The outlook for the worldwide oil and gas service sector is brightening.
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 shallow- water 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 (Table 1), 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 (Table 2).
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 short-term 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 long-term 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.
As illustrated in Fig. 1, 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 (Fig. 2).
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 (Fig. 3). 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 gas-fired 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 1980-81 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, New York. 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, New York. 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.
