Oilfield Services and Equipment Industry Transaction Trends Robert L. Moore, Jr. – [email protected] Matthew J. Springer – [email protected] Lidiya T. Deane – [email protected]

The oilfield services and equipment (“OFS”) industry is a large,

in size from Fortune 500 companies to small local retailers.1 The

highly-competitive industry that provides services and goods to

largest OFS participants, in terms of market capitalization, include

oil and gas exploration and production (“E&P”) companies. The

the Big Four diversified service providers, Schlumberger Ltd.,

industry and transaction market for its participants are noted for

Halliburton Co., Baker Hughes Inc., and Weatherford International

significant cyclicality. Over the last decade, the OFS industry has

and large equipment manufacturers, National Oilwell Varco, Inc.

undergone substantial changes, growth, and shocks, resulting

(“NOV”) and Cameron International Corporation.

from oil and natural gas commodity price growth, the development and expansion of U.S. unconventional

Global OFS Spending by Service

drilling and production, and the fallout from the Great Recession and the Macondo tragedy. Over the last couple of years, the transaction activity transitioned

Hydraulic Fracturing, 27%

to focusing on internal operational improvements and clarifying performance for investors. Consequently, we

Subsea Equipment, 14%

have observed muted merger and acquisition (“M&A”) activity and an interesting uptick in spin-off transactions.

Coiled Tubing Services, 4%

In addition, we have also seen increased utilization of master limited partnership (“MLP”) structures in the OFS

Main Team Members Surface Equipment, 5%

Roles

industry, a trend that is noteworthy for its expansion of qualifying income and investor acceptance.

Well Servicing, 5%

OFS Industry Conditions n n n

Specialty Chemicals, 6% Renting & Fishing Services, 6%

In general, OFS companies provide products and services to E&P companies but are typically not producers of oil

Rig Equipment, 13%

Completion Equipment & Services, 9% Drilling & Completion Fluids, 10% Source: Spears & Associates.

or natural gas themselves. In 2013, more than 10,000 companies operated in the U.S. OFS industry and ranged

1

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1

S&P Capital IQ Industry Surveys, Oil and Gas: Equipment and Services, March 2014.

OFS companies offer a wide variety of services. As seen in the

application of unconventional drilling techniques to oil plays that

chart on the previous page, the service and equipment subsectors

have followed, drilling activity and demand for OFS has increased.

are comprised of a number of segments with hydraulic fracturing

As shown in the chart below, the PHLX Oil Service Sector Index

(“fracking”), subsea equipment, and drilling & completion

(“OSX”), an index of the leading OFS service companies, has

fluids representing the largest segments. Fracking has grown

nearly recovered to the all-time highs seen in 2008 as a result of

to become the largest service segment. Although not without

improving industry and economic conditions. However, the OSX

its own challenges due to excess equipment capacity in recent

has trailed the performance of the S&P 500 in 2012, 2013, and

years, demand for fracking services has grown with increased reliance on horizontal drilling and fracking of denser rock formations in the unconventional

U.S. Onshore Drilling and OSX Index

plays. In addition to the segments presented in the chart, contract drilling (the provision of drilling rigs and related personnel) is another very significant service offered by OFS industry participants.

2,100

$400

1,900

$350

1,700

$300

OFS industry performance is highly correlated to

1,500

$250

the capital spending budgets of E&P companies

1,300

as demand is driven by the availability of capital for E&P companies as well as long-term expectations

$200

Main Team Members

1,100

regarding the prices of oil and natural gas. Over the

900

past five years, capital spending by E&P companies

700

has increased significantly, as many companies

500 6/30/2007

have retooled their property holdings and operations

$150

Roles

$100 $50

6/30/2008

6/30/2009

6/30/2010

6/30/2011

6/30/2013

$0 6/30/2014

OSX Closing Stock Price (Right Scale)

Onshore US Rig Count (Left Scale)

in pursuit of and development of unconventional

6/30/2012

oil plays. According to IHS Herold, Inc. (“IHS”), an

Source: Baker Hughes and Bloomberg

energy research and consulting firm, global upstream capital spending has increased from $493.5 billion in 2008 to $627 billion in 2012.2 However, increased investor pressures on E&P companies to become more operationally efficient and reduce spending caused capital spending by U.S. companies

year-to-date through July 2014 due to general margin pressures in many segments of the U.S. market as well as slower growth in overseas markets.

