The World According to Schlumberger
Each earnings season, The Energy Strategist takes a detailed look at oil services giant Schlumberger’s (NYSE: SLB) quarterly results and subsequent conference call with analysts. One of the best-managed firms in the business, Schlumberger’s international reach and diverse operations–not to mention former CEO Andrew Gould’s candor about emerging trends in the energy patch–made the company’s quarterly conference calls must-attend events.
Gould’s successor, Paal Kibsgaard, has proved equally perceptive and highlighted a number of profitable trends during Schlumberger’s conference call to discuss first-quarter earnings.
Oil services giant Schlumberger reported first-quarter earnings per share (EPS) of $0.98 on revenue of $10.611 billion, beating the Bloomberg consensus estimate, which called EPS of $0.97 and $10.541 billion in sales.
EPS slipped by $0.13 sequentially, reflecting the annual budget flush that occurs in the fourth quarter, when energy companies splurge on software and multi-client seismic data. Schlumberger’s software packages model and analyze field data, manage the production of wells and model oilfield behavior. Multi-client databases of seismic information include data on rock formations that’s available to multiple purchases.
Meanwhile, cold weather in the North Sea and parts of China and Russia often produces a seasonal slowdown in exploration and development activity in the first quarter. And although the US and Canada enjoyed one of the warmest winters on record, China endured one of the coldest in recent history, while temperatures in much of Russia were colder than usual.
Source: National Oceanic and Atmospheric Administration
Given these seasonal variances, year-over-year comparisons are a more relevant measure of Schlumberger’s first-quarter performance. On that basis, the firm’s EPS surged by 39 percent.
The stock’s post-earnings strength likely reflects the market’s low expectations and management’s bullish commentary on profit margins in international and deepwater markets. Here’s a review of the key takeaways from Schlumberger’s earnings report and subsequent conference call.
Schlumberger’s business in North America weakened in the first quarter, and management’s comments suggest that the outlook for this market remains cloudy. Schlumberger was the first of the major oil services firms to warn that profit margins in the red-hot North American market could take a hit. At the time, Halliburton (NYSE: HAL) aggressively expanded key service lines in this market.
First-quarter results give credence to Schlumberger’s early warning: The company’s revenue in North American declined 3.5 percent sequentially, while profit margins plummeted by more than 4 percent to 22.8 percent. Softening prices in the pressure-pumping business accounted for much of this weakness.
Pressure pumping is a critical service related to hydraulic fracturing, a production technique that’s critical to extracting oil and natural gas trapped in shale and other “tight” formations.
Oil and natural gas don’t exist in giant underground lakes or caverns. Rather these hydrocarbons are trapped in the pores, cracks and crevices of solid rock. In a conventional reservoir, these pores are well-connected so that when producers complete a well, the geologic pressure is sufficient to impel hydrocarbons through the reservoir and to the surface. But in shale formations and other “tight” plays, the reservoir rock lacks permeability.
Hydraulic fracturing is a process whereby producers pump a liquid into the shale reservoir under such tremendous pressure that it cracks the rock. This creates channels through which oil and natural gas can travel. Over the past several years, US producers have honed this technique in a number of prolific shale oil and gas plays.
Pressure-pumping services require huge compressors that pumping the fracturing fluid into the well under tremendous pressure. This formerly high-flying business line has come under pressure from several angles, including a collapse in natural gas-directed drilling activity.
This graph tracks the US oil-directed and gas-directed rig counts. With domestic natural gas prices below $2 per million British thermal units (Btu), even operators with the lowest production costs struggle to reap a profit.
Accordingly, producers continue to reduce drilling activity in plays that produce primarily natural gas, choosing instead to allocate capital to operations in fields bearing oil and natural gas liquids. In fact, the number of active rigs targeting natural gas has declined to 613 units from almost 1,000 units in early 2010. We expect the gas-directed rig count to decline even further, especially now that operators hold much of their acreage by production and don’t need to drill at a frenzied pace to maintain their leaseholds. (See Pugh Clauses and Shale Gas Actvity.)
As we’ve noted in previous issues of The Energy Strategist, We don’t see much upside for natural gas prices over the next two to three years. Schlumberger CEO Paal Kibsgaard echoed this assessment during an April 20 conference call with analysts: “In the US, production growth from unconventional gas, coupled with very mild winter weather has driven storage to record levels. This has sent gas prices to a 10-year low and has led to a subsequent drop in gas activity which is unlikely to recover in the near term.”
