The steep drop in oil prices over the past year forced the entire industry to cut back. Oil-field service companies such as Halliburton (HAL 1.91%) and C&J Energy Services (NYSE: CJES) reacted swiftly to slash costs by idling excess equipment, reducing headcount, and closing facilities. While these swift cuts were necessary to adjust to the current reality lower oil prices, they could have impaired the industry's ability to quickly respond once conditions improve.
The million-dollar question
This was a concern that came up on EOG Resources' (EOG 7.20%) third-quarter conference call, with an analyst on the call asking, "When it's time to ramp production for EOG and the rest of the industry, are you concerned about the deliverability of the service industry, given the sizable headcount reductions across the states and maybe some degradation on some of the pieces of equipment?"
COO Gary Thomas responded:
Yes, there is some concern with that and we've talked quite a lot about that and maintaining the activity level that we have maintained and what we've planned to do in 2016. We're focused on those companies that are really quality companies and have been tremendous partners to EOG, and we're spreading that word trying to keep them in good shape. So it's going to be hard on the industry. I believe you're correct there, but I think we're positioned so that we'll be able to get the top services.
While EOG Resources believes that its size and scale will enable it to have unrivaled access to the oil-field services that it will require when it ramps up activity, it isn't so sure its smaller rivals will be so lucky. One major concern is the significant reduction in the industry's headcount, with Halliburton, for example, cutting an estimated 14,000 jobs, or 16% of its global workforce. What's worrisome is the potential that a large portion of this workforce may no longer want to be part of such a cyclical industry, thus making it harder for the industry to scale back up its workforce.
Another concern is equipment. While a lot of equipment is being stacked, or idled, because of the slowdown in activity, most of what was stacked had been older equipment that was less efficient. C&J Energy Services, for example, "implemented a detailed action plan to better manage operational cost by stacking equipment that cannot generate acceptable rates of return," according to CFO Randy McMullen.
The problem is that that suggests that the industry is currently using up its best equipment at the same time it has cut investments on new equipment. This situation suggests that when activity rebounds, the equipment that's used to handle the incremental activity will be older, less efficient activity. Further, when the more efficient equipment burns out, it will be replaced by older equipment because there's not much new equipment coming down the pipeline.
Why this is a problem for oil companies
This scenario poses big problems for oil producers. First, one of the great achievements of producers during the downturn has been their ability to benefit from both lower oil-field service costs and efficiency gains. However, both probably go out the window when conditions improve. For the most part, oil-field service companies kept their most efficient employees, suggesting that when they need to hire they'll either be hiring back less efficient employees or new hires that need to be trained. Combine that workforce efficiency loss with less efficient equipment, and it could cut into some of the efficiency gains that producers have enjoyed during the downturn and quickly inflate the cost of drilling wells.
While the oil industry desperately wants higher oil prices, such a rebound in oil could come at a cost. That cost is the efficiency gains that producers have enjoyed during the downturn, which will probably be affected by a workforce and equipment that's less efficient than what the industry had grown accustomed to. While that's not something that a top driller like EOG Resources is worried about, it is potential problem for smaller drillers, which could mute their upside during a future upturn in the oil market.