OFSE quarterly: Volatile end to a positive quarter

OFSE quarterly: Volatile end to a positive quarter Crude oil prices rose during the third quarter to reach their highest level in four years, while increased E&P capital expenditures and continued efficiency improvements resulted in better OFSE performance. Nikhil Ati, Marcel Brinkman, Ryan Peacock, and Clint Wood NOVEMBER 218 OIL & GAS PRACTICE BalLi8Tic/Shutterstock

Crude oil prices rose during the third quarter to reach their highest level in four years, with the Brent price closing the quarter at more than $8 per barrel. However, oversupply concerns have already driven the price below $6 per barrel during the early days of the fourth quarter. Increased exploration and production capital expenditures (E&P capex) and continued efficiency improvements resulted in better oilfield services and equipment (OFSE) performance. The quarter ended with a subdued outlook for US activity and price uncertainty linked to sparring among Organization of Petroleum Exporting Countries (OPEC) over production levels. Key events shaping the third quarter of 218 While the direct effects of external events on the oil and gas (O&G) sector were limited, the sector continued to operate against a background of uncertainty in the business environment. OPEC September meeting. There was no clear agreement made during the meeting itself, however Russia and Saudi Arabia subsequently increased production, leading to an eventual drop in the oil price in October. During the OPEC meeting on November 8 in Abu Dhabi, OPEC reiterated its desire to keep the markets in balance; however, no clear commitments were made. Since then, Saudi Arabia has unilaterally announced a cut of 5, barrels per day, while a wider decision is expected at the next OPECplus meeting on December 6. More to follow as oil continues to fall due to oversupply concerns. Sanction on Iran. New sanctions on Iran are expected to come in full force in Q4, and this has started to weigh on the oil markets. However, the full impact on the oil markets may be diluted in the very near term due to exceptions granted to eight countries and increased production from Russia, Saudi Arabia, and other Gulf OPEC members. United States China trade tensions. American and Chinese trade relationships continued to evolve, with clarity expected during the upcoming G2 summit. Meanwhile, US crude exports to China fell 4. million barrels in August, the lowest level since September 216 and a decline of more than 75 percent versus the 16.9 million barrels in July. The election in Brazil. The election of a new president in Brazil, Jair Bolsonaro, is expected to reshape market policies and potentially give a shot in the arm to the Brazilian O&G industry. Saudi infrastructure contracts. Saudi Arabia signed $5 billion in contracts with services and engineering, procurement, and construction (EPC) companies, likely to significantly enhance its ability to increase output by 22. Permian export capacity growth. Plains All American increased capacity in the West Texas oil pipeline system by bringing online 5, barrels per day through the Sunrise pipeline. Moreover, the Sunrise pipeline will help ease Permian takeaway bottlenecks between Midland and Cushing, which its owner, Plains All American, estimates will provide 3, barrels per day of net takeaway capacity from the basin. While this is providing some relief to Midland differentials, the near-term outlook for Permian takeaway capacity remains tight. Oil-and-gas-market trends The third quarter showed mixed results: on one hand, oil prices rose steadily, reaching four-year highs, E&P capital expenditures continued to increase, reaching the highest third-quarter level since 216, and rig activity grew marginally across most regions. As a result, OFSE-sector performance improved slightly. However, by the end of the quarter, the positive picture began to be undermined by a softening demand outlook, declining oil prices 2

