Oil-Field Services: Analysis And Outlook

| About: Schlumberger Limited (SLB)
This article is now exclusive for PRO subscribers.

Third-quarter results in the oil-field services space reflected ongoing weakness in North America and steady improvement in international markets. Among the Big Four services companies, Schlumberger (NYSE:SLB) stands to benefit the most from the current environment, while Halliburton (NYSE:HAL) and Baker Hughes' (BHI) significant exposure to languishing demand for onshore services in North America remains a liability.

Each quarter, Energy & Income Advisor scrutinizes results and comments from the Big Four oil-field services companies. Not only will these names benefit over the long term from the end of easy oil, but their global reach and the breadth of their product offerings also give them unparalleled insight into trends in global energy markets and the sentiment of the world's biggest producers.

Schlumberger's quarterly conference calls often highlight a number of investable trends, and CEO Paal Kibsgaard has continued his predecessor's policy of answering in a reliably forthright manner.

Schlumberger posted strong third-quarter results, with earnings of $1.08 per share beating the Bloomberg consensus estimate of $1.06 per share. However, revenue of $10.61 billion--a 1.5 percent increase sequentially--fell shy of analysts' consensus estimate of $10.69 billion.

The challenging North American market accounted for this sales shortfall, as revenue in this segment declined 2.3 percent from the preceding quarter. Schlumberger's miss stemmed primarily from analysts' inflated expectations and eagerness to call a bottom in North American profit margins amid hopeful comments from Baker Hughes and Halliburton in conference calls to discuss second-quarter results.

But the weakness in Schlumberger's North American segment doesn't reflect strategic or operational missteps. In fact, the company boasts the best profitability in this geographic segment. Whereas Schlumberger's North American pretax operating margins fell 223 basis points sequentially to 18.54 percent, Halliburton's margins dropped to 14.1 percent and Baker Hughes' margins tumbled to 10.5 percent.

That's a far cry from the third quarter of 2011, when Halliburton's North American business posted pretax operating margins of almost 27 percent and Baker Hughes' operating margins in the region came in at about 23 percent.

An oversupply of pressure-pumping capacity, a service line that's integral to hydraulic fracturing, has driven much of the recent decline in the Big Four's profitability in North America.

Schlumberger and Baker Hughes noted that prices in this service category continued to deteriorate in the third quarter, as expired contracts were replaced with agreements that includes less lucrative terms.

In a conference call to discuss third-quarter results, Martin Craighead, CEO of Baker Hughes, admitted that conditions could continue to deteriorate further, even though the industry has attempted to hold the line on pricing by limiting capacity growth:

[W]e've been in the spot market, right or wrong, for all of this year. There's quite a bit of contracts that are still rolling off for some of the suppliers. And I think if that happens, it breeds a little bit more aggressiveness as those contracts come up. And I think that's going to be with us, if you will, for probably another couple of quarters.

Meanwhile, signs of weakening in Schlumberger's coiled-tubing business--spooled pipe used in well maintenance and repair--toward the end of the quarter suggest that the challenges afflicting pressure pumping may be migrating to other service lines.

CEO Paal Kibsgaard acknowledged this risk during a conference call to discuss Schlumberger's third-quarter results:

[F]racturing margins are going to come down further in Q4 and likely also in Q1, as the new pricing levels work its way through our contract volume. And as I also mentioned we also some margin pressure in coiled tubing.

Now, what's going to happen beyond Q4 or Q1, I would say there's really three main questions in my mind. Firstly, will there be a Q1 recovery in liquids rig count after Q4? This is key to maintaining the current land pricing overall both for fracking as well as for the other product lines?

The second question is will there be a [market] share play in the frac market and a new pricing floor given the fact that there is significant excess capacity in the market and also when new capacity comes, is this going to be another source of market share plays?

