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Everything in the oilpatch is down by half or more. This includes the price of oil, the active drilling rig count, the number of wells drilled, capital spending, staffing levels, revenue and – if your company is publicly traded – share prices. The only things that are more or less the same are the number of chief executive officers, executive management teams, corporate head offices and bank debt.
Unless there is a quick and significant increase in the price of oil and the amount of exploration and production (E&P) company spending, the oilfield services industry (OFS) is hopelessly overbuilt for current market conditions. There is simply too much of everything in every aspect of capacity. Not everyone is going to make it. Therefore, OFS should seriously embrace the concept and process of merging into fewer and more efficient product and service delivery units, which is what E&P clients need.
It’s increasingly a big company business nowadays and bigger E&P companies want to do more business with fewer and larger vendors. It’s the way of the world when money gets tight.
The only way the industry as a whole is going to survive an extended period of low oil prices is to figure out how to put the next barrel of oil on stream at or below market prices. To do this on a sustainable basis, the suppliers of the goods and services required must also earn a reasonable margin on every sale. In addition, the corporate entity behind each vendor must have an appropriate overhead and capital structure which allows it to work at lower-than-historical pricing levels and service its capital.
So how do you do that? The realignment of OFS pricing has already taken place. Looking at the financial performance of publicly traded companies service prices have clearly hit rock bottom. Many E&P companies are reporting to investors and shareholders their cost of goods and services is down some 25% across the board. That has virtually eliminated profits for the majority of OFS companies and positive cash flow for many.
When OFS managers talk about working for little or no margin in order to retain “market share,” what they are really doing is bleeding precious working capital from their balance sheets in a marketplace that is giving no signal of when the opportunity to rebuild that balance sheet will return.
The last expense OFS has not tackled in any meaningful way is a permanent reduction of corporate overhead. This goes beyond an executive team taking a pay cut, cancelling travel or cutting expense accounts. This is the complete elimination of one or more entire non-revenue-generating administrative structures by merging two or more businesses into a single corporate entity. The objective is to reduce what in the financial reporting trade is called SG&A (sales, general and administrative expenses) as a percentage of every revenue dollar. Another way of phrasing this is fewer CEOs (and related support costs) per dollar of OFS revenue.
This, of course, is much easier to say than do. It means OFS executives and managers will lose their jobs in a marketplace where replacing them will be difficult if at all possible, at least in the short term. Commonly called “corner office syndrome,” this is where executives ignore the advantages of consolidation for their own self-interest. It’s only human nature. But unfortunately, the current market situation is so dire that hanging on to every last paycheck until the company goes broke is not the right decision for other stakeholders including lenders, equity investors and the operations personnel who actually generate the revenue.
In past prolonged downturns, like the late 1980s and early 1990s, there was significant consolidation in the Canadian OFS sector. Thanks to Wikipedia, there exists an (assumedly) accurate history of Precision Drilling Ltd., today Canada’s largest drilling contractor. Founded in 1951 as a private company, in 1987 Precision went public through a reverse takeover of Cypress Drilling Ltd. Under the leadership of the soon-to-become legendary Hank Swartout, Precision went on an acquisition and consolidation binge not likely to ever be duplicated. But never say never.
Between 1987 and 2005 (when the company made its only major divestiture) Precision acquired Spartan Drilling, Sierra Drilling, Taro Drilling, Durango Drilling, Arrowstar Drilling, Geosearch Drilling, Brelco Drilling, Kenting Drilling and Brinkerhoff Drilling making Precision the largest drilling contractor in Canadian history. It also acquired the shares or assets of LRG Oilfield Services, Enserv Corporation, Gram Well Servicing, Columbia Oilfield Supply, Capital Oilfield Equipment, Live Well Service, Northland Energy Corporation, Inter tech Drilling Solutions, Widney Well Servicing, Computalog, Underbalanced Drilling Systems, CenAlta Energy Services, United Diamond., Premium Pump Services, Plains Energy Services, Big D Rentals, Ducharme Oilfield Rentals and Reeves Oilfield Services. Two companies were publicly traded and the rest were private.
Besides drilling, this gave Precision a vast suite of essential complimentary or post-well drilling services, including service rigs, underbalanced drilling, packers and service tools, snubbing, open hole logging, cased hole logging and perforating, slickline, downhole tool and drilling equipment rentals, camps and catering, oilfield supplies and directional drilling tools and services. Then in 2005, many of the non-drilling related services were sold to Weatherford International for US$2.7 billion.
Across downtown Calgary, soon-to become-Canadian oilpatch icon N. Murray Edwards was doing much the same thing with Ensign Drilling, better known today as Ensign Energy Services Inc. Ensign stayed a little closer to just drilling rigs than Precision but still enjoyed significant growth and success through acquisition and consolidation.