due to oversupply concerns, and a less positive US activity outlook in the very near future. Over the last several quarters, OPEC has demonstrated its resolve to keep the markets in balance, initially throttling back production during most of 217, and thereafter increasing production by almost one million barrels per day in the second quarter (June 218 meeting). Then, as prices reached four-year highs late in the third quarter, OPEC cut production again. Brent peaked at over $85 per barrel in early October (the September Brent price was $79) (Exhibit 1). With prices continuing to fall below $7 per barrel, OPEC reiterated its resolve to balance the market in its early November meeting. OPEC s attempt to play this balancing act has had the unintended consequence of increased volatility in the market. The broad demand-driven recovery of global oil markets seen in the first and second quarters slowed down in the third quarter (June year-todate demand of 99.6 million barrels per day versus September year-to-date demand of 99.8 million Exhibit 1 Oil prices increased in the third quarter of 218. Brent spot Oman spot WTI 1 spot Oil price, $ per barrel 14 October2 218 October 222 12 8.5 68.2 1 79.5 7.8 66.2 6.2 8 6 4 2 Spot Futures 26 28 21 212 214 216 218 22 222 1 West Texas Intermediate. 2 Average of monthly spot as of November 2, 218. Source: Bloomberg 3

barrels per day). Most notably, demand in the United States (2.2 million barrels per day in the third quarter versus 2.3 million barrels per day in second quarter), India (4.67 million barrels per day versus 4. 94 million barrels per day), and the Middle East (9.7 million barrels per day versus 9.31 million barrels per day) turned out to be below expectations. Going into 219, the oil-demand outlook remains bleak given concerns over the global economic outlook. But a demand upside could potentially come from the shift to Marine Gasoil (McKinsey s Energy Insights estimates a maximum MARPOL impact of.6 million barrels per day to 1.1 million barrels per day by 221) and any early resolution of trade tensions between China and the United States. However, any price fly-ups due to a supply demand imbalance will likely also put downward pressure on oil demand, as witnessed in the second and third quarter. On top of this, in the longer run (219-plus), accelerated switching to renewables could further weigh on demand growth. On the supply side, oil markets switched from being undersupplied (minus.33 million barrels per day stock change between global liquids production and demand) in the second quarter to being oversupplied (.17 million barrels per day) toward the end of the third quarter. Supply additions from US light tight oil (LTO) (.31 million barrels per day per day, according to the Energy Information Administration), OPEC (.29 million barrels per day), and non-opec and non-lto (1.9 million barrels per day) led to this oversupply, which eventually caused oil to drop below $7 per barrel. This contrasts sharply with the picture 12 months back, when the markets were undersupplied by 1.2 million barrels per day, resulting in the $27 per barrel price increase witnessed between the second quarter of 217 and the third quarter of 218. In the near term, Iran poses the largest downside risk in terms of volume (7 1,2 thousand barrels per day) due to sanctions reimposed by the United States. There could be further declines in Venezuelan output (3 5 thousand barrels per day) and from Libya (3 7 thousand barrels per day). Permian takeaway capacity constraints are already limiting the growth of US production. But, in spite of these near-term downside triggers, we expect the market to remain well supplied in the 219- plus range, particularly as a result of the planned additions to Permian pipeline capacity (over two million barrels per day coming online by end of 22) and the announced Saudi infrastructure investments ($5 billion). This forms the basis for our rather balanced oil activity and price outlook for the foreseeable future. For 219, the Energy Information Administration expects West Texas Intermediate (WTI) prices will average about $67 per barrel, while Brent will slip to a yearly average of about $74 per barrel. This estimate is broadly in line with McKinsey s basecase view of oil trading between $65 per barrel to $75 per barrel. A potential short-term upside in prices could be triggered by supply cuts by OPEC and MARPOL-driven demand shooting. Spending and capital expenditures During the third quarter of 218, capital expenditures stayed close to the levels seen in the second quarter, at around $57 billion the highest third-quarter capex in three years (Exhibit 2). Most of the growth came from national oil companies, with majors registering a slight reduction in spending compared with the second quarter. The totals are still well down on 214, when capital outlays exceeded $1 billion per quarter. Based on experience from previous years, expenditure levels are expected to show a seasonal rise in the fourth quarter, as operators use up the remaining cash in their 218 budgets although this may not apply to US onshore, where executives point to exhausted budgets and a likely spending downturn in the fourth quarter. Looking ahead to 219, most oilfield-service executives pointed to a likely rise in 4

