3 Plays in the Sexiest Sector of the Oil Boom

I like to bang the drum for oil field service companies. This sector of the energy biz offers great long-term investment opportunity, for reasons I’ll detail below. The best of the service companies are solid and well run, with long, profitable histories.

You should buy selectively over time, certainly during “down” periods. The service plays are attractive as core long-term holdings in every energy portfolio.

Why? Let’s begin with an illustration…

The other day — a chilly, crisp Sunday morning — I was driving along an old two-lane road in Washington County, south of Pittsburgh. I rounded a bend and saw this new production pad built by Range Resources.

Range Resources "Kearney Pad" in Washington CountyRange Resources “Kearney Pad” in Washington County, Pa. BWK Photo.

The photo shows separation and storage tanks. Also, behind what you see here are seven “Christmas tree” valve assemblies. These represent the topside equipment for seven directional fracked wells, at about $10 million each. So what does this photo represent?

Well, add up exploration, leasing, permitting, site development, drilling, completions and surface equipment. You’re looking at about $100 million of capital investment in this one field out in the middle of the woods.

Now multiply this scope of effort by several thousand across the U.S., from Washington County, Pa., to North Dakota or Texas and out to California. That’s a lot of capex. That’s a lot of work for companies to perform, for good money. Where does much of that money go?

That question brings me back to the oil service plays. Longtime readers of my Outstanding Investments newsletter know how much I admire the technical skills and business acumen of the oil field services “trifecta” of Schlumberger (SLB), Halliburton (HAL) and Baker Hughes (BHI). [I’m able to mention these tickers here because my paid readers have long since had the chance to cash in on these names.]

These three companies have global reach. They work pretty much everywhere that people drill for oil and natural gas. The things these companies do are absolutely critical to global energy production. They’ve had an excellent quarter in terms of share price appreciation, certainly compared with other market metrics.

S&P 500 vs. SLB vs. BHI vs. HAL, March 2013-Present

I won’t go deep into details of each firm in this note. But the quick summary is that SLB, HAL and BHI offer high-end goods and services to oil companies. Product lines include well drilling, drill bits and tools, down-hole chemicals, logging, well completion and much more — including pressure pumping (the more formal name for fracking).

In a collective sense, what the technical people of these great service companies don’t know or can’t do within the oil biz is likely not worth knowing or doing.

During recent earnings announcements, there was excellent news from all three companies, particularly Baker Hughes. Shares of BHI popped up over 10% a few days ago after the company announced that third-quarter revenue jumped 8%, to $5.79 billion, and net income rose 22%, to $341 million (77 cents per share — and after adjusting for one-time charges, the company made 81 cents per share).

It’s worth noting that it was not U.S. onshore demand that drove BHI earnings, despite the “shale gale” within North America that keeps the guys (and gals) in the field busy. This past quarter, the key driver for BHI was activity in the Middle East and Asia.

The story I told at the beginning of this note (and the picture from rural Pa.) helps illustrate the point. Here in the U.S. and Canada, it’s easy to fixate on what’s happening literally down the road — in my case, the Range Resources play that I saw the other day, down in Washington County, Pa.

But there’s much more happening across the globe. There’s more demand, and for higher levels of services and technology. It reflects the increasingly complex geological challenge of extracting oil and gas from where it hides in the rocks. I’ll expand on this below.

Then there’s HAL, with a 17% increase in third-quarter profits, to $706 million, or 79 cents per share (or 83 cents, absent one-time charges). This is up from $602 million, or 65 cents per share, a year ago. The bottom-line numbers are based on revenue rising 5%, to $7.47 billion, in the quarter.

According to Halliburton CEO David Lesar, the strongest revenue and profit areas were Russia, Saudi Arabia and Angola. “Our Eastern Hemisphere growth continues to lead our peer group,” stated Lesar in a conference call. “Consistent with prior years, we expect the fourth quarter in the Eastern Hemisphere to be our strongest quarter of the year due to seasonal year-end software and equipment sales.”

One growing cost element for service companies is that international expansion comes with certain “buy in” costs. Service companies are morphing into technology companies, and many host nations want to see “prestige” projects from the vendors.

For instance, CEO Lesar explained how Halliburton has invested about $1 billion in recent years in a new Singapore facility as well as technology centers in Saudi Arabia and Brazil. These kinds of facilities perform useful work, to be sure. But they also come with certain costs associated with stroking local egos in terms of hiring national talent.

