Oilfield service stocks faced choppy conditions in a first quarter that had already seen substantial weakening in the energy sector as a whole. A week shy of the end of the quarter, the S&P Oil and Gas Exploration & Production ETF (NYSE: XOP) was down about 15% from year-end, with the PHLX Oil Service Sector (NASDAQ: OSX) trailing not far behind, down 10.8%.

Crosscurrents have been swirling, with multiple nuanced explanations. Traditional drivers of oilfield service stocks—higher capex budgets by producers translating into a rapidly rising North American rig count—have not held sway. As West Texas Intermediate (WTI) slid through the bottom of a $50 to $55 per barrel (bbl) trading range, short-term money exited oilfield service and other energy sectors.

A number of factors unsettled investors, including questions over OPEC’s commitment to extend its production cuts beyond midyear, depending on progress made in bringing global crude oil inventories down toward the five-year norm. This, together with an equitable sharing of the burden of production cuts—to date borne disproportionately by Saudi Arabia—was among key considerations that have been cited by the Saudi oil minister, Khalid al-Falih.

Questions have also been raised domestically. There are few signs of restraint on the part of producers in terms of throttling back capex. With the impact of increased spending to be felt largely in late-2017 and 2018, a number of analysts predict U.S. production growth approaching or exceeding 1 million barrels of oil per day (MMbbl/d) next year, and they have lowered WTI price decks. As of this writing, the Nymex WTI commodity curve does not exceed $50/bbl through March of next year.

In addition, what was previously viewed as a lean oilfield service sector with little spare capacity—limited by producers having a greater share of economic rent in recent years—has in fact managed to access capital and bring on new capacity in a number of subsectors, including pressure pumping and proppant supplies. This has raised increased risk of pushing out pricing power that in some cases was expected to help boost margins for service providers barely generating positive EBITDA.

Following the sell-off in the energy sector—likely amplified by near-record net long non-commercial futures and options positions—it’s clear oilfield service stocks have been re-rated to bake in a greater ambiguity in the outlook. So, leaving aside some of the larger players, such as Schlumberger (NYSE: SLB), which have held up better, Oil and Gas Investor asked analysts to suggest names which they would recommend to clients.

J. David Anderson, CFA, is senior equity analyst covering the oilfield services and equipment sector at Barclays, which he joined in 2014. The Barclays team held a neutral rating on the sector for two years, before upgrading it to positive in the wake of the company’s global upstream spending survey earlier this year. Trends observed in the January survey were updated by Barclays in March.

“We realized spending was beginning to inflect after two very difficult years, particularly in North America,” recalled Anderson. “We thought E&P spending would be up over 50% this year, and that’s essentially been con-firmed as all the budgets have come out.”

Barclays’ latest survey shows North America leading the way in terms of capex increases, with 2017 spending by large-cap E&Ps and smid-cap E&Ps up 51% and 57%, respectively, over the prior year. In its international survey, spending by independent oil companies and national oil companies is projected to be up 22%. For U.S. independent oil companies, capex is expected to rise by just 3%. In total, global spending is projected to be up 9%.

“The survey results made us feel really positive about the economic rent,” said Anderson. “The economic rent tends to go back and forth between the E&Ps and the service providers. It’s been firmly in control of the E&Ps, except for a brief instance in 2014, for the last seven or more years.

“We see an opportunity for this to start swinging back into services, and we think investors will start to shift out of the E&P sector and into services,” he continued. “We see supply chains starting to tighten and pricing starting to improve.”

Anderson acknowledged, however, that a $50/bbl price was pivotal in the U.S. energy sector’s plans to continue to drive production— and, in doing so, drive the market for oilfield services and equipment.

“In a $50 to $60 oil world, people feel pretty confident that E&Ps will continue to spend and grow,” he said. “But if oil prices dip below $50, then everything changes; it’s like night and day. You don’t see the same growth as E&Ps curtail some of their plans. You don’t see the same tightening of the supply chain. You might actually even see more overcapacity of service equipment.”

