Demand Growth For Deepwater Drilling Services To Outpace Supply - Scott Gruber - Sanford C. Bernstein And Co., LLC
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Scott Gruber, CFA, is Senior Research Analyst for U.S. oil services at Sanford C. Bernstein & Co., LLC. He joined Bernstein in 2004 as a Research Associate on the energy team before taking on the primary coverage of oil services in 2009. Mr. Gruber was voted the Best Up & Comer Analyst within his sector in Institutional Investor's All-America Research poll in 2010. In 2003, he graduated with honors from the economics department at Princeton University, where he also received a minor in environmental studies.
TWST: When you last spoke to us in June, you were generally bullish on the oil sector. Is that still your overall view?
Mr. Gruber: Our view has become less constructive. What we see today is that crude prices are being supported by the number of hotspots in the Middle East; however, that is contrasted against the potential economic risk emanating from the European financial crisis, and certainly it appears that Europe is slipping into recession. The bigger question surrounds potential contagion and the impact on the U.S. and Asian markets, which causes concerns on the demand side of the oil picture. When we look at the underlying fundamentals in the oil market today, we see a market that is better balanced, and actually the tightness, which has really defined the last year, is slowly being alleviated by the return of Libyan export capacity.
And if you remove the European and Middle Eastern factors from the equation, underlying supply/demand for crude actually looks like it's going to weaken a bit in 2012. The metric that we follow most closely is OPEC spare production capacity. This is the output of the supply/demand balance globally, and we foresee that number moving some - it bottomed close to 3 million barrels a day in 2011 - and we forecast it moving back up toward four.
TWST: You expect capex to increase internationally but remain flat domestically. What is that going to mean for the sector, and which companies will be leading the international capex growth?
Mr. Gruber: What's interesting within the oil services is the great budget flexibility of the North American customer base, which is primarily independent E&Ps. So the growth in spending, which is going to dictate the pace of the activity in North America, is going to be determined, ultimately, by the commodity prices that prevail in 2012. So we're a bit cautious, we foresee low gas prices sustaining, and we're cautious on the crude side.
So we foresee the industry will be very challenged to grow drilling activity in North America in 2012, in contrast to the consensus opinion, which is more bullish. Now, within the international markets, the projects tend to be bigger and longer lived, and the budgets less flexible on a quarterly basis. The customers internationally are largely the majors and national oil companies with a sprinkling of E&Ps, and there is a lot less deviation from forecast annual budgets over the course of the year. The rebound in crude prices over the past two years has provided confidence for the international E&P industry to go back to work in earnest, and we're seeing that.
A plethora of new contracts have been signed for offshore drilling rigs, which provides confidence to us that customer capex is going to grow robustly in 2012, and we think customer spending is going to be up around 15% abroad. So relative to the last time we spoke, my confidence toward a healthy expansion in international capex by the customer base has only been enhanced by the data points we've seen over the past few quarters.
TWST: You expect deepwater rig supply to fall short of demand by 10% in 2013. Please tell us more about that hypothesis and what the ramifications would be for the sector.
Mr. Gruber: I should mention first that we reduced the forecast shortfall a bit based upon changes in our crude price expectations relative to one when the report was published. We still expect a shortfall, but we foresee about 6% shortage in 2013 versus 8% previously. I think the growth in deepwater drilling activity is one of the more attractive investment themes within the oil services space. Our report, which you referenced, highlights that we believe rig capacity will fall short of demand in 2013. As a result, the momentum behind deepwater rig rate inflation should continue.
We expect very healthy rates and continued inflation in deepwater rates in 2012. A number of offshore drillers are well leveraged to rising offshore rates, such as Ensco (ESV) and Noble (NE). Now, beyond the offshore drillers who, obviously, own and operate the rigs, one of the very few segments within oil services which has yet to secure pricing power is offshore drilling and well-completion services. And I think there is a very high probability that the international service companies like Schlumberger (SLB), Halliburton (HAL) and Baker Hughes (BHI) secure pricing power for their offshore services in 2012. The company most leveraged to this theme is Schlumberger, and that's why it's our top pick in the space.
There is great controversy around whether or not the industry secures pricing power, but if you look at customer spending plans and you look at the contracts, which have already been signed to execute the growth embedded in the plans, it provides great confidence to us that the demand growth for the deepwater drilling and completion services will outpace supply and allow the industry to resecure pricing power.
TWST: What are some other major themes or trends you expect to emerge in the sector here in 2012 that we haven't discussed?
Mr. Gruber: One of the other themes which could transpire is an increase in M&A within the space, and the reason I highlight that is a number of companies are generating significant cash flow from North American well-stimulation services. The companies today are reassessing whether they want to maintain the level of investment in new well-stimulation capacity. The conclusion many are coming to is that they want to start to reduce the rate of investment given the supply growth we're witnessing in that segment as well as the collapse in gas prices. The larger companies are likely going to seek alternatives for deployment and you may see them execute an increased number of transactions as a result.
TWST: Are there any potential deals investors should keep an eye out for at this point?
Mr. Gruber: Right now, I'd say the best way to approach is to think about the holes in the portfolio either from a product standpoint or a geographic standpoint that companies may want to address. So Halliburton does not participate in the artificial lift business - they may look to buy into that business. Baker Hughes is less well represented in Russia - they may look to buy a greater market share in Russia. I think that's the best way to approach it.
TWST: In addition to Schlumberger, which you mentioned, which names do you believe are the best way to get exposure to the sector?
Mr. Gruber: Schlumberger is our top pick for really three reasons. For the near-term investor, there is controversy around a key catalyst, and that catalyst is offshore well drilling and well-completion pricing. We're confident that Schlumberger secures pricing power this year and margins will rise, and as a result the earnings growth that we foresee into 2013 is achievable, and therefore, the stock is cheap at the current valuation.
For longer-term investors, it's one of the highest-quality companies in the space, and it has a healthy balance sheet. The company should generate 5 billion in free cash flow over the next two years, which will be used to facilitate continued buybacks. They are also very well positioned for secular growth in deepwater drilling as well as unconventional resource development globally. The other name I would highlight is Ensco. They are our top offshore driller pick.
As I mentioned, we believe offshore rig rates continue to inflate, and Ensco is capturing that opportunity both in the deepwater and the shallow water. The company, in our view, is the highest-quality offshore driller. They combine a high-quality fleet, well-maintained legacy assets, and they should also generate free cash flow over the next two years allowing the company to pay down debt that was placed on their balance sheet for a previous acquisition while also maintaining an above-S&P dividend yield.
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