Random weekend energy thoughts… Productivity, costs, and DSV asset values…

Permian shale and tight production in the third quarter was 338,000 barrels per day, representing an increase of 150,000 barrels per day. Let me say it again: this is up 80% relative to the same quarter last year. As many of you will realize, that’s the equivalent of adding a midsized Permian pure play E&P company in a matter of months.

Pat Yarrington, CFO, Chevron, on the Q3 2018 results call

John Howe from UT2 posted the photo above on Friday and kindly allowed me to reproduce the it. The Seawell cost £35m in 1987 and according to the Bank of England Inflation Calculator the same vessel would cost ~£94m in 2018 in real terms. In 1987 the USD/UK exchange rate was ~1.5 so the Seawell cost $53m and inflation adjusted around $132m (at current exchange rates).

Compare that with the most recent numbers we have for a new Dive Support Vessel (“DSV”) of a similar spec: the Vard 801 ex Haldane that was contracted at $165m (sold for $105m).  That price is roughly 25% above the cost of the Seawell in real terms. You get a better crane and lower fuel consumption but in productive terms you can still only dive to 300m (and no riser tower) and I doubt the crane and the lower fuel consumption are worth paying 25% more in capital terms.

These prices don’t reflect how much the MV Seawell pushed the technological boundary when she was built when and recognised as one of the most sophisticated vessels in the world. The major £60m/$75m upgrade she received in 2014 highlights again the myth that old tonnage will naturally be scrapped as an iron cast law is wrong, but more importantly highlights the technical specification of the vessel has always been above even a high-end construction class DSV (clearly visible in the photo the riser tower must have been seen a major technological innovation in 1987) and yet it is more economic to upgrade than build new for a core North Sea well intervention and dive asset. Helix has invested in an asset that brings the benefits of low-cost from a different cost era to a new more uncertain environment.

The reasons for price inflation in OSVs are well-known and I have discussed this before (here): offshore vessels are custom designed and have a high labour content which is not subject to the same produtivity improvements and lower overall cost reduction that manufactured goods have (Baumol Cost Disease). The DP system and engine might have come down in real terms, but the dive systems certainly haven’t. Even getting hulls built in Eastern Europe and finished in Norway has not reduced the cost of new OSVs in real terms (you only have to look at Vard’s financial numbers to see the answer isn’t in shipbuilding being a structurally more profitable industry).

That sort of structural cost inflation, a hallmark of the great offshore boom of 2003-2014, was fine when there was no substitute product for offshore oil. Very few OSVs were built in a series (apart from some PSV and AHTS). But the majority of the vessels were one-off or customised designs with enormous amounts of time from ship designers, naval architects, class auditors (i.e. labour) before you even got to the fit-out stage. Structural inflation became built into the industry with day-rates in charters etc expected to go up even as assets aged and depreciated in real economic terms because demand was outpacing the ability of yards to supply the tonnage as needed.

The same cost explosion happened in pipelay but did allow buyers to access deeper water projects. Between 2003-2014 an enormous number of deepwater rigid-reel pipelay vessels were built (in a relative sense) with each new vessel having even more top tension etc. than the last; but the parameters were essentially the same: they were just seeking to push the boundary of the same engineering constraints. The result was (again) a vast increase in real costs but one that was partially offset by advances in new pipe and riser technology that allowed uneconomic fields to be developed. Now Airborne and Magma are working on solutions that could make many of these assets redundant. Only time will tell if those offshore companies who have made vast investments in pipelay vessels will have to sell them at marginal cost to compete with composite pipe if the solution gets large-scale operator acceptance (i.e. Petrobras). However, if composite pipe and risers get accepted by E&P companies on a commercial scale those deepwater lay assets are worth substantially less than book value would imply (I actually think the most likely scenario is a gradual erosion of the fleet as it is not replaced).

But now there is a competitor to offshore production: shale. And it is clearly taking investment at the margin from offshore oil and gas. And shale production is an industry subject to vast economies of scale and productivity improvements. The latest Chevron results make clear that they have built a vast, and economically viable, shale business that added 150k barrels per day of production at an 80% growth rate year-on-year:

Chevron Q3 2018 Permian .png

To put that in perspective when Siccar Point gets the Cambo field up and going they will be at 15k per day and it will have taken them years (and the point is they are a quality firm with Blackstone/Bluewater as investors ensuring the do not face a financing constraint).

What makes shale economic is the vast economies of scale and scope available to companies like Chevron. E&P companies producing shale are adding vast amounts of production volume every year and theories that they are not making money doing this are starting to sound like Moon photo hoax stories. E&P companies throw money and technology at a known geological formation and it delivers oil. The more money they invest the lower the unit costs become and the greater the economics of learning and innovation they can apply at even greater scale.

