Playing oilfield-service stocks isn’t a 2015 game; it’s a 2016 game, according to several securities analysts. And this month may be the time to tee up. “There’s more to go,” Jim Wicklund said in late March.

The longtime oilfield-services analyst is currently managing director, energy research, for Credit Suisse LLC. He expected in late March that April would produce a trifecta of events that would push OFS stocks lower: first-quarter earnings results, second-quarter earnings guidance and a lower oil price as a result of a continued glut in U.S. supply.

“The stock prices haven’t gone down enough because the earnings estimates are still too high,” he said. He expected a roughly 20% decline in earnings estimates among the OFS stocks that Credit Suisse covers and a resulting 20% decline in their stock prices.

Superior Energy Services Inc., “one of my favorite stocks, is trading at the same multiple as a year ago,” he said. “I guarantee the next 12 months will not be as pretty as the last 12 months.”

"What doesn't worry me is the survival of most of these companies," said Jim Wicklund, managing director of energy research for Credit Suisse LLC.

The significant profitability and cash-flow challenges facing the E&P industry today are driven by escalating costs per barrel for new hydrocarbon development and the growing burden of stemming decline in the existing production base.

Global Hunter Securities Inc. analysts Ken Sill, Mark Brown and Zach Morrissey noted in a mid-March report that, while activity and pricing were falling rapidly at that time, many OFS firms “were unable, or unwilling, to provide any guidance whatsoever” during their year-end earnings calls.

The trio thus suggested at the time that buying OFS names should be limited to investors with an interest in a more than six-month hold.

Simmons & Co. International Inc. analyst John Daniel reported that “what is clear today—and, candidly, has been clear for the past several weeks—is that first-quarter results will be a disaster for most small- and mid-cap oil-service franchises. Second-quarter results will likely be even worse.”

Bernstein Research analysts wrote that “our research convinces us more than ever of the industrial logic that an oil-services recession is largely unavoidable.” They advised that long positions not re-enter yet and, instead, use the balance of this half to zero in on which stocks may be long-term winners.

Non-U.S. projects

Bill Herbert, Simmons managing director, co-head of securities and also a longtime OFS analyst, told Investor that this oil-price downcycle should not be played like the 2008-2009 cycle. At the time, OPEC responded to a global recession by cutting its production. This cycle is also the result of excess supply; however, OPEC declined to counter, opting to maintain market share instead.

Herbert said, “The resource narrative has changed from one of scarcity to abundance.” This isn’t the world oil market of the aughts.

Being pushed aside is U.S. onshore, offshore and non-OPEC spending, putting deepwater provinces and non-OPEC international at the end of the line for funding, according to various reports.

Simmons’ integrated oil analyst Guy Baber reported in March that a number of new-production projects globally have been postponed or canceled, from Canada to Australia and Indonesia to Mexico. The projects would have brought 2.8 million barrels of new daily production online in the next couple of years.

“As we have consistently highlighted,” he wrote, “while the industry is obsessed with U.S. production prospects, the combination of depressed pricing and the dramatic international upstream, capital-spending cuts—down 20% year over year—has profound and under-appreciated implications to the forward-supply narrative and oil-market balances.”

He added that projects to bring another 2.2 million barrels of new daily supply online in 2018-2020 “have yet to be sanctioned, meaning risks of further delay are elevated.”

The more nimble onshore-U.S. supply, which is more capital-efficient than international projects, will pick up a Lyft quicker, according to Herbert; “whereas, the international recovery is going to take longer to unfold.”

Wicklund had lost optimism for deepwater OFS demand in the fall of 2013. He forecasted rig-stacking “and, so far, we’ve stacked 26,” he said.

In the Gulf, Transocean Ltd. was idling its Deepwater Pathfinder and Discoverer Spirit in March, but Tudor, Pickering, Holt & Co. Inc. analysts were expecting them to be warm-stacked, as “these are both high-quality, dynamically positioned, fifth-generation, ultra-deepwater assets.” They added that demand offshore West Africa “simply isn’t there.” Transocean idled its Deepwater Discovery and GSF Jack Ryan, “both of which had recently been, figuratively, circling their literal, current locale of the Canary Islands.”

