Boats, Bitcoin, and (Asset) Bubbles…

[W]hereas gambling consists in placing money on artificially created risks of some fortuitous event, speculation consists in assuming the inevitable risks of changes in value.

H.C. Emory

 

“In order to pay out profits, the South Sea Company needed both to raise more capital and to have the price of its stock moving continuously upward… And it needed both increases at an accelerating rate, as in a chain letter or a Ponzi scheme.”

Kindelberger, Manias, Panics, and Crashes. 1986

 

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

Alan Greenspan, 1996

This is a bit different from my usual postings at the moment, but the overarching theme of this blog, from the name onwards, is economic history, the relationship between banking and the economy,  and investment and asset bubbles. One of the reasons the subsea market interests me so much, aside from obviously having worked in it, is that the latter stages of the 2014 boom were clearly the denouement of an investment bubble.

I have been interested in Bitcoin and other crypocurrencies from the standpoint of monetary economics and history. For those who want a primer on money and cryptocurrencies there is a good post here. I think they are basically an asset bubble with no discernable differences to Dutch tulips in terms of intrinsic value (there is a great article here on the Dutch Tulip Bubble that makes clear it really was irrational). There are also at least 842 crypotcurrencies, which looks like the IPO board of 1999, and you can now do an Initial Coin Offering (ICO)! I think this is a technology induced investment bubble where the distributed ledger technology combined with the token coin aspect is creating the hype. The distributed ledger technology is beyond my full comprehension, although from my basic knowledge it strikes me as a powerful technology, (although its worth noting that it is overloaded and transactions and there is a backlog) and that the Bank of Canada having assessed it:

 [t]he bank reached that conclusion after a closely watched year-long trial code-named “Jasper,” which sought to determine whether the technology, known as DLT, could be used to improve the performance of Canada’s wholesale interbank payment system.

“A pure stand-alone DLT wholesale payment system is unlikely to match the net benefits of a centralized wholesale payment system,” the Bank said in a report.

So mine is hardly an original opinion as Bitcoin prices are extremely volatile and rose to a new high this week of over USD 4000 but the case for the defence is here if you are interested (I don’t agree with it). It seems really simple that on a limited base of coins as the price has risen more people are simply betting it will rise more.

The hard part of an investment bubble is of course spotting it beforehand and defining exactly what one is? This defintion is commonly accepted:

Bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value. This can occur if investors hold the asset because they believe that they can sell it at a higher price to some other investor even though the asset’s price exceeds its fundamental value.

There are  two kinds of asset price bubbles:

  1. Unleveraged ‘irrational exuberance’ bubbles
  2. Credit boom bubbles with a positive feedback loop.

The reason the internet boom ended with a whimper was that it was equity financed. A large number of VC funds and investors took equity risk and lost. Technology induced investment bubbles are not new; the most obscure one I have found yet is the British Bicycle Mania (1895-1900) when share prices of the associated companies rose over 200% over the period, and were divorced from earnings potential.

In comparison offshore (and shipping) was leveraged credit boom and these are more serious “because their bursting can lead to episodes of financial instability that have damaging effects on the economy“. The reduction in shipping loan volumes I discussed earlier are an indicator of that and as Mishkin outlines here is what happened in offshore and shipping (in addition to the underlying dropping dramatically in both):

[a] rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more. This feedback loop can generate a bubble, and the bubble can cause credit standards to ease as lenders become less concerned about the ability of the borrowers to repay loans and instead rely on further appreciation of the asset to shield themselves from losses.

At some point, however, the bubble bursts. The collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for the assets declines further, and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets.

Again this is no recent phenomena and asset heavy industries are particularly susceptible: the railway boom of the 1840s was based on partly paid shares (“derivative like”) and as the author notes:

[t]he use of leverage can exacerbate both the boom and bust in asset price reversals, and it may be wise for policy makers to continually monitor changes in the use of leverage.

If you want to see a microcosm of this look no further than DVB Bank where losses in offshore effectively wiped out the entire tier 1 capital of the bank.

Bitcoin is an ‘irrational exuberance’ bubble and clearly into the realms of behavioural influences as its utility as a currency is minimal, exlcuding black market transactions, and it flutuates enormously as a store of value. Normal state issued paper (“fiat money“) can settle tax obligations and from this its a core part of its value derives, it is impossible to see the state giving up this prerogative. Bitcoin is a technology inspired bubble without any fundamental economic value. 

