The outlook for the worldwide oil and gas service sector is brightening.
Oil services outlook tied to upstream spending, improved fundamentals.
Oil & Gas Journal, last week's issue
By Alexandra S Parker and John Cassidy
Moody's Investors Service has given oil field service companies a generally
"stable-to-positive" rating, based on several factors, including improving
industry fundamentals.
The primary driver of the industry's recovery from its 1998-99 cyclical
trough has been a significant rise in North American natural gas drilling
activity, spurred by high reserve depletion rates and strong demand.
Improved discipline by service companies and contract drillers in expanding
their operations during cyclical peaks has also led to better control of
costs as well as financial leverage during downturns.
Although labor and equipment constraints likely will slow the rate of growth
in natural gas drilling in the near term, these supply constraints in the
face of rising demand will likely lead to further price hikes.
Expected increases in capital spending by major oil and gas producers on
international exploration and development projects should result in strong
fundamentals for the oil services industry over the next 2 years.
International markets have lagged the strong recovery in North America,
where capacity utilization and prices have been rising. (For purposes of
this article, "North America" means the US and Canada and "international"
means the rest of the world.) Because these markets for oil field equipment
and services have remained depressed, certain sectors, including geophysical
services, deepwater drilling, and offshore construction, have lagged others
in the current recovery.
Moody's expects these sectors to improve during 2001, as major and independent
oil and gas companies, flush with cash as a result of high oil and gas
prices, ramp up their exploration and development spending.
Moody's also says that further consolidation among service companies and
contract drillers is highly probable, as merger activity among major and
independent oil companies shrinks the number of customers and raises competitive
pressures.
Efforts by oil and gas companies to improve efficiency and enhance their
returns will raise the demand for advanced technologies, prompting service
companies and drillers to seek economies of scale and a broader array of
technologies with which to compete.
Industry rating outlook
The outlook for the sector continues to improve, but international markets
still lag the recovery in North America, and deepwater markets are still
lagging shallowwater and onshore markets.
The hot natural gas market in North America has been leading the recovery
to date, although in the near term, the rate of growth in natural gas drilling
is likely to slow due to labor and equipment constraints.
Moody's expects the overall sector to recover by the end of 2001, based
on strong oil and natural gas prices and higher budgeted capital spending
by major oil companies, national oil companies, and independent exploration
and production companies.
Consolidation will also continue. The key drivers for consolidation will
likely be strategies to expand capabilities to match the scope and activity
levels of the large integrated oil companies. This would involve building
up niches and gaining technical expertise, as well as increasing market
share.
In the drilling sector, consolidation can help companies to better control
capacity growth at the top of the cycle and exercise greater pricing discipline
in a downturn.
Moody's approach to rating the services sector attempts to look through
the normal commodity price cycle. As a result, few ratings were downgraded
during the recent industry downturn.
Conversely, as the current recovery continues, upgrades, if any, will likely
be a function of one or more of the following factors:
* Permanent improvements in capital structure.
* Improved cost structure.
* Increased breadth and depth of products or services offered.
* Material improvements in market position as opposed to top-of-the-cycle
earnings and cash flow.
Over the past 2 years, Moody's has taken nine downgrade actions in this
area. Eight of them were largely related to merger activity, which, in Moody's
opinion, resulted in material changes to the capital structure, cost structure,
or market position of the issuers.
Slow recovery
The capital spending patterns of upstream oil and gas companies drives
the performance of the oil field service industry. The most recent downturn
in the service sector demonstrated once again the typical 6-9-month lag
between a dramatic decline in oil prices and reduced activity. Oil prices
crashed in May 1998, but the market for oil field products and services
did not begin to soften materially until 4th quarter 1998. By 1999, both
sales and return on sales was down for the oil field service industry.
The current cyclical recovery has been unusual in that the lag between
oil price improvements and related increases in cash flow and capital spending
by producers has been longer than expected, particularly outside the US.
Crude prices began to rise in March 1999, but exploration and development
activities failed to keep up with crude prices, which, by the end of the
year had more than doubled from their low point in late 1998.
Until recently, the majors and large independents have been reluctant to
raise their capital spending because of uncertainty as to the sustainability
of higher oil prices.
