No Cakewalk for Oilfield Services Firms

NEW YORK (THE WALL STREET JOURNAL via Dow Jones Newswires), Jul. 27, 2009

Picture the oil price as a big, sticky cake. The government, refiners and producers all want a piece. The contractors that help extract it, oil-services companies, also get a slice.

Those contractors did very well when oil was heading toward its 2008 peak. Upstream operating costs, a large chunk of which are paid to oil services firms, doubled between 2000 and the third quarter of 2008 according to IHS Cambridge Energy Research Associates, a consultancy.

Crude's crash ended that run, but its rebound has reawakened hopes for the sector. The Philadelphia Stock Exchange Oil Service Sector index is up 40% this year, far outstripping exploration and production (E&P) or integrated energy stocks.

But it is hard to see oil-services firms escaping the lash of deflation. They have already taken one hit. Announcing second-quarter results, Halliburton was candid about oil producers getting discounts this year. Along with Schlumberger and Weatherford International, it suffered double-digit percentage declines in oil-services revenue and falling operating margins, year over year. Weatherford's margins dropped more than 5 percentage points. The biggest hits have come in the U.S., where drilling activity has plummeted amid low natural-gas prices. But even if that process has largely played out, pressure on the prices oil-services firms charge looks unlikely to abate for at least several more quarters.

Trouble is brewing among some of the oil-services companies' biggest customers: the majors. During the energy boom, the majors had cash to invest in replacing reserves and pay big distributions to shareholders. Now, they have to make hard choices. Buyback programs have been scaled back and borrowing has gone up already.

But, Neil McMahon of Sanford Bernstein calculates, the majors would struggle to make operating cash flow cover the cost of replacing reserves and increasing production while also paying dividends, even if oil averaged $80 per barrel and natural gas averaged $9 per thousand cubic feet in 2010. Both numbers are significantly above the Street's consensus forecasts.

To make the math work, oil producers could cut investment and dividends or borrow. But given already low reserve replacement rates, investment can't be cut too much. Riling shareholders with a dividend cut or risking a credit-rating downgrade doesn't look too palatable either.

That leaves cutting operating costs. Oil-services companies should prepare for more awkward price discussions.

A sharp rise in oil prices would solve this problem for majors and contractors alike. Even if oil prices rise further, however, investors might be better off targeting E&P stocks instead. Contractors would still face margin compression dealt by discounts agreed earlier this year. E&P companies, in contrast, which are more leveraged to energy prices than the majors, would expand margins both ways as their costs would also have come down. They could have their cake and eat it, too.  

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