Why Oil Service Providers’ Performance Diverges From Oil Prices

After two years of negative returns for oil service and equipment companies, 2016 was finally the turnaround year. Or so we thought. Three of the four oil equipment and services exchange-traded funds posted double-digit returns in 2016, corresponding to a strong acceleration of oil prices. From $35.97 per barrel at the start of the year, WTI finished the year at $52.82 per barrel, a 46 percent gain that helped stabilize the free fall that started in 2014.

But 2017 has not been as kind, as the four oil equipment and services ETFs are down on average about 14 percent year to date. Was 2016 a fluke?

The price of oil has remained relatively stable by hovering in the low-$50 per barrel range this year. Although ETFs that track the price of WTI have moved lower in 2017, the price deterioration experienced by the equipment and services providers has been more severe, surprising investors. What is causing the divergence between the price of oil and the performance of the oil equipment and services providers?

Predicting the long-awaited recovery, analysts have become increasingly positive on the oil industry. A recent note from Bank of America analyst Timna Tanners, citing data from Spears & Associates, said global capital spending by oil exploration companies for equipment and services is expected to increase 89 percent in 2017 and 71 percent in 2018, supporting a U.S. land rig count that is forecasted to grow over 60 percent in 2017.

These data, together with the November agreement between OPEC and non-OPEC members which appears to support an oil price floor of $50 per barrel, are positive signposts for the equipment and services providers. It seems, though, that the market had somewhat anticipated these in their price push last year.

The climb up, though, especially from such depressed levels, is rarely linear. While the price of oil may have recovered and stabilized so far this year, the equipment and services companies, who were forced to accept prices below their cost levels during the downturn, are still struggling to push prices higher and recover margin. A McKinsey & Co. report said, “…manufacturers have indicated they are likely to push prices up and recover some of the lost ground as soon as activity increases.”  

ClearBridge analyst Dimitry Dayen agrees. “As activity increases, service margins should begin to normalize as these companies claim their fair share of the economic rent of oil and gas production. Pricing for pressure pumping is up as much as 30% from recent lows while prices for land rigs, drilling fluids and most other services are also rising.”

However, he cautions in his March note, “There is a lag before service providers can pass on this inflation to their customers.” As a result, there is a gap in market performance.

Investment Options

Investing in the oil equipment and services sector paid off in 2016 and could provide some diversification in energy exposure. The four ETFs that ply this space all feature concentrated holdings since the universe of available securities is rather limited.

The VanEck Vectors Oil Services ETF (OIH) replicates the U.S. Listed Oil Services 25 Index. Composed of U.S.-listed oil service, equipment and drilling companies, this $1.1 billion fund has an expense ratio of 0.35 percent. Currently holding 26 securities with about 92 percent in U.S. stocks, the fund has an average market cap of just over $3 billion, according to Morningstar. Trading at a slight discount to net asset value, this ETF offers a dividend yield of 1.5 percent. The fund is down about 13 percent year to date.

The SPDR S&P Oil & Gas Equipment & Services ETF (XES) tracks the equal-weighted S&P Oil & Gas Equipment & Services Select Industry Index that is 93 percent U.S.-based. And like OIH, it has a bias toward small- and mid-cap stocks and an expense ratio of 0.35 percent. Trading at a slight discount to NAV, XES pays an annual dividend yield of 0.52 percent. Its year-to-date performance is negative 17 percent.

The iShares U.S. Oil Equipment & Services ETF (IEZ) offers access to U.S.-based oil equipment and services stocks by tracking the Dow Jones U.S. Select Oil Equipment & Services Index. This $239 million fund holds 37 positions with a focus on small- to mid-cap U.S. stocks. Its expense ratio of 0.44 percent is higher than both OIH and XES, but still slightly below the category average of 0.47 percent. Trading at a slight premium to NAV, IEZ pays a dividend yield of 0.84 percent. The fund has lost 12.65 percent so far this year.