notes - energy workforce

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Evercore ISI: Oilfield Services, Equipment & Drilling

May 20th, 2020

James West +1 212 653-9047

[email protected]

What Happened?

4

Already felt like the industry had been in a downturn since the middle of 2014 before going into this latest unprecedented decline driven by a decline in oil prices and enhanced by Covid-19 logistical issues.

Oilfield Services companies were facing challenging fundamentals, overleveraged balance sheets, and increasing investor apathy.

Many companies had started restructuring efforts, pulling costs out, making changes to strategy and compensation since 3Q19. These efforts have accelerated since March 2020 as revenue is poised to sharply decline in Q2.

Narrative has shifted towards survival and protecting liquidity.

Unprecedented Downturn

Key Timeline Since Start of 2020

Source: Bloomberg, FactSet, Evercore ISI Research

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$15

$25

$35

$45

$55

$65

$75

OSX Oil Price

Brent

WTI

OSX

Oil Services begin reporting 4Q20 earnings Oil price peaked

OPEC+ collapse,

Saudi declare war

China alerts

WHO of

several

pneumonia

cases China reports

first death;

disease

spreads

outside of

China

WHO declares outbreak a

global health emergency;

first death outside of

China; Trump restrict

travel from China

WHO names

COVID-19;

first death in

Europe

Disease spreads

to MidEast and

LatAm; Italy

begins lockdown;

Trump asks for

$1.25B emergency

fund

First US death;

Trump issues

additional travel

warnings

Trump declares national

emergency

OPEC+ Emergency

Meeting agrees to

9-10MMbpd cut

Texas RRC meets

with NAM E&Ps E&P companies begin

slashing capex budgets

Crude contracts

go negative

Macro Outlook Improving

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Supply will exceed demand and inventories will rise to record levels in Q2 2020. But the Tide is Turning - demand will exceed supply and inventories to draw by mid-year 2020 and fall further thru 2021.

Stronger demand and reductions in supply have flattened the curve for global oil inventories. We maintain our Brent forecast of $40 and $50/bbl at YE 2020 and 2021. Brent could move into backwardation during Q3.

Our forecast calls for 2020 global oil demand to decline by -8.7mmbpd while global oil supply will fall by -6.8mmbpd.

Record global inventories near 75 days are likely approaching a peak. Will fall to 55 days by year end 2020 and 45 days by YE 2021

US production growth has declined in 9 of the past 12 months. Declines will gain momentum in the coming months. NAM production exit rate at year end will likely exceed 2.0 mmbpd.

Global Oil Supply to Exceed Demand, But Tide is Turning

Oil Supply Will Exceed Demand in 2020 US Shale Production Declining

Source: IEA, OPEC, EIA, Evercore ISI Research Source: EIA, Evercore ISI Research

Is That Enough?

8

Investors have fled the energy sector in pursuit of higher returns driven by other sectors of the economy. Oilfield services equities have decoupled from crude prices for the past several years.

Capex never recovered to the 2014 peak and is now plummeting again. 2020 will likely be almost 55% below the 2014 peak.

We forecast a 40% drop in North American E&P spending in 2020.

Industry change is imperative. There is still too many companies (320 OFS firms at the end of 2019), too much debt (industry at ~$280B but nearly 85% held by E&Ps), too many assets, and too many management teams!

Sector Headwinds Will Continue Past Covid-19 Unless Behavior Changes

Price Performance of S&P 500 vs S&P 500 Energy Stocks E&P Capital Expenditures Will Fall Sharply in 2020

Source: Bloomberg, Evercore ISI Research Source: Evercore ISI Research

0

600

1,200

1,800

2,400

3,000

3,600

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

S&P 500 Index

S&P 500 Energy

Our Playbook for Value Creation (And Higher Stock Prices)

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The Path to Value Creation is Not Easy

Capital Discipline

Shareholder Aligned

Compensation

Consolidate

Market Share

The Original “Pledge” The Pledge: Part Two

A year ago when “The Pledge for Oilfield Services” was released we were adamant that companies do the following:

Espouse disciplined spending and consider returning surplus capital to shareholders.

