M&A’s and the Service Industry

In early 1998, the collapse of the Asian economy left the world awash in surplus oil. Within months, the price of crude dipped to record lows of $11 per barrel. Petroleum companies scrambled to cut costs, and exploration and production expenditures were the first to be curtailed. In Canada alone, E&P budgets slid from $13.5 billion in 1997 to $11.5 billion in 1998. Sources of capital dried up, and companies had to keep afloat through cash flow. Throughout 1998 and 1999, a host of oil companies merged or were taken over, including international giants, regional majors and tiny independents.

As a result, the multi-billion dollar geophysical services industry, which depends overwhelmingly upon the oil industry for its well-being, also went through a tumultuous period of restructuring, and a search for more profitable ways to do business. The Recorder spoke with several key players in the industry to understand some of the effects upon the service sector.

Did the loss of so many oil companies through M&A’s have a negative, long-term impact on the service industry?

For companies operating in the Canadian market, the impact has varied, depending on the focus of work. “Sometimes, when a bigger company swallows a smaller company, they take that smaller company off the processing market completely,” says Norbert Bernoth, manager of processing at Apoterra Seismic Processing Ltd. “On the other hand, sometimes a small company gets bought out by a larger company with lots of money, and their amount of exploration increases. Our core clientele are mostly small to medium companies, and we’ve seen both of these effects. I would say the net effect has been slightly less work.”

“This year has been our best year ever,” says Perry Kotkas, Chief Operating Officer at Arcis Corporation, based in Calgary. “Proprietary acquisition has been doing very well, as did our multi-client surveys. I would think that many acquisition and processing companies had a good year.”

“We’ve lost some clients and gained some clients, but we have a broad client base of medium and large firms, some 125 companies,” says Neil Towler, Western Canada Sales Manager for Kelman Processing. “We specialize in structural plays such as deep gas in Foothills, which has held up.”

“One of the things that happens when a merger or acquisition goes through is that the two companies momentarily take their data off the market,” says Barry Korchinski, President of Sigma Explorations Inc., which offers data brokerage services. “They say, don’t bother us for a month or two. After, the new company buys more data than the old, but they may not buy as much as two separate companies.”

“It seems that whenever there are companies merging, we think, this is not a great thing, there’s going to be less customers,” says Korchinski. “However, over the last few years, small companies have grown – for every merger there’s some aggressive young company coming up. The market is not dwindling, and we don’t despair about the mergers. There’s no distortion of the market place – there are many buyers and many sellers.”

For international markets, however, the loss of a potential client can have a much more significant impact.

“In North America, seismic is a commoditized market, with a lot of competitors going after work based on price,” says Ken Lengyel, former chairman of the Canadian Association of Geophysical Contractors and current manager of multi-client programs at Western Geco Canada. “For the rest of the world, which is mostly marine, there are not as many companies that can conduct large marine projects. They don’t have the money or expertise.”

In an article published in the SEG’s Leading Edge in June, 2000, Doug Elrod of Schlumberger examined the risk of fewer clients in an age where large, multi-client 3D shoots are the lifeblood of the industry.

Elrod noted that the nonexclusive data business is based on multiple sales of a survey, with each sale price at some fraction of the cost of creation. Therefore, the critical investment parameter is the number of expected sales.

Estimating the number of sales is the key to risk assessment. According to Elrod, several factors affect the estimate, the most important being market size. Prior to the current merger frenzy, 50-60 companies licensed 3D nonexclusive data (in the Gulf of Mexico region). On the other hand, in deep water, perhaps 8-12 clients license significant quantities of data. In certain settings, the entire market may be only 2-4 companies.

“We shoot spec programs where we carry a lot of risk,” says Lengyel. “A bad thing that could happen is us not to be aware of ongoing merge plans in one area. We want to avoid the situation where we shoot a spec program before the deal is consummated, and one of our prospective clients gets bought out.”

Have seismic prices come down due to competition for clients?

According to Perry Kotkas, the price of new seismic has held up, except for 3D. “Large 3D surveys became popular a few years back during a low market period, and prices were lower than they should have been at that time. There’s a legacy there from which the acquisition sector has not yet recovered The margin on 2D or small 3D programs is quite a bit higher.”

On the other hand, overhead remains high. “The front-end costs for acquisition of seismic – line clearing, surveying and drilling – have increased significantly over the last few years because of environmental concerns and regulations,” says Kotkas. “For instance, January 15 is considered a critical date for wildlife in the ‘deep basin’ Green Area, and you need to be finished by the 15th. That means that you now have to start in October before the ground freezes, and that makes it much more expensive”

Has there been downward pressure on processing fees?

