Why is Sentiment Cooling for Oilfield Services Stocks?

It looks like the market is selling many oilfield services stocks way before May this year. For instance the fracking companies Calfrac Well Services and Canyon Services Group have been losing a few feathers lately even though CFW increased its dividend 5 fold this year while FRC announced a significant dividend increase. How could this be happening in an environment of high oil prices? The issue lies not with oil prices but with natural gas prices. I believe the market is starting to price in another cut in spending by E&P companies as record low natural gas prices linger from one month to another.

Not surprising, several companies already cut their spending substantially relative to 2011 such as Perpetual Energy (-47%), Encana (-37%) and Fairborne (-30%). Spot natural gas prices in Canada are currently enjoying the $1 handle where there’s a very small amount of companies that can make money at these levels. Furthermore, natural gas producers missed out on hedging portions of their production this year thanks to an abnormally warm winter coupled with rising production. While a reduction in natural gas drilling should be offset by a shift to oil and liquids, there’s a toll to pay. This is highlighted by the 3rd largest oilfield services company, Baker Hughes, warning of a slow Q1 as a shift to liquids from natural gas leads to higher costs and lower utilization.

Canyon Services Group

Canyon Services Group In Action

This waning sentiment towards services companies could also be indicating there’s more pain to come for natural gas weighted producers this year. In fact several analysts are expecting the US will run out of natural gas storage space this summer if forecasters anticipating a mild summer are right which will trigger another round of spending cuts by E&Ps. This summer may well see natural gas prices collapse to new historical lows in North America. The pain is already visible through several companies reporting millions of dollars in net loss for 2011 as a result of a non-cash impairment charge due to the weak natural gas prices and the related write down of the company’s natural gas reserves at year-end 2011. Wait until the banks recalculate the credit lines of these companies using current natural gas prices. This is where many of these producers scramble to divest any liquids producing properties in order to fix their balance sheet (no one would want to buy their NG properties). This will present accretive buying opportunities for financially healthy oil weighted companies.

Investors can still make money in the services sector by holding companies with a diversified geographic focus or with no exposure at all to North America such as Tuscany Drilling TID.TO 0.02 [0.00]. Better yet, I believe that with a little bit of patience, there will be a golden opportunity to buy back into this sector if prices fall dramatically this summer. The key is to target the dividend payers as the dividend will support the share price once yield hits a certain level. There has been a host of companies announcing brand new dividends this year such as CanElson Drilling, Essential Energy Services, Strad Energy Services and Savanna Energy Services Corp.

Finally, activity could flatline for the next 2 quarters on the back of breakup and a potentially mild summer (a perfect storm). While the dividend payers will keep a few shareholders around as they get paid to wait, you should have your shopping list ready in order to buy at what could potentially turn out to be bargain basement prices. Horizontal drilling accounts for at least 60% of wells drilled in North America, in my opinion any weakness in the services sector will be temporary unless the EPA decides to stop the shale revolution dead in its tracks.

If a buying opportunity appears this summer, which oilfields services stock would you buy first?