Happy Sunday.
Quick DEP update. We kick off our first DEP Telluride Executive Series on Tuesday evening. The event will include leadership from over 50 energy-related companies – a nice setting for industry updates and networking. We hope to make this an annual event and are very grateful to our event sponsors: David de Roode at Lockton Companies, Flecha Azul Tequila (never leave home without it), Wildcat Oil Tools, Thompson Knight, Americana Partners and the Energy Workforce & Technology Council. We’ll publish our conference takeaways next week. Also, we moved our OKC Steak & Baseball to July 15th instead of the previously announced July 6th date. Instead, DEP will circulate through the DFW area next week, so please let us know if you are around. We would welcome the chance to come harass you. Finally, we include an update on our Permian BBQ Cook-Off at the end of this note.
U.S. Coiled Tubing Market Update. This past week we updated with a number of our coiled tubing contacts, including both service and capital equipment providers. Multiple discussions validate competitive tensions in the CT sector arguably make it one of the hardest playgrounds to play in. The combination of too many players and limited equipment differentiation creates a highly competitive market that is still characterized by aggressive price competition. Making matters worse are rising costs. Steel costs are up, with one company reporting steel prices up nearly 20%. Diesel costs are up nearly 50% with some CT companies still picking up the diesel burden and now with higher activity, maintenance expenses, as a percent of revenue, are on the rise.
A key concern with industry contacts is the growing people challenge. Yes, recruiting new people into the industry is difficult, but the looming threat on everyone’s mind is renewed crew poaching. The poaching, we believe, is the result of strong demand as multiple companies now report job turn-down’s due to insufficient crews. The solution, some believe, is to steal a crew to capture the work. However, this solution is not without challenges as crew poaching often involves higher compensation (i.e. a carrot to switch jobs). What we now hear are purported efforts by some players to enhance compensation and benefit programs as a tool to attract personnel. Such a move may have a short-term benefit, but prospects of subsequent industry labor inflation are sure to follow as other CT companies will be forced to match those benefits. The net result is higher labor costs for all. And, in all likelihood, higher labor costs will precede higher CT rates, not good.
As for the market, our working tally of large diameter CT units stands at roughly 211 units. We estimate ~95-100 are actively marketed while we are tracking at least two new CT units still to be delivered to the U.S. market. We also believe there are as many as 25-30 large diameter units in the hands of companies who stacked all units and/or shut down. We’d like to say we know where these assets are, but frankly, we don’t. Some of these units probably get recirculated back into the market.
Financial disclosure for CT is at its lowest point in many years as companies who historically reported CT data have dialed back information. No longer do public companies report CT margins, but many still report quarterly revenue. To put the CT market challenges in perspective, if one were to look at the collective revenue of those companies who used to report CT results (i.e. RES, NINE, KEG, BAS, PES, CJES, STEP.CN), this collective group generated revenue of roughly $143M in Q1’19. For Q1’21, we estimate this same group generated revenue of $45M. During Q1’19, PES generated gross margins of ~23% while KEG reported adjusted EBITDA margins of -8%. Today, PES is out of the CT market while KEG did not disclose its Q1’21 margins, but we would submit the margin profile of the industry is likely not much better than 2019 given the dramatic revenue drop-off.
As we update with our industry contacts, it is clear the CT strategy is being deemphasized by select players. These companies either lack scale or the CT business is no longer core. Consequently, multiple contacts acknowledge a willingess to shudder their CT business if market conditions don’t improve. Is this good? Depends. If a company elects to exit a business, the next step is to sell the equipment. We have seen this strategy already during the past few quarters and we can identify at least two new CT players who entered the market via used equipment purchases. We submit some OFS players believe a strategy of outlasting their peers will be ultimately rewarded with higher returns. We disagree given too many examples of companies emerging via used equipment purchases. Consequently, the right strategy today, whether it be the CT market or any other OFS subsegments where equipment differentiaton doesn’t exist, is to pursue defensive deals to remove equipment from the market. At least, that’s our opinion. And, just as the E&P sector (globally) has limited oil supply for the sake of higher prices, so too should the OFS sector. We recognize, of course, the idea of buying an underperforming business is generally unappealing, but what’s clear from our discussions is the major issue facing the CT sector is a lack of price. Charging low $30’s/day for a LD CT spread simply won’t cut it. Sure, it’s an improvement from the $20’s/day months ago, but today’s pricing remains below pre-COVID levels, yet the operational costs appear higher.
So does consolidation happen? That’s the million dollar question, but here’s our take. First, there are multiple CT players who are no longer committed to the space. Many would prefer not to sell for cash given diminished asset values witnessed at auctions. Some see greater value in rolling their business into a more viable player. This could, in some cases, require the seller to take paper/equity in another private player, but with more concentration should come pricing power which should yield margin expansion, thus enhanced valuations. Interestingly, those who don’t have bank restrictions which limit this type of transaction are amendable to pursuing this route as none want to sell assets for depressed prices. Rather, a call option on the business recovery is preferred. Others, however, argue the merits of transacting in one-off coiled tubing deals is too time consuming/frustrating. Rather, they argue bigger company-to-company mergers are necessary in order to extract maximum cost savings. Makes sense, but we are big “stick-to-the-knitting” believers and advocate for core segment consolidation as opposed to just getting bigger. The key thing to realize is everyone knows the sector needs consolidation and everyone claims a willingness the participate, thus the core ingredients for consolidation exists, but will rational minds prevail?
