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 $80 per barrel. However, oversupply concerns have already driven the price below $60 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 2018
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 500,000 barrels per day, while a wider decision is expected at the next OPEC-plus 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 G20 summit. Meanwhile, US crude exports to China fell 4.0 million barrels in August, the lowest level since September 2016 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 $50 billion in contracts with services and engineering, procurement, and construction (EPC) companies, likely to significantly enhance its ability to increase output by 2020.
- Permian export capacity growth. Plains All American increased capacity in the West Texas oil pipeline system by bringing online 500,000 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 300,000 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.
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 2016, 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 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 2017, and thereafter increasing production by almost one million barrels per day in the second quarter (June 2018 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 $70 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-to-date demand of 99.6 million barrels per day versus September year-to-date demand of 99.8 million barrels per day). Most notably, demand in the United States (20.20 million barrels per day in the third quarter versus 20.30 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 (9.07 million barrels per day versus 9.31 million barrels per day) turned out to be below expectations. Going into 2019, 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 0.6 million barrels per day to 1.1 million barrels per day by 2021) 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 (2019-plus), accelerated switching to renewables could further weigh on demand growth.
On the supply side, oil markets switched from being undersupplied (minus 0.33 million barrels per day stock change between global liquids production and demand) in the second quarter to being oversupplied (0.17 million barrels per day) toward the end of the third quarter. Supply additions from US light tight oil (LTO) (0.31 million barrels per day, according to the Energy Information Administration), OPEC (0.29 million barrels per day), and non-OPEC and non-LTO (1.09 million barrels per day) led to this oversupply, which eventually caused oil to drop below $70 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 2017 and the third quarter of 2018. In the near term, Iran poses the largest downside risk in terms of volume (700–1,200 thousand barrels per day) due to sanctions reimposed by the United States. There could be further declines in Venezuelan output (300–500 thousand barrels per day) and from Libya (300–700 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 2019-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 2020) and the announced Saudi infrastructure investments ($50 billion). This forms the basis for our rather balanced oil activity and price outlook for the foreseeable future.
For 2019, 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 base-case 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 2018, 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 2014, when capital outlays exceeded $100 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 2018 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 2019, most oilfield-service executives pointed to a likely rise in 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 106 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 third-quarter 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 2019, while the rig count should remain stable and production continues to rise.
Offshore, recovery has so far been on a project-to-project basis, and going into 2019, we expect to see this general recovery trend continue; however, a full-blown recovery in offshore is not expected before 2020 at the earliest.
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 second-quarter 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 2019, we expect the rig activity to increase only modestly year over year (about 5 percent higher than the 2018 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 (0.6 percentage points) compared with the second quarter of 2018, 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 2017, and other metals have seen similar increases of 10 to 40 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.
- 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 second-quarter 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 2018, while the backlog for equipment companies remained relatively steady (Exhibit 7).
- 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 outlook less certain. While revenues grew for the subsector, margins increased only slightly by 0.9 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 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.
- 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 book-to-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 2019 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.