Thelatest indication on drilling activity from oilfield service companies showsthat more contraction in activity will take place in the second quarter, butexecutives are sticking to their expectations for a recovery in the second halfof this year. Any tightening supply/demand balances that result couldeventually be bullish for oil and gas prices.

Conditions remain tenuous

"Thestart of a new year and a new budget cycle represented a further fall incustomer E&P spend, and we expect continued weakening in the second quartergiven the magnitude and erratic nature of the ongoing activity disruptions,"Paal Kibsgaard, chairman and CEO of SchlumbergerLtd., said in the company's first-quarter conference call. "Thisoutlook is backed by the latest 2016 E&P spending surveys, which indicatesharper falls than earlier figures."

Kibsgaardsaid another 8,000 employees were released during the first quarter and that42,000 have been cut since a peak in 2014.

"Whatwe see in certain markets and certain basins in North America and also certainmarkets international, that activity is coming down to basically critical masstype of levels," Kibsgaard said. "And at that stage, it is not onlyabout focusing in on cost reductions and managing margins, we are alsoconsidering what the startup costs again would be in the event we have to shuteverything down."

Atcompetitor Halliburton Co.,conditions in the oilfield services sector were also described as being verydifficult. The company reduced its workforce by more than 6,000 during thefirst quarter.

"Lifehas changed in the energy industry, especially in North America, and over thepast several quarters we have taken the steps to adapt to that fact," DaveLesar, chairman and CEO of Halliburton, said in the company's first-quarterearnings release. "Operators globally are under immense pressure, and manyof our North America customers are fighting to maintain some value for theirshareholders. Our goal is to work with those customers to get through thesetough times."

Lesarsaid that Halliburton's customers have taken defensive actions to solidifytheir finances including significant reductions to headcount and capitalspending. He thought that the reductions would lead to declines in productionin the second half of 2016.

Rig counts continue to drop

Despitea significant drop in the number of rigs deployed in the U.S. already, rigstargeting crude oil and natural gas continue to fall to new lows.

Thelatest data from Baker HughesInc. showed that the number of rigs in the U.S. targeting naturalgas reached their lowest levelson record since the data series began in July 1987. The total number of rigs inthe U.S. also reached a record low, while the number of rigs targeting crudeoil fell to the lowest level since the week ended Nov. 6, 2009.

U.S.production of crude oil peaked at 9.69 MMbbl/d in April 2015, according to datafrom the U.S. Energy Information Administration's "Short-Term EnergyOutlook." It has since fallen to 9.04 MMbbl/d in March and is expected toreach a low of 7.79 MMbbl/d in September 2017 before recovering slightly.

Naturalgas production, on the other hand, reached a record of 75.42 Bcf/d in September2015 and is forecast to continue rising until eventually reaching a record77.35 Bcf/d at the end of the forecast period in December 2017.

Turnaround rests on tightersupply, not higher prices

Crudeoil prices have risen nearly 80% between a low formed in mid-February and apeak made in late April, while natural gas has gained around 36% between itslow in early March and a high in late April. The rally was sparked by thesuggestion that OPEC would freeze production, but prices have remained firmeven as the cartel failed to reach an agreement.

Thegains have brought about the question of whether drilling activity andproduction will begin to increase again as several of the marginal shale playsbecome profitable; thus creating pressure on prices.

Tobe sure, the rate of decline in rig counts has slowed amid the price recovery.Rigs targeting natural gas fell to a record low of 87 in the week ended April29; however the year-over-year rate of decline was 60.8% and has improved froma drop of 66.9% in the week ended Feb. 5. Natural gas prices bottomed about amonth later on March 4 at $1.611/MMBtu.

Incrude oil, the rate of decline in rig counts also began to slow prior to thebottom in prices. The number of rigs targeting crude oil fell to 332 in theweek ended April 29, which was the lowest level since the week ended Nov. 6,2009, or nearly six-and-a-half years earlier. The year-over-year rate ofdecline was 51.1% and was an improvement compared to 66.1% at its worst in theweek ended Dec. 11, 2015.

