Our Permian field trip was somewhat overshadowed by Chevron’s announcement to buy Noble Energy (surprise); BJ Services bankruptcy filing (not a surprise) and HAL’s Q2 earnings (better than expected). We’ll let our Wall Street friends go into the deep dives into company specific modeling on the CVX/NBL deal as well as HAL earnings, but we’ll offer our high-level thoughts on the latter.
As for what we learned on our trip, key takeaways include (1) a steady ramp in the frac crew count; (2) persistent OFS pricing pressures (already known), but compounded by some customers’ requests for MSA amendments; (3) brewing discontent amongst some portfolio companies and their PE sponsors; and (4) ramifications of persistently low returns as workover companies push for extending the period for major derrick inspections. Actions have consequences.
Frac Crew Activity. Our field contacts point to a working frac crew count in the 40-42 vicinity with potentially high-single digit deployments expected to occur over the next several weeks. The Permian bottomed around 20 fleets. The increases are across the board as both public and private E&P’s have resumed activity. Meanwhile, some frac companies which had been completely idle now have crews being deployed. One E&P and one wireline company both point out the increase in crews is not all dedicated work, thus there is risk for this equipment to return to the yard once pads are completed. HAL alluded to this on its Q2 earnings call as a seasonal/budget impact appears reasonable, although we would contend if US/China tensions settle and COVID vaccine/anti-viral treatments make further progress, a mid-$40’s price deck could change the seasonal risk concern. Reminder, the CY’21 strip was approaching the $43-$45 range until last night’s closure of the China consulate in Houston.
The activity gains are also occurring in other completion-related businesses such as wireline, coiled tubing and workover. Makes sense as support equipment is needed during the completion process while E&P’s continue the push to bring production back online. In one case, a large well service company has seen a near doubling of its working rigs since the bottom while a small well service company has seen its working count jump from two to six.
MSA Changes Coming? A growing complaint from several well service contacts is growing pressure by customers seeking to tighten Master Service Agreement language. Notably, a number of the customers want to change “gross negligence” to “negligence”, a move which puts more risk on an already burdened industry. Well service contacts were quick to point out this is not a broad-based move by the E&P industry, but it would effectively raise the cost of doing business for the service company. Many OFS companies already have high deductibles, effectively making them self-insured.
These pressures are now being amplified by E&P customers who are extending payables. In some cases, a few are trying to recut deals. In one case, a troubled E&P is purportedly asking service providers to accept 50-80% of outstanding their A/R balance as this E&P navigates a restructuring process. Those who take 80% get the chance to continue working with the E&P while those who would rather avoid this E&P given its uncertain financial situation risk only getting 50% of their A/R. This doesn’t seem right when one considers the service companies were probably working close to breakeven already. So much for partnerships.
One anecdote on pricing pressures. We visited with one well service company who had been charging $250/hour pre-downturn. Rates fell to $185/hour. This level was unsustainable, thus the service company increased the rate to $205/hour. The customers then dropped the rigs, all because of a $20/hour increase. Purportedly, the E&P went to another player willing to offer the $185/hour. According to multiple contacts, that service company has a known history of safety violations, but at least it’s $20/hour cheaper. We get survival is the order of the day, but this approach to service company relationships is contrary to the principles of ESG and doesn’t jive with the community and stakeholder relations promotions espoused on this E&P’s website.
Actions Have Consequences: This is a theme we have written about extensively and we’ll continue to hammer home this message. Simplistically, the carnage afflicting the upstream industry, particularly the OFS sector, will not just be a short-term business disruption due to a cyclical slowdown. Rather, it will result in long-term damage. Massive headcount chop, facility closures, companies exiting basins, long-term reductions in R&D and reinvestment in equipment will all have long-lasting impacts to the sector. These impacts are, obviously, not good and will impact the ability for the OFS sector to properly meet the needs of the E&P sector should we ever witness another real (i.e. sustained) up-cycle. Here’s a real-life example.
In the well service industry, it is customary to conduct a category 4 inspection every 10 years. This would include a thorough review of the mast, including the equivalent of x-raying the structural integrity of the derrick. The process is meant to look for potential critical failure points and find them before a failure occurs. This is important because a derrick collapse would most likely be catastrophic, potentially resulting in death(s).
There is now an effort by some well service companies to extend the mast inspection cycle. Contacts tell us the objective is to inspect the mast every ~13 years instead of every ~10 years. Efforts are purportedly underway to get the API’s blessing on this change.
Advocates of the change claim the logic of the 10-year cycle is flawed as the measure should be dictated by utilization days and not an arbitrary year. Given the off/on utilization of well servicing, there are times the rig isn’t working, thus there is no wear-and-tear on the rig. To simply have an inspection period determined by a pre-set timeline does not capture the rig’s true utilization. Therefore, lack of utilization on a rig may render an inspection pointless since little-to-no wear-and-tear was placed on that mast. Makes sense to us.
