The oil and gas industry continues to experience one of the sharpest and longest downturns in its history. Unprecedented change is occurring, and a radical transformation of the industry has started.
Faced with changing customer behavior, some oilfield services companies are responding by embracing new technologies and contract models, fundamentally changing their business models and transforming their relationships with their customers. Others have not yet adjusted to the new market environment, facing balance sheet pressures or providing undifferentiated products and services in niche markets.
More fragmented than ever, the oilfield services industry is adapting to the new environment and is starting to consolidate as a response to the fundamental changes in its customer base. What are the drivers of this consolidation, and how do they differ from previous consolidation waves? How is the oilfield services industry responding, and what are the future expectations?
01 Previous downturn, mega mergers and economies of scale
The mega mergers among the majors in the late 1990s and early 2000s took place during the “mid cycle” when oil oversupply triggered the oil rice to fall from USD30/bbl in 1985 to USD10/bbl in 1986 and then average USD18/bbl during the 1990s. These mergers ere mostly driven by the belief that bigger is better with economies of scale leading to greater efficiencies and stronger balance sheets supporting complex mega projects. They were also the product of globalization, which led to greater concentration in the hands of a few mega caps, not only in the oil and gas industry but also in other industries, such as the pharmaceutical and automotive industries.
Faced with supermajor customers and greater cost pressures, the oilfield services industry was forced to react and started its on consolidation wave. As with the upstream and downstream industries, this consolidation was mostly horizontal, dominated by the combinations of companies providing similar services an products or operating in complementary markets.
Oil prices started to increase again in the early 2000s and remained above USD90/bbl for close to four years until October 2014. This strong oil price environment supported the oil industry move into frontier areas such as deepwater and arctic regions, and it resulted in an increased capital spending on finding and developing new resources.
With their customers demanding highly specialized knowledge, products and assets, and commodity prices rallying significantly from 2004 onward, the oilfield services industry grew quickly, which triggered another round of horizontal integrations. Meanwhile the industry continued to fragment as many companies with niche offerings started to emerge.
02 Why is this downturn different?
The significant growth in upstream capex spend during the period from 2000 to 2013 did not generate a commensurate increase in production and reserves, and the oil price fall of 2014 acted to intensify the challenges already faced by the industry in a high oil rice environment. In this challenging environment the response to the current downturn is different, because:
1. Operators’ behavior and competitive landscape are changing.
2. Onshore unconventionals have become a new core resource.
3. Digital is transforming the route to reserves and their monetization.
Operators’ behavior and competitive landscape are changing
The response to the downturn has varied according to various types of operators.
International oil companies (IOCs)
The large cap IOCs continue to focus on increasing their cash flows to reduce their leverage and sustain their ability to meet their dividend payment commitments. A combination of investments, downstream strength an working capital releases has helped support balance sheets, while significant efforts have been made to reduce an unsustainable cost base. IOCs have manage this by focusing on standardization and simplification measures and reducing project inefficiencies, while maintaining their focus on safe operations.
The significant cost savings of the past two years have reduced the break even of a large number of projects according to Woo Mackenzie, the cost per barrel in the upstream sector has fallen by 30% compared to the average recorded in 2014 while capex per barrel is down 45%. With many new projects expected to start in 2017 and more work to do to reduce capex spending, the focus on dividends and costs reductions is expected to continue, no matter the oil price.
In addition to further capex reductions, a greater focus on operational excellence is expected, which likely will involve robust and significant structural changes. Unmanned facilities, particularly in remote locations, provide significant potential for cost savings by means of reduced health, safety and environment; utilities; and logistics costs. Where on-site personnel are still required, a rigorous assessment of solutions maintaining safe operations an lo personnel count is performed, often in combination with favoring suppliers with cross-trained specialist functions.
Collaboration with oilfield service companies is increasing, primarily with respect to large and complex project developments, where the need to spread risks is the highest. More and more, contractors are being required to innovate and use technologies to reduce costs, improve reliability, mitigate risks and improve project profitability, often on a share risk-reward basis. In many cases, the traditional “cost-plus” contracts are being replace with “outcome-based” contracts with the contractors bearing risks such as equipment failures during the development of a project.
On the other hand, with unconventionals changing IOCs’ appetite for big capex developments, IOCs are looking for their suppliers to be able to switch on an off some large capex projects. The IOCs, like the independents, are looking for the supply chain to deliver onshore resources quickly, cheaply and efficiently, in a relatively commoditized way.