The core attraction, if you believe the Bitcoin adherents, beyond the obvious anonymity is the apparent stability of the base unit as there is a limit to how quickly new units are “mined” and an overall cap on many cryptocurrencies including Bitcoin (21m units). And indeed one valuation methodology for the currency bases it as a % of all black market transactions. The monetary system being emulated is the gold standard (with nomenclature of mining clearly being no accident) where national currencies were exchangeable for gold (at its peak). The gold standard failed, precisely because the monetary base was too inflexible, and led to and exacerbated the Great Depression.

 

That isn’t to say there isn’t a place for local monies and that they cannot help economic growth. Local currencies, such as the Bristol Pound, exist in the UK. Maybe Bitcoin can serve a similar functional value for the ethereal world.

The interesting thing for those with only passing knowledge of the subject is that this is a monetary system that is being created in relatively short order but because of its open source nature, and the specialised technical knowledge required to enter it, means it is dominated by computer programmers. Yet the Bitcoin system is actually very similar to a crude medieval monetary system and if you want to see how economic history can add some value to a current debate this is a good example. Medieval money systems had a relatively fixed base of currency as The Commercial Revolution was just beginning and much of the coinage used was reminted from Roman times with mining out insufficient to affect the overall supply level until the “New Silver” from Freiberg was found and started moving to Venice. So a lot like bitcoin the money supply expanded only very slowly.

One of the key drivers of the Bitcoin price rise recently has been the split of Bitcoins to Bitcoin cash and there has been a fight between those for and against the split along the lines of preserving coin value and purity versus the need for transactions and the increase in value that will come from acceptance. The Bitcoin cash split comes by splitting the size of each Bitcoin such that it can be mined independently as smaller file sizes containing a number of transactions. The technical innovation is also that it speeds up processing but it also makes it available for micropayments. This is very similar to how medieval mints operated by exchanging larger coins for smaller coins and the difference in the exchange ratio was the seignorage to the mint – although Bitcoin exchanges are private whereas mints were the domain of the King.  The small denomination split is well known to economic historians: In 1956 Cipolla noted:

‘Every elementary textbook of economics gives the standard formula for maintaining a sound system of fractional money: to issue on government account small coins having a commodity value lower than their monetary value; to limit the quantity of these small coins in circulation; to provide convertibility with unit money. . . . Simple as this formula may seem, it took centuries to work it out. In England it was not applied until 1816, and in the United States it was not accepted before 1853.’

This became known as ‘The Big Problem of Small Change‘ which observed that since medieval times during episodes  of inflation small coins disappeared from circulation as they were made up of the exact proportion of value in metal of the larger coins they represented. Small coins frequently disappeared from circulation and made transactional commerce difficult for micropayments (in the current Fintech jargon). The same problem occured during ‘The Great Inflation’ in the United States (1967-1982) when copper coins disappeared from circulation as they were worth more as scrap. It is a great paradox in economics where more money generates rising prices but rising prices generate a shortage of money.

The problem that the Bitcoin cash “fork” in the chain (as it known) is trying to solve is the “penny-in-advance” constraint where “small denomination coins can be used to purchase expensive items, but large denomination coins cannot be used to buy cheap items’. Over time, until the invention of “token” money for small denominations smaller coins depreciated more relative to larger over time. The Bitcoin solution is to develop Bitcoin cash which represents a monetary fraction of a Bitcoin and forks into a seperate chain in the blockchain and in this respect is similar to:

the gradual debasement of the denarius between AD 800 and AD 1200 [that] was not fiscally motivated,but was a reasonable response to economic expansion that exceeded the growth of monetary metal

This was also found in Venice where the :

debasement of imperial pennies by Italian mints from the ninth century to the twelfth has usually been attributed to the greed and completion of local lords, but it probably was in the public interest, because it met a growing need for coin that arose from the increased use of markets and the general expansion of trade.

Bitcoin cash may prove that technology that can solve some of the issues that took medieval monetarists such a long time to work out. Mint technology advanced making forgeries harder and in this case the Bitcoin cash is an exact unit of Bitcoin. But the Bitcoin cash fork is still going to have the same problem that different chains forks over different exchanges and locations still need to be brought together at a common rate to transact. I don’t see it but there is no doubt that in medieval times changing the types and value of coins changed welfare outcomes. So there is a sound economic basis for the Bitcoin split, the question is who will benefit from the changes. Like the mints the Bitcoin exchanges are privately owned and I suspect welfare benefits will accrue disproportionately to them.

