The oil services industry’s third-quarter results were respectable considering the speed and violence of the downturn over the last year. In most cases, we saw some sequential improvement in North American revenue and margins, thanks to a 13% sequential gain in the North American rig count and a seasonal bounce in Canadian activity. Overall, we believe the North American recovery is very fragile, as near-term oil demand and natural gas supply issues can easily shatter it. Internationally, we also saw the expected margin deterioration, which was led by contract resets, and a challenging Mexican market. Mexico was particularly weak this quarter, as flooding in the Northern and Central regions of the Chicontepec field reduced activity levels as well as the number of highly profitable well completions. In addition, Pemex is considering reworking both existing contracts and future awards to modify the services companies’ incentives toward boosting oil production after the Chicontepec field badly missed annual production targets. After reviewing the industry’s third-quarter reports, we present our key takeaways.
First, North American services pricing has reached the bottom. Services companies and oil and gas companies have indicated the pricing declines have generally halted. Going forward, future cost savings for the oil and gas companies are largely expected to be driven by reducing drilling times, as opposed to price concessions from services providers. However, we do not see any catalysts for improved services pricing in the near term, which means relatively flat pricing for the next few quarters.
Second, international shale gas plays are not viable in the near term. Schlumberger (SLB) CEO Andrew Gould mentioned that international infrastructure and drilling constraints make it unlikely that we’ll see a repeat of the industry’s success in the North American shale gas plays in the near term. Gould used the examples of Pakistan, which has large gas reserves but virtually no oil and gas infrastructure, and Germany, where oil and gas companies would not be permitted to drill as aggressively as they have in the Dallas/Forth Worth area. We think any type of success in breaking open the international gas shale plays is, at minimum, several years away.
Third, international markets still look weak. Halliburton (HAL) still believes contract resets will gradually force international margins down 300-500 basis points over next few quarters, while Schlumberger believes the situation may call for flattish margins, as contract resets and cost cuts offset each other. However, further out in 2011 and 2012, we think it will be difficult to boost international margins due to the long-term nature of the contracts, as well as the additional time needed by the services companies to upsell new technology to their customers.
North America 2010 Preview
In our opinion, the North American oil services market faces numerous challenges. The industry still needs to fix the persistent equipment oversupply problem, which has been in place for several years and is now causing problems in the highly demanding shale plays. As one of the few areas in North America experiencing strong demand, the shale plays have acted as a magnet for much of the industry’s excess capacity. For example, there are about 100 rigs (14% of the active natural gas rig count) and about 25%-30% of the industry’s pressure pumping capacity in Haynesville. Smaller players are working at near cash costs or even taking losses to work in the Haynesville for marketing purposes and to help equipment utilization. Patterson-UTI Energy (PTEN) mentioned that its traditional pressure pumping business has nearly disappeared and has been replaced by shale-oriented efforts.
The services companies argue that the oversupply problem will slowly diminish as the demanding Haynesville and Marcellus wells wear out equipment. In this scenario, the well-financed larger services companies will gradually gain more market share and boost their margins as the smaller players drop out of the market after their equipment fails. The equipment will fail due its age, and is more suited toward handling the less demanding requirements of the Barnett Shale rather than the hot and deep Haynesville wells. In particular, Haynesville wells demand high levels of pumping capacity as well as an increased number of fracs, which the smaller players’ equipment is ill-suited to provide for the long term. However, we don’t think the smaller players’ presence and competitive threat will disappear completely.
The barriers to entry for some services in the shale plays appear to be quite low, or else the small companies would not be able to compete so effectively on price. Small companies have effectively doubled their overall share of the pressure pumping market in North America over the last few years to 40% from 20%, thanks to the increased use of methods such as water-fracking in plays like the Barnett Shale. Water-fracking techniques have been perfected by the industry, and commonly available pressure-pumping equipment can do the work. The lower barriers to entry have led to stiff price competition as smaller players have entered the pumping market and captured substantial amounts of market share. In our opinion, a similar evolution could take place in the Haynesville and Marcellus Shale plays. We believe as today’s drilling techniques become perfected and the knowledge is eventually widely dispersed throughout the industry, the techniques and equipment will essentially become commodified. As a result, we should see intensive price competition between the small and large services players, which should lower well costs as well as profitability for the services companies. We think this situation means that market share gains and margin gains will be capped well below 2005-08 levels for the larger services companies such as Schlumberger and Baker Hughes (BHI(
A second challenge is the lowered demand from the oil and gas industry. For example, XTO Energy plans to double its rig count in several shale plays in 2010. Still, the company’s expansion program means the company will be running around 70-75 rigs in 2010, up from 47 currently but down from over 100 rigs in 2008. The 2005-08 boom was lucrative for the services industry because the increase in demand was unexpected, and the industry was largely unprepared to meet its customers’ demands. The inability to meet demand led to substantial pricing power. In contrast, during this downturn the services companies are retaining employees and equipment, with the expectation of a recovery in the second half of 2010. We believe there will be a sustainable recovery in the second half of 2010, but since the services industry is already prepared for it, it will be a volume-driven recovery rather than a price-driven one. We expect services pricing to be up about 5% in 2010. As the gap between services demand and supply will be much narrower, margin expansion will be limited, and North American margins will remain far below 2005-08 levels for years.
