[Editor's note: This story is the final installment of a three-part outlook series which appears in the December 2018 edition of Oil and Gas Investor. Subscribe to the magazine here.]

The oilfield service sector is making a comeback as margins have improved, but investors remain wary of the industry that bottomed out in 2016 when oil prices slumped.

As oil prices have rebounded and stabilized, drilling activity has also ramped up. The Baker Hughes Inc. (NYSE: BHGE) rig count rose on Oct. 19 to 1,067 after a decline that bottomed at 316 in May 2016.

While the Permian Basin rig count rose slightly in October, it retrenched in August and September. Some of the lower-end Permian rigs could be “laid down” toward the end of the year, but the super-spec rig count “continues to progress with some upgrades expected to commence work in the fourth quarter,” wrote Luke Lemoine, an analyst and CFA for Capital One Securities, in a research report.

“Our cash flow based model indicates the 2019 Lower 48 rig count could be +75 - 150 y/y [year-over-year], and our Permian takeaway model shows the upper end of the aforementioned range is needed to fill pipe in 2H19 [second-half 2019],” he wrote. “If the rig count does increase that much and there’s a further increase in ’20 as more Permian pipe comes online, the industry will chew through all of the upgradeable super-spec inventory ( about 150 left) and newbuilds will be required.”

The spot rates should also see improvements since the super-spec dayrates are already in the mid-$20,000 range, Lemoine wrote.

“It would take an upper $20,000 rate with a three-year contract to incentivize newbuilds, we believe spot rates will progress to newbuild economics by early 2020,” he wrote.

As the sector recovers, more consolidations are occurring. Precision Drilling Corp. (NYSE: PDS), a Canadian company, announced in October that it would acquire Trinidad Drilling Ltd. for $1.03 billion, including $477 million of net debt.

UPDATE - Ensign Energy Tender Gets Over 50% Of Trinidad Shares, Precision Ends Bid

The rationale for the deal includes cost synergies of $30 million in 2019, wrote John Daniel, a senior research analyst at Piper Jaffray & Co., in a research report.

“Beyond those synergies, the transaction is a positive for the land drilling markets in both the U.S. and Canada as it makes both markets more consolidated,” he wrote.

Oilfield Services Perspective

The outlook for the sector in the near term is positive for onshore North America, said James Wicklund, a managing director of equity research at Credit Suisse.

The Permian takeaway capacity has to slow down until the region’s pipeline construction projects are completed. The overall activity could rise by 40%, he said. The Permian takeaway capacity issues are the result of better-than-expected production growth and returns to the E&P sector and as soon as there is additional capacity, activity will resume. The Permian alone is expected to supply over 60% of global oil production growth during the next couple of years.

“We know there will be incremental takeaway capacity by the end of 2019. Activity could rise by 10% to 15% in 2019 and by 2020,” Wicklund said.

Recent rig county activity has been healthy compared to 2016. The rig count has risen by 250%, and the frack spread rose from 156 to 485 during the past 2.5 years, he said.

“The industry has had an opportunity to catch [its] breath with the dramatic increase in activity straining supply chains and causing significant inflation,” Wicklund said. “Now we have more visibility on the recovery than we’ve had in a very long time. The industry is increasingly focused on financial returns and capital allocation rather than just growth, which is very positive for an extended cycle.”

While drilling in the U.S. is pausing, international and shallow-water drilling has picked up during the past year, he said.

The increase actually started during the summer of 2017, but it was masked by “lousy pricing,” said Wicklund.

Drilling activity will continue to increase in both international land and shallow-water markets, and pricing should begin to improve in 2019, he said.

While deepwater drilling has been on a four-year hiatus, it could come back as soon as 2020 as companies have switched from production growth to return on investment.

“It has taken that long to adjust and 2020 will be the earliest we will see activity start to improve,” Wicklund said. “Barring a global recession, onshore drilling will move higher over the next year, international onshore also moves higher in a year and a half to two years while deep water will start in two years. It is a staggered recovery which is positive in extending the investment cycle.”

This recovery should be better compared with previous ones because the growth is much more normalized compared to the explosive growth that started two years ago, he said.

“This comeback has greater duration and should last for several years because there is already pretty good base activity,” Wicklund said.

Both drilling and E&P companies have been more efficient in deploying capital during this recovery, which are encouraging factors for institutional investors, said Byron Pope, a managing director in the equity research division at Tudor, Pickering, Holt, & Co. covering the oil service sector. Refiners have been disciplined financially for a few years, allowing them to generate more free cash flow.

“We’re on the verge of investor interest coming back to our space,” he said. “We are in a fairly unique time for the oil and gas industry.”

