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Schlumberger: The Much Awaited Recovery Is Here.

Updated: Aug 16, 2018

Summary

The oilfield services companies will likely get hit by the weakness in the Permian Basin, but Schlumberger can withstand a slowdown in drilling activity.


Schumberger doesn’t have as big of an exposure to the US market as its peers, and it has a great track record of generating decent profits and cash flows in.


More importantly, for Schlumberger, the drilling activity in the international markets, ranging from Asia to Africa, is finally recovering.


Demand for oilfield services outside of North America is quickly recovering, and pricing has also improved.


The persistent weakness in oil prices at the Permian Basin may push drilling activity lower, but Schlumberger is well positioned to meet this challenge. The problem, however, will get resolved by the second half of 2019. More importantly, Schlumberger's international business, which accounts for a vast majority of the company's revenues, is finally starting to turn around.

This year has turned out to be a tough one for many oilfield services stocks. The VanEck Vectors Oilfield Services ETF, the industry's benchmark fund, has fallen by almost 2% this year. Back in January, I wrote that Schlumberger stock will likely outperform in 2018, driven by continued strength in North America's drilling market and a rebound in the international market. But so far, Schlumberger stock has underperformed the oilfield services industry, falling by 2.8% on a year-to-date basis. I think this could be due to the fact that a major recovery in international markets failed to materialize, at least in the first half of the year. On top of this, there are dark clouds hovering on the US drilling market which has raised concerns about the continued strength of this important region.


A number of oilfield services companies, including Schlumberger and Halliburton, have posted strong, double-digit growth in revenues from North America in the last several quarters. That growth was led primarily by the surge in drilling activity in the US, in general, and the Permian Basin, in particular. The Permian Basin, located in the West Texas and New Mexico, is by far the most prolific oil-producing region in the US, given it alone accounts for nearly half of the onshore rigs and a third of the completed wells in the US. But Permian Basin's oil producers, which include companies such as Pioneer Natural Resources and Occidental Petroleum, have produced so much oil that it has overwhelmed the region's oil pipelines and trucks. Consequently, a supply glut has emerged that has pushed the region's prices more than $10 per barrel below the benchmark.


The oil price weakness will force Permian Basin's operators to cut costs by reducing drilling activity. That's going to hurt oilfield service stocks that provide services to Permian Basin's oil producers, particularly onshore drillers like Helmerich & Payne (HP) and Patterson-UTI Energy (PTEN). Schlumberger has warned that the takeaway constraints in the Permian Basin may "temper the activity growth" in the region, and the problem may not get "resolved until the second half of 2019." Halliburton, on the other hand, has said that the issues may have a negative impact on the third quarter earnings.


That being said, Schlumberger is in a better position than most of its peers to withstand a potential dip in drilling activity. That's because, firstly, Schlumberger doesn't have as big of an exposure to the North American market as its above-mentioned peers. In the second quarter of this year, for instance, Schlumberger got just 38% of its total revenues from North America while the rest came from international markets, even though Schlumberger has posted solid growth from North America in the last several quarters while its international business is still struggling. In the second quarter, Schlumberger reported 43% increase in revenues in North America on a year-over-year basis to $3.14 billion, while its international revenues dropped by 1% to $5.07 billion.


Secondly, Schlumberger has a history of generating a decent profit and cash flows throughout the business cycles. In the latest quarter, for instance, Schlumberger reported 11% increase in revenues and 23% increase in adjusted profits on a year-over-year basis to $8.3 billion and $0.43 per share, respectively. It also generated $987 million of cash flow from operations in the second quarter which was enough to cover the total capital expenditure of $735 million, including SPM investments and multiclient seismic data capitalized. As a result, Schlumberger ended the quarter with free cash flows of $252 million. But even in 2016, which was a particularly tough year for oilfield services companies, Schlumberger reported a small net profit of $1.14 per share, as adjusted, and free cash flows of $1.7 billion.


Moreover, it is important to remember that the Permian Basin's problems are temporary. Schlumberger itself is expecting an improvement by the second half of next year which, I believe, is a reasonable assumption. The takeaway constraints will get resolved once some of the major pipelines, like Phillips 66 Partners Gray Oak and Plains All American Cactus II, come online in the second half of 2019. Around 2-3 million barrels per day of pipeline capacity will get deployed at the Permian Basin in the near term, as per my rough estimate. This should ease the supply glut and push the region's prices higher which will fuel an increase in drilling activity.


Meanwhile, Schlumberger has said that it is already seeing signs of an uptick in international drilling activity. The international markets have lagged far behind the US, but this could change in the near future, particularly since OPEC and its allies, including Russia, have increased drilling and oil production. The positive trend was also confirmed by Schlumberger's peer Baker Hughes a GE Co., which has witnessed strong growth in orders from outside of North America. Baker Hughes has posted a greater sequential increase in international revenues than in North America.


Schlumberger has also put strong numbers which suggest that its international business is starting to turn around. The company has posted 4% increase in revenues from international markets on a sequential basis which was driven by 18% growth in Asia and Australia, 9% in Europe and Africa, and 3% in Latin America. On top of this, pricing has also improved, which indicates strong demand for Schlumberger's services and could be a precursor to the improvement in profit margins.


In fact, the demand has been so strong that Schlumberger has said that it has mobilized an "unprecedented" number of 29 rigs and will continue to deploy additional equipment for both drilling and production services in the coming quarters. This will get absorbed by a number of large-scale projects. In the fourth quarter, Schlumberger has said that it won't have any spare capacity as all of its equipment will be fully deployed. This will be a key milestone which will mark the turnaround of the company's international business and will be followed by further improvement in prices.


I believe that the rebound of Schlumberger's international business will have a positive impact on Schlumberger stock. The company's shares have underperformed this year, as indicated earlier, but investors should continue to hold this stock and consider buying on weakness as it will likely outperform in the coming months, particularly against other oilfield services stocks that have significant exposure to the US market and whose shares may remain subdued in the short term due to Permian Basin concerns. Source: Seeking Alpha.


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