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Year-to-date through August 8th, the Philadelphia Oil Services Index has gained +11.4% compared with a loss of -3.7% for the S&P 500. Last year, the Philadelphia Oil Services Index gained +9.2%, underperforming the S&P, which delivered a +28.7% gain. The Big Picture With all the talk of higher prices, many seem to forget that life in the oil patch hasn’t always been so bright. Oil prices traded for prolonged periods under $20 per barrel back in the 1990s, and during that period most energy stocks drastically underperformed the S&P 500. One of the worst-hit sub-sectors of all was the oil services group. Oil services is a tough sector to define precisely. Some companies in the group specialize in rehabilitating older oil wells to boost production. Meanwhile, others concentrate on using sophisticated technologies to find new reserves. But one generalization that can be made is that the group is totally dependant on the world’s major energy companies for its revenues and earnings. Even more specifically, the fortunes of oil services companies are directly tied to global energy exploration and production (E&P) activity. Below you will find a chart of global oil production since 1965. It’s important to note the broad trends here. The period from 1965 until the mid-1970s was marked by a fairly strong uptrend in production. During this time, domestic production in the U.S. was still growing and the massive Saudi oil fields had just been discovered. The bottom line: the world had major sources of largely untapped energy supplies.
The reasons for this are simple: U.S. oil production peaked in the 1970s and has been in a slow decline since that time. This doesn’t mean the nation has used up all of its available supplies. Instead, existing wells have simply been in a state of long-term decline and there haven’t been any major new finds since Prudhoe Bay in Alaska more than 2 decades ago. Globally the production picture is no better. Britain’s North Sea now looks to be in a state of decline, having passed peak production levels several years ago. In addition, some geologists have gone so far as to speculate that Saudi Arabia’s massive fields are beginning to mature. Of course, low energy prices are another reason for the deceleration in oil production. In the 1990s the rig count--defined as the number of oil and gas producing rigs in operation--declined rapidly in the U.S. because major oil companies couldn't profitably produce oil for sale at prices under $20 a barrel. In fact, the number of operating rigs in the United States declined from over 4,500 in the early 1980s to less than 750 by 1995. This decline in production activity made life extremely difficult for firms in the oil services group. However, what a difference a decade has made. Oil services companies are now in the sweet spot of the global oil market. Surging prices have prompted a race to find new oil and gas deposits around the world, and this has translated into a dramatic jump in new E&P activity. Global energy companies are fighting to keep production growing fast enough to meet new demands. Even better, many of the world's "easy" sources of oil reserves have already been depleted, especially in the mature U.S. market. As a result, new exploration efforts have increasingly focused on promising reserves in less hospitable environments. Such areas weren’t economical with oil at $20 per barrel, but are goldmines with oil well north of $30. These less hospitable environments include deepwater drilling and drilling sideways through underwater rock. Clearly, such drilling activities are more technically complex than old-style land-based drilling operations. Oil services companies are at the vanguard of this trend, offering ways of drilling these new, potentially vast reserves. Sector profitability is booming as the energy market is once again focused on increasing production. Defining the Sector Exploration That’s where seismic surveys come in. Basically, the process is similar to sonar. Sound waves sent into the Earth bounce back to the surface when they hit rock formations. Depending on the strength of that echo effect, geologists can garner a detailed picture, or “map,” of subsurface rock formations. On water the procedure is performed using seismic hydrophones. Hydrophones are sensors that can be towed behind a survey boat. The survey vessel releases high-pressure air just under the surface, which creates sound. The hydrophones then collect data on those sound waves as they bounce off deep underwater formations. Considering how expensive it is to drill deep underwater, this data has proven to be invaluable in reducing the frequency of dry holes. Oil services companies offer seismic data maps for both land-based and underwater rock formations. They then sell this information to energy companies interested in drilling a particular area. Drilling and Testing Newly dug wells have a tendency to collapse if not reinforced. As the drill bit moves through rock it creates myriad fractures that can sheer off and drop into the well. To prevent that problem, drillers insert what’s known as a casing--essentially a large, hollow metal tube--to reinforce the walls of the drill hole. In addition, that casing must itself be reinforced and bonded to the surrounding rock--a process known as cementing. Cementing doesn’t involve simply pouring concrete down a hole—each individual environment requires a specific mix of materials. For example, cold temperatures deep underwater require a special blend of cement that hardens quickly. Most rock formations won’t bond properly to casing without the right type of cement. Once the well is drilled to its maximum depth, it needs to be tested. Specifically, energy companies want to know how much oil they can expect to produce from a certain location. If a well doesn’t look economical, it can be permanently abandoned. A few different tests can be used to determine a well’s quality. Chief among these are well logging and core samples. Well-logging involves dropping a number of electronic sensors into a newly dug well to measure heat, gases and pressure--data that can be used to determine a well’s likely producing characteristics. Core samples are nothing more than small samples