With the Oilfield Service Index (OSX) up 23% through most of first-quarter 2005, hardly any investor needs to be told that service-sector stocks are hot. What investors may need to be told, however, is that the sector will likely remain hot for a long time. This is the consensus Street view shared by Marshall Adkins, managing director of energy research and senior oil-service analyst for Raymond James & Associates in Houston. "We're bullish on the sector-not just for 2005 but for 2006 as well," he says. He sees good fundamentals for an extended period of strong commodity prices averaging some $46.50 for oil and $7 for gas through 2006. This thesis is based on several salient points: the supply bubble for oil appears to have essentially disappeared, there is insatiable and growing demand for oil in developing countries like China and India, and bringing on more oil supply globally is becoming more difficult, as witnessed by Russia's sequential downward trend in supply during the past four months. "The net result of these events is that commodity prices have to go higher to either encourage more supply or discourage demand," says Adkins. "This means that E&P companies-whose project returns have recently been well in excess of 50%-will be spending more capital on putting holes in the ground." Poe Fratt, vice president and senior oil-service analyst for A.G. Edwards & Sons in St. Louis, is similarly sanguine about commodity prices with an estimate of $44 oil and $6.25 gas for 2005. He is also modestly upbeat about service stocks, even after strong share-price appreciation during the past 18 months. "Service companies should benefit from continued high capital spending by E&P companies in North America as operators continue to struggle to replace current production and offset steep decline curves," he contends. "At the same time, we see a broadening of drilling activity internationally-in the Middle East, the North Sea, West Africa and Latin America-due to deepwater development projects and the companies' need to expand production capacity." Although the major oils are still disciplined and spending as though oil prices are still $25, they're nonetheless more pro-growth today than they've been during the consolidation phase of the past five years, Fratt says. Meanwhile, independent producers, which have been acquiring large blocks of assets from the integrated oils, are also looking more pro-growth as they attempt to expand their production and earnings profiles. All this would appear to bode well for pricing and drilling activity levels in the service sector. But not all analysts share this perception. James K. Wicklund, managing director of equity research and senior oil-service analyst for Banc of America Securities in Houston, believes there could be some weakness in commodity prices in second-half 2005. At the end of this winter heating season, he expects 1.3 trillion cubic feet of natural gas in storage versus 700 billion cubic feet a year earlier. "So natural gas prices could decline at least $1 from where they've been recently. That could well translate into a flattening out of U.S. drilling activity and service-stock performance," he says. On the oil side, Wicklund is equally cautious. Institutions that have been passively buying into funds that own commodities have artificially propped up oil prices by as much as $10 to $12 per barrel, he says. "In addition, the market is going to recognize at some point that China's energy-demand growth-15.5% last year and widely expected to be 9% this year-could very well slow to 5% or 6% in 2005," the analyst says. "This could cause oil prices to pull back from their recent lofty highs and also trigger a flattening of drilling activity and a correction in service-stock prices." Investors who buy service stocks for their periods of spectacular growth might be less anxious to pay high multiples for those stocks in such an environment, he says. This aside, service companies with exposure to international markets-where predictable spending is controlled by the major oils-are likely to fare better than service companies focused solely on the U.S. market, where spending out of free cash flow by independents could more dramatically fluctuate with natural gas prices, he adds. In addition, all three analysts agree that some singular stock-buying opportunities exist today for investors who take a long-term view of the service sector, the fundamentals of which are uniformly believed to be very positive. What are those stock-buying opportunities? Service companies that have the greatest leverage to increasing dayrates and product margins and hence, the greatest leverage to improving earnings and stock-price performance. The analysts' top picks follow, in order of how frequently a service company was mentioned and highest projected percent gain in share price. National Oilwell Varco Inc. This new service giant is the result of the March merger of National-Oilwell Inc., a leading manufacturer of rigs and rig components, and Varco International, a manufacturer of rig components-including top drives, pipe- and mud-handling systems-and a provider of coiled tubing and tubular-inspection services. "With the creation of this $8-billion market cap company (NYSE: NOV) comes a lot of cost-saving synergies, broader product lines and a bigger footprint in the rig- and rig-component manufacturing business," says Adkins. "Most immediately, the biggest driver of its earnings will be