Boyd Heath, Network International, Houston
Capital spending projections within the oil and gas industry have historically been challenging due to economic activity, supply and demand, geopolitical issues, and weather patterns (among other factors). The current economic turmoil and pending recovery is making this point all the more apparent. And while there are numerous elements that companies commonly use to generate projections (rig rates, lease activity, worldwide consumption, energy stockpiles, capital availability, etc.), surplus pipe and equipment inventory is an area gaining awareness as a key indicator of future costs that drive the economics of drilling or development projects.
Within the equipment inventory arena, there are three key interrelated areas that can help analysts evaluate current and future pricing for equipment. These three areas are: the quantity of specific equipment inventory levels, the quality of this inventory, and the movement of the inventory levels.
Quantity of surplus inventory
A close examination of surplus equipment quantity levels (within specific equipment types) can provide deeper insight into future pricing. For example, over the past decade US OCTG (oil country tubular goods) inventories (months of pipe supply on the ground) have typically ranged between four and seven months.
When the months' supply of OCTG inventory broke out of this range sharply higher in late 2008 and early 2009 to 12 months or more, it was a clear indicator that pipe prices would soon come down until this inventory over-hang was/is worked off. The same dynamics hold true for drilling, production, gathering, processing, and transportation equipment.
Quality of surplus inventory
And while the quantity of surplus inventory is what many people within the industry look to first, the quality of this inventory must also be taken into consideration. In the previous OCTG inventory example, analysts need to further examine the quality of the surplus pipe inventory.
Generically speaking, if the surplus pipe inventory is comprised of 50% domestic "high quality" steel, 25% foreign "high quality" steel, and 25% foreign "low quality" steel that was purchased on a highly speculative basis, then the market impact of the surplus pipe inventory might be downgraded by up to a 25% factor. The reason is that in a down market buyers have the leverage and with so much high quality supply to choose from, they will likely elect to buy the high quality inventory first (and at lower prices). Correspondingly, due to the oversupply imbalance and mills typically producing high quality pipe at more competitive prices in a soft market, lower quality material is often marginalized, if not scrapped outright.
The same holds true for the other equipment categories mentioned earlier, such as drilling and well service rigs, whereby the marketplace may scrap older, low quality rigs in favor of utilizing newer, higher quality rigs that are in abundance (and at lower prices). So the quality of inventory, along with the amount of inventory, plays a key role in the future cost of material in the marketplace.
Movement of inventory surplus
After examining the quantity and quality of the inventory, companies need to look towards the "turn activity" levels, or overall movement, of surplus equipment. Similar in nature to inventory levels in the housing and automotive markets being indicators of future pricing trends in those markets, the "turning" of surplus inventory is a critical indicator in gauging current and future oil and gas equipment pricing.
Strong "turn activity" will allow excess inventory to be consumed into the market, thereby lowering a supply overhang. This, in turn, can indicate that manufacturers and distributors might soon gain pricing power as there is less surplus inventory already in the market competing with any new product they will manufacture and sell. The opposite holds true as witnessed by the OCTG inventory level example previously discussed.
Impact of raw material inventories
Similar to equipment inventories, the amount, quality, and movement of raw materials that go into manufacturing equipment are also key data points to examine. Some examples of key raw materials that influence equipment prices are iron ore (feedstock for steel based equipment), nickel (used in alloy tubing and wellheads, stainless steel, heat exchangers, piping, and valves), aluminum (used in castings, risers, alloy, and pipe fittings), zinc (used in primers and powders), copper (used in wiring and transformers), and scrap materials such as scrap steel which many steel mills purchase and melt as a feedstock for new steel production.
The same dynamics that apply with equipment inventories hold true for raw materials, only that raw material and scrap inventory is generally a much earlier indicator of what might happen to equipment prices in the future. For example, if nickel inventories begin dropping and new supply of nickel does not keep up with strengthening demand, the price of nickel is likely to increase, resulting in a price increase for equipment that is nickel-based.
Conclusion
By understanding the key factors surrounding surplus equipment inventories, as well as raw material inventories and their corresponding impacts on the marketplace, companies are able to make better-informed planning decisions. And importantly, it's not just the amount of surplus inventory in the market; it's the quality of that inventory and what's happening to that inventory that matters most.
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