Independents
The independents have undergone significant ownership changes during the past few years, with many transitioning from publicly listed to private companies owned by private equity. These new market participants are heavily focused on returns and more willing to share the risks and rewards with the oilfield services companies.
It is likely that risk-sharing agreements will increase as private equity owners further increase pressure on contractors to deliver better outcomes at lower costs. Such arrangements could provide contractors with an alternative approach for achieving market success an premium prices when other more traditional routes prove unsuccessful or with the ability to move into new markets ahead of competitors or to build partnerships with key customers.
Critical to the success of these arrangements will be to deeply understand how the products and services provided by contractors deliver value to the customer.
National oil companies (NOCs)
In general, NOCs have also responded to lower oil prices by driving down costs and improving efficiencies in their oil and gas production activities. For instance, in the UAE, the Abu Dhabi National Oil Company has undergone various initiatives since the appointment of a new CEO in February, including:
? Reducing headcount by approximately 10%
? Merging to large offshore concessions ADMA and ZADCO to benefit from economies of scale
? Merging three of its services units (The Abu Dhabi National Tanker Company, the Petroleum Services Company and the Abu Dhabi Petroleum Ports Operating Company) into one company
Over the past few years, NOCs have also continue a long-term trend of looking to take greater control of their resources and seeking to displace the IOCs by using service providers in a more integrated manner. Such examples include Saudi Aramco’s alliance with Nabors to own, manage and operate onshore drilling rigs in Saudi Arabia (October 2016) and joint venture (JV) with Rowan to operate offshore drilling rigs in the country (November 2016).
Many NOCs are also focused on creating more value within the hydrocarbon value chain and are increasing their vertical integration by creating a cohesive business that efficiently operates across the value chain.
? For many NOCs, collaboration with service contractors is key to:
? Reduce costs of services and materials
? Attract and retain to talent
? Develop new technologies
? Promote local content
? Promote the creation of jobs in the oilfield services industry and adjacent industries by setting up local R&D centers, often linked to in-country academic research and cosponsored by major international oilfield services firms
Onshore unconventionals have become a new core resource
The North American shale revolution has led to structural changes in global oil supply dynamics and dramatically lowered the fundamental economic equilibrium price point. Most participants in oil and gas markets now realize shale in particular changes the game. Because of its abundance, the number of economically rational operators involved, its short development cycle, low risk profile and ability to deliver returns quickly, US shale ill likely represent the marginal barrel of production at least in the medium term and potentially for much longer.
As a result, the oil market clearing rice is expected to be set with reference to North American shale. Shale producers are able to quickly respond to price signals. The speed from capital investment to initial production, coupled with the steep decline curve of shale wells, means that the commodity price cycle will likely be compressed to approximately three years. The ability to lock in project economics with hedges could lead to overinvestment when price signals are detected and might lead to more time spent in the trough versus the peak through the price cycle.
Digital is transforming the route to reserves and their monetization
The oil and gas industry is one of the world’s most advanced users of technologies. However, to date, these technologies have been primarily focused on improving time to first oil and improving the effectiveness of hydrocarbon extraction, rather than above ground operational performance and end-to-end integration.
Digital has the potential to disrupt the oil and gas industry on a scale equivalent to the US shale phenomenon by:
? Connecting critical assets and reducing system failure which can easily result in costly and often life-threatening emergency situations
? Monitoring and collecting data in real time without previously necessary human intervention
? Managing, storing and analyzing massive amounts of business data to drive better and faster decisions
? Further increasing reservoir management and drainage efficiencies
? Deploying digitally enabled technologies like artificial intelligence an robotics, reducing the need for human responses and changing the skill sets needed
The fundamental river is simple: leveraging the power of digital technology to transform business operations can deliver real, sustained value to the bottom line. And with oil prices depressed and the cost of technology low, the return on investment for digital technologies and analytics is attractive. GE’s merger with Baker Hughes, announced in October 2016, provides a clear example of the potential for digital in the oil and gas industry. With a strong technology platform and an approach designed to bring business value to an asset-intensive client base slow to adopt new technologies, GE is positioning itself to make the industrial internet a strong component of a more efficient oil and gas industry.
