No One Predicted This Downturn. Was Anyone Watching?
“The pain and turmoil that have engulfed the oil and gas and oilfield service industries were ushered in by the surprise abandonment of policy to support OPEC oil prices by Saudi Arabia in late 2014. This act caught everyone by surprise, and led to BP’s Bob Dudley’s famous “lower for longer” mantra. Schlumberger’s Andrew Gould helps us understand how we wound up where we are, and what it may take to survive. ”
Starting at the end of last year and continuing into the early months of 2020, we wrote a series of articles dealing with the history of the business cycles of the oil and oilfield service industries. We wanted to answer the question of how bad the current downturn is in relation to the one experienced in the 1980s. Today’s energy world is dealing with twin black swan events: a global demand collapse, as economies shut down to fight the coronavirus pandemic, and a supply shock from a price war between the second and third largest oil exporting countries – Saudi Arabia and Russia. These black swans drove West Texas Intermediate (WTI) oil prices into negative territory – something never experienced before. Chalk one up for the current downturn!
A critical question is whether this downturn reflects a new cycle for the oil and gas industry, or merely a continuation of the downturn that began Thanksgiving Day 2014? We have charts showing both scenarios, allowing the reader to decide. In our view, the 2020 collapse is an extension of the 2014 downturn, rather than a new cycle. If viewed that way, it makes for a more interesting comparison of the current cycle to the 1980s downturn.
Exhibit 1. Tracking Oil Prices In Downturns SOURCE: EIA, PPHB
When considering 2020 as marking a new cycle, Exhibit 1 shows the oil price record for 2014-2016, 2018-2020 and 2020 to now. In all three declines, the initial drops were similar, although the latter part of the 2020 decline has proven to be much worse than either of the prior cycles. In fact, we wound up in negative territory, before quickly rebounding. There were a number of reasons why we fell below zero, but they were largely unique. Overall, the similarity in the broad shapes of the oil price movements, especially the 2014-2016 and 2018-2020 cycles, at least until the last portion of the history, supports the view of 2020 being a new cycle.
Exhibit 2. Maybe We Are In A Long-Term Cycle SOURCE: EIA, PPHB
On the other hand, one can make a very strong case that the 2008 peak in oil prices began an extended cycle that is mirroring the 1980 downturn. Exhibit 2 demonstrates that view. The earlier downturn included the 1986 collapse in oil prices to below $10 per barrel in nominal dollars when Saudi Arabia abandoned support for OPEC’s marker price. That cycle lasted for 20 years. This cycle has its own Saudi Arabia move to disavow the OPEC price, as it strove to recapture market share lost to the U.S. oil shale business. Both events happened five years after the peak in oil prices.
We always wondered whether BP plc’s CEO Bob Dudley 2015 comment that “I do think the industry needs to prepare for lower for longer,” was a reflection of him recognizing that the 2014 downturn was not going to be a typical short-term industry cycle. Mr. Dudley coined the “lower for longer” phrase during interviews at the 2015 World Economic Forum in Davos, Switzerland. The phrase was highlighted during a CNBC interview, and reinforced when he spoke during CeraWeek in April 2015 in Houston. In the various forums, when pressed, Mr. Dudley talked about “longer” being at least three years. So, maybe he wasn’t thinking about the 1980s cycle.
Our friend and former competitor Jim Wicklund recently commented about how significantly the oilfield service giant – Schlumberger, Ltd. – was being impacted by the current downturn. His comments came after the company reported its 2Q 2020 earnings results. His firm’s analyst suggested that Schlumberger’s earnings per share were unlikely to exceed $1.50 in the foreseeable future. He was talking about a company positioned by its technology offerings, its global scale, and reputation for outstanding executive leadership, to be capable of earning a multiple of the analyst’s peak per share estimate. Mr. Wicklund was commenting on changes underway in the oilfield service industry and at Schlumberger due to the downturn, but his conclusion was profound: “Our first point is that no one, not even the biggest company out there, saw the downturn coming that we have lived through for the past five years.”
