The future is offshore and in deep water

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1 This is for investment professionals only and should not be relied upon by private investors INVESTING FROM THE BOTTOM UP MAY 211 The future is offshore and in deep water Our Investing from the Bottom Up series lifts the bonnet on Fidelity s research engine to provide an insight into the investment process from the bottom up, using case studies of specific stocks, which are widely-held by our investment managers and representative of some of the key themes driving sectors and markets. In this episode, we look at the prospects for the oilfield services industry given rising demand and constrained supply of the world s most important industrial resource. We highlight a specialist contractor, Saipem, outlining the investment rationale behind our positive rating on the stock, and pick out other beneficiaries of a bullish sector outlook. Case study stock: Saipem Category: Oilfield Services. Revenues (21): 11,16 million Euros, up 8.4% from 29. Operating profit EBIT (21): 1,319 million Euros, up 14.1% from 29. Thematic driver: increased demand for oil from industrialising nations is constraining excess supply and supporting a higher oil price that spurs the development of marginal fields in more challenging locations, such as deepwater. Other beneficiaries: Transocean, Noble Corporation, Halliburton, Schlumberger. Source: Saipem Annual Report 21. * For an explanation of industry terms, see the glossary at the end of this document. AN OUTPERFORMER... STOCK CHECK: SAIPEM Saipem is a leading global oilfield services contractor to the oil & gas industry. It specialises in delivering complex projects in the most challenging industry areas, such as offshore deepwater and Arctic environments.* Saipem was established as an autonomous subsidiary of ENI in 1969 (ENI continues to own 43% of the shares). Head-quartered in Italy, the company employs over 4, people globally, with sizeable service bases in emerging markets such as India, Nigeria, Saudi Arabia and Indonesia. STOCK STORY SYNOPSIS: A FOCUS ON OFFSHORE DEEPWATER Saipem is the largest oilfield services company in Europe; it enjoys a highly competitive position in the provision of EPC/EPIC* (engineering, procurement, installation and construction) services to the oil industry both onshore and offshore, where there are very high barriers to new entrants. At the end of the 199s, Saipem began to strategically focus its business towards deepwater, investing heavily in the latest deepwater vessels. The primary areas of focus were deepwater drilling, deepwater field development, floating production storage and subsea robotics. The acquisition of Bouygues Offshore in 22 also boosted the company s offshore asset base. In 26, Saipem began to invest heavily (around 8 billion) in building the next generation of Ultra Deep Water drilling and subsea construction vessels an area where tightness in the market now makes it particularly well positioned to reap the rewards of that strategy. Also in 26, Saipem responded to the recent industry trend towards large onshore projects, by acquiring Snamprogetti, a leading onshore contractor with particular expertise in gas monetisation and heavy oil extraction. Saipem s focus on the most technologically challenging projects (in remote areas, deepwater, stranded gas and heavy oil) is a distinctive feature, particularly in the context of a high oil price (Brent > $1) that makes these ventures commercially viable. Another striking feature of the company is its very strong local presence in emerging areas such as West Africa, North Africa, the Former Soviet Union, Central Asia, Middle East, and South East Asia. This allows the company to complete many of its projects cost effectively, with a high level of engineering done locally. A STRONG EARNINGS GROWTH RECORD Saipem FTSE W Europe Equity Index (total return) Share price (Euros) SAIPEM SAIPEM - 12MTH FORWARD EPS Month Forward EPS 5 5 May-9 Aug-9 Nov-9 Feb-1 May-1 Aug-1 Nov-1 Feb-11 May-11 May-9 Aug-9 Nov-9 Feb-1 May-1 Aug-1 Nov-1 Feb-11 May-11 Source: DataStream, as at Source: DataStream, as at

2 INVESTMENT RATIONALE: IN DEPTH Saipem is in a strong position to reap the rewards of its focused strategy to expand its offshore capabilities. I think the company is well placed to deliver earnings significantly higher than the market is expecting. Ed Ross, oil sector analyst The investment case for Saipem is built upon deep proprietary analysis of stock-specific, oilfield sector and oil industry drivers. Our analyst team believes that Saipem can beat conservative consensus earnings growth forecasts, which seriously underestimate the growth potential of its offshore construction business. This view is based on detailed industry and offshore fleet analysis which suggests that offshore activity will grow strongly, yet companies will face bottlenecks in getting access to deep water vessels and equipment over the next few years. First, our field production model highlighted that oil production from ultra deepwater locations was going to have to grow significantly to maintain the world s oil supply. The vessels required to develop these challenging fields are highly specialised and quite different to those used in conventional waters. Our analysts then created a proprietary deepwater demand model; this suggested that day rates will increase from 212 and remain tight for the next two years. Extending the analysis up the value chain by looking at deepwater drilling rig contracts for the oil majors, our research then revealed that Petrobras was still undersupplied in terms of deepwater rigs versus