Schlumberger-Smith Deal: A $11B Bet on Hard-to-Reach Oil and Gas

Schlumberger's (SLB) acquisition of Smith International (SII) really comes down to an $11 billion bet that oil and gas is just going to keep getting harder and harder to find.

The folks at Schlumberger, a company whose job is helping oil-and-gas producers reach fossil fuels, clearly figure that unconventional oil and gas -- those hard-to-reach resources trapped in tight geological formations and shale rock -- represent the future of the exploration industry. At least in North America, that is.

Schlumberger is a pioneer in directional drilling, a technique that allows producers to extend oil and gas wells horizontally from a rig, sometimes by miles. It's a literal giant in the oil field service field, with revenues last year of $22.7 billion. But Schlumberger lacks expertise in drill bit technology and drilling fluids -- products that are crucial if it wants to build up its position in the shale gas drilling industry. And Smith has them.

As Schlumberger Chairman and CEO Andrew Gould said during a conference call with investors Monday:

There is, I don't think, any doubt that long term shale gas is gonna be one of the big new energy sources both in the U.S. and overseas. However, as I tried to point out ... I don't think the actual optimum technology set for producing shale gas has yet been defined. At the moment, we're doing it by brute force and ignorance. In other words, we drill (horizontal) off the wells and then we frack them geometrically.

Smith's capacity to serve that market in North America is of great interest to me. It may not be the financial return in the oil field at this point in time, but long term what we can learn in that market is extremely interesting.

In other words, future supplies are dependent on breakthroughs in drilling technology. Smith's expertise in drill bits and fluids, at least in Schlumberger's view, will help it become the go-to company as shale and ultra deep-water projects become more complex.

Why is shale gas so important? For one, major oil companies must find more oil and gas each year to replenish and add to their reserves. If they didn't, then we'd all soon be riding bikes across town, not the bus.

Oil companies, however, have struggled with this task for the past few years. Exxon, for example, had real trouble replacing its oil and gas reserves in 2007, 2008 and 2009. As oil and gas becomes harder to access, replenishing reserves grows ever more costly and difficult.

Unconventional gas offers a way out of that box, so it comes as no surprise that more oil companies are counting on it to replenish their reserves. For instance, Exxon is paying $41 billion for XTO Energy, an independent producer that specializes in unconventional gas.

The consolidation within the oil fields services industry -- like the Baker Hughes-BJ Services acquisition last year -- and the complexity of oil and gas projects will help push costs higher. This could be problematic for oil and gas producers like Exxon and Chevron that struggled to control costs after oil prices plummeted from a high of $147 a barrel in July 2008 to under $40 a barrel by December 2008.

Here are some of the details:

  • Schlumberger is offering 0.6966 shares for each share of Smith International. The deal originally valued Smith's stock at $45.84, a 37.5 percent premium over Thursday's closing price;
  • Schlumberger expects to realize pretax savings after costs of about $160 million in 2011 and $320 in 2012;
  • The transaction is expected to close in the second half of 2010;
  • Some have speculated that antitrust regulators will complicate the acquisition and may force it to sell off its directional drilling business. Gould said he didn't expect that to happen because there was very little "overlap" between the two companies.
Schlumberger logo from Schlumberger; Map of shale gas plays in the United States from the U.S. Energy Information Administration