OCTG - oil country tubular goods - refers to the steel tubes and casings used primarily for drilling and producing oil and gas. This niche market has seen a stronger recovery since the 2009 trough than any other steel-consuming sector, particularly in North America, which consumes 40% of all OCTG used globally. The rig count, an important indicator of OCTG demand, has pedaled back in recent months just when the domestic supply of OCTG is poised to accelerate. We have examined the changing landscape and believe the market is still very promising for producers of premium OCTG, which are highly specialized for drilling and extraction in harsh conditions. A consolidated market and the specialized nature of these products give structural competitive advantages to the key players, namely Vallourec (OTC:VLOWY) and Tenaris (TS).
What Is the Outlook for OCTG Consumption?
OCTG consumption in the United States is already back to pre-recession levels of more than 6 million tons per year with the rig count in the 1,700-2,000 range for the past two years after bottoming below 900 in 2009. We are unlikely to see a higher average rig count in 2013 than in 2012 given exploration and production budget uncertainty, but this should be somewhat offset by greater E&P spending elsewhere, with Vallourec projecting a 9% increase in oil and gas exploration outside North America in 2013. Also, the composition of oil and gas rigs and what it means for OCTG consumption is changing.
Low natural gas prices have shifted the rig mix to oil, but the total rig count is more relevant because the majority of OCTG production can serve both oil and gas rigs. OCTG demand is not solely driven by the rig count, however. Changes in drilling needs have caused the rise in OCTG consumption to outstrip the rise in the number of rigs as a result of greater rig efficiency (as measured by feet per rig per month.) This is particularly true for premium OCTG, which has benefited from the increase in offshore drilling, increased depth of extraction, increased use of horizontal and directional drilling, and exploitation of higher-pressure formations. We think this is only slightly offset by a reduction in wells per rig per month, caused by longer, deeper wells.
The commercialization of shale oil and gas, increased deep-water production, and development of new drilling technology has required greater use of horizontal and directional drilling in addition to the typical vertical-only drilling activity. Horizontal drilling increases the length and the thickness of the tubes, particularly for shale extraction. Unconventional wells also demand a higher-grade tube that can withstand higher pressure and harsher temperatures, requiring more heat-treat processing. Horizontal drilling represented 60% of all North American oil and gas drilling in 2012, up from 29% in 2008.
Acceleration in the number of deep-water discoveries started in 2009, prompting an increase in planned deep-water drilling activity. Morningstar's energy equity research team estimates that deep-water (depths exceeding 4,500 feet) oil production will reach 9 million-10 million barrels of oil equivalent per day by 2015, a more than 50% increase from 2012, growing significantly faster than onshore or shallow oil production. Deep-water absorbs about 25% of global oilfield capital spending, and this share is likely to rise over time. It is one of the last pools of meaningful undeveloped resources for exploration, dominated by activity in the Gulf of Mexico, Brazil and West Africa, though other regions are seeing some activity, particularly for deep-water gas.
Morningstar's energy equity research team forecasts natural gas demand to climb 50% by 2035; this is a slower rate than oil, but consumption could increase faster if China decides to turn away from coal or if natural gas is increasingly used as a substitute transportation fuel. Already, natural gas has made significant strides as a replacement for thermal coal. Coal's contribution to electricity generation in the U.S. dropped below 40% in 2012, down from around 50% five years ago. Most of these losses were natural gas' gain, with gas' share at around 30% in 2012, up from 25% in 2011, as natural gas prices slid to a 10-year low below $2 per thousand cubic feet equivalent in April 2012. While we expect long-term natural gas prices to recover to about $5.40 per Mcfe, we doubt that natural gas will lose much of its market share gains, as coal has faced more scrutiny from environmental regulators and shale production has greatly increased the supply of gas. In addition, 70% of the global natural gas reserves are located in Russia and the Middle East and North America is the largest consumer, but liquefied natural gas technology developments are designed to allow gas to be more easily traded and moved all over the world.
Premium OCTG required for shale and deep-water drilling is the sweet spot for tubular producers Tenaris and Vallourec. About 80% of Vallourec's sales are to the energy sector, the majority of which is in oil and gas, producing seamless OCTG for oil and gas exploration and production as well as offshore oil and gas line pipe. The firm's petrochemical business produces welded tubes for natural gas liquefaction plants. Tenaris derives nearly all of its revenue from tubes and related products to the oil and gas sector, and the majority of its OCTG production is premium grade. Only one other company, Sumitomo Metal Industries, has any sizable share in the global market for premium OCTG, and it still represents less than 15% of Sumitomo's total product mix.
Is Too Much OCTG Capacity Coming Online in North America?
North American demand for OCTG exceeds domestic capacity by around 40%, by our estimation, but an import market share close to 50% puts operating rates for domestic energy pipe producers in line with the domestic steel sector as a whole, around 70%. Some new capacity is needed to meet the strong long-term demand trends, particularly in premium OCTG, but this demand has been widely anticipated and we are concerned about the sheer volume of new OCTG production capacity that is ramping up or planned for rollout in the next three years. Tubular producers are in the process of nearly doubling domestic OCTG capacity, adding around 4 million tons. Almost half of the new supply will be in high-grade seamless OCTG, but only the new tonnage from Tenaris and Vallourec (about 25% of the total) is slated for premium products, designated mainly for shale and deep-water use.
While some of this new capacity will be used to produce line pipe and other tubular products, the lion's share is intended for OCTG, in our view. By our estimates, OCTG capacity was around 4 million tons in the U.S. before these additions. Even if demand continues at a robust pace, we would need to see a meaningful decline in OCTG imports for this new production to be absorbed. In 2012, OCTG imports into the U.S. totaled 3.3 million tons, approaching the all-time high of 3.5 million tons in 2008. Federal trade cases against OCTG imported from China in late 2008 caused imports to drastically decline. China has yet to re-enter the market, but this created an opening for South Korea, which is now the main source of U.S. OCTG imports. Executives at many domestic OCTG producers, including Tenaris, Vallourec, and U.S. Steel (X), have warned of further trade action and there have been more trade cases filed on pipe and tube products than any other steel product in the past 20 years. We expect these voices will grow louder as the new domestic supply rolls out. But the main battle for market share, in our view, will be between commodity-grade new capacity and commodity-grade imports.
The highly specialized nature of premium OCTG and the related connections and services require a long-term relationship between the tubular producer and the E&P company, whereas the import market caters to price-sensitive commodity-grade steel buyers. Vallourec and Tenaris have operated at around 95% of capacity for the past two years, and we believe their concentration in premium OCTG largely shields them from the threat of overcapacity from new supply and high imports. We believe the combination of a consolidated market and the specialized nature of the main products sold gives both Vallourec and Tenaris a narrow economic moat, protecting their market positions.
What Is the Best Way to Play the Positive Outlook for Premium OCTG?
Demand trends in oil and gas are driving the need for premium energy tubulars at twice the growth rate of conventional oil and gas pipes. Vallourec participates in 75% of the largest deep-water projects worldwide, and nearly half of its shipments to the oil and gas markets are for offshore projects. Its largest geographic regions are North America and Europe, each constituting about 25% of sales, with South America close behind. Around 60% of Vallourec's production capacity is in Europe, but this will soon change with the advent of production at the company's latest capacity projects. Its roughly 50/50 joint venture with Sumitomo in Brazil is slated to produce 1 million tons of crude steel and 600,000 tons of premium OCTG, intended to further penetrate offshore drilling. In the past five years, two thirds of all offshore oil discoveries were off the shores of Brazil. Vallourec's other expansion project in Youngstown, Ohio, will add 350,000 tons of small-diameter pipe (OCTG, line pipe, drill pipe, and premium threading) particularly for shale plays in North America, such as the Marcellus and the Utica. Both projects should fully ramp up by 2014, increasing Vallourec's oil and gas production capability by around 70%.
Tenaris is even better positioned to benefit from energy production trends as it is more fully exposed to oil and gas, particularly in premium OCTG. The company has its own sizable capacity expansion project under way in Texas and already has greater exposure than Vallourec to North America - the largest market for OCTG - and South America, where OCTG consumption is expected to grow at a rapid rate. However, Vallourec's mix shift will close the gap somewhat in 2014. The need to develop shale gas resources plays right into Tenaris' strengths of technical service and field support capabilities critical to product performance and customers' productivity. The new Texas facility will better support its business model of being close to customers from a service and inventory delivery standpoint. The superior end market mix has protected revenue and margins for Tenaris more so than for Vallourec in the past couple of years, with weak demand in non-oil and gas markets, particularly in Europe, combined with hefty startup costs for the new plants creating a significant earnings drag for Vallourec. However, we believe 2011-12 represents trough profitability for both companies. The combination of continued E&P spending, increasing need for premium OCTG, and the rollout of new capacity should drive meaningful revenue growth and margin expansion. It is worth noting that it is rare for any steel company to consistently generate EBITDA margins above 15%, demonstrating the appeal of the premium OCTG market for Tenaris and Vallourec.
Vallourec's partial exposure to industrial end markets and Europe in particular limits the upside potential, and we believe some of its European capacity will be permanently shut down when the new plants in the U.S. and Brazil are fully ramped up. However, capital requirements will be greatly reduced, with little spending remaining for Vallourec's new plants. Tenaris has greater execution risk, in our view, given the later startup of the new facility and hefty capital requirements in the next several years.
Vallourec suffered a few setbacks executing its capacity expansion projects, with cost overruns and delays in the timeline to ramp-up. This, combined with an inferior product and geographic mix, has restrained revenue and profitability relative to Tenaris, particularly in 2012. The lack of visibility in the non-oil and gas segments (40% of revenue) continues to create an overhang on Vallourec's stock price, which is down around 20% in the last year while Tenaris' has moved up some 5%. But we believe the lower execution risk of its new plants, first-mover advantage in ramping up two to three years before Tenaris, and positive mix shift trends leave greater long-term upside for Vallourec's shares from current levels.