Shale watch… Lucky or smart?

” I have spent my whole professional life as an international economist thinking and writing about economic geography, without being aware of it”

Paul Krugman

From a great article in Businessweek:

today the Permian is so important to Chevron’s fortunes that saving 10 seconds each time drill pipes are linked can translate into millions of dollars in cost savings across Chevron’s huge operations there…

“We were ready to let others spend their money and work through those 5,000 ways how not to make a light bulb before the opportunity to make money really presented itself,” he says. “The decision to hold the Permian Basin was very deliberate.”

On a day in which the EIA upped its well productivity numbers for US shale:


It’s all about productivity. Which is why, without an industrial cluster, I can’t see this Saudi dream working for many years…

E&P versus offshore strategy plans… Not what you think?

Last week ExxonMobil released its analyst day presentation. It has a number of interesting things, but I wanted to highlight the fact that although it feels like E&P companies are back making real money, which they are, it may not feel like that to them. And as this article on Bloomberg makes clear investors in these companies want management to keep the lid on CapEx, which is one of the cash flows they really can control:

Exxon argues it has a formidable set of projects, pointing to such goodies as offshore Guyana discoveries, as well as the Permian basin. The problem is that investors have seen this story before, and quite recently, with the oil majors. And while Exxon’s reputation might once have enabled it to simply be trusted to deliver, that is no longer the case.

Here is a Bloomberg shot showing you what would have happened had you purchased 1000 ExxonMobil shares in 2013 and sold at the end of 2017 (about when plans were probably being agreed):


You were down fractionally in the share price and up overall marginally only after reinvesting dividends. So the Directors are probably not coming under massive pressure to throw more money at production when 4 years after the price slump the owners of the ExxonMobil are trading below their 2013 entry cost (or fund market value). This is very oversimplified, but I make the point only because it has become an article of faith amongst some in the offshore space that E&P companies are verging on the irrational by not increasing offshore project spend when it is far from clear they are, or that they face pressure to do so.

Which is why you end up with a slide like this from a company that has just made some huge offshore discoveries:

Disciplined value.png

ExxonMobil focuses on Brazil and Guyana in terms of offshore development. I think the larger E&P companies switching to larger developments only offshore continues to mark a real shift in the market because the smaller companies just don’t have access to the development funding they used to for smaller fields.

I thought this was interesting:

XOM Guyana.png

Versus shale:

XOM tight oit.png

ExxonMobil appears to be implying shale has a lower breakeven pricing at $35 to get to a great than 10% return? And as always productivity is increasing:

XOM productivity increase.png

The other thing that struck me about the presentation was just how many investment opportunities management have across the portfolio, and they are increasing CapEx across the forecast period from USD 24bn to USD 30bn, but it is clear that downstream and other activities are also important. Investors want growth but maybe some at lower volatility that a fluctuating oil price offers, and as this graph shows ExxonMobil will make money at USD 60 ppb oil, but not ridiculous amounts.

XOM Fundamental.png

Obviously XOM is a leveraged bet on the price of oil increasing. But at the moment the upstream managers probably feel they have a free option on the excess capacity in the offshore supply chain that means any rapid price increases can be met with shale and a slower commissioning pace of offshore fields. Also these larger discoveries allow greater flexibility to speed up infield developments at a lower cost and asset utilisation.

Bourbon Offshore recently released it’s Bourbon in Motion strategy which to my mind is one of the most honest assessments of the scale of the challenge facing offshore companies I have seen. I think Bourbon are well worth listening to because I cannot think of another company that has played the capital markets as well as they have in financing their operations. Here in 3 simple points is the problem every offshore company faces:

3 issues.png

And it was really nice to see it wasn’t followed by a slide which said “but we are doing lots of tendering”.

A little history is required: In 2008  Bourbon had €1.3bn in debt and was focusing almost exclusively offshore. The annual report for that year described the returns in the offshore business as “exceptional”, and like all good companies it took this as a price signal to invest and grow the business further. Bourbon did this, because as the financing market was so flush it could borrow a lot of money, by 2013 debt had increased by €1bn to reach €2.2bn and the Directors were so confident about the business they proposed a 34% increase in the dividend.

In 2013 and 2014, taking advantge of the exceptional sentiment in the market Bourbon sold, and then leased back, vessels worth €1.65bn to Standard Chartered and ICBC which also allowed them to write up the value of the rest of the fleet by €900m in value. It’s hard to overstate how good the timing of this transaction was, timed literally to perfection, as the vessel market peaked in value they got two banks to pay not only top dollar for the assets but lease them back at less than 11% per annum. I doubt if sold on the open market here these now commodity vessels would fetch a third of that.

