Shares digital

After the significant correction in the price of crude oil, sentiment is likely to remain cautious, so it might not pay to be too aggressively bullish on the Oil Equipment and Services sector

by Tom Sieber

As the world digests the decision on output from this week’s Organisation of the Petroleum Exporting Countries (OPEC) bi-annual meeting in Vienna, investors are looking for a signal they can re-enter a sector which currently offers a level of organic earnings growth not readily available elsewhere in the market.

Yet after the significant correction in the price of crude oil, which has rattled back from July’s $147 peak to $106, sentiment is likely to remain cautious until visibility on future price trends improves. It would therefore not pay to be too aggressively bullish on the oil equipment and services sector, especially as it is already the second best ranking of the 40 sub-sectors which comprise the headline FTSE indices. That the analyst community remains resolutely bullish on the sector – with 26 ‘buy’ ratings on stocks to just 1 ‘sell’ is also a cause for concern, as oil equipment has lofty expectations to meet at a time when oil prices are volatile.

That said, Shares, which first noted talk of a rapid move to $200 oil was fanciful (8 May) and then predicted a fall back to around $100 (07 August), does not believe the price of black gold will sink too far below current levels. So long as the oil price remains above $80 the sector’s long-term prospects look healthy and patient investors should look to tuck away stock in Bateman Litwin (BNLN:AIM), Petrofac (PFC) and Velosi (VELO:AIM).

No storm warning

Trading in the oil markets is less febrile than it was during summer when the price reached its peak. The relatively muted response to – ultimately inaccurate – predictions Hurricane Gustav would cause significant damage to oilfield infrastructure in the Gulf of Mexico is an indication of this.

Supply remains tight so demand destruction caused by $147 oil and a slowdown in the global economy should not be enough to send the price below $80. If oil holds its ground at roughly the $100 mark through the rest of 2008, and helps convince investors a real price collapse is not upon us, it would be worth selectively returning to the sector ahead of full-year results. These are due at the turn of the year and should reveal strong growth in earnings and order backlogs.

In light of the sector’s recent relative weakness – it may rank second of 40 for the year as a whole but comes in at number 36 since 1 July – there are some companies that are worth picking up straight away, even if others are potential value traps for investors.

Given the indiscriminate way in which all small caps have been punished during the summer correction some of the sector’s minnows look particularly interesting. Aim-listed engineering and construction firm Bateman Litwin looks set for a recovery after re-focusing under a new chief executive, and health and safety specialist Velosi has a story which still seems under-appreciated by the market, given its prospective price/earnings ratio (PE) of 9 for 2008 and 7.9 for 2009. FTSE 100 firm Petrofac is focused on engineering and construction and looks the best bet among the larger operators since it offers one of the best earnings growth profiles within the sector – broker Goldman Sachs is forecasting earnings per share (EPS) growth of 70% in 2009.

Those to avoid include Offshore Hydrocarbon Mapping (OHM:AIM), which is facing severe difficulty in selling the industry on the merits of its controlled source electromagnetic (CSEM) technology, which is designed to augment existing seismic techniques. Portland Gas (PTG:AIM) is also one to be wary of, given its lofty £217 million market cap and the obstacles it still faces in developing its gas storage project in Dorset. Even though Sovereign Oilfield Group (SOGP) looks very cheap, with a market cap of £4.4 million compared with sales in the year to March 2007 of £51.5 million, the fabrication specialist is struggling to address the debt it took on in 2007 in an untimely bid to grow the company more quickly through acquisitions.

Performance leaks

When Shares (24 April) last reviewed the oil equipment and services sector, we took a positive view and this was rewarded with an initial 25% rise. Since then a significant sell-off has eroded most of those gains, even if there has been a small recovery in the wake of the reporting season.

In order to gain greater clarity on the future prospects for the sector, a close study of the global macroeconomic environment is required. Keith Morris, oil services analyst at broker Evolution Securities (EVO), says ‘valuation [in the sector] will be compelling when macro sentiment turns’ and adds: ‘the UK/European oil service sector forward PE multiple is now at its lowest level since early 2004, when the oil price was $30 a barrel and oil companies were spending $211 billion a year on capital expenditure versus over $400 billion budgeted for 2008. The sector is 25% below the ten year average.’

As Morris hints though, valuation counts for very little without a catalyst. Even a very encouraging reporting season for the first half, which saw significant earnings growth and bullish outlook statements virtually across the board, has failed to stoke a fresh surge in the sector.

Engineer Amec (AMEC) said net profits rose 30% in the first six months of the year to £67 million, compared with the same period last year, while Hunting’s (HTG) net profit rose 45% to £34 million.

