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Brian Uhlmer: Elevated Oil Prices Push Interest in Service Stocks
Source: Brian Sylvester of The Energy Report (4/26/11)
Large oil-drilling projects in the U.S. and abroad, the price of oil and new drilling technologies have brought growth and stability to oil field services and equipment companies. Read why investors are looking at this sector in The Energy Report's exclusive interview with Brian Uhlmer, managing director and senior analyst of Global Hunter Securities' Energy Group.
Brian Uhlmer: For about a year.
TER: What was the reason for getting into this particular sector?
BU: The founder of our firm really knows both the exploration and production (E&P) and oil service sectors and has strong relationships there.
TER: What is your strategy with the sector?
BU: We try to pick stocks well; Global Hunter looks for good, investable names with quality management teams and long-term secular growth. We distribute research on the best companies in the space. We are in Houston and on the ground talking with management teams, as well as middle management, customers and suppliers. We really understand every detail of the sector.
TER: Is the growth in the oil field services and equipment sector coming from the increase in the oil price, or are there other significant growth catalysts?
BU: The majority of the growth is coming from oil being above US$70 a barrel (bbl). Once we broke US$70 and people believed the price would stay above that for an extended period of time, long-term investment and project decisions were made. That meant capital equipment was ordered with a two- to four-year lead time. Drill programs have been started, and it's not just drilling a couple of wells and producing them—it's developing full fields. That's really led to improvement in the long-term story for the service sector. These oil prices prompted the development of oil fields in the U.S., as well. Having oil developed here so we can do something to decrease our reliance on foreign oil has led to a secular uptrend on U.S. land. And that's been affected by oil prices being high.
TER: With oil well over US$100/bbl, are increased margins finding their way down to the oil services companies?
BU: Not necessarily. It's a slow-moving process getting equipment back to work. You've got to have equipment that's highly utilized to get the pricing power needed to expand margins for oil service companies. It's really company specific; several areas of oil services have seen pricing improvements beginning in late 2010. They're starting to accelerate a little bit in 2011 and taking some of that margin away from E&P and putting it into their pockets.
In other segments, most notably the offshore sector, day rates have not accelerated or moved upward in that space. There is still a lot of capacity that was sidelined during 2009 and is slowly getting back to work. It's more a factor of the long-range forecast versus the current spot price of the commodities.
TER: Can you compare the history of oil services and equipment companies with what you expect in the future?
BU: The last 30 years have been highly cyclical for oil services, especially with companies levered to North America and to land plays. The offshore market has been like that as well, with short-term contracts and high cyclicality. You've seen margins, revenues, everything, go up fast and go down fast, with the stocks seemingly reacting the same way. As we moved through this cycle, beginning in 2007–2008, we started to see a lot more term contracts for offshore and land, with some growth in the mega projects. With those, we have a lot more stability in terms of revenues, margins and earnings because they are long-term projects. Then there are incremental margins, upward or downward, for short-term contracts. In the U.S., we've seen mega projects begin.
We've got larger operators saying, "I'm going to develop this full field, whether it's in the Marcellus or Eagle Ford Shales, the Bakken, or the Permian Basin. I'm going to make a plan for multiwell packages. I'm going to contract my rig for two to three years. I'm going to contract my service provider for two to three years to complete that program. I'm not picking up the phone and saying 'come out and drill this well today,' and then letting the rig go as soon as that well's done.
TER: Are the small margins of E&P companies eating into the margins of oil field services and equipment companies? Or are there so many of the latter that they can set their price and explorers and producers (E&Ps) have to meet it?
BU: At this point in the cycle, the service companies have more leverage than E&Ps. There are equipment shortages and premium rates, premium-pressure pumping equipment and access to high-tech services for horizontal drilling. So, with any of the more difficult wells you're drilling, the service providers absolutely have the leverage right now.
TER: How long do you expect that to last?
BU: The rig count is increasing and is expected to continue rising over the next 12–18 months. We expect that to continue through the remainder of 2011 and into 2012. During this cycle, a lot of the equipment and service providers haven't built much new equipment on speculation. They have told the E&Ps that if they want something built, they have to sign it up for a long-term contract. That is keeping excess capacity from entering the market.
Also, the economies of scale are large this time around. A premium rig is going to cost $18M–$20M. Previously, you could build a rig for $4M–$5M. A smaller company could build rigs back then; now, you've got to be fairly well capitalized. A pressure-pumping crew will cost almost $40M. It's no longer a couple of trucks for around $2M. You need a full crew of 15 trucks and a lot of ancillary equipment that costs a substantial amount of capital. Many of the smaller service companies are out of business and do not have the ability to get back into the business.
TER: So, these companies need to be big just to compete?
BU: Yes, absolutely—not huge like Halliburton Co. (NYSE:HAL), but big enough to get $40M–$100M together.
TER: Is the stability coming from development of shale plays?
