The Oil Services Industry's 2Q--Still No Rebound
We discuss the industry's second-quarter results and highlight our top picks.
The oil services industry's collective second-quarter results were terrible, thanks to another significant decline in North American drilling activity. Weatherford (WFT), BJ Services (BJS), and Patterson-UTI Energy (PTEN) reported losses in North America, and industry-leader Schlumberger (SLB) was barely profitable. A late surge in the North American rig count, led by higher oil prices, may lead to some business stability in the industry's third-quarter results. However, in line with our earlier forecast, we note that most of the industry has thrown in the towel on 2009 and is looking toward 2010 for a more sustainable North American recovery. Internationally, as we expected, Schlumberger and Halliburton (HAL) confirmed that contract pricing resets would lead to lower operating margins in the second half of 2009. Further, Halliburton's latest Chicontepec win implies more intense competition for future awards, which makes the contract economics questionable for a key industry tail wind.
Overall, our stance on the industry remains unchanged, and we think a sustainable recovery is unlikely until the second half of 2010. Some new data points about North American and international services pricing are negative, and Iraq is unlikely to be the near-term panacea to boost industry growth. After reviewing the industry's second-quarter reports, we present our key takeaways.
First, North American services pricing is much closer to a bottom. Prices across many product lines have declined 35%-45% from peak levels. However, we do not see a catalyst for improved services pricing in the next few quarters. The acquisition of BJ Services by Baker Hughes (BHI) may provide another indicator that the oil services bottom is close. However, Baker Hughes plans to integrate BJ Services slowly, which means the difficult near-term equipment supply picture remains unchanged and similar to what it was before the merger announcement.
Second, the Baker Hughes rig count reached a short-term bottom at 876 rigs, which was not too far off from our 900 rig forecast. The rig count currently stands at 1,009 rigs. If this bounce holds, it will mean the third quarter's North American revenue for our oil services companies will probably be roughly flat or increase slightly from second-quarter levels. The industry's operating margin could improve a few hundred basis points in the third quarter due to further cost cutting.
Third, the international services market downturn traditionally follows the North American market by three to six months. We are concerned that contract repricing in the next six to nine months could damage the industry's long-term pricing power and growth prospects for several key international markets such as Mexico (Chicontepec), Iraq, and Brazil. Given the difficult current market and intense competition for work, we think that some recent contracts awards may be much less profitable than contracts signed from 2005 to 2008. For example, contract terms may include weaker cost protections for the oil services firms if their own costs happen to rise again like they did over the past few years.
Weak Outlook for Domestic Markets
As we forecasted in our first-quarter review, oil services pricing declined dramatically during the second quarter, leading to losses for some of the firms we cover. For pricing to improve over the next few quarters, we need either a large contraction in supply (equipment capacity rationalization), or a sharp spike in services demand. In certain product lines, we are seeing significant amounts of equipment being retired, as Halliburton and BJ Services plan to retire about 15%-20% of their pressure pumping and wireline fleets by the end of 2009. We believe Schlumberger has similar plans for its own fleet. However, as pressure pumping is one of the most price-sensitive product lines and the companies face stiff competition from low-end players (such as Chesapeake's (CHK) FracTech), extrapolating this capacity reduction to other product lines may be too optimistic. Further, early indicators from services customers indicate that 2010 drilling budgets may be flat, dashing any hopes for a significant boost in near-term services demand. In this scenario, services pricing may bounce along an L-shaped bottom for the foreseeable future.
With a weak pricing outlook, the industry is firmly in cost-cutting mode. Still, once pricing begins to rebound, the industry faces the challenge of successfully ramping up off a cyclical bottom. The oil services industry usually becomes highly efficient at the bottom of the cycle, as the companies have squeezed any cost inefficiencies out of their businesses. The problem arises when customers start to put more rigs back to work, and the industry has to hire new and inexperienced roughnecks to replace the experienced hands that have left the industry. This situation creates substantial operating inefficiencies, due to the additional time needed by the services industry to train new workers to cope with the surge in demand. As a result, we think the improved services pricing that occurs as demand ramps up will go to the companies with the best-prepared workforce. We believe Halliburton and Schlumberger may be the best-positioned due to the quality of their workforces and stringent training programs.
International Outlook is Getting Worse
Compared with the North American outlook, the near-term international forecast for our oil services companies is not much better. For example, Schlumberger indicated the economics for future Chicontepec awards were unattractive after Halliburton won its first Chicontepec contract. However, Schlumberger CEO Andrew Gould also complained about the Chicontepec contract economics after Weatherford won two Chicontepec contracts last year, yet still bid and won a new contract in the field in February. Unfortunately, none of the companies have revealed any details surrounding the Chicontepec well economics. Still, we find it hard to see how more competitors forcing well pricing downward can result in improved financial outcomes for the contract winners without large cost savings. In addition, both Halliburton and Schlumberger indicated that international margins will probably decline 300-500 basis points in the second half of 2009 and potentially into 2010. We note that Halliburton expected its North American margins to decline 300-500 basis points from its first-quarter numbers, and they subsequently declined 900 basis points.
Unfortunately, Iraq is unlikely to be a near-term boost to the industry's international fortunes. Schlumberger CEO Gould candidly stated that the potential for Iraq to be a $1 billion-$2 billion business for the company within two years was zero. We agree, as most companies within the industry are building operations in the country on speculation, with no firm work in hand. The recent failure of the Iraqi auction to obtain more than a single winning bid for a field means that further contract awards in the country are unlikely until 2010. We believe the results of the second round of auctions for the Iraqi fields in November may give us more clues into the timing and size of future oil services contract awards.
The key issues for the services firms are managing security (which can cost up to 7.5% of the well cost) and the lack of oil and gas infrastructure. In our conversations with our companies, most firms believe the security costs are manageable. The challenge will be managing with the near-complete lack of oil and gas infrastructure, which could give some pricing leverage to the largest oil services companies such as Schlumberger, Halliburton, and Weatherford. The firms have more experience managing integrated project management projects and therefore being responsible for significant amounts of oilfield equipment. If the companies can successfully solve these issues, the long-term outlook looks bright.
Companies Worth Considering
Schlumberger and Helmerich & Payne (HP) are still our top picks to outperform over the full cycle. Year-to-date results for both firms have been significantly better than peers, demonstrating their strong customer value proposition and excellent operational execution by both management teams. Further, both companies are well-positioned to benefit from any improvement in the North American natural gas supply or services equipment picture. Please see our Analyst Reports for further long-term investment opportunities within the industry.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.