production forecasts. Saipem is my key pick in the oil sector and a good example of the type of stock that I favour. Capable of delivering strong earnings growth, the company benefits from its position in ultra deep water vessels, an area in which strong activity is expected given the current and expected price for oil. Alexandra Hartmann, portfolio manager, Saipem s management team recognised the developing shortage of ultra deepwater assets and made a strategic decision to focus heavily on the offshore deepwater area, in which it has considerable specialist expertise. In 26, the company launched an 8 billion investment programme that was aimed at reinforcing and expanding its drilling and construction fleet in order to meet the specific challenges of extracting hydrocarbons in ultra deep waters and frontier areas. Subsea construction currently accounts for around 5% of the company s profits. But, overall profits look set to grow handsomely as Saipem is well placed to fill surging demand for deepwater equipment. A good example of Saipem s state-of-the-art offshore fleet is the FDS2 (see graphic) - a new field development ship for use in deepwater that includes a dynamic positioning system and a 1 tonne capacity crane; it is expected to be 1% utilised like FDS1 and is already contracted to go to Brazil to install pipelines for the new pre-salt fields. Similarly, the Castoro 1 is a new ultradeepwater pipe-line laying vessel which is expected to be able to lay 6km of pipe per day twice as efficient as the nearest competitor. SAIPEM S UDW FLEET: THE FDS2 FIELD DEVELOPMENT SHIP THE OIL PRICE IS ULTIMATELY DRIVEN BY MARGINAL COST Source: Saipem company website. Source: Horizon Oil and Cambridge Energy Research Associates (CERA). April 29. The underlying demand for oil from China is something everyone should be worried about. China is going from 9m barrels a day to 15m in 4-5 years. That s 6m barrels. Where s it going to come from? John Hofmeister, former president of Shell USA

3 In the onshore area, management has successfully integrated Snamprogetti into its engineering business and invested heavily in strategically located developing countries; the result is a unique contractor with enormous in-house engineering capabilities that is able to win a huge range of contracts globally, including the largest and most complex projects. Through its vast grid of offices, engineering centres, fabrication yards and logistics bases, Saipem is able to cope with all aspects of engineering and construction activity, onshore and offshore. While its industry peers tend to have around 5% of their own people on a project and use contractors, Saipem does around 15-2% of contract work using its own resources. This allows it to take on the most complex work itself and use smaller, lower cost contractors for the rest of the project. It has also encouraged its engineers to design solutions that are easy to build in remote locations and are made up of standardised components. Our analyst team expects orders to accelerate this year as oil majors sanction projects for delivery in Using history as a guide, we believe Saipem could trade on a multiple of up to 2 times 213 earnings as the oil sector goes into an up-cycle and the order backlog builds faster than revenues. Indeed, the company is already bidding for over 2 billion of projects that it has a good chance of winning due to its competitive advantages. And this is just the tip of the iceberg; there are many more contracts to come that Saipem can win. We believe the strong likelihood of a backlog building up will give tremendous visibility on earnings and warrant a higher stock rating. LONGER-TERM DRIVER: THE OUTLOOK FOR OIL I favour businesses that have competitive advantages in their industries. Saipem is a growing business that has strategically invested ahead of the anticipated growth in offshore deepwater activity. Anas Chakra, portfolio manager, Saipem, and the broader oilfield services sector, is a major beneficiary of a high oil price that makes deepwater projects and other challenging oil extraction ventures commercially viable. A high oil price also supports investment - oil industry spending is expected to increase in 211, boosting the outlook for the oilfield services industry. Schlumberger CEO Andrew Gould recently stated that exploration and production companies will have to substantially increase investment to maintain supply. A lack of industry investment has been an issue in recent years. Poor industry returns during the 198s and 199s caused capital to be re-directed into new economy industries such as technology, media and telecoms. This starved oil firms of capital and as result, by 2, the oil producers began to use up spare capacity in response to surging demand from industrialising nations. Given that large emerging countries like China and India only consume a fraction of the oil and commodities today that they are expected to in coming decades, further economic growth in these markets will exert a strong pull on the world s finite hydrocarbon resources. Indeed, for all the talk of a geo-political premium on the oil price due to recurrent tensions in the Middle East, that has only been one aspect of the higher oil price in recent years. Physical imbalances have been the key structural driver of the oil price over the last decade as relative scarcity coincided with strong growth in emerging market demand (see charts below). EXCESS SUPPLY HAS BECOME CONSTRAINED CHINA S SURGING CONSUMPTION HAS PRESSURED SUPPLY Thousand barrels daily Oil Consumption and Production since 1965 Total World Consumption (LHS) Total Global Production (LHS) Total China Consumption (RHS) Oil oversupply as a % of world oil production 8% 6% 4% 2% % -2% -4% -6% -8% Excess Oil Supply China's share of consumption (RHS) 3.% 25.% 2.% 15.% 1.% 5.%.% China's share of world energy consumption Source: BP Statistical Review 21. Published June 21. Source: BP Energy Outlook 23. Published January 211.