But dig deep into the issue and well service companies actually concede the real driver behind the desired change is due to money (or lack of it). Field contacts claim the inspection can run $75,000 to $100,000. That’s a huge expense for a sector with no cash. Case in point, we visited with a well service company whose hourly rate is $205/hour (production, not completion work). Let’s generously assume with add-on’s the effective rate is $300/hour. Let’s now assume the rig works 48 weeks/year and averages 40 hours per week. Probably a generous assumption as well given the current market. This implies revenue of $575,000/year. EBITDA margins for many well service companies vary, often between 10% to 15%, so let’s use 15%. This implies ~$90,000 of rig level EBITDA/year. Don’t forget there is a normal maintenance capex burden. Some companies still have interest burdens and for large companies one should burden the segment EBITDA margins with a corporate overhead allocation. For the lucky few, some may pay cash taxes. All of this math equals ugly. In other words, we submit most well service companies simply don’t have the cash to conduct these necessary inspections and/or make major repairs.
And we know the money is not there because several well service companies on our trip openly acknowledged they are stealing parts from idle rigs to keep working rigs running. In fact, this cannibalization process was underway on the day we toured one yard. So, if a company can’t purchase the small stuff, how do you spend money on the big stuff? You don’t, hence an effort to push out the inspection cycles. Some may even defer regular maintenance. Short-cuts, we submit, are occurring as people fight to stay alive. This is what happens when customers make service providers work for $185/hour. This is why we believe industry consolidation is needed as the sector needs to charge a “fair” price in order to safely reinvest in both the people and equipment. This can’t happen in a heavily fragmented market. Moreover, we believe there are cases where it’s in the best interest of the E&P to pay higher pricing. Sounds silly, but it’s true.
By the way, rig builders with whom we also met strongly disagree with the potential change to mast inspections. They, of course, have a bias as these companies usually do the derrick inspections and corresponding repairs, thus it is in their financial interest to have a more frequent inspection cycle. But while money is at play here, these companies regularly see the impact of years of corrosion as well as the ongoing wear-and-tear on the masts. They know the risk of not properly maintaining the derrick and they vigorously contend the change puts employees at risk.
Another point to consider. Masts are typically rated to a certain hook-load. One could argue the ongoing push towards longer laterals means greater lifting needs as more equipment/pipe goes downhole. Therefore, one could assume the demands and stress levels on derricks today might be greater than in prior years. If you agree with this logic and therefore assume the average job puts more weight on a derrick, could this not yield greater wear-and-tear on the mast? Seems like a reasonable supposition, thus it’s a question we put forth to both rig builders and well service companies. Neither pushed back on our theory. Again, assume that theory is correct, it would therefore lead us to believe greater lifting requirements may necessitate a more frequent inspection cycle, not a less frequent one. Presumably, this would be considered by the API review process.
Money Problems = Discontent. Dad’s love to give fatherly advice. Sometimes it’s wanted, other times, it’s not. Just before I got married, my father told me that marriage is bliss until money problems arise. That, according to him, is a fast way to kill romance. Well, that logic seemingly applies to the business world as well. Notably, on recent trips we visited with several contacts, all of whom have some form of PE sponsorship/relationship. What we learned is the joy of sponsorship has quickly transitioned into growing discontent.
Now, before we ruffle too many feathers and upset our PE friends, we acknowledge our sample size is small, but when 100% of the sample size says the same things, we pay attention. Why? First, our field contacts have both the customer and employee relationships, not the PE. Second, field contacts equity ownership in their business, we believe, is most likely worthless or close to it, thus there isn’t really any real retention tool or reason to stay. Third, many are now being starved of capital and/or have differing operational strategies with their PE sponsor. Fourth, these field contacts see growing opportunities to buy assets on the cheap and some are now asking why they continue to bother with their respective PE sponsor. Some believe the growing list of OFS bankruptcies and restructurings will simply lead to even lower asset prices, an intriguing opportunity to go “do it again”. We, of course, want harmony and bliss. But, when field contacts start raising these concerns and questioning what to do, we pay attention. Why? We don’t want to see a current situation where management teams revolt and go off to start newco. At least not now when the OFS market is too fragmented. Let’s wait until consolidation happens and the sector returns to profitability. Today, we need less competitors, not more.
HAL’s Q2 Earnings: Respectable Q2 results which came in above market expectations. Of note, we found HAL’s reference to ongoing capex requirements intriguing. The company noted capex will now range between 5-6% of revenue, down from an historic range of 10-11%. Part of this driver is better built equipment as well as lower costs to build the equipment. Some skeptics might argue lower capex numbers could materialize due to equipment cannibalization. Frankly, some merit to this exists, particularly if one believes the call on U.S. frac equipment is structurally lower on a go-forward basis. HAL essentially alluded to this prospect.
HAL did point out recent improvements in frac activity. This is not new news, but it does see Q4 seasonality/budget shortfalls materializing in Q4. As noted earlier in this note, we heard similar industry views in Midland as well. Again, the magnitude of any Q4 slowdown, we believe, will be a function of commodity prices and with several months to go, it’s a tough one to predict.
