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3 Stock Picks in the Oil-Services Sector

Matthew Coffina, CFA
Robert Bellinski, CFA

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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Coffina: That sort of gets to what I think is an important point: Even though this is cyclical business, we think there are some pretty strong secular growth tailwinds. Could you go into a few of those and what you see as an earnings-growth trajectory for these companies over, say, a five- or 10-year time horizon?

Bellinski: Like you said, there are a number of drivers that we see playing out in the marketplace. First is deep-water [drilling]. This is something that has a long cycle time. There is a lot of investment needed that will benefit the oilfield-service companies. It's very capital intense for the producer. Second would be unconventional [oil]. The [exploration and production companies] and the majors that are in unconventional in North America continue to have to spend additional dollars in order to keep volumes growing.

Then, the third is kind of a wild card, which is Mexico. The country has undergone some energy reforms, which have opened up opportunities for new oil exploration and development in the country. All of these things added up, I think that it's not unreasonable to expect earnings growth on an average basis of double digits. Let's say in the teens every year.

Coffina: Why should investors focus on oil services as opposed to other parts of the energy value chain--for example, the oil majors or smaller exploration-and-production companies?

Bellinski: Well, I think it's important to remember that relationship: that the oil producers or the oil majors, their capital spending equals the revenue for the oilfield-services companies. It just depends on which team you want to be on. And here at Morningstar, we think that oil is becoming increasingly difficult to find and increasingly more expensive to produce. As a result, we think that's a great tailwind for the oilfield-services companies that they should benefit from.

Coffina: Thanks for joining me, Rob.

Bellinski: Glad to be here.

Coffina: In conclusion, energy is one of the few sectors that's out of favor right now, but we think that leading oilfield-services companies have wide economic moats, based on their intellectual property. The increasing complexity and capital intensity of oil and gas drilling is creating significant opportunity for these companies over the next five or 10 years, regardless of where the cycle takes us in the near term. So, our top picks, all wide-moat firms, are Core Labs, Schlumberger, and National Oilwell Varco.

For Morningstar StockInvestor, I'm Matt Coffina. Thanks for joining us. 

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