That statement got us thinking about this downturn. The first realization was that we are barely four months away from completing the SIXTH year of this downturn! Of course, if you believe we have just started on a new cycle, then we are only six months into it. So far, as our chart above shows, 2020 has been a more severe industry downturn, at least measured by the fall in oil prices and its accompanying collapse in oilfield activity, than seen in the past. If 2020 marks the start of a new industry cycle, we can establish an interesting historical pattern. Working backwards from when industry downturns started, we have the following record:
2020 – the twin black swans of an oil demand and supply shock
2014 – Saudi Arabia’s decision to end support for OPEC’s oil price and regain market share
2009 – the global recession following the financial crisis
2001 – the recession associated with the 9/11 attacks and the ending of the dot.com stock market boom
That is an interesting list of downturns, notable in that they are 5-8 years apart. The challenge in continuing this pattern is that the next earlier downturn was associated with the 1998 Asian currency crisis, which occurred at the same time Saudi Arabia stepped up its output intending to capture market share in Asia as that region’s economic growth was projected to surge. When Asia’s growth failed to materialize due to currency problems, oil prices dropped. That downturn was barely three years earlier than the 2001 downturn, raising questions about whether that fits our cyclical pattern.
A greater problem for the historical cyclical pattern is that one must strain to find anything looking like an industry downturn, between 1986 and 1998. If there wasn’t a clearly identified industry cycle during that span, it becomes harder to argue that the oil and gas industry operates with fairly regular cycles, even though 1980-1986 fits the 5-8-year pattern. That conclusion suggests there may be other issues unique to the oil and gas business or to the overall economy, that have influenced the pace and cyclicality of oil prices since we entered the twenty-first century.
An alternative scenario is that 1986-1998 was the oil industry’s historical aberration once it entered a free-market era. Up until the early 1970s, the Texas Railroad Commission managed surplus oil production to control pricing. Once the U.S. exhausted its ability to be the marginal supplier, pricing power shifted to OPEC. The organization had been formed in 1960 to fight oil price reductions by the international oil companies operating country concessions. A second factor in oil pricing was the closing of the gold window. In 1973, President Richard Nixon ended the ability of countries holding U.S. dollars to exchange them for gold, which contributed to rising interest rates, greater inflation, and depreciation of the U.S. dollar’s value. These conditions strengthened the case for higher oil prices.
Exhibit 3. Trying To Establish The History Of Oil Cycles SOURCE: EIA, PPHB
The idea that the 2020 and 2014-2016 cycles are merely extensions of a longer industry cycle that began in 2008 raises other questions. It suggests that the oil price spikes that dominated the 1970s and the 2000s were aberrations, and should have been viewed as warning signs. Maybe it means we should consider the 2009-2014 high-oil price period as an aberration and, thus, should view this downturn as beginning in 2014. If so, then we are left to ponder whether this cycle will last as long as the 20 years of the 1980 cycle. Should we be thinking about an oil cycle that doesn’t end until the mid-2030s? That is certainly a depressing thought.
The optimists in the industry, and among Wall Street analysts and investors, believe that the under-investment in oil and gas exploration and development over the past 3-5 years means we are destined to revisit $100 a barrel oil prices again, maybe as soon as 2021-2022. If that happens, does it mark the end of the current downturn or just a reflection of increased oil price volatility?
In trying to answer the question about short-term versus long-term oil industry cycles, it helps to consider the views of one of the key players in the business and an astute industry strategist. We are referring to Andrew Gould, the former Chairman and CEO of Schlumberger, whose tenure ended at the top of the last boom, but whose career allowed him to play a key role in reshaping the company and its strategy during many challenging environments.
Let’s review some of Mr. Gould’s bona fides. His education involved a degree in Economic History from the University of Wales, Cardiff. He served as the CEO of Schlumberger from February 2003 to August 2011, and continued as Chairman until the annual shareholder meeting the following April. WTI averaged over $103 per barrel that month, after peaking the prior month above $106. Timing is everything!
His 36-year career at Schlumberger began in the finance group, after he had worked initially for Ernst & Young, a major global accounting firm. He rose through the finance group ranks, serving as an internal auditor, controller, treasurer and vice-president of finance of various Schlumberger divisions around the world. In 1991, Mr. Gould became vice-president of operations of Sedco Forex, the company’s contract drilling group, rising to its presidency in 1993. His tenure at the contract drilling group extended to 1998, at which point significant restructuring of the global oil and gas and oilfield service industries commenced. He then moved to the presidency of the Wireline & Testing division, before moving up to become the president of the Oilfield Services Products group. From there he stepped up to executive vice president of the entire Oilfield Services business of Schlumberger, before becoming president and chief operating officer and then chairman and CEO.
