Unlock fracking profits

Yet the 'shale bonanza', as we termed it in a recent article, is set to run and run, with the US believed to be sitting on 40bn barrels of oil equivalent in its shale formations and the 23 most prospective fields outside the US containing an estimated 175bn barrels of oil equivalent.

Energy giants such as the world's biggest listed oil and gas group ExxonMobil (XOM: NYQ) and London-listed Royal Dutch Shell (RDSA: LSE) are mostly associated with fracking. In the short term both have struggled to make money after the costly acquisitions of rivals and drilling rights. While the energy giants attract the greatest media interest (and public ire), the service companies and modern day providers of 'picks and shovels' have direct responsibility for the extraction process. Contrary to popular belief, it hasn't been plain sailing for them, either, as low US natural-gas prices also affected their activities.

Two key elements

Fracking involves drilling horizontally into the rock and then injecting fluids (essentially water and chemicals) under high pressure into the drilled wells to create cracks and fissures that improve the rates of production and flow of either oil or gas. Those key elements are the responsibility of service companies providing drilling and/or casing and pressure pumping services. Pressure pumping has been the fastest-growing piece of the oilfield services jigsaw in North America, now worth an estimated $31bn (£19bn).

The exploitation of shale formations in the US and Canada over the past few years caused a huge expansion in drilling and pressure pumping activity and of course the capital investment needed to support it. This ultimately resulted in over-capacity as excess supply of natural gas in a slowing economy forced North American natural gas prices lower and resulted in the under-utilisation of the expanded drilling and pressure pumping fleets. Many of the specialist oil services groups - notably those with greatest exposure to North American drilling and pressure pumping activity - subsequently experienced a big fall in activity and tumbling share prices.

Who are the pressure pumpers?

The 'big four' pressure pumpers are Halliburton (HAL: NYQ), Schlumberger (SLB: NYQ), Baker Hughes (BHI: NYQ), and privately held FTS International. Hart Energy Consulting suggests that these groups operated 49 per cent of total US fracking capacity in the third quarter of 2012, but that their total capacity will decline to 45 per cent by the end of 2013, with medium and smaller groups expanding their share of the market. Perhaps not surprisingly, given the dominance of the big four, the pressure pumping industry in the US is currently the subject of anti-trust investigations.

Fracking is all about horse power

Pressure pumping capacity is talked of in terms of horse power, with energy sector experts PacWest Consulting Partners forecasting 15.8m hydraulic horsepower ('MMhhp') capacity by the end of 2013, of which around 20 per cent could be idle.

With fracking having its origins in North America, where key technologies have been developed, US groups lead the way on international markets as well.

Industry giant Schlumberger has a huge presence internationally across all aspects of oil and gas activity, including the pressure pumping market. In 2012, Schlumberger's Reservoir Characterization, Drilling, and Production Groups each represented about one-third of their $42bn of global revenue, which was broadly equally split between their geographic operating areas of North America, Latin America, Middle East and Europe/Central Asia (the latter including Russia). This market leader operates a staggering 150,000 mobile assets, including vessels, vehicles, surface equipment, and downhole tools and consistently generates operating margins of over 15 per cent. According to S&P Capital IQ, over the past decade Schlumberger's free cash flow of $21.9bn was almost five times the combined amount for Halliburton and Baker Hughes, making it the benchmark against which all others in the industry are judged. The shares have performed reasonably over the past few years but have yet to attain the heady levels reached back in 2011. Schlumberger generally forms a core holding for many energy investors.

Despite being embroiled in the BP Gulf of Mexico oil spill disaster, Halliburton has performed quite strongly over the past few years at the operating level, with declining North American activity supported by expansion internationally. In its last results announcement, Halliburton drew attention to a trend toward drilling more wells in a single location, extending horizontally underground in different directions. This means more work for oilfield services companies even without an increase in the number of rigs in the field. With a focus on shareholders’ returns through increased dividends and share buy-backs, shares in Halliburton could look attractive.

Baker Hughes and the rig count

The share price of Baker Hughes has languished far below the highs reached in 2011, with the group’s declining North American pressure pumping business dragging down overall results. However, the group has been making progress internationally and should North American activity rebound, as many are expecting, shares in Baker Hughes could react very positively.

The group is well-known in the industry for publishing its worldwide drilling rig count, which is an important barometer, not only for the drilling industry and its suppliers, but also one that many investors look at when contemplating investment in the oil and gas sector.

International 'frac' expansion

Hart Energy Consulting estimates that international fracking capacity is expected to grow 243 per cent by 2017 from 4.4 MMhhp in 2012 to 15.1 MMhhp in 2017, with China expected to overtake Canada as the second-largest fracking market in the world by the end of 2014 in terms of MMhhp.

The Canadian 'big three' are Toronto-listed Trican Well Services (TCW: TOR) and Calfrac Well Services (CFW: TOR) and privately owned Sanjel, which have a combined 1 MMhhp capacity. Both Trican and Calfrac have a growing presence in Russia, although this market still only represents a small element of their overall revenue.

