Travelers on a Road to Nowhere

This post was updated on June 24, 2019. 

Imagine a contest between two horses. History suggests one of the animals, having lost most of its races to the competitor, is the slower of the two. You are given even odds. Would you bet on the reliably slower horse?
 
The answer, of course, is no. Only a glutton for punishment would take even odds on a horse that’s expected to lose.

Now, imagine an opportunity to invest or work in one of two segments of an industry. The first segment, the longtime laggard, has the same chance of outperforming the other—in terms of rewards and opportunity—as does the slower horse of beating the faster. Would you invest your time, money and resources in the laggard? Would you recommend others do so?

Again, for most of us, the answer is no. Only a dupe or wide-eyed romantic would invest in a space that’s expected to so regularly come up short.

But here’s the hard truth: those who bet on the oilfield supplier sector year after year do just this.

Think we’re exaggerating? We’re not.

Consider that stocks of oilfield suppliers as measured by the PHLX Oil Services Index (OSX) are at the same level as in 1997—when WTI crude was below $25 a barrel. Today, oil is near $60; yet only a small number of suppliers are profitable.

The OSX is down almost 75% since 2014, while the NYSE Arco E&P Index (XOI) is down less than 30%—a huge performance gap.

Chart showing underformance of oilfield suppliers since 2014

It’s the record of suppliers over decades, however, that’s especially damning.

To illustrate, we calculated a variety of annualized returns for suppliers and E&Ps going back more than 20 years. For 1998, this included 21 discrete holding periods, ranging from one to 21 years in length. The year 1999 included 20 such periods, 2000 included 19, and so on. We then compared supplier and E&P returns within each period.
 
What we found was sobering.
Out of 231 holding periods since 1998, suppliers have underperformed the E&P sector 64.9% of the time. This means a random investment in oilfield suppliers made at any point since 1998 had an almost two-thirds chance of generating a lower return than a similar investment in E&Ps. In 20 of 21 holding intervals, supplier returns underperformed those of E&Ps more than half the time.
The compounding effects are devastating. In terms of hard dollars, $1,000 invested in the oilfield supplier index in 1998 would be worth approximately $675 today. By comparison, a similar investment in the E&P index would be worth $2,700. That’s a four-fold difference.

Oilfield Supply Returns vs. E&Ps

What’s driving the underperformance?  
Too much emphasis on the near term for one thing. This includes large periods focused on merely surviving. There’s little commitment to consistent, much less exceptional, performance across cycles. The indispensable-provider model, whereby customers willingly pay up for better execution and quality, is not embraced by most managers in the segment.
 
The upshot is customers—who aren’t overly pleased with oilfield products and services in general—see suppliers as interchangeable. With few standouts, vendors are easily pitted against one another until there’s nothing left to give. In an attempt to cope, some providers push bundled offerings at reduced prices, hoping one or two profitable lines sufficiently offset losses elsewhere. They rarely do.

Executives are often too far removed from customers to grasp the reality. A weakness for both funding and advice from investment banks, private equity and others with short-term interests doesn’t help. In fact, it’s led to an injurious influx of expansion- and survival-capital for a segment that, quite frankly, can’t handle it and doesn’t deserve it.
 

In the U.S. alone, a total of 167 oilfield service companies filed for bankruptcy from Q1 2015 through Q1 2018, according to the law firm Haynes and Boone. Over half were in Texas, where many of the industry’s most experienced operators reside.

Houston-based Weatherford International could be the poster child for the segment’s unavailing ways. Resting on the belief that customers wanted another global supplier to provide a diverse set of wellsite products and services, Weatherford set out in the mid-1990s to join the ranks of Schlumberger, Halliburton and Baker Hughes.

The company’s growth-through-acquisition strategy was an investment banker’s dream. It fed off the premise that customers would look past inconsistent quality in return for lower prices and packaged offerings. The conceit, which Wall Street analysts happily validated, led others to emulate.

But it turns out the market didn’t need another integrated provider, especially one so sold on price and size over quality and performance. In 2016, Weatherford’s long-time CEO, Bernard Duroc-Danner, was finally forced out, but not before the market laid bare the company’s widespread failings. In May of 2019, Weatherford signaled it would file for bankruptcy, but not before posting 18 consecutive quarterly losses.

Chart showing financial metrics for both E&P companies and oilfield suppliers

Despite the lessons of Weatherford and others like it, there’s little reason to believe other suppliers are prepared to break bad habits. Many remain gripped by an almost-inexplicable inertia, one driven by a conviction that cut-rate pricing and middling quality remain the answer—even as debt levels rise.
 

This weird ethos hangs like a millstone over the sector—and its reputation. As one ex-executive from a capital equipment manufacturer recently mused: “Why would anyone ever invest in the oilfield supply segment given how often it’s in the tank? Even when times are good, money pours in at rates that depress margins. On average, it’s a terrible business.”

Chart comparing debt levels of oilfield suppliers and E&Ps

To survive, and then prosper, suppliers need to be better, shrewder, and more disciplined. Crushing odds await those that aren’t.
 

Yes, some will endeavor to reduce costs further by downsizing or combining. Others will attempt to innovate their way out of their predicament—a strategy that will fail for most.

Only a handful of companies will up their games. They’ll embrace quality, execution, stability, and customer focus as central tenets. The long-term winners will emerge from this group. That they can lift the performance—and esteem—of the entire segment remains to be seen.

Top-rated companies in EnergyPoint’s surveys like Valaris, Helmerich & Payne, Core Laboratories, Gardner Denver, Newpark Resources, Derrick Equipment, MarkWest Energy Partners and Plains All-American seem poised to outperform.

These providers, and others like them, are the rare opportunities—for investors and employees. They tend to run their businesses knowing good times don’t last. As competitors fall away, they take up the slack bit by bit, steadily growing market share and earnings—usually organically. All the while, they build expertise, invest in their brands, and guard their reputation.

But mostly, there’s an enduring commitment to excellence at top companies. It’s who they are. Some have rated number one with customers for several years running, a feat made easier by competitors that lack the will to be anything other than “in the business.” In the process, top suppliers delivered portly rewards in a grudging sector.
 
Still, these are the exceptions. Most industry suppliers have no objective customer satisfaction data  or related performance metrics about themselves or their competitors. Nor have they much interest in building cultures that value such data. The sector’s customer scores reflect the deep indifference.


ACSI & EPR Segment Scores - Final v. 1.00 (Chart)

Stocks of oilfield suppliers are down more than 30% over the last 20 years, even as E&P stocks have appreciated 170%. How is this disparity so easily ignored by executives, markets, employees, and others? No industry can thrive when its supplier base languishes like this.

It’s not clear why industry suppliers don’t get that higher quality and customer satisfaction lead to stronger financial performance. But clearly, most don’t. And it’s a big problem.

It’s been said that hope is not a strategy. Yet, hope—that suppliers will finally and magically get the credit they deserve, that commodity prices will cooperate, that marginal competitors will soon capitulate—has fueled the space for decades. Isn’t it time we acknowledge this illusory mindset isn’t working?

Chart comparing growth rates for oilfield suppliers, E&Ps and rig counts.

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