In-depth Overview Of Oil & Gas Dynamics & Valuations
TWST: Let's start with the big elephant in the room, which is the oil spill in the Gulf. I know it's early in the game, but what's your initial take on it?
Mr. Minervino: I think the key here is that there is probably going to be some increased scrutiny and safety checks on this industry going forward. This is going to probably be more preventative measures, maybe more equipment redundancies. This industry has had an excellent safety record. There have been thousands of wells drilled and very, very few serious incidents up until this point. So what we are going to have to deal with going forward is probably increased scrutiny, more channel checks, potentially additional backup equipment along the way, and it will probably benefit the industry more going forward. Nobody wants to see this happen again - not the companies, politicians, investors or business owners who depend on the Gulf for their livelihood.
TWST: What will this mean for the industry?
Mr. Gerry: I think the disclaimer is nobody knows, and we don't know what's going on. My first take is that ultimately, it's going to mean more regulation and more red tape, and probably more redundancy in terms of safety equipment. Coming down the pipe, regulations are going to be tougher; testing, surveys, stuff like that is going to be more rigorous. I think there is probably going to be an increased amount of capital equipment and pressure equipment that's going to be required in wells. That, to me, is the most obvious conclusion. Now from a red tape and bureaucracy, and getting things filed and everything like that, that's the part I don't know. But that would be my first guess at this.
TWST: It sounds like a higher cost of doing business.
Mr. Gerry: Absolutely.
TWST: That's something the industry will have to face up to. How long will it take to sort this all out? Certainly, it's a political football at this point. Will that keep the ball in the air and the spotlight on this for an extended period of time?
Mr. Minervino: I agree. It's going to take some time here before this is all sorted out. There was news out today that the Department of the Interior delayed looking at offshore Virginia oil and gas leases. So that's another implication of all of this. I think the first order of business here is if they can solve this problem of the oil leak sooner rather than later, I think that will actually do the industry a great deal of good going forward. It may show that they can respond to and solve unforeseen disasters in a timely manner. It may soften what could be stricter, more expensive regulations that these guys are thinking about putting in place.
TWST: How long will it take for things to return to how they were before?
Mr. Gerry: That's a tough one. I agree, the sooner we can get this thing done, the better. That will diminish the fears, and all the implications are eased and maybe the regulations are a little bit less. Certainly, the insurance costs and the litigation are what I am more scared about. These will raise the cost of doing business, as you said earlier.
TWST: That will be with us for a while probably.
Mr. Gerry: I don't think that this actually slows down rigs that are currently drilling. It's a stretch for me to think that those have to stop. In terms of the eastern Gulf of Mexico or the Atlantic getting opened up, I am not holding out on any hope anytime soon. That's my first take. I could be wrong, but that's just kind of how I see things going.
TWST: Would you agree this will put a halt to Obama's mission of more drilling?
Mr. Minervino: The recent news out today is that the Department of Interior is delaying this Virginia offshore oil and gas leases sale at least for the time being. However, they do say it is not going to change the planned offshore lease in 2012. So it's really hard to predict this sort of thing. In this industry, things moving to the right is not uncommon. To the extent that this issue improves overall safety and prevention, that can't be a bad thing. Granted, it might increase costs, but it can't be necessarily a bad thing that there are more checks along the way. And people will get more confident that offshore drilling is good for the oil industry and our own energy policy; it will result in positive outcomes down the road.
TWST: How important is the Gulf? Where are there other opportunities for this space?
Mr. Minervino: There is no doubt that the Gulf is a meaningful piece of business for the services companies. Of the 360 or so rigs drilling offshore, about 50 of them are in the Gulf of Mexico. Beyond the Gulf, offshore Brazil is a tremendous opportunity, given Petrobras (PBR)' plans and its findings in the Santos Basin. West Africa continues to emerge, and what we are also seeing is that offshore India and offshore China have really great opportunities. You have a number of new rigs entering the market over the next three years - I think it's about 75 new deepwater rigs. Several of them are contracted and will be going to work. So there is quite a bit of opportunity out there for this industry.
TWST: It seems there is a lot of opportunity in places other than the Gulf.