providing rig-replacement parts in the U.S. and handling new rig-build activity in international markets." The analyst sees the company's earnings, on a pro forma basis, rising from $1.88 per share in 2005 to $2.60 in 2006, as the stock climbs to $60. "As drillers like Todco and Grey Wolf buy more rig parts-and eventually build more rigs-they're going to have to turn to a National Oilwell Varco," says Adkins. "That's what makes it an attractive play." Collectively, these two companies hold 80% of the industry's current capacity to build land rigs and supply components for offshore rigs, notes Wicklund. "This puts National Oilwell Varco in a perfect position to benefit from what is expected to be a capital-equipment construction cycle during the next several years." During the past 14 months, the industry has ordered the construction of 24 new jackup rigs-the most ordered since 1981, Wicklund adds. "Furthermore, the industry during the next seven years is going to have to spend anywhere from $2- to $10 billion on new land-rig construction." Halliburton Co. The continued strong level of drilling activity in North America-particularly natural gas drilling-is helping Halliburton achieve above-average pricing and margins in its pressure-pumping business, says Fratt. "Pricing in that segment during the past year has risen 10%, with operating margins up more than 2.5%." Meanwhile, across its other business lines-drillbits, drilling fluids, directional drilling, wireline logging and seismic data processing-the company is experiencing average price gains of 6% to 7% while operating margins are up more than 3%. "As long as natural gas prices remain above $5, Halliburton should realize further pricing and operating margin gains in North America-as well as in the Middle East, the North Sea, West Africa and Southeast Asia where gains in pricing and margins tend to lag the domestic market," says Fratt. The company is also looking at separating its oilfield-services business from its lower-margin engineering and construction business, KBR, the analyst says. "Such a move would make Halliburton a pure play on the positive fundamentals for the oil-service industry." He adds that Halliburton is a good value play, trading at close to a 20% discount to Schlumberger on the basis of both earnings and EV/EBITDA (enterprise value/earnings before interest, taxes, depreciation and amortization) multiples. Wicklund agrees: "With Halliburton's asbestos liability behind it and active plans to shed its engineering and construction division, the company will return exclusively to its oilfield-service roots and focus all of its management and financial resources on growing that business." He eyes robust margin improvements for Halliburton across all its business lines. "Its oilfield-service margins this year are expected to be 19% versus 16% in 2004, 12% in 2003 and 9% in 2002." Wicklund also believes, as Fratt, that the stock is undervalued relative to its peer group. "It trades 15% cheaper than Schlumberger and Baker Hughes on an EV/EBITDA basis." Todco This driller, which operates primarily in the shallow Gulf of Mexico and the inland waters of the Gulf Coast, has a fleet of 68 rigs, comprised largely of low-end jackups and barge rigs. "With nine shallow-water jackups and 14 barge rigs that are all idle, this company has the largest inventory of stacked rigs of any offshore driller," says Adkins. "So as operators demand more jackups and barges for shallow-water drilling, and as pricing for that equipment improves, Todco will have more earnings power through this cycle-more leverage to improved dayrates-than any other offshore driller." Two years ago, the dayrates for shallow-water jackups were around $20,000; today, many of those rigs are commanding dayrates in the mid-$40,000s, he notes. What's more, he sees another doubling in dayrates for those rigs as the jackup market tightens. Meanwhile, he expects dayrates for the company's barge rigs, $22,000 in 2004, to rise to around $28,000 by 2006. Ensco International Inc. This offshore driller has a fleet of 45 jackups, seven barge rigs, three platform rigs and one deepwater semisubmersible, and operations in West Africa, Southeast Asia, the Middle East and the Gulf of Mexico. It is one of the two most leveraged drillers to improvements in jackup-rig dayrates and utilization levels, Wicklund says. "Sometime in late second-quarter 2005, we believe that the global demand for jackups will outstrip global supply; as a result, dayrates for that rig class will exceed current consensus expectations of $64,000, driving the earnings and stock prices of jackup drillers higher." Wicklund, who sees Ensco's dayrates averaging $65,000 this year, asserts that exposure to international markets and working for major oils and/or national oil companies is more lucrative for jackup drillers today than drilling for independents in the Gulf of Mexico, where there is a dramatically flatter return curve than in the past due to the smaller size of discoveries. "Majors and national oil companies, which are pursuing the economic development of major LNG (liquefied natural gas) projects globally, are willing to pay higher dayrates in order to ensure rig availability," he says. "And during the past 15 years, the drilling for and development of stranded gas reserves around the globe has been done almost exclusively by jackup rigs." BJ Services Co. A leading provider of pressure-pumping services, this company has