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Oil and gas is such a big business that there is an entire industry focused on providing products and services to the oil companies. Typical services that the oil companies tend to outsource include seismic studies to find the oil as well as services related to drilling and maintaining wells. Halliburton, Schlumberger, and Baker Hughes are some of the giants of oil services.

While the oil companies themselves have long histories of high profitabil­ity, most oil services firms have had a much tougher time creating value for shareholders. This is because the services industry tends to be highly competitive, and economic moats are difficult to come by. Unlike the oil producers, the oil services companies do not reap the benefits created by the OPEC cartel.

The financials show what a tough industry oil services can be. Of the top four oil services firms "we covered at this writing, none had earned above their cost of capital over the past five-year period. Profitability tends to be only mediocre in the boom years when oil prices are high, but bottom lines have tended to dip into the red when prices "were low. The net effect has been an industry that has struggled to create any value for its shareholders.

In addition, the health of the industry tends to be extremely cyclical, with short-term demand for drilling services and equipment highly volatile and dependent on commodity oil and gas prices. When oil prices are high—as they were in 2OOO—Baker Hughes' phones are ringing off the hook with oil producers scrambling to drill more wells so they can get more oil to market while profits are high. But when oil prices tank to near $IO a barrel—as they did in 1998—demand can quickly evaporate and come to a grinding halt. Budgets for new drilling are often the first to be cut when oil companies are operating with lean cash flow. This makes the stocks volatile in the short term as the markets try to guess the next cyclical movement, while long-term investors are hampered by the red Ink typically created In the cyclical lows.

Luckily, there are some bright spots in the industry because long-run demand for advanced oil services should increase as oil companies have to dig in more far-flung places and at deeper depths to find and produce from fresh oil fields. There are also significant opportunities today in newly opened markets such as Russia and Iraq , where the reserves are large but the production technology is outdated. Although there will inevitably be some bumps along the road when oil prices are low, we expect modest long-term sales growth for the overall oil services field. But it will continue to be difficult for companies in the services industry to parlay this growth into higher profitability because profits will likely continue to be competed away.

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