Halliburton's (HAL 0.34%) nickname should probably be "North America's oil industry cheerleader." On almost all of its investor conference calls, it goes out of its way to champion the shale industry and how it's the company best positioned to service -- and profit from -- this part of the overall oil and gas industry. Its most recent conference call was no different, as it explained the trends it's seeing in the oil patch while taking a few jabs at its competition. These five quotes from Halliburton's management encapsulate what management is thinking and what investors should be looking for in 2017.
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Dem's fightin' words
Halliburton always seems to be locked in a battle with its larger competitor Schlumberger (SLB -0.89%) for dominance of the oil patch. So when Halliburton can make a dig at its competition, it never hesitates to do so. Here's CEO Dave Lesar explaining how Halliburton sees itself outperforming its peer:
We finished the year with total company revenue of nearly $16 billion and adjusted operating income of $690 million. And once again, we believe we outpaced our primary competitor in growing our market share. ... We achieved incremental margins of 65% in North America, and we continued to clearly gain market share as we outgrew our primary competitor in not only North America but Latin America and the Eastern Hemisphere. We gained significant market share throughout the downturn, coming out of it with the highest market share in North America that we've ever had.
While Halliburton can certainly make this claim, it wasn't as much of a fight as management makes it out to be. Schlumberger has said on multiple occasions throughout this downturn that it is much more interested in maintaining a rate of return rather than market share. So management was much more willing to idle equipment if it wasn't profitable. It should be no surprise, then, than Schlumberger was able to produce a pre-tax operating income margin last quarter of 11.8% while Halliburton's was 8.2%.
The big question for investors is what strategy is better for the long run: preserving market share or preserving rate of returns. That probably comes down to personal preference.
Shale market sorting itself out
For most of the past year, there was this odd feeling that a recovery was coming in the North American shale market, but the data wasn't completely backing that idea up. Lesar explained that a large reason is that some companies were pursuing some different corporate moves to get ready for the inevitable increase in activity across the American oil patch:
On the second-quarter call, I told you that customer animal spirits were back in North America. Last quarter, I said that these animal spirits were alive but somewhat caged up. Now these animal spirits have broken free and they are running. However, not all customers are running in the same direction or as a pack, but they are running. These animal spirits can be seen by the dramatic increase in customer M&A activity, energy industry initial and secondary company offerings, the significant private equity capital moving into resource plays, and of course, the increase in the rig count. Customers are excited again. And our conversations have changed from being only about cost control to how we can meet their incremental demand.
Getting selective
One of the clear benefits that Halliburton's management thinks it has from its increased market share is the ability to pick and choose the operators with which it will work. As Lesar explained, it has a bench of clients it is willing to keep and let go depending on what kind of pricing power it can get from each:
The historically high level of market share we built in the downturn gives us what we call the power of choice in the recovery. This is the ability to work with the most efficient customers who value what we do and who reward us for helping them make better wells. With this power of choice, we continued to execute our strategy of high-grading the profitability of our portfolio with customers that value our services.
... In Q4, as demand for our equipment increased and availability tightened, our customer discussions revolved around the unsustainable pricing that was in place and the need for us to make a return before we were willing to continue to work for them or add new equipment. If a customer agreed to better pricing, we continued to work for them. If not, we took that equipment and used it to fill the incremental demand with a customer that shared our view on how to work together and make better wells.
These conversations about the need for a healthy, profitable, and viable service industry were sometimes hard, but they needed to happen. So in effect, we kept active equipment working at a higher price while we believe our competition brought equipment into the market to fill that demand at a lower price point. They gained share that we no longer wanted while tying up their equipment at a lower price point in an accelerating market. By executing this strategy, we intentionally gave up some market share in the short run, but we met our goal of returning to operating profitability in North America. We did this because it's important to keep in mind that above all, we are a returns-focused company.
This move to trim the client base is going to be critical, especially if it wants to get up to Schlumberger's levels of margins. North America has been Halliburton's lowest-profit margin region as of late, and it will need to show some sort of improvement to justify all of those assets.
Throwing some shade on offshore
Lesar's optimism for the future of oil and gas activity doesn't apply to every part of the market, though. His views on offshore are much more tempered:
Now there's been a lot of debate as to what commodity price will reactivate the higher-cost basins, such as the deepwater complex. It is clearly higher than the price that we are seeing today. Also impacting the price will be OPEC compliance with its new production guidance.
Most people agree that the U.S. is now the world's swing producer. And it has demonstrated its ability to ramp up production quickly at a price that may make it difficult for deepwater projects to compete. We believe that the race to get deepwater project costs down versus the impact on commodity prices on increasing U.S. shale production will have to play out over the course of 2017. Therefore, we do not expect to see an inflection in the international markets until the latter part of 2017.
This is indeed true, but there are some overtones of a company trying to take a dig at Schlumberger here. Since Halliburton is so much more tied to U.S. drilling -- particualrly shale -- having that market look so much more promising than deepwater and international markets is somewhat by design.
Something's gotta give
All of the talk from oil services companies has been on increasing activity leading to better revenue. One thing that isn't as often discussed, though, is price. According to Jeff Miller, president and chief health, safety, and environment officer, many of the company's oil services competitors are operating under contracts that simply cannot persist.
During the downturn, our industry went through a steep regression in profitability as pricing and activity declined. The industry moved from positive operating margins to negative operating margins then to negative EBITDA and ultimately wound up struggling to cover variable cash costs. It was a fast and hard road that caused a dramatic shift in the landscape of the service industry and wiped out a significant amount of shareholder equity.
The pricing brawl continues as the industry recovers and equipment availability tightens. Pricing at the margin is ultimately set by whoever is satisfied with the lowest returns. It's important to understand that our competitors' motivation for margin returns is largely built around where their pricing is anchored today. For example, if they're at negative variable cost, then they're trying to get to a negative EBITDA. If they're at negative EBITDA, then they're trying to get to negative margin, and so on.
I can tell you, despite what you hear in the market, it's clearly a bridge too far to skip from negative variable cash to positive operating margin in one step. So the industry pricing regression I discussed earlier needs to become a pricing progression. This means that for now, Halliburton will have to compete with companies that are satisfied with lower levels of short-term profitability. But we don't believe their pricing is sustainable. You can't have negative margins forever.
This is something to watch in all parts of the oil and gas business. For services companies, it could mean a return to improved margins and returns as these contracts get renegotiated. Conversely, oil producers that have been touting such high levels of cost savings may see an uptick in costs as they have to pay up for contract services.
