Schlumberger

Kibsgaard Speaks at Morgan Stanley E&P and Oil Services Conference

Date: 5/9/2016

Thank you, and good afternoon ladies and gentlemen.

Let me start by thanking Morgan Stanley, and Ole Slorer in particular, for the invitation to speak at this conference.

Today I would like to cover three main subjects.

First, I will discuss the current industry challenges, which are not only partly driven by the massive drop in oil prices but are also a result of our industry’s failure to sufficiently improve performance over the past 15 years to tackle increasingly more complex hydrocarbon developments.

Second, I will stress the urgency for the industry to accept that the current commercial and collaborative model between operators and service companies is suboptimal. And I will outline how changes to this model can benefit our customers and what we at Schlumberger are doing to lead this process of change.

Third, I will share with you our latest market outlook and the short-term and medium-term implications this has for our activity levels. I will also comment on how we are continuing to navigate the challenging commercial landscape and how we are creating one of the strongest technical and financial platforms in the industry, which continues to make us a very exciting investment proposition.

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

Some of the statements I will make today are forward-looking. These statements are subject to risks and uncertainties that could cause our results to differ materially from those projected in these statements. I therefore refer you to our latest 10-K and other SEC filings.

Today the E&P industry finds itself in the deepest financial crisis on record, with profitability and cash flow at unsustainable levels for most oil and gas operators which in turn has created an equally dramatic situation for the service industry.

In spite of the unique structural nature of this downturn, oil and gas operators have once again activated the traditional playbook they have used to navigate every industry downturn since the 1970s. This dictates halting investments in exploration, aggressively curtailing development activity, and relentlessly squeezing service industry prices.

Going forward, the industry is likely facing a ’medium-for-longer’ oil price scenario, subject to periods of volatility, as the national oil companies within OPEC can still generate significant returns for their owners in such an environment due to the low cost base of their conventional resources.

The combination of a moderate price and higher market share could largely restore the oil revenues for many of the challenged oil-producing economies and is also likely to prevent uncontrolled production growth from higher-cost resources. 

So what are the implications of a medium-for-longer oil price scenario?

Assuming a 1% demand growth scenario, it first means that the ‘hold-your-breath’ approach of the oil and gas operators will be unable to deliver the required production growth.

The apparent cost reductions seen by the operators over the past 18 months are not linked to a general improvement in efficiency in the service industry. They are simply a result of service-pricing concessions as activity levels have dropped by 40-50% and most service companies are now fighting for survival with both negative earnings and cash flow. The unsustainable financial situation of the service industry together with the massive capacity reductions mean that the cost savings from lower service pricing should largely be reversed when activity levels start picking up. 

The fact remains that the industry’s technical and financial performance was already challenged with oil prices at $100 per barrel as seen by the fading cash flow and profitability of both the IOCs and independents in recent years. Over the past decade, our industry has simply not progressed sufficiently in terms of total system performance to enable cost-effective development of increasingly complex hydrocarbon resources. This can be seen by the escalating industry cost-per-barrel.

So what needs to change to overcome these challenges to the benefit of all the operators in the industry?

We firmly believe that the combined capabilities of the E&P operators and the leading service companies have the potential to realize the required performance upside for the industry. Still, this requires a willingness to modify the existing commercial model because the procurement-driven contracting model of the late 1990s is today the main obstacle to create the needed performance progress.

In the procurement-driven approach, all aspects of project scope selection and technical design for new hydrocarbon developments are done by the technical teams of the operators. The work scope is then fragmented into a myriad of small parts and subsequently put out for bid by the procurement organization, seeking the lowest price for each element and expecting that this will bring both the lowest project cost and the highest project value.

The rationale behind this approach is driven by two factors.

First, service companies are generally perceived to have little to offer towards creating fit-for-purpose designs or optimized planning and execution, and are therefore engaged too late to have a meaningful impact on project technical and financial performance.

And second, the procurement organizations simply assume that all suppliers are equal as long as they meet the minimum qualification criteria, which creates a constant drive towards commoditization and fragmentation.

The consequences of this procurement-driven approach are threefold:

First, a failure to drive forward a sufficient rate of intrinsic performance improvement in quality and efficiency because there is no real incentive for the service providers to create any performance differentiation.

Second, a highly fragmented approach to technology system innovation and system performance as project solutions are a mosaic of individual services and products with no common data model or optimization platform.

