State of the nation…a slow trip towards equilibrium…

Loads of news happening that seems to sum up to me the state of where the offshore and subsea industry is at the moment. Dare I say it but we appear to be approaching a sort of equilibrium point where demand and supply are converging around more stable levels.

The FT reported on Monday that:

The US shale oil revolution has reached a landmark moment, with the sector’s top companies for the first time earning enough cash to cover the cost of new wells…

From the time the first shale oil test wells were drilled in the US in 2008-09, the industry’s capital expenditure has exceeded its cash from operations, with producers only able to stay in business by attracting hundreds of billions of dollars in financing from bond and share sales and bank loans. From 2008 to 2017, US exploration and production companies raised $293bn from bond sales, according to Dealogic.

That is what should happen to a marginal producer: they must become profitable at a cash flow (and economic) level so there is an incentive for them to supply the next barrel of oil required. The great hope for some in offshore that shale was an ephemeral phenomenon can be firmly put aside.  To put that bond number into perspective the UKCS spent £14bn offshore in 2014, its best year ever! Efficient US capital markets have channelled the funds into an industry where the long term prize was clear.  And as I constantly say here it wasn’t just a capital story it is a productivity story:

Scott Sheffield, chairman of Pioneer Natural Resources, said its wells in the Permian Basin of Texas and New Mexico were now 300 per cent more productive than four years ago, driving down the oil price needed for them to make a profit.

“In 2014 our break-even price in the Permian Basin was probably $55 or $60 a barrel,” he told the Columbia Global Energy Summit last week. “I would never have thought that the Permian Basin could drive down the break-even price to the low $20s. And we did it.”

So it is hardly surprising that today Heerema announced they are pulling out of pipe-lay, converting the Aegir to a heavy lift vessel that will also work on renewables, and laying off 350 people. The Aegir was only added to the fleet in 2013, yet a mere 5 years later the market has changed so much that a premium asset must now be re-engineered as a completely different economic proposition. I have statistical issues with microcosms but this struck me as one.

Heerema have called it right in my opinion: the deepwater lay market, and pipe-lay in general, is now totally over supplied. Some companies and assets will have to leave the industry in order for it to rebalance. Heerema simply doesn’t have the  financial resources or integrated solution of the “Big Three” (TechnipFMC, Subsea 7, Saipem).  Heerema were annoyed when EMAS seemed to copy many of the unique features of the Aegir for the Constellation (which is of course now in the Saipem fleet), but the economist in me says that only reflects how high returns have to be in this industry to reflect the risks. Saipem have arguably appropriated some of the value from the Aegir and Heerem’s IP…. although the trade-off was an asset built in TriYards Vietnam so maybe it will all even out… Quite what move Allseas makes next remains to be seen but they must be starting to feel lonely.

Maintenance spend will increase as higher prices make it economic to refurbish older wells or those shut in now. But the installed base on which future demand predictions were made will be permanently smaller. Prices for E&P companies will eventually have to rise to recognise that someone building a $600-700m construction vessel, with no forward order book, is a very risky business model and investors need to be compensated for this. Especially when the downside can be at least a 50% discount to build cost in a managed sale.

But this time as the oil price has crept up E&P companies have failed to shine as in previous eras of rising prices as they are burdended with excessive debts and sceptical investors who want to share more of the upside in a boom. There is a very good article from Bloomberg here:

At fault, a toxic troika that combines gushing supply with fears that long-term demand will flat-line as electric vehicles and renewable energies grow, and climate change policies proliferate. And while cash flow for oil’s majors in 2018 is likely to be the highest in 12 years, investors are largely unmoved…

Oil executives acknowledge that it’s too soon to win back investors. Shell CEO Ben van Beurden has openly talked about a “credibility and track record gap” between the major oil companies and its shareholder base.

“We need to show a little bit longer we mean what we say in terms of capital discipline,” he told reporters last week. “This newfound religion and confidence is, to say the least, fragile.”…

“The investment community still is not sure we’re going to handle these higher prices with discipline,” BP Plc Chief Executive Officer Bob Dudley said Tuesday. “Then there’s a section of the investment community that wonders why we’re not investing more in batteries and cars and renewables.”

E&P versus market.JPG

You can see above that higher oil prices haven’t meant much for E&P companies. One central issue is CapEx spend where large companies are making a promise to investors not to spend on mega projects in an era of rising prices. Smaller companies, offshore companies, are struggling to get finance at all. If you want it set out explicitly here it is:

Big Oil’s first quarter results are “a chance at redemption” after a poor fourth quarter of 2017, Biraj Borkhataria, a London-based analyst at RBC Capital Markets wrote in a note. Investors will reward companies whose cash generation rises at the same rate as oil prices in the period, and no new plans to raise capital spending, he said.

Get that…? An increase in oil price goes out in debt reduction, dividends, and stock buy-back not offshore projects to increase supply. No to hitting the supply chain with massive orders that cause a spike in prices as the spot oil price increases.  E&P companies are going to make money in an  era of rising oil prices from higher prices, not from taking the money from rising prices and putting it into more production to take advantage of potentially higher prices in the future. It is a very different investment dynamic. It might change in the future, but it will take a long time to be felt in the offshore supply chain, and there is no guarantee it will.

And by the way it doesn’t matter if you believe the “toxic troika” theory or not… the people who buy the shares in E&P companies, and therefore ultimately fund large projects, do. And collectively they are making it harder for these projects to be funded by insisting on higher cash payments from E&P companies. So perception has become reality.

This is an environment that favours offshore field developments to supply a baseload of high volume/low lift cost supply while using shale for marginal demand. Some smaller field developments will of course happen, TechnipFMC has an good video here about how standardised they will be in shallow water for example, but it is harder not to see offshore developments being marked by larger projects or infield work.

This is a market heading for equilibrium, yes there will be rising oil prices, but no one, not even the E&P companies, feel like this is a boom. Yes, it is better for E&P companies than the offshore supply chain, although the onshore supply chain is booming in US onshore. A number of offshore contractors are making money, they are more than cash flow positive, but the order book is weak and few points utilisation either way is the difference between a breakeven and a loss. The supply side will still face a contraction, sensible M&A will occur, services will be more profitable than owning tonnage, and companies will make money. But returns in excess of the cost-of-capital look a long way off for the offshore industry given that the last boom showed how expensive the cost-of-capital should really be on a cyclically adjusted basis.

2 thoughts on “State of the nation…a slow trip towards equilibrium…

  1. […] As I said yesterday this is a different world from 2013. Shell shares actually dropped on the news despite the fact they are making higher profits than on $100 oil. And the hangover from the 2014 downturn is still there for E&P companies because Shell paid dividends with shares recently to cut the cash cost, the commitment to reduce the number of shares on issue is just the slowburn effect of the downturn that reduces cash available for projects. […]

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