Schlumberger (SLB +0.07%) is having a good run lately. Shares of the services provider to the oil and gas industry are up about 7% so far this year. This is due to the company's improving financial strength. Revenue is growing due to strong demand for Schlumberger's technology as the oil and gas production boom continues in the United States. Profits are also up thanks to expanding profitability, as customers increasingly flock to Schlumberger's higher-margin services.
Still, no company is without a number of risks. Buying stock requires an investor to do their due diligence about not just everything that can go right, but also about all the things that can go wrong for a company.
A good place to start looking for possible reasons why a stock might decline is the company's own SEC filings. Companies are required to list possible risk factors which could have a material and negative impact on their business. With this in mind, here are the three biggest risks Schlumberger has to deal with, which may cause the stock to decline.
Declining capital expenditures by Big Oil
As Schlumberger readily acknowledges in its annual reports, the biggest risk the company might have to deal with would be lower capital spending by its oil and gas customers. Schlumberger's financial performance is highly dependent on demand. Recently, however, several of the world's biggest energy companies have made it abundantly clear that they are about to cut spending due to lower oil prices.
This has not happened yet, as Schlumberger is a best-in-class operator with a unique lineup of technology and services. The company is still seeing strong demand, but if its customers cut spending, there would be an inevitable tipping point in which Schlumberger would see orders drop.
Lower demand for Schlumberger's oilfield services would most likely force the company to accept lower prices as well. This would put significant margin pressure on the company. Fortunately, Schlumberger does have pricing power, as it saw margins expand last quarter. Pricing power helps mitigate this risk somewhat.
Falling oil prices
In a way, this is related to the first risk mentioned above. Schlumberger management states that a prolonged decline in oil and natural gas prices, or a perceived downturn in commodity prices, could prompt customers to stay on the sidelines and reduce capital investment. This is important to note because the environment Schlumberger describes is exactly what the oil and gas industry is facing at the present time.
Recently, we have seen what a major drop in oil prices can do to energy companies. Crude oil in the United States has dropped from $107 per barrel all the way to $78 per barrel over just the past few months. This represents a 27% decline, and as you'd expect, Schlumberger's stock price has declined during this period. However, the stock drop is based on fears of reduced earnings that have so far not materialized. Schlumberger's revenue and earnings are still growing, but the key question for investors is whether the current downturn will continue, which is very hard to predict.
International turmoil
Operating in international markets is often a savvy business decision. After all, growth potential in many international regions, particularly the emerging markets, is far more compelling than in the United States. That is because under-developed nations are growing faster than economies in North America. However, operators in the oil and gas industry which conduct business overseas face a unique set of risks, due to rising geopolitical tensions in many oil-producing countries in the Middle East and Africa.
One specific geography that is a concern for management is the ongoing slowdown in Northern Iraq. Revenue in Iraq fell significantly last quarter due to production disruptions in Kurdistan, caused by ongoing unrest. Fortunately, strong exploration activity in Saudi Arabia offset the declines in Iraq, which allowed Schlumberger's Middle East & Asia segment revenue to remain flat. However, further deterioration in Iraq may be too much for Saudi Arabia to counter-act.
Schlumberger is particularly at risk from international turmoil, because it derives the vast majority of its revenue from international operations. In fact, Schlumberger generated 73% of its revenue from outside the United States last year. Among the risks associated with this, Schlumberger lists political and economic conditions, social unrest, war, or acts of terrorism. In the energy sector, these threats are unfortunately realistic possibilities as part of doing business.
The Foolish bottom line
Schlumberger is one of the biggest energy companies in the world and has grown its business this year due to its leadership position in the technology it provides to the oil and gas industries. However, it's important to consider the risks that could pose a danger to a company's bottom line going forward. When it comes to Schlumberger, three of the biggest risks facing the company are falling demand for its services, declining oil and gas prices, and geopolitical risk posed by its status as a global company. These are three distinct risks that Schlumberger investors should continue to watch closely.