And the third question in my mind is in terms of how North America overall is going to perform, what are really the normalized frac margins? The way I see it, or we see it, the frac market in North America today is largely a commodity market with a very low barrier to entry, where capacity is really driving the pricing, and we peaked around 30 percent margins, and the trough is now in low single digits. And I would say in my mind that the normalized margins are more in the middle of this. They're certainly not toward the upside.

The most important takeaway from Kibsgaard's comment is that, absent a stabilization of the US rig count, the pricing weakness afflicting the North American market for pressure pumping and other drilling-related service lines could deepen.

The Schlumberger CEO elaborated on this outlook later in the conference call, asserting that another 10 percent decline in the US rig count would exert additional pressure on prices charged for drilling-related services. Kibsgaard noted that he "would probably worry about" such a development.

Unfortunately, the US rig count has declined to 1,826 units from 1,839 active rigs in the week that Schlumberger hosted its quarterly conference call. Although the number of drilling rigs targeting natural gas has declined precipitously since the third quarter of 2011, the oil-directed rig count has recently slipped from its 2012 high.

Source: Bloomberg

Although US natural-gas prices have recovered significantly from the nadir hit in spring 2012, we don't foresee much additional upside to pricing.

For one, climbing prices have already prompted some utilities to increase the amount of coal that they burn in thermal-power plants at the expense of natural gas. (See A Tale of Two Commodities: The Intertwined Fortunes of Coal and Natural Gas.) Moreover, the increasing efficiency of drilling operations and rising production of associated gas in liquids-rich plays have offset the sharp decline in the US gas-directed rig count, ensuring that US gas production remains elevated. With the domestic market for natural gas still facing a significant supply overhang, investors shouldn't bank on a sustainable recovery in the gas-directed rig count.

The outlook for the number of drilling rigs targeting oil is a bit murkier, though additional deterioration could be in store. Although the price of West Texas Intermediate (WTI) crude oil has declined to about $86 per barrel from almost $100 per barrel in mid-September, operators in oil-rich unconventional basins such as North Dakota's Bakken Shale should still generate a solid internal return on investment. However, prevailing oil prices might dissuade producers from expanding their existing drilling programs.

North American producers and oil-field services firms also appear to be engaged in a game of chicken, a situation to which Halliburton's CEO, David Lessar, alluded in a conference call to discuss third-quarter results:

Across the North American market we have seen customers curtail spending compared to the first half of the year and believe they will continue to decrease activities to operate within their capital budgets for the remainder of 2012. Couple this with expectations that our customers will take significantly more holiday downtime than prior years, and this could have an even more than normal negative impact on the rig count as we approach year-end.

Some North American exploration and production outfits claim to have spent the lion's share of their capital budgets in the first half of 2012, a situation that's corroborated by the steady increase in the oil-directed rig count in the first two quarters. Accordingly, some producers plan to reduce their activity levels in the fourth quarter, a departure from the torrid pace of drilling in recent years. Martin Craighead, CEO of Baker Hughes, noted that these delays have been particularly pronounced among small- and mid-capitalization operators.

The producers' strategy involves an ulterior motive: exacting a bigger discount on services to reduce costs and bolster profitability. Both Schlumberger and Halliburton's management teams indicated that they'd idle pressure-pumping capacity and crews rather than accept lower margins.

Consider the following exchange between CEO David Lesar and an analyst during Halliburton's quarterly conference call:

Analyst: We've been hearing a lot of talk about E&Ps [exploration and production companies] using up their 2012 CapEx [capital expenditure] budgets. And I guess. on the one hand, I guess there is a first for everything, but it's pretty unusual, considering that these guys are cash flow driven and WTI is above 90 [dollars per barrel].

So I'm just wondering. It seems to me like a lot of the weaker activity levels is really about them looking to drive down cost through lower service pricing. Now along these same lines, Dave, you just made a pretty big change there in your strategy, saying you're not going to be seeking full utilization anymore. So should I be reading this or should we be reading this as basically you guys drawing a line in the sand, saying this is as far as we're going to go on pricing, and we're not going to devalue our services anymore, compared to the one-dimensional players?