One benefit in the aftermath of the painful downturn is that the management of companies has focused more on generating free cash flow, which is “unheard of for these companies,” said Pope. “Investors are getting comfortable that E&P companies found religion so to speak and can be disciplined in deploying capital and returning it to shareholders.”

An oilfield service comeback is finally closer two and a half years after the trough, said Colin Davies, an energy analyst with AllianceBernstein.

“We are constructive for the outlook for 2019, which is largely commodity price-driven as production rates has dropped in Iran and Venezuela,” he said. “We expect industry spending to increase, and there will be more balance between international and offshore drilling and the U.S. onshore companies than we have seen in the past.”

The industry will “eventually find its operational cadence” in early 2019 after adjusting down for dealing with the Permian’s bottlenecks, Davies said.

During the second half and especially during the third quarter of 2019, activity could increase again and quite aggressively, which gets companies past this temporary situation.

“This sets up an opportunity for investors going into next year when they realize the worst of the issue is over, and they will see constructive growth late in the year around completion activity and hydraulic fracturing,” he said.

While offshore recovery in 2019 remains the big question for investors, the industry will come back, analysts say. Investors should expect more material recovery in 2020.

Overall activity in the offshore sector remains “very low” with some improvement in the shallow-water area, but deep water is still lagging other areas. Investors are wary of offshore drilling as the sector has had too many false starts in its recovery, Davies said.

“It’s been two steps forward and one step back,” he said. “However, we are closer to the floor in activity, and the optimism for these stocks is starting to get heated up.”

Investors are more cautious about international and offshore drilling, and these stocks are reacting accordingly, Davies said.

“We are finding the trough of the cycle,” he said. “We are starting to see an upward inflection particularly in the North Sea and for high specification shallow-water jackups.”

The land drilling sector is still robust as the demand for the high-spec rigs is still high, utilization is strong and rig rates are reasonably good.

“We are about to see a slowing of that growth, but not a collapse,” he said.

Some companies, like Schlumberger Ltd., the biggest oilfield service sector company, have been discussing an international recovery for the past two to three years, but it has failed to materialize.

“The company’s forward estimate has been steadily down the past year,” Davies said. “Investors are still very, very cautious about level and pace of recovery, particularly in the international sector.”

The sector is demonstrating a lot of optimism, said Robert Shearer, a partner in Akin Gump’s global energy and transactions practice.

“The rig count has increased steadily during the past two years, and E&P companies are increasing their capital expenditures, which means that drillers and equipment manufacturers are also steadily rising,” he said.

North American oilfield service companies are expected to rebound, wrote Praveen Narra, an energy analyst for Raymond James, in a research report.

“We think the U.S. centric completions stocks have already passed the point of maximum pain!” he wrote. “Yes, sell-side estimates for the rest of 2018 still need to fall further, but we believe most of that is already priced into the stocks. More importantly, we think the pain of the past few months should translate into even better earnings and stock price gains in 2019.”

The recovery is due to a reversal in the backlog of drilled but uncompleted wells that will “likely swamp the ability of the U.S. oilfield service industry to complete these wells as completions activity resumes in early 2019,” Narra wrote.

This news could impact companies such as Propetro Holding Corp. (NYSE: PUMP), Superior Energy Services Inc. (NYSE: SPN), Patterson-UTI Energy Inc. (NASDAQ: PTEN) and Halliburton Co. (NYSE: HAL), he wrote.

Since U.S. activity will move faster compared to the current consensus expectations, oilfield prices should move higher sooner than most are expecting in 2019, Narra wrote. The next several years will be “very profitable” for U.S. oilfield service companies, he wrote.

“Put simply, given the coming improvement in NAM oilfield service activity, we think investors should be buying U.S. oilfield completions on any weakness created by late 2018 earnings estimate reductions,” Narra wrote. “Finally, it appears that the oilfield completion stock technicals are beginning to align with our bullish fundamental outlook, adding further support to our bullish outlook.”

The Opportunities

The sector is facing fewer threats now compared to when the market had bottomed out, said Shearer.

This is a capital-intensive industry, and companies that are demonstrating healthier balance sheets are opportunistic for acquisitions.

As crude oil prices rise, budgets will increase in tandem next year, said Davies. However, E&Ps and majors will be under “immense pressure” from investors not to ramp up capital too quickly and return value to shareholders.

“If the service sector can address this growth without ramping spending too quickly, the level of cash-flow generation in the sector can increase,” he said. “This will be positive for service sector stock performance.”

Threats To The Sector

Over a longer term, the sustainability of high oil prices is more important than the nearer term price to support recovery and growth in the offshore, Davies said.

“These are long-cycle, multiyear capital commitments and oil companies need to have confidence in during the construction cycle,” he said. “Any weakness will undermine that sense of sustainability to the price framework we have seen recently.

