Joe Gibney | Capital One Securities
A look at operating model adjustments, M&A, and collaboration within the oilfield equipment manufacturing sector through the industry decline of the past year and a half.
The butcher’s bill for the whole of the oilfield services sector has been extensive in the wake of WTI’s mid $20s bottoming and the resulting CAPEX austerity. With liquidity preservation understandably serving as priority one for E&P customers during the maelstrom, short-cycle activity ground to a standstill and orders – both via capital equipment deferral/cancellation and inventory cannibalization for consumables – dried up completely. The recent WTI recovery to the mid $40s has only just now begun to shake loose an increase in customer inquiries. While the rig count has shown signs of modest uplift with speculation regarding the return of completions work, most operators are still characterizing the inquiry lift as yellow shoots – that is, the phone is ringing more but it’s not yet meaningfully translating into purchase orders or booked jobs.
The butcher’s bill itself is staggering. The U.S. total rig count bottomed 77% from peak levels in the fourth quarter of 2014. The international total rig count is down 33% and still declining. The global contracted offshore floating rig count is down 36%. Fifty-eight floaters have been retired since October 2014 (equivalent to the amount retired over the last 30 years). Full year 2015 industry-wide subsea tree orders were down 34% year over year, following 58% declines in 2014. National Oilwell Varco’s (NYSE:NOV) Rig Systems orders have averaged $93 million over the last two quarters versus $2.6 billion per quarter at the peak.
This is where the industry began using the cleaver, as its initial operating response was blunt force trauma, attempting to match headcount reductions and facility closures with the plummeting drilling activity. General and administrative spending trends from peak 2014 levels serve as a reasonable proxy for this cleaving, with average reductions across our covered OEM universe around 35%. NOV alone has closed more than 200 facilities, and every operator has looked at ways to re-trench into core facilities, insource machining hours, move to single shifts, and reduce wages.
As the velocity of the activity and order declines slowed, however, we began to see operators put down the cleaver and pick up the scalpel. This has been a more challenging and nuanced exercise that involves ascertaining what level of forward capacity is appropriate and trying to balance the last 18 months of acute cost control against the need to preserve the ability to participate in the inevitable upcycle. On the short-cycle side, this is more of a near-term geographic positioning exercise with restructuring of management and service-line consolidation shifting to a desire to keep field personnel and positioning them in basins likeliest to see the most near-term improvement. How much incremental activity can be absorbed by this level of field personnel is an oft-discussed topic but most operators seem confident they can absorb an activity rebound back to more than 800 rigs in the United States without adding much in terms of incremental cost other than logistics, transport, and overtime. This is a balancing act that pales in comparison to longer-term structural planning on the manufacturing capacity front.
Instilling lean initiatives and de-layering organizations in order to deliver sustainable cost reductions are the main drivers of the ongoing scalpel moves within the OEM space. Standardization of processes (machining, assembly, testing) enables consolidation into fewer locations and greater efficiency. These initiatives are underway within FTI’s Subsea division, within NOV Rig Systems, and across the board for all OEMs with a global footprint. Forum Energy Technologies (NYSE:FET) set a goal to consolidate global manufacturing and distribution facilities by 20% without sacrificing capacity. This consolidation, along with procurement initiatives, is driving a targeted $100 million improvement in cost structure that is expected to increase margins in a recovery scenario by 500 basis points. Some costs are inevitably going to rise with an upturn but these scalpel initiatives should enable a core of permanent cost reductions that should lead to healthier incremental margins in the upturn.
A cyclical recalibration of this magnitude requires putting everything on the table and rethinking prior accepted processes, considering out-of-the-box thinking to grow share in a smaller opportunity pool, and working with customers to realize the needed cost reductions that will lead to acceptable project economics. Overhead and price reductions only go so far – fundamental changes in development approach are also required. This is where the strategy through the downturn shifts to the glue, as collaboration, consolidation, and M&A now begin to coalesce.
The genesis of this thinking can be seen in the August 2015 Cameron-Schlumberger merger (following their OneSubsea JV which became operational in June 2013). Some aspects of this transaction were hard to reconcile: a greater than 56% premium and marrying a service provider with a manufacturer seemed incongruous in terms of culture and process, and CAM’s drilling franchise was (and is) an overhang given order/throughput challenges. However, in an effort to achieve total well cost savings with better integration of equipment and service, SLB had already progressed from reservoir characterization to downhole tool and rotary steerables integration, SII/M-I bits, and fluids, leading to a fully integrated downhole system along with tucking in select completion hardware into the service offering. With a target of $600 million in synergies and a “pore-to-pipeline” emphasis on product and service deliverability, CAM carries this progression to its next iteration – marrying downhole/reservoir expertise with manufacturing process/installed base, overlaid with instrumentation/automation to create an end-to-end product-service concept with significant scale synergies.
The FTI-Technip collaboration via the Forsys JV (announced March 2015) that progressed to a full company combination (announced May 2016) provides another collaborative example. Similar to CAM-SLB, questions arose: a long wait on $400 million cost synergy realization, uncertain customer embrace of the EPIC/integrated approach, and how onshore will benefit from the integration beyond a more bundled product/service sales approach. Despite these questions, the original intention of Forsys remains: demonstrate that early involvement in the FEED stage, standardization of products and interfaces, technology sharing, and end-to-end coordination of subsea production systems and subsea installation (which constitute approximately 1/3 of offshore total well costs) can result in meaningful cost reductions of more than 25%.
In July 2016, NOV and GE Oil & Gas also furthered the collaborative agenda with the announcement of an agreement to jointly develop FPSO solutions. This brings together NOV’s product positioning on turret mooring systems, flexible risers/flowlines, composite piping, cranes, and fluids pumping & treatment with GE’s positioning in topsides power gen and compression. It’s been slow going on the FPSO front, as NOV has built its product suite via a series of acquisitions, primarily APL, Prosafe, and NKT going back to 2010 with the aim to create a standardized FPSO kit similar to a deepwater rig package. The company remains involved with several FEEDs, bidding both separate turret/mooring systems along with a full standardized package. Marrying up the power gen/compression piece of GE completes the full topsides package and, with standardization of interfaces and supply chain efficiencies, can now more meaningfully drive reduced costs.
The final application of glue will inevitably center on a return to bolt-on M&A. Bid-ask spreads have understandably been misaligned for the last 18 months, as all prospective deal-making parties have been searching for the bottom and some sense of the pace of initial recovery. M&A historically begins to pick up as activity inflects off the bottom and we are now only in the nascent stages, as the free cash flow and liquidity survivors of the space look to expand product portfolios and market share.
While smaller in scale, the recent NOW Inc. (NYSE:DNOW) acquisition of Power Services (finalized June 2016) demonstrates an effective combination of innovative thinking coupled with market share-driven, bolt-on intent. The acquisition bolsters valve content with spooling and modification capabilities and more meaningfully pushes DNOW outside its distributor core and into fabrication with Power Services’ modularized tank battery solutions. This provides DNOW with a more competitive turnkey solution to well completion sites and potentially serves as a differentiator to garner market share in a smaller North America upstream opportunity set.
It’s been a challenging 18 months for the industry, with the velocity of commodity and activity declines making this cyclical downturn one of the most severe in history. But with the cleaving behind us, select scalpel work being finished up, and the first signs of meaningful glue being applied, we’re all looking forward to hopefully better days ahead as a new upturn inevitably begins to coalesce.
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