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Energy Stocks

Getting Pumped Up

By Peter Staas, on Jan. 26, 2018

Editor’s Note: In this feature article, Mr. Staas discusses companies involved in energy drilling, including Halliburton (NYSE: HAL), Schlumberger (NYSE: SLB), Superior Energy Services (NYSE: SPN), Concho Resources (NYSE: CXO) and Forum Energy Technologies (NYSE: FET).

Whereas pricing power remains a dream deferred in the onshore US drilling market, a favorable supply-demand balance in the pressure-pumping service line has enabled operators to push through significant price increases in the first half of the year.

In part, this recovery comes because the US market for pressure pumping—the horsepower that propels the fracturing fluid and proppant into the reservoir rock to form cracks—faced a persistent oversupply even before oil prices began to weaken in summer 2014.

Accordingly, the market has had more time to heal on the supply side, with operators idling capacity and deferring maintenance. As of the first quarter, pressure-pumping capacity had declined 31 percent from the peak reached two years earlier.

On the other side of the equation, surging rig productivity has driven a significant increase in the number of drilled wells awaiting completion, as the existing fleet of pressure-pumping capacity struggles to keep pace. The inventory of uncompleted wells has grown rapidly in the Permian Basin.

(Click to enlarge.)

This lag between drilled wells and completed wells, coupled with recent strength in oil prices, suggests that oil and gas producers may allocate more capital to hydraulic fracturing in the first half of 2018 to work through this backlog–especially in the Permian Basin. After the rate of price increases in the US pressure-pumping market softened in the third quarter, stepped-up hedging by upstream operators suggests that activity levels could support further upside in 2018.

The big question for the pressure-pumping market is whether capacity additions—aside from capital, the business has a relatively low barrier of entry—will overwhelm demand, a real concern in a shorter-cycle market where customers can quickly scale activity up or down in response to commodity prices. Albeit a blip, exploration and production companies’ lack of urgency to complete underscores this point.

To date, most of the capacity growth in this business has come from reactivating equipment idled during the down-cycle. In many instances, new capacity merely replaces older frac spreads that have worn out.

Meanwhile, management teams from across the industry have asserted that prices haven’t yet recovered to levels where an industry-wide building cycle would make economic sense. We’d expect more activity on this front once the tight market—many pressure-pumping specialists report that their existing capacity is sold out—translates into more term contracts.

During Halliburton’s (NYSE: HAL) third-quarter earnings call, CEO Jeffrey Miller dismissed concerns about potential overbuilding, citing the wear and tear on equipment from additional fracturing stages and the larger volumes of sand and water involved in the current iteration of shale wells:

Now, first let me be clear. I believe that the [US pressure-pumping] market is undersupplied today. At the same time, equipment is being used harder and maintenance costs are higher. As a result, there will be a greater call for new equipment just to replace the active equipment that’s being worn out more quickly, meaning the day when supply and demand come into balance is further out than people think.

 

Next, completions intensity is not slowing down. We are pumping more sand with less equipment and as a result, the maintenance cost associated with today’s completion designs are increasing. The design of our equipment gives us an advantage over the market that even we have seen an increase in maintenance costs. I believe deferred maintenance is happening throughout the industry. A proxy for deferred maintenance and the simplest place to see it is in the industry horsepower creeping crew size. And while Halliburton continues to operate with an average fleet size of 36,000 horsepower per crew and have for the last several years, the rest of the industry is now averaging closer to 45,000 horsepower per crew. Deferred maintenance is creating this equipment redundancy on location.

Miller’s comments echo those of his counterpart at Superior Energy Services (NYSE: SPN), who continues to assert that the early phases of any new-build cycle would be geared more toward replacing existing capacity. CEO David Dunlap delved into this topic at length during Superior Energy Services’ second-quarter earnings call:

To supply and demand [in the pressure-pumping market], I mean, listen, from – all signs are that the market is extremely tight for capacity. I personally believe that some of the capacity that industry has activated in the first half of 2017 is capacity that did not have a whole lot of useful life of remaining to it. So, I think, even in a flattish demand market for hydraulic fracturing services that we continue to see tightness in the market, we’ve got fracturing fleets now that, with the types of hours that they operate are only good for four to five years. So, you think about the amount of equipment that we have working today and the amount that should be rebuilt or replaced during 2017, I don’t think we have that much capital rebuild and replacement going on today. So, that leads me to believe that we continue to see tightness in that market for quite some time.

Miller also observed that smaller pressure-pumping outfits will struggle to expand capacity beyond their current take-or-pay commitments, a claim that may apply to smaller, legacy operators but seems dubious when applied to the handful of names that completed initial public offerings earlier this year.

