By Stephen Ellis
One of the biggest problems in the oil and gas industry today is water management. Solving the technical and economic challenges around managing the millions of gallons of water used to properly fracture tight oil and gas wells has been called the holy grail of the industry by Southwestern Energy CEO Steve Mueller. He estimates that water transportation (primarily trucking) costs around $1.5 million (25%) of the $6 million that an average Marcellus well costs. Solving this issue, whether through reducing the volume of water needed, increasing the level of recycling used, or other applications of services technology such as on-site recycling, offers a compelling growth avenue as well as an opportunity to steal economic rents from the trucking industry.
We think Halliburton (HAL) and Schlumberger (SLB) are best positioned to win here, as they have the broadest product portfolios, relationships, and research and development firepower to develop technology that will address the market's needs. FMC Technologies (FTI) is also a player through its purchase of Pure Energy, which provides fracturing flowback trucks, for $285 million in mid-2012. We believe an understanding of the market, its future competitive dynamics (which reinforce our economic moat ratings), and the upside opportunity in water management is an important advantage for any oil services investor today.
The Challenge of Water Management Means Opportunity for Oil Services Firms
Before a well can be drilled and hydraulically fractured, the operator must secure water for drilling. Drilling an average 6,000-foot well requires several hundred thousand gallons of water. Next, the oil and gas company fractures the well anywhere from 10 to 50 times, typically requiring 500,000 gallons of water per stage. Within two to three weeks of completing a well, 15%-70% of the water used will flow back to the surface. The resulting water can be partially treated on site for reinjection as part of the next fracturing effort, but usually some untreatable (too dirty) water has to be transported to a disposal well. Alternatively, the water can be transported to a treatment plant and then returned to the well site. There are multiple challenges here for the oil and gas industry, and thus an opportunity for well-positioned oil services firms to extract economic rents.
The amount of water required for properly fracturing a well ranges from 2 million to 4 million gallons per well (47,000-95,000 barrels per day) in the Barnett shale to more than 13 million gallons per well (more than 300,000 bbl/d) in the Eagle Ford. This is vastly higher than the amount of water needed in the past because of the intensity of water usage around today's modern hydraulic fracturing methods. Access to the needed amount of water from a nearby water reservoir is in some cases a challenge. Firms have shut in production because of lack of water access and in other cases trucked in water over long distances at great expense to meet their needs. Also, water flowback is a large and growing problem. Of the millions of gallons of water injected as part of the fracturing in some wells, 15%-70% flows back to the surface within a few weeks and needs to be stored, hauled, treated, disposed of, and tracked.
Water-disposal opportunities are neither consistent nor standard. Class II injection wells are the favored way to dispose of contaminated water by reinjecting it far below the aquifer level, but state-by-state regulations differ greatly. For example, there are hundreds of Class II injection wells available in Texas, but only seven or eight wells in Pennsylvania, creating severe challenges for Marcellus producers who need to use expensive trucking services to transport the water to Ohio for reinjection.
Produced water-- which is produced alongside the oil and gas as part of the regular well-production process and continues for as long as the well is active, which is typically 20-30 years--promises to be a long-term headache. Produced water can total an additional 4 million gallons over the lifetime of a Marcellus well, effectively doubling the water-management needs for a single well.
Public water-treatment plants cannot handle the oilfield waste. The chemicals used in the fracturing process typically kill the biota essential to a water-treatment plant's operation. The wastewater also contains a very high level of total dissolved solids, and conventional water-treatment options generally do not remove the solids from the water; they typically focus on heavy metals instead. To properly remove the solids from the water, the plant needs to use evaporation/distillation technology, which is not standard at municipal sewage plants. As a result, the states and oil and gas firms need alternative options for handling their wastewater.
EPA's Impact on Water Management Could Be Profound
We think a key catalyst that could unleash waves of change throughout the water-management industry is fast approaching. The Environmental Protection Agency is studying the relationship between hydraulic fracturing and a number of water-quality issues--including water acquisition, chemical mixing, well injection, flowback and produced water, and wastewater treatment and disposal--and plans to issue a report in 2014.
Separately, the EPA is also examining the different water-disposal methods used by the industry to ensure that the regulatory and legal frameworks remain sound; it plans to issue a rule-making report for coal bed methane in 2013 and tight gas in 2014. At this stage, the EPA is considering whether to make water pretreatment a standard practice, while also developing standards for treatment plants handling wastewater.
