Shale, mental models, strategic change, renewal, and railways…

“In other words the problem that is usually being visualised is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them………However, it is still competition within a rigid pattern of invariant conditions, methods of production and forms of industrial organization in particular, that practically monopolizes attention. But in capitalist reality as distinguished from the textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization….”

(Schumpeter, 1943, p. 84.)

On a day when the oil price dropped to its lowest point in seven months Bloomberg reported that:

There’s yet another concern growing as oil prices continue to erode: A record U.S. fracklog.

There were 5,946 drilled-but-uncompleted wells in the nation’s oilfields at the end of May, the most in at least three years, according to estimates by the U.S. Energy Information Administration. In the last month alone, explorers drilled 125 more wells in the Permian Basin than they would open. That represents about 96,000 barrels a day of output hovering over the market.

Yesterday Energen, a US shale E&P company, reported numbers yesterday with increasing productivity of “Gen 3” fracking:

Energen Wells with Gen 3 Fracs Outperforming

In central Midland Basin, cumulative production of 5 new Wolfcamp A and B wells averaging ≈15% above the high‐end, 1.3 MMBOE EUR type curve for a 10,000’ lateral (77% oil) at 75 days. Cumulative production of 2 new Wolfcamp A and B wells with 80 days of production history in Delaware Basin averaging ≈80% above the high‐end, 2.0 MMBOE EUR type curve for a 10,000’ lateral (61% oil).

If you don’t understand the implication of the text above for offshore they have a handy graph that makes it abundantly clear:

Energen 3G Frac Performance.png

This is simply a productivity game now as I have said before.  Yesterday I mentioned the DOF Subsea potential IPO, it’s worth noting that investors could choose between a company that took a bigger asset impairment charge than they made in EBITDA in the subsea projects division, or a company like Energen. When deciding to allocate capital it starts to become an easy decision.

There is a technical and industrial revolution taking place on the plains of the US. Ignoring this won’t make it go away. The Industrial Revolution didn’t happen overnight: steam engines were invented, coal production capacity increased, canals were built, railways invented etc, a series of interlinked innovations occured in a linear and dependent fashion. No one woke up one day and experienced them all. Productivity is a never ending journey. In the Cotton Revolution Kay invented the “Flying Shuttle” (1733), Hargreaves the “Spinning Jenny” (1765), Arkwright the “Water Frame“, (1769), the Crompton Mule (1779) was a combination of the Spinning Jenny and the Water Frame, and Boulton and Watt (1781) invented the condenser steam engine for use in a mill (ad infinitum).

The same thing is happening in shale. Shale won’t come up with a rig that kills deepwater productivity and lower lift costs overnight, but a series of systemic and interdependent innovations that advance the productivity of the sector as a whole is a certainty. That red line above will become steeper and move to the right with irregular monotony now until new technological constraints are reached.

For those of us, and I include myself in this camp, new to the shale productivity revolution Energen included another chart:

EGN Frac Design Evolution.png

And after this will be 4G and 5G… just like mobile phone evolution. Each generation will offer greater productivity than the one before. The image at the top of the page highlights the advances multi-well pad technology has already made to shale.

I am still not convinced everyone in offshore has understood the scale of the change occurring in the industry. I still think some people, particularly banks and those with fixed obligations, are using the 2007/08 years as a frame of reference when a short and sharp drop in demand was followed by a boom. I don’t see that happening this time. Telling people it will change one day isn’t a strategy it’s a hope.

Mental models I think are crucial here. One extraordinarily interesting paper is from Barr, Stimpert, and Huff (1992) who looked at the cognitive change managers underwent to successfully renew an organisation in light of externally driven change. (This is actually the paper that made me want to become a management consultant, a decision I quickly regretted I hasten to add). These researchers basically found two almost identical railroads operating in the same state and compared what happened to them in a longitudinal study spanning 25 years. The mental models of managers were examined by content analysing the annual reports and in particular the comments to shareholders. It is a rare example of a perfect natural control group so rare in social sciences and it’s a brilliant piece of research. The key findings were essentially the managers who were outward focused and changed their strategy accordingly survived while the railroad that went bankrupt always blamed industry factors beyond management control. The analogy to offshore at the moment needs little development.