Mr. Gerry: Absolutely. The word or the phrase used in the industry is the "golden triangle" in terms of exploratory success. The triangle - the points of Brazil, West Africa and the Gulf of Mexico. The Gulf of Mexico deepwater market - the shallow-water market is not all that great right now - but the deepwater market has been extremely robust in terms of discovery, rig opportunities and rigs coming to market. So it's still going to be a meaningful part of U.S. drilling and frankly of the U.S. economy from a tax perspective and from a jobs perspective, which is certainly relevant these days. Brazil is the elephant in the room. I mean their plans are as aggressive as this industry has ever seen, talking about building 40 high-spec deepwater rigs. That's going to cost close to $20 billion, not to mention all the other infrastructure that's going to go along with that. So their plans, like other things in the industry, have been pushed to the right. There is a lot of political upheaval there, but bottom line is the resource is there, and that's a tremendous opportunity. Same thing in West Africa from a deepwater perspective. We're just now beginning to touch other markets, such as China, Southeast Asia and India, to name a few, in terms of deepwater. So I think the deepwater market is still a very strong, longer-term market because of the success we've had. But also there is a lot unknown out there that could make it even stronger.
TWST: As we look out, does the industry have the financial wherewithal to support this amount of opportunity?
Mr. Gerry: It's kind of a chicken-and-egg situation. If they don't, then oil prices just go higher. Then all of a sudden, you do. When I look at that, most conversations we have with most companies we talk to, $80 a barrel is more than sufficient to support deepwater drilling. And we look at all their models - we look at the five-year or even 10-year plans; we see structural problems on the supply side. And demand is going to be what demand is going to be. Today we don't know what the economies are going to do - global economies, certainly a lot of risk there. But on the supply side of oil, I think it underpins a pretty bullish long-term outlook. So I think that we are going to have the cash necessary to pursue those opportunities. Not all drilling is done on an economic basis. You are seeing more and more of the customer base, more and more of the guys drilling, national oil companies who are not necessarily out to make a buck, but more support their own internal growth or have some for security measures. So the list goes on, but it's not always economic when you are talking about national oil companies.
TWST: Does the industry have the capacity to go ahead with these opportunities?
Mr. Minervino: Absolutely. You are talking about some of the wealthiest companies in the world that really drive this process. Some of the NOCs still need to get capital lined up, but when you move beyond that, you are talking about the Exxon (XOM)s of the world, Chevron (CVX)s of the world, etc. These companies have among the strongest balance sheets in the world. And they do have the capital, and they are out seeking these opportunities. Deepwater is among the few out there that they actually have access to, and so I do think that they have the capital to develop these in a big way. And that's what created the demand for the new rig build-up cycle and the seismic activity that led to some of these discoveries offshore. This is the next frontier of drilling opportunity. They are not finding very many big oil fields on land anywhere; it's moving further offshore, and that's where the opportunity is. So I think that's where the capital gets allocated.
TWST: Are you seeing any new players? We talked about China and India as new opportunities - what about those two countries as new competitors?
Mr. Gerry: "No" is a relative term. I think most of the assets kind of belong to the legacy offshore drillers, mostly U.S.-domiciled companies. You have some smaller companies, like Scorpion (SCORE.OL), and you have some Chinese - the Chinese have a lot of rigs. You are seeing more rigs. Especially over the last five years, a lot of rigs were built, and not all of them were built by the legacy guys. So I would say of any critical mass, it's hard to point to somebody that's really out there, but there are other assets, absolutely.
TWST: One of you mentioned 75 rigs coming down the pike. As we look out, will that change the space's economics or dynamics going forward?
Mr. Minervino: It adds a much-needed layer of supply to this market, a very tight, deepwater rig market for quite sometime. Over the past several years, the economics of owning deepwater rigs were so compelling that it did lead to this major build-out, with demand so high, with oil prices rising towards the latter parts of that up cycle. So I think the market will be able to absorb these new rigs in an economic manner. Does it put some downward pressure on current day rates? Perhaps it does, but that gets offset by the increased layer of opportunities out there as a result of this.
TWST: Collin, what's your take on these dynamics?