What Precision accomplished in its incredible growth spurt was making every one of these companies more profitable by consolidating the SG&A of scores of corporate entities into a single unit with one CEO, one CFO, one COO, one lender, one head office and one downtown Calgary salesforce. The company also reduced fixed costs across the WCSB by closing or rationalizing dozens of yards, shops and facilities. Through oilfield supplies and camps and catering Precision actually became, to some degree, vertically integrated. Through the Rostel Industries acquisition Precision built its own rigs. This cut costs to the company without increasing prices to the client. This was what the E&P sector needed at that time in the marketplace and it contributed to the success of not only Precision but the entire upstream oil and gas industry when it was very difficult to make a buck.
Most importantly, Precision was a bank. Using its shares as capital, what Precision was able to do was consolidate companies and assets in a manner that treated owners, executives, lenders and equity investors with dignity. Dignity is defined as money. Recognition of sweat equity and replacement cost asset values regardless of the current market environment. Those who had to leave because they lost their jobs in the SG&A rationalization process got a decent severance package. Owners and investors who traded their equity for Precision stock eventually made a lot of money. Lenders were delighted their debts were being assumed by corporate entity with the capacity to pay them back.
So why isn’t more consolidation taking place in OFS when it is so clearly required? Besides CEOs reluctant to lose their jobs, there are other factors. For instance, lenders are deferring principal payments and relaxing lending covenants in ways most might have once thought impossible. On December 14, pressure pumper Calfrac Well Services announced its main lenders had waived any EBITDA covenant whatsoever for the first six months of 2016. Who knew? At September 30, 2015 Calfrac reported it had more than $850 million in long-term debt. Without some sort of rationalization of the pumping services sector, it will take a mammoth activity recovery for Calfrac to pay this back from cash flow. The other options is a significant equity dilution at an unknown price.
Lenders to other companies experiencing debt covenant challenges are for the most part working with clients to get them through a prolonged downturn with a currently unknown end by providing debt relief that is clearly only available when the borrower is in severe financial difficulty. Healthy companies wouldn’t borrow money under these terms, nor would banks lend it.
Lenders at some point will be forced to become more realistic about how much of their capital is actually recoverable. Part of this must include an analysis of how much debt an OFS company operating in the 2016 and beyond marketplace can realistically carry and remain competitive. Back in the 1980s, banks converted debt to equity in order to give their clients a fighting chance. The current strategy of banks appears to be loan deferrals for the bigger borrowers and recovering what they can through receivership or special credit for the companies which appear hopeless.
There is said to be significant debt and equity capital on the sidelines looking for bargain-basement deals. However, these entities don’t seem to understand the importance of preserving the CEO or the capital providers’ dignity. What the OFS market needs today is another Hank Swartout. Since that mold is surely broken (the Canadian oilpatch can only ever create and support one guy like “Humble Hank”), the other option is special purpose consolidation entities with access to capital, an open and frank relationship with lenders, a demonstrated ability to run OFS companies through difficult as well as prosperous markets, and an understanding of the importance of protecting and nurturing the people element of OFS.
Merging and acquiring OFS companies is different than E&P. Oil and gas in the ground can be recovered by different management teams. Developing, sourcing, marketing and delivering oilfield services and products to clients requires knowledgeable and dedicated people at all levels.
Existing publicly-traded OFS companies can easily enter the acquisition game so long as they can forget past valuation levels. The companies or assets they wish to consolidate are likely worth close to the the same depressed value as their own stock. Issue some shares to the key entities to get the deal done and when the tide comes in – as it always does – all boats will rise. Dignity. People. Respect for sweat equity. This business is not that complicated.
Take care of the people – all the people – and essential OFS consolidation will take a mighty step forward.
The fallout from the December 4 OPEC meeting continues to reverberate through global oil markets. As predicted in this newsletter on December 8, the short-sellers have been having a field day, driving WTI below US$35 a barrel briefly on December 14. While the price has recovered somewhat because of the news the U.S. may consider crude oil exports, the business press is again rife with stories about how the price of oil may still go lower and will certainly see no improvement until the latter part of 2016.
The British newspaper
The Telegraph carried an article December 15 which indicated at least two OPEC members are lobbying for an emergency meeting of the oil cartel within weeks. Outgoing OPEC president Emmanuel Kachikwu of Nigeria had hoped oil prices would recover as soon as February, as low oil prices force production declines in the U.S., North Sea and Russia. The article quoted Russia’s Finance Minister Anton Siluanov who said, “There is no defined policy by the OPEC countries: it is everyone for himself, all trying to recapture markets and it leads to the dumping that is going on. Everything points to low oil prices next year and it’s possible that it could be US$30 a barrel and maybe less. If someone had told us a year ago that oil was going to be under $40, everyone would’ve laughed. You have to prepare for difficult times.”
