Initiating coverage of the Energy Services sector

Waqar Syed, MBA 720-683-6705

Generating positive investment returns in energy services has been a difficult proposition of late, as rising shale well productivity has pressured commodity prices and reduced energy service take on a secular basis. E&P talk of parent-child well intervention and other recent datapoints indicate that we may be in the latter stage of the well productivity improvement cycle, the end of which may herald a positive upcycle for energy services, although the exact timing of inflection is still difficult to determine. In the meantime, owing to macroeconomic concerns weighing on investor minds, we recommend a barbell approach to stock picking in the energy services space. Our Outperform ratings are heavily weighted towards defensive stocks in the context of energy services, which we characterize as those with: (a) a high and safe dividend yield (SLB/HP); (b) a strong balance sheet; and, (c) significant exposure to secular themes like LNG (FTI/BHGE). We take selective beta (higher risk) bets with ESI, PD, and TCW, who offer leverage to the Canadian market, which we believe could see stronger activity growth in 2020e than the US/International markets. While we are negative on US pumping given market oversupply, equipment obsolescence risk, and macro risks, we recommend PUMP and LBRT, as they are profit leaders in the industry and could lead the next phase of innovation/transformation in a sector that badly needs a new type of pumping hardware. We view consensus 2020 estimates to be high, which could be an overhang on the group.

Highlighting our Barbell Approach to Energy Service Investing

• The Defense – SLB/BHGE/HP/FTI: Our defensive recommendations have high and safe dividend yields (SLB: 5.5%, HP: 5.8%, BHGE: 3.2% versus S&P500: 2.1%); very strong balance sheets as investor appetite for weak balance sheet stocks is limited (net debt to capital ratio at Q1/19 end was 9.7% for BHGE, -7.2% for FTI, 27.1% for SLB, and 4.6% for HP); and exposure to a key secular theme in energy services, LNG project FIDs (FTI/BHGE) and/or LNG after-market services (BHGE).
• Riskier Bets – The “Beta” Play On Canadian Activity Inflection – TCW/ESI/PD & PTEN: E&P spending in Canada fell nearly 18% in 2019e, owing to production curtailments and from a lack of export capacity, making it the worst major energy services market this year. Canadian activity is significantly below normal levels and a rebound is now projected for 2020e, albeit from a small base. However, regulatory/permitting hurdles could still derail our positive outlook (see Figure 14 for details), and as such until the outlook is derisked, we recommend Canadian completions exposure through TCW, who has a strong balance sheet (Q1/19 net debt to capital ratio of 5.2%) and a share buyback program. In land drilling, which is lower risk than the completions business, we recommend ESI/PD, where the risk of weaker balance sheets is balanced by geographical diversification, contract backlog, and high FCF yield. ESI also offers a 10.1% dividend yield and we view its dividend to be safe.
• “Alpha Through Likely Disruptors In Pressure Pumping – PUMP/LBRT: The pressure pumping business is in need of innovation/transformation owing to its high repair and maintenance expenses. A new type of pump has recently been introduced, which dramatically lowers R&M costs. In our view, this and other innovations could disrupt the pumping market over time, just like AC rigs did to the conventional rig market. HP, who introduced AC rigs in 2003, outperformed peers NBR and PTEN by 8%, 150%, and 305% in the ensuing three, five, and 10 years, respectively. We think PUMP/LBRT could lead disruption in pressure pumping and offer an “alpha” opportunity.