Q3 Earning Season: The Margin Expansion Playbook

OFS companies have had to take the same basic tactics as their customer base to attract Wall Street investors:

1. Stock prices reflect the present day value of cash flows way into the future

2. Most believe the future won’t be as dependent on fossil fuels, creating uncertainty in valuation

3. Firms need to attract investors with money today, not into the future, by way of dividends and buybacks

4. Firms need more profit to keep doing it

This has every OFS CEO doing their best Mark Twain magic to tout their margin expansion story with the goal of beefing up investor attractiveness.

From Consolidation to Execution

OFS consolidation swept up much of the low-hanging fruit for margin growth. Larger entities benefited from economies of scale, slashing G&A and OPEX, while reduced competition buoyed pricing power. The math was simple; the execution, straightforward. But now, the dust has settled, and in the evergreen pursuit of investor attractiveness, the focus has shifted.

Insert margin expansion; Margin growth requires a strategic vision, and each company is pursuing its own path. SLB’s Q3 call spotlighted digital and AI initiatives. Liberty emphasized its DigiTechnology. The list goes on and on.

But, similar to life, talking is one thing. The street rewards action and results. And you don’t have to look far to see one segment doing it right.

Compression Companies: Margin Titans

Enter the public compression companies: Archrock (AROC), USA Compression Partners (USAC), and Kodiak Gas Services (KGS). These firms, which control 75% of the outsourced compression market, are clear leaders in margin expansion within the OFS space.

Here’s the scorecard through Q3 2024:

• Archrock: 24% YoY margin growth

• Kodiak: 19% YoY margin growth

• USAC: 9% YoY margin growth

All-time highs in utilization rate have created what the USAC CEO declared to be “the best fundamentals in the compression industry in the last two decades”

This creates a problem for Operators – one all of our clients want to address.

1. The leverage KGS, USAC and AROC wield is an anomaly in today’s market

2. Compression typically accounts for the second largest OPEX category

3. Operators are trying to tell their own margin expansion story, so optimizing LOE is critical

The time tested tactics of simply RFP’ing and re-contracting one by one are insufficient against a high leverage counterparty like compression companies.

We need an elevated negotiation approach. That starts with understanding your counterparty.

Compression Market Fundamentals

I spent much of my last post covering the circumstances which led to enhanced conditions for compression companies.

In short – COVID hit. E&Ps sent back units. Compression companies could cull and standardize their equipment. Supply chain strained acquisition of new units, enabling these companies to use customer dollars for new CAPEX purchase. Laterals got longer, fracs got bigger, well density per pad increased – collectively driving the need for larger HP compression. Large compression is “stickier”, since it is hard and expensive to move. Finally, each compression company picked a dance partner, consolidating and concentrating power.

The result? Pricing skyrocketed & contracts got longer.

So as an operator, how do we reverse the tide? It starts with understanding what picture these compression companies are trying to paint in the public markets. And the best place to look for that information is in investor presentations and disclosures.

The quick, Sal Goodman sales pitch compression companies have made to the street is rather straightforward:

“Demand for moving gas is growing due to LNG and AI energy demand. Yes, our customers are Oil and Gas companies subject to commodity pricing variability, especially as it relates to natural gas markets, but most of our revenue comes from the Permian Basin, a liquid rich area which requires a significant amount of compression to produce wells and move gas for the companies you like to own stocks in. These customers are big and credit worthy, reducing our revenue risk. Finally, our contracts are longer term (and getting longer) and our product is costly to move, increasing switching costs.”

With a 30,000ft understanding of the Compression Industry dynamics, we are ready to put our negotiating hat on to find the strongest possible strategy (or any) for compression contracting.

Negotiation Science

First, we need a basic understanding of negotiation science. Every strategic negotiation starts by quantifying the Best Alternative to Negotiated Agreement, or BATNA. There are two sets of BATNA in any negotiation; my BATNA and the Counterparty BATNA. Both of these can be normalized to a monetary figure, and the difference between these endpoints defines our Zone of Possible Agreement (ZOPA). The ZOPA marks the possible range of outcomes for that negotiation. The ZOPA range is the key driver behind Mainline’s Leverage Utilization calculation.

These BATNA’s are independent of each other and need to be calculated as such. A good analogy is blackjack; both I and the dealer have a hand. I can do certain things to build my hand. However, the dealer’s hand is independent from my hand. I can do my best to assess probabilities with the information that is available, but our hands are separate. That’s not the case in vendor negotiations; we can “count cards” through an understanding of macro sector and individual vendor level dynamics.

