As the price of a barrel of crude approaches $50 for the first time since spring 2015, many anticipate that E&P operators will begin to crawl out of their bunkers and—finally—add rigs again. Some bullish analysts, even, anticipate a sudden flip in supply and demand dynamics in the second half of this year, pushing WTI prices into the range of $70 per barrel (bbl). That would be good news for an industry starved of oxygen, but after a year and a half of falling rig count, the spotlight turns to the beleaguered service sector. Will oilfield services be able to respond when the call to ramp comes?

Oil and Gas Investor separately surveyed two service sector analysts and a consultant to explore the issue. Marc Bianchi is managing director and head of oil research for Cowen and Co., based in New York. John Daniel is managing director for Simmons & Co. International and is based in Houston. Richard Spears is vice president of oilfield market research firm Spears & Associates, based in Tulsa.


Following are their insights.

Investor Will the service sector have the capacity to respond when capital begins flowing back into the E&P space?


Bianchi There’s going to be a phase of increase that the service sector can respond to pretty quickly without a lot of cost. A general rule of thumb is that after six months you can get back about 50% of the work force you’ve let go. We’ve dropped close to 400 rigs in the last six months, so maybe that means we can put back some 200 rigs, or at least the people associated with 200 rigs, in six months. Everybody’s got some level of preparedness for a recovery.


Look at what HP is doing in West Texas where you see all the rigs stacked up. They’re set up vertically, and they’re turning them on once or twice a week, depending on how quickly they’re planning to return them to work. They’re ready. That’s not all their rigs; it’s a portion of them. So there’s a first layer that’s going to go pretty easily.


After we add 200 rigs, the next layer is where it’s a little bit harder to add equipment and people. Costs may need to go higher, so it’s more expensive for service companies to put those people and that equipment back to work. They may need a price increase to justify putting that equipment back into the field.


Daniel It varies by product line. With a land drilling contractor, as the rigs get laid down, each of those rigs is going to have a rig supervisor. So you take those rig supervisors and put them on another working rig, your most experienced people, and those are the people you’re going to need when you start deploying rigs again. Then you just have to get the hands, and that won’t slow the rate of ramping higher. The same holds true with services such as well servicing and several other product lines as well.

Fabricators and manufacturers have been working employees in shifts of four days a week, 32 hours a week. They can take those guys to 40 hours or put them on overtime, so you automatically have some built-in flex initially on a recovery.

In the heyday, when things were booming, we were moving lots of people doing seven days on, seven off schedules and moving from location to location around the country. Getting the folks from great distances will be a bit more challenging. But for the people living in the Midland-Odessa area and other towns in or near popular oil and gas basins, getting that element of people back is going to be easier.


In the initial phase of the recovery, I don’t think labor is going to be a big constraint. There are going to be people that want to go back to work, that need to go back to work. The oilfield historically has paid its employees well, and I suspect that will be the case once again when the market recovers.


Spears The hydraulic fracturing market will be the first to enjoy the upturn because of all these drilled uncompleted wells [DUCs]. The thing they need is a frack job. And for the frack companies that still exist, they can take on about 20% more work. They’ve got people and equipment ready to go and can go from 100 jobs a month to 120 without adding any equipment or hiring more people. That’s the flex.


And all the support companies around that—wireline, plug and perf, coiled tubing, rental yards—they’ve all got that same capacity to increase their number of jobs by 20%. That part is going to be easy.


But to increase by 30% to 35% will require both hiring people and getting some money together to fix trucks that aren’t currently capable of working. That’s specific to the frack industry. Most other sectors don’t suffer from this same attrition rate. Their equipment doesn’t wear out like the frack guys does. Their ability to bring in another truck or drilling rig is easier than for the frack service companies.


Investor How hard hit is the service side?


Spears The biggest, most high-profile segment of the oilfield in the U.S. is the hydraulic fracturing market. In 2014, the global hydraulic fracturing market was right at $43 billion. This is the amount of money oil companies spent buying frack jobs from Halliburton, Schlumberger, Baker Hughes and the other 45 frack companies out there. Even though it’s a global industry, it’s mostly a U.S. market. That was the peak.


