By Brian Williams
Over the course of the pandemic, the U.S. oil field services industry experienced an existential threat as E&P companies dramatically cut spending in response to the COVID-19 shutdown and reduction in demand for oil and natural gas. Every dollar of revenue an OFS company makes comes from an E&P company and in 2020 US E&P companies cut CapEx by ~40 percent, with a further ~10 percent cut in 2021.
As a result, the average US drilling rig count fell over 50 percent from ~900 in 2019 to ~400 in 2020, up only 10 percent in 2021. These cuts came against an industry backdrop that showed only partial recovery from prior declines in 2015 and 2016, when US drilling fell from 1,800 rigs on average in 2014 to less than 500 in 2016.
Many U.S. based service companies took full advantage of government support from PPP and ERC programs to bridge cash flow shortfalls and stay in business. These programs contributed to more oil field service (OFS) companies staying in business, which E&P companies then took full advantage of to keep pricing depressed.
Lenders to OFS companies were faced with few, if any, attractive options to deal with borrowers that defaulted on loans originating in 2018 and 2019, when activity and profitability were orders of magnitude better. Traditional methods that lenders use to recover their investments (foreclosures or forced company sales in or out of bankruptcy) were likely to result in recoveries well below loan values. OFS competitors were dealing with their own challenges, while PE buyers abandoned the OFS market. With no going-concern buyers, and no need for so much OFS equipment any time soon, values at liquidation auctions in 2020 and 2021 were typically 10 percent or less of replacement value.
In some cases, lenders got creative and worked with their OFS company borrowers to kick the can down the road, giving borrowers 12–24-months interest and principal holidays with minimal covenants and agreed take out prices at 50 percent or less of face value to incentivize owners and management teams to keep going.
Given this confluence of dynamics, the U.S. OFS industry that began to emerge from the pandemic in the second half of 2021 and into 2022 continued to have an excess of players and equipment. Pricing and utilization remained persistently low as E&P companies took full advantage of excess capacity across too many competitors.
The E&P industry itself was also undergoing a transformation over this period as historical sources of capital to fund drilling programs beyond internally generated funds essentially abandoned the market. Even as oil and gas prices improved throughout 2021, E&P companies remained extremely disciplined, using increased cash flows to further pay down debt, and return capital to shareholders, rather than quickly ramping up drilling and completion activity. Driving efficiencies even further, several large independent operators merged or were acquired.
What Changed in 2022?
The material run up in oil and gas prices throughout 2022 had less impact on industry activity than would have been expected if historical trends held. Spending time in Midland or the HQ of an OFS company in Houston in 2014, when oil prices were $100/bbl or better, you could literally feel the energy vibrating through the industry. So much excitement and optimism: The oil and gas industry was being revolutionized by unconventional drilling and completion technologies, everyone was making money, and everyone was having fun.
However, in the early summer of 2022, when crude oil was trading at $100/bbl and natural gas was at $10/mcf, Houston and Midland felt more like oil was at $45/bbl and natural gas was at $2.50/mcf. While U.S. E&P company operating cash flows were up over 200 percent in the last 12 months, CapEx budgets for 2022 were only up by 30 percent over 2021.
OFS activity has responded, with U.S. rig count up 30 percent in the first nine months of 2022. OFS companies have secured some pricing improvements (particularly in fracking services and more recently in drilling rig day rates), but higher labor costs, overall inflation and supply chain challenges have limited profit gains.
The headwinds that OFS companies have faced are continuing to ease and consensus across the industry is that they are in for a period of slow and steady growth. Several observations support this argument.
Pricing is continuing to improve, primarily in frac and other completion related services. Cannibalization of excess frac equipment has run its course, and E&P companies are looking for service companies to add more electric power driven and dual-fuel equipment. Day rates for high-spec land rigs are quickly moving up, with utilization reaching an inflection point, and E&P companies are once again talking about multi-year rig contracts.
The rate of technological and operating efficiency gains that revolutionized the U.S. oil and gas industry has slowed to a crawl with maximally optimized drilling and completions techniques now the rule, not the exception. Many of these gains have also been democratized across the industry, with essentially all operators and service companies having access to and providing best practice services and equipment.
There is also a belief that external capital has not, and likely will not, return to the OFS sector for the investable future. The banks, alternative lenders and PE sponsors eager to fund the expansion and acquire OFS companies before 2020 will not be there to fund equipment expansion and company exits. Too much pain from too many losses and strong ESG sentiments are leading many capital providers to continue to say “no” to any traditional hydrocarbon investments. As a result, OFS companies also are going to have to live within their means, utilizing internally generated profits to fund their expansion, and keeping the rate of growth more measured.
The lack of external capital, with much of Wall Street treating oil and gas investments like tobacco companies in the 1980s, has also materially impacted the ability for potential investors to realize a return on the capital through an eventual sale to a larger strategic buyer or PE sponsor. Investment banker-led sale assignments of OFS companies today are typically receiving zero interest from generalist PE firms that, pre-2020, were the most aggressive buyers for OFS companies looking to exit. Today, it’s more common to see two OFS companies combining or high net worth individuals or family offices that are already part of the energy community emerging as buyers and investors in OFS companies at very attractive valuations.
Lastly, there are two important issues facing the industry right now: labor and politics. Labor shortages are already a major issue for OFS companies today. Despite high wages, many former oil field workers are refusing to return due to industry cyclicality, and the new generation of workers is not interested in the long hours and tough conditions of many OFS jobs. The recent political environment in Washington, D.C., has also contributed to negative sentiments and has discouraged people and companies from investing in the sector.
Will the Fun Return in 2023 and Beyond?
The US OFS industry that exists at the end of 2022 and going into 2023 is not as fragile as many think. In fact, it may actually be on the precipice of a step change in activity, pricing and profitability. Will external capital return? Will political and social views of the oil and gas industry change? Will the industry attract enough skilled labor? Historically, the lure of outsized returns for investors and high paying jobs for workers has solved these issues.
It is also the case that OFS activity and profitability forecasts are always wrong, not usually in direction but in magnitude, both up and down. If history repeats itself, as it often does, 2023 may be the year optimism, excitement and even fun return to the OFS industry.