And third, a complete lack of concept and design phase collaboration between the operators and the suppliers, which has large implications on project cost and performance.

Altogether, this contracting model leads to suboptimal technical solutions and corresponding project performance from both a design and executional standpoint as well as financial returns.

Based on this, we believe that project performance can only be improved by finding ways of breaking with the past and replacing the existing model with a new approach based on collaboration and commercial alignment between the operators and the largest service companies. From the Schlumberger side, we are ready to engage on a completely different level, and we are well advanced in evolving our company to excel in such a new industry environment.

So let’s take a closer look at what this entails.

For several years we have made the case for change in the way the E&P industry works.

This is based on the fact that a quadrupling of global E&P investments over the preceding 10 years had only yielded a 15% increase in global oil production. We have expressed the view that a transformation was required to restore technical performance and financial results to match that of other technology-based industries.

The past two years have only strengthened my view.

And at Schlumberger we have not only laid out a plan for transformation  based on the pillars of technology, integration, reliability, and efficiency, but we have also executed a number of phases of that plan  that have delivered significant performance improvements. These in turn have permitted us to deliver strong financial performance in the past few years as seen by our industry-leading operating income margins and free cash flow over this period.

The company-wide transformation and change-management framework we have developed over the past four years has also led us to expand the scope of our transformation, which initially was focused on the efficiency and quality of all our processes and workflows. This scope has now been broadened to first include our efforts to develop total drilling and production systems that are fully digitally enabled and also our drive towards expanding and strengthening the commercial and collaborative models we use in working with our customers.

There are three complementary dimensions to this transformation.

The foundation is the large opportunity we see to improve the intrinsic performance of our processes and workflows, including our internal support functions as well as our external product and service delivery. We identify and capitalize on these improvement opportunities by being willing to challenge our existing ways of working and by actively seeking insight and learnings from the best companies in other technology-based industries.

As mentioned, we have already seen noticeable impact on our technical and financial results in recent years demonstrated by solid improvements in the areas of HSE, quality, capex intensity, and free cash flow in spite of the ongoing industry challenges. And there is still significant upside potential to be realized in all aspects of our intrinsic performance which we will capitalize on in the coming years.

In the second of the three transformation dimensions, we are looking to accelerate the rate of technology system innovation by shifting our development focus from discrete technologies to the creation of complete digitally enabled technology systems.

These integrated technology systems will significantly reduce the cost-per-barrel of future hydrocarbon developments by introducing software control and optimization on top of the best hardware products in the industry, while fully leveraging the latest advances in big data analytics and machine learning. The rationale for the acquisition of Cameron is fully predicated on this total technology system transformation where we will combine Cameron’s surface technology with our leading downhole and subsurface offering.

This dimension of the transformation will give us a technology capability that is unrivalled and that can offer the step change in financial performance that the industry really needs going forward.

To illustrate this let’s look at one example of an integrated technology system we are currently working on.

Our new land drilling system of the future represents the ultimate integrated drilling platform, bringing together digitally enabled surface and downhole hardware on top of a common optimization software to create a step-change in operational efficiency.

In this technology-system project, we bring together five years of research effort from our drilling center in Cambridge, UK, with the leading expertise and downhole technology from our Drilling Group product lines.

From the drilling equipment portfolio of Cameron, we get top-drives, pipe handling, and blow-out preventers, while T&T Engineering, which we acquired in 2015, brings world-class expertise in rig design. We also have access to unmatched German manufacturing capabilities from the joint-venture we signed last year with Bauer.

The software backbone of this project, which includes all aspects of well design, operational planning, and drilling optimization is being jointly developed by our software centers in Houston, Texas, and Beijing, China, and is further supported by our Big Data and Cloud Computing technology center in Menlo Park near Palo Alto, California.

Five engineering prototypes of the new system will be ready for field testing in 2016 in Ecuador and the US, with full commercial introduction on track for 2017.

The third dimension of our transformation focuses on the deployment of more aligned business models between us and our customers, which fully leverage our respective complementary capabilities and shares the risks and rewards in more commensurate parts.

Today as much as 80% of our work is still performed under a single-product-line contract that, in most cases, fits the standard procurement-driven contract model I previously described. Within this standard contracting model we price our differentiated technologies separately, and generally include these in the final contract.

