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.

If you're investing in the oil business, what do you put your hope in these days?

OPEC? Maybe, but it's tough to keep the faith when seemingly every day another member of the group demands special treatment.

Banking on OPEC and chums to bail out everyone in the industry with a little price manipulation is the most dog-eared of playbooks. And, if Exxon Mobil's CEO Rex Tillerson is right, it may not work quite as advertised.

A world in which oil prices don't rebound sharply would require a transformation of the industry. Among other things, megaprojects will need to actually come in on time and on budget rather than rely on a build-it-and-they-will-come mentality. And investment cycles will shorten, as shale production proves more responsive to swings in oil prices and thereby corrects those swings.

In other words, it will pay to be flexible.

So far, much of the industry's flexibility has manifested itself in the usual way of slashing headcount and investment. The independent E&P companies have supplemented this with adept capital-raising.

The most far-reaching expressions of fundamental change, though, have come from oilfield services firms -- although the market doesn't seem to recognize this yet.

Poor Relation
While E&P stocks' weighting in the S&P 500 has recovered strongly, oilfield services remain unloved
Source: Bloomberg

This was David Lesar, Halliburton's CEO, on the company's quarterly earnings call last week:

Our industry will likely experience shorter commodity price cycles going forward. So we see the future market as a combination of shorter cycles in range-bound commodity prices. In that environment it is imperative that returns-focused companies like Halliburton be more asset light.

"Asset light" is one of those McKinsey-ish phrases that understandably may have caused your eyes to temporarily glaze over.

But Lesar's point is important. While forgiving capital markets will allow any CEO to cover cash outflows, truly valuable companies are sustained by generating good returns on invested capital. What has put the oil majors in the penalty box, including Exxon, is that they spent much of the windfall from the oil boom on huge, complex projects that ran over budgets and schedules, crushing their return on capital employed.

In Halliburton's case, lightening up can mean choosing to lease assets rather than buy them, essentially switching a balance sheet item to an expense on the profit-and-loss statement. In a way, this mirrors the demands E&P companies have placed on contractors over the past 2 years for contracts with shorter time-spans. No one wants to be locked in with the outlook so uncertain.

Lightening up on assets will also help with restoring pricing. Halliburton characterizes the current market for pressure pumping in U.S. shale as a "brawl." Getting better utilization of existing equipment, rather than adding more, is therefore key.

Schlumberger echoed this during its own call on Friday, contrasting the pricing power it enjoyed for technology helping E&P companies complete so-called "super laterals", or very long horizontal wells, versus generic pressure pumping. Those longer wells reflect efforts by E&P companies to get more bang for their buck -- the very essence of oilfield services' value proposition. Schlumberger will, accordingly, try to win more market share for the former, rather than the latter.

Similarly, Baker Hughes, due to report results Tuesday, has begun a big strategic shift of its own. The company announced back in May it was pulling back in some geographic regions where it would instead partner with local services firms, piggybacking on their sales channels -- another way of lightening up on assets while staying in the game.

Ultimately, what this means is that oilfield services firms should be able to adjust their spending more in sync with the market's cycles. For example, whereas the big three typically reinvested 10 to 14 cents out of every dollar of revenue prior to the crash, capital expenditure now runs at about half that level. This may increase over time as things improve, but likely not back to where it was.

Lighten Up
The big 3 oilfield services companies have slashed their reinvestment rates during the downturn
Source: Bloomberg
Note: Data show capital expenditure divided by revenue on a trailing 4-quarter basis.

As a consequence, fixed assets have begun to shrink as a proportion of the balance sheet:

Unfixing The Problem
Fixed assets are starting to decline as part of the overall mix for the big 3 oilfield services firms
Source: Bloomberg
Note: Data show net plant, property and equipment as a share of total assets.

Does this raise the risk the entire oil industry fails to invest to cope with future demand, setting up a future price spike? Yes. Equally, though, a nimbler oilfield services sector focused on helping E&P companies extract more with less helps mitigate that risk.

Above all, it beats simply repeating the process of over-investing and over-hiring only to then take big asset impairments and fire tens of thousands of workers when expectations don't pan out. And given the number of moving parts in the oil market today, you can expect those expectations not to do so.

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

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

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