The outlook for oil-directed drilling activity is decidedly more sanguine. With West Texas Intermediate crude oil prices currently fetching more than $100 per barrel and Brent crude oil going for almost $120 per barrel, the number of US rigs targeting oil has climbed to more than 1,300 from less than 200 in spring 2009.
Thus far, the upsurge in oil-directed drilling has largely offset waning activity in the Haynesville Shale and other plays that primarily produce natural gas. The overall rig count has held steady this year but still hovers near its highest level since the early 1980s.
Although the overall rig count hasn’t declined significantly, the great migration to liquids-rich plays from dry-gas fields will continue to weigh on profit margins associated with pressure pumping.
Kibsgaard elaborated on these challenges during the Q-and-A portion of Schlumberger’s recent conference call:
Now there’s another thing to realize as well, and that is that in the liquids, there are more [fracturing] stages per well but the horsepower required per stage is actually much lower because we pump at lower pressures and lower rates. So while you need the [pressure pumping] fleets in liquids, you actually need fewer pumps or less horsepower per fleet in the liquids, which again, is going to contribute to the oversupply of horsepower. So if you add to these factors the fact that there’s significant horsepower on order for the industry, we believe there is considerable uncertainty around the outlook for pressure pumping prices and the margins.
As Kibsgaard explains, pressure-pumping requirements in shale oil and shale gas plays differ dramatically. Oil wells in unconventional plays usually involve more fracturing stages; in the Bakken Shale of North Dakota, for example, some producers routinely use more than 40 fracturing stages along the lateral portion of the well.
Successfully fracturng the reservoir rock in a high-pressure gas field requires a lot of horsepower to overcome the counterforce.
Although oil wells in unconventional plays usually involve more fracturing stages, less horsepower and fewer pressure-pumping trucks are required than in a natural gas-bearing shale formation. In short, as the industry shifts its sights from natural gas to liquid hydrocarbons, rig demand should hold steady. But companies that provide pressure pumping will feel the pain.
At the same time, services firms have expanded their pressure-pumping capacity significantly in recent years to take advantage of pricing power as producers rushed to drill wells in shale gas plays and hold their acreage by production. With a backlog of pressure-pumping units that have yet to be delivered, this business line faces the challenge of weakening demand and rising capacity–a nightmare scenario for profit margins.
Kibsgaard noted that pressure-pumping providers now bid against each other to secure work, a far cry from six to 12 months ago, when producers paid up to ensure access to horsepower.
Schlumberger’s CEO also estimated that this deteriorating supply-demand balance had driven down prices for this service by 20 percent in gas-producing basins and 10 percent in liquids-rich plays. In his commentary on the company’s fourth-quarter results, Kibsgaard indicated that the price of pressure-pumping services had declined in shale gas plays and held steady in unconventional oil fields.
In his most recent comments, Kibsgaard stated that further pricing deterioration in the second quarter was “a given” and predicted that profit margins in this business line would tighten in the second half 2012.
Schlumberger can afford to be candid about the challenges facing pressure-pumping operators because the firm has less exposure to North America than any of the Big Four oil-field services outfits. Whereas Schlumberger generated roughly one-third of its 2011 revenue from North America, the region accounted for almost 60 percent of Halliburton’s sales, 55 percent of Baker Hughes’ (NYSE: BHI) revenue and 47 percent of Weatherford International’s (NYSE: WFT) sales.
Although the Big Four don’t disclose how much pressure pumping contributes to their top line, we can get a reasonable idea by looking at the performance of certain business segments and weighing management’s comments.
Halliburton and Baker Hughes, for example, report results for completion and production, a category that accounts for about 60 percent of each firm’s annual revenue and would encompass pressure pumping and other service lines. The two management teams have also highlighted their respective companies’ aggressive investments to build pressure-pumping capacity and take advantage of growing margins in North America.
Meanwhile, Growth Portfolio holding Weatherford International generates about 17 percent of its revenue from stimulation, a business line that’s predominantly pressure pumping. Despite Weatherford International’s outsized exposure to North America, the firm has relatively little exposure to challenges in the market for pressure pumping.
In the past, Schlumberger has attributed roughly two-thirds of its revenue from exploration-related services, a business mix that would limit its exposure to production-related services such as pressure pumping and hydraulic fracturing. Add in the company’s relatively modest presence in North America and it becomes clear that the firm’s exposure to the weakest part of the oil-field services business is minor compared to its peers.
