Energy investors are looking for something, anything that might indicate the worst is over. Based on recent earnings results from some oil services companies, though, we're still a ways away. That doesn't bode well for National Oilwell Varco (NYSE:NOV) because the core of its business is supplying the industry with the equipment to get almost any drilling job done.
For those who want a signal that might signal a turnaround in the oil and gas market, there is a segment of National Oilwell Varco's business worth keeping an eye on when it reports its earnings. Let's take a look at why this business segment is a leading indicator of what is to come in the market and what may be in store this coming quarter for National Oilwell Varco.
Lagging versus leading business segments
For the most part, National Oilwell Varco's business has a bit of lag compared to the production side of the business. Its rig systems and Completion & Production Systems segments mostly involve manufacturing large pieces of equipment such as the drilling package for a rig or the equipment for a floating production, storage, and offloading -- FPSO -- vessel. These types of projects can take years to produce, and the companies that purchase this equipment -- rig owners like Seadrill (NYSE:SDRL) -- make their decisions to buy new rigs after producers have made their capital spending decisions.
This is a large part of the reason why these business segments have large backlogs and have been able to keep working to a certain degree through the decline. Ever since demand for new rigs started to dry up about 18 months ago, National Oilwell Varco has seen its backlog decline from its peak of $17.5 billion in the second quarter of 2014 to $10.2 billion last quarter. There doesn't appear to be many new rig opportunities coming, either. Recently, Seadrill announced it was delaying the delivery of 10 rigs by as much as two years and has even cancelled the delivery on one rig. These kinds of moves have been common for rig owners as they try to right-size their fleets, but it will drastically impact National Oilwell Varco's backlog in coming quarters.
For those investors that want to get an idea of when the oil and gas market will start to turn for the better, though, there is another National Oilwell Varco business segment worth watching: rig aftermarket. This segment is the one that supplies spare parts for rigs in the field. Recently, there are trends in the oil patch that suggest this will be an important segment to watch as a potential indicator of a rebound.
Patch jobs in the oil patch
During last quarter's conference call, CEO Clay Williams mentioned a trend that has been going on in the oil field that has been hurting the company's numbers: Rig owners have turned their fleets into chop shops. Basically, rig owners have a lot of idle rigs, and they are trying to keep costs on working ones to a minimum. So, instead of buying new replacement parts for these working rigs, they have been stripping parts off idle rigs to keep their equipment running. It may be effective at keeping costs down today, but in reality it simply delays buying new equipment until further down the road.
Eventually, rig owners will work through their inventory of spare parts and will need to start purchasing new equipment. What could really be a game-changer, though, is if producers want to increase drilling activity. Then rig owners will need to buy all the equipment to get their idle equipment in working condition again as well as continue buying for their already working rigs. When this does happen, chances are we will see a surge in orders for National Oilwell Varco's rig aftermarket segment.
What a Fool believes
Wall Street has become very enamored with watching National Oilwell Varco's backlog as a sign of its health. It's not a bad way to look at the company since its rig systems segment has been by far the company's largest revenue generator. However, the lag in that business segment could give a false impression on the future health of the company. This is why keeping an eye on the rig aftermarket segment is a better indicator that better times are around the quarter.
Looking at where oil prices have been in this past quarter and the anticipated cuts in capital spending from producers, chances are we won't see much improvement this quarter or even next. When it does turn, though, National Oilwell Varco will be ready to supply the industry with a majority of the stuff they need and will see its own prospects surge in the process. National Oilwell Varco reports third-quarter earnings on Oct. 28.
The Motley Fool owns shares of and recommends National Oilwell Varco. The Motley Fool recommends Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.