to decline by approximately 16% in 2013, with development

The major overriding trend in the U.S. market is the development

spending being the only category to increase as companies drilled

of unconventional oil plays. The rig count for oil-directed wells

out acreage acquired in recent years. In 2013, acquisitions of

has increased from approximately 20% in the early 2000s through

proved and unproved properties also declined by approximately

2007 to over 80% in 2014. This has been the result of both an

50% and 60%, respectively. According to IHS, gas-weighted E&P

acceleration in activity for oil-directed rigs and a collapse of activity

companies decreased capital spending for the third consecutive year, while oil-weighted E&P companies

Rig Count – Oil/Gas Spilt

reduced capital spending for the first time in several years. IHS further projects that capital expenditures by E&P companies are expected to increase by approximately 2.5% in 2014.3

100.00% 90.00% 80.00%

The drilling rig count increased from 2007 to 2008 (as

70.00%

evidenced by the increasing number of onshore U.S.

60.00%

rigs) primarily due to increasing oil and gas prices

50.00%

and favorable economic and industry conditions. In

40.00%

2009, oil and gas prices dramatically decreased as

30.00%

a result of the Great Recession. At that time, E&P

20.00%

companies reduced capital and operating budgets

10.00%

and reduced drilling activity, which reduced the demand for the OFS industry. As oil prices began to

Main Team Members Roles

0.00% 2000

3

2002

2003

2004

2005

2006

% Oil

rebound in the second half of 2009 and the broader

2

2001

2007

2008

2009

2010

2011

2012

2013

2014

% Gas Source: Baker Hughes

IHS Herold, Inc. IHS Herold, Inc.

2

©2014

for natural gas-directed rigs. The natural gas-directed

M&A Transactions – Oilfield Service and Equipment

rig count increased through mid-2008 following the discovery and development of unconventional gas

180

60.0

plays in the early and mid-2000s and peak natural

160 50.0

140

the recession, many E&P companies needed to drill

opportunity cost of giving up drill-to-hold leasehold acreage from inactivity has declined. The large

100 In Billions

environment of sustained low natural gas prices, the

120

40.0

in order to maintain their leaseholds. However, in an

30.0 20.0

40

10.0

Eagle Ford plays which have seen rig counts increase

20

0.0

2008

from 771 in 2011 to 1,008 as of June 30, 2014 (on an aggregate basis).4

2009

Asset

2010

2011

2012

Corporate

requires more drilling- and equipment-intensive operations due to horizontal drilling and fracking. The percentage of rigs drilling horizontal wells has increased from 20% in 2007 to nearly 70% in 2014. As mentioned previously, investor pressures intensified beginning in 2012 for E&P companies to become more focused on internal cash flow generation, lower well costs (particularly relative to lateral length), and faster development. As a result, advances such as shortened horizontal drilling times and multi-well pad drilling have been more broadly deployed and have put pressure on margins and equipment utilization in this segment of the industry. The offshore oil and natural gas industry has also undergone significant changes over this time period. E&P companies have ventured into deeper and more challenging development environments as the next frontier for large projects, pushing the envelope on technological capabilities. The Macondo tragedy and subsequent moratorium halted activity on these massive projects in the Gulf of Mexico. As oil prices remain attractive for development and the government and industry have adapted to the new regulatory scheme, exploration and development of these projects has resumed and in many cases expanded following successes. Recent oil prices and improvements in technology to identify drilling targets have also increased drilling on the shallower shelf.

Transaction Market Activity n n n With this back-drop of OFS industry conditions set, we will now provide an overview and discussion on the transactional activity in the industry, including the OFS merger and acquisition environment, a recent increase in OFS spin-offs, and the continued

2013

YTD 6/30/14

0

Deal Count Source: IHS Herold, Inc.; SSR research

The development of unconventional resource plays

use of OFS MLP structures.

