OilVoice

People forget how fast you did a job - but they remember how well you did it…
Howard Newton

……and how much you charged!

Our image of the oil & gas industry is mainly driven by the Majors through their marketing arms – after all, we see the names Exxon, BP, Shell, Total etc every day as we drive. Subsequently, we recognize that these big companies explore for, develop and produce oil and gas, and figure in the ‘top ten’ when all types of companies are ranked by market capitalization. In contrast, most members of the public would struggle to recognize the name of a single AIM oil & gas company.

There is another sector of the oil & gas business that bypasses public recognition, but that ‘professionals’ in the industry know all about, and that is the oilfield service contracting industry that is driven by revenues from the Majors, from NOCs, and others. Bernstein Research estimate that the oilfield services industry generated revenues of almost $246bn globally in 2007 and that this figure will rise by more than 10% in 2008.

So companies in the oilfield services sector can be regarded as a play on the vast amounts of cash headed in their direction (although a 29th July 2008 article in the Financial Times under the headline “National’s champion: How the energy-rich rely on Schlumberger” only just stopped short of celebrating their role in bringing world peace!). However, the sector has a reputation of being highly cyclical, with the drilling and seismic contractors particularly responsible: in an earlier article (“House of Cards”, from early 2007, but which can be accessed in my OilVoice columns with a 17th April 2008 date), I looked at the seismic industry’s painful history since 1990 and I don’t plan to earn more brickbats from my friends in the geophysical service sector by focusing on that time again!

Drilling and seismic are but two of a dozen or so separate sectors within the broad oilfield services industry which is quite diversified technically, but US and European-centric, with typically a small number of larger companies having the dominant share of any one sector. As a general guide, ~4% of the total spend is on seismic, ~25% on drilling (onshore and offshore combined), defining these as ~$10bn and ~$62bn per annum sectors respectively.

So, there is a lot of money flowing into the oilfield services sector in general and into drilling and seismic in particular. The sector may not be visible to the general public but are knowledgeable investors (including canny oil & gas ‘professionals’) rewarding the companies involved with share price growth in these good times? The answer seems to be – it depends.

The table below shows the change in share price of nine oilfield service companies from early April 2007 to early April 2008. The first three, Schlumberger, Baker Hughes and Weatherford, can be described as integrated, offering services across a number of sectors; Petrofac is a global facilities and infrastructure provider; the next two, PGS and CGGVeritas, provide a broad range of seismic services; the next three, EMGS, OHM and GETECH provide specialist or ‘niche’ geophysical services:

Company % change in Share price, April 2007 – April 2008
Schlumberger             +43%
Baker Hughes              +5%
Weatherford              +62%
Petrofac                    +40%
CGGVeritas                -1%
PGS                          -18%
EMGS                      -82%*
OHM                        -64%**
GETECH                   -47%***
     * from IPO in early April 2007
   ** -72% from mid-2007 peak price
 *** -54% from IPO in early April 2006

So what’s going on here? Let’s start at one end so to speak and look at the most recent Interim Results (April 2008: http://www.ohmsurveys.com/news.php#apr08 ) from OHM (it could equally well have been EMGS’s, for example) - this is what the Chairman had to say:

“This first half year to 29 February 2008 has been a challenging market for all CSEM companies with no large proprietary surveys completed by the Company in the winter season. Against this backdrop OHM is directly addressing market adoption and our market penetration through the strategic developments announced last year. We remain focused on developing the reach of CSEM, and OHM as a leading developer of the technology, in the following ways:
• Increasing our sales channels through our relationship with CGG Veritas, the world’s largest seismic company;
• Enhancing the operating window of our CSEM surveys in terms of weather tolerance of our field crews, depth of targets that can be imaged, and developing solutions for challenging geological problems, like imaging of sediments below basalts and salt. We are the only CSEM provider able to demonstrate a track record of successful performance in shallow water CSEM surveys;
• Further improving the efficiency and quality of our surveys including the anticipated introduction of our third crew on the vessel, OHM Leader, enabling us to operate effectively in multiple regions; and
• Continued commitment to R&D aimed at integrating CSEM with seismic and reservoir data to enable CSEM to become a major tool in development and management of reservoirs as well as in efficient exploration.

