Igor Borisenko/iStock via Getty Images

Igor Borisenko/iStock via Getty Images

The energy rebound has been one of the biggest stories in the market lately. Frequently, the Energy Select Sector SPDR Fund (XLE) is showcased as a benchmark, but XLE is a bit of a hodgepodge of exploration & production (or E&P) companies, downstream refiners, midstream operators, integrated majors and oilfield services (or OFS) providers. These different types of companies are indeed all exposed to oil prices ( CL1:COM) but they don't quite share the same risks. In fact, the market conditions may even influence their fortunes in opposite ways. For example, OFS derives its revenues from selling services and equipment to E&Ps; from the latter's perspective this is a capital expenditure and cash outflow. Excessive services capacity can be detrimental to OFS but a boon for E&Ps and vice versa.

Focusing on an industry aggregate such as XLE can also mask what could be differential performance among the different segments. Indeed, if we look at the SPDR S&P Oil & Gas Equipment & Services ETF (XES) as a benchmark for OFS, we will see that oilfield services have consistently underperformed the broader energy index for the last 10 years:

OFS tracked overall energy quite well until 2014 when the prior oil bull cycle ended. Since then, it has been on a steady decline except for the bounce from the 2020 lows in the midst of the pandemic. An E&P company has some inherent optionality; it can invest in expanding production when the times are good or in bad times focus on producing from its developed reserves with minimal capex, at least in the short run. In 2014 most E&Ps curtailed spending and in 2020 they did so even further; by reducing capex, E&Ps were able to preserve more of their cash flow while OFS companies don't really have anything to fall back on when capex-driven activity stalls. That is why the stock price declines in OFS have been much worse.

As oil prices lifted off in 2021, E&Ps saw significant stock price appreciation as they held capex steady, thus greatly improving their cash flows. While in past bull cycles, higher oil prices spurred more drilling activity which also benefitted OFS, in the current cycle drilling has not been as responsive to the oil price environment as shown in the chart from the American Petroleum Institute (or API) below:

As a consequence, while E&P (and hence XLE) had a great 2021, the OFS segment has stayed flatter. Importantly, the underinvestment in capex hasn't been limited only to U.S. based shale players which have been facing headwinds since 2014. International producers, including OPEC, have now also fallen behind.

With this background in mind, my investment thesis is based on the following points:

I see OFS as a reasonable value investment on standalone basis, i.e., just based on the relative underperformance and shifting market conditions. However, exposure to OFS could also be additive to an oil producer portfolio and provide some hedge against increased services prices or even falling oil prices if private businesses and OPEC end up being the ones increasing the supply that brings the prices down in the first place. I discuss below three possible investment ideas to get exposure in this space.

The capital discipline narrative has dominated much of 2020 and 2021. Domestic U.S. E&Ps have been largely guiding towards "maintaining production" and prioritizing returning cash flow to their shareholders over new capex. The reluctance to invest in new production has been justified for much of this period in the anticipation that OPEC may step in to fill any supply shortage. However, it now appears that OPEC itself is capacity constrained as the cartel has been consistently producing under its agreed quotas for the last few months.

In the meanwhile, despite the "capital discipline", the U.S. rig count (which is also a major indicator for OFS activity in general) has been slowly creeping up:

S&P Global Platts

S&P Global Platts

Admittedly, most of the recent increase is due to private companies who have acquired interests in shale; since, unlike their publicly traded peers, privates are not accountable to shareholders, analysts or ESG activists, they are likely going to be the first ones to take advantage of the supply gap.

According to S&P Platts which quotes Evercore:

Oil and gas capex for [Evercore]'s independent and integrated E&P coverage universe -- which includes most of the large public names - has increased 15% in 2021 year over year to $19.5 billion, outpacing the 8% yearly increase in production on a boe/d basis.

Independent E&P spending has ramped 76% year over year [in 2021] while production is up only 16%.

Capex outpacing production may be partially driven by inflation cost pressures, but it looks like production is indeed set to increase.

