A fairly light company news week now that we have transitioned out of Q1 Earnings season. Nevertheless, here are a few observations and know in advance that this evening’s note is more of an editorial piece as opposed to investigative journalism. Topics we touch on this weekend.
- Our thoughts on an industry pricing pressure comment
- U.S. frac fleet considerations
- Key Energy earnings recap
- Land rig count down again
- Fort Worth Tour this week.
- Permian Basin Tour next week
- Bakken/DJ/PRB Tour in three weeks. The father/son team will drive to the Bakken from Houston on June 5th for a week of meetings. Any gasoline or Dairy Queen sponsor’s out there?
Persistent pricing pressures – time to reflect. Research analysts often need to play the role of Switzerland as large distribution lists such as ours are comprised of contacts throughout the U.S. upstream industry. Be critical of the OFS space and OFS friends get upset. Conversely, criticize the E&P world and another constituency group is offended. It seems like people are easily offended these days which often steals the joys of writing research. Sometimes, though, we hear certain things which we believe warrant a comment, but we know ahead of time that objective comments could tick off loyal readers. At the same time, ignoring controversial data points because of fear someone may cancel their subscription would effectively neuter our research product. Thankfully, the luxury of being one’s own boss is you can do what you want. So here goes.
Earlier this week we updated with an oil service contact. For anonymity reasons we won’t name the company. We will also assume this individual’s representations are 100% accurate. Here’s the essence of the message with a loose bit of our interpretation. Remember, we are keeping this very general in nature.
We have been operating our equipment with this customer for some time. We have performed such a good job that many competitors have been let go, but the customer keeps us. We have data to prove our service is more efficient than others. We enjoy a strong working relationship with this customer. Our price is already very low, yet the customer is now asking us for even more price concessions. If we don’t lower our price, we will likely lose the work to a competitor. If we lose the work, then we will have to let go of the employees assigned to this work. If we drop our price, we lose money. If we don’t drop our price, we lose the work, thus we lose money.
Our initial thoughts and questions: If you are already the most efficient rig provider and you have data to support this, isn’t the customer taking a risk by potentially shifting to a competitor who may be less efficient? Shouldn’t the customer implicitly know this since the other providers were let go and not you? Are executives at the E&P company so naïve as to think low price is the best way to go? Does your customer measure the all-in cost or simply look at the quoted price? Don’t they look at the financial statements of their vendors and see no one is making any money? Yet, they still want lower prices? Have they no heart?
There are, of course, two sides to every story and sometimes emotion needs to be removed from the analysis. So to be fair and balanced, we conferred with other industry contacts and then assessed the rationale of the E&P company. First, we don’t know who the E&P player is. If we don’t know the E&P company then we don’t know their respective internal stresses such as balance sheet leverage, liquidity availability, etc. Perhaps this is a company in such bad financial shape that its survival is dependent on near-term cash flow, thus it will take unnecessary supplier risk because what’s the downside. Perhaps, the decision to drive price lower is the need from the procurement/operations person to post a win in order to keep their job, thus they are willing to take a short-term risk in order to maintain employment. On the other hand, maybe this is an isolated example and we are making much ado about nothing. Possible, but discussions with other OFS companies this week suggests these requests to rebid work lower are the norm.
In our moment of reflection, we chatted with a friend in the commercial banking industry. According to this contact, the plight of this downturn to the E&P industry will be far worse than the impact to the service sector, in part given less financial leverage in the service sector. Seems hard for us to believe, but this contact sees a broad portfolio of energy loans, thus they should be more informed than us. According to our contact, the liquidity stress on the E&P industry will be severe as borrowing bases likely move lower in 2H’20. Thus, some E&P’s have no choice but to get service costs as low as possible while simultaneously raising production in order to survive. This doesn’t make us feel too good as an implication of this comment is some of our service friends who are aggressively pricing lower to win work may ultimately end up not getting paid. Alternatively, if the strategy is to obtain lower prices and then quickly return to work, the implications to the improving oil macro narrative may fade as the market doesn’t want to see growing production anytime soon. Nevertheless, from the perspective of the E&P there is a legitimate reason to get your cash costs as low as possible which is why oil service companies should continue to expect price concession requests as long as oil prices remain depressed. And yes, $30 WTI remains depressed, notwithstanding the recently rally over the past few days.
