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Strong Earnings at Schlumberger Suggest Oil-Field Services Industry in Midst of Up-Cycle
Posted by: Elliot Gue (IP Logged)
Date: August 15, 2012 10:13AM

Oil-field services giant Schlumberger grew its second-quarter revenue by 5.3 percent sequentially, led by the reservoir characterization segment, where sales increased by 7.4 percent to $2.8 billion and pretax operating profit margins ticked up 223 basis points to 28.2 percent.

Schlumberger’s reservoir characterization unit includes services and products that help exploration and production companies find new oil and gas fields, delineate their size and evaluate their potential productivity and economics.

The end of easy oil has forced oil and gas companies into the deepwater and other expensive-to-produce plays, increasing demand for Schlumberger’s reservoir-description services. Based on data gathered from the field and analyzed using sophisticated software packages, operators can model how a particular reservoir will behave over time and use this information to develop an appropriate development plan.

Given the service intensity and expense required to develop deepwater fields, producers are eager to pony up for services and products that expedite the exploration and development process and limit costs.

Boasting the most advanced technology of its peers, Schlumberger dominates the industry and stands to benefit as oil and gas companies ramp up capital spending on deepwater exploration and development.

Among the various service lines and products that fall under the banner of reservoir characterization, Schlumberger’s WesternGeco subsidiary has benefited from a tightening supply-demand balance in the market for offshore seismic data.

WesternGeco and other marine geophysical companies gather this valuable data on vessels that discharge sound and pressure waves into the depths of the ocean. These emissions, which bounce off formations under the seafloor, are received by hydrophones attached to lengthy streamers that are affixed to the vessel’s stern and drag beneath the water’s surface. From this data, powerful software extrapolates an image of these formations. In general, the more streamers attached to a ship, the more data it can collect and the faster it can perform surveys.

How robust is demand for these services? WesternGeco has already booked all of its available capacity to perform seismic surveys in the third quarter and 60 percent of its capacity in the fourth quarter–traditionally a period of seasonal weakness.

During a conference call to discuss second-quarter earnings, management noted that WesternGeco has raised prices on these services by 10 percent from year-ago levels and emphasized that unless global economic conditions change dramatically, this strength should carry into 2013.

The company’s brass also discussed IsoMetrix, an isometric marine seismic technology that Schlumberger plans to introduce later this year. The firm officially unveiled this technology in a June press release, and, judging by reports in a number of industry publications, IsoMetrix has attracted considerable buzz.

One of the largest engineering projects in Schlumberger’s history, IsoMetrix technology collects seismic data with an unparalleled level of granularity. A sophisticated software package uses this information to generate detailed, easier-to-interpret three-dimensional maps of offshore oil and gas fields. Management indicated that a vessel towing 12 of these advanced streamers produces output that’s equivalent in resolution to the results from a ship dragging 144 streamers (a physical impossibility).

Schlumberger plans to equip a single vessel with the technology and put it through additional testing and evaluation. Management expects to introduce IsoMetrix to the market in 2013 and expressed confidence that the technology will command a premium price.

After reservoir characterization, Schlumberger’s drilling group posted the second-best performance during the quarter, growing revenue by 5.7 percent sequentially and pretax operating margins by 107 basis.

This business segment comprises a range of services and products involved in drilling wells and field development, another business line that stands to benefit from increased investment in exploration.

M-I Swaco, which Schlumberger acquired through its takeover of Smith International, specializes in drilling fluids, a heavy concoction that operators pump into the well during the drilling process to counteract reservoir pressures and prevent a blowout.

Designing drilling fluids involves a combination of art and science. Drilling liquids that are too heavy for the application could unnecessarily impede drilling or damage the well, while a concoction that’s too light might result in environmental damage if hydrocarbons gush from the field.

M-I SWACO also performs mud-logging, a service that analyzes recirculated drilling fluids to identify the hydrocarbons dissolved in the mud or examine the shavings of rock that come from the bottom of the well. These findings provide the operator with additional information about the field.

During the conference call, management singled out M-I SWACO’s products and services for their strong quarter and highlighted growing demand for services related to directional drilling, or the sinking of wells that deviate from the vertical bore.

Schlumberger’s management team also noted that superior technology and execution in its reservoir characterization and drilling group has enabled the firm to push through price increases to customers that are increasingly less-willing to settle for inferior or inefficient work. In fact, the company replaced competitors on 39 service jobs during the second quarter, while losing only six gigs to rivals. CEO Paal Kibsgaard discussed this phenomenon at length during the q-and-a segment of Schlumberger’s conference call:

Paal Kibsgaard: I would just say that we continue to replace our competitors on key projects and key rigs. So this whole focus around operational integrity and quality, I would say, has now become quite a significant market share driver. We’ve been quoting this D&M [Drilling and Measurements] replacement ratio number over the past couple of quarters and that number again this quarter was 39-to-6. So we replaced our competitors 39 times; we were replaced six times. So that ratio us maintained, and I would say that the driver behind that is being able to perform within the contracts that you initially win. So the key is to win the contract on reasonable pricing to allow you to invest and perform. That’s really the only way to maintain the contracts in the international market.

