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Minnows braced for M&A wave

The oilfield services sector is being hit harder than most by the collapse of the oil price and financial markets, leaving smaller companies vulnerable to take-overs, writes Ian Lewis

FALLING share values and the effects of the credit squeeze have significantly impaired the fund-raising ability of providers of rig and drilling equipment – the smaller ones in particular. This could lead to a wave of mergers and acquisitions as larger firms seek to buy assets from strugglers lower down the food chain.

Despite robust third-quarter results from many of the smaller services companies (see box), they may attempt to strengthen their finances through asset sales as market conditions deteriorate.

Some consolidation has already occurred. In June, Smith International announced the acquisition of directional-drilling specialist, W-H Energy Services, for $3.2bn, establishing a company with a similar profile to Baker Hughes and creating a fifth globally integrated oilfield services group. A month later, China Oilfield Services, part of state-owned China National Offshore Oil Corporation, agreed to buy Norwegian drilling-rig company Awilco Offshore for $2.5bn, as it strives to boost drilling capacity, its technology base and expand in overseas markets.

Big firms are likely to make further acquisitions, says Mark Urness, head of energy research at Calyon Securities in New York. "This market environment is going to provide services companies with a lot of opportunities. Several have said they are shifting their emphasis away from share repurchases to preserve cash so they can be opportunistic on the acquisition front," he says.

Schlumberger acquisitive

Andrew Gould, Schlumberger's chief executive, says his firm will remain acquisitive. "If valuations fluctuate to a point that makes things irresistible, we have to be slightly opportunistic," he told analysts at an investor conference in late September. But he said it would be the underlying strength of the businesses concerned rather than their lower stock valuations – market capitalisations in the sector roughly halved between July and November – that would be the main driver for acquisitions.

Dan Pickering of Tudor Pickering, a Houston-based energy research and investment firm, argues that the volatility of financial markets is likely to discourage many potential acquirers from making large asset purchases – at least until they have greater confidence in the economic outlook.

Neither does the downturn presage consolidation among the bigger oilfield services companies, says Calyon's Urness. "What you will see is the larger companies buying small and medium-sized firms, rather than merging among themselves. The big companies all have critical mass and diverse portfolios, so they are able to grow organically. They can do small deals that enhance their technological or market positions, but they don't need to do a large strategic deal to grow."

Constraints on the operating ability of smaller companies will also benefit larger firms, Halliburton's chief executive, Dave Lesar, told equity analysts in a meeting after the firm's third-quarter results. "The inability of some services providers to raise capital could lead to a tightening of supply," he said. This could create "the opportunity for market share gains in a constrained activity environment".

But market volatility is making long-term planning difficult. "It is so dynamic – in two weeks' time it could be completely different," according to Gould. He forecast that spending by Schlumberger's customers will continue to rise in 2009, but more slowly than in 2008.

Some analysts say this is an overly optimistic view. "[The company] has been saying for sometime that global recession would slow growth in production spending, but I think there could even be a modest contraction," says Urness. Pickering expects a contraction in oilfield services firms' spending in the US during 2009. But he says international markets will probably continue to grow, albeit at a slower rate than recently.

The outlook for the rig market supports this forecast. Analysts are predicting a reduction of 20% or more in the global rig count over the next 12 months. North America, which accounts for over two-thirds of the world's rigs, is set to be hardest hit, as independent oil and gas producers shed rigs to cut costs. Chesapeake Energy, a US gas producer, has made repeated cuts in its capital-spending budget and financial projections recently, for example.

Outside North America, the demand picture is slightly less pessimistic, given that production contracts tend to be based on longer-term arrangements, making it harder to halt projects already under way. But further oil-price falls will inevitably hinder growth in international markets to some extent. All the large services companies have said they will be reviewing their 2009 spending plans over coming months.

Decision-making on expenditure levels will be tricky, as executives try to second-guess the direction of the oil market. In contrast to previous oil price slides, oil and gas supply remains relatively tight and is set to get tighter. The International Energy Agency forecast in its World Energy Outlook that, without extra investment to raise production, the natural rate of output decline from the world's oilfields would be more than 9% per year. This has led to optimism in the sector that oil prices may not remain depressed for long.

Schlumberger's Gould told analysts in October that a series of mergers between producers, and reduced spending might reduce overall output initially, but could lead to a rapid recovery in the oil price later, as demand outstrips supply. That, in turn, would prompt a new wave of investment.