recently gone through a few rough quarters, in terms of cost overruns and not meeting analysts' earnings estimates, says Adkins. As a result, the stock has been trading at a 2006 earnings multiple that represents a 25% discount to the average for its peers. "The company, however, has issued guidance that it's going to grow its business long term in line with its peers-thus the 25% discount isn't warranted," the analyst contends. He looks for the greatest earnings growth for BJ Services to come from the U.S. market, "where the company is being too conservative in its rig-count assumptions," as well as the North Sea and Mexico. "From what we've seen during the past five years in those markets, the demand for pressure-pumping services has gone up four times faster than the rig count," observes Adkins. "That's because 85% of the rigs working in those markets are drilling natural gas wells which have to be hydraulically fractured." Grey Wolf Inc. This U.S. land driller, with a fleet of 127 rigs-102 of which are currently operating in the Gulf Coast, Midcontinent, East Texas and the Rockies-has done a good job of cleaning up its balance sheet in recent years and putting incremental rigs to work, says Adkins. "Based on land-rig demand going up faster than supply, the rising trend in dayrates and the fact that Grey Wolf has some elbow room in bringing on rigs from cold-stacked status, we see its earnings rising from 35 cents per share in 2005 to 45 cents in 2006-with meaningful additional upside to that 2006 estimate." The analyst notes that Grey Wolf, whose debt/total capitalization is down to 35% from more than 50%, has seen its margin per rig climb from an average $1,700 per day in 2003 to $3,100 in 2004. "The real move, however, will come this year and next," he says. "For 2005, we're modeling for Grey Wolf a daily margin per rig of $5,500, rising to $6,100 in 2006." Rowan Cos. With a current fleet of 24 jackup rigs and three more under construction, Rowan Cos., which operates mainly in the Gulf of Mexico, is similarly exposed to the tightening market for jackups and the improving dayrate outlook for that rig class, says Wicklund. Because it has eight premium Gorrilla- and Tarzan-class jackups-capable of drilling in more than 300 feet of water-the company is leveraged to above-average dayrate increases. Wicklund sees dayrates for Rowan's premium Gulf of Mexico rigs, recently $50,000 to $70,000, increasing to $65,000 to $85,000 by year-end 2005. One of the company's new Tarzan rigs-specifically designed for drilling deep-shelf tests of more than 15,000 feet below the ocean floor-is now drilling a prospect for ExxonMobil that is the deepest, most expensive jackup well ever drilled in the Gulf of Mexico, he adds. "The well is being drilled to 35,000 feet at an estimated cost of $100 million," Wicklund says. "If it's successful, it will likely trigger a rush of companies trying to copy ExxonMobil, and Rowan, having the greatest capacity of this rig type, would stand to benefit most." Baker Hughes Inc. This company, which provides drillbits, electric submersible pumps, drilling fluids and directional-drilling services, has a broad exposure to the positive outlook for the oil-service sector in both North America and internationally, says Fratt. During the past five years, Baker Hughes has placed a greater emphasis on growing profitability versus growing market share, he points out. "So the company is taking a much more disciplined approach towards expansion than it has in previous cycles which should help it continue to improve margins." The company's operating margin, nearly 16% in 2004 on revenues of $6.1 billion, should grow to about 18.5% in 2005 on revenues of $6.6 billion and to 19.5% in 2006 on revenues of $7.1 billion, Fratt says. The principal drivers of this margin growth: the sale of drillbits, electric submersible pumps and directional drilling tools. "Also, the company is experiencing margin growth from restructuring efforts within its drilling-fluids business. In addition, it owns a 30% interest in Western Geco-a joint venture with Schlumberger-which is benefiting from the recovery in the seismic business." Nabors Industries Ltd. The largest land driller in the world, Nabors has a fleet of 400 land rigs in the U.S., 90 in Canada and 120 land and offshore rigs internationally. "With steep decline curves in North American gas supply, the amount of drilling required to replace productive capacity should remain high," says Fratt. He believes Nabors will be able to expand rig capacity or drilling activity in North America by about six rigs per quarter. "More importantly, pricing should improve such that Nabors' operating margins expand by more than the consensus estimate of $400 to $500 per day, per quarter, even after a stronger-than-expected first quarter." Put another way, operating margins for the company in North America are likely to move up from a first-quarter 2005 level of $2,800 per day to $4,700 by the end of 2006. Nabors, whose rig-utilization level in North America is currently 65%, has plenty of room to bring on more rigs, or to move more rigs to oversea markets where demand is picking up, he says. "Right now, international drilling accounts for only 25% of the company's operating profit; during the next two years, we expect expanded drilling in places like Saudi Arabia, Venezuela, Algeria and Oman to make a much greater contribution."
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