If you are looking for oil stocks that are poised to report better results in the 2Q2022 and beyond, I suggest you consider oilfield service (OFS hereafter) providers Halliburton Company (NYSE:HAL) and Schlumberger Limited (NYSE:SLB).
Below, allow me to explain why I think so.
OFS In The Early Stage Of Recovery
As part of the oil industry, oilfield service vendors tend to experience strong business cycles. The big three OFS companies – Halliburton, Schlumberger and Baker Hughes (BKR) – saw their revenue drop by some 25-52% from pre-Covid 3Q2019 to the bottom reached in the 2Q2020. In the past seven quarters since 2Q2020, Halliburton was able to grow sales at a CAGR of 18.23%, Schlumberger at 6.32%, and Baker Hughes at 1.19% (Fig. 1).
The pace of recovery varies among these companies, but margins at Halliburton and Schlumberger began to improve in 2021, while profitability was regained by Baker Hughes in late 2021 (Fig. 2).
- The big three are yet to attain the FCF margins they used to get in pre-Covid times. The aggregate FCF margin at Halliburton was at 10.93% in the past five quarters, although it used to be as high as 14.53% in the last three quarters in 2019. Schlumberger managed an aggregate FCF margin of 8.52% in the past five quarters, which is nowhere near the 15.12% averaged in 2Q-4Q2019. Baker Hughes’ FCF margin is some 9.48% below that in pre-Covid times. As the industry cycle swings higher, these companies are expected to post higher than middle teen FCF margins.
- Please note, the apparently weak performance in the 1Q2022 was due to seasonality, severe weather conditions, supply chain issues, and/or Russian invasion of Ukraine, each of which are expected to be none or less of a factor going forward.
Asset turnover has recovered nearly to the pre-Covid levels for Halliburton and Schlumberger (Fig. 3). Asset to equity ratio, which had blown out during the 2020 oil crash, continued to decline (Fig. 4).
Consequently, Halliburton and Schlumberger delivered an average ROE of 22.12% and 13.76%, respectively, in the past five quarters, while Baker Hughes returned positive ROE in the past two quarters (Fig. 5).
In the 1Q2022 earnings call, Halliburton CEO Jeff Miller allowed that its customers’ international spending would increase by mid-teens this year. The completion tool order book increased 50% year-on-year in the 1Q2022, which represents work to be delivered in the rest of the year. The company also has a pipeline of new projects scheduled to start in the 2H2022, particularly in the Middle East.
In North America, which contributes >40% of its revenue, Halliburton sees market tightness across all service segments.
- In 1Q2022, average U.S. rig count increased 14% sequentially and was up some 62% year-on-year (Fig. 6). E&P operators are expected to continue to add rigs as drilling activity picks up momentum, although a seasonal decline in software sales in the quarter may lead to a 125-175 basis point decline in margins for the drilling and evaluation division.
Hydraulic fracturing (or fracking) of shale is the largest service segment in North America, where both equipment utilization and day rates are favorable:
- After winter weather and supply chain disruptions earlier in the quarter, fracking activity surged in March 2022. Its fracking fleet remains booked out, and the overall market appears all but sold out for the second half of the year.
- Today, the largest four pressure pumping companies account for ~2/3 of the market. Increasing industry concentration has resulted in a competitive environment where OFS providers command a pricing power over E&P companies.
- As a result, Halliburton CFO Lance Loeffler expects “[the] second quarter revenue to grow in the mid-teens, and margins to improve 350-400 basis points” for its completions and production division.
Halliburton achieved 24.14% year-over-year revenue growth in the 1Q2022 (Fig. 1), in line with the company’s forecast given late last year. However, according to Miller, the outlook has improved to >35% year-on-year as a result of accelerating E&P activity and high inflation. Confidence is palpable in his words:
“With our unique value proposition, clearly defined strategic priorities and global presence, I expect Halliburton will deliver profitable growth, solid free cash flow and industry-leading returns and outperform as this upcycle accelerates.”
In its 1Q2022 earnings call, Schlumberger echoed the optimism as expressed by Halliburton.
- Following a 14.15% year-on-year growth in the 1Q2022, Schlumberger guided toward around mid-single-digits revenue growth for the second quarter, primarily driven by the international market. The company also anticipates the operating margins to expand 50-100 basis points.
- For full-year 2022, Schlumberger maintains its ambition of year-on-year revenue growth in the mid-teens, and adjusted EBITDA margins exiting the year >200 basis points higher than the 4Q2021 (i.e., >17%).
The oilfield service companies are typically busier in the second half of the year. Schlumberger CEO Olivier Le Peuch said,
“Looking further ahead, the 2H of the year is shaping up to be particularly strong, based on our view of a significant pipeline of customer activity, upcoming product backlog conversion, and the growing impact of net pricing… and critically, we anticipate that net pricing impact will further extend in breadth and scale as the year progresses, to benefit margin expansion during the second half, and become a unique attribute of this upcycle.”
Both Miller and Le Peuch pointed out that, in this cycle, the oil industry – both in North America and internationally – responded to high commodity prices by pivoting to short-cycle barrels (e.g., shale oil over deepwater, tie-backs over new infrastructure, development over exploration), thanks to investor return requirements, regulatory hostility and public ESG pressure.
Given its greater market penetration in North America where short-cycle shale is the game in town, Halliburton may have an upper hand over its peers. However, Schlumberger and Baker Hughes may use their respective strength to cater to the short-cycle biased industry.
Each of the big three is currently valued at an EV/EBITDA multiple of ~13X on a 1Q2022 run-rate basis. However, Halliburton guides toward faster growth and greater margin expansion in full-year 2022, which points to its undervaluation on a forward basis relative to peers.
The afore-described positive outlook in the rest of the year comes with a number of risk factors.
- Supply chain disruptions are a serious issue in this cycle. The big three are believed to be better positioned than their smaller peers in dealing with material shortage and de-bottlenecking supply chain.
- All big three OFS vendors will be impacted by the uncertainty linked to Russia, although Schlumberger has the greatest exposure there among the three.
- Inflation is exerting pressure across the entire oil and gas value chain. Tightness in spare parts, input materials, and skilled labor is evident. However, as in previous cycles, the OFS providers will be able to pass these increased costs on to E&P operators.
Talking about labor costs, each Halliburton employee on average pulls in $428,400, each Schlumberger employee $259,200, and each Baker Hughes employee $351,600 on a 1Q2022 run-rate basis (Fig. 1; Table 1).
The oilfield service vendors are still in the early stage of a recovery from an unprecedented industry recession, probably with years of favorable business environment ahead.
Against that backdrop, both Halliburton and Schlumberger anticipate a strong 2Q and 2H, guiding toward significant revenue growth and robust margin expansion.
Cost expansion in an inflationary environment will erode the margins of E&P players. However, costs to oil and gas producers are revenue for oilfield service providers. That’s why I believe investors should allocate a serious amount of capital to OFS stocks, of which Halliburton and Schlumberger are the industry leaders. If I have to choose between the two, I’ll probably take Halliburton for its exposure to North America.