Two New Wide Moats in Oil Services and Rig Equipment
National Oilwell Varco and Schlumberger now have wide economic moats.
We believe National Oilwell Varco (NOV) and Schlumberger (SLB) have earned wide economic moats. After following these companies for years, we've gradually been convinced that it will be extraordinarily difficult to snatch away their competitive advantages. Furthermore, we were impressed by the management teams' response to the downturn, as they took advantage of it by making value-creating acquisitions. The downturn also demonstrated the resiliency of the companies' business models. It could be argued that the wide-moat advantages are as obvious now as they were years ago, but the same could be true for many firms in 2007-08, when many companies were turning in solid results only to crumble in the downturn. In our view, National Oilwell Varco and Schlumberger are the best franchises in oil services, and recent events (acquisitions, secular trends, weak competition, and increased bargaining leverage over key customers) only serve to reinforce their competitive advantages and wide economic moats.
National Oilwell Varco's Wide Economic Moat
National Oilwell Varco is one of the largest equipment suppliers in the drilling industry. It provides a comprehensive line of equipment for rigs and consumable products, such as blowout preventers and drill pipe used in oil and gas production. The company also provides distribution services, which include maintenance, spare parts, and repair services for its equipment.
We upgraded NOV to a narrow moat in early 2008, as we recognized the value of its low-cost position in rig equipment. The company's equipment is on more than 90% of the world's rigs, and we estimate it has about 60% market share in rig equipment. NOV's competitive position has been built piece by piece through decades of acquisitions after the 1980s bust. The opportunity to acquire many of its competitors and rationalize the industry during a multidecade bust was unique, and existing and new entrants will find it impossible to duplicate NOV's size and reach. As a result, many offshore and onshore drillers have standardized on NOV's equipment, including Ensco (ESV) and Transocean RIG, and large chunks of Patterson's (PTEN) and Nabors' (NBR) onshore fleets have come from NOV as well. The company is so dominant in the industry that its nickname is "No Other Vender."
Why Wide Now?
We believe National Oilwell Varco has a wide economic moat because of its low-cost, comprehensive position in rig equipment that was achieved through decades of acquisitions. In our view, this position cannot be duplicated by peers because NOV already owns brands with reputations and market positions that stretch back decades. Competitors that focus on extracting premium prices for niche product lines can weaken the dominance of a low-cost position. However, NOV has effectively marginalized competitors by raising switching costs for its customers that already largely standardize on its equipment. A few examples of these higher switching costs are rig stores on rigs, consistent acquisition activity that extends NOV's product line into new niches (APL, Grant Prideco), and the complete integration of all its rig equipment into a single operating system, which should boost rig performance over time while lowering costs and levels of rig downtime for the drillers.
Bargaining Power of Customers: Medium and Decreasing
Our biggest long-term concern remains the bargaining power of NOV's powerful customers, which include national oil companies such as Petrobras (PBR). Petrobras is a particularly important customer because it is developing the Santos Basin, which encompasses tens of billions of barrels of oil and represents tens of billions of dollars in orders for NOV over the next decade. Petrobras produces roughly 20% of the world's deep-water oil, and Brazilian discoveries over the past five years make up a third of global deep-water discoveries, which suggests Petrobras' importance in the deep-water market is increasing rapidly. This opportunity for NOV is quite large in relation to its existing $7.8 billion backlog. The need for deep-water rigs and thus NOV's rig equipment is immense, and we view Petrobras as a key source of incremental demand. Other sources of demand are in Africa and the deep-water Gulf of Mexico.
Recent events have indicated that even Petrobras cannot leverage its bargaining power against NOV to cut prices. First, Petrobras' tender for 28 rigs, which has been ongoing since late 2009, was canceled after just 7 rigs, and Petrobras has indicated that it will retender for the remaining 21 rigs later. Petrobras wants to build the rigs in Brazil, yet refuses to acknowledge the additional costs (as much as 50% higher than building rigs elsewhere) in doing so. Thus, there has been immense pressure from Petrobras to force suppliers into offering lower prices, and the cancellation of the tender after 1.5 years of delays indicates the oil firm was unsuccessful. Second, shortly after the tender was canceled, Petrobras, through the EAS shipyard, awarded all seven rig equipment orders to National Oilwell Varco for $214 million per rig. By claiming 100% share from its toughest customers at a price that doesn't immediately indicate NOV discounted the orders (typical opportunity set is $200 million-$300 million per rig), NOV appears to have the upper hand in bargaining leverage.
