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Midyear 2011 Outlook for Oil Services

A red-hot sector is set up to continue its winning ways.

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This is shaping up to be quite a year for the oil services sector. Already in the first few months of 2011, we've seen a very unusual environment with global unrest in the Middle East, the loss of Libya's oil production for the foreseeable future, and abnormal weather events across the globe. In our view, it's been one of the most difficult global services environments in recent memory. The challenging environment took a toll on the services industry's international margins in the first quarter, but the rest of the year looks quite a bit better. There are several key takeaways from the first quarter that offer some insight into the industry's performance in the second half of the year.

First, we believe that the international growth story for the industry has been rebooted, and the industry is set up for some very healthy growth rates in the later stages of 2011 and early 2012. Saudi Aramco plans to boosts its active rig count to 118 by the end of the year from 92 rigs today, and Abu Dhabi also is adding another 16 rigs. The unexpected shift in rig demand by two key services customers should tighten up services capacity internationally as other national oil companies follow Saudi Aramco's lead. National oil companies have noted that global oil spare production capacity has become stretched and it may not be enough given the current political unrest in the Middle East. The loss of production from Libya, likely for the rest of 2011, the strengthening global economies and recovery in demand, and the events in Japan have all accelerated the need for more oil and gas investment. Even  Schlumberger (SLB), which is typically conservative, indicated that its drilling services group should see significant pricing power internationally starting in the second half of 2011. The pricing benefits shouldn't just accrue to Schlumberger, as its peers will benefit from a preference for quality work in this rapidly tightening environment. Our top idea to play this trend is  Halliburton (HAL), which trades slightly below our fair value estimate.

Second, the North American market looks very healthy and is positioned to continue to deliver solid performance for the rest of the year. Oil and gas producers continue to clamor for more pressure-pumping equipment and additional fracturing capacity so that they can drill the highly services intensive shale wells. As  National Oilwell Varco's  (NOV) CFO Clay Williams noted in a recent conference call: "Shale drilling is not elegance. Shale drilling is a brute force enterprise. It hurls massive iron and horsepower at a plentiful, fairly pedestrian rock in exchange for a secure and protected production volume. It is underground shock and awe that makes oil and gas give up and surrender." Unsurprisingly, numerous companies, including  Nabors (NBR),  Baker Hughes  (BHI), and  Patterson-UTI Energy  (PTEN) struggled to train pressure-pumping crews and meet demand this quarter. The shortages caused revenue and margin hits in some cases. However, as the companies continue to add new pumping capacity, U.S. revenue and margins should resume their upward climb.

Speaking of North America, it's worth noting that the Canadian market appears to be positioned for a great year after four years of weak results. The underlying trends that are benefiting the Canadian market are virtually identical to the U.S. market, with services intensive wells and healthy oil prices driving drilling activity and services prices higher. Nabors' rig margins during the first quarter hit an all-time high at $12,000 a day. The company had 50 rigs working in the region during the quarter, which is a substantial improvement over last year's 35 active rigs. Furthermore, the company has 45 rigs committed for work in the second half of the year, versus prior years where rig activity levels were in the teens. Companies such as Baker Hughes should also benefit, as it is now the largest services company in Canada after the acquisition of BJ Services. We estimate Canada will generate about $2 billion in revenue for Baker Hughes this year, or about 11% of its overall revenue.

Third, the deepwater Gulf of Mexico appears to be slowly regaining its health. The Bureau of Ocean Energy Management, Regulation and Enforcement (BOEMRE) has issued drilling permits for 12 unique deepwater wells that meet the regulator's new safety and environmental requirements, including subsea containment systems. Granted, the issuance pace of permits is about one fifth of 2010 levels, but we think the environment will continue to improve as we move into 2012. A recovery in the Gulf is critical to seeing further margin expansion in the North American segment for the services companies because the amount of revenue earned per rig is about 11 times the amount of services revenue that can be earned per onshore rig. In addition, the services industry has chosen to largely maintain an extensive services infrastructure in the Gulf in anticipation of an eventual recovery. The fixed cost of maintaining this underutilized infrastructure has been a several hundred point drag on operating margins for the last few quarters. As drilling activity in the Gulf picks up, the increased absorption of the infrastructure should lead to additional margin expansion for the sector.

Overall, we believe the industry has placed a dismal 2009 in the rearview mirror where single-digit operating margins in North America were routine across the industry. Operating margins in North America largely have recovered from their 2009 declines, and are again at healthy levels at 20%-plus, with continued equipment shortages in sight for the rest of 2011. The international markets appear to be poised for a return to strong revenue growth, higher prices, and the resulting margin expansion in the second half of 2011, thanks to the sudden and unexpected changes in drilling activity by two major oilfield customers. We also think the secular trends that have driven the need for oilfield services during the last few years--the increased complexity of unconventional wells, the need for more production from services intensive deepwater wells, and boosting recovery rates from ancient or previously mismanaged wells--remain intact. As we previously mentioned, our most undervalued idea in the space continues to be Halliburton, but Schlumberger, Baker Hughes, and  Weatherford (WFT) will all benefit from these trends.

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