"Ithink that clearly [our customers are] marginally more optimistic about things,"Lesar said on the conference call. "I don't think we've seen that optimismtranslated into any set plans to actively increase the rigs in the back half ofthe year; certainly those discussions are taking place."

Oilfieldservices companies suggest that there is more to rig counts and industrydrilling activity than just the rebound in prices and said that there is notone magical number for prices that would bring back activity.

"Wemaintain our view that there's going to be a lag between oil prices andsignificant increases in E&P spend," Kibsgaard said. "And I thinkour customers will take a cautious view on how much they're going to spend aswell, given the balance sheet state of many of them and also the significantvolatility that you might also see going forward."

"It'sdifficult to come up with one specific number. I think [our] various customergroups and the customers within these groups will have different views on whenthey are getting comfortable to invest," Kibsgaard said. "But I wouldthink both aspects, the oil price movement and the supply trends, are probablywhat they're going to look at when they make decisions."

Kibsgaardsaid he believes that the current oversupply situation will shrink toward zeroby the end of 2016 and that the industry will face supply challenges in 2017.

Comeback may be strong,efforts continue

Kibsgaardsaid that he believes a gradual comeback in investment could take place in thesecond half of this year as oil prices increase.

"Thenit's going to be I think a function maybe of how severe the supply situation isgoing to be," Kibsgaard said. "I think that might be a good guide inaddition to the movement of the oil price because if supply is clearlyweakening, I think it's going to be much safer to increase investments goingforward."

JeffMiller, president of Halliburton, communicated similar expectations, withactivity potentially bottoming in the second quarter.

"Thesecond quarter average land rig count is already down more than 20% sequentially,and setting new record lows every week," Miller said in the company'sfirst-quarter earnings release. "Nevertheless, we believe we will see thelanding point for the U.S. rig count during the second quarter."

Inthe conference call, Miller described how a potential rebound in activity maylook and discussed how efforts to improve productivity have continued despitethe low price environment.

"Commodityprices and markets will move up and down, but the one thing about which I amcertain, one thing that won't change over time is that the lowest cost per BOEwins," Miller said. "We continue to believe that the longer it takesfor the recovery to occur, the sharper the recovery will be."

Apossible reason for a sharper recovery could come from the state of equipmentthat has been sidelined.

"Ourthoughts are that about half of that equipment is idle today and that idledequipment is not being maintained," Miller said. "We hear companiestalking publicly even about cannibalizing equipment that is stacked, and that'sequipment that really doesn't go back to work. It gets rained on, it sitsthere, it's more and more difficult to bring back."

Kibsgaardagreed and said that a lot of equipment will need maintenance and repairs inorder to be brought back into service.

"Istill think most of it is going to come back. I think some of it today probablyisn't operational because it needs maintenance," Kibsgaard said. "ButI think when activity starts to increase, most of this equipment through somemaintenance investment can be brought back in."

Milleralso highlighted some transformation that the industry has continued to gothrough despite the weakness in prices and the difficulty with which olderequipment handles the current needs of hydraulic fracturing.

"Thevolumes pump, which probably has more impact on equipment continued toincrease, so we saw 17% increase in sand volume on a per well basis, which saysthat the equipment has to work harder than it ever has," Miller said. "Andso for that reason, we are really happy with our Frac of the Futureconfiguration and the Q10 pumps just because they handle it so well."

Whilethe outlook appears to be brightening somewhat for drillers, and in turn,oilfield services companies, there are still risks in the longer term asdrilled but uncompleted wells, or DUCs, and overcapacity in the industry remain.

Therise in prices will make completing DUC wells attractive and could weigh onprices by boosting supplies, but may not be impactful.

Millerestimates DUCs to total around 4,800 to 5,000 wells. "We don't see thatvolume continuing to build and in fact it's kind of being worked off in thestream of work that's out there today. So I don't see them as impactful, all atone time. We continue to describe them as deferred revenue for us as they getdone."

Kibsgaardsaid that overcapacity is still prevalent in North America; a point which isalso shared by Halliburton.

"[ForCapEx], I think at least in the near term, we're probably at a structurallylower level," Lesar said. "Clearly the whole industry isovercapitalized at this point in time, and it's overcapitalized with somereally good equipment."

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