Oil & Gas/ Oil Services/ Industry Dynamics 0 comments

(P.S: The following were extracted from another source and is not my original work.)
Oilfield service companies supply the products, services, and systems that enable major integrated, independent, and national oil companies to explore for petroleum reserves and complete and produce oil and gas wells. The major service companies typically market their services to the end-user on the basis of availability, performance, quality, reliability, technical support and service, and price. Like contract drilling, oilfield services is an intensely competitive and cyclical industry.

Periods of flush demand, tight inventories, and strong pricing are followed by periods of weak demand, excess inventories, and cutthroat pricing. Although no one firm dominates the market, certain companies have or share dominant positions in specific applications, and several companies are distinguished by their ability to weather the industry's challenging fundamentals. As a result, investment-grade ratings are possible for these companies. Risks to oilfield service providers are exacerbated by the lags that typify product-line recovery. Macro environment demand factors for oilfield services mirror those affecting drillers.

Competitive Position Analysis

An oilfield service provider's competitive position is, above all, a reflection of management's operating strategy and attitude toward financial risk. These factors determine a company's vulnerability to cyclical demand swings, as well as its customer base, growth strategy, and financial durability, and can be evaluated by looking at certain factors that underpin its business and financial strength. Several elements make up an oilfield product and service provider's business strength.

The technological complexity of its products and services.

A firm's ability to develop and quickly implement cutting-edge applications can establish it as a technological leader, allow it to build demand and market share, and enable it to establish alliances with producers, possibly without direct competition. The degree to which a technology contributes to exploration and production (E&P) success rates and cost improvement (e.g., faster production, reduced drilling rig time, cleaner processing) determines the company's value-added. Always-improving oilfield technology enables operators to lower the costs of drilling and producing wells and to pursue reserves and production in increasingly complicated, ultra-deep water, and extreme environments. To create or maintain an edge, service firms must continually spend on engineering, R&D, or acquisitions of niche providers. Product-line entry barriers and price competition vary according to the technical complexity and capitalintensity of the services rendered. But proprietary rights, such as patents for high-value technical processes or products, pose effective entry barriers for new competitors.

The cyclicality of demand for product/service lines.

Most companies specialize in a limited number of exploration, development, or production needs and, as such, are more financially vulnerable to cyclical swings in the industry. Large companies are highly valued by large operators because they can address needs throughout the E&P cycle. Participation in more than one—ideally complementary--line mitigates a firm's exposure to the risks of a single market, provides opportunities for related follow-on sales, and creates a platform for growth.

When product-line breadth is matched with extensive geographic scope, a service company is well positioned to meet the oilfield needs of a major international operator. This tends to result in smoother operating cash flow and can mitigate a company's vulnerability to phase-specific demand fluctuations.

Geographic scope of operations.

Operating in more than one major petroleum-producing region acts as an internal hedge against demand fluctuations and broadens a provider's ability to serve large customers. In international locations, services firms typically use independent local sales agents, distributors, or joint ventures. Most large services providers maintain field service centers near their customers. The world's major drilling regions are North America, Latin America, the Middle East, Asia-Pacific, Europe's North Sea, West Africa, North Africa, and Russia . Major service providers operate in most or all of these areas.

Relationships with customers (particularly the major oil companies).

Service providers compete ultimately on value-added capabilities, price, and their ability to deliver. During weak or tepid demand conditions, customers will pressure prices downward, limiting providers' profitability and prospective free cash flow. But, strong market conditions enable providers to be more price-resistant and to increase prices regularly.

Financial Strength Factors

Conservative debt levels and low fixed charges strengthen a company's operating flexibility during an industry downturn. This is important because a downturn can last for several quarters, during which time demand for individual product lines can collapse completely.

Financial flexibility.

Similarly, adequate liquidity (matched against typically low maintenance capital, R&D, and operating costs) in cash, cash equivalents, and borrowing capacity enhances financial flexibility during cyclical troughs. Companies that enter a downturn with strong liquidity are well positioned to make economical acquisitions of firms that can augment product lines or geographic scope. Most service companies have relatively low fixed costs. But when market activity is strong, working capital needs are high. In a downturn, the ability to liquidate working capital can materially augment financial flexibility.

Geographic diversification of operating cash flow.

As mentioned earlier, operating in more than one region acts as an internal hedge against demand fluctuations in isolated phases of the oil cycle in individual markets. This insulates operating margins and cash flow protection measures companywide throughout the cycle.

Operating philosophy during cyclical downturns.

A service provider's approach to a market downturn (inventory liquidation, manufacturing plant closures, workforce reductions)—-particularly a firm providing technically sophisticated and internally manufactured products–-affects the amount of liquidity necessary to meet fixed and variable charges and the company's ability to respond promptly and credibly to a recovery. Skilled labor can be the scarcest commodity in a rebound, as can ready manufacturing capacity. When commodity prices go up, demand for development and production-related services tend to rebound first, followed by exploration. Apart from timing lags, rejuvenated demand is typically immediate.

In general, oilfield service companies that have sophisticated product lines that span the E&P cycle and geographically diverse operations that enable them to support customers' full drilling programs should be able to maintain reasonable cash flow levels in cyclical troughs and do extremely well during cyclical peaks. In contrast, local providers of niche services and/or commodity equipment related primarily to exploration and development are more likely to exhibit volatile cash flow patterns, necessitating permanent offsetting levels of liquidity.

Large oilfield service companies generally can carry higher debt levels than can similarly rated drillers. A high proportion of variable costs, very low maintenance capital requirements, operational diversification, and the ability to squeeze working capital enable large service firms to better withstand attenuated demand troughs. Still, financial strength necessitates having a moderately strong capital structure and good liquidity to weather unpredictable cycles produced by such uncontrollable factors as:

The aforementioned expectations for oil, natural gas, and refined product supply, demand, and pricing, and the consequent capital outlays by upstream operators; Changes in the customer base and how customers source oilfield services; and The commoditization of oilfield products and services.

(The above was extracted from Magpi's post in Shareinvestor.com on 1 Feb 06; it had originated from the Reference as shown below)

References:
(1) Standard & Poor's, a Division of The McGraw-Hill Companies, Inc.