As the rig count rises in the U.S. and oil companies begin drilling again, the market for oilfield services (OFS) has “reached the bottom of the cycle.”
Oil companies have squeezed service companies as much as they can over the past couple of years, and there is little room left for further reductions. Just recently, the CEO of the world’s largest oilfield services (OFS) company, Schlumberger, said that his company will fight to claw back some of those savings by demanding higher rates for drilling equipment and the services needed to develop oil projects.
His comments suggest that the oil market is at a turning point. As the rig count rises in the U.S. and oil companies begin drilling again, the market for oilfield services (OFS) has “reached the bottom of the cycle,” Schlumberger’s CEO Paal Kibsgaard said in an earnings call to investors. As a result, OFS companies will no longer swallow the painful price reductions demanded by production companies.
At the same time, however, the savings achieved by the broader oil and gas industry could be fleeting. Over the past two years, oil companies of all sizes have boasted about efficiency gains and cost reductions, eagerly citing lower “breakeven prices” in presentations to their shareholders. However, rather than structural savings, the reductions could be cyclical. An increase in drilling activity will grant greater leverage to OFS companies, who may ultimately pass on higher expenses to oil companies.
OFS companies hit bottom
It has been a rough two years for the oil industry, as the collapse of crude prices hollowed out balance sheets across the globe, but it has been a particularly bad period for oilfield service companies. While oil majors such as ExxonMobil or BP can count on oil production from existing oil fields during a downturn or earnings from refineries that are less vulnerable to swings in oil prices, OFS companies do not have that level of security; when drilling activity falls, so does business. The four largest OFS companies have slashed 140,000 jobs over the past two years.
Recently, however, as The Financial Times noted, the four largest OFS companies have stopped shedding personnel. The headcounts at Schlumberger, Halliburton, Baker Hughes, and Weatherford International were roughly unchanged in the third quarter compare to the second, with only Baker Hughes cutting about 2,000 employees.
“Going forward is critical for us to recover the large pricing concessions we have made over the past two years to allow us to restore investment levels.”
The U.S. rig count has increased by about 150 since hitting its lowest point in May of this year, and oil prices have firmed up to the $50 per barrel level in recent weeks. With drilling activity picking up, Schlumberger CEO Paal Kibsgaard no longer feels like his company is at the mercy of upstream companies. He told investors on Schlumberger’s third quarter conference call that his company will only consider work that is profitable and won’t discount services any further.
In fact, after seeing profits fall by 82 percent year-on-year in the third quarter, his company will try to raise prices for its services and equipment, asking oil companies to pay more. The recent uptick in oil prices grants companies like his greater leverage. “Going forward is critical for us to recover the large pricing concessions we have made over the past two years to allow us to restore investment levels,” he said.
Cost savings cyclical or structural?
OFS companies will remain cautious, however. Schlumberger’s CEO noted that while drilling activity is gaining momentum, details of 2017 drilling plans from much of the industry is limited, as the financial state of many E&Ps is still “fragile.” Still, his insistence on raising the cost of oilfield services and equipment raises a question about the extent to which the cost savings across the oil industry over the past two years will stick around.
While drilling activity is gaining momentum, details of 2017 drilling plans from much of the industry is limited, as the financial state of many E&Ps is still “fragile.”
“It goes back to the ultimate issue of which cost deflation has been structural and which has been cyclical, and the cyclical costs are what, in our view, is going to drive the marginal barrel of oil,” Michael Cohen, an oil market analyst at Barclays, said earlier this year, according to Reuters.
In fact, Kibsgaard himself emphatically stated earlier in 2016 that savings seen in the oil industry since 2014 are illusory. “The apparent cost reductions seen by the operators over the past 18 months are not linked to a general improvement in efficiency in the service industry. They are simply a result of service-pricing concessions as activity levels have dropped by 40-50 percent and most service companies are now fighting for survival with both negative earnings and cash flow,” Kibsgaard said in March at an energy conference. “The unsustainable financial situation of the service industry together with the massive capacity reductions mean that the cost savings from lower service pricing should largely be reversed when activity levels start picking up.” In other words, the “savings” or “cost reductions” that oil companies like to cite are largely due to squeezing their suppliers, and OFS companies are tired of the shakedown.
Rising production costs
Putting costs back on to oil producers threatens to raise the cost of producing a barrel of oil. That, in turn, could impact the economics of the marginal barrel. A higher breakeven price for an array of shale projects may push some of the less compelling projects to the backburner. OFS companies will need to balance demanding higher rates versus keeping projects viable so that they do not lose work.
Nevertheless, there is a new sense of determination among the top OFS companies. Halliburton, the second largest OFS company in the world, is intent on seeing higher prices for its services, even if that means it loses market share to competitors. “In the U.S., we believe we now have the highest market share we’ve ever had. And at this point, if we have to give some of it back to move margins up, we might take that approach,” Halliburton CEO Dave Lesar told investors on its Q3 earnings call. If the world’s top two oilfield service companies begin demanding higher rates, it will likely ripple across the entire OFS industry.
North American oil companies could ratchet up spending by roughly 25 percent, rising from $88 billion in 2016 to $110 billion next year.
OFS companies will have more leverage at this point than they’ve had at any time in the past two years. With oil prices at $50 per barrel, upstream spending is set to jump. According to Evercore ISI, North American oil companies could ratchet up spending by roughly 25 percent, rising from $88 billion in 2016 to $110 billion next year. That assumes oil prices remain unchanged at $50 per barrel. Should crude prices post further gains, upstream spending could rise by 30 to 40 percent. Higher investment on a growing number of oil projects would likely spur demand for services from the likes of Schlumberger and Halliburton, and that means oil companies are going to have to pay more.