As for Halliburton itself, management emphasized that the oil-field services giant wouldn’t expand its capacity without commitments from customers, leading-edge pricing that boosts profit margins, and an acceptable return on investment. Other operators have also indicated that prevailing prices don’t support spending on capacity growth.

Bottom Line: Higher average oil prices in 2018 and robust hedging by US exploration and production companies–coupled with expected proppant savings as operators rely more heavily on local silica sand in the Permian Basin, Eagle Ford Shale and the Haynesville Shale–should provide a supportive environment for pressure-pumping pricing next year. Conditions also look favorable on the supply and demand side.

Going Big

Despite the profusion of pure-play pressure pumpers, we prefer Halliburton (NYSE: HAL) for its superior scale, a distinct advantage in a business line where the number of consumables (valves and proppant, for example) make well-oiled logistics a critical component of efficient operations.

Halliburton’s strength in other oil-field service and product categories can also help to limit the number of contractors (and therefore complications) at the wellsite and facilitate cross-selling. In an environment where oil and gas producers remain focused on unlocking efficiencies and improving well productivity, Halliburton’s scale advantages and superior uptime make it a reliable partner.

At the same time, oil-field service companies themselves aim to attract the highest-quality operators to maximize the utilization rate of their pressure-pumping capacity. Halliburton CEO Jeffrey Miller highlighted the importance of securing work from the strongest oil and gas producers:

Equipment utilization comes in a couple of forms. First, it has to be working and second, it has to be working for the right customers. Our fleet is sold out for the remainder of the year and into 2018. We continue to place our equipment with those customers who know how to effectively and efficiently use us to increase their productivity, which improves our utilization.

The disappointing profit margins posted by Superior Energy Services in the third quarter underscore the importance of working for the right customers and having a top-notch logistics game.

Management attributed this weakness to customer-specific delays stemming from unexpected well interference and logistics headaches. But perhaps the bigger challenge came from a smaller-than-expected proportion of so-called zipper fracs—the high-volume, single-site pressure-pumping jobs at the larger, multi-well developments pursued by Concho Resources (NYSE: CXO) and other high-quality operators.

Halliburton’s scale should also enable the company to push the envelope on automation and machine learning—innovations that promise to unlock further productivity gains.

Among the major US oil-field service companies, Halliburton boasts the best leverage to accelerating activity and pricing gains in the North America; in a momentum-driven market, Halliburton should benefit disproportionately from inflows to exchange-traded funds offering one-stop exposure to the industry.

Although Schlumberger (NYSE: SLB) remains a high-quality operator and is the industry leader in key service categories, its outsized exposure to international markets have helped to make Halliburton the go-to name for generalist portfolio managers seeking exposure to oil-field services.

Halliburton has also taken market share internationally in recent quarters, while investors have questioned Schlumberger’s recent pursuit of production management deals that involve taking an equity interest in upstream projects. With market and business momentum on its side, Halliburton is a buy up to $50.

Although we see fewer near-term upside catalysts for Schlumberger, the company leads the industry in many product lines and has a solid track record of execution and innovation. Ongoing weakness in international markets will remain a challenge, but Schlumberger’s stock looks cheap for patient investors who have a longer time horizon. Schlumberger rates a buy up to $65, but we prefer names with more exposure to North America, as we expect short-cycle shale plays to take market share.

Although our initial entry was poorly timed, we continue to like Forum Energy Technologies (NYSE: FET) for its leveraged exposure to the upgrade cycle in the US pressure-pumping market and the increasing wear and tear associated with intensifying fracturing jobs.

Management deserves credit for a recent spate of smart acquisitions—Cooper Valves (January 2017), Multilift (July 2017), and the remaining interest in Global Tubing (August 2017)—that have shifted the company’s business mix further to completions. The stock has underperformed despite Forum Energy Technologies’ strong revenue growth and 80 percent exposure to the North American onshore market.

Recent weakness in the stock reflects negative investor sentiment toward oil-field services and Forum Energy Technologies’ disappointing profit margins—a product of capital expenditures needed to ramp up manufacturing capacity.

These headwinds should moderate in 2018, while drilling and completion activity should accelerate, driving demand for the consumables in which Forum Energy Technologies specializes. The start-up of the company’s valve production facility in Saudi Arabia could also provide an upside catalyst.

Management also highlighted efforts to right-size its subsea business and use some of that segment’s manufacturing capacity to address productivity challenges on the completions side. Forum Energy Technologies rates a buy up to $22 for aggressive investors.

Peter Staas is managing editor of Conrad’s Utility Investor and Energy & Income Advisor.

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