This year, the number will be more like $16 billion. That’s a 63% decline from the peak. That collapse has been felt by every frack company large and small, public and private. Everybody is suffering from the same situation.


Bianchi The bellwether of the sector, Schlumberger, posted a 70 basis point loss in the first quarter in North America for EBIT margins. That’s compared to 20% in third-quarter 2013. We’re modeling that they’re down double-digit margins in second-quarter 2016. That’s a pretty shocking number for a company that previously said they were going to hold the line on 5% margins in North America. That’s what they thought they could defend through the downturn. They haven’t been able to do that.
Daniel Everybody’s in survival mode; that’s the reality.


Investor How much of an impact is cannibalization of equipment having on deliverability of the pressure pumping sector?


Daniel No doubt cannibalization is going on. Margins of the pressure pumping industry have been some of the most severely hit—a lot of companies are reporting negative EBITDA. That is a product line where the useful life, depending on the utilization, is shorter. You have the combination of a relatively shorter useful life and very weak cash flow, so the reinvestment levels are depressed.


If you go into the Permian in the Midland-Odessa area on I-20, you can drive by the yards where the equipment is parked against the fence, where engines and power ends and fluid ends have all been pulled off, because these frack companies are taking parts from idle equipment to keep other equipment working. You can see similar sights in El Reno, Oklahoma, and I presume many other places as well. I was with an aftermarket company that does equipment rebuilds, and they had a situation where a frack company brought in three pumps to get the good parts to rebuild one pump. I have had other companies specifically tell me that they are robbing parts from equipment to keep other equipment running. That’s the definition of cannibalization.


When the public oil service companies report their capital expenditures, you can see significant declines in capex spending, but you can verify that by going out into the field and speaking with the aftermarket providers, and they will tell you that virtually no one is doing anything because they are conserving cash.


Spears It’s pretty bad. Nobody really knows what the fleet status is. None of the frack services companies have to tell you the state of their equipment.


From what our team is able to observe, about 8 million of the 22 million in horsepower is in some sort of condition that makes it not able to go back to work without a major capital investment. Most of the independent privately owned frack companies, even some of the public ones, are struggling financially and may not currently have the capital to repair their equipment and bring it back to work.


When a downturn is only one year long, you don’t cannibalize all your equipment; you just leave it sitting there. In this case, the downturn has gone on so long that even the healthy companies are doing only the barest minimum to maintain their equipment, especially in the frack world. Some companies just cannot sustain themselves anymore.


When a component on a frack truck fails, like the engine, transmission or pump, that is a quarter--of-a-million-dollar component. What does a frack company do? They drag that piece of equipment back to the yard, park it by the fence, get one of the remaining trucks that’s idle and plug it into the system. They can do that until the one idle frack spread is completely decimated. Now what do you do when the next truck fails? You lose your ability to work. It’s a race to the bottom.


Bianchi The best estimate I’ve seen is there’s about 2 million horsepower that’s permanently been taken out of the marketplace—this is on an 18 million horsepower base—and ultimately 30%, or 5.4 million, will come out. There’s another estimate out there that 8 million in horsepower will go away.


I’m skeptical about the higher-end numbers of attrition that people are talking about. This isn’t going to be fixed by [equipment] supply attrition. Just because something is unfit to go back to the market today doesn’t mean that it can’t be repaired in an upcycle. That can turn quickly when the market comes back.


Certain pressure pumping companies have talked about having a certain number of crews sitting on the fence ready to go. The equipment’s in great shape, they’re prepared, waiting for the business to come back.


Investor What about the drillers?


Spears A lot of the rigs that have disappeared from the market are vertical rigs, and they don’t represent all that much spending. The horizontal rigs are a big driver of this business.


The top four drilling contractors—H&P, Precision, Nabors and Patterson—each one of those companies has strong balance sheets, each has stacked rigs in a way that are ready to go. Those guys don’t have the same problems that the frack guys do, where they worked the equipment to failure then shoved it out by the fence. With very little investment, they can deploy those rigs back out into the field.


The drilling side is so much easier to bring back to full throttle than the completions side.