The steel tariffs will raise costs of capital equipment by 10% to 15%, said Wicklund. The low unemployment and labor costs are likely going to generate a larger problem than tariffs, he said.

One of the challenges facing the industry is that E&Ps became more disciplined during the past few years on how they deploy capital, Pope said. “This does not bode well for organic growth for U.S. companies,” he said.

Organic growth for oilfield companies has become more muted compared to the past 24 months.

“The challenge for the domestic oilfield industry is how they grow,” Pope said.

Drilling in shale areas in the U.S. has lessened partly because of the bottleneck in the Permian in New Mexico and Texas.

Halliburton, a Houston-based company and the largest provider of hydraulic fracturing services, reported in October that its third-quarter earnings performed well and beat analysts’ estimates because of its international activity.

Why Further Consolidation Is Needed

Additional consolidation is needed in the near term in the well service space, wrote Mike Urban, a senior analyst at Seaport Global Securities, after meeting with management from Key Energy Services Inc. (NYSE: KEG). Basic Energy Services Inc. (NYSE: BAS) rejected an acquisition offer from Key Energy Services in September.

“Fundamentally, the production services business continues to improve in spite of (and arguably because of) Permian takeaway constraints, although labor shortages seem to have reached critical levels and, similar to other companies, KEG’s completion-related segments saw a slowdown in the third quarter.”

The only way for oilfield service companies to demonstrate growth in the cycle is to be more acquisitive, said Pope.

“I think we need more of it,” he said. “There are way too many onshore service companies, especially the ones serving the North American market. They are really ripe for industry consolidation.”

After scaling back in the years following the downturn, companies are now entering joint ventures in order to be able to react to opportunities quickly, said Shearer.

“Joint ventures allow companies to mitigate their risk by minimizing the amount of capital required,” he said.

Additional mergers and acquisitions are likely to occur, said Davies.

“When the trends are pointing in the right direction, it leads to higher valuations and more merger and acquisition opportunities as companies gain confidence in future growth opportunities and can see upside to a deal,” he said.

While the industry has a history of consolidation, Halliburton and Baker Hughes have proven that large-scale mergers are impractical, Davies said.

The “poster child” for additional acquisitions lies in the $2.38 billion merger of offshore drilling companies Ensco Plc (NYSE: ESV) and Rowan Cos. Plc (NYSE: RDC), he said.

“Other moves by larger players are likely to continue,” Davies said. “This all-stock deal was the most rational deal in several years and positioned as a merger of equals.”

After the largest ever offshore rig build cycle, offshore drilling is oversupplied, with most assets sitting on relatively small balance sheets while the businesses are still struggling to get pricing traction.

“It’s a recipe for larger consolidation to get assets onto bigger balance sheets and gain some scale in the market,” he said.“Increasingly, scale does matter, and I expect to see significant consolidation in the next three to five years.”

Margins In OFS

The oilfield service sector is not feeling the same optimism as the E&P sector because margins remain tight, said Shearer.

While there is a positive outlook because there is growth, during the downturn pressure was placed on pricing, he said. As demand continues to increase, the prices will follow the rise in revenue.

Since E&P companies are now more disciplined in how they utilize capital, it has not resulted in the service industry receiving pricing improvements, said Pope.

“The service industry does not feel the same level of optimism as they are reporting lower profit margins vs. the 2013 to 2014 prior-cycle peak,” he said.

Many of the service companies that have international exposure are just now entering the recovery in rig counts after a four-year downturn.

“They certainly aren’t feeling as constructive because service prices have not risen enough,” Pope said.

Oilfield service companies are still struggling on producing higher earnings, said Davies. Even though demand is rising, the companies are still “drawing down on that excess buildout in capacity that has caused a knock-on effect on the income statements of some service companies.”

If oil prices hold at their current levels, then these companies can “eventually draw down” on excessive capacity, and the service sector shouldn’t need to invest so heavily, he said.

“Free cash flow and margins will improve and start to increase quite nicely,” said Davies. “It should have a positive impact on stocks.”

Subsectors Performing Well

The one area in the U.S. that has done better during the past 18 months is the market for high-end, super-spec drilling rigs, said Pope. These types of drilling rigs are within 10% of prior-cycle day-rate peaks.

“That’s where we’ve seen the pricing environment become more constructive, and the outlook on returns appears to be robust,” he said.

The consolidation in drilling rig contractors reduces the number of providers and helps with pricing pressure, said Shearer. In addition, there are a number of drilling rig contractors who have emerged from Chapter 11 reorganizations with healthier balance sheets and are now in a good position to pursue acquisitions.

The completions and pressure pumping sectors are less active currently as a result of Permian infrastructure constraints, but there is optimism for mid-2019 and beyond, he said.

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