We remain of the view that the value-proposition for exploration and production companies in using CSEM represents a market of significant growth potential for OHM.
Controlled Source Electromagnetic imaging (CSEM) measures and maps subsurface electrical resistivity. In the oil and gas industry, CSEM is a game changing application where this electrical resistivity can be used as a direct hydrocarbon indicator.
The OHM Group leads the industry in developing, improving and integrating CSEM technologies with other existing technologies and we have the quality of people and resources to continue to be at the forefront of the industry. There are many hurdles to cross in making this technology commercially operational. Developing and producing effective high-power electromagnetic transmitters and extremely sensitive electromagnetic receivers poses significant engineering design challenges. Creating the complex mathematical analysis code to create meaningful images of the subsurface from the measurements made in CSEM in the presence of real-world noise and signal distortion requires theoreticians and computer scientists of the highest calibre.
The challenge the Company now faces is to achieve mass adoption of the CSEM technique by an industry that is generally slow to embrace new technologies. To date, we have made significant progress in assisting the early adopters of technology, like Exxonmobil and Shell, to appreciate the benefits of CSEM. We also have seen encouraging take-up by a number of oil companies of various sizes who recognise the value of the information that CSEM provides. We are pleased to note that our client base has expanded to over 40 companies.
As the investment community shies away from funding exploration due to the current very high cost of and relative lack of success from drilling, we expect more companies to seek ways of reducing the risk of exploration drilling. This, together with increasing awareness of the CSEM technique and application in both deep and shallow water, should ultimately drive more business for OHM.
A recent market research report in the oil service industry (conducted by Welling and Co.) showed that only about a third of the oil companies polled were currently users of CSEM technology confirming our view that there is considerable scope for further growth in the CSEM market. Encouragingly though, three quarters of those who had used the technology were satisfied with the results they achieved.”
My apologies for quoting this statement at such length but I do so because it illustrates a fundamental problem of both ‘niche’ and ‘single sector’ service providers, namely predicting what the order book, and therefore revenues, will look like over a 12 month period (corresponding to their customers’ capital expenditure/budget cycles); at an IPO for example, my guess is that brokers are drawn towards the more optimistic predictions.

More integrated companies, offering services across several sectors, are probably more able to predict what their total order book and revenues will look like and, perhaps, benefit from drawing at least in part on their customers’ operating expenditures which tends to be a little more stable than capital expenditure (as I recall!). Although specialised, deep water drillers are able to negotiate 3+year deals for new 4th and 5th generation rigs; such extremely predictable revenue is not available, say, to drillers onshore in North America.

The table above suggests that canny investors recognise these issues and are rewarding integrated companies and/or those that are somewhat specialised but with good geographic spread – direct sensitivity to high oil & gas prices seems less important.

So in predicting the future for the oilfield service sector, it may be sensible to focus rather less on oil & gas prices – although there will obviously a downward shift in spend if there’s a significant fall in oil and gas prices – and look at the future another way, namely by considering the question as to whether the current high level of spend is delivering value for money? Before seismic and drilling companies send me some (even more!) hostile e-mails, let me say that what I mean is whether there is any evidence that as a whole companies and NOCs are improving their situation by spending this amount of money?

To think about this, I want to review what’s happened recently in:
1. global exploration performance, and
2. delineation drilling, to mitigate field production decline
towards which we can assume that much seismic and drilling spend is targeted (although I’m conscious that I am neglecting the whole area of development drilling).