Investors should commend Schlumberger’s management team for its prescient diagnosis of the emerging weakness in North American profit margins–a contrarian call at a time when its peers were rushing to add capacity. Based on this outlook, the company made only moderate additions to its pressure-pumping fleet and targeted the high-end of the market with its HiWay fracturing system.
Rather than relying on the brute force of additional horsepower to complete hydraulic fracturing jobs, Schlumberger focused on optimizing the design of each job and the composition of the fluids involved in the process. These innovations produced a system that uses less water and less proppant–sand or ceramic material that props open the cracks created by pressure pumping–than traditional approaches to hydraulic fracturing.
Despite the weakness in the pressure-pumping market, Schlumberger’s HiWAY system continues to win market share; in the first quarter, the company completed 25 percent more HiWAY fracturing stages than in the final three months of 2011.
This success represents only the latest instance of Schlumberger’s commitment to innovation and focus on the high-tech services, a strategy that often yields higher margins and distinguishes the company from the competition. In 2011 Schlumberger spent almost $1.12 billion on research and development (about 2.7 percent of revenue), dwarfing its peers’ investments.
We share management’s enthusiasm for the SPARK program, a new business model for hydraulic fracturing that replicates the strategies that have made Apple (NSDQ: AAPL) such a success in the tech space.
Apple designs and engineers its popular iPhones, iPads and related software in California, while outsourcing the manufacture of components and assembly of the devices. In this instance, the design of the product itself and Apple’s intellectual property is the most valuable part of the process.
Under the SPARK program, Schlumberger provides customers with access to its engineering expertise and advanced technologies but outsources the grunt work. The firm designs the fracturing job and optimizes the fluid mix–the high-margin, proprietary part of its business–but allows its customers to secure the trucks, work crews and pressure-pumping horsepower.
Not only does the SPARK platform appeal to producers that own and operate their own fracturing equipment, but this approach also sets the table for Schlumberger to eventually disaggregate the technology and advanced engineering segments of fracturing from the capital-intensive, lower-margin components of the business.
Outside of the pressure-pumping arena, Schlumberger’s North American business fared well in the first quarter, with its onshore operations growing revenue on higher sales volumes in the wireline logging, coiled tubing and other drilling product lines. Management reported that sales prices were flat to slightly higher.
Wireline logging enables producers to monitor electronically the rock formations surrounding a well and the fluids and gases in the reservoir, information that’s critical to developing an optimal, site-specific drilling plan. Coiled tubing is a long, flexible pipe that’s inserted into a well to perform drilling, maintenance and repair operations.
Demand for these offerings may benefit from the move to oil basins from gas-focused plays, and neither service line faces excess capacity.
Meanwhile, Schlumberger’s business offshore North America continues to gain momentum, as activity in the deepwater Gulf of Mexico has benefited from an uptick in the number of drilling permits issued this year. The firm’s operating profit margins in the Gulf of Mexico have returned to levels that prevailed before the Macondo oil spill–an encouraging sign for future earnings growth when you consider Schlumberger’s leading position in deepwater services
Kibsgaard offered a good summary of the issues facing Schlumberger in North America during the company’s April 20 conference call with analysts:
[I]t is clear that Q2 [margins] are coming down and that’s due to the fact that there’ll be more impact on the pressure-pumping pricing and we have the Canada breakup. Now, what is going to happen in the second half of the year, I think that pressure-pumping margins are going to continue to be under further pressure. Now, to what extent can we offset this from seismic, from deepwater drilling in the Gulf of Mexico, and from the other part of our land offering, which is actually holding up well in activity and actually holding up very well in margins , obvious, we have the ambition of trying to offset as much as possible of this. Now, whether we’re going to be able to do that is going to be a function of how severe the pressure-pumping and margin decline is going to be and at this stage I simply don’t know.
In short, the challenges in the pressure-pumping market have weighed on the company’s North American operations to an extent, but the company’s resurgent offshore business and thriving onshore product categories help to offset these headwinds.
Pricing trends in international markets continue to improve. Although Schlumberger’s revenue from these operations dipped by 4 percent sequentially, this weakness reflects the customary, year-end surge in sales of software and multi-client seismic data. Colder-than-usual weather in China, Russia and the North Sea also disrupted business in the first quarter.
Despite these seasonal challenges, profit margins held steady at 19.1 percent–an indication that Schlumberger earned more from the work that it performed during the quarter.
