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With demand increasing, supplies diminishing and costs increasing, the oil industry is feeling the pressure. So what are the prospects for the various oil players? Tom Sieber taps into the changing fortunes of black gold

The oil industry has always been cyclical – when the price of the commodity is high oil & gas companies will in the main benefit – but alongside the years of plenty there are more than enough years of want. And in any downturn the pain has been just as acute for the firms which provide the infrastructure and manpower to oil explorers and producers, as it has been for those exploration and production (E&P) companies themselves.

The only difference is the gap between a downturn in the prospects for E&P firms and a similar effect being felt by oil service companies. This lag can principally be explained by the time it takes for changes in the spending plans of the former to filter down to the latter – something which holds true when prices are on the way up as well.

As an illustration, in 1998 the oil price hovered around $10 barrel as OPEC, underestimating the effects of the economic crisis in Asia, continued to increase output. That year and into 1999 the market became oversupplied and this began to be reflected in the spending of the major oil companies.

In 1998 Royal Dutch Shell’s (RDSB) capital expenditure stood at around $14 billion, but just two years later it had slipped to $6.1 billion. To put this into even sharper perspective, it compares with some $25 billion last year.

Observers are now forecasting double digit growth on upstream projects at least through to the end of the decade as the majors in particular attempt to replenish rapidly diminishing reserves.

This see-saw in fortunes has caused problems and continues to do so. In the late 1990s, for example, a pessimistic outlook on prices led to consolidation and redundancies – as a result there are currently insufficient qualified people to meet demand and the average age of someone employed in oil services is around 54.

On the other side of the coin, when there has been a resurgence in the oil industry people have convinced themselves – despite bitter experience – that it is ‘different this time’ and in response capacity is massively expanded, leading to over capacity. With the almost inevitable downturn comes increasing pressure on prices.

Will the same thing happen again? A recent update from the world’s largest listed oil service company Schlumberger (SLB:NYSE), often seen as a barometer for the fortunes of the industry as a whole, was disappointing – with management revising market expectations downwards.

However, while analysts did express concern over the short-term prospects for the company their long-term view was far more favourable and this reflects a growing belief that, for a number of reasons, it is ‘different this time’ and that oil service firms can break the cycle of boom and bust.

Analyst Craig Howie, of Blue Oar Securities, says: ‘We believe that the oil services sector should now be a core holding for investors seeking exposure to long-term energy market fundamentals. This is against the back drop of falling production and rising costs at the big oil companies, traditionally the default choice for investors.’

Supply and demand

An obvious way in which the industry is changing is in terms of the simple fundamentals of supply and demand. The amount of oil being produced is struggling to match the amount of oil required in the global economy – Chinese consumption has doubled in the last decade and the other emerging economy in the east, India, is not too far behind.

Even if, as widely predicted, there is a slowdown in the economy the long-term picture is unlikely to change. As we have already observed this has fired record levels of spending on E&P, as the big oil companies scramble to meet demand, although this growth has and may continue to be held up a little in the near term by capacity constraints.

Peter Hitchens, energy analyst at Seymour Pierce, says: ‘With the pick up in the cycle in 2005, the industry found it difficult to recruit trained personnel and was also competing with the integrated oil companies.

‘This has limited the potential to increase capacity leading to even higher prices. Although the oil industry wanted to do more projects, this was limited by a shortage of equipment such as drilling rigs.’

Against that backdrop daily rig rates have soared, with operators attempting to secure rig capacity through multi-year contracts – the average day rate for deep water floaters in the Gulf of Mexico and Brazil stands at around $500,000, which compares with a figure of around $200,000 just four years ago.

Additionally the Baker Hughes worldwide rig count (see bar chart), which is the main measure of of the number of drilling rigs actively exploring for or developing oil or natural gas, shows a clear increase over the last decade.

Another key development over the last few years has been the emergence of the national oil companies (NOC) as the key players in energy markets.

Resource nationalism is a phenomenon that tends to rear its ugly head whenever the oil price is high but it is probably fair to say we are in unique territory when around 80% of the world’s 1.1 trillion barrels in proven oil reserves are controlled by governments that seek to significantly restrict access to international companies.

In a reflection of the shifting tides, last year saw PetroChina, the state controlled Chinese firm, surpass ExxonMobil (XOM:NYSE) to become the world’s largest energy company by market capitalisation.

This trend obviously puts extreme pressure on the international oil companies in a world of ever diminishing oil reserves. It does, however, leave a vacuum that can be filled by oil service firms as most state operators still lack the technical expertise to operate entirely on their own.

And companies on the UK market could be well placed to benefit, as Howie observes: ‘Although the diversified US service companies including Haliburton (HAL:NYSE) and Baker Hughes (BHI:NYSE) enjoy international footprints, European competitors arguably enjoy a strategic advantage because of their closer proximity and post colonial links to many locations.’

Russia, in particular, has seen a massive increase in spending, promising opportunities to both indigenous and external companies. Having received a number of offers for its oil services arm Imperial Energy (IEC), a FTSE 250 E&P company working in Siberia, is considering spinning it off and floating it on Aim.

Deep blue sea

A final key development supporting growth among oil service firms is the increasing importance of offshore production and the burgeoning move into deep water that represents the industry’s last true frontier in exploration.

