The graph below compares annual price increases of a barrel of oil (WTI) to annual cost increases for finding a barrel of oil (as reported by a sample of super majors). The data for 2002 through 2012 indicates that the price of oil increased 2.5x while the costs to find oil increased 3.5x. Of further note is that the price increases for oil have categorically lagged cost increases (this is indicated by the gray line always below the blue line). This means that marginal benefit to shareholders of an incremental barrel of oil has decreased consistently since 2002.
When I was young…I spoke to my parents with a certain disdain for their forgetfulness. I would wonder how they could not remember in complete detail each and every word we exchanged and every promise they had made. I did not know how humans could operate this way. Thirty five years later my own children wear a similar disdain for theIr father whose powers of memory are diminished.
Imagine a business where commercial exchange relied on the “But You Promised!” parent/child memory system. Imagine the level of disagreement that would occur if commercial facts were contemplated not until a full 30 days after they occurred and at a location hundreds of miles away from the origin of those facts. A significant part of oil field service, in fact, does this – let me explain.
Most oilfield transactions occur in remote locations. Generally the economic terms of those transactions are negotiated well in advance however many of those terms are conditioned on the facts of the situation. These facts might be about on-site risks or punctuality or mechanical breakdowns or the like. It is these facts that many times are not reviewed until 30 days later and miles away the result of which is the same parent/child forgetfulness gap I observed 35 years prior. This GAP finds its way not only into what should be paid but also the institutional perceptions of quality.
HISTORY SHALL BE KIND TO ME FOR I INTEND TO WRITE IT.
The value of mobile technology is that we are able to all AGREE NOW on every aspect of a commercial oilfield service event including the relationship. I can walk up to you on site with my mobile device and we together (customer and service provider) can create a single memory on the spot in the middle of nowhere. An entire month is made to disappear and the anxiety of “but you promised” is forced into exhile. How much would you pay for an entire month?
A Never Ending Industry Problem
The Oil & Gas Industry has long been characterized by huge “boom or bust” cycles during which many fortunes have been made and lost (see chart below). The industry’s boom or bust personality results in a supply chain that is highly unstable marked by rapid industry expansion and contraction. This instability results in supply chain costs that present huge economic risks to oil & gas companies who prefer to find oil & gas for the least amount of money.
The Oil & Gas Industry operates in remote locations which complicates its manufacturing process . The most favored oil field service companies earn their reputations based on an ability to address complications quickly and reliably. The cost of superior responsiveness comes at a high price invariably passed on to the operator. As industry activity increases tension in the supply chain is magnified causing material price inflation. Operators are constantly looking for ways to reduce these costs (we want cheap oil).
How do I Keep My Costs Down?
An operator’s primary strategy to fight increasing prices is to “rationalize” its vendor list – which in plain english means they fire a bunch of vendors in sight of remaining vendors in order to get price concessions. An operator’s secondary strategy is “synchronization” which means better coordination across the supply chain so as to reduce delay. A heavily relied upon tactic to bolster synchronization in oil & gas has been for service companies to place equipment (i.e. inventory) at customer sites. This means “inventory” is available when needed thus reducing delays.
What Does the Rest of the World Do?
An opportunity exists for the oil industry to use remote communications infrastructure, remote communications devices and mobile process improvement software to exploit weaknesses and cost overruns in its management of operations in remote locations.
Information flow technologies have made it to the oil field in the last several years, but companies have not yet maximized the potential cost savings available with intelligent management of inventories, supplies and people in remote drilling locations. Full exploitation of information flow could result in the kind of cost savings that, for instance, retailers have seen in the smart management of their inventory during demand spikes and troughs.
And in Conclusion
The oil & gas industry has among the least stable supply chains in the world. This attribute is completely at odds with its goal of decreasing finding costs. The ingredients necessary to positively impact this goal through improved supply chain management now exist.
Large oil companies typically rely on oilfield service companies to perform work in places where they find oil. Finding and producing oil depends on a wide range of tasks performed by service companies who combine labor (employees), equipment and knowhow to get the oil out of the ground.
There are three ways a company can retain the employees it needs: it can (a) hire them from the outside, (b) hire them from the inside (generally least expensive), or (c) borrow them (i.e. sub-contract – generally most expensive). These choices present different business considerations to a company trying to determine a strategy that best suits its industry and individual conditions. The range of contemplations include (i) what skills do we need today vs. tomorrow? (ii) how much investment do I need to make in my workforce before I realize a return? (iii) how do I source for mission-critical functions vs. short-term requirements? Service companies appeal to their customers for a number of business reasons including that they handle recruiting and retaining the specialized workforces needed to operate in locations all over the globe.
In the context of the Energy industry we can observe that by relying on oilfield service companies, oil companies are “borrowing” a workforce to perform mission critical functions. In other words, oil companies are relying on the most expensive form of sourcing labor to complete an essential function. This expense is compounded by the detrimental effect of a oilfield workforce with more inexperience currently than ever before. Stated another way, oil companies are sourcing their workforce through the most expensive means available (i.e. borrowing), doing so at the highest rates ever, and subject to a notionally less productive labor pool. Add it all up and you get the chart below:
To put this in terms of math, available oilfield employment statistics indicate that average hourly rates for field workers rose approximately 35% during the period 2006 through 2011. During the same period (per the chart above) finding costs per barrel of oil rose 28%. If we assume that labor comprises 20% of the total finding costs, we can infer that each one dollar increase in the cost of labor during the period 2006 to 2011 corresponded to a three dollar increase in all other finding costs.