Adding to the pressure on oil markets was the December 11 report from the International Energy Agency (IEA) of Paris which publishes a monthly analysis of world oil markets. The IEA reported growth in oil demand may level off next year, an increase of only 1.2 million barrels per day in 2016 compared to 1.8 million barrels per day in 2015. The IEA report was characterized as bearish, but in fact it was not materially different than reports from the past few months which show global oil supply and demand reach equilibrium in the second half of next year.
Source: International Energy Agency December 11, 2015
World oil supply is represented by the green line and demand the yellow line. The blue bar is the growth in inventories (stock) and refinery activity. The peak in Q2 2015 is what led to current high storage levels and the softening of prices in August. OPEC’s decision to abandon any production ceiling is what has caused the current run of very soft prices.
But by the second half of next year, and despite Iran ramping up production (read the fine print top a graph), the IEA sees supply and demand falling into line and storage diminishing. These are the key ingredients of an oil price recovery. The IEA wrote, “Consumption is likely to have peaked in the third quarter and demand growth is expected to slow to a still-healthy 1.2 million barrels per day in 2016, as support from sharply falling oil prices begins to fade. Shrinking non-OPEC supply and on-trend demand growth should lead to a marked slowdown in the pace of global stock builds next year.”
If the IEA is accurate about demand estimates, the world will exit 2016 consuming a whopping 96.71 million barrels of oil per day, up 6.6 percent from only 90.75 billion barrels per day in the first quarter of 2013. This phenomenal growth in demand over only a three-year period is occurring despite growing concerns about carbon-based fuel. But supply in Q3 2015, which ended September 30, was 96.91 million barrels a day, which explains the current pricing mess.
The question for oil prices next year is whether the addition of Iranian oil to export markets (which does not yet exist) plus additional OPEC production will be greater than the increase in oil demand plus the natural decline of all reservoirs. Add to that new production which will not come on stream because of massive decline in exploration and development spending in virtually every country in the world except the most prolific OPEC producers.
As awful as it looks, the IEA data from December 11 is not as bearish as the trade press indicated.
If the Canadian oilpatch did not have enough problems in its own backyard, the giant United Nations’-sponsored climate change conference which ended in Paris on December 12, attempted to precipitate a global transition away from carbon-based energy. Read crude oil and natural gas. Earth to oilpatch: We don’t want your product.
Hailed as a success because some 194 countries ratified the final text, more analysis has been performed on whether or not something major was actually accomplished. News reports indicated the text would be legally binding, but in fact it is not since no world government or agency exists to enforce compliance. Following are three quotes from different commentators on various sides of the issue, extracted from a column by Terence Corcoran in the December 14 edition of the
John Kerry, U.S. Secretary of State and a cheerleader for the Paris process said, “It has to be voluntary… The result will be a very clear signal to the marketplace of the world that people are moving into low carbon, no carbon, alternative energy market. And I think it’s going to create millions of jobs.”
James Hansen, a former NASA scientist who has become a leading climate activist, claims nothing was accomplished at all. “It’s a fraud really, a fake. It’s just bullshit- for them to say, ‘We’ll have a 2C warming target and try to do a little better every five years’. It’s just worthless words. There is no action, just promises. As long as fossil fuels appear to be the cheapest fuels out there, they will continue to be burned.”
Bjorn Lomborg of Denmark emerged on the world stage over a decade ago with the book titled
The Skeptical Environmentalist and went on to become president of the Copenhagen Consensus, a gathering of scientists who concluded tackling global warming through expensive carbon taxes was one of the least effective and lowest-priority ways of improving the global environment. Lomborg said, “To say that Paris will get us to well below 2° C is cynical posturing at best. It relies on wishful thinking…Until there is a breakthrough that makes green energy competitive on its own merits, massive carbon cuts are extremely likely to happen.
Former Prime Minister Stephen Harper was of the view Canada would indeed move to tax carbon as a method of discouraging carbon dioxide production and carbon fuel consumption, so long as other countries the same. His concern was Canada, as a major oil and gas producer, should not be economically handicapped if our sacrifices would ultimately be meaningless on a global scale.
New Prime Minister Justin Trudeau and Alberta premier Rachel Notley clearly hold a different position.
Drilling activity in Canada and the U.S. continues to decline because of low oil prices, past production coming off hedges and reducing cash flow, credit reviews restricting E&P borrowing capacity, low equity prices and squeezed production economics. Since the disastrous OPEC meeting on December 4, the drop in the rig count in Canada and the active oil rig count in the U.S. reflects the depressed cash flow and investment opportunities current low oil prices ensure. Normally in Canada, there is an uptick in drilling at this time of year as the frost goes into the ground, reducing access costs. As has been forecast on many fronts, drilling in the first quarter of 2016 will most certainly be down significantly from 2015 levels.
Source: Baker-Hughes Rotary Rig Count December 16, 2015
Source: North Dakota Department of Mines & Resources
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