Industry Watch: Early Stages of Oil Services Recovery Could Stall Dealmaking Activity

The oil patch has recovered from its severe price downturn of 1998 and early 1999, but its nascent return to good times may act as a brake on further industry consolidation in the oilfield services sector. “Higher commodity prices tend to strengthen the resolve of some companies to go it alone,” said Poe Fratt, the oil services analyst at A.G. Edwards Inc. in St. Louis. He added that the higher commodity prices often encourage potential sellers to ask too much for their assets. Oil prices soared to as much as $34 a barrel in early March after spending much of last year in the low teens. On the gas side, prices are up by 50% from 1999 levels. Others argue that high oil and natural gas prices and a resulting pop in stock valuations in the 350-company universe that makes up the oil services sector doesn’t destroy the rationale for some deals, but it does delay the timing of companies getting together. “This is a cyclical industry, and m&a activity typically occurs at the bottom of the cycle, which should come in another 12 to 18 months,” said G. Allen Brooks, a senior analyst at CIBC World Markets in Houston. However, some observers point to overcapacity in parts of the oil services sector, like seismic monitoring and shallow-water drilling, and maintain that if a deal makes strategic sense, it can defy Brook’s cyclical timetable. Regulatory roadblocks prevent blockbuster deals While assessments of coming deal flow vary, most observers said they don’t see any likely megamergers among the Big Three of the oil services industry: $19 billion market cap Halliburton Co., $40 billion market cap Schlumberger Ltd., and $10 billion market cap Baker Hughes Inc. In the oilfield services business, Schlumberger, headquartered in New York, ranks second to Dallas-based Halliburton in terms of revenues. It is far bigger than Halliburton in terms of market capitalization, but both companies have non-oilfield businesses that prevent a simple comparison of market capitalization. Baker Hughes ranks third. A Baker Hughes spokesman said that regulatory constraints would preclude an outright merger between any of the Big Three players. He did say that depending on each of the companies’ strategic plans, they could move to fill gaps in their line-up, and noted that competitors Halliburton and Schlumberger are not in the oilfield chemicals sector and could expand there. But for those looking for sizeable transactions, he cautioned that he expected to see small deals that fill technical niches rather than larger pacts. Despite a slowly improving picture for the sector, earnings for the first quarter of 2000 at the Big Three didn’t come out looking as good as participants had hoped. Halliburton, the world’s largest oil services firm, reported a fall in first-quarter earnings but said that earnings per share still met analysts’ expectations. Halliburton said that net income, excluding one-time charges or gains, fell to $49 million, or 11 cents per diluted share, from $81 million, or 18 cents, during the same period in 1999. Revenues from continuing operations fell 12% to $2.9 billion. Analysts had expected Halliburton to report earnings per share of 11 cents, according to data compiled by First Call/Thomson Financial. In its earnings statement, Halliburton also announced plans to sell off its Dresser Equipment Group unit, its last remaining capital equipment type business, and launch a share buyback program. “While low levels of international business activity have hampered the company’s financial progress in recent quarters, I am enthusiastic about the second half of the year and the future outlook for our strong international business operations,” Halliburton Chairman and CEO Dick Cheney said in a printed statement. He said that Halliburton had decided to sell off Dresser Equipment because it was not a good fit with its core oilfield services and engineering and construction businesses. Price firmness spurs drilling Schlumberger said in late April that its first quarter earnings rose 7% to meet Wall Street expectations. Income from continuing operations and before one-time charges rose to $136 million, or 24 cents per diluted share, from $127 million, or 23 cents, in the first quarter of 1999. Operating revenues rose 1% to $2.14 billion. On average, Wall Street analysts had expected Schlumberger to report diluted earnings per share of 24 cents, according to First Call/Thomson Financial. “OPEC’s determination to hold oil prices at around $25 per barrel bodes well for sustainable increases in oil demand and oilfield activity,” Schlumberger Chairman and CEO Euan Baird said in a written statement. Schlumberger’s oilfield services division said early in the second quarter that it had acquired Houston-based Operational Services Inc., a leading supplier of oilfield operational management services. As a wholly owned subsidiary of Schlumberger, Operational Services will work in close cooperation with other Schlumberger reservoir optimization services, including Integrated Project Management and Production Operators, to deliver a systematic approach to oilfield management. The third-largest company among the Big Three, Baker Hughes, has endured top management turnover in recent months. But although its first-quarter earnings fell sharply from a year earlier, the company managed to beat Wall Street expectations by returning to profit, after posting a loss in the fourth quarter of 1999, as business strengthened late in the first quarter of 2000. Baker Hughes, which ousted Chairman and Chief Executive Max Lukens in January because the company’s stock had underperformed that of its oilfield peers, reported net income, excluding one-time items, of $13.8 million, or 4 cents per diluted share, in the first quarter. In February the company forecast that it would merely break even in the first quarter after losing 3 cents per share in the fourth quarter of 1999. Analysts had expected a break-even quarter, according to First Call/Thomson Financial. Baker Hughes’ first-quarter revenues of $1.2 billion were down 4.7% from a year earlier but up 4.8% from the final quarter of 1999. In the first quarter of 1999 the company earned $44.4 million, or 14 cents per share. “For the first time since the second quarter of 1998, we saw increases in operational earnings and cash flow generation compared with the prior sequential quarter,” interim Chairman and CEO Joe Foster said in