Majors have also been distracted by merger activity and have been more
focused on combining their operations and on rationalizing investment opportunities
than on revising their investment plans.
National oil companies were affected by national budgetary constraints
resulting from the drop in oil prices, as well as high volatility in the
financial markets and currency depreciation.
The pace of recovery has varied by product line and geography. Demand for
products and services related to drilling and completing oil and gas wells
(e.g., drill bits, drilling muds, pressure pumping) and for production-related
equipment such as artificial lift systems has improved significantly.
On the other hand, products and services for large-scale development projects
such as offshore construction and subsea production systems -- and for geophysical
and other services related to exploration -- have been slow to recover.
Even within the contract drilling sector, the number of vertical wells
drilled has far outpaced directional and horizontal wells.
Geography has also been a factor, with service companies that derive their
earnings mainly from North America experiencing more rapid improvement
in their earnings and cash flow than companies that are more internationally
focused.
In general, service companies that participate in all phases of the oil
field life cycle and that operate in several different geographic regions
tend to experience less dramatic declines in cash flow during cyclical
downturns than companies whose operations are more concentrated.
The most diversified service companies in the industry-Halliburton Co.,
Baker Hughes Inc., and Schlumberger Ltd.continue to exhibit strong debt
protection measures, despite the slower-than-anticipated recovery
Utilization, day rates vary
In the contract-drilling sector, utilization levels and day rates have
differed according to rig class and location.
Shallow-water jack up rigs in the US Gulf of Mexico, which represent 39%
of the world's commercial jack up fleet, have led in the recovery, but
they also were the first to experience significant declines in utilization
and day rates during the downturn.
Jack ups tend to work under shortterm contracts and are highly sensitive
to changes in commodity prices. In contrast, second and third-generation
semisubmersibles that operate in deeper waters did not experience revenue
declines until later in the downturn, when their longterm contracts expired.
The market for these lower-end semisubmersible rigs remains depressed,
whereas demand for ultradeepwater rigs (fourth and fifth-generation semisubmersibles
and drillships) has remained strong throughout the recent downturn. This
stronger demand is due to the longer-term nature of their contracts, coupled
with the long lead times and significant dollars that producers have committed
to deepwater projects.
Currently, tight markets exist for premium jack ups in the Gulf of Mexico.
Utilization rates for this rig class are estimated to be at about 95% in
the gulf, and day rates are rising.
The market for all jack ups is currently very strong in most regions of
the world, with utilization estimated at about 90%. The driving force behind
the increased activity in the gulf, an area largely abandoned by the majors,
has been higher spending by independent E&P companies, primarily for natural
gas-related projects.
Recovery of drilling activity outside the US and Canada continues to be
slow, but some key markets are beginning to show signs of life. Several
drillers have recently indicated an increase in activity in West Africa,
Brazil, and the North Sea.
Utilization rates in many of these areas are still below the 80% generally
required for meaningful increases in day rates. However, bidding activity
for some major projects has increased, and it appears to be only a matter
of time before oil service companies that depend more heavily on international
markets begin to benefit.
Technology's key role
Advances in technology will be critical to E&P companies as they attempt
to become more efficient in finding, developing, and producing oil and
natural gas.
Unit lifting, finding, and development costs in the US have declined
significantly since the late 1980s, and non-US costs have generally
either remained flat or have risen slightly in recent years.
Because most of the reserves currently being produced in the US are from
mature basins, it is clear that advances in technology are responsible
for cost decreases.
The same can be said for some international areas such as the North Sea,
where production costs have dropped by about one third over the past decade.
Producers are constantly faced with the challenge of replacing production
that will ultimately require drilling to deeper depths or using different
drilling techniques and technologies.
Moody's believes that oil and gas producers will continue to look for outsourcing
opportunities to reduce costs and therefore will continue to depend on
technology provided by the service sector.
Although first-tier players in the services sector will be required to
provide integrated-technology solutions, there also will be room for specialization
by the smaller companies.
A service company with a significant market share in a high-end product
or service will have more credibility with its customers, particularly
with majors and large independents seeking the highest degree of technical
expertise for increasingly complex development projects.
Gas leads recovery
Rig utilization rates and pricing are on the rise. Drilling activity is
up significantly in North America, but as mentioned before, international
rig counts are lagging.
