Fitch IBCA remains cautious on oil field service sector outlook

The improvement in energy industry commodity prices and industry fundamentals have strengthened the performance of the oil field services sector the past 6 months. But Chicago-based ratings service Fitch IBCA, Duff, & Phelps said it's taking a wait-and-see approach to making possible changes to ratings of the 50 oil service companies it follows.

Sep 18th, 2000


Karen Broyles
OGJ Online

The improvement in energy industry commodity prices and industry fundamentals have strengthened the performance of the oil field services sector the past 6 months. But Chicago-based ratings service Fitch IBCA, Duff, & Phelps said it's taking a "wait-and-see" approach to making possible changes to ratings of the 50 oil service companies it follows.

Rather than "chasing industry cycles with ratings," Fitch analyst Randall P. Biang said the company, preferring to base its rating improvements solely on an industry upswing, will wait to see if the latest recovery can be sustained. Biang did say in a recent report that the improved performance of the oil service sector will likely be sustained over the next 2 years as E&P companies begin boosting their spending the second half of 2000.

The rise in drilling rig day rates and prices for other services is expected to continue through next year. However, the long-term outlook, closely tied to volatile commodity prices, remains more uncertain.

It's still to early to tell if this will carry over to all oil field products and services, said Biang.

Biang said he and Fitch are seeing positive signs that could eventually prompt them to boost ratings, such as companies paying down debt, consolidating with other companies, or making other changes to their capital structure.

M&A, consolidation activity
Transocean Sedco Forex Inc.'s recently announced $8.8 billion stock acquisition of Houston-based R&B Falcon Corp. "is a real plus," said Biang. The acquisition will solidify Houston-based Transocean's place as the largest offshore drilling contractor and third largest oil-service company after Halliburton Co., Dallas, and Schlumberger Ltd., Paris.

"They're building an 800-lb gorilla that can compete around the world with no problem," noted Biang.

Continued consolidation within the drilling sector would help it withstand cyclical industry downturns as the companies would have more control over the rates they charge their customers, he said.

Mergers and acquisitions receive high marks from Fitch, given the excess capacity in certain energy sectors such as offshore seismic contracting. Biang said he sees the need for capacity to be brought out of that sector, especially in terms of boats, referring to efforts by Houston-based Petroleum Geo-Services Inc. (PGS) and Veritas DGC Inc. to reduce capacity by drystacking vessels.

Biang said the joint venture of Schlumberger's Geco-Prakla with Houston-based Baker Hughes Inc.'s Western Geophysical into a new business, Western GECO, is another positive step. Biang notes that Western Geophysical will likely be inclined to reduce capacity in order to improve rates for seismic data.

Fitch said it expects this trend to reduce competition for seismic projects and prompt companies to retire more of their older vessels. Higher data prices, longer-term contracts for vessel exclusivity, and longer lead times for proprietary work also are expected.

Fitch said it also anticipates more arrangements in which one company contracts with one supplier to fill its oil field and other service needs. This trend could reduce costs by streamlining project management for suppliers' clients.

The drilling sector, after being burned by building new rigs on a speculative basis as the drilling markets turned south in the mid-1980s, seems to have learned its lesson on expanding too quickly. Instead, drilling companies are building new rigs or converting existing rigs for deep water strictly on a contract basis.

"Even in 1996 and 1997, you were seeing some speculative building, but that's gone now," said Biang, noting that it's "better not seeing everyone who can drill go out and do so." Biang said the drillers' approach "should help maintain a balance between supply and demand for this market."

R&D efforts encouraged
Despite the remaining tightness of operators' fists, the analyst recommends that service firms spend money on technology development in order to improve their long-term profitability.

Biang noted that technology research and development would require substantial funding to allow companies to update their drilling technology and stay competitive. Companies such as Smith International Corp. and others are investing in efforts to develop drill bit, 3D seismic, and drilling fluid technology.

"In Fitch's view, companies with technological advantages or lower-cost services are clearly in the best position in today's cost-driven market." Larger companies that can maintain strong cash flows via their ability to gain new contracts are in the best position to maintain a more stable R&D effort, said Fitch.

Companies such as Veritas are funneling money towards programming used to interpret geophysical data, resulting in better sensors, said Biang. Deepwater completion techniques also are being improved tremendously, while companies such as Core Laboratories NV are making major headway in well stimulation technology.

The oil field service sector's position is the strongest seen in the past 15 years, said Biang. Improving fundamentals such as technological advancements have lowered the production and development cost on a per-unit basis, thanks to newer drilling techniques such as horizontal drilling and multiple lateral completions from a single wellbore.

Biang cited other improvements, such as the fact that wells now be drilled to more than 10,000 m from a single platform, compared to less than 4,000 m in 1993, and that the accuracy of these wells has also increased to within 4 m of deviation from their planned targets.

Besides improvements in 3D seismic data and horizontal drilling, industry research and development efforts also have improved deepwater completion technology, casing cements, drill bits, drilling muds, compressors, and well-stimulation components used to bolster oil and gas flow.

Instead of cutting their R&D budgets, offshore seismic companies such as PGS are finding other ways to reduce costs, such as raising the number of seismic recording streamers being towed behind each ship and improving their data acquisition techniques and equipment. Better 3D seismic acquisition techniques also allow for a faster, more thorough evaluation of geological features, bringing the chances that a successful well will be drilled from 1 in 10 to 1 in 3. And new 4D and 4C seismic acquisition techniques will improve surveys, help closely monitor reserves during production and increase production rates.

These efforts also save on personnel costs, noted the analysts.

Outsourcing a powerful factor
Consolidation, a major trend in the oil field services since the mid-1980s oil price collapse, remains prevalent in the service industry, which experienced "dramatic consolidations" during 1998 and 1999. It will likely continue as smaller technical service companies find it difficult to market to major oil companies, which are seeking integrated services and wanting fewer suppliers, said Biang.

Fueling the consolidation trend is the fact that technical innovation is emerging from industries outside the energy sector.

While major oil companies used to conduct most of the industry's research and development efforts, the supplier industry has taken up those reins as energy companies find it easier to spread out expensive research costs over a wide base rather than conducting much of the work themselves. The number of exploration and production companies outsourcing more of their technical services after oil prices tumbled in 1998 also triggered consolidations.

The fact that petroleum service suppliers are merging�giving E&P companies access to a highly skilled technical pool for various needs while being able to limit the number of contractors�also has supported the consolidation trend.

Ironically, service companies could make themselves more vulnerable to commodity price risk by expanding their capacity with new drilling equipment or seismic crews to meet surging demand. Fitch said that, after oil prices sharply declined during 1998, companies like Schlumberger, Baker Hughes Western Atlas, and PGS were forced to scale back their capacity after expanding their fleets to meet high demand.

Commodity price volatility still poses a risk, despite current high domestic natural gas prices and high world prices for crude oil, however, said the analysts. And while those prices aren't expected to fall any time soon, onshore and offshore drillers remain vulnerable to delays or cancellations of drilling projects. Service providers also are affected, but some are more directly exposed to short and intermediate-term commodity price changes than others.

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