Employ returns-based performance goals at the C-suite that will likely increase intrinsic value in the equity market (ROIC).

That framework is still intact, although this year’s The Pledge: Part Two goes one step further and calls for a heightened

sense of urgency for companies to consider consolidation. Value creation for OFS is a “nice-to-have” at this point and

given some of the perils facing a number of upstream companies at current commodity price levels, service

providers catering to E&P customers need to consider greater scale in order to avoid significant value destruction.

There simply are 1) too many assets, 2) too many companies, 3) too many management teams, and 4) too much debt! The

opportunity to raise new capital (debt or equity) isn’t available. The industry needs massive consolidation.

The Oilfield Service sector has low returns on capital, declining revenue and is highly fragmented. Standardization, saturation

in key markets, declining product differentiation and rising buyer sophistication nullifies assertive pricing strategies across the

sector.

It’s of little coincidence that the most fragmented product lines within OFS are also some of the more economically

challenged. Market growth and the invention of U.S. oil shale are the key reasons why new entrants entered the

market.

Hydraulic Fracturing Offshore

Drilling

Offshore Construction

Land Drilling

Subsea Equipment

Artificial Lift

Cementing

Completion Equip.

Geophysical Equip.

Rig Equipment

Rental & Fishing

Supply Vessels

Downhole Drilling Tools

Unit Manufacturing

Well Servicing

Casing & Tubing

Logging While Drilling

Inspection & Coating

500

1,000

1,500

2,000

2,500

3,000

3,500

-12% -8% -4% 0% 4% 8% 12%

Concentrated

Moderately Fragmented

Fragmented

HH

I S

co

re

10 Year Revenue Growth

It’s Simple: The Four Too’s

10

Time Is Of The Essence

Increases in returns on invested capital are typically followed by a growing number of small companies that enter

the market. We’re not against a competitive marketplace but this kind of behavior has been counter-productive to the sector.

The number of companies with less than 5% market share in their respective product line increased by nearly 30% from 2008

to its peak of nearly 500 in 2016. Despite the massive amount of stress placed on the OFS industry these past four years,

today there is only 3.4% less of those companies operating within the industry. More work needs to be done.

One mental heuristic that companies could abide by is that they should pursue consolidation until they have at least

a 15-20% market share in their product line. The benefits of scale and a more concentrated operating environment should

hopefully raise the barriers to entry and inhibit adverse pricing behavior and unfavorable supply/demand scenarios.

386 397 411 422 439 470 484 491 496 488 480 479

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

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# of Firms With <5% Share in Each Product Line OFS Companies With <5% Share In All Product Lines

11

Where Are We Now?

13

US land rig count was relatively resilient in Q1, declining by 4.2% sequentially. This compares to the prior three quarters of -11%, -7.5%, -5.5% respectively.

Thus far in Q2, the US land rig count has declined by 39% from Q1 levels. It fell below the 400 level in early May for the first time since June 2016.

We now expect the US land rig count to decline by 55% in 2020. Most of the rig count decline will occur in Q2.

E&Ps have been quick to revise lower capex budgets, with North American changes being more acute than International (where we expect capex to fall a more modest ~15%).

US Land Rig Count Pulled Back Sharply in April and May

Source: Baker Hughes Rig Count, Evercore ISI Research

Evercore ISI US Land Rig Count Forecast

Negative Revisions to Capex Budgets by Region

Source: Baker Hughes Rig Count, Evercore ISI Research

14

Several pressure pumpers deployed spreads early in Q1 as completion activity picked up and utilization improved.

Then the industry quickly cutback on completion activity in March. The active completion crew count fell below 100 in April and then below 50 in May. It could be in the 30s today.

We expect pressure pumping utilization will now fall quickly from the low-to-mid 50% range in Q1 into the 25% range in Q2 before improving briefly in Q3. We think utilization falls below 2016 levels.

Pressure pumpers are responding by stacking spreads, laying off workers, and lowering costs. Quick change in direction from adding spreads to stacking in less than 2 months time.