It is interesting to note that, at the start of the downturn in May 1998,
utilization rates in the US and land drilling declined more quickly than
elsewhere and that they were the quickest to rise again during the current
recovery.
At the end of September 2000, rig counts in the US were up 39% vs. a year
ago, whereas in the rest of the world they were up only 26%. The US rig
count at that time was the highest it had been since January 1991.
US drilling has been skewed toward natural gas. Unusually strong
natural gas prices have been the primary driver for this increased drilling
activity, both on land and in the Gulf of Mexico. The number of rigs drilling
for natural gas in the US reached an all-time high of 855 at the end of
October and accounted for about 80% of total rigs exploring for oil and
gas. Well completions were up nearly 40% compared with a year ago.
It is mainly the independent E&P companies that have increased capital
spending in reaction to the higher oil and gas prices.
The outlook for natural gas prices remains favorable because of high reserve
depletion rates, rising demand for gasfired power generation, low storage
levels, and concerns about possible gas shortages.
Another factor contributing to the bias toward natural gas drilling is
the fact that US natural gas prices are not linked to international oil
prices, whose near-term direction is much more uncertain.
Although Moody's expects average natural gas prices to be somewhat lower
next year-based on new supplies from current drilling activity and additional
imports from Canada-the fundamentals for natural gas are likely to remain
strong for the foreseeable future once new pipeline capacity is added later
this year.
Rig day rates up
Increased utilization is driving up rig day rates. Typically, whenever
rig utilization levels rise above 80%, market day rates begin to rise.
In North America, rig utilization was about 80% at the end of October 2000.
Nabors Industries Inc. recently experienced sizable increases in rates
on its land rigs.
Ensco International Inc.'s average day rate for its jack up rigs was about
$38,000 during 2000's third quarter, compared with only $20,500 in the
third quarter 1999. In contrast, day rates for deepwater rigs remain relatively
low.
While over 90% of the world's deepwater rigs are contracted, not all of
them are working, which has kept rates in the secondary market at competitive
levels.
Global Marine Inc.'s Summary of Current Offshore Rig Economics (SCORE),
which compares the profitability of current mobile offshore drilling rig
rates with the profitability of rates at the 198081 peak of the drilling
cycle, when speculative new rig construction was common, has been slowly
rising since September 1999.
In September 2000, the worldwide SCORE for all types of offshore drilling
rigs was 33.8, representing an increase of 47% compared with September
1999 but still 54% below the peak in April 1998.
Overall, rig utilization and day rates have not yet returned to their 1997-98
peaks, but this could occur in 2001-02.
Labor and equipment constraints are likely to slow the pace of growth in
North American drilling activity and related services.
Due to the sizable layoffs implemented during the downturn and the significant
recent increase in the rig count, there are likely to be shortages in qualified
personnel, crews available to work the rigs, and rig parts required for
maintaining existing fleets.
However, these capacity constraints will also lead to price increases for
oil field services and equipment.
International outlook
Moody's expects the outlook for international exploration and development
to improve. Oil and gas producers are expected to raise their E&P capital
spending by 15-20% in 2001, compared with an estimated 10-15% increase
in 2000 and a 22% drop in 1999 (OGJ, Jan. 8, 2001, p. 20). The increase
in spending will be driven largely by the majors and the large independent
E&P companies.
While Moody's does not expect that oil prices are sustainable at their
current lofty levels-the highest since the Persian Gulf War in 1991-they
are likely to remain in a range that will encourage international investment
in the near term.
This trend bodes well for international oil field service activity, as
the majors, aside from the national oil companies, continue to account
for the bulk of exploration and development spending overseas.
The US and Canada have mature hydrocarbon provinces, with declining production
from conventional oil and gas reserves and limited opportunities for "elephant"
discoveries. As a result, the larger producers will be investing in international
provinces with higher-rank exploration potential, and the continuing focus
is likely to be off Brazil and West Africa. For example, over the past
two years, ExxonMobil Corp. has participated in 10 deepwater discoveries
off Angola.
The integrated oil companies will likely continue to exhibit greater caution
in allocating capital than in the past, which could result in fewer opportunities
for the oil field service sector.
Conversely, oil and gas companies, currently flush with cash as a result
of high oil and gas prices, will be under pressure from their shareholders
to grow reserves and production, which cannot be achieved without higher
capital spending.
