Smooth ride turned bumpy

In this formerly flourishing marketplace, OFS companies generated impressive financial results. On one level, industry sales grew at a compound annual rate of 11% since 2005, to reach US$440 billion last year (See Figure 1). Moreover, if we consider other financial metrics, the largest OFS companies outperformed their oil and gas company counterparts in revenue, EBITDA, market capitalization, and stock price CAGR gains since 2006 (See Figures 2 and 3).

A primary reason that oilfield 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%; 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. Moreover, the oilfield services sector typically invests more in R&D than IOCs do. In 2014, the largest OFS companies earmarked an average of 2.2% of sales for R&D, compared with an average of 0.4% for the oil majors, 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 breadth of their footprints. Together, they control about one-third of oilfield 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 glance, 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 limited production gains. Indeed, industry analysts expect that capital investment budgets globally will be slashed by as much as 10% this year - and oilfield services companies will increasingly bear the brunt of the reduced construction activity in lost business. Compounding this revenue hit, IOCs are actively negotiating 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, oilfield services companies have lost about US$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 US$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%, with other offshore drillers announcing similar dividend cuts. 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 oilfield services sector - and those viewing this problem as purely a cyclical pricing concern will make the mistake of neglecting 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%.

Typical of the costly organizational complexity that strained OFS companies and their margins was the establishment of such non-core 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 rough-and-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: portfolio optimization, cost management, contracting and pricing and integrated offerings.

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 non-core 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 oilfield 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 announced a US$1.7 billion deal in January 2015 to acquire a 45% stake in Russia's largest oilfield 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.

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 oilfield 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.

CONTRACTING AND PRICING

As 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 oilfield 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 results-linked 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 oilfield 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 oilfield 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 oilfield services contractor can potentially grab a bigger piece of a smaller pie in a shrinking business landscape.

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.

CONCLUSION

Oilfield 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. Oilfield services companies that aggressively move first to change and adapt to current market weaknesses will most likely emerge from this crisis with sustainable growth.

ABOUT THE AUTHORS

Viren Doshi is a senior partner and leader of the energy practice at Strategy& (formerly Booz & Company). Doshi has over 30 years of industry experience in the energy, oil, and gas sectors. Key areas of expertise include managing supply and trading in volatile markets, designing innovative business models, and implementing pioneering strategic transformations and mergers. He has been involved in developing bold strategies and in shaping agenda at senior levels for oil and gas oil and gas groups across the several regions and across various parts of the value chain and businesses. Doshi holds an MBA from Cranfield School of Management and an honours degree in electronic engineering from Southampton University.

John Corrigan serves as a partner in Strategy&'s Dallas office 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 government-owned utilities in the US and Canada. Corrigan joined Strategy& in 2004 from Deloitte. Prior to consulting, he spent 10 years in the energy industry working primarily in the midstream and markets area with roles in trading, business development, and finance, including one year as CFO at Aurora Natural Gas. He holds an MBA and a BA in Economics from the University of Texas.

Adrian Del Maestro serves as director and head of research for Strategy&'s energy, chemicals and utilities practice. He has over 12 years' experience in driving operational improvements in the professional services sector. Prior to joining Booz & Company in 2004, Del Maestro was the Head of Knowledge Management for the global energy practice at Ernst & Young and senior researcher and managing director at the boutique energy consulting firm, CMA Consultants. He holds a BA in Spanish and French at Southampton University and a MSc in International History at the London School of Economics.