BU: Absolutely, without a doubt. You've got tougher wells, deeper drilling, longer lateral length, more complex tools and higher intensity. You use a lot of service intensity, such as the number of trucks and people needed on site. A well is not a $300,000 or $400,000 event anymore—it's a $4M–$10M event because the service intensity is so high. Horizontal drilling and high-pressure hydraulic fracturing (fracking) have led to a large increase in service intensity. That's how we're getting the hydrocarbons out of the shales and tight sands.
TER: Do you think the current backlash against shale plays near urban areas will slow down the demand for oil field services and equipment companies?
BU: No, because there's enough in rural areas. The big areas of growth, such as the Bakken, the Permian Basin in Texas, the Eagle Ford Shale in South Texas and the Niobrara Shale in the Rockies are fairly remote. Shale plays are an issue in New York state, Pennsylvania, the Marcellus and the Barnett Shale in Fort Worth.
TER: How many oil field services and equipment companies do you cover, and how do you determine which ones are worthy of coverage?
BU: Nineteen. We find stories that are not followed by a lot of people or where we have found a differentiating opinion or point through our knowledge of their customers, suppliers or management teams. We only cover companies that have high-quality management teams that we can trust. Sometimes, we may end up with a Sell or Neutral rating based on valuation metrics; but we always trust that the management team will do what's in the best interest of the shareholders. We won't cover a company unless we believe that 100%.
TER: Tell us about National Oilwell Varco (NYSE:NOV).
BU: NOV is a large-cap manufacturer in the oil service space. The post-Macondo shakeout has meant operators want the newest, best and highest-tech equipment for two primary reasons. The first is safety. Nobody in the oil and gas (O&G) business wants to be unsafe. Nobody wants a well to blow out. Nobody wants to pollute. We all have families. We all believe in protecting and being good stewards of our environment. Therefore, as we see step changes in technology that can improve the safety of our operations, there's going to be a big push toward investing in that equipment. Second, increased efficiency comes with this newer equipment—it's faster to move, bigger and drills faster. Whether a land rig or an offshore rig that jacks up on the water or a floating rig that's $600M–$650M, they've all improved safety and efficiency. Over the last five years, there have been technological changes to the way equipment performs operations, how fast it works and how safe it is.
TER: Are you saying it's somewhat of the antithesis of Transocean Ltd. (NYSE:RIG; SIX:RIGN)?
BU: Absolutely not. I mean NOV manufactures the rigs that Transocean will use. The Deepwater Horizon rig was a 10-year-old rig. It was a high-quality rig. There were a lot of other events that led to the Macondo disaster; however, since that occurred, nobody wants to take a risk on an older rig where the potential for something unsafe to occur exists.
TER: So, NOV is building these new, bigger, more efficient, faster rigs.
BU: Absolutely. The company receives about $200M of the $600M total bill per offshore rig ordered. We've already seen a fairly sizeable amount of rigs ordered in the past six months—around 40 floating rigs and another 40 or so jack-up rigs. With the jack-up rigs, the company gets anywhere from $25M–$65M out of the $200M billed. The same can be said for the land rigs targeting the shale plays, specifically. You need a bigger, sturdier rig and it needs to be quick moving to get from well site to well site. Those rigs cost about $18M to $20M apiece.
We foresee NOV getting orders close to 100 rigs this year. So, operators have expressed interest in ordering new rigs. Some of them have signed letters of intent with the yards that build them. Because NOV is an equipment supplier, it doesn't actually build the steel—it supplies all of the equipment. We've seen those orders with the yards and that will flow down to NOV over the next couple of quarters.
NOV's management has built the most dominant rig-equipment supplier in the world over the last 10–15 years. They've bought up their competition and engineered new designs, so they're the highest-tech company. They've positioned National Oilwell Varco and it's garnered almost 70% market share in the floating rig market, in terms of rig equipment.
TER: Let's move on to another company called Pioneer Drilling Co. (NYSE:PDC).
BU: Starting in mid-2008, Pioneer Drilling bought a well-servicing and wire-line company, paid a nice price for it and used its revolver to purchase it. There was a fast economic downturn right after that. Pioneer spent all of 2009 making sure it stayed in business. In 2010, the company put permanent financing on its books. The company didn't have covenant issues and was able to use some money to upgrade its rig fleet. Moving through 2010, it turned out that the 2008 acquisition actually was of very good equipment and provided the foundation for a solid well-servicing business.
All of that equipment has been operating at close to 90% utilization. It also has seen pricing increases through 2010. As we move through 2011, it's still at full utilization. Pioneer now has a balance sheet that allows it to add new equipment and build its fleet. The company is adding this new equipment into a very hot market in well servicing and has built new rigs targeting the Permian. It also has some mid-tier rigs that aren't the fastest moving and best rigs for the shale plays; but, in the Permian Basin, you don't necessarily need the Cadillac or the Rolls Royce—sometimes a Ford F150 will do the trick.
That market has seen accelerating day rates and dramatic increases in utilization over the last several months, and that's anticipated to continue. All of the E&Ps in that area have stated their intent to add rigs. They're willing to add these middle-of-the-road rigs throughout 2011, and we expect that to continue into 2012. The Permian Basin is an oil-directed play. As long as oil is holding above US$75–$80, we see no reason to slow down drilling at all. They are going from negative earnings in 2009 and 2010 to positive earnings in 2011. They may triple their earnings in 2012.
