Fully Outsourced Field Management
During its earnings call last Friday, Schlumberger (NYSE:SLB) commented on the company's recently announced Eagle Ford joint venture with Forest Oil (NYSE:FST). While Schlumberger stated that "this is a one-off deal in terms of taking working interest" in an E&P project and the company "has no plans of pursuing this type of contract model further," it is nonetheless abundantly clear from the commentary that Schlumberger is aggressively targeting the U.S. shales market for its integrated field management offering.
The development deserves some attention as the concept behind it is quite transformational in nature and, if accepted in the market, may - in the long run - have consequences for the way the U.S. E&P sector is currently organized. In essence, the integrated project management model would allow E&P companies with high quality acreage but somewhat limited technical expertise and resources to outsource a significant part of field management function - from technology to logistics - to the "ultimate shale expert," Schlumberger or another integrated oil service major such as Halliburton (NYSE:HAL), Baker Hughes (BHI) or Weatherford (NYSE:WFT), in exchange for shared upside in the project. The framework also allows the E&P company to pay for a portion of the development costs with future oil and gas revenues. In addition to E&P companies, the approach may have potential appeal to private equity funds and foreign investors with limited or no operational involvement in the area where the project is located.
The proposed framework seems to bear certain similarities to Production Sharing Agreements that dominate the international oil business (in Schlumberger's model, Schlumberger would effectively play the role of an Exxon Mobil while the E&P company with the acreage position would play the role of a national oil company; the significant difference is that Exxon would need to hire a Schlumberger to perform oilfield services whereas Schlumberger has those capabilities in-house).
Schlumberger-Forest Oil Eagle Ford Joint Venture
As a reminder, Forest Oil and Schlumberger two weeks ago announced a joint venture to develop Forest's Eagle Ford acreage in Gonzales County, Texas. Under the agreement, Schlumberger will pay a $90 million drilling carry to earn a 50% working interest in Forest's Eagle Ford acreage position (a total of 55,000 acres are expected to be held by production which represents ~688 drilling locations based on 80-acre spacing). Once the drilling carry is fully utilized (by mid-2014 or even earlier), Forest and Schlumberger will participate in future drilling on a 50/50 basis. (A detailed transaction analysis can be found in this note).
As an important part of the agreement, "Schlumberger will provide assistance to Forest in the form of integrated service offerings and asset management support, including drilling, completion and lifting technologies; reservoir management technologies; and development of unconventional resources workflows." Forest will continue in its position of the properties' operator.
Two aspects of the joint venture are important. First, Schlumberger will provide a full integrated suite of services and technologies to the project and will have a much larger involvement in the planning and management of the development program than it would traditionally. Second, Schlumberger will risk its own capital and will participate in the economic upside from the project.
Schlumberger's SPM Model
Under the traditional practice established in the U.S. oil and gas industry, the exploration and development process in a field is anchored by the "operator" - an E&P company that leases mineral rights, hires oil service providers (such as Schlumberger), and owns the entire economic risk and upside in the oil and gas project. The operator makes all the decisions with regard to well location and design, choice of extraction techniques, timing of the development, production optimization, etc.
Schlumberger is offering an alternative schema under which the E&P operator would subcontract the larger part of field management function to Schlumberger. Schlumberger calls its product SPM, which stands for Schlumberger Production Management.
SPM is a step further, and is different, from Integrated Project Management (IPM) that Schlumberger has successfully offered for many years, mainly to its international clients. Under the IPM model, Schlumberger offers a package of bundled oilfield services, which often include logistics and procurement, however the overall decision making is generally governed by the E&P company. Under the SPM model, Schlumberger takes full control in terms of operation and decision making when it comes to the field development: Schlumberger would get to decide where to drill, how to drill, how to work over, and how to further invest into the field.
Also, under the SPM formula, Schlumberger would contribute and put at risk the value of its products and services and, in some cases, also risk cash in the deal (but predominantly it's the value of Schlumberger's products and services).
So what differentiates the SPM model is mainly the deal's overall risk profile combined with the fact that Schlumberger has complete management control of the operations within the SPM deal structure.
Schlumberger has been marketing its SPM product for a number of years and has been awarded about 10 SPM projects worldwide since the product was officially inaugurated in 2011. These are generally fee-per-barrel contracts (with no working interest). The existing projects are located in Ecuador, Colombia, Mexico, Romania, Malaysia, China, and U.S. and have combined production of more than 140,000 bbl/d of oil equivalent.
