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A Tale of Two Industries
Last year was a wild one for the Oilfield Services industry. Oil and natural gas prices plunged in anticipation of a prolonged recession, and domestic and international rig counts (with which oilfield service earnings strongly correlate) followed suit, hitting six-and-a-half year lows in the U.S. and two-and-a-half year lows globally, both in mid-2009. Average earnings for the four major diversified oilfield service companies, Baker-Hughes (BHI), Halliburton (HAL), Schlumberger (SLB), and Weatherford (WFT), were down 58% in 2009.
Since mid-2009, however, the U.S. rig count has increased 46% from its low, and the international count is up more than 8% during this time span. As the commodity-price rebound in the second half of 2009 and resulting rig-count build-up suggest, the energy patch is on its way to some sort of recovery in 2010. But what sort of recovery will that be?
Rig counts, and the earnings of oilfield services companies, rise and fall with the spending of oil and gas exploration and production (E&P) companies; thus the capital spending trends of major and regional E&Ps should give some idea of the fortunes for oilfield service companies in the coming year. When drilling budgets were falling in 2009, they did not decline at the same rate in all places. Worldwide spending dropped 13%, but spending in North America plunged 29%. With a few exceptions, drilling budgets are rising in 2010. But will they rise at the same rate in all places? We are cautious about predicting a simple mean-reversion in North American drilling expenditures and look, instead, to both acquisition activity and the results of exploratory drilling announced in the second half of 2009 in order to forecast where the E&P spending recovery will be strongest. Our findings suggest that the recovery will not lift all boats equally.
Exploratory drilling results were especially promising in two areas: the so-called “ultra-deepwater” U.S. Gulf of Mexico and the onshore North American shale-gas basins. In the deepwater Gulf, BP PLC (BP) announced yet another find in the lower tertiary geologic zone in early September, its Tiber well, which could hold up to three billion barrels of oil. Combined with the already-producing Atlantis and Thunder Horse fields, BP finds itself with plenty of reasons to pour capital into exploration, development, and well-enhancement activities. Other areas yielding impressive results in deepwater exploration were the Campos and Santos basins off of Rio de Janeiro in Brazil. Not surprisingly, Petrobras (PBR) is expected to raise its spending by some 25% in 2010. In the onshore shale-gas basins, Devon Energy (DVN) reported the highest-ever recorded initial production reading on its Kardell gas well in the Haynesville shale deposit, likely setting off an exploratory-drilling boom in nearby leaseholds, in the hope that the basin will produce as the mature Barnett basin has. To fund its 45% greater 2010 drilling budget, Devon is working to sell off its share of the Cascade, St. Malo, and Jack deepwater Gulf prospects, which brings us to the story told by 2009 acquisition activity.
The biggest energy deal of 2009 was Exxon-Mobil’s (XOM) $31 billion purchase of XTO Energy (XTO), substantially increasing the supermajor’s exposure to shale-gas. In a similar move, Total SA (TOT) purchased 25% of Chesapeake Energy’s (CHK) Barnett shale operations, in a move widely seen as a way for Chesapeake to maintain its drilling budgets in that basin and elsewhere. Then there is Devon’s ongoing attempt to sell its deepwater prospects for something in the neighborhood of $4.5 billion-$7.5 billion.
Exploratory drilling showed its best results in ultra deepwater prospects globally and in North American onshore shale gas basins in 2009; as a result, acquisition capital flowed to the same areas, as companies sought to purchase access to these promising fields. We thus predict that as drilling budgets go up, they will be directed to domestic and international ultra deepwater fields and North American onshore shale basins.
The major oilfield service companies Baker-Hughes, Halliburton, Schlumberger, and Weatherford will benefit from the increases in these specific areas, because their diversified operations give them exposure to onshore shale gas, ultra deepwater and everything in between. But we feel that nimble niche oilfield service companies may well outperform the major companies, provided that they are in the right niche.
The group of oilfield service companies with the greatest stake in onshore shale gas and the ultra deepwater includes CARBO Ceramics (CRR), Diamond Offshore (DO), Oceaneering International (OII), and ION Geophysical (IO). All have promise.
Diamond Offshore operates 45 mobile offshore drilling rigs, including 21 semisubmersibles rated to drill in up to 4,000 foot depths and nine high-specification semisubmersibles that can drill in depths greater than 4,000 feet. Diamond does a lot of work for Petrobras (see above) and was barely dented by the drilling downtown in 2009, with share earnings rising 5%. Transocean (RIG) is a bigger deepwater driller and a good bet too, but we like Diamond’s focus and stellar earnings track record.
Oceaneering is the market leader for remotely operated vehicles, used to service ultra deepwater platforms especially, and for subsea trees, which control hydrocarbon flow for deepwater wells. It, too, has weathered the downturn well, with earnings falling a modest 4% from 2008 to 2009. An increase in ultra deepwater exploration should benefit Oceaneering.
CARBO dominates the North American market for ceramic proppant, which are piles of ceramic spheres pumped into tight shale hydrocarbon deposits when they are fractured in order to “prop” the cracks open. Although it is expensive, ceramic proppant substantially increases hydrocarbon recoveries in fractured deposits. However, only about 20% of fractured deposits use ceramic proppant currently, which, combined with an expected jump in development capital for shale-gas drilling, suggests that CARBO has enormous growth potential. Earnings per share at CARBO fell 8% in 2009.
Finally, ION provides seismic image and data collection services to aid Exploration & Production companies in determining the size, nature, and economic viability of newly discovered hydrocarbon deposits. We feel that in 2010 some cash-strapped E&P companies are likely to be more interested in delineating their finds than in aggressively drilling them, in hopes of making their assets attractive to possible buyers. We caution that ION is the most risky bet and had a tough 2009.
By leveraging portfolios to ultra deepwater- and onshore shale gas-oriented service names, we feel investors can outperform the major oilfield service names and even limit losses in the event of a deep drop in commodity prices.