We have modest expectations for 2010. We’re expecting single-digit revenue growth and operating margins to range between 11% and 13% for Weatherford (WFT) Halliburton, and Schlumberger. Most of the growth and margin improvement will come in the second half as the oil and gas companies cautiously add more rigs and the services companies continue to improve their efficiency. We believe the North American rig count will average 1,100 active rigs and range between 1,000 and 1,200 rigs, with most of the changes due to the strong fundamental outlook for oil. We expect to see the oil rig count average 350 rigs and range between 300 and 400 rigs. The natural gas rig count should average 750 rigs and range between 700 and 800 rigs.
International 2010 Preview
Our international outlook for the oil services industry in 2010 is guardedly positive. In our opinion, there are large opportunities for new contract awards from the Middle East, North and West Africa, Russia, and Brazil, which should help boost revenue. For example, Gazprom plans to boost capital expenditures about to $28.5 billion in 2010, up 40% from 2009 levels. Over the past few years, Gazprom’s spending efforts have focused on acquiring assets, such as a stake in the Sakhalin-2 field, rather than reinvesting in its existing fields. The change in focus should benefit Schlumberger and Weatherford, which have large Russian presences. Also, we expect to see awards for offshore services from Petrobras (PBR) as it continues to drill wells and learn more about the Santos Basin. In addition, about 50 new offshore rigs will be delivered, and each will require high-end services and equipment.
However, we believe contract resets will cause most services firms’ operating margins to gradually decline several hundred basis points in 2010 from 2009 levels. We think international oil companies will continue to delay certain projects to take advantage of raw-material cost savings and lower prices for oil services. The delays and contract resets, in our opinion, should result in services pricing down 10%-20% in 2010. As international services contracts tend to be for several years, this means any margin expansion in the international markets will be fairly limited in 2011 and probably 2012. We could see significant margin expansion if the new contracts awards are integrated-project-management (IPM) projects, which require significant startup costs but can offer performance-based bonuses. This is an unlikely near-term scenario, in our view, as one of the largest national oil companies, Saudi Aramco, is still in the experimental stage with IPM efforts.
We expect the international rig count to average 1,000 rigs and range between 950 rigs and 1,050 rigs in 2010. We think this indicates modest single-digit growth numbers for most in the industry and operating margins in the 15%-20% range for most large services markets. However, areas of strength for certain companies, such as the Middle East for Schlumberger and Latin America for Weatherford, will continue to turn in above-average margins. We expect Schlumberger’s Middle Eastern margin to decline to 28% 2010 from 32% in 2009 and Weatherford’s Latin American margin to expand to 18% in 2010 from 16% in 2009. Overall, we forecast Weatherford’s international performance to be one of the best in the industry in 2010.
Internationally, Weatherford turned in the one of the worst quarterly performances, yet it has one of the industry’s strongest international outlooks in 2010. Flooding in Chicontepec affected 14 of Weatherford’s 45 rigs in Mexico, which led to lower efficiency and a 800-basis-point decline in Weatherford’s Latin American margins sequentially. However, the company has secured numerous contracts for 2010, which should add about $2 billion in incremental revenue over our 2009 revenue estimate of $8.7 billion. In Mexico, Weatherford has won three Chicontepec contracts, which should deliver around $2 billion in 2010 revenue, an increase of $800 million over 2009. In addition, the company is earning another $300 million-$400 million in revenue from contracts in Iraq, as well as an additional $300 million in revenue from the acquisition of TNK-BP’s oilfield services arm. Weatherford also sees incremental opportunities for work in Africa, the Middle East, and Asia. We believe Weatherford’s aggressive integrated-project management efforts are benefiting it immensely, and we expect it to gain market share in 2010.
Companies Worth Considering
Further out, however, our top picks are Helmerich & Payne (HP) and Schlumberger. We believe both companies are the highest-quality oil services companies we cover, and they should outperform the industry over the full cycle. However, we would look for a better entry price, as both companies trade substantially above our Consider Buying price. Please see our Analyst Reports for further long-term investment opportunities within the industry.
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