During his tenure at the top of Schlumberger, Mr. Gould was acknowledged as the leading light of the industry in dealing with customers and investors, setting the tone in discussions about activity levels and the direction of the business. When he assumed the CEO role in 2003, he moved quickly to lead a renaissance of the company, which included boosting financial returns, improving the balance sheet, and realigning the firm’s strategic focus on its oilfield services business, the foundation of the 80-year-old company. In two years under Mr. Gould’s direction, Schlumberger boosted its return on capital to 13% from 7%, cut its net debt to $2 billion from over $4 billion, and divested non-core assets such as Sema, Smart Cards and Electricity Metering, raising in excess of $2 billion. During this time, Schlumberger’s oilfield revenues and earnings per share increased by 9% and 28%, respectively.
Mr. Gould set out his strategic plan for Schlumberger in a speech on September 2, 2003, to analysts at the Lehman Brothers CEO Energy/Power Conference. He told the audience: “What is sure is that if the world is going to have a reasonably priced energy supply to continue to fuel economic growth, we need to rapidly adapt to more volatile times, risk and reward opportunities will therefore abound. In these circumstances, I am confident that in the coming decades, Schlumberger will be a major beneficiary in the renewed investment that will be required to guarantee our energy future.”
Given Mr. Gould’s record at Schlumberger, although one cannot underestimate the strength of its franchise, something we always referred to as the company having a printing press in the basement, his observations about the financial history of the oilfield industry warrant attention. The wireline technology developed by the Schlumberger brothers in the 1920s, and controlled by them, as opposed to almost every other oilfield technology, earned the company huge returns. Those profits enabled Schlumberger to deal with some horrendously poor investment returns due to acquisition decisions in the 1970s and 1980s, often driven by the need to continue to curry the support of French political leaders.
A few months after leaving Schlumberger, Mr. Gould spoke at the Energy Summit at the British Business Embassy in 2012. We also have the benefit of his recent discussions with Michelle Foss, Fellow in Energy and Minerals, Center for Energy Studies at Rice University’s Baker Institute for Public Policy. In these various presentations, Mr. Gould provided perspective on the evolution of the global oilfield service industry, and how much the profit cycle and shifting interactions with its customers shaped its growth. As he pointed out, and something not well appreciated, the oilfield service industry was largely a North American affair prior to the oil price shocks of the 1970s. Oil companies maintained their own service divisions – drilling and well completion equipment, as well as well servicing and production maintenance operations. This was largely due to the oilfield service industry having an immature geographical presence in the eastern hemisphere. These divisions were also considered excellent training grounds for oil company petroleum engineers and explorationists.
Exhibit 4. Understanding Drilling Cycle In 1970s-1980s SOURCE: Baker Hughes, EIA, PPHB
The easiest way to confirm Mr. Gould’s point about the oilfield service industry’s growth is to look at the history of active drilling rigs by geography. The United States’ drilling rig count rose dramatically once the shock of higher oil prices convinced companies to expand their fleets. Exhibit 4 (prior page) also shows how quickly the rig count fell once the oil price dropped. The chart also highlights the relative size of the non-North America market and how slowly it responded to the rise in global oil prices. Activity in those markets didn’t retreat as quickly as North American activity once oil prices peaked in 1980. It wasn’t until after the OPEC battles that resulted in the collapse in oil prices in 1985/86 that international drilling also declined, but at a slower pace than North America, reflecting the long-term nature of contracts outside of North America.
Two additional charts illustrate points made by Mr. Gould: the growth of the service industry and the shift in its emphasis towards more international work. Exhibits 5 and 6 (next page) were taken from data compiled from Offshore Data Services and show the growth in the offshore drilling rig fleets and the number of offshore drilling contractors during 1975-1985. When we focus on the number of drilling contractors, we see that over the decade 1976 to 1985 there were 55 new competitors, representing a 40% increase. Over 70% of the new companies began operating during the first half of that 10-year span.
