Q3 2016 marked the bottom of the V-shaped recovery which is now under way

In the company’s Q4 conference call this morning’s , Core Laboratories (ticker: CLB) CEO David Demshur and other members of the CLB executive team laid out their company’s view of where the oil and gas industry stands today and their thoughts on where it is heading in 2017. After 80 years providing reservoir description, management, and production enhancement technologies and services for E&Ps, Core Lab has a global presence in 55 countries and its customers are the most significant oil and gas producers in every major oil and gas province.

Comments from Core Lab CEO David Demshur

Core Lab: Q3 2016 marked the bottom of the V-shaped recovery which is now under way

David Demshur, CEO, Core Laboratories. Image: Oil & Gas 360

Core believes that the worldwide crude oil markets are currently under-supplied as indicated by several consecutive months of declining worldwide crude oil inventories, and we believe the projected December draw will be the fifth consecutive month in a row.

Projected OPEC cuts of 1.344 million barrels of oil per day and other cooperating countries pledging to cut another 600,000 barrels of oil per day will lead to extended worldwide inventory declines and a continuing rally in oil prices and energy prices in 2017.

As Core has continually stated, the Middle East was producing oil at unsustainable levels, and we are sure that some of these cuts were more than welcome by several Middle Eastern producing countries. All that Core did was listen to the reservoirs and not the rhetoric.

Also importantly, U.S. crude production peaked at 9.7 million barrels a day in March of 2015, and then declined approximately 1.3 million barrels a day into December of 2016. At that time, Core calculated a U.S. net decline curve rate of 11% per annum. U.S. crude supplies have increased on a net basis for October and November in response to increased activity levels, largely in the Permian Basin.

However, conflicting data sets and completion statistics, especially in the large crude supply increase reported by IEA in October, especially from the Bakken, make calculations and projections for U.S. land production too difficult and uncertain to offer at this time.

In 2016, production gains in the Gulf of Mexico were disappointing. Originally projected by Core Lab to add 200,000 barrels of production per day during 2016, the production added was essentially flat to up slightly year-over-year owing to larger-than-expected activity declines and less production addition from legacy deepwater projects.

2017 is off to a better start as BP’s Thunder Horse South complex completed ahead of schedule and under budget is set to add 40,000 barrels of new 2017 production. Globally, Core estimates that the net decline curve rate is currently approximately 3.3%.

Applying the 3.3% net decline curve rate to the worldwide crude oil production of approximately 85 million barrels a day means that the plant will need to produce an additional 2.8 million barrels of new oil by this date next year to maintain current worldwide productive capacity totals.

With limited long-term sustainable spare production capacity, coupled with the aforementioned production cuts, Core believes worldwide producers will not be able to offset the estimated 3.3% net production decline curve rate in 2017, leading to a further decline in global crude oil production.

Also weighing on future production capacity is the fact that operators discovered less than 4 billion barrels of new oil in 2016, while the globe consumed over 55 billion barrels.

Therefore, Core believes crude markets more than rationalized in late 2016, and price stability followed by price increases, some occurring as we speak, are returning to the energy complex. Remember, the immutable laws of physics and thermodynamics mean that the crude oil production decline curve always wins and it never sleeps.

On the demand side of the crude oil market, new IEA estimates have increased worldwide demand in 2017 by approximately 1.4 million barrels of oil per day over the 1.3 million added in 2016.

The U.S. is now using approximately 10 million barrels of gasoline per day and 20 million barrels of total demand of hydrocarbon near record levels. Recent Chinese imports, coupled with strong demand out of India, are near all-time highs. In addition, China, the world’s largest energy consumer, is probably in terminal decline as year-over-year production has dropped more than 400,000 barrels a day to 3.8 million barrels a day in 2016. That is near a six-year production low.

Other countries posting significant 2016 production decline, which will continue into 2017 include Mexico, Venezuela, Colombia, Angola, Kazakhstan and Oman, amongst others. As projected by Core in early 2016, the third quarter of 2016 marked the bottom of the V-shaped recovery which is now underway. This recovery should continue to strengthen with higher commodity prices and subsequent activity levels as 2017 progresses.

CLB Financial Review

During the fourth quarter of 2016, Core generated free cash flow that exceeded net income for the 10th consecutive quarter as free cash flow has exceeded net income in 11 of our past 14 years. Free cash flow for 2016 was $121 million equal to 190% of net income. Clearly, one of the best in the oilfield service industry. Moreover, and more importantly, Core converted over $0.20 of every 2016 revenue dollar in free cash flow, again, leading all oilfield service companies.