Now, step back and take the 30,000 foot perspective on this situation. And, know that this perspective is no different than what has transpired in previous up/down cycles. First, how is this bantering on price good for either the E&P or the service provider? We know from history that the feast or famine dynamic which characterizes the upstream industry is not a long-term winning business strategy for either party. Depressed energy equity prices and years of weak returns tell us this. E&P’s who seek rock bottom price and/or slam on the activity brakes essentially kill the service companies as the service industry is forced to defer equipment maintenance and/or quietly dial back proper safety practices. Good people are lost and leave the industry as well. Is this really what either the E&P customer or service company want? Does this lend itself well to efficient operations? Do the beatings distill into the partnership concept which so many E&P C-Suite teams profess exists? Nope. Meanwhile, service companies yearn for the day when the price stick shifts hands. All unequivocally tell us they will stick it to their customers as soon as possible. Yes, that will feel good for the moment, but much liking drinking a cold six-pack, you will eventually suffer the consequence. Why? The short-term windfall of excess profits will eventually lead to either a rapid reactivation of industry capacity or new competition or both. Remember, customers like choice and if they don’t have it, they will create it. No one wants to be beholden to only one or two providers. Investors, meanwhile, want long-term sustainable returns.
And, while some might scoff at the idea of new competition, particularly in this market, just go talk to some of the equipment builders. Some are taking calls from people looking to buy equipment (new or used) at rock bottom prices. No one is pulling the trigger today, but there are a lot of good people who are now out of work. Many of them have great customer relationships as well as significant industry experience. With a modicum of capital, it would be easy to build a good team. Smart family offices will eventually seize on this opportunity. Consequently, for an E&P customer who feels backlash from aggressive service price increases at the onset of the market recovery, they may just be able to find entrepreneurial folks who will start new companies at their behest. This has happened before and it will happen again. The speed at which it happens will be largely influenced on the (i) the ability of the existing service complex to react to rising demand and (ii) the pricing tactics employed by the service industry.
U.S. Frac Fleet Thoughts. In recent weeks, we have noticed a bit more social media activity with people making predictions and/or bets on the direction of the U.S. frac fleet. We have no objections to speculation since that’s precisely what we do. But while some seem to be fixated on whether the U.S. frac crew is 30-40 or 40-50, at this point it really doesn’t matter. All of these levels are Armageddon to the U.S. oil service complex. As we opined two weeks ago, actions will have consequences. The real question is not whether there are 20 crews in the Permian or 15, rather it’s how long will we be at these low levels. And then, the question is how should the industry prepare itself for the eventual recovery. Remember, E&P commentary on Q1 earnings calls suggest frac crew demand will be rising in 2H’20, in part given the expectation of higher oil prices. Recall, the forward curve 3-4 weeks ago was much better than the negative spot prices which then shocked the market. Today, the forward curve is a tad better as WTI is trading in the mid-$30’s for much of 2021, a function of growing evidence of rapidly declining U.S. oil production. Moreover, if the EIA is right, WTI prices could be mid-to-high $40’s by mid-2021. Either scenario would yield higher activity. By the way, in keeping with the spirit that completion activity will rebound as oil prices move higher, a small private frac company shared with us this week that it will soon head out to do a couple vertical frac jobs. Yes, this is low calorie work, but it is indicative of what we should expect to see in 2H’20.
One thing we know today is limited equipment rebuild activity is occurring. A prolonged abyss will yield a structurally lower U.S. marketable frac fleet. This will speed the rebalancing of supply/demand when the market recovers. One thing which we didn’t hear from our OFS friends during Q1 earnings season is what they want their company to be when the cycle recovers. For example, let’s say you were a 20+ fleet player in the Permian and you now work low single-digit fleets. Should your ambitions be to return to the 20+ working fleets or should you instead be a solidly profitable 12-15 fleet player? Or, what if you are a best-in-class multi-basin frac provider who not long ago ran over ~15 fleets, but is now running low-to-mid single digits. What’s the right size in a market recovery? Should market share dictate the strategy or should cash returns to shareholders be the focus? Are companies better served spending money to reactivate fleets or perhaps making tuck-in defensive deals in order to take competitors out of the market? What do your investors really want? Or, how would you run it if you were privately-held?
Lots of questions here, but these are questions which were not asked during earnings season, but should have been. Frankly, modeling questions about one’s Q2 outlook really isn’t that important, but one’s strategic objectives and how these will be achieved are. In our view, the OFS space should use a play from the E&P playbook and withhold capacity until higher pricing ensues. Sorry E&P friends, but they need to make money too. And, by the way, this is somewhat analogous to E&P’s suspending completion operations and shutting in production. These extreme steps were partially made in response to a commodity price which incinerated. Given a similar incineration to OFS pricing, a similar strategy is warranted, so here’s what we would do.