Wicklund told Investor, “Deepwater E&P has suffered from cost inflation in the last six years.” Meanwhile, these operators’ shareholders wanted increased dividends and more stock buybacks to counter flat cash-flow growth. “The cash-on-cash return cycle is seven years from a deepwater project and your returns on a new field are 11% to 14%. They’re directing more of their capital to onshore the U.S., where cash-on-cash returns are three years and returns in the Eagle Ford, for example, could still be 50%.”

On a percentage basis, U.S. capex cuts seem larger than non-U.S. cuts but, on a dollar basis, non-U.S. cuts “are bigger numbers,” Herbert noted.

For example, international-weighted ExxonMobil Corp.’s 2015 capex plan is some $4 billion less than its 2014 spend. Meanwhile, one of the largest U.S. independents, “EOG [Resources Inc.]’s, total budget is $5 billion.”

Offshore projects' returns are greatly diminished by just $80 oil, compared with when these long-lead-time developments were launched.

Also, international E&P is a longer-lead-time business. “It will take longer to unfold; whereas, all you need in the U.S. is a higher oil price.” U.S. producers are well capitalized too and are accumulating more ammo while capital markets have been open to them this year, issuing more than $14 billion in equity by late March, by Herbert’s count.

If annual growth in daily demand returns to 1 million barrels, “who’s going to meet that? It’s going to be the U.S. or OPEC. For the U.S. to do that, producers will have to start increasing drilling and completions considerably, probably beginning in the second half of this year.”

OFS consolidation

Reduced OFS competition as a result of supplier consolidation or evaporation will result in some service-pricing improvement eventually, Herbert said. “What we’re confronting right now is an industry that is structurally over-capitalized. There are just too many participants.” This is partly the result of the Federal Reserve’s free-money policy and the industry’s robust equity access, fueling the sector’s growth during the past five years and its deconsolidation.

“Too much money has been invested in the domestic OFS industry. The result is that it is exceedingly fragmented and we have seen, since 2008, progressively lower margins.” The damage the space is encountering now “is pretty profound. The OFS industry is, essentially, hip deep in blood in terms of the head-count reductions.”

But employees that have been cut loose are “waiting on the sidelines. They will come back. That’s going to be important to jump-start the growth engine, once we have sufficient oil prices.”

What the new OFS industry looks like will be more apparent in the second half of 2016, Wicklund said. Will it look like 50% of its year-ago self? Maybe like 60% to 65%. “And, then, we will start to grow again and it will be a long-term, industrial type of growth,” he said.

North American unconventional-resource monetization is a manufacturing model. “Instead of 10% annual growth, it will be 3% or 5%,” Wicklund said, “but it will grow 3% to 5% continuously for the next four, five … eight, nine years. So it will be a better industry.”

He counted the number of privately held pressure-pumping suppliers; there were 37. “Most of them will go away in some fashion,” he said. “You’ll see technology—and the efficiency of technology—matter more and more. The business will look more high-tech. You’ll see corporate efficiencies, supply-chain efficiencies; all of these matter more. The OFS companies that will survive are those being managed today for returns, rather than growth—the companies that understand that no one is going to grow real fast for a while.”

Herbert said the OFS industry’s make-over “is not going to be as dramatic as one might imagine.” Capital formation will be revitalized, balance sheets will be regenerated and “people will be focusing on how high oil prices will go and how many rigs we will need—as opposed to the reality that the E&P industry is very quickly figuring out how to do more with the same or less.

“That has negative implications and I think the economic law of the jungle requires that some consolidation take place. Will it take place? I think it will be a function of how long these weak oil prices persist.”

In mid-March, the TPH oil-services team wrote that, except in distressed situations, deals are unlikely this early in the cycle, while shop owners want last year’s value and buyers are looking at this year’s “evaporating EBITDA.” They recommended, “… Don’t hold your breath for headline-grabbing deals in oil-service subsectors like North American land drilling … and large-cap capital equipment. … Rather, we suspect we’ll see more bolt-on-type acquisitions during this … downcycle, which don’t individually grab investors’ attention but collectively add up.”

Too much money has been invested in the domestic OFS industry, with the result that it is exceedingly fragmented and, since 2008, has had progressively lower margins, according to Bill Herbert, Simmons & Co. International Inc. managing director and co-head of securities.