Scottish-based Wood Group’s (WG.) profits were up 44% on last year to more than $200 million and flexible pipe manufacturer Wellstream Holdings (WSM) reported a 501% jump in first-half pre-tax profit to £40.8 million, as its businesses in the UK and Brazil increased both usage and capacity. In a display of confidence, Amec also hiked its profit margin forecasts for 2008 and 2010 by 50 basis points, to 6.5% and 8.5% respectively.

In a sense the sector is the victim of its own success. Oil equipment firms have consistently surprised on the upside with their earnings in the past 12 to 18 months, but this has driven earnings forecasts ever higher and potentially to a level where it could be difficult to beat them again. These companies also face the challenge of securing new work. Visibility is extremely important and any slippage in the order book would dramatically affect confidence. Equally, further order book expansion – which would increase confidence in earnings growth forecasts – would help the stocks. Wellstream should get a boost if it firms up a contract with Brazilian state oil company Petrobras to supply flexible pipeline for deep water developments in the prolific Santos basin.

It is not so much the size of these backlogs that is important, but the rate at which they are growing.

There does not appear cause for concern in this area just yet. In Wellstream’s case the backlog increased by 42% on the same period last year to £295 million, a figure which already represents two-thirds of next year’s consensus forecast for sales. Petrofac announced alongside its results it had managed to grow its backlog of orders by 9% to a total of $4.8 billion, which is more than the £2 billion consensus sales forecast for 2008. Middle East-based rig refurbishment specialist Lamprell (LAM:AIM) has said its order book at June 30 was about $890 million, up 62% from the backlog seen at the end of April.

Broker Goldman Sachs estimates backlogs for the European oil services companies under its coverage will increase both this year and next, although it expects growth to be slower for 2008 (see chart, right).

Goldman observes there have been fewer contracts awarded on major offshore developments this year, particularly in west Africa but also elsewhere in the world, as governments have sought to renegotiate the terms of access to reserves as the crude price has risen. In fact, while the broker forecast in April 25 projects would be sanctioned, this year only three have been approved since that prediction was made. Goldman’s analysis also reveals the sector’s backlog actually fell as a percentage of revenues last year, even if it increased in absolute terms, although encouragingly this situation is expected to improve in 2009.

Confidence tricks

Backlog growth and macroeconomic sentiment are therefore the keys to the sector for the rest of 2008 and beyond. Greater confidence in the idea a ‘super cycle’ in commodities will continue and is required to help drive the stocks onward, although the prospect of a global economic slowdown has taken some of the gloss off this notion of late. If Shares’ assumption of oil staying around the $100 mark is correct then it is unlikely any major oil and gas projects would be cancelled.

This in turn would suggest the long-term trend for drilling activity looks strong. The Baker Hughes worldwide rig count, which is the key industry measure of the number of drilling rigs actively exploring for or developing oil or natural gas, has increased steadily over the last decade and continues to rise. The count for July increased by 292 in the 12 months to July, for a 9% year-on-year increase to 3,436.

The larger independent oil companies still have to invest in order to bolster their rapidly diminishing reserves. Nor are oil services companies likely to be marginalised in the development of projects by national oil companies, as the majors have been, because the former still require their expertise to get hydrocarbons out of the ground.

Particularly risk-averse investors might like to avoid companies which are chasing contracts for work in extremely deep water, such as Wellstream, or in the exploitation of less conventional sources of hydrocarbons such as the tar sands in Alberta, Canada, where Kentz Corporation (KENZ:AIM) recently agreed a joint venture. A drop in the oil price below $80 would threaten the commerciality of these projects.

It is also worth emphasising $100 oil is still a historically high figure. Investment bank Lehman Brothers, which is bearish on the oil price, acknowledges: ‘Even if oil prices fall from current levels in the near term, as we expect they will, we believe the economics for the most complex of developments are sustainable even in an $80 barrel world. In order to compensate for two decades of under investment, the search for hydrocarbons is likely to continue in earnest.’

Cycles of over and under investment have always characterised the industry. Companies that carry out seismic surveys for the explorers are a current example of over investment. Offshore Hydrocarbon Mapping has seen its share price decimated, with the extra capacity it has brought onstream not being taken up, though this is in part due to specific concerns over the viability of its CSEM technology.

Under-investment is exemplified by comments from Hungarian energy giant MOL’s director Laszlo Szocs, who says: ‘15% of explorations in the worldwide oil industry fail to get

off the ground for want of the necessary expertise.’

This is largely a result of the days of $10 oil at the end of the last century when the industry laid off staff on a massive scale and then made no attempt to replace them. These constraints apply to other resources such as materials, and the lack of both equipment and expertise is an ongoing problem.

