Conventional wisdom would have it that all the stocks in the oilfield-service sector have enjoyed such a run-up in price during the past two years that the pickings left are slim to none-and slim just left town. At first blush, that perception would seem unassailable. Witness: during the past 24 months, the shares of Global Marine have soared from a low of around $7.50 to a high exceeding $34; Nabors Industries, from the midteens to $63; Ensco, from $11.50 to more than $44; and BJ Services-the current darling of investors in the service sector-from the high teens to more than $86. But smile. Despite all these quadruplings and more in market value, remarkable buying opportunities still remain in oil-service stocks, among both drillers and equipment providers. Amid strong demand pressures and steep production decline rates throughout North America, $4 to $5 natural gas prices look like they're here to stay for some time. Meanwhile, the international and deepwater markets are recovering as the majors begin to step up their capital spending for both drilling and development projects in those areas. Thus, not only are rig dayrates rapidly heading toward newbuild levels as utilization rates close in on 100%, but also other later-cycle plays in the sector, such as drill-pipe and rig-parts manufacturers, are about to experience explosive earnings growth. Exactly which service companies will be the greatest beneficiaries of these unfolding phenomena in the Patch? To find out, Oil and Gas Investor recently visited with three top oilfield-service analysts. Participating in the discussion were J. Marshall Adkins, managing director, energy research group, and senior oilfield-service analyst for Raymond James & Associates in Houston; Arvind S. Sanger, managing director and senior oilfield-service analyst for Deutsche Banc Alex. Brown in New York; and Poe Fratt, vice president and oilfield-service analyst for A.G. Edwards & Sons Inc. in St. Louis. Investor What macro trends will affect the oilfield-service industry this year and next? Adkins We see tight markets for oil and gas that will result in healthy commodity prices-above $30 for West Texas Intermediate (WTI) crude and north of $5 for Henry Hub natural gas in both 2001 and 2002. We're not going to be able to improve the supply side as quickly as many think. Also, if we have a return to a more robust economy next year, that's going to put upward pressure on demand and hence, pricing. As we move forward this year into next, look for oilfield-service earnings to show up big, first in the North American land-drilling market-which should see close to 2,000 rigs active by year-end-then in the international and deepwater markets, as industry spending increases in those areas. Investor Arvind, the macro trends you see? Sanger Spending by oil companies this year is going to be up a fair bit. The U.S. rig count is already running 26% ahead of last year's average while the international rig count is up 13%. Meanwhile, pricing for service equipment in the U.S. has risen 7% to 10%, and 2% for international equipment. With an expected 20% to 25% increase in overall industry spending this year, earnings growth for the service companies under our coverage should be up more than 130% in 2001-this off a very low earnings base in 2000. Moreover, with energy demand rising, we believe this growth is part of a multiyear cycle. For 2002, we're looking for another 25% jump in bottom-line gains for the service sector. Currently, service stocks are not reflecting this long-term earnings growth potential. We also believe, like Marshall, that we're going to see international spending by the oil industry become an increasingly important portion of the revenues and earnings of the oil-service sector. Investor Poe, your macro takes? Fratt We see continued strong North American drilling activity because of favorable natural gas fundamentals, which should keep average Henry Hub prices around $5.25 this year and $4.50 next year. We also have an outlook for strong oil prices-an average $27 for WTI this year and $25 for 2002. Against this backdrop, we see North American rig utilization levels, both onshore and offshore, reaching 95%-plus during 2001. This should push dayrates up to $20,000 for high-end, deep-gas land rigs, and up to $70,000 per day for 350-foot jackups in the Gulf of Mexico. Also, like Marshall and Arvind, we see a broadening of the oilfield service recovery in international markets during second-half 2001, as the large integrated oils increase their overseas drilling budgets. Investor Marshall, your top favorites among North American land drillers? Adkins Probably the best value today in that group is Unit Corp. It's a bit of a hybrid company, given that it has a significant gas-slanted E&P component, as well as a fleet of 52 U.S. land rigs. And because half the company's business comes from E&P, the stock-on a per-rig basis-isn't as highly valued as the shares of other land drillers. In fact, on that basis, Unit trades at roughly half the value of its larger peers. Nevertheless, Unit will have very high earnings visibility during the next three quarters. Dayrates for its high-end rigs at this time last year were less than $10,000; now, they're more than $15,000 per day. Meanwhile, on a fleet-average basis, its dayrates have risen from as low as $7,000 to as much as $12,000. So this company's earnings potential is explosive, with plenty of upside beyond our annual estimates. Also, it should be close to debt-free by year end. Investor What about service-equipment providers? Adkins In that group, we like Maverick Tube Corp. , the largest North American manufacturer of welded tubular goods. It follows that if you're drilling a lot of wells in North America, you've got