TER: What's the competition for Pioneer Drilling in that segment of the market?
BU: It's a fairly competitive market. During 2009 and halfway through 2010, that rig count was very, very low. We did see quite a few bankruptcies and rigs laid down that have not come back to work. The competition is actually a little bit less than it was in 2007–2008. They are standard, mid-tier land rigs, which are not differentiated products. It's really a factor of the lack of available equipment—people are not building these rigs; they aren't state of the art. A lot of the older ones were laid down permanently in 2009–2010 and aren't active on the market anymore. Utilization is breaking 80%, which leads to pricing power.
TER: What is the typical utilization rate for most companies in this sector?
BU: It varies by company. Right now, the average for the marketed fleet is about 86%, which is fairly high. Once you break 90%, you've got a very, very tight market. When you're kind of in the low 70s, the market is perceived as loose. You're not going to get any day-rate improvement; you cannot charge more for your equipment because customers know there's plenty of other equipment out there.
Some of these companies have a 60% utilization rate. However, in the rig classes that matter, such as the higher-end rigs, it's 80%–90%. While some companies may have 60% utilization, in the decent equipment category, they're in the mid 80s. We consider anything over 80% very strong.
TER: You mentioned there is a new build? Is that a brand new piece of equipment?
BU: Yes. It's a new rig.
TER: Are there such things as rebuilds?
BU: You can retrofit rigs.
TER: So, a brand new rig costs an estimated $15M–$20M?
BU: Yes. And, that's what NOV is building. Some companies add pieces of equipment to help drilling in a horizontal place, such as a top drive or a bigger mud pump. Also, you can upgrade the steel so it holds more weight and can drill with heavier drill pipe or a bigger casing. Older rigs can be retrofitted for several million dollars, which can adapt them for some jobs.
TER: One other company that you have a report on is Xtreme Coil Drilling Corp. (TSX:XDC). How is this company a good story for investors?
BU: Xtreme Coil Drilling is a company that is somewhat differentiated. Xtreme designs a rig that has a coil tubing unit, drill pipe and top-drive drilling capabilities, and then has the rig built. You can use those in the same well, which is beneficial when you're out in the field. Drilling with cool tubing is done on almost half of the holes in Canada, but it's not done a lot in the United States. It hasn't been accepted for a variety of reasons.
This company is starting to put rigs to work in the U.S. Much of it is drilling with drill pipe but it has the tubing on the rigs, as well. When there is a need for it, the company will actually end up using coil tubing and building the résumé out as a dual-purpose rig. No other drill company in the U.S. has that capability. Xtreme Coil Drilling and Baker Hughes Inc. (NYSE:BHI) have taken this technology over to Saudi Arabia, and the two rigs have reported very strong results when compared to its competition.
Xtreme is expanding its international footprint, doing it with a high-quality service provider and working for Saudi Arabia's state-owned national oil company—Saudi Aramco, which is the biggest oil company in the world. The company is building a very solid resume with some well-capitalized customers, who have strong growth ahead of them and should be able to continue to add to their rig counts. In the U.S., Xtreme's largest customer is Anadarko Petroleum Corp. (NYSE:APC), another very well capitalized company with lots of drilling programs on U.S. land.
TER: What are some rules of thumb for investing in the oil field services and equipment sector?
BU: I think the number one rule is to make sure that you've got a top-quality management team in which you believe and have confidence. The number two rule is to remember that, overall, the sector is pointing up and to the right. Don't be scared that the stock prices have accelerated fairly quickly over the last several months. These companies spent that last two years fighting through the pain and have really leaned out their operations, manufacturing processes and supply chains.
As they add orders to their backlog, we should see fairly rapid improvement. We've got good capacity availability, good lean operations and strong supply chain management. We've got to look at U.S. land as a secular play—not a cyclical play. It has always been a boom-and-bust cycle for these companies. While you'll have ups and downs on pricing for services based on capacity and utilization, overall, you're going to have stronger earning power throughout the entire cycle. We've taken a step upward. That's primarily due to new drilling technologies and the re-emergence of oil in the U.S. that we can drill and produce to support our own oil demand in country.
TER: Thank you for your time.
Brian Uhlmer is managing director and senior analyst of Global Hunter Securities' Energy Group. He has more than a decade of relevant energy industry experience, most recently as director of research and senior oil service and engineering and construction analyst with Pritchard Capital Partners, where he covered companies ranging in market capitalization from $100M–$20B and was responsible for commodity price forecasts. He developed the Pritchard Morning Note layout, Weekly Rig Count note and other new research products. Uhlmer is a lifelong energy veteran, growing up in Australia, Malaysia, London and New Jersey as the son of a 30-year Esso employee. He received a BS degree in chemical engineering from the University of Florida and worked for Halliburton, KBR and Sifco in engineering, and then business development roles. A U.S. Navy veteran, he holds an MBA from the University of Texas and is a CFA charterholder.
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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3) Brian Uhlmer: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.