The marginal revolution and offshore contractor demand… the shrinking market thesis…

Mankiw’s third principle: Rational People Think At The Margin

 

It is not that pearls fetch a high price because men have dived for them; but on the contrary, men dive for them because they fetch a high price.

Richard Whately, Introductory Lectures on Political Economy (1832)

The Marginal Revolution refers to the discovery of the concept of diminishing marginal returns, which led to indifference curves, and ultimately the demand and supply curves that define modern microeconomics. A marginal revolution is also happening in offshore contracting and supply as E&P companies develop less marginal fields. I think most people know this intuitively so I hope this provides something of a framework around this.

I have written a lot here about how I think the smaller offshore contractors are less well positioned than the larger contractors in the current downturn. This isn’t just a balance sheet effect: it relates to how the whole market is structured and the types of projects that were developed as the oil price rose and how the smaller tier 2 contractors built their business models and asset base around these.  [I am also taking some methodological short-cuts here and mixing dyamic and static analysis slightly but I have done this in the interests of simplification].

Firstly, lets imagine the demand and supply for offshore services at any time up until 2013. I would argue they looked broadly like this:

A HYPOTHETICAL SUPPLY AND DEMAND CURVE FOR OFFSHORE SERVICES

Supply shortage.png

I.e. there was a supply shortage. Offshore contractors could not supply all the demand for offshore services at a price the E&P companies wanted to pay. And actually as the oil price continued to rise the E&P companies would have paid to get more work done, and develop more fields, but the long run nature of the supply curve meant that offshore companies simply could not move up the supply line fast enough to reach the equilibrium point.

Driving the demand side was E&P companies pushing ever more marginal fields into development. The costs of doing this were high as this data from McKinsey shows (for the North Sea but I believe these numbers to be broadly representative of a global trend):

North Sea Cost Inflation

What this meant for the market as a whole is that ever more marginal fields were being developed: these fields had a higher economic breakeven cost per barrel as the cash cost was higher in construction terms but often the reservoir itself was of lower quality in a relativse sense to previous developments. But the capacity was being added on the service side by companies with a higher marginal cost of capital and who were adding assets that were marginally more expensive than their competitors who had built a portfolio of assets up over a longer time frame with a lower (real) average unit cost. This happens because the cost of bringing each new unit of production becomes more expensive: the marginal cost increases.

These marginal fields, with the highest level of breakeven output, the highest levels of risk, and the smallest production lives, were often backed by the smaller E&P companies, in the North Sea think Enquest, Ithaca, Premier. When the oil price declined in 2014 it had dramatic effects on the North Sea as Oil and Gas UK reported:

  • Capital investment is falling rapidly to around £9 billion this year [2015] from a record £14.8 billion in 2014.
  • Only one new field has been approved so far this year [2015], with less than £100 million of fresh capital committed to the basin. This compares with five greenfield projects sanctioned in 2015 with associated development capital in excess of £4.3 billion.
  • The rate of brownfield investment is also slowing. Just five new projects were approved in the first eight months of 2016, compared to ten in total in 2015.

Activity appears to have picked up mildly in 2017, but mainly due to bigger projects that the larger SURF and offshore contractors are doing. And that is my point: the smaller projects grew the market and allowed a reduction of competitive behaviour in the market have gone. The number of marginal projects has been reduced. [Hardly rocket science I realise].

On the supply side these were companies who came to the market later and therefore paid the highest cost in real terms for their assets and missed the technical evolution (path dependence) of some of the more complex technologies (e.g. rigid reel pipelay) which they simply didn’t have the capital or market share to get into. Almost without exception these tier 2 contractors did take on the most debt as well though which is why there is a balance sheet effect as well as they have the least financial flexibility.

This leads me to my theory of why the smaller contractors have lost not just market size but also market share:

Representation of Change at the Margin in Offshore Contractor Supply

[Not to scale.]

JPU Theory.png

  1. There has been a change in the demand curve (not a change along the demand curve) so severe that it had dramatically lowered the amount of work demanded and the pricing equilibrium (Demand to Demand’). Simply lowering price hasn’t helped offshore contractors and supply companies. This is a secular change not a cyclical one
  2. Demand above the top orange line in each demand/supply combination is the most marginal demand and supply. It is where the price had to be the highest to attract new supply but also the costs are the highest and demand from E&P companies the most fragile
  3. Only fields that aren’t marginal are developed offshore now. The economics have to be compelling under even low oil price scenrios to work, and that generally favours larger projects with lower average lift costs
  4. The tier 2 contractors were pulled into the market, and committed more assets, as the shortage in demand in graph 1 led to cost pressures in the E&P companies. The scale of the transformation in the demand curve has led to a smaller market of marginal projects and they have lost market share in this as tier 1 contractors re-deploy capacity

This is clearly a generalisation to which there will be exceptions.

The combination of the most marginal contractors being heavily reliant on the most marginal projects has been toxic for the smaller general contractors. I am not picking on DOF Subsea, Bibby Offshore, Ocean Installer, Hallin Marine, EMAS Chiyoda, BOA, Fugro etc. but there are simply too many relative to the amount of work available when the demand curve moves that significantly to the left (i.e. a whole drop in demand that a price movement cannot correct). Unfortunately I don’t see 2018 being different for these contractors (those still in business) as they have similar asset bases and and higher costs than the larger global contractors.

Unfortunately if I am right the smaller offshore contractors/supply companies will also be the last to feel any upswing in the market. Consolidation and rectructuring will continue.

 

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