A bet to procure a big reserve of guar gum, an additive used in hydraulic fracturing (fracking) fluid, proved to be a costly mistake in the second quarter, Halliburton Co. CEO Dave Lesar told energy analysts on Monday.
Halliburton’s operating income fell 19% sequentially in 2Q2012 driven by four factors, with the top one being guar cost inflation, Lesar explained during a conference call to discuss 2Q2012 operating and financial results. The Houston oilfield services giant also was impacted by the Canadian spring breakup, pricing pressures isolated to its production-enhancement product line and efficiency disruptions associated with ongoing equipment relocations in the U.S. onshore.
Lesar spent several minutes discussing Halliburton’s decision to stock up on guar for its North American division. India supplies about 70% of the global guar market, and suppliers have not been able to keep up with demand. Halliburton warned in June that its North American margins were being impacted more than expected in 2Q2012 because of the increased cost of guar (see Shale Daily, June 8).
Because Halliburton has had “a “well functioning machine” in the United States, “we did not want that machine to miss a beat” against the competition, Lesar said, in explaining how the guar expenses had become so impactful to the company’s bottom line. “Since we were unwilling to compromise this reputation, we made a strategic decision that on top of our normal guar purchases that we would procure a large reserve of guar based on the demand we saw in the market coming out of the first quarter.
“At that time, rising customer requirements in the oil and gas basins was driving up demand for gel-based systems and the elevated commodity prices at that time supported our ability to push price increases to our customers in order to counter the incremental higher input costs of our guar,” Lesar said.
For Halliburton, “the equation was a simple one: having the frack spread that made maybe 20% margin using higher-priced guar was better than the one that made no margin because we had no guar to pump. So during the quarter we were able to meet all of our customer needs and in a number of cases, we were able to catch jobs our competitors could not get to because they lacked the supply of guar. This enabled us to take market share while demonstrating to these customers why they can rely on Halliburton when supply chains get stretched.”
However, guar supply concerns now have eased and spot prices have declined but costs remain high relative to historical levels, noted Lesar. “Furthermore, the decline in oil and gas prices in the second quarter have made our customers more reluctant to accept price increases to cover our incremental guar costs.”
Now, with a “large reserve of extra guar inventory” on hand, the “results will reflect an even higher average cost of sales impact over the remainder of this year as we work through our supply of this higher-than-average cost guar. At this point, there is no shortage of guar, but most of the industry will have to work down their inventories of their higher-priced product.”
With “20-20 hindsight,” said Lesar, “we made the wrong decision…We bought too much guar too early and paid too much for it. We should not have purchased the extra inventory. The impact was dramatic in the second quarter as we absorbed these higher prices and even more so in the third and fourth quarter as we work off the inventory. I want to be clear with you, I supported and agreed with the decision to secure the strategic guar reserve and I will take the heat for it.”
About two-thirds of Halliburton’s North America margin compression in 2Q2012 “was due to the impact of escalating guar costs, which rose approximately 75% from the first quarter. As we go into the third quarter, traditionally our busiest quarter in North America, we expect our total guar costs will rise an additional 25% over the second quarter as we work off our high-cost reserve and then costs should reduce as we close the year.”
Halliburton expects guar pricing will decline “but the situation is still volatile,” said Lesar. “Spot prices for unprocessed guar splits fluctuated more than 30% just last week alone as the market reacted to the monsoon weather outlook. And depending on how the monsoon season plays out, our current excess guar supply may, in fact, become a strategic asset for us in North America if this year’s crop falls short. But to help protect us against these issues in the future, we are actively developing alternatives to guar…”
Spot frack pricing in North American dry natural gas basins had been “under siege” in 2Q2012 but “it now appears to be leveling off in many cases because there are so few competitors left in these basins today,” said the CEO. “We are also seeing increasing pressure in the oil and liquids markets as we negotiate the renewals of existing stimulation contracts and win new market share. In contrast, the majority of our other product lines continue to maintain relatively stable pricing.”
Halliburton is continuing to add new equipment to North America to support its “Frac of the Future” initiative, said Lesar (see Shale Daily, Oct. 18, 2011). In 2Q2012 the company marked the deployment of its first Q10 fleets. “In the event that the market does deteriorate to where we are not earning our cost of capital, we would likely idle or retire older fleets and continue to bring new fleets out and build up our Q10 operations,” he said.
Today the company’s frack fleets remain fully utilized, noted the CEO. “Every truck we build is committed to a customer before it comes off the line and where an existing customer has reduced demand for our services in a particular basin. We have been successful at displacing the competitor on other work for either that same customer or for a new customer we could not get to in the past.
“Our strategy in this environment has been and will continue to be to take advantage of our market position, differentiated technology, a more complete set of product offerings and the general flight to quality, which appears to be underway. Historically this has resulted in market share gains during the downturn, which we have positively then leveraged during the ensuing up cycle. We see no reason for it to be different this time, and our second quarter versus our competitors certainly bears that out.”
Halliburton expects to see a “modest reduction” in the U.S. natural gas rig count through the rest of this year as operators remain focused on basins with “better economics,” said Lesar. “We believe that despite recent improvements in natural gas spot prices, downward pressure will continue throughout the injection season. Oil and liquids-rich drilling has mostly offset recent reductions in gas rigs, and the majority of our customer base remains committed to previously stated activity levels. However, we believe that recent volatility in oil and softness in natural gas liquids may prompt certain customers to adopt a more cautious tone toward the timing of their drilling and completion activities.”
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