Frac Holiday – Not Much Completion Activity Happening Right Now

Source: IHS Pacwest, Evercore ISI Research

Evercore ISI Pressure Pumping Forecast

Pressure Pumping Demand Collapsed Quickly


15

Brent moves into backwardation from contango in Q3.

Drilling permits likely near a bottom as April levels were the lowest permit count since 2006. On a YTD basis, permits are down 61% YoY with privates driving most of that decline (-98% YoY).

Weekly rig count declines are starting to shallow out. Last two weeks have averaged a decline of 33 rigs dropped versus 50 since the downturn has started.

Recovery likely looks like a ‘W’ in US land – Q2 activity down sharply, Q3 rebounds slightly, budgets get fully exhausted early in Q4 which then causes another decline in activity levels into year-end.

Bottoming Process Starting?

Drilling Permits Bottoming Declines Shallowing Out

Source: Evercore ISI Research Source: Baker Hughes Rig Count, Evercore ISI Research

16

Offshore activity is typically more resilient to oil price shock due to longer rig contracts, a high mix of development activity, lease commitments, customers taking longer term views, and a host of other reasons.

But offshore has been less resilient this time around than in pass cycles.

Both the floater and jackup rig count are falling at an unprecedented rate due to early contract terminations or as contracts are completed and options are lapsed.

Offshore Falling At An Unprecedented Rate

Global Floating Rig Count Global Jackup Rig Count

Source: IHS-Petrodata, Evercore ISI Research Source: IHS-Petrodata, Evercore ISI Research

17

Contracting activity tracked steadily lower for five straight months as oil prices declined, but new contracting activity appears to be stabilizing at a floor run rate of 2-to-3 signings per week.

Operators announced several contract force majeures, rig tender cancellations and project deferrals in March and April but the pace of these announcements have also eased.

Contractors announced several rig retirements, cold stacking, impairments, write-offs and restructurings during 1Q earnings, confirming a day of reckoning has arrived.

But The Fallout Looks To Be Bottoming As Well

Monthly New Offshore Rig Contracts

Source: IHS-Petrodata, Evercore ISI Research

18

Companies going through restructuring will emerge stronger and unencumbered to kick off a much needed consolidation wave in the fragmented offshore drilling industry.

The reacceleration of rig retirements will result in a dramatically smaller global fleet, floater supply down 32% from the 2014 peak to 220 vs. the long term demand estimate of 180-220 rigs.

The shallow water replacement cycle is entering a second phase and the global fleet has significantly high graded.

Pricing power may finally shift back in the hand of contractors when demand improves.

Set-up Is Encouraging For The Long Awaited Multi-Year Upcycle

Global Floater Supply Global Jackup Supply

Source: IHS-Petrodata, Evercore ISI Research Source: IHS-Petrodata, Evercore ISI Research

200

220

240

260

280

300

320

340

YE '13 YE '14 YE '15 YE '16 YE '17 YE '18 YE '19 2020

Newbuilds Retirements

400

420

440

460

480

500

520

540

560

580

YE '13 YE '14 YE '15 YE '16 YE '17 YE '18 YE '19 2020

Newbuilds Retirements

What’s Next?

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Peak US production had already been reached with growth limited by geology, technology, technique and capital.

Shutting in 5+ mmbpd in 2Q20 does further irreparable harm to the reservoirs.

Fewer oilfield services suppliers are needed in the new normal, but more technology is needed rather than brute force.

Re-sizing The US For A 10 mmbpd Supply Chain

Reimaging the US Upstream

Alaska

0.5 mmbpd Permian

3.6 mmbpd

180 rigs

$25 Bn capex

GoM

1.75 mmbpd

Williston

1.2 mmbpd

25 rigs

$6 Bn capex

Eagle Ford

0.95 mmbpd

25 rigs

$5 Bn capex

Mid-Cont

0.4 mmbpd

15 rigs

$2 Bn capex

Niobrara

0.5 mmbpd

10 rigs

$1.8 Bn capex

Other L48

1.0 mmbpd

Source: EIA, RigData, Evercore ISI Research

21

We are making a call for technology to disrupt the Oil Patch. In our view, the combo of learning to survive in a $35/bbl world and an industry largely still in the “intermediate stage” of technology adoption makes this a ripe opportunity.