Exhibit 2 Capital expenditures grew in the third quarter of 218. 4Q moving average growth Majors Independents Integrated NOCs Quarterly capital expenditures, $ billion 15 14 13 12 11 1 9 8 7 6 5 4 3 2 1 4Q moving average growth, 3 25 2 15 1 5 5 1 15 2 25 3 28 29 21 211 212 213 214 215 216 217 35 218 Note: Sample includes 8 majors,17 independents, 14 integrated, and 8 national oil companies (NOCs). Source: S&P Capital IQ; McKinsey analysis annual capital-expenditure budgets, given higher underlying oil-price expectation going forward. According to Baker Hughes Rig Count data, the average global rig count rose to 2,258 in September, up 16 from 2,152 in June. Offshore, the number of active rigs increased by nine units (September compared with June), while the onshore rig count saw an increase of 97 rigs in September when compared with June. The average weekly thirdquarter US onshore rig count edged up by eight rigs, compared with the second quarter, but has remained largely flat over the last six to nine months, despite fast-rising production underlying the ongoing improvement in US onshore production efficiency. We expect a softening in completions as we head toward 219, while the rig count should remain stable and production continues to rise. Offshore, recovery has so far been on a project-toproject basis, and going into 219, we expect to see this general recovery trend continue; however, a fullblown recovery in offshore is not expected before 22 at the earliest. 5

OFSE market performance The third quarter was a mixed one for the sector. On the positive side: Rig count, a key indicator of activity, increased in both onshore (136 rigs) and offshore (15 rigs) compared with the second quarter (third-quarter rig count average versus secondquarter average) (Exhibit 3). In US onshore, activity in the Permian increased slightly, with an average of 18 additional rigs drilling in the third quarter compared with the second quarter. Meanwhile, other basins, such as the Bakken (minus one rig when comparing average rig count in the third quarter versus the second quarter) and the Eagleford (increased by two rigs), didn t expand as expected. The fourth quarter is expected to remain less active than previous quarters. Going into 219, we expect the rig activity to increase only modestly year over year (about 5 percent higher than the 218 average). Revenues rose by an average of 2.6 percent for the overall OFSE segment compared with the previous quarter, though there was a wide range of performance (Exhibit 4). Earnings before interest, taxes, depreciation, and amortization rose slightly (.6 percentage Exhibit 3 Global rig count increased both onshore and offshore in the third quarter when compared to the end of the second quarter. North America Asia Pacific Latin America China Middle East Eastern Europe Africa Western Europe Onshore rigs, number of rigs 12-month moving average growth, Offshore rigs, number of rigs 12-month moving average growth, 3,6 3,4 3,2 3, 2,8 2,6 2,4 2,2 2, 1,8 1,6 1,4 1,2 1, 8 6 4 2 28 29 21 211 212 213 214 215 216 217 218 4 35 3 25 2 15 1 5 5 1 15 2 25 3 35 4 45 45 4 35 3 25 2 15 1 5 28 29 21 211 212 213 214 215 216 217 218 4 35 3 25 2 15 1 5 5 1 15 2 25 3 35 4 45 Source: Baker Hughes rig count; McKinsey analysis 6