We think any new rules or conclusions from the reports could drive up water-management costs by as much as 20%. Any changes could include tougher permitting regulations around injection wells, extensive inspections, detailed well-construction practices, and harsher rules for water treatment and freshwater usage. More importantly, we think the report could serve as a catalyst for the states, which are the primary regulators for well-injection issues for the vast majority of oil and gas production in the United States, to pursue new water-quality, treatment, and disposal regulations. Given the states' propensity for controlling well-injection regulations, we'd highlight Pennsylvania (home of the Marcellus) as a state that could see a significant change. Any new EPA regulations could prompt the state to change its own rules so it can assert primacy over the EPA, which means a much tougher regulatory (and more expensive) picture for Pennsylvania oil and gas firms.
The states' primacy over well-injection regulations means that there is little regulatory agreement on common standards for water management. For example, pits are commonly used in the industry as temporary storage for wastewater before it is transported to a disposal site, and thus pit liners serve as a useful way to prevent groundwater contamination. Ohio has no rules on the books, whereas Colorado specifies a 40-mil thickness for the liner. Flowback transportation tracking regulations are similarly wide-ranging, with North Dakota requiring only a permit, whereas Oklahoma requires a permit and records to be kept for three years. We think the EPA's efforts over the next two years could force the states to introduce tougher regulations, but some states may choose to only meet the EPA's latest recommendations while others may go further. We expect the current patchwork of regulations to grow even more complex due to the lack of a single controlling regulatory framework to ensure a consistent approach to water management.
The Importance of the Marcellus to the Oil Services Industry
A key test case for the oilfield water-management industry is the Marcellus shale in Pennsylvania. Pennsylvania is an instructive case study when it comes to dealing with wastewater disposal, and we think the state's shift toward recycling efforts away from public treatment plants serves as a good example of how the rest of the states may follow suit. This shift toward more recycling efforts by the states should lead to large opportunities for the oil services firms to capture economic rents.
The scale of the water-management challenges within the Marcellus today is vast, growing, and not unique to the play. We estimate that produced water and fracturing waste levels topped 1.6 billion gallons in 2012, up from around 600 million gallons in 2010. We estimate annual Marcellus gas-production levels increased to 325 million barrels of oil equivalent from 34 MMboe over the same time frame. More critically for the services industry, we estimate that recycling takes places on almost 40% of the overall wells drilled within the Marcellus, up from just 6% in 2009. We expect these numbers to increase and other oil and gas plays to show similar trends, greatly expanding the overall market opportunity for the oil services industry.
The changes in how water is managed in Pennsylvania have taken place over several years. In 2008, water samples from the mid-Monongahela River showed high levels of total dissolved solids, which can disrupt the local water ecosystems. State officials were concerned that the pollution came from large truck deliveries of wastewater to local water-treatment plants and ordered the treatment plants to accept less wastewater, but it turned out that local mines were actually responsible for the contamination. However, the volume was so great that by 2011, both state and federal regulators had stepped in to order the public treatment plants to halt acceptance of wastewater from oil and gas wells because they were concerned that the facilities were not properly equipped to handle the volume. Also in 2011, 11 water-withdrawal permits were suspended due to low stream levels in Pennsylvania's Susquehanna River Basin, which hints at possible future conflicts between oil and gas water usage and the public use of water. In response, some Marcellus shale operators have largely switched to recycling 90% or more of produced and flowback wastewater volumes to continue drilling.
Today, we think the biggest opportunities in water management for the oil services industry lie in solving four key problems, which have arisen due to the developments in Pennsylvania: (1) reducing the cost of treating flowback and produced water, (2) lowering the amount (and therefore costs) of freshwater needed, (3) cutting transportation costs, and (4) combining the treatment, freshwater, and transportation cost reductions into a single integrated solution.
Pulling together everything into a single solution is the most efficient option for the industry, as it means that oil and gas firms can deal with just a single provider on the well site, and they can ensure consistent services quality across multiple plays. Standardizing on a single provider can also take advantage of the firm's detailed knowledge of the fluids' chemistry to extract additional economic efficiencies. It would be harder to duplicate this success using multiple providers because the fluids makeup and chemical interactions are considered competitive advantages.
Halliburton has several case studies that, while they probably paint the firm in a highly favorable light, also indicate that operators are turning to the oil services industry to help solve their water-management challenges. For example, Halliburton had a customer in the Permian Basin where the produced water had very high levels of undesirable solids. Cleaning this water to make it suitable for fracturing operations was too expensive, forcing the producer to use freshwater. However, drought conditions in the Permian Basin had forced up the cost of freshwater. Furthermore, the oil and gas firm was looking for an on-site recycling solution in order to reduce the transportation costs for the freshwater.
