The world's largest oil-services company is getting into the royalty business.
On its most recent earnings call,
Schlumberger Ltd. (NYSE: SLB, Stock Forum) announced it will accept royalty-like payments for some of its oilfield services. In short, the company is now prepared to foot the entire bill for bringing certain wells to production. In exchange, Schlumberger's CEO said the company will "get paid back in production."
This is a game changer for Schlumberger. And it shows why it's one of the most innovative oil companies out there...
Regular Growth Stock Wire readers are familiar with today's oil story. Despite a recent uptick, the price of benchmark West Texas Intermediate (WTI) crude oil is down around 45% from its June 2014 high.
With that big drop, oil exploration and production (E&P) companies have been receiving much less for every barrel of oil they produce. It has been impossible for many to earn profits. So, these companies are doing everything they can to lower costs and cut spending. And oil-services companies have been helping them.
Oil-services companies provide drilling equipment and service crews to E&P companies. In short, these companies can't survive unless oil producers are drilling wells. So, they're cutting their costs across the board – making it cheaper for oil producers to drill.
One of my boots-on-the-ground contacts in the energy industry told me certain E&P companies have negotiated 20% decreases in the cost of oilfield services.
This means oil-services companies are seeing their profits decrease. For example, Schlumberger recently announced its first-quarter earnings were down 12% from last year.
But now, Schlumberger has found a way to keep its customers drilling AND set itself up to profit. For certain wells, it will likely accept a portion of the value of oil production (or a "royalty") for the life of the well in exchange for its services. Essentially, Schlumberger will be following a royalty business model for these wells. (Schlumberger hasn't confirmed whether it has entered into any of these agreements yet, and it hasn't announced what the exact terms would be.)
Some may think this is a riskier way of doing business. After all, Schlumberger usually gets paid cash to do its work. Now it's spending cash to bring wells to production. It's also running the risk that the wells it drills may be dry. And even if the wells produce, the oil price could fall. That would lower the value of oil production Schlumberger receives.
It's true that some of the wells Schlumberger drills may be dry or produce very little. But the company has some of the best engineers and geologists in the world. If anyone can identify the best oil wells... it's these guys. So, the risk of taking a royalty on a dry well is low.
As I said, Schlumberger will also have exposure to the oil price. It has options here, though. The company can "hedge" the oil by locking in a future sale price. For example, Schlumberger could agree to sell oil for today's price through next year.
As long as the wells produce and Schlumberger addresses its oil-price exposure, its royalties will likely be more valuable than the cash it would have earned under its previous contract structure.
And as we've shown you in these pages before, oil is tremendously cyclical. That means its price moves in waves. It goes through huge cycles of boom and bust. While the oil price may be in "bust" mode right now, eventually it WILL rebound. When that happens, Schlumberger's oil royalties will become much more valuable. And it'll go straight to the company's bottom line.
So the company is making sure it stays profitable as long as oil prices remain low... and it's setting itself up for big profits in the long term.
I expect other oil-services companies like Halliburton, Baker Hughes, and Weatherford to adopt similar royalty structures soon.
In short, when you're investing in energy companies, you need to find ones that can withstand the inevitable "busts" and profit during the "booms." With its new royalty business model, Schlumberger is a great example of one of these companies. I recommend looking into it today.