Source: Tom Armistead of The Energy Report (9/4/14)
Consolidation is coming to the oil and gas industry, says Brandon Dobell of William Blair & Co. As economic recovery takes root, oil prices will stabilize at current levels and interest rates will remain low, creating conditions for mergers and acquisitions among explorers and producers and, in a ripple effect, among the oil field service companies they employ. In this interview with The Energy Report, Dobell offers a surprising prediction for a service company he expects to see playing in the big leagues soon.
The Energy Report: Brandon, oil prices are declining globally. Should investors be concerned about that?
Brandon Dobell: There are a couple of angles to focus on here. Oil prices were strong in May, June and July, and geopolitical tensions in the Middle East, as well as Russia, put stress on expectations for supply. On the heels of that, in recent weeks relatively weak economic data points have come out—out of Europe, in particular.
For investors in the U.S., let's call oil prices a mixed bag. After a run-up in both West Texas Intermediate (WTI) and Brent prices, recent economic data points have forced oil prices down a bit. They were high, so weaknesses off a high level are not too concerning. But investors, like explorers and producers (E&Ps), have to pay attention to the prices they can realize in the market. They must pay attention to the price level, but also to the trajectory or velocity of change in commodity prices.
Most conventional basins are economical at current levels. Production costs, or break-even costs, are $60, $70, even $80/barrel ($80/bbl) in some of the unconventional basins and the offshore theaters. Weighing concerns for operators, price per barrel is a graduated scale. At $90/bbl, I don't think anybody is too concerned. At $80/bbl, you're going to have some concerns about production in some of the unconventional basins. Some of the shale basins in the U.S., for example, start to get a little wobbly. Operators get nervous about the prices they can realize in the global markets. As you track below WTI of $80/bbl, you start to impact activity levels a lot.
The plus side is there's not an awful lot of spare capacity globally. The Middle East, in general, doesn't have the ability to flip a switch and pump more crude oil, like it had in the 1970s or 1980s. North American production has helped buffer some of the lack of spare capacity in the Middle East, but we can't turn that production on and off automatically—that's not the way unconventional shales work. Prices have more downside protection than in previous years given the lack of spare capacity and the types of basins generating oil and gas.
But there is concern, of course, which has been reflected in energy services stocks and in oil and gas stocks in the last three or four weeks, post-Q2/14 earnings and performance reports. The weak performance since late July is a reflection of both high expectations going into Q2/14 earnings, and concern that oil prices below $90/bbl will get operators to think about how much money they deploy to drill and complete new wells.
TER: Do you foresee any further slippage than what's already occurred?
BD: It wouldn't surprise me, but I don't expect a major downtick. I would expect the geopolitical wrangling in the Middle East and Russia, which are about supplies of energy, to continue. Whether we've seen de-escalation of tensions in those regions is a tough question to answer. De-escalation would probably put pressure on oil prices because people would be less concerned about supply.
It feels like the path of least resistance is for prices to move lower, but the lack of global spare capacity continues to be important to the overall commodity price. If capacity goes too low, supply starts to dry up. Projects on the verge of becoming economic get delayed. Any geopolitical shock could tighten up supplies quickly. Those factors would tend to put a higher floor on oil prices than we would have seen three or four years ago, when there was more spare capacity in the market.
TER: You mentioned low prices in the shale market. Are there any signs of weakness in the U.S. unconventional oil sector?
BD: Not really. We approach the shale market from equipment and services companies, so our perspective is a bit different than that of investors focused on producers. After a rough finish to 2013, when activity levels were down year-over-year, we have seen a decent rebound in activity levels for service companies like pressure pumpers. The equipment companies are talking about restocking inventory, and are back selling more into distribution channels.
Initial production rates on a lot of the shales are quite good for new wells. Technology continues to improve, which means successive wells tend to generate better returns for E&Ps. There is more takeaway capacity in many of the unconventional basins, meaning you don't have huge gluts of oil and gas stuck in a particular part of the country because you can't get it out either by rail or by pipeline.
The decision to widen the definition of what is OK to export from the U.S., with a couple of the E&Ps given the go-ahead to export condensate, or crude that has been distilled in condensate, has given E&Ps more confidence that, over the coming years, the definition of what is exportable from the U.S. will be expanded. If there's enough momentum to export natural gas and other types of products, companies won't get stuck with a lot of oil or gas sitting in storage in the U.S.
At the same time, the E&Ps are getting better at driving down well costs. They drill wells faster and more cheaply than they could have two or three years ago. The technology is getting better, and so well completions are driven more by science and less by horsepower, which tends to generate better initial production or better decline rates.
In general, the U.S. shale environment is in good shape. Of course, global prices could influence the E&Ps' confidence level. But if WTI prices are $90–110/bbl, which seems like a reasonable range for the foreseeable future, there's a good amount of confidence that E&Ps working in the shales can continue to employ capital and generate solid returns for the equity and debt investors.
TER: Are you expecting oil prices to rise again anytime soon?
BD: No. I think they were overdone on the high end because of geopolitical clashes. For prices to go back up, we're going to need geopolitical escalation—Russia pushing harder on the Ukraine, the Islamic State in Iraq and Syria (ISIS) pushing harder in the Middle East or, potentially, China doing something in the South China Sea to get Japan or the Philippines up in arms. China has been a big driver for the marginal price of oil, because it is the marginal buyer right now.
As we get closer to year-end, you'll see some stronger economic data points, and that will bolster confidence around demand. Upward pressure on oil prices toward year-end wouldn't surprise me, as people think about economic growth and start gearing up for 2015.
TER: There has been a lot of merger and acquisition (M&A) activity in the oil field services in North America recently. Is this level unusual?
BD: There wasn't an awful lot of M&A coming out of the financial crisis and in the following periods of weak activity. M&A is difficult in a financial crisis because debt financing is hard to get. When there are inflections in activity, especially to the downside, companies in strong financial positions are not willing to take a risky bet on an acquisition because they have spare capacity, both in equipment and people. When the financial picture gets good, sellers want a premium price.
On a longer-term basis, I'd expect more consolidation. The U.S. unconventionals require, or are necessitating, a different approach to development, completion and production.
The term "manufacturing" has been thrown around in the oil field space. Rigs have gotten more efficient and more powerful. Drillers and E&Ps are able to drill wells in less time, and they're able to use processes that are repeatable across a basin and across wells. Efficiencies have been driven into the development process. Those efficiencies necessitate larger organizations that can deal with rapid turnarounds, tight supply chains, and serving a customer across multiple basins, even though those multiple basins have very different geologies.
Also, given the duration of the shales—we're going to have a lot of oil and gas production for a long time—I think we will see a healthy amount of E&P consolidation, either within independents of decent size or with supermajors buying out independents to get bigger positions in the bigger basins, especially as larger E&Ps look at risk-adjusted capital returns.
The Western Hemisphere has been, and will continue to be, an attractive place to deploy capital. The big oil companies have big balance sheets, and have to deploy capital in big ways. That will drive E&P consolidation. And E&P consolidation is going to drive service company consolidation, because the E&Ps won't want to deal with five or 10 different vendors.
As long as credit markets and the oil prices remain solid, companies will bulk up both organically and through acquisitions. Current interest rates certainly make doing M&A in any sector an attractive proposition, especially in energy in the U.S., where you have a good horizon for growth and activity levels.
TER: Are you excited about any particular companies in the oil field services sector?
BD: Two that stick out for me are ENSERVCO Corp. (ENSV:NYSE.MKT), which we recently initiated coverage on, and C&J Energy Services Inc. (CJES:NYSE), which we've covered for a couple of years now. They are primarily U.S.-focused services providers. Both companies have good reputations. I like their strategic positioning. I like the fact that the companies are in North America, where I feel activity levels are going to be good for quite some time. They're also companies that have, for a variety of reasons, fallen between the cracks for investors. When you find a stock that hasn't been dug into by the institutions or other analysts, and if that company can execute on its strategy, that's an opportunity for outsized returns on investment.
TER: Why did you initiate coverage on Enservco in July?
BD: We had been talking with Enservco for a while. We were waiting to see if management was going to be able to execute on its guidance commentary and on deploying capital. It's not easy to cover a micro-cap company, so we've taken extra time to understand how the company fits into our broader thesis, including getting a better understanding of the services offered, how the management team communicates with the investment community, and whether the company can do what it says it's going to do.
