[Editor's note: A version of this story appears in the May 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]

The oilfield service sector is in dire straits, and it’s going to take a fundamental change in its relationship with the E&P sector for that to change. And E&Ps better get on board with effecting that change or learn to drill and frac a well themselves.

That essentially was the message of a discussion panel at the Houston Producers Forum in March. Panel moderator and prognosticator Jim Wickland, a long-time service company research analyst now with Stephens Inc., premised the discussion by pointing out that the oilfield service index in February was “dead flat” to where it was 15 years ago in 2004. Compare that to a 300% increase in the E&P index, even considering the current malaise in the public markets.

“So we’ve taken drilling a well from 28 days to 15 to five, and all they’ve done is work themselves out of a job, because they still charge the same day rate. There has been no value accretion to the land drillers,” he said. And if you look at the value accretion that the oil service industry has provided to the E&P industry in that 15 years, “it all accreted to the E&P industry and not to the service industry.”

Land drillers, in particular, have seen no upside resulting from their amazing leaps in efficiencies. Loren Singletary, vice president of industry and investor relations for National Oilwell Varco, which manufactures much of the equipment used in the service sector, noted that just five years ago some 20% to 25% of an AFE to drill a well went to the drilling contractor. Today, it’s a mere 9% to 10%.

“We as an industry are drilling as much hole—as much footage—today with 1,000 rigs as we did with 2,000 rigs four or five years ago,” he said. Even with good day rates for a super high-spec rig at $25,000 to $28,000 per day, that rig, to accomplish what it’s accomplished, is not recovering the cost of capital for doing business, he emphasized.

“The drilling contractors are not able to cover the depreciation of the equipment on that rig, using that equipment like they never have in the past. That sort of relationship with the oil companies is not sustainable long term. That relationship needs to change to make it beneficial for both parties.”

And how, pray tell, does it need to change to save the OFS? Performance-based contracts.

“The oil service industry has been trying to convince the E&P industry for years to hire them on a performance basis,” Wickland said. Simply, if an E&P contracts a driller to finish in seven days and they do it in five and a half, then the driller makes money for its efficiency.

“If I can’t generate a return on a performance-based contract, then it’s my problem in not being able to execute well. The industry has to figure out a way to get paid for performance, and the E&P industry has to learn how to adapt to that, because that’s how they’re going to get the best service and keep their suppliers in business. That automatically weeds out the least efficient people out there.”

Richard Spears, vice president and co-founder of Tulsa-based market research firm Spears & Associates, doesn’t believe the E&P sector will be swayed willingly. Rather, he believes the OFS sector needs to consolidate in dramatic fashion to wield more leverage. Focusing on the frac side, he noted that in a $27 billion industry in North America, Big Red Halliburton accounts for $6 billion in market share. The rest is made up of billion-dollar-revenue companies.

“There’s no leverage there. There’s no ability by that company to affect change in any way except for the four oil companies they work for,” he said. “One of the ways you change the market is you can’t have a bunch of 1% or 2% or 3% oilfield service companies out there. You have to be in a bigger league. That’s where you change the story.”

Spears imagined combining nine completions companies: Liberty Oilfield Services, Keane Group, BJ Services, Calfrac Well Services Ltd., Patterson-UTI Energy Inc., FTS International, ProPetro Holding Corp., Cudd Energy Services and C&J Energy Services. Together, they would make up a company slightly larger than Halliburton’s frac business, he said. “You should do that.”

But the onus remains on E&Ps consuming the services.

Addressing producers in the room, Wickland asked, “So, are you guys going to change your behavior on how you hire oilfield service companies? Are you going to pay oilfield service companies to the point where they can afford to maintain their equipment? Or, once their equipment begins to break down, you just drop them and hire the next guy, and we go on a daisy chain?

“If it’s the latter, this business is going to be very challenged going forward.”

It’s time to decide. Will E&Ps be part of the solution now, or wait for a catastrophic problem to act?

Steve Toon can be reached at stoon@hartenergy.com.