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For oil and gas companies, it is important for reserve replacement to production ratios to be at least at a level of 1; otherwise, they are depleting resources faster than they are finding new products. Some concerns are now being raised that this ratio is weaker than some oil companies are reporting, and that the weakness bodes ill for the industry. However, it bodes very well for the businesses that help them find and produce more.

Don’t build the mine; sell the picks and shovels

There is an old adage in the investment world alluding to the fact that more wealth is created selling picks and shovels than by digging the mines. After all, every pick and shovel sold produces a profit but not every hole dug with one does.

While the oil companies only get paid when a well produces oil or gas, the companies that provide the equipment and services required to produce the hole get paid regardless. Providing exploration equipment and services to the oil industry is today’s equivalent selling picks and shovels to the miners during the gold rush days.

Unless you believe that our dependence upon fossil fuels to provide the primary power supply for our lives will disappear in the next 10 years, you need to have an investment in the businesses that will prosper whether the wells drilled in search of those fuels are gushers or duds.

Big names offer big opportunities here

The big, well-known names in a given industry don’t always constitute great investment opportunities; but it seems some do today in the oil services industry. Three names that will be familiar to most investors who have even a casual interest in the oil and gas industry are Schlumberger (NYSE: SLB), Halliburton (NYSE: HAL) and, Baker Hughes (NYSE: BHI). These businesses are going to exist and prosper as long as oil and gas companies are searching for and accessing new sources of supply. Even better, these businesses are currently valued as if they have more risk exposure than the overall stock market; when they probably have much less.

Low valuations and risk create big opportunities

With 2014 P/E ratios projected at 13.2, 10.52, and 10.97 and projected five-year earnings growth rates of 15.7%, 16.1%, and 15%, respectively, Schlumberger, Halliburton, and Baker Hughes all trade well below a PEG ratio of 1. These valuations are nothing short of astonishing. The shares of these businesses could easily rise higher and still only be trading at a very reasonable price to earnings growth ratio of 1. This would still allow the share price to continue rising in tandem with the projected double-digit growth in earnings without becoming the least bit overvalued.

The one concern I have within this group is Baker Hughes. With the return on equity, assets, and capital over the last five years at 10.6%, 6.6%, and 7.9%, respectively, the numbers are somewhat low and 30% to 50% below those achieved by Schlumberger and Halliburton.

Global demand for energy is not going to go away, and as we continue to see improvement in the global economy, demand for new energy resources will grow.

Schlumberger is one of the few businesses in the industry that can deploy its assets anywhere in the world and literally take an energy project from the start of exploration and defining of the resource once a find is made, through their Reservoir Evaluation Group, to drilling the wells, and then managing the entire project during its life through their Drilling and Production Groups. They can also be brought in to correct problems that arise on existing projects. This wide range of expertise virtually assures them of continued growth, as future energy supplies become more difficult to find and access.

Through its Drilling and Evaluation Group and Completion and Production Group, Halliburton can provide a complete package of services from initial exploratory drilling right through oversight and management of the production. With existing operations in 80 countries and 55% of revenue derived from U.S.-based projects, Halliburton is poised to profit from the domestic energy exploration and drilling boom currently underway, and take advantage of the growing demand for drilling services around the globe.  Even without any growth in demand for oil and gas, demand for Halliburton's services will grow as existing projects reach the end of their useful life and the production must be replaced.

A real surprise

Every so often, when researching industry specific investment opportunities, a name so unexpected pops up that I have to go back and double check to make sure I did not make a mistake in the search criteria. That happened with this analysis when I found myself staring at a report prepared by International Business Machines (NYSE: IBM) discussing the cost savings applications they provide for oil and gas production businesses.

After giving a bit of thought to the concept, it makes perfect sense that an industry and process as complex as oil and gas exploration and production would be a perfect customer for a business built around the management of complex data solutions designed to increase efficiency and reduce cost. While I was surprised to see how successfully IBM has integrated itself into the information infrastructure of the oil and gas industry's data management function, now that it has, it will remain with them forever as there will never be enough of an incentive to go through the pain that would be involved in removing them.

I believe it is fair to value a business and its prospects for share appreciation based upon the sum of its five-year projected earnings growth rate plus the dividend divided by the next year's project price to earnings ratio and seeking a result of 1 or less. In the case of IBM, that calculation produces a result of 1. Given that IBM has increased its dividend payment at an annual rate of 17% over the past five years and has a sum of dividend yield plus earnings growth rate of 11%, investors in IBM today should easily expect to satisfy expectations for an 11% return on their investment for years to come.

When a provider of critical services integrates itself into an industry that provides a critical product, it is virtually guaranteed to be a winner if purchased at a reasonable price.

Unusual final thoughts

It is very unusual for me to find businesses that I can buy and forget about for the next 10 years. Today, I have found three at the same time. Lazy investors, such as myself, who love double-digit annual gains but detest hard work can buy Schlumberger, Halliburton, and IBM today, sit back, and enjoy the profits for the next 10 years…….maybe longer.

Domestic oil & gas service companies have taken a hit in the recent past due to a slowdown in the natural gas drilling boom of the last couple of years. As this market looks to rebound, investors would be wise to consider Halliburton, one of the top companies in the business and one of those most in tune with the domestic market. To access The Motley Fool's new premium research report on this industry stalwart, simply click here now and learn everything you need to know about how Halliburton is positioning itself both at home and abroad.


Ken McGaha has no position in any stocks mentioned. The Motley Fool recommends Halliburton. The Motley Fool owns shares of International Business Machines.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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