Things have been pretty bad for the various oil stocks over the last year or so. Prices for crude oil — and natural gas for that matter — continue to drop as supply consistently outmatches demand.
But the producers of oil have had it quite easy when compared to some other subsectors of the energy market — for instance, oil companies providing the drilling equipment required to frack a well or drill in deepwater oceans.
Lower capital expenditure spending by the energy producers has already decimated many of the oil-services stocks. And yet, it could be much worse. Several analysts are already pointing to larger capex cuts throughout 2016.
For some of these oil stocks, the lowered spending predictions could be a death sentence.
Oil Stocks Are Still Hurting
“Lower for longer” seems to be the new mantra across the energy sector. Prices for crude oil and natural gas seem to be caught in a range bound market and show no signs of surging upwards.
And at this $40 to $55 per barrel mark, some of the more ambitious projects have been put on hold. Heck, even some of the less than ambitious projects have been put on hold. Analysts at Wood Mackenzie cite a reduction of capex of about $220 billion so far in 2015.
And more capex cuts could continue through 2016.
Wood Mackenzie predicts that at $50 per barrel, there is more than $1.5 trillion (with a “T”) worth of new global oil and gas projects that aren’t “in the money.” Meaning they aren’t profitable, and that includes plenty of U.S.-related shale assets.
Adding insult to injury, many of the currently operating projects aren’t doing so well either. Investor ratings agency Moody’s suggests that the entire energy sector will see negative cash flows of around $80 billion this year. That compares to a negative cash flow metric of just $26 billion last year when oil began to tank.
In order to deal with that scenario, Moody’s predicts that many oil stocks will have to cut spending further into 2016 to stop the bleeding. For some, that becomes a do-or-die situation to service their debts. Wood’s estimates that North America alone will see capex cuts of up to 45%, most of which will come from shale producers.
And already these capex predictions are coming true.
Royal Dutch Shell (RDS.A, RDS.B) recently announced that it would further cut capex spending this year by $7 billion. Similarly, Marathon Oil (MRO) also made plans to remove $600 million from its already reduced budget for next year. The list goes on … and we haven’t really hit the point where most oil firms usually announce capex plans for the next fiscal year just yet.
None of this is great news if you are firm that provides fracking equipment, rents drilling rigs or operates in other oil services — the environment is already so combative. Many oil-services firms offer monster discounts on their wares just to retain market share and gather some revenues. On average, production-based oil firms have been able to secure rates at 20% lower than last year. Although, discounts of up to 50% have been reported.
The balance of power is firmly in the hands of energy producers.
More Suffering for the Oil-Services Stocks
At the end of the day, less money flowing in the sector and bigger discounts does not a great investment make. Now, the big boys — Schlumberger (SLB), Halliburton (HAL), General Electric (GE) — shouldn’t have any trouble surviving through this.
They are deeply entrenched and have the ability to cut prices to pick up market share. Of course their margins, profits and revenues will take a hit, but King Hal and the others will be here when oil prices finally pick up.
That can’t be said from some of the smaller players.
Order books and backlog recordings have taken a beating. Since the last quarter of 2014 (when oil really started to plunge), smaller service stocks have seen a huge decline in future orders. The backlog of business now sits to just two or three quarters behind. That’s terrible.
So have the various contract drillers; and Land drillers like Parker Drilling (PKD) have already been cut in half as rig counts have dropped. In total, Moody’s has placed 11 different offshore drillers on review for credit downgrades as orders continue to be canceled.
For investors, what we are left with is a bifurcated market for the oil-services stocks. On one hand, you have the HAL’s, SLB’s and potential buyout candidates like FMC Technologies (FTI) — essentially, the good guys. On the other hand is a grouping of misfits that could really get squashed as capex spending keeps falling.
The best way to play could be using a pair trade. Buying one of the major oil-services stocks and opening a short position in the SPDR S&P Oil & Gas Equipment & Services ETF (XES). Unlike many of its rival funds, XES equal weights its portfolio. In this scenario, the good eggs in this exchange-traded fund (your long position) don’t have as much of an effect on XES’ underlying performance. But since most of the sector is going to be hit hard, XES will be dragged down as well. And since you’ll be short, you’ll profit.
The Bottom Line: When it comes to oil stocks, the service players are still in for a world of hurt. Capex spending is still going to sink like a stone. Going short on the XES, while going long on one of the stronger major oil-services players could be the best way to play the year ahead.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.