Surviving the worst: It’s time for oil services to address shortcomings and find strategic solutions

It seemed as if nothing could go wrong for oil-field services (OFS) companies — until recently. This year, the dramatic collapse of oil prices and the need for oil and gas producers to sharply curtail their capital budgets have revealed fundamental shortcomings and weaknesses in the OFS sector. Throughout the growth period, OFS companies have actually suffered declining profit margins. Now, to survive the growing financial turmoil, OFS companies will need to creatively pull a number of strategic levers: more innovative risk-sharing contracts, restructuring of internal costs, integration of complex service offerings, and a more coherent framework for reviewing their asset portfolio.

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Surviving the worst It’s time for oil services to address shortcomings and find strategic solutions

Contacts

About the authors

Amsterdam Douwe Tideman Partner +33-1-44-34-3127 douwe.tideman @strategyand.pwc.com Beirut Georges Chehade Partner +961-1-985-655 georges.chehade @strategyand.pwc.com Dallas John Corrigan Partner +1-214-746-6558 john.corrigan @strategyand.pwc.com Shawn Maxson Partner +1-214-712-6691 shawn.maxson @strategyand.pwc.com

Dubai David Branson Executive Advisor +971-4-390-0260 david.branson @strategyand.pwc.com Houston Juan Trebino Partner +1-713-650-4151 juan.trebino @strategyand.pwc.com London Viren Doshi Senior Partner +44-20-7393-3572 viren.doshi @strategyand.pwc.com Andrew Clark Partner +44-20-7393-3418 a.clark @strategyand.pwc.com Adrian del Maestro Director +44-20-7393-3558 adrian.delmaestro @strategyand.pwc.com

Melbourne Malcolm Garrow Partner +61-3-9221-1928 malcolm.garrow @strategyand.pwc.com Milan Giorgio Biscardini Partner +39-02-72-50-92-05 giorgio.biscardini @strategyand.pwc.com São Paulo Arthur Ramos Partner +55-11-5501-6229 arthur.ramos @strategyand.pwc.com

Viren Doshi is a senior partner with Strategy& based in London, in the oil and gas practice. He has more than 30 years of energy industry experience, and specializes in implementing pioneering strategic transformations and mergers, managing supply and trading in volatile markets, and designing innovative business models. John Corrigan is a partner with Strategy& based in Dallas, aligned to the firm’s energy, chemicals, and utilities practice. His main focus is on natural gas midstream and energy markets, and he has worked with public and governmentowned utilities in the U.S. and Canada. Shawn Maxson is a partner with Strategy& based in Dallas, working with the energy, chemicals, and utilities and operations practices. He is a 20-year veteran of the upstream oil and gas industry, where he is a widely recognized expert across all supply chain management domains. Adrian del Maestro is a director with Strategy& based in London. He leads the firm’s global research capabilities in the oil and gas practice.

Strategy& principal Ahmad Filsoof and associate Jahanzeb Sheikh also contributed to this report.

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Executive summary

It seemed as if nothing could go wrong for oil-field services (OFS) companies — until recently. With oil and gas reserves expanding, and oil and gas producers increasing their capital investments annually, the innovation and technological expertise of the OFS sector were in high demand. However, the dramatic collapse of oil prices and the need for oil and gas producers to sharply curtail their capital budgets have laid bare fundamental shortcomings and weaknesses in the OFS sector that were papered over by the industry boom. Throughout the growth period, OFS companies have actually suffered declining profit margins as up-front development and project costs soared; prices of raw materials vacillated; poorly chosen acquisitions failed to meet growth, synergy, and integration targets; and complexity, with its attendant costs to business and organizational models, increased in tandem with demand. To survive this growing financial turmoil, OFS companies will need to creatively pull a number of strategic levers that include more innovative risk-sharing contracts, restructuring internal costs, integrating complex service offerings, and a more coherent framework for reviewing their asset portfolio with the goal of divesting noncore businesses.

