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OFSE quarterly: Firmer oil supports mild offshore recovery, while US onshore remains weak

As prospects of a longer-term structural recovery remain somewhat dim, challenges grow for oil-field services and equipment.

The precipitous fall in crude prices in the fourth quarter of 2018 was somewhat reversed by the supply-restricting playbook deployed by the Organization of Petroleum Exporting Countries (OPEC), but not before dampening the activity outlook for the first quarter of 2019. The ability of US producers to add capacity and take market share continues to dampen hopes for a longer-term structural recovery in more expensive basins (“lower for longer”). Oil-field-services-and-equipment (OFSE) performance, in turn, struggles, reflecting this reality.

Key events shaping the first quarter of 2019

  • Venezuela political situation. Prevailing political uncertainty and additional sanctions continue to put further pressures on the country’s output—with production falling to approximately 800,000 barrels per day (b/d) in April, down from 2.4 million b/d two years earlier. Supply to US Gulf Coast refineries has already fallen to zero (from 509,000 b/d in December), with the final cargoes arriving in April.
  • Iranian exports sanctions coming into play. In late April, the Trump administration announced it would cease sanction exemptions granted to eight countries in November. While the situation in the region remains volatile, an outright disruption of the full regional supply seems unlikely at this moment.
  • OPEC cut extension; adherence remains tight. OPEC and its allies decided on March 18 to maintain their 1.2 million b/d oil-production cuts until the end of June, when they will reconvene in Vienna. By the second week of May there were signs that Saudi Arabia and the United Arab Emirates were beginning to dip into their spare 2.8 million b/d of production capacity in response to falling Venezuelan and Iranian output.
  • Civil war threatens Libyan output. Increased fighting as rebel general Khalifa Haftar approaches the capital of Tripoli is challenging the UN-backed government, causing uncertainty over the country’s political future and threatening up to 1.1 million b/d in oil production.
  • SLB sells Mideast drilling business; drops management contracts. Schlumberger has sold its onshore oil-rig business in Iraq, Kuwait, Oman, and Pakistan for $415 million to Saudi Arabia’s Arabian Drilling Company, a subsidiary of Taqa and joint venture with Schlumberger. In mid-May it sold its noncore US drilling assets to private equity–backed Wellbore Integrity Solutions for $400 million. Schlumberger also decided not to take on any more field-management contracts.
  • Occidental acquires Anadarko. Occidental has reached an agreement to acquire US independent Anadarko for $57 billion. The deal is part of an ongoing consolidation in the US shale sector.

Oil and gas market trends

Global supply dropped through the quarter. OPEC output fell almost 1.6 million b/d between December and March, from 31.6 million b/d to 30.0 million b/d—the lowest level since February 2015, according to OPEC. Saudi Arabia’s March output fell to its lowest level in two years at 9.79 million b/d, leaving its compliance with supply cuts at 153 percent (OPEC was at 116 percent in April). The International Energy Agency (IEA) estimated Venezuelan output fell to 870,000 b/d in March, from 1.14 million b/d in February, although OPEC put the level higher.

US crude production rose by 100,000 b/d in early March, back to its all-time high of 12.1 million b/d. US gas output also reached a record high at 109 billion cubic feet per day in February.

On the demand side, forecasts are being lowered slightly. OPEC cut its outlook for growth this year by 30,000 b/d, to 1.21 million b/d, as a result of “slower-than-expected economic activity.” OPEC has now revised demand projections for 2019 down to 99.96 million b/d—the first time it has dropped below 100 million b/d since last July. The trade dispute between the United States and China is the biggest factor dampening global growth.

Inventory. OECD oil stocks fell counter seasonally by 47.5 million barrels in February and March, to 2,849 million barrels (just below the five-year average), according to the IEA, after three months of increases. The US Energy Information Administration expects global stocks to keep falling this year at an average of 0.2 million b/d as demand outpaces supply. But in 2020, it expects a rise of 1.9 million b/d in supply (mostly from the United States), which will outpace demand growth and should see inventories rise by 0.1 million b/d.

Crude prices. Prices rose through the quarter, with Brent averaging $71.9/barrel in April, up from just under $50.0/barrel at the end of Q4. Looking at the long-term forward curve, after a flattening last quarter as prompt prices fell back, this quarter saw the curve steepen once again, with April 2023 Brent prices at $60.7/barrel—well over $10/barrel below prompt month prices (Exhibit 1). Sweet/sour differentials have widened out again despite the loss of Venezuelan and Saudi heavy sour grades, as refiners reconfigure toward lower marine-transport sulfur rules from the end of this year.

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LNG spot prices. These have reached multiyear lows as a flood of new liquefaction capacity came onstream in Q4 and Q1, while demand from the number-one and number-three buyers, Japan and South Korea, fell back. A recent rise in the number of liquefaction-plant final-investment decisions (FIDs) aims to plug a market gap expected in about five years’ time.

Spending and capital expenditures

Capex in Q1 2019 ($64 billion) was lower than Q4 2018 ($89.7 billion), which was the highest since 2015 (Exhibit 2).

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In North America, capex is still being squeezed despite rising output, with most observers expecting a decline of around 10 percent in onshore exploration-and-production (E&P) investment this year compared with 2018 (exceptions include BP, which is raising US onshore capex to $2 billion to $2.5 billion, from $1 billion in 2018 1 ). The cuts are being driven by demands from investors to live within cash flow and return cash to shareholders, rather than reinvesting or drilling more wells. Many shale producers say they will aim to spend within cash flow and focus on drilled but uncompleted (DUC) wells instead of drilling new ones. The number of DUCs has continued to rise, reaching 8,504 as of February 2019, roughly 25 percent higher than February 2018.