We also see how during that first phase of the 10-year span, contractor growth was primarily in the U.S., although all sectors grew. The National drilling contractor sector showed the most dramatic increase over the decade, rising by 14 contractors for an 88% growth. Foreign contractors also showed stronger growth over the decade, with U.S. contractors growing the least. In fact, during the second half of that span, the number of offshore drilling contractors shrank, due to consolidation and the exit of oil companies who elected to sell their offshore drilling assets.
Exhibit 5. How Offshore Contractor Population Changed SOURCE: Offshore Data Services, PPHB
When it comes to the offshore drilling rig fleet, we see, over the period, essentially a doubling in the number of rigs. U.S. contractors added the most with 224 new rigs, a 50% increase in the group’s fleet. Both foreign and national contractors added nearly as many new rigs as U.S. contractors, but the percentage increases were significantly greater at 220% and 402%, respectively. As the data shows, the share of the global offshore rig fleet represented by U.S. contractors fell from 76% at the end of 1975 to only 55% by January 1986. Foreign contractors increased their share from 16% to 25%, but the national group more than doubled its share from 8% to 20%.
Exhibit 6. How Offshore Rig Fleet Changed 1975-1986 SOURCE: Offshore Data Services, PPHB
While the dynamics of the oilfield service industry were influenced initially by the 1970s oil price shocks and a shift in focus to the eastern hemisphere, there was another change in industry dynamics. It involved the role of technology, a subject key to Schlumberger’s growth. Following the 1980s oil price peak and initial downturn, the oil companies began divesting their oilfield service divisions in what was their first cost-cutting effort. In turn, this drove oilfield service companies to start spending on R&D to improve their relative competitive positions. After the 1986 oil price collapse, activity was down for a decade. R&D was directed to reducing finding and development costs. This led to oil companies closing whole departments and laboratories, as well as selling their drilling rigs and seismic vessels that they had built to ensure they always had access to supply.
As the oil companies began exiting their service operations and relying more and more on service companies, there was a broad push for service companies to expand their technology offerings. In some cases, the service companies were pushed to invest more in technology as the oil companies looked for greater integration at the level of the service companies to reduce costs. Mr. Gould pointed to Shell’s “Drilling in the Nineties” and BP’s “Partners for Profits,” both aimed at reducing drilling costs in the North Sea through greater integration of the service providers. He also commented that for several years during the 2000s “Mexico’s PEMEX was by far Schlumberger’s largest customer due to the appetite for fully integrated projects.”
Technology also proved critical for the development and success of both national oil companies and independent producers. As Mr. Gould explained, the nationalizations of major oil company operations in many foreign locations led to the national oil companies being forced to rely on the service industry for technology, which they previously obtained indirectly from their operator partners. Additionally, a new generation of national oil companies understood that technical skills were essential to their future and actively cooperated with the service industry to obtain technology. The ability to purchase technology from service companies has also enabled the independents to play a greater role in the evolving industry.
Shifting to the 2000s, Mr. Gould discussed the unprecedented growth in activity, driven by the rapid demand growth from China, and the increasingly challenged global resource base. Increases in activity included a surge in offshore drilling rig construction. Prior to 2015, there were 50-100 new offshore rigs under construction per year. Such growth had not been seen since the 1980s.
Exhibit 7. How Offshore Rig Fleet Grew Through History SOURCE: Offshore Data Services, PPHB
He highlighted how the low investment during the 1986-1999 period contributed to the explosion in exploration and production capital expenditures. In the four years prior to the 2008-2009 recession, E&P spending had more than doubled. The emergence of the U.S. oil shale plays added $200 billion a year in domestic onshore industry spending. Prior to this downturn, the International Energy Agency (IEA) estimated that upstream oil spending would need to total more than $500 billion a year between 2018 and 2030. The IEA also said that about $400 billion a year would be needed for natural gas infrastructure and supply over the same period.
To demonstrate the magnitude of the spending, Mr. Gould cited data from Schlumberger’s Business Consulting Group. Between 2000 and 2011, capital spending grew at a compound annual rate of 14%. This produced both inflation and inefficiencies. The number of mega projects, ones with budgets over $1 billion increased from approximately 50 to 200 in 10 years. The number of operators managing projects over $1 billion increased from 12 to more than 40 in the same period. According to Mr. Gould, “these 200 projects represent 33% of the total spend leaving a long tail, all of which has to be supplied and staffed.”
