Oil company-owned service companies can be a risky choice for most operators

Oil companies expect that investments made in an in-house service company will be lower than the expenditures to be paid for the services of independent contractors. However, is this assumption correct?

Imre Szilágyi, Exploration Geologist and Petroleum Economist, Budapest, Hungary

Drilling and completions, well workovers, seismic data acquisition and processing, well and production logging are the typical services to the upstream industry. Normally these services are provided by service companies on a market basis.

In the "normal" business model the contractors and the clients are separate legal and business entities and the parties are negotiating and concluding contracts by the rules of a competitive business environment. In contrast with that market-oriented logic, we can find many examples of vertical integrations when oil companies own service companies – most of all in Central and Eastern Europe, in North Africa and the Middle East, as well as in the countries of the FSU and in China. The study that follows attempts to analyze the business rationales and the risks of these venture solutions.

Business rationales

The oil companies' financial performance is largely dependent on the availability of cost-efficient services. It is vital for the operators to have access to the given service at the lowest price – of course quality requirements should be met.

Soaring service prices are nightmares for the oil companies' exploration and asset managers as they jeopardize the profitability of their projects. Therefore, from time to time it becomes the topic of strategic discussions that setting up an in-house service company instead of taking the risk of market price fluctuations might be a reasonable option. The oil companies choosing this option expect that the investments made in an in-house service company will be lower than the expenditures to be paid for the services of independent contractors.

For some recently privatized independent oil companies, in-house service companies are the heritage of their national oil company past. Among these ventures we can find the Central and Eastern European companies which – in parallel with their gradual privatization – tend to become global players, while drilling, logging, and seismic service companies still remain part of their portfolio.

The strategic question for them is whether the running forward or the sell-out of their service assets is the better choice. The question usually becomes hot when the management of the service company calls for some capex to replace the amortized equipment. At this point the business rationale behind the capital expenditure is much the same as it is in the case of the above-mentioned example: the hope is that the expenditures will be recovered as the market prices rise and the in-house company operation costs decline.

Risks and concerns

When the oil companies are spending capex either to establish service companies or to develop their service companies' infrastructure, in fact, they are taking a long forward position. They agree to buy an asset (the service company) in the hope that the investments (expenditures of the service company setup/development) will be cheaper than the asset price (the market priced cost of the service) at a specified time (when the need for the given service arises).

The problem with the deal is that, unlike brokers of the capital markets, the oil companies are unable to cover their deals by taking opposite positions at the same time.

Similarly, in every market the upstream service prices are driven primarily by the demand-supply balance in the given market segment. Once the former exceeds the latter, prices go up. And, vice versa, prices go down if the demand lags behind the supply.

The oilfield services market is subject to the same fluctuations that other markets have. If prices for services are rising, the long forward proves to be beneficial. Investments made into the development of the in-house asset are recovered because the extra profit is left in the owner's pocket.

On the other hand, if the development of a demand-driven market proves to be wrong or if the market turns out to be supply-driven, the long forward deal may fail. Once this happens, the service companies may suffer serious losses due to the fact that their incomes are not covering their costs and their shareholders' profit expectations.

When the shareholder of the service company is the oil company itself, it can decide if it wants to suffer the loss as a shareholder of a losing enterprise or as a client by paying more for a service than it would be reasonable on a market price basis. Needless to say, the latter choice is unrealistic for companies in a concession partnership with other oil companies and/or operating in a recoverable cost-based PSA environment. Both the concession partners and the host country government authorities insist on competitive prices, and they will not accept the operator's argument that they should pay higher-than-the-going rate to the operator's in-house service company.

Even if the in-house service company happens to prove competitive, the strategy may fail for the simple reason that the owner itself may cancel or postpone exploration programs due to the limitations of the in-house service company. In this case, the outcome is the same as it would be if the service company is not competitive. The in-house service capacities become redundant for their owner.

The obvious optional solution – the theoretical hedge of "the long forward" – could be if the service company tries to sell its capacities to third parties. I call this attempt "theoretical" because in the long run it cannot be successful due to the fact that the owner of a service is an oil company. At least we can align three serious arguments jeopardizing the success of the "hedge."

First, the potential clients of the in-house service company are the peers of the owner oil company. They may be concerned that sensitive information about the operations will be passed on to a competitor or possible competitor by the contractor. Another concern of the client might be that its peer might bias the operation by directly instructing the service company on the grounds of ownership rights. As a consequence, the service company might have to reduce the offer prices to compensate the clients' concerns – if the concerns can be compensated at all.

Second, the in-house service company may be viewed internally in the owner oil company as a non-core business within the company. The relevant market risk (the beta) is higher in the oilfield services business than it is in the oil and gas exploration and production industry. It means that – due to the higher cost of capital – an investment made into a service companies will have a lower performance index (PI) than the E&P projects. As a consequence, when the capex allocation decisions are made, the in-house service company may easily find itself below the bottom line. Besides, there are no strategic or stakeholder interests found in the favor of investing in a service company instead of spending the scanty capex for drilling a well or for a seismic survey.

In fact, it is a vicious circle. The more reluctant the shareholder is to finance the development of its service company infrastructure (or the replacement of the amortized tools), the less profit is realized as the operational costs of the service company grow because of the use of technologically outdated and amortized equipment. Time is growing short as the decline of the actual profits triggers negative sentiments about capex allocation.

Third, the in-house service company will not accommodate the corporate management systems (HR, IT, Procurement, etc.) and policies of the oil company. Service companies and oil companies follow very different management logics. This could lead to serious operational difficulties if the management of the oil company forces its own governance system on the service company.

The end result of the realization of these assumptions is the irreversible decline of the in-house service company's efficiency: costs are constantly growing while the market share is getting less and less. At the end of the day, the liquidation of the in-house service company remains the only solution.

Conclusions

Investments made by oil companies to build in-house oilfield service capacities are very similar to long forwards. In our case, however, the investor most likely is unable to hedge the deal. Despite some of the apparent lures of developing an in-house services operation, I would not advise an oil company to do so.

Oil companies already operating are advised to sell or outsource their service companies as soon as conditions are favorable. (Favorable conditions include that the NPV-expectations are still positive and a there is a buyer that is willing to pay more.) If no such conditions prevail, the liquidation of the service company is the only realistic choice. The earlier it is done, the less painful it will be.

Finally, I have to note that the assumptions and considerations of the above study are limited to a real market environment and are valid if the companies are viewed as profit-making investments. If a regional market is monopolistic or the given oilfield service is not available in that market, an in-house service company might be a reasonable option. Similarly, if the oil company is driven by other than the profit motive (for example, a national oil company), it may finance in-house services without any concern.

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