Oil Services: Consolidation Ahead?

11/28/2014 7:00 am EST

Focus: STOCKS

Standard & Poor's Economics sees an average crude oil price of $80 per barrel in 2015, implying that we think we've probably bottomed on crude at this point, suggests S&P Capital IQ Equity Analyst Stewart Glickman in S&P Marketscope.

However, forecast or not, the fear of a protracted decline is real, because if upstream customers pull in the reins on capital spending, that directly affects the revenue stream for oil services.

In this environment, with other parties possibly fearing the same thing, we could see further industry consolidation as a way of coping with crude oil weakness.

Oil services household name Halliburton (HAL), the second-largest name in the oil services industry, agreed to acquire #3 player Baker Hughes (BHI).

The deal is more than three times the size of the last major transaction in the space, when industry leader Schlumberger (SLB) announced it would acquire the former Smith International.

We see two potential targets out there. One is the #4 player in the industry, $13 billion market cap Weatherford International (WFT) and the other is a mid-cap-sized name, $3.7 billion market cap Superior Energy Services (SPN).

In the case of WFT, this is a company that two years ago was attempting to compete as a fully diversified peer to industry leader Schlumberger, as well as Halliburton and Baker Hughes.

In November 2013, it announced some intended strategic changes, and today, WFT is aiming to compete in what it deems core product lines, where it has sustainable and attractive operating margins, and divesting non-core product lines where it does not.

In the third quarter, WFT achieved an average operating margin in its core product lines (well construction, completions, production systems, and reservoir evaluation) of about 17%. This compares pretty favorably with non-core asset operating margins of less than 3%.

WFT has sold off its Russian and Venezuelan land rig business, its pipeline and specialty services business, and now looks to sell off its remaining land rigs as well as a few other peripheral businesses.

We think the slimmed-down WFT could be an attractive set of businesses in oil services.

Superior Energy, unlike WFT, is a company that has been growing through acquisition, not slimming down via divestitures. SPN competes in many product and service lines in North America, but it lacks the full suite of products that the bigger players cover.

However, given the importance of North America in worldwide upstream spending, a company like SPN could add significant oil services business.

For investors who are interested in participating in the broader oil services sub-industry, but in a relatively low-cost investment vehicle, we note that the iShares US Oil Equipment & Services ETF (IEZ) has both HAL and WFT among its top ten holdings, as well as four other Buy- or Strong Buy-recommended names.

However, we also note that SLB comprises over 23% of the assets in this ETF, with the top ten comprising 67%, so diversification is not as wide as one might find in other energy sector ETFs.

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