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.

You may have heard this week that America has hit bottom.

That's right, we're talking U.S. oil and gas drilling.

Two giants of the oilfield services industry, Halliburton and Schlumberger, reported second-quarter results this week and gave their assessment of where the oil and gas industry stands. Unlike what you might have heard last night from Cleveland, these two actually see light at the end of the tunnel.

Halliburton was boldest, declaring that its E&P clients had stopped focusing on "survival" in favor of "growth." Schlumberger was a little less forthright. Even so, on Friday morning's call, CEO Paal Kibsgaard agreed drilling activity in North America had bottomed out.

What comes next, though, is a curious mix of arm-wrestling and hand-holding that will decide where oil prices go over the next couple of years.

In different words, both companies said the same thing: The collapse in drilling has stopped, but now we need to get paid.

The Big Squeeze
Ebitda margins have collapsed as the oil-price crash has taken hold
Source: Bloomberg

Halliburton tied its message together with a nice soundbite: "900 is the new 2,000" -- referring to the number of rigs it would take to absorb all the pumping capacity ("horsepower" in industry parlance) available for fracking in the U.S. In other words, a lot of machinery has been left to rust or been cannibalized for parts as E&P companies have retrenched during the downturn, even as the intensity of ongoing drilling has ratcheted up. The implication is that, with the rig count currently around the 450 mark, it won't take long to exhaust fracking capacity -- and pricing will have to recover to encourage more of it onto the market.

Schlumberger's Kibsgaard, meanwhile, summed it up this way:

What has taken place over the past 21 months is instead a redistribution of the profit and cash flow shortfall from previously sitting mostly with the oil producers to now representing an unsustainable burden for the supplier industry even after a massive reduction of costs and capacity.

Besides the impact of this on margins -- note the ugly chart above -- you can see what Kibsgaard means when you look at what's happened to Schlumberger's receivables compared to revenue:

Waiting For That Pay
Receivables as a proportion of revenue at Schlumberger has jumped in recent quarters
Source: Bloomberg

The upshot of all this is two-fold.

First, it suggests strongly that U.S. shale cannot fulfill the role of swing producer in the global oil market, as some have hoped. When two of the largest service contractors are saying they will need a big share of the rewards from any increase in oil prices, that leaves less extra cash flow for E&P companies to plow back into the ground. In other words, E&P companies' cost per barrel will have to rise, meaning oil prices will have to reflect that to encourage more drilling. You can see here that, over the long run, oil prices and industry costs are best buds:

Following The Money
U.S. E&P cost inflation mirrors movements in the oil price
Source: Bloomberg, Bureau of Labor Statistics
Note: Indexed to 100

However, this doesn't mean shale can't act at all to cap oil-price rallies. The resources are still there -- as a recent report from Rystad Energy served to underline -- they just require the proper application of people, machinery and capital to exploit them. The swing factor is time: How long to re-recruit laid off workers, build new horsepower, and raise more funds? Halliburton and Schlumberger suggest this isn't a matter of mere months, and they are likely right. But even if it takes two years to stabilize and turn around U.S. oil production -- as estimated in a recent report by Evercore ISI's James West -- that would still be a big change from the much longer cycles that prevailed before this downturn. Expectations of the size and duration of future oil rallies will have to adjust accordingly.

The other implication is that the business of fracking has to change fundamentally. Schlumberger on Friday pointed out that, even with a recovery in oil prices, the E&P industry has to find a way to reduce its cash burn. Looking at a sample of 87 U.S. E&P companies screened on the Bloomberg terminal, you have to agree Schlumberger is onto something:

The Burning Issue
The E&P business was burning cash even before the collapse in oil prices in late 2014
Source: Bloomberg
Note: Free cash flow. Sample of 87 U.S. E&P companies with a market capitalization of at least $50 million.

E&P companies, too profligate when oil was at $100, cannot prosper over the long term by simply passing losses up the supply chain. As the 30,000-odd job losses at Halliburton and Schlumberger in just the first half of 2016 warn, E&P firms risk not having a supply chain to use.

The services firms are, of course, talking their own book when they say E&P companies need to work more closely with them to ensure that cost savings coming out of this downturn are structural rather than just cyclical. But they are also right, which bodes well for their shares, as they are providing resources that are scarcer today than a year or two ago.

And despite the fact that E&P firms will have to share some of the spoils of higher oil prices as they appear, they can also take heart from this. The fact is, operators have already shown they can wring higher productivity from shale -- certainly far more easily than the majors have with their mega-projects. Looking ahead, once the arm-wrestling is over, a bit of hand-holding between E&P companies and their contractors should reap some sustainable gains in the form of lower costs.

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