Unconventional verus offshore demand at the margin…

Economic growth occurs whenever people take resources and rearrange them in ways that are more valuable. A useful metaphor for production in an economy comes from the kitchen. To create valuable final products, we mix inexpensive ingredients together according to a recipe. The cooking one can do is limited by the supply of ingredients, and most cooking in the economy produces undesirable side effects. If economic growth could be achieved only by doing more and more of the same kind of cooking, we would eventually run out of raw materials and suffer from unacceptable levels of pollution and nuisance. Human history teaches us, however, that economic growth springs from better recipes, not just from more cooking. New recipes generally produce fewer unpleasant side effects and generate more economic value per unit of raw material…

Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has underestimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. The difficulty is the same one we have with compounding. Possibilities do not add up. They multiply.

Paul Romer (Nobel Prize winner in Economics 2018)

Good article in the $FT today on Shell’s attitude to US shale production:

Growing oil and gas production from shale fields will act as a “balance” for deepwater projects, the new head of Royal Dutch Shell’s US business said, as the energy major strives for flexibility in the transition to cleaner fuels. Gretchen Watkins said drilling far beneath oceans in the US Gulf of Mexico, Brazil and Nigeria secured revenues for the longer-term, but tapping shale reserves in the US, Canada and Argentina enabled nimble decision-making.

“The role that [the shale business] plays in Shell’s portfolio is one of being a good balance for deepwater,” Ms Watkins said in her first interview since she joined the Anglo-Dutch major in May…

Shell is allocating between $2bn and $3bn every year to the shale business, which is about 10 per cent of the company’s annual capital expenditure until 2020 and half of its expected spending on deepwater projects. [Emphasis added].

Notice the importance of investing in the energy transition as well. For oil companies this is important and not merely rhetoric. Recycling cash generated from higher margin oil into products that will ensure the survival of the firm longer term even if at a lower return level is currently in vogue for large E&P companies. 5 years ago a large proportion of that shale budget would have gone to offshore, and 100% of the energy transition budget would have gone to upstream.

The graph at the top from Wood MacKenzie is an illustration of this and the corollary to the declining offshore rig numbers I mentioned here. Offshore is an industry in the middle of a period of huge structural change as it’s core users open up a vast new production frontier unimaginable only a short period before. The only certainty associated with this is lower structural profits for the industry than existed ex ante.

Note also the split that the – are making between high CapEx deepwater projects and shale. Shell’s deal yesterday with Noreco was a classic case of getting out of a sizable business squarely in the middle of these: capital-intensive and not scalable (but still a great business). PE style companies will run these assets for cash and seem less concerned about the decom liabilities.

You can also see this play out in terms of generating future supply and the importance of unconventional in this waterfall:

Shale production growth

As you can see from the graph above even under best case assumptions shale is set to take around 45% of new production growth. When the majority of the offshore fleet was being built if you had drawn a graph like this people would have thought you were mad – and you would have been – it just highlights the enormous increase in productivity in shale. All this adds up to a lack of demand momentum for more marginal offshore projects. The E&P companies that are investing, like Noreco, have less scale and resources and a higher cost of capital which will flow through the supply chain in terms of higher margin requirements to get investment approval. This means a smaller quantity of approved projects as higher return requirements means a smaller number of possible projects.

Don’t believe the scare stories about reserves! The market has a way of adjusting (although I am not arguing it is a perfect mechanism!):

Running Out of Oil.png

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