As the unconventional drilling and fracking revolution has spread across North America, all the firms providing the drill bits, fracking pumps and other essential rig equipment have been riding high. After all, these companies are doing the heavy lifting.
Broad exchange-traded fund measures of the oil and gas services sector — like the Market Vectors Oil Services ETF (NYSE:OIH) — have soared 30% or more the past three months and continue to mint new 52-week highs. However, venerable investment bank Goldman Sachs (NYSE:GS) thinks this is just the beginning for the sector’s returns.
According to the firm’s latest research report, the previous four quarters of sequential declines in North American drilling activity and oil service profitability has finally broken, and the new year has signaled a turnaround in activity. Revenues and profit margins for many North American service companies bottomed in Q4 2012, marking a major inflection point.
Goldman believes service providers’ stocks should get a boost from increased free cash flow, and the potential for dividend increases and share buybacks. Likewise, expansion of margins, asset restructuring, rising horizontal rig counts and the possibility of leveraged buyouts will drive the sector upwards over the next few years.
Given these factors, the investment bank has some pretty specific targets in mind for its “conviction” buy list. Here is a look at some of Goldman’s top picks for the sector:
While some oil service firms have suffered during the past few quarters in the wake of lowered drilling activity, Cameron International (NYSE:CAM) has been resilient. That’s because in addition to its onshore products and services, the company has shifted focus toward the more profitable deepwater and offshore drilling market.
However, with the onshore market beginning to turn around, Cameron could provide a powerful one-two punch for investors as it still is a major supplier of valves, compressors, blowout preventers and other flow-control equipment used in horizontal rigs.
Already, CAM’s efforts on both fronts are beginning to pay off.
Cameron saw its profits more than double last quarter. Additionally, its backlog of new business rose to $8.6 billion — a company record. At roughly $64, Cameron shares can be had for just 21 times earnings. However, that’s not too pricey considering analysts estimate that CAM’s profits will jump 30% next year.
Pioneer Energy Services
Shares of contract driller Pioneer Energy Services (NYSE:PES) have floundered during the past year as falling rig counts and lower drilling activity have taken hold. However, PES could be a perfect example of Goldman’s predicted oil service turnaround.
The onshore driller posted per-share profits of 6 cents, beating expectations for a 4-cent loss, and grew its revenue 12% to again beat the Street’s projections. Pioneer CEO William Stacy Locke credited the quarter’s success on generalized return to drilling by E&P firms, as well as the company’s new-build drilling rig program, which “will generate substantial cash flow.” PES shares jumped nearly 19% after its earnings beat.
More good times could be ahead for shareholders as Pioneer’s small market cap and recent return to profitability makes it a prime candidate for a buyout. Already we’ve seen some big deals in the contract driller space, such as Sidewinder‘s $242 million deal to snatch up Union Drilling (NASDAQ:UDRL).
Basic Energy Services
Even Goldman admitted that some firms on its buy list might take an extra quarter or two to see the bottom in the services sector. However, these companies also could provide the most opportunity for investors.
One example on the investment bank’s roll is Basic Energy Services (NYSE:BAS).
BAS provides a range of well-site services, including completion and remedial services, fluid services, well servicing and contract drilling. Yet, unlike some of its peers, it still has work to do on the earnings front.
Q4 2012 revenue decreased 11% to $302.1 million, which also was 15% lower than the $354.4 million reported in the fourth quarter of 2011. Basic blamed the results on lower U.S. land drilling rig counts in addition to the fact that most E&P companies had spent their annual capital budget by the beginning of the quarter and were content to coast into year end.
A new year equals new CAPEX spending. That, plus the improvement in onshore activity, could finally provide a big bump to Basic’s shares.
Another candidate on the “wait another quarter” list is unconventional drilling specialist Nabors Industries (NYSE:NBR).
The world’s largest land-rig contractor fell hard after forecasting lower margins for its U.S. unit this quarter. According to its latest conference call, normalized margins for the company’s drilling business in the Lower 48 is expected to fall by about $1,000 a day. This is because many rigs are about to roll off expiring higher-rate contracts and work for lower “spot” prices without long-term agreements.
Yet, there are plenty of positives at the firm. Nabors completed about $460 million in net debt reductions and added nine additional long-term unconventional land rig contracts to its order book.
All in all, Goldman Sachs estimates that Nabors is currently trading at a 34% discount to its book value and will be the biggest winner as onshore drilling heats up in the new year.
If you’re going to buy just one oil service stock, though, it should be king of them all: Schlumberger (NYSE:SLB).
The company basically provides every service function a well operator could ever want and need. Its sheer size — 118,000 employees across 85 countries — provides it economies of scale and profit margins that some smaller players only dream of. As such, it makes a great global play on the need for more energy.
That global reach has been the reason why Schlumberger managed to produce better earnings results than more U.S.-focused rival Halliburton (NYSE:HAL). SLB recently reported a big increase in revenues to $11.17 billion, which was considerably more than analysts’ estimates.
There could be more increases on the horizon. Roughly 32% of SLB’s revenues come from North America. With 2013 expected to start with a bang as rig counts are up in both the U.S. and in Canada, SLB will stand to profit even more from its hydraulic fracking offerings.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.