One of the interesting things that has occurred in the past few weeks as we roll through Q2 earnings season is that oil (NYSEARCA:USO) prices have fallen from the upper $40s to the current $40/barrel. With the fall, the tenor of the conference calls has also changed from the initial group of oil service companies that we discussed in Part I (Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL), Core Labs (NYSE:CLB), etc.) to the current crop (Superior Energy Services (NYSE:SPN), Helmerich & Payne (NYSE:HP) and Baker Hughes (BHI)).
As analysts digested the initial rounds of earnings releases and management commentary, the same questions, albeit in greater detail, were then posed to these later reporting companies. The second batch of companies provided more nuanced views on the likelihood of an oil price recovery in the face of the recent declines.
Testing our Views
In the prior calls we noticed a distinct focus on needing to improve margins and increase prices. As oil service providers much of the efficiency gains claimed by oil and gas E&P companies have been borne by the service providers. In a bid to keep business, service providers have slashed prices to unsustainable levels. Consequently, it's no surprise that the service providers have begun to clamor for higher rates.
The higher rates, however, can only come if the industry can absorb it. We've held two views on this:
1. We believe that as the industry comes off of the bottom, service providers will still compete aggressively for business, and only when demand approaches saturation will oil service providers recapture their negotiating power. As such, the reduced capital expenses and increased capital efficiencies currently enjoyed by the drillers can last a little while longer, eventually ending when a surge of demand for rigs hands back pricing power to the service provider. Given the initial call with SLB and HAL and the discussion concerning higher margins, we weren't entirely certain that this view would prove true. As oil prices have declined in recent weeks, however, oil service providers have stated that prices won't necessarily increase wholesale. Increases will likely occur first for the most advanced rigs, and then later broaden when overall demand rises (more details below).
2. We also believe that once oil service providers regain some pricing power, the costs to drill will inevitably increase, and in turn, oil drillers will need a higher oil price to break even. We hadn't seen much discussion on this until the Baker Hughes call.
In contrast to the media and most investment bank analysts (who have said that drillers will dramatically increase production when oil achieves $50/barrel), BHI's CEO Martin Craighead stated
" . . . as far as North America, I don't subscribe to the whole full commentary that I think, gets thrown around a lot by your community. And I think that the customers are going to need something that's coming and vectoring in on around $60 or high $50s just because certain costs on our side are going to go up. And I just would feel a lot more confident that we see some stability well north of $55 before there is a lot of motivation for us to be bringing back capital into North America."
This elevated oil price is important as it increases the price E&P companies will need to break even and grow. We'll monitor this going forward, and see if this "pricing range" is later parroted by the E&P companies themselves (we doubt this as the upstream drillers are all currently motivated to publicize the lowest number).
Other observations to note:
1. As Prices Soften, So Have Expectations for a Fast Recover . . .
BHI - ". . . And looking back over the past few months, it's clear to me that the movement of oil prices has been driven more by one-off events such as temporary supply disruptions and not by changing the fundamentals underpinning supply and demand . . . . As we said in early May, we don't expect to see a meaningful recovery in the second half of the year, and that's still the case . . . . I've yet to see an economic catalyst that will create a step change to demand, that would lead to materially higher oil prices."
BHI - "On the demand side, growth is only forecasted to be modestly higher than expectations at the beginning of the year. In fact, the economic impact of recent events such as the Brexit vote leading to a stronger dollar and significantly weaker British pound has created more uncertainty and historically there's been a strong correlation between a strengthening dollar and a weakening oil price, which could continue to be an unfavorable headwind."
H&P - "Well, I think, I don't know that we've seen any significant change in call volume over the last several weeks, obviously, we're all painfully aware that, that oil continues to pull back."
A. Perhaps the latter half of the year
H&P - " . . . I think, in general, I described our customers is continuing to be very disciplined in their focus, looking at performance and reliability. I do think, all along, it seems like, at least many of our larger customers have been more focused on probably a September, October, November, timeframe. I think starting at the earliest in September . . . [b]ut, I think, in general, I think we all saw the optimism, there is some concern and I think drives a little bit of lower confidence levels as it relates to this lower oil price environment."
SPN - " . . . Let's spend a few minutes on outlook and how we see the U.S. land market unfolding in the second half of the year. First, there is a concentration of our customers in the U.S. that continue to battle balance sheet challenges and reduced credit facilities . . . we expect many of our customers to maintain lower spending levels for the remainder of the year. Second, many of our customers and much of the market produce from acreage that does not generate reasonable returns at prices below $50 per barrel, in some cases, below $60 per barrel. And we expect continued low levels of spending in these areas, until oil prices improve further. Finally, sentiment is a function of oil prices. In June, as we flirted with WTI prices of $50 per barrel, sentiment was euphoric. Today, prices have retreated and are below $45 per barrel . . . . In the U.S. land market, the third quarter will be a transition period. The pace of transition will likely be aligned with oil prices."
2. Costs will continue to rise, not only because of demand, but also because of increasingly complex well designs
HP - "I think, we've - we've felt pretty - or consistently said that coming off of bottom, pricing is going to be highly competitive. At the same time . . . the drilling environment is becoming more and more complex, which means that, contractors are having to upgrade rigs. And so, I think, that in and of itself would potentially drive some higher rates - again, not right off the bottom, but maybe earlier in the cycle . . . . So, I know it's not a direct answer. I don't think anybody has the direct answer; but I think, in general, it's going to be different than previous cycles. I do think pricing kicks in at a much lower rig count than what we've seen historically.
SPN - "In all likelihood, you're not going to get to a price to support that in the very early-stages of the cycle. So here is a way we think about early-stage pricing. Of the fleets that we have working today, there is not a single price that all those fleets work at, right. I mean, there is a range. And for us, that range of price has got about 20% spread in it, from the lowest price to the highest price. And what we'd like to do is we hire crews to activate new equipment is to at least be priced in the upper end of that range. The effect of that is it raises your prices in total."
Overall, the second batch of calls was helpful to understand how oil service provider costs will rise and at what pace. Understandably we witnessed more "table pounding" for higher rates in the earlier round of calls when oil prices were higher. The second batch (in the face of declining prices) were more subdued. Nevertheless, it's important to note that you can only fight economics so long. When higher oil prices lead to increased production, it will eventually increase costs. It's an inevitable cycle, but at this stage, any delay to this cycle will allow upstream E&P companies to generate much needed excess cash to repair damaged balance sheets and reinvest in CapEx. As investors in the upstream segment, this is what we're looking for.
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