Overdiscounting… the future of offshore…

The qualities most useful to ourselves are, first of all, superior reasons and understanding, by which we are capable of discerning the remote consequences of all our actions; and, secondly, self-command, by which we are enabled to abstain from present pleasure or to endure present pain in order to obtain a greater pleasure in some future time.

Adam Smith, 1759

 

For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence.

John Maynard Keynes, 1936

 

The slide above taken from Transocean highlights how competitve offshore has become on a per barrel recovered basis. I’ll ignore the fact that the cost estimates for shale appear high because it isn’t my point: the real point is that to compete in the modern environment offshore oil production will have to be significantly more profitable on a per barrel recoverable basis because there is significant evidence managers underestimate (“overdiscount“) future financial returns the further away they are. Shale returns, while lower, are produced in a much shorter time period than offshore and behavioral finance shows strong evidence that managers prefer these sorts of returns at lower levels when compared to higher returns further away.

In  2011 Andrew Haldane, Executive Director, Financial Stability at the Bank of England, and Richard Davis, and Economist at the Bank of England spoke at a Bank for International Settlements conference and noted:

[r]ecently, in 2011 PriceWaterhouseCoopers conducted a survey of FTSE-100 and 250 executives, the majority of which chose a low return option sooner (£250,000 tomorrow) rather than a high return later (£450,000 in 3 years). This suggested annual discount rates of over 20%. Recently, Matthew Rose, CEO of Burlington Northern Santa Fe (America’s second biggest rail company), expressed frustration at the focus on quarterly earnings when locomotives lasted for 20 years and tracks for 30 to 40 years. Echoes, here, of “quarterly capitalism”.

In 2013 McKinsey & Co and CPPIB surveyed 1000 Board members and found:

  • 63% of respondents said the pressure to generate strong short-term results had increased over the previous five years.
  • 79% felt especially pressured to demonstrate strong financial performance over a period of just two years or less.
  • 44% said they use a time horizon of less than three years in setting strategy.
  • 73% said they should use a time horizon of more than three years.
  • 86% declared that using a longer time horizon to make business decisions would positively affect corporate performance in a number of ways, including strengthening financial returns and increasing innovation.
  • 46% of respondents said that the pressure to deliver strong short-term financial performance stemmed from their boards—they expected their companies to generate greater earnings in the near term.

The implications for offshore investment (decision tree here) versus the certainty of a short payoff from shale investment are obvious. It has been well known in economics for years that managers overdiscount future returns: in behavioural economics it falls under time preference problems. Humans are neurologically wired with a preference for immediacy that affects economic behaviour. As Haldane and Davis make clear:

This evidence – anecdotal, survey, quantitative – is broadly consistent with popular perceptions. Capital market myopia is real.

As early as 1972 Mervyn King, who would later become Governor of the Bank of England, noted that managers in the UK overdiscounted returns from long term investments. This stream of literature dried up as the Efficient Market Hypothesis took over as the vogue theory but it doesn’t change an actual reality.

The fact is that in competition for marginal oil investment dollars there are institutional and behavioural factors pushing for short-term solutions. This article in the Financial Times notes that Shell is under pressure as the CFO hasn’t outlined when the promised $25bn share buyback will start. Do you think the CFO at Shell is pushing for a new Appomattox because it has lower economic costs (but high CapEx) or will she simply seek to favour short pay-off, lower margin, projects?

Managers pushing offshore projects in E&P companies are running into senior managers who represent exactly those type of Board members surveyed by McKinsey and CPPIB. These managers aren’t wilfully myopic, the shareholders are pushing them to be, but they are more focused on immediate payoffs and overdiscounting the costs of the offshore projects. Again this quote from Haldane and Davis seems apposite:

Graham, Harvey and Rajgopal (2005) surveyed 401 executives. They found three striking results. First, managers would reject a positive-NPV project if that lowered earnings below quarterly consensus expectations. Second, over 75% of the sample would give up economic value in order to smooth earnings. Third, managers said that this was driven by the desire to satisfy investors.

When there was no shale this wasn’t an option as the question was “Do you want oil or not?”. The question is a whole lot more complex now and involves and assessment of certainty, risk, payoff potential and timing, and the pricing uncertainty of a volatile commodity over the long run. All this points to the fact the the financial and institutional barriers to new offshore projects are much higher than simple “rational” expectation models of future payoffs would suggest.