Mr. Gerry: I couldn't agree more. I think you had a very robust build cycle - partly driven by economics, partly driven by cheap capital - that's brought a lot of rigs that are coming down the pike. Seventy-five on the deepwater side sounds right. I would say that close to 75% of those have long-term contracts. So it's not as ominous as you would think, but still we are seeing that contracting behavior from the operators has slowed down a little bit. Deepwater, on this part of the market, it's a much slower-to-turn market. You're looking at longer lead times, you're looking at multibillion-dollar development projects, not just a quick turnaround prospect, as on land. So things typically roll over slow, and they are slower to rebound. That rebound slowness has kind of been perfectly timed, with a lot of these rigs coming online and a lot of rigs rolling off contract. So you have what I would call an air pocket of demand that's resulted in day rates and pricing for deepwater rigs starting to slide. I don't think that's a long-term phenomenon; I think we're probably close to a bottoming process. More or less, it's a 2010 phenomenon. And then we're stabilizing and maybe moving higher for the next five years. So the short answer is yes, I do think that the dynamics and economics of the deepwater still work. From an operator perspective, lower price is always good, but I don't think it's a complete nightmare from the oil service guy.
TWST: Nobody is crying the blues yet?
Mr. Gerry: Some people might be, if they top-ticked the market, and they built them on the highest possible cost on a day-rate expectation that's probably $100,000 or $150,000 lower. Some people, they got caught with their hand in the cookie jar. But it's certainly a positive for the industry.
Mr. Minervino: If you go back and look at Petrobras' plans to buy rigs and how many rigs they've talked about needing, even the Petrobras' CEO was publicly saying that there is a shortage of deepwater rigs in the market. Just Petrobras' plans alone could absorb quite a bit of the supply out there.
TWST: The longer-term outlook is fairly bright?
Mr. Gerry: I would agree with that.
TWST: What's the risk in this space? The picture hasn't changed a whole lot.
Mr. Gerry: The picture hasn't changed. In this industry, the risk is always the commodity price. There is no reason to get too cute about it, it's very simple. If oil prices take a meaningful fall below the $50 range, it changes the deepwater momentum. I personally don't think that's going to happen, but we certainly have a lot of risk in the global economy right now. So I would just say global economic demand for oil is the biggest risk right now and in particular, out of the developing nations, that's been driving most of the incremental growth in oil demand. If that space is fairly robust, then I think that's the most important factor. I see oil prices been underpinned by strong growth in developing-nation demand and limited supplies. We see non-OPEC in a peaking-type scenario.
Mr. Minervino: I think that we can't be blind to what's happening before our very eyes as we speak - this European debt situation. We don't really know the ultimate global economic outcome; there is uncertainty to the extent that it could spill over to the U.S. economy, which is really in the early stages of recovery, and it's still a fragile recovery right now. So to the extent that these issues that are hampering the European markets right now spill over and affect us and then affect our economy, then what does that ultimately mean for the Chinese and the Indian markets that ultimately export to us? So if our demand levels go down and our economy slows down, how does that affect the true drivers of oil demand in coming years, which is your emerging markets, like India and China? Does it spill over and affect those markets? That is one of the big issues out there right now. That's the number one risk. And then this oil spill issue - it's still too early to know what the ultimate implication is going to be from something like this in terms of long-term offshore drilling. But does it slow down offshore drilling? No one truly knows what the current administration will do as a response to this. It's the uncertainty out there that does cast a cloud over this industry right now. Personally, I think we are in those early stages of an oil services recovery - demand is picking up all around the globe. And this just puts an element of risk to that, which, you have to understand, is affecting the stocks.
Mr. Gerry: I guess it already has to a great deal.
TWST: Are we likely to see more M&A activity, given what's going on in this market?
Mr. Gerry: That's a tough one to call. I think what we have seen is some pretty sizable deals, with Smith (SII), BJ Services (BJS) and NATCO (NTG), to name a few, and with a very high-equity component. And I think sellers were short-sighted as valuations in the sector rose not long after these deals. I think a lot of people wanted to participate in the equity upside if they were to get bought, which changed the economic floor from a buyer perspective. I think that risk element is getting into the seller's mind a little bit, and so maybe the cash component starts becoming more of an issue. But M&A, I think there are businesses that could use consolidations. This industry is just like any another industry - a lot of personalities and a lot of pride. So a lot of times, it takes a lot of extraneous factors to get two companies to come together. By and large, I still see opportunities for consolidation, but I don't think it's a huge issue that we have going forward. I think it's going to be one-off.
