Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

When you're the hired help, you tend to bear the brunt of your employer's misfortunes. And yet Schlumberger, the biggest of Big Oil's service providers, seems in one way to be doing better than its clients:

Help Needed
Trailing four-quarter free cash flow after dividends
Source: Bloomberg, Schlumberger
Note: Schlumberger figure is after deductions for investments in Schlumberger Production Management and multi-client seismic data.

On top of covering its dividend, Schlumberger had enough cash flow over the past four quarters to cover most of the cost of buying back $1.9 billion of its own stock -- more than even Exxon Mobil did during the same stretch.

Of course, indulging in schadenfreude over the misfortune of some of your biggest customers isn't a wise strategy. Those negative bars in the chart above are ultimately bad news for oilfield services companies -- because the way oil majors try to fix them isn't, funnily enough, cutting dividends to shareholders:

Not Today, Thanks
Schlumberger's revenue this year is forecast to be the lowest since 2010
Source: Bloomberg
Note: 2016 figure as per consensus analyst forecast.

The majors have been simultaneously putting off some projects and demanding discounts on others, dealing oilfield services revenues a double blow. Signs are mounting that the industry is really struggling. For example, Baker Hughes, despite having just gotten a $3.5 billion break-up fee from Halliburton after their failed merger, is pulling back in certain countries to stretch resources more efficiently. And only last week, FMC Technologies and Technip announced a cross-border, nil-premium, all-stock merger -- not the sort of deal bankers pitch in good times.

But Schlumberger is making the best of a bad situation. For one thing, its margins have held up well despite a real drag from its North American business:

Serviceable
Unlike its main rivals, Schlumberger's operating margin hasn't turned negative
Source: Bloomberg
Note: 2016 data are implied by consensus analyst forecasts.

There's more to this than cost-cutting, though. What really marks Schlumberger out is that it isn't treating this downturn in the energy market like business-as-usual. Instead, as its CEO Paal Kibsgaard has been laying out in various presentations, Schlumberger doesn't think triple-digit oil prices are coming back anytime soon. That means the "hold your breath and hope for better times soon" playbook isn't going to work.

What's more, the oil majors' business model wasn't performing terribly well even when oil prices were bobbing around the $100 mark.

Something's Gotta Give
Big Oil's return on capital employed was sliding even before oil prices began to collapse in 2014
Source: Bloomberg, company reports
Note: Weighted average for Exxon Mobil, Chevron, Royal Dutch Shell, BP and Total.

The oil industry's problem is that its costs tend to follow prices, rather than the other way around. So while the supercycle produced fantastic returns on capital until the financial crisis, it also provoked a spending boom and rampant cost inflation -- $100 oil makes almost any project look like a good bet.

What the majors need to do is take a leaf from their smaller brethren in the independent exploration and production sector. They've been busy boosting productivity in the shale fields, leading to structurally lower costs through speeding up drilling times and experimenting with different methods of fracturing rock, rather than simply squeezing their contractors.

We Shale Overcome
Shale producers have made dramatic and sustained productivity gains to reduce their breakeven prices
Source: Rystad Energy
Note: Breakeven price for projects started in each year, assuming a 10 percent internal rate of return. Offshore price is for Brent crude oil; shale reflects wellhead prices.

If oil majors are to achieve the same type of productivity gains, they will need to change the way they work. Schlumberger proposes that the old model, of having multiple contractors tender bids to build this or that bit of equipment or run this or that process, won't do the job. While it might have yielded competitive bids for discrete elements of a project, the drawback was a lack of incentive for service companies to really innovate and a disjointed approach from having so many cooks rubbing elbows in the kitchen.

Instead, an integrated approach, whereby a contractor can offer a suite of technology and services covering the entire project, may ultimately prove more efficient if it boosts the overall amount of oil and gas recovered from a field or, crucially, compresses the timescale from discovery to production. That is what lies behind Schlumberger's $15 billion acquisition of Cameron International last year and initiatives such as its integrated hydraulic fracturing system -- a plug-and-play shale-development platform -- due to launch next year. The Technip-FMC deal follows a similar logic to offer efficiencies via integration rather than fragmented bidding.

Low oil prices also open up the opportunity for Schlumberger to keep nibbling at the oil majors' lunch. Its in-house Schlumberger Production Management business effectively replicates the exploration and production business that is the oil majors' bread and butter, putting the company's own capital to work and taking over direct management of an oil or gas field.

Underappreciated

That makes it a higher-risk business, but also one with higher returns. Schlumberger currently manages about 250,000 barrels per day of oil production, just a sliver of the global market. But with petro-states coming under pressure from low oil prices, they will need to access foreign capital and expertise to maximize their production and sell every barrel they can. The oil majors are sniffing countries such as Mexico and Iran already, but their desire to own reserves directly tends to rub nationalist politicians the wrong way.

Schlumberger, in contrast, is happy to operate as a contractor and brings a formidable array of technology and expertise to boot. Its addressable market for these sort of directly managed projects could be 5 or 6 million barrels a day, according to James West, an analyst at ISI Evercore -- at least 20 times the size of its current operation.

When companies and nations depending on oil need all the help they can get, getting hired shouldn't be a problem for Schlumberger. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net