Natural Gas Intelligence (or NGI), also relying on the Evercore research, similarly suggests a capex rebound is starting:

U.S. E&P spend is forecast to increase overall by 23.5% y/y, led by the privates, which are seen boosting their capex by 42%. U.S.-based independents are likely to raise their spending too, by about 26.5% in 2022.

While North America is turning the corner to lead with 21% growth, international is accelerating to 15% growth, with ambitious capacity growth targets established for leading Middle East companies, while both Latin America and Africa also rebound from very low bases.

The privates' 42% spend increase is noteworthy as it confirms most increases so far aren't due to publicly traded companies. However, if the private activity continues to scale up, public E&Ps may not have much of a choice to expand their own capex either.

The NGI article also comments that:

Onshore operators in the United States are up against a wall, faced with "declining well productivity and increasingly challenging geological conditions limiting production growth"

While more challenging conditions (as presumably easier drilling opportunities are being exhausted) are negative for E&Ps, it could actually benefit OFS as it implies more and pricier services.

For a more global view on capex, Rystad Energy comments for 2022:

Global oil and gas investments will expand by $26 billion this year as the industry continues its protracted recovery from the worst of the pandemic and the hurdles imposed by the Omicron variant. An analysis by Rystad Energy projects overall oil and gas investments will rise 4% to $628 billion this year from $602 billion in 2021.

A significant factor behind the increase is a 14% increase in upstream gas and LNG investments. These segments will be the fastest-growing this year, with a jump in investments from $131 billion in 2021 to around $149 billion in 2022. Although this falls short of pre-pandemic totals, investments in the sector are expected to surpass 2019 levels of $168 billion in just two years, reaching $171 billion in 2024.

Upstream oil investments are projected to rise from $287 billion in 2021 to $307 billion this year, a 7% increase, while midstream and downstream investments will fall by 6.7% to $172 billion this year.

Rystad also sees an increase in offshore investments of 7%, from $145 billion to $155 billion.

The final data point I review here is the dwindling inventory of drilled but uncompleted (or DUC) wells in the U.S. A big part of the story how U.S. E&Ps were able to maintain production with less capex was liquidating their DUC pool:

According to data from the EIA, the average DUC count in 2019 stood at about 8,000. DUCs peaked at 8,853 in June 2020 as E&Ps brought to a halt most developments in the aftermath of the initial pandemic lockdowns. Since then, the DUC inventory has been on a steady downtrend and stood at 4,616 in December 2021, which is well below the pre-pandemic level. Again, going back to my earlier point, oil companies have the optionality to defer capex spend, but not indefinitely. At some point (maybe happening already) U.S. E&Ps will struggle even to maintain production especially with the high decline rates for shale. The unprecedented DUC reduction appears very bullish for OFS.

The recent OFS earnings calls have been positive too. The industry trends imply a reversal point should happen, but it isn't clear exactly when; on the other hand, positive earnings guidance suggests the turning point may much more imminent.

First, the CEO of OFS powerhouse Schlumberger Limited (SLB) commented recently that the oil market appears "strikingly similar to last industry supercycle." More detail from SLB's CEO from the Q4 earnings call:

[We] fully operationalized our returns-focused strategy, leveraging our new division and basin organization to seize the start of the upcycle. In North America, this resulted in full-year topline revenue growth...

Internationally, we also grew the top-line and expanded margins significantly, as international activity strengthened in the second half of the year. This also resulted in full-year international margins that exceeded 2019 levels.

Taken together, these margins resulted in the highest global operating margins of the last six years.

SLB then guided towards 25% EBITDA margin by the end of 2023 which would exceed the 2019 levels in dollar terms; the dollar reference is quite important as the margins could in principle be applied to a lower revenue base.

To an analyst question on the "looming investment cycle", SLB's CEO responded:

[The] attribute that we put first is the outlook of economic GDP growth that considering the oil intensity and energy intensity will fill and will drive the oil demand as a key attribute beyond the previous peak, no later than at the end of this year, according to the latest projection, and is set to expand visibly beyond not only in 2023, but a few years beyond this. So the first is the macro demand situation is set to be favorable for the next few years.

