Where we all went wrong… Remember Marginal Production…

sanction-oil-2013

The above chart was published in 2013. I was a believer. A total believer. What could possibly go wrong? Yes, shale was important, but look at the stats?! The logic holds, Deep Water with high CAPEX and low OPEX, and very big reserves, beats high OPEXpex and depletion rates… Deepwater with fields further from ports would require greater transit times and use more vessel days and require a greater number of new vessels…

All investment bubbles start with a degree of rationality. Tulips, being an import into the Netherlands in the Golden Age, and therefore not easy to grow, were originally expensive to develop and had a high cost of production. The Dutch economy had grown strongly and there was an influx of foreign capital leaving locals and institutions packed with liquid funds… However, by the time the bulbs were going for more than 10x a craftsman’s income your can be sure it was moving into the Great Man’s “Greater Fool Theory”.

tulipomania

Likewise, the South Sea Bubble had reasonably rational financial roots. Like the oil market as long as you buy-low and sell-high you are fine…

south-sea-bubbleBuy in at January 1720 and sell in late 1721 and you have doubled your money; buy a load of leveraged oil and gas ships in 2014 and … oh hold on I digress, that was me…

So we all, the market in its collective wisdom I mean, based our decisions on forecasts like this one of 2013 (complete with regression analysis):

oil-forecast-2013

We wish… right?:)

Anyway, back to reality, this was a circuitous way of getting to this graph from 2016…

global-liquids-cost-curve-2016

You see the change? I mean I get the supply glut in production assets has helped drive the cost curve down. A CFO from a small E&P told me the other day his three well campaign had gone from USD 150m to 50m! And yes politics and the Saudis, and all that short-run stuff that bores me because it’s all microeconomic pseudo-science and econometrics , had some effect. But while that sideshow was going on we all, as is always the case, underestimated the ability of American manufacturers to fundamentally drop down the  cost curve i.e. in economic terms forge an effectively new curve with greater capacity of output for each unit of input) :

average-well-completion-costs

So but 2012 prices had peaked and were on the way down by 2015 somewhere between 20-40% depending on the geographic area. Ah I hear you say… a surplus of equipment… but no…

shale-historic-cost

Casing and capital equipment dropping like a stone. Innovation, technical progress and economies of scale combine. The hallmarks of American capitalism that when matched with such efficient capital markets allow an industry to grow so quickly in a self-reinforcing cycle. Notice also the much lower CAPEX costs per well. USD 6m barely brought you a couple of mobilisations in 2013, yet alone some serious vessel and offshore execution time offshore. Financial markets are efficient but they have frictions and it means at the lower bound small incremental CAPEX is easier to organise more often that larger one-off bets. That is why shale will be the marginal producer of the future.

The Rystad data isn’t all bad for offshore. Offshore offers volume and reserve replacement potential unavailable to shale producers (until their next technological breakthrough). But the scale of the CAPEX costs reductions in shale should worry investors in the offshore energy sector. Shale companies are seeking to move those red boxes down the left-hand axis and widen the horizontal spread. Offshore operators, especially those locked into historic asset prices, need to be realistic about what this means going forward.

I see a bifurcating market where large field developments, with huge reserves and daily output, and smaller step-outs; and infield developments to existing infrastructure in low-cost regions, with much lower risk profiles (and often NOC led, as in Asia) continuing to be developed. But marginal field development offshore (the clue is in the name), the green space in the top 25% above the blue dot in the green boxes in the Rystad graph, is going to take the longest to come back. And the problem at the moment is the industry supply side is geared to fill all those green boxes and more.

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