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By Matthew Coffina, CFA and Robert Bellinski, CFA | 09-23-2014 10:00 AM

3 Stock Picks in the Oil-Services Sector

The increasing complexity and capital intensity of oil and gas drilling creates significant long-term potential for these undervalued wide-moat companies, says Morningstar's Rob Bellinski.

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Rob Bellinski, who is an equity analyst on our energy team. We are going to talk about the oil-services sector. Rob, thanks for joining me.

Rob Bellinski: Thanks for having me.

Coffina: So, it's hard to call any sector out of favor these days; but if any sector is out of favor, it's got to be energy--in the last couple of weeks, at least. What do you make of the recent weakness in crude prices? How does that compare to your long-run forecast for crude prices? And more importantly, what does this mean for oil-services companies?

Bellinski: So, there are a couple of factors--both supply and demand--that are weighing on oil markets. Right now, we continue to see additional supply from the United States as unconventional [oil] pushes additional barrels into the market. We're also seeing Libya production come back online, which is increasing supply. On the demand side, China and emerging markets are seeing fears of weakness in their economies, which is pulling down demand.

I will say, though, that both WTI and Brent are trading right around our long-range forecast of about $90 per barrel for WTI and about $100 per barrel for Brent. As far as what this means for oilfield-service companies, obviously higher oil prices are better because higher oil prices translate into higher spending for the producers, which then turns into revenue for oilfield service. At the same time, though, a dip--even if it's $10 or $15 a barrel--is not going to crush their earnings in the near term because the producers are hedged and they can supplement with borrowing costs, which are very cheap right now.

Coffina: Undervalued wide-moat stocks are extremely hard to find right now, but you actually have three of them on your list Schlumberger (SLB), National Oilwell Varco (NOV), and Core Labs (CLB). We actually own the first two of those in StockInvestor's Hare portfolio. What's behind these companies' wide moats?

Bellinski: There is a lot of intellectual property in oilfield services, and the real driver of the moats for all three of these companies would be the intangible assets. Schlumberger spends an incredible amount on [research and development]. NOV has done over 200 acquisitions and has also rebuilt how we think about oil rigs and how they work. And then Core Labs has not only a geologic database and a warehouse full of core samples from different geologic basins around the world but they also have a staff of over 1,200 scientists--far greater than anyone else.

In addition to intangible assets, we also see switching costs for Schlumberger and NOV. It's very difficult to replace them once you start working with them. And we see a network effect with Core Labs, where they'll do multiclient reservoir studies. And the more clients that sign up for those, the more valuable they become.

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