Secondly, I think the supply-demand imbalance and the supply, I would almost call it tardiness that we are facing is pointing not only to an uplift in the commodity price, but also is pointing to investment ‑‑ return to investment across the broad portfolio of our customers. So you have seen it in North America, no surprise. North America is still and will remain structurally smaller than previous cycles due to the capital discipline, but also due to the crunch of supply, including on the services side...

I think the international underinvestment for the last few years ‑‑ actually, the last down cycle ‑‑ combined with the dip in the last two years is creating conditions for a necessary injection of short-cycle capital and then long cycle capital investment to respond to the supply. So we are seeing growth in North America, albeit a cut, we are seeing a rebound ‑‑ a visible rebound in short and long cycle investments internationally.

And I will insist on the long cycle because I believe that both oil capacity is being looked upon by some OPEC members to secure future supply market share, but also the international and majors are investing into their advantage offshore basins and we are seeing not only infill drilling, but we are seeing FID for offshore that are accelerating going forward. So it's a mix of offshore rebound, solid including deepwater, international short cycle, and oil capacity in land, and finally, solid growth in North America. So these are unique conditions that are tightening the capacity and that are creating the underlying pricing improvement conditions.

SLB's competitor Halliburton Company (HAL) also shared very positive sentiment. During HAL's Q4 earnings call, the CEO commented:

Now, let's review our fourth quarter 2021 performance and expectations for 2022. As OPEC+'s spare capacity returns to normalized levels this year, we believe sufficient pent-up oil demand will support a call on both international and U.S. production, and lead to increased activity. International activity accelerated in most markets in the second half of the year and finished strong in the fourth quarter with a 23% rig count increase year-on-year. All Halliburton regions grew revenue, led by Asia Pacific, the Middle East and Africa with both of our divisions contributing to the revenue and margin expansion.

I'm excited about our future international growth. Despite typical first quarter seasonality, we are starting 2022 a lot higher than where we entered 2021. I expect our customers' international spend to increase by mid-teens this year. We anticipate projects in the Middle East, Russia and Latin America to attract the most investment with activity increases in Africa and Europe limited to a few markets.

Asset owners are eager to reverse base production declines caused by multiple years of underinvestment. We expect that operators will focus on shorter cycle production opportunities to meet increasing oil demand. This disproportionately benefits Halliburton as these short-cycle barrels require higher service intensity and spending directly focused on the wellbore as opposed to long-cycle infrastructure investments...

Turning to North America. In 2021, the recovery in North America was faster and more pronounced than in the international markets. In the fourth quarter, U.S. land rig count increased 84% year-on-year, and drilling activity outpaced completions as operators prepared well inventory for 2022 programs. Completed stage count growth moderated slightly due to the holidays, sand supply tightness and lower efficiency levels typically experienced in the winter months. In the fourth quarter, we finished the plant upgrade of all fracturing fleets to the next generation fluid end technology that extends the life of our equipment and helps reduce maintenance cost.

We expect a busy 2022 in North America. Given a strong commodity price environment, we anticipate North America customer spending to grow more than 25% year-on-year. We believe the highest increase will come from private operators. Public E&Ps will continue to prioritize returns while delivering production into a supportive market.

To sum up, both SLB and HAL seem to be already feeling an increased spend in North America and international markets alike. The comments from the two CEOs also confirm both the increased role of private operators as well as the pressure on OPEC+ spare capacity along with the cartel realization they need to invest to counter this trend.

I also took a look at two job boards, Indeed.com and the more specialized Rigzone job forum. Here is how the OFS job postings compare to the 2014 peak cycle and to 2020 headcount for SLB, HAL, Baker Hughes Company (BKR) and Transocean Ltd. (RIG):

Source: Job boards, company's 10-K filings.

