Permian export capacity, marginal investment, and disintermediation…

“O human race, born to fly upward, wherefore at a little wind dost thou so fall?”
Dante Alighieri, The Divine Comedy

Big news on capital investment in Permian takeout capacity today:  Trafigura Group and Enterprise Product Partners are independently looking to build significant VLCC  export terminals in Houston. The two combined terminals would allow for 2.4m barrels of crude a day to flow out of Houston ports: given that global liquids production is ~100m barrels a day these two terminals allow for around 2.4% of global production to be reallocated through one location.

Permian pipeline capacity is growing by 2m barrels in the next two years. If you were wondering where that oil was going this is one large trading house and one infrastructure provider making their respective moves. This is just a further example of the continued capital deepening in the region that will only further enhance and encourage greater investment in shale-based production.

One cannot help but note the contrast between the Trafigura business model and that of an offshore energy company. Trafigura is providing infrastructure and distribution capability to a whole host of smaller E&P companies that will concentrate on production and require CapEx only to hook-up to a pipeline (or less commonly a rail) network. Trafigura gets (at least) an infrastructure style return on the export facility and full exposure to the commodity price and volume as a trading house (which is what they want). But what it doesn’t have to do is develop a major E&P presence in the basin : in economics/ management speak they have disintermediated the E&P supply chain. It might sound like a dot-com era buzzword but it’s real.

Trafigura has the perfect supplier base of small companies, who wish to sell 100% of output at the marginal (i.e. spot market) price, and are constantly seeking innovative ways to extract that product at the lowest possible cost. In an industry where a host of smaller companies supply rigs and crews to drill wells the expensive coordination costs of this are being farmed out to the smaller companies. Very low barriers to entry, literally $10m per well and full rig crews for only a deposit, will ensure that greater offtake capacity keeps margins capped (at the level required to induce new firms) while Trafigura controls returns that require capital and market power. It is the sort of market and business that locks in structurally higher profits for the infrastructure and distribution arm while pushing CapEx back to E&P companies and their supply chain. If oil prices slump and some of the production companies go bankrupt then their assets will simply attract new buyers at a level that reflects the marginal cost of production and they will still need export and distribution facilities.

This for offshore is where competition for marginal investment dollars resides. A core of finance theory is that returns are linked to risk. You might well be able to get a lower per barrel cost from an offshore field but you have to risk your capital for a significantly longer period of time in an era of very volatile oil prices. Not only that but most offshore developments require that you invest in subsea processing equipment and offtake capability to get to a shared pipeline or increasingly to a FPSO for larger developments. Finance theory also teaches you that all projects that are NPV positive should be funded but the institutional mechanics of raising capital, and the impact of market sentiment on sector investments, mean that isn’t always the case (although really you could just argue that the finance providers have a different view of the risk involved).

Regardless, as the graph at the top of this article shows capital expenditure to offshore projects has declined ~29%!! as a proportion of the total allocation since 2016 (from 41% to 29%) while capital to onshore conventional and shale has grown (IEA) . This is well below the 2000-2010 average and if continued is a large structural industry change. Competition for capital and marginal production is driving this change and there is real competition. There is no ‘inflection point’ for offshore demand, or ‘recovery to prepare for’, without a marked change in this trend. Offshore is losing the battle for capital at the margin and remains competitive only by supplying assets below their economic cost.

Since the downturn in 2014 the holy grail of subsea investment has been to try and find investors willing to buy and lease the infrastructure as opposed to taking E&P risk. The problems with such an idea are legion: the kit is very site and customer specific, has limited residual value, and may struggle to get seniority over the reserves below in the event of a default driven by low oil prices. It is in short very difficult to create something that isn’t simply quasi- equity in the field and surely should be priced at the same level? The ability to genuinely split exploration and production risk from distribution risk, the hallmark of the US midstream system, offers a financing and business model innovation that makes it easier to allow large sums of capital to be raised and further deepen the capital base for production in the region. Finance matters in innovation.

As I keep saying this isn’t the end of offshore but it heralds a new kind of offshore surely? Large deepwater developments allow fully integrated E&P majors to take signficant development complexity, capital, timing, and offtake risk. These companies talk of ‘advantaged oil’ and they have it in these developments. Trading houses with export capability and infrastructure have advantaged oil in their network of production companies who aim to sell 100% of output at the margin, none of whom are large enough to impact the price they pay for the product, but mid sized offshore companies strike me as under real threat and limited in size to the proportion of oil shale/tight oil can supply.

Mid-sized offshore companies do not have the portfolio advantages that large oil companies do. Every development represents a significant fraction of their investment plans and there is a limit to the technical complexity and capital required of projects they can undertake. Previously their ‘advantaged oil’ was access to a resource basin that was needed but did not move the production needle for larger companies. As riskier investments they raised capital on smaller markets (AIM, Oslo OTC, TSX) and used reserves-based financing and bonds along with farmout agreements. But this took time and the higher leverage levels make this risky. The cost of equity, when available, is much higher than in the past because the expectation is that the price of oil will be more volatile. And now the returns are capped by the marginal cost and volumes at which shale companies can supply, which is a new and significant risk factor, particularly in an investment with a multi-year gestation period.

Yet these small-mid sized offshore E&P companies represented the demand at the margin for offshore assets. Large complex drilling campaigns and projects for tier 1 E&P companies always attracted good bids and a relatively efficient price from contractors, but smaller regional projects did not. The margins were higher and the risks greater. On the IRM side these companies negotiated harder on the price but they still had a volume of work that needed to be undertaken. It is these companies, their inability to get finance because of their complete lack of advantaged oil, that are also ensuring now that CapEx (and therefore demand) is not recovering as in previous cycles. These E&P companies are price taking firms with signficant operational leverage/fixed commitments and limited financial or operational flexibility in the short-term. Currently they rely on developments being profitable via the supply chain providing assets below their economic cost. That is not a great strategic position to be in. When there was no competition for your product the story was completely different, but the shale revolution is real.

This chart shows you that demand growth for crude slowed 1% year-on-year for two months and the market became oversupplied (hence the drop in the price of oil recently):

IMG_0731.JPG

Investors in oil closely watch volatility indicators like this and as I have said before the logical investment strategy is to invest more secure lower margin companies.

The three major risks to supply listed hy Woodmac at the moment are Venezuela, Libya, and Iran. These are geopolitical risks that could easily end in the short-run. Iran is self-induced and the situation in Venzuela so unsustainable (the real question isn’t why someone tried to assasinate Maduro but why everyone else isn’t?) that it surely cannot last? In prior eras the solution was to build long lasting production capacity in politically stable places. Now surely the solution is to use temporary production capacity where possible and let the price signal take some of the strain?

I think it is axiomatic that offshore cannot boom without a recovery in offshore CapEx spending. At the margin offshore has ceded significant market share in this competition to shale. Major structural change will be needed in the industry before the situation reverses based on current trends.

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