The Energy Report: James, you have said the energy industry is in the early stages of a strong, sustained upside trend. What's driving that?
James West: Sustained high oil prices are driving a trend toward higher capital spending. Oil prices have been at elevated levels—above $100 per barrel ($100/bbl) for Brent and $85 and above for WTI (West Texas Intermediate)—for close to 40 months. Those are exceptionally good levels for most companies; they can make good profits on projects. Capital investments seem to be accelerating somewhat, particularly in the international markets.
North America is going through a little bit of an efficiency phase and a slowdown from rampant growth. That started after the financial crisis. Now the international markets, which are slower to recover after a financial crisis or downturn, as we saw in 2009, are starting to accelerate.
We recently released an update to our spending outlook, where we survey well over 300 companies in the oil and gas space. These companies represent about 90% or so of capital expenditures (capex) on exploration and production (E&P), and they are showing about 13% gain year-over-year (YOY) in the international markets for capital budgets. There have been some regional shifts, but that's a pretty healthy number. Also, globally we're showing about a 10% gain in spending. This is the fourth year in a row of double-digit gains driven by high, sustained oil prices, behind which are many factors, one being limited OPEC spare capacity.
TER: Is the trend equally strong for gas?
JW: I think it's similar. It depends on what region of the world you're looking at. The international markets tend to be more oil-focused—75–80% of the drilling in international markets is for oil. In the U.S., starting with the early 1980s up until two to three years ago, we were mostly a natural gas market. That's changed, and now we're mostly an oil market. About 75% of drilling is for oil, but we still produce a good amount of gas in North America. The expenditures, I think, are still more focused on oil, although natural gas is becoming a bigger mix of the overall energy consumption pie, and we expect that to continue.
We expect to see more drilling for natural gas in the future. We're in a mini-downturn for natural gas in North America. But things like the industrial renaissance, the chemical renaissance, LNG (liquefied natural gas) exports and more LNG-fueled vehicles will spur more demand for natural gas, and that should help prices rise somewhat. I don't think we're going to go to the $10-plus/thousand cubic feet ($10-plus/Mcf) range, like we saw back in the early 2000s, but I think we'll get back to the $4.50–5/Mcf range, which will spur more activity on the gas side of the U.S. and in Canada. But right now it's more depressed. We're focused on oil today.
TER: Geographically, where is it stronger and where is it weaker?
JW: International markets are generally stronger than North America, and the strength is in the Eastern Hemisphere. The majority of the growth today is in the Middle East. We see the Middle East growing some 28% YOY. That's the highest growth in the industry. The second-highest growth for the industry this year is going to be in the area of India, Asia, Australia and the broader Asia-Pacific region, which is up about 19% YOY.
We do still expect about 12% growth in Latin America and probably about 10% growth in Russia, but Latin America is lagging the Eastern Hemisphere overall. There have been some budgetary shifts in Latin America and the elections in Venezuela; things typically slow a bit during election periods. That's passed now and Venezuela's ramping back up, but it's going to impact the 2013 spend. In Mexico, they're actually looking at a declining budget this year, as they've slowed spending in the north, although that should change as we go into 2014. Brazil is still growing as a market, but the new president of Petrobras (PBR:NYSE; PETR3:BOVESPA) is taking her time going through all the major contracts that company has, and growth in Latin America has slowed. The Eastern Hemisphere is really the biggest growth area for the industry, with the Middle East in the driver's seat.
TER: And is the growth equally strong onshore and offshore?
JW: There is a bias toward the offshore. That's true of the international markets in general. With international spending up 13%, as I said, I think that onshore spending could increase in the high single digits, with offshore spending up probably in the mid-teens in terms of percentage growth. That's because of the vast number of new offshore rigs coming to the market, plus the secular growth that we see in the deepwater arena.
TER: And which companies do you like in this sector?
JW: The large-cap, diversified oil services companies are best positioned. They get the benefits of a rebound in the well count in North America, particularly the U.S. land market, which is in a recovery mode now, but also they are the companies that dominate the international business. That would be Schlumberger Ltd. (SLB:NYSE), our favorite in the group. Halliburton Co. (HAL:NYSE) is number two.
