A friend asked me this week what my view on the graph above was (courtesy of Sparebank1 Markets) given my views on shale? I have been pretty consistent here that shale isn’t going to displace offshore, but it doesn’t need to in order to have a major impact on the economics offshore: It just has to take demand at the margin.
There are many graphs floating around like the one above. The Seadrill restructuring presentation contains this:
Oceaneering had this graph recently:
Ocean Rig has this one (while I agree with the headline the logic and data supporting this don’t make sense to me as the sanctioning replacement ratio has been historically over 100% for meaningful periods so a drawdown as firms pay down debt in a low price environment is logical):
You get the idea.
Schlumberger recently put the scale of shale production into perspective:
So to be clear: all tight oil had to do was add ~5% to the global supply and it has turned the entire offshore industry into a financial mess. Now it isn’t a strict causation, offshore has suffered a severe financial bubble based on oversupply as well as a demand crisis driven by the speed of change in the shale industry, but still it shows how finely balanced things were.
And indeed if you look at all the stories of hope and recovery that aim to recreate the world cast in a 2013 shadow they all profess unrealistically high utilisation and day rates at their core. The reason is obvious: the industry from 2007 was built on very high day rate levels and utilisation figues and any small change in those realities, given the very high fixed cost base, causes financial chaos.
A few percentage points in utilisation and day rates is all it takes to massively swing profitability in such a high fixed cost industry. Economic change happens at the margins.
Look at this chart from HugeStadSea which sums up the dominant thinking in the market (Q2 2017):
Back to a cheeky 90% utilisation from 60%. Nice… what could go wrong?
Seadrill has the same:
Everyone has the same story. But the problem is unless everyone is at very high utiilisation then day rates won’t pick up as the economic incentive for anyone with idle tonnage is to bid it cheap. Rowan in their latest results stated that they believed the market had to hit 85% utilisation before day rates improved.
So shale has an importance on the economics of offshore far beyond it’s output in the physical market displacing offshore oil as a source of supply. Shale only needs to reduce the utilisation of the offshore fleet by a few percentage points and that fundamentally changes the economics of rig and vessel companies. Seadrill, Solstad, Bibby, Technip DOF, in fact EVERYONE in the industry, is a completely different financial proposition at 51% utilisation compared to 91% with concomittant increases (or decreases) in day rates.
You also get an idea how large the investment in shale has been (Source: Schlumberger) since 2008:
25% investment since 2008 has gone into tight oil and it has seen productivity improvements like this (although the presentation highlights these rates are slowing):
So I repeat again that that shale will not displace offshore as a source of supply. But it doesn’t need to in order to completely upset the economic structure of the offshore industry by lowering the amount of marginal demand generated where offshore service companies made profits above their fixed costs. By that I mean if your rig/vessel covered its costs and overheads on 85% utilisation and profits came after that (i.e. at 86% utilisation and above you started to be profitable), and the impact of tight oil is such that you only ever get to 85% for ever, then shale will have managed to removed excess profitability from the industry by ensuring a drop in demand at the margin. All shale needs to do is meaningfully alter the global fleet utilisation, and win a significant amount of E&P CapEx share, both goals shale has achieved, to have a massive impact on the offshore industry.
In economic terms this is what looks likely to happen:
The Demand (for offshore services) = the extra unit of revenue firms get for selling (Marginal Revenue) which matches the point where the extra costs of supply (Marginal Cost + Average Total Costs) balance. So yes, there will be more work, and assets may well be busier than they are now, but it could be just enough to keep everyone in the industry cash flow positive but making zero economic profit. I am not saying there won’t be accounting profits, that all firms will all be loss making, and all shares will go to zero, but I am saying firms will find it very hard to earn returns above their cost of capital.
The one prediction I will make is that any business model in this industry that just relies on an increase in day rates and utilisation is doomed unless it has a massive cash pile (because getting there is going to take a very long time) or you are buying assets at distress prices. But most of the distress investors have moved far too early and there is so much money floating around from these funds I think the distress funds are killing the price discovery mechanism in this market.
It is clear that the quantative deployment of capital in large E&P companies will have a significant portion focued on tight oil as well as offshore. A few percentage points, that could go either way in many companies, collectively have a huge impact on the global offshore fleet utilisation (and therefore dayrates) and that is the core impact shale has.