What the “One-Stop Shop” Approach Means for Oil Field Services Stocks

by | published January 23rd, 2014

Oil field services (OFS) companies seem poised to head even higher…

The question now is whether this is sustainable and, if so, how wide the range will be?

As for the sector, it has gone through several waves of consolidation, with the big boys each working to build their own vertical markets.

Through an ongoing series of foreign mergers and local acquisitions, Halliburton Co. (NYSE: HAL) and global leader Schlumberger Ltd. (NYSE:SLB) have managed to prune out much of the competition.

These two giants (among others), have been absorbing support entities, delivery systems, and most importantly the manufacturers of the equipment used in field work.

Think of it as movement to create a “one-stop shop.” But for OFS investors, the results of this trend have been a bit uneven.

Here’s where I think this all-important sector goes from here…

Working to Create “Super-Majors”

But first, let’s take a look at how we got here in the first place.

In a more sector-specific way, the trend toward the “one-stop shop” mirrors the vertical moves of the big oil majors of the past decades. Then, the objective for big oil majors was to control every aspect of the process from the wellhead through transit and processing, to refining, distribution, and retail sales of oil products.

The idea was simple enough. By owning all of the various components, the resulting “super-majors” could save on costs and boost profitability.

Instead of paying market rates to trade with genuinely separate companies in “arms-length deals,” the exchanges could be completed via transfer pricing between composites or subsidiaries of one corporate structure.

Unfortunately, for the “super-majors” that came to an end when they recognized that greater efficiency would result from specialization rather than consolidation. Now, there are just a few of these verticals left.

But even cases where these arrangements remain, spinoffs have occurred. Exxon Mobil Corp. (NYSE:XOM) has departed from the retail sales side, as has Valero Corp. (NYSE:VLO) – the independent refining major who had attempted to expand downstream by introducing a series of service stations.

What’s more, all of the majors have divested themselves of their oil field services divisions, preferring to contract out such services rather than carry expensive technology, equipment, inventory, and specialized staff on their own books.

The Uneven Results of the “One-Stop Shop” Approach

And that brings us back to the ongoing movement toward verticals in the OFS business.

As this OFS divesting intensified, the main players in the sector became bigger. And as the M&A activity centered on the provision of field services, genuine competition began to decline.

Both SLB and HAL, along with Weatherford International Ltd. (NYSE:WFT) and Baker Hughes Inc. (NYSE:BHI) and a few others, intensified their agreements and acquisitions in the global market. This brought major operations further under the effective control of fewer participants.

Such an approach, of course, had a downside.

Geopolitical events abroad or demand constrictions at home ran the risk of severely pressuring bottom lines as these companies balanced expensive inventories and storage costs against market uncertainty.

Even still, the new OFS controllers still concluded providing a “one-stop shopping” approach for all manner of services outweighed the risks.

After all, providing the convenience of coordination to the end user also allows for some nice markups on the composites. Revenue flows would also often extend to percentages of the market values realized from the production itself.

The main providers, therefore, embarked on campaign to build sector-wide verticals by consolidating under their increasing control what had been specialty provisions. These extended to initial site clearage and project infrastructure through seismic study and analysis, to broad well drilling and completion, water separation and initial on-field raw material processing, well work overs and enhance recovery applications.

These moves were extended even further “upstream” to the companies making the equipment and “downstream” into the transport of OFS components and even production.

Now this occurred largely in stages dictated by overall oil and gas production market needs on the one hand, and prices for the resulting extraction on the other. But it has continued.

However, the results for shareholders have been somewhat uneven.

Despite some volatility, SLB and HAL have done well. Shares of SLB are up 64% since I began tracking the sector, while HAL improved more than 40% by the end of 2013 before a pullback at the beginning of this year.

SLB and HAL are showing some signs of slowing down the acquisition machine, although this may signal more a region-by-region consideration than anything else. Given their worldwide presence, however, both of these giants remain vulnerable to pressure from events elsewhere.

Meanwhile, WFT and BHI have posted declines with each down more than 20% over the past 18 months, a clear indication that move toward vertical has produced very uneven results.

Where We Go From Here…

As it stands, there are now two broad categories of obstacles to the further expansion of the dominant OFS providers.

For one, there are some regional service companies with established networking and established client bases that have been able to establish a beachhead against the larger competitors.

As I have noted on several occasions, smaller is often better.

These regional providers emphasize areas they know well and can operate on thinner margins. The problem (and the reason why SLB and HAL believe they will still win out) is the exceptional volatility experienced by the local application of these services.

For instance, Basic Energy Services Inc. (NYSE:BAS) works almost exclusively in the Southwestern U.S. It has been performing better of late – up 15.5% for the current month through close yesterday; 13.8% in the most recent week. Yet, it remains down a whopping 42.4% since the first week of April 2012.

The other impediment comes from OFS companies that have been able to specialize to the degree that it prevents wholesale absorption.

Drillers such as Diamond Offshore Drilling Inc. (NYSE:DO), Ensco plc (NYSE:ESV), also a major offshore driller, along with contract onshore drillers like Helmerich & Payne Inc. (NYSE:HP) and Key Energy Services Inc. (NYSE:KEG) are good examples. Yet, only HP is currently in the black, and even then it’s marginal.

Other examples of specialty companies still going it alone are those with technical expertise providing a niche presence.

CGG SA (NYSE:CGG), the world-leading analyst of seismic data, and Joy Global Inc. (NasdaqGS:JOY), a major manufacturer/distributor of field and mining equipment, are prime examples of these niche companies. Once again, while both are essentially flat for the most recent month, they have been significantly weak performers (down 35.3% and 54.9%, respectively) over the past year and a half.

The good news is some potential new opportunities are beginning to emerge in technical applications arising from the new wave of fracking for unconventional oil and gas. While I am tracking a number of these smaller companies, it remains too early to conclude they can withstand the pressures of the major OFS players.

That means the OFS consolidation is likely to continue, with those able to withstand the move toward verticals probably having to expandthemselves horizontally to protect their presence in particular stages of the overall OFS process.

Opportunities will be revealed here, but you can expect the overall number of participants to continue to shrink.

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