Analyst: And you’re doing that with incremental pricing power?

Kibsgaard: Yes, we are not going in to replace our competitors at their pricing or at the average pricing. We need a premium to do that.

Note that Schlumberger isn’t replacing competitors on jobs by offering to do the work for a lower price; rather, customers are willing to pay Schlumberger a higher price because of its superior technology and execution.

This focus on quality rather than price reflects the upsurge in the day-rates charged to lease deepwater rigs. And recent activity in the contract-drilling market suggests that this trend could persist for the foreseeable future.

SeaDrill (SDRL) recently secured a fixture for three of its rigs–one unnamed rig that’s in operation and two new drillships slated for delivery in first and second quarters of 2013–that covers a total of 19 rig years and equates to a day-rate of $575,000.

Thus far, the majority of fixtures that have involved day-rates in excess of $600,000 have featured a relatively short duration of one to three years. As I said in The Will to Drill, that a producer has opted to lease three rigs for a period of more than six years at such an elevated day-rate suggests that the supply-demand balance for deepwater drilling rigs will remain tight for the foreseeable future.

In this pricing environment, delays or inefficiencies can severely impact a project’s economics; oil and gas producers are willing to pay up to secure the best-in-class service provider. This dynamic prevailed during the 2004-08 up-cycle and should bolster the industry’s profit margins once again.

Schlumberger’s reservoir production segment was the lone laggard during the second quarter. Although the group increased its revenue by 5.7 percent from the prior three months, pretax operating profit margins slipped 117 basis points.

Much of this weakness stemmed from North America and services related to hydraulic fracturing, largely because producers are shifting drilling activity from primarily gas-producing basins to those that yield oil and natural gas liquids (NGL). There’s even speculation that the recent decline in NGL prices could prompt operators to ramp up activity in shale oil plays at the expense of NGL-rich gas fields such as the Granite Wash. Linn Energy LLC (LINE), for example, has indicated that it will adopt this strategy.

Although this great migration hasn’t caused a drop in activity–the onshore rig count is flat this year–natural-gas deposits are often found at greater depths than liquids-bearing formations. Accordingly, these plays usually require additional horsepower to pump the fluid and proppant into reservoir at such a force that the rock fractures, creating fissures through which the hydrocarbons can flow. Unlocking natural gas from these deep-lying plays requires substantial horsepower.

In short, the industry’s transition from natural gas-focused plays to liquids-rich fields hasn’t diminished demand for drilling–only horsepower for pressure pumping. Schlumberger has weathered this challenge with relative ease, but Halliburton (HAL), with its substantial exposure to North America and heavy investments in pressure pumping, continues to struggle with margin compression.

Schlumberger’s management team indicated that prices for pressure pumping have declined almost 20 percent from their peak in both oil and gas basins and suggested that further downside could be in the cards.

Fortunately, the remainder of Schlumberger’s business in North America fared well during the quarter, with prices for wireline services and directional drilling holding steady. The firm’s North American operations also received a welcome boost from a resurgence of activity in the Gulf of Mexico.

Although weak demand for pressure pumping drove the 2 percent sequential decline in Schlumberger’s North American revenue, a recovery in international activity and profit margins offset these headwinds. The company’s revenue outside North America surged 9 percent in the second quarter, and pretax operating profit margins gained 161 basis points as the supply-demand balance tightened.

Schlumberger continues to raise prices on smaller contracts, as the proliferation of these deals usually limits the amount of competition relative to the hotly contested mega-projects. Although winning work on massive projects garners more headlines, Schlumberger generates about 80 percent of its revenue from smaller contracts.

The Verdict

Schlumberger reported strong second-quarter earnings, and management’s comments support my view that the oil-field services industry is in the midst of a cyclical up-cycle that’s being driven by exploration and development in international markets.

Despite the encouraging news, oil-field services stocks remain undervalued. Shares of Schlumberger–the undisputed industry leader–trade at 2.25 times trailing revenue, roughly the same valuation that the stock fetched at the height of the market implosion in 2008. The stock also trades at about 16.5 times the 2012 Bloomberg consensus earnings estimate, a figure that has increased since the firm reported second-quarter results.



Stocks Discussed: SLB, SDRL, LINE,
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