60

Roles

increase in oil-directed rigs can clearly be seen in the Permian Basin, Mississippian, Bakken, and

80

Main Team Members

Number of deals

gas prices. In addition, following the recovery from

M&A Market M&A activity in the OFS industry collapsed in 2009 from its historically high level in 2008 as a result of the fallout from the Great Recession. M&A activity was particularly robust in 2008 and the years leading up to that point as demand for OFS grew rapidly and participants sought to provide a broad range of services for E&P companies. M&A activity rebounded to strong levels in 2010 and 2011, driven primarily by consolidation by large players. The downward trend in 2012 and 2013 reflects a slowdown in deal activity which has been driven by companies’ focus on internal efficiencies and operations due to pressures from the E&P industry. Many of the major global diversified oilfield services players generally spent 2013 integrating prior acquisitions and/or consolidating existing product and service offerings for improved efficiency and profitability. The largest OFS deal in 2013 was General Electric’s (“GE”) acquisition of Lufkin Industries Inc. (“Lufkin”), primarily an oilfield pump manufacturer, for $3.1 billion which accounted for approximately 20% of the total transaction deal value in 2013. GE has grown its oil and gas business through a number of acquisitions in recent years, and the acquisition of Lufkin was targeted to expand GE’s support division with artificial lift capabilities. In 2013, drilling rig owners and operators within the OFS Industry continued to consolidate and focused on specializing by asset type. For example, the acquisition of a 49.1% interest in Sevan Drilling ASA by Seadrill Limited (“Seadrill”) for approximately $589 million is an example of a company attempting to specialize its product and service offering by gaining exposure to ultra-deepwater rigs. The oilfield products manufacturing segment remained robust throughout 2013, with deals primarily focused on strengthening the global suppliers’ positioning in key markets and implementing cost efficiencies within supply chains.5

4 5

Baker Hughes, rotary rig count database. EY, Global Oil and Gas Transaction Review 2013.

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3

Looking forward, M&A activity has been rebounding through the

Upon completion of the spin-off, the parent company and the

middle of 2014 as a result of improved activity levels in the market

separated company are both publicly traded companies that

as well as the strengthening of the capital markets. One of the

have exactly the same shareholder base. The pure play spin-off

major deals that has closed thus far in 2014 was C&J Energy

structure is more transparent and may attract investors who more

Services, Inc.’s (“C&J”) acquisition of the hydraulic fracturing

highly value the separated operations.

business of Nabors Industries, Ltd. for approximately $2.9 billion. The new company, C&J Energy Services Ltd., will be incorporated in Bermuda and run from its current offices in Houston. According to C&J, the acquisition was made in an effort to improve profitability through utilization improvements over the larger fleet and reducing overall taxes by being incorporated offshore. The acquisition represents another signal that the fracking business is

Below we present the recent spin-offs involving OFS companies. In each of these instances, the parent company has sought to provide greater clarity of the operating units by separating the business units. Following the success of MRC Global’s IPO in 2012, NOV has sought to achieve a similar, higher multiple for its supply business which was created by combining Wilson Supply,

improving following a difficult 18 months.

which it acquired in 2012, with its own supply business. The Civeo

OFS Spin-off Activity

the second major step in retooling OIS’ business over the last

In addition to the M&A activity previously discussed, the market is also rewarding firms that concentrate on their core business and improve operating efficiencies. As such, many OFS companies are increasingly using spin-offs as a strategy to unlock value. A spin-off allows companies to separate part of their businesses by creating a new publicly-traded entity. As a result, companies can focus on the strategic and operational plans of the separated entity without diverting human and financial resources from the parent company. Also, the parent company and its spin-off may have different capital requirements that may not be optimally addressed under a single capital structure. In a pure play spin-off, a parent company distributes 100% of its ownership interests in a

Inc. (“CVEO”) spin-off by Oil States International Inc. (“OIS”) is year, following a divestiture of Sooner, Inc., a tubular service distribution company. These moves have streamlined its focus as a technology-driven and equipment manufacturing-oriented business, which have received premium valuations by the market. Chesapeake Energy Corp.’s spin-off was executed to achieve the benefit of improved transparency and focus as well as to reduce indebtedness for the parent. Paragon Offshore Ltd. (“PGN”) follows a trend in the contract drilling market whereby many companies have sought to increase focus on particular service lines. Each of these newly spun-off companies has received a positive response in the markets, with the exception of PGN, which has declined in a difficult trading environment over its first two months.

separate entity as a tax-free dividend to its existing shareholders.