 

The trade-off between shale and offshore investment and the effects on marginal demand…

The rising oil price is about to test one of the major tenets of this blog: namely that there has been a structural change in how oil is produced and that a sharp comeback in offshore demand, as has been seen in previous cycles, is extremely unlikely. At the moment all the data appears to be pointing to the ever increasing importance of shale over offshore for marginal investment dollars, and in fact the higher price may be encouraging shale investment over offshore as smaller E&P companies can meet volume increases through cash generated and open capital markets and larger E&P companies take a margin hit but keep CapEx commitments steady and not expanding offshore much beyond long signalled commitments.

It is also worth noting that this recent price rise does not seem related to demand factors:

physical markets for oil shipments tell a different story. Spot crude prices are at their steepest discounts to futures prices in years due to weak demand from refiners in China and a backlog of cargoes in Europe. Sellers are struggling to find buyers for West African, Russian and Kazakh cargoes, while pipeline bottlenecks trap supply in west Texas and Canada.

At the moment Permain is trading on a discount to WTI of between $7-12 per barrel given transportation constraints via pipeline out of the region. Something like 1.5m barrels per day opens up by March next year though so this is a temporary problem. The process of capital deepening for shale is also occuring as refineries in the region change their intake capacity for the ‘light sweet’ crude that currently needs to be mixed with heavier Brent. This will take time, and cost billions, but every year this capacity slowly increases with each maintenance cycle at the large refineries, incentivised by the large discount to Brent.

PVM has reported that as the oil price has rised Texas’s energy regulator issues 1,221 drilling permits in April, up around 34% from a year ago. The BH rig count added another 10 rigs to the US oil fleet last week but also another 2 offshore rigs, but that only brought the offshore count back to a year ago, the same for the Gulf of Mexico (+1); whereas the land rig count is up ~19% from a year ago.

BH rig count 11 May 2018.png

Again this leads directly to higher production. In June alone US shale production will add the rough equivalent of a Clair Ridge to their output levels:

IMG_0511.JPG

The US shale industry is the single biggest transformation to the oil and gas industry since the pre-salt fields were discovered and developed in Brazil. Those developments led to an extraordinary rise in the price of tonnage and changed the entire offshore supply chain. It is simply not logical to accept that a change as big as this in volume terms is occurring in the US and that it will not have similarly profound impact on the offshore industry.

The correlation between the oil price and the US rig count and the oil price and US production levels has an r-squared of ~.6 according to IHS Markit (data below) if anyone is interested. That means each $1 increase in the price of oil leads to a .6 increase in the rig and production volumes.

IMG_0512.JPG

Whereas for offshore a strong increase in the price of oil over the last twelve months has seen this happen to the jack-up and floater count:

Jackup and rigs 11 May 18.png

Source: Pareto Securities.

Jack ups and Floaters demand has been effectively static over the past year. The workhorses of future offshore production increases and demand simply haven’t moved in a relative sense. The cynic would argue their correlation to the oil price has been reduced to zero (which clearly isn’t true), but it shows how time delayed this recovery cycle is for the front end of offshore. But the flat demand for jackups and floaters is exactly what most subsea vessel and supply companies are saying: demand has bottomed out but over supply and a lack of pricing power persists. The good explanation of why so many OSV and subsea companies claim to be doing record tendering and their  continued poor financial performance lies in the data above.

What I call (sic) “The Iron Law of Mean Reversion”, which seems to substitute for thoughtful analysis, can be seen in this slide:

Transocean Iron Law.png

The heading is simply a logical fallacy. There is a load of evidence to say shareholders are more comfortable with lower reserves now and less offshore production is being sanctioned because the money is being spent on shale.

At some point the disconnect between companies like Standard Drilling, buying PSVs at pennies in the dollar and keeping them in the active fleet, and the general oversupply will be realised. In the CSV/ Subsea fleet things are no different: Bourbon, Maersk, and other vessel owners state they are building up contracting arms, yet again all they do in total is keep supply high for a relatively undifferentiated service and erode each others margins (and spend a lot on tendering). The service they operate has no real differences to the ROV companies like Reach, M2, ROVOP, IKM ad infinitum and other traditonal vessel contractors like DOF Subsea. Sometimes they have a good run of projects… and other times…

Bourbon Q1 2018 Susbea.png

Project work is lumpy but Bourbon stated that the project market was especially poor versus suppy. In the old days boats were scarce and enginneering had a relatively small mark-up which the mark-up on the vessel accentuated and flattered. But getting a CSV with a large deck and crane now is so average it is no wonder everyone claims to be tendering: E&P companies are clearly getting them all to bid to reduce project costs. There is clearly more work being done on vessels at the moment, but there is a limit as shown above, and no project delivery companies have any pricing power.