TWST: What's your take here, Chuck? Will we see more M&A and industry consolidation?
Mr. Minervino: I do, I think we will. To the extent that we see major further announcements along the lines of Schlumberger (SLB)'s Smith deal and Baker's (BHI) BJ Services, you are getting to the point now where there are very few very large companies. I would say there are still quite a few smaller- and mid-cap companies that are potential targets for a number of these big companies. I am a believer of the bundled-services offering. The greater ability for a services company to bring more products to the table, the better. I don't think from an operator's perspective, that they want to go out and have to contract several different smaller players that provide all different individual products. In the early stage of a recovery, you do tend to get this kind of M&A. I expect it to continue, with additional clarity in the overall market right now, which just hit us hard over the last couple of days. The last thing I would just add is that the balance sheets of a lot of these services companies are extremely strong; they have very little debt. Most of the deals that they've already announced are stock deals, so they still have a lot of cash on their balance sheets. They don't tend and lever up in any real meaningful way, and you have a couple of companies out there, the Halliburton (HAL)s of the world and National Oilwell Varco (NOV)s of the world, that have a lot of cash and are building more cash. They have to figure out something to do with it. A couple of them have been very vocal about wanting to do acquisitions. So I do think you are going to see more M&A. I don't think you've seen quite that much of it in the driller space yet, but that's been a topic of conversation recently as well. So I think you will see more.
TWST: If we look historically, have acquisitions made sense in this space?
Mr. Minervino: Yes, I think so. When you look at some of the deals recently in the States and National Oilwell Varco's deal, these guys tend to be able to bring margins from the companies that they acquire up to company-wide levels fairly quick. So it's hard to make a blanket statement that acquisitions tend to work or tend to not work. But I think that when you look at these larger companies, Baker Hughes or Schlumberger, they make good ones, and they make bad ones. But for the most part, they tend to make pretty smart decisions that improve their returns and allow them to better take advantage of the key secular growth opportunities.
TWST: As you talk with investors - let's leave aside the Gulf oil spill - are they interested in the space?
Mr. Gerry: Absolutely. I think energy is a fun industry to cover because there are a lot of subsegments. I think there is a highly topical debate over the direction of natural gas prices. The bears seem to be in control, and what that means for drilling activity and for lot of the E&P companies that are customers for these guys is an open question at the moment. That's one side of the argument. The other side of the argument is oil prices, which, I think there is a large constituency of investors who are bullish on oil over the longer term, and they want to know the best way to play that. There is a constant technology push that the bigger guys are always going to be at the forefront for the Halliburtons and the Schlumbergers, and so forth. So going back to your question, is there interest on the investor side? I would say absolutely.
TWST: What's your take, Chuck, on investors who want to know what's going on beyond the oil spill?
Mr. Minervino: Since the oil spill recently occurred, that immediately has become the focus of attention. I was just down at the Offshore Technology Conference in Houston, and at a lot of the booths people were talking to these companies, trying to gain more understanding of what may have happened on the rig. So that has dominated the topics of conversation lately. But prior to that, and I think still even going forward, this industry is very much in the attention of investors. These are companies that had earnings trough in 2009, and you are now in the early stages of the recovery. You're going to get very rapid earnings growth from a lot of these companies in 2010, 2011 and 2012 - outsized earnings growth - so that always draws the attention of investors. Now as you get these other issues added into the fold, it creates some volatility, but that isn't necessarily a bad thing in the sense that there becomes more differentiated views. I would say two months ago, it was very hard to find someone who was bearish on the oil services industry.
TWST: Now there are a few more?
Mr. Minervino: Now you've had a couple of more elements of risk. So undoubtedly that pendulum has swung back more towards the middle.
TWST: What are you telling investors to do at this point?