The challenges of organizing and managing these projects became a serious issue. The fact that there were a number of large cost overruns was not a surprise. But, the size of the cost overruns was.
Mr. Gould said, “25% of projects budgeted at less than $5 billion have a greater than 50% overrun. 35% of projects of over $5 billion have a greater than 50% overrun.”
According to the Schlumberger Business Consulting Group’s survey of customers, the top issues driving the cost overruns were people and organizations. “The difficulty of matching skill sets with project challenges and geography combined with an acute industry skill shortage” was at the heart of the problem. The second contributing factor was “technical challenges;” companies taking on more complex projects. And finally, “governance,” a largely internal management issue was the final factor.
In commenting on these issues, Mr. Gould said, “To summarize, the complexity in capital projects comes from multiple sources, and the impact of this complexity can only be reduced when companies become aware of gaps in their capabilities to manage the complexity through developing experience and continual improvement.” As a result, he suggested that the oil and gas industry should examine how other industries work with their contractors – for example, the automobile industry. After suggesting this course of action, Mr. Gould noted, “The car industry may not appear as a shining example of profitability, but it is one of the best optimizers of supply chain, which was driven by cost concerns.”
Furthermore, Mr. Gould stated, “Very few operators in my experience consult their contractors or service company on what technology they think will be available in seven years-time when they are in the planning stage of their projects.” For such a change to occur, Mr. Gould said it would require “a radical change in contracting philosophy.” Such a change requires “full recognition that the human resource and knowledge within the contracting industry can really add value.”
While the history Mr. Gould recounted was significant for Schlumberger and the industry, it was based on how the evolution from the 1970s to 2012. It ended during the height of the last oil price boom. Since then oil prices have crashed, bounced, crashed again, and are now slowly recovering. Crude oil supplies continued to increase, while demand has been slower to grow. Renewables have been promoted by politicians, governments and utilities, and now are being embraced by some major international oil companies.
In his interviews, Mr. Gould expounded upon the history of oilfield service industry profitability, which is paramount in the minds of industry executives pondering the recovery and what, if any further actions, they should undertake to enhance financial performance. Mr. Gould’s response to a question from Ms. Foss provided insight. She asked whether, when considering the industry’s recovery, anyone has thought about new financial models for oilfield service companies? Mr. Gould’s answer was intriguing:
“Michelle, there are three basic ways that OFS has made good margins in the past and only one of them proved sustainable, at least it was until the recently departed CEO of Schlumberger decided to indebt the company to invest in E&P.” Ouch!
The three times Mr. Gould referenced were described thusly:
“Method 1: Periods when short-term demand for OFS exceeded supply and services were rationed to customers through pricing.”
“Method 2: Early mover in geographical presence and political risk taking.”
“Method 3: Sustained technology lead and creating value for the industry.”
Mr. Gould presented examples of each method. In the case of Method 1, when short-term demand exceeded supply, he pointed to two times in his career: 1) the few years following the departure of the Shah of Iran in the late 1970s; and 2) 2005-2006 when China’s oil demand surged. In both cases, there was a surge in activity due to oil supply shortages – the loss of Iran’s oil output and China’s surprising demand growth as it embarked on massive infrastructure investment as it readied its country for the upcoming Olympics. In both cases, as the service industry scrambled to meet the increase in activity, equipment and engineers were rationed through price, which led to healthy profit margins.
In Method 2, which involved geographical presence and political risk taking, there were two periods. Again, the years immediately after the Shah’s departure. In that case, in Asia, the only real oilfield service presence was represented by Schlumberger and Halliburton, who dominated their respective core product lines and commanded huge market shares, and thus pricing power. The second time was after the opening of the Soviet Union. In 1997, the ruble collapsed and state oil and gas assets were vacuumed up by the first generation of Oligarchs. They then turned to western service companies to try to improve their performance. In Schlumberger’s case, it advanced $200 million to Mikhail Khodorkovsky of Yukos, which he was to reimburse at the end of the first year. Twelve years later, Schlumberger had a $2 billion business in Russia, which Mr. Gould indicated remained one of the most profitable geographies in the company.
