It’s grim up North… And the labour theory of value…

It’s Grim Up North.  The Justified Ancients of Mu Mu

Ricardo, Marx, and Mill believed that prices were determined by how much people had, in the past, invested. And that blinded them to any understanding of the workings of the market.

Friedrich Hayek

[I am not really a Hayek fan (in case anyone is interested). But he was a very smart guy who understood social and economic change processes better than most. Beyond that you get diminishing returns. As an aside I have been too busy to blog much lately, which is a shame as some really interesting things have been happening, but it doesn’t seem to have affected my visitor numbers much, which just goes to show maybe my silence is more valuable.]

The Oil and Gas UK 2018 Economic Report is out. For the North Sea supply chain there is no good news. There is clearly a limited offshore industry recovery underway as we head towards the end of summer. However, the market is plagued by overcapacity, and while service firms without offshore assets are starting to see some positive gains, if you are long on floating assets chances are you still have a  problem, it is only the severity that varies.

The UKCS is what a declining basin looks like: fewer wells of all types being drilled and dramatically lower capital expenditure. There is no silver lining here: an asset base built to deliver 2013/14 activity levels simply has too many assets for the vastly reduced flow of funds going through the supply chain. The report makes clear that the base of installed infrastructure will decline and there will be a relentless focus on cost optimisation to achieve this.

UK Capital Investment 2018.png

The volume of work may be increasing marginally but the overall value may even down on 2017 at the lower end of the 2018 forecast (purple box). Clearly £10bn being removed from the oil and gas supply chain, c. 60% down on 2014, is a structural change.

And the OpEx numbers unsurprisingly show a similar trend:

UKCS OpEx 2018.png

Party like it’s 2012 says Oil and Gas UK. Unfortunately a lot more boats and rigs were built since then.

Unit Operating Costs 2018.png

An unsurprisingly the pressure on per barrel costs seems to have reached the limits of downward pressure.

This should make supply chain managers seriously consider what their investment plans are for assets specific to the region and the likelihood of assets having to work internationally to be economic. It should also make people reassess what stuff is actually worth in a market that has reduced in size by that quantum and from which there is no realistic path to 2014 activity levels.

Technip paid $105m for the Vard 801, about $55m/45% discount to the build cost. Such a deal seems realistic to me. Some of the deals I have seen in offshore remind me of The Labour Theory of Value: if you dig a massive hole that costs a lot it must therefore be worth a lot. In reality with so much less cash floating around for assets that will service the UKCS an asset is worth the cash it can generate over its life, and the fact that it is substantially less than its replacement cost is just another clear example of how the industry will reduce its invested capital  as production levels in the basin decline. Like airlines offshore assets have a high marginal cost to operate and disposable inventory which is why you can lose so much money on them.

Boskalis appears to have paid an average of c. $60m for the two Nor vessels which equates to a similar discount on an age weighted basis. Quite where this leaves Bibby needing to replace the 20 year old Polaris and 14 year old Sapphire is anyone’s guess. But it is not a comfortable position to be in as the clear number four by size (in terms of resource access) to have competitors funding their newest assets on this basis. Yes, the shareholders may have paid an equivalent discount given the company value they brought in at, but if you want to sell the business eventually then you need a realistic economic plan that the asset base can self-fund itself, and at these sort of prices that is a long way off. Without an increase in the volume and value of construction work 4 DSV companies looks to be too many and this will be true for multiple asset classes.

As a mild comparison I came across this article on $Bloomberg regarding Permian basin mid-stream investment:

Operations in the Permian that gather oil and gas, and process fuel into propane and other liquids, have drawn almost $14 billion in investment since the start of 2017, with $9.2 billion of that coming from private companies..

That is just one part of the value chain. I get you it’s not a great comparison, but the idea is simply the ability to raise capital and deploy it in oil production, and it is clear that for Permian projects that is relatively easy at the moment. The sheer scale of the opportunities in the US at the moment is ensuring it gets attention and resources that belie a strictly “rational” basis of evaluation.

IMG_0957.JPG

That is what a growth basin looks like. The narrative is all positive. Once short-term infrastructure challenges are resolved that stock of drilled but uncompleted will be turned into production wells.

Oil and Gas UK go to great pains to explain the economic potential of the UKCS. But finance isn’t strictly rational and I still feel they need to be realistic about the cycle time tradeoff offshore entails. Shale, as we have seen, has an enormously flexible cost base relative to offshore and that has value.

The comments I make below are part of a bigger piece that I keep wanting to write but a) don’t have the time; and, b) probably doesn’t work for a blog format. But I think the impact of the private equity companies taking over North Sea assets needs to be realistically assessed.

Don’t get me wrong here I am a massive supporter of them. In terms of the volume of cash, and the ability to buy and invest at the bottom of the cycle, the North Sea would clearly have been worse off without private equity. But the results are in and there has not been a development boom… there has been a focus on the best economic assets that may make the fields last longer, but that is a different test. There may clearly have been an investment boom relative to what there would have been without private equity money, but again that is a slightly different point.

Private equity firms have a much higher cost of capital than traditional E&P companies and at the margin that will limit the number of projects they fund. The focus on lowering costs and returning cash as quickly as possible, often to compensate for how hard it will be for the owners to exit such sizeable positions, also adds to the change in the investment and spend dynamic (on the downside obviously). I am genuinely interested to see how these large multi-billion dollar investments are exited given how much trouble the super-majors are having at getting out.

Private equity may well be the future of the North Sea but that has huge implications for the supply chain. It is also worthwhile pointing out that while the smaller companies maybe able to sweat old assets they have a limit for larger projects. Quad 204 is a classic project where it is hard to see even one of the largest PE backed companies having the technical skills and risk appetite to take on such a vast project.

The majority of the larger deals also involved significant vendor financing from the sellers. Shell had to lend Chrysaor $400m of the $3bn initial consideration. This happened not through generosity, or a desire to maintain economic exposure to the assets, but because debt finance from the capital markets or banks was simply unavailable even to such large and sophisticated buyers. Siccar Point went to the Norwegian high-yield market in January borrowing $100m at 9% for five years. The fact is finance is scarce, and when available expensive, and this is impacting the ability of E&P projects to get financed. Enquest has had to do a deeply discounted rights issue, and borrow off BP, to complete Sullam Voe.

The E&P majors are helping to finance their own exit because it is the only way they can get out. The turnaround from that to an investment boom that could raise asset values in the supply chain is a long one.

In order to make money in this environment the E&P companies, particularly those backed by private equity, are focusing on driving down costs and limiting Capex with a ruthless efficiency and commitment few in the supply chain believed possible long-term. Where offshore assets are concerned the oversupply situation only assists with this. I met one of the private equity investors last week and I can assure you there is no pressure to replace old assets, safety first definitely, economics and finance second just as definitely.

The reality for the supply chain is this is a market where it will be very hard to make money for a very long time, and in reality the glory days of 2012-2014 look extremely unlikely to return. The Oil and Gas UK report gives some important data in explaining why.

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