2017 began on a solid note for the oil and gas industry, as commodity prices showed signs of recovery on the back of 1.8 million barrels per day (bpd) of production cuts implemented by the Organization of Petroleum Exporting Countries and some Non-OPEC members. While this led to a strong rise in drilling and exploration activity worldwide, the world’s largest oilfield services company, Schlumberger has not fared as well year-to-date.

Despite showing improvement in its quarterly results, the company’s stock has dropped more than 25% since the beginning of the year, underperforming the 10% rise in crude oil prices during this period. The major reason behind this underperformance has been the company’s fairly weak outlook for the drilling markets in the coming quarters. Below, we discuss the rationale behind Schlumberger’s outlook for the drilling markets, particularly the North American markets, and its impact on the company’s valuation.

U.S. Oil Production To Grow, Capital Investments To Decline

The announcement of OPEC supply cuts in November 2016 caused oil prices to surge, with WTI prices trading in the $50-55 per barrel range in the early part of 2017. Consequently, U.S. oil and gas producers, many of whom found it uneconomical to produce oil at sub-$50 per barrel levels, began to expand their operations to leverage the rising commodity prices. This led to a rise in demand for drilling and exploration activities, resulting in a steep improvement in the U.S. rig count – both oil as well as gas – in the first half of the year. As a result, oilfield services companies such as Schlumberger witnessed a boost in their profitability in the first six months of the year.

However, as the year progressed, the company’s management came to believe that the growth in U.S. drilling demand in the first half was not sustainable in the long term. This is because, while the profitability of U.S. oil and gas companies improved over the last few quarters, their cash flows have remained under pressure. Accordingly, many are now focused on generating higher financial returns and operating within their available cash flows, rather than chasing production growth. In other words, the appetite to invest in exploration and drilling activities is expected to be low in the coming quarters.

Accordingly, Schlumberger expects the North American drilling markets to continue to expand going forward, but at a slower rate compared to previous quarters this year. And while it likely makes sense to be fairly conservative given the aforementioned factors, investors have penalized the company’s stock significantly over the last few months.

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