Mr. Gerry: If you consider the events over the last week, that's one thing. If you take it a step back further and look at it from a broader perspective, it's another. So I guess right now, our thesis has been that it's a stock picker's market now more than it has been for the past five years. For the better part of the 2000s, you could a throw a dart at any energy company and you would have done pretty well. We had a bullish natural gas environment; we had a bullish oil environment. I think those two commodities have gone separate ways - natural gas is a different scenario and oil still looks pretty strong. If you then boil it down a little bit further - who's going to provide earnings growth, who has sectors that are tight, where you are starting to see pricing leverage to find investable companies - I think the most topical one that I continue to hear about is pressure pumping. You listen to a lot of the comments going on right now from the E&P guys and the services guys - is that the high grading we've seen in the U.S.? The horizontal rig count market share just exploded out of the downturn, has really driven a huge increase in demand for pressure pumping, which had been a severely oversupplied market for two or three years. So that's tightening faster than anything, and that's a lot of focus right now. I think we are going to start building a lot of capacity for that, so that's a supply chain or one thing that we are looking at, but also international growth. I think if you listen to - we call them the "big uglies" - but the big diversified companies, a similar refrain you heard from almost everybody was that margins internationally are bottoming and you are seeing things pick back up. So I think you have to be selective. But if you go to the international community, which is much more of a oil-driven market, you are going to see growth. And I would agree with Chuck that in certain scenarios you are starting to see, if you look at 2011 numbers, you can have some pretty substantial growth scenarios, especially within that subsector. So I could go on forever, but there is a ton of nuance to the marketplace now. Whereas I would say for the better part of 2000, it was just up into the right.
TWST: So now you have to be a little more selective?
Mr. Gerry: Yes, there will be more fun. It's always fun.
TWST: What are you telling investors to do?
Mr. Minervino: I'm a buyer here. The Oil Services Index has basically corrected by 20%. You've got a combination of two major issues that have affected the space in a big way. If you run out and buy in the middle of a very volatile, uncertain environment, that is a little bit more debatable. But I think during these times, you look at these corrections as buying opportunities for core long-term holdings in this space, like Schlumberger and Halliburton. If you take a look at valuations historically - back to that 2001-2002 time frame, coming out of the last down cycle - and you look at the valuation throughout that up cycle, you had a very steady 20x-plus valuation multiple on this group for basically six or seven years. The earnings growth carried very strong equity returns throughout that period. So you had 20%-plus earnings growth, and then you also had stable multiples that gave you very strong stock returns. Now if you look where we are today, you are basically below 20 times the first year of the up cycle. So to the extent that you believe that we are in the early stages of an economic recovery, that these events will not completely disrupt it and put us back to into a recession, we are going in the right direction here. You could potentially have multiple years of earnings growth and valuations that stay in that 20-times range, and you can get very attractive returns on the stocks.
TWST: What companies are at the top of your list?
Mr. Minervino: Right now I don't think we need to overthink things too much in this space. I truly mean that. My two favorites right now are Schlumberger and Halliburton. These companies are levered to the great secular trends within our space. They have the best capabilities for the three key secular themes - unconventional land, offshore and international. In unconventional, they have several services, but pressure pumping, directional drilling, logging while drilling and completion all come as a benefit. There is going to be quite a few more deepwater rigs, and these guys are the number one and number two players in offshore services, so they are very levered towards that. Then just the broader theme of more international opportunities over the next several years. These companies are the top two players internationally as well. So I think those two stocks, while being among the biggest, also are very well positioned for the current trends right now.
Mr. Gerry: I agree with everything Chuck just said. I am a huge fan of Schlumberger and Halliburton for those very reasons. They seem to be in the right markets, both from a product line perspective and a geographic perspective. But outside of that, I think our two favorites are somewhat contrarian calls. One would be National Oilwell, NOV. I would say they have a tremendous balance sheet, a rock-solid track record of doing M&A, and I think that could be a catalyst for earnings growth. They are the leading franchise in terms of market share in their space; they kind of have a dominant position there. I think ultimately Brazil is going to start building rigs, which will mean a pretty high degree of inbound orders for NOV - timing that is going to be very tough, very cheap valuation there. And a stock, well, I think the market is saying, "They have this backlog that was built up in the peak, orders haven't really gotten back to that level, so we are seeing this backlog slide." I think when I look at this story, I see a very cheap stock that's one among the best run within the industry, with a ton of dry powder. In terms of execution, they have beat seven quarters in a row by an average of 12%. They continue and the stock is sold off on almost each one because everyone is focusing on the backlog. So if we just look at the core business and take away the big, what I would call a kind of "overdone concerns" on troughing backlog from a quarterly basis, this is a tremendous value.