On global exploration performance, we can say that by the end of 2007:

1. Global exploration discovery volumes had been on a generally down-ward trend since the first half of the 1970’s, with 2006 volumes down on 2005, and, whilst the facts about 2007 are not yet fully recorded, it does seem that:
2. Overall, global exploration performance was again weak, despite significantly increased expenditures, with a shrinking number of large (>250mm boe) discoveries.
3. Deep water exploration saw a surge in activity but a further down-turn in success, with total discovered volumes and average discovery size, continuing a 21stC declining trend, despite the 2006 opening of the so-called “Lower Tertiary” trend in the western Gulf of Mexico Deep Water and of the sub-salt play in the Santos basin, offshore Brasil (in 2007).

Many industry analysts and observers call for even more exploration expenditure so as to increase global discovery volumes. However, it’s my view that this is a bad call – global exploration as a whole is hitting a buffer that’s due to the rocks and simply escalating expenditure won’t solve the problem.

Global exploration is an ‘open book’ compared with figuring out the impact of delineation drilling on lessening production decline. Matt Simmons has reported on the decline issues many times: a good recent example can be found at:
http://www.simmonsco-intl.com/files/NYC%20SCI%20Investor%20Lunch.pdf
The issues are that there is a general vacuum of decline data, especially from the major OPEC producers, and that where field decline data is available, for example, in the Deepwater Gulf of Mexico, the North Sea, Alaska, Mexico and Oman, the picture is alarming. Fields routinely decline at ~20% per year and even ‘hyper-active’ drilling campaigns merely lessen the rate, as opposed to returning the field to any sort of plateau. Again, individual fields are hitting the buffers due to the rocks. Interestingly, in the Schlumberger presentation mentioned above, their CEO makes pretty much this point using examples from China and Oman: of course, even more drilling and use of advanced technology is suggested as a means to attack this problem!

Linking these two points, the fundamental issue concerns reserves growth – the money being spent, the drilling being done, the technology being deployed is not translating into enough discoveries, additions and extensions. Data on this subject from the major OPEC producers is also more or less non-existent but if we accept that the Majors and the bigger Independents are reasonably representative of what’s going on, then the picture looks something like this: for 25 IOCs, average reserve replacement ratios have slid from around 150% in 1998 to around 80%, or slightly less, in 2007 (this is illustrated by Slide 7 in the aforementioned Schlumberger presentation).

It’s my opinion that the combination of ‘oil patch’ cost inflation and the above outlined poor reserves growth performance must lead at least some of these IOCs to a strategic re-think – indeed a recent article in World Oil that can be found at:
http://www.worldoil.com/Magazine/MAGAZINE_DETAIL.asp?ART_ID=3508&MONTH_YEAR=Apr-2008
suggests that ExxonMobil have already reached this conclusion regarding exploration, with the company’s message being reported as:
“Despite high oil prices, exploration is irrational in today’s highly competitive and restricted business environment. Rudolf described the unacceptable cost of international opportunity capture because of increased competition, tougher production-sharing terms by host governments, and the rising cost of products and services.
Remaining opportunities in the international arena are relatively small, because most available blocks are in their second or third phase of appraisal; there is just not much left that is attractive. Rudolf calls this the “winner’s curse,” because if you win a bid round in today’s environment, you lose because the reward doesn’t justify the cost.”
Arguably, BP and Shell’s focus on cost reduction is at least in part a reaction against spending more and more with 3rd parties but not improving results.

It seems that companies that are very exposed to strategic re-thinks by some or all of the leading IOCs, especially the Majors, have already found themselves unloved by investors – these would include any of the ‘pure’ seismic companies, especially those with a narrow geographic focus, and also the ‘niche’ geophysical companies.

My message to my fellow sub-surface professionals is that we need to be doing this (re-)thinking in earnest: if you work for one of the ’25 IOCs’, average reserve replacement has been on a downward slope from just over 100% in 2000 – so far this decade has not really ‘worked’!

Author: David Bamford

Thursday, April 17, 2008 14:28