David Lesar: I guess that's a great way to summarize it, Dave. As I indicated, one of the lessons we learned coming out of the last dip is that chasing the transactional market essentially sets a lowest common denominator for pricing, and it's that point that you have to then battle uphill on getting price increases out of. And so our view is that that is a relatively transitory market for us to chase into, given the percentage of 24-hour crews we have.

Therefore, we are not going to chase into it this time. We're not going to lower our prices to get that work, therefore giving us a higher baseline to move forward when some of these other issues get out of the way. So yes, that is a strategy change, and one that ultimately, I think, will be successful, and is just a lesson that we learned from the past.

While Halliburton and Schlumberger appear committed to holding the line on pressure-pumping prices to the detriment of their market share, exploration and production companies are unlikely to curb spending in liquids-rich shale plays as long as the price of WTI crude oil remains above $80 per barrel in 2013. Of course, smaller operators will likely prove more willing to work with producers on pressure-pumping prices.

This market readjustment is fraught with uncertainty. For example, what are "normal" margins for pressure-pumping? Kibsgaard suggests that operating margins on this business line would stabilize in the mid-teens, while his counterpart at Halliburton, the largest provider of pressure-pumping services in North America, asserts that margins would settle somewhere in the mid-20s.

We tend to side with Schlumberger's longer-term outlook for operating margins in the pressure-pumping market, as Halliburton's outsized exposure to this business line inherently makes Lesar more optimistic about an eventual recovery. With few barriers to entry and significant overcapacity, pricing trends in the pressure-pumping market should remain highly cyclical.

When will the pressure-pumping market rebalance itself? Halliburton asserted that profitability in this business line tends to bottom when pricing hits smaller operators' break-even rates. CEO David Lesar indicated that the market is approaching this inflection point, which would force these companies to halt further price reductions. But given the extent of the supply overhang, it remains to be seen whether this rule of thumb will hold true this cycle.

All told, there remains a great deal of uncertainty in the North American services business. Within the industry and the analyst community, the consensus view appears to be that operating margins in the region will bottom in the second or third quarter of 2013. We see plenty of downside risk to this estimate, especially if pricing in other drilling-related service lines comes under pressure.

Meanwhile, a meaningful recovery in the pressure-pumping market is unlikely, barring a turn in the gas-directed rig count; deep-lying reserves of natural gas usually require significantly more horsepower to fracture than shale oil plays. But a sustainable uptick in gas-focused drilling activity should prove elusive, while even a modest decline in the number of rigs targeting crude oil would further erode profit margins.

Against this backdrop, investors should avoid Halliburton and Baker Hughes--both of which generate about 55 percent of their annual revenue from North America--until signs of a legitimate turnaround emerge and analysts begin to raise estimates. Investors should also note that Baker Hughes currently has significant exposure to the spot market for pressure-pumping capacity.

We regard Schlumberger as the best-positioned of the Big Four oil-field services firms for the following reasons:

  1. Less Exposure to the North American Onshore Market: Schlumberger derives about one-third of its revenue from the North America.
  2. Superior Exposure to the Gulf of Mexico: Drilling activity in the Gulf continues to accelerate and is approaching pre-spill levels-a significant tailwind for Schlumberger. We expect upcoming lease sales of blocks in the western Gulf and the central Gulf to fuel further exploration and development.
  3. First to Right-Size: Management identified the potential for an oversupply of pressure-pumping capacity in 2010 and added horsepower in a far more disciplined manner than Baker Hughes and Halliburton. Schlumberger was the first of the Big Four to set minimum profit margins for its pressure-pumping operations, preferring to idle crews instead of chasing cut-rate contracts. The firm also restructured its North American business two years ago to optimize its supply chain and lower its cost structure, a process that Baker Hughes is still tackling.
  4. Industry-Leading Technology: Schlumberger has focused on developing advanced technology related to hydraulic fracturing, as opposed to merely adding horsepower. The company can provide customers with three-dimensional models of the shale reservoir to optimize production while its Hi-Way fracturing system uses less water and proppant. In the third quarter, Schlumberger completed 2,100 fracturing stages with the Hi-Way system-up 60 percent sequentially. A recent study shows that the use of this completion technology on wells in the Eagle Ford Shale yielded average production that was 65 percent higher than standard horizontal wells.