I am not implying Bourbon knew this would happen, what I am saying is they worked out that perhaps this was as good as it was going to get in the industry and they should bank what they could and take some (more) money off the table for their shareholders. As a management team it made them look very smart.

So when Bourbon tell you things are grim I think it comes with a degree of credibility few can match. Particularly when backed by some solid data:

The worst crisis ever

Which we all know by now. As I have said here repeatedly understanding that CapEx expenditure is what drives utilisation at the margin, and therefore overall fleet profitability, is crucial. And the reason I used ExxonMobil above was to show that this CapEx number, which I call “The Demand Fairy”, is unlikely to miraculously change in the short-term.

Offshore will still be an important part of the energy mix, but the growth of shale, as the left hand graph below makes clear, is having a huge impact on vessel utilisation and therefore industry profitability:

Bourbon Offshore production.png

The region reserved for shale is an area 3 or 4 years ago most people investing in offshore would have believed their assets would be servicing. And when you rely on 75-80% utilisation just to break even that in effect changes the whole economics of the industry, because if it knocks even 10% utilisation back across the fleet everyone is struggling to break even on their assets.

The right hand graph shows the enormous drop in CapEx. The fact that more projects are being sanctioned but the spend is lower just highlights what company results are showing: the volume of work has increased slightly this year but the value being paid for it has not (or reduced in some cases). This is likely to be a structural feature of the industry going forward that previous margin levels will simply not recover.

Like everyone else Bourbon is making a play to drive down the cost of operation of its commodity assets and add more value to the value of its subsea assets through moving up the value chain. Across the industry an entire species of contractor that used to make a good living by supporting larger contractors now aims to do more projects directly with E&P companies. Bourbon, like others, will likely win some market share, but they will do this by competing on price and driving industry margins down overall. For Bourbon it will still feel like more revenue than running the vessel alone, and in the long run it maybe, but grow to big and the larger contractors will be unlikely to charter your vessels. That slow increase in the blue bar on the graph is a result of all this extra capacity coming to market on the contractor side and why good Bus Dev staff in the industry are still remarkably employable.

It’s a post for another day the problem for offshore demand in shallow water, where projects could be done by flexibles and a vessel-of-opportunity, is that the smaller companies who used to do these projects simply have no access to the capital markets. Capital markets prefer smaller projects to be shale-based now where the cash-flow cycle is shorter. Think of the last time an Ithaca Athena development was commissioned on the UKCS?

Obviously the E&P companies are doing better than the offshore supply chain, the point is that they are not doing so much better that things are likely to change immediately. Bourbon seems to realise the future may look a lot like the present on the demand side and adjusting its business model accordingly.

(Hat-tip: SE).


Oil prices, speculators, and supply expansion…

An article from the FT here touches on an issue that has been discussed since there was an oil market:

Who trades oil is changing, however. Investors who bother little with details such as inventories and pipeline flows are replacing dwindling ranks of specialist commodities hedge funds. The shift could alter the way prices are formed…
Then who is driving oil positions higher? Newly prominent oil speculators are not necessarily reacting to news about supply and demand or utterances from Riyadh. Instead, they may be buying and selling oil based on moves in currencies, interest rates or the price of oil itself.

Namely, are speculators affecting the price of oil? You can see from the graph above that the exponential growth of Brent Ice futures contracts, which is cash settled and does not require physical product delivery, bears no relationship to the relative steady increase in the demand for oil. Some demand for these futures clearly reflects increasingly sophisticated financial risk management techniques, but some clearly represents purely speculative capital trading on price moves (often with large amounts of leverage).

There has been an entire industry in trying to ascertain the economic effects of speculators in oil markets. The IMF view is that they have no effect, but reputable economists at institutions such as the St Louis Fed disagree. A good summary is here.

My own (simplified) view, that accords to a well researched positions, is that speculators affect the volatility of the oil price but the not the final price over the long run.  Basic economic logic alone should dictate that if there is an increased amount of capital being invested in an asset class it will cause the price to rise, but when combined with leverage it adds huge volatility (quite simply if you have borrowed money to buy something and the price drops you tend to liquidate quickly to minimise loses). Which is why you see such huge swings in oil investment positions with a clear procyclical bias:

The big long.png

But the major point for those involved in service industries to my mind is that this is part of the explanation why there is not a linear relationship between the oil price and demand for oil field services. Directors at E&P companies make decisions about the long term price but ultimately the market for physically delivered product is more important when investing in production infrastructure, despite the large trading arms of the supermajors,  because they obviously do have deliver in the physical form eventually. They also benefit from miscalculating demand on the upisde through rising prices and a higher ROE on invested capital, so although they give up some amount of market share it’s a fairly small downside for erring on the side of caution.

