Schlumberger Set to Benefit From International Recovery

Among oilfield-service companies, Schlumberger SLB has long been in a class of its own. Underpinned by its moat and strong management, the company has earned solid economic profits for decades. It reached the front of the pack in wireline evaluation in the 1920s and hasn’t relinquished that position. Since then, Schlumberger has used its unrivaled expertise in understanding oil and gas reservoirs to drive a continuous stream of profits in its legacy business lines and also apply this knowledge to develop other oilfield-service business lines with nearly unwavering success. As an example, the company pioneered directional drilling in the mid-1980s, a technology that today is recognized as an indispensable ingredient in the shale revolution.

Schlumberger is now aiming its expertise in a new direction: lowering the cost per barrel of oil and gas development via the provisioning of integrated, performance-linked services. Management believes that a combination of Schlumberger’s unique technologies along with a new business model embodying full integration and alignment of interests will allow for transformational leaps in oilfield efficiencies and reservoir productivity, and early signs have been positive.

This cost-cutting focus puts Schlumberger in an ideal position in the coming years as international oil and gas activity recovers. International producers have struggled with rising costs for decades thanks to limited efficiency improvements. We think the success of Schlumberger in addressing this problem will drive market share gains in the years ahead.

Intangible Assets and Cost Advantages Dig Narrow Moat We award Schlumberger a narrow economic moat rating. We believe the company's history of generating strong returns on capital is very likely to continue.

Schlumberger has delivered strong returns on capital for decades via its ability to develop and sell differentiated products and services in the oilfield-service industry. Often these differentiated products are new, or novel variations of older technologies, which particularly limits competition and ensures high margins and returns on capital for Schlumberger. New products’ share of revenue has averaged about 20% for about three decades, since the company began reporting the metric.

Schlumberger’s ability to develop differentiated products with low product development costs (or, equivalently, high returns on R&D) is enabled by the company’s intangible assets and cost advantage. Intangible assets include intellectual property, organizational know-how, brand, and (increasingly) data. The existing stock of thousands of patents alone should provide a long runway of existing and new products, and hundreds of new patents are filed each year.

One unconventional source of intangible assets is the company’s human capital. Schlumberger is superior, particularly in international markets, in providing an excellent platform for human capital, including scientific and engineering talent. The company has a distinguished record in utilizing local talent internationally, which is cheaper, more captive, and in many cases better suited to adapt technology to local conditions.

Additionally, Schlumberger benefits from a cost advantage in terms of economies of scale in its international service lines as well as economies of scope in its R&D investments. Not only does Schlumberger invest more in R&D than all its peers combined, but we believe it earns superior returns on this, with these economies of scope being a major contributor. The company has long been successful in utilizing its core knowledge in reservoir characterization to drive new product development in that segment as well as others, like drilling and production’s artificial lift.

Reservoir characterization is composed of business lines like seismic and wireline logging, which have traditionally been used to discover and understand new oil and gas reservoirs. Although its share of revenue shrank from perhaps over 50% in the mid-2000s to only 19% in 2016, the segment has generally yielded the highest returns on capital. More important, it nourishes Schlumberger’s core capabilities in understanding oil and gas reservoirs and downhole environments, allowing the company to best its peers in many non-reservoir characterization business lines like those in drilling or production.

The ongoing shift away from the discovery of new conventional oil and gas resources to the development of shale oil and gas is a challenging development for Schlumberger’s reservoir characterization segment. Before the ascendance of shale, a race to explore new oil and gas reservoirs in increasingly difficult environments, such as the presalt deep-water reservoirs, was a key driver of high exploration activity and Schlumberger’s competitive advantage in reservoir characterization. Schlumberger has long maintained a large share of sales coming from new products that carry very wide margins owing to limited or no competition.

Following the fall in oil prices in 2014, exploration and production expenditure shriveled up. The value of new oil discoveries has diminished tremendously due to the unlocking of abundant U.S. shale resources. Future exploration activity is likely to be not only lower but also somewhat less complex, focusing on targets more similar to existing developments of oil and gas, such as deep-water Mexico. This would seem to increase the likelihood of competitors being able to narrow the gap with Schlumberger, challenging the company’s returns on capital.

However, the closing of the exploration frontier does not mean that Schlumberger will lose all ability to stay ahead of the curve in reservoir characterization. Mature fields, in which Schlumberger has developed a leading expertise, in many respects require a large degree of reservoir characterization input. Maintaining production from mature fields requires a dynamic understanding of the reservoir (necessitating continuing gathering of data), as well as a very fine-grained understanding of the reservoir, in order to identify bypassed hydrocarbons and maximize total production of oil in place.