Weatherford (WFT) is one of our other favorites. It is definitely a contrarian call. Weatherford - it's funny, when you look at this space, sometimes stocks can go from a darling to the other side of the spectrum. Weatherford was one of the darlings during the up cycle, and then when the music stopped, they were very exposed. And they've had some operational issues for the year or so. There is no company more levered to oil prices and rising international activity. I think ultimately a lot of their assets start getting better utilization. You start getting a little bit more fixed-costs absorption, and you start seeing numbers go the right direction, which I think is really the play in the story. I have seen a lot of earnings misses and a lot of guiding lower; $80 oil and a strong international community can turn that around very fast. And I think if you listen, the sentiment coming out of this industry right now is that that's exactly where we are. So I think both of those are very unique value stories and that the market is fixated on near-term events. And the longer-term story is very strong, and you have very cheap valuations supporting them.
TWST: Those are two phrases I don't think I've heard for a while in this space, "cheap valuations" and "really undervalued." Times have changed.
Mr. Gerry: Sure.
TWST: What will it take to get investors to step up and do something?
Mr. Minervino: Right now I think it's going to take a little bit more clarity on what's going on in Europe. That's the issue that needs to get sorted out here right now, because that's the top of the conversation today. I don't know how long that's going to take. I think it's hard to know if we are going to get a snap-back in these stocks over the next couple of weeks. It really depends on that issue at hand. I don't really believe that we are going to get a major, major correction in oil prices. I think we are going to stay in that $70 to $80 band for quite some time. It may be premature to believe that it goes to $100 anytime soon, but I also don't see it going down below $70 either. So you might see some stabilization in the near term. And then as the details of Europe and its impact unfold, then people understand the impact a little bit better and we start to see these stocks start moving in the right direction again.
Mr. Gerry: I think you cannot underappreciate the value of North America to oil service. I mean, this is where most drilling activity, most revenues historically have been earned. For the last 10 years, that has been a natural gas market. So you have the scenario where natural gas has been a big driver of the profitability of the oil service industry as a whole. Right now, like we said, natural gas is a very topical debate. It appears, at least to me, that we are in a very oversupplied market and that is likely to be the case for the next couple of years. Longer term, there may be some sort of Btu parity argument that takes hold, and you can certainly make that case. But for the next couple of years, the natural gas fundamentals certainly don't look as strong as they did for the better part of the 2000 decade. So I think understanding North America and what that ultimately means for our companies, where the rig count is going to go in North America, is also a very topical debate right now. It's something that we need to get ahead of to understand.
The other point I will make is that I think that the market is not ignoring the oil service space. If you look at the recovery coming out of the March 2009 lows, I'm pretty sure that oil services is one of the better-performing industries. In a strong economy, you don't need an economy to just rip, but you just need a strong, stable economy. I think energy is seen as one of the better places to be. You are going to have a tight market for oil that's going to ultimately trickle down to higher profitability for the oil service companies. So when you get the rug pulled out from under you, like you have with the European fears, it's going to go the other direction on you. That's kind of how we see the world. Natural gas is going to be very relevant still and also, I think, oil service as whole is probably a higher way to play economic recovery.
TWST: Chuck, anything else we should touch on or anything we missed here?
Mr. Minervino: No, I don't think so. I think we hit the industry, the regions that are topical right now and all the key issues that everyone is really asking about right now. So I think you are okay.
TWST: Anything else we should touch on?
Mr. Gerry: There is not shortage of headlines these days. I think we have covered most of them, especially that relates to our space. So nothing is jumping off the page to me.
TWST: Thank you. (TM)
Note: Opinions and recommendations are as of 05/07/10.
Oil Field Services Analyst
Raymond James & Associates, Inc.
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