It might be an exaggeration to suggest that the wider energy market is now locked into survival mode, but the rollout of oil and gas companies that have pared back capital budgets for 2016 continues apace. Estimates vary, but capital spending across the industry is set to contract by around 30 per cent through 2015-16. And recent analysis from Wood Mackenzie indicates that large-scale projects with contingent reserves equivalent to 20bn barrels of oil have been deferred as a consequence of the prolonged slump in oil prices. Obviously this explains why FTSE 350 constituents engaged in the supply of oil equipment and services have taken such a beating of late. Unfortunately, prospects for 2016 remain gloomy.
Assumptions for a depressed oil price environment came after a decade-long boom in upstream investment, so the negative effects on service providers have been amplified. In all likelihood, oil majors will prioritise dividend commitments and debt retrenchment over reserve replenishment, at least until it's generally assumed that we've reached an inflection point in crude oil pricing. Until that point, and probably for a lengthy interval thereafter, exploration/appraisal remits will be thin on the ground.
It’s worth noting that while the recent lifting of economic sanctions against Iran promises to exacerbate the existing glut in global crude markets, as Tehran activates first-phase plans to lift oil production by 500,000 barrels a day, over the long-haul the move could prove highly lucrative for the oil services sector. Iran’s energy infrastructure is largely dilapidated following a decade of sanctions, but now the country will have access to billions of petrodollars frozen in foreign banks. It’s little wonder that representatives of the UK oil services sector were among the first business delegates to visit Iran ahead of the lifting of sanctions.
Although the average forward earnings rating for the FTSE 350 constituents is well below the long-term average, Neill Morton and Brian Gallagher, industry analysts at Investec, recently ventured that valuations for the oil services sector are now subject to a structural derating. Valuations across the sector have pulled back alarmingly as industry capital budgets were slashed in response to the ‘new normal’ in crude pricing. Only a small number of producers have released their 2016 budgets to date, but early estimates point to a 35-38 per cent contraction in industry capital expenditure from its high-water mark in 2013. Admittedly, expenditure mandated by National Oil Companies, and remits from the Gulf region, have held up reasonably well, but there are only a limited number of sector constituents that carry a favourable mix within their contract portfolios.
| NAME | Price (p) | Market cap (£m) | PE (x) | DY (%) | 1-year change (%) | Last IC view |
| AMEC FOSTER WHEELER | 382 | 1,488 | 5.0 | 11.4 | -53.2 | Buy, 478p, 18 Nov 2015 |
| PETROFAC | 712 | 2,463 | 7.5 | 5.9 | 13.7 | Hold, 752p, 26 Aug 2015 |
| WOOD GROUP (JOHN) | 590 | 2,233 | 8.7 | 3.2 | 6.8 | Hold, 574p, 19 Aug 2015 |
Favourites
Petrofac (PFC) may be a bright spot. The oil services engineer has already entered into development analysis for the Kuwait Oil Company's (KOC) Lower Fars heavy oil development, while an increase in activity at the group’s onshore engineering and construction (OEC) business has helped to support revenues.
Nevertheless, the group’s market value has contracted by around 40 per cent over the past 12 months, suggesting that the potential revenue streams linked to the KOC projects and a relatively defensive contract mix hasn’t been enough to sway the market. Admittedly, full-year profits will be held in check by delays at the troubled Laggan-Tormore gas plant project, located in the Shetland Islands. But even taking Laggan-Tormore into consideration, the group trades at an undemanding 14 times forecast earnings. Petrofac also offers a yield in excess of 6 per cent, with a cover ratio of 2.4. As such, it’s relatively secure and even has headroom to grow over the medium term.
Outsider
At the tail-end of 2015, the share price of Amec Foster Wheeler (AMFW) headed south after the group announced it was halving its dividend and pushing through another $55m in cost savings on the back of a profit warning. The severity of the sell-off seemed rather severe at the time, particularly given the group's diversified revenue streams - surely a bull point in the current environment. The stock trades at a sizeable discount to peers based on historic multiples, but it's unlikely the shares will re-rate before gearing is brought down.