Too many models that forecast the demand for oilfield services work are based on the forecast oil price rather than physical volume required. Too many management teams in offshore are using a rebound in the oil price as “proof” the “market” will eventually recover in demand terms when it is clear there is no linear relationship. As shale becomes the swing production method of choice offshore demand in particular should be relatively easy to forecast because in the new environment it will be supplying a baseload of physically demanded production while short-term changes in demand are managed by tight-oil. If someone in oil services tells you their business model is fine because the price of oil will rise I would suggest examining things a lot more carefully.

The shale productivity revolution in context…

“[W]e can see the computer age everywhere but in the productivity statistics”

Robert Solow


A great article in the FT today (behind paywall) on the boom in shale being driven by productivity increases (a near facsimile earlier version appears here). Readers of this blog will notice a consistent theme, as Krugman said, “productivity may not be everything, but in the long run it’s nearly everything”. The importance of this is that the US is turning shale into a manufacturing industry, small incremental improvements day-in, day-out, that cummulatively dramatically lower overall per unit costs:

In 2015, shale oil producers on average used 3,300 tons of sand per well, according to Petronerds, a consultancy. By last year, that had almost doubled to 6,100 tons per well. Delivering that much sand to the well site can require 250 truck movements. Other techniques for shale production have also been refined to increase the amount of oil that can be extracted. Modern rigs can drill faster, further, and more accurately than their predecessors. The process of hydraulic fracturing is being split up into more “stages”, allowing effort to be focused more precisely on oil-bearing rocks.

Innovations using the latest computing and communications technology, including remote operations, are also starting to be used more widely. Schlumberger, the oilfield services group, says that in 2014, 13 per cent of jobs it worked on at US onshore wells were supported by technical experts watching from its Houston campus. By 2017, that was up to 31 per cent.

This coincided with the IEA forecasting that the US will become the world’s largest oil producer by 2023 (graph above). [It is well worth having a look at the 13 slides at the bottom of the page of the IEA link]. Investment remains depressed in all but tight oil and the comment at the bottom of this slide regarding offshore is telling:

IEA Upstream Spending.png

The IEA is worried:

that despite falling costs, additional investment will be needed to spur supply growth after 2020. The oil industry has yet to recover from an unprecedented two-year drop in investment in 2015-2016, and the IEA sees little-to-no increase in upstream spending outside of the United States in 2017 and 2018.

“The United States is set to put its stamp on global oil markets for the next five years,” said Dr. Fatih Birol, the IEA’s Executive Director. “But as we’ve highlighted repeatedly, the weak global investment picture remains a source of concern. More investments will be needed to make up for declining oil fields – the world needs to replace 3 mb/d of declines each year, the equivalent of the North Sea – while also meeting robust demand growth.”

The real questions here revolve around how much capacity is being replaced annually, and it is simply not true that 3mb/d are not being replaced at the moment. The producutivity improvements in shale above are part of the solution. Other questions are what sort of price increases would crimp demand? etc. There appears to be no change in investor expectations that they want E&P companies, certainly large ones, to reduce debt and increase shareholder payouts, and therefore capital projects will remain subdued. There is also a strong feeling in the investment community that reserves can be run down.

Without wishing to sound like a broken record the “Demand Fairy” isn’t saving anyone in offshore. Offshore needs to re-engineer it’s business model to compete. The IEA is clear that this weakness will be felt from 2020 onwards, so even if you accept their reasoning, that is a long time to keep burning OpEx if your business model cannot even breakeven in the current climate.

I view shale as a technological revolution and believe that no economy is better suited to maximising its potential. Perez defines the major economic technical revolutions since 1770 into five categories, and the US is dominant in the last three:

Tech Rev 1770 -2000s.png

Revolution is an overused word. But according to Perez’s definition, that I agree with, the shale industry is a Technological Revolution (TR):

Tech Rev Definition.png

This to me is the most interesting part of economic history, because while there are nuances the broad economic development of industrial patterns are really well understood. A classic article here compares the development of the computer industry to electric dynamo. Like shale it is a story of how US capital markets funded ambitious companies, vast economies of scale, manufacturing efficiency gains, and the slow initial diffusion of producitivity gains (think tight-oil 2007).