The larger contractors appear to be winning a greater porportionate share of work at ever lower margins as TechnipFMC recently showed:

Technip Q1 2018.png

Given Technip is now winning as much work as it burns through demand has clearly hit the bottom. But even it has to lower margins to win. The commodity work, where you grab some project engineers and a couple of ROVs on a cheap boat (often IRM related), is clearly going to have all the profit bid away for a long time, whereas construction work still has value even in the downturn; but it entails serious risk and range of competencies that are beyond the realms of dreaming about for the smaller contractors.

This relationship between the rising price of oil and marginal demand for shale verus offshore will make this recovery cycle for offshore different to any other. IRM is important in the short-run, but the fewer wells and pipes laid now will ensure not only is future construction work lower but so to is the installed based. There will clearly be a recovery cycle, demand is above last year’s levels and subsea tree orders are well ahead of 16/17 lows, but there is clearly huge competition at the margin for E&P investment dollars in offshore versus onshore which is a competitive dynamic the offshore industry has never had before.

Devil take the hindmost…

“They run all away, and cry, ‘the devil take the hindmost’.”

Philaster

You can’t make this up: the above slide from the latest SolstadFarstad results sums up the problem: in putting together 3 companies to create a “world leading OSV company”, before they can even get the first annual report out, they have to admit that one of the three is insolvent and  another of the three has a serious covenant breach. This was always a triumph of hope and complexity over a serious strategy.  Having spent NOK 986m in Q1 to get NOK 875m in revenue, a NOK 469m loss after adding back depreciation, a financial highlight was considered a NOK 12m saving in overhead due to synergies! Personally I would have forgone the NOK 12m in synergies to not have two subsidiaries in default that threatened the entire company’s solvency? You don’t get any sense from the public announcements that anyone has a handle on how serious this is.

If there was any value in it stakeholders might want to have an honest look about what got them to this point? In reality I don’t think it is anything more complicated than wanting to believe something that couldn’t possibly be true: namely that at the back end of 2016 the market would recover in 2017. Not confronting that meant not having to come up with a proper financial structure for this enterprise, but really it meant not having to liquidate Farstad and Deep Sea Supply. But it also means that management and their financial advisers were unable to structure a credible 12 month business plan to be accurately reflected in the transaction documentation. This a serious failure and any realistic plan forward needs to recognise this. Talk of SolstsadFarstad being part of industry consolidation, as anything other than a firesale by the banks, just isn’t serious either.

Prospect theory, an area of behavioural finance that recognises people overweight smaller chances of upside rather than accept losses, and the disposition effect where people hold losing investments for longer than they should, seem apt for the lending banks  and management here as an explanation. But the current plan of getting waivers from the banks and waiting for the market to recover is clearly not a serious plan either.

SolstadFarstad will not survive in its current form. There is absolutely no way the assets are worth NOK 30bn (under any realistic valuation  metric be it cash flow, economic, or asset) and no way that they can ever hope to pay the banks back NOK 28bn, without even worrying about the bondholders. The scale of increase in day rates in a few years time would have to be so extreme it just isn’t credible, and every year day rates stay  low requires you add back the forgone assumptions about their increase on a future year increase. The assets are aging and maintenance costs are going up. SolstadFarstad is like a zombie bank where it has no capital because no one will lend it any money to grow (wisely) but it cannot get any equity because the debt is so high. The only chance of survival would appear to be a massive debt haircut, I don’t know what the number is but I would guess at least NOK 15-18bn, and then to get new equity in and come up with a sensible plan.

However it isn’t just money. I don’t think I have ever seen a major merger go wrong so quickly and then have senior management so blithely unaware about how serious the situation is.  The timing on the Deep Sea/ Solship 3 announcement being just one example. A good study here shows management who look beyond the external environment are more likely to survive significant industry change.

