How OFS Stocks Predict the Oil Market

On Friday, I gave you two signals to watch out for in the energy sector recovery (see "My Two 'Forward Indicators' for the Energy Sector," October 7)—oil field services (OFS) and midstream companies.

Given the spurt taking place in the market today, I want to return to one of these "forward indicators"—the OFS sector—and discuss what has happened there over the past several trading sessions.

You'll see why I always keep an eye on these guys. . .

Remember, OFS concerns everything that happens at an oil or gas field before volume comes out of the ground. These companies provide the full range of services, from initial field exploration and seismic services to well construction and completion. OFS companies also provide essential support and well work over services while production is underway.

A pop here predicts both a rise in production, and an increase in returns for the broader sector.

Through 10:30 this morning, the price of crude oil has increased 13.4% in less than four trading sessions in New York (the West Texas Intermediate, or WTI, traded benchmark). During the same period, prices have increased 6.7% in London (for Brent, the other dominant global benchmark).

To be sure, the prices of both benchmarks have been pushed well below effective prices lately.

Still, WTI is now trading higher than at any point since September 20; and Brent since September 21.

That might indicate little more than over-concern about volatility among futures contract traders, especially in light of the two significant declines registered in short periods of time over the past several months (April 29-May 6, five sessions; and July 22-August 8, 11 sessions).

But only if you have been ignoring the signals coming from the OFS sector.

You already know that OFS stocks have gotten hammered over the past several months, as fears of significant demand construction have depressed prices.

Those fears were quite unwarranted, as it turns out.

Recently, OFS stocks are moving strongly higher across the board.

All of these indicators have preceded the current rise in crude oil prices by a full day, and have been rising more strongly than either crude oil benchmark rate or the markets as a whole.

Let's take a look.

In the last five trading sessions, the Oil Service HOLDRs ETF ( AMEX: OIH), the exchange-traded fund reflecting the broadest range of OFS providers, has increased 15.1%. The more-focused (but less capitalized) ETF PowerShares Dynamic Oil & Gas Services Portfolio (NYSEArca: PXJ) is up 20%.

Individual shares among the leading providers are also rising, and are now poised to lead the sector moving forward.

Basic Energy Services Inc. (NYSE: BAS), an OFS company that services the well-developed southwestern U.S. basins, has risen 31.2% over the last five sessions.

Meanwhile, Halliburton Co. (NYSE: HAL) is up 23%, and Weatherford International Ltd. (NYSE: WFT) has gained 21.4%.

The other two members of the "big four" OFS companies are also showing strong performances. Baker Hughes Inc. (NYSE: BHI) is up 16.8% during the week, while global leader Schlumberger Ltd. (NYSE: SLB) has improved 12.8%.

As the most internationally exposed OFS provider, SLB has been subject to some pronounced pressure arising from geopolitical events, especially the ongoing debt crisis in Europe.

And that remains one of the major factors to keep an eye on moving forward.

The Oil Market and the Europe Debt Factor

Fitch's decision on Friday to reduce the ratings of sovereign debt in both Italy and Spain is a good example of how the oil market in general—and OFS in particular—remains particularly sensitive to threats of default and downgrades.

Yet it seems the energy sector is now factoring in the likelihood that the European Union, the European Central Bank, European Investment Bank, and, most importantly, the Germans are now on the same page.

Much of the rhetoric about declining oil demand has been just that—rhetoric.

While the talking heads on TV have bemoaned the economic problems on both sides of the Atlantic among developed countries, the rise in oil demand has continued among the developing ones. And that has mitigated any real impact on global demand.

Both OPEC and the International Energy Agency have predicted that global demand will end this year at all-time highs, and will rise even further in the first half of next year.

As demand increases, there are sure to be renewed questions about adequate supply.

Consider the following. . .

Over the past three years, the top 10 producing companies in the world have replaced only about 70% of the extractable reserves they have taken out of the ground. These are not the figures loudly proclaimed in annual reports, by the way, but the volume that both available technology and market conditions justify lifting up.

With demand intensifying in places other than North America and Western Europe, the movement is already underway to increase field development.

And that's where this recent rise in OFS shares comes in.

It might look like ESP, or even magic. But remember. . .

Before the volume comes out of the ground, someone has to provide the exploratory, development, infrastructure, construction and drilling support. That's why better OFS performance always precedes better performance by oil and gas producers.

Sincerely,

Kent