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Analysts warn oil services sector that rapid price hikes could stall recovery

Companies operating in the oilfield services, equipment and drilling sectors are looking for a bump up in activity to start 2019 as capital spending for exploration and production bounces back from slow growth to close out 2018. However, capital discipline will limit the economic benefits to oilfield service companies as analysts warn rapid increases in costs for services and equipment could stall the recovery.

At the end of 2018, the oilfield services sector was trading near the lowest price-to-book ratio level in the past 20 years. Many of these book values were written down during the downturn, and the stocks also decoupled from oil prices since the downturn, analysts with Evercore ISI said in a Jan. 11 note.

"In our view, this disconnect represents the economic rent paid at the expense of OFS firms, as E&Ps exacted efficiencies and pricing concessions, driving a collapse in [returns on investment capital]," Evercore ISI analyst James West said.

But the outlook for oilfield service sector businesses was improving as the fresh year unfolded, with West Texas Intermediate crude oil futures on the New York Mercantile Exchange recovering from a Dec. 24, 2018, low at $42.53/bbl to a settle at $52.59/bbl on Jan. 10.

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The crude oil price recovery prompted analysts to revise crude oil price outlooks for 2019 to a range from $50/bbl to $70/bbl for WTI and from $62/bbl to $70/bbl for Brent.

With most forecasts pointing to higher crude oil prices, capital spending for exploration and production is expected to grow by the low- to mid-single-digits in 2019, Moody's analysts said in a Jan. 3 report. "E&P companies have dramatically reduced their cost structures since 2015, and today most companies can break even, reinvest enough to sustain production, and even grow modestly in most regions with oil prices at $50-$55/bbl," the analysts said.

Historical data supports the outlook for stronger 2019 capital spending. After exhausting budgets in the fourth quarter 2018, slow growth in the first quarter should lead to higher spending in the second quarter and beyond.

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A boost in capital spending for exploration and production bodes well for oilfield service businesses, but the sector could still struggle with pricing, the analysts said. Opportunities to boost pricing should exist for oilfield service companies operating in U.S. land and international markets, however offshore markets could continue to struggle.

The U.S. onshore markets present more growth opportunities than other oilfield services markets. "The strong producer focus on low-risk, flexible and quick-payback shale assets in a low and volatile price environment should lift utilization and pricing in the oilfield services sector in 2019 while infrastructure hurdles gradually dissipate," Moody's analysts said.

Likewise, international land market activity has increased with Brent crude prices above $60/bbl during most of 2018 and the growth trend is seen continuing through 2019. However, the pace of growth will likely be slow with the recent price decline and continued competitive pressures, Moody's said.

In the offshore markets, while there has been a slight increase in capital allocation from upstream companies after four consecutive years of steep cuts, Moody's expects oilfield services activity and customer orders will increase sequentially, although pricing and earnings recovery could remain elusive.

"Producers are still deferring offshore exploration, appraisal, and large-scale development decisions, while on the supply side, overcapacity has posed a persistent threat for rig, vessel, remotely operated vehicles, helicopter, manufacturing and seismic specialists," Moody's said.

Most of the incremental drilling and development activity in 2019 will occur in shallow-water markets such as the North Sea and the Persian Gulf, Moody's said. Deepwater activity will primarily target projects that are low risk, can leverage existing infrastructure, or have relatively short cycle times. A number of large offshore gas development projects will also increase oilfield services activity in 2019, Moody's said.

While the offshore recovery will be somewhat choppy, the path to higher day rates, higher cash flow, and high net asset value is clear, Moody's said.

West said day rates have bottomed, and rig contractors are cautiously optimistic. "There is now a visible path towards higher day rates with effective utilization improving for jackups and floaters," he said.

Despite improvements, the health of the oilfield services sector is still quite weak, and while earnings are improving, a large subset of companies are still carrying excessive amounts of debt, and any sustained drop in crude prices will create stress, Moody's said.

With U.S. unemployment at record lows, oilfield service companies and their E&P customers are all seeing significant inflation in labor costs. Most oilfield service companies also need to reinvest in their operations to boost service capacity and meet customer demand, Moody's said.

"So even if OFS companies book more revenue in 2019, they may not generate significant discretionary cash flow and boost financial flexibility, which makes the sector's recovery a long, drawn-out process," Moody's said.