For several quarters, Schlumberger's (SLB +0.09%) management team has probably been the most pessimistic about when the recovery for the oil and gas market might come. Yet after a couple years of pessimism, the company's executives seem to think that this is the bottom in terms of oil and gas. For anyone invested in the oil and gas industry, Schlumberger is a company worth listening to when it comes to these things. Here is a quick look at what CEO Paal Kibsgaard had to say about the oil market during his most recent conference call, in October, and what this could mean for investors.
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The bottom has finally arrived...
Schlumberger has been much more hesitant to say when the recovery in the oil and gas market might take place. However, Kibsgaard was finally ready to call it:
After seven quarters of unprecedented activity decline, the business environment stabilized as expected in the third quarter, confirming that we have, indeed, reached the bottom of this cycle. Our third-quarter revenues still decreased 2% sequentially, but this was largely driven by the anticipated reduction in activity at Cameron as the product backlog continued to decline. Excluding Cameron, revenue increased 1% sequentially driven by higher activity in North America land, Middle East, Russia, and Australia.
One interesting nugget about this that investors should keep in mind is that a recovery in the oil and gas industry as a whole does not mean that every company is in recovery mode. It's even right there in the statement about Cameron's results. Cameron International's business is much more tied to the offshore and deepwater part of the industry, and chances are that will take much longer to recover than other parts of the business -- such as North American shale.
...but don't expect the rise to happen as quickly as the fall
The oil and gas industry's fall came hard and swift as everyone realized all at once that the market was oversupplied. Thing is, though, Kibsgaard doesn't see the recovery happening as fast for a couple reasons.
In terms of 2017 E&P investments, details are still limited. However, we maintain that a V-shaped recovery is unlikely, given the fragile financial state of the industry. Still, we do see upside in 2017 in North America land, the Middle East, and Russia, and we are making sure we are optimally placed to capture a large share of this upside and, importantly, turn this additional activity into positive earnings contributions.
A passing glance at the balance sheets of any company in the exploration and production business shows that companies need to clean up their balance sheets. There is also the fact that it takes so little time for a shale well to go from an empty field to a producing well that it may prevent oil prices from rising very quickly. This could translate to some parts of the oil and gas industry recovering quickly -- shale -- while others continue to lag -- offshore. Schlumberger isn't the only one that thinks this, either. Halliburton (HAL +2.45%) CEO Dave Lesar said very similar things about the timing of the recovery across the oil and gas industry.
Getting choosy
One of the big focal points for Schlumberger over the past couple years has been preservation of market share. In doing so, it was forced to make large pricing concessions that ate into margins pretty hard. Now that Shclumberger says the bottom is here, it plans on changing its priority back to making sure that the company is focused on generating returns.
Going forward, it is critical for us to recover the large pricing concessions we have made over the past two years to allow us to restore investment levels in technology innovation, system integration, and operational quality and efficiency, which are all key enablers of our customers' project performance. ... Looking forward to the activity recovery phase, we will only allocate investments, operating capacity, and expertise to contracts in basins that meet our financial return expectations in the same way our customers allocate capital to projects in their portfolios. Currently, a noticeable part of our contracts do not meet these financial return criteria, and this is our starting point for reestablishing sustainable customer relationships that will warrant allocation of our capital, capacity, and expertise.
An odd symptom of the recovery
There is no denying the fact that service cost deflation has played a big part in shale drilling becoming much more economical over these past couple of years. One question that has yet to be answered is whether or not those cost savings are here to stay. According to Kibsgaard, some of those gains may be short lived, and the one place to watch this immediately is in frack sand. The combination of longer drilling laterals, more frack stages per length of lateral, and more sand per frack stage has drastically increased the amount of sand used per well. Kibsgaard sees this as a potential hindrance.
In the hydraulic fracturing market, the stage count increased by 17% sequentially, driven by higher drilling activity and also by customers now actively depleting their DUC [drilled, uncompleted] well inventory. Still, the fracturing market continues to be completely commoditized than significantly oversupplied with a large number of very hungry players. In addition, the significant increase in sand volume pumped per stage is already starting to create inflation on both product and distribution costs, which will further obstruct and delay the hydraulic fracturing industry's path toward restoring profitability.
The combination of all those factors above means that it will take much less drilling activity to lead to similar sand sales that we saw prior to the downturn. So unless we see a large ramp up in frack sand capacity, then we could be in a situation where sand costs could slow drilling.
Economics wins again
When OPEC decided to not curb production levels in November 2014, the reasoning was that it wanted to recapture market share. The initial market reaction was that it was a direct threat to the North American shale industry. A lot of people thought this was a politicized move that would only be resolved when North American shale conceded. In reality, though, the very thing that OPEC said it wanted to do -- gain market share -- happened, it just didn't happen where everyone expected. According to Kibsgaard, the ones that lost out were other sources that weren't considered to be under threat.
The supply and demand of crude is now more or less in balance as seen by the flattening global petroleum inventories and the start of consistent growth toward the end of the quarter, in particular in North America. In addition, oil demand was again revised upwards in September and is now forecasted to be around 1.2 million barrels per day for both 2016 and 2017.
At the same time, global supply is plateauing as non-OPEC production continues to experience significant declines and even offsetting record production levels from OPEC in September. Based on current investment levels, we believe that 2017 non-OPEC production will at best be flat as any production upside from the U.S., Canada, and Brazil will be offset by further declines in the rest of the global production base.
What a Fool believes
For any investor that has been waiting for the market to turn around, it appears that the turn has finally come. That doesn't mean investors should go out and indiscriminately buy oil and gas stocks because there are clearly some parts of the industry that will do better than others. Schlumberger should be one of those stocks doing better as its focus now is getting back to generating returns for investors, something that it has consistently done better than its largest rivals. It may not be the fast recovery that some investors were hoping for, but it shouldn't be overlooked.
