Since the beginning of the year, oil and gas service companies such as Halliburton (NYSE:HAL), Schlumberger NV (NYSE:SLB), and Baker Hughes (NYSE:BHI) have had extensive runs. Reaching their recent lows in mid-January and early February, their share prices have increased by ~34%, ~27%, and ~39% respectively. But are these companies still buys, and if so what will drive their valuations moving forward?
Iraq and oil prices
A key factor driving oil and gas service stocks recently has been the rising price of oil. Due to political tensions in key regions of the world, the price of oil has climbed to ~$107 per barrel. Keeping pressure on the current price of oil is the situation in Iraq. Iraq's political tensions have been creating concerns over crude supplies thus driving prices up. Issues related to Iraq have already hindered the country's oil production. These issues have translated to a reduction of about 300,000 barrels a day.
A recent article published by News 680 states, "Without the oil production from the south of Iraq, the market would be stripped of an estimated 2.5 million barrels per day." The writer then estimates the effect on the price of oil: "The sharp price rise in the last two days shows that this oil supply is no longer viewed as secure, either."
The current volatility is in line with the EIA's predictions. The EIA estimated that oil prices will bounce around over the short-term but as the chart below indicates, oil prices will rise over the long term in a slow and steady manner. The EIA predicts Brent crude oil prices to average $108/bbl in 2014 and $102/bbl in 2015 with the WTI discount to Brent to averaging ~$9/bbl and $11/bbl in 2014 and 2015, respectively.
Within North America the price of natural gas is expected be on a slow and steady increase over the long term. The EIA believes a driving factor behind the increasing demand for natural gas within North America is exports:
Exports (will) continue to grow at a rate of about 17.7% per year from 2020 to 2040. Net exports in 2020 are less than 1 percent of total consumption; in 2040 they are 12 percent of consumption.
In the chart below, the EIA displays five different scenarios regarding the price increase of natural gas. These scenarios are based on a multitude of events. They range from a shortage of natural gas where the price increases very quickly, to a glut of resources where the price acceleration is much slower.
Looking forward over the next couple of years, the Henry Hub natural gas spot price, which averaged $3.73/MMBtu in 2013, will average $4.74/MMBtu in 2014 and $4.49/MMBtu in 2015. Beyond that, price estimates are expected to continue to move upward.
Global consumption Oil
As the chart below indicates, the thirst for energy continues to grow. Global consumption of liquid fuels has increased significantly over the past five years and is not showing signs of slowing anytime soon.
According to the EIA, global consumption increased by 1.2 million bbl/d in 2013. The organization is expecting global consumption to grow at a similar pace this year and increase to 1.4 million bbl/d in 2015.
Even though the major producers have stated they are reducing spending in 2014, the global picture is still robust. Regions outside North America are expected to create the "lion's share" of opportunities moving forward. Leading the way in E&P spending is the Middle East as this region is expected to grow by more than 14% over the short term. Other strong regions are Latin and South America, which are expected to grow by 13%, and growth is expected to increase by ~11% in Russia. So, looking forward, the major oil and gas service companies that have significant global branches have good reason to be very optimistic.
United States and North American demand
Growth in North America is also expected to remain robust as well. Over the next couple of years, oil and gas wells within the United States are expected to see a surge of activity. Recently, RBC Capital predicted the 2014 horizontal well count within the United States to increase to 20,061. Driven by increased activity in the big 4, being the Permian, Eagle Ford, Bakken, and Marcellus basins, this represents approximately an 8% increase over 2013's well count of 18,580.
As the chart above issued by the American Oil and Gas Reporter indicates, drilling permits and overall well count have increased extensively thus far in 2014. Looking forward to 2015, growth within the U.S. looks to be gaining speed as well counts are expected to reach 21,551.
The vertical-to-horizontal rig switch in the Permian Basin is accelerating faster than expected, with the overall domestic rig count on pace to be higher than forecast this year. The chart below supplied by Baker Hughes illustrates the increased activity within the Permian Basin compared to last year.
Within North America, as rig counts increase and E&P companies utilize advanced technologies to access the oil and gas, this is providing oil and gas service companies with ample opportunities for growth.
At current valuations, Baker Hughes has an EV/EBITDA of 9.56. Halliburton has an EV/EBITDA of 10.87 while Schlumberger NV has an EV/EBITDA of 11.90. All of these ratios are above the industry average of 8.63, but they are trading above the average in part based on the reasons stated above.
At this point in the market it is my opinion that oil prices are at the high end of the meter. Currently, political issues overseas, mainly in Iraq and Ukraine, are creating concerns over crude supplies thus driving oil prices up. Having stated that, as the need for energy continues to escalate and global consumption is increasing, the need for oil and gas service companies continues to be in demand.
Even though major E&P companies stated they were cutting spending to focus on margins, the fact is, the oil and gas is in the ground and these companies will want it. An advantage that Schlumberger, Halliburton, and Baker Hughes have over smaller companies is that they are technological leaders and are globally diversified. They have the ability to capitalize on a "hot" market, and as each market possesses different challenges, technological leadership allows the company to access the energy whatever the challenge may be.