If could play pretend and be a market leading OFS company, we would clearly state to our investors and our customers a principled strategy towards equipment reactivation. Doesn’t matter whether we identify as a frac company, workover company or drilling rig contractor. We would not hide behind numbers, but would lay it out for all to see. We would seek a take-or-pay contract or upfront payments to reactivate any equipment which necessitated a material capital investment. We would tie management compensation to hitting specific return metrics. We would exit non-essential markets and prune non-core business lines. We would never sell idle equipment in businesses which we compete, nor would we build new without a take-or-pay arrangement. The recent newbuild activity in 2018/2019 by those without contracts is now a debatable strategic move, particularly if such equipment is sitting idle. We would not wait for competitors to fail, only to be recapitalized and raised from the dead. We would make strategic tuck-in acquisitions of private competitors and we would make sure any transaction structure had a sizeable hold back such that the sellers couldn’t go out and immediately start a new company. We would want them to have skin in the game. We would be open to merger of equals and we would be sure to maintain a lean G&A structure in a market recovery. Importantly, from a pricing perspective, we would use the land drilling industry as a proxy for our approach. Short-term to one-year contracts. Don’t extort your customer in the upturn and don’t give your business away at cost in a downturn. Under the premise of being a market leader, we would hope our actions cause others to follow suit whether by their choice or from investor pressure. These are our views and we are open to critical feedback. We do not, however, embrace a do-nothing strategy.
Key Energy Services Earnings: Quick thoughts on KEG’s Q1 earnings. Activity declines reaffirm what we opined in early April as workover rigs have largely been sent to the yard. KEG reported an average of 117 rigs working in Q1’20 vs. an average of 132 in Q4’19. The company exited Q1 at 95 rigs, but in the month of May, KEG is running between 50-60 rigs. The company is responding to market pressures with price discounts in the high single-digit to low double-digit range. Lower activity and pricing necessitate aggressive cost cuts as the company implemented wage reductions, less overtime, benefit reductions and a suspension of the 401k match. These actions are occurring throughout the oilfield and aren’t sustainable. During Q1, KEG restructured its balance sheet while management has dramatically cut the G&A profile of the company. The company’s CT activity commentary is reflective of a challenged and oversupplied market. During Q1, KEG operated 1.4 large diameter CT units vs. 0.9 in Q4’19. Revenue in this segment totaled just under $5.0M. On paper, KEG owns one of the largest CT fleets in the U.S. As for capex, KEG will spend less than $5M this year. This level of spend is emblematic of the challenges facing the U.S. well service industry. Too much capacity in the hands of too many people yields weak pricing and no earnings. The only solution is massive consolidation, a concept we’ve been preaching for years. The good news is we are seeing baby steps in this direction and we hope more will continue. We are looking forward to the next update from SPN to see how the progress with Forbes Energy is progressing.
Land Rig Count: The Baker Hughes land rig count continues to march lower as it declined another 32 rigs on Friday. Our forecast on April 8th called for a bottom in the 150-200 range. The recent move northward in WTI prices likely renders our forecast a tad too penal.
Upcoming Tours. We will be driving up to Fort Worth tomorrow morning for three days of meetings. There are a couple open slots, so text me if you have some free time. On Thursday, Daniel Energy Partners, Galtway Industries, Benchmark Houston Builders and Karbach Brewing Company will host a welcome back lunch at Super Chicken in Houston (BW8 feeder location) as we seek to support small businesses. On Tuesday, May 26th we’ll be driving back to Midland for two days of meetings. If you have some time and are open to a quick visit, please let me know. On June 4th, Daniel Energy Partners will host its Kingwood Golf Outing. We have about two open slots left. Lastly, on June 5th, my son Trevor and I will depart for the Bakken. Anyone who would like to be a gasoline or DQ sponsor, shoot me an email. As a start-up business, we have no shame asking for your support.
Concluding Thoughts: A loyal reader astutely pointed out our recent notes were a bit less frequent this past week. Indeed, he is correct. In full disclosure, as a small team there will be some weeks where we have multiple notes and other weeks where the volume is light. This past week we spent time working on internal administrative matters, such as our website design and the rollout of our consulting practice. Our objective is to write ~2-3 notes per week with the occasional thematic report. During earnings season, we’ll publish more. Some weeks when the news flow is limited, our publications might be light. What we don’t want to do is to simply write worthless notes which serve only as clutter to your inbox. Let’s hope you don’t put this note in that category. Currently, we are knee-deep in our first thematic report on the U.S. well service sector, a report we hope to have published by the end of the month. Friends in the well service industry, let me know if you can spare a few minutes to catch up.
As always, this is not investment advice as we don’t give investment recommendations.