Thus, while we think that reservoir characterization revenue and economic profit will be smaller than in the past, we are confident that economic profit will not erode entirely. We expect Schlumberger’s moat and excess returns on capital in the segment to remain in place for years to come.

In the drilling group, Schlumberger creates the basis for a moat by delivering drilling products and services that lower operators’ cost of drilling relative to alternatives. The value created is shared with Schlumberger. Most commonly, this comes in the form of premium pricing, which is value-accretive to the operator by reducing the operator’s total drilling cost in other areas, often from reducing drilling operating days per well or project.

For decades, Schlumberger has benefited from its ability to transfer its unique knowledge from its core reservoir characterization business lines to its drilling business lines to develop new technologies. The company has since at least the late 1980s been a dominant player and earned high margins in directional drilling, logging while drilling, and associated business lines. With the 2010 acquisition of Smith International, however, the company made a bold move to enter a much broader array of drilling businesses, including drillbits and other drilling tools. Management’s thesis was that future improvements in drilling performance would come predominantly from companies able to integrate the full spectrum of downhole drilling products and services. This ability to deliver differentiated drilling performance would drive value creation for Schlumberger and its customers alike.

At first, the Smith acquisition was not accretive to shareholder value, owing to the high price paid for the business, as well as slightly lower operating margins relative to mid-2000s levels. By 2014, this had turned around, with drilling earning solid economic profits. To some degree, this was due to a strong uptick in industry drilling activity. But it also was due to Schlumberger’s ability to launch new drilling products derived from a synergy of Smith’s capabilities with its own expertise.

Steep competition in U.S. shale is likely to hold down North American drilling group margins at midcycle relative to 2014 levels. We think Schlumberger, along with other large integrated service companies, has benefited thus far from an ability to transfer select leading-edge drilling technologies pioneered in markets like deep-water offshore into U.S. shale in order to drive horizontal drilling efficiencies. Competition here is likely to escalate as we believe operators are willing to experiment with cheaper alternative products.

But with North America accounting for only 25% of 2014 drilling group revenue and 27% of our forecast 2021 revenue, weakness in this market shouldn’t hold back Schlumberger’s ability to generate economic profits at midcycle in the segment overall. Without the combination of local engineering talent, entrepreneurial drive, and high-rep trial-and-error opportunity afforded by U.S. shale development, international customers will continue to rely on Schlumberger’s expertise to select the right combination of drillbit, mud, directional drilling tool, and other drilling products.

Schlumberger’s differentiation in this regard will only increase with continued moves toward integrated provision of services. Integrated projects have increased as a share of revenue across Schlumberger in recent years. We believe a large portion of this increase has come from drilling group revenue associated with integrated drilling services projects, with major projects in the Middle East, Russia, Latin America, and the North Sea. Particularly in international markets, the data and knowledge that Schlumberger will glean from its integrated projects will be vital in allowing the company to market and develop products that boost drilling efficiencies, substituting for the bottom-up experimentation that prevails in U.S. shale.

We incorporate much lower offshore deep-water drilling activity into our model. But Schlumberger has strong exposure to non-deep-water international drilling markets, and profits overall will still be sufficient to generate high levels of economic profit on the company’s drilling capital base even including its large amount of goodwill.

The production group comprises a relatively diverse array of business lines. Although North American pressure pumping does not have a moat, in our view, we believe most of the other business lines of the segment do.

These include completion products (used just prior to starting a well) as well as artificial lift products (essentially pumps used to boost well production). Completion products include many technologies used in conjunction with pressure pumping in the hydraulic fracturing process but much more differentiated. The company’s BroadBand products, along with Halliburton’s offerings, stand as the most effective diverter solutions in the industry and yield better, more distributed fracturing jobs with higher production levels.

In artificial lift, Schlumberger’s sales are predominantly in high-complexity products like electrical submersible pumps, where Schlumberger and Baker Hughes dominate the market with about 50% share collectively. These pumps are highly efficient but must be customized to various downhole operating environments, allowing Schlumberger to derive a competitive advantage through its downhole/reservoir knowledge base.

