Sectornomics: Energy

Energy stock boomers that aren't about to go bust

Energy sector near record highs

You would have been hard-pressed to find anyone who wanted to buy an oil field services company like Halliburton two years ago.

Drilling activity was going through fits and starts, oil prices were below $90, and demand for its services—fracking, drilling, fuel transportation and more—were weak. In July 2012, Halliburton was firmly in the doghouse with its stock trading at $27, which was only a few dollars higher than its recession lows.

Things have certainly changed over the past two years. Since July 1, 2012, Halliburton's stock is up an incredible 147 percent, and it's climbed 35 percent this year alone.

Ameese | iStock | Getty Images

Its competitors have also seen massive gains. Baker Hughes is up 72 percent since the summer of 2012, and it's up 28 percent in 2014, while Schlumberger is up 60 percent and 15 percent, respectively.

Oil service stocks are whipping the S&P 500, which has returned 42 percent since Halliburton's 2012 lows and just 5 percent year-to-date. The stocks are also far outperforming some of the top exploration and production companies. ConocoPhillips, one of the better-performing Big Oil stocks, has seen gains of 43 percent since July 2012 and 13 percent this year.

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Clearly, investors who bought in when the oil field services sector was out of favor have made a mint off these companies. Some, though, are likely looking at the industry's performance and wondering if they should sell out. And for investors who missed out on the big rebound in the oil service sector, can the oil service stocks possibly go higher still to justify a bet now?

Demand for rigs is outpacing growth in supply, and that’s taking away the overhead that used to exist in the market.
Matt Marietta
vice president and oil field services equity analyst, Stephens

Analysts don't see this boom going bust yet, even if the oil service rally does moderate.

Kurt Hallead, managing director and co-head of global energy research at RBC Capital Markets, said that oil field services companies should see 18 more months of strong gains.

Hallead thinks Halliburton, which is trading at $65 today, could rise by about 8 percent to $70 over the next 12 months. Baker Hughes could climb by about 4.2 percent, to $74 a share, while Schlumberger could rise by nearly 10 percent to $115. "The outlook is very positive," he said.

A classic rule of thumb for investors is to leave a little money on the table if you've had big gains, rather than stick around for the last legs of a rally. Another way of saying it is, don't get greedy. Another 4 percent to 8 percent gain may not seem like much to hang around for, especially for stocks tied to a sector that can always be prey to macroeconomic shocks.

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For a current bull like Hallead, there is one main reason to stay invested in these stocks: strong energy prices. These companies do well when oil and gas prices are stable or climbing.

"The revenue stream of an oil field services company is equal to the cash flow stream of an oil company, and that cash flow stream ties back to crude oil and natural gas prices," he explained.

Since January 2013, crude oil prices have mostly been in the $90 to $100 range, while natural gas prices have climbed by 127 percent from hitting rock bottom in April 2012.

Hallead points out that most investors think prices will stay strong. A recent RBC poll found that 75 percent of investors think crude oil prices will remain stable at around $100, while an equal number think gas prices will hover around the $4.50 (per million British thermal units) it's at today.

Getting away from gas

The oil field service sector's fortunes began taking a turn for the worse when natural gas prices fell between 2008 and mid-2012, with a nadir below $2, and exploration and production companies suspended gas projects.

While that caused stock prices to plummet, it also forced a lot of producers to turn their attention to the crude oil market, and activity levels in that part of the industry started to climb, said Stephen Gengaro, managing director and oil field services analyst at Stern Agee & Leach.

"There was an immense shift in activity levels from gas to oil," he said. "People were more excited about crude's long-term prospects."

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At the same time, drilling was getting more complex and required more fracking stages. Energy production was becoming a more service-intensive business, he said, and that was good news for the oil field service companies, especially ones with a higher exposure to the booming U.S. crude market.

Oil service stock performance

SymbolCompanyYTD %Chg1 YR %Chg
SLBSchlumberger 17.32%44.23%
HALHalliburton Company31.67%57.78%
NOVNational Oilwell 7.47%22.07%
BHIBaker Hughes 30.21%57.73%
WFTWeatherford Int.47.29%64.14%

Still, it took a while for these companies to rebound. Crude-oil rig counts were rising, but the number of natural gas rigs were falling, so work didn't increase.

That's changed over the last year—there's now good growth in both oil and gas rigs—and the gap between the supply of services versus the demand will continue to narrow, said Matt Marietta, a vice president and oil field services equity analyst with Stephens.

"Demand for rigs is outpacing growth in supply, and that's taking away the overhead that used to exist in the market," he said.

Where to drill for stock growth

If oil prices stay above $90, then American oil production should continue to expand.

RBC estimates that oil production will increase from 8 million barrels a day today to 11 million barrels a day in 2018, which means demand for services should be strong for some time.

Investors will see stock prices moving higher, though, once the oil field services companies start increasing their prices, said Hallead.

For years these companies have only been able to increase revenues by adding new business. However, as demand for their services picks up, they'll finally be able to raise their rates on customers.

Hallead expects to see rate increases of about 5 percent to 10 percent by the end of this fiscal year.

"It's a fixed-cost business, so this will drop directly on the bottom line," he said. "We'll see some companies get an upward earnings revision."

However, he pointed out that Halliburton shareholders might want to consider moving into Baker Hughes or Schlumberger. The former is the most well known name in the sector, and a lot of people rushed into it when the industry started to rebound. The latter two are more attractively valued, he said. They're in the middle of their enterprise value-to-EBTIDA range, while Halliburton is trading closer to its valuation highs. Longer term, there's more value to be had in these still large-cap but less-brand-name companies.

It's still attractive. You'll still see good growth, good returns on capital and good free cash flows. Overall, this market is improving.
Stephen Gengaro
oil field services analyst at Stern Agee & Leach

Investors who want to buy in now should look for land drillers that operate in Texas' Permian Basin and Eagle Ford Formation, said Hallead, adding that production at these two basins should grow faster than other formations over the next five years.

It's also a good idea to buy companies with a higher exposure to the U.S. market—that's where the most oil and gas growth is coming from—but watch out for companies that do a lot of work in the offshore drilling space.

"Offshore is still out of favor, and the supply-and-demand fundamentals don't look as good," said Hallead.

Since even the bulls believe the oil-service rally can't keep up its pace, the message seems to be for existing and new investors to focus on the big, diversified names within the Oil Service Sector Index (OSX). The OSX is merely keeping pace with the S&P year-to-date, at a 5.5 percent return, but Halliburton and Baker Hughes are both still plus-30 percent, while Schlumberger is up 17 percent.

"It's still attractive," Gengaro said. "You'll still see good growth, good returns on capital and good free cash flow. Overall, this market is improving."