“The four most expensive words in the English language are, ‘This time it’s different.’”
Sir John Templeton
In investment theory a key part of recognising that a bubble is close to bursting is the logic that “this time it’s different”, the internet boom of 1999-2000 being the classic case. The core argument is actually regression to the mean: eventually all profits drop back to normal levels, but this time, they won’t.
In oil services, particularly offshore, there seems a view that this downturn is the same as others. Everyone wants to believe that next time will be the same. Somehow, magically, demand will equal supply, day rates will rocket, and everyone will go back to building USD 100m vessels with USD 20m equity, to put on the spot market and and that will be the new normal. I think the narrative is driven by the extremely mild (in hindsight, it didn’t feel like it at the time) dip in 2008/9, and the strong recovery in 2000, where people who had invested early, and took serious risk, made some exceptional returns (Integrated Subsea Services springs to mind). It might happen, but I doubt it.
For one thing the daily fascination with the oil price seems entirely inappropriate for offshore contractors. The industry is wallowing in a sty of capacity: it’s the supply side that important in the short-run here not the demand side. As everyone in the industry knows (deep down) the number of project staff laid-off will ensure it would take a long time for the E&P companies to ramp up projects even if they wanted to.
The oil production industry is clearly undergoing a structural shift with the impact of shale. It won’t be the end of deepwater and offshore, but it seems unlikely to return as before. I wrote before about the changing economics of shale and the extraordinary drop down the cost curve that has affected that industry. My core point is that when you can drive standardisation you get massive efficiencies that can transform the cost curve, and therefore, the underlying economics of an industry.
In that vein, inspired by this piece from the FT (which is broadly dismissive of electric vehicles), I read this from the Grantham Institute. The report focuses on the Solar Photovoltaic and Electric Vehicle cost reductions that come from scale improvements in the manufacturing process and producitivity of the units (particularly battery efficiency for electric cars). Under their model oil demand peaks in 2020:
E[lectric] V[ehicle]s account for approximately 35% of the road transport market by 2035 – BP put this figure at just 6% in its 2017 energy outlook. By 2050, EVs account for over two-thirds of the road transport market. This growth trajectory sees EVs displace approximately two million barrels of oil per day (mbd) in 2025 and 25mbd in 2050. To put these figures in context, the recent 2014-15 oil price collapse was the result of a two mbd (2%) shift in the supply-demand balance.
Now there are a number of caveats in the research and I also get that they have an agenda. So of course does BP. No one is lying here, it’s just that humans are “boundedly rational“; they can only process so much, and what they do therefore is referenced in cognitive analogies and models. The arguments form part of a “dominant logic” of analysis and decision making. Both are statiscally sophisticated models with regression analysis at the core and therefore one is reminded of the Great Man’s warning (to Koopman’s) on the problems with this sort of analysis:
Many thanks for sending me your article. I enjoyed it very much. I am sure these matters need discussing in that sort of way. There is one point, to which in practice I attach a great importance, you do not allude to. In many of these statistical researches, in order to get enough observations they have to be scattered over a lengthy period of time; and for a lengthy period of time it very seldom remains true that the environment is sufficiently stable. That is the dilemma of many of these enquiries, which they do not seem to me to face. Either they are dependent on too few observations, or they cannot rely on the stability of the environment. It is only rarely that this dilemma can be avoided.
Letter from J. M. Keynes to T. Koopmans, May 29, 1941
The point is I guess that somewhere between BP and the Grantham Institute we are likely, barring a major technological development, to see the outcome. But directionally the Grantham Institute research seems to be right side of change, and that is important when you see this graph:
In the long run I favour productivity and technical improvement over most other drivers in the economy. You can pass an inflection point where the whole economics of an industry changes. Shale has had it, and solar and EV might have it as well. But a core point is it requires standardisation and scale combined with technology improvements, and my worry for offshore is it has none of these except the potential of marginal improvements.
As I have argued offshore energy isn’t going to go away: in volume terms it too much of an important part of the supply chain for that. But is it going to be on the scale and have the importance it did before? BP and the other oil companies are right to keep investing, that is their business and their shareholders believe that, it’s capitalism, and a very efficient market mechanism. These productivity improvements are marginal at the moment, and car replacement cycles are long, competition is never stagnant etc. But it is hard to see a dramatic fall in the price of oil extraction productivity given it’s maturity (blended across production sources), and the same cannot be said for electric vehicle productivity. I accept that I have said that about shale, and there appears to be much further to run down the productivity curve, but subsea production is subject to dimishing returns, high capital utilisation, and asset productivity limits. Subsea is very efficient at scale but it is not easy to transform the limits of that scale, which isn’t true for manufacturing electric batteries and their potential capacity increases and price decreases (in real terms), and also to a lesser degree shale, which is limited by a high-service/labour input element.
There are issues with this negative theory: production that ends is harder to track and much less visible, I think I am biased by being amazed how quickly Tesla seems to to be growing, resource constraints could be found in battery manufacture etc. But it feels to me like we are passing a stage where after having been dependent on one source of energy for so long, admittedly a remarkable one on a calorie/output efficiency basis, other technologies are catching-up.
I don’t have a crystal ball, but going long on 25 year assets like drilling rigs and vessels, on the logic that it will always bounce back, because it did before, unless it’s part of a portfolio investment, strikes me as more risky than at anytime in the past 25 years. Whatever the industry will looked like in five years from now I doubt offshore will look like it did in 2013 ever again.