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Keith Schaefer

Keith Schaefer

Keith is the publisher of the Oil & Gas Investments Bulletin – an investment newsletter that looks at opportunities within the Canadian small cap oil…

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Investing in Energy Services Stocks

Why the entire sector should see a rising tide of revenue and profits... for the next few years.

The rapid increase in horizontal drilling and the shale revolution, the energy sector is re-defining the need and demand for North American energy services companies.

This has created a work backlog that has the entire industry - drillers, fracking companies, fluid specialists, water services - stretched to the limit, which will keep revenue and profits rising for the sector for at least three years, say research analysts.

Peters & Co., a Calgary based oil and gas boutique brokerage firm, estimates 2011 cash flow per share will increase 40% over 2010 for their coverage universe in the energy services sector - 40%.

Securities firm Raymond James says oil and gas companies will increase spending 25% this year alone to US$133 billion.

Even more, they estimate spending will have to increase by about 56% above 2011 levels, to roughly US$206 billion, as more powerful rigs are needed to drill deeper - and longer -- horizontal wells. Oil & gas companies spend that money; energy services companies receive that money.

It means the energy services sector will be one of the safest and most lucrative investment opportunities during that time. A rising tide of revenue and profits will lift all stocks, and create M&A activity that will also enrich investors.

With oil back up over $100/barrel, oil producers are drilling as fast as they can. But the big difference between 2011 and 2007 - the last height of the drilling industry - is the number and percentage of horizontal wells being drilled.

Everyone is drilling horizontal wells - they may cost 2-3x as much as a vertical well, but producers often get 4-7x as much oil or gas out of those wells. The economics of horizontal drilling are very strong, and that's why horizontal wells now make up 44% or more of all wells drilled in Canada, more than triple the 14% in 2007 - only four years ago.

The other important factor to mention is that these shale plays often extend over a large area deep underground, so once a shale formation is deemed economic it can often provide tens or even hundreds of low risk repeatable drill locations - Easy money for the services sector.

Drilling a horizontal well takes a different set of technologies and skill sets that the industry is discovering and developing as they go. As an example, companies that just do hydraulic fracturing - sending water and sand down into the well at super high pressure that breaks up the shale that holds the oil -- are constantly perfecting their technology to increase the amount of oil or gas they can get out of the new shale plays.

Drilling fluid companies are developing new technologies that allow the drill bit to glide along a horizontal well bore with less friction - dramatically reducing the amount of time and money it takes to drill a well. But these specialty fluids cost more. $$$$ ;0)

One of the biggest success story from our portfolio has been with Canadian Energy Services (CEU-TSX). Since I bought it in the portfolio at $15, it has increased its dividend three times... and the stock has more than doubled in stock price to $32.

Despite all the technology creating savings and increasing profits for the energy producers, well costs are still going higher, as is the number of metres drilled per well and the length of time it takes to drill a well. All of these factors mean more money in the pockets of the energy service providers.

The Daily Oil Bulletin, a trade magazine in Canada, reported that the average metres drilled per rig jumped to 8,336 metres in the first quarter, up from 7,240 metres per rig in the same three months last year, as wells go deeper and the horizontal legs get longer.

The Petroleum Services Alliance of Canada says the average number of days it takes to drill a well has climbed to 11.5 in 2011 from 5.7 in 2008. Wells are, on average, almost 600 metres deeper than they were in 2008. Some of the deeper wells in Canada are taking 25 days or more to drill.

All these statistics means more work, and more profits for services companies.

And having rigs spend more time at one job site means more rigs, more fracking set-ups and more ancillary services are needed to fill the demand. The industry is building new rigs and more fracking equipment as fast as they can.

Macquarie Capital estimates the US industry needs an additional 550 rigs over the coming four years to meet demand - much of it the new larger rigs that can bill out at higher profit margins.

Raymond James estimates that day rates for Canadian drillers were up 10% in Q4 2010, and will be up another 5% in Q1 2011. I'm seeing gross profit margins go from 25% up into the low and mid 30% range -- sometimes higher.

That pricing power should mean drilling stocks stay in an uptrend.

Now - let's look at the services sub-group that's really benefitted from today's shale revolution: the fracking industry.

After you drill an economic well you have to "complete" it, which means get the oil out of the ground. In shale plays, or any tight sand oil or gas play, fracking and completing have basically become the same thing.

Whereas drilling used to be the highest cost component of a well, it is now completions and testing. Today that comes to roughly 54% of the total well cost... vs. just 17% in 2000. (In Canada, the largest fracking companies generate as much cash flow as the biggest drilling companies.)

The fracking industry is judged not by the number of fracking rigs or setups, but the amount of horsepower (HP) any one company can provide. Macquarie Capital estimates that in the U.S., HP demand will jump 62% in 3 years, from 9.1 million HP now to 14.8 million HP in 2014 - and they expect the market to still be under-supplied then.

In Canada, oil and gas companies can wait up to four months for a fracking crew. There is one other very positive trend to throw into this mix - the fact that the energy industry in North America is now becoming oily. This continent has been known as a gas basin for the last 50 years, and a boring mature one at that.

The last five years has turned that idea upside down, and that has very positive implications for the valuation of energy services companies.

As recently as 2008, more than 80% of all drilling in North America was for dry gas (methane that heats your home). It's now 50% oil.

The gas industry was notoriously cyclical, as it depended on the weather. Cold summers and warm winters meant a glut of gas, low gas prices, and low cash flow for producers... so drilling was low.

Of course the market likes predictable cash flow - it will pay more for a less-profitable well that will last for 25-30 years than it will for a highly profitable well that is depleted in 5 years.

And now that half of all drilling is for oil, Macquarie Capital is calling for higher valuations in the energy services sector. Oil is not driven by unpredictable weather (but by unpredictable geopolitical issues ;0)).

But overall global demand for oil is strong, and even if oil drops back to US$90 per barrel, almost all oil plays in North America are profitable... and will sustain steady drilling and fracking levels - keeping the cash flows of service companies high.

In conclusion, the services sector is the place to be in the energy sector for 2011 - and the next three years - for the following reasons:

1. The number of horizontal wells being drilled is increasing because they're so profitable.

2. The depth and length of horizontal wells is increasing.

3. The industry is at capacity right now, and will be for three years.

4. One brokerage firm is expecting cash flow per share to increase 40% for the full services sector.

5. A more predictable, steadier work schedule -- due to oil exploration vs. gas exploration -- will mean higher valuations for energy services companies... even without increased cash flows.

As I said, fracking and drilling companies are all but maxed out. (The industry is building new rigs and more fracking equipment as fast as possible.)

And that makes natural gas the "X" factor. If natural gas prices ever pick up, it's safe to say demand for gas rigs will go up.

In such a scenario, we could see energy services stocks really take off.

By. Keith Schaefer





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