Looking beyond the single-product-line contracting model, the first level of integration we offer is Integrated Services Management (ISM), where our specially trained project managers provide scheduling, planning, and activity coordination for the various Schlumberger product lines involved in the project. The next level of the offering involves our Integrated Drilling Services (IDS) and Integrated Production Services (IPS) offerings where we house a large part of our project management, engineering design, and technical optimization capabilities as these contracts are fully performance-based.

And the highest form of integration we offer is through our Schlumberger Production Management (SPM) model where we take full-field management responsibility using the complete range of Schlumberger products, services, and technical expertise. Today we see a broad range of business opportunities related to integration, which we are actively evaluating, with each of them having different value propositions, technical challenges, and contractual structures.

One exciting line of these lies is in the area of stranded gas.

Stranded gas fields are characterized by being too small or too remote for conventional development due to infrastructure transportation or financial barriers. Upwards of 40% of worldwide proven gas reserves can be classified as stranded either in smaller remote reservoirs or as the associated gas which is commonly flared off during liquids production.

Conventional LNG projects cannot meet the economic hurdles to develop stranded gas, however innovations in mobile floating LNG production facilities can significantly lower the capital investment and operating costs needed to bring these reserves to the market in an economical way.

Over the past year, we have worked closely with Golar LNG to understand and assess their FLNG technology, and we are convinced that their offering combined with our reservoir, well, and production system knowledge represents a compelling offering to address the stranded gas market globally.

We are therefore in the process of further formalizing our cooperation framework with the aim of developing end-to-end stranded gas production solutions to address this market. Golar LNG will contribute the Floating LNG assets and technology as well as the regasification assets, while Schlumberger through our complete range of integration capabilities, will provide upstream development knowledge, technical resources, and the required well and field operations.

This new and completely integrated approach will reduce risk, reduce costs, and accelerate time to monetize stranded gas reserves and hence totally transform the economic viability of many stranded gas projects.

Ladies and gentlemen, I would now like to move on to discuss the market outlook and the short- and medium-term implications on our activity.

The current downturn has now persisted for 19 months since the US land rig count peaked in October of 2014. Using this rig count as a proxy, we have seen three distinct phases as the downturn has deepened.

So far, we have successfully managed the challenging commercial landscape of this downturn by balancing margins and market share and by aggressively reducing our global capacity. In parallel, we have steadily improved our intrinsic performance through our ongoing transformation program and this has enabled us to protect our financial strength.

Going forward, we will continue to tailor cost and resource levels to activity in order to protect our financial strength and as much as possible while also factoring in the need to preserve the long-term technical capabilities of the company.

Looking at the macro picture, the physical balances in the oil market continue to tighten with OPEC production outside Iran now appearing to stabilize and with decline accelerating in non-OPEC production.

On the other hand the IEA global oil demand forecast was recently revised upwards and 2016 growth now stands at 1.2 million barrels per day.

The latest market data have in recent weeks sent the oil-price over $40 per barrel, and we would expect the upward trend to continue as the physical balances tighten further in the coming quarters.

In spite of this, we maintain our view that there will be a noticeable lag between higher oil prices and higher E&P investments given the fragile financial state of our customer base, which means that there will be no meaningful improvement in our activity until 2017.

Still, in the midst of this unprecedented industry downturn, there are several positive elements of the scenario that make me optimistic and confident about the medium-term outlook for Schlumberger.

First, the magnitude of the ongoing E&P investment cuts is now so severe that it can only accelerate production decline and upward movement in the price of oil with a growing chance that we will be facing an upside spike in prices.

Second, our underlying cash flow is still solid, and with more than $10 billion of cash and short-term investments on the balance sheet after the close of the Cameron deal we can operate in this environment longer than most.

Third, while we have reduced capacity significantly, we have still safeguarded the core expertise and capabilities of the company above the current market needs.  This, combined with the strategic moves we have made during the downturn, leaves us very well positioned as the industry starts to transform.

And fourth, with the massive capacity reductions undertaken by the entire service industry we are optimistic that we can restore a good part of the temporary international pricing concessions we have made as oil prices and activity levels start to normalize.

In closing, we firmly believe in a medium-for-longer oil price environment where there is an urgent need for the industry to move to a contracting model with significantly more collaboration and commercial alignment between operators and leading service companies.

In the scenario I have just described, Schlumberger is perfectly placed to lead the way.

Thank you.

Paal Kibsgaard

Schlumberger Chairman and CEO Paal Kibsgaard addressed the Morgan Stanley E&P and Oil Services Conference held in Houston.

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