A Bullish Take on Oilfield Service Stocks

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Oil basin crowding, input pressure, and margin erosion in pressure pumping have put a damper on oilfield service firms, particularly those targeting domestic markets. However, it looks like the worst has been factored in. Multiples are at historic lows at a time when there are several long-term tailwinds that need to be considered. Below, I review three companies that I believe have favorable risk/reward profiles.

Baker Hughes (NYSE: BHI): Feeling the Pressure

In recent days, Baker Hughes, a heavily North American-exposed oilfield service company, pre-reported that margins and top-line would come out below its internal guidance. However, shares are still up, since this weak outlook was actually better than what the market expected or feared. The problem with Baker Hughes comes from margin erosion relating to the slowdown in domestic land drilling and reduced demand for pressure pumping. Pressure pumping, which is a technique used to extract resources from shale formations, has also seen new competing equipment enter the markets.

But how long can this headwind last? One analyst notes that pumping demand has fallen quicker than rig count has. Over time, these two variables should equilibrate, and thus produce a rise in oilfield service activity. Barclays is predicting the rig count to increase next year from greater capital outflows, a reversal from the 17% sequential decline seen in the third quarter and three consecutive weekly declines in natural gas drilling rigs. I further believe the company is well positioned to gain from growing natural gas demand, since it is proving itself to be in tune with upstream producers's desire to forgo empire building and focus on maximizing the returns of existing wells. This is evidenced by how they have increased wells per rig by 15% y-o-y and are expected to increase it 10% more next year. And as much as investors lament the company's domestic exposure, it is still the leading supplier in Brazil with 90 rigs. So, these three variables--(1) a recovery in pressure pumping and rig count, (2) focus on efficiency, and (3) unappreciated international exposure--make an investment very compelling. The potential to tap into more markets, as we shall see, is huge…

Why You Should Buy Both Halliburton (NYSE: HAL) and Schlumberger (NYSE: SLB)

To target international markets, the obvious company to buy would be Schlumberger. 27 of 29 reporting analysts call the stock a "buy" or better, and the other two are at "hold." It generates 70% of its business from international markets versus just 44% for Baker Hughes. The 12.9% return on invested capital also means that Schlumberger, the world's largest oilfield service company, is creating value.

However, investors have to pay big bucks to get in at Schlumberger. At a respective 17.4x and 14.6x past and forward earnings, Schlumberger is more expensive than peers. To put this into perspective, consider that the company is valued at 2.7x book value versus 2.1x for the industry average. Halliburton, by contrast, which is heavily concentrated in North America, trades at just 11.1x past earnings and is forecasted for a strong rebound in profits. Specifically, analysts anticipate 20.7% annual EPS growth over the next five years, which is more than enough to generate considerable value creation at these multiples, more than what is even expected for Schlumberger.

So, what are these "markets" that Halliburton and Baker Hughes can "tap into?" MarketWatch has described how the "shale boom" is driving faster growth in discoveries than in production. Unlike traditional oil & gas drilling, shale gas is "unconventional" and requires horizontal drilling. As the largest provider of hydro fracking equipment, Halliburton thus has a tremendous secular tailwind that completely dismisses today's discount. Unconventional drilling is expected to represent half of North American production over the next decade, roughly double what it was in 2010. And then there is the Asian market, which, according to Credit Suisse, will help make natural gas the leading energy source. The analyst claims that "gas's dethroning of 'King Coal'… look[s] increasingly inevitable, as China and India move to diversify their energy mix… Chinese shale gas production has the potential to be a game changer."

In particular, the emerging market is looking to produce 6.5 Bcf in gas by 2015 and 100 Bcf by 2020. Though Chinese state-owned companies have been doing shale gas projects in the United States to gain expertise for some time now, they would be much more effective consulting with Halliburton to develop resources at home. China, after all, holds the world's largest shale gas reserves and has signaled market liberalization through the auctioning of 20 blocks. Since China lacks the geological data, infrastructure, and technology to properly meet the "shale gas boom" demand, it is also inevitable that it will have to go to Halliburton, the leader in 3D mapping and formation evaluations, for help.

China isn't the only Asian market that is need of oilfield service deals to help make up for the lack of internal know-how. Malaysia produced 630,000 boe/d in 2004, which marks a 26% drop off from 2004 production. The maturing of oil fields has been driving this decline. With 70% of the world's oil production coming from mature oil fields, you can rest assured that Halliburton has the intellectual capital to meet Asian demand. In recent days, the company inked a $1.2 billion deal with Malaysia-based Dialog Group to assist with offshore activity in Southeast Asia. This partnership calls for two companies to take 50-50 respective ownership of Halliburton Bayan Petroleum for the next 24 years.

So, from the shale gas boom, which calls for hydraulic fracturing in general, to the incredible emerging market demand for services and pressure pumping / rig building equilibration, the tailwinds far outweigh the headwinds. Short-term variables like guar gum cost volatility and oil basin crowding are dwarfed by the secular prospects. And for "buy-and-hold" investors, it makes sense to get in when the market is only focused on the worst and then sell when it finally recognizes the best.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Halliburton Company. Motley Fool newsletter services recommend Halliburton Company. 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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