Schlumberger Production Management has become the company’s new star business unit. Management has said that SPM has delivered returns on capital about 700 basis points higher than the rest of the business since 2011. In SPM contracts, Schlumberger takes full responsibility for managing the development and production of a large oil or gas field. Such arrangements have been long sought after by large oilfield-service companies, but only Schlumberger has had success at such a large scale thus far. In SPM, Schlumberger’s margins are driven by either the cash flows the project generates or the production the project yields above a baseline level. Because Schlumberger has been able to consistently produce more oil and gas at a lower cost per barrel, it has been rewarded handsomely.

Cameron contributes to Schlumberger’s narrow moat, although our confidence is slightly lower owing to the segment’s historically lower pregoodwill returns on invested capital as well as the possibility that lasting overcapacity in erstwhile high-return business like blowout preventers and well trees could depress profitability in the business. These businesses remain essential oligopolies, dominated by Cameron along with giants like General Electric and National Oilwell Varco in blowout preventers and GE and TechnipFMC in trees. The barriers to entry, in terms of intellectual property acquisition, are quite large.

In OneSubsea, which includes subsea trees and production systems as well as a variety of technologies contributed from Schlumberger before the merger, we think there is healthy room for Cameron to differentiate itself. For example, its ability to deliver small one- to three-well subsea projects that are tied back to existing infrastructure at a lower cost to offshore operators has led to several contract wins. Such projects, which benefit economically from the ability to utilize sunk costs in the form of existing infrastructure, are likely to be a higher share of offshore development moving forward.

Success Depends on Long-Term Oil and Gas Demand Like essentially all oilfield-service companies, Schlumberger would be vulnerable to an economic or technological shock that reduced the long-term growth in oil and gas demand. Short-term, cyclical movements in economic growth, oil and gas demand, or oil and gas prices are all less consequential for the value of the enterprise.

Like most diversified oilfield-service companies, Schlumberger faces significant geopolitical risk. Oil resources are spread across a wide variety of countries, meaning that oil producers have less available discretion with respect to choosing political partners compared with participants in other industries. The ability of oil-producing countries to seize oil assets means that Schlumberger’s receivables to national oil companies entail counterparty risk. This has been demonstrated in Venezuela, where Schlumberger was forced to write down the value of its receivables by $500 million.

Many oilfield-service companies also face legal risk stemming from environmental or operational catastrophes. Peer Halliburton incurred nearly $1.5 billion in expenses related to the Macondo disaster of 2010, of which only about one third is expected to be reimbursed by the company’s insurers.

Unsurprisingly for a company that has long generated high returns on capital, Schlumberger has superb financial health. Net debt has not risen above 2 times adjusted EBITDA in over a decade, and we expect net debt to shrink to below 1 by the end of our forecast period. Even in our bear case, we believe net debt/EBITDA will be below 1 by 2023.

Stewardship Is Exemplary Within Schlumberger's core oilfield-service business, management has long demonstrated an outstanding ability to derive great value from investing in a combination of capital expenditure, research and development, and bolt-on acquisitions. Along with the intrinsic moat of the business, management deserves a large share of credit for the outstanding shareholder value creation of the last 10-15 years. Because a large part of Schlumberger's moat derives from its diversification and scale--via R&D efficiencies and the ability to integrate services--management is uniquely positioned to either squander or supplement the value stemming from the Schlumberger moat. Management faces the unceasing mandate to allocate capital across a diverse array of business lines. For other integrated service companies, this responsibility has been borne quite poorly by management in the past (most notably Weatherford). Comparing Schlumberger's remarkable performance with that of peers starkly highlights management's contribution. We applaud management's foresight and aggressive initiative, which has played a large role in maintaining Schlumberger's edge over peers.

Schlumberger has a more mixed record when it has ventured into larger, more ambitious acquisitions. Prior management’s infatuation with becoming an oilfield services/information technology conglomerate led to large amounts of value destruction, culminating in the multi-billion-dollar loss stemming from the 2001 acquisition and 2003 sale of Sema. More recently, we think management created a modest amount of value via the $11 billion acquisition of Smith in 2010 but likely destroyed an offsetting amount of value in the $15 billion acquisition of Cameron in 2015 via the too-hopeful offshore recovery expectations embedded in the purchase price. In any case, with Schlumberger now possessing an essentially complete portfolio of upstream oil and gas services, we think chances are remote that the company will embark on another mega-acquisition in at least the next decade. Furthermore, Schlumberger’s 2018 exit from its seismic acquisition business, while likely coming too late to create substantial value for the company, at the very least signals management’s continued discipline in avoiding future value destruction.