Bargaining Power of Suppliers: Low and Stable
National Oilwell Varco is the largest company in the rig equipment market, and its suppliers have yet to demonstrate any type of bargaining power.
Intensity of Competitive Rivalry: Low
Competitors like Cameron (CAM) and Akers have struggled to compete with NOV over the years and are a fraction of NOV's size. Peers have generally found success in offering single product lines such as blowout preventers or drilling risers. Some drillers are willing to pick and choose rig equipment components, but the majority prefer to deal with a single vendor. Even in a difficult year, NOV's rig equipment division--at $7 billion in 2010 revenue--is much larger than its key competitors combined. Startups have failed because they cannot duplicate NOV's comprehensive product line, prices, or reputation. We view competitors as largely ineffectual.
Cameron's recent agreement to purchase LeTourneau for $375 million illustrates the uphill battle peers face against NOV in rig equipment. In 2010, LeTourneau generated roughly $515 million in drilling equipment revenue and reported an operating loss of $18 million after $42 million in inventory write-downs. Excluding the write-downs, LeTourneau generated mid-single-digit EBITDA margins compared with NOV's 31% EBITDA margin for its rig equipment segment. We believe the vast difference in profitability shows the strength of NOV's position in the industry. That said, Cameron should be able to derive significant benefits from pushing LeTourneau's equipment through its global distribution network, which is far larger than what former owner Rowan (RDC) could offer. In fact, we estimate Cameron's newly enlarged drilling equipment operations generated about $1.3 billion in 2010 revenue. However, virtually all of the operating income that LeTourneau generated in 2008-10 came from providing premium jackup rig equipment to Rowan. Rowan has now shifted its attention toward adding deep-water rigs, and its two new deep-water rig orders primarily contain equipment from National Oilwell Varco. Rowan's lucrative under-construction jackup program, which made up 40% of LeTourneau's 2010 revenue, wraps up at the end of 2011. The loss of this tailwind exposes the shortcomings in LeTourneau's product lines, as National Oilwell Varco retains well over 80% of the mud pump market, and LeTourneau does not have significant share in the top drive, rotary table, draw works, and land rig markets.
Substitute Products or Switching Costs: Medium
National Oilwell Varco's products are designed to work with competitors'. Nothing is preventing a customer from building a rig using a single component from NOV and a variety of equipment from peers. However, we believe National Oilwell Varco has built switching costs through a number of ways. First, we like NOV's operating system for rigs and its recent efforts to offer supply stores on rigs. Alongside its rig equipment, NOV also offers a rig operating system, similar to Windows for computers, which fully ties together all of the rig equipment together on a rig. The driller can then remotely diagnose and solve equipment issues, as well as control the rig from a single console. The complete integration of all of the controls on a rig offers savings in terms of rig weight, reduced rig downtime, and lower installation and support costs. By not offering a comprehensive drilling solution, competitors by default cannot offer this level of integration and cost savings. Second, NOV offers rig supply stores, where it places a store on a rig and takes over consumables and inventory management from the driller. This is a win-win, as it removes a chore for the driller and raises NOV's switching costs. Third, many of NOV's customers have simply standardized on its products, and the firm's equipment is on more than 90% of the world's rigs.
Threat of New Entrants: Low and Decreasing
National Oilwell Varco has spent decades consolidating the industry and now owns virtually every single important brand across the rig equipment niche. The firm's sheer size, distribution network, and comprehensive offering make it nearly impossible for a new entrant to successfully compete in the niche over time. The last startup that tried to enter the market with a comprehensive offering of products failed because it was unable to get any traction and financing.
