The OCTG Cycle
In many ways, upstream oil and gas activity represents a classic commodity cycle. Oil and gas prices go up, we overproduce, prices go down, we produce less, prices start to go up, and we gear up to produce more. We’ve written ad nauseam in the Preston Pipe and Tube Report about how we think oil and natural gas differ from other commodities so we won’t repeat that here. Suffice to say, there are market forces at work that are different from those in other commodities. But this commodity cycle feeds a cycle in the OCTG industry that is as regular as clockwork in its phases, but not necessarily in its timing or the slope of all of its lines. It’s important to understand the commodity cycle so we can be prepared for the phases of the OCTG cycle.
For those of you on the sell side of the OCTG industry, what is the question of the day? Of course you know what it is, even if you’re afraid to ask it out loud. You’ve asked it quietly a number of times, even before today when the rig count report finally showed an uptick in U.S. drilling. It was Thanksgiving 2014 when this downturn started, 75 weeks ago, so you can understand the hubbub over a mere 4 rig climb in the count. Sure, there was an interruption or two along the way in the downturn but those points just really never ‘felt’ like the bottom, and of course they were not. But this seems to be right now…..right? Oil prices have improved of late and many wonder if this is a sign. So, back to the question – when is the rig count going to start back up? Is this it? Is it time? We are going to use an old cowboy movie quote here, from our youth, “Well now just hold your horses here sonny!” Being in the OCTG industry, you want to know the answer because it affects your order books, inventory, livelihoods, etc. It is so intertwined with your business that you ask, “When will the rig count start back up?” instead of what you really want to know which is “When will orders improve?”
In order to frame the conversation, we have to distinguish between new mill orders/import orders and orders placed by end users on distributors. The OCTG cycle refers more often to mill orders or import orders as typically orders on distribution follow the wells drilled (or rig count) line more closely. In different time periods in the past however, end users have moved in and out of the inventory business. In the latest run-up, end users were back in the inventory business. This has the effect of making the distribution order pattern more closely follow the OCTG cycle. If you are a pipe mill or importer, the importance of where we are in the cycle is clear. But for distribution, the importance is less obvious. In our OCTG Cycle graphic on the previous page, we illustrate the typical path of new OCTG orders in relation to upstream activity. As demand goes up, the industry builds inventory, as demand declines, inventory liquidates, then we start the process all over again.
Mills and Importers
If you are in the new pipe business, as in importing or producing, knowledge of where we are in the cycle will help you with cash flow management, profitability, and servicing your customers. Mistakes here can be costly. In a flat or even declining market, there are cash inflows supporting raw material purchasing etc. In a growing market, cash can be tight for producers as cash is being consumed to add raw material but cash is not yet coming in as orders are beginning to ramp up. In addition, as demand declines, margins decline. As business begins to improve, the first business is likely to be at the lowest margins in the cycle. Probably not healthy to fill your order book with the cheapest business – if demand is growing. The other factor is timing. If you have reduced operations – as everyone has done in this cycle, you have to decide when to rehire, when to buy raw material, etc. Just a few of your most crucial decisions.
Distributors & End Users
Distributors obviously have the same cash issues as the mills/importers. In addition, they have to know when to begin to ramp up inventory additions or to place orders to secure the limited available capacity as producers ramp up. End users have to be able to get pipe when they want to drill new wells. We’re all very familiar with DUCs now, since most of the pipe is in these wells already, they provide a pipe demand cushion for the end users.
So where are we in the cycle?
As OCTG experts, we keep a close eye on this this very topic. Of late, our industry contacts have been telling us that things are firming up. Generating a feeling that things are better but combined with a sense of wonder regarding what is behind the improvement. People appear to be returning to purchasing, they tell us, not in a big way, mind you, but there are new orders. A look at where we are in the cycle will provide the answer. As our readers are aware, and as you can see by the illustration at on the previous page, inventory plays a role in the cycle. As completion practices and geographies change different pipe products are used. As a result of these shifting patterns, and the lead time between order and manufacture as well as the service levels end users have become accustomed to, inventory has always been an important part of the supply cycle. When upstream activity declines domestic shipments adjust pretty quickly but imports continue for approximately 3 months before tapering off some. A combination of lower demand and a run on of imports, we end up with inventory overhang. In the months following, drilling that continues begins to consume items in inventory declines. Since this cycle began, the industry has consumed about 1.2 million tons out of a peak inventory of about 3.2 million tons. At some point, the items currently being used begin to run out. While overall inventory suggests that we remain at about 12 months of supply – about two times the industry average – the portion of the inventory that is turning is closer to being in line with more traditional levels.
So what happens to the part that is not moving and maybe has not moved for a year? In past cycles this material has been either preserved or has been sold into limited service applications or scrapped. Our sources tell us that this time however, a guy could make a living for the time being in the brush, roll and spray business. Not only does this suggest that inventory is being maintained but it also confirms that a significant portion of inventory is not moving. The inventory has been segmented as we discussed and the currentactive portion of the pile is priced at or very near the market because it is active. The need to move it because we will need to invest in it for cleaning is not there – it is moving anyway. So where are we in the OCTG cycle? We believe we are at the point where shipments begin to grow. This assumes, of course, that the rig count is truly at or very near the bottom. While everything seems to point to that, remember that a fight for market share started all this and the actions of OPEC are difficult to predict.
One other wild card in the OCTG cycle is the slope of the lines. Orders are not happening at this point because the rig count is increasing. In our opinion, it means that the slope of the shipment line – while trending upward – will remain relatively flat. Activity will begin to grow – slowly if commodity prices are supportive. But as activity improves and our inventory pile gets smaller, orders will continue to improve. How much will be activity improvements? We believe that the rig count could grow in the U.S. by 40 rigs +/- over the next 3 – 6 months. This assumes, of course, that all current factors remain relatively the same as today. That depends on how much of today’s oil price is related to the temporary outages that have been all over the news – Canada, Nigeria, Mexico, Venezuela, others. We expect price of oil to continue to go up and down but given it centers around the $50 mark, our forecast should hold.
The best news about this situation is that as the market bounces along, with a few more orders here and there, inventory will start to look better. Sure the dogs, defined as the pipe grades and sizes that will ONLY be used when the most expensive drilling comes back, will still exist and may end up being scraped but for now the sizes in demand in the areas where drilling is still going on will continue to turn and operators/distributors will continue to get a better idea of what to have on hand. We think that in the beginning that will be less pipe that turns more often. This leads, all said, to lower inventory levels and inventory in better condition, slow movers aside. Well that is early recovery 101, at least for this cycle. Stay tuned!