Halliburton used its CleanWave service (an electrocoagulation process that removes impurities) to treat the water, customized a new frac fluid to better work with the still-dirty water, and successfully fractured eight wells. All of the treatment was done on site, which meant 1,400 fewer truck deliveries, an 8 million-gallon reduction in freshwater usage, and a savings of $500,000-$700,000 for the customer. Another example involved a customer in the Rockies requiring a water solution in the middle of winter at a well site that was only accessible by a single truck road 40 miles long. Halliburton was able to set up its CleanWave unit on site and treat 55,000 barrels of water, which meant 1,000 fewer truck trips and $250,000 in savings for the customer.
Finally, we already see operators pursuing integrated water-management solutions. El Paso in the Haynesville play elected to use Halliburton's CleanSuite technologies (water treatment, hydraulic fracturing, bacteria control, dry polymer blender) on a single well. The end result was a significant savings on transportation costs through the use of an on-site recycling model, which resulted in a 25% reduction in the amount of freshwater needed, the elimination of the need for 2,400 gallons of biocides used to treat bacteria growth, and the use of an environmentally safe fluid system.
How Large Will the Economic Rents Be, and What Firms Are Best Positioned?
In our view, the stars are aligning for the oil services industry to extract considerable and growing economic rents from the oil and gas industry for water-management efforts. Exploration and production firms are increasingly growing frustrated over water transportation, freshwater, and treatment costs and are looking for more cost-efficient solutions, particularly as their water and fracturing waste volume is increasing rapidly. The EPA is nearly ready to issue several key reports in 2013 and 2014, which will probably set tougher rules for the industry regarding wastewater treatment and disposal, leading the states to upgrade their own regulations in response. Accordingly, we think the need for a fully integrated water-management solution provided by a reputable oil services firm is reaching an inflection point, and there is now a significant opportunity for oil services firms to steal economic rents from the trucking industry.
The overall market structure for the water-management niche is small in 2013, and what rents are available are going toward the trucking companies, which capture 85%-90% of the water-management costs. We think the overall water-management market will grow to an estimated $22 billion in 2018 from $11 billion today, mainly driven by the increased number of wells being drilled in tight oil and gas plays. Water-management costs over the well's lifetime should remain fairly flat at today's levels between $500,000 to $1.5 million per well, as we expect any cost increases from new regulations to be offset by efficiencies gained from applying services technology to reduce and better manage water volumes. Basin-by-basin differences today in water-management costs tend to be driven by the expense of disposal options. Several fundamental factors such as freshwater availability, geological structure, terrain, and the state regulatory structure drive varying requirements for expensive trucking needs. We don't expect these fundamental factors to change, which means that like today, basins will have different cost structures and thus different market sizes.
We See Market Shifting to Knowledge-Based, Integrated Options
We think this market will evolve from a very asset-intensive, highly competitive one based on trucking toward a knowledge-based one where consulting expertise, knowledge of the fracturing fluids used in the well, and having on-site recycling options available as part of a fully integrated offering will be more important. The market should move away from smaller providers and heavily customized solutions based on individual customers' needs toward a more standardized offering based on reservoir characteristics while incorporating a more restrictive regulatory environment. Profit margins should be accretive to current margin levels for the services providers, which will be able to apply their services technology to reduce water usage (thus reducing costs), offer cost-effective treatment options for the remaining water, and track and manage all of the water to likely meet any new regulations around tracking. The rent extraction will occur because duplicating the technology, R&D strength, and reputation required to be successful is far harder than simply starting up a water-transportation trucking business.
Increasingly, we think the market will shift toward an integrated option, which follows how the North American oil services market evolved to integrate pressure pumping and other drilling technologies into a single solution over the past decade. Therefore, we view the water-management business as one that can earn an economic moat over time and be accretive to firms with existing moats. We think larger services providers will be better positioned to set up hub-and-spoke models and serve customers using powerful integrated solutions that make up the entire range of oilfield services they offer. We expect oil services firms will serve multiple well sites from a single centralized location, driving significant cost savings for the customer. Furthermore, the major oil services firms are best positioned to execute this model because they have the capital to build out the facilities needed and the relationships in place to ensure an attractive book of business that can be immediately used. Finally, services providers will also be able to use existing product lines to push or pull customers toward water-management solutions, thus extending their own existing competitive advantages.
