The Energy Report: James, welcome. What were the most significant takeaways for you from the Barclays Conference in September?
James West: There were five major takeaways. Four of those were very positive. One was negative. The first was that the outlook for North America in 2014 has improved. We're getting some tailwinds from commodity prices, of course, but the oil companies that previously were gas companies have now arranged their drilling programs for 2014–2016 and are relaying that visibility to oil service companies that have been operating in North America in a fairly volatile environment for the last two years. Companies are much more optimistic on the outlook for 2014 in North America.
Number two, the Eastern Hemisphere is booming at this point. Both Southeast Asia and the Middle East are growing very rapidly, as is Russia, and then there are good trends in East and West Africa. The only market not doing well, for obvious reasons, is North Africa, but I think we'll see far-reaching effects of that strength in the Eastern Hemisphere as companies report results in the near term.
The third takeaway was the bullishness around Mexico, mostly for 2014 and beyond, because Mexico is a slight headwind for the industry right now, but should turn into a tailwind as we go into next year. There are two parts to Mexico: Number one, PEMEX (Petróleos Mexicanos) has ten tenders outstanding, which are being referred to as mega tenders by the industry, for integrated project management (IPM) work that would start early next year. The tenders are out, the bids are due soon. Those should start up pretty quickly in the first quarter of 2014 (Q1/14) and that should be a very nice boost to overall activity level. It represents about 50-plus rigs going to work.
Second, most company managements and all the consultants and people that we speak to believe that there will be constitutional reform in Mexico that will break the monopoly on the oil and gas business and allow private capital to flow in. That could take a little bit of time, and there's a congressional vote expected at some point in October and, of course, a change to the Constitution has to be ratified by the leaders of the various states in Mexico. That should be done by year-end or early next year. Following that, we'll see private capital coming to the market, probably to go after the five shale plays in Mexico and deepwater activity, but it may take several quarters.
The fourth takeaway was a lot of bullishness on China, both because of recent deepwater discoveries in Bohai Bay and the South China Sea, and because of the potential shale opportunity in China. That's a market that's been for the most part closed off to western service companies. The service activity is done primarily by the service entities of the Chinese oil companies, but shale and deepwater activity are things that are going to be done by the traditional western services companies because many Chinese service businesses lack the capabilities and expertise.
The last takeaway, as I mentioned, is a slight negative: Rig rates for floating rigs are starting to moderate. We're starting to see some rigs that are coming down in the $25,000–50,000/day range as they absorb new capacity.
TER: Were any of those surprises?
JW: I would say that the increased optimism on North America was a surprise and so were the rig rates. More CEOs talking about the declines in offshore rig rates was a surprise. It's pretty rare for drilling companies to expect their rigs to drop. They're usually all very optimistic about rigs moving higher.
TER: Did the conference's presentations change your thinking on any of the companies you cover?
JW: We came away feeling more positive of the near-term prospects for Schlumberger Ltd. (SLB:NYSE) given the bullishness around the Eastern Hemisphere, where Schlumberger is the largest international company. We also came away feeling better about some of the recent changes we had made. We upgraded Key Energy Services (KEG:NYSE). We launched coverage of C&J Energy Services Inc. (CJES:NYSE). Both are U.S. land-focused companies, so the cautiously bullish outlook for U.S. land should be a good tailwind for those two companies.
TER In our last interview, you said North American oil services was a market of haves and have-nots. You included some small-cap and midcap companies among the haves. What makes a company one of the haves?
JW: The companies in the haves group are those that are currently able to service larger E&Ps and major oil companies. That means sophisticated supply chains, higher technology content, better equipment, better crews and typically multiple service lines rather than the mom and pops or the one-product-line companies that exist in North America.
TER: You have a number of small-cap and midcap companies under coverage. Can you talk about how some of them are positioned to succeed in the strong and sustained upside market trend that you forecast?
"Mexico is a slight headwind for the O&G industry right now, but should turn into a tailwind as we go into next year."
JW: We do have a lot of small-caps under coverage. We think several are poised to succeed very nicely, especially in North America. A lot of these smaller ones tend to be North American-focused, given that it's the largest market in the world. Superior Energy Services Inc. (SPN:NASDAQ) is one the companies we're recommending. Then we like some of the companies that are exposed to the Gulf of Mexico because that's one of the fastest-growing markets in the world today. Hornbeck Offshore Services Inc. (HOS:NYSE) is our preferred supply vessel company followed by Gulfmark Offshore Inc (GLF:NYSE), which actually has exposure both to the Gulf and to the North Sea. Right now the North Sea is extremely tight in terms of vessel availability.
TER: Your return on Key Energy Services has been modest, but your return on Global Geophysical Services Inc. (GGS:NYSE) and ION Geophysical Corp. (IO:NYSE) both have been very poor. Why are you rating them Overweight?
JW: We just upgraded Key three or four weeks ago, so it hasn't been that long. Key really is a call on 2014, both the U.S. land market and the tailwinds in Mexico because it does have exposure to Mexico. You're right about Global Geo and ION Geophysical. Global Geophysical has suffered from some liquidity concerns. Those should be going away with this next quarter as it gets its revolver credit facilities in order and also starts to generate more cash. ION Geophysical has had several quarters of earnings misses. We think that's coming to an end. The company's been in transition and we think shareholders will be rewarded as that transition is finalized and the earnings trajectory is better understood and growth returns.
TER: Why has Global Geo had liquidity problems and why do you think they'll abate soon?