The greatest challenge is Method 3, which involves a sustained technology lead that can help create value for the customers. As Mr. Gould put it, “there are, in fact, very few products or product lines in oilfield services that contain technology that can make material differences to the oil company performance.” As he put it, much of what the oilfield service industry does is “fairly complex civil engineering or industrial construction.” In his view, “the only product lines that add true value are those that enable the oil companies to find, understand, plan and ensure that the maximum of the discovered hydrocarbon is extracted from the subsurface.” The product lines he singled out included some seismic, open hole wireline logging, directional drilling combined with logging-while-drilling, geosteering and rock and fluid analysis. He also would include some subsea equipment, due to the demand for its reliability equaling that of space travel.
In looking at how technology helps open up new exploration and development basins with challenging geophysical properties, Mr. Gould cited the deep and hot, offshore, and particularly deepwater markets where the technological services needed are so vital that they have relative price elasticity. These profit opportunities contrast with shale, which Mr. Gould finds to be a “fool’s errand.” As he pointed out, shale possesses none of the three methods in which oilfield service companies are able to make money. In his view, “the method of exploitation required very little technology, let alone unique technology.” He went on to describe the history of long horizontal drilling and massive hydraulic fracturing. In his view, the improvements in the process of tapping shale oil and gas has involved incremental improvements in operational efficiency and reducing the cost of fracturing, by using slick water. Is there hope for shale?
In Mr. Gould’s view:
“The North American Shale ‘revolution’ has not yet achieved a level of operational and financial stability that will allow it to be a responsible part of the world supply system. It will remain volatile until the necessary elimination of the marginal players and accumulation of debt has taken place. What is true of the operators is true for the service industry, and in the next phase of shale, the use of technology and the concentration of more responsible operators will lead to improved market conditions for the remaining service players. In the meantime, we will see production declines and financial distress again.”
While offering hope for the oilfield service industry working in the shale basins, his outlook for what has to change signals there is a long road ahead for these basins to become profitable. Erasing the debt of companies and eliminating marginal players to reduce capacity are not easy steps. In fact, most of the bankruptcies so far reflect reorganizations of balance sheets, in many cases still leaving large amounts of debt, and less about restructuring the industry, i.e., eliminating equipment and companies to improve the competitiveness of markets.
A report by the oilfield analysts of Wall Street broker Bernstein focused on the industry’s labor situation and what it portends for the entire oil and gas industry, highlighted some of Mr. Gould’s points. We are going to borrow several charts from that report that show the financial deterioration for the oilfield service sector since the mid-2000s. Several of these charts demonstrate how pricing power and profits shifted from the service sector to the producer sector. One reason for that shift was the rush of new capital into the service industry to capitalize on expectations that the 2012-2014 boom would continue and drive activity substantially higher. Several of the charts contain forecasts for the particular data series. We are not commenting on the forecasts, but rather want readers to focus on the historical data presented.
One of the most telling charts shows an index of revenue and EBITDA per employee (head) from 1998 to 2019. What the index shows is that during the Expansion Cycle, profitability per employee grew rapidly, as oil prices rose in response to the supply shortages driven by China’s economic expansion. That was one of the periods Mr. Gould cited for the service industry’s profitability improvement. Although revenue per employee remained essentially flat from 2008 through 2018, profitability was eroded quickly, largely because the service industry invested in additional equipment and the number of competitors expanded, increasing competition. That competition resulted in less pricing and return-on-investment discipline. The lower pricing is demonstrated by the fact that increased activity during the boom and recession necessitated adding employees, but did not improve profitability.
Exhibit 8. History Of Oilfield Service Performance SOURCE: Bernstein
A second chart shows how the natural profitability that should accrue to the oilfield service companies has been coopted by the customers. Again, this reflects the inability of the service industry to manage pricing and capital allocation during a period when capital was flooding the industry to expand capacity for meeting activity growth and projections for even greater growth.