Pressure pumping

Already, there are some signs of pressure pumping capacity getting ahead of demand.

“We’re seeing a tremendous amount of pressure pumping capacity being added,” said Anderson. “We’re seeing companies that plan to double the number of frack spreads they operate in the next 12 months. Frankly, I struggle to see how they’ll crew those up efficiently and without problems.

“We’ve known other pressure pumping companies that have had crews together throughout the downturn, and they’re very efficient. But when you put together 30 new guys who have never worked together, the lack of expertise translates into poorer quality and you’re bound to have less efficient services. That’s the point at which E&Ps will turn to Halliburton and say, ‘OK, how much do I need to pay you to come out?’”

Two oilfield service stocks he favored are Fairmount Santrol Holdings Inc. (NYSE: FMSA) and Forum Energy Technologies Inc. (NYSE: FET). Both have pulled back substan­tially since the end of last year, but are viewed as early beneficiaries of the higher activity levels.

Fairmount is a proppant provider based in Chesterfield, Ohio. Barclays’ target price on Fairmount is $9/share, representing just under 35% upside from a March 24 closing price of $6.67. As a group, Fairmont and its peers have benefited from the industry trend toward markedly longer laterals and higher intensity completions. However, when news arose of sand capacity additions in the industry, Fairmount and its peers sold off hard.

Barclays believes the re-rating of Fairmount’s stock, which traded above $12 for a period earlier this year, offers an interesting opportunity on several counts.

First, some 10 million tons per year (mtpy) of additional capacity, including newly found regional capacity at lower cost, will have only a modest impact on a sector with such steep demand growth expectations. The sector has a current run-rate of production of around 60 mtpy—roughly in line with the prior peak demand year of 2014—and yet, demand is forecast to rise to about 100 mtpy in 2018. The sector’s nameplate capacity is 110 mtpy, but effective capacity is closer to 80 mtpy, noted Barclays.

Additionally, Fairmount’s stock price reflects margins of $20 to $25/ton, well below the $40/ ton peak in margins earned in 2014, according to Barclays. And even as the sector is facing rapidly rising demand, the stock market value accorded to Fairmount and its peers has come down by about 3.5 turns—from close to 10x to almost 6x—in terms of enterprise value-to-EBITDA (EV/EBITDA). On an EV/EBITDA basis, the group now trades one full turn below the pressure pumpers they supply, added Barclays.

“We’re already back to 2014 peak demand levels, and the upturn is just getting started,” said Anderson. “I wouldn’t get too worried about capacity additions—we’re going to need them. It’s principally the fine mesh sand that people are having problems getting. E&Ps may have to start testing other types of sand. Maybe they’ll start trying ceramics again, although it’s at a much higher price point.”

Inventory correction

Forum Energy, based in Houston, offers a play on North American short-cycle equip­ment, especially the completions segment and refurbishing land rigs. Barclays’ target on the stock is $24/share, representing 29% upside from its closing price of $18.60 on March 23.

“There are very few ways to play short-cycle equipment,” said Anderson. “When we talk about the supply chain tightening, this is one area that’s going to be very tight. As service companies bring their pressure pumping equip-ment back to work, they’ll need to replace all sorts of parts, including manifolds and fluid ends. Rigs will need upgrading with 7,500-psi mud pumps, which are now almost a requirement for drilling 10,000-foot lateral wells.”

Forum Energy’s stock pulled back on the company’s release of fourth-quarter earnings, which included incremental margin guidance that was weaker than expected. While its order intake was solid, up 26% from the prior quarter, start-up costs of adding shifts were higher than expected, pointing to lower fixed cost absorption than anticipated. Nonetheless, Barclays is sticking with its positive stance.

“It’s an inventory correction story,” said Anderson. “A lot of parts and equipment are in customer inventory. When the market goes down, customers use up their internal inventory, so you get a double hit from both the market drop and inventory correction. On the flip side, the opposite happens, and we think that is a second-half event. Demand not only picks up, but you get almost a turbo boost on that demand, as customers start to restock their inventory.”