Staking Out Territory Through Moats
We believe the oil services industry is recognizing the potential for growth in water management and companies are actively staking out a position in the market. Halliburton started its water solutions unit in late 2011, and FMC Technologies purchased Pure Energy (which provides fracturing flowback treatment services) for $285 million in mid-2012. Heckmann bought Power Fuel in late 2012 and is now one of the largest providers of water transportation, water disposal, and water rental tanks, which are all services that run the risk of being commodified and displaced by on-site solutions over time. Schlumberger is also a significant player in the market and offers services similar to Halliburton in water management. Both firms seek to provide consulting and related services around managing state regulations, waste tracking, monitoring, recycling, and water conformance (through gels and other chemicals).
FMC's Pure Energy owns a fleet of a little more than 200 fracturing flowback and wireline trucks located in all of the major tight oil and gas basins in the United States and Canada that we estimate generated around $175 million in revenue (roughly 25% related to U.S. fracturing flowback) and $60 million in EBITDA in 2012. In our view, Pure likely is one of the leaders in a highly fragmented market, where it controls a single-digit share. We estimate Pure would on an annualized basis generate around 8% of FMC's EBITDA, which makes it perhaps the most exposed today to water-management efforts, but we think the other major services firms will have larger opportunities thanks to their broader portfolios.
We believe these opportunities will be available for the major oil services firms because of their existing competitive advantages, or moats. For example, Schlumberger's water services business provides consulting services and related water-management technologies. However, the firm's oilfield water management team provides equipment for water-treatment facilities. Schlumberger has the ability due to its size and broad product portfolio to offer both consulting, where it will help the customer figure out the best solution to its water-management issues, as well as the technologies required in a single integrated offering. Schlumberger's knowledge of its own stimulation fluids lets it better treat the wastewater to remove the fluids after fracturing the well. In a similar vein, FMC's presence in the pressure pumping equipment market means it already has the relationships in place to rapidly upsell its fracturing flowback services.
In addition, the major services firms' experience with deploying electric submersible pumps and artificial lift solutions and monitoring the wells remotely over years better positions them to capture the work for monitoring produced water over the lifetime of the well. Only about 60% of the well's lifetime water production flows back within the first few weeks in many cases, with the remaining 40% produced over decades. Smaller services providers won't have the knowledge, relationships, or R&D budgets to ensure cost reductions over time, or the simple manpower to compete successfully on a national scale required by large majors and independent E&Ps.
The biggest opportunity for the oil services industry is primarily in the disposal and treatment arenas. We estimate that trucking controls about 85 cents of every water-management dollar today, with disposal and treatment services controlling the remaining 15 cents. However, over time, as new regulations are enacted and E&Ps seek to reduce transportation costs and comply with stiffer regulations through using oil services solutions, we think the services portion of the pie will expand. We forecast that in 2018, the oil services industry will have an opportunity to take 40 cents of every water-management dollar because of the increased use of onsite recycling solutions, water tracking, consulting, and other types of technologies, whereas trucking will only get about 60 cents of every dollar.
The oil services industry will evolve to extract more economic rents from the water-management industry, while the trucking industry will gradually return to its highly competitive roots where economic rent extraction approaches zero. As a result, we think the water-management opportunity for the oil services industry will increase to around $9 billion in 2018 from $1.7 billion in 2013, and we estimate EBITDA margins will be around 35% for this type of work, given its high growth and the fact that the market will probably consolidate around a few major powerful services providers.
FMC, Halliburton, Schlumberger Are Best Positioned
Given that we see the water-management industry increasingly consolidating behind several key services ecosystems, we think the best-positioned companies today are FMC Technologies, Halliburton, and Schlumberger. All three have established product portfolios, relationships, and the capital and engineering expertise necessary to push forward any needed water-management technology efforts. In particular, Halliburton's and Schlumberger's success at developing integrated drilling technology solutions for North American tight oil and gas plays over the past few years gives them ample experience to replicate the playbook for the water-management opportunity.
While FMC doesn't have quite the same broad services portfolio as the other larger providers, it does have decent equipment franchises in fluid control. Also, the size of the Pure purchase at $285 million in cash is noticeable, particularly as FMC generated only $165 million and $138 million in operating cash flow in 2011 and 2012. We think this commitment by FMC's managers, whom we view as reasonably intelligent capital allocators, indicates their confidence in the growth prospects in water management. We believe Pure could easily triple in size within five years because of its crucial role in providing on-site recycling efforts for fracturing flowback fluids. While we are not explicitly incorporating the water-management market into our oil services models, we see it as a key growth driver for the industry over the coming years, and as the impact of the shift becomes clearer on the companies, we do see modest (5%-10%) upside to our fair value estimates.
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