BP results, the future of offshore, and myopic loss aversion…

The myopic loss aversion explanation rests on two behavioral principles: loss aversion and mental accounting. Loss aversion re-fers to the fact that people tend to be more sensitive to decreases in their wealth than to increases.

Thaler, Tversky, Kahneman, and Schwartz (The Quarterly Journal of Economics, 1997

 

Let me start by saying, as I have many times before, I am a believer in offshore oil and gas production. My issue at the moment isn’t that it is going to go away, rather it is that too many vessels have been built, and that 2012-2014 was a peak bubble of activity. There will still be good money to be made offshore, I am just not sure it will be through owning vessels (and rigs) until a very painful, and in all likelihood prolonged, restructuring process has been completed.

I recently wrote my thoughts on economic research and dividend policy and why this may lead to an undersupply of offshore projects in the future. I am not conviced this will happen at all, but it seems to be the great hope for all involved in offshore. The BP results yesterday highlight what I was saying with one perfect graph:

BP Cash vs Capex 17Q1

For BP the dividend doesn’t change, CapEx, the driver of future production and profitability potential, is the moveable number. And in a large corporation it is surprisingly flexible in the short-term. (“A billion here, a billion there, pretty soon you are talking real money…”). I think this is typical of all the supermajors, their shareholders want dividends.  The data reveal that Shell and BP alone were responsible in Q1 2017 for £4.8bn of the total £12.5bn (38%!!) of total FTSE 100 dividends. BP and Shell shareholders, UK pension funds especially, want the money now not the hypothetical billions available from a shortage of capacity in a few years time.

Another way to look at it is this: the BP dividend was USD 10.0 cents per share in Q1 2017, and Q4 2016, but this is way more than the company is earning per share (bold Q1 2017, then Q4 2016, then Q1 2016):

BP EPS Q12017

BP is making up the numbers by increasing the debt and divestments in the portfolio. The last thing they want, and their shareholders I suspect, is a large and capital intensive bet on risky offshore projects. As if to reassure everyone this is the case the CFO gave look ahead guidance for CapEx at these levels until 2021.

There is a really good interview with Starlee Sykes, BP VP Global Projects, that is well worth a read – the cost on the Mad Dog phase 2 project was cut to USD 9bn (from USD 20bn). Several parts struck me but none more than this:

We looked for analogies to what we had done before and focused on the Atlantis project in the gulf, which came online in 2007, and its semisubmersible-platform design concept. Atlantis was, and is, viewed as a very economic, very good development. We decided to adopt this simpler design concept. Compared to the original Mad Dog 2 stacked-deck spar design, the semisubmersible is flexible for building future capacity, while fulfilling minimum technical requirements. That was the big idea around Mad Dog 2. Rather than designing for a future that may not happen, the principle was to build what we need at day one, and then allow for the expansion later. So, for example, we did not install all of the water-injection capacity that we needed on day one. It’s a more incremental approach.

A total change of mindset for the industry where everything in offshore was bespoke and future proof. This is part of a slow path to standardisation where possible to reduce costs. Mad Dog Phase 2 can produce 140 000 bpd at peak capacity, far beyond anything tight oil can dream of. At that level, and with efficient lift costs, it’s well worthwhile dropping a cool USD 9bn. But as I have said before I see offshore bifurcating into developments like this with very high flow rates and very high CapEx commitments, normally at deepwater, (only the Norwegians seem to get lucky enough to find huge fields at shallow depths now), and a base of demand in Asia and the Middle East where NOC’s are more security supply focused where they will develop in shallow (often alone) as well as deeper water (where they will need a supermajor partner for technical expertise).

I fear for the shallow UKCS which is somewhat caught in the middle: SPS technology isn’t standardised and cannot feel the effects of scale and scope that tight oil has, yet these fields cannot provide the reserve capacity in a high cost environment. One of the reasons the Norwegian basin seems to do better than the UKCS is an understanding of Loss Aversion Theory, that in essence states that investors would rather not lose $5 than gain $5: in Norway tax incentives for drilling are heavily front ended loaded versus credits for production in the UK (making a massive generalisation of a very complex issue). A classic article on myopia and and loss aversion in risk taking is available here. Which is a lot like shareholders in E&P companies who have seen paper wealth vanish as the oil price drops.

To be effective shallow offshore fields will have to be subject to some form of standardisation around production equipment and SURF installation, and we are a long way from that at the moment because a core component of that is drop volume which drives the experience curve. And of course as the E&P companies cut CapEx, that is distinctly lacking.

The other problem offshore has at the moment is management focus and resource constraints. I have mentioned before the power of narrative in economics, as Shiller argues:

[w]e have to consider the possibility that sometimes the dominant reason why a recession is severe is related to the prevalence and vividness of certain stories, not the purely economic feedback or multipliers that economists love to model.

The industry meme at the moment is all about cost and tight oil. Changing that mindset in large organisations is hard – it can take at least 12 months if peoples bonuses have just been contractually set for exmaple and they are based on cost savings. A recovery for the offshore contracting industry is going to rely on changing this narrative somewhat.

I have discussed here mainly the demand side of the market which I believe will be structurally more unattractive for the next few years going forward. I still think for the supply side, the offshore contractors, there can be a bright future if positioned clearly: a tight fleet of core enabling assets (mainly lay capability) and a strong EPIC competency, and an ability to position the firm to respond to this structural change in the industry.

I am generally sceptical on alliances and integration between SPS and SURF because I think they add more  value to the contractor than customer, and as Exxon Mobil showed with the Liza award, an educated customer can drive the price down by splitting workscopes. But I am writing a fuller piece on this.

2 thoughts on “BP results, the future of offshore, and myopic loss aversion…

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