4 OIL INDUSTRY DRIVER: FROM EXPLOITATION TO INVESTMENT While the short-term outlook for the oil price is sensitive to global economic activity and demand from China, the longer-term outlook is more a function of constrained supply and the higher cost of extracting a barrel of the black stuff from increasingly challenging locations. I am overweight Saipem as I believe the market has yet to appreciate the company s earnings growth potential in the offshore area. The company has already performed well as the market has recognised its onshore capabilities, but I believe there is more to come as investors recognise the company s strong comparative advantages in its offshore division as well. Alberto Chiandetti, portfolio manager, Italian equities The fundamentals for the oil equipment sector are positive. A number of companies - including Saipem, Transocean and Noble Corporation - stand to benefit from the fact that the high oil price leads to greater investment in marginal fields that would not otherwise be commercial. Alexander Scurlock, portfolio manager, The market is, in fact, an excellent discounter of the future; there has been an underlying shift that has accompanied the last decade of more persistent commodity price strength. Economic growth in China and emerging markets has considerably raised the demand profile for finite natural resources like oil to the point where it is has begun to constrain excess supply (see chart above). The underlying shift has been apparent in the oil industry, which has moved from an exploitation phase in the resource to an investment phase. Proven, easily accessible reserves (the lowhanging fruit) are being steadily depleted and extraction rates are deteriorating. New and expensive projects to access previously less accessible oil reserves are required to meet increased global demand, primarily from industrialising emerging markets. A major part to understanding the outlook for the oil price lies in the cost of extracting an extra barrel. In short, this marginal cost of production has been rising significantly (see chart above). The cost of producing a barrel of oil in well-established Middle East fields is as low as $2. However, the cost of eking out a barrel from the oil sands in Canada or from the deep water off the shore of Nigeria is estimated to be anywhere between $7 and $1 a barrel; harsher regulations and stricter safety measures in the wake of the BP oil spill could push up this range further. Over time, the price of oil should approach its marginal cost. If it is lower, producers will simply cut exploration and production to avoid losing money. Significantly, at the current level of oil price (above $1 a barrel of Brent), the major oil companies are able to put much needed capital expenditure to work on projects that would not have been commercial at lower prices. It is revealing to note that despite a significant lag time before they pay off, large projects in more challenging fields are being undertaken, suggesting that industry executives believe the longerterm outlook for the oil price is also positive. While some of the big recognisable companies will obviously benefit, the part of the industry that is most sensitive to these developments is the oil equipment sector. This is because a higher oil price encourages greater oil industry investment. The offshore drilling sector is an area benefitting from a pick-up in oil exploration in spite of the only gradual recommencement of drilling in the Gulf of Mexico. It is notable that the overwhelming majority of oil production still comes from conventional fields discovered prior to However, in recent years the industry has not hit anything remotely approaching the huge Ghawar field in Saudi Arabia first discovered in 1949 and it seems unlikely to. While there have been a slew of new discoveries off the coast of Brazil in recent years that have strong potential, production comes at a higher marginal cost. The fields are technically difficult in 4km of deepwater and under a further 2km of thick but unstable salt layers. New techniques and vessels are required to drill and operate these fields. Brazilian oil major Petrobras has driven up the rates for deepwater drilling in recent years by tying up much of the existing deep-sea rig fleet in long-term contracts. Since shipyards are slow to build additional capacity, this makes the outlook very attractive for many firms in the oil equipment sector, particularly those which specialise in deepwater, such as Saipem. OTHER BENEFICIARIES OF THE THEME While Saipem is our highest-conviction pick in oilfield services, the bullish outlook for the sector makes several other companies interesting. Transocean is another company that specialises in offshore drilling, which benefits from excellent management and it also has a large order backlog. The company suffers a little from having claims made against it for liability in the BP oil spill. However, its indemnity protection makes the likelihood of a significant financial impact unlikely. Noble Corporation is a smaller offshore driller incorporated in Switzerland that also has deepwater capabilities. Seadrill is a Norwegian offshore drilling company that has a fleet of Ultra Deep Water rigs, but the stock is fairly valued and has less potential for positive earnings surprises than both Saipem and Transocean.