Parent Company

SpinCo

Spin Description

National Oilwell Varco, Inc. (“NOV”)

Now, Inc. (“DNOW”)

DNOW, which is doing business as DistributionNow, began trading on June 2, 2014 with an implied market capitalization of $3.8 billion.

Rationale: This spin-off provides a clearer delineation of NOV’s equipment manufacturing activities and should improve NOV’s profitability once the lower margin distribution business is separated from the company. Additionally, the clearer delineation was hoping to capitalize on higher valuation multiples for distributionfocused providers, like DNOW.

Oil States International, Inc. (“OIS”)

Civeo Corp. (“CVEO”)

CVEO commenced trading on June 2, 2014 for $23.25, which implied a market capitalization of $2.5 billion.

Rationale: With the spin-off, OIS and CVEO will allow both companies to better pursue growth opportunities in each of their respective businesses. The transaction was intended to allow both companies to capitalize on their respective market opportunities and further enhance shareholder value creation. Additionally, CVEO may pursue options to convert to a real estate investment trust structure.

Chesapeake Energy Corp. (“CHK”)

Seventy Seven Energy, Inc. (“SSE”)

SSE commenced trading on June 30, 2014 at $23.55, which implied a market capitalization on $1.1 billion.

Rationale: Allowed CHK to further focus its efforts on its core E&P business, allow both companies to have greater flexibility and appeal to a larger investor base, further reduce the oilfield subsidiary’s dependence on its parent company, and reduce leverage for CHK.

Noble Corporation (“Noble”)

Paragon Offshore PLC (“PGN”)

PGN commenced trading on August 4, 2014 for $11.21, which implied a market capitalization of $948 million.

Rationale: Following the spin-off, Noble will continue to focus its efforts in the higher margin and growth high-specification drilling market, while PGN targets the standard specification drilling sector.

4

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Master Limited Partnerships While 2014 is on pace to be among the most active years for initial public offerings (“IPOs”) in U.S. market history, U.S. IPO activity has been relatively muted

Characteristics

MLP

Stock Type/Income Stream

LLC

C Corporation

Units/Distributions Units/Distributions Shares/Dividends

Taxation Level

Investor Level

Investor Level

Corporate & Investor Level

Tax Reporting

K-1

K-1

DIV-1099

Tax Deferrals on Distributions/Dividends

Yes

Yes

No

Majority Retail

Majority Retail

Institutions

Yes

No

No

Often

No

No

No

Yes

Yes

in the OFS industry. Through the first seven months, only five IPOs have been completed. One trend that we observed among the IPOs is the continued and broadening use of MLP structures by OFS companies. Over this time period, the two largest IPOs were MLPs, which raised proceeds of nearly five times that of the three corporate issuers.

Investor Base General Partner Incentive Distribution Rights

An MLP is a state law partnership or limited liability company that does not pay federal income taxes and

Voting Rights

Source: CBRE and Latham & Watkins

is publicly traded on a securities exchange. Following what some deemed as an abuse of the structure in the 1980s, MLPs were required to ensure that 90% or

Market Capitalization and Number of MLPs

more of their gross income is “qualifying income” to the U.S. Internal Revenue Code of 1986, as amended

The modern trend in MLPs has been predominantly driven by the midstream oil and gas industry, which popularized the use of the structure beginning in 1997 and 1998. Such MLPs generally produce regular, reasonably predictable cash flow and distributions. Since then, and buoyed by their high yields in a low yield investing environment, MLPs have become a major asset category in U.S. capital

Market Capitalization (in Billions)

(the “Tax Code”).

