Oil Services: Ready to Serve Up Profits

Includes: BHI, HAL, SLB, WFT
by: Elliott Gue

During Schlumberger’s (NYSE:SLB) conference call to discuss second quarter results, management outlined the case for continued strength in North America and rising demand for oil services in international markets. The company’s executive team tends to be more conservative in its bigger-picture outlook than its peers, so management’s upbeat comments - arguably the most optimistic in three years - carry even more weight.

The North American market for energy services has been a pocket of strength for the big four services firms - Baker Hughes (NYSE:BHI), Halliburton (NYSE:HAL), Schlumberger (SLB) and Weatherford International (NYSE:WFT) - for well over a year. In fact, robust demand for pressure pumping and other key services in onshore shale oil and natural-gas plays has enabled providers to raise prices substantially.

The critical process of hydraulic fracturing - an innovation that enables producers to tap oil and gas reserves trapped in tight reservoir rocks - would be impossible without pressure pumping.

Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant - typically sand, ceramic material or sand coated with ceramic material - ensures that these passages remain open.

Over the past year, producers have ramped up drilling activity in these unconventional fields, focusing oil-rich plays such as the Bakken Shale of North Dakota and regions that contain substantial amounts of high-value natural gas liquids (NGL). Rising output from shale oil and gas fields translates into increased demand for pressure pumping and other services. At times, producers have reported waiting at least 90 days for hydraulic fracture because of capacity constraints. Insufficient pressure pumping supply and rapidly growing demand equals higher prices for service providers.

Although Schlumberger has benefited from robust demand for pressure pumping, the company’s management has adopted a far more cautious outlook regarding the sustainability of the up-cycle. Former Schlumberger CEO Andrew Gould, who retired on Aug. 1, had previously suggested that overzealous capacity additions could outstrip demand for pressure pumping. Management’s comments during the Q-and-A portion of the company’s July 22 conference call indicate that the firm has modified its outlook:

Analyst: Many of your big competitors are adding frac(turing) equipment in North America as quickly as they can. How would you say your equipment adding strategy differs from them?

Andrew Gould: I don't think it does. But I'll let Paal comment on that.

Paal Kibsgaard: No, I think while we generally believe that there is opportunity to bring service intensity down from this brute force approach we have shale development, we are still pursuing both sides of the equation there, right? So while we continue to promote the workflow that I alluded to in my comments, we are also adding significant horsepower this year into our pressure pumping business. So as I mentioned in my commentary, we added in the first half of this year more horsepower than we've done in any full year previously. And I think that just basically signals that we are part of this thing as well.

The analyst’s question reflects the company’s traditional business mix - Halliburton (49% of 2010 revenue) and Baker Hughes (50%) have more exposure to North America than Schlumberger (21%) - and former skepticism toward the sustainability of pricing gains in the pressure pumping market.

CEO Paal Kibsgaard’s response indicates that Schlumberger has changed tactics. The company added more pressure pumping capacity in the first six months of 2011 than it has over any full year. This about-face suggests that management expects drilling activity in liquids-rich shale plays to justify further investment.

At the same time, Kibsgaard mentions efforts to reduce the service intensity of these shale fields - likely an allusion to the firm’s HiWay fracturing and shale reservoir modeling technologies. Schlumberger’s technology helps operators to identify the most productive portions of each horizontal well, reducing the number of fracturing stages and boosting profit margins. Not only does the producer save money on water and proppant with this approach, but wells can also be fractured much more quickly.

In his prepared comments, Kibsgaard noted that Schlumberger has performed more than 1,200 HiWay fracturing stages worldwide and that this approach has saved 60,000 tons of proppant relative to conventional drilling techniques. Fifteen producers have adopted Schlumberger’s HiWay technology thus far. Many of these customers operate in the Eagle Ford Shale, a field in South Texas that contains windows of crude oil, natural gas and natural gas liquids (NGL).

HiWay and similar technologies cut drilling costs and allow operators to better understand how oil, gas and fracturing fluids move through the fields they produce. Over time this could go a long way toward reducing populist fears about fracturing.

Not only is Schlumberger on board with the North American pressure pumping pricing cycle, but management also expressed confidence in potential pricing upside for other services related to unconventional drilling. In particular, the firm highlighted growing demand for its drilling and measurement (D&M) services and emphasized the potential to push through price increases and boost profit margins.

D&M encompasses a wide range of services, from directional drilling to cementing, mud logging and supplying drilling fluids.

Schlumberger acquired its directional drilling capabilities from its acquisition of Smith International. By deviating the wellbore from its downward path (i.e., drilling directionally), operators can target the most productive zones of a particular reservoir and improve their wellhead economics.

