We Should Watch: Is Key Energy Right And US Service Costs Will Return To 2015 Levels in 2017?
Mar 7, 2017
The who’s who of the energy world are in Houston for CERA week. The reporting has started and it is on the global view of oil and gas being said by OPEC, supermajors, politicians, and major energy agencies in their speeches or on the sidelines. But we expect energy followers will walk away with a major impression on something that isn’t a focus of the speeches – the US oil and gas service sector is running at full tilt. CERA is in Houston, the center of the US oil and gas industry and that means the day to day oil and gas buzz will be evident to anyone. And the buzz of a full speed ahead US service sector will then focus on how much capacity is there to expand, in what time period, and are service prices (costs to the producers) going to break out.
Our March 5, 2017 Energy Tidbits highlighted “the first service sector warning heard to date (by Key Energy) that service sector prices will return to 2015 pricing levels by year end 2017.” We have not seen other US service companies or producers come out with this bold of a prediction for US service costs, but its worth watching. If Key is even directionally right, higher service costs on the top plays will ultimately flow thru to all US plays and spill over into Canada. It will change the assumption of modest service price increases in 2017 and continuing in 2018. Higher service costs can be absorbed by the higher quality plays, but as always happens in rising costs or declining prices, it’s the lesser quality plays that get hit the hardest
Quarterly reporting is data overload time, and the focus is on individual company detail and valuations. But quarterly reporting also provides nuggets of information that are relevant to a broader view of the sector, oil and gas commodity and markets. The primary concept driving this “We Should Watch” series of blogs (more blogs in this series to follow!) is to look at the massive overload and try to identify potential trends or changes to help shape investor’s view to the energy sector. A key source is quarterly earnings calls. So far, we have reviewed ~100 Q4 calls for the <5% of any call that has broader sector implications. We also believe it is critical to review as many calls as possible to get these individual company nuggets and form a broader picture of the sector theme and not just a specific company event. Hidden behind the volume of detail on numbers, forecasts, wells and valuations is often a comment or tidbit that makes us pause and think what if this is right, or what if this continues to build. In other words, its something we should watch.
Key sees a return to 2015 service sector pricing in 2017. Key made a bold comment in their Q4 call that service sector pricing was increasing strongly in 2017. Key is a small cap (~$0.6 billion market cap) US service company, who held its Q4 call on Feb 28. Key said they started to move to increase its pricing in Dec. Mgmt said “So, to that end, we began pursuing pricing discount recovery in December in some market services with increases in the range from 5% to 25% depending on the service and location. Those efforts continue today.” But the bold statement was looking ahead to the balance of 2017, saying “With that said, we expect a continued uptick in activity throughout the course of 2017. We expect more pricing discount recovery as we get into the second half of the year as the market continues to tighten further. Broadly, we would expect the pricing to return to 2015 levels by the end of this year as activity returns to comparable levels.”
US rigs today are down 58% from 2015, but high end rigs/crews are fully utilized. The big service sector prices in 2015 were based on entering 2015 at record drilling levels. But even though rigs are down 58% from 2015, the service sector is running full tilt in all the major areas i.e. The service sector is nearing a comparable level of utilization. In 2014, US rigs were between 1,800 to 2,000 total rigs (~1,600 oil rigs, ~300+ gas rigs). US rigs were >1,800 starting 2015, but steadily declined ending 2015 at ~700 rigs (560 oil, 140 gas), kept declining to its trough of 404 total rigs (316 oil, 88 gas) on May 27, and have increased 87% since then to reach 756 total rigs today. However, at today’s ~800 rig, the service sector is running at full utilization, or at least full utilization of the services that can work in the top US resource plays. The common comment from the Q4 service sector calls was that all high end rigs are utilized and that rigs are having to be reactivated to meet increasing demand. So even though rigs are less than half Jan 1, 2015 levels, the service sector is running at full utilization, at least for the high end rigs. Another key constraint is labor. The service companies say that all experienced crews are at work and that labour has to be added and trained for the next round of rig increases. There are other stress points noted in the Q4 calls, in particular the hugely increasing demand for sand/proppant with the increasing proppant per frac, increasing fracs per well and increasing drilling.
US shale players only see modest service price increases in 2017, but they locked in long term prices in 2016. We reviewed all of the big US shale player Q4 calls and their common message was that 2017 service cost increases would be modest. However, there is a reason for only modest price increases in 2017 – most of them proactively locked in lower 2017 service costs under long term contracts in 2016 when service prices were weak. Two of the many examples are Cabot Oil & Gas and ConocoPhillips. COG said “Approximately 75% of our costs are locked in under term contracts, so we are anticipating only a slight increase in well cost by year-end.” In its Q4 call Q&A, COP replied “And then the third piece is that we have, as you heard me talk about before, done some locking of cost levels, and so we’re benefiting from that as we go through 2017. We’ve got cost locks on various contracts that are on the order of over a year or less that will kind of slow down how we see some of this inflation as we go through 2017. So overall, with what we’ve seen so far, I think we’re kind of broadly in line in 2017 with where we were in 2016.”
Big US service companies see more demand, but did not provide guidance on service price increases at year end 2017 and for 2018. Key was basically a lone voice to predict or guide to a strong level of price increase for year end 2017. Rather the big service companies (Baker Hughes, Halliburton, Helmerich & Payne, Nabors, National Oilwell, Patterson UTI, Schlumberger, and Weatherford) in their Q4 calls were positive on increasing demand for services and service sector prices. The big question for service companies was best said in the Baker Hughes Q4 call Q&A, when mgmt. replied “We’re starting to – I think we’re on the cusp of a sustained recovery. The question is timing and intensity, but it’s certainly looking a lot more positive.” So we shouldn’t be surprised that, in the Q4 calls, the big service companies didn’t provide guidance on any specific level of price increases to end 2017 or for 2018. Plus most of the big service companies shares are doing well so we suspect the last thing they want to do is overpromise in a positive stock price environment. The only one who stepped out in a more aggressive outlook was Weatherford, who said “In 2017, absent the U.S. pressure pumping business, we expect strong growth in North America, driven by completions, artificial lift, managed pressure drilling, and drilling services, with pricing power improving right through the year as supplies tighten”, and in the Q&A mgmt. replied “And so, international pricing is going to be recovered more gradually. North America pricing is going to recover in a more robust fashion.”
Increasing service costs in the big US ultimately have a spill over to impact Canada. Other than Key, we haven’t seen US service or producers make a specific call for a big increase in service prices for year end 2017 or into 2018. As a result, most assume modest service price increases in 2017 and 2018. These assumptions will change if Key is even directionally right that US service costs will reach 2015 levels by year end. Higher US service costs ultimately flow thru more broadly to all the US plays and have a spill over impact to Canada. Offsetting the potential for higher than expected service price cost increases is that producers continue to get better completions/wells in all the key resource plays. These materially stronger per well results mean that stronger than expected service prices can be absorbed in all the quality plays in the US and Canada. It will just make the producer growth in these quality plays a little more expensive and take a little longer than expected. However, as normally happens in a cost escalation scenario, the higher costs have a bigger impact on the lesser quality plays pushing them back to the margin. So for the good plays, it may well be that $55 oil is the old $70, but for the lesser quality plays, $55 oil may turn out to be the old $45.