of rock removed from a well. A more careful analysis of sample rock can help determine both the quantity of oil in a well and the best means of extracting it. Completion & Stimulation The casing wall is normally perforated with many holes using a “gun” or a series of small explosive charges that are controlled electronically from the surface. Oil can then flow through the sides of the casing and into the well shaft fairly easily. However, oil can have trouble flowing naturally through the rock and into the casing if the surrounding rock is too thick. That’s where well stimulation comes in. During well stimulation the rock surrounding the casing is cracked to create fractures and small channels that allow oil to flow more easily through the formation. This process, known as hydraulic fracturing, involves pumping gel-like liquids under high pressure into the rock formation to break it apart. Also more popular recently has been the use of explosive charges to fracture formations--in some environments this can be the only viable means of stimulating a well. Finally, sometimes years after a well is dug it may need a little artificial help to continue producing at or near full capacity. This is another piece of the oil services puzzle. Lifts and pumps can be installed underground to help pull the oil to the surface once it no longer has enough pressure to rise on its own. In addition, over time well shafts often become clogged with debris and need to be cleaned. Wellbore cleaning involves using scrapers to remove this debris from the inside of a well. -------------------------------------- Favored Oil Services Pick: BJ Services (BJS,
$45.90) Revenue Mix BJ produces a range of pre-mixed cement slurries that can be transported and stored for long periods of time in liquid form. This eliminates the need for mixing at the well site. And because the liquids can be stored, it’s possible to keep a supply of this ready-mixed cement on site for use when needed. Also important is the company’s Deep Set line-up of deepwater slurries. These cement mixes are able to harden at sub-zero temperatures very quickly. That speeds up the drilling and cementing process dramatically. Stimulation services account for just over half of BJ Services' total revenues. The firm is a world leader in the hydraulic fracturing business. In addition, the company makes acids that can be used to literally dissolve holes in the rock surrounding a well. But more interesting are the company’s cleaning systems for wells, particularly horizontal wells. Horizontal drilling has gained in popularity in recent years because it allows energy companies to reach previously inaccessible oil and gas formations. As the name implies, horizontal drilling involves drilling sideways through rock rather than directly lower. This type of drilling has become increasingly important for areas in which the environment needs to be carefully protected, such as the Alaskan wilderness. By using horizontal drilling, energy companies can access huge plots of oil reserves without dotting the landscape with oil derricks--a few wells located on a relatively small plot of land can drill horizontally to reach new supplies. Of course, horizontal drilling comes with its own unique set of challenges, including increased risk of sedimentation in wells. Horizontal wells tend to get clogged with debris more easily than vertical wells. That's where BJ’s jet cleaning system comes in. The company’s cleaning system actually sprays cleaning fluid in a well and vacuums out the sediments and debris. This service is absolutely critical for modern horizontal drilling operations. The company operates oilfield stimulation vessels in a number of markets, including the North Sea, Gulf of Mexico and South America. BJ Services derives the remainder of its revenues from a division it calls “other” oilfield services. The most important part of this business involves casing and completion services. More specifically, BJ sells and puts into place casing materials used during the drilling process. In completion services, the company recently acquired OSCA to improve its line-up of completion tools and fluids. BJ Services derives approximately two-thirds of its revenues from the North American market. Given the long history of drilling activity in the U.S., wells in North America tend to be very mature. Because mature wells require additional attention from oil services companies, this has proven to be a boon to BJ’s business. For example, the firm provides additional stimulation services to keep mature wells producing at near full capacity. In addition, wells need periodic repairs to make sure they remain safe to drill. With global oil production flattening out, energy companies are keen to get every last drop of oil from existing wells.
Financials and Valuation BJ Services reported a drilling rig count increase of about 15% over the past year. Internationally, rig counts were up on the order of +5%. The Gulf of Mexico region, where BJS holds a particularly strong position, showed the best growth of all. Price hikes coupled with strong demand have boosted the company’s operating margins to record levels. BJS has raised revenue and earnings guidance several times this year as profits have rolled in at an accelerating pace. BJ Services never paid a dividend in its 14-year history until this year. Sporting a debt-free balance sheet and strong free cash flows, the company recently instituted a 32-cent annual payout, which translates into a yield of about 0.7%. That relatively small payout doesn't amount to much at this point in time. However, we expect the firm's dividend payout to rise rapidly as it becomes clear that higher energy prices and a solid pricing environment for the services business are here to stay. Long-term earnings growth should top +15%, yet the company’s forward price-to-earnings multiple stands at only about 19. That’s despite a +30% run-up in the stock over the past year.
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Now,
check out the second half of our chart. While production globally has
still grown after the late 1970s, it hasn’t been growing as quickly.
Production also seemed to flatten out even further in the late 1990s.
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