Barr, Stimpert, & Huff (1992): COGNITIVE CHANGE, STRATEGIC ACTION, AND ORGANIZATIONAL RENEWAL

Barr Stimpert and Huff

BSH found four things mattered, 3 of which are directly related to offshore at the moment:

  1. Renewal requires a change in mental models
  2. A munificient environment may confirm outdated mental models
  3. Changes in the environment may not be noticed because they are not central to existing models
  4. Delays in the succession of mental models may be due to the time required for learning.

I’d argue there was another factor present in offshore that is the commitment to fixed assets and the associated liability structure makes it impossible to change the core business model even if the need for change is realised. Very little can be done outside a restructuring event in that case, although it is likely to actively influence management mental models.

Offshore will survive and prosper as an industry but it won’t be a reincarnation of the 2013/14 offshore. A new and different industry with a vastly different capital structure and strategic option set will appear I would suggest.

BP results, the future of offshore, and myopic loss aversion…

The myopic loss aversion explanation rests on two behavioral principles: loss aversion and mental accounting. Loss aversion re-fers to the fact that people tend to be more sensitive to decreases in their wealth than to increases.

Thaler, Tversky, Kahneman, and Schwartz (The Quarterly Journal of Economics, 1997

 

Let me start by saying, as I have many times before, I am a believer in offshore oil and gas production. My issue at the moment isn’t that it is going to go away, rather it is that too many vessels have been built, and that 2012-2014 was a peak bubble of activity. There will still be good money to be made offshore, I am just not sure it will be through owning vessels (and rigs) until a very painful, and in all likelihood prolonged, restructuring process has been completed.

I recently wrote my thoughts on economic research and dividend policy and why this may lead to an undersupply of offshore projects in the future. I am not conviced this will happen at all, but it seems to be the great hope for all involved in offshore. The BP results yesterday highlight what I was saying with one perfect graph:

BP Cash vs Capex 17Q1

For BP the dividend doesn’t change, CapEx, the driver of future production and profitability potential, is the moveable number. And in a large corporation it is surprisingly flexible in the short-term. (“A billion here, a billion there, pretty soon you are talking real money…”). I think this is typical of all the supermajors, their shareholders want dividends.  The data reveal that Shell and BP alone were responsible in Q1 2017 for £4.8bn of the total £12.5bn (38%!!) of total FTSE 100 dividends. BP and Shell shareholders, UK pension funds especially, want the money now not the hypothetical billions available from a shortage of capacity in a few years time.

Another way to look at it is this: the BP dividend was USD 10.0 cents per share in Q1 2017, and Q4 2016, but this is way more than the company is earning per share (bold Q1 2017, then Q4 2016, then Q1 2016):

BP EPS Q12017

BP is making up the numbers by increasing the debt and divestments in the portfolio. The last thing they want, and their shareholders I suspect, is a large and capital intensive bet on risky offshore projects. As if to reassure everyone this is the case the CFO gave look ahead guidance for CapEx at these levels until 2021.

There is a really good interview with Starlee Sykes, BP VP Global Projects, that is well worth a read – the cost on the Mad Dog phase 2 project was cut to USD 9bn (from USD 20bn). Several parts struck me but none more than this:

We looked for analogies to what we had done before and focused on the Atlantis project in the gulf, which came online in 2007, and its semisubmersible-platform design concept. Atlantis was, and is, viewed as a very economic, very good development. We decided to adopt this simpler design concept. Compared to the original Mad Dog 2 stacked-deck spar design, the semisubmersible is flexible for building future capacity, while fulfilling minimum technical requirements. That was the big idea around Mad Dog 2. Rather than designing for a future that may not happen, the principle was to build what we need at day one, and then allow for the expansion later. So, for example, we did not install all of the water-injection capacity that we needed on day one. It’s a more incremental approach.

