Subsea 7 and Conoco Phillips… industry bellwethers…

[N]othing can have value without being an object of utility.

Karl Marx

[I couldn’t agree more with the philosophy outlined in the Conoco Phillips graphic in the header].

A stark contrast in the fortunes of two companies reporting numbers yesterday and it doesn’t take a genius to work out that an E&P company (Conoco Phillips) is benefitting from a higher oil price while an offshore contractor (Subsea 7) is suffering from lower committed offshore spending. But I think it’s worth delving into a little deeper because the scale of the changes taking place in investment terms I think provide a note of guidance for how the future of the industry will look.

CP makes an excellent E&P company to use as an example. In 2015 CP announced they were giving up deepwater exploration but not deepwater production. All economic change occurs at the margin, the change in preferences of different actors in the economy melding into demand and supply curves which intersect at equilibrium points: in this case the decision to invest in deepwater production, or not, depending on market conditions. CP looks to be a hard task master in this regard: based on the statements and actions they have taken if CP decides to invest in offshore production others will as well.

I start with CP because E&P demand for offshore services is obviously crucial. Firstly, and this is not an original thought, the entire tone of this presentation (Q3 2017) is geared to financial returns to shareholders (you should actually read the whole thing to sense this) at the expense of production growth. Just as Shell, and other E&P companies have done, there is a signalling effect that this is a company that will not turn an oil price rise into a feast of mega-growth projects:

CP Priorities

The whole focus is being able to pay dividends even at a $40 per barrel price, gone are the 2013 days of boasting about reserve replacement ratios in excess of 170%. CP helpfully shows that this focus has helped them outperform their peer group: Executive level pay generally includes a link to performance against a defined peer group, if other E&P managers start losing bonuses by not being as disciplined on returning money to shareholders as CP, and their share price appreciation is less, their strategy will change extremely quickly. But in reality all the big companies reporting now are making “credible commitments” to return any excess cash to shareholders and focus on demand increases through short cycle production. Just as it would take years to turn investment decisions into projects now so much offshore engieering capability has been turned off, so too it will take a long time to change this investment narrative and performance incentive system in E&P companies that drive offshore demand. Any perceived linear link between an increase in the oil price and an increase in offshore demand is wrong in my view.

COP Works.png

Secondly: CapEx: for the 2018-2020 period CP is guiding sustaining CapEx at $3.5bn per annum and $2.0bn for expansion. Of the $2.0bn expansion $1.2bn is short-cycle unconventional and only $0.5bn for conventional/offshore and $0.3bn for exploration (split evenly between conventionals and short-cycle). To put that in context in 2012, when the offshore industry was going long on boats and rigs based on future demand, CP guided 2013 CapEx at USD $15.8bn! Of that 10% alone ($1.6bn) was for the North Sea and Alaska (i.e. offshore), 26% ($4.2bn) was for short-cycle, 15% ($2.4bn) for offshore Angola and GoM, and another 14% ($2.1bn).

Graphically it works like this: To keep production constant CP will spend $3.5bn

2018-2020 Flat Production.png

The green is entirely offshore. But to increase production:

COP Growth Production.png

The green in the second graph is almost all historic commitments. That is the future of offshore in a microcosm for the largest independent E&P company in the world and historically a major investor in deepwater offshore. The point is, for those bored of the minutiae, that CP have knocked ~$9.5bn off theirCapEx (60%) in 5 years (they have also divested assets so its not a straight relative comparison) and that the portion devoted to offshore is really related to legacy investments only now, not new fields or developments.

Third: productivity. I keep saying this but the productivity improvements look real to me the economist, as opposed to some of the geologists I know, who argue shale is bound fail:

CP Shale Productivity.png

The last line: >50% more wells per rig line! It’s all about productivity and scale and large companies investing in R&D are extracting more for less on a continuous basis from their shale wells. This is becoming a self-reinforcing cycle where they invest, improve, and re-invest. As I say here often: Spencer Dale is right.

This is the link point to Subsea 7, and all the other subsea contractors frankly. Subsea 7 have performed better than most other contractors throughout the downturn (not McDermott), but the issue is backlog and the pace of future work delivery: as CP seeks to please the stockmarket by avoiding all but the most promising of offshore investments (if any), SS7 and others must show huge declines in their order backlogs which de-risk a hugely expensive and specific asset base. I have said before I think you almost need to value subsea contracting companies like a bank: they fund long-term assets with a series of shorter duration contracts of uncertain redemption value, yes they have a much higher equity cushion, but they need it as they are borrowing short from a market to fund long term assets. Certainly smaller contractors are susceptible to “runs”.