The point is that the Oil Industry is locked into a labor strategy designed to mitigate downturns but whose course now has a compounding negative consequence. We believe that the implied costs of on-the-job training is revealed in the three dollar increase. All other things held equal the only way to reverse the consequence of this course is to decrease dependence on labor in general and reduced exposure to its inexperienced elements.
On September 3rd, we announced that Geoforce (www.Geoforce.com) had accepted a significant round of financing from Houston Ventures and Palmetto Partners, two of Houston’s most respected investment firms. For those who know me well, I thought I’d proactively address a few questions that are surely headed my way, such as:
- Why now? Haven’t you always wanted to maintain full control of Geoforce, so that you can mold it into a company that excelled across the board?
- You’ve made it into your sixth year without institutional equity investors, and the company is already financially sound. Has something changed?
- Will anything at Geoforce be different going forward?
So what did lead us to finally decide to take on Institutional Equity Financing partners?
Over the past year a couple of things became clear:
- We had more opportunity as a company, particularly in international expansion, than we had resources to capitalize on them. In oil and gas, timing is everything, so we risked missing out on some great opportunities without increased investment in growth.
- As we grew, we continued to enter new frontiers where the experience of people who had “been there/done that” was needed. We knew we could benefit from relationships with others who had been down this road before within the oil and gas technology sector.
Once we made the decision to go for it, then came the tough decision about who to work with. Over the years, we had conversations with over one hundred growth capital companies. But only a handful of these companies had a true understanding of the oil and gas market, how technology should be applied in the oilfield, and how, and where, we should grow. If we were going take funding from institutional equity investors, we wanted more than capital; we wanted a true partner.
Given their extensive experience with international oilfield technology companies like Rignet and LiquidFrameworks, Houston Ventures (and their friends at Palmetto Partners) clearly had an understanding of the oil and gas industry that eclipsed anyone else we spoke with. After many discussions, it was obvious that we thought alike on the sense of urgency – and priorities – for continued rapid expansion. And we also were in alignment about the high level of service required to succeed with oil and gas customers. Finally, we realized that without giving up day-to-day control, we could also gain a trusted advisor in Houston Ventures. So, at that point, the path was clear.
With this investment, we will create a more proactive and hands-on customer experience group, offer more premium products, and establish a presence everywhere our customers are, globally. One thing that won’t change is our commitment to doing things right – for our customers, our employees and, now, for our investors.
It’s fitting that this funding announcement takes place today, September 3, 2013. It was almost exactly one year ago that Geoforce announced our acquisition of Sypes Canyon Communications. At the time, I blogged about the reasons for that move. In looking back at those comments a year later, they remain extremely relevant.
So here we are – AGAIN. It’s – STILL – an exciting time.
In the late 1990′s, there was high demand for investments related to the Internet and eCommerce. The number of companies racing to create an on-line presence for themselves caused stocks of IT service/web-enablement providers to price like those of software product companies. It made little sense and everyone knew it but humans found ways to rationalize the whole thing.
After the tech crash of 2001, two things happened that substantially reduced the trading prices of these companies: (a) demand for software development (IT services) dropped, and (b) many of the things that were repeatedly built on a custom basis became software products. Turning custom web development services into products had the effect of increasing the IT labor pool which compounded the decline in value of IT service company stocks.
It is arguable that EBITDA among oilfield service companies is hovering around an all-time high. This dynamic reminds me much of the pre-tech crash IT service companies where prices were driven by tight labor supply. Here we make the argument that oilfield service margins have exposure to increased automation of the human component. While margins on people are not overly significant, overall margins (which are significant through a combination of people and equipment) are impacted by the supply of people. It goes like this:
- A substantial portion of the gross margin realized from oilfield service derives from equipment used/rented in the field. If demand exceeds supply then margins go up.
- Humans are required to move and/or run the equipment. If there are not enough people to do so, there is, in effect, an equipment shortage which causes margins to go up.
- If suddenly there was a large supply of people available to move and/or run the equipment, there is no longer an equipment shortage and margins go down.
So today’s oilfield labor shortage is revealing itself in the form of higher equipment margins. As a result, there is a drive to decrease human involvement and otherwise increase human productivity. This drive will have the ultimate effect of reeling in equipment margins and making service oilfield companies price more like oilfield service companies. This problem will likely repeat wherever large shale oil plays are found and a sudden need for equipment and labor occurs.
The other day one of our investors commented, “EBITDA is going down” in the oilfield service industry. As evidence, he noted that the number of companies reaching record EBITDA and putting themselves up for sale had increased drastically. His view was that the demand for oilfield services had peaked, causing a downward pressure on prices the companies could charge, and the company owners knew that the best days for gross margins were over.
Between 2002 and 2011, the average cost to find a barrel of oil increased 4.5x. Several variables contributed to this average cost but the increase was driven largely by price inflation. Service companies availed themselves of high demand and tight supply to increase prices, and operators are now responding by “rationalizing” their vendor lists. Said plainly, each vendor that does not find the means to help customers control their costs will suffer with a loss of business – so suddenly everyone is for sale. In order to preserve their market share, service companies are transitioning from price makers to price takers.
As a means to mitigate the effects of price taking, many service companies are adopting techniques that improve their trustworthiness among their operator customers. Much of this involves creating visibility on the service company work stream through which operators can gauge billing veracity. Information technology enables a tighter coupling of customer/provider, meaning the customer can track acitivity and billing more closely, and thus this technology becomes an instrument of competitive differentiation. This in turn reduces the weight of price as a factor for vendor choice and encourages vendors to prize other company services.
The tension level around prices is high (see chart above) and the probability of movement in that tension is high. If I had to forecast directionally this movement, I would bet that EBITDA is going down.