Baker Hughes (NYSE:BHI) will report its Q1 2013 earnings on Friday, April 19. Like most other U.S. based oilfield service companies, Baker Hughes has been hit by weaker on-shore drilling in North America and also by increasing raw material prices which resulted in lower margins through most of 2012. In Q4 2012 , the company’s quarterly revenues remained relatively stable year-over-year, while income from continuing operations declined by around 36%. For this quarter, we expect the firm’s results to be weighed down by weak North American gas drilling that has dropped to a 14-year low and also because of slower than expected winter drilling activity in Canada. This weakness could be partially offset by better operational efficiency, better control over raw material costs and a stable international performance.
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North America Pumping Market Will Remain Tough, But Expect Some Cost Improvements
Baker Hughes derives around 52% of its revenues from North America, a region where drilling activity has been sluggish for some time now. Low gas prices have caused gas directed activity to plummet from around 726 active rigs (in both the U.S. and Canada) to around 464 active rigs over the past year. This has adversely impacted pricing for services such as pressure pumping which are used for fracking shale wells.
Since Baker Hughes derives nearly 30% of its revenues from pressure pumping, it one of the firm’s most important businesses.  The company estimates that there is up to 25% of excess pressure pumping capacity in the U.S. alone. Even though oil directed drilling has increased from around 1,437 to 1,474 rigs, it hasn’t been enough to absorb the excess capacity since shale oil wells require less pressure and stimulation compared to shale gas wells. The chances of a reversal occurring in 2013 look slim given that around 300 additional rigs must be active to absorb the excess pumping capacity. 
Over much of 2012, the company’s margins were also hit by high prices of guar gum, a raw material used in the fracking process. However, guar prices have softened of late and the firm is expected to have consumed most of its higher priced guar inventory that it accumulated in early 2012, meaning that direct costs could decrease in this quarter. Additionally, the firm has been substituting around 20% of its guar gum requirements with cheaper alternatives that it has developed in-house. Baker Hughes has also been carrying out other operational improvements to counter the lower margins in pumping services. For instance, it now operates around 40% of its pumping fleet on 24-hour shifts and has also begun using natural gas along with diesel to power a portion of its fleet.
Possibility That Gulf Of Mexico Activity Could Have Been Hit Temporarily
Over 2012, the firm put up a solid performance in the U.S. Gulf of Mexico with revenues from the region growing by over 30%, outpacing the 22% growth in rig count thanks to better pricing on contracts and market share gains. However, there could be a threat in this quarter as around 25% of all rigs in the Gulf faced maintenance related downtime (estimated at over 2 weeks) due to the replacement of bolts on some safety related equipment.  While it’s unclear whether Baker Hughes was providing services to any of the rigs under maintenance, competitors like Schlumberger (NYSE:SLB) did mention that their Q1 activity was impacted.
Canadian Winter Drilling Season Was Not As Strong As Last Year’s
Drilling activity typically picks up in Canada over the winter and remains particularly strong during Q1 every year with some Canadian companies spending as much as 50% of their drilling budgets over this season. The average number of rigs in Canada in Q1 was around 530 compared to 370 in Q4 2012. However, activity hasn’t been as strong as last year’s since the average Q1 rig count is around 10% lower year-over-year. This is because many oil and gas companies in Canada have been scaling back on their exploration and production budgets due to volatile prices for heavy oils and natural gas.
Global Operations: Iraq and Africa Important For Growth, One-time Forex Charges In Venezuela
Africa Will Be Growth Driver For The Europe/Africa/CIS segment: The overall rig count in Africa grew by around 15% in Q1 as big oil and gas companies have been scaling up their presence in this vast yet relatively undertapped market. Over the last year, Baker Hughes has benefited from increased activity in Mozambique, new facilities in Pemba and its strong position in Nigeria, the Ivory Coast and Angola, and we expect these regions to continue to perform well.  North African countries like Libya and Algeria also have also seen their drilling activity pick up over the last year, but there are several geopolitical issues and security risks related to operating in these regions.
Progress In Iraq Is Important From A Margin And Growth Standpoint: While Iraq has been a source of margin contraction for Baker Hughes over the last few quarters due to high mobilization and start-up costs, it is a strategically important market given its massive and underexploited hydrocarbon reserves. As of Q4 2012, the firm had 7 operational rigs in the region and could add two more rigs during Q1. We will be closely watching the firm’s progress in ramping up activity in the region.
Venezuela Forex Loss: Baker Hughes is expected to take a one-time $25 million foreign currency related charge in Q1 for its Venezuelan operations.  Since Venezuela’s government relies heavily on oil exports, it recently devalued its currency from around 4.3 bolívar to the dollar to around 6.3 bolívar to the dollar in a move to improve its finances. The devaluation has impacted most U.S. oilfield services firms. As of last year, Venezuela accounted for around 2% of Baker Hughes consolidated revenues. 
We have a $50 price estimate for Baker Hughes, which represents a 7% premium over its current market price.Notes: