CHOW – OFS exposure by operator, 2H19 spending, and potential revenue impact. Building upon our E&P capex-themed charts from the past several Rumblings, this week we attempt to frame the 2H completions slowdown by determining pumper-specific exposure to each operator. Combining E&P capex guidance and Rystad completion data, we calculate the potential revenue impact and percentage fall-off from 1H19 levels (ex-price/efficiency fluctuations). Given a high percentage of “unallocated” E&P completions (i.e. OFS unknown), the chart may underserve market share volatility and pumper exposure to a particular E&P. Nevertheless, well-tabulated FracFocus records for HAL (larger 2H falloff) and SLB (modest falloff) show somewhat divergent trajectories as the broader frac complex braces for activity to decelerate. Please reach out for further explanation of the methodology/results.
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We led off 2Q OFS earnings with an update on our US shale productivity thesis, calling out a near-term Permian productivity peak as E&Ps shift fully to pad development. So far, CXO’s Dominator spacing test has (appropriately) dominated the Permian discussion, and our E&P colleagues have covered and spoken extensively on the topic. For OFS, the most important implications go beyond Permian acreage inventory/M&A. For NAM OFS, well/stage up-spacing could offset continued per-rig and per-frac crew efficiency gains (positive for domestic OFS demand). For global OFS, a peak/inflection in US shale productivity, particularly in the context of the low-growth E&P framework, could be a stabilizing force to supply-side oil broadly (predictability from which could stimulate int’l activity with better OFS earnings power, key for SLB, HAL, BHGE and investability of the sector).
Yesterday (07/30/19) was one of the greener days for OFS in recent memory, with chatter suggesting that rotation (out of momentum?) into energy, and the subsequent short squeeze amplified an otherwise decent oil tape. For those companies that reported (NBR +30% & NOV +11% in our coverage) the moves were more pronounced. While neither NBR/NOV print signaled a drastic upward earnings inflection (although int’l momentum is helping to stabilize estimates) both companies followed the familiar 2Q OFS playbook of 1) caveating 2H19 friction in NAM, and 2) cutting capex (for NBR, a more pronounced FY20 capex cut in-line with peers). If it stands, the reported API crude draw last night could inject more life into an underperforming OFS subsector that is aligning costs/capex quickly with E&P.
An acceleration of May/June filings in the Permian/Bakken suggests a steady grind higher from the March 1Q peak, while auxiliary basins (namely Anadarko & Northeast) remain lumpy. Nevertheless, 2Q turned out to be a modest growth quarter for USL frac activity. On the one hand, Rystad data squares with E&P commentary around a “pull forward” of 2H activity (in the context of YE budget exhaustion). On the other hand, the data update also overstates frac revenue growth for the handful of OFS companies that have reported (all else equal). Bottom line, if higher-than-expected Rystad frac growth is correct for 2Q, then L48 production should still see positive supply adjustments in lieu of counter-seasonal inventory builds. Also, OFS really needs to stop shedding price.
So far, investor feedback from what we viewed as constructive SLB/HAL earnings commentary has been decidedly split between 1) those encouraged by the capital discipline as a “bridge” to refreshed FY20 NAM budgets, and 2) those dubious that the bottom is in for pricing/margins (or that cost takeout will not offset a weakening NAM outlook). We came out in our preview (link) citing stronger-than-expected FCF as the key 2Q19 catalyst/theme (either in print or 2H19 guide), and so far both SLB (link) and HAL (link) have leveraged continued capex cuts to drive (modest) incremental positivity back into the sector. Beyond cost/capital allocation, clearly generalist investors need to see evidence of sustained earnings power improvement, which we believe will follow SLB/HAL discipline as equipment cannibalization/scrapping accelerates and the E&P spending mix shifts to higher-quality int’l/offshore activity. So far so good through early 2Q earnings – clearly OFS is ready to mirror E&P discipline – but earnings power follow-through is still difficult to discern given lack of upward revisions.
Today’s (7/22/2019)result supports our HAL vs. SLB thesis (link), which lays out that HAL is in an advantaged competitive position in the context of 1) revenue growth, 2) margin expansion & 3) FCF growth. We believe long-only perception of HAL as a “NAM pressure pumper” is overly punitive with respect to #1-3 above, especially given the int’l D&E growth avenue that uniquely exists for HAL (vs. USL frac growth avenue for SLB). While its largest peer is more of a melting ice cube, defending share in higher margin D&E segments/growing in US frac, HAL is growing into int’l D&E and transforming its domestic C&P franchise into a lean FCF machine. For every $1 of revenue growth for HAL/competitors moving forward, we argue that HAL will benefit from higher margin expansion and FCF conversion compared to its largest peer – int’l D&E share is both margin accretive and capital-light compared to the domestic frac market. We believe consensus ests and valuation do not capture this HAL/SLB dynamic (7x vs. 10x NTM EBITDA).
This morning (7/22/19), HAL posted 2Q19 EPS of $0.35/sh (vs. $0.30 cons), adjusted for $247M in severance/impairment costs ($0.26/sh). Cost control drove a 7% EBIT beat (particularly in C&P), with total revenue of $5.9B largely in-line with consensus. FCF of $43M underwhelmed street expectations, but as noted in our OFS preview, fears of an FCF neutral quarter (or worse) had largely been captured in recent underperformance. Longer-term, we see this as an encouraging result given the strong, 64% incremental EBIT margins as evidence of robust cost takeout – particularly for C&P (71% inc EBIT margins QoQ) as NAM heads into a softer 2H19 for frac. Similar to SLB last week, a potential 2H19 FCF guide represents a key, intraday catalyst. Overall, we see cost takeout as the key, positive surprise given market focus on pricing/margin friction in the context of go-forward earnings power for the sector.
To kick off what we viewed to be a make-or-break year for US shale & OFS (mostly break for the equities of late, but OFS is flat YTD – score reset), we published our first US Productivity Report (link). In the report, we postulated that a lower E&P spending cadence, combined with productivity frictions across key shale basins, would yield underwhelming US supply growth (and likely alter the market perception of shale growth over the coming years). Since then, demand considerations (Margolin link) and US-China (& US-Iran) tweets have dominated the oil tape, but US supply is still a crucial piece of the crude puzzle, and we think it important to revisit this (mainly in pictures/charts) ahead of SLB’s commentary tomorrow morning (7/19/19).
Late last week, we published a 2Q OFS earnings preview (link) that was perhaps a bit more optimistic than recent OFS performance would reflect in the broader energy market. Our thesis is simple – with recent underperformance having captured the impending negative revision across the sector, another down-cut to OFS capex (particularly in frac) could drive stronger-than-expected FCF through the balance of FY19. Nearly every company that we caught up with alluded to further capex reductions in response to E&P budget exhaustion. With OFS growth/reactivation capex having already been deployed through FY17/18 (e-frac overhaul notwithstanding – although we see slower adoption) ) the evolution of a lower-growth E&P spending paradigm over the coming years could portend a more stable & sustainable FCF environment for NAM OFS.
In light of particularly morose investor meetings in recent weeks, perhaps the OFS sector should call out a Weatherford fishing hand to retrieve buyside sentiment. In our view, an impending negative revision to 2H19 NAM estimates is largely priced into an OFS sector that has underperformed the XLE by 400bps YTD (and the commodity even more substantially). With the expectation that US E&P spending growth will moderate over the next 3-5 years, and that oil prices will remain range bound, OFS FCF will become increasingly scrutinized in the context of appreciably lower earnings power (compared to prior cycles). Into 2Q earnings, we see further capex reductions and upside to FCF as a powerful positive catalyst against an otherwise negative macro backdrop for OFS.
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