Baker Hughes' Management Is Much More Excited About This Than an Oil Recovery in 2017

By Tyler Crowe Markets Fool.com

2017 is going to be a big year for Baker Hughes (NYSE: BHI). Not only can investors expect the company to see a rise in revenue and earnings from increased oil and gas activity, but two big corporate changes are set to completely transform this business. When Baker Hughes' management discussed earnings during its most recent conference call, it really went out of its way to talk about these changes and its outlook. Here are several quotes from that call that investors should know about.

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Image source: Getty Images.

Outlook for recovery

Much of what CEO Martin Craighead said regarding the outlook for the coming year was very similar to what other oil services executives said on their own respective conference calls. What really stood apart in Craighead's statements, though, was that he explained in a little more in detail some of the uncertainties that could really throw a wrench in these outlooks:

First, we said the supply/demand surplus had to rebalance, allowing commodity prices to improve. Since October, two things have materially changed. We've seen OPEC's decision to scale back production and we have seen forecasted demand for 2017 to increase by 1.6 million barrels a day. Taken together and adjusting for drawdown of global inventories, this would point toward a balancing of supply and demand in the second half of '17. However, as we also said previously, the North American shale segment remains a wild card in all of this. Since details of OPEC's plan surfaced, rig counts have increased by 33% in the United States, with over 170 rigs added and a corresponding increase in U.S. shale production already under way.

Second, we said that commodity prices needed to stabilize for confidence in the customer community to improve and investment to accelerate. We continue to believe that North American operators need sustained prices in the mid- to high-$50 range for this to occur. The North American shale operators' ability to rapidly increase production has resulted in commodity price recovery being shallower than expected and bringing uncertainty to the sustainability of these recent price increases.

And third, we said that activity needed to increase meaningfully before excess service capacity could be absorbed and pricing recovery could take place. We are seeing the first signs of this in select product lines in a few of the North American basins, but I still believe there remains a fair amount of capacity that must be absorbed before service pricing will become more tightly correlated with higher commodity prices and increased activity. With this backdrop, it's clear the market has taken a positive turn, and we have all the elements in play for recovery.

That increase in rig counts is pretty remarkable, and it will most certainly play a large role in oil prices over the next several months. It's worth keeping in mind, though, that shale production alone won't be enough to back-fill the supply decline from other oil reservoirs around the world and meet increasing demand from the developing world. Eventually we will see an uptick; it just may be a little slow in the beginning.

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Better late than never

One of the big questions for Baker Hughes in 2016 was whether the now-defunct merger with Halliburton was so much of a distraction that it took its eye off the ball with things like cost control. Craighead wanted to point out that even though the company got a later start, it did a pretty bang-up job in right-sizing the business:

On the first point, costs. We achieved the savings target by the end of the third quarter, three months ahead of schedule, and then we exceeded it. Today, I'm pleased to say that we achieved nearly $700 million in annualized cost savings by the end of '16. Now this was not just an exercise in removing costs. It was a complete restructuring of the company to improve efficiency, foster more accountability and enhance performance. Yet even as we underwent significant structural changes, the company never took its eyes off the long game. We achieved record safety performance, and our employee retention rates exceeded 2015 levels.

The other corporate deal

With so much attention being paid to the potential merger with General Electric (NYSE: GE), one thing that did get a little overlooked was that Baker Hughes made another major corporate move this past quarter. Both Baker Hughes and its private equity partners CSL Capital Management and West Street Energy Partners will combine their fracking and well cementing business into a single, privately held entity. Baker Hughes will retain 46.7% ownership of the new business. Craighead explained the company's rationale behind this deal:

To maximize shareholder value, we contributed our North America land fracking and cementing business into a new company that is now the largest pure-play pressure pumping provider throughout the North American market. ... This deal allows us to more efficiently benefit from the improvement we're already seeing in this market while also allowing Baker Hughes to reduce capital intensity and resource requirements.

One thing that was incredibly challenging for Baker Hughes and others this past downturn was managing loads of idle assets like pressure pumping and cementing equipment. Also, these kinds of services are lower-margin than some of the higher-technology services Baker Hughes provides. By doing this deal, it will have the benefit of having an equity ownership in the fracking and cementing aspect of the business without having to allocate much capital to it and focus more of its capital spending on those higher-return businesses.

Image source: Getty Images.

Don't freak out when revenue is down next quarter

Another aspect about this fracking and cementing business segment deal is that it will change some of the accounting for the company. CFO Kimberly Ross was quick to point out that the company's outlook reflects this accounting change:

Now looking ahead to 2017. In North America, we are forecasting revenues in the first quarter to slightly decline as activity growth, primarily in our well construction product line, will be more than offset by the deconsolidation of the onshore Pressure Pumping business and reduced activity in the Gulf of Mexico. Our 46.7% noncontrolling ownership in our North America Pressure Pumping venture will be reported as an equity method investment. Prior quarters will not be restated.

The big change

Of course, the merger between General Electric and Baker Hughes was going to be at the top of the list of things discussed during this conference call. Craighead wanted to explain why he sees this tie-up as a game changer in the oil and gas business:

[O]ur conversations with customers have clearly indicated that they have grown frustrated with the broader oilfield services sector because there is still a sizable gap between their needs and what the service industry as a whole has been delivering. They're looking for a different set of solutions that address productivity and not just operating cost structure, which, in many ways, is an opportunity that, frankly, has run its course. As such, they want service and equipment providers to deliver on the vast promise of data analytics to enable them to make the right decisions and investments at the right time. By combining with GE Oil & Gas, we will be better able to meet these customer demands. We will have a much broader full-stream portfolio of productivity solutions that will provide the new company with more revenue diversity and resiliency throughout the industry cycles.

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Tyler Crowe owns shares of General Electric. The Motley Fool owns shares of General Electric and Halliburton. The Motley Fool has a disclosure policy.