Jerry,
Hi there!! Good call on WLA and LLY, your drug dealers seem to be doing pretty good. LLY today announced a deal with LGND (have a big position in it) on their diabetes drug, hope LGND goes up like LLY too.
Briefing recently had a Q&A session with experts in the Oil Services Industry, here it is:
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Panelists: James K. Wicklund, Senior Vice President, Senior Oilfield Service Analyst and head of Energy Research at Rauscher Pierce Refsnes. Mr. Wicklund spent eleven years in the oil and gas industry working in the areas of finance, geophysics, and engineering. He has covered the industry as an analyst for the past eleven years.
Thomas R. Bates, JR., President and Chief Executive Officer of Weatherford Enterra. Mr. Bates has twenty two years experience in the oil and gas industry, holding various positions with Schlumberger Limited and Shell Oil Co. He has published a number of papers on drilling technology and other subjects.
Q&A
Briefing: Oil service companies, particularly in the offshore segment have recently seen extremely strong earnings growth. How long do you anticipate this boom continuing? What obstacles might curb this growth?
James Wicklund: The oilfield service industry went through more than a decade of recession/depression following
the oil crash of 1986, adding virtually no capacity or equipment and going through a number of reorganizations to try
and stay alive. There was a brief but unsustained recovery in 1990-1991 but when it failed to continue, again the
industry went through a final round of cost reductions, rationalization of obsolete equipment and started to focus on
computer-aided technologies that were increasing productivity in other industries. In early 1994, the effects of
significantly lower drilling levels over several years started to be felt, constraining supply of oil and gas, and demand
for these hydrocarbons, which had been moving up steadily for years, accelerated with higher demand growth for
natural gas in North America and crude oil in developing countries worldwide.
With no capacity added for years, continued attrition of marginal equipment and increasing demand driving prices
higher, activity and utilization of the offshore drilling rig fleet started to increase significantly. With a fixed operating
cost base, higher dayrates provided dramatic earnings leverage. If a rig with a daily operating cost of $10,000 per
day and a dayrate of $17,000 had its dayrate move up, and today that rig gets a dayrate of $60,000, operating
income increased seven-fold. This increase over only about 2-3 years has provided the dramatic earnings growth
seen. And with dayrates expected to move up to $85,000-$95,000 per day before new capacity is added, this
growth should continue. About the only potential weakness we see is a substantial drop in natural gas demand and
pricing but with the current reserve base in decline, continued switching to natural gas as a clean fuel and the
shut-down of nuclear capacity over the next few years, the possibility is remote. An increase in supply of rigs could
shift the economics but with dayrates not justifying new construction and lead times in excess of two years, there is no
near-term potential for over-supply.
Thomas Bates: Sustained growth will continue as long as the supply and demand trend in the oil and gas sector
stays healthy. The underlying fundamentals are stronger today than they have been at any time in the recent history of
the oil industry. Crude oil demand, for example, has increased by 11 million barrels per day in the last ten years and it
is forecasted to increase by another 16 million barrels per day over the next 20 years. So this demand driven
recovery could last 10 years, 15 years or even 20 years powered by the growing economies in the Pacific Rim. I
think the biggest obstacle that we have to worry about is if the price of oil drops outside of, say a range from
$17-24/bbl, either on the low side or on the high side. At $20/barrel for oil, energy is very affordable, both in
developing countries and in the already developing nations.
Briefing: What role has technology played in the resurgence of the oil service industry?
James Wicklund: Technology has played a very dramatic role and in more ways than conventionally assumed.
Three-dimensional (3-D) seismic technology is the more heralded and discussed technology of the oil and gas
industry over the past several decades and rightly so. 2-D seismic was the primary method of detecting potential
oil/gas reservoirs for many years but was similar to the old adage of describing an elephant by feeling its tail. The
technology told us that a potential oil/gas bearing anomaly was in the area but did not define its location. 3-D
technology is similar to throwing a sheet over the elephant. While you cannot directly see the elephant, you do know
its location and shape. As a result, a great deal of unsuccessful drilling is now avoided. The success rate of finding oil
and gas has increased. The cost to the oil company of finding oil and gas has dropped significantly.
In a broader sense though, this is just a single example of what is happening in the oilfield service industry. While the
oil/gas industry has always been very technical, desktop computing capability to boost productivity did not come into
the industry until about 4-5 years ago because of the very large processing requirements. While grocery stores and
video stores made use of computer and software technologies to improve their businesses years ago, the oil/gas
industry was still using paper analog displays to locate oil and gas. With computing costs dropping dramatically over
the past few years, we have seen all facets of the oil/gas service industry enter the computer age, bringing the same
efficiencies and improvements seen in other industries. Inventory control/bar coding of equipment, CAD/CAM design
of equipment, simulation of well treatments, the ability to steer the drillbit to the exact location and increased
predictability of production have all had dramatic impacts on the efficiency and productivity of the industry.
Thomas Bates: Technology really has been integral to the growth of the industry over the last ten years. In the early
to middle 1980s, there was demand for additional oil at moderate prices, but oil companies couldn't produce oil
economically for less than about $30 or $35/bbl in some swing producing locations, like the North Sea and the
deepwater Gulf of Mexico. In the interim, technologies have evolved, including 3D seismic, horizontal drilling, subsea
wellhead and subsea completion technology, and extended reach drilling. Those developments have made $20/bbl
very profitable for our company clients.