03 How the oilfield service industry is responding
The segmentation of the oilfield services industry — the Big Four, the drillers and well services providers, the seismic companies, the engineering and construction companies, the equipment manufacturers, and the logistics providers — has started to change as boundaries between subsectors become more blurry following vertical consolidation, and as digital technologies and their impact on operations create new opportunities for all players.
This transformation is only in its infancy; however, based on the changes highlighted above, the industry could converge into the following groups:
The integrated service providers who are leading the current consolidation wave and using the downturn to grow market share, acquire new technologies and capture project efficiencies through vertical integration an opportunistic acquisitions (these include the large OFS companies such as TechnipFMC and GE)
The specialists who are focusing on a niche art of the market or a single or small set of technologies, offering specialist products and services, with or without any differentiation
The logistics providers who are providing assets (vessels, rigs, helicopters, etc.) and a range of support services to the industry and are responsible for oilfield logistics, supply and training of personnel, warehousing, etc.
Integrate service provider
The integrate service providers are breaking with the past, understanding that the cost-efficient development of increasingly complex hydrocarbon resources will not occur without fundamental changes in their operating models, innovative technologies and greater collaboration with the upstream industry.
Recognizing the inexorable diminishing of boundaries between industries, the integrated service providers are actively forming partnerships or involving themselves in networks with other organizations.
The recent collaboration agreements between some oilfield services companies and operators (such as Det norske, Subsea 7 and Aker solutions, or Schlumberger’s JV with Golar LNG) illustrate this fundamental shift in how operators and suppliers might be able to work together on some oil and gas developments, as one “integrated” or “aligned” team.
Recent examples of vertical integration illustrate the integrate service providers’ response to the need to reduce overall project costs by offering more integrated solutions an combining technologies, products and services from different parts of the value chain. Schlumberger’s acquisition of Cameron, for instance, combines expertise in reservoirs and wells with surface, drilling, processing and flow control technologies. Technip’s merger with FMC illustrates the combination of engineering and project management capabilities with technology, manufacturing and services capabilities, in an effort to provide greater value to customers at a lower cost.
Integrated service providers are working closely with operators to develop leading practices and provide the greatest value to their customers, locking out many of their smaller competitors, who might only work as their subcontractors with less control of their own supply and associated margins. With a range of capabilities in various parts of the value chain (e.g., LNG, GTL, gas to power), they are able to present integrated solutions that are attractive to their customers and governments alike.
The integrated service providers also benefit from a strong balance sheet that allows them to share some of the risks and rewards in certain projects and to be more comfortable with outcome-based contracts. Baker Hughes’ recent agreement with CSL Capital Management and Goldman Sachs Group’s merchant banking division to create a hydraulic fracturing company illustrates how some integrated service providers are looking to reduce their capital intensity to maximize shareholder value as well as the return of some financial investors looking to create pure plays operating in niche segments of the market.
Finally, the integrated service providers are using technologies as a way to increase their market differentiation and competitive positioning, and to create competitive hooks to secure new contracts in a market where the number of contracts is dwindling.
At the forefront of the changes in the industry, the integrated service providers are able to choose in which market they want to operate (e.g., niche versus mass market, commoditized versus differentiated offering) and to drive consolidation, with the goal to create a broader portfolio of solutions and technologies to be able to innovate an reduce capital and operating costs for the ultimate benefit of the customer.
Specialists
The specialists either operate across the value chain and provide niche products and/or services or operate in niche markets. While it is hard to generalize this market, it is likely that most of them will have some differentiation through technologies or through bespoke assets (for example in drilling) allowing them to effectively compete with the integrated service providers. To thrive as specialists, they need to be best in class in their specialty and market as their position may erode rapidly.
Depending on their market positioning, they may be dealing directly with the operators and could consider risk-sharing contract structures, although most are likely to follow the general trend of acting more and more as subcontractors to the integrated service providers and other tier 1 suppliers. Niche markets and technologies make them very attractive to the integrated service providers and to private equity, and it is therefore anticipated that the specialists will be involved in private equity-sponsored buy-and-build and consolidation transactions in the near term.
Logistics providers
With high leverage an man assets on their balance sheets, the logistics providers face significant challenges in the current market and a business model that is likely to be challenge in the future. They need to join forces to survive the downturn and to think about business models that increase their differentiation and value to operators.
They tend to work directly for the operators, although this might change as a consequence of the ongoing restructuring of both the supply chain as well as the business models associated with equipment, tools, consumables and personnel logistics.