Management highlighted several areas of strength in international markets, including deepwater exploration and development in East and West Africa and strong onshore drilling activity in the Middle East and North Africa.
Kibsgaard’s assessment of the pricing trends in international markets should encourage investors who have patiently waited for profit margins to improve:
[I]t’s also worthwhile to note that over the past two years, most of the international contracts have been rebid, so there’s now an opportunity to start raising prices in the smaller upcoming contracts, which we are in the process of doing. And if you look at what’s happening in rigs and in seismic, typically there the contract size is smaller and that’s why you can see them move quicker in terms of testing prices.
With big multi-segment, multi-year and multi-rig contracts, like some of the big ones we have been bidding on over the past two years, you really don’t want to be shut out, and I think that’s where pricing on the large contracts has been very competitive and with that kind of slightly negative pricing sentiment. But I think most of those contracts are now either bid or even awarded and there’s now an opportunity to start raising prices on the smaller upcoming contracts without any significant risks.
Over the past several years, profit margins in international markets have lagged those in the US and Canada, in part because North American producers ramped up activity in shale oil and gas plays after the financial crisis subsided. Frenzied drilling led to a shortage of capacity, which sent profit margins through the roof.
In recent years, mega-projects have predominated in international markets. These capital-intensive, multiyear endeavors often include contracts for a wide range of services, with providers competing to win the most lucrative work and avoid being relegated to a minor role.
To ensure their slice of the bounty, service providers offer price cuts and concessions, which lower profitability. This competition intensified in the wake of the financial crisis and collapse in commodity prices; the Big Four oil-field services firms had plenty of excess capacity and often sought to underbid the competition to ensure their assets were fully utilized.
Fortunately, many of these high-profile contracts have already been bid or awarded. Going forward, most of the contracts on offer outside North America are smaller deals or shorter-term projects. With less competition for these deals, oil-field services firms should be able to test higher prices.
Moreover, the sharp rebound in commodity prices has led to an upsurge in exploration and development, tightening capacity in international markets. At this point, much of the excess equipment and manpower that was idle in 2009 has returned to work. We expect this tightness to support margin growth in coming quarters, especially for Schlumberger and Weatherford International, both of which have significant overseas operations.
Schlumberger’s marine seismic division, WesternGeco, has been a pocket of strength, as surging demand has bolstered profit margins.
The percentage of WesternGeco’s fleet that’s been engaged to collect seismic data was elevated in the first quarter and is completely booked for the second quarter. Management also reported that the order book for the third quarter is filling up quickly and that the backlog of seismic work climbed by 16 percent in the first three months of the year.
Much of this uptick in activity has involved contract work–collecting seismic data for a particular company–rather than assembling multi-client data.
Although some of these contracts were inked last year and feature lower prices, management noted that the company has boosted the charge for new work by 10 percent sequentially and expects pricing power to improve as the year progresses.
This development suggests that producers plan to increase spending on deepwater activity and that the excess capacity plaguing the marine seismic industry has finally abated.
Asked by an analyst whether WesternGeco’s profit margins could hit their 2007-08 peak by 2013, Kibsgaard offered a guardedly optimistic response:
With only three seismic vessels capable of collecting 3-D seismic data slated to enter the global fleet in 2012, tight capacity should enable operators to push through price increases. Although Kibsgaard is careful not to go out on a limb, his response suggests that WesternGeco’s profit margins could approach the peak of the last cycle as early as next year.
Again, I think it’s too early to say. We are starting to see the signs of pricing traction, which we have been looking for, for the past 12 or 18 months. So capacity has tightened. If I look at the number of 3D vessels coming into the market scheduled for this year, which I think for the total market is only around three, I don’t see any issues with further capacity additions in terms of how it will impact pricing. So I think there are good chances of getting sustained pricing traction, at least through this year, and then it’s going to be a function of, I think, how much capacity is being added to the market. But the fact that margins are coming up is clear, but I think it’s too early to say yet whether we’re going to see the peak margins of the previous cycle, and I think multi-client activity is also going to play into that equation.
With the least exposure of the Big Four oil-field services firms to weakness in the North American pressure-pumping market and significant leverage to improving profit margins in international markets, shares of Schlumberger should outperform in the near term. Over the long haul, the stock remains one of our top plays on the end of easy oil, or the reality that producers must step up drilling in complex plays to generate incremental output growth. Buy Schlumberger up to 100.