Exhibit 4 Overall, the third quarter s oilfield services and equipment (OFSE) revenues increased both quarter over quarter and year over year. 4Q moving average growth Quarterly revenue, $ billion 4Q moving average growth, Revenue growth, 9 25 2 15 Quarter vs previous, Q3 218 vs Q2 218 Year on year Q3 218 vs Q3 217 1 Total 2.6 8. 6 5 Equipment 2.3 18.5 5 1 EPC 1 4.7 1.1 3 15 Assets 1. 1.8 2 25 Services 1.4 11. 28 29 Q1 21 Q3 211 212 213 214 215 216 217 218 3 35 Integrated 1.7 9.1 Note: Revenue as announced, adjusted for different accounting/disclosure policy. Sample includes 1 equipment, 9 EPC, 2 asset, 3 integrated, and 6 services companies. Integrated companies include Schlumberger, Halliburton and Baker Hughes, a GE company; services companies include Weatherford, Superior Energy Services, Basic Energy, Calfrac Well Services, Key Energy, and C&J Energy Services. 1 Engineering, procurement, and construction. Source: S&P Capital IQ; McKinsey analysis points) compared with the second quarter of 218, driven by improved pricing in US onshore and ongoing performance improvements across various companies (Exhibit 5). However, these positive developments were offset by a number of negatives: Cost pressures on OFSE margins. Labor and trucking cost pressures continue to weigh on margins for US onshore services companies. Additionally, increased tariffs and steel prices (spot steel price has experienced an increase of 36 percent since 217, and other metals have seen similar increases of 1 to 4 percent during this period) played a crucial role in keeping the margins well below historical levels. We believe there is a case for OFSE companies to pass on these input cost increases to their customers. But, given the current oversupplied situation, pricing discipline has been hard to achieve. 7

Exhibit 5 Margins are continuing to strengthen throughout 218, with positive quarter-over-quarter growth in the third quarter. EBITDA 1 margin, 5 4 3 2 1 EBITDA margin change, percentage points Quarter vs previous, Q3 218 vs Q2 218 Year on year Q3 218 vs Q3 217 Assets 1.2 3.2 Integrated.2.4 Services 1.7 3.3 Equipment.9 1.6 EPC 2.9.1 1 2 28 29 21 211 212 213 214 215 216 217 218 Note: Revenue and EBITDA as announced, adjusted for different accounting/disclosure policy. Sample includes 1 equipment, 9 EPC, 2 asset, 3 integrated, and 6 services companies. Integrated companies include Schlumberger, Halliburton and Baker Hughes, a GE company; services companies include Weatherford, Superior Energy Services, Basic Energy, Calfrac Well Services, Key Energy, and C&J Energy Services. 1 Earnings before interest, taxes, depreciation, and amortization. 2 Engineering, procurement, and construction. Source: S&P Capital IQ; McKinsey analysis Total returns to shareholders (TRS) continued to be weak for the entire sector, although they were two percentage points better than the second quarter for the sector as a whole (average secondquarter TRS versus average third-quarter TRS for assets, EPC, equipment, OFSE, and E&P) (Exhibit 6). EPC book-to-bill ratios continued to decrease in the third quarter of 218, while the backlog for equipment companies remained relatively steady (Exhibit 7). Sector performance Equipment. Revenues were up 2.3 percent compared with the second quarter and almost 19 percent compared with the third quarter of the previous year. In our opinion, this revenue increase doesn t indicate a structural return to capital reinvestment. We continue to believe that for most OFSE subsectors economics still don t justify capital reinvestment, and any growth witnessed by equipment manufacturers is a result of higher well-construction activity (versus capital rebuild), making the direction of revenue 8