Halliburton did plead guilty to a misdemeanor with the Department of Justice because of the Macondo incident and paid a $200,000 fine as a result of that, but that's pretty de minimis relative to the $1.4-billion ($1.4B) fine that Transocean Ltd. (RIG:NYSE; RIGN:SIX) paid to the Department of Justice and, of course, the BP Plc (BP:NYSE: BP:LSE) fines are well in excess of that. We think Halliburton's ultimate exposure to the Macondo incident is going to be larger. It has taken a charge for about $1.3B, but has yet to fully settle with the Planning/Steering Committee and the states. That step has been pushed out a little bit because BP is trying to renegotiate its own settlement. So BP, being the biggest part of the whole puzzle here, is going to step to the front of the line.
That's $1.3B on a company that is doing well over $30B a year in revenue, and we have forecast EBITDA for Halliburton of $6.2B this year and $7.7B in 2014. It can easily handle a fine of that nature. Recently Halliburton announced a $5B share-buyback authorization coupled with a $3.3B Dutch auction, which is underway right now to buy back shares.
TER: Going back to a subject you touched on, what could reverse slowing growth in Latin America?
JW: I think Venezuela's already turned. It's just going to take a little while to get the ramp-up going in Venezuela. It's happening now, but it just takes some time to get moving. Mexico's intention, at least the intention of the current President, appears to be to alter the constitution to allow international oil companies (IOCs) to invest in Mexico or to help Pemex, the national oil company, with unconventional resources like shale and deepwater. That would, of course, lead to more spending in Mexico. Brazil does have another production decline this year. It had a production decline in 2012 and again in 2013. Petrobras may reconsider its plans and may look to put more capital dollars to work. Other markets in Latin America are all going nicely—Colombia, Ecuador, Peru, Argentina. It's just that Mexico, Brazil and Venezuela happen to be some of the bigger markets in Latin America.
TER: Hasn't the opening to IOCs in Mexico been offered before? I thought it had been pretty strenuously resisted.
JW: It has been so far. Pemex has had a monopoly on Mexican oil and gas activity since 1938. I think at this point, with production hitting a 10-year-plus low in May, that it's now understanding the need to bring in some talent to produce the unconventional resources that it does have both in shales and offshore. The resistance has been there and it's been pretty strong, but it seems to be lessening somewhat.
TER: In Latin America then, which players would benefit the most from a turnaround? Are we talking mainly just the national oil companies?
JW: Well, they would certainly benefit from increased capital spending because it would drive their production, but really the big service companies are the ones that dominate those markets as well. For Schlumberger and Halliburton, those are $1B-plus markets in Mexico, close to $1B-plus in Brazil, probably a little bit less in Venezuela, but if those markets were to start to show better growth then certainly that would drive better revenue and better earnings from Latin America for all the companies involved.
TER: How is the unrest in Iraq affecting that country's production?
JW: Very little at this point. The unrest is mostly in Baghdad, so the south is relatively safe. Kurdistan is actually probably one of the safest areas, as well the north. I think there are 11 international carriers that now fly into Erbil, which is the airport and the major city in Kurdistan. That tells you something about the comfort level of the international airlines that fly into Erbil.
Production is really being held back by two things. One, some of the major oil companies are shifting out of Iraq, not because of security issues, but because of contracts that they don't like. They're getting better contract terms elsewhere in the world. They have global portfolios that they have to manage. Number two, Iraq lacks the export capacity to export much more oil than it is already producing today, so we need to build export capacity in Iraq.
TER: What companies in Iraq are being affected then?
JW: All the big four service companies—Schlumberger, Halliburton, Baker Hughes Inc. (BHI:NYSE) and Weatherford International Ltd. (WFT:NYSE) are all in Iraq. There are some private operators as well. The only one that's showing significant profitability in Iraq is Schlumberger, who has built up quite a franchise both in the south and in Kurdistan. It is benefiting the most from the growth in overall activity levels in Iraq. On the oil companies' side, you can see who's buying up the major oil company properties. It tends to be Russian oil companies and Chinese oil companies.
TER: There are other oil-producing countries that also have issues. Libya has strikes. There are sanctions on Iran. Between Sudan and South Sudan there are disputes. How are these issues affecting the world oil market and the companies you cover?
JW: It is holding some oil off the markets and keeping oil prices at elevated levels. If Iranian production were to return instantaneously, we would probably see a correction in the oil price. I'm not sure it would be a huge correction, but some correction in oil prices. The service companies do not work in Iran. Schlumberger is the only one, but it is winding down its operations now per its agreement with the U.S. government.
I don't think any oil service companies have been able to work in Sudan for multiple years. Those two countries really have little impact to earn revenues and earnings for the oil service companies. With respect to Libya, there's not a lot going on in Libya since the Arab Spring. While it used to be historically 1–2% of revenue and earnings for the industry, it basically went to almost zero and it's remained that way for the last three years. Not much of an impact at this point in Libya.