Schlumberger impressed the market too this week with a 20% increase in net income year over year, to $1.7 billion. Revenue grew over 11%, to $11.6 billion, up a healthy amount from last year’s $10.5 billion. Operating margins exceeded 20% across all four of Schlumberger business areas, with oil field services delivering excellent returns.

Things are good for Schlumberger’s North American business, which delivered a strong performance despite weakness in the pressure pumping/fracking market due to increased competition from other firms.

Overall, the best action for SLB was overseas, where revenues from markets outside North America jumped 12% year over year as margins expanded by 23%.

Improving on its North American numbers, SLB increased revenues in the Middle East by 25% over last year. Schlumberger enjoyed strong growth in Saudi Arabia, Iraq, Qatar and the United Arab Emirates. In fact, Schlumberger is currently moving equipment and personnel to Saudi Arabia, where demand continues to grow.

It causes me to recall a comment by a Schlumberger rep at the Offshore Technology Conference in Houston a few years back. “Oh, if only all of our clients were as good as Saudi Aramco,” he said wistfully.

Other Schlumberger efforts in Indonesia, Malaysia and China also boosted profits. In fact, Schlumberger inked its first production management project in China during the quarter and will move personnel and equipment into the region during the fourth quarter.

There’s a growing buzz across the service industry that indicates customers are tending to spend more funds on equipment and services in 2014, although it may not show up in the basic rig count. That is, customers are pushing to do more with less at well sites.

As for numbers, the Baker Hughes U.S. rig count should average about 1,750 active rigs for 2013, down 9% from 2012. Still, the industry has improved efficiency and is drilling about 6% more wells per rig. Internationally, BHI expects the rig count to average about 1,300 rigs in 2013, up 5% from 2012.

In a sense, the new makeup of service company earnings reflects the changing nature of demand in the oil fields of the world, as well as long-term supply dynamics. That is, in North America, the demand is growing for complex services associated with fracking. But elsewhere — even in regions where not a single well has ever been fracked — demand is growing for high-end services because the down-hole geology is more difficult.

How to explain this? We’re looking at a reflection of the Peak Oil thesis! Yes, yes, yes… I know that skeptics say Peak Oil is bogus and an idea that’s far beyond its shelf life.

Actually, that’s exactly the wrong way to think about it. Peak Oil was, and remains, a valid working tool — which I’ve been discussing for almost nine years in my work with Agora Financial. It’s possible to apply Peak Oil methodology to global numbers as well as to regions. Indeed, one can look at many sorts of oil plays — offshore, onshore and even fracking movements — using the basics of Peak Oil analysis.

Distilled to its essence, Peak Oil tells us that the “easy” oil of the olden days is long gone. Today, across the globe, the energy industry MUST look for the difficult hydrocarbons. Thus, complex “conventional” plays and super-complex “fracking” plays are the new norm.

It’s all very expensive technology whichever way you look at it. So we’re destined to have “$100 oil” and more over the long term, absent an economic crash that temporarily tanks the price of oil while the world falls off a cliff.

This large-scale idea is part of what makes the oil service guys so attractive. The profitability is there for the long haul.

So don’t just rush out and buy up oil service shares willy-nilly, of course. As I stated above — and as I’ve said over many years of writing to my paid-up readers — buy oil service shares judiciously, especially on dips. In the case of Schlumberger, the shares never get “cheap” and seldom stay down for long. But over time, the oil service trifecta can deliver great gains with minimal downside risk.

That’s all for now. Thanks for reading.

Best wishes…

Byron W. King
for The Daily Reckoning

P.S. One of the biggest opportunities I see brewing in the U.S. comes straight from the top. It all surrounds a recently leaked government “Black Budget.” And it’s a virtual blueprint to cash in on the next big wave of government spending. I recently gave readers of the Daily Resource Hunter email edition an opportunity to learn more about this “Black Budget” and how they could profit from it. If you didn’t get it, don’t worry… I’ll be offering a similar opportunity in forthcoming issues, so there’s still a chance for you to get it. Sign up for the Daily Resource Hunter, for FREE, right here to ensure you don’t miss it.

Original article posted onDaily Resource Hunter