Turbulence and volatility are in Steven Salz's forecast for the energy market. The special situations analyst at M Partners tells The Energy Report that falling oil prices are hurting oilfield services companies in different measures depending on their specialties, but that all are taking hits. A sign of the times: He thinks the Halliburton/Baker Hughes merger may be the first of a series of consolidations in the space.
The Energy Report: Steven, is the price of oil nearing the point where North American exploration and production companies (E&Ps) will have to curtail production?
Steven Salz: Yes. We're already starting to see hints of a pullback in drilling activity, with the Baker Hughes Inc. (BHI:NYSE) rig count showing a slight decline on a forward basis. In the Q3/14 earnings of major E&Ps, we saw language suggesting more modest plans for 2015 than previously anticipated. We're expecting around a 10%-20% drop off previous expectations in capex for 2015. That translates into a near equivalent drop in the well count year over year (YOY), which has a direct impact on the energy service space.
“Enterprise Group Inc. has seen a doubling in revenue YOY.”
If oil prices continue to decline, or even hold steady at $65–70 per barrel ($65–70/bbl), it's going to be important for investors to position themselves with companies exposed to basins that have low breakeven oil prices per barrel.
TER: Do you think the Baker Hughes/Halliburton Co. (HAL:NYSE) deal is partially a result of this fall in price?
SS: I do. Thoughts on that deal originally fell into two polarized camps. Some thought maybe this was a bottom, and we were going to see a recovery. That's the immediate reaction when investors see deals with such large majors. But I thought—and we now see—the deal was more about Baker Hughes thinking that tougher times were ahead, and Halliburton wanting to be opportunistic. That's consistent with the recent moves in oil prices. When you have a massive drop in the commodity price, it's expected that companies with a comfortable balance sheet are going to be opportunistic.
TER: Are unconventional and conventional E&Ps equally affected by this price situation?
SS: You would get hurt more on the unconventional side. Both have their advantages, with conventional arguably being lower beta in a falling oil price environment because there's typically a lower cost of production, thus a lower breakeven price per barrel. It's going to depend on which plays you're exposed to. Generally though, unconventional, on average, would need more capital to sustain production given higher costs and quicker declines.
TER: Natural gas prices have been stable and are actually rising again. Is this causing E&Ps to shift their focus to gas production now?
SS: Not at a level that has become apparent. These things have a lagging effect. Oil's really only come off the past few months, so you wouldn't see any material shift in the production profile over less than a quarter's time of decline. We're not seeing a shift yet, but it's possible.
TER: Has the price of natural gas liquids (NGLs) tracked the fall in oil prices?
SS: We are seeing some price compression in NGLs. Crude oil prices impact the price ceilings for propane and butane because they compete with oil-based products, like heating oil and gas oil. That being said, the move has not been as volatile or significant, and that's due to the fact that NGLs don't have the same export restrictions in the U.S. as crude oil exports.
TER: Does that mean dry gas is becoming more highly valued now than it was?
SS: It does. Dry gas wells have a lower cost of production than wet gas. In an environment where the oil price is low, there is compression in NGLs, which reduces the wet gas well netbacks because it can be sold at lower prices. The cost of production is the same, so you get a compressed netback. With stable natural gas prices, or an increase in natural gas prices, you get deeper value in a dry gas play.
TER: How are oilfield services companies responding to the price situation in oil and gas?
SS: Many have sold off. Energy service companies are impacted by E&P capex. When the oil price falls and capital programs are at risk to be cut or moderated, the pie gets smaller for service companies to fight over. Declines vary by subsector within the energy service space: Drillers and pumpers get hit a bit harder. Those are down 35–45% year-to-date. Field service and infrastructure companies are down 15–25% year-to-date. I'd say the latter would be considered more maintenance and sustaining services versus exploration spend for the drillers and pumpers.
If you're an energy company facing lower oil prices, you're going to cut new production; you're going to cut your capex programs on new exploration and new projects. You'd rather deploy capital into maximizing existing resources and existing wells. That results in more pain for the exploration service companies, versus companies working in maintenance and sustaining.
TER: How is the situation affecting the companies you cover?
SS: Among the companies we cover, Northern Frontier Corp. (FFF:TSX.V) is more on the maintenance and sustaining side—that generates almost all of the company's revenue. It has sold off a bit more than the sector due to a recent lengthy financing process, but generally Northern Frontier is more insulated in the current environment and should begin to trade as such.
On the other side, there's Xtreme Coil Drilling Corp. (XDC:TSX), a drilling and coil operator. This company has been hit quite hard. It was up 30–40% year-to-date in August, and once oil rolled over, Xtreme sold off, now down about 60% year-to-date. The impact and effect was almost immediate on that side.