A total change of mindset for the industry where everything in offshore was bespoke and future proof. This is part of a slow path to standardisation where possible to reduce costs. Mad Dog Phase 2 can produce 140 000 bpd at peak capacity, far beyond anything tight oil can dream of. At that level, and with efficient lift costs, it’s well worthwhile dropping a cool USD 9bn. But as I have said before I see offshore bifurcating into developments like this with very high flow rates and very high CapEx commitments, normally at deepwater, (only the Norwegians seem to get lucky enough to find huge fields at shallow depths now), and a base of demand in Asia and the Middle East where NOC’s are more security supply focused where they will develop in shallow (often alone) as well as deeper water (where they will need a supermajor partner for technical expertise).

I fear for the shallow UKCS which is somewhat caught in the middle: SPS technology isn’t standardised and cannot feel the effects of scale and scope that tight oil has, yet these fields cannot provide the reserve capacity in a high cost environment. One of the reasons the Norwegian basin seems to do better than the UKCS is an understanding of Loss Aversion Theory, that in essence states that investors would rather not lose $5 than gain $5: in Norway tax incentives for drilling are heavily front ended loaded versus credits for production in the UK (making a massive generalisation of a very complex issue). A classic article on myopia and and loss aversion in risk taking is available here. Which is a lot like shareholders in E&P companies who have seen paper wealth vanish as the oil price drops.

To be effective shallow offshore fields will have to be subject to some form of standardisation around production equipment and SURF installation, and we are a long way from that at the moment because a core component of that is drop volume which drives the experience curve. And of course as the E&P companies cut CapEx, that is distinctly lacking.

The other problem offshore has at the moment is management focus and resource constraints. I have mentioned before the power of narrative in economics, as Shiller argues:

[w]e have to consider the possibility that sometimes the dominant reason why a recession is severe is related to the prevalence and vividness of certain stories, not the purely economic feedback or multipliers that economists love to model.

The industry meme at the moment is all about cost and tight oil. Changing that mindset in large organisations is hard – it can take at least 12 months if peoples bonuses have just been contractually set for exmaple and they are based on cost savings. A recovery for the offshore contracting industry is going to rely on changing this narrative somewhat.

I have discussed here mainly the demand side of the market which I believe will be structurally more unattractive for the next few years going forward. I still think for the supply side, the offshore contractors, there can be a bright future if positioned clearly: a tight fleet of core enabling assets (mainly lay capability) and a strong EPIC competency, and an ability to position the firm to respond to this structural change in the industry.

I am generally sceptical on alliances and integration between SPS and SURF because I think they add more  value to the contractor than customer, and as Exxon Mobil showed with the Liza award, an educated customer can drive the price down by splitting workscopes. But I am writing a fuller piece on this.

More Uber madness… Devil take the hindmost…

The additional rise above the true capital will only be imaginary; one added to one, by any stretch of vulgar arithmetic will never make three and a half, consequently all fictitious value must be a loss to some person or other first or last. The only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost

A participant in the South Sea Bubble quoted in “The South Sea Bubble”, John Carswell, 

 

I’ve decided to keep a vague running tab on Uber. It’s an investment bubble, I don’t know quite how its’s going to pop… but it’s going to. My previous thoughts are here. In his Nobel award lecture “Speculative asset bubbles” Robert Shiller defines and investment bubble as:

[a] situation in which news of price increases spurs investor enthusiasm which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase and bringing in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawnto it partly through envy of others’ successes and partly through a gambler’s excitement.

Nothing seems to sum up the investment psychology of Uber more. Having watched the extraordinary returns others have made in companies such as Facebook, and seen a group of tier 1 VC’s get involved, the next round gets fund managers involved (at USD 40bn), and then gets a sovereign wealth fund involved to keep the valuation at USD 62.5bn. I quite like the irony of getting the Saudi’s to put in USD 3.5bn into an unprofitable Uber while convincing them to sell shares in Saudi Aramco… kind of like bait and switch only better… a new modern version of Petrodollar recycling but without the adverse consequences?