One very simple fact of the environment changing is was made by Subsea 7 recently:

John Evans

Yeah. So, what we’re seeing in the market today is the return to the seasonality we saw five to six years ago where the North Sea was relatively quiet in quarter one and quarter four. It’s really, really straightforward that, you know, the weather conditions are particularly extreme in those periods, and therefore then, clients are not looking for their work to be performed during those periods. During the high point in the market, we work right away through those periods and clients were prepared to pay the additional cost to get their first production online faster. Our aim is that we will see in quarter one and quarter three our active fleets and we’ll be back towards a reasonable level of utilisation in line with previous percentages for active fleet utilisation. But then we expect to see again the corner of sea market going relatively quiet in quarter four. So that’s what we really see and in terms of seasonality for us. [Emphasis added].

SolstadFarstad used to charter ships on a 365 basis. Now it has a large number of vessels that take time risk on some other company’s projects. These vessels are going to have less utilisation than before because 2 of the 4 quarters of a year are quiet. Unless there are very high day rates, which there aren’t, a ship that works 50% of the year is worth less than one that works 100% of the year. SolstadFarstad, Bourbon, Maersk, all these similar vessel owners are dealing with a fundamental change in the market and therefore the economic value of their asset base is dramatically lower given the fixed running costs. SolstadFarstad pretending they can ever make the banks whole in such a situation is absurd. A major restructuring gets closer by the day.

[Book recommentdation: Devil Take the Hindmost: A History of Financial Speculation]

Shale productivity, oil prices, and marginal demand…

The quote above comes from the CFO of NOV Global, Clay Williams, in 2011. Clearly he understood the transformative nature of shale before many (as well as putting it as eloquently as anything I have ever read). The question for a long time for many was when will shale stop getting funded? But actually the shale revolution is beyond quetion now and the real question for offshore in a era of rising prices again is what proportion of new investment is directed to offshore versus onshore? Particularly for asset owners with high fixed running costs, and rates at below cash break-even on an annualised basis, what is likely in the short-term?

One of the reasons shale continued to be funded wasn’t just rising oil prices it is because capital markets in the US are efficient enough to support business models with high rates of productivity improvement even if the payoff is not immediate. This recent presentation from Helmerich & Payne, the largest US land based driller, shows why:

HP Well efficiency.png

H&P are targeting a 40% increase (as a stretch goal) in efficiency/productivity, an outcome that would further rapidly enhance the economics of shale. Not only that they are doing it with an assumption of pricing power for the drilling contractor where a 20% improvement in efficiency in operations for the customer leads to a 33% increase in their prices (15k-20k), and the next 20% increase brings them another 25% (20k-25k). With these sort of possible productivity improvements, and a much shorter payback time, it is hard to see a freeze in capital funding anytime soon, and in fact at current prices the investment boom is self sustaining anyway. This incremental learning-by-doing and constant improvement is a core part of manufacturing efficiency and has become part of the standard DNA of manufacturing companies (for a fascinating look at how this came to be in the car industry read The Machine that Changed the World). Deming would be proud.

Those sort of productivity improvements, on a per barrel delivered equivalent basis, are the competition for offshore production at the margin for project investment decisions. I continue to believe this will favour much larger, high volume, offshore fields over shallow water developments. Offshore faces the hurdle of clong lead times that were previously just assumed as an unavoidable part of the oil basis. A blog post for another day is the insights behavioural economics offers to this.

Pioneer Natural Resources also came out this week talking up their productivity:

Pioneer Improvement.JPG

This data point is interesting and is the crux of future demand across the offshore supply chain:

Shale rigs vs offshore.JPG

That index ratio is really what will drive the strength of any offshore recovery. Since May 16 up until January 18 rising oil prices (much slower than currently) were met with a massive increase in the shale rig count and continued decreasing demand of the offshore rig count. In May 16 the price of WTI was ~$44.00 and Jan 18 the price of WTI ~66.60 so a ~51% increase in the price of oil was followed by a 160% in US land rigs and a 22% reduction in offshore rigs. Any statistical model of industry demand that not have this relationship in the regression is to my mind invalid. Any statistical model without a period break from c. 2014-2016 should similarly be treated with exceptional caution. The future, statistically speaking, will not be like the past.

There are a host of reasons (many covered here previously) but the argument that increasing oil prices will be met at the margin first with an increase in demand for short cycle shale seems irrefutable. Any “offshore recovery” post the shale revolution is clearly going to be very different to recovery cycles prior to this enormous investment and capital deepening process that has taken place in the last 5-7 years.