The US big three in Canada (Schlumberger, Halliburton, and Baker Hughes) come in with about 770,000 hhp. Other listed Canadian frackers worthy of attention are Canyon Services (FRC: TOR), which will have an estimated 225,000 hydraulic horsepower (hhp) capacity at the year end, and GasFrac Energy Services (GFS: TOR) with 150,000 hhp.

A distinguishing feature of the Canadian oilfield space, compared with their US peers, seems a greater enthusiasm for dividends, with many of the Canadian listed groups offering yields well in excess of 3 per cent.

Enter the dragon

China is now the largest fracking market outside North America, with technically the world's largest recoverable shale gas reserves. While China nearly tripled its pressure pumping capacity to 1.4 MMhhp by the end of 2012, it has limited technical knowledge in this space and has been dependent on the technical expertise of the major US groups. In other words, investors wanting exposure to growth in Chinese fracking need look no further than the large diversified US-listed groups.

A direct approach for the more adventurous could be Hong Kong-listed Anton Oilfield Services Group (Stock code: 3,337HK), a leading independent oilfield services provider in China with a market capitalisation of HK$9.84bn (£800m). Anton has a growing presence in the Chinese pressure pumping market with 24,000 hhp of available capacity at the end of 2012 and 38,000 hhp to be delivered in 2013. It therefore remains a tiddler compared with the US giants - however, Schlumberger was interested enough in its potential to acquire a 20 per cent stake in Anton back in July 2012.

Despite being embroiled in the BP Gulf of Mexico oil spill disaster, Halliburton has performed strongly over the past few years at the operating level.

What about the drillers?

The flow pressure of gas and oil from shale wells tends to decline significantly after the first high-pressure rush, resulting in a high demand for drillers to drill more holes in the rock to maintain the flow.

The latest Baker Hughes' worldwide rig count for August was 3,416 rigs up from the 3,362 in July, although down from the 3,471 counted in August the prior year. Of this, international rigs represented 1,267, US rigs 1,781 and Canadian rigs 388. The greatest move on a month-to-month basis was a decline of 38 internationally. The horizontal rig count in North America is currently at record levels, with approximately 75 per cent of all wells in the US drilled horizontally and a similar trend occurring in Canada.

The large drillers, many of whom have suffered the same over-capacity issues as the pressure pumpers, therefore see an improving market as international growth picks up the slack from a flat to modestly rising North American market.

Modern technology is key

As the offshore deep-water drilling space is benefiting those groups with the most modern rig fleets, such as Norway's Seadrill (SDRL: OSL), new technology is also influencing the land-based drillers with the latest land-based rigs halving drilling time and saving costs. At the end of last year, 75 per cent of the 1,750 active land rigs in the US were legacy diesel-powered units, with the remainder newer machines that have alternating current (AC) motors.

The share price performance of the 'haves' and ‘have-nots’ is mostly clearly illustrated by US-listed driller Helmerich & Payne (HP: NYQ), which dominates the AC rig market and has a market capitalisation of $7.4bn. Helmerich & Payne generated revenue of $3.15bn in 2012 and pre-tax profit of $903m. Its operating margins have averaged over 25 per cent over the past three years despite the apparent over-capacity in the market. Helmerich & Payne also possesses a robust balance sheet, with terrific cash flow which boosted its net cash to over $200m at 30 June 2013. With AC rigs having grown their overall share of the US market to 40 per cent in August 2013 from only 15 per cent in 2008, HP looks well-placed to continue to benefit as it is also at the forefront of 'pad drilling', which offers further efficiency improvements through reducing the time it takes to move from one well to another. Helmerich & Payne's shares trade at approximately 12 times current year estimates, which, given its market-leading position, strong balance sheet and dividend growth potential, looks relatively modest.

By contrast, peer Nabors Industries (NBR: NYQ), another giant US driller with a market capitalisation of $4.8bn, has a much bigger overall fleet (which includes offshore rigs as well) but approximately 100 fewer AC rigs. While Nabors had revenue of $6.7bn in 2012, operating income came in at only $275m, with three-year average operating margins only 6 per cent. Nabors currently trades around 85 per cent of its net tangible asset value, suggesting that it could either be a potential recovery play (assuming its aged fleet can be put to better use or sold) or that huge impairments of its fleet are on the cards.

An interesting small cap (market capitalisation of C$270m) is Canadian-listed AKITA Drilling (AKT.A: TOR), which has a total fleet of 38 rigs including 16 pad rigs. It is in the process of decommissioning older conventional rigs and investing operating cash into new pad rigs. At the current share price (C$15), the group is valued close to its tangible net asset value, has zero debt and a healthy bank balance. For the prior year ending December 2012, it generated revenue of C$240m and operating profit of CAD$37m, resulting in operating margins of just over 15 per cent. For the half year ending 30 June 2013, weaker markets conditions, particularly for conventional drilling rigs, as well as wetter than normal weather in June, impacted results. However, lower activity was more than offset by having stronger day rates due to the company's high percentage of pad drilling rigs. With a robust balance sheet and trading at just under 10 times current year estimates, falling to 8.3 times for 2014 and a forecast yield of around 2 per cent, the shares are worth a look.

