After several years of challenging market conditions, the outlook for the North American onshore oilfield services (OFS) sector looks to be on stronger footing, with many indicators pointing to the beginning of a multiyear upcycle.   Crude oil and natural gas prices are well-above the breakeven levels needed to support new drilling, and we believe the unique confluence of macro factors that have unfolded in recent months are likely to support prices and drilling activity for the next year or so. These include tight supply and demand fundamentals, underpinned by unprecedented low global spare production capacity and inventories, years of underinvestment in new drilling and exploration, and a renewed global focus on energy security, with an urgency to establish more diverse and reliable sources of oil and gas supply following the Russian invasion of Ukraine. With this backdrop, we expect that demand for oilfield services will continue to increase at least through 2023, spurring improved earnings and credit quality for the sector.

While the risk of a global economic recession continues to loom large--S&P Global Ratings economics team most recently raised the risk of a recession within the next 12 months to 45%--we believe that due to the aforementioned factors, oil and gas prices will remain at levels supportive of new drilling even in a mild recession. Additionally, we note that prices have far to fall before reaching levels that we would expect to significantly slow activity levels.

Largely due to shareholder demands, the North American E&P sector has been focused on capital discipline and spending within cash flows, which has negatively impacted the oilfield service sector. However, with higher commodity prices in 2022, the E&P sector is now generating stronger cash flows, enabling them to increase capital spending while also increasing shareholder rewards and generating positive free cash flow. We now expect North American E&P capex to be up as much as 35% in 2022, due to a combination of higher activity levels and higher oilfield service pricing, and a further increase in 2023, which will support further OFS revenue growth. So far this year, West Texas Intermediate (WTI) crude oil has averaged almost $99 per barrel, compared with about $68 per barrel in 2021, while Henry Hub natural gas has averaged about $6.40 per million BTUs, up from about $3.75 per million BTUs in 2021.

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Upbeat Second Quarter Earnings Cycle

The second quarter earnings cycle recently wrapped up and the OFS sector tone was more positive than in recent quarters.   Financials showed evidence of improved demand and strengthening pricing for oilfield products and services, while outlooks for the remainder of the year were optimistic, notwithstanding a major global recession. For the largest rated diversified oilfield service providers--Schlumberger Ltd., Halliburton Co., and Baker Hughes Co.--revenues jumped 12% sequentially. S&P Global Ratings' adjusted EBITDA decreased 3% sequentially, although this decrease was due to noncash charges related to the impairment of Russian operations. Excluding these impacts, EBITDA was up by about 20% relative to the first quarter. The messaging related to the North American market was unified across the group that demand for services and equipment is strong and equipment availability is tight, particularly for the pressure pumping and land rig subsectors. Not only is equipment tight in 2022, but 2023 schedules are getting locked-in well in advance of the usual timeline due to operators concerns around the limited equipment availability.

International OFS demand has also strengthened, and we expect robust activity to continue, particularly in the Middle East and Latin America regions. Although the recovery in offshore deepwater has lagged that of shorter-cycle onshore projects, supportive commodity prices and the renewed focus on energy security are likely to entice national oil companies, integrated oil companies, and larger independents to move forward with offshore developments that have been delayed in recent years, with offshore exploration drilling to follow.

Pressure Pumping Sector At Near Full Utilization, Leading To Sharply Improved Financial Measures.

We believe the oversupply of fracking equipment, which weighed on pricing and hurt the sector's financial performance in recent years, is now close to fully absorbed through a combination of improved demand for services and reduced fleet count as well as capacity that has been removed from the market through equipment attrition and cannibalization of fleets for parts.  Capital constraints and supply chain inefficiencies have also limited the number of newbuild fleets coming to market, with current lead times for newbuild frac spreads anticipated to be 12-plus months.

We expect a sharp improvement in credit measures in 2022 and 2023 for our rated pure-play pressure pumpers, which has driven positive rating actions for both over the past several months.   NexTier Oilfield Solutions Inc. and ProFrac Holdings LLC, reported a combined 46% sequential increase in revenues for the second quarter, while EBITDA more than doubled. We expect funds from operations (FFO) to adjusted debt, a metric which is a key consideration in our financial risk profile assessment, to average more than 100% in 2022 and 2023 for both NexTier and ProFrac, compared with just 17% and 33% for the two companies, respectively, in 2021. With utilization high across the sector, the pressure pumpers are now realizing improved pricing power, which is finally trickling down to their bottom line. Although the pressure pumpers face high cost inflation for labor, parts, and proppant, we expect the tight market will enable them to pass through most of it to customers, allowing further net pricing gains and margin improvement in the coming year.

