“Productivity isn’t everything, but in the long run it is almost everything.”
There was an excellent article in the Telegraph this week on the economics of shale (“short-cycle”) investment that is so important for the future of offshore demand. This comes at the same time the IEA is raising concerns that lack of current investment could lead to a “sharp increase” in prices and effectively says shale is not the solution. I back the economics of marginal supply over future concerns that large mega-projects are not occurring.
I note the IEA itself says:
The demand and supply trends point to a tight global oil market, with spare production capacity in 2022 falling to a 14-year low.
In the next few years, oil supply is growing in the United States, Canada, Brazil and elsewhere but this growth could stall by 2020 if the record two-year investment slump of 2015 and 2016 is not reversed. While investments in the US shale play are picking up strongly, early indications of global spending for 2017 are not encouraging.
I have to admit to being slightly perplexed having read the IEA release on this report (and not the whole report) because I am not sure I get why a tightening of supply would lead to increased volatility in prices? Surely it would mean a gradual increase in investment to meet the tightening supply? Or maybe a period of underinvestment would lead to rising prices (but would surely be a signal for investment)? It may be true that large mega-projects are not replacing the previous number of similar projects, but that is exactly the point shale producers make, their production is more marginally driven.
Dr Fatih Birol, the IEA’s Executive Director. “But this is no time for complacency. We don’t see a peak in oil demand any time soon. And unless investments globally rebound sharply, a new period of price volatility looms on the horizon.”
I understand the IEA may want low prices for consumers permanently but that isn’t rational for E&P companies who need a return on capital? Volatility would surely come as a result of large changes in the supply or demand in an industry with a relatively long-run supply curve for larger increases in marginal demand? Volatility in prices is the result of one side of the market being unable to respond to the other and there is limited evidence of that at the moment.
Not investing isn’t necessarily complacency it looks like rationality. E&P companies projects are fundamentally riskier when the variation in oil prices can be anywhere from USD 30 to USD 130 pboe, they need greater returns to cover that risk. The lesser investment could well lead to higher, more stable prices, on lower supply because that is the rational way to behave given past overinvestment cycles. E&P companies certainly don’t have to worry that the offshore supply chain could not assist in raising production very quickly, given the severe over capacity, a situation very different to past downturns.
Shale has become a manufacturing process like any other and subject to declining unit costs and experience curves as the Rystad Energy graph makes clear. For well over 150 years the US economy has been defined by an ability to reduce unit costs through productivity increases. Given the opportunity to make money in shale by continuing to do this I see no reason why this trend should not continue.
As a comparison:
Offshore energy has advantages with larger reserve access and lower per unit costs. But the big disadvantage offshore has is that by its very nature it is non-standardised and it is very unlikely in the future this will change given the engineering challenges. The price reductions at the moment are the result of overcapacity and financial losses, not an increase in productivity, as is occurring in shale. This is not sustainable and prices for the supply chain will have to rise for the offshore supply chain to be viable again.
This ties in with the behavior that supermajors have been making in their investment programmes e.g. Chevron announced yesterday that offshore CAPEX would be USD ~12bn, a 30% drop from 2016, but still 67% of the total budget, which is down 12% YOY. Exxon has announced USD 25bn of CAPEX for 2017 with 1/3 for shale rising to 1/2 in a few years. The higher constant capital cost for shale, but shorter lead times, may mean marginal demand and supply are more easily balanced via pricing than has traditionally been the case in the past. E&P companies are not ignoring offshore but are using it for a large base of supply while having flexibility at the margin to change their capital and operating costs in a way offshore simply cannot offer.
The losses that have been sustained in the offshore supply chain by investors, and the growth of shale, point to a few constant themes to me here:
- There will need to be a “boom” to encourage new investment in offshore. When oil prices can be significantly below project forecasts for ~5 years then you need to make a higher return as an investor. That won’t be a boom it will be a return to a rational economic pricing level where supply and demand meet.
- A smaller number of offshore mega-projects could supply the base of new energy supply while shale picks up the more variable, and uncertain, demand.
- In order to ensure unit costs are lower the offshore supply chain is likely to be significantly more integrated into E&P companies than is currently the case. It is simply not viable to build USD 700m rigs and USD 100m vessels and have them on the spot market. Banks and financiers will insist on a better risk sharing mechanism (slowly and over time) or the capital required for these units (and therefore the day-rates that E&P companies pay) will become irrational and uncompetitive. Brazil, so long an outlier for the lack of spot market, may, in fact, become a model for the sort of integration required to make offshore more competitive (in theory not fact as anyone who has worked for Petrobras can testify).
- This new industry structure will favour larger companies with a more diversified asset base.
- The real worry for basins such as the North Sea is that in size the projects are more akin to shale, but in economics closer to deep water, and therefore as a risk/return basis they look unattractive. That is not the end of the North Sea but it does mean all but the most attractive small fields are developed. It is very bad news for the supply chain which has built a fleet for far greater demand.
- Given current supply levels a “boom” offshore production is unlikely to flow through to the supply chain given current capacity levels.