Schlumberger

Kibsgaard Speaks at 42nd Annual Howard Weil Energy Conference

Date: 3/24/2014

Thank you and good morning ladies and gentlemen.

Let me start by thanking Howard Weil and Bill Sanchez in particular for the invitation to speak here today.

In my talk, I would like to cover four main subjects.

First, I will give you our perspective on the current financial challenges facing the entire E&P industry and how we, through our various transformation programs, are working on converting these challenges into unique growth opportunities for Schlumberger.

Second, I will elaborate on one of our key transformation programs, namely technology innovation and development, and show you how this program which was kicked-off 6 years ago now, is starting to have a significant impact on our R&E performance.

Third, I will demonstrate how we, through focused execution, are already starting to convert our ongoing transformation programs into differentiated financial performance which should further strengthen in the coming years.

And fourth, I will review how our markets are evolving so far in 2014 and give you a business update, both in terms of Q1 expectations, as well as the full year outlook.

But before we start let’s get the formalities out of the way.

Some of the following statements are forward-looking.

Actual results may differ, please see our latest 10-K.

Starting off with the current industry challenges, let us first look at a few numbers that summarize the situation.

Over the past 10 years, total E&P capex spend has grown by around 400% while global oil production is up by only 15 percent.

Over the past 3 years, the upstream E&P industry has spent on average $600 billion per year with the only net increase in global oil production coming from North America unconventional resources.

The combination of escalating finding and development costs, relatively flat global oil production, and range-bound commodity prices is therefore putting significant pressure on profitability and free cash flow in the entire E&P value chain.

Part of the reason for this is an extended period of underinvestment in the 1980s and 1990s.

And more importantly, the aging production base requires more investment to fight decline and new resources such as deepwater and unconventionals are more complex and expensive in terms of cost per barrel.

However, it is also clear that our industry has fallen behind other industries over the past decade in several key aspects of our technical performance, and this has again created cost and efficiency levels that are now catching up with us.

So how do we address this problem as an industry?

In the E&P value chain, the oil companies are the ultimate integrators of all the technical work associated with finding developing and producing hydrocarbons.

At the same time, the oilfield services community also holds a clear responsibility for the performance progress, or lack thereof, within our industry and hence, a large part of the industry’s performance improvement has to start here.

It is also clear that the required improvement will not come from yet another round of procurement-driven price reductions across the E&P value chain, while we continue to do business as usual.

The current underlying technical performance will simply not support that.

The required step-change can only be achieved by taking a new approach to how we drive our business forward; by learning from what has been done in other industries and by actively challenging the status quo of our current performance.

We believe that the companies in the E&P value chain that have the appetite and ability to transform themselves in this way stand to gain a major competitive advantage.

We therefore see the current industry challenges as a major opportunity for Schlumberger where we will leverage our ongoing transformation programs to further strengthen our market position and widen the performance gap to our competitors.

Let us therefore take a closer look at our transformation programs in terms of how they relate to the ongoing industry challenges, and how they will help drive our technical and financial performance going forward.

Our first transformation program is focused on technology innovation and development and was already launched in 2008.

The goal of the program is firstly; to increase the rate and magnitude of innovation to create more products that can facilitate step changes in technical performance, instead of having the more traditional evolutionary impact.

We also aim to accelerate the speed of our product development cycle in order to reduce time to market for our new innovations.

And lastly, we look to dramatically improve the initial ‘out-of-box’ performance of the new products we introduce to the market.

The second transformation theme is reliability where we, as a company, are looking to elevate our performance to the 5 Sigma level seen in the automotive industry.

We will do that by emulating their design test and qualification methodologies and their approach to equipment maintenance and repair, and also by creating a step-change in the way we adhere to clear and simple operating procedures.

The third transformation theme is process efficiency, where we for a wide range of our internal workflows, are looking to better leverage the scale of our operations to reduce costs by utilizing the latest advances in IT infrastructure and transportation.

And the fourth transformation theme is integration where we see a significant performance upside by further expanding the level of project management and integration we do for our customers.

Today, there are in general, too many individual suppliers involved in our customers’ workflows which adds unnecessary complexity in terms of establishing the optimal technical solutions and also in achieving full commercial alignment with the customers’ goals.

By moving towards fewer, larger service providers, who have broader technical offerings, a full range of integration capabilities and the ability to better align commercially through new business models, we can significantly improve both the technical and financial performance of our customer projects.

