Mega deals to shape oil services

The aggregate value of sector-wide deals this year comes in at $83.2bn, which eclipses the previous high-water mark in 2007 by 39 per cent. The bridging loan linked to the Halliburton bid has pushed global M&A lending to a post-Lehmans high of $665bn for the year to date, according to Thomson Reuters. And the white noise on company bulletin boards, together with analyst conjecture, suggests there's more to come.

European operators like Saipem SpA (It:SPM) and Subsea 7 (No:SUBC) are touted as likely targets. Saipem's principal shareholder, Italian oil major Eni SpA, has already brought in Credit Suisse to map out options for the sale or part-sale of its 42 per cent stake in the oil services company. Even Norway's Seadrill, which has suffered due to its strong commercial links with Russian state-controlled energy giant Rosneft, saw its share price rise amid takeover speculation.

Oil prices have sunk below $80 a barrel, which is broadly held as the level below which oil majors will start mothballing capital projects. The great imponderable is how long the price slump will last. Interestingly, however, valuations within the sector began to pull back even before crude oil prices started to fall in July. The majors were already cancelling lower-margin exploration and production projects as part of an industry-wide focus on capital rationalisation.

Short of a definitive move by Opec to tighten supply, the near-term risks to the price of Brent crude are weighted to the downside, particularly if - as some analysts maintain - Saudi Arabia is trying to put the squeeze on lower-margin shale producers in North America. However, even if the cartel makes meaningful cuts to its production quota, any subsequent price recovery could be short-lived. Opec's production policy is still a key price driver, but it exerts far less influence than it used to. A sudden supply outage would make this all the more obvious: Saudi Arabia has less and less of the spare capacity necessary to offset a production shut-down in the more turbulent pockets of the Middle East.

There are so many permutations to the oil supply-demand balance that it's impossible to assess its likely price trajectory with any degree of certainty. While the market bears currently hold sway, perceptions can change rapidly. The last time crude oil prices fell by more than 25 per cent was in June 2012, when they hit a 12-month low of $90 a barrel. But by August the price of crude had recovered to $115. Commentators seem resolutely downcast on the oil price, but that may be more backward- than forward-looking.

Whatever happens to the oil price, the UK domestic industry could be open to consolidation, due to its relative fragmentation. The trend in the US has been towards the formation of companies that offer a comprehensive range of oil services to their clients, whereas there still seems to be room for specialist providers in the UK. There's no doubt it's possible to reinforce margins through economies of scale, but novel technologies can also act as an effective buffer against market volatility. So which UK oil services companies are best equipped to see through the current difficulties? And which industry specialists afford the best long-term growth prospects?

Favourites: Shares in Hunting (HTG) have underperformed the wider market over the past month, as fears mount that the decline in West Texas Intermediate prices could hit the rig count for US shale drillers. However, a third-quarter update earlier this month confirmed that the group remains on track to deliver on full-year profit guidance. And we remain positive on the long-term prospects for the group, as its specialist product offering should benefit from the industry-wide shift to directional drilling.

Another company driven by technological dynamics is Plexus Holdings (POS), an Aberdeen-based developer of POS-GRIP wellhead technology. This is a proprietary system designed to work at extreme pressures and temperatures. It is not only uniquely well suited to the new wave of deepwater or unconventional projects, but also offers safety performance well in excess of industry standards - a compelling combination in a post-Macondo world. Plexus has already made significant inroads into the market, with its technology employed at over 300 wells owned by the likes of BG Group (BG.), Shell (RDSA), ConocoPhillips and Repsol. The potential for the roll-out of the POS-GRIP is enormous, which could make Plexus a target for one of the big US players.

Amec Foster Wheeler (AMFW) has been the strongest performer among the larger sector constituents in the UK over the past three years, possibly because it's not a pure oil services play. The group, which has delivered a total return of 43 per cent since 2011, adapts its engineering and design expertise to meet the needs of a variety of sectors, ranging from mining through renewable energy to pharmaceuticals. AFW has established a strong presence in both nuclear and transport cum infrastructure, which provides a degree of predictability on revenue streams.

The company generated £279m from so-called growth regions in the first half of 2014, but about 85 per cent of revenues are still linked to the Americas and Europe. Two-thirds of European revenues came from oil services, with the bulk of the remainder drawn from clean energy. Of the £1.06bn in half-year revenues generated in the Americas, 36 per cent was attributable to clean energy, while oil and gas provided 29 per cent, infrastructure spending 20 per cent and mining 15 per cent. Amec's commercial offering was broadened through the £1.9bn acquisition of US-based Foster Wheeler, which completed earlier this month.

Outsider: The rumour mill has had plenty of grist lately, with UK operators like John Wood Group (WG.) and Petrofac (PFC) mentioned as possible takeover targets. The latter - a FTSE 100 constituent - is looking all the more vulnerable after it revealed this month that net profit for the current financial year would be at the lower end of previous guidance. In a profit warning that wiped nearly 30 per cent off its market capitalisation, the group also warned that next year's profits would be arouind $500m - more than a quarter lower than current expectations - because of the falling oil price and poor project delivery.

IC VIEW:

Sentiment towards the sector is lukewarm at best, although the recent merger speculation has provided some support. The UK oil services industry may follow the lead of its US peer, but we think any financial benefits from mergers could be offset by the effects of over-capacity as the oil majors cut capital spending. However, recent history suggests technological innovation is likely to be the key driver of growth in the sector - hence our preference for specialist plays Hunting and Plexus. Speculations on Opec strategy aside, the oil services sector could receive boosts next year from the implementation of recommendations from the Wood review into North Sea production and the ongoing liberalisation of Mexico's oil and gas industry.