While the number of job postings is not as high compared to the existing workforce, I see it as a positive sign because these companies have gone through years of consecutive layoffs as the comparison of 2020 to 2014 shows. Most OFS players had hiring freezes for many years too so the fact they are actively recruiting now is a major trend reversal.

The quickest way to get sector (in fact, any sector) exposure is through an ETF. I reviewed three ETFs which focus on oilfield services and equipment:

From a fee perspective, the funds are quite similar:

Where the ETFs differ is in their concentration. The top 10 holdings for each fund are summarized below:

Most notably, IEZ and OIH are market-cap weighted whereas XES tracks an equal-weighted index. Consequently, IEZ and OIH have much greater exposure to SLB, HAL and BKR.

Looking at the funds' performance over the past year, the price movements have been strongly correlated:

However, OIH and IEZ gained more than the equal-weighted XES. My view is that in the current environment bigger is indeed better. Supply chain issues will pressure OFS margins, so having the scale to negotiate down supplier prices may be an advantage. Second, digital technology is becoming more important in the OFS space, so larger players should also see some scalability with regard to developing and deploying these new technologies. For these reasons, I personally would favor OIH or IEZ over XES.

A second natural option is to pick the top company in the field. Although HAL, BKR and SLB all have advantages and specialisms in various niches, by most accounts Schlumberger can be considered as the leading player. I previously outlined my thesis for Schlumberger in a separate article, but in a nutshell SLB has the largest global footprint and higher international exposure. In my subjective view, SLB has probably also been more successful in integrating its past acquisitions. Baker Hughes, in contrast, is still dealing with the aftermath of the merger with General Electric's (GE) oil and gas business and subsequent separation from GE.

Analysts' opinions on the three stocks appear pretty consistent:

However, to the scalability point I already made, SLB's size approximately equals the other two combined, which in my view is another reason to bet on SLB if you had to only pick one.

I recently discussed in a separate article Transocean, one of the most prominent offshore drillers. I will not reiterate my full thesis on RIG here, but basically offshore drilling has been the most beaten down sub-sector within the already beaten down OFS sector, so it likely will see the strongest rebound as well. RIG in turn was one of the few drillers who avoided bankruptcy and its balance sheet is at a disadvantage compared to competitors such as Valaris who already underwent bankruptcy and emerged from it with less debt. However, if things go well for the industry, Transocean's leverage can also turn into an advantage for the equity holders.

The energy rally we have seen in 2021 and so far in 2022 has been largely led by the E&P companies who have been taking advantage of the higher oil prices while holding back on capex, thus maximizing their short-term cash flows. In contrast, oilfield services players have been left behind as the lack of capex has been limiting their revenue potential.

However, this situation cannot continue forever. First, E&Ps need to start investing in capex even just to maintain their current production. Second, if U.S. public oil companies are hesitant to increase shale production, someone else is going to step in and do so, and I have cited some evidence that privately held companies are indeed taking the lead. Third, on the international side OPEC is apparently also seeing a deterioration of spare capacity and needs to step investments to avoid losing market share. All these factors should boost the demand for oilfield services, and the recent earnings calls of two of the largest OFS players provided quite some optimism that this is indeed happening.

Last but not least, valuation matters too. While some E&Ps are getting close to their all-time highs, OFS is still well behind in valuation. The IEZ fund for example trades 5-6 times lower than its peak point. An investor who wants to be ahead of the curve and is bullish on energy should definitely consider adding some OFS exposure, either through individual oilfield services stocks or using one of the ETFs addressed here.

Do you have any favorite stock picks in the oilfield services sector? Please feel free to share your insights in the comments section.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of IEZ, SLB, RIG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: My articles, blog posts, and comments on this platform do not constitute investment recommendations, but rather express my personal opinions and are for informational purposes only. I am not a registered investment advisor and none of my writings should be considered as investment advice. While I do my best to ensure I present correct factual information, I cannot guarantee that my articles or posts are error-free. You should perform your own due diligence before acting upon any information contained therein.