5 SUMMARY The outlook for the oilfield services industry is bright, as the industry moves into an up-cycle of exploration and development, on the back of the higher oil price. This investment phase is badly needed it is in part due to underinvestment in previous years and the recognition that surging demand from industrialising nations is constraining supply, making the exploitation of new and more challenging fields necessary. Saipem is a specialist in the exploitation of these new and more challenging fields and its heavy strategic investment in the offshore sector now appears prescient. The company looks set to reap the rewards of that strategy as the oil majors line-up new contracts to gear up for the exploration and production up-cycle. Other key beneficiaries of this positive outlook for oilfield services include Transocean and Noble Corporation. BRIEF GLOSSARY OF KEY TERMS Conventional water: depths up to 5 metres. Deep water: depths of 5 metres or more. Heavy oil: a type of highly-viscous crude oil that does not flow easily due its heavier molecular structure. Closely related to tar sands, which do not flow at all. EPC: Engineering, Procurement, Construction a type of contract typical of the onshore construction sector. The term turnkey indicates that the system is delivered ready for operations. EPIC (or EPCI): Engineering, Procurement, Installation, Construction - a type of contract typical of the offshore construction sector, which relates to a complex project where the contractor provides engineering services, construction of the system and its infrastructure, transport to site, installation and preparatory activities for the start-up of operations. Oilfield services industry: companies that provide services to the oil exploration and production sector that are typically not directly engaged themselves in oil production. Stranded gas: natural gas in locations where it has historically been either physically or economically difficult to commercially extract. Turnkey project: a project that is delivered ready for operations (used in relation to EPC & EPIC). Ultra deep water: depths of 15 metres or more. This document is for investment professionals only and should not be relied upon by private investors. It must not be reproduced or circulated without prior permission. This communication is not directed at, and must not be acted upon by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity/ Fidelity International means FIL Limited, established in Bermuda, and its subsidiary companies. Unless otherwise stated, all views are those of the Fidelity organisation. Investors should note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this material is gathered by Fidelity for its use as an Investment Manager and may have already been acted upon for its own purposes. Reference in this document to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Fidelity only offers information on its own products and services and does not provide investment advice based on individual circumstances. Fidelity/ Fidelity International and the pyramid logo are trademarks of FIL Limited. Past performance is not a reliable indicator of future results. The value of investments and the income from them can go down as well as up and investors may not get back the amount invested. Fidelity s legal representative in Switzerland is BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 82 Zurich. Paying agent for Switzerland is BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 82 Zurich. Malta: Growth Investments Limited is licensed by the MFSA. Fidelity Funds is promoted in Malta by Growth Investments Ltd in terms of the EU UCITS Directive and Legal Notices 27 ad 39 of 24. The Fund is regulated in Luxembourg by the Commission de Surveillance du Secteur Financier. Issued jointly by FIL Investments International (registered in England and Wales), authorised and regulated in the UK by the Financial Services Authority and FIL Distributors International Limited (registered in Bermuda and licensed to conduct investment business by the Bermuda Monetary Authority). SSO3657/512