Briefing: Oil service companies have been raising prices as the strong demand for oil services and equipment outpaces supply. How long do you think this imbalance will persist? Do you see a point where supply is greater than demand and if so, who will this effect growth?
James Wicklund: The fiscal discipline of the oil service company managements is having the greatest impact on
these concerns. In previous cycles, oil service companies would use free cash flow to build more of whatever
equipment they offered because demand was high and they could. Greater emphasis is now placed on return on
capital employed, return on shareholder equity and other measurements that cause managements to examine potential
returns before new investment takes place. This has had the effect of keeping supply/demand of equipment in much
tighter balance and for a longer period of time, pushing prices higher so that when new investment is made, adequate
returns are generated. This means that there is no real imbalance just a closer balance than we are used to seeing in
the industry. If the company management adhere to these types of fiscal discipline, the potential of too much supply
coming onto the market is reduced. When the cycle does eventually roll over and the industry has always been
cyclical in nature, than there will be some over supply of equipment but it will be minor in comparison to the levels
seen at the end of past cycles and the recovery from that point should be sooner and less painful to industry
participants.
Thomas Bates: First of all, I don't believe that a strong imbalance exists between supply and demand. The price
movement that has taken place merely reflects the returns that the service industry requires to maintain its capital base.
If there were an imbalance, you would see speculative increases in capacity and that is not happening. As a result, I
don't see that supply will exceed demand by any significant margin unless there is a collapse in the oil market.
I think a more important issue is whether today's price increases for rigs, equipment and services will result in
underlying inflation which forces the price of oil up. Technology is the key to sustained moderation on the price of oil.
As long as technology improves production efficiency faster than prices rise, there will be no impact on the cost of
producing oil.
Briefing: To what level would the price of oil need to drop to pose a threat to the oil
service business? Is this group in a better position now than it was in the 1980s to weather
a slowdown in oil production?
James Wicklund: The increased use of technology we have mentioned has brought the finding and development
costs of oil/gas down dramatically meaning that the economic break-even point for oil companies is much lower. As
an example, all of the deepwater Gulf of Mexico projects have economic thresholds at about $8-$9 per barrel.
Subsea completions, multi-lateral completions, directional drilling, marginal field development systems, 3-D and 4-D
seismic, all technologies offered by the service industry, help boost the returns to oil companies in low commodity
price environments. The fact that most of the R&D effort is now done by the service sector rather than the oil
companies, putting the technologies into the public domain much faster, also provides protection against drops in
activity from lower pricing.
All of these factors taken into consideration mean that oil prices would have to drop to about the $13-$14 per barrel
level and stay there for some time before there is a real threat to the service sector. If commodity prices two years
ago had dropped, and they did in 1992, oil companies would have shifted or cut capital spending budgets in
uncertainty over the future, having a detrimental impact to the service sector. Today, oil companies are convinced that
based on their view of engineering and physics, oil and gas supply/demand are in such a tight continued balance that
any near-term weakness in commodity pricing would not justify changes in capital budgets.
These continuing improvements in technology combined with memories of the mid-1980's and the focus on
performance based-results will keep the service sector lean, competitive and in much better shape to weather future
shifts in production and pricing.
Thomas Bates: I think that if we saw a sustained price of less than $16/bbl, it would create some damage to the
prospects for growth. That problem should be self-correcting because as the price of oil gets lower, it creates an
acceleration in demand for energy. If we go back to the decade of the '80s, we can clearly see the impact of
extremes of price on demand. When the price of oil went up in 1980, demand dropped by 15% in the space of five
years. Then, when the price of oil crashed in 1986, energy became more affordable and demand recovered very
quickly.
Is the group in a better position now than it was in the '80s to weather a slowdown in oil production? The answer to
that is definitely yes. Let's look, for example, at the drilling rig business. I think it is characteristic of the reticence to
over capitalize the industry. In December of 1981, there were roughly 500 rigs working in the offshore market, the
dayrate for semi-submersibles was $80,000-$100,000/day, and there were 239 new offshore rigs under
construction. Today, we have more or less 500 rigs working in the offshore market, the dayrates for
semi-submersibles are essentially at the same inflation-adjusted price and today there are only 20 or so rigs under
construction. So I think there is certainly a great deal more restraint in the industry. There is a whole industry full of
executives who have been tempered by the downturn that we saw in the 1980s. So I think there's a reticence on the
part of the management teams to invest at overcapacity at this stage and that clearly puts us in a better position to
weather any slowdown that might occur.
Briefing: Which companies are you recommending and /or avoiding?
James Wicklund: We are recommending exposure to the offshore and onshore drilling contractors specifically
Falcon Drilling (FLC), Transocean Offshore (RIG), Noble Drilling (NE), Rowan Companies(RDC), Atwood
Oceanics (ATW), and UTI Energy (UTI). Tidewater (TDW) continues to be our top pick in the transportation
sector. Mainstream oilfield service equipment and supply companies including BJ Service (BJS), Weatherford
Enterra (WII), and Tuboscope (TBI) still represent excellent investments. 3-D Geophysical (TDGO) is currently
our only seismic technology recommendation but that sector is looking more attractive and American Oilfield
Divers (ADGI) represents our participation in offshore construction. The well service sector is seeing significant
increases in demand due to new re-entry technologies and Key Energy Group (KEG) and Dawson Production
Services (DPSI) are our plays in that sector. |
