Like many cyclical businesses, Schlumberger (NYSE:SLB) has been reeling from the knock-on effects of COVID-19. The pandemic has practically brought business activity to a standstill and created demand destruction for oil. SLB is down over 45% Y/Y; its Q2 revenue fell 28% Q/Q, while EBITDA was off 39%. The company announced a restructuring that would involve laying off about 21,000 employees. In my opinion, some of the company’s problems began with its ill-timed investment in North America.
Schlumberger has been known as a well-diversified, international player in the oil services space. Baker Hughes (BKR) and Halliburton (HAL) have traditionally dominated the North America land drilling market. North America land drilling had previously been white hot, putting Halliburton and Baker Hughes in the catbird seat. Schlumberger’s revenue from North America had previously been in the 23% to 25% range pursuant to total revenue.
In early 2017, Schlumberger made a concerted effort to increase its exposure to North America. In Q1 2017, the company announced a joint venture (“JV”) with Weatherford (OTCPK:WFTLF), targeting North America. Both companies were expected to contribute their North America fracturing assets. Weatherford was to receive $535 million in cash and a 30% stake in the JV, while Schlumberger was to own 70%.
In Q2 2018, Schlumberger acquired Weatherford’s pressure pumping assets outright, scrapping the JV. This gave Schlumberger even more exposure to North America. The following chart outlines Schlumberger’s historical revenue by region.
In Q2 2016, the company’s revenue from North America was 25%. It ramped up to 30% in Q2 2017; it peaked around 38% in Q2 2018, making North America Schlumberger’s largest region.
The timing seemed right for Weatherford. Brent oil was above $65 – more than enough for shale oil plays to make money. The play for Schlumberger was that the acquired assets could allow it to go head-to-head with Halliburton in North America land drilling and exploit a hot market. The risk was that, if oil fell below $45, it could be difficult for shale companies to make money. In that scenario, E&P in the oil patch may dry. Secondly, oil prices had spiked due to OPEC supply cuts. How long could U.S. drillers expect OPEC to support the market and their profits?
By April 2018, I openly questioned whether North America had jumped the shark:
Schlumberger’s North America revenue was only up 1% sequentially. According to management North America land drilling continues to grow, but Q1 results were negatively impacted by pricing pressure and lower than expected pressure pumping activity. Oil services firms with strong liquidity will likely survive any pricing war. This would play into Schlumberger’s hands given its fortress balance sheet; however, it would not be positive for earnings in a region where the company has increased its investment in. In Q2 2017 Halliburton’s management team intimated North America shale oil plays may pull back on additional E&P. If Q1 2018 results are any indication then North America may have already jumped the shark.
The stimulus-induced global economy could not grow in perpetuity. At some point, the stimulus had to end, and the economy would falter, I surmised. Lastly, oil markets had been propped up by OPEC, which had spurred E&P. At some point, demand for oil would have to drive oil markets. Relying on demand in an uncertain economy sounded foreboding.
Since the Weatherford deal, the U.S. rig count has fallen hard; the U.S. rig count declined from 929 at the end of 2017 to 266 at October 2, 2020; that represented a decline of over 70%. It also connoted a decline in E&P in the oil patch, a decline in completion activity and a fall-off in oil services revenue.
Schlumberger Cuts Its Losses
Prior to the pandemic, the rig count was off in the double-digit percentage range in comparison to year-end 2017. In 2019, several shale oil plays suffered from budget exhaustion and cut back on E&P in North America. This left Schlumberger with heightened exposure to an oversupplied market. The pandemic exacerbated the company’s problems. Q2 GDP fell over 30% as business activity practically ground to a halt. Brent oil fell below $10 in April, yet was later buoyed by supply cuts from OPEC, Russia and certain U.S. drillers.
Schlumberger recently sold its hydraulic fracturing business to Liberty Oilfield Services (NYSE:LBRT), reducing exposure to North America. Liberty will give up a 37% stake in its company for Schlumberger’s hydraulic fracturing fleet and two Texas sand mines. Liberty will become one of the largest oilfield services firms in North America. Schlumberger’s sale to Liberty sounds eerily similar to the deal Weatherford tried to cut with Schlumberger a few years earlier.
However, the damage to Schlumberger’s balance sheet and earnings could be long-lasting. At the time of the Weatherford deal (Q2 2018), Schlumberger had cash of $3.0 billion and debt of $17.6 billion. At Q2 2020, the company had cash of $3.6 billion and debt of $17.4 billion. Some of the cash flow generated over the past two years may have been used to pay dividends or tread water in the oversupplied North America market.
The company’s EBITDA has free-fallen. EBITDA at Q2 2018 was $1.7 billion, versus $811 billion at Q2 2020. This represented a decline of over 50%. The company’s debt-to-EBITDA is now at 3.1x. If EBITDA remains flat to declining, then Schlumberger’s credit metrics could become cause for concern. The company is left with having to service its debt load in a cyclical industry after the global economy appears to have peaked. The investment in North America (when the economy was much stronger) may have been better spent on paring debt.
Schlumberger trades at 6.4x run-rate EBITDA. Its valuation likely reflects the headwinds ahead. Servicing its $17 billion debt load with its remaining assets could be a challenge. Sell SLB.
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