Free cash flow matters to Core Lab shareholders. During the fourth quarter of 2016, Core once produced oilfield-leading return on invested capital for the 29th consecutive quarter. As activity levels continue to increase in North America and with deepwater and international markets bottoming in the first half of 2017, Core expects return on invested capital to expand in 2017. Return on invested capital matters to Core Lab shareholders.

And finally, during the fourth quarter of 2016, Core returned over $24 million back to our shareholders via our quarterly dividend. Core will continue to return all excess capital back to its shareholders in future quarters via quarterly dividends, and is expected to start repurchasing additional shares in 2017.

Core Lab CFO Richard Bergmark added additional expectations

We are clearly benefiting from increased U.S. onshore activity and expect revenue and operating income to increase further in 2017 as international and offshore markets improve with additional major capital project announcements. These activities should drive our revenue higher in consecutive quarters throughout 2017, also expanding incremental and operating margins.

As we projected earlier this year, our third quarter results established the bottom of expected V-shaped recovery that we believe will continue into 2017. We believe that the global crude oil market is currently undersupplied. This is indicated by recent IEA worldwide crude oil inventory data that has declined over the past four months and is projected to decline for the fifth straight month in December of 2016. Projected OPEC production cuts in early 2017 of 1.3 million barrels of oil per day, along with other operating countries, which does include Russia, pledging to cut another 600,000 barrels a day should lead to extended worldwide inventory declines, which could create a continuing rally in energy prices throughout this year.

As customary, we expect traditional, typical, seasonal, sequential industry activity patterns that will cause the first quarter of 2017 to be similar to the preceding quarter. Within that context, we expect activity levels to further increase in North America, but international and deepwater markets to be flat or slightly down placing our company-wide revenue at approximately $150 million. Reservoir Description operating margins are expected to remain near 18% while operating margins for Production Enhancement are expected to expand to low double digits with company-wide operating margins expanding slightly. Assuming those operating margins, we project first quarter 2017 operating profit to be approximately $22.5 million, which is a slight increase over the prior quarter.

Using that first quarter operating scenario, we project an EPS of $0.42 if the same assumed 6% effective tax rate is used as in the fourth quarter of 2016 for comparability purposes. However, given that the effective tax rate can vary based on the jurisdictions where income is earned, we believe an effective tax rate of 14%, as stated during the last quarter’s call and Chris’s comments, is more likely in the first quarter of 2017, as a result of the shift in activity to the U.S. On a GAAP basis, we project EPS in the first quarter of 2017 to be $0.38, which compares favorably to the GAAP EPS of $0.35 earned in the fourth quarter of 2016. First quarter 2017 free cash flow is expected, once again, to exceed net income. Core expects to continue to make opportunistic repurchases of our shares using that free cash flow in excess of our dividend payments.

CLB Chief Operating Officer Monty Davis added an operations review

During the fourth quarter, enhanced oil recovery, laboratory investigations on unconventional oil bearing reservoirs, continued to be designed and initiated for several large oil companies with development operations in the Permian Basin in South Texas regions of the United States. Both areas exhibit low hydrocarbon recovery factors, which have been interpreted to be the result of excessively high initial drawdown pressures, and associated pressure dependent permeability loss, early pressure drop below the bubble point, and preferential gas phase mobility.

In one approach to these analytical programs, reservoir conditions EOR laboratory testing is conducted on unconventional reservoir samples using cyclic gas injection to validate methods for our improved oil recovery. Newly designed automated laboratory systems are being utilized to cycle miscible fluids into the rock matrix to quantify additional hydrocarbon recovery through multiple testing cycles. This testing is also used to determine how recovery factors vary in response to the range of cycled gas compositions and in different stratigraphic horizons.

Core’s proprietary reservoir condition, high-frequency nuclear magnetic resonance testing is incorporated into this test regime. This unique service allows our laboratory experts to better identify and characterize fluid movement in the rock matrix during the cyclic gas injection, and to identify changes in the physical properties of the hydrocarbons during each test cycle.

Produced hydrocarbons are captured and compositionally analyzed to further understand reservoir fluid, phase behavior, and the ultimate enhanced recovery mechanism efficiency. Hydrocarbon recovery efficiency in the laboratory test is influenced by several factors including rock type, pore geometry, fluid saturation, crude oil and natural gas properties, as well as the selected cycled fluid.

