Oil Services &Equipment:Thoughts from the Road

We've spent the past month crisscrossing the U.S. meeting with investors andwould like to share our perspective on the state of the oil services investor's mind.While we argue the surprise OPEC decision doesn't likely change long termfundamentals for the stocks, we can't ignore the market's near term perception of asturdier (and higher) floor for the oil price. Our conversations remain (as theyhave for well over a year) principally focused on the timing and slope of a U.S.onshore recovery in activity. Dedicated investors had grown more skeptical inrecent weeks while generalists and PMs had been more dismissive of themounting near term headwinds for the group. And while we would argue the bullshave gotten it right for the wrong reason of late, the stocks’ initial lurch higherpost-OPEC (OSX +12%, WTI +12% since Sep. 27) has been driven more by shortcovering than new longs. As the market shifts its focus to the uncertainty into (andbeyond) the Nov 30 OPEC meeting, we see the potential for a risk-off trade in 4Q.We thus recommend shifting toward more defensive stocks, while fading recentcover bids in certain names (RIG, NOV, PTEN) and taking profit on consensusNAM beta trades (BHI, FET, HP, SPN). On a relative basis, our top picks inlarge caps remain SLB and HAL; in small caps CLB, MRC and TTI.

OPEC throws the bulls a life line; what a difference a week makes. Over thepast few months, we've noticed growing uneasiness among the mostly bullishlong-only crowd as the prospects for a robust recovery in U.S. onshore activitycontinues to slip right and the realization of a narrower one that constricts OFSprofitability takes hold. Whereas confidence in a 2Q16 earnings trough waswidespread early in the summer, our discussions this fall have focused more onthe prospects for 2017 profitability to resemble 2016's (or lack thereof). Post-OPEC, we have witnessed more relief than a reassertion of bullishness in ourinvestor meetings. There are puts and takes around Saudi’s (prisoner’s) dilemmaand uncertainty over where the plan will ultimately stick, but the plain effect ofOPEC's decision to (potentially) restrict its own production is to shift thatmarket share to U.S. shale, a positive for our coverage universe near term.

Dedicated energy analysts less bullish than their portfolio managers. Asexpectations were deflating among oil services investors, we noticed a growingchasm between dedicated long-only energy analysts and their respectiveportfolio managers. Near term challenges for oil services such as 1) poorcustomer mix off the bottom, 2) lack of pricing traction and 3) anemic marginprogression have tempered OFS expectations for most energy analysts, thoughmany noted difficulty in gaining PM agreement to adopt more defensivepositions. We believe dedicated energy hedge funds had turned bearish into thefall and were positioning for a reset of 2017 (and 2018) estimates lower. Whythe growing divide The lack of attractive alternatives across consumer, tech,healthcare, etc. With a dearth of true growth stories across the broader market,PMs are more willing to wait on a potential upcycle in energy, where the mainmacro driver (oil) remains half what it was two years ago. The uptick inbullishness last week appeared more cynical to us, predicated on the hopefulnessof the crowd rather than a marked shift in fundamentals.

Consensus NAM trades remain quite crowded. OPEC’s agreement has drivenshort covering among NAM beta, perhaps leaving the remaining long positioningrelatively more crowded (since Sep. 27: SPN +28%, PTEN +22%, HP +18%, NOV+10%, FET +18% v. OSX +12%). We think shorts are hesitant to press near termahead of headline risk around the November 30 OPEC meeting, and weacknowledge the near term commodity price environment is more constructive for2017 NAM E&P budgets as they are debated this fall.

Well productivity is a key point of debate; we err on the side of more, not lessis coming. Anecdotes pointing to improved well productivity in key U.S. basinshave been plentiful of late. However, we think the potential for productivityenhancingpractices to spread is somewhat underappreciated and could act as aheadwind to pricing increases for services into next year. PXD’s v3.0 completionsin the Midland are generating 17% better IP rates compared to v2.0 (per our E&Pteam) while both CLR and OAS have used enhanced completions with higherproppant volumes in the core Bakken, with EURs up to 25% above historic typecurves. Enhanced completion uptake remains relatively low across the Midland,Delaware and Bakken (despite successful tests). Spreading best practices coulddrive better average productivity for an extended period, even if drilling starts toextend beyond the core with higher WTI prices. Though this process also boostsservice intensity per well, 10-15% average IP improvement in 2017 risksdampening the activity ramp.

BHI becoming a battleground stock. Baker has become one of the most popularstocks in our recent meetings. The market has long assigned the shares a premiumin anticipation of an eventual catch up to HAL’s earnings power. The bull case isstraight forward (if familiar): best-in-class balance sheet thanks to HAL, biggestpotential delta on costs given BHI's delayed start, and impending catalysts in theform of asset sales and activism if execution falters. We view this as "new cycle,same old Baker pitch". Bears remain skeptical of BHI’s ability to execute and notethe lack of specificity in the company’s path forward. Rather than catch its largerdiversified peers, we believe BHI is more likely to lag on growth, margins andreturns (as it did in the previous cycle). Shedding pressure pumping shouldundoubtedly help NAM margin mix, but we think investors may be overestimatingboth the resiliency of the balance product lines’ margins at this point in the cycleand their potential operating leverage in a recovery. International markets are alsolikely to offer stiffer headwinds for Baker than investors appreciate. We would beencouraged by a more aggressive divestment program in a recovery (e.g., wireline,coiled tubing) to further focus on BHI's core strengths as a product developmentand manufacturing leader. We also await more details on the company’s plans tobetter compete abroad.

Meanwhile, investors’ boycott of WFT continues; risk/reward attractive. The53% upside to our Dec-2017 PT for WFT draws many (if varied) comments fromthe buy side (v. avg –9% downside). We’ve been surprised by the stock’s lack ofparticipation in the Big Four's outperformance since June WTI top (-14% WFT v.+3% large caps, -8% OSX). Though free cash generation is no longer an existentialnecessity, it remains the bogey for most in determining whether or not WFT can be"investable" again. While we expect WFT to reset FCF guidance (again) thisquarter, the shares more than reflect it already in our view, and at 6.6x our 2018EBITDA, WFT offers one of the most attractive relative values in the group.

Consensus for offshore bottom in 2H17 still a year premature. We believe theconsensus for incremental offshore activity continues to be simply the ever hopeful“next year”, and see scope for hallmark FIDs in the GOM (e.g., APC’sShenandoah, RDS’s Vito, BP’s Mad Dog II) to slip further right and incrementalFEED studies to convert into E&C work in 2018 earliest. Continued challenges inLatAm and ongoing backlog sanctity issues (e.g., RIG’s ~25% termination feecoverage from Reliance) suggest further secular headwinds. While operator farmdowns/M&A (APC-FCX GOM sale, STL-PBR partnership, potential Maerskdivestitures) provide some hope for investment optimization, we see downsidecatalysts outweighing green shoots for now, and expect prospects to worsen beforethey get better. Still, we envision a scenario in 2H17 where we could get moreoffensive on offshore equipment (i.e., FTI-TEC, DRQ, OIS, OII), playing for ainflection in orders in 2018. For now, given the time horizon of our outlook andcurrently embedded expectations, we remain cautious.