Meanwhile, Schlumberger boasts superior exposure to accelerating activity and margin growth in international markets. In the third quarter, the company grew sales in its international segment by 3 percent sequentially, while pretax operating margins jumped 73 basis points to a three-year high.

The Middle East and Asia led the pace, posting a 7 percent increase in revenue and expanding segment margins by 126 basis points. However, Schlumberger failed to grow sales in Latin America-a market that had been a key growth driver in recent quarters-and margins slipped 113 basis points from the preceding quarter. Management attributed this softness to mobilization costs and operational delays on some projects, not weakening demand.

More important, Schlumberger maintained its upbeat outlook for drilling activity in international markets, where demand hinges on the price of Brent crude oil. Over the past year, Brent crude oil and other international benchmarks have fetched a substantial premium to WTI, which remains depressed because of a glut of supply at the delivery point in Cushing, Okla.

Schlumberger's management team expects the price of Brent crude oil to remain elevated; non-OPEC countries outside North America have struggled to grow production, while OPEC's spare capacity hovers near a five-year low. (I'll update my outlook for oil prices next week's free Live Chat, but we generally concur with Schlumberger's assessment--assuming that the US avoids recession and economic growth in China doesn't slow considerably.)

This price outlook prompted CEO Paal Kibsgaard to predict that the oil-field services firm would grow its revenue by 10 percent in 2012 and that this momentum would continue into 2012. Management also reassured listeners during the quarterly conference call that "no material change to overall customer activity plans or sentiment" has occurred in international markets, despite the recent volatility in oil prices.

Schlumberger noted that seismic services, wireline, and drilling and measurement have continued to benefit from tightening capacity, while the supply-demand balance has also improved for well testing.

The firm's seismic division, WesternGeco, has driven results in recent quarters. Acquired in 2006, WesternGeco is the industry leader in marine geophysical services, a business line that's critical to oil and gas companies' exploratory efforts in the deep water.

By emitting sound and pressure waves and tracking their subsequent reflections, WesternGeco's fleet of specially designed vessels accumulates data about the positioning of subsurface rock formations to identify areas that are prospective for oil and natural gas.

Schlumberger's most recent innovations in this space enable the firm to render highly detailed, three-dimensional models of geological formations. This data is highly prized by exploration and production firms, which rely on seismic information to determine the best locations to drill exploratory wells.

As an ancillary business, Schlumberger provides technology and software to analyze the raw seismic data and consulting services to help customers formulate their drilling and development plans. With prevailing charter rates on ultra-deepwater drillships exceeding $600,000, high-quality geophysical data is critical to saving money and avoiding every oil company's nightmare: the dry hole.

Demand for marine seismic services often moderates in the fourth quarter, as producers delay exploration-related expenditures until they've established their budget for the upcoming year. But this seasonal lull hasn't occurred this year; WesternGeco has booked all of its seismic vessels for the fourth quarter, with year-end demand particularly strong in the south Atlantic.

The tightening supply-demand balance in this business line enabled the company to increase prices by about 10 percent in 2012, and management has raised prices by about 15 percent for work in 2013.

Whereas the market for marine seismic services began to improve more than a year ago, Schlumberger's management team indicated the supply-demand balance has recently tightened in other service lines, including wireline, logging and well testing.

The company also stands to benefit from its traditional strength in exploration-related services and products, an area where burgeoning demand in international markets has enabled the industry to push through price increases. Meanwhile, with fewer mega-contracts on the horizon, the industry should be able to raise prices on smaller projects. Schlumberger's solid execution commitment to technological innovations also gives it up a leg up on the competition, enabling the firm to .