This week Uber announced the were gearing up for a flying taxi service:

Uber Technologies Inc. disclosed the initial steps of its air-travel vision this week, announcing five partner companies with various specialties aimed at making the sci-fi staple affordable and common. The initial testing is expected in 2020 in Dallas and Dubai, two car-clogged cities where aviation interests wield great influence.

“If you’re not planting the seeds for five, 10 years out, you have no company in five to 10 years,” Jeff Holden, Uber’s chief product officer, said.

The cynic in me see’s this a) as the equivalent of vapourware and b) a desperate attempt to show there may be some inherent value in a company that is clearly going backwards massively in terms at c. USD 2bn a year in cash terms. Uber are trying to fire the “gamblers excitement” that Shiller refers to (“don’t worry this taxi thing is just a smokescreen for our real route to profitability … autonomous drones…”)

But this line really tested my intellectual patience:

“There are a lot of compelling elements to this vision,” said Brian Wynne, president and CEO of the Association for Unmanned Vehicle Systems International, who attended the Uber event in Dallas this week where the plans were unveiled… 

“Whether this becomes a niche service … and how quickly it scales is anybody’s guess,” he said. “But they’ve got the demand.”

Don’t you need a price to gauge (potential) demand? I’ve got a lot of demand for a new Concorde from London to NYC at £500 per ticket… at £500 000 per ticket much less. It’s just all hype an no substance.

It’s not just me either… FT Alphaville (hardly the doyen of left-wing communism) came to the conclusion that:

[u]ltimately Uber’s success comes down to convincing the world that it has made a progressive leap by allocating cheap human resources towards the job of waiting around at the beck and call of an increasingly powerful elite.

From an aggregate economic allocation and welfare point of view that’s an obviously nuts proposition. What it amounts to is a transfer of labour from high productivity sectors to ultra low productivity sectors on the assumption that if this workforce is given autonomy over their non-productive time they can deploy it more efficiently in the market than if it was being allocated by a scaled-up specialist operator.

Since that, by definition, inhibits specialisation or skill acquisition in labour markets, all it really encourages is the purposeful unscaling of the economy and thus the entrenchment of a suppressed, underpaid, servant class with no prospect to ever benefit from a consumer surplus.

I sometimes think that all you need is an idea so outrageous sometimes it will get funding because people don’t want to say no. I half joke that I am thinking of registering the name http://www.chinaflng.com and then raising 10bn from investors and using it to buy a couple of broken VLCC’s for conversion purposes… and then worry about what to do… it’s a better idea than a $400 juicer…

Doug Evans, the company’s founder, would compare himself with Steve Jobs in his pursuit of juicing perfection. He declared that his juice press wields four tons of force—“enough to lift two Teslas,” he said. Google’s venture capital arm and other backers poured about $120 million into the startup. Juicero sells the machine for $400, plus the cost of individual juice packs delivered weekly. Tech blogs have dubbed it a “Keurig for juice.”

But after the product hit the market, some investors were surprised to discover a much cheaper alternative: You can squeeze the Juicero bags with your bare hands. Two backers said the final device was bulkier than what was originally pitched and that they were puzzled to find that customers could achieve similar results without it. Bloomberg performed its own press test, pitting a Juicero machine against a reporter’s grip. The experiment found that squeezing the bag yields nearly the same amount of juice just as quickly—and in some cases, faster—than using the device.

On second thoughts I am going to go with this… It will be an FLNG company that uses blockchain and has a cloud computing element to it with a big data social media engine driving it’s utilisation…. any maybe a really good juicer in the galley… please leave VC details in the comments section…

One day over a beer remind me to tell you the story of guy who walked into my office and wanted to build a fake tropical island in an abandoned Zeppelin factory, and then tried to shoot the messanger…