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What’s in Store for the Energy Sector?

For the year to date, the S&P/TSX Energy Index (^SPTTEN) has outperformed the S&P/TSX Composite Index (^GSPTSE). The energy index has a year-to-date return of 22%, compared to the market return of 11.7%, and it is the best-performing sector on the TSX.

The energy sector has definitely come to life again, as the demand and supply sides of the equation have both been bullish. A bitterly cold winter precipitated soaring demand for natural gas, and therefore a spike in its price. On the supply side, natural gas inventories are 29% below the five-year average of 2.72 billion cubic feet.

These things have precipitated a steady shift in fundamentals for oil service companies, which have tremendous leverage to rising drilling activity. Here is why I believe that this sector will continue to perform well this year.

Revenue growth is strong and accelerating

Calfrac’s (TSX: CFW) shares are up 36% since the beginning of the year. Trading at $21.50, the stock has hit a new 52-week high. The company’s first-quarter results were positive, with a 29% increase in revenue and rising activity levels. While pricing has still not strengthened, the fundamentals are setting the stage for an increase there as well.

Precision Drilling (TSX: PD)(NYSE: PDS) reported a 13% increase in revenue in its first quarter, as drilling rig utilization rates increased 3% in Canada, 16% in the U.S., and 38% internationally. Precision’s shares have increased 57% for the year to date to its new 52-week high of $15.55.

Cash flows are healthy

Not only are oil service companies finally seeing strengthening demand, but a number of them are also seeing improving cash flow generation. Precision Drilling, for example, reported a 60% increase in funds from operations in its first-quarter results.

Activity levels picking up

In the first quarter of 2014, Enerflex (TSX: EFX) reported a 33% year-over-year increase in backlog. Overall revenue was lower in the quarter due to a struggling international segment, while revenue in North America showed strength. The stock has seen its share price increase 38% to a new 52-week high of $20.56.

The company recently announced the acquisition of Axip Energy Services for $430 million. This deal has been well received by the market — the stock was up over 10% on the day of the announcement — because it will increase recurring revenue streams and expand the company’s global reach. Additionally, the deal is expected to be immediately accretive to earnings per share, and margins are expected to increase from the current 9% to 12%.

Growth in liquefied-natural-gas-related drilling

There are a number of current proposals to build LNG plants along the coast of British Columbia, with anticipated start-up times of 2015 and beyond. There is a flurry of activity in a number of deep basin plays in northwestern Canada, including the Montney, Duvernay, Horn River, and Liard Basin plays, all of which are well positioned to be a source of supply for the LNG market. This has increased demand for deep, modern drilling equipment in Canada.

Trinidad Drilling (TSX: TDG) announced a new rig-building contract for LNG-related drilling in Canada. This highly technical rig will be designed specifically to drill natural gas in the Liard Basin, an area that is being developed to supply natural gas for future LNG plants that are being proposed for the west coast of British Columbia. The rig is expected to be in operation in the second half of 2014.

What this all means

Illustrating confidence in their respective outlooks, Precision Drilling announced a 20% dividend hike, and Ensign Energy Services (TSX: ESI) announced a dividend hike of 6.8%.

As natural gas prices rise, drilling activity will also continue to rise. With strong balance sheets, increasing activity, and improving pricing, investors will continue to be happy if they stay invested in these stocks. The sector will be reporting second-quarter results at the end of July, and I will definitely keep a close eye on them. Investors should expect continued strength in activity levels and revenue, and hopefully pricing increases will kick in in a more meaningful way.

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Fool contributor Karen Thomas owns stocks in Precision Drilling.

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