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04/23/15 05:00:18 PM
FUND STRATEGIES

UPSTREAM CAPITAL SPENDING BEGINS DECLINE

Capital spending by upstream players is now in the early stages of a major pullback after years of steady increases. Collectively, the upstream names in S&P Capital IQ's STARS coverage universe are expected to spend about 30% less in 2015 for capital projects, based on S&P Capital IQ consensus estimates as of late March 2015. Looking ahead to 2016, total capex for this group of companies is expected to rise a modest 3%.

In 2010, the group was weighted toward natural gas. Today, as U.S. exploration & production activities have begun to focus on unconventional oil and natural gas liquids, the proportion of liquids production is on the rise and expected to hit 56% of total production by 2016, up four percentage points from 52% in 2014.

S&P Capital IQ's fundamental outlook for energy equipment & services equities is negative, due to the sudden and dramatic decline in crude oil prices, which began in late 2014.

S&P Capital IQ equity analysts expect the oil and gas industry to experience a significant decline in revenues in 2015 and focus its efforts on cost reduction and efficiency improvements. For 2016, we think the industry should stabilize but do not expect any kind of meaningful recovery. Following efficiency efforts made in 2013 and 2014, we do not anticipate that there is considerable room for further cuts (in other words, not much low-hanging fruit) and, as a result, we see margins being adversely affected in 2015 before recovering slightly in 2016. Earnings will likely weaken in 2015 and show little improvement in 2016.

The revenue stream for energy equipment & services companies depends on the willingness of their upstream customers to continue spending on oil and gas projects. That willingness, in our view, is likely to be lower everywhere in 2015 (relative to past years) but relatively better outside of North America. In international projects, long project timelines should lead customers, in many cases, to look past short-term weakness on the basis that long-term economics remain intact. Within North America, however, we see greater likelihood of spending cuts, which should weigh on rig counts and, ultimately, in production, if the cuts are sufficiently long-lasting.

Overall, the industry's balance sheets are in reasonable shape, with recent efforts to improve the balance sheet putting many companies in a position to weather the downturn.

Although valuations have decreased for individual company share prices, forward estimates have decreased even further, yielding relative valuations that are in line with historical averages or slightly expensive. From a valuation perspective, both the energy equipment & services industry and the broader energy sector are experiencing higher valuation levels based on forward enterprise value to EBITDA (EV/EBITDA) ratios. In the case of the energy equipment & services industry, first-quarter 2015 forward EV/EBITDA valuation was about 8% above the average since 2009, which we think suggests that stock prices have retreated by relatively less than EBITDA estimates have declined. Meanwhile, in the case of the broader energy sector, first-quarter 2015 forward EV/EBITDA valuation was about 48% above the average since 2009, which we think points to EBITDA estimates being slashed by a far greater degree than stock prices.

In general, S&P Capital IQ thinks the market is essentially indicating that this year is likely to be a bit of an anomaly in upstream earnings power and is thus looking past 2015. We think that if 2016 upstream earnings were being used in lieu of 2015 earnings, forward multiples would not look quite so expensive.

S&P Capital IQ has sell or strong sell recommendations on three oil & gas drillers - Diamond Offshore Drilling (DO 30 **), Nabors Industries (NBR 15 **), and Patterson-UTI Energy (PTEN 21 *) - as well as two companies in the oil & gas equipment & services sub-industry - Basic Energy Services (BAS 8 *) and Superior Energy Services (SPN 24 **).

SPDR S&P Oil & Gas Equipment & Services (XES 28 Marketweight), a $260 million ETF that trades with a tight bid/ask spread, has 73% of its assets in oil & gas equipment & services companies. The top-10 holdings for XES include NBR, SPN and PTEN. These and other holdings have below-average S&P Capital IQ Quality Rankings.

To learn more about S&P Capital IQ's views on the energy equipment & services industry, please see the recently published Industry Survey at the Sectors tab of MarketScope Advisor or contact wealth@spcapitaliq.com. Reports on the above mentioned stocks and ETFs can be found on this platform.

 

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