WORLDWIDE FORECAST 2001 - Industry disparity: Majors enjoy record earnings while services struggle

Oil companies are lean and mean. They've shed people and competencies in an effort to focus on developing or buying oil and gas reserves. As a result, service companies are taking up the slack in historical producer functions. Research and development (R & D) is an example. Once soundly established within the ranks of the majors, the function was taken up by service providers. Of course, this means a great deal of overhead that cannot be passed along through fees or contracts.

There have been consolidations and belt tightening among service companies at a time when oil prices, and oil company profits, are rising steadily. Although the service sector is dominated by a handful of players, the companies continue to cut prices to compete for contracts.

Why can't the service companies recoup this investment from these clients the research was designed to serve? According to Jim Wicklund, Managing Director of Energy Research at Dain Rauscher Wessels, the competition is too tight. In an effort to secure contracts with operators, the service companies are cutting their fees and ignoring the value of their own technology. He said there is real value to be had from advancements in technology made by the major service companies.

Services future

Speaking at the 12th Oilfield Breakfast Forum in Houston, Wicklund gave the example of seismic companies. While no other service provider has done more in the last five years to reduce the risk involved in exploring for oil and gas offshore, only two of the major seismic companies are profitable.

This lackluster stock performance can be traced to the volatility of the service industry. Fortunes of these companies rise and fall with the price of oil, scaring away investors who would prefer a steady rise to the dramatic peaks and valleys. While an oil company still has value, even when oil prices are at $11/bbl, what is the value of a service company?

If there is no activity, then the service company has no contracts. In an effort to please Wall St., Wicklund said he predicts the service companies of the future will be less vertically integrated and more segmented. With only a handful of companies competing in a particular service sector, there will be greater bargaining power.

The service companies have steadily attracted some of the best minds in the industry. By picking up the experienced engineers let go by the majors, service companies have built a strong brain trust that would be hard to duplicate. High turnover, due to layoffs, has made petroleum engineering a less attractive career. The US graduated 150 petroleum engineers last year, and Wicklund said there are only 300 students currently enrolled in these programs.

Take on risk

To benefit from this advantage, the service companies need to take a fresh look at their role in offshore exploration and production. Rather than taking the traditional fee for service, these companies need to overcome their risk aversion and participate in the profits of oil plays.

This is where the oil companies make their money, and the improved margins are in a big part due to new seismic, drilling, and production technology developed by the service companies. "If oil companies benefit from new seismic technology, who should pay for the research and development?" Wicklund asks.

He advocates partnerships between the oil companies and service companies. Joint ownership of the technology would fulfill the two companies' mutual needs and provide the service companies with adequate returns.

Shifting perspectives

Historically, amidst competition, service companies break down and reduce their fees, rather than stand by the price, with a willingness to walk away from what they perceive as inadequate compensation. The fear is that if they don't compromise on price, then the oil companies will take their business to someone who will compromise. "Their thinking is: We're just a service company, if they decide to stop using us, we're dead," Wicklund pointed out.

The difference now is that there are only about three providers in each of the major service areas. It used to be that hundreds of "mom-and-pop" companies were competing for this business. Because there has been such consolidation, the oil companies do not have as many options as they once did.

If a service company refuses to buckle on price, then the business would go to a competitor at a lower price, allowing the first company to seek other, full-price business. In the wake of recent industry growth, the idea that service companies would not be willing to lose customers to the competition at any price is changing. If the service provider was working at capacity, then this new business would force it to put on an additional crew for no additional revenue. That means winning the work would actually generate a lower rate of return.

Technology shift

In the past, when new technology was generated by oil producers, it was proprietary. Only the company that developed the technology could use it, and this would last until the competition could copy the advancement. Now that the research and development resides in the service sector, new technology is offered across the board to any oil company willing to pay for it. This is an advantage the service companies do not make use of.

According to Wicklund, it all comes down to realizing the value of new technology. If the service companies can explain the value of the technology they paid to develop, and stick by a price that reflects the value of this technology, then the producers may be forced to share the enhanced savings or profitability resulting from the deployment of the new technology. Until that time, the service companies will continue to offer similar advanced technologies to the same clients and compete strictly on price.

Win-win

The solution is a win-win arrangement, in which the oil companies turn over control of a field to a service company, agree on a fee, and then offer a bonus if the project is completed under budget or before the deadline. On the other hand, there would be a penalty if the project goes over budget or misses deadline.

This allows service companies to make use of their high-value technologies to earn the bonus. Because this would bring a project online earlier, producers would realize production earlier, improving the net present value of the capital. This, in effect would generate a bonus for the service company. It is a win-win situation because this is revenue that would not have existed if the service company was not able to bring the field or product online early.

The only thing standing in the way of this improved method of compensation is the producer's attachment to approaches developed years or decades ago. The major oil producers are concerned that if the service company can beat its goals and earn a bonus, then this makes the producer appear as a bad performer. "It's the dilemma of the oil companies, they want value, but they want it cheap as a buyer," Wicklund point out.