CEO Paal Kibsgaard highlighted these and other growth drivers for during a conference call to discuss Schlumberger's third-quarter results:

First start with Q3 performance, I'll say I'm overall pleased with the progress. We are keeping very strong focus on execution, as we've been talking about in earlier quarters, and we also are doing quite well when it comes to cost and resource management.

We also continue to work on our internal improvement programs, which, by the way, is included in our normal operating costs. So in terms of margins, we saw further progression in Q3 and we had very good incrementals and as I said in my prepared remarks, our international margin is now at a three-year high. Some of the drivers behind this is slow but steady pricing increase driven by new technology sales, as well as strong operational performance.

But I would also say that the quality of service is still the market share driver for us. The D&M [drilling and measurement] Q3 replacement ratio was again 34 to 3 so we're maintaining this 10 to 1 ratio, and this is actually starting to become meaningful for D&M now which showed significant improvement in financial performance during this year.

So if you then take that performance and try to look forward we maintain our positive view on international markets and also our performance there. We have a very strong international contract portfolio and this portfolio has solid upside when it comes to both technology and performance.

And the other thing I would like to highlight as well is that we continue to expand the international presence of our smaller product lines. If you look at operations internationally today, we operate in over 80 countries, and we have 17 product lines. But in 50 percent of these countries we only have 50 percent of our product lines present.

So I would say that we still have a lot of runway in terms of growth as for market penetration. So in terms of margins going forward I would just say we would continue to leverage the size and the infrastructure and the execution capabilities to drive both the top line and further margin expansion. So as overall, our view on the international market remains positive, and I'm pleased with the progress in terms of how we were executing, and I would expect us to continue to improve going forward.

In the near term, expect Schlumberger's stock price to rise and fall based on expectations for Brent crude oil prices and the macroeconomic picture. However, we still regard oil-field services as one of the best-positioned subsectors within the energy patch over the next six to 12 months, as the group will reap the rewards of accelerating exploration and development in deepwater fields.

Investors looking for exposure to these trends will gravitate toward Schlumberger because of the firm's superior technology, exposure to international markets and relative insulation from deteriorating market conditions in North America.

Weatherford International (NYSE:WFT) has yet to report third-quarter results, though the firm's business mix should provide a degree of insulation from the collapse in pressure-pumping margins. In fact, the company has the least exposure to this troubled business line among the Big Four services firms.

We also like the firm's industry-leading position in artificial lift, a category of products and services that enhance output from mature oil wells. In Baker Hughes' quarterly conference call, management highlighted this business line as one of the few growth stories in the North American onshore market.

At the same time, Weatherford International has the most exposure to Canada of the Big Four oil-field services firms. Baker Hughes expects Canada's active rig count to average 340 units in the fourth quarter, a decrease of 28 percent compared to year-ago levels. Although CEO Martin Craighead noted that activity would likely remain robust in Canada's oil sands, the depressed price of natural gas has prompted operators to scale back spending in basins that primarily produce this oversupplied commodity. Craighead elaborated on this trend during Baker Hughes' conference call:

Canada has traditionally been a predominantly natural gas-driven market. And while our customers are largely targeting oil plays, their existing natural gas assets still account for a significant part of the revenue base. And with uncertainty over forward-looking commodity prices, our customers are taking a conservative approach to their business right now. For us, that means activity in Canada did not ramp up as high as expected. And looking ahead, we only predict a slight activity improvement through the rest of the winter drilling season.

These developments prompted Craighead to warn, "We expect pricing in product lines could become an issue as service companies begin adjusting to the new market realities in Canada."

Although these headwinds pose a risk to Weatherford International, the company's oil-weighted business mix in Canada and robust demand for artificial lift should provide a bit of a buffer.

However, management must also effectively address the long-standing tax accounting issues that have plagued the firm in recent quarters. That Weatherford International won't report results until Nov. 13 suggests that the firm is working to finalize these accounting statements. Resolving these accounting issues could help the stock rally into the mid-$20s per share.

Disclosure: I am long SLB, WFT. 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.