As president and chief executive officer of one of the Big Four service companies, Martin Craighead manages Baker Hughes Inc., a company that does business in 80 countries. He became chief executive officer in January 2012 when former chief executive Chad Deaton became executive chairman. Craighead, a petroleum engineer out of Penn State with an MBA from Vanderbilt, joined the company in 1986 and has served in a number of roles.

Today in Iraq, Baker Hughes is operating six rigs. In Russia it just drilled the two longest extended-reach wells ever on the mainland, and in the challenging environment above the Arctic Circle. In Saudi Arabia, it recently won a turnkey contract to drill 75 wells in Shaybah Field. It also opened a new research center in Dhahran in February.

In the first half, BHI’s net income was $818 million, up about $100 million from the same period in 2011. But like all service companies, it is dealing with margin pressures, supply chain issues for materials such as guar used in fracturing, and the big shift from natural gas drilling to oil.

After more than 100 years in the oil industry, Baker Hughes can’t rest on its laurels. Its research focuses on four themes: sustainable chemistry, advanced measurement and actuation, designer materials (think nanotech), and high-performance information and simulation. Six technical communities across the globe conduct workshops, sponsor research and share best practices.

We caught up with Craighead at his Houston headquarters shortly after the second-quarter earnings season, to get his views on the macro picture, relationships with national oil companies, recruiting the best and brightest, and more.

Investor What’s your best guess on where the rig count is going through year-end?

Craighead For North America, we now expect the average annual rig count to grow by 3% year over year, from an average of 2,296 rigs in 2011, to an average of 2,371 rigs in 2012. For oil, we expect to exit 2012 with 1,430 rigs in the U.S., which is an increase of 300 rigs compared to last year. We expect to exit 2012 with 488 natural gas rigs in the U.S., which is a decline of 321 rigs compared to last year.

We could even see a bit more decline in the gas rig count. That hasn’t fully shaken out yet. I think there’s quite a bit of cushion in the oil price for our customers, and a lot of opportunity out there in new or emerging plays. The shift from gas to oil is not over, but it is slowing down. We saw a vast shift in the fourth quarter, first quarter and second quarter, but I think the rig count is pretty much flat from here on out.

Investor What effect is that having on Baker Hughes?

Craighead Any time there’s any dislocation from one basin to the next, there’s a disruption in activity. The second negative can be (not just for us but for the service industry as a whole) capacity. Is there infrastructure there? Do you have enough trained employees there? You have to be very close to your customers and know what their plans are, almost before they do.

Fortunately, like some of them, we have an oily portfolio in terms of our products and services. By that I mean that, for example, we are one of the leading ESP companies (electric submersible pumps placed downhole). We are the world’s largest upstream chemical company. Aging oil wells need a lot more chemicals and services, so our chemical business and our artificial lift business grow at differential rates.

Investor But what about the frac side, as we switch to more oil drilling?

Craighead Generally, it’s harder to push an oil molecule through the rock than a gas molecule, so you have to have more frac stages. However, gas wells have their own unique technical challenges, so all things being equal, it’s pretty much a wash for us.

Investor What about the guar shortage and other supply-chain issues?

Craighead The guar issue is a bit overstated. For about 5% of our slickwater fracs in the second quarter, we introduced an alternative, a polyacrylamide that’s cleaner than guar. We’re seeing market acceptance on that, and the whole industry is working on the next-generation of cross-link gels. As these alternatives become more readily used, it dampens the whole guar shortage issue.

Also, roughly three times the normal acreage has been planted with guar this year in India. There was a lot of speculation in the market, but overall, this is a manageable issue for us.

Investor What’s your outlook on the big picture for the service sector?

Craighead We are very bullish on the near-term and longer-term prospects for our industry. But our customers are telling us they face a variety of challenges: they have access issues, they have reserve replacement issues, and they have resource constraints or capability constraints (by that, I mean it’s a talent issue, it’s not about money).

Investor How do these touch on Baker Hughes?

Craighead For a technical provider like ourselves, if our E&P customers have an access issue, that elevates the role of the resource owner (often a national oil company). And so, at an increasing pace the NOCs are partnering with the service side for a variety of reasons.

On the reserve replacement side, that’s predominantly a technology-driven issue. Customers have to drill deeper wells, in geologically hostile areas that are more difficult to interpret, in harsh areas and complex reservoirs. Technology can help lower their geologic risk or their production risk. As an example, a deepwater well today in the Gulf of Mexico or Brazil can have significant flow assurance issues. It must be chemically treated, or have an ESP installed at the mudline to pump the thicker oil up to the surface. Increasingly, the challenges for the E&P industry create opportunities for the service sector—and we live and die on our intellectual property.

Investor How are customer relationships evolving for you?

Craighead We now take pay-for-performance contracts. We take on operational risk, where if we can drill a well faster, or if we can improve the recovery, we are rewarded for that. You take on more risk, you get more reward. We are also now taking on geological risk.

Investor Geological risk? How does that work?