Exhibit 9. Producers Have Profited While OFS Were Hurt SOURCE: Bernstein
Two additional charts from the Bernstein report show what has happened to pricing in two important oilfield sectors – offshore drilling and hydraulic fracturing. These two product lines have been important drivers of oilfield activity and U.S. oil production growth. As we saw in Exhibit 9, the oilfield service industry has contributed to a dramatic increase in oil and gas output. We should not lose sight of the impact this production growth played in the economic growth of the United States in recent years and the geopolitical leverage it gave the country.
Exhibit 10. Offshore Sector Is Being Hurt By Too Many Rigs SOURCE: Bernstein
Exhibit 11. Pressure Pumping Sector Is Struggling SOURCE: Bernstein
It is difficult to imagine either of the two important sectors reversing current trends until excess capacity is removed through scrapping rigs and pumping horsepower. The number of service companies in each sector that have entered, or are contemplating entering, bankruptcy offers hope that the industry is closer to the days of equipment supply and demand balance, or possibly even a shortage. As of now, we don’t know whether the reduced debt loads of restructured companies will need to be reduced further, thereby prolonging the pain. Possibly new company shareholders following bankruptcies will have a greater willingness to scrap equipment. These questions play into final thoughts from Mr. Gould.
In concluding his interview with Ms. Foss, Mr. Gould offered two observations that seem obvious but appear to have been ignored. “OFS companies can only survive the cycle with fortress balance sheets,” he said, pointing to the history and philosophy of the Schlumberger founding family. The challenges the company is dealing with now are a reflection of the deviation from the philosophy by Mr. Gould’s immediate successor as CEO of Schlumberger.
The second guiding principle he offered was: “There has never been a shortage of [oil] supply, only dislocations in its availability. The industry has never learned that what goes up in cyclical business[es] will come down and has never properly protected itself against its own eternal optimism.”
What is the significance of Mr. Gould’s conclusions about the cyclicality of the oilfield service industry, and especially the current cycle? As Mr. Wicklund said, which we quoted earlier, no one saw the current downturn. We would ask whether no one saw it coming because no one was paying attention? Maybe everyone was blinded by the glow of the shale revolution? Exhibit 12 presents an interesting perspective on what was happening prior to the 2014 OPEC meeting, and then the industry’s reaction. The reaction to the 2020 downturn has been very different.
Exhibit 12. Was No One Watching The Market In 2014? SOURCE: EIA, PPHB
As the chart shows, from the June 20, 2014, oil price peak to the date of the OPEC meeting, the price declined 32%. Over the same period, the total and oil drilling rig counts increased by 59 and 27 rigs, respectively. The fall in oil prices drove the smaller members of OPEC to call on Saudi Arabia to cut production to support prices. Saudi Arabia, instead, decided to go after its lost market share, and thereby defied the calls and kept its production up. It took a while for the impact of Saudi Arabia’s decision to register with industry executives. That may have been partly because they expected OPEC to “get its act” together and restore pricing support. Lower-for-longer only became obvious a couple of months later.
In the current downturn, the industry reacted faster to the oil war erupting between Russia and Saudi Arabia. The faster reaction was probably helped by the onset of the Covid-19 pandemic that was shutting down economies around the world and in various U.S. states. There had also been extensive posturing by the key parties heading into the March 5, 2020, OPEC meeting, so executives were alert to the possibility of what happened, actually happening.
In our view, this spring’s oil supply and oil demand shocks were comparable to the 1986 oil price collapse, and makes what we are experiencing now part of a longer cycle. From the 1980 price peak, and the subsequent 1986 price collapse, the recovery needed years to recover – 20 years, in fact. The start of the next cycle began in the late 1990s when the oil and oilfield service industries went through a massive restructuring. To date, the industry restructurings seem more like those experienced during the second half of the 1980s when oil industry and service company bankruptcies exploded. Are we looking at a 20-year total cycle as in the 1980s? If so, we have years of rough times ahead for this industry. While substantial debt is being wiped out in the reorganizations, many of them retain meaningful chunks of debt on company balance sheets, likely meaning further indigestion before a complete recovery can be achieved. Many companies will revisit bankruptcy, unless there is a massive uptick in activity. With oil companies and banks reducing their long-term oil price forecasts, and the growing push for renewables as key parts of government economic recovery plans, the oil and oilfield service industries of the future will be smaller, but hopefully solidly profitable. The journey to profitability is just beginning. How long it takes is unknown, and it will be bumpy.