The service and supply sector has been bruised and buffeted in the past couple of years. In 2012, service companies suffered sinking natural gas prices and faltering pressure-pumping rates. In 2013, E & P spending was so-so, with widely varying surveys indicating spending was up 4% or plummeting by as much as 3.2% from the previous year.

Regardless of these negatives, in 2014 more money will be spent. How much? A Barclays Capital survey estimates U.S. E & P spending could spike 8.5%. A Cowen and Co. survey reported a 5.3% increase possible.

Oil and Gas Investor talked with analysts about their expectations for the sector in 2014 and where activity is likely to pick up or slacken.

Good bets are to be found. Frac sand, one analyst says, is poised to bring solid returns. More demanding work cycles will increase the efficiency of frac time as E & Ps look to supercharge their productivity. And calls for re-examining the ban on oil exports could have a dramatic impact on the industry if it appears more oil wells need to be drilled.

Service sector giants—Halliburton and Schlumberger in particular—are expected to dominate activity in 2014. Other large-cap companies, Baker Hughes Inc. and Weatherford International, are formidable but in states of flux, some analysts say.

One clear trend: Many E & Ps will have the throttle wide open on full-scale development drilling as they turn to a growing backlog of untapped wells.

The atmosphere for the service sector promises to be competitive and challenging, especially for those that lack differentiated technology or product service line portfolios.

“I think where the industry is going, it's basically a game of increasing velocity in terms of converting an E & P's assets into production faster,” says William A. Herbert, managing director and co-head of securities for Simmons & Co. International.

James C. West, lead oil service and drilling analyst for Barclays Capital, is bullish on oilfield services, especially given Barclays' expectation for an uptick in E & P spending in North America.

“We expect market fundamentals to favor service companies for the next several years,” West says. However, that won't initially benefit most companies, which will operate at maintenance capital levels.

“The first splash of this capex is going to absorb the equipment that's already in the field,” West says. “I really don't expect the oil service industry to throw a lot of additional capital at the shales until we get to the back half of the year or into 2015. Right now a lot of product lines are underutilized.”

Making the play

The Permian Basin is a microcosm of what faces service companies in 2014.

It is the leading engine of growth for the service industry. Over the course of 2013, the Permian horizontal rig count expanded by 65% while the like rig count in the Eagle Ford and Williston Basin treaded water and the Marcellus declined by 13%, Herbert says.

The money being thrown at the Permian will spark activity. But service companies weathering the Texas heat in 2014 won't be that much better off than those in other plays. All are dealing with a glut of service equipment across multiple products tied to new well completions, West says.

As many as 10,000 companies provide services and supplies to the industry, according to the American Petroleum Institute.

Simmons & Co. projects horizontal well count growth from 2013 to 2015 at 8% per annum. Given the price of natural gas, horizontal oil wells in particular are anticipated to grow at a 13%-per-annum rate over the period.

The most worked basins, currently representing close to 60% of the domestic horizontal rig count, will continue to drive the lion's share of activity. Of the roughly 1,200 horizontal onshore rigs in the US, 237 are in the Permian, 194 in the Eagle Ford, 178 in the Williston and 83 in the Marcellus, Herbert says.

Growth is in the offing in the Bakken, Niobrara and the Marcellus, West agrees.

Despite the level of competition, investors should be positioning in small- to mid-cap service company names likely to benefit from incremental improvements in equipment or crew utilization, according to analysts. They should also look to well-count-driven stocks rather than those levered to rig count.

Small- to mid-caps will eventually “do just fine in a rising tide,” West says. Across the spectrum, none appear to have distressed balance sheets. While they might be more leveraged than large-cap companies, they're not cash-flow negative.

Companies that West views as having upside include C&J Energy Services, Calfrac Well Services, Key Energy Services, Patterson-UTI Energy, Superior Energy Services and Trican Well Service. He also likes National Oilwell Varco, but said his top stock pick is capital-equipment company Cameron International.

“While Cameron's execution problems and persistent guide-downs have been an issue, we believe execution is poised to improve and think estimates are now at achievable levels,” he wrote in a report.

Herbert, too, likes Patterson-UTI Energy in the small- to mid-cap group. In an analyst note, he wrote that the company remains “our favorite land driller based on a combination of valuation (cheap on EBITDA, not so cheap on earnings after tax net income), balance-sheet quality and management's continued willingness to return capital to shareholders.”

With enough money put to work by operators, the outlook could be rosy for service companies in certain plays. The Permian, for instance, could experience net additions for horizontal rigs in the range of 50 to 70 units, about 35% more than current levels. “We think the demand tied to these units would help fully rebalance the market for pressure pumpers and provide better utilization for coiled tubing units, wireline equipment and land rigs,” West says.

The Eagle Ford should turn in a good year, too, and contribute to growth in 2014 despite it “fading as a play” in some people's minds, says Brad Handler, managing director and senior oilfield services analyst with Jefferies & Co. Activity could also increase in the Utica, though the prevalence of dry gas there may dampen enthusiasm.

“There is talk about the Bakken kicking up a little bit,” Handler adds. “It's been relatively disappointing.”

Handler says the Permian may be interesting to watch for different reasons. Inconsistent production from Permian horizontal wells could be worrisome.

“The shale is not very thick. Sometimes you're dealing with 10 feet or 20 feet of pay,” he says. “If you attack that, especially if you don't use rotary steerable systems, it's easy to fall out of the zone. So your production may disappoint, which may take some of the wind out of the sails of the Permian.”

The Big Four

In the realm of large-cap, well-managed service companies, odds are that investors are focused on the balance sheets of either Schlumberger or Halliburton. Along with Baker Hughes and Weatherford, they make up the Big Four, the powerhouses of the sector.

