Halliburton Co., the biggest oilfield services operator in North America, on Wednesday upended Wall Street’s expectations and reported strong first quarter results, despite challenging conditions in North America as producers moved operations from natural gas basins to oil targets.

Profits in the first three months of this year rose by 22.7%, with net income at $627 million (68 cents/share), versus $511 million (56 cents) in 1Q2011. Revenue jumped 30% year/year to $6.87 billion. Excluding a $300 million charge related to estimated losses related to the Macondo well blowout in 2010, in which Halliburton was the well cementing contractor, the company earned 88 cents/share in the quarter. Wall Street had expected the company to earn 85 cents/share on revenue of $6.79 billion.

This year will prove challenging for oilfield service companies as they move from gas fields to oil prospects, but for Halliburton, “I believe it will just be another opportunity for us to differentiate ourselves from our peers and continue to drive our strategy of superior growth, margins and returns,” CEO Dave Lesar said during a conference call.

“We believe increased activity of our customers due to the strong liquids prices, access to capital and increase in service intensity are supportive of a healthy market for us in 2012.” However, the company expects to see “continued short-term inefficiencies and, therefore, downward pressure on margins in the near term due to the shift in our equipment, commodity price mix and pricing pressure, and the spring breakup in Canada. We currently expect these transitory disruptions to decrease the second half of 2012.”

In North America Halliburton’s 1Q2012 revenue grew sequentially by 1%, compared to a U.S. rig count decline of 1%. “Now while 1% seems small, it’s actually the net impact of a significant rig shift that is taking place in the U.S. between natural gas and oil,” said Lesar. “And operating income was down sequentially by 5%, driven by the inefficiencies associated with equipment relocations, cost inflation and certain pricing pressures in certain basins.”

During a conference call earlier this year to discuss 4Q2011 and year-end 2011 results, Lesar noted that he had spoken about the disruptions in North America that were resulting from rig movements between basins as operators abandoned dry gas plays.

“Depressed natural gas prices have accelerated the shift from natural gas to oil plays during the quarter,” Lesar said of the first three months of 2012. “In the U.S., the natural gas rig count declined 151 rigs, or 19% just since the beginning of the year. And that slightly outpaced the oil-directed rig count increase of 125 rigs, or 10% over the same period. So while the total rig count only declined 1%, the shift from natural gas to oil was dramatic and disruptive to operations.”

CFO Mark McCollum noted in North American operations, “inefficiencies associated with equipment relocations, continuing cost inflation and pricing pressures in certain basins impacted our margins during the first quarter. We expect disruptions related to rig movements to impact us in the near-term. And perhaps with the exception of guar, we anticipate some relief from suppliers in the second half of the year related to high cost of proppants and other materials.” Guar, a material used to thicken a fracking component, is mostly grown in India, and it has been scarce. The next harvest is this fall.

“Due to these challenges and the negative impact of the seasonal Canadian spring breakup, we expect to see lower revenues, and margins dropping by 200-250 basis points in the second quarter” in North America, said McCollum. “We also now anticipate margins could drift toward the low 20% range by the end of 2012. The market is understandably very dynamic right now. These margin expectations depend on, among other things, our success in recovering inflationary cost increases from our customers and how soon the natural gas rig count levels off. We should have a better feel for this after the second quarter.”

In January Halliburton’s top executive said eight hydraulic fracturing (fracking) fleets were moving from primarily gas plays to liquids plays. Lesar said the company now has an additional five frack fleets “that have moved or in the process of moving this quarter. Due to the stability of oil prices, oils in the liquids-rich plays are generating higher returns for our customers. This shift is very positive for us as completing these wells requires higher levels of service intensity due to the advanced fluid and completion technologies, which creates an additional opportunity for us to differentiate ourselves from our competition.

“While these moves are beneficial to us in the long run, they do not come without a short-term impact on our margins. With spot natural gas prices down approximately 50% from this time last year due to the resiliency of natural gas productions in a very mild winter, so at the current prices, we expect to see further declines in the natural gas rig count until we begin to see a meaningful decrease in production levels. Over time, we believe any future weakness in natural gas rig count will be offset by an increase in oil and liquids-rich activity, resulting in an overall yearly percentage increase in the U.S. rig count in the mid single digits.”

North American margins also are going to be impacted this year, said Lesar. Revenue was strong in the first three months because of better-than-expected activity levels. However, “our margins were just below our expectations, given that the drop off in the natural gas rig count was more pronounced than we anticipated. Continued significant cost inflation also negatively impacted our margins…There is often a delay between vendor price increases and when we are able to pass these increases to our customers. In the natural gas basins, in particular, this is becoming more difficult, and we are working with our vendors for price relief. However, this will take time and may continue to impact margins throughout the remainder of 2012.”

As Halliburton renews service contracts and is awarded new contracts, the company expects to see frack pricing become “more challenging, but the impact will vary by basin,” said Lesar. “The dry natural gas basins will be the most challenged, followed by those more easily accessible oily basins that are located close to natural gas basins, such as the Eagle Ford. We expect pricing pressure in some of these markets in the near term but believe that these pressures will decline over the remainder of the year. On the other hand, our other product service lines continue to have relatively stable pricing.”

In the Gulf of Mexico, where Halliburton is a top contractor, the company remains “optimistic about the recovery of activity and believe that margins will continue to increase as our customers adapt to new regulations and industry efficiency improves,” said the CEO. “The increase in permit approval should lead to additional deepwater rigs arriving throughout 2012. Our first quarter margins in the Gulf were lower than the prior quarter due to a different mix between drilling and completion-related revenue activities, mainly driven by customer delays of certain completions, an area where we hold the highest market share.

“We are very optimistic about the future work we see in the Gulf and we have secured additional directional drilling, drilling fluids, wireline and completion work on a number of the new deepwater rigs coming into the Gulf and some of the rigs that are going back to work in the next few quarters.”

The CEO also took note of Halliburton’s growing presence in Canada, which he said had been “underestimated due to the size of our U.S. business.” This year Halliburton expects the Canadian operations to deliver a $1 billion revenue stream.

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