“Not all barrels are created equally,” she said. “60 per cent of our cash flows are not coming from our upstream business. There shouldn’t be a correlation with our reserves or capital expenditure in upstream. It’s not tied to that.”
Jessica Uhl, CFO Shell
Money is not the value for which goods are exchanged, but the value by which they are exchanged.
John Law, Money and Trade (1705)
Roughly a year ago this week I gave an address at the OSJ Conference where I was pretty gloomy about the future for offshore. I was invited back this year but unfortunately a change of work circumstances mean it is no longer really the thing for me to do. Having said that I don’t think it is a bad time for a State of the Union speech.
You can guess where this is going…
Last year we had a mini-rally in offshore mid-year. Some of the more outlandish ideas raised more money and invested more capital in an industry already suffering an excess of capital and the share prices of all these public investments are seriously underwater. The banks also continued to pretend things could only get better, when in fact they were clearly getting worse. Solstad and Pacific Radiance are the two most prominent examples of this philosophy but there are a slew more in offshore supply and drilling.
And all the while shale simply grows in scale and scope. I am actually bored now with the really complicated theories about how and why the shale revolution will die. The offshore optimists who touted this theory have been comprehensively wrong in the past and will continue to be so in my opinion.
A few data points show the scale of the infrastructure being used to grow the shale fields:
- “A flooding of biblical proportions”… This article from $Bloomberg highlighting the enormous growth in pipelines and offtake capacity supporting Lower 48 production. We are here now.
- This article from Reuters on the refinery expansion in Texas that will process shale-oil for end US markets
- “The oil shock that never was” … So 2015 how by 2019 we would be back to the good old days… Another great story from $Bloomberg on the forecasting of 9 of the last 0 shortfalls in supply
- Technip is forecasting LOWER utilisation for 2019. Given the high proportion of their revenue comes from engineering this should terrify the smaller contractors
That folks is your offshore recovery: prices above breakeven at best and lower utilisation as the prices are just high enough to keep zombie companies in business. Welcome to the new normal.
Shale growth may be slowing down, but it will still grow over 1 million barrels a day in 2019. This slide from Exxon Mobil is reflective of the huge amounts of capital going into Lower 48 production and the continuous productivity immproveents creating the virtuous feedback loop:
So you can believe some really complicated story about this “offshore recovery” and how it has to happen because reserves are low, or demand will outstrip supply, or shale production isn’t economic, or you can look at what is happening in the US now and accept the logical conclusion: this is the offshore recovery.
Just like the steel industry in the US when it was hit with Asian competition so offshore now has a serious competitor for production investment at the margin. Offshore production isn’t going away but nor is there a boom in store. Projects at the margin are being delayed or cancelled and never coming back. The fleet built for 2014 is still too large by an order of magnitude and operating well below economic break-even. Only a massive increase from the demand fairy can save the current industry structure and that isn’t happening. There are too many boats and rigs with too many operators and this year will bring the start of the slow rationalisation needed. We will end the year with less companies and less tonnage and still the job will remain incomplete.
The most likely scenario at this point is years of oversupply with grindingly poor margins, struggles to get to economic profitability, and a gradual reduction in the fleet as ever so slowly those with less commitment and cash drop out of the race to stay alive. Eventually prices will have to rise to pay for new investment in the offshore supply chain but that looks years away and most firms don’t have the liquidity to wait. Raising new money is getting near impossible for all but the most serious candidates: hedge funds who piled in last year are underwater and look unlikely to wade back in unless the terms are extraordinary, and long-term investors are rightly terrified at the losses the Alternative fraternity have suffered calling the recovery far too early.
The interesting thing is why? In this paper “The elasticity of demand with respect to product failures” by Werner Troesken (pdf) shows that while markets are selection mechanisms they don’t always choose the best products. People continued to buy snake oil in the US long after its efficacy could be argued for. Maybe the offshore crowd waiting for the boom can comfort themselves with this fact?
However, I see however that in an era of mass production, and rapidly increasing efficiency and unit cost reductions in shale production. To avoid shale, to take your firm off the technological trajectory, would so limit the future options of a large E&P company that it would not be a wise strategic decision. More marginal capital will be deployed not less. has It is far less risky to invest in a lower margin product like shale, with a shorter payback period, than those custom designed deepwater fields with economic lives vastly in excess of price forecast accuracy.
Worringly for people in offshore is this paper: “Depression babies” by Ulrike Malmendier and Stefan Nagel. If you want to understand how formative experiences can be in lifelong economic actions then this paper demonstrates that investors whose careers were built in recessions invest in fewer equities (i.e. risk capital) even in positive economic times. My rough analogy, which I have no intent to take further, is that E&P execs who lived the 2014 downturn are in no hurry to turn on the CapEx spigot to satisfy all those who tell the world is running out of energy (and as 3 above shows are consistently wrong). And they will be like this forever. Just as those in offshore sit around waiting for the next boom E&P company execs sit around trying to avoid the next investment driven crash.
I have said before loss-aversion theory greatly explains the behaviour of the banks who are crucial to the clean-up of the industry (particularly in Europe and Asia as American losses have been equitized). Every time they have delayed the losses pretending the comeback will happen. And offshore supply in particular was dominated by European and Asian banks. Sooner or later, when the cash flows from the offshore supply and rig asset base cannot make even token payments, and the banks loan books are revealed to be more like Italian regional banks, the real contraction will begin. John Law intimately understood the link between a banks assets and liabilities in a way that would do a modern risk officer proud.
I also mentioned the DSV market last year. I am not mentioning names but building a $150m DSV and selling the vessel for 100k per day for 150 days (at best per annum) is a fools errand in economic terms regardless of the outstanding organisational skills required to deliver it in physical terms. It is simply not possible in a market as competitive as as the Asian DSV market for one firm to outperform others over the long run.
The sale of the Toisa DSVs for between $20-34m shows the economic clearing price of such assets. Such a large gap between actual economic values of operational assets and the historical build costs of new assets can be met by the Chinese taxpayer forever, but eventually the unsustainable nature of this will catch-up with itself. I shall say no more. But Uber can lose money on running taxis for longer than I thought… eventually I will be right here too. Delivering cold Starbucks at $5 won’t keep Uber at a $60bn valuation and IRM work in Malaysia cannot pay for $150m DSVs.
Offshore will continue to be an important part of the energy mix. But the supply chain supporting it to be like that has a great deal of shrinkage to be an economic part of this mix.