Halliburton’s (NYSE:HAL) stock is now down over 30% from its peak, despite strong second quarter earnings and positive guidance for the remainder of the year and into 2023. This may be somewhat confusing for shareholders, but looking at the prospects of the macro environment, Halliburton’s current performance is likely to be short lived. Beyond a looming downturn, there are a number of factors that could cause Halliburton to perform reasonably well over a 5-year time frame.
Second Quarter Results
Revenue increased 18% sequentially and adjusted operating income grew 35% in the most recent quarter. Impressive results that were only marred by a $344 million charge related to their decision to exit Russia, that depressed profits. While this is a one-time cost, it cannot be completely ignored as these types of write-downs are a semi-regular occurrence.
Frac activity increased steadily through the second quarter, and is likely the primary driver of Halliburton’s performance. Halliburton’s frac fleet remains sold out in the second half of 2022, as is almost the entire market. The market for frac services is expected to remain tight due to service company discipline, long lead times for new equipment (12 months for meaningful supply) and supply chain bottlenecks for consumables.
As should be expected in an upcycle, margins are improving rapidly as utilization and pricing increases. Halliburton points to the operating leverage in their business as a good thing, which is true when activity is increasing, but with a recession potentially looming, profits could vanish as quickly as they appeared. Halliburton has structurally removed $1 billion of costs from their business over the past few years and are targeting CapEx of 5-6% of revenue, rather than the 10-11% of previous upcycles. This better positions the company to manage any potential slowdown in activity going forward.
Net interest expense for the quarter was $101 million, which is still relatively high, particularly if revenue falls or margins compress. Since the start of 2020 Halliburton has retired $1.8 billion worth of debt and $600 million just this year. This looks set to continue and will better position the company to better manage any future downturns.
Viewed on a cash flow basis, Halliburton’s performance is also considerably less impressive, as working capital investments are consuming cash. Halliburton only generated $376 million of cash from operation and $215 million of free cash flow during the second quarter. It is anticipated that free cash flow will improve in the second half of the year though as working capital investments moderate.
While Halliburton’s recent financial performance is impressive, oilfield services is a highly cyclical industry, and past performance becomes meaningless when economic conditions are deteriorating. While consumer spending and corporate profits appear to be fairly resilient so far, a broad range of leading economic indicators are signaling a probable recession. This is likely driven by a housing boom and bust, along with excess consumer spending on goods during the pandemic leading to an oversupply.
Housing contributes approximately 15-18% of US GDP on average, making it extremely important to the economy as a whole. After a recent boom, rising mortgage rates appear to have burst the bubble, meaning a protracted period of depressed activity is likely.
Pandemic lockdowns caused a massive spike in spending on goods, which manufacturers have struggled to keep up with. In recent month retail inventories have begun to build rapidly in response to this increase in spending. If retail sales moderate, retailers will be left with a large amount of excess inventory that will take an extended period to dispose of.
Manufacturing new orders are expected to decline significantly over the next 6 months, and the Future New Orders Index is already approaching levels typically associated with recession.
There is also the prospect of slower growth in China, and what this would mean for the global economy and demand for commodities. China continues to pursue a zero COVID policy which is highly disruptive to economic activity, and is dealing with ongoing property market turmoil.
Despite a deteriorating macro-outlook, Halliburton’s CEO still believes there will be a multi-year upcycle. Miller pointed to tight markets for oil and gas, reduced demand from China due to lockdowns, below average demand for jet fuel, a lack of spare OPEC capacity and unsustainable releases from the strategic petroleum reserve as reasons to be optimistic. The supply response has been muted so far though, which has been pinned on operator discipline and regulatory pressure. While this may be the case to some extent, it also should not be overlooked that operators may not be that optimistic about short-term oil and gas fundamentals.
Halliburton continue to believe that North America operator spend will grow by 35% this year, driven by private E&Ps. Discussions with customers about 2023 capacity also continue to point towards increased demand for equipment and services, not recession, and Halliburton expect 2023 to be tighter than 2022. Halliburton expect their Completion and Production division to grow revenue by mid-single digits and for margins to improve by 75 to 125 basis points in the third quarter. The Drilling and Evaluation division is expected to grow revenue in the low to mid-single digit range and improve margins by up to 50 basis points in the third quarter.
Compared to previous cycles, operators are more focused on developing known resources and less on long-term exploration programs. While this is a positive for Halliburton, it also means that on the whole, more will be produced with less activity. This is a change that has been apparent for a number of years though, with Schlumberger selling some of their seismic assets in 2018. As regulators become more hostile towards fossil fuels and the long-term future of the industry becomes less certain, companies will prioritize current profits over future profits and current production over developing reserves.
While Halliburton remains positive, investors should bear in mind that management teams are often just as blind to future prospects as investors. Baker Hughes (BKR) is exposed to a lot of different markets to Halliburton, but their earnings call is worth listening to, to gain a less sanguine perspective on the market. Halliburton may be reasonably well positioned for the next 5 years, but their stock is down over 30% for a reason. The extent to which a slowdown destroys demand and how quickly the economy recovers afterwards will determine how much further downside there is from here.