The lab data generated through detailed PVT and core testing can assist in the determination of optimum fluid cycling procedures for subsequent field testing. Laboratory testing shows a range of results. In many cases, with proper design, oil recovery in these laboratory experiments can be improved from high-single digits into low-mid to mid-teens or better.

Production Enhancement revenue of $43 million grew 15% sequentially over Q3. Operating earnings of $3 million yielded operating margins of 7%, more than double Q3 margins. In the fourth quarter, Core’s Production Enhancement segment experienced the highest use of our HERO PerFRAC perforating system.

As operators search to optimize the pumping of their fracing jobs, they have begun to understand the importance of a uniform perforating hole size throughout each frac stage. Core’s HERO PerFRAC system provides an industry-leading consistent hole size around the wellbore, which results in all stage perforations breaking down during the pumping operations and uniformly contributing to the placement of fracture proppant at consistent hydraulic pressures.

In the horizontal well, conventional perforating system produced smaller holes on the high side, and lower – and larger holes on the low side. When the pumping operation takes place, the proppant placement occurs through the largest holes, limiting contribution from others, resulting in a 65% or less perforating efficiency. Core’s HERO PerFRAC family of charges can – will allow the frac engineer to select a range of hole sizes with minimal standard deviation throughout the frac stage.

Pumping frac proppant through equal-size holes minimizes hydraulic horsepower and utilizes 100% of the perforations throughout the stage, facilitating the uniform placement of the proppant while experiencing minimal wellbore tortuosity.

Our clients save money on completions and achieve a higher EUR. Reservoir Management revenue of $7 million was up 23% over Q3, generating $1.2 million in operating earnings at an 18% margin.

In the fourth quarter, Reservoir Management saw an increase in study sales from Q3 2016, and also an increase of the value of these sales. This resulted in greater revenue and a major increase in EBIT versus Q3.

In the U.S., products focusing on the Permian Basin outweigh sales for the studies of other plays by almost two to one. The Permian plays continue to drive the high margin – high levels of merger and acquisition activity in the industry as operators moved to consolidate their land positions in favorable areas in the Midland and Delaware Basins of West Texas.

Outside North America, study sales dramatically increased in Q4 with five projects sold versus one project in all of Q3. All of these studies of offshore plays are in the Atlantic margin from West Africa to Brazil.

It is encouraging to see this increase in offshore activity, as it indicates operators have not abandoned the big plays and still see the merit in continuing to develop these opportunities.

Core Lab Conference Call Q&A

CLB:  The inquiries that we’re getting are strongly suggesting that we have or will see a bottom in international activity first, and actually may have seen that, followed by offshore and deepwater.

If you just look at some of the most recent press releases, and there was one this morning on Exxon Liza, which will be FID-ed sometime in 2017. Projects like these are good news for Core Lab. We’re doing the full battery of rock analysis there, and we’re following up with a detailed reservoir fluids suite of projects that will continue over the year.

Chevron Tengiz is going to be very active. We believe that outside of Mad Dog Phase II in the Deepwater Gulf of Mexico, we will see other FIDs there in the Deepwater Gulf of Mexico that will benefit Core. So, from the international theater, we believe that as the year progresses, that we will see Reservoir Description revenue increase, bolstered by that from the offshore and deepwater. And for the company, we saw the bottoming of the V in Q3. We’ll probably see the bottoming of Reservoir Description in Q1.

Q: And are customers, again, willing to pay up for technology? And the past few years seems to have been a sort of race to the bottom as far as quality and prices and everything. And are you sensing – to what extent are you sensing the change now?

CLB: the North American clients into those that are technologically sophisticated clients, and in that camp, certainly we would put Pioneer, Occidental, Apache, certainly Concho Resources certainly would be another. These companies have been and continue to be innovative like the project that we’re working on at HRL, formally known as the Hughes Research Laboratory, and Pioneer where we’re using machine learning expert-guided analysis to pinpoint more highly productive areas within the acreages owned by Pioneer, which we’ll be able to leverage to some of these other technologically sophisticated clients.

For Core Lab, additional revenues that have higher margins and incremental margins because these projects are really at the cutting edge of the technology and instrumentation that are available today. And for a number of these projects, for instance, like Apache, in the Southern Delaware Basin, certainly we had to manufacture that equipment because we were using NMR technologies at the frequencies not produced by any other equipment maker, so we went ahead and make that equipment ourselves.

