[Editor’s note: Opinions expressed by the author are their own.]
Recent smart market research has shown that in the last 20 years publicly traded E&P companies have increased their worth (pre-COVID-19 and KSA/Russia price volatility) while the oilfield services companies have had 0% growth in the same period. This points to oilfield service companies not being invited to the “party” when it comes to generating healthy returns to their investors.
Economic theory predicts that this trend can’t last long. At the same time there are no indications that this trend is changing worldwide—at last check large publicly traded oilfield services companies have lost frighteningly significant portions of their enterprise value in the last 12 months.
In the time period 2019-20, the oil and gas industry has faced many a headwind. The headwinds did start in the last quarter of 2018 to be precise. In addition to the complex geopolitical risks involved with supply and COVID-19-related demand issues the industry has been exposed to new challenges from public and investor sentiment arising from climate change and cash flow discipline. In this environment, most of the large producers (i.e. supermajors and NOCs) have the operation and financial scale to “survive” this onslaught. Independent oil and gas producers, primarily in the U.S., have struggled. As have the oilfield services (OFS) companies.
Under this backdrop, the OFS companies have taken the brunt of “punishment” in terms of their revenue generation and enterprise value. This is somewhat expected, as the OFS segment is quite fragmented and is typically at the beckoning of producers to deliver services of value fast and most often at the lowest price.
The result has been the top tier OFS providers have lost north of 60% of their market capitalization in the while those in Tier II have lost upwards of 75%. This would be shocking in any industry but in the oil and gas industry these outcomes have apparently been taken as a “sign of the times.” Is it really a sign of the times?
The oil and gas market, like most industry segments, is divided into producers (OEMs in some industries) and suppliers (OFS companies). By sheer size, the number of producers is less than 50 while the suppliers is greater than 500 firms. This scale differential provides the producers with choice and what economists call “pricing power.” Technically, the OFS company should have pricing power but that has not been the case in recent times. How have other industries fared in an environment of high fragmentation of service providers historically?
One historical analysis, from more than 50 years ago, has shown us that the steel, computer mainframes and metal container businesses while operating in a highly fragmented market generated consistent high returns on investment. How? The analysis suggested these companies share four common characteristics: careful market segmentation, efficient use of research and development funds, think small, and chief executives’ influence is pervasive.
Another study of more than 1,340 mergers and acquisitions discussed in the Harvard Business Review article “The Consolidation Curve,” concluded that a new industry once formed goes through four phases as it matures: opening, scale, focus, balance and alliance. These four phases are expected to happen over 25 years. This is termed as the “industry consolidation cycle,” with its Stage 3 (balance) appearing to be quite relevant for the OFS industry.
“Companies in Stage 3 industries need to emphasize their core capabilities, focus on profitability, and either shore up or part with weak businesses,” the article stated. “The well-entrenched competition at this phase will attack underperformers. Recognizing start-up competitors early on allows focus-stage competitors to decide whether to crush them, acquire them, or simply emulate them.”
Global headwinds including risks of a recession-driven by geopolitical price “wars” and the COVID-19 add to the “existential” crisis that the oil and gas industry is currently going through. On one hand, investors and management teams must acknowledge global sentiment of demanding cleaner sources of energy and balance that with the knowledge that the world’s thirst for conventional energy will remain for the foreseeable.
So how to generate returns on investment in this climate if you are in the OFS segment? Is consolidation the answer? Is focusing on differentiating technology the right path? Or is it taking the pricing power back from the operators? Are all these related? It will certainly be interesting to watch how the industry responds in the next 6-24 months.
A few things for small and medium enterprises in oilfield services to consider—reward and continue to train their best people, undertake a rigorous diligence of product portfolio, deploy only those that have differentiating technology, provide quantitative evidence of value created to clients, and be brave and stick to pricing while continuing development and cost optimization.
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