These four transformation themes are actively being pursued in our organization and are at various stages of maturity and implementation.

Today, in the interest of time, I will elaborate on the technology transformation program.

In doing so, I will show you what we have achieved since the program  was kicked-off six years ago and also how the program is starting to have an impact on our results through a few examples from our Drilling Group.

Technology has been a core value for Schlumberger since the creation of the company over 87 years ago, and we have continuously reinvested a significant part of our profits into innovation and new product development.

In 2007, with our annual R&E investment already exceeding $700 million and in preparation for further expanding the size and breadth of our offering, we decided to challenge our already successful technology approach in search of even better performance.

We did this by creating a team of young scientists and engineers from our R&E community to review the best practices from the best industries and to recommend how we could further improve our approach and our performance.

Following a comprehensive nine-month study where we engaged a range of leading engineering and manufacturing companies outside of our industry, the team came up with two high-level recommendations.

First, that our engineering and manufacturing organization, which at the time was managed in separate product line silos, should be unified in order to better leverage our size and capabilities.

And second, that we should re-write our entire R&E operating system using the latest best practices from other industries such as automotive and aerospace and implement this system in the new unified R&E organization through a complete, multi-year transformation.

This transformation process which started in 2008 has had the following focus areas:

First, to increase the rate of innovation by taking a broader approach to fundamental research and by complementing our internal innovation with more external collaboration and targeted M&A activity, accepting that we do not have a monopoly on coming up with the best new ideas.

Second, to reduce the number of engineering iterations and shorten the time to market for new products by more extensive use of software and modeling to do rapid prototyping, and by developing a catalog of standardized technology building blocks that can be shared and re-used throughout the entire R&E organization.

And third, to improve the technical ‘out-of-box’ performance of our new products as they are introduced to the market by focusing on reducing design complexity and also by introducing more elaborate  test and qualification methodologies, both in the lab with our suppliers and through investing in full-scale test facilities and rigs.

The scope of this R&E re-organization and transformation has been monumental and one of the largest change management challenges we have undertaken as a company.  

And the progress has been excellent; with the new organizational structure put in place in 2008; the design of the new R&E operating system finalized and piloted by 2010; and the full transformation roll-out completed in 2012.
 
The transformation program has cost over $350 million and has taken a full six years of steadfast implementation in the face of many challenges.

Not the least, motivating and engaging our community of outstanding and highly successful scientists and engineers, to make them believe in the new direction and to transform the way they work together.

We are now starting to see the early benefits of our R&E transformation in the form of a significant ramp-up in high-impact commercializations, suggesting a clear improvement in both the rate of innovation as well as the time to market.

We are also seeing marked improvement in the ‘out-of-box’ performance of the new products we are now introducing, and this should only grow in impact over the coming years, as we continue to commercialize new products.

I will give you a few examples of these new technologies and their performance, but before I do that, I would like to highlight two additional areas that are central to the technology transformation.

The first area is IP, where we have significantly ramped up our rate of patent filings in the past six years, in particular in the areas of Drilling and Production and over the past three years our total US patent grants have been on par with our two largest competitors combined.

In parallel with this, we have also stepped up our efforts to enforce our patent rights and pursue cases of potential infringement, and we will continue to protect our R&E investments in this way going forward.

The second area is M&A where we have established a broad capability in terms of identifying the right targets, timely closing of transactions, and seamlessly integrating the new companies into Schlumberger.

The range of our M&A activity spans; complete mega-acquisitions such as Smith International; conversion of minority interests to full ownership such as the pending Saxon Energy Services transaction; partnering through joint ventures such as OneSubsea; compiling numerous smaller targets in new spaces such as Rod Lift in North America Land; acquisition of disruptive technology companies such as NovaDrill; and smaller investments in start-up companies such as Liquid Robotics.

Given the breadth of our commercial offering, M&A will continue to play a complementing role in how we drive technology innovation and development and we will allocate part of our growing free cash flow to these types of investments going forward.

Having outlined several of the factors that will further extend our technology leadership over the coming years, I will now give you a few specific examples from the Drilling Group of recent technology successes stemming from the transformation program.

The Stinger cutter, which is a revolutionary conical-shaped diamond cutter, was a key part of the NovaDrill acquisition in 2010 and is an example of innovation through targeted M&A.

The novel cutting structure of the stinger significantly reduces shock and vibrations when the element is placed in the center of the bit.