UK engineer Weir is the obvious UK-listed play on fracking as a big supplier of pumps to the US pressure pumping market.

Alternative exposure to fracking

Exposure to fracking can also be gained through investing in the key providers of consumables, most voluminous of which is the ‘proppant’ used to keep the fractures in the rock open, being typically sand, chemicals and water. With each shale well demanding about 5m pounds of proppant, it's a huge market. Two of the largest specialist providers of sand used in the fracking process are US Silica Holdings (NYSE: SLCA) and Hi-Crush Partners LP (HCLP: NYQ). The latter is structured as a US Limited Partnership and therefore offers a very high dividend yield, currently 7 per cent.

Another proppant supplier is US-listed CARBO Ceramics (CRR: NYQ), which manufactures ceramic proppant to use in place of sand. As fracking fever gripped the US back in 2011, shares in CARBO soared ever higher only to fall dramatically as over-capacity (and investor fear) took hold. CARBO refers to itself as a "leading production enhancement company" and not simply a provider of proppant, providing higher-margin software and consulting services in addition to the material. The shares are highly rated for a group exposed to the US fracking market, and trade at around 21 times 2014 full-year estimates, although in support of this it generates operating margins of over 20 per cent, excellent operating cash flow and can present a rock-solid balance sheet with plenty of cash.

Returning to the concern of water contamination there are several interesting investment opportunities on the Canadian market. Highly-rated Secure Energy Services (SES: TOR), with a market capitalisation of CAN$1.5bn, is involved in oilfield waste processing and the recycling of fracking water. With growing concern over the reliable treatment of oilfield water products, its business has been growing rapidly both organically and by acquisition. Trading at over 30 times current year estimates it doesn't look cheap on that single metric - however, with stable recurring revenue underpinning forecasts and cash flow, the company has long-term utility-like attractions.

GASFRAC Energy Services (GFS: TOR) adopts an entirely different approach, having developed a stimulation process and injection method using gelled LPG rather than conventional frac fluids (water) in the fracking process. The majority of LPG used in its process can ultimately be reused or resold. Unfortunately, the environmental and claimed performance benefits have not yet been borne out in the financials as the company remains loss-making. Nevertheless, GASFRAC could be an interesting share to follow as pressure grows from the environmental lobby and its technology becomes more widely accepted.

Where to find fracking equipment and services on the UK market

UK engineer Weir Group (WEIR: LSE) is the obvious UK-listed play on fracking as a big supplier of pumps to the US pressure pumping market. Since seeing a big sell-off in its share price in the first half of 2012, the shares are back close to previous highs as some barometers suggest a rebound in demand for its products could be around the corner and the group itself pointed to signs of recovering upstream oil and gas demand in its July update. Weir was one of the most heavily shorted stocks in the FTSE 100 a few months ago but, as sentiment has turned and the share price surged higher, those short-sellers hanging on have suffered. The shares currently trade at around 15.5 times current year estimates, falling to 14.3 times for 2014, modestly cheaper on that single metric than US rival Flowserve (FLS: NQ).

The alternative UK investment

An alternative UK investment in the directional drilling arena is Alternative Investment Market (Aim)-traded Enteq Upstream (Aim: NTQ). Enteq came to Aim in July 2011, raising an initial £15m at 100p followed by a further capital raise of £42m at 100p in 2012. The group was established by the founders of Sondex, which was acquired by GE Oil & Gas for a whopping $583m back in September 2007. As a result of management's tremendous track record, this small Aim group has attracted a high-quality institutional shareholder base. Enteq is adopting a so called 'buy and build' model with its first acquisitions being three businesses in the 'Measurement While Drilling' (MWD) equipment space. MWD addresses the directional drilling market and, as the term suggests, involves technology that performs downhole drilling-related measurements that are transmitted to the surface while drilling a well.

The group's products are supplied principally in the US, although it has also recently signed a contract with a large Russian drilling group which was historically a customer of former employer GE. The timing of the first acquisitions weren't ideal as the North American market subsequently suffered a bit of slump, which pulled down initial results at the acquired businesses. As a result, the shares suffered and currently sit well below the IPO price. The group had cash of $24m at 31 March 2013 and is actively seeking further acquisitions. The senior management is highly experienced and respected in the industry, with institutional supporters believing it can repeat the success of Sondex.

The fracking arena clearly presents numerous investment opportunities in virtually every element of the process outside the traditional sphere of the big energy explorers and producers. However, given the vast amount of material and machinery needed to effectively exploit the resource, to any serious degree, it's hard to imagine that the over-crowded UK could ever be in a position to effectively fully commercialise its reserves - thankfully international opportunities abound.

Drillers and pressure pumpers