The Coming Year: More Tension Spouts in Oil World in '99

About the only thing rising in the oil patch these days is the tension between oil-service companies and their oil-producing customers.

The two groups have long subsisted on a symbiotic relationship, with oil companies saving money by farming out work and oil-service companies readily supplying gear, expertise and labor in exchange for generous profit margins. But oil's pitiful price is subtly changing this, slowly creating an environment in which companies look out only for themselves.

Oil companies are breaking drilling rig contracts and refusing to reimburse cost-overrun claims, a scenario similar to General Motors' (GM) tack earlier this decade when it infuriated suppliers. In return, service providers are threatening legal action against some of their largest customers.

It's still possible for oil companies and oil-service providers to reach a truce and decide that working together offers a much better chance for long-term wealth, much as Chrysler years ago decided to work with suppliers to cut costs and then share those benefits with them.

As one manager at a large oil-service company who spoke on the condition of anonymity says, the relationship between oil-service companies and oil companies is strange. Although it has become much more cooperative than it was 25 years ago, in hard times, even the best of brothers can fight, he says.

How these relationships develop in this highly tense period for the industry is crucial, this manager says. In theory, a depressed period can be an opportunity for oil-service companies to strengthen relationships with their customers. That will pay off when the industry recovers. But flare-ups between operators and service contractors can have ramifications down the road, such as when operators award new contracts.

Either way, how the patch responds to this changing environment is surely one of the developing stories of the new year.

All of this stems from weak oil prices -- they're down about 40% from a year ago -- and their impact is expected to continue into the new millennium. Last year alone, the average oil-company cash flow fell 25% to 30%. As a result, oil companies are merging, slashing budgets and cutting payrolls.

For oil-service companies, this leaves fewer customers, and those that remain are watching every dime. Less spending drains oil-service earnings -- industry analysts continue cutting earnings estimates.

The latest casualty was Halliburton (HAL), which announced Dec. 28 it is expecting $60 million in fourth-quarter pretax losses from the inability or unwillingness of some if its joint-venture partners -- many of which are large international oil companies -- and major subcontractors to pay their financial obligations for projects in the North Sea, North Africa and Latin America. Dallas-based Halliburton, the largest oil-service company based on revenue, said it expects to earn between 14 and 16 cents for the quarter because of these losses, well below the First Call consensus estimate of 36 cents. The stock dropped 8% the day after the announcement, indicating all the bad news isn't priced into this group of stocks.

Just a few weeks ago, R&B Falcon (FLC) said it intends to pursue "legal remedies" after Mobil (MOB) terminated a drilling contract early.

In another indication of the environment, even squabbles among service companies are on the rise. Just Thursday, Venture Seismic (VSEIF) announced a contract dispute with Western Geophysical, now a division of Baker Hughes (BHI), which was using a Venture vessel for a yearlong seismic shoot. Under a motion filed by Western Atlas in Alabama for breach of contract and damages, the Venture vessel was seized. This type of situation would have been unthinkable about a year ago in the small world of the oil patch.

As long as oil prices remain in the $10 to $15 per barrel range, service companies will be squeezed, leading to competitive pricing for market share. Even if, as some industry bulls predict, oil prices recover later this year, there is a lag of up to a year before oil companies gain the confidence to expand spending. Only then will oil-service contractors be able to justify price increases in rig rental rates and drilling products and services.

Even in this atmosphere, examples of cooperation abound -- especially in frontier areas such as deep-water Gulf of Mexico or the waters offshore eastern Canada. Chevron (CHV) set up a strategic alliance last year with several service providers to ensure it had the services it needed as it set up deep-water operations in the gulf.

"These are agreements and relationships we value very highly," says Andy Hardiman, a Chevron vice-president in the company's Gulf of Mexico deep-water business unit. The alliance was set up to benefit all participants, Hardiman adds, with no price-gauging on either side.

But even in this pocket of cooperation, Hardiman offers a warning: Oil-service costs have got to come down, he says, if there is to be any hope for an oil company to be an efficient operator.

And they most assuredly will, given the competitive pricing environment with major customers being swallowed up in mergers and the constant fight for market share among service providers. On the horizon is fallout from low oil prices in two crucial markets for oil services: the North Sea and the Middle East. With major budget deficits projected for Saudi Arabia and Kuwait, drilling activity is sure to be scaled back in that major producing region. In the North Sea, one of the world's highest production-cost areas, the profit margin on a barrel is nil right now. One major drilling contractor estimates that third-generation semisubmersible rigs will soon be working at rental rates close to cash operating costs -- that's a $30,000 per day drop from current average prices.

While these two areas account for roughly 30% to 35% of oil-service revenue, says Wes Maat, who follows the group at Deutsche Bank Securities in New York, the percentage of profits generated from these areas is sharply higher. That will have a sharp earnings impact in 1999 and into 2000, he says, an impact not yet fully realized by the market.

"We still have some of the most important areas of the world that are very vulnerable right now," Maat says. What sets the tone for both drilling levels and cooperation between oil-service companies and their customers is the commodity price.

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