Passing on Cactus and NexTier Oilfield Services

Today, we're going to look at a couple of companies that operate in the oil and gas equipment and services space.

In general, "green dot" stocks are going to be pretty hard to find here. It is extraordinarily difficult to build durable competitive advantages in commodity markets, leading to below-market returns on invested capital. Oil and gas prices are also notoriously volatile. This causes wild and unpredictable swings in revenue for these companies, in turn presenting serious business challenges, even the risk of bankruptcy for firms with lots of debt.

There are a number of oil and gas stocks showing up in the Green Screens right now. The reason is simple: the Russia-Ukraine war, and the subsequent shunning of Russian oil and gas from Western energy supply. This shock to supply has caused a sharp jump in oil and gas prices. While oil spent most of the stable 2017-2020 period trading between $45 and $70, in 2022 it soared to over $110 for much of the first half of the year.

It will be a while before Western countries rely on Russia for energy supplies again. The fallout has been a scramble to increase supply from more "reliable" partners, which includes the U.S.

On the other hand, oil prices have fallen back into the $70s recently, as commodity investors weigh the risk of recession over the next year. This illustrates my key issue with investing in the space - oil prices are impossible to predict with any accuracy!

Nevertheless, let's take a look at a few firms that are benefiting from these developments.

Cactus (WHD)

Cactus sells equipment and services for drilling and completing hydraulic fracturing wells, primarily targeting U.S. producers.

In addition to commodity price challenges, equipment is a competitive market, with established players like National Oilwell Varco (NOV) and ChampionX (CHX), among others. Political sentiment against fracking (and oil in general) represents another major risk.

Despite this, Cactus has performed excellently. Since going public in 2018, its stock has absolutely crushed the performance of oil as a commodity, the oil suppliers index (OSX), AND the S&P 500! In its niche of wellhead equipment (hence the WHD ticker), Cactus has gained market share every year since its founding, now holding a leading 42%. The company's adjusted EBITDA margin of over 30% embarrasses its competition, who live more in the 10-12% neighborhood.

It is a really impressive company in a really tough industry. How has it done it? Great leadership. Scott and Joel Bender (2 brothers) founded the firm in 2011 and still sit as CEO and COO today. Scott's son Steven is SVP of operations and a natural candidate to inherit the business. The firm has succeeded by focusing on a particular niche that represents a relatively small part of overall drilling cost, but can deliver large increases in completion time, safety, and environmental friendliness. By going for quality in this niche, the firm has been able to charge higher prices and earn out-sized economic returns.

I'm passing simply because this is a really, really tough industry with a lot of unpredictable challenges, many of which are outside of the company's control. The competitive edge here is based on great leadership and business strategy, which are not particularly durable advantages. Still, if I was forced to buy an oil and gas equipment stock, Cactus would be a top candidate.

NexTier Oilfield Services (NEX)

NexTier Oilfield Services also operates in the hydraulic fracturing oil and gas extraction space. Instead of selling equipment, though, this firm sells services, basically allowing clients to contract out some of their operational needs to NexTier. They also operate mainly in the U.S.

NexTier Oilfield Services gets rejected for a similar reason: it relies too closely on oil prices to drive business. In 2020 and 2021, when oil prices were sub-$70, NexTier was unprofitable and cash flow negative. Recent high oil prices are unlikely to last for long, and indeed have fallen quite a bit since the summer. In more "normal" times, NexTier is barely an economically sustainable business.

Also, unlike Cactus, NexTier has not been a particularly well-performing company. It has been built on an acquisition strategy and has mediocre returns on capital even in good times. Since 2017, the stock is actually DOWN 55%, trailing oil, the OSX, and the S&P 500. There's just not a whole lot to get excited about here. NEX is an easy pass.