Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

It is hard to love the oil services sector right now:

Worst Block In A Bad Neighborhood
Oilfield services stocks have fared even worse than their E&P clients
Source: Bloomberg
Note: Performance indexed to 100.

The problem is, of course, the oil price. E&P firms have cut costs and got a bit of a tailwind from the rally in oil prices earlier this year, leading to a sharp increase in the number of rigs in operation. But it's hard to maintain that sort of enthusiasm when oil futures don't rise above $50 a barrel until early 2020. So the number of oil rigs being added has slowed markedly:

Dog Days
Weekly additions to the U.S. oil-rig fleet this summer have slowed to about a third of the pace in the spring
Source: Bloomberg, Baker Hughes
Note: Four-week moving average

That, along with signs of a slowdown in drilling permits being issued, is bad news for companies that provide land-drilling equipment and services, such as Precision Drilling Corp. That stock has fallen 42 percent this year. A jump on Wednesday, in response to bullish U.S. oil inventory numbers, shows it would stand to gain from a sustained move by crude futures above $50.

But another sub-sector of the oil services industry could be more deserving of investors' interest (if not love) in the second half of the year.

I wrote here about the rapid build-up in drilled but uncompleted wells, or DUCs, in U.S. shale basins this year. The DUCs represent potential oil supply of perhaps several hundred thousand barrels a day (for their first year of production) once they've been fracked.

With the E&P sector as a whole having set ambitious production growth targets for 2017 earlier in the year -- when futures prices were higher -- the most important aspect of the second-quarter earnings calls about to begin will be any sign companies are dialing back their plans. It's a tricky balancing act because prudence demands they protect balance sheets, but investors in the sector have traditionally rewarded growth.

One likely outcome, though, is that the emphasis in investment swings away from the first half's drilling frenzy toward completing wells, which can then add to production. Even at an oil price of around $50, a new well producing 350 barrels a day -- about average for Permian wells last year, according to Wood Mackenzie -- would still pay back a completion cost of $4.5 million in less than a year.

If E&P companies start to work off the DUC hoard, then that should make providers of pressure-pumping equipment and services, along with sand providers, a relatively better oil-services bet through the end of 2017. And these stocks sit toward the bottom of the sector in terms of valuation:

You Complete Me
Pressure pumping and sand stocks are relatively cheap versus the oil services sector overall
Source: Bloomberg
Note: Enterprise value as a multiple of forecast Ebitda, next four quarters.

Another interesting stock to watch there is Halliburton Co. While it is one of the big, diversified services companies, Halliburton is number one in fracking and pressure pumping. You may remember that, back in March, it issued a profit warning because it was ramping up spending on reactivating equipment to meet rampant demand from clients. Earlier this month, it acquired Summit ESP, a manufacturer of submersible pumps that have become more important to enhancing the flow of oil to the surface as E&P companies drill longer wells.

With Halliburton due to report second-quarter earnings on Monday, not only should investors be attuned to what the company says about what's happened to demand for completion services since March, they should also note Halliburton's lower multiple relative to Schlumberger Ltd.'s potentially makes it a more attractive DUC call.

The wild card here is, of course, the oil price. U.S. producers have been victims of their own success, with their higher output undercutting OPEC's efforts to raise prices. Should Saudi Arabia decide to abandon this strategy in order to force a rethink in Texas, any stock with the faintest whiff of oil would drop precipitously. Thus far, though, Saudi Arabia seems committed to seeing the current strategy through (it does, after all, have a certain upcoming IPO to consider).

The oil market's relatively new tug-of-war between shale and OPEC portends shorter price cycles in a narrower range than was previously the case. So setting the DUCs free would ultimately be bearish for prices, E&P profits and, ultimately, the services of the contractors helping to bring wells online. For now, though, they look better placed than the rest of a struggling sector.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net