In addition, as mentioned previously, producers will seek greater outsourcing
of certain activities to reduce costs, which should also provide new opportunities
for service companies.
Although the majors will continue to rationalize their oil and gas reserves,
purchasers of such assets, mainly the large independents, will require
services and equipment to explore and develop the acquired properties.
Hence, additional property sales by the majors are unlikely to have a detrimental
effect on oil services activity.
Moody's expects a full recovery in international oil service markets by
yearend 2001.
By the end of September 2000, the Baker Hughes international rig count
was up for the fifth month in a row to 714, the highest level since September
1998.
Transocean Sedco.Forex recently reported improved utilization in the UK
sector of the North Sea and sees improved prospects in Asia and in the
Middle East. Global Marine has seen improvements in West Africa and is
also beginning to see signs of improvement in the North Sea.
Consolidation effects
Low oil prices in 1998 prompted a wave of mergers among some of the largest
oil companies to lower costs and improve operating efficiency.
Mergers among the likes of Exxon Corp. and Mobil Corp. and BP PLC and Amoco
Corp. increased the ranks of the "supermajors" and have already raised
competitive pressures for the "big three" service companies (Halliburton,
Schlumberger, and Baker Hughes) by shrinking their customer universe.
More recently, the pending merger between Chevron Corp. and Texaco Inc.,
as well as mergers among independent E&P companies such as Anadarko Petroleum
Corp. and Union Pacific Resources Group Inc. and Devon Energy Corp. and
Santa Fe Snyder Corp., will pressure service companies to offer more competitively
priced and technologically advanced products and services, as well as integrated
technology solutions.
The recent consolidation among upstream oil and gas companies will inevitably
lead to additional mergers and acquisitions in the oilfield services sector,
as companies seek economies of scale and a broader array of technologies
with which to compete.
The oil service industry has been consolidating since the 1980s oil price
collapse, but it remains highly fragmented, and even the largest service
companies have only limited pricing power. This is because there are still
a large number of "mom and pop" companies providing commodity-type products
and services.
The largest companies will seek to become sole providers of a wide range
of services, whereas the smaller companies will seek to specialize in certain
products and technologies in which they can achieve leading market positions.
For example, BJ Services Co. has become one of the top providers of pressure
pumping services, along with Halliburton and Schlumberger.
Capacity expansion
Strong utilization could ultimately encourage capacity expansion among
the service companies. Day rates in certain land markets and in the market
for premium jack ups have risen to levels that could justify adding new
capacity.
National-Oilwell Inc.'s backlog of equipment orders has increased from
a year ago, and the company is in discussions with its customers regarding
plans to refurbish and build land and offshore rigs.
Diamond Offshore Drilling Inc. is upgrading some of its second-generation
semis for greater water depths. Some upgrades are being undertaken without
firm contracts as drillers modify older equipment to meet the changing
demands of producers as they move into deeper water.
Many drillers view upgrades as advantageous to new construction in terms
of cost and a shorter ultimate delivery time. As they typically replace
older equipment, they do not tend to increase the world's overall drilling
fleet.
However, if markets continue to tighten, and day rates reach a level that
would justify adding new capacity, especially on a speculative basis, newbuilds
could eventually have a negative impact on rig day rates as the supply
of rigs increases and eventually exceeds demand.+
The authors
Alexandra S. Parker is vice-president and senior credit officer at Moody's
Investors Service, NewYork. She covers a diverse portfolio of US and Latin
American energy companies and structured financings, including major integrated
oil companies, independent exploration and production companies, oil field
service firms, and independent refining and marketing companies.
Prior to joining Moody's in 1994, she worked at Chase Manhattan Bank as
vice-president in the oil and gas group. Parker completed the Wharton School
Executive MBA program at the University of Pennsylvania and graduated magna
cum laude from Mount Holyoke College, where she earned a BA in economics.
John C. Cassidy is vice-president and a senior analyst covering US and
Canadian oil and gas exploration and production companies, oil field service
companies, and midstream energy companies at Moody's Investors Service,
NewYork. Prior to joining Moody's in May 2000, John spent 10 years as an
industry analyst at Citibank in the company's energy and mining group.
He earned his BS in finance and insurance from Northeastern University. |
