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Baker Hughes Banks on Shale Gas in BJ Services Deal

Baker Hughes Inc.'s $5.5 billion cash-and-stock trade to acquire shale fracturing expert BJ Services Co. may be the largest oilfield services acquisition in more than 10 years, but it won't be the last oilpatch transaction this year, experts said last week.

BJ Services is one of the largest pressure pumpers in the world, a process used in unconventional natural gas plays to break up rock. Pressure pumping now accounts for 75% of BJ Services' business; it is expected to be 20% of the combined company's revenue. In 2008 pressure pumping accounted for 1% of Baker Hughes' revenue.

The merger would give the combined company the ability to compete around the world, said Baker Hughes CEO Chad Deaton. Because of the complexity involved in drilling today, services companies often work together by "bundling" their service offerings.

"While we are merging with BJ now, as the industry consolidates, we see opportunities to grow, both in individual shale markets in North America and in the rest of the world in the future, and in deepwater drilling," said Deaton. "We've begun discussing the next step to integrate the business. We know each other; our organizations have worked closely with each other...

"Our two companies have highly complementary products and services with very little overlap," he told energy analysts during a conference call. "Baker Hughes has a long record of partnering with BJ Services on major projects. The proposed merger will make Baker Hughes a stronger, more efficient service provider for our customers worldwide, by integrating pressure pumping with Baker Hughes' wide range of products and services."

The impetus to merge was a natural, Deaton explained. The two companies began talking about possibly merging around two months ago, and the companies reached an agreement in the wee hours last Monday (Aug. 31), he said.

Companies with an array of oilfield services have an edge worldwide, said BJ Services CEO Bill Stewart.

"We are seeing many of the pressure pumping jobs are being bundled into larger integrated projects," Stewart said during the conference call. By combining services, Baker Hughes expects annual cost savings of about $75 million in 2010 and $150 million in 2011.

"BJ Services broadens our portfolio by adding products, technologies and talented people that are key to helping our customers unlock value in their reservoirs, particularly in unconventional gas and deepwater fields," said Deaton. "It will better position us to drive international growth and to compete for the growing large integrated projects by incorporating pressure pumping into our product offering."

The transaction also is a bet that natural gas will play a bigger role internationally.

"We think the conventional type opportunities are the main driver" for the transaction today, said Deaton. "But U.S. unconventional gas will get bigger and prices will rebound. Down the line overseas these shale plays will come on, but three or four years down the line." Baker Hughes expects to see "some recovery" in gas rig drilling in 2010, but "not real aggressive."

Baker Hughes is "doing the right thing at generally the right time," said Tudor, Pickering, Holt & Co. Securities Inc. (TPH). There is a "clear operational fit," and the merger makes Baker Hughes "more competitive as pressure pumping is currently a gaping hole" when bidding for international work and bundled U.S. services. The merger "puts more on the plate while in the middle of transitioning to a geomarket organization..."

Baker Hughes would move into the No. 3 spot in market value behind oilfield services leaders Schlumberger Ltd. and Halliburton Co. National Oilwell Varco Inc. is now the No. 3 oilfield services provider. Based on closing stock market prices for Aug. 28, BJ Services stockholders would receive 0.40035 shares of Baker Hughes stock and $2.69 in cash for each share they own. Once the merger is completed, BJ Services shareholders would own more than a quarter stake in Baker Hughes, and two of its board members would join Baker Hughes' board. The transaction requires regulatory approvals, and it also requires approvals from both companies' shareholders.

Morningstar analysts said they had "long anticipated such a deal between the two companies, as it fills major holes in both product lines and makes a great deal of strategic sense. Baker Hughes will be better able to compete by offering a more complete bundled services offering, which could help it win international integrated project-management efforts. The deal gives BJ Services' pressure pumping operations a bigger global platform, and probably makes reentering Russia a much more palatable option."

Some BJ Services shareholders were unhappy with the merger price offered; the share price has fallen by more than half in the past year. Stewart was asked why the company would agree to a merger with gas prices so low.

"We've been consistent in our belief that there is a tremendous surplus of natural gas," said Stewart. "We are doing well in a competitive North American market, but we don't expect to see a rebound real soon unless we get some consolidation [in the industry]. We do think there'll be some capacity come out of the market...wear and tear, if you will, from shale formations wearing on equipment. Demand is down, significantly, and that is contributing to an extended period of market recovery.

"What BJ Services needs is a broader scope of product offering, and what BJ Services needs is a better position than what we currently have in the marketplace. What BJ Services needs is products, services other than pressure pumping. It just so happens that now is when Baker Hughes decided they were interested, and it fills a tremendous void in their service offering, and it makes us more competitive throughout the world.

"You can't pick and choose the exact time that a combination comes together," Stewart said. "It just so happens that now is the time, and it's a good deal for both sets of stockholders."

Deaton said he doesn't think his company's merger announcement will be the last of the year. There is "a lot of talk" about more acquisitions in the oil and gas business, he said. "We haven't seen any deals yet, but there's lots of chat."

Gerson Lehrman Group analyst Michael Lynch said the transaction "continues the trend toward the creation of super-sized oilservice companies that began during the long oil industry slump of the 1980s. While the major international oil companies continue to be primary sources of work for these huge companies, over the last two decades, mega-contracts with national oil companies have become equally important...

"Today, nearly all development wells require horizontal laterals and most are fractured for completion," said Lynch. "BJ Services is a leader in this technology and in addition has expertise in the drilling fluid business. Both of these abilities strengthen Baker Hughes. The international oil and gas business is set to recover faster than the general economies of the world. It is probably not the end of the consolidation."

Domestic gas shale drilling is forecast to jump 50% or more in 2010, even though overall gas activity will be up by only half that (23%), said TPH analysts last week.

"We expect [the] total U.S. rig count to grow 55% over the course of 2010" from an estimated 968 rigs in the last three months of 2009 to 1,500 by the end of 2010, said TPH. However, U.S. drilling activity isn't expected to increase much beyond 4Q2010 levels, said the TPH analysts. The 2011 year/year (y/y) increase is seen as "mostly a full year of the 2010 recovery."

Because of the increased use of hydraulic fracturing on shale wells, TPH analysts think there is a "better recovery outlook" for pressure pumping than for drilling rigs. The coming years' forecast is "gas price dependent," said the TPH team. "We are confident 2010 gas prices will rise from current levels, but if it doesn't reach our $7.50/Mcf forecast level, activity and oil service earnings could under perform our expectations." Exploration and production companies also may not cooperate and could "sit on their hands more than we expect as [the] gas price improves," said the analysts. "If this happens, gas price is biased higher than we expect, while an oil service earnings recovery would be delayed."

Analysts with SunTrust Robinson Humphrey/the Gerdes Group (STRH) agreed that companies are producing more gas with fewer rigs. According to the STRH analysts, fundamentals support a $7/Mcf gas price in 2010 and an $8 gas price in 2011. The U.S. gas rig count "needs to increase almost 15% next year to 900 rigs on average to maintain gas market balance, which is below our prior expectation of 975 gas rigs," wrote STRH analysts. "The lower level of rig activity next year is attributable to better-than-expected well/rig productivity."

This year "we anticipate a 30%-plus increase in well/rig productivity, which compounds the 24% increase experienced in '08," said the STRH team. "Consequently, we now forecast a shallower U.S. gas production decline of almost 3 Bcf/d (5%) y/y by year-end and nearly 5 Bcf/d (8%) peak-to-trough decline by next summer. In '11, a 20%-plus increase in drilling activity (1,100 average gas rig count) appears necessary to increase production sufficiently to maintain gas market equilibrium."

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