There was a split in fortunes in the OFSE sector, with North American onshore continuing to be squeezed while spending in most other areas started to recover.

In the Mideast, Saudi Arabia and other members of the Gulf Cooperation Council are investing heavily in downstream sectors, as well as gas E&P for power generation to free up oil for export. There is also major upstream spending to boost crude capacity reserves in preparation for the fallout from sanctions and other recent developments—leaving activity at record levels (see rig activity in OFSE section).

Majors are ramping up offshore activity on a project-by-project basis, with some keen to lock in current low costs. In the Gulf of Mexico, however, the mood in OTC was generally muted, with operators not planning a significant ramp-up in activity in the next two to three years.

OFSE market performance

Once again, there was a split in fortunes for those involved in the OFSE sector, with the North American onshore continuing to be squeezed while spending in most other areas (international onshore, offshore) starting to show some recovery. US onshore operators are highly sensitive to price fluctuations (albeit with a slight lag), as can be seen from the fall in Q1 activity following the crude weakness in Q4. Strong activity in gas/liquefied natural gas (LNG) and midstream is helping those with a significant presence in these sectors.

The tough conditions are continuing to result in consolidation. Rig owners Ensco and Rowan have merged, becoming EnscoRowan. The merger provides stronger market positioning with high-specification floaters and jack-ups as well as a more diverse customer base. Ensco’s shareholders will own 55 percent and Rowan’s 45 percent.

Looking at the key OFSE metrics for the quarter

Baker Hughes North American rig count fell by about 60 rigs over the quarter (Exhibit 3), reaching 1,092 in the first week of April (and just 1,049 in the first week of May). In the Permian, where the bulk of rigs are located, numbers fell by 25 (from 487) in the beginning of January, to 462 at the end of April (and 459 at the beginning of May). The number of DUC wells rose again in most basins through the quarter, with Permian totals up from 3,700 at the end of December to 4,021 at the end of March. Away from North America, onshore-rig numbers were up sharply in the Middle East, and down in Latin America.

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Offshore-rig numbers rose to 294 in April, up from 289 in January, and building on the significant rises in Q4 (up 15 percent), especially in the Middle East. The biggest rises were in Africa, Latin America, and Western Europe, where the number of active offshore rigs rose to 32 in April from 27 in January.

Overall revenue for the OFSE sector was down 7.7 percent on Q4 (after a 1.5 percent quarterly rise in Q4) but was still 2.4 percent up on Q1 2018 (Exhibit 4). Equipment and engineering, procurement, and construction (EPC) segments performed most poorly in Q1, while all segments remain up on Q1 2018, apart from services.

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Average earnings before interest, taxes, depreciation, and amortization dropped in all segments apart from EPC compared with the previous quarter, building on falls in Q4 (Exhibit 5). All, apart from assets and equipment, are now below the levels of a year ago, although only slightly (margins had improved through the middle part of last year).

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Total shareholder returns (TSR) gained ground through most of Q1 2019, after sharp falls through Q4 (Exhibit 6). However, while oil prices outperformed the market, OFSE share prices did not—coming in well below other sectors (E&P also lagged behind the crude gains and general equity market). This recent significant underperformance of major oil-field-service companies relative to the market is probably reflecting a major structural change in long-term expectations. In addition, many fossil-fuel-related stocks now have a discount associated with potential action regarding climate-change risks.

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Segment performance

Equipment: Revenues saw a quarterly fall of over 10 percent, after a 7 percent rise in Q4 (Q4 was 15 percent up on Q4 2017). However, revenue remained 2.9 percent up on Q1 last year. Margins were little changed on Q4, after slipping slightly last quarter, but did maintain some strength relative to last year, gaining 0.8 percentage points (pp) on Q1 2018 (Exhibit 7). Equipment book-to-bill ratios rose in Q1 and are now 0.30 above year-ago levels.

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Assets: Revenue was down 1.5 percent on the quarter, after a rise of 1.2 percent in Q4. However, they remain over 6 percent up on Q1 2018 as a result of strong performance during the middle part of last year. Margins were down 2.2 percent after little change in Q4, and they remain just above the levels seen for Q1 2018.

Services: Revenue was down 3.8 percent compared with Q4 2018, after falling 10.0 percent in Q4, and was 9.6 percent down on the year. Margins were down 0.8 pp on the quarter and 2.6 pp compared with Q1 2018. Service companies reported, as expected (several executives flagged this in Q4 earnings calls), that North American demand for completion services fell through Q4 and into Q1, leading to lower pricing for fracking services.

Integrated companies: Revenue was down 5.6 percent compared with the previous quarter, after a flat Q4, but remains slightly (1.4 percent) up on the year. Margins were down 1.7 pp compared with Q4 2018 and 1.3 pp on the year. Business exposed to the US onshore suffered most, with big falls in US onshore revenue (driven particularly by lower pricing for stimulation services), although this was offset by gains in some offshore areas. Halliburton (the integrated company most exposed to US onshore) said overall completion and production revenue was down, while drilling and evaluation revenue gained ground. Its top spot globally was Latin America, where increased stimulation and fluids activity helped boost revenue.

EPC: Revenues for EPC firms were down over 10.0 percent in the quarter after a 2.0 percent rise in Q4, and they are now 4.4 percent above Q1 2018 levels. Margins fared a little better, however, gaining 1.9 pp in Q1, although they are still 0.3 pp down on Q1 2018. The year-on-year revenue growth reflects an increase in new projects being sanctioned, which has boosted the fortunes of some EPC providers.

About the author(s)

Nikhil Ati is a partner in McKinsey’s Houston office.

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