Schlumberger's Wide Economic Moat
Schlumberger is one of the largest oil services companies, with more than 100,000 employees across 80 countries. It offers a near-complete array of oil services--from seismic surveys to artificial lifting--to oil majors, exploration and production companies, and national oil companies. The acquisition of Smith in 2010 added drill bits and complete control of the industry leader (M-I SWACO) in drilling fluids.
Schlumberger is benefiting from many of the same trends that led us to upgrade Halliburton's moat to narrow last year (see "Why We're Increasing Halliburton's Moat to Narrow"), but to a lesser extent, because it was behind Halliburton in terms of recognizing the integrated opportunity in North America. However, Schlumberger's international dominance has never been in question. The firm holds leading positions in Russia and Europe and is a key player in every single major services region around the globe. Its comprehensive product portfolio, research and development and financial strength, and technology acquisition strategy make this firm an enduring franchise that is extremely unlikely to be toppled. The firm has spent decades building up its international workforce, which helps build closer relationships with national oil companies. The international exposure is important because the vast majority of the world's reserves are under the control of national oil companies, where Schlumberger has the closest relationships.
Why Wide Now?
We believe Schlumberger has a wide economic moat partially because of the oligopolistic nature of the oil services industry, where the largest players have significant advantages in terms of expertise, R&D, scale, and reputation/relationships. Schlumberger is differentiated from its three main competitors through its sheer size and overall industry leadership (number one or two in most product lines and regions), which allow it to pursue avenues such as lowering the cost of oil and gas megaprojects or integrated project-management efforts through operational improvements. These efforts cannot be pursued by competitors because they do not have the necessary global scale, purchasing power, or organizational strengths to address these key issues. In contrast, Halliburton's narrow moat was earned through largely focusing on addressing the needs of shale plays in North America.
Bargaining Power of Customers: Low/Medium and Decreasing
We believe industry dynamics are improving, thanks to recent industry consolidation, and secular trends (onshore and offshore development trends, improving reservoir recovery rates) are favoring Schlumberger. We believe the company is best in class, and as a result of the recent changes in the industry, its competitive advantage should extend over a longer period than before. Halliburton and Schlumberger are the only firms out of the big four services players to earn more than their cost of capital through the last cycle every year from 2005 to 2010. In addition, the services industry has rolled out numerous pricing models (IPM, integrated, bundled, and discrete) for its services, giving it an ability to be more discriminatory on pricing with customers and capture the best economics. Given its industry-leading position, we view Schlumberger as a franchise that can withstand the test of time as well as industry cycles.
We also believe the long-standing debate over whether the integrated or services firms add more value in terms of R&D has been decided in favor of the services firms. This trend strengthens Schlumberger's bargaining power over its customers. In the past, the criticism against whether services firms deserve moats has been that the integrated firms add more value in terms of R&D and deliver the most "important" innovations to the oil field. We believe this is incorrect for several reasons. First, Schlumberger's R&D budget (adjusted for the inclusion of Smith, it was $993 million in 2010) is now greater than those of most of the largest oil and gas companies in the world. Second, patent surveys routinely rank the oil services industry ahead of the majority of the majors, and the industry typically obtains more patents every single year. Third, many of the integrateds' innovations have come out of partnerships with the oil services firms, where the integrated companies outsourced the R&D to the services company and used the resulting technology for their own drilling activities. Fourth, the significant increase in horizontal drilling and the exploitation of the shale plays in North America have largely come from the oil services industry's innovations in terms of drilling and fracking technology. The integrated majors have had to buy back into the plays through acquisitions and joint ventures because they do not have the expertise to properly exploit the fields.
Bargaining Power of Suppliers: Low and Stable
Schlumberger is not vertically integrated and thus faces long lead times for equipment during industry booms. However, we do not think it has had any issues with passing on cost inflation to customers through its contracts. We do not think suppliers have any type of meaningful bargaining leverage over Schlumberger.