Offshore has a place but it needs to match the productivity benefits offered by shale because it is at a disadvantage in terms of capital flexibility and time to payback.The cost reductions in offshore that have been driven by excess capacity and an investment boom hangover, these are not sustainable and replicable advantages. In offshore everything, from the rig to well design and subsea production system, has traditionally been custom designed (or had a significant amount of rework per development). When people talk of “advantaged” offshore oil now it generally means either a) a field close to existing infrastructure, or, b) a find so big it is worth the enormous development cost. Either of those factors allow a productivity benefit that allows these fields to compete with onshore investment. But to pretend all known or unknown offshore reserves are equal in this regard is ignoring the evidence that offshore will be a far more selective investment for E&P companies and capital markets.

One of the reasons I don’t take seriously graphs like this:

IMG_1067.JPG

…and their accompanying “supply shortage” scare stories is that the market and price mechanism have a remarkably good track record at delivering supply at an economically viable price (since like the dawn of capitalism in Mesopotamia). Modelling the sort of productivity and output benefits that E&P majors are coming up with at the moment is an issue fraught with risk because 1 or 2% compounded over a long period of time is a very large number.

As an immediate contra you get this today for example:

(Reuters) – The oil market’s two-year bull run is running into one of its biggest tests in months, facing a tidal wave of supply and growing worries about economic weakness sapping demand worldwide.

Which brings us back to DSVs in the North Sea, their asset values, and the question of whether you would commission a new one at current prices?

Last week the OGA published an excellent report on wells in the UK and its grim for the future of UK subsea, but especially for the core brownfield and greenfield projects in shallow water that DSVs specialised in. And without a CapEx boom there won’t be a utilisation boom:

OGA wells summary 2-18.png

Future drilling is expected to pick-up  mildly, although it is unfunded, but look at this:

EA well spud.png

Development Drilling.png

So the only area in the UKCS that isn’t in long-term decline is West-of Shetland which is not a DSV area. CNS and SNS were the great DSV development and maintenance areas and the decline in activity in those areas are a structural phenomena that looks unlikely to change. Any pickup is rig work is years away from translating into a Capex boom that would change the profitability of the UKCS DSV and small project fleet.

DSV driven projects have become economic in the North Sea because they are being sold well below their economic cost. Such a situation is unsustainable in the long run (particularly as the offshore assets have a very high running cost). The UKCS isn’t getting a productivity boom like shale to cover the increased costs of specialist assets like DSVs and rigs: E&P companies are merely taking advantage of a supply overhang from an investment boom. That is no sustainable for either party.

So while the period 2003-2014 was “The Great Offshore Boom” the period 2015-2025 is likely to be “The Great Rebalancing” where supply and demand both contract to meet at an equilibrium point. Supply will have to contract because at the moment it is helping to make projects economic by selling DSVs below their true economic worth, and the number of projects will have to contract eventually because that situation won’t last. E&P companies will need to pay higher rates and that will simply make less projects viable. You can clearly see from the historic drilling data that a project boom in shallow water must be a long time coming given the lags between drilling and final investment decisions.

The weak link here in the North Sea DSV market is clearly Bibby Offshore (surely soon to be branded as Rever Offshore?). As the most marginal player it is the most at risk as marginal demand shrinks. Bibby, like other DSV operators on the UKCS, serves an E&P community that is facing declining productivity relative to shale (and therefore a higher cost of capital), in a declining basin, where the cost of their DSVs is not reducing proportionately or offering increased productivity terms to cover this gap. Both Technip and Boskalis were able to buy assets at below economic cost to reduce this structural gap but the York led recapitalisation of Bibby still seems to significantly over value the Polaris and the Sapphire – particularly given implied DSV values with the Technip purchase of the Vard 801 (TBN: Deep Discovery).

DSVs made the UKCS viable and built the core infrastructure, but they did it in a rising price environment where the market was based on a fear of a lack of supply. One reason no new North Sea class DSVs were built between 1999 the Bibby Sapphire conversion in 2005 is because the price of oil declined in real terms but the price of a DSV increased meaningfully in real terms. A new generation of West of Shetland projects may keep the North Sea alive for a while longer but this work will be ROV led. A number of brownfield developments and maintenance work may keep certain “advantaged” fields going for years that will require a declining number of DSVs.

North Sea class DSV sales prices for DSVs are adjusting to their actual economic value it would appear not just reflecting a short-term market aberration.

#structural_change #this_time_it_is_different #supplymustequaldemand

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