Bianchi There is a difference in pressure pumping and land drilling. The land-drilling equipment just sits there idle, and it’s going to be ready to go back to work whenever they decide to without a whole lot of investment or repair required.


HP, for instance, has a handful of rigs that are hot-stacked in West Texas and ready to go. If they have visibility of putting those hot-stacked rigs out, they then take warm-stacked rigs and start doing the things to hot-stack them. The difference is basically how often you turn the engine on. It’s not like offshore drilling where the stacking process is more involved.


Daniel We’re roughly at 400 rigs drilling in the U.S., compared with nearly 2,000 rigs not too long ago. But considering those that are higher quality—walking capable, skidding capable—by my tally that’s around 980 rigs total in the U.S. fleet. If you make the assumption that all of those rigs have been properly maintained, that the equipment is a longer-lived asset than of a frack company, you could estimate 400 to 500 rigs that are reasonably ready and could quickly go to work.


The governing item is not going to be the equipment; the governing issue initially will be labor. But in that first wave of the recovery you’ll have a certain level of embedded people in communities that want to go back to work. Also, the magnitude of any potential labor problem will be dictated by the speed at which customers want to return to work. Our sense is that we will not have any major challenges at the start of the recovery.


I’m less concerned about equipment quality for product lines such as land drilling, well servicing, wireline and coiled tubing. I do believe, however, that we are structurally overcapitalized in a $40 to $50/bbl world.


Investor Will we experience an attrition of oilfield equipment, or just a consolidation with few companies?


Bianchi Here’s the problem: The company may go away, but the equipment and infrastructure is not going to get sent to the scrapyard. You see external capital providers come in and put new capital into these businesses, repair their equipment that might be underinvested, so that they can fight another day. Then it’s back out working a few months later. That’s the concern.


Spears Very few companies just simply close and their equipment disappears; that doesn’t happen. Factories close, but the factory still exists. Drilling rigs still exist. Coiled tubing units still exist. The capacity of the industry in terms of buildings and machine tools and units that can go into the field—that doesn’t decline all that much, even during a period like this. The only part of the industry where the capacity is actually evaporating is the hydraulic fracturing part, because equipment works so hard when it’s working.


Daniel Of those companies that have shut down, those assets have either been sold at auction or are sitting in used equipment yards. There are fewer competitors now, but that equipment is still for sale. If you want to start up a frack company, you can get the assets.


Other companies in the frack business took deliverability of new equipment over the last couple of years, but because the market was turning, they never deployed it. So these companies have brand new equipment that’s ready to go. A large number of companies have equipment that is idle, and with some degree of capital, could have it back to work in relatively short order.


Investor How short a period of time?


Daniel Thirty, 60, maybe 90 days. The employees have been let go because there hasn’t been the work, but the working assumption is they can bring them back. Some of the equipment packagers are located in more populated areas, thus the ability to find people will be easier. For those companies to start ramping capacity is one, maybe two quarters. Will they get back to the peak production levels of 2011 and the efficiencies? Not right away. That takes time. But you’ve got greater infrastructure today.


Investor What about consolidation in the sector?


Bianchi Consolidation would make sense, but I don’t think we’re going to see much. The consistent response we’ve gotten from companies is they’ve already got enough equipment. If they’re running at less than 50% utilization, why would they want to buy more? They want to see their own equipment increase utilization first before they go out and buy something else.


Daniel Balance-sheet challenges are limiting acquisition opportunities, and everybody knows we’re structurally oversupplied today. A buyer of assets probably has a significant portion of its own assets that are idle, so why would it want to buy someone else’s idle equipment unless there is a very good purchase price?


Investor Are oilfield equipment manufacturers a weak link in the supply chain?


Daniel The equipment manufacturers might not be manufacturing a significant amount of a particular product today, but they’re still there. They still have the roofline and the machinery with which to manufacture. All that is necessary is to bring the machinists back in, and you can ramp it up relatively quickly. There are plenty of new component parts on the sidelines, so that won’t be a constraint.


Investor What price is it going to take to get people back to work?