HAL’s Q2 results included ~$2.1B in charges which was comprised of $1.3B for asset impairments, $0.5B in inventory write-downs and nearly $250M in severance as well as some other stuff. The stock meanwhile closed up on Monday, another sign most investors often don’t care about “one-time” charges. Therefore, smart OFS companies will use the awfulness of Q2 as a chance to write-off everything possible. Really smart companies who provide granularity into their results and activity measures would also be wise to announce structurally lower fleet counts. No one believes or models the U.S. frac crew count returning to the glory days of 300+ fleets, so why try to advertise large fleets? That just implies industry utilization is even worse than it really is. Rather, we believe companies should come out and say a large percent of the total fleet will be transitioned to spares for cannibalization purposes. This would help elevate cash flows by reducing near-to-medium term capex requirements. The reduced fleet size would optically look good. It’s no fun to say we are working 5 of our 20+ fleets. Instead, say we are running 5 of 10 fleets with plans to raise prices when we return to 8 fleets or 80% utilization. Less market share and more profits is better than more market share and bankruptcy.
BJ Services Files Bankruptcy: Another victim of too much debt and little-to-no profitability. The company announced a Chapter 11 filing, but the way we see this, it almost feels more like a Chapter 7 as assets are being sold. This is the WORST outcome for an already terrible U.S. frac market. We need companies and assets to go away, not be recirculated into the market. As we understand the bankruptcy process, BJS will sell portions of its frac business. Translation: Could one frac company now become 2+ frac companies? Also, field commentary suggests there are more frac companies preparing for a similar process as BJS. If true, does this portend a potential for mass volumes of frac equipment potentially coming to market via forced asset sales? Already, we have seen frac equipment at auctions and brokered sales. This equipment has/will come back into service. If more equipment comes to market, the laws of supply/demand suggest it could push asset prices lower. Translation: We just made it easier and cheaper for speculators to step in, thus market fragmentation gets worse, not better. And while HAL and other leaders will push for digitalization and other technology improvements, there are a number of E&P’s who don’t care and simply want low bid. The more players in the market will ensure low bids persist and this will suppress pricing, at least in the short-term. In time, the market will require newer, emission friendly equipment, but that’s a process in the making. Now, it’s all about price.
Other Field Observations: (1) More employers report struggles to get people back to work given the lucrative unemployment benefits. Now at least two companies claim they are reporting this to the unemployment office. We are told the employees could lose benefits if they are offered back their jobs, but decline that work. (2) One OFS company recently participated in an online bidding process for work. The E&P (not named) had all vendors participate in an online bid where each service company could see the price being offered. Purportedly, the service companies had to qualify ahead of time, thus the E&P did, in theory, vet the companies before allowing them to bid. Nonetheless, this is another example of today’s “partnerships” in the oilfield. (3) OFS contacts are thrilled to see E&P’s letting go of their field consultants. Many report the consultants often look after their own self-interest and not the E&P customer. By not having to work through an intermediary, the service companies claim a bit more professionalism ensues (i.e. no request to use my brother-in-law’s business or sponsor some event (i.e. donate and keep work or don’t donate and Sayonara).
Final Comment: We often banter about the lack of pricing and competitive tensions within OFS. Some may say we sound like a broken record. Fair point. But let’s be sure to see the forest through the trees. The service industry needs to get smarter and drive efficiency so that E&P’s can make money at $40/bbl. Remember, they control the wallet and more affordable and efficient service will allow them to reinvest back into the business. This means more work for you. Therefore, the old model of OFS needs to change. Digitalization and automation will need to be embraced. Being lean and low-cost will be critical. Companies need to shrink to grow again. OFS enterprises need to be slammed together to eliminate duplicate costs. Prices need to flex higher so you can reinvest in your business. We should all be prepared to make less money for some time.
Don’t dismiss the CVX/NBL deal or the OXY/APC deal. And don’t underestimate why PE-backed E&P enterprises are being smashed together. They too need scale and need to lower duplicate costs. Theme here? You bet. We are all trying to survive. Bigger E&P’s will continue to get bigger. They will insist on more efficient and ESG friendly solutions. This is why there is a growing call on dual fuel engines – just one example. Those businesses who can invest in themselves or those who figure out how to work smarter/cheaper will survive. Those who can’t won’t. This transition will take time, thus there is still an opportunity for relationship-based businesses to thrive, hence our concern if good managers walk away and go start new businesses. There actually is money out there (admittedly not much) and ways to be creative. Family offices, in our view, or well-funded retired industry execs might just be licking their chops. We’re already tracking one of these start-up’s now. HAL hit the nail on the head on its earnings call. Its comments on technology innovation are spot on. We suggest other OFS enterprises pay attention.
BTW – first person who reads this long note to its entirety (and replies to me) will get a steak dinner on me. Also, as stated in numerous other notes, this is not investment advice. We don’t give stock advice, because we’re not good at picking stocks. Hope everyone has a great day.