Service & Supply Outlook Report

Executive Summary

Cost-cutting to manage cash flow is the dominant trend in the service and supply sector in 2015. That trend will continue in 2016.

After five years of over-investment in the global oil and gas industry, supply outstripped demand in late 2014, leading to an almost 50 per cent decline in 2015.

The low prices, combined with rapidly inflating finding and development and lifting costs, squeezed producer cash flows, resulting in a 20 per cent cut in capital expenditures globally.

With high supply costs and lower oil and gas prices due to lack of market access, the western Canadian industry was hit particularly hard in the 2015 downturn. Producers cut capital expenditures by 40 per cent, representing over 20 per cent of the global expenditure cut. The capital expenditure cut resulted in an over 50 per cent decline in field activity as producers went into survival mode. Service companies faced demands for major pricing concessions as the industry restructured for a lower-for-longer commodity pricing decline.

Early in 2016, the overhang in supply continues, resulting in accelerated price declines. While there is little clarity of 2016 capital expenditures for Canadian producers, our preliminary analysis of 45 producers indicates a capital expenditure cut of 29.5 per cent in 2016 compared with 2015.

While industry activity forecasts for 2016 have been flat to slightly declining compared to 2015, most came out in early winter before the major price slide in December and January. We are expecting the well count to decline by a further 19 per cent based on well licensing data, rig utilization and company drilling intentions early in 2016.

To understand how the western Canadian service and supply industry are managing their operations in a lower-for-longer commodity price downturn, JWN, in partnership with Grant Thornton, conducted a detailed review of the oilfield service and supply market and an exhaustive survey of service and supply company leaders concluding in mid-January.

MARGINS BEING SQUEEZED, RAPID DOWNSIZING UNDERWAY

What we found was an industry facing deteriorating financial health, with the majority of respondents reporting declining profitability in 2015. After five years of expansion, the survey respondents said they were focused on downsizing operations to reflect activity declines, while looking for cost savings in response to demands for pricing concessions. However, only a minority of service providers seemed focused on restructuring their operations to survive and prosper if prices remain low for the longer term.

Almost three-quarters of survey respondents reported declines in profitability in 2015.

Two-thirds reported laying off employees to help manage cash flow, while 63 per cent reported nonemployee related cost reductions. Nearly 40 per cent reported selling down inventory or selling assets to manage cash flow. Surprisingly, only 16 per cent reported restructuring or renegotiating debt payments. Only seven per cent attempted to raise additional capital.

Sixty-five per cent of respondents were asked to take price cuts of some kind, with 31 per cent reporting customers asking for cuts of over 30 per cent.

While half of service companies reported cutting their own costs in 2015 due to market pressures, a quarter of respondents reported costs actually increased. Service cost declines failed to keep pace with revenue declines, resulting in narrowing profit margins.

Going into 2016, the survey respondents expect continued downward pressure on profitability. Around 29 per cent said they were pessimistic or very pessimistic they will be able to maintain operations if low prices continue for the long term.

Around 28 per cent expect to struggle to access necessary capital in 2016. Nearly one quarter expect to go under a financial restructuring in 2016, while around 15 per cent expect to sell assets.

Most expect to continue downsizing in 2016 as industry investment and field activity continues declining. Half expect downward pricing pressure from customers to continue, with almost a quarter expecting demands for greater than 10 per cent price reductions.

POCKETS OF OPTIMISM

Despite the widespread pessimism in the service sector, some respondents see opportunity and are capitalizing on it. Around half of respondents said they are optimistic or very optimistic their organization will have enough capital reserves to remobilize when prices improve. And around 30 per cent are optimistic or very optimistic they will find new business opportunities in 2016.

Industry consolidation is expected to pick up in 2016 as financially stronger enterprises prey on the weak. Around 13 per cent of survey respondents expect to be active in the mergers and acquisitions market, with larger companies most focused in this area.

Efforts to restructure operations in light of market conditions, however, have been slow to take hold. Most respondents seem willing to wait for the market to improve rather than taking proactive steps to ensure their future viability in a lower-for-longer market.

When it comes to innovation, 38 per cent rated cost cutting as their number one priority. Respondents said they are looking for their customers to take the lead in driving innovation forward, rather than taking the initiative themselves.

Despite many oil-producing regions facing less drastic cutbacks than the Canadian industry, few respondents are looking to expand geographically. Less than 10 per cent are pursuing international opportunities.

OTHER KEY FINDINGS

The survey respondents said they were taking a number of steps to manage cash flow through the downturn. They are also looking at M&A opportunities, and they are looking at developing new markets.

• Service and supply companies have instituted widespread layoffs and salary cuts across the sector. Equally important is the depth of the cuts, with exploration and development and field operations executives at the two workshops reporting cutting as much as 55 per cent of their staff. They said they had cut employees down to the core and expect to have difficulties rehiring when better times return. This will likely make skilled worker shortages worse in any recovery. It will also create opportunities for companies with the financial ability to pick up top talent. The attendees also reported that cutting employee compensation is difficult for companies that work in the field, as wages have to be high enough to attract people to an industry with largely seasonal work.
• M&A activity is expected to pick up in 2016, mostly focused in companies with over $50 million in revenues. Workshop attendees in Calgary said both consolidation and integration are needed in the service and supply sector to reduce costs. Consolidation needs to happen in companies targeting the same market, as there are too many players. This would provide economies of scale and cut costs. Integration needs to happen between companies offering complementary services. Currently there can be as many as 100 different suppliers involved in drilling a well. There was agreement that banks have a lot of power right now and could play a key role in forcing consolidation and integration. There was also general agreement that consolidation and integration would have to be forced on the industry.
• Investing in improving business processes presents the best opportunity for service companies to cut costs, according to the respondents. Workshop attendees and interviewees said companies should focus on automating as many processes as possible to cut labour costs. They should also look closely at their supply chain with a goal of consolidating suppliers.
• The days of oilsands megaprojects are over. If oil stays below $50/bbl and remains volatile for the next few years, no new large-scale projects will begin. With shale oil wells paying out in 18 months, they are a much lower risk than greenfield SAGD development, which can take three to five years to ramp up production, according to workshop attendees. Service and supply companies targeting the oilsands should focus on the MRO market and smaller-scale thermal developments.
• Twenty-nine per cent of respondents were either pessimistic or very pessimistic they could survive sub-$50 oil for an extended period of time. Smaller companies were much more pessimistic than larger companies, which could create the opportunity for bolt-on acquisitions.This could lead to an increase in M&A activity, more asset sales and further capacity issues in the event of a turnaround.

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