Exposure

Which sector’s most exposed? Land rigs, pressure pumping, offshore? “All of the above,” Herbert said, but completion services will be where pricing will experience the most pressure. “On average, two-thirds of an unconventional well’s cost comes from the completion process.”

Simmons analyst John Daniel noted in a report that producers were increasingly seeking lower-cost sand to reduce their well costs. Ceramic-proppant-maker Carbo Ceramics Inc., which was already experiencing decreased proppant-market share, closed a plant in McIntyre, Georgia, in March. In predicting Carbo’s first-quarter earnings results, Daniel wrote that his was only an attempt. “…Candidly, there are so many moving parts with Carbo and industry right now, it is difficult to have a precise estimate other than to point out the obvious, which is that near-term results are likely to be really bad.”

How to play OFS stocks in 2015? Herbert said, “If you’re going to play it in ’15, you’re not playing it for ’15. You’re playing it with a view that, eventually, U.S. production growth is going to be needed to meet normalized, global demand growth, so you’re playing this on a multi-year outlook.

“At this juncture, I don’t see any particular reason to get too exotic or too aggressive.”

Which stocks will shine on the other side of this cycle? Herbert liked Halliburton Co., whose combination with Baker Hughes Inc. will generate “considerable” cost synergies and the option of making meaningful share buybacks, he said. “As a result of the oil-price implosion, if the deal looked rational when it was announced in November, it looks that much more imperative today—that is, the need for significant consolidation.”

Weatherford International Plc is poised to pop, he added, having just undergone a restructuring, resulting in an improved balance sheet, streamlined asset base and high-graded management team. “It is a much more rational business model, so we like that one as well.”

Schlumberger Ltd. is solid. “It continues to offer the highest value proposition to the global E&P industry. Investors continue to underestimate Schlumberger’s economic-machine characteristics. The naysayers think that they have too much deepwater and international exposure. Schlumberger generates better free cash flow and its execution prowess is second to none so, in an oilfield recovery, Schlumberger is not going to be left behind.”

Among small- and mid-cap names, Herbert was optimistic about Superior Energy, C&J Energy Services Ltd., Patterson-UTI Energy Inc., RPC Inc. and Helmerich & Payne Inc. “If you had to pick a pure land driller, HP would be at the top of the list. We like Patterson as well, because it doesn’t have just land drilling; it has pressure pumping.” He added that these smaller-cap stocks will work well if the U.S. recovery is “vigorous. If the recovery is methodical, however, they will underperform; thus, these are different investment propositions versus more robust enterprises such as Schlumberger and Halliburton.”

He wasn’t in favor of buying deepwater-weighted stocks. “I think one of the more troubled sectors coming out of this is deep water because the deepwater-growth narrative has been considerably redefined,” he said, “based on the anemic discoveries of the last few years, the need to drive down costs considerably lower and the ongoing, secular shift from offshore to onshore.

“While these stocks have been eviscerated, we’re not in any particular hurry to recommend owning any of them at this stage.”

Additional stocks

Several of Herbert’s picks were also on a Global Hunter Securities analysts’ list, which consisted of Superior, C&J, Patterson-UTI, Oceaneering International Inc., Hornbeck Offshore Services Inc. and Cameron International Corp. and represented “a mix of offense and defense,” the GHS team reported. Superior Energy had cash, a strong balance sheet and a good record as an acquirer. Also, it had a hefty weighting to North American completion and production services. They added that C&J is almost triple its size as a result of its transaction with Nabors Industries Ltd.

Meanwhile, Oceaneering “is a defensive pick.” The GHS team expected that most of the newer, deepwater rigs will continue to work, thus its ROVs will continue to work. As for Hornbeck, “we harbor no illusions that the global OSV (offshore-supply vessel) market is about to turn the corner,” they wrote, “but Hornbeck is a name with enough fuel for the long haul.”

Patterson’s operational skill and its assets “are under-appreciated,” they added. Its 16 new-build rigs planned for 2015 have contracts. “We also consider the 30% of its EBITDA generated by pressure pumping to be well positioned, as attrition will eat up the marketed supply base of equipment during the downturn.”