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The good, the bad

Until the past few months, the global oil-field services (OFS) sector was basking in rarefied air. Although these companies do not get the headlines or even the stock market attention of the oil and gas producers they serve, they have been the backbone of the recent rapid expansion in resource exploration — and they have enjoyed the fruits of outsized capital spending campaigns that increased year over year. As the firms that provide the equipment and technological know-how for hydrocarbon exploration and production — ranging from 4-D seismic services to horizontal drilling — OFS businesses played an indispensable role in helping international oil companies (IOCs) and national oil companies (NOCs) enhance oil and gas production yield during a boom that saw global oil reserves increase 27 percent to 1.7 trillion barrels between 2003 and 2013 and natural gas reserves grow 19 percent to 186 trillion cubic meters during that time. In this flourishing marketplace, OFS companies generated impressive financial results. Industry sales have grown at a compound annual rate of 11 percent since 2005, to reach US$440 billion last year (see Exhibit 1, next page). That’s perhaps not as surprising as the fact that the largest OFS companies handily outperformed their oil and gas company counterparts in revenue, EBITDA, market capitalization, and stock price CAGR gains since 2006 (see Exhibit 2, page 6, and Exhibit 3, page 7 ). A primary reason that oil-field services companies have been so successful is their record of innovation. As the shale and unconventional resource revolution widened, OFS firms continued to push the envelope with breakthroughs like multistage fracking, which gives a shale project access to multiple wells and resource beds; steerable rotary bits that reduce drilling time by some 50 percent; and pad drilling, which lets companies target a wide swath of underground reserves from a proscribed region on the surface. Their ability to innovate made OFS companies attractive partners for hydrocarbon producers, especially NOCs, which pay them fees for their services but don’t have to give them equity stakes in the reserves the way IOCs sometimes do.
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A primary reason that oilfield services companies have been so successful is their record of innovation.

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Exhibit 1 Global oil-field services market by sales
US$ in millions

450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

+11%

Source: Spears & Associates Oilfield Market Report, 2005–14

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Exhibit 2 Oil supermajors vs. leading OFS players
CAGR for selected metrics, Q3 2006–Q3 2014
% growth

14 12 10 8 6 4 2 0 -2 Revenue EBITDA Market capitalization
Supermajors OFS

Note: Supermajors are BP, Shell, Total, Chevron, and Exxon. OFS leading players are Schlumberger, Halliburton, and Baker Hughes. Source: Bloomberg; Strategy& research

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Exhibit 3 World oil services index vs. world oil & gas index, rebased 2006–15
Index

200 180 160 140 120 -23% 100 80 60 40 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 -33%

Bloomberg World OFS Index Bloomberg World O&G Index

Source: Bloomberg; Strategy& research

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Moreover, the oil-field services sector typically invests more in R&D than IOCs do. In 2013, the largest OFS companies earmarked an average of 0.7 percent of sales for R&D, compared with an average of 0.4 percent for the supermajors, according to Strategy&’s analysis. With money flowing freely in its direction, the OFS sector has become heavily fragmented. The top five companies by market share — namely, Schlumberger, Halliburton, Baker Hughes, National Oilwell Varco, and Weatherford, according to the latest stock exchange data — stand out by the depth of their scaled operations and the width of their footprints. Together, they control about one-third of oil-field services business. That leaves a myriad of smaller players with a combined majority share, hoping to stake a claim to some slice of the business. A few of these smaller, often younger, companies have become so emboldened that they ventured into the domain of the IOCs, acquiring assets to operate themselves (Petrofac’s Malaysian offshore holdings are a good example). However, the smooth ride for OFS companies has suddenly turned bumpy. At first blush, it would seem that the obvious reason is the dramatic collapse in oil prices since June 2014, when a barrel of Brent crude cost about twice of what it does today. Under scrutiny by shareholders to demonstrate greater financial discipline even before prices tumbled, the large oil and gas companies have begun to rein in spending quickly, hoping to wipe out the negative effects of their historically large capital expenditure programs that have produced relatively insignificant production gains. Indeed, industry analysts expect that capital investment budgets globally will be slashed by as much as 10 percent this year — and oil-field services companies will increasingly bear the brunt of the reduced construction activity in lost business. Compounding this revenue hit, IOCs are likely to seek new, discounted contracts with OFS players to make up for weaker oil prices. Simply put, the impact of the price collapse cannot be underestimated. In a matter of months, oil-field services companies have lost about $210 billion, or about one-third, of market capitalization. And recent financial statements have been disconcerting. In its third-quarter 2014 results, Transocean booked a charge of $2.79 billion for the drop in the value of deepwater rigs and warned that more write-downs were possible. More recently, Transocean cut its dividend by 80 percent. In addition, Petrofac warned investors of a “difficult period” due to troubled North Sea assets and lower oil prices. But the sharp downturn in oil prices is too glib an answer for what ails the oil-field services sector — and those viewing this problem as purely a cyclical pricing concern will make the mistake of neglecting
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Viewing the problem as purely cyclical neglects the fundamental survival threats that OFS companies face.