Spears It’s not $90 anymore; it’s in the $70 to $80 range. Absolutely, drilling rigs can go back to work at $50 to $60/bbl, but as soon as that happens, the price of a frack job and a drilling rig day will begin to rise rapidly. And no longer will it be economic to drill a well at $50/bbl; you’ll need $60, then you’ll need $70, then $80.


The cost of a well about a year from now is going to be 20% higher than it is today, and a year after that it will be 20% more.
The service sector is willing to work at its cash-cost basis right now. There is no profit built into these prices, but you can’t sustain that. As long as you do that, you’re not repairing your equipment, you’re not upgrading your technology, you’re not paying your people any more. You can do it for a little while to stay in business, but not long term.


Bianchi That’s the $64,000 question. A lot of balance-sheet repair needs to occur in the E&P sector first when cash flows improve. Historically, these guys spend every single dollar that comes in, but now, does 50 cents go into returning rigs to work or paying debt?


At $55, I don’t think every single service company needs to exist. You need something higher to absorb all the capacity. I don’t know if that number’s $65 or $75, or if it’s quite a bit higher.


Daniel The mood was better on my most recent trips to the Permian and Midcontinent. The hope was that if we could reach the mid-$40s and stay there for a few months, then we’d start to see production-related work pick up: well servicing, workover projects and getting DUCs completed. I did not get the sense that $45 oil would initiate a huge ramp in the rig count.


But if oil’s on its way to $50, the pricing for equipment is so low right now, with high-quality land rigs that are priced below the mid-teens, that’s a great deal and forward-thinking E&Ps would be wise to try to lock in pricing.


Investor Will service providers have enough capital to ramp?


Bianchi Certain companies won’t, but enough of the industry will have capital to meet a gradual increase. If you need borrowing capacity, banks have tight purse strings right now, but if commodity prices run to $65, maybe there will be more willingness to extend credit.


Investor What’s your visibility going forward?


Daniel The key ultimately that’s going to dictate how quickly we can ramp is the depth and the duration of this downturn. Our view is that we stabilized in the second quarter and will begin to see a gradual uptick. And it’s easier to adapt to a gradual recovery. If we go vertical because all of a sudden oil goes to $60 and everybody wants a rig right away, then it will be more of a challenge. That’s the unknown.


Our working view at Simmons is that we’ll exit 2018 in the range of 900 rigs—call it an increase of roughly 500 rigs from here. That assumption assumes a normalization in oil prices of $50 to $60 over the next couple of years.


Bianchi Our base case is that the rig count will increase over the next couple of years. We’ve got the U.S. land rig count averaging 420 rigs in 2016. We have a bit of an increase starting in fourth-quarter 2016, and then we have an average of 565 in 2017. It’s a pretty gradual recovery compared to other estimates.


You’re seeing strength in the oil price now, and if it continues, you could see industry adding activity in the back half of the year. Four to six months later, you will see a production response to that. Not necessarily that oil production reverses, but the pace of decline is not as severe as everybody was anticipating.


That ends up being bearish for the commodity price. So we have this production increase, and then the commodity price rolls over. Repeat that cycle. We may have one or more of those to go before we’re actually off to a more sustainable increase.


Spears We believe that second-quarter 2016 is the low point. Our firm has said for a long time now that the second half of this year is when the growth occurs again. Once the market starts to recover, our view is the market begins to recover and continues to recover. We’ll enter into a two- or three- or four-year period where each quarter shows greater activity than the prior quarter. Drilling activity rises by 5% in the third and again in the fourth quarter.


Spending on completion-related services rises faster than that in each of those quarters. All those DUCs come flooding into the market right away, which all demand a frack job. The price of a frack job and everything related to well completions is going to start climbing by 5% to 10% per quarter, so these cheap jobs that make it possible to drill and complete a well economically at $45 to $50/bbl, those economics rapidly evaporate. By the time we’re a year beyond the bottom, prices are almost all the way back up to where the price was before the downturn.


That’s why fracking becomes the sector that runs into a capacity problem the quickest. It’s a capital-intensive initiative to get another frack spread operating again, so we can grow by 20%, no problem.


After that, the ability to respond to demand growth gets really difficult. It’s going to be a massive undertaking.