Oil Field Services Surprise: The Upstart That Could Compete With The Big Three

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.

"ENSERVCO Corp. is an insider-heavy stock; having equity ownership helps keep key people focused on driving the business in the right direction."

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.

"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."

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.

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