The current active U.S. frac spread count is now approaching 300, its highest level since early 2020.   We estimate that close to 75% of the frac market horsepower is controlled by six public oilfield service companies (Halliburton Co., NexTier, ProFrac Holdings, Liberty Energy Inc. [not rated], ProPetro Holding Corp. [not rated], and Patterson-UTI Energy Inc.), which will enable continued discipline related to pricing and fleet reactivations and supports our view that pressure pumping equipment will remain close to sold-out through year-end 2023. Although a limited number of reactivations and newbuild fleets have been announced for deployment in the remainder of 2022 and 2023, we expect much of the new capacity will just cover equipment attrition and net fleet gains will be moderate.

High Super-Spec Land Rig Utilization Is Driving Up Dayrates

Similar dynamics are at play for land rig operators, with industrywide rig utilization for super-spec rigs above 90%.   The active rig count in the U.S. has climbed more than five-fold since bottoming in mid-2020. So far this year, the oil-directed rig count has increased 25% to about 600 while the gas-directed rig count is up 50% to about 160. Availability of crewed super-spec rigs is very limited as customers aren't willing to release active rigs, and many contracts are being extended to longer terms stretching well into 2023. Like the pressure pumpers, the land rig operators have shown discipline with equipment reactivations. We believe the remaining inventory of idle super-spec rigs and idle rigs that can be upgraded to super-spec at a lower cost is very limited, which will support higher pricing and improved margins for the time being. As a result of the tight market, leading-edge dayrates are now reportedly reaching the mid-$30,000 per day range, up from around $20,000 per day in early 2021. Once the remaining lower-cost reactivations have been completed, further equipment additions--either newbuilds or reactivations requiring greater amounts of capital to bring them up to spec--will require dayrates to step up further from current levels to make economic sense.

As a result, we anticipate that credit measures will strengthen for our rated land drillers, Helmerich & Payne Inc., Patterson-UTI Energy Inc., and Nabors Industries Inc. in 2022 and 2023. The three companies reported a combined 17% increase in revenues sequentially, and 39% increase in EBITDA and we expect this trend to continue into 2023 as contracts roll over and are repriced at higher dayrates. While the land rig sector also faces steep cost inflation related to labor and parts, we again expect the tight market will enable most of this to be passed on to customers and therefore expect higher dayrates will drive stronger margins.

Smaller Diversified OFS Providers Improving At Slower Pace

Other onshore OFS subsectors such as wireline, tool rentals, and coiled tubing, are also seeing pricing improvements as overall activity picks up, although these markets are more fragmented and not yet experiencing the same equipment tightness.   We expect the larger diversified players that can provide customers with a wide range of services and products will be the preferred choice of operators in this constrained market. As such, we expect a slower improvement in financial measures for the smaller diversified U.S. oilfield service companies that we rate, including KLX Energy Services Holdings Inc. and Nine Energy Service Inc. Further consolidation will likely remain important for smaller players to scale-up their businesses and reduce costs.

Energy Transition And Cost Inflation Will Pose Challenges

The focus on environmental, social, and governance (ESG) factors and the energy transition will be a growing headwind to which oilfield service companies will need to adapt to in coming years.   Many of our rated oilfield service companies have budding new energy businesses that leverage their existing capabilities to service clean energies like offshore wind and geothermal. Others are adapting their operations to support their existing oil and gas customer base in reaching their own emissions reduction targets through the roll out of lower emissions equipment, such as electric powered frac fleets. In most instances, we don't expect the new energies businesses to make material top-line contributions for at least the next several years but believe they will be necessary to satisfy the shareholder base longer term.

Cost inflation, extended lead times for parts, and a shortage of labor will continue to be a challenge for the sector in the near-term, driving up costs across the board and potentially becoming a bottleneck to growth. Although we do expect much of the incremental cost burden will land on the E&P customers, there is likely a limit to the extent of this.

Nonetheless, if the recovery in OFS continues to unfold as anticipated, we would expect stronger credit metrics and improved financial risk profiles for the sector, which support current ratings and could drive positive rating actions in the coming years.

Rating Outlooks On Most OFS Issuers Are Stable.

We currently rate 20 North American OFS companies, 25% of which are investment grade and 75% speculative grade.   Companies in the 'CCC' rating categories are predominantly offshore service providers with leverage that we consider to be unsustainable and/or with material debt maturities on the horizon, or smaller onshore U.S.-focused service providers that have weak credit metrics.

We have a stable outlook on 70% of our rated OFS providers, following a number of revisions from negative the past year as commodity prices increased and the sector outlook improved. We have positive outlooks or have placed ratings on CreditWatch Positive on 15% of the group, and negative outlooks on the remaining 15%. The negative outlooks are skewed to issuers in the 'CCC' rating categories, composed of offshore drillers Transocean Ltd. and Vantage Drilling International, and onshore services provider Nine Energy Service Inc.

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