In a wide range of field applications, the first generation Stinger Bit with a central cutter element has demonstrated greater durability and stability compared to standard PDC bits while also increasing rate of penetration by around 15% on average, and as much as 60% in single cases.

And we are rapidly advancing this technology towards a second generation, where the average increase in rate of penetration is over 30% compared with conventional PDC bits.

In its first 50 runs, the second generation technology is even more durable, drilling on average 92% further than the standard bits. 

The MicroScope imaging-while-drilling service, which provides a range of unmatched formation evaluation measurements, is an example of how we are significantly improving the ‘out-of-box’ reliability performance of our new products.

MicroScope supersedes the geoVISION imaging service, which has been around since the mid-1990s, and for a long time has been the industry bench-mark in while-drilling imaging technology.

In addition to providing a step-change in image resolution, MicroScope was one of the products that we used to pilot test elements of the new R&E operating system, with particular focus on reliability.

As can be seen from the chart when MicroScope was commercialized in 2012, the ‘out-of-box’ reliability was more than two times higher than that of geoVISION, despite geoVISION having benefited from over ten years of reliability improvements.

This clearly demonstrates the performance potential of our new R&E operating system when it comes to reliability.

Another example is the PowerDrive family of rotary steerable tools which has now been in service for 16 years and has drilled more than one-hundred-and-thirty-five million feet globally.

The latest generation PowerDrive Orbit was introduced to the market in North America earlier this month and has a series of new design features that extends the reliability performance and operating envelope of this already industry-leading technology.

The new design advances made in PowerDrive Orbit, together with other design upgrades made to previous generations, have helped drive both operational performance for our customers as well as increase asset utilization for Schlumberger.

As can be seen from the graph, over the past three years, we have managed to increase the asset utilization of our global PowerDrive fleet by over 30%, which again, has created capex savings.

While these results are in part due to better asset management in our operations, the increased reliability performance from improvements in the engineering design also played a major role, again demonstrating the financial potential of the new R&E operating system.

The three technologies I have just shown are clear examples of what our technology transformation has delivered so far and also indicates its future potential as we finish a new engineering cycle in the coming 3-4 years.

Although it is still early innings, the technology transformation has already had an impact on the Drilling Group financial performance.

With a compounded annual growth rate of 11% in revenue, we have clearly outpaced the market over the past 3 years and in the process, for the first time, captured the number one market share position in Drill Bits.

And in terms of operating margins, we have managed to improve by over 400 basis points over the same period in a market where pricing, at best has been flat, bringing our drilling group margins, which contains  most of the Smith product lines as well as IPM more or less in line with the company average.

Let’s then turn to the financial performance of the oilfield services industry.

The first statement that can be made is that the pressure on profitability and cash flow now facing the IOC’s has already been felt for a number of years in the oilfield services group.

In our part of the industry, the increases in activity in recent years have been partly offset by pricing headwinds, and in some cases, activity disruptions from geopolitical events impacting both revenue growth and profitability levels for most of the players.

However, looking at Schlumberger’s financial performance over the past three years, our numbers clearly stand out and show a widening performance gap versus our peer group.

In terms of revenue, we have outgrown our major competitors in spite of being significantly larger in size.

And in terms of operating margins, we are the only company that has managed to improve margins in each of the past two years, in a period where several of our competitors have seen their margins eroded by as much as 500 basis points.

In terms of operating income and earnings per share, Schlumberger has also posted consistent double-digit growth over the past two years, while in comparison, our competitors have either declined or at best stayed flat.

These financial results, which clearly stand out, were achieved while facing the same pricing and activity headwinds as our peer group in North America Land, North Africa and parts of Latin America and the Middle East.

Contrary to the rest, however, we have been able to overcome the market challenges and post improvements in all of our financial indicators over this period.

So why is that?

Well partly, because we are significantly bigger and better balanced in terms of the breadth of our technology offering and the reach of our global footprint.

Partly, because we simply have a more capable organization, and a stronger management team that performs better in challenging situations.

And partly, because we are starting to see an impact of the transformation programs that we are currently implementing.

Of the four transformation themes I outlined earlier, the technology and integration programs are further along in terms of implementation than the reliability and efficiency programs.

However, common to all of them is that they are clearly starting to impact our results, that they together hold significant further performance upside, and that they are all a result of the foresight and investments that started between three and six years ago, and hence cannot be  replicated overnight.

