More evidence this is the offshore “recovery”…

I was going to write this anyway today and then looked at the oil price as I was leaving work… down 2.7% at the time of pixel… The graph above comes from the Dallas Fed blog which makes this salient point and helps explain why:

Given current market prices, U.S. shale production will continue growing this year. Indeed, a recent report by the International Energy Agency highlighted that shale production is likely to be a major driver over the next five years. This does not rule out the possibility of major oil price movements, but it does point to a strong tendency that oil prices will be range bound in the near future.

Read the whole thing. Shale has structurally changed the oil industry and fundamentally changed any realistic scenarios for an “offshore recovery”.

Contrast that with the investment boom in shale: If you want to see how the whole ecosystem of companies and innovation are working in a harmony to make US shale more efficient, deepen the capital base, and thereby work in a virtuous circle then this article from the Houston Chronicle that showcases a GEBH project to turn flared gas into power in the region is a great anecdote:

Baker Hughes is using the Permian Basin in West Texas to debut a fleet of new turbines that use excess natural gas from a drilling site to power hydraulic fracturing equipment — reducing flaring, carbon dioxide emissions, people and equipment in remote locations…

Baker Hughes estimates 500 hydraulic fracturing fleets are deployed in shale basins across the United States and Canada. Most of them are powered by trailer-mounted diesel engines. Each fleet consumes more than 7 million gallons of diesel per year, emits an average of 70,000 metric tons of carbon dioxide and require 700,000 tanker truck loads of diesel supplied to remote sites, according to Baker Hughes.

“Electric frack enables the switch from diesel-driven to electrical-driven pumps powered by modular gas turbine generating units,” Simonelli said. “This alleviates several limiting factors for the operator and the pressure pumping company such as diesel truck logistics, excess gas handling, carbon emissions and the reliability of the pressure pumping operation.”

More capital, greater efficiency, and capital deepening. It is a virtuous circle that increases productivity and economic returns and is the signal for firms to invest more. It is a completely different investment dynamic to the one driving offshore projects at the moment.

Shale productivity.png

The above graph from the IEA makess a point I have made any times here: there is no real cost pressure in shale beyond labour (which will drop in the long run). Shale is all about productivity and cost improvement driven by mass production, something the US economy has as an almost intrinsic quality. The cost improvements in offshore are solely the result of over-capitalised assets earning less than their economic rate of return (i.e. oversupply) and is clearly not sustainable in the long run.

That is why firms with a low cost of capital are vacating fields like the North Sea to firms with a higher cost of capital: one requires steady investment and scale, the other investment is a punt on a shortage and price inflation. [A post for another day will be on how on earth some of these larger investors actually get out of the North Sea.]

This IEA data also tells you why this is the offshore reocvery:

IEA 2019 investment mix.png

The IEA is also forecasting overall spending to increase just 6%. So offshore just isn’t getting investment at the margin that will drive fleet utilisation and expansion. In company accounts this is showing up as depreciation significantly outpacing investment and is a constant across the industry. The economics of offshore are such that profitability is dictated by marginal demand (i.e. that one extra day of utilisation at a higher rate) and this graph shows the industry built a fleet for a far higher level and the only realistic prospect here is for structurally lower profitability. Given the high capital costs of the assets this is going to take a long time for the oversupply to work out.

For manufacturers (i.e. subsea trees) the recession is generally over, although not for Weatherford, but if it floats nothing but a wall of oversupply and below economic pricing and therefore sub economic returns is the logical consequence of this industry structure and market dynamic.

The hope of a massive demand boom kept banks from foreclosing and led hedge funds and other alternative capital providers putting money into assets that were (and are) losing cash but seen as “valuable” in the future. Slowly it is becoming apparent there is no credible path to anything other than liquidation for many companies still in business.

Rates will slowly rise, and so will utilisation levels, but only to economic levels i.e. covering their cost of capital in a perfectly competitive market. Absent a demand boom liquidity slowly, and then quickly, vanishes. And that is finally starting to happen now. For example the McDermott 10.25% 2024 bonds, already very expensive, were trading at well below par today implying a 13.5% yield, in effect locking them out of the unsecured credit market completely (and in reality all credit markets). A restructuring beckons. MDR will not be the only one by any stretch. Many rig companies will do a Chap 22 and a wave of supply companies in Europe and Asia are uneconomic and simply cannot survive under realistic financial assumptions.

Slowly the overcapacity in the industry will work its way out to more economically sustainable day rates with higher utilisation levels in a smaller global offshore rig and vessel fleet. But it won’t be a return to 2013, it will be a return to a far lower profitability level despite the smaller fleet, higher prices, and less time and utilisation risk taken smaller companies. There will be a complete wipe-out, almost without exception, of investors who backed offshore “recovery” theses of asset backed companies and an inability of these companies to access funding almost at any price levels. Theories about assets recovering to values implied by book value will be realised for what they are: a fantasy no serious person could believe.

But a far more rational industry and market will emerge. The only thing that could change the dynamic outlined above is a massive demand boom, and the graphs above show you why that isn’t going to happen.

IEA global upstream investment 2019.png

One thought on “More evidence this is the offshore “recovery”…

  1. […] Ignoring this fact lets you produce a “Key Financials” slide that bears no obvious relationship to how the market is really going to evolve. There is a lot of pain to come for the offshore industry as the need for banks to make painful writeoffs starts to permeate through the system and finally even more painfully capacity will be permanently removed from the market. This is an industry that needs significantly less capital and capacity to generate economic profits. And as I say: this is the recovery. […]

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