We spent a handful of quarters making sure we had all our ducks in a row. The timing on the coverage involved recognition that the North American market, after a tough finish to 2013 and a tough start to 2014, was in better shape. The end market backdrop was more supportive of smaller companies. We also recognized that Enservco had gotten its capex plan squared away and was starting to deliver equipment. It makes our job easier if a company has some visibility on how its business is going to play out. It's easier to model it financially, as well as tell the story with investors.
TER: How deeply is management invested in the company?
BD: Michael Herman, the former CEO and current chairman of the board of directors, owns around 40% of the stock. Enservco is one of the more insider-heavy stocks: All the ownership together owns about 45% of the outstanding stock. Having alignment between outside shareholders and inside shareholders is a good thing. It also creates risk, of course. The small equipment and service companies are highly dependent on people. Having equity ownership helps keep key people focused on driving the business in the right direction.
TER: Does Enservco have the means to deepen its bench?
BD: It is a relatively small organization. You have service line heads, a chief operating officer, a chief financial officer and a CEO. Organically, over time, the bench will get bigger.
It wouldn't surprise me if Enservco were to make an acquisition in the next year or two. That might bring in people who would supplement the bench. But for the time being, we're OK with the team that's driving the train we're on.
TER: The big news at C&J Energy Services is the acquisition of Nabors Industries Ltd.'s (NBR:NYSE)Completion and Production Services unit. How does that benefit C&J?
BD: The thesis has a couple of different components. The acquisition gives C&J a broader list of services to sell to its existing customer base. The company is now also in a better position to go after some international opportunities over the next 10 years, in some unconventional basins in the Middle East in particular, but perhaps elsewhere.
The part of the story that gets me most excited is that a lot of the equipment in the Nabors completion segment has been underutilized. C&J has been a metrics-driven, utilization-driven company. It has a sales force that finds opportunities to deploy the company's equipment, to keep utilization high. I don't think the same management or operational strategy was deployed on the Nabors side as well as it will be by C&J. C&J can put the Nabors equipment to work quickly, whether it's coiled tubing units, wireline units, pressure pumping fleets or all three. You'll see the evidence of how C&J plans to make more money, both on the top and bottom lines, after this deal closes and we move into 2015.
With this acquisition, C&J will be a significant player in every service line necessary for completion services—pressure pumping in hydraulic fracturing, wireline, coiled tubing, cementing and workover rigs for down the line, when well intervention and recompletion opportunities abound. C&J is now much better able to compete with the likes of Schlumberger Ltd. (SLB:NYSE), Halliburton Co. (HAL:NYSE) and Baker Hughes Inc. (BHI:NYSE) in every basin and every service line, whereas previously it was viewed as a midtier player. It has the scale and capacity to serve the market better. That should afford the company opportunities to drive more benefits of scal e than we've seen in the past.
TER: Schlumberger and Halliburton? That's fast company. Is there any drawback?
BD: Yes. There's the risk that C&J is now a bigger company but not necessarily a better company. M&A can work for you or against you. Getting bigger doesn't necessarily mean you're going to be better at what you do.
But the big three—Schlumberger, Baker Hughes and Halliburton—dominate the market for pressure pumping and completion services. I think having an upstart—somebody new on the scene with a different approach—is nice positioning from a go-to-market strategy perspective.
But, as I said, C&J has to execute—utilize the Nabors equipment better and convince customers that it can perform at a high level. If the company can do that, it has a good opportunity to move into the top echelon as a premier provider.
I also think scale is going to afford C&J the opportunity to sit at the table for the Middle East unconventionals, as the large Middle Eastern national oil companies get more confident that C&J can execute in the Middle East like it can in North America. If you're really small, it's tough to convince big oil companies you can travel halfway across the globe and do the same kind of job you're doing in Wyoming or Texas.
TER: Are there so few opportunities for a company like this in the U.S. that it would look offshore? That seems kind of risky.
BD: C&J did a pilot project with Saudi Aramco in Q2/14. It was a coiled tubing pilot project. The company did a good job, so now it has a larger contract with Saudi.
