Valuations in the oil services sector are low by historic standards following some tough years blighted by a North American gas glut, a massive oil spill in the Gulf of Mexico and general global economic uncertainty. But all this looks like it could be about to change, making it a prime time to buy into the sector. North Sea expenditure is predicted to boom between now and the end of 2017. In addition, according to US-based GBI Research, emerging markets' demand will underpin a 72 per cent rise in the value of the global oilfield services industry in just five years. Activity in the Gulf of Mexico is beginning to recover. Meanwhile, offshore licences in Brazil and West Africa (Angola, Ghana and Nigeria) are set to draw in the largest deepwater investment receipts over the next few years.
Eighties Nostalgia
From midway through the 1980s, a number of US integrated oil and gas majors started to outsource their 'upstream' drilling and extraction functions to third-party operators. At the time it would have seemed a fairly unremarkable decision given that the business end of the industry was still perceived as a labour-intensive, low-tech affair that simply sucked in capital and pushed up fixed costs. All the value-added functions were performed 'downstream' - or so it was thought.
Twenty-five years on, and some of the executives behind the switch to outsourcing might have come to regret their decision. During this quarter century, many of the majors became effectively self-exiled from what was to become one of the most profitable corners of the energy market. In addition, the expansion of a large-scale oilfield services industry also served to embolden national oil companies (NOCs), which, through a lack of technological expertise, had previously been in thrall to the integrated majors. It's therefore reasonable to suggest that the rise of NOCs - detrimental as it has been to the interests of western oil companies - is an indirect consequence of the industry's move towards upstream outsourcing.
By the end of the 1980s, adjusted for inflation, the oilfield services sector was valued at around 40 per cent of what it is worth now. Back then, most oil service providers, even established names, were relative minnows by comparison with their paymasters. Now, the value of industry leader Schlumberger (NYSE: SLB) outstrips that of ConocoPhillips (NYSE: COP) and BG Group (BG.) and isn't that far adrift of the likes of BP (BP.) and Chevron Corp (NYSE: CVX). And the largest oilfield services companies, those with the biggest research and development budgets, have demonstrated double-digital compound annual growth rates since the turn of the millennium.
What happened to tilt the apparent balance of the oil industry in favour of service providers over producers? The answer, in short, is technological innovation. As much of the world's remaining untapped sources of conventional hydrocarbons are relatively inaccessible, either in terms of geography or geology or both, oil service providers have been forced to invest heavily in order to develop a new range of extraction technologies - chief among them directional drilling - which have not only changed the economics of the oil and gas industry as a whole, but have effectively pushed up barriers to entry within the oilfield services sector.
Consolidation post Deepwater Horizon
It could also be argued that the increasingly capital-intensive nature of the sector has provided a catalyst for consolidation. The proposition is certainly supported by industry trends. In fact, the push towards consolidation within the sector was given added impetus by BP's Deepwater Horizon disaster, as it was subsequently felt that some oilfield services providers would need to become more geographically diversified and retain larger capital reserves in order to manage risk effectively in the wake of the disaster.
These factors were partially behind the 2010 merger that resulted in the formation of Subsea 7 (OB: SUBC), a NOK 47.2bn (£5.52bn) seabed-to-surface engineering specialist that is one of our preferred long-term plays in the sector. Subsea 7, with its regional expertise of operating off the Norwegian Coastal Shelf, was recently awarded a $380m (£253m) contract from Statoil ASA (OB: STL) linked to the development of the Aasta Hansteen gas field in the northern Norwegian Sea. That means that Subsea 7 has won around $960m in new contracts since the end of January, and it underlines an overall step-up in North Sea exploration and expansion, which is generating the highest level of investment in 30 years, according to analysts at UK Oil & Gas. Subsea 7 is also strongly placed in West Africa.
North Sea boom
The North Sea resurgence is due in part to favourable long-term Brent Crude projections, together with advances in offshore drilling techniques, which have brought a number of depleted mature fields - once classified as marginal - back into play. Additionally, moves by the Exchequer to bring the tax regime for UK producers more into line with their counterparts in Norway has removed a degree of uncertainty, especially with regard to the level of decommissioning tax relief available.
A lack of clarity over decommissioning costs acted as a major disincentive over the past decade, and this was at a time when annual spending on exploration and production still rose fourfold in nominal terms, while oil production increased by only 12 per cent. In other words, at constant prices, producers have had to contend with diminishing returns on capital employed. Rising oil and gas prices have obviously acted as a buffer for producers, but the last thing they needed under these circumstances was an opaque tax regime.
| Price | 1-yr high | 1-yr price change (%) | Forward PE (1 yr) | Return on equity | 1-yr EPS growth (%) | DY (%) | Analyst consensus buy/hold/ sell | |
|---|---|---|---|---|---|---|---|---|
| AMEC | 1,052p | 1,172 | –9.6 | 12.1 | +17.6 | +14.4 | 3.5 | 11B 6H 4S |
| Baker Hughes | $45.84 | $50.10 | –15.1 | 15.0 | +7.99 | +8.2 | 1.3 | 9B 23H 1S |
| Halliburton | $42 | $43.32 | +27.3 | 13.9 | +18.2 | +15.4 | 0.9 | 26B 9H 0S |
| Hunting | 942p | 968p | +2.7 | 15.0 | +17.1 | +49.5 | 2.0 | 7B 6H 2S |
| National Oilwell Varco | $67.68 | $84.83 | –11.1 | 11.3 | +13.2 | +37.4 | 0.7 | 27B 7H 0S |
| Petrofac | 1,502p | 1,772p | –11.3 | 11.0 | +47.5 | +25.2 | 2.9 | 9B 12H 2S |
| Schlumberger | $77.78 | $81.56 | +10.5 | 16.5 | +16.6 | +14.3 | 1.4 | 33B 5H 1S |
| Subsea 7 | NOK 141 | NOK 148.25 | +15. | 15.8 | +13.4 | +29.4 | 2.4 | 25B 5H 1S |
| Wood Group (John) | 862p | 876p | +20.2 | 12.8 | +12.3 | +44.3 | 1.3 | 9B 7H 1S |
IC VIEW
We've certainly been here before. From 2005-07, sector earnings were buoyed by price inflation linked to unprecedented rig utilisation rates, exacerbated by a rapid expansion of the US domestic rig count. In a two-year period through to July 2007, the S&P 500 Oil & Gas Equipment Services index rose by 189 per cent. Subsequent events have had a deleterious affect on index values - not least of which the collapse of Henry Hub gas prices in the US. As a result, the index has recorded a marginal contraction (minus 0.97 per cent) on a total return basis over the past five years, but its recent strong performance adds ballast to the view that the industry has exited a trough in terms of cyclical expenditure. The S&P index is currently 15 per cent adrift of its 2007 high, with oilfield services companies now trading at an average 12.7 times 2014 forecast earnings (against a historic multiple of 14.4). Consensus estimates point to 15 per cent earnings growth this year, followed by a rise of 22 per cent in 2014.