$800

160

$700

140

$600

120

$500

100

$400

80

Main Team Members

$300

60

Roles

$200

40

$100

20

$-

Number of MLPs

maintain partnership status under Section 7704(c) of

0 2005

2006

2007

markets, attracting substantial investment flows and

2008

2009

2010

2011

Market Cap

acquiring and developing vast energy assets. IPO

2012

2013

2014

Count Source: Bloomberg

activity among MLPs was the highest on record in 2013, as 28 companies completed their initial offerings in the year. As of June 30, 2014, MLPs had a total market capitalization of approximately $635

OFS Segment

billion, the vast majority of which were engaged in

Contract Compression

midstream activities such as gathering, processing, transportation, and storage. Approximately 20% of all MLPs engage in real estate, investment and financial activities, hotels, motels, and restaurants.

Offshore Contract Drilling

While the capital markets have been highly receptive to MLPs following their strong performance, there is a clear broadening of industry segments utilizing

Fractionation Sand Supply

the structure both in OFS as well as other areas of the energy sector, like refining. Companies outside

Saltwater Disposal

the traditional midstream space have increasingly received Private Letter Rulings (“PLRs”) from the IRS as to determinations of their qualifying income. For example, in 2013, the IRS released 30 PLRs compared with 21 in 2012 and 11 in 2011.6

6

Alison Sider, Energy Spinoffs are Moving Into Tax Limbo, April 9, 2014.

©2014

5

MLP

IPO Year

Exterran Partners, L.P.

2006

Enerflex Ltd.

2011

USA Compression Partners, LP

2013

Seadrill Partners, LP

2012

Transocean Partners, LLC

2014

Hi-Crush Partners

2012

Emerge Energy Services LP

2013

Cypress Energy Partners, LP

2014

This broadening use of the MLP structure can clearly be seen in the

Conclusion n n n

OFS industry. OFS segments that have seen a rise in companies using the MLP structure have included the natural gas compression

Although the OFS industry has experienced lower transaction

segment, the offshore contract drilling services segment (Seadrill

activity levels in recent years, M&A market activity appears to

and Transocean Partners, LLC debuted in 2012 and 2014,

be rebounding in 2014 as spending by E&P companies remains

respectively), and the saltwater disposal segment (Cypress Energy

strong. The OFS companies are expected to remain focused on

Services debuted in 2014). Clearly investor demand continues

strengthening their core businesses and improving operating

to support this new OFS MLP concept. Although many of the

efficiencies by continuing to seek ways to streamline operations

companies have not traded over a cycle.

and strategically separate business segments. As a result, investors and companies are expected to seek additional shareholder value

Following the increase in MLPs in recent years, the IRS elected

through transactions to support such ends.

to temporarily put a pause on issuance of PLRs in March 2014 until further study can be conducted to better understand tax

Robert L. Moore, Jr. is a Managing Director in the Valuation &

implications and what the appropriate rules should be going

Financial Opinions Group at SRR. He has over 15 years of financial

forward. While the length of the delay was not known as of the

services experience and focuses on providing fairness opinion

date of this publication, investors and OFS industry participants

and business valuation services. Mr. Moore can be reached at

will need to proceed with caution in the interim. In 2013, the

+1.713.221.5131 or [email protected].

7

IRS conducted a similar review on non-traditional real estate investment trusts (“REIT”) such as timber, data centers, document storage facilities, and cell towers. In the second half of 2013, the IRS resumed ruling on REIT PLR requests.8

Matthew J. Springer is a Senior Vice President in the Valuation & Financial Opinions Group at SRR. He has experience providing valuations and economic analyses for estate, gift and

income

support,

tax

estate

requirements, planning,

and

fairness

opinions,

employee

stock

litigation ownership

plans. Mr. Springer can be reached at +1.713.221.5130 or [email protected]. This article is intended for general information purposes only and is not intended to provide, and should not be used in lieu of, professional advice. The publisher assumes no liability for readers’ use of the information herein and readers are encouraged to seek professional assistance with regard to specific matters. Any conclusions or opinions are based on the specific facts and circumstances of a particular matter and therefore may not apply in all instances. All opinions expressed in these articles are those of the authors and do not necessarily reflect the views of Stout Risius Ross, Inc. or Stout Risius Ross Advisors, LLC.

7 8

Amy Elliott, IRS Has Stopped Ruling on Publicly Traded Partnership Qualifying Income, Tax Notes Today, March 31, 2014. Latham & Watkins, IRS to Resume Work on REIT Conversion Ruling Requests, November 22, 2013.

6

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