Baker Hughes (BHI)

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While the company is focused on expanding in high-growth sectors, the success of its ventures is not guaranteed. Since the services that are expected to generate a large amount of money in the near future are very costly, oil prices must stay high in order for companies to demand risky and expensive forms of oil exploration and production like deepwater. If prices stay up, oil and gas companies will be willing to pay big bucks for BHI's services; deepwater exploration has been shown, when it yields, to pay off well. Furthermore, lower output from maturing wells has sparked industry interest in extracting from more difficult reserves, increasing demand for BHI's high-efficiency drill bit business and driving up segment margins. But the company faces threats from seasonal storms that damage expensive equipment and slow production. BHI's competitors include Schlumberger, Halliburton, and Weatherford International, all of which are focusing their energies on the same market as Baker Hughes: the Middle East.

[edit] Business Financials

As one of the largest, most diverse oilfield services companies, Baker Hughes offers services and products to oil exploration & production companies.

• Drilling and Evaluation: The Drilling and Evaluation segment of Baker Hughes produces and sells drill hardware components, from the fluids necessary to lubricate and cool the drilling process to the drill bits used to bore into the earth. The company also owns a number of its own drills, and provides the equipment and employees necessary to perform services from environmental management to exploration and extraction. BHI's evaluation segment provides the personnel and technology necessary to evaluate oil and natural gas wells in order to determine (among other things) well boundaries, volume, and accessibility.
• Completion and Production: Completion involves finalizing the creation of a well so that it yields hydrocarbons to the surface as safely and efficiently as possible. Baker Hughes provides the hardware and chemicals necessary for proper well completion, as well as the pump and monitoring systems needed for proper extraction.

Source: 2006 Annual Report^[3]

WesternGeco was a joint venture with Schlumberger in the field of seismic imaging, as used to explore for reserves. BHI owned a 30% stake in the venture and Schlumberger owned the rest. In April 2006, BHI sold its rights to profits from the venture to Schlumberger for $2.4 billion^[4]. This explains the near one and a half billion dollars in the "Corporate and Other" section of the income chart above. It also explains why WesternGeco's profits were lower in 2006 than in 2005 - despite rising demand for imaging, the BHI sold its stake in the venture during the second quarter, cutting off revenue early.

BHI's organization by product segment rather than by geographic location has created issues for the company in the past. When opportunities in Russia and the Middle East began to heat up, the company missed out on early contracting opportunities that Schlumberger, Halliburton, and Weatherford International were able to take because those companies had bases and employees in the areas. Baker Hughes seems to have seen the error of its rigidity, however, and is currently investing heavily to establish regional bases worldwide.

Source: 2006 Annual Report^[5]

[edit] Trends and Forces

As an oilfield services company, BHI's fate is intimately connected to the fate of the oil industry as a whole.

[edit] BHI's Big Picture: Capitalizing on High Oil Prices

Oil prices recently hit the magic mark of $100/barrel. As oil prices go up (and stay up), oil companies like Exxon, Shell, Chevron, and BP all have greater incentive to increase production; thus, price shifts have been a major driver in the recently increasing demand for exploration and drilling, which is in turn pushing up dayrates for exploration and drilling equipment, increasing industry profitability. Rising oil prices could mean that oil is getting more difficult to obtain, and there are many analysts who believe we are near, or even past, peak oil production. Many easy-access oil reserves are nearing maturity, but with oil prices so high, oil companies are now looking to more expensive means of increasing output.

[edit] Baker Hughes Is Focused on Expanding in High-Growth Regions

Baker Hughes' growth strategy involves expending most of its energies in high-growth markets. Recently, this has taken the company to Russia and, especially, the Middle East, where new expensive high-tech equipment designed to operate more efficiently on complex geology and in mature wells has allowed oil and gas companies to increase output where not previously possible. High-efficiency drill bits are in increasing demand in these markets, and BHI's drill bit business could benefit; over the last few years, BHI has pumped money into these two regions, and it appears to have paid off, as revenue between 2005 and 2006 increased in the Europe-Africa-Caspian-Russia region by 22.8% and in the Middle East by 27.4%. Most of BHI's investment has been in the Middle East, where the number of active Baker Hughes rigs increased by 25.3%^[6].

[edit] BHI's Profitability in the Middle East Is Far from Guaranteed

Turbulence in the Middle East poses a threat to BHI because the region is a smoldering hotbed of drilling activity. BHI's facilities, as "western establishments", would be likely targets for terrorist attacks. Aside from harming the employees at such facilities, terrorist attacks could slow production and effect costly damages to expensive equipment - all leading to declines in regional profitability. Furthermore, investing in the equipment required for success in the Middle East is costly, as the technology that is needed is complex. In the current price climate, demand for such expensive equipment is high, but if oil prices were to fall, Baker Hughes could be left high and dry.