How long can this positive productivity feedback loop, where innovations throughout the system positively affect other inputs, continue? A long time I suspect. Shale may not be subject to the same volume effects as the PC industry but it still makes an interesting comparison (Allen):

Computers deflator.png

(For those who can’t remember logarithmic maths from school all the left hand bar of the top graph means is “this is a really big number… so big we have a formula to make it shorter”. And the bottom graph just means that even though the price dropped really quickly a lot of new features were added as well). This is a hallmark of the US economy and a manufacturing industry based on constant productivity improvements.

An earlier, and slightly different technical revolution, can be seen with the invention of Corliss Steam Engine,  which allowed America to break free from the constraints of water power in the 19th century (Rosenberg and Trajtenberg). Like shale this was an energy revolution, one that changed the structure of the US economy and allowed manufacturing and urbanization to begin in earnest. Corliss Steam Engine.png

Everytime I write about shale I want to write something about the incredible economic period of the 1930s: How US mass production techniques, a revolution in both managerial skill and capital formation, led to the creation of the economy that created Victory Ships and transformed the Ford factory at Willow Run (YouTube watch this, seriously) into the manufacturer of the B-24 (“the Liberator“), innovations that arguably changed the course of the WWII, and ultimately the post-war global economy. There are surprisingly (and disappointingly) few journal and web references to this, and all are about the mathematics of productivity, when this is really a story to be told at the company level. However, economic development is path dependent and these processes and learnings today are being applied in the shale basins every day, even if unwittingly. (For a broader read about what an incredible period the 1930s was in microeconomic terms this the best I have turned up so far).

So although I don’t understand the individual impact of every innovation listed on this slide I understand where they came from and the process driving this:

Nabors Rig.png

Once upon a time a PSV went for the low-to-mid USD 20ks a day. At the time of writing the BHGE rig count hit 800, the revolution therefore continues…

End of an era… goodbye to Orelia…

The end of an era as the DSV Orelia is scrapped (above). I would wager she has been one of the most profitable offshore assets in an economic sense over her life. With a build cost much lower in real terms than new build tonnage, and in a market with a much lower number of competitors, this asset would have paid for her keep many times over.

As she goes it is worthwhile considering that the huge margins Orelia generated were a signal for other players to try and replicate this formula and build competitive assets and businesses. Such is the long run nature of the supply curve these new assets continue to arrive long after the margins have vanished, and despite some new-builds costing vastly more in a nominal and real sense, it is not clear, beyond being more fuel efficient, that they are superior economic assets. It is notable that Technip has sold off a large potion of her diving businesses and assets and is only really present in the North Sea now, which is a clear signal how profitable they think the SAT business will be in the coming years. The unwillingness of Technip to commit to specialised replacement tonnage for the North Sea market I also thinks signals their view, and mine, that there has been a structural change in the North Sea SAT diving market and anyone going long on it should have a very robust business case, because without a rebound in construction work, the market looks oversupplied for years. Soon the well Wellservicer will join her and a new generation of assets moves to the fore.

The latest rumour I heard regarding replacement tonnage was that the Vard new build had been sold to Middle Eastern interests (specifically Bahrain) who were going to charter the vessel back to Technip. Given that this is the third version of this story I have heard (although from two sources now) I treat it with a degree of scepticism (linked to JMT!): surely with TechnipFMC’s balance sheet the best option would be just to make Vard a take-it or leave-it cash offer? Vard have always insisted on a clean sale, maybe time and reality have intruded on this wish.

The French Revolution and Venezuela…

As a follow on from my post on Venezuela a really interesting, and short, article at FT Alphaville (free) comparing Venezuela’s proposed “Petro” and the Assignats of the French Revolution. Maduro is well on his way to becoming a modern Robispierre, with exile or a similar fate awaiting him. Tony Yates highlights that nothing in Venezuela, not the revolutionary tendencies, or the economic solutions of the revolution’s leaders, have changed over time much over time as real options dry-up.

A more in-depth paper here for anyone really interested.

The Nemean lion of debt in offshore supply…

The slaying Nemean lion was the first of the twelve labours of Heracles. The lion had an indestructible skin and it’s claws were sharper than mortals swords. I sometimes feel that the first task in getting some normality into the offshore supply market is to find a Heracles who can begin to slay the debt mountain built up in good times…

In Singapore Otto Marine and Pacific Radiance appear all but certain to enter some sort of administrative process as their debt burden divorces from the economic reality of their asset base. The best guide to what they need to achieve, and the enormity of the task, come from the recent MMA Australia capital raising. I think MMA is a company that understood the scale of this downturn, and reacted accordingly, but they still have a tough path to follow, but at least they have an achievable plan.