Our proprietary survey of 160 Energy executives paints the “Digital Road Ahead”. Expect for AI / Machine Learning, Mobile Operations, and the Industrial Internet of Things (IIoT) to play a pivotal role across the oil and gas value chain.

Hopefully new commercial models distribute the value capture accordingly. It remains to be seen whether or not Oilfield Service providers can earn adequate returns on technology investments that have largely benefited the customer.

The Digital Road Ahead

Source: Evercore ISI Research Source: Evercore ISI Research

Where would you consider your company in terms of its digital journey?

3% 17%

46%

27%

7%

Not started /n/a

Novice /beginner

Intermediate Advanced Elite / Fullyintegrated

What role do you believe technology and especially digitalization and / or AI

and automation will play within the Oil Patch?

8%

1% 8%

46%

38%

Non-issue Not importantSlightly important Important Critical

What About The Equities?

79% 109% 117% 66% 67%

40%

55%

70%

85%

100%

115%

130%

3/10 3/17 3/24 3/31 4/07 4/14 4/21 4/28 5/05 5/12 5/19

Group 1 Group 2 Group 3 Group 4 Group 5

Balance Sheets Will Drive Near-Term Stock Performance

We recently updated our bi-annual liquidity analysis for our entire coverage universe and believe that the “Haves” and “Have Nots” that we identified will see their equities predominantly driven by perceived liquidity sufficiency or shortfalls.

The companies in the lower half of the bottom-left chart were identified as those with potential liquidity challenges across the near-term. Our liquidity-driven investing framework has identified a half-dozen firms that have entered restructurings or cut their capital distributions.

The average stock price performance of all Group 1-3 companies indexed to March 9th, 2020 have significantly outperformed their peers in Group 4-5 companies. Forget the fundamentals and ESG considerations, liquidity will become the key indicator to focus on as the sector works through this downturn.

Group 1: Strong survivors

Group 2: Solid but cuts will be made

Group 3: Fine, with less breathing room

Group 4: OK but keep an eye on it

Group 5: Critical challenges ahead

The Results of Our Liquidity Analysis Price Performance of Stocks by Group Indexed to 3/9/2020

Liquidity Trade

23

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BKR NOV TS FTI MRC HAL PD.ca HP SLB LBRT SOI

APY EXTN NR RES ASPN BASX OII SLCA CLB FI OIS SND ERII ICD PUMP THR GTLS NEX QES PTEN

CFW.ca TDW DO RIG HCR RNGR NBR SHLF.osl TCW.ca

BDRILL.osl IO VAL CVIA PACD ESI.ca SMHI FET SPN FTSI TTI

1

2

4 5

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Each month Evercore ISI surveys institutional equity managers and asks them if they are overweight of underweight the 11 S&P sectors.

Energy clearly remains underweight and well below historical holdings.

S&P Energy underperformed the S&P 500 for the 7th time in 8 years in 2019. Significant capital discipline, corporate governance and pay for performance issues plague the sector.

Return on capital employed for S&P 500 Energy stocks declined from 19% to 8% during the past decade and valuation declined.

Institutional Equity Sector Allocation Survey

Source: Evercore ISI Research

Energy Remains Well Below Historical Holdings

Portfolio Managers Remain Underweight Energy


Questions & Answers

Analyst Bio:

James West is a Senior Managing Director responsible for the research coverage of the Oil Services, Equipment and Drilling industry consisting of detailed fundamental research on over 70 companies. Prior to joining Evercore ISI, Mr. West was a Managing Director and Senior Research Analyst at Barclays and Lehman Brothers for a combined 15 years.

Since assuming lead coverage in 2011, Mr. West has been top ranked in Institutional Investor, including number three in 2011, number two in 2012 and number one from 2013 to today. Prior to joining Lehman Brothers, Mr. West worked at Donaldson, Lufkin & Jenrette. Mr. West received his B.A. in Economics and a minor in History from the University of North Carolina at Chapel Hill.

26

James West Oil Services, Equipment & Drilling Evercore ISI

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