So, the impact it’ll have in Reservoir Description will be higher revenues that also contain higher margins. So a number of these projects that we’re working on, like the one with Pioneer and HRL, we can process more data more quickly, leading for them to make quicker decisions on what areas they’re going to complete and what types of stimulation packages they’re going to use.

We would still agree that longer laterals and more proppant is a blueprint for higher returns and higher EURs. However, you run out of the length of the lateral that you can drill based on the metallurgy on some of these coiled tubing that’s available, so we will see denser completions using some of the new technologies, certainly seeing the use of sand go up, and that sand could be either northern white or some regional sands that are available, looking at the use of 100-mesh size and maybe finer grain sizes, depending on which stage of the frac that you’re pumping.

So, a lot of exciting technologies that will bear fruit here over the next couple of years. In Core Lab, we think we’ve got the pulse right on this.

Q: Are you seeing any signs that is there a return of higher crush-resistant products like ceramics or is it all sand?

CLB: I would say in some deeper penetrations, just due to pressure requirements, there is still going to be a need for ceramic. But at this stage, we would say sand, sand, and more sand, and 100 mesh and finer sand is something the industry will probably trend to because we can see it here in our laboratories that that is probably the way to go.

Q: Are we still kind of in early days, and is that really going to just sort of replace a lot of the existing tools you’re using – or PerFRAC’s over the next sort 12 to 18 months?

CLB: The HERO PerFRAC system has – is one we introduced in the second quarter really of last year and has gained acceptance, and of course, that means revenue. Throughout the year, December was our biggest month. That’s probably going to be superseded here in January, as more people see the benefits of it.

It is, we believe, the best way and should be used by everybody if you’re going to frac a well. There’s no sense fracing the well and only getting 65% or less efficiency from the perforating system before you frac the well.

So, it’s a system that is helping us gain market share as well as, certainly, replacing older technology for everybody, including older technology that we were selling. So, it’s a system that we see continuing to grow as fracing continues, and we’ll see that a lot in – growth in 2017 and onward.

We’re working right now on a project. We’re on a pad, one well by this operator was perforated using conventional perforating systems, and the neighboring well was used – totally a PerFRAC system. It will be a nice proof of statement paper that we’ll come out with. And we think that that will increase the acceptance of the industry and further market penetration of this technology.

Q: It’s really great to hear how excited you guys are for just the down or the bottoming of deepwater and international in the first half, and, Monty, I was particularly curious about your comments regarding Reservoir Management international study sales increasing dramatically over the last quarter? Is this a sign that maybe you guys are starting to see a bottom for offshore exploration, that maybe there’s going to be a churn to come in the next couple of years in that area?

CLB: I think what it says, Samantha, as we’ve been trying to say is that the interest in these projects is growing a lot. People are interested in looking back at bigger projects that have more cost, higher technology needs, and that’s good for us. So, we’re thinking that the international offshore, or even international deepwater, is picking up interest, and that will probably lead – people don’t invest in these projects without following through with some work. So, we think there’s going to be a pickup in that. Timing is hard to say, but in the not-too-distant future.

There has been plenty of oil found in deepwater. Some of which has not been developed. We think the purchase of these studies is to add for the development of that. Company like Conoco has said that they will no longer explore for new deepwater deposits. However, the ones that they’ve already discovered, they will go ahead and develop it. We believe that those projects will continue along.

That being said, although, exploration is not a big part of Core Lab, less than 10% of our business, we’re going to have to have somebody going out and finding some new oil. Because last year, new discoveries totaled only 3.7 billion barrels, and you’ve got the globe using over 55 billion barrels. Sooner or later, you empty that bank pretty quickly.

Q: just on the Gulf of Mexico; Dave, I caught your comment that production was not as much as you guys had anticipated. And I was just kind of curious about this new JIP that you guys are launching. Is that targeting more of those like brownfields? I mean, just can you tell me a little bit more about this new JIP?

CLB: The difference – we’ve had a JIP on deepwater. You could refer to this, actually, as ‘deeper water’. This is a move out further into the Gulf into new areas that are of interest. Some activity there, but there is an increase of activities in that area as we move further out into the Gulf. And that’s what this study is about: how do you operate in the deeper water to produce and increase your EOR from those reservoirs that are a bit different. Every reservoir is different from the last one but they are different as you move further out into the Gulf of Mexico, and that’s what that study is about.