J.P. Morgan holds a neutral opinion on the oilfield services sector, according to senior equity research analyst Sean Meakim, CFA, who looks for quality names capable of outperformance in a range-bound crude oil price environment. Two names that he favors: Keane Group Inc. (NYSE: FRAC), which went public in January; and seasoned land driller Nabors Industries Ltd. (NYSE: NBR).

A scenario of range-bound oil prices, between $40/bbl and $60/bbl, is based on Saudi Arabia having “effectively underwritten an oil price of around $50/bbl, in turn taking the bear case of $40 oil off the table in the near to medium term,” according to Meakim. “But if Saudi Arabia is your floor somewhere in the $40s, shale is your ceiling as you get close to $60.”

Meakim attributed the pullback in oilfield service stocks to a downshift in consensus oil expectations. Whereas the stocks previously baked in a move in oil to $60/bbl—and possibly $70/bbl thereafter—the market has recently “refocused on the potential capping of the upside case for oil as shale productivity has grown stronger and shown itself capable of doing more with less,” he said. “I think that’s becoming the consensus view.”

Given the more limited upside seen in the commodity outlook, Meakim’s approach is to identify high-quality names, with a focus on strong balance sheets and “idiosyncratic rate of change” stories. While the pressure pumping sector is expected to be deluged by “a tide of capital coming into frack,” Meakim views Keane’s prospects positively. He has an overweight rating on the stock and a target price of $27/share, offering upside of 70% from its March 23 close.

Keane is one of the largest pure-play pressure pumpers, with operations in major basins, including the Permian, Scoop/Stack and Marcellus-Utica plays. The springboard for its growth was the purchase of Canadian Trican Well Service’s U.S. operations in the first half of 2016. As of mid-March, in its first report as a public company, Keane had 16 active fleets—of 23 total—up from 13 at the end of 2016.

“We see Keane as a likely participant in further consolidation,” commented Meakim.

Relative to its fourth-quarter revenue of $151 million, Keane has guided to 30% to 40% growth for the first quarter, helped by recent rig reactivations and traction in pricing. Higher prices are projected to drive revenue per rig from an average of $49.3 million in the final quarter of last year to $63.4 million in fourth-quarter 2017, according to the J.P. Morgan model. Keane’s active fleet count is forecast to rise from 15 currently to 19 fleets in the fourth quarter.

As for Keane’s mix of customers and contracts, “it’s fair to say you want to have spot exposure at this point in the cycle; you want to have the operational leverage that can come with improved pricing,” said Meakim. “But I think Keane is willing to term out some contracts with their best customers.

“The key to this business, when pricing is 75% to 80% off the 2011 peak, is that you need to get the right customers to drive a high-efficiency model,” observed Meakim. “Keane recognizes that the best way to drive margin expansion is through high-efficiency frack operations. And that’s where I think their value-add is: If you have the right customers, you can go fast.”

Meakim also highlighted Nabors, a veteran land driller with both U.S. and international operations. Nabors’ short-term U.S. contracts “offer better prospects for dayrate recovery,” said Meakim, while its international drilling “is already poised for growth” ahead of prior expectations. J.P. Morgan’s price target for Nabors is $24/share, offering more than 80% upside from its March 23 closing price of $12.66.

Meakim favors the “differentiated strategy” pursued by Nabors following the sale of its “commodity services assets” at the June 2014 peak of the cycle. Proceeds were re-invested in technologies used to develop a suite of higher-value services “adjacent to its core drilling business” under the Nabors Drilling Services umbrella, providing a “much better strategic fit than what they owned historically.”

Importantly, in late 2016, Nabors also signed a joint venture agreement with Saudi Aramco, in which Nabors is “locking in its position as the leading land driller in the most stable, more durable international land drilling market,” said Meakim. While “not without risks,” the joint venture is “a long-term positive for the stock in the form of a stronger, more sustainable cash flow profile.”

Barclays recommended veteran land driller Nabors, crediting the company with future international growth and good prospects for short-term contracts in the United States.

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