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Stock Strategist Industry Reports

Our Outlook for the Oil Services Industry

Which firms have the competitive advantages to outperform?

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We believe the oil services industry is currently suffering through one of the most difficult industry environments since the 1980s. The industry's earnings reports for the first quarter reflect this, and unfortunately, we think things are unlikely to improve anytime soon. In our opinion, many of the services firms are too optimistic in their opinion that a significant and sustained recovery will begin in the U.S. market as early as the second quarter. We think that a recovery is unlikely to occur prior to 2010 due to continuing credit market tightness and reduced drilling as oil and gas firms are being forced to live within cash flows. We have reviewed the industry's collective first-quarter reports, and we think the following themes bear emphasis.

We expect services pricing to decline dramatically in the United States over the next few quarters. We think oil services firms have little choice but to cave in the face of sharply lower natural gas prices and constrained credit markets, which has led to a 50%-plus collapse in drilling activity. Services firms are offering lower prices for each new well a customer wants to drill, and pricing for many services is off 15%-30% over the past few months. In short, services buyers are wielding a significant amount of market power currently. We believe a services recovery is likely to be a tortured affair, as the supply of natural gas is increasing, while demand for the commodity is declining. Until services customers start to see some stability in their short-term business prospects, services firms are unlikely to find any relief. We believe these issues will remain unresolved until 2010 at the earliest. Therefore, in the short term, we see little chance of the services industry rebounding until at least the second half of 2010.

Contract renewals are likely to pressure international pricing in the short term. International spending lags U.S. spending because of long-term contracts, as generally customers take a long-term viewpoint toward their oil and gas development. However, as the contracts come up for renewal, international customers will battle just as fiercely as their U.S. peers, and win as well. We should start to see the effects of lower international pricing in the next few quarters. For instance, Saudi Aramco has been very aggressive about delaying key projects for the oil services industry (such as Manifa, which is a multibillion-dollar project), and is cutting at least 30 onshore and offshore rigs from its contracted fleet this year.

We think this downturn marks the beginning of a long-term secular decline in the U.S. services market. We believe that the market is intensely competitive in most product lines, and we believe the long-term trend for most product lines is toward commoditization. The massive shale plays have driven U.S. services firms to add significant amounts of high-end equipment, which has created an equipment bubble. That new equipment is now sitting idle. Further, rather than the high-end market expanding, we've seen it shrink. The pressure pumping market is one example, as the collapse in  BJ Services(BJS) margins over the past few years demonstrates. The company has indicated that it will be lucky to have the U.S. pressure pumping division at break-even levels in the second quarter. We expect this type of marginalization of the high-end services market to continue to occur, as oil and gas firms are consistently trying to drive down well costs by utilizing cheaper low-tech technologies (such as water-fraccing) and forcing services firms to compete on price where possible. We realize that the U.S. market will continue to be volatile, and we accept that it is very likely that there will be powerful short-term recoveries in oil services demand. However, we think long-term sustainable margins for the U.S. market are likely to be far below the margins the industry enjoyed from 2005 to 2008. For instance, U.S. operating margins in 2006 for  Schlumberger (SLB) and BJ Services were 30% and 38%. The operating margin in the first quarter for 2009 was 14% for Schlumberger and 5% for BJ Services. We expect long-term U.S. margins to average in the high-teens for Schlumberger and the midteens for BJ Services.

International markets will remain a long-term growth area. For instance, Schlumberger generated $1.8 billion in integrated project management (IPM) revenue in 2007, roughly double what it earned in 2003, and more than 5 times its 1999 IPM revenue.  Weatherford (WFT) had about $1 billion of project management work in 2008, and recently won another $648 million award for IPM efforts in Pemex's Chicontepec. The rise of integrated project management efforts at Schlumberger, Weatherford,  Halliburton (HAL), and others is particularly intriguing because it treads directly on the toes of the major international oil companies such as  Shell (RDS.A) and  Exxon (XOM) and their long-standing relationships with national oil firms. We discussed one example of how these relationships are changing over time with our industry report on Russian oil services. Please see our industry report "Mauled by the Russian Bear" from March 9 for additional detail.

Overall, we believe oil services firms and drillers with competitive advantages will outperform over the full commodity cycle. Our favorite companies are Schlumberger and  Helmerich & Payne (HP). Please see our Analyst Reports for further long-term investment opportunities in this industry.

Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.