Exhibit 6 Returns to shareholders increased at the start of the third quarter but crashed toward the end of the quarter. Assets EPC 1 Equipment OFSE 2 E&P 3 S&P 5 Oil price, Brent Total returns to shareholders, Jan 211, indexed to 1, as of Nov 5, 218, $ TRS, 211 Nov 218, TRS, Jan 215, indexed to 1, as of Nov 5, 218, $ TRS, 215 Nov 218, 28 153.7 16 26 24 22 2 18 16 14 12 1 8 6 4 2 211 15.8 1.8 16.4 36. 47. 66.9 212 213 214 215 216 217 218 219 15 14 41.3 32.4 13 12 15.4 11 1 5.6 9 13.4 8 24.7 7 6 46.5 5 4 Jan 215 Jan 216 Jan 217 Jan 218 Jan 219 1 Engineering, procurement, and construction. 2 Oilfield services and equipment; includes asset, EPC, equipment, integrated, and services companies. 3 Exploration and production; includes majors, national oil companies, integrated, and independent companies. Source: S&P Capital IQ, Thomson Datastream outlook less certain. While revenues grew for the subsector, margins increased only slightly by.9 percentage points. Weaker completion activities late in the quarter and cost pressures, due to increases in tariffs and raw-material costs, continued to weigh on sector performance. Assets. Revenue grew marginally by 1 percent compared with the previous quarter and almost 11 percent compared with the third quarter of the previous year. Most of this growth reflects the slight increase in offshore rig activity seen this quarter. Offshore vessel contract rates saw a marginal improvement in Southeast Asia, the Middle East, and the US Gulf of Mexico (the platform supply vessel sector, in particular), but they remain at very low levels. In the North Sea, the number of vessel fixtures started to dip toward the end of the third quarter as seasonal maintenance work in the area came to an end. Meanwhile, global offshore rig utilization remained relatively steady in the third quarter. As a result, most offshore drilling day rates also remained steady during the third quarter, albeit 9

Exhibit 7 EPC book-to-bill ratios continued to decrease in the third quarter of 218, while equipment ratios remained relatively steady. Book to bill ratio, 1 backlog/revenue 1x 8x Change, Absolute Quarter vs previous, Q3 218 vs Q2 218 Year on year Q3 218 vs Q3 217 6x EPC 2.15.86 4x 2x Equipment.2.12 21 211 212 213 214 215 216 217 218 1 Revenue and backlog as announced, adjusted for different accounting/disclosure policy. Sample includes 5 equipment and 6 EPC companies. Equipment companies include Dril-Quip, Dover, NOV, Oceaneering, and Oil States International. EPC companies include KBR, McDermott, Saipem, TechnipFMC, Fluor, and Subsea 7. 2 Engineering, procurement, and construction. Source: Company filings; S&P Capital IQ; McKinsey analysis at low levels, with some improvements observed in day rates for ultradeep floaters in the US Gulf of Mexico, Africa, and Southeast Asia. Margins for the subsector increased by a small amount (1.2 percentage points versus the second quarter of this year). Services. Revenue saw a 1.4 percentage increase compared with the second quarter of this year and 11 percent compared with the third quarter of the previous year. Margins continued to improve at a slow rate, driven by some price increases that the sector was able to extract and ongoing efforts to improve productivity. Integrated companies. Revenue grew marginally by 1.7 percent compared with the previous quarter and 9 percent compared with the third quarter of the previous year. The revenue growth was uneven across product segments and geography. For example, directional drilling witnessed a rise in international revenue, while pressure pumping in US onshore was flat due to limited takeaway capacity in the Permian and the exhaustion of yearly capital expenditures. The higher revenue did not boost margins, which stayed flat due to lower pricing and higher pressure-pumping maintenance costs. 1

EPC. Revenues for EPC firms were up almost 5 percent compared with the second quarter and relatively flat (up 1 percent) compared with the third quarter of the previous year. This revenue volatility is not atypical for the subsector, given the lumpiness in operators spend profiles. Margins edged up, helped by a rise in EPC bookto-bill ratios in the quarters leading up to the third quarter, although this slipped back slightly during the third quarter itself. While the month of November has brought unexpected gloom in the market, we are hopeful that 219 will turn out to be a better year than the previous few. We wish all our readers the very best for the upcoming holiday season and the New Year. Nikhil Ati is an associate partner in McKinsey s Houston office, where Ryan Peacock is an associate partner with McKinsey s Energy Insights, and Clint Wood is a partner and leader of McKinsey s Oilfield Service & Equipment service line. Marcel Brinkman is a partner in the London office. The authors wish to thank Dominika Balikova and Asong Suh for their contributions to this article. Designed by Global Editorial Services. Copyright 218 McKinsey & Company. All rights reserved. 11