Service sector not expected to rebound

According to at least one CEO, the service sector has gone through a structural realignment and is not just experiencing the trough of a classical cyclical market.

Leading CEO predicts flat future, mergers

William Furlow
Editor-in-Chief

According to at least one CEO, the service sector has gone through a structural realignment and is not just experiencing the trough of a classical cyclical market. Curtis Burton, presi-dent and CEO of Grant Prideco's Marine Prod- ucts and Services, points to the consolidation of major operators and the application of new technology as drivers behind the market change for service companies.

To remain competitive in this market, Burton says, service companies must recognize that the market has fundamentally altered and adjust accordingly.

Mature Industry

"One need look no further than the major consolidations, mergers, and realignments that have occurred among the operators over the past five years to appreciate the fact that market fundamentals today differ dramatically from the past," he said.

More than 50% of the service industry's market has vaporized through mergers and consolidations. An additional 10-25% of the market has disappeared due to the impact of technology, Burton said.

"The service industry portion of the energy industry is not cyclical. It has begun the age-old transformation to a mature industry," Burton said. By "mature industry," Burton means an industry that remains vital to society but is likely to play a significantly different role in the future to what it has in the recent past. It is also one that will collapse if it attempts to continue business as usual.

Fewer, larger contracts

The total number of service company employees is now around 50% of what it was 15 years ago, Burton said. While technology has clearly been a contributor, the primary cause for this drop is the reduced size of the customer base. In the boom times of the early 1980s, the world was worried it would run out of oil. Operators popped up everywhere, trying to identify new reserves.

Once adequate reserves were identified, a bust occurred, and the number of major operating companies can now be counted on the fingers of one hand. Fewer customers mean fewer contracts. Substantial reserves mean less exploration drilling. Larger finds represent a shrinking number of overall contracts. The fact that there are now a small number of very large contracts means the service companies face stiff competition to win the projects that are out there. Often, the competition results in service providers winning contracts that are unprofitable. In the short view, this is a problem for the service provider; on a larger scale, it ultimately undermines the viability of the industry as a whole because companies can't get paid a return for the product they deliver.

People asset erosion

Pressures exist on the operator side as well. To remain healthy, operating companies rely on outside investment. To attract investment from Wall Street firms, these companies need two things: growth and lower fixed costs and overhead. "Translate fixed costs and overhead to facilities and employees," Burton said. "Wall Street expects you to behave in a certain way in order to get them to purchase your stock."

So for the past 10 years, operators slashed head counts and consolidated operations in an effort to appear as attractive as possible to the investor. Additionally, he said, oil companies figured out long ago that it is cheaper and less risky to replace reserves by buying other companies' assets instead of drilling for them. This was the logic driving the huge number of mergers in the late 1990s. A 27% decline in E&P spending accompanied massive consolidation after the mergers took place. Drilling dropped off by a third.

This consolidation activity removed a significant pool of manpower from the operator side of the industry. Individual operators controlled more properties, but the logic was that they would need fewer people to operate them. The operator's rationale on head count cutting extended to the whole of the system. In other words, operators often expected their former employees to still be available as consultants from service or engineering companies or as direct employees from service companies.

While in many instances this occurred, the service sector could not afford, on reduced margins, to be the manpower pool of the industry. As a result, much expertise that was once resident in the industry no longer exists, Burton says. This is especially evident when an operator does make a major new find and needs to quickly "ramp up" personnel and activity levels. The tightness in the industry's knowledge base/head count makes this restaffing and engineering challenge practically impossible.

"Mergers have placed a cap on what industry is capable of doing in a given time," Burton said.

The consumer and the 'free market'

"The reaction to this statement in the consumer world might well be, 'So?' Or at least that is the response until gas hits $7/tcf and oil trades at $35/bblU then the consumer wants to know why he is being gouged," Burton said. "The oil industry has done perhaps the worst job in history of educating the public and government about the realities of our business."

Free market pricing can swing both ways. As a result, Burton said, he does not think the public really wants "free market" pricing on energy.

Free market pricing means that when there is an adequate supply, prices are low; when supply tightens, prices jump. The only part of this free market the public, or congress, wants is the low price segment. Unfortunately, when natural processes occur and prices spike, the public doesn't see a free market, they see conspiracy and price gouging. It is exactly the reason the country needs a national energy policy – a nation cannot survive without a sustainable, dependable, reasonably priced energy supply. A simple free market policy cannot provide that, Burton said.

"Up to now, the result of 'free market' has been unpleasant cost surprisesU continuing without a real energy policy and plan will ultimately result in energy not being available at any price," for reasons stated above, Burton said. "Because of the mergers, people issues, and other limitations that exist, there is coming a day when America needs energy that the system cannot supply for a finite period. Maybe this will be a month, maybe it will simply be a protracted period of tight supply – but it will wreak havoc with our economy."

High prices/low activity

Despite high commodity prices over the last five years and increased profits, oil companies have not increased drilling activity. Stagnant activity, combined with already reduced operator staffs, means a smaller market overall. The service companies do not have as much work as they once did.

"Half to three-quarters of the market has just gone away," Burton said.

If half the service companies' clients have disappeared and spending is down by a third, this is not a cycle, he said. The majors have stopped exploring for average-sized fields and turned their attention and resources toward the next "big find." This approach further exacerbates the inactivity in the service sector because the stakes are so high and the necessity is so great that the "big find" must work.

The result is projects that are longer in duration on the front end to ensure they are commercial. This delays contract award, and because the projects being sought are large, there is a concentration of industry activity into a select few, long-duration projects. The overall effect of all these influencing factors is to diminish the available work in the market place.

In addition, because of the massive cutbacks, there is no flexibility left in the staff of the service companies to support these efforts when schedules clash or overlap. Machines and technology can only replace so many workers. Only so many positions can be outsourced, Burton said. If the operators make a major new find, it will require additional service personnel to exploit. This means rapid hiring. Burton said the limited number of remaining employees with experience means service companies that land these large contracts will have to hire these new workers away from the competition. The increase in demand will drive up salaries and costs. The operators refuse to bear the cost of these new hires so the responsibility falls on the service providers. Service companies then run the risk of rapidly rising fixed costs while contracts, which are fewer and larger, become more competitive to obtain.

Supplier side mergers

From the supplier perspective, the thing that has been noticeably absent from the scene has been a parallel consolidation in suppliers and industry capacity to accompany the shrinking customer base. Real profitability and long term viability for the service sector can only come from consolidation. He said the concept that the cycle is down this year but will rebound next year is not a viable approach to a healthy business in the 21st century.

While acquisition among service companies has brought a lot of new technology and capabilities in house over the past few years, this is not the type of merger Burton is referring to. These deals were, for the most part, acquisitions by the large service companies of smaller, key players. What Burton is looking for would be similar to what has occurred among the drilling companies. Larger, integrated provi-ders coming together to further reduce fixed costs and, more importantly, according to Burton, provide a unified front to avoid exploitation by a shrinking customer base.

Burton said it is a mistake to look at a merger strictly in terms of synergy. While there will be some cost savings by eliminating redundancy, the idea that the one big company will run more efficiently that the two smaller ones simply has not been borne out in fact. The real drivers are final company size, matching capacity to industry needs, and streamlining of operations. By increasing the scope of a service company and at the same time reducing the number of competitors for the larger contract service company, mergers would insulate and protect this sector of the market, guaranteeing a stronger negotiating position and supporting reasonable profits. Otherwise, the service companies will become increasingly unprofitable as they fight amongst themselves for a dwindling number of contracts.

"Bad things are just going to get worse, if major changes aren't made," Burton said.

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