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.
Our Take – Curious stock reaction to an otherwise solid quarter, but the road to recovery is long (in an unloved sector, burden of proof is high). We were contemplating a much more positive stock reaction compared to the one that SPN got for an otherwise positive 2Q result and constructive call commentary. The short cover rally earlier in the week perhaps dulled today’s positive surprise, or perhaps quant sell pressure (see QES Malessa ranking within) and self-fulfilling market cap constraints are keeping fundamental investors on the sidelines. In lieu of any great grasp on the intraday idiosyncrasies plaguing the stock, we see the combination of 2Q results, upside to the 2H19 FCF guide, and evidence of a healthier-than-expected OFS divestiture market as all fundamentally positive for balance sheet survivorship. We maintain SPN Outperform and YE19 PT of $3, based on 5x our 2020 EBITDA of $311 million (down from $317 million).
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.
Although way too early from a timing perspective, our double upgrade was predicated on what we perceived to be appreciable equity option value ahead of SPN’s Dec 2021 maturity wall. We believed then (and still do) that equity/credit markets overestimate both 1) go-forward frac EBITDA contribution, with SPN actively winding-down PumpCo, and 2) “RemainCo” capex (understating FCF through FY20). A strong 2Q earnings result checked all the balance sheet recovery boxes – the company beat street EBITDA by 7% with lower-than-expected contribution from OC&W (every non-USL segment beat EBITDA estimates), and drove modestly-positive FCF on lighter capex. Furthermore, the company executed a non-core divestiture of its land drilling business for $74 million in cash (10x annualized 1H19 EBITDA), and ended the quarter with nearly $70M less net debt vs. street. Maybe not the divestiture some were hoping for, but still compelling proof of SPN’s willingness and ability to divest non-core assets.
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).
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.
The key OFS takeaway from Monday’s Wolfe Energy quarterly lunch was that USL volume beats (due to peak March completions) and a well-timed wind-down of 2Q E&P capex would be a tough look for OFS earnings vs. supply-side macro. The expectation that 2H19 OFS estimates need to come down is already reflected in the recent OFS UP, in our view, and we believe that the market may be underappreciating further OFS capex reductions associated with softening activity through the back half of FY19. Within, we refresh the capex outlook for our coverage – Front end loaded OFS spending, combined with WC friction (related to collections from tight E&P budgets) may not bode well for 2Q earnings themselves, but back half capex reductions that offset downward consensus revisions (already priced in) could yield key upside catalysts for those OFS companies with decent-enough visibility to provide FCF guidance. We have a few names in mind following recent catch ups.
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