[edit] Baker Hughes Is Learning to Swim in Deeper Waters

With oil prices so high and offshore well output decreasing in shallower waters, the offshore oil and gas industry is turning to deepwater exploration to increase output. This new demand has pushed up dayrates for deepwater technology, making it very profitable; BHI has taken notice, and has increased its spending in order to make strides in the market. In January 2006, for example, Baker Hughes acquired Nova Technology Corporation for $55.4 million, in order to absorb Nova's deepwater monitoring and chemical technologies^[7]. The research and development involved in deepwater drilling is very expensive, and the complexity of the technique means that striking oil thousands of feet below sea level is far from assured. As long as oil prices are high, however, oil and gas companies will be willing to pay. Despite the risk of failure, deepwater fields have been found to yield huge amounts of oil and gas; for example, in November 2007, Brazilian oil company Petrobras discovered 5-8 billion barrels of oil equivalent in the deepwater Tupi field off the coast of Brazil^[8]. With oil prices so high, the possibility of large yields makes deepwater technology worth the price. If oil prices fall unexpectedly, however, the demand for these more expensive extraction techniques will decrease dramatically, causing deepwater dayrates to fall and profits to drop.

[edit] Seasonal Fluctuations Pose Threats to BHI's Profits

With so much revenue coming from pulling oil and gas out of the Gulf of Mexico (see Business Financials), the hurricane season creates a large seasonal risk to the company. Third-quarter income tends to lag when production is brought down to prevent damage from the storms that sweep the coast in late summer. Similar problems exist during the fourth quarter in the turbulent North Sea. The extent to which the storm season affects BHI is dependent on the strength of the storm season - obviously, stronger storms mean lower margins.

[edit] Renewable Energy Poses a Long-Term Threat to BHI's Demand

Whether it’s because of climate change fears, the rising price of oil, or the desire to separate energy needs from terrorist regimes, people are slowly becoming disillusioned by the world's dependence on oil and gas. Many developed, politically-progressive regions like Europe are beginning to transition away from these sources of energy, and towards renewable energy. In emerging markets like China and India, however, the drive for economic growth supersedes environmental concerns, and oil, despite being well over $100/bbl in 2008, is still less expensive than most renewables. Since emerging markets are where most of the future opportunities in the global economy lay, the oil and gas industry, including oilfield services companies like Baker Hughes, could continue to grow in conjunction with a growing renewables industry.

[edit] Competition

As a diversified oilfield services company, Baker Hughes faces competitors like Halliburton, Weatherford International, and industry leader, Schlumberger. All of these companies offer oilfield services ranging from exploration drilling to well completion, and all three of these companies have recently been focusing on expansion in the Eastern Hemisphere, especially in the Middle East. Since this region is also a major focus point for Baker Hughes, the large amount of opposition could put pressure on BHI's margins, as increased competitive pressure would lead to lower dayrates and higher R&D costs from attempts to create better technology.

• Schlumberger is the largest oilfield services company, by market cap. Aside from all the standard services, the company now holds a 100% stake in WesternGeco, a company that offers seismic imaging services for observing, monitoring, and developing reservoirs.
• Halliburton, aside from being one of the larger oilfield services companies, offers logistics and engineering supports to the United States military in the Middle East. The company has cut the middlemen and moved its headquarters and executives across the pond, to the oil capital of the world: Dubai.
• Weatherford International appears to be focusing almost all its energy outside of the U.S.; with only 25% of its spending and 25% of its workforce in and from this hemisphere^[9], the company is building a low-cost workforce to make itself more appealing to margins-seeking oil and gas companies in the Middle East.

In the deepwater sector, BHI faces its greatest competition from newly formed giant, Transocean, as well as some smaller drilling companies like Noble and Diamond Offshore Drilling. BHI might be spreading itself thin by developing both in the Middle East and in the deepwater sector, as diversified spending could prevent the company from differentiating itself in either field.

[edit] Notes

1. ↑ BHI 2006 10-K, Item 7, Pages 25-26, http://sec.gov/Archives/edgar/data/808362/000095013407003991/h43740e10vk.htm#102
2. ↑ BHI 2006 10-K, Item 8, Page 56, http://sec.gov/Archives/edgar/data/808362/000095013407003991/h43740e10vk.htm#102
3. ↑ BHI 2005 10-K, Note 13, Page 68, http://sec.gov/Archives/edgar/data/808362/000095013407003991/h43740e10vk.htm#102
4. ↑ BHI 2006 10-K, Item I, Page 10, http://sec.gov/Archives/edgar/data/808362/000095013407003991/h43740e10vk.htm#102
5. ↑ BHI 2006 10-K, Item 7, Page 28, http://sec.gov/Archives/edgar/data/808362/000095013407003991/h43740e10vk.htm#110
6. ↑ BHI 2006 10-K, Item 7, Pages 25-26, http://sec.gov/Archives/edgar/data/808362/000095013407003991/h43740e10vk.htm#102
7. ↑ BHI 2006 10-K, Item 8, Page 56, http://sec.gov/Archives/edgar/data/808362/000095013407003991/h43740e10vk.htm#102
8. ↑ http://www.plenglish.com.mx/article.asp?ID=%7BF7FB5E40-66BA-421F-9111-061341EA40CF%7D&language=EN
9. ↑ Morningstar Report, WFT, August 20th, 2007