to put casing in those wells. Maverick is one of the largest players in that business. And as gas drilling increases, Unit is going to be one of the biggest beneficiaries of that trend, in terms of earnings growth. In 1999, the company was getting an average $540 per ton in the U.S. for its production pipe. Last year, it received $651 per ton for its tubulars; this year, it should get around $700 per ton. But where Maverick really benefits is the lower cost it pays for flat-rolled steel. Costs have come down more than $50 per ton off a base of $300 per ton-and that savings flows straight to the bottom line. Investor What about its balance sheet? Adkins After its purchase last year of Prudential Steel in Canada, its long-term debt was only $70 million-less than 25% of market cap. Fratt We also like Maverick Tube. Its average pricing for tubulars has gone up almost 10% during the past 12 months and we're looking for the company to achieve at least another 5% improvement in pricing during the next 12 months. Another important point is that Maverick is expanding its product line to include larger, 16-inch-diameter tubulars, which should enable the company to profitably enlarge its position in the North American pipe market. Investor Marshall, what other later-cycle plays do you like in the service sector? Adkins One that investors should keep an eye on is the offshore construction business. Within this sector, we like Global Industries . It has the largest share of the pipeline construction market in the Gulf of Mexico, as well as a third of that market in West Africa. It also has a foothold in Southeast Asia and the Middle East. The investment thesis here is that a lot of wells are being drilled offshore and international activity, in particular, is beginning to pick up. Generally, the offshore construction business lags the drilling business by six to 18 months. So a year from now, offshore construction is going to pick up as well. And with its strong domestic and international presence, Global Industries is going to see a phenomenal increase in activity-and earnings-as shallow and deepwater projects are brought on line. Investor The other later-cycle play to watch? Adkins The rig infrastructure business. If land- and offshore-drilling dayrates continue to ramp up, and we continue to see rig-supply constraints, a lot of new rigs and rig infrastructure will have to be built. The two names we like here are National Oilwell and Grant-Prideco. National-Oilwell , with 22% debt to total capitalization, is the premier rig manufacturer that can put all the pieces of a rig together. In 2001, we're estimating that they're going to build 25 new domestic and international land rigs, each of which will likely cost drillers around $11- to $12 million-and higher as we move through 2002 into 2003. Also this year, National-Oilwell's rig-parts business is booming as rig operators attempt to get more of their drilling fleets back to work. Grant Prideco , meanwhile, has the lion's share of the burgeoning market for drill pipe-a key component in putting a rig to work. Already, we're seeing a surge in demand for this hardware. Concurrently, the company-with new management at the top-is targeting per-foot prices for its pipe at $38 for 2002 versus $31.50 last year. At the same time, it's attempting to squeeze more costs out of its manufacturing system. As with a lot of later-cycle plays, now is a good time to buy this stock-before the train leaves the station. Sanger With the big moves already made by the early-cycle players in the North American drilling sector, our top picks are also some of the mid- to later-cycle names in the service industry-one of them Grant Prideco. Since drill-pipe demand is driven by the capital spending of rig companies, Grant Prideco's business lags that of the typical oil-service company by several quarters. Indeed, only recently has demand for its pipe picked up. But we see the company entering a sweet spot, in terms of backlog growth and earnings visibility. We also view the company's recent change in top management as a positive. It is now more focused on aggressively implementing price increases and production throughput-consistent with the higher demand for drill pipe. Currently, it's charging new customers about $35 per foot for pipe. Investor Your top pick among later-cycle drillers? Sanger Transocean Sedco Forex . With a fleet of 135 rigs and 50 barges, it's the largest offshore driller in the world, focused primarily on the deepwater and international markets. These markets, including the North Sea, West Africa, the Middle East and the Far East, are starting to recover very strongly. And as they continue to recover, they should drive earnings improvement for the company. Adding further to incremental earnings, Transocean has four newbuild rigs set to go to work in the next three months. Also, the company's jackups and barges in the Gulf of Mexico have some surplus capacity, so there's utilization improvement going on there. Overall, we expect the company's rig utilization to average 85% by mid-2001, up from a current level of some 79%. Average dayrates for its fleet, meanwhile, should increase by 25% to 30%. Investor Any other international drillers you like? Sanger Pride International . Earnings are improving rapidly. Last year, this financially leveraged company, with net debt of $1.6 billion, made only one cent per share; this year, we're forecasting earnings of $1.32. Much of this earnings improvement will come from Pride's drilling in later-cycle markets such as onshore Venezuela, which is starting to recover; low-end jackup activity in the Gulf of Mexico; the continued deployment of medium-depth semisubmersibles internationally, which are rolling over at higher dayrates; and