The Oilfield Services/Equipment Industry is made up of a mature set of companies, the fortunes of which are dependent on the drilling expenditures of oil and natural gas producers. Since demand for such fuels fluctuates with the economy, oilfield services stocks are considered cyclical.
Companies in this industry are of two main types: those that rent drilling rigs and those that provide the various services required to evaluate, construct, and maintain oil and gas wells. The top service and equipment providers offer the broadest array of capabilities. Smaller players usually focus on a market niche. Contract drillers may be classified as land and/or offshore operators. Offshore drilling equipment is graded according to its ability to work in deep water and in rugged environments. Notably, rigs capable of drilling in the stormy North Sea have historically earned higher rental rates than those in the Gulf of Mexico. Industry margins are excellent during boom times, but can narrow supply during slow periods.
The level and direction of oil and natural gas prices are key indicators of performance for the industry. Energy demand, one of the main factors affecting quotations, is determined by global population growth, economic development, and general business conditions. In the case of oil, the Organization of Petroleum Exporting Countries’ (OPEC) ability to set and maintain production comes into play. Other factors that affect prices include production from non-OPEC countries, exploration and production costs, and weather conditions. Higher prices mean customers have more cash to spend on projects and exploration. Customer spending is also reliant, to an extent, on credit availability.
The global rig count also tells a tale of the industry’s fortunes, although its meaning continues to evolve. As a point of reference, there were about 2,500 active rigs worldwide in early 2010, with oil drilling having more of an international focus and natural gas drilling mostly centered in North America. Over the years, technological advancements have made it possible to do more with each rig in service. Thus, the total rig count probably won’t ever reach its high of about 5,000 hit in 1981.
Moreover, during the course of the last decade, the number of North American natural gas rigs first rose significantly without a corresponding increase in production, but then fell sharply as output moved higher. When the new century began, it took more equipment to maintain production levels, as drilling prospects dwindled. In recent years, however, the ability to tap natural gas trapped in shale formations has caused an industry shift, given the high volume that can now be pumped from shale. Nevertheless, the rig count still provides a useful gauge of activity on a regional basis and during periods when rapid change isn’t the norm. A rising rig count is the precursor to a better equipment-and-services pricing environment.
Over the years, the mature North American market has been well scouted for drilling prospects, a noteworthy disadvantage. With the industry based in Houston, it’s just been easier to devote personnel and equipment to nearby opportunities. Now, however, the largest companies are, to a greater extent, setting up operations abroad, given attractive growth possibilities and a crowded market at home. Industry leaders are opening offices, research centers, and factories around the globe to take advantage of expanding markets in North Africa, West Africa, Brazil, and the Russian Caspian. But competition is still a factor. Companies need to offer customers a solid brand name with a good reputation, which may entail sizable capital investment.
Getting the product line up to speed generally requires spending on R&D or acquisitions. Acquisitions are usually quicker and, although often expensive, sometimes necessary, considering the high level of performance customers expect. Most of the companies in the group are adequately capitalized. There are too many ups and downs in this business for them to rely solely on debt financing. Cash is a ready source of funds.
Oilfield services companies tend to be valued based on where the economy is in terms of the business cycle. At a trough, for instance, a rig company’s shares might be worth the market value of its equipment. Coming off the bottom, cash flow is often used to value these stocks. Cash flow is a more stable measure than profits, which might be spotty during the early stages of an upturn. Earnings increasingly come into play, once an upswing is firmly established. Finally, expected future earnings are more heavily relied upon at a cycle’s peak. A drilling rig or manufacturing facility under construction would enhance future profits, for instance. Oilfield services stocks typically start to turn up before earnings do in a recovery.
The level of industry activity depends on orders from crude oil and natural gas producers. Research firms poll the oil companies in December and January to get a sense of their year-ahead capital spending plans. Plans are subject to change, of course, if oil and gas prices move significantly in either direction. Stocks take their cue from indications of increased drilling activity, triggered in the short term by oil and gas price movements, with earnings more important over time. Regular dividends are usually nominal here, although some companies make special payouts.