The reason to look overseas is that there's less competition for unconventional completion services outside the U.S., so the pricing and margins are better than in the U.S. If you have the capital to deploy, one could argue that you should deploy that capital against opportunity in the Middle East just as you would deploy it here in the U.S. C&J has an opportunity to use its experience with Saudi Aramco, along with its relationship with Nabors, to utilize its international equipment at higher rates.
I wouldn't anticipate C&J taking equipment from the U.S. and putting it to work overseas. C&J sees a tremendous amount of opportunity to take market share in a growing market here in the U.S. But the two businesses are going to generate an awful lot of cash flow. If C&J can deploy its cash flow into two or three markets and generate good returns in those markets, no matter what theater we're talking about, the stock is going to benefit.
TER: C&J has four big lines of business. Which lines contribute the most to its revenue, and which has the highest margin?
BD: The biggest single piece of revenue is in pressure pumping or hydraulic fracturing, where C&J is doing the work for an E&P to fracture a well in the early part of the completion process. Within that segment is the coiled tubing business; coiled tubing has a lot of different applications. Coiled tubing is the highest-margin business for the company, although wireline is also quite profitable. The pressure pumping business can produce a very good margin.
C&J has been impacted by pass-through costs for the last several quarters. The company will buy sand, or ceramic proppant, or resin-coated proppant, and then resell that as part of a package deal it gives to an E&P. That transaction usually comes at a low margin. So margins on the fracking business have fallen, whereas the wireline and coiled tubing margins remain quite strong. That's consistent across the space, where, coming out of three or four quarters of difficult pricing and activity levels for pressure pumping, operators are now starting to talk about stable prices or prices going up a bit.
If prices increase, that falls right to the bottom line. The Nabors acquisition should allow C&J to generate better margins because there will be better utilization across the entire fleet, but I think you'll see growth first in the coiled tubing and wireline opportunities.
TER: Are you excited about anybody else right now?
BD: Yes. Shifting from North America and heading offshore, we've focused on RigNet Inc. (RNET:NASDAQ). Think of it as a telecommunications service provider for the oil and gas industry, primarily for offshore rigs, platforms and vessels, but also for the onshore markets. It installs and services equipment on rigs, like antennas and routers. It provides bandwidth from the big satellite companies, as well as microwave providers. It is one of the two companies—the other is Harris CapRock, a subsidiary of Harris Corp. (HRS:NYSE)—in the offshore space that connect rigs and production facilities back to headquarters, remote offices or other bases of operations. It provides these services for E&Ps leasing rigs to drill in the Gulf of Mexico or offshore Africa, and, on occasion, to service companies like Schlumberger, Halliburton, Baker Hughes and Weathe rford International Ltd. (WFT:NYSE), which are on the rigs as well.
RigNet does not own satellites or bandwidth. It's a bandwidth reseller. The business model looks more like that of a telecommunications service provider or a cell tower company. The company enters into multiyear contracts with good revenue visibility based on the amount of bandwidth provided, the location, and the breadth of services RigNet is offering.
We think the growth rate opportunity over the next several years is strong, driven by site growth, meaning RigNet will continue to add offshore rigs, offshore vessels and production facilities to its network. There is big opportunity in the oil and gas space, both onshore and offshore, for more information, bandwidth, real-time video and similar services. Rigs, operators, E&Ps and service companies not only generate, but need to access more information. RigNet stands right in front of what we think is a good trend for the next several years.
TER: If exploration and production in the Atlantic Ocean is approved, how will that affect RigNet's business?
BD: It's a net positive. The more areas that open to exploration and development, the more opportunities E&Ps have to put capital to work. There are going to be rigs drilling wells and, eventually, there are going to be facilities producing oil and gas from those wells. This net positive number of rigs, vessels or production facilities operating globally gives RigNet opportunities for market share.
I'll give you another example. Reforms in Mexico could open up deepwater Mexico on the Gulf of Mexico over the next five or 10 years. That should be a net positive as well, particularly because RigNet has a very good telecommunications network, as well as service capability, in the Gulf of Mexico. On the Atlantic, RigNet has good onshore and offshore presence, which it should be able to parlay into opportunities.
