Monday, April 26, 2010
The $40 Billion Opportunity In Iraq
Iraq represents a significant opportunity for the oil services industry. We believe the success of the recent Iraqi oil auctions has created a multi-billion dollar opportunity for major oil services firms such as Schlumberger (SLB: 72.83, 0.16), Baker Hughes (BHI: 54.16, 0), Weatherford (WFT: 18.24, 0.52), and Halliburton (HAL: 34.5, -0.46). The winning oil and gas companies have committed to boosting production capacity in Iraq to around 12 million barrels per day in six to seven years, from just 2.5 million barrels per day today. If this goal is achieved, it would mark one of the greatest capacity increases in the industry's history.
We have our doubts that Iraq can reach this level of production by 2016. At this time, we do not have enough data to make an informed estimate of achievable production levels in such a short time frame. However, if we assume that Iraq oil production reaches 8 million barrels per day by 2016, which reflects 75% of the committed targets, we expect there could be up to $40 billion in services contracts available from 2010 to 2016 for the industry's drilling and services expertise.
Even if one third to one half of the awards go to local Iraqi firms for nationalistic reasons, we believe all four major services firms will benefit from this unprecedented opportunity. Currently, Weatherford has the early lead in the region, with several rigs drilling under contract. The company also shared along with Schlumberger in BP's (BP: 58.23, -1.63) $500 million award for services work in Iraq's Rumaila field. The other major services firms are behind for now, but rapidly building out their infrastructure, and hiring workers in the country. We expect that Iraq-related revenue for each of the major players could cross $1 billion annually by 2013. We think Schlumberger will regain its traditional position as the industry leader, thanks to its experience and comprehensive product portfolio. The merger with Smith (SII: 49.16, 0.05) could strengthen Schlumberger's position in the region, provided that there are no integration or divestiture issues.
Iraq's Oil Production May Explode
The history of oil production in Iraq has been challenging. Iraqi oil production topped 3 million barrels per day in 1979. Saddam Hussein's subsequent rise to power led to decades of rocky production and overall industry stagnation. Iraq's current oil production, around 2.5 million barrels per day with reserves of about 115 billion barrels, is the third-largest amount of proven reserves after Saudi Arabia and Iran. Industry estimates suggest that Iraq could contain over 200 billion barrels in reserves, and potentially as much as 400 billion barrels. Despite these massive hydrocarbon riches, the oil industry was at one time once convinced that persistent war and civil unrest would permanently deny it access to Iraq's sprawling oil and gas fields.
However, this all changed in the middle of 2009. At that time, the Iraqi government offered technical services contracts to develop some of Iraq's largest fields to international and national oil companies. The first auction was widely viewed as a failure, as the majority of the fields offered failed to obtain bids. This was largely due to the onerous bidding terms set by the Iraqi government. Only one consortium, BP/CNPC, successfully bid for the Rumaila field, although several other deals were completed later under revised terms.
The second auction, held in November 2009, was a stunning success. Numerous industry consortiums bid successfully for contracts which, when added together, suggest that Iraq's oil production capacity could reach 12 million barrels per day in six to seven years. Actual oil output will be based on market demand, and there is language in the contracts to compensate the oil and gas companies if oil production is reduced. A significant near-term hurdle is the passage of a comprehensive oil law that justifies the legal framework for the auctions.
Infrastructure Issues Loom Large
Infrastructure challenges present one of the biggest short-term constraints. Iraq produces 2.5 million barrels per day, and exports 1.9 million barrels per day. The country has indicated that it is working on a new plan to build pipelines and export terminals. The amount of cash being spent on the issue is immense, as Iraq is expected to receive about $200 billion annually from the development contracts, and the oil and gas companies have indicated plans to spend about $100 billion developing the fields. Two floating oil terminals are already under construction, and the country plans to build two more, bringing its oil handling capabilities to about 3.6 million barrels per day. Foster Wheeler (FWLT: 31.56, -0.44) has been awarded a contract to assist with the engineering for some new oil export facilities which would bring Iraq's exporting capabilities to 4.5 million barrels per day. Water constraints are also being addressed, with ExxonMobil (XOM: 69.36, 0.13) and Iraq working on plans to use seawater for pumping operations.
