Diverging results point to the future of offshore… procyclicality reverses…

Colin, for example, has recently persuaded himself that the propensity to consume in terms of money is constant at all phases of the credit cycle.  He works out a figure for it and proposes to predict by using the result, regardless of the fact that his own investigations clearly show that it is not constant, in addition to the strong a priori reasons for regarding it as most unlikely that it can be so.

The point needs emphasising because the art of thinking in terms of models is a difficult–largely because it is an unaccustomed–practice. The pseudo-analogy with the physical sciences leads directly counter to the habit of mind which is most important for an economist proper to acquire…

One has to be constantly on guard against treating the material as constant and homogeneous in the same way that the material of the other sciences, in spite of its complexity, is constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple’s motives, on whether it is worth while falling to the ground, and whether the ground wanted the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth.

Keynes to Harrod, 1938

 

A, having one hundred pounds stock in trade, though pretty much in debt, gives it out to be worth three hundred pounds, on account of many privileges and advantages to which he is entitled. B, relying on A’s great wisdom and integrity, sues to be admitted partner on those terms, and accordingly buys three hundred pounds into the partnership.The trade being afterwords given out or discovered to be very improving, C comes in at fivehundred pounds; and afterwards D, at one thousand one hundred pounds. And the capital is then completed to two thousand pounds. If the partnership had gone no further than A and B, then A had got and B had lost one hundred pounds. If it had stopped at C, then A had got and C had lost two hundred pounds; and B had been where he was before: but D also coming in, A gains four hundred pounds, and B two hundred pounds; and C neither gains nor loses: but D loses six hundred pounds. Indeed, if A could show that the said capital was intrinsicallyworth four thousand and four hundred pounds, there would be no harm done to D; and B and C would have been obliged to him. But if the capital at first was worth but one hundred pounds, and increasedonly by subsequent partnership, it must then be acknowl-edged that B and C have been imposed on in their turns, and that unfortunate thoughtless D paid the piper.
A Adamson (1787) A History of Commerce (referring to the South Sea Bubble)

The Bank of England has defined procyclicality as follows:

  • First, in the short term, as the tendency to invest in a way that exacerbates market movements and contributes to asset price volatility, which can in turn contribute to asset price feedback loops. Asset price volatility has the potential to affect participants across financial markets, as well as to have longer-term macroeconomic effects; and
  • Second, in the medium term, as a tendency to invest in line with asset price and economic cycles, so that willingness to bear risk diminishes in periods of stress and increases in upturns.

Everyone is offshore recognises these traits: as the oil price rose and E&P companies started reporting record results offshore contractors had record profits. Contractors and E&P comapnies both began an investment boom, highly correlated, and on the back of this banks extended vast quantities of credit to both parties, when even the banks started getting nervous the high-yield market willingly obliged with even more credit to offshore contractors. And then the price of oil crashed an a dramatically different investment environment began.

What is procyclical on the way up with a debt boom always falls harder on the way down as a countercyclical reaction, and now the E&P companies are used to a capital light approach this is the new norm for offshore. The problem in macroeconomic terms, as I constantly repeat here, is that debt is an obligation fixed in constant numbers and as the second point above makes clear that in periods of stress for offshore contracting, such as now, the willingness to bear risk is low. Contractors with high leverage levels that required the industry to be substantially bigger cannot survive financially with new lower demand levels.

I mention this because the end of the asset bubble has truly been marked this week by the diverging results between the E&P companies and some of the large contractors. All the supermajors are now clearly a viable entities at USD 50 a barrel whereas the same cannot be said for offshore rig and vessel contractors who still face large over capacity issues.

This chart from Saipem nicely highlights the problem the offshore industry has:

Saipem backlog H1 2017 €mn

Saipem backlog Hi 2017.png

Not only has backlog in offshore Engineering and Construction dropped 13% but Saipem are working through it pretty quickly with new business at c.66% of revenues. The implication clearly being that there is a business here just 1/3 smaller than the current one. You can see why Subsea 7 worked so hard to buy the EMAS Chiyoda backlog because they added only $141m organically in Q2 with almost no new deepwater projects announced in the quarter.