Cementing supports and protects the well cashing, a thick steel pipe that’s installed to isolate certain parts of a well prevent leakage and environmental contamination. For example, if you drill a 10,000-foot oil well through an area that contains water at 2,000 feet, the casing would prevent this underground aquifer from gushing into the well. Selecting the proper cement for each unique job is a critical task that can have disastrous consequences. Some industry insiders have suggested that a shoddy cementing job contributed to the blowout of the Macondo well and the worst-ever oil spill in the U.S. Gulf of Mexico.

Schlumberger’s M-I SWACO division specializes in formulating drilling-fluid systems and additives that are pumped into a well as its being drilled. The pressure of the drilling “mud” that’s injected into the well counteracts the geological pressure of the oil and gas in the field, preventing a blowout, or the uncontrolled flow of oil and gas into the well. The composition and weight of the drilling fluid used depends on the type of reservoir and the pressure and temperature of hydrocarbons in the field.

The drilling mud circulates through the well and then returns via the annulus, or the empty space outside the drilling pipe. As mud returns to the surface, the operator can analyze its contents to hone its understanding of the reservoir rock and the hydrocarbons contained therein. This process is known as mud logging.

This discussion of Schlumberger’s roster of drilling-related services is illustrative rather than exhaustive. The key takeaway from management’s discussion of the North American market: Emerging pricing power in service lines besides pressure pumping suggests that drilling activity remains strong and producers have begun to hit capacity constraints. In other words, services firms aren’t always available immediately to perform these tasks. A tightening market for other services explains why Schlumberger had decided to bet on a continued up-cycle in North America.

The North American oil-services market would go into overdrive if exploration and production (E&P) activity picked up in the deepwater Gulf of Mexico. Such a development would be welcome news for the oil-services industry in general and Schlumberger in particular because of its traditional competitive strength in deepwater drilling. In this regard, rumblings about a potential lease sale in the deepwater Gulf of Mexico are an encouraging sign.

With demand on the upswing for oil and natural gas services on the upswing in international markets, the Big Four could soon be firing on all cylinders. The industry serves three geographic end-markets: North America, Latin America and the Eastern Hemisphere, which includes Europe, North Africa, the Middle East and Asia Pacific. Markets in the Eastern Hemisphere have lagged in recent quarters, offsetting robust demand in North America and Latin America.

Elevated oil and international natural gas prices have encouraged major integrated oil companies and state-owned entities to step up drilling activity and investment throughout the Eastern Hemisphere. However, up until recently, overcapacity has prevented oil-services firms from pushing the line on pricing. To worsen matters, many of the big services firms have built a substantial presence in the Middle East and other key markets - a major fixed cost.

These challenges have prompted some of Schlumberger’s competitors to bid on projects at prices that don’t guarantee long-term profits. For a time, the industry appeared bent on winning new work at any cost with scant regard for the long-term consequences. Profit margins would continue to languish in this cutthroat and irrational competitive environment until the supply-demand balance at least normalized.

It has been a waiting game. For the past several quarters, the major oil services firms have offered anecdotal evidence that pricing power in the East Hemisphere had begun to turn the corner. The consensus outlook from most of the Big Four called for pricing to improve at some point in late 2011 or early 2012.

Schlumberger’s second-quarter results suggest that the waiting game may be over. Demand for the company’s services improved significantly toward the end of this three-month period, and management suggested that this momentum had continued into the third quarter.

During the Q-and-A session that followed management’s prepared remarks, former CEO Andrew Gould and his successor Paal Kibsgaard addressed the sustainability of these pricing improvements:

Analyst: Just wanted to follow up as it relates to the revenue and margin improvement sequentially we saw in Eastern Hemisphere in 2Q. Is that mostly just a snap-back as guys you see it from the seasonal declines in the first quarter, or have we started to see some of the improving operating fundamentals really creep into results yet? I guess my first question. And then second, given the pricing and mixing outlook, I think the expectation has been kind of a back half of 2011 to be more of a volume-led margin expansion story. I'm just curious if there's anything that you guys see in Eastern Hemisphere as far as a sharper margin inflection in the back half of the year, or is that still pretty much a 2012 story?

Andrew Gould: No, I think I was quite clear in the commentary that it's not general yet, but individually on small contracts, pricing improvements have begun. And I think that - I don't see any reason why that would go away now. Now, there is a snap-back effect partly in MEA, of the Australia and Egypt. But it's not significant in the overall picture. And, yes, you have definite activity pickup. And what I would point out to you is that, we pointed out at the beginning, is that a lot of the pickup was in characterization. And therefore that tells you that a lot of the pickup is the beginning of some of these exploration campaigns that we've been waiting for.

Paal Kibsgaard: And maybe just adding to, that I agree with what Andrew is saying. I think if you look at the sequential margins overseas, there's really two main components. One is that the volume is actually going up. And the way we're set up with our timeframe and our infrastructure, we are actually able to leverage the volume and the fixed costs we have to generate good pull-through, even on relatively flat pricing, right? That's No. 1. And No. 2, as Andrew alluded to, the part of the company that grew very well was the Reservoir Characterization, where the average margins are obviously higher than for the other two product groups.

