U.S. crude oil closed at $48.06 per barrel on Wednesday, nearly reaching a 4-month low as the market appears to discount the credibility of any OPEC output cut extension talk. Despite current weakness in the oil price, Moody’s published a report on Monday calling for a recovery in the global oilfield services (OFS) and drilling sectors on revised expectations for upstream spending. (See also, Are Contract Drillers Recovering?)

Moody’s is most bullish about the sector’s improving operating margin and an expansion of upstream drilling budgets. They go on to say that oilfield activities are expected to accelerate in the U.S. and Canadian markets and stabilize in most onshore international markets. Baker Hughes released its weekly report last Friday showing that the number of U.S. oil rigs surged by 14 to 631, the highest level since September 2015, in the week ended March 17, the ninth straight week of increases.

Moody’s may be a bit early with its call, coming at a time when the Wall Street Journal reports that Royal Dutch Shell (RDS.A) is trying to pioneer offshore drilling at a fraction of the cost. Shell believes it can be profitable with oil trading at $60 per barrel, as it has cut drilling costs by 50% and drilling times by 30%, the Journal says. Moody’s does concede in their report that, “in deepwater and ultra-deepwater markets, reduced investments and project deferrals are likely to persist at least through mid-2018.”

What Do Valuations Tell Us?

Looking at the big three OFS providers, Schlumberger (SLB), Halliburton (HAL) and Baker Hughes (BHI) may offer some clues. Share price performance for these names has been fairly robust over the last twelve months, especially for Halliburton, with a total return up 39.95% and Baker Hughes up 29.74%. These are both in excess of the sector’s largest ETF by assets under management, the VanEck Vectors Oil Services ETF (OIH), which is up 11.57% over the same 12-month period.

Valuations seem stretched at these levels. For example, the forward 2017 price-to-earnings (P/E) ratios for Baker Hughes is 145.3x, while Schlumberger is 43.3x and Halliburton is 43.7x. Despite these lofty valuations, analysts still see upside in these stocks.

Out of the 39 analysts covering Halliburton, for example, 36 have a buy recommendation on the stock with an average price target of $64.30 per share, or 27% upside potential. Citigroup reiterated an “overweight” rating on the stock on March 11th. Baker Hughes has 32 analysts covering the stock with 19 buy ratings with average upside potential of 16%. Finally Schlumberger has 38 analysts covering the stock with 31 buy ratings and 23% average targeted share price upside potential. In February 2017, FBR & Co rated Schlumberger “outperform” and increased the price target to $105-107 per share.

The Bottom Line

The OFS sector is undeniably healthier than it has been over the past two years following the crash in oil prices and many companies filing for bankruptcy, defaulting or restructuring debt. With oil prices again very volatile and trending lower, it may be a bit soon for Moody’s to be calling the bottom in the sector. Upstream budgets are easily amendable, and as Shell has demonstrated, the large producers are working hard to take costs out of the value chain. Moody’s says they would need to see EBITDA grow in excess of 10% in the next 12-18 months for them to be more positive on the sector. They may have to wait a bit longer than that if oil prices continue downward or remain volatile.

Disclaimer: Gary Ashton is an oil and gas financial consultant who writes for Investopedia. The observations he makes are his own and are not intended as investment advice. Gary does not own any mentioned stocks or ETFs.

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