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Schlumberger CEO Warns of Mounting Pressure on North American E&Ps to Build Cash Flow, Profits

Schlumberger Ltd. CEO Paal Kibsgaard said this week the North American exploration and production (E&P) sector is facing mounting pressure to build free cash flow and profitability, even as it bucks up against stable oil and natural gas prices that "potentially remain range-bound for some time to come."

In a two-day investor presentation, the company’s first since 2011, the CEO and the entire senior management team highlighted new technology and financial expectations. Kibsgaard, as he does during quarterly conference calls, also spent some time over the two days to offer his forecast on the macroeconomic environment globally, and specifically for North American natural gas and oil.

Schlumberger has set a compound annual growth rate of 40%-plus on incremental margins through 2017, with earnings/share growth of 17-20%. Much of the growth is forecast to come from international operations, not from North America.

Traditionally, producers have cut costs to buffer against headwinds from falling commodity prices, Kibsgaard told the audience. "What is different this time is that commodity prices are stable and could potentially remain range-bound for some time to come."

The "current headwinds are entirely internal to the industry and potentially not temporary in nature, which means that the traditional cost-cutting measures may not offer a sustainable solution."

Kibsgaard has never been wishy washy in offering the company's assessment of the markets. The latest assumptions are based on an oilfield service operating environment expected to be not much different in the next three years than it's been in the past three. Annual growth in the global economy is expected to be 3-4% to 2017, barely more than current levels in developed countries.

That growth won't come because of gains by dry gas drillers in North America, he said. Schlumberger assumes there will be no significant rebound in dry gas drilling because of the resilience in the existing production base and on "limited demand impact" from liquefied natural gas exports by 2017.

"There are plausible supply and demand scenarios that could lead to a tightening of the global oil market, as well as the North American gas market, with a corresponding impact on commodity prices and investment levels, but we have chosen not to factor this upside into our 2017 targets."

Oil demand should increase by 1-1.5% per year, supported by developed nations and a rising demand in emerging markets.

"On the supply side, we are assuming continued production growth from North American shale liquids, although we are cautious in extrapolating current growth rates for the longer term," Kibsgaard said.

"Several of the North America liquids basins see first-year decline rates in excess of 50%, and around 80% of all the new wells added in these basins only service to maintain current production levels."

As long as North American drilling accelerates, with new acreage production potential, free cash flow and balance sheet leverage, "the pace of the system can be maintained. However, this will likely level off at some stage, with a corresponding impact on production."

Between 2011 and 2013, total global E&P capital expenditures increased by 9-10%. This year, the growth rate has been cut by 6-7%, forced down by international oil companies that are focused on improving returns.

"In the absence of higher oil prices, the only permanent solution to our industry's current financial problems is to create a step-change in the technical performance of our entire E&P spend, which is in line with the 2014 level of 6-7%," said Kibsgaard.

Schlumberger derives most of its revenue from the well-related part of the E&P spend, which today makes up around 30% of the total, and because of its proximity to cash flow, "is generally expected to grow somewhat faster than the total E&P spend."

There's not much growth in 2015 expected either. Exploration spend should remain "subdued as the industry focuses on cash flow and carefully evaluates new prospects. However, from 2016 and onward, we believe there will be a renewed industry focus on exploration, with corresponding growth in activity levels." That will hold true for the onshore and deepwater.

Even with its strong activity outlook for North America's shale liquids, Schlumberger doesn't expect to see much improvement in operating margins for basic service pricing in North America on a lack of available service capacity in some of the new-growth basins, and cost inflation for labor, sand and transportation.

It's "obvious," said the CEO, that E&P activity won't be scaled back indefinitely, but the service industry after years of competitive bidding is challenged equally on profitability and free cash flow "and has therefore little to offer in terms of pricing concessions."

The "real problem is that the E&P industry has fallen behind in its ability to handle the growing complexity and cost of finding, developing and producing hydrocarbons." The service industry, which does most of the infrastructure and well-related work, now has a "key role to play in overcoming these challenges."

Kibsgaard's comments and those by other company executives convinced Tudor, Pickering, Holt & Co. (TPH) that the company is doing "better than we expected." A $150 billion market cap "puts it in a class of its own among oil service" and gives it the opportunity "to steal further mega cap energy investor dollars (from the majors) more so than from other oil service names," wrote TPH’s Jeff Tillery and Byron Pope.

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