Intensity of Competitive Rivalry: Low and Decreasing
We believe two key long-term competitive threats--the rise of Chinese oil services players and further industry consolidation by Halliburton (HAL) or Baker Hughes (BHI)--are unlikely to injure Schlumberger too much. First, we think China's primary near-term goal will probably be to exploit its own oil shale reserves. China has been partnering with U.S. exploration and production companies in joint ventures designed to share knowledge that China can use for its reserves. There's no way around it for the services firms, and it is inevitable that key services technology will leak to China. However, the threat of local oil services firms springing up and weakening Schlumberger's position is not new. The oil services industry has been working overseas for decades, and generally over time has managed to innovate and protect its competitive advantages and intellectual property. We believe that if China wants to develop its shale reserves over a reasonable time frame, it will need Schlumberger's help, and in order to gain Schlumberger's assistance, it will probably have to respect the firm's position on technology and intellectual property.
We've also been concerned that Halliburton or Baker Hughes might purchase Weatherford (WFT), the redheaded stepchild of the industry. Weatherford uses considerable financial leverage and isn't afraid to cut services prices, usually to the industry's and its own detriment. If Halliburton or Baker Hughes chooses to buy Weatherford, it would greatly close the size gap between the rest of the industry and Schlumberger. However, any acquisitor would have to manage Weatherford's substantial financial leverage, probably fully integrate the firm's hundreds of past acquisitions, and generally improve a culture which has tended toward growth at all costs. The acquisition would be a difficult one, and the Weatherford franchise itself wouldn't necessarily strengthen the acquisitor's competitive advantage materially. However, what the acquisition is likely to do is strengthen the overall industry's pricing power by consolidating the big four to the big three. Thus, depending on how things shake out, an acquisition of Weatherford could actually strengthen Schlumberger's moat.
Substitute Products or Switching Costs: Medium and Decreasing
Schlumberger's size and experience give the firm an ability to pursue unique opportunities. In terms of integrated project management, Schlumberger is the unquestioned industry leader, which is important because inexperienced national oil companies are increasingly turning to oil services firms for technical help in exploiting their fields. The company is also targeting a step change in terms of improving its product functionality and reliability while reducing its total cost of ownership. Part of the reasoning behind this shift is that roughly 30% of oil and gas projects overrun by 50% or more, which is equal to billions of dollars in overruns industrywide every year. This new operational effort, plus Schlumberger's comprehensive product portfolio, R&D budget, and services expertise should enable the firm to be well positioned to reduce overruns and costs for its customers, which should earn it premium prices. A key beneficiary from this initiative will be Schlumberger's IPM efforts, where it provides end-to-end field services for its customers, which are usually inexperienced national oil companies. Schlumberger's IPM efforts appear to be going very well, as the company drilled its 5,000th IPM well earlier this year and now manages for its customers around 140,000 barrels per day of production. We think Schlumberger has a rich opportunity to mine here, as technically inexperienced national oil companies will be glad to hand off troublesome fields while not giving up reserves ownership.
Threat of New Entrants: Low/Medium and Decreasing
We acknowledge that it is relatively easy for an ex-Schlumberger employee to start up a services firm, purchase equipment, and offer some specialized services. In fact, during 2005-07 in North America, we believe many new entrants broke into the industry, particularly in pressure pumping, and undercut Schlumberger on price. Furthermore, the supermajors' capital spending budgets are so large that many startups can claim a relationship with ExxonMobil (XOM) or Chevron (CVX), among others, which appear to be interested in funding any number of new innovations. However, we believe the staying power of these startups is fairly low. The changes in the North American services market during the downturn in 2009 and subsequent recovery in 2010 indicate the value of several key attributes: financial strength (measured by ability to replace failing equipment), technology, quality services delivery, and reputation. These attributes led to many startups and small players being forced out of the industry. More important, we believe it is nearly impossible to duplicate the sheer global scale, reach, and reputation that Schlumberger has around the world, which means the threat of new entrants in terms of new global services providers is extremely low. Finally, we believe that the big four services players have generally increased their collective global market share over the years, forcing out smaller players and indicating that the risk from new entrants is declining.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.