Energy business analysts Douglas Westwood’s World Offshore Drilling Forecast 2007-2011 forecasts that global offshore oil & gas expenditure will rise by 48% in that four year period and annual deepwater capex is expected to hit $25 billion by 2012 with activity centred in the Gulf of Mexico, Africa and Brazil.

The most obvious beneficiaries of this development are the offshore drillers but a number of firms in the sector can benefit. Newcastle-based Wellstream Holdings (WSM), for example, provides flexible pipe line to offshore operators in Brazil.

Many of these use Floating Production, Storage and Offloading vessels (FPSO), a type of floating tank system, to facilitate oil production and such systems are very difficult to operate without flexible pipeline.

Merrill Lynch, which recently initiated coverage on the stock, can see increasing potential in the business: ‘As FPSO-based developments gain traction in the Gulf of Mexico and other deepwater basins, such as Asia, open up to the benefits of flexibles over rigid risers (ease of use, re-deployment), we see potential for Wellstream to expand its regional footprint in the medium term.’

It is always dangerous to assume that it is ‘different this time’ but even if that argument does not fully convince then few are expecting anything other than growth in the sector over the next few years. This may well be supported by M&A activity if the deals agreed last year for Abbot Group (ABG) and Sondex are any guide.

Hitchens adds: ‘We expect the oil service sector will continue to perform well. This has seen solid earnings momentum over the last two years on the back of increased expenditure from the industry.

With little ability to increase capacity, the sector has been able to pass on significant price increases allowing the companies to beat market expectations. With further increases in capital expenditure we believe that this will continue over the next few years.'

Driller killers

Obviously every company will not share equally in this success. More than most the oil services sector is not a homogeneous mass of firms all doing more or less the same thing.

There is a clear delineation to be made between the big firms such as Amec (AMEC), John Wood Group (WG.) and Petrofac (PFC) and the smaller niche players on Aim such as Velosi (VELO:AIM) or Offshore Hydrocarbon Mapping (OHM:AIM).

Also, different firms provide different services at different stages of the exploration curve and there are at least four distinct sub-groups within the sector. These include seismic and survey, drilling, down-hole services (the tools, equipment and instruments used in the well bore) and engineering and construction.

Drilling is obviously the most fundamental activity in the exploration and production of oil and gas. Day rates for rigs may begin to come under pressure as more rigs come on to the market and there is little direct equity exposure to drilling in the UK and Europe.

The only obvious example in this country is Abbot Group, but as mentioned above, that will be taken off the market in 2008 after private equity firm First Reserve made a successful bid last year. Equally there are not a huge number of seismic companies on the market – the best example being the aforementioned Offshore Hydrocarbon.

Down-hole services are better represented with companies like Expro International (EXR), Hunting (HTG) and, at the other end of the scale, Aim-listed Plexus (POS:AIM), and there are a number of UK listed companies involved in engineering and construction – obvious examples include Bateman Litwin (BNLN), Wood Group and Lamprell (LAM:AIM).

In order to benefit from the opportunities offered by the sector investors should look to companies with a technological advantage in a high growth area and/or a geographic focus in a region such as the Middle East where high levels of activity look set to continue. We have picked out five companies from across the spectrum who should fit the bill.

Five smart sector plays

Bateman Litwin (BNLN:AIM) 147p BUY

The firm is based in the Netherlands and numbers among its contracts a role in the development of the Kashagan oil field in Kazakhstan. A recent trading update revealed that both operating performance and net income for the first half would come in ahead of expectations. According to broker Evolution Securities Bateman Litwin is on a prospective PE of less than 10 times, and is the cheapest company among the engineers and constructors in the oil service sector.

Hunting (HTG) 663.5p BUY

The company’s growth is being driven by the Hunting Energy Services division which supports well drilling internationally. Gibson Energy is a lower margin business based in Alberta, Canada, involved in the transportation and marketing of oil produced from the Abathasca tar sands – an activity that is seeing unprecedented expansion due to high oil prices. The energy services arm should continue to perform in the medium to long term and Gibson’s prospects should improve as the tar sands project gathers steam.

Lamprell (LAM:AIM) 360p BUY

This stock offers exposure to the growing activity in the Gulf of Arabia. Based in the United Arab Emirates, its core business lies in refurbishing jack-up rigs, but it also has a growing engineering arm and has acquired a facility to produce new rigs for the market. Lamprell benefits from the fact that it has no true competition in the region, with most other operators in its space based in Asia and the US.

Offshore Hydrocarbon Mapping (OHM:AIM) 104p BUY

Last year’s deal with industry leader CGG Veritas will give this seismic operator the opportunity to effectively market its new technology, a seismic technique called Controlled Source Electromagnetic (CSEM). The industry has begun to adopt CSEM alongside traditional seismic survey techniques and last year its first dedicated vessel came into service – its fleet should double this year. Broker Seymour Pierce believes recent weakness in the share price represents an excellent buying opportunity.

Wellstream (WSM) £11.02 BUY

The Newcastle company, which designs and manufactures offshore flexible pipeline, has had an excellent run since its flotation in April with the share price up more than 250%. The momentum behind the performance has been the uptake of its product in Brazil, where as noted above there is a particular demand for the type of pipeline the company produces. Despite the soaring share price there remains some upside due to the potential for expansion to other regions.