It is not that industry conditions are “challenging” but clearly the industry is undergoing a secular shift to being a much smaller part of the investment profile for E&P companies and therefore a much smaller industry as the market is permanently contracting as this profile of Shell capex shows:

Shell Capex 2017

A billion here, a billion there, and pretty soon you are talking real money. The FT had a good article this week that highlighted how “Big Oil” are adapating to lower costs, and its all bad for the offshore supply chain:

The first six months of this year saw 15 large conventional upstream oil and gas projects given the green light, with reserves of about 8bn barrels of oil and oil equivalent, according to WoodMac. This compared with 12 projects approved in the whole of 2016, containing about 8.8bn barrels. However, activity remains far below the average 40 new developments approved annually between 2007 and 2013 and, with crude prices yo-yoing around $50 per barrel, analysts say the economics of conventional projects remain precarious.

Not all of these are offshore but the offshore supply chain built capacity for this demand and in fact more because utilisation was already slipping in 2014. And this statistic should terrify the offshore industry:

WoodMac says that half of all greenfield conventional projects awaiting a green light would not achieve a 15 per cent return on investment at long-term oil prices of $60 per barrel, raising “serious doubt” over their prospects for development. By this measure, there is twice as much undeveloped US shale oil capable of making money at $60 per barrel than there is conventional resources.

The backlog (or lack of) is the most worrying aspect for the financing of the whole industry. E&P companies have laid off so many engineers and slowed down so many FIDs that even if the price of oil jumped to $100 tomorrow (and no one believes that) it would take years to ramp up project delivery capacity anyway. Saipem and Subsea 7 are not exceptions they are large companies that highlight likely future work indicates that asset values at current levels may not be an anamoly for vessel and rig owners but the “new normal” as part of “lower for longer”.

I recently spoke to a senior E&P financier in Houston who is convinced “the man from Oaklahoma” is right but only because he thinks overcapacity will keep prices low: c. 50% of fracing costs come from sand, which isn’t subject to productivity improvements, and he is picking that low prices eventually catch up with the prices being paid for land. I still think that the more large E&P companies focus on improving efficiency will ensure this remains a robust source of production given their productivity improvements as Chevron’s results showed:

Chevron Permian Productivity 2017

Large oil came to the North Sea and turned it into a leading technical development centre for the rest of the world. Brazil would not be possible without the skills and competencies (e.g. HPHT) developed by the supermajors in the North Sea and I think once these same companies start focusing their R&D efforts on shale productivity will continue to increase and this will be at the expense of offshore.

It is now very clear that the supermajors, who count for the majority of complex deepwater developments that are the users of high-end vessel capacity, are very comfortable with current economic conditions. They have no incentive to binge on CapEx because even if prices go up rapidly that just means they can pay for it with current cash flow.

That means the ‘Demand Fairy’ isn’t saving anyone here and that asset values are probably a fair reflection of their economic earning potential. Now the process between banks and offshore contractors has become one of counter-cyclicality where the asset price-feedback loop is working in reverse: banks will not lend on offshore assets because no one knows (or wants to believe) the current values and therefore there are no transactions beyond absolute distress sales. This model has been well understood by economists modelling contracting credit and asset values:

Asset Prices and Credit Contracttion

Getting banks to allocate capital to offshore in the future will be very hard given the risk models used and historical losses. Offshore assets will clearly be subject to the self referencing model above.

I remain convinced that European banks and investors are doing a poor job compared to US investors about accepting the scale of their loss and the need for the industry to have significantly less capital and asset value than it does now. Too many investors thought this downturn was like 2007/08, when there was a quick rebound, and while this smoothed asset prices somewhat on the way down this cash was used mainly for liquidity, it is now running dry and not more will be available (e.e. Nor Offshore) at anything other than penal terms given the uncertainty. Until backlog is meaningfully added across the industry asset values should, in a rational world, remain extremely depressed and I believe they will.

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