“There has been price competition over the last few years,” says Bernoth. He believes the price competition may arise when some exploration departments come under pressure from management to hold costs down. “So they put work out to bid, and there are some processors that aren’t that busy, and they may bid prices down by around 25%.”

Towler says Kelman has also been under price pressure, but thinks over-capacity might be the culprit. “There’s been some consolidation in the processing sector – Integra, Pulsonic and Scott Pickford came together – but computers are less expensive, and capacity has increased.”

Bernoth notes that costs to processors remain high. “Some of (the downward pressure) is justified with the cheaper price of computers, but there are also fewer qualified processors out there, and they are more expensive to hire.”

Has the sale of proprietary libraries depressed the acquisition market?

Recently, Shell, Amoco and Chevron sold large packages of their exclusive seismic libraries to Olympic and ReQuest, (some estimates say it represented over 20% of the total proprietary amount of data in town). The two companies subsequently offered license rights to the huge amount of data to the community.

“The fire-sale of large amounts of data (especially 2D), by some of the data companies is having quite an impact,” says Kotkas. “Some oil companies have acquired large amounts of this data, and until they get through it, they’re not in a position to shoot new seismic.”

Lengyel disagrees that resellers of proprietary data are licensing all seismic at unacceptably low prices. “Some of the old data sets, like the Chevron data sets from the 70s, are going at fire-sale prices, but the newer 3D and 2D stuff is not going cheaply.”

He agrees that access to huge amounts of formerly-proprietary data has had an effect on acquisition, however. “The winter season is developing slowly. Part of that is the slow freeze up, and part of that is environmental, but also, oil companies are reliant on trade data. They try to get into production as quickly as possible, and they want seismic overnight, so they buy trade data. A lot of geophysicists would like to shoot 3D, but because of this demand for quick turnaround at the drill bit, they have to make do with trade data.”

Most processors find that the trade data has had a positive impact on their business. “We’ve seen our capacity rise significantly this year, and part of the reason is greater availability of trade data,” says Bernoth.

“We’ve seen a 25% increase in revenues this year,” notes Towler. “Reprocessing of data makes up over half our work. A lot of companies are using this (economically-priced) seismic instead of shooting new seismic.”

Oil companies, especially juniors and intermediates, see the trae data as a bonanza. “Data that they could never get before from major oil companies is now available t them,” says Doug Uffen, Chief geophysicist with Canadian Forest Oil. “Their front-ends costs of developing a play could potentially be lower because they are able to purchase the data as opposed to acquiring it.”

Will the sell off of large proprietary data continue?

Korchinski doesn’t believe that many other companies will follow in Chevron, Shell and Amoco’s footsteps. “It was huge news, but only three companies sold their data into a unique window of opportunity. It’s not a trend, because after two or three do it, there’s a limited window of appetite for such data. the market gets saturated quite quickly.”

Rather than passively accept many of the knock-on effects of the oil industry’s M&A activity, the service sector has responded with its own initiatives.

Service industry M&A’s

Mike Doyle, chairman of the Canadian Association of Geophysical Contractors, notes that the industry has been engulfed in its own wave of mergers and acquisitions over the past two years. “These are business case solutions. You reach a certain size where you’ve maximized share value; do you merge or go into debt to expand?”

On December 1st, Baker Hughes/Western, and Schlumberger/Geco Prakla formed a joint company and combined Western and Geco to form Western Geco, the largest geophysical contractor in the world.

Being the biggest means that a company can chase after international jobs that others can’t. And, with an estimated 150 oil companies in Calgary spending almost $2 billion annually in such remote locations as West Africa and the North Sea, Western Geco is now able to mount large, offshore projects. “A client has a foreign asset that they want to exploit,” says Lengyel. “We’re now repositioned to go offshore and give them more support.”

Vertical Integration

The majority of Canadian E&P budgets are spent at home, and some Calgary-based geophysical service companies have evolved toward vertical integration to better serve the market within the Western sedimentary basin, the Far North and East Coast. Arcis, for instance, brought a host of services under its corporate umbrella, including acquisition, surveys, processing and data management and brokerage. “Arcis put together a business model on the expectation that it would be a successful company because it would allow a client the opportunity to stay within our company for acquisition, processing and other services,” says Kotkas.

According to Kotkas, the response from the oil industry has been varied. “Some clients find that there are significant efficiencies, while others have long-term relationships with other companies for acquisition, etc.”