a statement. Baker Hughes’ shares fell sharply in December – leading to a flurry of lawsuits from angry investors – after the company revealed accounting irregularities at one of its units. James Wicklund, an oil services analyst at Dain Raushcer Wessels in Dallas, said that investor confidence had already been undermined by concerns that the company’s $4.8 billion acquisition of seismic services firm Western Atlas in 1998 was too expensive and had not delivered anticipated benefits. Realignments likely for second-tier players Beneath the Big Three, there are about 65 publicly traded companies in the sector, with about 20 of those companies large enough to rack up a billion dollars in sales, said Brooks. Among the players in this sector are Weatherford International Inc., BJ Services Co., Key Energy Services Inc., and Belden & Blake Corp. These larger, second-tier players, along with the Big Three, are feeling the brunt of the oil industry’s mega-mergers. The initial impact of these big deals is the slowing of external spending as the newly linked companies integrate operations and concentrate on squeezing out costs. This, after all, was a primary rationale for these mergers. “We’re seeing a slowing down of activity. The majors haven’t ramped up spending, and this has delayed the recovery, especially in markets where the majors dominate, among the oil services companies,” Wicklund said. He added that the process of reengineering and reducing redundancies would be the main concern of newly merged majors for the first half of this year. Looked at from another perspective, Brooks said, the first impact of the integration process after a megamerger is a decrease in discretionary spending, which is the lifeblood of the oil services sector. Part of the pool of money in a newly merged oil company’s holdings, he said, is used for severance benefits and other costs associated with paying people to go away. He also noted that the big combinations reduce the number of customers for the sector. A second step, and an optimistic one for the oil services sector, is the selling off of projects and properties that are too small for the majors to keep in-house. This trend and an increase in outsourcing that is expected going forward should benefit oil service companies, Brooks said. But even before the majors complete their reorganizations, there are sectors of oil services that are doing well. Fratt said that the giant combinations of major companies haven’t hurt small players in niche markets in North America. The most vigorous niche he identified contains the independent natural gas exploration and production companies in North America that are benefiting from high gas prices and increased popularity of gas as an environmentally friendly fuel. “You don’t have the geopolitical problems that you have with the oil industry and, for domestic producers, you don’t have any transport problems,” Fratt said. Speaking at a conference earlier this year, Andy Szescila, president of oilfield operations at Baker Hughes, said that the industry recovery has been narrowly based, fueled mainly by smaller, independent companies drilling for gas. “It’s truly been, in this first stage of the cycle, a North American gas play driven by the independents.” Fratt estimated that about 70% of North American drilling activity is for gas, with the remainder dedicated to oil production. The A.G. Edwards analyst said there is room for consolidation among on-shore and shallow-water drillers. He pointed to the 1999 spin-off of Schlum-berger’s offshore contract drilling business, Sedco Forex Offshore Inc., and the subsequent merger of that unit with Trans-ocean Offshore Inc., as an example of that trend. Brooks agreed that gas is the primary driver for new well drilling. He identified the hottest segments as on-shore and shallow-water drilling for gas in the U.S. He also mentioned the upsurge in the fortunes of companies that repair existing wells, whose production is booming because of overall low rig counts and improved prices. Brooks pointed to the recently collapsed talks between Global Marine Co. and Noble Drilling Corp. as a deal that made strategic sense but fell apart when the parties couldn’t agree on valuations. Each party is now considered a likely candidate to hook up with another partner, he said. The role of the “lake house factor” But going beyond spreadsheet data and P/E multiples, Brooks said that there is a larger motivation that could drive upcoming deal activity in the oil services sector. Reiterating Wicklund’s point about the cyclicality of the oil industry, as well as oil services, the CIBC specialist noted that for a whole generation of executives – those who would now be in their ’40s – the industry didn’t look attractive when they were making a choice about whether to enter it or stay in it. As a result, oil service companies’ senior managers tend to be in their ’50s and ’60s. Another generation of managers, perhaps with only 10 years of experience, are in their ’30s. “You’ve got a huge generation gap in the management of these companies,” Brooks explains. Based on conversations with the senior tier of management, Brooks said that when the older generation is ready to retire, companies are going to change hands, regardless of commodity prices or stock prices. In some cases, the deals will pass companies into the hands of colleagues and competitors and, in some cases, into the hands of financial buyers. He added that for the older owners, the easiest way to get out of the business is to sell the company or merge it with one that has a better management structure age-wise. “When the wives of these senior executives – many of whom started their companies – say, It’s about time we started spending most of our time at the lake house,’ companies are going to be sold,” Brooks said. Deals motivated by these personal concerns are going to occur sooner rather than later, Brooks said, because the oil services sector is starting its recovery and the overall economy is booming. Even if executives say that they are cavalier about oil and gas prices, they are less likely to not take advantage of their company’s current high valuation. Brooks added that deals that conform to this pattern should make for briefer and less lucrative assignments for the m&a professionals involved. “You’re not going to have bankers creating deals in this sector; they’ll be used more for fairness opinions and to provide shareholder protections and things like that.”