TER: Are you expecting, then, that the Atlantic would draw entirely new rigs, and not just rigs moved from elsewhere?
BD: That remains to be seen. Part of the volatility we've seen with RigNet's stock has been driven by uncertainty around rig utilization. Are there too many rigs out there? Are there not enough rigs out there?
I think the general consensus is that there are too many midwater rigs, and too many low-specification rigs, and that's putting pressure on day rates for the rig operators. That's started to worry people looking at a stock like RigNet, or other stocks related to offshore drilling. If the initial move to the Atlantic does turn into an interesting opportunity for the E&Ps, you'd probably see low utilization rigs move that direction. Some might come from the Gulf, some might come from the Middle East. If there are too many rigs, and operators are worried about utilization, having the Atlantic or Mexico open up would take up some of the slack. That would be a good thing for RigNet. Fewer concerns about rig utilization or the number of rigs working in the Gulf, the Atlantic or globally, would mean fewer concerns for investors about RigNet's ability to grow revenues.
TER: How is the Inmarsat Plc (IMASF:OTCMKT) acquisition affecting RigNet's margins and its share price?
BD: Initially, Inmarsat came in as a much lower margin business. The acquisition was quite dilutive to RigNet's overall operating margins and earnings before interest, taxes, depreciation and amortization (EBITDA) margins, after you take into account appreciation for the deal. Part of that is just scale. The Inmarsat energy business that RigNet acquired, which provides communications and project management services to the onshore and offshore oil and gas industry, similar to RigNet's business, was underscaled and probably undermanaged. RigNet has the opportunity to do things better, smarter, and on a larger scale; it could generate some better margins.
Over the long run, the acquisition affords RigNet the opportunity to consolidate the number of bandwidth providers it uses, which should be a tailwind to gross margin. It's certainly afforded the company that opportunity in the Gulf of Mexico and onshore. It got a lot more scale in both those areas, so there should be better operational leverage with every dollar of revenue. But, as you look at our financial projections comparing 2015, 2014 and 2013, the margins we have in our model this year and next year are lower than they were in 2013. That's a direct reflection of RigNet's buying a lower-margin business.
RigNet has said it thinks it can get the Inmarsat margins up to par with RigNet's core business over time, which would mean taking it from a 5% EBITDA level to something in the 25% range. RigNet made a smart acquisition because it puts the company in a much better strategic position with regard to technology and bandwidth access over a longer period of time.
TER: Do you have any parting words of advice?
BD: My big picture commentary is that North America is the right place to be. The activity levels in this sector will be good for a long time. From a research perspective, we're focused on finding ideas in energy that are off the beaten path. We also like to align ourselves with management teams that are thinking about customers first, and deploying capital in ways that generate good returns. The three companies we highlighted today line up well with that. It's been a hallmark of how William Blair looks at companies on the sell side. We try to find good growth businesses with good returns on capital that have management teams that can executive and are aligned with shareholders. Enservco, C&J and RigNet are all good ideas in that regard.
TER: Brandon, thank you for your insights.
BD: My pleasure.
Brandon Dobell, partner and group head, global services at William Blair & Co. LLC, specializes in the energy, real estate services and technology industries. Dobell was previously group head, global services research at Credit Suisse. He also worked in equity research at Bank of America Securities. Dobell has won two awards in the Financial Times/StarMine "World's Top Analysts" listing, including the No. 2 earnings estimator rank for 2008 in diversified consumer services, and the No. 1 earnings estimator rank for 2009 in real estate management and development. Dobell has a master's degree in business administration (finance) from the University of Southern California Marshall School of Business, and bachelor's degrees in history and political science from the University of California, San Diego.
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1) Tom Armistead conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: Enservco Corp. Streetwise Reports does not accept stock in exchange for its services.
3) Brandon Dobell: I own, or my family owns, shares of the following companies mentioned in this interview: Enservco Corp. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has or may have a financial relationship with the following companies mentioned in this interview: Enservco Corp., C&J Energy Services Inc., RigNet Inc. William Blair receives or seeks to receive compensation for investment banking services from these companies, is a market maker in the security of these companies and may have a long or short position. William Blair intends to seek investment banking compensation in the next three months from these companies. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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