However, analysts note that identifying the turnaround point will be difficult. "Gould is correct that a significant drop in spending would provoke an even stronger recovery, but it is the timing of that recovery that is in question," says Urness, who believes another price spike could occur in one to two years' time.

Fleetness of foot

If and when demand does pick up, fleetness of foot will be crucial, as firms seek to boost equipment manufacture and provision as fast as possible. Halliburton is one company that claims to have made significant improvements on this front. Tim Probert, vice-president of strategy and development, told analysts in October that the company had cut its lead-time for manufactured items from almost a year down to three to nine months over the course of 2008. Firms across the sector are making similar fine adjustments to their operations as they seek to weather a storm that is far from over.

Before the storm

THE TALK in the oilfield services sector may be all about gloomier times to come, but the outlook needs to be placed in the context of a highly successful first nine months of 2008.

Three of the four largest services companies reported better-than-expected third-quarter results, as they benefited from buoyant demand in most regions and high oil prices. The biggest drag on earnings was an eventful hurricane season in the US Gulf of Mexico, which caused several drilling stoppages.

Schlumberger, the sector's largest firm, reported a rise in third-quarter net profit to $1.53bn, up from $1.35bn a year earlier. Revenue increased by 22%, to $7.26bn. Operating profit in oilfield services rose by 13% to $1.7bn, while profits at its WesternGeco seismic unit rose by 16% to $355m. The company remains not only the largest, but also by far the most regionally diversified of the large firms, a comfort factor reflected in its share price, which was trading at around 10 times projected 2009 earnings in early November, compared with around seven for the big four – Schlumberger, Halliburton, Weatherford and Baker Hughes – as a whole.

Halliburton posted a net loss of $21m, compared with a $0.727bn profit a year before. The figure was dragged down by a loss of $0.693bn related to the cash settlement of a convertible senior-notes premium and a $15m charge relating to its acquisition from Shell Technology Ventures of the 49% of well-completion technology firm WellDynamics it did not already own. Analysts say Halliburton's underlying performance was sound, as indicated by a 23.5% rise in revenues to $4.85bn.

Weatherford, meanwhile, reported income from continuing operations of $384m, a rise of 28% from the same quarter 2007, while revenues were up by 29% to $2.54bn.

"The primary drivers of the strong third-quarter performance was US and Canadian gas-directed drilling activity, but growth outside North America was also quite solid in virtually all areas," says Calyon Securities' Mark Urness, head of energy research in New York.

The US rig count for September 2008 rose by 27 to 2,014 from the August figure and 231 higher than September 2007, according to the Baker Hughes database. The Canadian rig count for September fell by 14 from August to 435, but was still 84 higher than a year earlier.

Latin American operations continued to perform well for the sector as a whole. Only the North Sea, where oil and gas production is on the wane, failed to shine, according to market observers. The worldwide rig count for September 2008 rose by 34 to 3,557 from August and jumped by 391 from September 2007.

Weatherford particularly impressed the markets, because of strong growth in Latin America and other non-US markets. The company also put in a solid performance in North America – from which it still derives almost half of its total revenues – where a 19% rise in revenues was made on a 13% rise in its rig count. The company's overall rig count rose by 11% in the quarter.

Of the big firms, Baker Hughes provided the one disappointment for the market. Earnings were up by just over 10% to $428.9m and revenues were up by 12% to $3.01bn – a relatively weak performance in the context of the sector as a whole, prompting Calyon to lower its rating on the shares. "We were looking at average sequential [quarter-on-quarter] revenue growth for the big four of about 10% and year-on-year revenue growth of 25%. The reason we downgraded Baker Hughes was that it was lower than the average."

Baker Hughes' under-performance can be attributed, in part, to the effects of its decision to plead guilty in April 2007 to violations of the US Foreign Corrupt Practices Act, Urness says. The firm admitted bribery of foreign officials to win oilfield contracts in Kazakhstan, while settling civil charges filed by the Securities and Exchange Commission regarding illegal payments in five other countries. At that time, the company agreed to appoint a government-approved monitor for three years to ensure it complied with the law in future, which restricted the company's ability to use agents to secure contracts – a common practice in the industry – so greatly slowing down its ability to secure new business. n



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