TheChek News Flow

Concentrated oil services sector looks to shrink, again

The best way to think of oil services companies: a levered bet on the marginal cost of oil production relative to the price of oil. And with oil prices falling sharply, it is no surprise this concentrated industry is looking to shrink again as Halliburton and Baker Hughes hold deal talks.

Explorers use the expertise and equipment of companies such as Halliburton, Schlumberger, Baker Hughes and Weatherford to get oil out of the ground. If explorers can’t make it economical to drill, there is no need for support services. Since peaking in July, the shares of these four services companies have fallen by an average of 24 per cent.

The companies’ tone in their third-quarter conference calls was oddly bullish. Even with slowing global GDP, Halliburton and Schlumberger predicted that oil demand would remain healthy, citing International Energy Agency world oil demand growth expectations of 1 per cent in 2015. The recent price collapse has been a function of excess production, they asserted. But the supply glut could reverse quickly because of risk in Iraq and Libya.

The US is the main cause of the service companies’ underperformance. Ninety per cent of worldwide oil supply growth in the past three years has come from the US. This had been a boon to the companies because of the complexity of recovering that oil from “unconventional” shale deposits. Third-quarter results from US explorers made clear that cash concerns will curtail investment. Credit Suisse has lowered its US oil rig count estimate by 15 per cent for 2015.

Still, the bank forecasts oil production will pick up in 2016, as 2015 supply cuts leave demand unmet. With Baker Hughes’ current forward earnings multiple down 36 per cent from its peak, it is understandable why Halliburton would come knocking. Why Baker would sell at this moment is less clear.

Abengoa’s Q3 key metrics fell considerably short of our expectations: E&C new orders came in at

EUR653m (0.6x book-to-bill), 23% below our estimate, while E&C revenues and EBITDA

contracted by 5% and 21% y/y respectively, below our estimates by a considerable 15% and 32%.

Given the decline in E&C revenues in Q3, we take Abengoa’s reported corporate FCF of

EUR164m with a degree of caution. Following yesterday’s 6% cut to the FY14 group revenue

target, the only two silver linings were in our view the order pipeline of EUR27bn Abengoa has

identified for the next four months and management’s expectation that E&C margins will be

stronger in Q4 14.

Key positives and negatives

Positives: (1) Abengoa’s identified order pipeline of EUR27bn, some of which management

expects to convert into firm orders over the next four months; (2) Management upheld yesterday its

target for FY14 corporate FCF (ex-disposals) to be >0, despite the negative FCF of EUR712m in

9M14; (3) The Biofuels’ EBITDA margin of 13.6% in Q3 14 (c.2x our estimate), though Abengoa

does not expect to sustain this level of profitability in the medium term.

Negatives: (1) 6% cut to FY14 group revenue target, to EUR7.4bn-7.5bn; (2) The order intake of

EUR653m (23% below our estimate), which was the lowest since Q1 12; (3) The sudden

contraction in E&C’s EBITDA margin to 13.5% in Q3 14 (vs. 17.7% in H1 14 and our 17.0%

forecast for Q3 14); (4) Abengoa reduced its disclosure in Q3 14, with no consolidated CF

statement or calendar of engineering works on own concessions made available.

Maintain Underperform

We appreciate that Abengoa’s potential as both an engineering and concession owner group has

increased through Abengoa Yield. Nonetheless, to turn more positive on the shares, we will need

to see more evidence of sustainable FCF generation at the corporate level.

- ALU will be profitable this year (FY14 consenus EPS is -$0.03e)

- Seeing massive demand for our products from internet, cable, and finance companies

- Have done what is necessary on cost reductions

- US fundamentals remain strong