the fundamental threats to their survival that OFS companies face. In fact, the recent boom period in the sector was a bit of a mirage — a golden era that hid the many shortcomings that had begun to infect these companies. In the current environment, these weaknesses are exposed. Although few observers have called attention to these issues, throughout the growth period many OFS companies have actually suffered falling profit margins as development, labor, and project costs soared; prices of raw materials vacillated; poorly chosen acquisitions failed to meet growth, synergy, and integration targets; and complexity with its attendant costs to business and organizational models increased in tandem with demand. Between 2009 and 2013, year-over-year profit margins at each of the five OFS majors have been flat or declined by as much as 5 percent. Typical of the costly organizational complexity that strained OFS companies and their margins was the establishment of such noncore activities as venture funds to invest in risky infrastructure projects and educational arms to train oil company employees in skills development, as well as periods of overhiring (and sometimes paying a premium for new employees) to ramp up quickly as business expanded. How rapidly the OFS sector has moved from rarefied air to the roughand-tumble that is commonplace for most companies. Yet OFS firms are not without strategic options. Today’s choices may be more arduous and risky than those of the recent past, but aggressive and farsighted management teams can still steer their companies into a position of strength that would allow them to successfully navigate the current lull in prices and to anticipate the next rise. These strategic options fall into four categories: contracting and pricing, cost management, integrated offerings, and portfolio optimization (see Exhibit 4, next page).

Strategic options fall into four categories: contracting and pricing, cost management, integrated offerings, and portfolio optimization.

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Exhibit 4 What should OFS companies do to survive market and business model disruption?
Four strategic options

– Realign pricing and risk-sharing to echo current conditions – Seek more collaborative development/performance contracts – Offer end-to-end and turnkey services contracts

– Horizontally integrate across processes/ segments

Contracting and pricing

Integrated offerings

– Offer integrated systems vs. components to capture more value – Provide process and systems development to enhance customer value

– Negotiate input prices downward to reflect reduced demand and rising costs – Restructure internal costs with flexible operating models and cost rationalization – Outsource and offshore to minimize costs

Cost management

Portfolio optimization

– Shed marginal or incoherent businesses or products – Acquire businesses and products to fill in integrated offerings – Exit markets and geographies that are subscale or poor performers

Source: Strategy& research

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Contracting and pricing

As the oil and gas companies become more allergic to risk and more parsimonious, OFS firms need to solidify relationships with these customers and generate new accounts by offering a greater number of services and a greater willingness to share the costs and, by extension, the profits. Performance-based contracts, which have become more routine in recent years, can provide a significant degree of joint financial risk, along with the real possibility of improving margins for oil-field services companies. These contracts typically trade up-front OFS discounts for higher bonus payments on the back end tied to improvements in well output. Understanding the complexities of these arrangements can open many opportunities for OFS companies beyond existing customers. By offering sufficient incentive for the oil company, OFS firms may be able to persuade NOCs to forgo their normal preference of merely buying technology and services from the OFS majors and instead enter resultslinked partnerships. However, these contracts, while forging critical partnerships between oil and gas producers and OFS firms, come with increased risk, especially in offshore work. OFS companies must vigilantly manage the liabilities of distributed risk against an environment of increasingly stringent health and safety regulations. Although existing contracts between oil and gas producers and oil-field services companies may favor OFS providers because they were signed when oil prices were at their peak, OFS companies cannot afford to stand on principle and refuse to negotiate discounts. Insisting on the sanctity of old contracts in this significantly altered environment, when IOCs are desperately seeking cost savings and apt to try to squeeze oil-field services contractors, will only harm OFS companies in the long run, particularly with loss of new business down the road. For that reason, it is imperative for OFS firms to offer a wider range of services, such as turnkey systems, that enable the oil and gas producers to minimize their costs by limiting the number of contractors they must manage and thereby enhance their efficiency on a project. By becoming a more holistic provider, an oil-field services contractor can potentially grab a bigger piece of a smaller pie in a shrinking business landscape.
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OFS companies cannot afford to stand on principle and refuse to negotiate discounts.