With a capex per barrel averaging over $40, the urgency of finding these solutions is highest for tight oil and deepwater fields, which today consume around 40% of the global liquids-related E&P capex, while only representing around 12% of global oil production.

And, Cameron’s OneSubsea unit is likely to “land a handful of major project awards this year…despite well-documented concerns that operators are recalibrating project scopes and spends.” Orders for blow-out preventers will continue, they forecasted, as well as demand for after-market servicing.

TPH analysts Jeff Tillery and Byron Pope noted in a report the benefit of Cameron’s servicing revenue as well, which was nearly $1 billion in 2014. The company’s overall, operating margin may be between 10% and 15% this year, down from 19% in the second half of 2014, they conceded, “but not a disaster.”

Schlumberger forecasted in March that daily global oil demand will grow from some 92 million barrels in 2014 to nearly 96 million in 2017. “Based on this, we do not see any reason to question the resilience of … demand in the years to come,” Paal Kibsgaard, CEO, told Scotia Howard Weil conference attendees.

TPH analysts Tillery and Pope noted that Kibsgaard’s remarks included “‘structural changes’ and other serious words.” These included “short-term visibility is limited” and “North American market facing extended period of service over-supply.” These are aligned, they wrote, “with our view that the oil-service industry will be sizing its businesses for the near term and not making a ‘hope bet’ on late-2015 or early-2016 activity recovery.”

Low-cost oil

Wicklund told Investor he was worried about what may be the duration of this cycle. “What doesn’t worry me is the survival of most of these companies.” He estimated three or four publicly held OFS shops and some 15 E&P companies will be restructured. The others will be able to cut capex and generate free cash flow. “So survivability isn’t really a concern,” he said, “although we think this is an extended downcycle.”

What worried Herbert? “It’s not a worry; it’s an intellectual unknown at this stage as to what will be the production response on the part of U.S. unconventional wells as a result of this implosion of drilling activity.”

If U.S. production declines are as expected, there should be a correction in supply. “But, in the event production is more resilient than we believe, that would, obviously, be a negative surprise. We’re going to find out really soon.”

The Simmons research team doesn’t expect this, though. “I think the folks who are in the doomsday camp of weaker-forever oil prices keep drawing on the parallels of natural gas, but natural gas has significant differences.”

Abundant, continued U.S. gas-production growth in a sub-$5 market was derived in the past few years in part from associated gas from new oil wells; otherwise, it was derived from the advent of the Marcellus play. “The Marcellus, basically, redefined low-cost gas production in the U.S.,” Herbert said.

Meanwhile, “there is not another Marcellus in regards to U.S. oil. We know what the big oil plays are in the U.S.; they are the Eagle Ford, Bakken and Permian. That’s it. There are no other leviathan, low-cost, oil basins looming in the shadows.”

Wicklund said the horizontal-targeted rig count of 2014 “probably won’t be seen again for four years or so. That’s not a V-shaped recovery; that’s not even a U-shaped recovery.” Borrowing a term used by Jeff Miller, Halliburton president, when presenting in a Credit Suisse conference in February, Wicklund called it a “bathtub-shaped” recovery.

“We have to stop growing. You have to get the oil price low enough and keep it low enough for long enough to get production growth to zero. That’s going to take at least six quarters. It takes a while to kill a vampire with toothpicks; it takes a while to get an oilman to stop growing his production.”

Some subsidiaries of OFS companies, such as Halliburton’s logistics business, may be suited for spin-off as MLPs, particularly since the U.S. oil and gas industry is more manufacturing in nature today. “The refining industry did it and created a great deal of value,” Wicklund said. “The service companies have large parts of their business that are MLP-able.”

What will be the indicator that OFS stocks have found bottom? “My grandfather said, ‘You take the biscuits off right before they burn.’ They will bottom when the oil price bottoms. How do you know the oil price has bottomed? When it doesn’t go down any more. So there really is no leading indicator.”

If buying OFS stocks, however, be prepared to hold them for a good while, he said. “This is not a V-shaped cycle.” Wicklund managed a hedge fund in 2009. “My stocks bottomed on May 9; by July 1, the OFS index was up over 60%. That won’t happen this time.”

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