2016 was a volatile year for oil and gas. WTI traded to lows in the mid $20s, then rebounded to finish the year around $54. The road to recovery for the energy industry in 2017 can be characterized as cautiously optimistic as WTI prices have stabilized over the past couple of weeks and energy companies have started to slowly hire and ramp activity.
There were a number of themes that emerged as the year progressed including:
- Rebounding rig counts and the return of service cost inflation
- The Dallas Fed and Permian-focused E&Ps expressing concerns over rich Permian Basin acreage valuations
- Another year of low oil prices and OPEC production cuts
- The RINsanity of ethanol blending and a possible border adjustment tax
- Natural gas coming out from the shadow of oil with demand catching up to supply
We will review the themes of 2016 and those themes going forward into 2017.
Oil Field Service Cost Inflation
After the rig count recovery of 2016 and stabilization of oil prices, it is clear that the North American land market has clearly turned the corner. For the oilfield services sector, 2015-2016 was dominated by cost deflation as drillers dramatically reduced activity. The most resilient E&Ps that were able to maintain some level of drilling activity were able to push OFS providers for costs reductions to bring down their economic breakevens.
Now that North American onshore has turned the corner and activity is increasing, we need to monitor for service cost inflation, either from materials like proppant or labor. With a relatively tight labor market and unemployment rate of 4.70%, other industries like construction are competing for the same labor pool. The next couple quarters should begin to reveal whether cost inflation is beginning to bite and what sort of pricing power OFS companies have in early stages of the upswing.
With Doc Search you can set up keyword searches to monitor this. A search for “cost inflation OR price increase” filtered by sector and only transcripts has started to return instances of those keywords on Q4 earnings calls:
As the upcycle begins, growth in E&P investments will be led by the North America land operators who appear to remain unconstrained by years of negative free cash flow, as external funding seems more readily available and the pursuit of shorter-term equity value takes precedence over full-cycle return. E&P spending surveys currently indicate that 2017 North America E&P investments will increase by around 30% led by the Permian Basin, which should lead to both higher activity and a long-overdue recovery in service industry pricing.
There’s been a lot of change in North America over the last few months. Dave shared with you how we used our market share strategy to regain profitability. The next step in boosting profitability is increasing prices, so let me start by talking about where we see pricing. Wild rumors are circulating in the industry about huge price increases. That’s just not a universal fact. Given our position in North America, no one knows more about pricing than we do and here is what I do know.
First, I like talking about price increases more than decreases. It’s a nice change. Second, the service price recovery is starting from an extremely low base; in many cases, below variable cash cost. Third, the level of pricing that satisfies a particular service company depends on where they are on the profitability continuum. And finally, even though the industry is starting at different profitability levels, every company will have to march back up the same path to profitability.
During the downturn, our industry went through a steep regression in profitability as pricing and activity declined. The industry moved from positive operating margins to negative operating margins, then to negative EBITDA and ultimately wound up struggling to cover variable cash costs. It was a fast and hard road that caused a dramatic shift in the landscape of the service industry and wiped out a significant amount of shareholder equity.
The pricing brawl continues as the industry recovers and equipment availability tightens. Pricing at the margin is ultimately set by whoever is satisfied with the lowest returns. It’s important to understand that our competitors’ motivation for margin returns is largely built around where their pricing is anchored today. For example, if they are at negative variable costs, then they are trying to get to a negative EBITDA. If they are at negative EBITDA, then they are trying to get to negative margin and so on.
I can tell you, despite what you hear in the market, it’s clearly a bridge too far to skip from negative variable cash to positive operating margin in one step. So the industry pricing regression I discussed earlier needs to become a pricing progression. This means that for now, Halliburton will have to compete with companies that are satisfied with lower levels of short-term profitability, but we don’t believe their pricing is sustainable. You can’t have negative margins forever. In the meantime, Halliburton will continue to maintain our focus on execution and service quality as we defend our position without sacrificing price. I believe that superior service quality is a prerequisite to having a meaningful pricing discussion and our dedication to service quality helped create the profitable results for the quarter.
However, as we also said previously, the North American shale segment remains a wildcard in all of this. Since details of OPEC’s plans surfaced, rig counts have increased by 33% in the United States with over 170 rigs added and a corresponding increase in US shale production already underway.
Second, we said that commodity prices needed to stabilize for confidence in the customer community to improve and investment to accelerate. We continue to believe that North American operators need sustained prices in the mid to high $50 range for this to occur. The North American shale operators’ ability to rapidly increase production has resulted in commodity price recovery being shallower than expected and bringing uncertainty to the sustainability of these recent price increases.
Third, we said that activity needed to increase meaningfully before access service capacity could be absorbed and pricing recovery could take place. We are seeing the first signs of this in select product lines in a few of the North American basins, but I still believe there remains a fair amount of capacity that must be absorbed before service pricing will become more tightly correlated with higher commodity prices and increased activity. With this backdrop it’s clear the market has taken a positive turn and we have all the elements in play for recovery.
Marc Bianchi, Cowen and Company – Analyst 
Okay. What sort of cost inflation items are you watching? Where do you think we’ll see cost increase first? Any comment on how much those could increase, or have increased?
Andy Hendricks, Patterson-UTI Energy, Inc. – President & CEO 
You know, it’s going to be the traditional cost inflation. The first one and probably the most challenging for the whole industry, not just us, is going to be around labor. In drilling, for instance, we kept the wages at the drilling rigs the same for the position. In pressure pumping we’ve cut back on overtime. We’ve cut back on per diem. It’s just been a more challenged business environment.
And so there