Geophysicists at oil companies don’t see vertical integration or consolidations causing any restriction of competition within the services sector. “I think the service companies are doing it in order to diversify their revenue base,” says Uffen. “If one sector of their business is down, then another sector is OK.”

Multi-client (spec) data.

“The amount of proprietary data acquired is declining, and the amount of 3D multi-client data is increasing,” says Kotkas. “This is a more significant trend than the merger of companies.”

The popularity of multi-client surveys, explains Kotkas, is primarily due to economics. “Let’s say a 200-square-kilometre program costs $5 million. A data company can sell it for $2 million to three clients and make $1 million. As an oil company, you look and see that the 3D survey is available in an area you’re interested in, and you know that there’s no sense in doing a proprietary shoot; it’s less expensive for the oil company, and of course, the data already exists.”

“Spec data is an opportunity to keep front-end capital costs down,” agrees Uffen. “More spec surveys means more choice and opportunities.”

“In the end, spec will be the saviour of the industry because it will be a commodity that the seismic companies can control,” says Doyle. “If you can control the product, you have a better chance in the long run.”

Data Management

The management of seismic data within oil companies has evolved dramatically over the last several years. “There’s been a shift in the way companies are thinking about proprietary data,” says Korchinski. “Before, it was jealously guarded, now, it’s just information.”

That decision has been driven by a number of reasons, including the in-house cost of storing and managing data, the need to raise revenues, and the shift away from an area of exploration.

Several years ago, Canadian Forest Oil decided to examine its large stash of proprietary data. First and foremost, it needed a trustworthy wall map to show all seismic data coverage. Geologists wanted it for seismic coverage over new plays/land sales; landmen wanted to know if available for farmout agreements; and geophysicists wanted to cut down on the time spent searching out data. They also needed a better handle on metadata information (ownership status, ownership percentages, AFE costs, acquisition parameters, etc).

In 1997, Canadian Forest decided to catalogue and load all of their data. They brought data management specialists Excalibur Gemini onboard to help sort the information. “If a company is 15- 20 years old, they may have had 10-15 people trying to take care of records,” says Jan Hay, vice president of information management services. “They often don’t know where to start.” Excalibur Gemini examines all data and converts it to electronic form. “We have to ensure they’re getting accurate, complete and reliable information.”

The M&A activity in the oil business has doubled Excalibur Gemini’s business in the last two years. “Most companies haven’t had the staff required for integration of data and information that’s required when they do an acquisition,” says Hay. “We’ll go through and ensure they’ve received all the data that they’re entitled to, and make sure it’s complete.”

After Excalibur Gemini was finished, Canadian Forest decided to manage their own data in-house. “By doing it yourself, you can manage it more effectively,” says Uffen. “But you have to have resources internally, as well as the inclination.”

Many companies prefer to contract their database management needs out to specialty companies. “Our data management business has doubled ever year over the last four years,” says Neil Baker, vice president of Kelman Archives. “Kelman Archives did approximately $5.9 million this year.”

Much of their growth is also being driven by M&As. “When Gulf and Crestar amalgamated, it was a large data management opportunity to go in and take Crestar’s data bases and transform them into gulf’s database and get rid of duplication.”

There are several unresolved issues that still remain from the M&A activity, including the training of new graduates. “Multinational oil companies used to hire and train large numbers of university graduates, but they haven’t done that for a long time,” says Kotkas, who is currently serving as president of the CSEG. “The CSEG rejuvenated the continuing education committee in order to supply training to members because we think there is a need. Together with the CSPG, we’re also helping to fund a training facility being put together at the University of Calgary. Continuing education is a necessary and important role for the CSEG.”

What will the future bring? One exciting prospect is the potential for interpretation to emerge as a lucrative geophysical service. “It was suggested at the recent SEG conference that, in the future, oil companies might outsource interpretation,” says Kotkas. “A lot of people I now say, “That wouldn’t happen at my company – we’d never trust it to a service company”.”

However, the demographics of geophysicists show a huge bulge of baby boomers who are getting older, and in another ten years, many of them will be retired; there may simply not be enough younger geophysicists available to replace them. “It’s going to cause a huge shift in the way our business is done,” says Kotkas. “A lot of small and medium companies have, for years, used independent consultants. Unless more geophysics grads enter our business, some further change will be forced upon oil companies. Personally, I’d prefer that service companies not be involved in interpretation and drill site decisions; that should remain in the domain of the oil companies.”