Oil prices have rebounded to $50, raising the possibility of an uptick in new drilling in U.S. shale basins. Texas shale driller Pioneer Natural Resources said in April that it would consider adding five to ten horizontal drilling rigs if oil prices hit $50 and “the outlook for oil supply/demand fundamentals is positive.”
Oil producers see light at the end of the tunnel as oil prices have started to rise, but for oilfield service (OFS) companies, which thrive on drilling activity, the road to recovery will be much longer.
For now, though, drilling activity is a shadow of its former self. North American oil rig counts continue to decline, hitting 316 in the last week of May, the lowest level in decades. Many E&Ps were burned last year when they added rigs back to the oil patch after prices rose to $60 per barrel, only to see prices collapse again. This time around, oil companies will be more cautious. Even if some short-cycle shale plays see an uptick in new rigs, the drilling wave won’t begin anew. Moreover, larger-scale capital-intensive oil projects offshore will need much higher prices in order to justify their expenses.
Oil producers see light at the end of the tunnel as oil prices have started to rise, but for oilfield service companies (OFS), which thrive on drilling activity, the road to recovery will be much longer.
Drilling dries up
The market for oilfield services could remain depressed through the end of 2017 at least. According to a May report from Moody’s Investors Service, volatile energy prices and low spending from E&P companies could push EBITDA for oilfield services down by 30 to 40 percent in 2016. “The OFS industry is facing the worst downturn since the early 1980s after an unprecedented drop in global oil and North American natural gas prices,” Moody’s AVP-Analyst Sajjad Alam said in a statement. “Drilling activity has plummeted in most oil producing regions, curbing demand for oilfield support services.”
Oilfield service companies have been hit especially hard from the collapse in oil prices. Upstream producers can survive off of existing oil production, but servicers depend on steady drilling, something that has all but vanished over the past 18 months. Oil companies have slashed spending to try to trim high debt levels, pushing off or cancelling drilling plans altogether. In April, according to Moody’s, global onshore drilling hit a 17-year low, having declined in nearly every month since November 2014. With their customers underwater, oilfield service companies have been slammed by the lack of work.
There have been a series of large rig cancellations hitting the OFS industry this year. In February, ExxonMobil cancelled a contract with Transocean for a rig that was to be used in Angola. Murphy Oil also terminated a contract with Transocean for a rig it had planned to use in the Gulf of Mexico through November 2016.
Statoil scrapped its contract with Seadrill in May for a rig that was to be used in Norway. That announcement came just as Seadrill lost another contract with ExxonMobil for a drillship to be used in the Gulf of Guinea.
In March Saudi Aramco forced Hercules Offshore to accept lower rates for a second time, lowering its day rate from $67,000 to $63,650 per day. That came after Aramco initially moved to cancel the contract in 2015, leading Hercules to cut its rate in half from the original $117,000 to $136,000 rate. The cuts have hit Hercules hard—in May, Hercules announced its intention to once again file for bankruptcy, having exited the Chapter 11 process for the first time last year.
There are numerous other examples of rigs slated for large offshore drilling projects that have been idled. These come on top of the hundreds of smaller onshore rigs that have been scrapped in the U.S. shale patch. OFS firms are in bad shape and are desperate for an increase in oil prices, which they hope will spur new drilling.
“We expect the U.S. rig count to set a cyclical bottom in 2016 and then inch up in 2017 as oil markets narrow the supply/demand gap,” Moody’s analyst Sajjad Alam said in May.
Oilfield servicers bear the brunt of “cost savings”
Oil producers have trumpeted their efficiency gains over the past two years, pointing to their success in lowering breakeven costs. But much of the improvements in cost structures have come from squeezing their suppliers, including OFS companies. E&P companies have forced servicers to lower the cost of rig contracts, as well as fees for well casing, completions, inspection, maintenance and an array of other services.
However, the lower prices for services is not sustainable and will likely be cyclical. If servicers are forced out of the market and equipment is mothballed, the cost of servicing will rise when drilling activity returns. “Labor and service availability likely becomes a major constraint on the ability to meet activity demand,” Raymond James analysts wrote at the beginning of the year. “This should be compounded by oilfield service pricing increases as the market for services gets tighter.”
“The apparent cost reductions seen by the operators over the past 18 months are not linked to a general improvement in efficiency in the service industry. They are simply a result of service-pricing concessions as activity levels have dropped by 40-50 percent, and most service companies are now fighting for survival with both negative earnings and cash flow.”
The CEO of Schlumberger, the world’s largest oilfield services firm, largely agrees, arguing that much of the savings do not add up to real reductions in the cost of producing a barrel of oil. “The apparent cost reductions seen by the operators over the past 18 months are not linked to a general improvement in efficiency in the service industry. They are simply a result of service-pricing concessions as activity levels have dropped by 40-50 percent, and most service companies are now fighting for survival with both negative earnings and cash flow,” Schlumberger CEO Paul Kibsgaard said at an energy conference in March. Kibsgaard said the financial state for his industry is unsustainable and that “the cost savings from lower service pricing should largely be reversed when activity levels start picking up.”
Real cost savings needed
If OFS companies are to survive the downturn, they will need to do more than slash prices for their customers. Kibsgaard says that instead of just squeezing OFS firms, both oil companies and OFS firms could obtain true costs savings, but only if the industry pioneers a new model of collaboration. In the current system, operators contract out different parts of a single project to different oilfield service companies, a model that has prevented innovation. The results have shown. Between 2007 and 2010, only 8 percent of the oil industry’s sanctioned projects were completed on time, on budget, and also met their production target. Roughly 80 percent of the projects sanctioned between that period were either late or suffered from cost overruns, or both.
This hodgepodge of operational and procedural reforms won’t make headlines, but unless they occur, the industry will continue to suffer from high-costs and project delays.
Schlumberger has called on the industry to develop a new model that leads to much closer alignment between operators and servicers. For example, operators should bring in OFS companies much earlier in the process, allowing them to participate in the planning phase, rather than operators designing a project and then simply contracting with an OFS firm to carry it out. Greater cooperation would also allow for a standardization of equipment, which, remarkably, is not the norm across the industry. A December 2015 report from Bain & Company identified a variety of places where savings can be obtained—from just-in-time supply chains, to modularizing products, and the appropriate use of new technologies to cut costs.
The conclusions largely back up Schlumberger’s call for a whole new way of doing business between OFS companies and their clients. This hodgepodge of operational and procedural reforms won’t make headlines, but unless they occur, the industry will continue to suffer from high-costs and project delays. Ultimately, the squeezing of oilfield service companies over the past two years will only result in illusory cost-savings for oil producers, reductions that will disappear once drilling returns.