These will be the ultra-deepwater fields in the southern Perdido Fold Belt, which is usually referred to as the lower tertiary. So, these are nearly international line with some of the discoveries that Mexico has made, and are looking to the IOCs worldwide to develop that. So, this will entail some additional information over the – what we look at is the southern Perdido Fold Belt, and from the Mexican side, the northern Perdido Fold Belt. So, it will be extension of the deepwater, as Monty said, into ultra-deepwater.

So, we’re getting some real good interest on that, more on that in Q1, but we think that project does get fired up in Q1.

Q: I wanted to come back to the Pioneer, HRL technology, and see if you can give us a little feel for – I know you talked about – in the couple of clients you think it applies to, but how – when does that commercialization you think started? And how many clients in the aggregate – how big can that be here?

CLB: Well, essentially, Rob, it is commercialized. We were out there two weeks ago, signed the agreements. They actually went through the description of a core that had literally thousands of different environmental phases in it. And out of all of the phases that were identified by this computed learning, there were only three in question.

So it is, right now, a commercially-viable service that we will offer not only in the Permian Basin but expanding that worldwide. What it does is it reduces big data in a big hurry for the operator. So we think that saves him time, money, and he makes smarter decisions.

Right now, that is ready to start generating revenue. The size of it, don’t know. Hard to quantify, but we think, like some of our other technology, it is certainly cutting-edge and will take time for client acceptance. But from what we’ve seen so far, we’re very pleased with the application of that technology. And not only for unconventional reservoirs, we think this has huge application offshore where we’re looking at maybe thousands of feet of Core that can be analyzed and described within, if not minutes, hours as opposed to days. And with spread rates back in 2014 at a $1.1 million a day, you can see the considerable savings for our clients, all-in, by allowing us to perform that service.

Q: How about savings for you guys in terms of perhaps being able to scale revenues while hiring, if anything, very few incremental technical staff?

CLB: When you look at that, the machine has to be taught by the expert. So our geological staff that we have here has been involved in that.

No, that really wasn’t part of it, Rob. It was really more the mix as we’ve seen the shift in the business to go more North America from international. And when you think about, today, the size of the projects in North America, they are just smaller. Their reservoirs are not as complex, so the level of technology that we employ is lower. And so, the reason for margin degradation has really been that shift towards North America.

The things we’re trying to do to shift that, to pivot that back to higher margins, are exactly what you just talked about: the EOR and the machine-learning technology that Dave just talked about. Both of those should help us in North America to improve margins.

In the future, we may have to hire less incremental geologists. But the staff that we have right now will be full-time busy machine-learning this from expert guidance. And the thing that we had mentioned was our Worldwide Rock Catalog, where we really have thousands of phases around the globe. It will take us to machine-learn – over a period of several quarters, if not a year, to machine-learn from our expert geologists on how those phases should be interpreted.

Q: We’ve seen this surge in the rig count, you know, into the holiday season in the fourth quarter and it’s continued here earlier in the year. From your perspective, I was just curious how much you think the continued shift towards pad drilling, higher wells per pad, all of that elongating the lag between drilling and completions activity, and then, how does that eventually translate into something like a completion’s tailwind for North America?

CLB: Yeah, Sean, I think, you make a very good point there. If you look at the number of drilling rigs added compared to the number of completions, completions were up 2%. And of course, that’s what makes a revenue event for Core Lab.

Certainly, pad drilling, if we look at a pad that’s going to drill five wells, that’s going to be, let’s say, somewhere around 60 days to drill all five of those wells at a very efficient drilling process. You are probably going to look at some delay in the completion of that entire pad by somewhere between 90 and 120 days. So, you are exactly right.

We’re building up. We’re slowly building up a backlog of wells that have been drilled but uncompleted. And actually, if you look at the number of DUC wells that are out there, at the end of the quarter, it was nearing an all-time high. These aren’t stale DUCs. These are DUCs that have been drilled in pad drilling, that are waiting on completions, that are going to start to occur probably in Q1, certainly in Q2.

NOTE: Core Laboratories earnings release is available here.

Core Lab Conference Call: Industry Bottomed in Q3

EnerCom Dallas investment conference Mar 1-2 2017

Core Lab is a featured presenting company at EnerCom Dallas, Mar. 1-2, 2017. For details and to register, please visit the conference website.


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