Cost management

Short-term tactical measures to curtail costs during a downturn, such as wholesale reductions in head count, are not a sustainable strategy. Not only does this approach fail to explore structural cost savings — for example, operations and procurement inefficiency, or creeping waste and complexity — but it eliminates much of the medium-term growth potential of OFS firms, as they may be caught flat-footed, undertrained, and understaffed when the business environment rebounds. To avoid the pitfalls of this approach, OFS companies should implement a program that combines intelligent cost cutting with improvements in contracting and operational performance. One of the first steps that an oil-field services firm should take is a strategic review of its global manufacturing footprint to explore immediate opportunities to move production and back-office functions to low-cost countries through either offshoring or outsourcing. As a result of this assessment, the number of field offices may be trimmed to minimize overlapping functions, but not so drastically that it would be impossible to provide local support if new orders came in. Similarly, any outsourcing arrangements should be made with an eye toward enhancing flexibility by allowing the OFS company to ramp up services quickly as the oil and gas market improves. Permanent savings can also be generated by a thorough analysis of sourcing and supply chain contracts. The goal here is to identify alternative, less costly suppliers; simplify the supply chain by using fewer vendors; obtain volume discounts for a steady stream of materials and services; and more fully centralize the procurement process to manage contract details with greater consistency and rigor.

One of the first steps that an OFS firm should take is a strategic review of its global manufacturing footprint.

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Integrated offerings

Other strategies include integrated offerings, with products and services bundled into a single package. A good example is the trend in the subsea segment in which systems of various components that include valves, piping, controls, pumping, measurement, and monitoring are combined into one integrated system. Clients value the single-vendor simplicity, as well as an asset whose pieces were designed to work together. The OFS companies benefit by profiting from a broader set of products and less competition for service following the sale. Turnkey services are a popular offshoot of integrated offerings. For example, Weatherford is offering turnkey water treatment programs to provide clients with usable water for drilling and completions. With this service, Weatherford hopes to attract customers with faster facilities installation as well as reduced water costs; at the same time, Weatherford enhances its revenue stream beyond the drilling and completion stage into production, where investment returns are less volatile. In addition, offering integrated and turnkey products can be an effective way for an OFS company to broaden relationships with customers, giving oil and gas producers less reason to go to competitors for services that are available from their existing OFS suppliers. However, it is important to note that these all-in-one projects involve significant up-front engineering and design efforts due to their multicomponent systems and require a sufficiently skilled organization that can maintain and support the equipment after installation. These ongoing expenses and exposures must be monitored and managed capably or they will introduce additional organizational and product complexity and costs.

Offering turnkey products can be an effective way for an OFS company to broaden relationships with customers.

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Portfolio optimization

This is ground zero for a sector facing uncertainty, like OFS. Many companies have vastly extended their asset portfolios to take advantage of rising demand, but now they must do the opposite: assess which businesses are noncore and therefore worth divesting, and similarly identify assets worth acquiring to help the firm grow. This process is already under way. For example, Halliburton recently announced a $34 billion acquisition of rival Baker Hughes, a move that will make the new company the largest oil-field services business by market share. Halliburton took this step to enhance its customer offerings with Baker’s technology to boost production in aging wells and its prized oil tools. Halliburton expects savings from operating synergies to reach as much as $2 billion and anticipates significantly higher returns on capital for shareholders. In addition, Schlumberger paid $1.7 billion in January for a 45 percent stake in Russia’s largest oil-field services company, Eurasia Drilling. Schlumberger hopes to profit from the country’s vast oil reserves, particularly when geopolitical tension between Russia and the West over Ukraine abates. Each of these moves — and more are certainly on the way — reflects the need for OFS companies to focus their portfolios on profitable and sustainable businesses in the low-price environment. In the current landscape, companies seeking to “fill in” their service offerings will have a great selection to choose from and those selling will be able to sell from a position of relative strength. Both situations will reward the first mover. For instance, by snatching up Baker, Halliburton was able to strike one of the first substantial blows in industry consolidation, an inevitable result of the current troubles in the OFS market. Through consolidation, companies in the sector can deliver more high-margin integrated products that are not broadly available today, such as A to Z subsea systems and downhole unconventional drilling services.

Companies seeking to “fill in” their service offerings will have a great selection to choose from.

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Conclusion

Oil-field services companies are clearly facing a difficult period, perhaps made worse by the fact that even during the recent boom time, they didn’t protect themselves well enough from margin declines. Under current conditions, survival for OFS firms will involve much greater diligence about key strategic facets of their business, including portfolio rationalization, innovative contracting and pricing, delivering greater efficiency and a wider range of services, and managing costs with a keen eye on margins. Though OFS companies may not be experiencing the extreme cash flow shortcomings that are plaguing many smaller upstream operators, they must nonetheless quickly address the fundamental weaknesses in their sector. Oil-field services companies that aggressively move first to change and adapt to current market weaknesses will most likely emerge from this crisis with sustainable growth.

Survival for OFS firms will involve greater diligence about key strategic facets of their business.

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