Frac Fleet Expansion. BJ Energy Solutions announced this week additional contracts to support is emission-friendly fleet expansion. The company announced two additional take-or-pay arrangements, bringing the total number of contracted new TITAN fleets to four. Financial terms of the agreement were not provided, but these are multi-year arrangements with one E&P. We would suspect (and hope) the returns on these contracts will be above the market rates reported during Q1 earnings season. All of the fleets, we believe, will work in the Haynesville/East Texas region initially. As a reminder, the TITAN fleet uses a 5,000HP pump which is powered by a mechanical direct drive 100% natural gas-fired turbine.
Frac Fleet Expansion Considered. Think of this for a moment. We know private E&P’s have been and continue to be more assertive with respect to D&C activity relative to their public peers. These companies enjoy the beauty of being private, thus they can prosecute the highest return projects without blowback from fickle public shareholders. Yes, we get debt reduction is important, but the returns on new wells at $70 WTI / $3.00 nat gas are probably better than paying down debt. Private E&P’s know this, thus they are allocating more capital (on a relative basis) to new wells. Now consider the parallel with the OFS space. Returns for the sector have been abysmal. Many public companies are still fighting for profitability while free cash flow remains an aspiration for some. Now consider the fact that E&P companies are striving to drive emissions lower. This puts the OFS sector in a bind. Do you invest to support your customer and hopefully earn market share? On the surface, this makes sense, but for those who are public, will the shareholder base support a heavy capex plan when returns, thus far, have been lacking? Moreover, the perception of an oversupplied, fragmented market remains, thus does fleet expansion make sense in this evironment? It’s a fair question. However, for private players such as BJ Energy Solutions, there is a unique advantage at hand. Adopt the fleet differentiation strategy, take market share and position yourself for something better down the road. Arguably, for the private OFS player, this might just be the right strategy. Within the realm of E&P, it seems to have worked in recent quarters for some. In the world of OFS, what makes one attractive? We submit differentiated equipment, for one. People is a differentator, but they move too easily so buying a business for the people is fool’s gold. Most likely the highly motivated folks will quit if bought. Finally, one could argue for buying a business to get the customer list, but let’s not kid ourselves, E&P companies like choice, as well as low price, thus there’s no certainty buying a business for a customer list will be a winning strategy. Therefore, we default back to good equipment. On this basis, we believe it is a reason why BJ is a fast mover with its TITAN roll-out. It’s likely a similar reason why Alamo has one of the newest fleets and was a fast mover in its adoption the Tier 4 DGB solution. And, for this reason, we would expect to see other private frac companies take a more assertive roll with the development and rollout of new technology.
Permian Basin BBQ Cook-Off Update. Cooking spaces are almost gone for the DEP Permian Basin Cook-Off. Suffice it to say, we anticipate a fun event with excellent participation from leadership across all facets of the upstream sector. Look for a BBQ update each month with a final update the week prior to the event. We would like to give a shout-out to the following companies who have stepped up and agreed to generously sponsor our event. Your support is very much appreciated.
Latham & Watkins, EnCap Investments, Silvertip Completions, Patterson-UTI Energy, Simmons Energy, Vulcan Industrial, Lime Rock Partners, ConocoPhillips, Endeavor Energy Resources, Target Logistics, Merit Advisors, Downhole Chemical Solutions, VoltaGrid, Black Bay Capital Partners, David de Roode, High Roller Sand, Range Valuation Services, Standard Pump Parts, ASAP Industries, NexTier Oilfield Solutions, Diamondback Energy, iNet, Oklahoma Forge, Pitts & Spitts and Valbridge Property Advisors.
We are still in need of sponsors, so if you feel inclined, please let us know and we’ll get you the sponsorship brochure. Any and all support is appreciated. As a reminder, DEP will be making a minimum donation of $25,000 to the winning cooking team’s charity of choice. We will then make a matching donation to the Bynum School in Midland.
For our E&P friends who have graciously agreed to serve as BBQ judges, we really appreciate your support and culinary expertise. We promise to make this a good use of your time. We will also do our best to make sure you don’t get food poisoning.
Event Registation. We are working out a few kinks in the registration system, but hope to formally launch the registration process shortly after the July 4th holiday. Cooking companies and event sponsors will then be allocated their invites for employees and guests. DEP will also independently extend registration invites to our formal subscribers. As a quick reminder, this event will be invite-only for DEP clients & friends, cooking teams, our event sponsors and guests of the sponsors. We will further limit capacity at the event to no more than 2,000 people. Sadly, if you don’t fall into one of those categories, a ticket might not be available – a function of limited capacity and a need to lift up clients/sponsors first.
Our 2021 cooking teams are listed below. Subsequent to this design, two new companies signed up: Lime Instruments and Target Logistics. We’ll get their logos added on our next update.
Sunday Evening Addendum:
DEP often chastises those who fail to see the forest through the trees. Well, tonight we eat crow as DEP is the perfect example of the pot calling the kettle black. You see, in our haste to publish our Sunday evening note (i.e. look at this afternoon’s 3:30pm CT publication time), we failed to acknowledge the fact that the largest private frac player, Pro Frac Services, is also the largest private owner/operator of Tier 4 engines, many of which have dual fuel capability and idle management systems. We should have also highlighted other private players such as Catalyst Energy Services and REV Energy Services who similarly operate emission friendly equipment as well. Thankfully, we are reminded of and find a modicum of solace in the words from the famous philosopher and music artist Hannah Montana, “Everybody makes mistakes, everybody has those days”.
We humbly acknowledge that today is one of those days for DEP. We will strive to be more thorough in future notes.
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