TER: Why did you change your forecast from flat to 2% growth in North American E&P spending for this year?
JW: Twice a year, we survey some 300-plus oil and gas companies worldwide about their spending intentions, and these are the numbers we came up with in our discussions with the oil companies. The majority of the ones that permanently spend in the U.S. and in Canada were increasing budgets, mostly in the U.S. Actually, we revised Canada downwards whereas the U.S. we revised upward to a little over 3%. The net impact for North America was up 2% versus the flattish numbers we had been expecting in December. I think what drove that is better-than-expected cash flows for the oil companies, which were driven on one hand by somewhat higher natural gas prices than they anticipated and, on the other, by higher oil prices than they anticipated going into the year.
TER: So what plays are showing strength?
JW: The Bakken, the Permian, the Eagle Ford and certain parts of California are showing the most strength right now. On the gas side, the Marcellus is showing the most strength. There are some large, prolific service wells being drilled in the Marcellus.
TER: Which companies in North American oil and gas will benefit the most?
JW: In the oil areas, because these plays use more technology, you don't need just fracturing equipment; you also need to understand the geology better, so you need seismic in some cases. You need better well placement technology, better well chemistry technology. It does play into the hands of the major oilfield service companies.
If you look at the big four, again, Schlumberger, Halliburton, Baker Hughes and Weatherford, and their market share in North America, 10 years ago they were probably 14–15% of the market. They're now about 25–26% of the market. They're benefiting a little disproportionately. We think the North American market is somewhat a market of haves, which would be the major oil companies and certain small mid-cap companies, and the have-nots, which don't provide technology, but are more commodity players, and they're being shut out of certain areas of the market and are unable to compete with the likes of a Halliburton or Schlumberger.
TER: You have said E&P companies are basing their spending budgets for this year on a WTI price of $86.50/bbl and a Brent price of $101/bbl, but the spread between the two has shrunk to a few dollars. What does this mean for oil E&P?
JW: We think that E&P companies are going to realize higher-than-expected commodity prices, which will drive higher-than-expected cash flow, which will drive capital spending probably higher than even our June forecast suggested. If you just look at the companies that reported so far this earning season, many have suggested two things: One, that they would spend at the higher end of their guidance range for capex. Two, several companies actually increased their guidance range for capex.
TER: Do you think the spread is going to get wider again?
JW: Our integrated oil analyst who covers the refiners does believe that this spread will widen once again and will be a positive driver for the refiners. It appears that we're getting very sold out and moving oil by railcars. If that is the case and we start to see pockets of production that have no way to get out of the basin, then certainly the differentials could widen again.
TER: Can you give me the pluses and minuses on Schlumberger, Halliburton, Baker and Weatherford?
JW: Sure. The big four dominate most of the major technology-driven product lines of the industry. They are the largest in the international markets, which I think are growing faster, as we discussed. They are the companies that dominate the deepwater markets, particularly the first three, Schlumberger, Halliburton and Baker. Weatherford is more of a land-focused company and focused more on well integrity as its niche product lines.
Schlumberger is the biggest and the bellwether for the industry. It is larger in deepwater and offshore and in the international markets, whereas Halliburton and Baker are number two and number three and have a little more exposure than Schlumberger to the North American business, which, as we mentioned, is growing slower than the international markets.
The big four, though, even with the moves their stocks have had this year, are still trading at least a standard deviation off their historical averages. Schlumberger has been trading below the market multiple today, which is rare for the oil service industry. The oil service group, except in times of very low commodity prices and very little activity, trades at a premium to the market because the superior growth that occurs in the oil patch or within the oil service companies in general. Not only are they well positioned for how the spending is returning to the cycle, we also think these companies, on a valuation perspective, are inexpensive. In addition to that, we do believe that we're on the cusp of earnings revisions higher for the oil service group, and as the market recognizes the growth cycle that we're in, we think we will see better multiples placed on shares as well.
TER: Thank you very much for your time.
JW: You're welcome.
James C. West is Barclays' lead oil services and drilling analyst. West joined Barclays in September 2008. Prior to that, he was at Lehman Brothers beginning in October 2000. His broad coverage universe includes large-cap, diversified oil services companies, niche technology providers, offshore and onshore contract drillers, supply vessel providers and energy capital equipment companies. Prior to joining Lehman Brothers, West worked at Donaldson, Lufkin & Jenrette. He earned a Bachelor of Arts from the University of North Carolina at Chapel Hill.
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