Though infrastructure is a challenge, we believe that the initial wells will not be technically difficult. Oil and gas companies indicated that they plan to target easy-to-drill wells to boost the fields' initial production rates by 10%, which will trigger the cost-recovery portion of the contracts. After the first year, the drilling will graduate to more technically challenging wells. Therefore, we expect that the services firms will be able to generate above-average margins drilling easy wells for the first year, and Iraq oil production should move towards 2.6 million barrels per day by the end of 2010.
Schlumberger and Weatherford Are Early Leaders
The scale and success of the production increases in Iraq are uncertain. However, we think the winners are easier to identify. The Western oil services companies such as Schlumberger, Halliburton, Baker Hughes, and Weatherford will all play key roles in Iraq's oil production plans. The firms are valuable because they bring needed services expertise and numerous Western services technologies that will help the country fully exploit its long-neglected reserve base. The short timeline of the production ramp-up suggests that the industry should generate healthy operating margins in the 15% to 20% range.
If we assume that Iraq oil production reaches 8 million barrels per day, we think Iraq-related services revenue will start to ramp up in 2011, and cross $1 billion in revenue for each of the major services firms in 2013. By 2016, we estimate potential annual revenue will top $3 billion per firm. At that time, we assume over 400 rigs will be working, and the number of wells drilled will run between 1,500 and 2,000 annually.
We believe about $40 billion in services contracts will be awarded to Western and Iraqi oil services firms over the next six to seven years for the necessary drilling and needed services expertise to develop the core Iraq oil fields. In 2016, we're forecasting a potential annual market size between $18 billion and $20 billion. For comparison, we estimate the global oil services market was worth about $83 billion at the end of 2008.
In this case, we think Iraq poses the greatest opportunity for Weatherford, especially given its status as the smallest of the four major services firms. The firm has won a number of early contracts in the region over the past few years, while its competitors are still trying to build out their presence in the country. However, we expect the capital investment required in Iraq will be extensive, and Weatherford's constant reliance on the markets for cash may prevent it from taking full advantage of its Iraq opportunities. The need for additional capital could make a merger with industry peer Halliburton, which has very healthy balance sheet, a strong possibility in 2011 or 2012.
The impact of Iraq on industry leader Schlumberger will be diluted, thanks to its wide-ranging international operations. The reduced contribution is despite the fact that we believe Schlumberger is positioned to earn above-average market share some of the industry's highest margins, thanks to its wide-ranging portfolio of services. However, our estimates could be revised higher after the merger with Smith is completed, if Schlumberger can successfully establish more of its product lines in the region. We also think the company has best-in-class experience at executing integrated-project-management (IPM) contracts. In our view, the IPM contract framework is the most likely way Iraq will choose to hand out the services contracts. The difficult operating environment could make quarterly profitability lumpy for the services firms, as we believe the contract framework depends on a stable drilling environment to earn the greatest profits.
If Iraqi oil production turns out to be around 5 million barrels per day in 2016, we assume a much-reduced level of Iraqi services expenditures. We estimate the annual market size would be about $10 billion in 2016, and it would take about $20 billion in services contracts from 2010 to 2016 to drill the needed wells in the auctioned-off fields. We assume it will take until 2015 for Iraqi revenue to cross $1 billion for each of the major services firms. The number of wells drilled annually will only be between 800 and 1,000, and about 200 rigs will be operating in the country. Understandably, the opportunities and profits for Weatherford, Schlumberger, and others will be greatly reduced from an 8 million barrel-a-day production scenario.
If everything goes very well for Iraq and the services firms, production could reach 11 million barrels per day in 2016. In this case, infrastructure, security, and political concerns are all mostly resolved, and the country becomes quite stable. The annual market size could approach $30 billion in 2016, and services contract awards could total $60 billion from 2010 to 2016 in this optimistic case. We believe Iraqi-related revenue for each of the major services firms could cross $1 billion annually in 2012. We expect over 600 rigs to be operating in the country by 2016, and the number of annual wells drilled to be between 2,500 and 3,000. This scenario would be an extremely positive one for the services firms, and the industry would benefit from sharply higher revenue and profits.
Overall, we think it is clear that there are large opportunities for the services industry in Iraq, but the country must overcome numerous hurdles for the industry to obtain any measure of success. If Iraq manages to add just 3 million barrels a day to its production during the next decade, the achievement would still rank among the industry's greatest accomplishments. Thus, adding 10 million barrels a day in production is a huge undertaking. Still, if Iraq can come close to realizing its potential, we think the services industry is extremely well-positioned to earn considerable profits.