Overcapacity in the Oil Services Industry? What You Need to Know

North America has been a bright spot for the oil-services industry in recent quarters, thanks to robust activity in North Dakota’s Bakken Shale and other prolific shale oil plays. In fact, North Dakota produced almost 450,000 barrels of oil per day in August, up almost 30 percent since the end of 2010. The state trails only Texas, Alaska and California in terms of annual oil output.

This incredible animation from Energy Information Administration demonstrates how rapidly drilling activity and oil output have increased in the Bakken Shale. Investors unfamiliar with these unconventional fields should consult the Oct. 20, 2010, Investing Daily article, Rough Guide to Shale Oil.

Rising oil production in the Bakken Shale and other unconventional plays has translated into a surge in demand for oil services and equipment. Depending on the characteristics of the field, a horizontal oil well in a shale formation can be up to 10 times as service-intensive as a vertical well in a conventional field. Services related to hydraulic fracturing are essential to extracting hydrocarbons locked in shale and other tight formations.

Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing oil or natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant–typically sand, ceramic material or sand coated with ceramic material–ensures that these passages remain open.

Rapidly growing demand for pressure pumping has outstripped supply in the nation’s hottest shale plays, enabling services firms to push through price increases. Rising prices and activity levels translates into fat margins and impressive earnings growth.

Though important, pressure pumping isn’t the only product category that’s benefited from rising demand and supply shortages. Management also noted that Schlumberger (NYSE: SLB) has pushed through price increases on wireline services, a product category that provides data on reservoir characteristics and the effectiveness a particular fracturing job.

Schlumberger’s strong momentum in the North American market continued in the third quarter, with revenue up 15 percent sequentially and margins surging 179 basis points in the region. These results indicate that Schlumberger is enjoying an uptick in volume and raising the prices it charges for these services.

Nevertheless, the company’s management team has expressed concern that pricing on pressure pumping eventually would peak and begin to moderate, largely because the services industry would build too much capacity. The economics in the space were so attractive that any incremental pressure-pumping capacity quickly paid for itself several times over.

These worries haven’t prevented Schlumberger from making its hay while the sun is shining. The firm has expanded its pressure-pumping capacity substantially in 2011 and has transitioned its units from 12-hour days to 24-hour days to meet demand. As a result, Schlumberger’s crews completed 20 percent more fracturing stages in the third quarter.

Until recently, Schlumberger’s caution hinged on a potential slowdown in pricing gains, as opposed to evidence that prices had moderated. But Schlumberger reported flat prices for pressure pumping had flattened in some oil- and liquids-rich plays. Management also indicated that that pricing for these services had declined modestly in shale gas plays.

Any overcapacity in this business line would show up in gas-rich formations first because many producers have scaled back their drilling activity in favor of more remunerative liquids-laden fields.

Although Halliburton (NYSE: HAL) should continue to perform reasonably well, the firm’s bias toward the North American market and pressure pumping could cause its revenue and profitability metrics to lag in coming quarters. Management’s downbeat tone during Halliburton’s conference call to discuss third-quarter likewise supports this thesis.

From early 2011 to July, shares of Halliburton outperformed those of its larger rival. However, Schlumberger’s stock has fared better since then, and I expect this outperformance to continue. For more of my outlook on Schlumberger, check out this article.

Nevertheless, investors shouldn’t extrapolate a moderation in pricing in one service line to a bearish growth outlook for the whole of North American oil services.