Where are We in the OFS Cycle?
Where are we in the oilfield services (OFS) cycle? It’s a question that has been asked a thousand times since we started measuring and analyzing company performance, in every industry. The market for both oil producer and service company stocks plunged, as the price of oil dropped in late 2014. Stocks bottomed out across the board in early 2016. E&P stocks have been basically flat since—despite the price of oil more than doubling since January 2016—with oilfield services stocks still about 15% lower than in early 2016.
Notwithstanding all the buzz about electric vehicles and renewable power, it is safe to say the oil age isn’t over quite yet. Even if costs and performance come into line and consumers come along quickly, it will take a while for the cars and the infrastructure to turn over. Gas demand from petrochemical and power generation is also continuing to grow. So it’s fair to assume that the oil and gas industry will stay busy drilling wells, refining oil into gasoline and other products, and delivering it to consumers. Meanwhile OFS companies will continue to provide the vessels, rigs, equipment, facilities, and the people to bring energy to consumers.
In the here and now, it’s easy to understand why investors have turned away from OFS companies. The earnings and returns simply haven’t been there. As oil prices have recovered, the oil majors have been able to make more money: end 2017, international oil companies’ (IOC) returns on capital reached their highest point since 2014.
The IOCs have undertaken extensive cost-cutting, much of which has come at the expense of service companies in terms of volume and price. When the oil cycle turns down, the operators have (and exercise) the option to stop exploring and drilling. That’s their first line of defense when they need to preserve cash during difficult times. The service companies on the other hand have made investments in equipment that cannot be unmade when their customers stop working. The only way they can keep the vessels, rigs, pump trucks, and cementing units busy is to cut their prices.
Oil prices have recovered somewhat and operators are making money again. So why haven’t the service companies been invited to the party?
Oil cycles usually have a fairly predictable rhythm: high prices encourage investment in new resources, and operators and service companies build up and man up. Production outgrows demand, prices fall, profits crash, investment dries up, production goes flat, demand continues to grow, prices recover…and it starts all over again.
The current cycle, however, has been different. One of the features of the shale revolution has been that rig productivity has improved exponentially. As a result, it has been possible for production—particularly in North America—to grow steadily in the face of flat or falling capital investment. Unsurprisingly then, it is here that the upswing has been concentrated to date. Prices have only recovered as OPEC has continued its program of production discipline.
Eventually though, productivity gains will run their course; ultimately the only way to produce more oil is to put more capital into oil wells. Our expectation is that this time is nearly upon us.
During the downturn, operators concentrated their operations in the most productive fields. In order to expand production further, operators will need to drill into less-productive rocks, or the global oil market will need production from other places such as deepwater fields for instance. Either way, the demand for services will see an uptick.
For the past 10 years, OFS intensity has been on a steady upward march. This is easy to understand. On the land, unconventional wells are inherently more service-heavy than conventional wells: horizontal drilling is more resource-intensive than vertical drilling. Over time, wells have become bigger, using more sand and water, and at sea, the operators have ventured into deeper water, using more expensive rigs and more sophisticated vessels and equipment. All of this adds up to more services per rig.
Our analysis of the total revenues of 19 service companies (accounting for about $125 billion in 2017), divided by the total worldwide rig count, shows a trend toward rising service intensity with two notable deviations during the past 10 years. The first was in late 2009 and early 2010, as the economy was emerging from the financial crisis and oil prices began to recover. The second started in 2017.
So, what happened and what does it tell us about what’s next? It probably has something to do with how pricing is typically approached. We’ve already noted that service companies are under the highest levels of pressure during a downturn. The typical (and rational) response from them is to cut prices and keep the equipment busy. In the initial stages of a downturn, operators and service companies have contracts in place that can sustain them for some time, and if those contracts expire before the market recovers, it becomes a matter of survival. This is where many OFS companies stand now. When activity picks up there is a lot of work going on, equipment utilization rises first, followed by margins, which means the service revenue intensity will rise again.
We are already seeing signs of greater tendering activity, idle rigs securing new contracts and utilization increasing, both on- and offshore. While pricing has not yet improved—except in high-utilization pockets of the North Sea or for specific assets that were in the right location at the right time—there are clear signs that we are already at the bottom of the cycle and have even passed it in some sub-segments, such as onshore conventional and shallow-water offshore drilling. However, it will still be many quarters, if not years, before rates improve and the market moves to medium- to long-term contracts.
So, is the OFS sector poised for a comeback? Is it time to invest and grow? We think so.
There are clear opportunities to seize, including buying companies and/or assets from distressed players, acquiring assets/businesses through M&A or as a result of large contractors rationalizing their portfolios.
Some private-equity-owned companies have also passed their original (and extended) investment horizons and are no longer aligned with their owners’ current strategy. Even if valuations do not meet previous expectations, these investments will be sold and their owners will move on. The same is true for privately owned companies facing the prospect of a slow recovery and years of hard work ahead.
Before the recovery gets stronger, there is also a short window of opportunity to buy assets or businesses outside of the formal auction processes as owners (especially large ones), prioritize managing operations or integrations, rather than running longer and more competitive processes that may only marginally increase the value of their divestments.
For service companies looking to reconfigure their services portfolio with a view to aligning more closely with the production, customer, and technology landscape of the future, now may be the best time to execute the M&A-driven component of this transformation.
The status quo isn’t sustainable from the perspective of the service sector. The market has already turned in the US principally, and consolidation has started with new players already emerging. There are now opportunities to seize that will not be available for long. If you don’t yet know your strategy, now is the time to prepare, as M&A activity is set to pick up from now on.
The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.
Céline Delacroix leads EY’s transaction advisory services in the oilfield services sector across the Europe, Middle East, India, and Africa region, which include mergers and acquisitions, due diligence, restructuring, operational transaction services, valuation and business modeling, and corporate finance strategy. She has over 20 years of corporate finance experience working on a range of M&A, financing, and restructuring transactions involving contractors as well as financial investors.
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04 June 2019
03 June 2019