MPV Everest and DSV business models….

So it appears the Russians have paid equity and have fully taken delivery of the MPV Everest. Well done Keppel on getting paid the full contract value for such specialised tonnage in this market. I was wrong to cast aspersions on the soundness of the contract. And well done MCS for following through and taking full asset risk on this. I am not sure anyone esle can claim such a credit across most offshore asset classes?

The vessel looks close to signing some short-term work in Asia and will have the dive system commissioned as part of this. But…

The problem is the day rate… particularly as this is a vessel that looks set to operate at not that much more than cash breakeven on the first job and it has an empty schedule beyond that. The fact is the entirely speculative strategy of building high-quality DSV assets and thinking they would get a premium day rate, while displacing older tonnage, is having an extremely expensive initial experiment and proving its instigators both wrong and right…

Right in the fact there is a premium, but wrong in total economic terms because it is nowhere near enough for people to cover their cost of capital or hope to recover the builkd cost. The Everest was always a rescue job, having been built for a terminated contract, but others are not. UDS is rumoured to be getting USD 50k a day from McDermott for the Qatar job, but sitting in Singapore waiting for someone else’s boat to break is a high-risk strategy and unlikely to be profitable in the long run. The Everest looks like commanding a 10-15% premium to competitor vessels in the spot market but would need a ~400% premium to have any hope of recovering the build cost. This reflects the overspecification of the vessel, the fact it cannot command ice/polar rates, and the oversupply in the DSV market.

My only point on this has been that when a wall of oversupply meets a very weak market then economic returns will be substantially below economic costs. Continuing to deliver high quality tonnage to undercapitalised operators and chartering parties will just prolong any downturn for the existing fleet owners. But if initial indications are anything to go by MCS are in this for the long run, they have been burning c.10-15k per day Opex with Fox since delivery and purchased some second hand ROVs (from M2 I understand); and having put USD 200m into the vessel are unlikely to walk away quickly. Unfortunately the most logical, and likely, reaction from competing owners is simply to drop prices even more.

Sunny Sunday afternoon reading…

Very interesting podocast/transcript with Scott Sheffield, Chairman and ex-CEO of Pioneer Natural Rescources…

Pioneer is listed as number one, lowest breakeven, $19 — $20 breakeven price. And so, anything about $20, you start getting your money back. So, you really need something to get a 10%, 15% return. You need something probably in the mid 30s, long term. And the company has come out recently over the last 12 months saying it’s going to a million barrels a day plus and it could easily do that at $45 oil price flat for the next 10, 20 years…

[on Permian growth:]

And I think this year will probably be more in the 1.3 million barrels a day from year end 2017 to year end 2018, we’ll grow about 1.3 million barrels a day. And roughly about 800,000 will be from the Permian. We had about 800,000 from the Permian last year, of oil. Probably they have another 800,000, it can be a little bit higher. There are some issues I’ll talk about later with you, the backwardation, the constraints, pipeline constraints, people constraints, but I’m predicting another 800,000 long term in our discussion. Long term, Permian basin will get up to somewhere — seven million barrels a day, it could go higher. But at least seven in the next 10 years from the 3.2 that you mentioned earlier….

A long way to go. We’re only drilling three benches. There’s about 12 benches of that 4000 feet of Shale and people are only focused on three of those benches. So, we’ve got another nine benches of Shale formation to drill as we play out the Permian basin over the next several years..

Random Friday afternoon thought… Borr and McKinsey….

They both can’t be right can they?

From a downbeat McKinsey view on the jackup and floater market:

McKinsey jackup demand 1.0.png

From a recent Borr Drilling presentation:

Borr Jackups business.png

I know you can argue high-end jackups will recover etc… it’s just not a booming market if you have this much uncontracted capacity:

Borr fleet status.png

And maybe you would prefer less analysis like this from McKinsey:

After seeing rig activity stabilize during the first half of 2017, it resumed a declining trajectory in the second half of the year, hitting record low levels (estimated at about 300 units for jackup rigs and 140 for floaters). This will keep downward pressure on day-rates, with the few rigs that are finding new contracts, doing so at a sharp discount to the rates earned prior to the oil price decline (about 25 percent for jackups and about 75 percent for floaters from 2014 levels). This means lower margins for rig owners, even though they have reduced operating costs by around 70 percent since 2014.

Roll the dice!