In this excerpt, Schlumberger’s management team makes it clear that the recent improvement in operating fundamentals is more than just a rebound from normal seasonal declines. More important, the company has been able to hike prices on smaller contracts, suggesting that the supply-demand balance has tightened considerably in the Eastern Hemisphere.

The industry often regains pricing power on smaller contracts in the earlier stages of the recovery cycle because the competition for larger contracts is more intense and operators expect to receive a volume-based discount. It might take a quarter or two, but this pricing power eventually will spread to larger projects.

Schlumberger’s unique product mix also contributed to the uptick in its international profit margins. The major oil-services companies offer many of the same basic product lines, but each has a reputation for performing certain kinds of work. Schlumberger is best-known for its technological innovations and the strength of its exploration-related services.

The company’s commitment to research and development has produced a steady stream of cutting-edge technologies that give the oil-services giant a leg up when bidding on major contracts and enable the firm to charge more than its peers. Without giving away too many details, management indicated that 2011 and 2012 will be big years for new products and services related to drilling efficiency - a key to controlling costs. We expect these product introductions to help Schlumberger win market share as demand ramps up.

Schlumberger replaced competitors on 47 jobs in the second quarter, as producers opted to jettison low-cost providers that failed to perform the requested services at the desired level of quality. Project delays stemming from inferior work can cost an operator far more than any price discount. Operators appear increasingly willing to pay for superior performance.

In the early stages of a recovery cycle, producers usually try to squeeze as much output as possible out of their existing fields to take advantage of rising oil prices. They may also begin to develop fields they’ve already discovered. Once management teams gain confidence that oil prices have stabilized at levels that incentivize further investment, producers plow money into exploring for new oil and natural-gas fields to develop. Among the Big Four, Schlumberger’s product mix offers the best exposure a recovery in spending on exploration.

This trend appears to gaining strength. Former CEO Andrew Gould discussed this recovery at length during the company’s July 22 conference call, highlighting the uptick in demand for seismic services:

The distinguishing factor of Schlumberger is Reservoir Characterization. It was very clear in this quarter that an acceleration in the exploration cycle is such that that is going to be a distinguishing part of the company. And if we look at the level of demand for seismic over the last few months and the global demand for seismic, coupled with some form of return in the Gulf of Mexico – and there have been encouraging noises out of Washington about holding a lease sale – that makes the seismic business look a lot better than it did even three months ago.

And the second thing is that there have never been so many deepwater rigs on order. So to the extent that we have exploration success in deepwater - and there's no reason to believe we won't have reasonable success. I think that the exploration cycle can be a lot more sustained than it was last time, when it was abruptly terminated by the financial crisis and by the Macondo incident. So I think that's the first thing.

And the second thing, as I've said forever - a long, long time, ever since I took over - to renew the production base when we're close to 90 million barrels a day, is just going to take a lot more CapEx (capital expenditures) than it did - and OpEx (operating expenses), by the way - than it did when the world was even at 80 million. So to the extent that, as you say, if you exclude the macroeconomic risks, which are not inconsiderable at this point in time, I'm back to my sort of theme of stronger for longer.

In this except, Gould explains why the company’s reservoir characterization business may be approaching an important inflection point, noting the broad demand for seismic services in international markets and increasing optimism about a potential recovery in the U.S. Gulf of Mexico.

A year ago, the panic surrounding the Macondo oil spill prompted many analysts to claim that the accident marked the end of deepwater drilling in the Gulf. Over the ensuing months, reports have suggested that the damage from the spill hasn’t reached the levels that many had expected. Moreover, the risk-reward equation has shifted: Consumers are willing to accept the risks of deepwater drilling in the Gulf because of the region’s growing importance to the nation’s oil supply.

Gould’s comments about the structural trends that underpin this upswing are even more important. His assessment of these market dynamics reflects our long-held thesis on the end of easy oil. According to Gould, declining output from mature fields will force producers to spend more money than in the previous cycle - and that’s just to maintain global oil production of 90 million barrels per day.

In its discussion of the turnaround in the Eastern Hemisphere, management highlighted bullish developments in two markets: Iraq and Saudi Arabia.

The company’s operations in Iraq managed to generate more than $100 million in quarterly revenue, while profit margins have approach the average level in the Middle East and Asia. The latter is a key development because many analysts expected these operations to offer subpar margins. Services firms had bid aggressively to win contracts in this rapidly growing market.

Meanwhile, the development of Saudi Aramco’s massive Manifa field should continue to ramp up in the back half of the year.

The global services cycle is entering a sweet spot roughly a quarter earlier than most analysts had predicted at the beginning of the year. This bullish development pushes the oil-services that I track for The Energy Strategist model portfolio to the top of my buy list.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.