In the last quarter SS7 had revenue of ~$1bn but it took in orders of only .5 of that (book-to-bill ratio) in new orders which left it with a backlog of $5.3bn (against liabilies of $2.4bn). At Q4 2013, when companies like CP were spending all their CapEx, SS7 had backlog of $11.8bn (against $3.8bn of liabilities).

Now SS7 is a well managed company and as can be seen they have reduced debt as the downturn continued, continued to return chartered tonnage,  and they have over $1.2bn in cash, so there are no problems in the short-term. But if you were owed money by SS7 I would rather be owed a higher amount backed by nearly 3x backlog than owed a smaller amount by 2x (a declining) backlog. The problem is the pace at which all the contracting companies are eating through their backlog of contracted work that was at a significantly higher margin than the work they are bidding for now. The actual booked backlog number is the only certainty guiding real expectations of future profitability.

It is a function of the SS7 business model that they have an extremely long position in very specialist assets that sap meaningful amounts of money from companies if they are not working as the graph from the FMC Technip results makes clear:

Technip margin erosion.png

The single largest fact in Technip’s declining subsea margin is lower fleet utilization. If Technip and SS7 are expecting poor utilization in 2018 then it is locked in for the rest of the supply chain.

The fact is the huge offshore CapEx pull back and reallocation by the E&P companies is continuing unabated. Offshore allocations may not be declining in real terms any more but E&P companies are making clear to their shareholders that it isn’t going to materially increase either. The offshore fleet built for 2014 isn’t getting a reprieve from the Oil Price Fairy, the gift from that fairytale should it come true for the E&P companies will be given to shareholders, who after the volatility they have suffered in recent years feel they are owed higher risk weighted returns. E&P companies are locking in systems and processes that ensure their procurement in the supply chain will systematically lower their per unit production costs for years to come and ensuring that other asset owners get lower returns for their investments is a core part of that.

And it’s not only backlog the SURF business now is declining year-on-year of you look at the Q3 2017 SS7 results:

Q3 2017 BU performance.png

~$50m is a meaningful decline in revenue (6.3%) for SURF alone and the decline in i-tech shows that the maintenance market hasn’t come back either. Both CapEx and OpEx work remain under huge margin pressure and in the maintenance market the smaller ROV companies with vessel alliances are all mutually killing any chance of anyone making money until a significant amount of capacity leaves the market. The point of reinforcing this is that it is clear that the E&P companies do not view higher prices the start of a relaxation of cost controls: this is the new environment for offshore contractors.

Subsea maintenance costs involving vessels are time and capital intensive. Internally E&P companies are weighing up whether to invest in maintenance CapEx for offshore assets or new CapEx on short cycle wells. At the margin many like CP are choosing short cycle over offshore and hence the demand curve for offshore is likely to have shifted permanently down and price alone is simply not clearing the market.

I have only used SS7 as they are the purest subsea player in the market. I definitely think it is one of the better managed companies in the industry buut it is impossible to fight industry effects this big when demand is falling, and therefore the size of the market is shrinking, and you have such a high fixed cost base. Not everyone can take market share.

SS7 will be a survivor, and longer term given the technical skills and scale required to compete in this industry I think it likely in the long run they will earn economic profits i.e. profits in excess of their cost of capital, along with the larger SURF contractors excluding Saipem. But they will do this by being brutal with the rest of the supply chain that has gone long on assets and simply doesn’t have the operational capability and balance sheet to dictate similar terms. For everyone below tier one the winter chill is just beginning.

So what does this point to for the future of the industry?

  1. It is a safe bet with all the major E&P companies CapEx locked in for 2018 now and all the OpEx budgets done that demand isn’t going to be materially different from 2017. Slightly higher oil prices may lead to some minor increases in maintenance budgets but nothing that will structurally affect the market
  2. A smaller number of larger offshore projects of disproportionate size and importance fot the larger contractors and industry. Only the largest will have the technical skills and capability to deliver these (hence SS7 ordering a new pipelay vessel). These projects will have higher flow volume and lower lift costs and will be used by E&P majors to underpin base demand
  3. A huge bifurcation in contractor profitability between those capable of delivering projects above and the rest of the industry who will struggle to cover their cost of capital for years
  4. An ROV market that uses surplus vessels and excess equipment equipment that keeps margins at around OpEx for years as vessel owners seek this option for any utilisation
  5. E&P companies consistently seeking to standardise shale production, treat it as a manufacturing process that drives down per unit costs, and increase productivity. Any major offshore CapEx decision will be weighed against the production flexibility of shale
  6. Structurally lower margins in any reocvery cycle for the majority of SURF contractors

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