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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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The Oilfield Services Model Is Broken

The traditional oilfield services business is broken and the only way to fix it is a complete rethink on how the industry does business.

At least that’s what the Paal Kibsgaard, the CEO of industry leader Schlumberger is telling the world. Oilfield services has been a strong business for about a decade now, but in the last year it has become absolutely abysmal. North American onshore rig counts have collapsed, offshore services have been in the tank for a couple of years, every oil major out there has renegotiated every part of their service contract to slash their own costs (and correspondingly OFS profits), and the pressure shows no sign of abating. Related: Are The Saudis And Russians Deliberately Sabotaging Doha?

The situation is bad enough that it has led Halliburton and Baker Hughes to try consummating a very difficult merger that is getting significant pushback from many quarters. Against that backdrop, it’s little wonder that Kibsgaard is calling for the industry to rethink its practices. His view is that OFS firms and their clients have become disconnected; a fact that has significantly hurt the industry’s cost structure and technological progress.

For evidence, Kibsgaard points out that while investment into oil production has quadrupled in the last decade, global production is only up 15 percent. Much of the current cost savings that exploration companies are seeing now won’t be sustainable in the long run either. These savings are due to competition in the OFS market rather than improved methods in the sector. “The unsustainable financial situation of the service industry together with the massive capacity reductions mean that the cost savings from lower service pricing should largely be reversed when activity levels start picking up,” Kibsgaard said. Related: Oil Stages Comeback On Bullish EIA Data

To reverse the situation, Kibsgaard says that the industry needs to move OFS firms and E&P firms closer together. Current practice in the industry is for E&P firms to draw up drilling plans in house then subcontract out different aspects of the project to different suppliers. The practice can be very economically efficient if the process is well managed and coordinated. But E&P firms which are simultaneously trying to run a business and oversee the development of new wells are likely to be poor stewards of shareholder dollars. Greater collaboration between OFS firms and E&P firms could help to alleviate some of the communications issues that lead to higher financial costs.

Kibsgaard’s suggestions make a lot of sense from an economic standpoint. OFS firms exist because of the inefficiency associated with vertical integration in the space. E&P firms simply don’t drill enough on their own to warrant buying their own rigs and equipment. Thus hiring an E&P firm makes sense in the same way that hiring a construction company makes sense when a manufacturer wants to build a new factory. Related: Huge Fire Erupts at ExxonMobil Refinery Near Houston

Essentially E&P firms are currently trying to do the role of both manufacturer and general contract, which makes little sense from an economic specialization point of view. It’s little surprise of course that the CEO of Schlumberger would be advocating for E&P firms to work more closely with large OFS firms like his own and consolidate the supplier base. That does not mean he is wrong though. Typically complex construction projects require multiple sets of suppliers and contractors. That’s not going to change. But having a single overseer firm that coordinates the project and operates on an efficient contracting scheme can make the overall process run more smoothly.

Financial contracting systems in E&P today are not efficiently designed and their incentives often lead to competing priorities among suppliers, contractors, and the client. That can be fixed by paying attention to the economics of contracting theory and by rethinking the typical business style and mindset of the industry. With the current chaos across the oil patch, there has never been a better time for such reforms by E&P firms.

By Michael McDonald of Oilprice.com

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  • David on April 10 2016 said:
    Another sucker that got taken in by a sales job. Ivory tower academics are the easiest. Did it ever occur to you that he wants the new model so that he can sell more (lucrative) IPM jobs??
  • John Scior on April 11 2016 said:
    I believe this is just a normal part of a cyclical business. when Iraqi oil was taken out of production, oil was very high priced. Also the QE policy adopted by the Fed gave the impression that dollars were being "printed"and thus people who wished to preserve their wealth would move their investments to commodities such as oil futures or gold. This had the effect of creating a commodity bubble which is now being deflated. Lower commodities ( oil included ) prices are hurting the E&P firms as they desperately deal with oil that is not economically recoverable at the lower price and thus the OFS business is also suffering. If the Fed keeps a slow but steady hand at raising interest rates, a unprecedented era of world growth will occur that will allow all producers to benefit. Conversly, too fast movement in raising rates will attract money from the developing world back to the US and lower oil prices will crush the high cost producers out of production.
  • Bill on April 12 2016 said:
    The integrated OFS model as the GC for the operator has been tried and has failed every time. Drilling, completion and production are core competencies within any respectable operator however, although larger OFS companies may offer a myriad of necessary services, they are painfully siloed. In addition, rarely does anyone in the OFS organization have the skill set for the overall project management that a well seasoned engineer in an operating company does. Please.....don't waste our time and money on another embarrassing experiment that has tried and failed.

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