Oil services a long-term buy

by Levi Folk | September 13, 2008

Oil-services companies are again offering good value. Sector earnings may slow in the near term in sympathy with the global economic slowdown, but the economics of the oil sector are very supportive of growth for oil-services stocks over the long term.

Oil prices have fallen by roughly one-third over the past month and recent sentiment appears to favour the bearish case. However, pessimism is contagious and is creating an opportunity for long-term investors in oil-services companies.

The likelihood of oil prices breaking down in the near term is associated with the credit crunch and the possibility for a protracted global economic slowdown. This event would undoubtedly cause prices for these companies to fall further. However, even in this worst-case scenario, it would not change the long-term story.

The long-term case for oil-services companies is as follows: Oil supply needs to rise to accommodate rising demand from emerging markets; Oil companies—state-owned and otherwise—are spending hundreds of billions of dollars to increase supplies; Cost overrun is eating up the real value of this spending and is benefiting suppliers at the expense of producers. This trend will continue over the next decade.

Oil-supply growth is proving inadequate to create a significant production capacity cushion to alleviate high oil prices. The International Energy Agency has revised forecast supply lower due to cost overruns, delays and declines from mature oil fields.

The IEA reports project slippage on major production projects of roughly one year. This slippage translates to lower predicted supplies over the next five years. Scarcity of resources (“an endemic shortage of qualified labour, raw materials, drilling and fabrication/ engineering capacity,” according to the IEA) and cost overruns are the most important causal factors here.

Cost overruns range from 25% to 400% at Qatar's Pearl GTL Project. “With little sign of engineering and labour bottlenecks easing for the medium term, higher oil company revenues via higher prices will continue to be offset by high costs,” reports the IEA.

There are roughly 250 “major” non-OPEC production projects due on stream between 2008 and 2013 which will altogether add 16 million barrels per day (mbd) of new crude and condensate. This is a major increase in production, which will create opportunity and put tremendous strains on oil-service companies. However, that number represents gross production and therefore does not portend a collapse in oil prices by the end of that time.

High rates of decline in non-OPEC production means that roughly three mbd of non-OPEC productive capacity disappears each year. Therefore, net non-OPEC supply growth is predicted to rise by only 1.2 mbd over the next five. Contrast this net growth over the next five years with non-OPEC growth over the previous decade: Net growth was 2.1 mbd during 2003-2008 and nearly 4.5 mbd for 1998-2003.

Part of the problem is resource nationalization. In Russia, for example, projects have been delayed or abandoned due to state intervention. Independent oil majors are finding conditions highly unfavourable to business and many are getting shut out, the latest saga being the joint venture between TNK and BP.

Resource nationalism favours the service companies over the integrated companies because the former are willing to work for cash rather than own a piece of the action. Since the integrated companies want to own the reserves, their business model is in direct conflict with many governments' agendas. Moreover, these companies largely sold off their services divisions in the last energy bear market.

Decline rates are also being revised higher. This means that mature oil fields are producing less oil per year on average. Implied decline rates for "global baseline supply" are revised higher from 4% per annum to 5.2%. This results in reduced forecast capacity levels of 2.7 mbd lower than the IEA's prior year's estimate.

In January, 2007, I recommended oil-service companies based in part on the following comments: “All told, the IEA expects investment to rise to US$470-billion in 2010 and calls for US$8.1-trillion (using 2005 dollars) in capital spending in oil and gas infrastructure between 2005 and 2030, with half that amount being used just to maintain current supply capacity.”

Schlumberger Ltd. (SLB/ NYSE) the biggest service company is also the most diversified with roughly 22% of its income coming from North America. The company trades at a multiple of 18 based on this year's earnings and are expected to see earnings growth of almost 17% this year according to Thomson Financial. Even better value, National Oil Well Varco (NOV/NYSE) is trading at a multiple of 11 based on 2008 earnings, according to Thomson Financial, with expected growth of 33% this year. Haliburton Company (HAL/ NYSE) is trading at a multiple of 12 times 2008 earnings with 17% expected growth. Finally, Cameron International Corp. (CAM/NYSE) is trading at a multiple of 15 with expected earnings growth of 25%.

This thesis is premised on the idea that oil prices will trade in the US$90 to US$100 range over the next year. If that is the case, capital-spending plans in the oil sector should not change radically and oil-services companies appear to offer very good value.