Another aspect of our financial performance is our ability to generate free cash flow, driven by continuous improvements in operational efficiency.

Despite solid growth in activity over the past three years, we have been able to lower both capex investments and the consumption of working capital by focusing on improving asset utilization and better managing inventory levels.

This has resulted in strong growth in free cash flow, which reached $5.5 billion in 2013 and subsequently allowed us to increase the return of cash to our shareholders.

In 2013 alone, we bought back $2.6 billion of shares, and in January of this year, we increased dividends by 28% while at the same time reducing our net debt by around $700 million.

Going forward, we will continue to put significant focus on generating free cash flow as this is becoming another competitive advantage for us, and allowing us to further increase the return of cash to our shareholders.

Let us then turn to the market and how it is evolving so far in 2014.

In spite of continued concerns relating to some of the emerging markets the global economy is likely to see the fastest growth in four years driven by encouraging data from the United States; expansion in all major Eurozone countries; promise of a stabilizing situation in China; and strong growth in the rest of Asia.

While most analysts were expecting a comfortable supply situation in 2014, the oil market appears to be significantly tighter than anticipated driven by two main factors:

First, demand has been surprisingly resilient in the OECD countries.

The IEA has, since August last year, revised the 2014 oil demand forecast for these countries upward by 600,000 barrels per day due to  stabilizing oil demand in Europe and increasing demand in North America.

Second, spare capacity figures have fallen in recent months as the steady production growth in North America has not been enough to overcome the decline in mature basins and continued supply disruptions in North Africa.

Based on the tighter supply-demand balance, we therefore maintain our view that Brent crude prices should remain well supported around $100 per barrel in 2014.

In the natural gas markets, the past few months have been dominated by a strong rally in US spot prices, driven by extreme weather conditions, pushing gas demand and storage withdrawals to record highs.

US supply trends however remain strong as the Marcellus continues to offset production decline in conventional fields and other shale gas plays, leaving US dry gas production stable at record highs.

As the weather normalizes, the North American market will likely return to a balanced supply-demand situation and we do not expect the recent natural gas price trends to translate into significantly higher dry gas activity levels.

In the international gas markets, prices continue to be supported by strong demand throughout Asia and by another year of limited LNG capacity additions.

Based on this macro situation and what we have seen in the first two months of this year, we maintain our positive view on 2014 where we expect well-related capex to grow more than 6%.

So far this year, the growth in well-related spend is driven by the NOCs and the Independents, while activity for the IOCs is more or less flat.

We target solid double-digit growth in earnings per share also in 2014, driven by a combination of topline growth and further improvements in our operating margins.

Looking at the first quarter, we historically see a sequential decline in earnings per share ranging from 8-12%, due to lower product sales and lower seasonal activity in certain countries.

This year we have, so far in the first quarter, seen severe winter conditions in Western Siberia and North America Land, but still expect strong year-over-year growth in earnings per share compared to Q1-2013, which further supports our positive outlook for the year.

We will give a more detailed update on the market trends in April, after closing the first quarter.

Ladies and gentlemen, in closing let me leave you with the following points.

Rising cost levels limited growth in global oil production and range-bound oil prices is putting pressure on cash flow and profitability in the entire E&P value chain.

These industry-wide challenges can only be addressed by creating a step-change in technical performance throughout the E&P value chain, by learning from other industries, and by showing willingness to transform the way we approach our business.

The companies that have the appetite and ability to take on this challenge stand to gain a major competitive advantage.

In Schlumberger, we see this as a significant opportunity, where we will leverage our ongoing transformation programs to further strengthen our market position and widen the performance gap with our competitors.

The scope and magnitude of our ongoing programs is massive; and takes careful upfront planning; years of steadfast implementation; and significant investments to deliver results; and can therefore not easily be replicated.

These ongoing changes are starting to contribute to our financial results where we, in 2013, by also leveraging our other strengths, clearly outperformed our competitors in revenue growth, margin expansion, EPS growth and free cash flow generation.

The impact of our transformation programs will increase, and this together with the breadth of our offering, the reach of our global footprint, and the strength of our workforce puts us in a great position to extend the trend of outperformance going forward.

This is why I am proud of working for Schlumberger and why I believe Schlumberger represents a great investment proposition.

Thank you.

Paal Kibsgaard

Schlumberger CEO Paal Kibsgaard addressed the Howard Weil 42nd Annual Energy Conference held in New Orleans.

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