The logistics providers are facing a more aggressive type of consolidation, primarily opportunistic and driven by the financial stress of many companies in this group. These include the offshore support vessel industry, which is currently significantly oversupplied and highly fragmented and has been strongly affected by the sharp reduction in day rates an utilization. These companies have significant challenges associated with their current structures and business models. Consolidation is driven by the need to create larger entities with financial and operational strength to accelerate the timing of recovery by removing more vessels from the market, with the creation of significant synergies as a key premise for this more traditional type of consolidation.
Whether they are large integrated service providers, specialists or logistics providers, the key for these companies will be to think strategically about where they want to position themselves for the future. The question of how small companies will compete also remains, as operators reduce the number of interfaces with suppliers, encourage standardization and seek broader solutions and integration with their suppliers.
04 Opportunities for M&A in the oilfield services sector?
The large transformational transactions already witnessed in the oilfield services sector are likely to be the prelude for a large wave of consolidation activity across the entire value chain.
There are six drivers of this transformation:
Long-term change in customer behavior
The current changes in the industry, in terms of capex reductions and opex focus, seem to indicate a long-term response to an industry that was already struggling to deliver adequate returns with oil prices above USD100/bbl. This change is expected to persist even if oil prices gradually increase. As operators are seeking greater alignment with the supply chain across the entire asset life cycle, a continuation of transactions targeting vertical integration an technology is likely.
Technology
The acquisition of technology is becoming increasingly important as the sector increases its investment in the digital space. The ability to integrate technologies is going to be an equally important differentiator. Such providers can become integral to a development’s success and will be viewed increasingly as project life cycle partners. Companies need to acquire the right talent an innovation capabilities to navigate the changing business environment, and more acquisitions of technologies (from the oil and gas sector or other industries) should be expected.
Market share protection
At the top end of the market, more consolidation is expected as large companies continue to consolidate as a response to their competitors’ consolidation in order to protect market share, retain leadership positions in key markets an protect their operational leverage.
Portfolio optimization
While several of the recent transactions have been complementary with little overlap between the entities combined, some post-merger divestments are still to be expected as a result of anti-trust processes, portfolio optimizations and continued efforts toward operational excellence.
When companies have operate a range of loosely adjacent services, more consolidation should be expected to focus portfolios on the right offering and, in some cases, create pure players best able to service customers.
Financial restructuring
The industry is undergoing significant financial restructurings with companies and assets being marketed out of necessity as art of broad restructuring or administration processes. With the downturn continuing, more stress is likely to emerge with a resulting increased volume of distressed transactions. These financial restructurings are also resulting in significant changes in the ownership structure of many companies that are now owned by their lenders, bondholders and/or other financial investors.
So far, banks have taken a supportive stance with borrowers avoiding any actions to enforce their security and take ownership of assets. With the downturn persisting and little to no signs of immediate recovery in some segments, it remains to be seen whether this support will continue and what role banks and financial investors will play in this consolidation trend.
As the market reaches the bottom and the valuation gap between buyers and sellers reduces, more investment from private equity and financial investors is expected. In some segments facing significant oversupply with no short-term sign of recovery, such as the drilling and offshore support vessel markets, banks may find it harder not to crystallize their losses, which could lead to greater consolidation or jeopardize the bare existence of many companies in these segments.
Industry diversifications
As the oil and gas sector continues to undergo transformation, external influences such as growing climate change and digital disruption are compelling companies to look beyond their core sector for acquisitions. To reduce their carbon footprint, oil and gas companies are seeking to increase the share of natural gas and to invest in renewables and clean technologies, which has driven several oilfield services companies to already focus on these markets. The nuclear and power industries are also becoming of increased interest to some contractors as a way to reduce their volatility of earnings.
Conclusion
The oil and gas industry is undergoing a fundamental change, which is unlikely to reverse if and when oil prices increase. Companies need to embrace these changes and decide which approach to follow and which market to play in. The integrated service providers are well-placed to drive the major changes needed in the industry — to be successful, they need to offer a genuinely differentiated risk-based offer. The specialists own valuable technologies and expertise and need to e be best-in-class from a cost and market perspective to remain relevant in the new world. The logistics providers currently face significant challenges and need to join forces and adapt their business model to increase their differentiation and the value they provide to their customers.
The industry has change rapidly over the past two years. The window to join the club of the integrated service providers is open, for now.
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