Answers From Schlumberger's Top Brass

Schlumberger's (NYSE:SLB) third quarter earnings report gives investors useful information as to the extent and direction of the energy cycle. This is especially important this quarter due to the economic slowdown and cutbacks in spending by exploration and production companies as a result of the credit crisis.

Schlumberger reported $7.26 billion in revenue and earnings per share of $1.25. Although both items represented strong growth over the same period last year and sequentially from the second quarter, investors were more interested about the future trends.

The Company Line
The management thesis on the downturn was outlined in both the press release and conference call on October 17, 2008.

During the conference call held to discuss the quarter, Chairman and CEO Andrew Gould initial statements included:

• The deterioration in the credit markets will have an effect on its customers, but this will largely impact North America only.
• Management does not know the extent to which current events will hurt 2009 drilling activity.
• Management is still looking for a slowing in the rate of growth in customer spending - not a decline.
• Even if activity is curtailed, due to the "age of the production profile and the decrease in reserve replacement ratios", any significant slowdown in exploration and production investment will cause a sharp drop in production, which will lead to a recovery.

Gould and the other executives were then questioned, some may say "interrogated", by analysts as to the extent and duration of any downturn.

Dan Pickering, of Tudor Pickering & Co. tried to get Gould to officially lower the growth rate of Schlumberger's international business from the previous 15-20% top line to something lower, suggesting a single digit growth rate. Gould said that he didn't have enough visibility in the international business and that they would take things "quarter by quarter".

Michael LaMotte of JPMorgan asked about the effect of the credit crisis on the liquidity situation at the company. Schlumberger CFO and executive vice president, Simon Ayat said the company had $4 billion cash, $2 billion in established credit lines and $1 billion cash flow the last quarter after capital expenditures. He further assured LaMotte that Schlumberger doesn't "have any immediate concerns over the credit markets". (For related reading, see Conference Call Basics and Top 9 Questions Investors Should Ask Management.)

Whither Pricing
A major concern during the call was pricing and the extent, if any, that it would go lower in a downturn. LaMotte asked how much of the price increase in the last few years was due to supply and demand being tight, and how much was due to new technology brought to market by the company - the implication being that oil service companies with a technological lead would be more insulated from price declines. Gould said that the last two years much of the pricing in some areas was driven by technology rather than supply shortages, but in previous downturns his customers tend to use less technologically driven solutions to save money when possible. (For more on this sector, check out A Guide To Investing In Oil Markets and The Industry Handbook: The Oil Services Industry.)

Gould was also asked about the possible duration of a downturn. He referred to the self correcting oil cycle, where a drop off in drilling activity would lead to a drop in production, which would stabilize prices, and eventually lead to a resumption of drilling. Gould said that if demand for oil were flat, then it would take 18 months to balance the market.

Geoff Kieburtz of Weeden & Co., LP pressed Gould on the similarities and differences to the last large downturn in energy in 1998. Schlumberger's CEO said that in 1998, the financial crisis was restricted to Asia, while now it is worldwide. He tempered that pessimism by noting that the supply situation today was much worse than 1998, with much more difficulty in keeping production up when drilling drops off.

Gould said there were few similarities between this downturn and "the Hiroshima of the oil patch" (the downturn in the early 1980s). He cited much higher interest rates at that time, and the inability of oil users to cut demand as significantly as the early 1980s when oil had a large share of power generation.

Timing Is Everything
Schlumberger spent $545 million to repurchase 5.96 million shares of stock during the quarter. Unfortunately, the average price paid was $91.45 compared to the current price around $54.00.

Other oil service companies will be reporting earnings over the next few weeks. Important ones to watch include Smith International (NYSE:SII) on October 28, which has a large drill bit business that is tied to the drilling cycle, and BJ Services (NYSE:BJS) on October 30, with a pressure pumping business that is also very sensitive to the drilling cycle.

National Oilwell Varco (NYSE:NOV) will also be important because of its large capital equipment business that is less sensitive to drilling, and investors will want to know if customers have started to pare back on these long-term projects.

Final Thoughts
Schlumberger's conference call gave a mixed view of the current situation in the energy cycle. Investor should watch closely as other companies report. The next few weeks will give investors a good indication of where the oil sector is headed.

Find out how to invest and protect your investments in this slippery sector in Peak Oil: What To Do When The Wells Run Dry.