putting two new deepwater semis to work offshore Brazil. Currently, it's the cheapest driller in our coverage universe, in terms of where it trades on multiples of 2001 and 2002 earnings and cash flow. As the company's newbuild rigs come on line, we expect Pride to use the cash flow to help pay down debt substantially. By year-end 2002, we see the company's net debt dropping to around $1.1 billion. Fratt We also like Pride, which has a fleet of more than 100 onshore drilling rigs, 17 jackups, seven semis and two drillships. Not only is this driller benefiting from a strong gas market in the Gulf of Mexico, which accounts for about a third of its revenues, but it has a leading market position onshore Argentina, Ecuador and Bolivia, which accounts for another third of its revenues. The remainder of its revenues comes from semis and drillships operating offshore West Africa, in the North Sea and, later this year, offshore Brazil. So Pride has a balanced exposure to improving earnings in both domestic and international markets. Right now, dayrates for its mat-supported Gulf of Mexico jackups are approaching $45,000; dayrates for its semis that are under five-year contracts to Brazil's Petrobras start at about $140,000. Pride's drillships offshore West Africa, meanwhile, are enjoying dayrates of around $165,000. Notably, the company has been acquiring and building new rigs during the past three years, and as those rigs begin generating cash flow, that should enable Pride to start paying down debt-now close to 60% of its total market cap. Investor Arvind, who do you like among equipment suppliers? Sanger Cooper Cameron , which has a strong market position in the wellhead equipment market and one of the best management teams in the industry. Again, this is a later-cycle earnings recovery story because it takes a while before wells are hooked up for production. The company is now starting to see backlog orders for major subsea projects in West Africa, the deepwater Gulf of Mexico and offshore Brazil, as well as orders for other wellhead equipment. So we expect to see a big earnings jump, particularly as we move into 2002. That's why you want to own the stock now. Investor Any other equipment supplier you like? Sanger We have a Strong Buy on Halliburton . In 2000, it lagged badly among large-cap service companies because the earnings recovery in its oilfield services group-involved in pressure pumping, directional drilling, drilling fluids and wireline logging-was anemic, its equipment and construction segment was showing no signs of earnings recovery, and it still hadn't sold its Dresser equipment group. Since then, the earnings in its oil-services business has improved dramatically, registering a 12% gain in fourth-quarter 2000 versus the prior quarter. It has also announced the sale of its Dresser group for about $1.1 billion after-tax, which should help it pay down debt and give it greater financial flexibility to make accretive acquisitions or repurchase stock. In addition, its engineering and construction business could surprise investors this year, in terms of backlog. That business has built about half of all the LNG plants worldwide-and we see a big boom coming in global LNG plant construction, driven by demand for liquefied natural gas in both North America and Europe. Investor Poe, any other top pick among drillers? Fratt In the offshore drilling sector, Rowan Cos. , which has a fleet of 23 jackups and one semisubmersible. The company operates in the Gulf of Mexico-a very strong gas market-where it's experiencing 95%-plus utilization and improving dayrates, which have recently averaged $55,000 and could reach at least $65,000 by year-end. In addition, the company, whose debt to total capitalization is only 27%, has the ability to move several of its high-end rigs out of the Gulf into lucrative international markets, should dayrates improve there during the second half of 2001. In the last peak, in 1997, dayrates for high-end jackups in the North Sea went as high as $150,000. Investor Who do like among equipment suppliers? Fratt Baker Hughes , one of the largest suppliers of drillbits, drilling fluids and electric submersible pumps, and a significant player in the directional-drilling market. We anticipate BHI, which through restructuring has now become the purest oil-service play among the larger-cap service companies, will benefit from increasing international drilling activity during second-half 2001 as the result of higher oil-company spending abroad. Also, the company has formed a seismic joint venture with Schlumberger , which helps to consolidate that market and improve pricing going forward. In addition, Baker Hughes received about $500 million in cash from Schlumberger for entering that joint venture, while retaining about $100 million of working capital. It has used much of that money to pay down debt, and during the next 12 months, we anticipate the company will be able to reduce its debt to total capitalization to around 30% from just under 50% currently. Investor Any picks among onshore drillers? Fratt While we like the outlook for the sector and its fundamentals, we wouldn't buy into this group unless there's additional weakness. Very simply, these stocks have done so well that much of the good news is already incorporated into their current market prices. But if an investor wanted exposure to this sector, Nabors Industries would be the stock to buy. It's the biggest onshore driller in North America and it'll be a major beneficiary of the favorable gas-drilling trend in that market. Right now, we have a Maintain on the stock, but would view it as attractive if its price dropped back into in the mid- to low-$40 range.
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