Schlumberger is West's top pick, with Halliburton second. But the companies are often neck-and-neck to analysts.

“They're the clear favorites in my mind,” West says. Schlumberger benefits from international growth he thinks will expand in 2014.

Schlumberger appears to be executing at higher levels than most of the companies in the sector, with the best margins and cash-flow profile. Halliburton, the leading frac company, stands to benefit from international expansion as well as upticks in the U.S. land market.

“Most of that growth is in markets that are national-oil-company dominated, and SLB has the best relationship among the Big Four with the national oil companies,” West says.

Herbert's top pick is Halliburton.

Large-cap service and capital-equipment stocks have, on average, the potential to appreciate by 15% to 20% over the next six to 12 months.

In the coming year, Herbert sees a potential 25% upside for Halliburton. But Schlumberger offers the best downside support in the large-cap service and capital-equipment group and offers commendable upside, he says.

Whether it's more horizontal drilling, US shale development or deepwater and offshore activity, the technical requirements favor the sophisticated capabilities of the Big Four.

Weatherford is in the midst of considerable change, Handler says. “Weatherford has indicated that roughly a quarter of its revenue comes from activities that have not been as profitable as management would like,” he says. “So it will attempt in various ways to step away from those or at least to fix them.”

The company will likely put some small businesses up for sale and exit certain activities in Iraq. “You'll also see a spin-off into a separately traded entity of its international land-drilling business,” Handler says.

West says Weatherford will stick to four high-quality businesses: well integrity, artificial lift, formation evaluation and stimulation.

Meanwhile, Baker Hughes had a rough patch or two in 2013. The company will be a little more of a “self-help story” in 2014, West says.

The company underperformed significantly in North America, with trouble in the pressure-pumping business.

However, market dynamics will play to its favor in 2014. “It's much easier to fix the business in a market that is improving rather than a market that is deteriorating, which is what it had been doing,” West says.

And although pressure-pumping demand appears to have bottomed, a full recovery is unlikely before the second half of 2014, says Daniel R. Leben, analyst for Baird Equity Research, in a December report.

Good, on sandpaper

In the coming year, E&Ps will focus on delivering the lowest-cost barrel possible. Service companies that can help them achieve that will be the winners. Therefore, the gap between best-in-class companies and the rest will continue to widen, Herbert says.

In 2014, that means more frac stages, more wells drilled per rig and around-the-clock operations. And for some supply companies, that lines up nicely as a potential money-maker, Handler says. “There are a lot of initiatives underway to use even more sand per well or per stage, and that can keep that market tight and drive a lot more revenue growth.”

Handler is enthusiastic about supply companies, particularly frac-sand suppliers such as US Silica. The company is adding capacity, “and we're glad they're adding capacity,” he says. “I like how they run their business, and more fundamentally, in terms of demand for their product, more 24-hour work, more completion stages per well and rising quantity of sand used per stage, all imply a lot higher demand for sand. So there's a revenue opportunity there.”

Jefferies' outlook points to 18% growth in year-over-year demand for frac sand by the fourth quarter of 2014. Some of that is due to companies performing more 24-hour fracturing work than in 2013. Companies are attempting to work two 12-hour shifts per day, and thus perform six or more completion stages per day instead of three or four, effectively cutting their frac times in half.

While 24-hour work has been done for years, more companies are now trying to make it work. “This shale-development process is encouraging efficiencies across the chain,” Handler says. “This is oil companies bringing a manufacturing mindset, trying to make it all sort of very predetermined” and, as a result, faster and more efficient.

Far off from all that grit, Handler also recommends the deepwater-focused service company Oceaneering International Inc. It estimates its EBITDA will increase to $845- to $880 million in 2014 from about $745 million in 2013.

Service and survival

Herbert describes the plight of the U.S. onshore service market as a “Darwinian struggle.”

The companies' fates are tied to the stupendous production growth prospects offered by domestic resource development. But the sector remains overcapitalized and fragmented. Consolidation should be in the works, but no signs have emerged for what Herbert calls a more rational, competitive industry. Instead, the domestic oil service market will remain “challenging for essentially all participants, but especially for those companies that either don't have differentiated technology or differentiated breadth with regard to their product service line portfolio.”

Growth, rather than capital spending discipline, remains the singular aspiration of the domestic E&P industry, which augurs reasonably well for oil service revenue growth this year, Herbert says.

The prospects for increased spending should boost revenue growth. That's partly due to the surge in commodity prices late last year and a favorable hedging opportunity that allowed E&Ps to secure cash flow.

But service companies are seeing their prices bottom, Herbert says, even as activity increases. Stagnation may follow, barring a revival in natural gas drilling and increased basin breadth driving growth. Adding to competitive pressures, the production onslaught in the US will cause oil prices to shrink from “unsustainably higher levels given the resource abundance.”

Herbert sees one potential wild card in the mix, though he finds it unlikely to be played soon. In December, Secretary of Energy Ernest Moniz said the federal government's policy of restrictions on crude exports was born from oil disruptions that no longer apply. “There are lots of issues in the energy space that deserve new analysis and examination in the context of what is now an energy world that is no longer like the 1970s,” he said.

The U.S. exports fewer than 100,000 barrels of crude per day, mostly to Canada.

As things stand, the US could see deteriorating domestic crude prices and fewer dollars invested in the energy sector.

Were restrictions lifted, the potential consequences would be profound for price differentials, compressing them with a combination of weaker Brent and stronger domestic grades and refined-product pricing. E&P companies would likely spend more, too.

For now, the importance of improving efficiencies and lowering costs will become more acute. In 2013, the service industry began to embrace “the doctrine of realism and the virtues of capital” restraint, Herbert says. Companies have lowered capital spending, improved free cash flow and returned cash to shareholders.

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