A long-term imbalance between supply and demand should favour the sector and recent weakness in share prices has prompted an increase in industry merger and acquisition activity. Private equity firms First Reserve and Candover Investments have already snapped up Abbot Group and Expro International respectively and Hunting chief executive Dennis Proctor admitted last month his company has a ‘big target painted on its back’ after selling its mid-stream business Gibson Energy to a private equity group. Hunting is planning two acquisitions of its own in short order to avoid being swallowed up and Shares would fully expect there to be fewer companies to consider when we next take a detailed look at the sector.

CONCLUSIONS: Oil Equipment & Services

Risk to earnings forecasts: 3 (5=upside risk, 1=downside risk)

Earnings predictability: 3 (5=very high, 1=very low)

Valuation: 1 (5=cheap, 1=expensive)

Balance sheet strength: 3 (5=cash rich, 1=heavily indebted)

Cashflow: 3 (5=very strong, 1=very weak)

Over-owned?: 1 (5=all brokers negative, 1=all positive)

TOTAL 14 / 30

Stocks to buy: Bateman Litwin, Petrofac, Velosi

Stocks to avoid: Portland Gas, Offshore Hydrocarbon, Sov. Oilfield Gp

Total Broker Buy Ratings on Stocks: 26

Total Broker Hold Ratings on Stocks: 12

Total Broker Sell Ratings on Stocks: 1

SHARES RATING: NEUTRAL

TRADES TO MAKE THIS WEEK

Bateman Litwin (BNLN:AIM) 77p BUY

Weakness looks overdone

Shares rated the £86 million market cap as a ‘sell’ in April’s review of the sector but a further 30% plunge in the share price means the weakness now looks overdone.

A forward earnings multiple of 6 is difficult to ignore and new broom David Lamont should provide the catalyst needed to restore the Dutch company’s fortunes.

Lamont has signaled his intention to deal with the ill-advised investment in US refinery plant designer and biofuel technology firm Delta-T, which has affected both operational performance and sentiment on the stock.

July’s trading statement saw Bateman temper expectations for full-year profits, saying they would be in the range of $15 million to $20 million on revenues of more than $800 million. The caution reflected higher organisational costs and a weaker dollar. But at the same time the firm also announced a number of significant contract awards and a record high order backlog of just over $1.3 billion.

This provides increasingly good visibility going forward and the recent reversal in the dollar could even help earnings surprise on the upside now a more sensible level of expectations has been set.

Portland Gas (PTG:AIM) 283.8p SELL

Project figures do not stack up

While the company has made progress in developing its gas storage project the valuation looks lofty given the amount of work left to do.

The £217 million market cap has secured planning permission for both the development of its planned gas storage facility underneath the Isle of Portland in Dorset and construction of the pipeline necessary to transport the gas into the national network. It must now bring in a farm-in partner to provide the financing for the scheme.

Given the importance of energy security there is clear demand for greater gas storage capacity in the UK. But the challenges associated with developing and successfully bringing onstream such a complex project are significant and require huge amounts of capital – Portland itself estimates at least £500 million.

Portland says it will require any farm-in-partner to pay 100% of the costs for a 50% equity stake in the project. Tim Heeley at Daniel Stewart believes this to be unrealistic and says the current share price trades at a significant premium to his discounted cashflow model of the project. Heeley adds a farm-in partner will be unlikely to adopt anything greater than a 70% capex exposure as it would otherwise be unable to break even on its investment, according to his assumptions.

In the circumstances the best way of realising value for shareholders may be to sell the business, and a takeover is the main risk to bears on the stock.

Offshore Hydrocarbon Mapping (OHM:AIM) 31p SELL

Too much, too soon

The beleaguered seismic company is suffering after bringing on too much capacity too soon. Last year the £13 million market cap signed an agreement with seismic specialist and industry giant CGG Veritas to help market its controlled source electromagnetic (CSEM) technology. OHM also doubled its fleet, adding another survey vessel, which it has now been forced to sub-charter to reduce costs, with utilisation rates for its two vessels remaining unacceptably low.

CSEM is used in conjunction with other seismic techniques to increase explorers’ understanding of the sub-surface and ultimately where they will have the best chance of discovering oil.

OHM’s share price has sunk to a record low of 31p, down almost 90% from a year ago, after a string of profit warnings. Prior to these alerts, the company had been predicted to make a maiden profit this year but a trading statement earlier this month (2 September) revealed the £13 million cap now expects to post a pre-tax loss of at least £9 million, compared with a loss of £1 million a year ago.

The group also warned full-year revenue may miss forecasts by more than 20%, with management admitting uptake of its technology was ‘frustratingly slow’. At least a net cashpile of £8 million will offer some support, although this could be eroded by any further future losses.