JW: The company had focused up to 2012 on multiclient data library shoots in North America, and those are very capital-intensive. It spent a lot of capital on that and was not getting a return on that investment. The company brought in a new CEO at the end of last year. His focus is on cash generation and on shifting more into proprietary surveys, which are cash-generating surveys. That's ongoing right now. Q1/13 showed some good progress. In Q2/13, I think people got concerned because the cash balance dropped. That was more of a timing issue, in our view. I think you should see the cash balance rise once again for Q3/13.
TER: How has Key's share-repurchase program affected its share price? You said it's been 12% of its market cap since 2008.
JW: It hasn't done a lot. Because of some poor earnings results and lack of recovery in some of its businesses, along with the slowdown that we saw in Mexico this year that caught everybody by surprise, the stock has been punished. Although it was certainly helpful to buy back stock, it's not being reflected in the share price because of some of the other fundamentals in the business.
TER: Your target price for Key Energy is $10 right now, but the last time it was there was May 2012. It's now around $7.50/share. What does the company need to do to make that target?
JW: It needs better traction in North America, for which the fundamentals are supportive of that happening. Number two, the earnings-revision cycle has ended for the company. In fact, starting about 12 months ago, if you look at 2013 estimates, they are down about 40% from where they were. We thought that was the bottom. That's one of the reasons we upgraded. As we see revisions higher, or at least holding their place, that will cause a valuation rerating. In addition to that, Mexico should be a very good market next year and that's going to be a nice tailwind for the company.
TER: You're pretty sure that Mexico is going to make constitutional changes. What's the basis for your confidence there?
JW: The coalition government wants to make the changes. It publicly stated as such and it's holding a vote in late October and writing the law right now. Since that coalition government controls Congress, it looks like it will pass. We think it will be ratified. This is probably the best chance we've had for this constitutional change since Mexico's industry was nationalized 70-plus years ago.
TER: What will enable Global Geo to reach your $6/share target from the $3 range, where it is now?
"People should be increasing exposure to oilfield services given the constructive commodity prices and the constructive capex trends in the industry."
JW: I think continued transition toward proprietary surveys, generating cash and bringing the leverage down will help boost performance. It's a fairly simple strategy—maybe harder to execute than we thought at first, but the stock's trading like a distressed company right now. We think as cash builds and leverage comes down, we'll see a rerating of that stock much higher.
TER: Global has been in that range for a number of months. What's changed to give you hope for now?
JW: We have spent a lot of time with the company about the situation. It's confident in re-signing its credit facility and it's confident in its capabilities to generate cash, and we're confident in the management team. The new CEO has a very strong background in seismic; we're impressed by the CFO as well. We think they're making the right decisions and the right moves to put the company back on track.
TER: The ION CEO at the conference announced a transformation. How is that transformation going? Why is it doing the transformation in the first place?
JW: ION is trying to position itself more as a provider of services, in particular services to the oil companies—surveys, multiclient data libraries, data processing, things of that nature—and getting away from its legacy as an equipment manufacturer that sold to seismic companies. That transition has been bumpy, but we're getting closer to the end. That's why we're still recommending it. We think as that transition finalizes, there will be upside for shareholders.
TER: What other small-cap or midcap companies look promising to you here?
JW: We like Hornbeck Offshore because it's mostly a pure play on the deepwater Gulf of Mexico vessel market; that's probably the tightest market in the world right now. Utilization is full for its assets. I think that Hornbeck has the best supply vessels in the market. Its fleet is entirely high-end, so it doesn't have an old-vessel issue. It has a forward-thinking management team.
With Superior Energy Services, you have a CEO who has very good market understanding and is formerly the COO at a company called BJ Services, which was acquired by Baker Hughes Inc. (BHI:NYSE). It's had a long history in the industry and is very much incentivized to drive growth internationally, in the Gulf and in the U.S. markets. We really like management there. We like management at both companies.
C&J Energy Services has done a good job integrating some acquisitions that have put it in the camp of the "haves" in North America. It also has leverage to two plays that we like in North America: the Permian Basin, which we think is going to go more and more horizontal over the next several quarters, which is good for its business, and the Eagle Ford. I think C&J also is likely to announce some international expansion in the next quarter or two. C&J is newer to our coverage universe, but we've been very impressed so far with the management team. It has good financial strength. They've been disciplined about their overall growth trajectory its geographic placement put it right in the sweet spots where we think most growth will occur.
TER: Any other thoughts you'd like to share on investing in this market right now?
JW: The group itself is still attractively valued. People should be increasing exposure to oilfield services given the constructive commodity prices and the constructive capex trends in the industry. We think we're in the early stages of a recovery in North America and in the early stages of good growth in the international markets. Our favorites on the large-cap side, which we talked about in our last interview, are and remain Schlumberger, Halliburton Co. (HAL:NYSE) and Cameron International Corp. (CAM:NYSE).
TER: You've given us a lot to think about. Thank you.
JW: You're welcome.
James C. West is Barclays' lead oil services and drilling analyst. James joined Barclays in September 2008. Prior to that, he was at Lehman Brothers beginning in October 2000. His broad coverage universe includes large-cap, diversified oil services companies, niche technology providers, offshore and onshore contract drillers, supply vessel providers and energy capital equipment companies. Prior to joining Lehman Brothers, James worked at Donaldson, Lufkin & Jenrette. He earned a Bachelor of Arts from the University of North Carolina at Chapel Hill.
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1) Tom Armistead conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family owns shares of the following companies mentioned in this interview: None.
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3) James C. West: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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Barclays Bank PLC and/or an affiliate has received non-investment banking related compensation from SLB, SPN, GGS, HAL, and CAM within the past 12 months.
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