Energy-Service Profits To Slow

, Apr 18, 2007 (From the Wall Street Journal via Dow Jones News)

U.S. energy-service companies are expected to report a slow increase in first-quarter profits, further evidence that the sector's four-year boom on the back of surging commodities prices has ended.

While analysts and the companies they cover agree that the fading North American market is responsible, no consensus has formed on the duration and depth of the drop in profits.

Halliburton Co., the largest oil- and gas-field-services firm by North American revenue, and Nabors Industries Ltd., the largest driller in the U.S. and Canada by fleet size, set the tone for the quarter when both warned in March that first-quarter earnings would come in below Wall Street expectations. While disappointing results last quarter from Baker Hughes Inc. and BJ Services Co. came as a surprise to many investors, analysts are cautioning that nearly any company with significant North American operations could be vulnerable this time.

"We see more art than science at this point" in predicting who will best weather the downturn, said Alan Laws, a Merrill Lynch analyst, in a research note. "A softening [North American market] shouldn't be a big surprise to anyone, although the magnitude may ultimately be troubling."

Companies tilted toward oil are seen faring better than those with a focus on natural-gas production. International and deepwater markets remain strong, meaning companies with a smaller North American presence, such as Schlumberger Ltd. and offshore drillers, including Transocean Inc. and Noble Corp., are more likely to continue reporting a strong increase in profits.

The prospect of a downturn has haunted the services sector since early 2006, when gas prices stabilized between $7 and $8 a million British thermal units after a four-year climb. A labor and equipment shortage allowed service companies to continue charging boom-era rates, eating into producers' margins and leading to a sharp pushback on pricing at the end of last year. Even the most optimistic companies complain of falling prices and a stagnant amount of drilling activity.

"'A pause' is probably the best way to put it," said Poe Fratt, an analyst with A.G. Edwards in St. Louis. "If natural-gas prices are $8, it'll end up being not that long before drilling activity is back up."

Energy producers, however, say they won't be quick to give up the pricing power they have regained during the last couple of quarters. Several of the largest North American operators cut back on their 2007 exploration and production budgets and have vowed not to consider additional spending unless gas prices rise sharply to justify it.

"There is a margin in every business," said Apache Corp. Chief Executive Steven Farris. "In 2006, we gave the margin that we got in 2005" to the service companies, but in 2007 "costs are going to go down."

The service companies maintain that they continue to hold onto some leverage even in a declining market because many U.S. and Canadian fields are nearly tapped out, requiring constant exploration and servicing to maintain production levels.

"Investors will have to come back into the market if they want to maintain production levels," said Don Herring, managing director of the Canadian Association of Oilwell Drilling Contractors.

Both service companies and producers agree that it will take at least until the second half of this year for the market to sort itself out. Anecdotal evidence points to a decline in service prices, but gas futures closer to the $8 end of the current trading range in recent weeks could have some producers thinking about diving back into the market, Mr. Fratt said.

The slowdown in drilling activity is varying between the U.S. and Canada, and even within specific regions in the two countries. The number of rigs operating in Canada is down significantly from last year. But last week, Baker Hughes, of Houston, reported 32 more rigs operating in the U.S. than the previous week, and 148 more than a year ago.

While all eyes are on North America to separate the first quarter's winners and losers, the next boom-and-bust cycle is more likely to be determined in Siberia than Saskatchewan.

Today, three of the top four service companies earn 40% or more of their revenue from North America. But that makeup is changing rapidly, with service companies such as Weatherford International Ltd. reporting double-digit expansion in demand from the Eastern Hemisphere and Latin America, even as the U.S. treads water and Canada declines.

"Within a year they're going to have much more of a weighting toward international markets," said Mr. Fratt.

Copyright (c) 2007 Dow Jones & Company, Inc.

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