Craighead If the well doesn’t produce at rates the operator and we expected, there’s a penalty. But if it produces at higher rates, then we are rewarded. The NOC is really asking us to give them an assessment: would you drill this well? How would you maximize the recovery? These resource owners, the NOCs, have a different buying approach. I think they’ll continue to move into more capital-intensive projects like deep water or the Arctic.

Investor And you say you are taking on financial risk?

Craighead Resource owners are increasingly asking the service sector to fund some of the drilling on their behalf. It’s all part of an increasing alignment so that we have the same agenda. It’s just a much healthier, more sustainable relationship. We are both tied at the hip based on the financial performance of the reservoir. This idea is still in its infancy, but it’s the area of our business that grew the fastest for us in 2011.

Investor Isn’t this just project management?

Craighead That’s a component of it. But certainly it goes well beyond project management if you are sharing financial risk. We’ve had to build additional capabilities for this. We bought Gaffney Cline, as well as several other reservoir characterization companies and software companies, in order to get to that next level of the risk curve and better manage reservoir risk. If we are going to help our customers not only from an operational and technical standpoint, but from a financial standpoint, then we’ll need broader capabilities. So we are very optimistic about the service sector.

Investor Do you think the service companies generally are shouldering too much of the R&D responsibility?

Craighead We relish the opportunity to carry the burden on R&D because there is an oppor- tunity to end up monetizing it. We spend about $400- to $500 million annually on R&D. This is a lot of money, and we manage this rigorously. We now have a research center in Saudi Arabia working on tight-gas reservoirs that rivals anything we have in Houston. We also have a new technology center in Rio de Janeiro that is working on pre-salt optimization, and the facility is similar to the one in Saudi.

Another example is in Novosibirsk, Siberia, where we are partnering with the Russian Academy of Sciences. Russia has some of the best mathematicians in the world. Spreading our intellectual capital around the world complements the brain trust we have in Houston.

We estimate the Big Four service companies spend about $2 billion a year on R&D and then another $10 billion a year in capital for new equipment and facilities. That’s a lot of value being injected into the marketplace, and I would argue that the service companies aren’t being fairly rewarded for that investment. Frankly, our industry’s returns in the last few years have not been acceptable. We have to get paid for the value we provide and the investment assumed. Which leads me to believe service pricing will continue to increase.

Investor Is that some kind of warning?

Craighead No, not at all. Resources (technology, people, equipment) always go where they’re loved the most, and that’s where the returns for us are highest. Customers who are willing to pay for the best people and the latest technology, will ultimately see the best returns on their own projects.

Investor You said you have a new class of customer emerging.

Craighead Yes, the pure financial customer who has acquired acreage and turns to the service sector to produce those reserves because they don’t have the capability in house. They say, give us an opinion. Tell us how to produce this.

Investor Do you see a time when you’d form an E&P company with one of these, the way Nabors and First Reserve formed NFR?

Craighead No. Absolutely not. But that’s a very good question. We don’t want to be an E&P company; we want to help our customers be successful. What we’re trying to become is a better service company. You have these changes on the E&P side, changes to the traditional models, and we must respond. But for us, it’s more fun being a service company—we have tremendous opportunities ahead of us.

Investor How do you convey that excitement when you’re recruiting young people?

Craighead When we hit the college campuses, we invite students to our research centers and show them what we’re doing. We are hiring PhDs from nontraditional sources that are not your usual petroleum universities, such as Georgia Tech, Caltech or Stanford, and we are recruiting in disciplines like thermodynamics, materials sciences and such. We know they can go to aerospace or pharmaceuticals or virtually any industry with those science disciplines. But they choose our industry.

You know, we have a pool of PhDs from all over the world working on a vast variety of exciting technical challenges. Our ability to attract brilliant young minds has never been greater, so it gives me a great feeling on where this industry is going. I believe it’s a very noble cause right now to help the world find the energy it needs. Our sector has the means to invest in this exciting technology and research.

Investor Which technology offers you the highest margins?

Craighead Horizontal drilling, driven by Baker Hughes AutoTrakTM Curve Rotary Steerable System.

Investor Do you see more acquisitions down the road?

Craighead Yes. The service sector will continue to expand in order to manage that higher risk curve I mentioned and in order to keep building broader capabilities. We’ll grow in size organically and through acquisitions because you can’t always create everything internally; sometimes you have to acquire it.

Investor Which new technology are you excited about?

Craighead There are a lot of areas that we are excited about. Of particular interest right now is materials sciences. We’ve already applied nanotechnology to completions in the Bakken. In these long horizontals with 30 or 40 frac stages, each stage has to be isolated. To do that we use Baker Hughes IN-TallicTM disintegrating frac balls. They are multiples stronger than steel yet lighter than aluminum, and the key thing is, these nanotech balls are designed to disintegrate in about two weeks, so you don’t have to bring in a coiled tubing unit to get them out.

I think nano science is going to be revolutionary for our industry, and Baker Hughes has already commercialized a number of applications. To your previous question, this is a great example of how we can recruit these new folks to the industry. They see this going on and say, Oh my gosh! This industry is insatiable when it comes to solving intellectual challenges.