The MMA plan involved raising AUD 97m new equity (AUD $92 cash after AUD$ 5m in fees, which is steep for a secondary issue and shows that this wasn’t easy) compared to bank borrowings of AUD $ 295m i.e. 33% of the debt of the company, or over 100% of the equity value (at AUD 88m) was raised in new capital in one transaction in November 17. In order to do this the lending banks involved had to agree to make no significant dent in the debt profile before 2021, reduce the interest rate, and extend the repayments. “Extend and pretend” as it is known in the jargon. All this for a company that in the six months ending 31 Dec 2017 saw a revenue decline of 22% over the same time last year (AUD $119m to AUD $92m) and generated an EBITDA of only $7.6m (which excluding newly raised cash would give a Debt/EBITDA of 14.3x when 7x is considered high).  I’d also argue the institutions agreed to put the money in when the consensus view (not mine) was that 2018 would be a better year, raising money now looks harder. (Investment bankers can sometimes come in for some stick but this, in my opinion,  was a really good deal for the company and the banks earned their money here).

The fact that MMA’s Australian banks have far less exposure to offshore supply than the Singaporean banks made them more pragmatic (while still unrealistic), but this shows what needs to be achieved to bring in new, institutional quantities, of money to back a plan. As a portfolio move from large investors, making a small bet on a recovery in oil prices leading to linear increase in offshore demand, I guess that is sensible. I don’t think it will work for the reason this slide that Tidewater recently presented shows:


There is too much latent capacity in an industry where the assets, particularly the MMA ones, are international in operational scope. By the time the banks need to start being repaid these 20-25 years assets will be 3 years older, 7 since the downturn, yet expected to bear an unmarked down principal repayment schedule. It’s just not realistic and requires everyone else but you to scrap their assets. It maybe worth a punt as an institutional shareholder… but I doubt that few really understand the economics of aging supply vessels.

This contrasts with Pacific Radiance where this week the bondholders refused to agree to accept a management driven voluntary debt restructuring and management seem to be relying on the industry reaching an “inflection point”. As soon as you hear that you know there is a terrible plan in offing that relies on the mythical demand fairy (friends with the Nemean lion I understand) to save them.

I would have voted against the resolutions this week as well had I been a bondholder, but mainly because of the absurdity of agreeing to a plan without the banks being involved or new money lined up. The bond was for SGD 100m… have a look at the debt below on the latest Pacific Radiance balance sheet (Q3 2017)… can anyone see a problem?

PR Balance Sheet Q3.png

Pacific Radiance has USD 630m in debts. Even writing off the bond would mean you are in a discussion with the banks here. I have no wish to take people through the math involved in what the bonds are worth becasue in reality all anyone owns here is an option on some future value, and if you are not the bank you don’t even have that. In order to bring the plan into line with MMA, Pacific Radiance would be looking at presenting an agreed plan with the banks, and ~USD 220m capital raise, an amount that is real money for a company that is still losing money at an operating level.

No one believes the vessels and the company are worth USD 710m. If the banks really thought they could get even .80c in the dollar here by selling to a hedge fund they would be out tomorrow. A large number of the Pacific Radiance vessels are well below the quality of the Mermaid vessels and in the real world it would seem reasonable for the banks to have to write down their debt significantly to attract new money. If vessels are sold independently of a company transaction, like MMA, then they go for .10c – .20c of book value, so it would make sense for the banks to be sensible here. However, I fear that so many have told shareholders they are over the oil and gas exposure that major losses here will be resisted despite economic reality. I suspect the write-off number here would need to be at ~50-60% of book value to make Pacific Radiance viable and get such a large quantity of new money, an amount that will have risk officers at some Singaporean banks terrified.

As I keep saying here the real problem is that if everyone keeps raising new money for operational expenditure, on ever lower capital value numbers, then the whole industry suffers as E&P companies continue to enjoy massive overcapacity on the supply side. Eventually without a major increase in demand a large number of vessels are going to have to leave the industry and this will happen when the  banks have no other options, and we are starting to get close to that point.

In reality the Pacific Radiance stakeholders need to sit around the table, have a nice cup of tea, and accept the scale of their losses. Then all the stakeholders can come up with a sensible business plan and the new money for operational expenditure can be found. But the banks here will be desperate to be like the MMA banks and get the new money in without suffering a serious writedown while trying and push the principal repayments out until a later date. I don’t see that happening here and the bondholders may as well sit around with all parties rather than be picked off indepdently. A major restructuring would appear the only realistic outcome here and if Pacific Radiance is to continue in anything like it’s present form there will be some very unhappy bankers.