Schlumberger’s (SLB) next quarterly earnings report on October 20 will be a major test of the company’s new business model.
I hold the shares in my long-term 50 Stocks portfolio. For me the quarter will provide an early indication of how much volatility this new business model has added to the stock and whether with this new model I want to keep it in the 50 Stocks portfolio.
Schlumberger has seen the future of the oil and gas drilling and production sector and it hasn’t liked what it has seen. The rise of production from U.S. oil shales has led to an extended period of underinvestment in drilling, exploration, and development for the conventional international resources that are Schlumberger’s strongest market. That has led to a forecast of lower for longer at the company and among some Wall Street analysts. For example, in the company’s Resource Characterization business Morningstar was projecting that revenue would recover to 92% of its 2012-2014 average by 2021. Now that analyst is looking for only an 81% recovery. Margins, which Morningstar had expected to see recover to the 2012-2014 level are now forecast to remain about 4 percentage points lower by 2021.
To the company’s credit, management has recognized the problem and responded proactively with a big increase in a new business called Schlumberger Production Management. This new effort puts Schlumberger directly into day to day decisions on drilling, oil field management, and other aspects of managing oil production at a client’s field. This gives Schlumberger extraordinary power to recommend and then buy its own services for the oil producer. In exchange for that power Schumberger is in effect investing in its customers oil projects and linking its compensation to increases in oil production and decreases in costs.
For example, at the mature Shushufindi field in Ecuador Schlumberger used the services of its Reservoir Characterization unit to better place new infill wells to drive higher production per well. In drilling the wells, Schlumberger used services from its Drilling Drop to lower drilling costs. And it used services from its Production Group to extend the productive life of existing wells.
This model leverages the returns that Schlumberger makes from its services but it also increases the company’s exposure to swings in oil prices. The company is now providing financing for many of these joint venture production projects with that investment in Schlumberger Production Management climbing to $2.6 billion as of the end of the June quarter. As an investor in those joint ventures the company increasingly shows some of the risk/reward characteristics of an actual oil production company. For example in June Schlumberger agreed to invest $700 million in an oil exploration project with the Nigerian National Petroleum Company. That joint venture requires an oil price between $50 and $60 a barrel to achieve a 20% profit, according to projections from Bernstein. In another project Schlumberger agreed to invest $390 million in a joint venture with Argentina’s YPF (YPF) to develop the Vaca Muerta shale field.
When oil prices are low for extended periods, there are, of course, no extra profits from this model. There may even be write-offs. And those have started to appear in Schlumberger’s quarterly financial filings.
So far Schlumberger Production Management has been a relatively small part of overall revenue at the company, accounting for 8% of 2014 segment revenue, according to Morningstar. But management is projecting that revenue will grow to 24% of segment revenue by 2021 and listening to recent presentations, management clearly thinks of Schlumberger Production Management has the new star business unit at the company.
It clearly has the potential to be that. Returns on capital, management haas said, are about 7 percentage points higher than on the rest of the business since 2011.
The volatility in oil prices during the third quarter of 2017 will give investors in Schumberger the ability to judge the costs–in volatility to revenue and margins–from this new model.