Schlumberger's CEO Paal Kibsgaard commented during the earnings call:
It is a part of our business which we are looking to grow because it is highly accretive to our margins, if you look at the portfolio we have. At the same time, it is resource intensive. The whole sales cycle is quite long. Also, we are very careful in terms of evaluating the project that we get ourselves into. So we are interested in growing our... SPM module, but it is an area where we can afford to hurry slowly. So there is nothing that we are looking to ramp dramatically.
If you look at reasonable size project, we might look to add two, maybe three, a year. I would say that's probably the maximum at this stage.
The key impetus behind Schlumberger's SPM strategy in the North American unconventional arena, that became manifest with the Forest Oil joint venture, is the company's heavy investment over the past several years into a portfolio of technologies for North American shales. In the past, Schlumberger has not really had a significant focus on developing new and high-end technologies that would have a significant application in North America's onshore plays - the company's primary focus had been on the International and Offshore markets. Now, over the past five years, with the renewed focus Schlumberger has on North America, the company has invested significantly in the shale technologies and shale workflows, focusing on an integrated technological approach to drive production and recovery increases. Schlumberger now needs to get these technologies further into the marketplace to get return on these investments. By Schlumberger's own admission, uptake on its high-end technology portfolio has been somewhat slow among North American shale customers relative to what Schlumberger has been able to achieve internationally.
Schlumberger's Comments On Forest Oil Joint Venture
According to Schlumberger, the venture with Forest Oil is the opportunity to showcase the full suite of its shale technologies and demonstrate the effectiveness of its "shale workflow" model. Paal Kibsgaard commented:
The Forest deal became such opportunity. Schlumberger initially aimed for the traditional SPM contract model with Forest. However, that wasn't workable for a variety of reasons, so the working interest was really only solution to get the deal done, but it was much more of a consequence rather than the objective, so this is a one-off deal in terms of taking working interest and we have no plans or pursuing this type of contract model further and it's really key for us to demonstrate our capabilities within the shale technologies and shale workflow and get a higher return on the significant R&D investments we made into this area, so that is the whole rationale for the deal.
Forest will continue to be the operator. When I say operational control, we don't take on operatorship in any of these deals, but we have a much more of a say how we go about developing these fields, so there's always some dialogue with the E&P company who maintains operatorship, but if you look at it from a well construction type of interaction in IPM, where we are told where to drill and we just go by drilling the well, there's much more of a dialogue around the entire development plan within an SPM project and we have a lot more of a say in how they go about development.
Clearly, the Schlumberger-Forest Oil joint venture is just one small episode in the context of the very large North American oil and gas industry and is very unlikely to create an even remote perception that Schlumberger is "competing with its own customers." However, one important observation is in order: in unconventional resource plays, oil service companies have played the role of designers, carriers and disseminators of cutting-edge evaluation and extraction technologies. By providing services to a wide range of operators across many plays, oil service providers often have the broadest exposure to technical information flow and deepest "case" experience.
As a result, one might argue, integrated oilfield service majors (which include Schlumberger, Halliburton, Baker Hughes and Weatherford) have deeper technical capability in formation evaluation, well and completion design, and development workflow and optimization than what many E&P operators can assemble in-house. Outsourcing all these functions would seem to make sense for some E&P companies or for some portions of E&P companies' portfolios, and the concept of an integrated project management solution should have some validity.
Outsourcing would require some changes to the existing structure of the operator-vendor relationship. Outsourcing is hardly possible without a proper alignment of economic motivations. From that perspective, an IPM contractor's significant participation in the project's upside seems almost a must. The contractor would also need to have a high degree of execution autonomy. Schlumberger's SPM model clearly attempts to address both of these requirements.
What appears to be a bigger and more difficult to solve issue is the fact that Schlumberger is both the owner and the exclusive provider of oil services to the project. It is difficult to imagine a structure where the potential conflict of interest (service pricing; "must have" versus "nice to have" services; transfer pricing, etc.) can be easily managed.
With the SPM being the new format for Schlumberger in the U.S., the company will need to establish a track record of managing an E&P project effectively and efficiently (including cost control) - something that E&P operators have had as their core function.
It is no surprise that the IPM- and SPM-style models have yet to win market share in North America (some precedents already exist but they are an exception rather than the rule). The North American market has no shortage of E&P operators with exceptionally strong and deep technical benches. In addition, competition among service providers is strong. It would be very interesting to see if the joint venture between Schlumberger and Forest Oil, by transferring a significant part of execution responsibility and control (at least, as it seems) into the hands of Schlumberger, can achieve a breakthrough in well results and reduce costs. A positive result would certainly make the industry pay closer attention.
Disclaimer: This article is not an investment recommendation. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. This article is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.