These are a series of key dimensions such as our revenue impact, relevant switching cost and other strategic variables from the perspective of the counterparty. Mainline does this analytically through the use of our Strength Index. Calculating Strength Index is important for several reasons. First, it helps us determine which vendors we have the weakest leverage with for a certain category. We rarely negotiate (nor would we advise such) with one party. We need to know which vendor we have the greatest leverage with and negotiate first with them, since this allows us to use precedent to our advantage. Additionally, it helps us determine the proper messaging for the next vendor negotiation while allowing more margin for error. This will allow us the most effective path at maximizing our ZOPA capture.

Mainline has a series of proprietary Strength Index metrics for all key accounts on an AFE or LOS, but even without that you can start by reading the counterparty 10Q.

Here are a couple of key drivers for Compression:

1. Revenue Concentration: Almost every compression company gets ~50% of its revenue from the top 10 customers; figure out where you stand at a regional level

2. Insourcing: KGS, USAC and AROC dominate the outsourced compression market, but it is estimated to capture 75% of the total market. Therefore, there is significant discussion on insourcing pressure on the earnings calls and within the 10K.

3. Artificial Lift Changes: A significant amount of compression is used for artificial lift, especially with the rise of HPGL.

If you have time, your can dive into the relative debt situation for each compression company. Debt servicing competes with dividends and buybacks. Thus, higher Net Debt / EBITDA, relative to their competition, puts a compression firm in a weaker position.

Let’s put this into use with an example.

For the sake of simplicity, let’s assume I am advising Mainline E&P Co in a strategic sourcing evaluation with Kodiak (KGS).

Mainline’s BATNA is relatively easy to quantify and understand. Who would we use if not for Kodiak? RFPs are a great way to build our BATNA in this regard. Utilizing a Multiple Equivalent Simultaneous Offer (MESO) allows us to negotiate beyond price, so we can discuss operational terms (uptime, discharge pressure), quality terms and safety factors to ensure we compare “apples to apples” between companies. We then can utilize Mainline’s normalization tool to put every evaluation on the same plane and simply to compare terms (dollars). Another strategic activity we could do is begin to evaluate our own insourcing strategy – we don’t need to act on it, the power is in having one that can be shared externally. This builds our alternatives and is a significant worry from the perspective of the compression company.

With our BATNA assessed it is time for the difficult work; assessing the BATNA from the perspective of KGS. At Mainline we always advise to start with an estimate for your revenue contribution on a regional scale.

The plot below shows KGS revenue by region over time. As you can see, the distribution follows the theme we stated above; Nearly 70% of the revenue comes from the Permian. A couple of things to also note from Mainline’s supplier relationship dashboard:

• 12% of KGS’ compression inventory was M-T-M as of the end of Q3

• ⅓ of compression contracts come eligible every year

• The top 10 customers account for nearly 60% of total revenue!

Moreover, we know who most of those customers are:

There is a lot we can do with this data.

We see that KGS made an estimated ~$5MM in Q3 2024 from the DJ basin. On a monthly basis, this equates to $1.68MM. Thus, our $.620MM per month contribution equates to ~33% of KGS’ total DJ basin revenue, a meaningful contribution when broken down regionally. Again, thinking about BATNA from that perspective, it would be difficult for KGS to replace that revenue. We could calculate out just how difficult it would be, which is much of the work we do on the consulting end. To do so, we can tie to Colorado air permits to estimate the distribution of the remaining 67%. We could also calculate it out among the other compression companies by market share to understand the entire outsourced market.

Now, of course, not all of these contracts come up from renewal at the same time. However, we want to aggregate as much volume as possible so that we create a meaningful volume of that 33% to negotiate at one time. This is the power of rolling as many MTM as possible or at least trying to sync up renewal dates to come around the same time.

I can also pull forward volume. If I know my development plans, even loosely over the next couple of years, I can pull forward that volume to negotiate at a singular point of time. Furthermore, I can use public information to understand my peers’ activity level and model how the market would probabilistically shift over time.

Again, at Mainline Ventures, our proprietary software calculates this on behalf of our clients to determine ZOPA, strength index and leverage utilization capture. But the exercise above can be used on the back of a napkin to begin the analytical quantification – knowledge is power, and that knowledge is readily available if you know where to look.

The job isn’t done; next comes the more qualitative messaging portion leading into our MESO creation. I will cover that in my next post.