work on that by broadening its technical capacity and offering a wider range of integration capabilities.
A major method by which Schlumberger widened its capabilities was through select joint ventures and targeted acquisitions. Be it the mega-merger with Smith International or the acquisitions of smaller companies in new spaces such as NovaDrill and Liquid Robotics, Schlumberger ensured that it remained atop the oilfield services value chain.
One thing is undoubtedly clear: Schlumberger has shown that it is an early mover in the oil services industry. Yet from an investor standpoint, the market has yet to fully recognize its growth prospects. The company's flexibility to adapt to any situation, thanks to its diverse geographical presence and the ability to capitalize on any market opportunity, seems underappreciated.
The market hasn't really appreciated the stock
In fact we notice that over the last 24 months, Schlumberger stock has soundly underperformed its peers, Halliburton and Baker Hughes. While the Big Three in oilfield services have all outperformed the overall market, Schlumberger seems to have just about scraped past the S&P 500. Is it justified?
Digging into the fundamentals, we see a different picture though. Schlumberger has had the best operating margins in the industry for the last eight straight quarters -- a feat that wasn't achieved under easy conditions. Here's how the numbers look like since end of 2011:
SLB Operating Margin (Quarterly) data by YCharts
Going through the latest quarterly results, North American operating margins (pre-tax) did drop slightly from the previous year to 18.5%, but they are still better than the 15.4% and 9.3% recorded by Halliburton and Baker Hughes, respectively. Schlumberger, in fact, has had the best North American margins for the last seven quarters. Moreover, there has been a positive change in the company's language around the pricing environment in this region despite a severe winter and contract rollover pricing.
Even across geographic segments, Schlumberger's operating margins have been the best among the Big Three. In terms of revenue growth, except for Europe/CIS/Africa, Schlumberger has had the highest growth in the first quarter. Keep in mind, Schlumberger's base value is higher than those of Halliburton and Baker Hughes. In the last two years, this is how cash flow from operations (quarterly) grew for the Big Three:
SLB Cash from Operations (Quarterly) data by YCharts
A Foolish takeaway
Schlumberger looks much better positioned to take on the ever-changing dynamics of the oil services industry. The company has created a large moat over the last six years -- an effort that can't be replicated overnight by competitors. Finally, oil markets in 2014 are tighter than anticipated. Oil demand in OECD countries is more resilient than previously anticipated. The International Energy Agency has revised demand forecast upward by 600,000 barrels per day for these countries. The opportunity created for oilfield services companies is immense, and Schlumberger seems to be perfectly placed to cash in.