Like all economic issues there is not universal acceptance of the solution to the Big Problem of Small Change. An excellent paper here argues that at times small coins experienced periods of munificence as often as scarcity and that the value of large demonimation coins is the “dollar-in-advance” problem where small coins are impractical for large puurchases due to high transaction costs (i.e. verification and clearing).  The other problem with the “Big Problem” is that it may have been small because actually credit was common and debts were settled in kind or when they reached a certain limit.

The distributed ledger technology is also reminiscent of private clearing of notes that used to take place amongst banks when private money was more common. Research into the antebellum Suffolk Bank by the Minnepolis Fed (and others) concluded that there was a natural monopoly in note clearingand explains why clearinghouses and banks such as Suffolk developed that ties into the technology of argument the Bank of Canada. 

The increasing number of cryptocurrencies seem to mimic the early period of US banks where notes were privately issued and traded at a discount depending on the perceived regulatory effectiveness on the state in which they were domiciled or the strength of the bank issuing the currency (in an era prior to depsoit insurance). An extremely readable 20 page history of how complicated it was for the US to actually get a national unit of currency is here (and highlights some of the challenges for the Euro).

Bitcoin strikes me as technology being done because it can (as opposed to the blockchain technology behind it which is clearly powerful), and because, like selling tulips in the 1630’s, it is extremely profitable for some people. Is it an advance? I don’t think so, it adds nothing to the utility of money, doesn’t seem to make the economy more productive and offers the possibility of eroding the tax base. I have made this note here to mark how my views change over time more than any other reason and I will be interested in how this evolves.

Further evidence on the shale narrative and rational decisions…

The FT noted yesterday:

Kosmos, which had a market capitalisation of $2.5bn in New York on Tuesday, has earned a reputation as one of the most successful international exploration companies after a string of big discoveries off the coast of west Africa. Andrew Inglis, Kosmos chief executive, said the company wanted to widen its shareholder base beyond the US, where offshore exploration has been eclipsed by onshore shale oil and gas production in investors’ affections. “The US shareholder base has become very focused on shale and we believe there is a better understanding in the UK market of the opportunities that exist in conventional offshore exploration,”

It is not a good sign for offshore that the deepest and most liquid capital market in the world doesn’t seem to recognise the value in offshore. This is a further sign that the investment narrative is moving to shale. Ultimately even large E&P companies feel responsible to their shareholders, if the largest capital market in the world starts preferring companies that invest in shale then companies will alter their capital investment plans to relfect this, there is an element of marketing in this not just based on strict economic evaluation of the potential investments available.

If you want further proof that financial decisions aren’t always rational and markets the human interaction that is part of this look no further than this fascinating paper (from Matt Levine) “Decision Fatigue and Heuristic Analyst Forecasts” where it is found:

We study whether decision fatigue affects analysts’ judgments. Analysts cover multiple firms and often issue several forecasts in a single day. We find that forecast accuracy declines over the course of a day as the number of forecasts the analyst has already issued increases. Also consistent with decision fatigue, we find that the more forecasts an analyst issues, the higher the likelihood the analyst resorts to more heuristic decisions by herding more closely with the consensus forecast and also by self-herding (i.e., reissuing their own previous outstanding forecasts). Finally, we find that the stock market understands these effects and discounts for analyst decision fatigue.

Did you get that? Act on investment banking notes if they come out early in the morning! I love the findng the market understands this. The authors note that analysts may start the day by looking at companies they have the best information about but ask why they would do this?

The link here is just that financial decisions are not always purely rational and are based on herding, narrative, and other behavioural instincts. Managers who believe they will be rewarded by the stock market for moving their investment profile to shale will do this regardless of how attractive other investment opportunities may be on a strictly “rational” basis. Not every decision, but as I always say economic change happens at the margin.

Diverging results point to the future of offshore… procyclicality reverses…

Colin, for example, has recently persuaded himself that the propensity to consume in terms of money is constant at all phases of the credit cycle.  He works out a figure for it and proposes to predict by using the result, regardless of the fact that his own investigations clearly show that it is not constant, in addition to the strong a priori reasons for regarding it as most unlikely that it can be so.

The point needs emphasising because the art of thinking in terms of models is a difficult–largely because it is an unaccustomed–practice. The pseudo-analogy with the physical sciences leads directly counter to the habit of mind which is most important for an economist proper to acquire…

One has to be constantly on guard against treating the material as constant and homogeneous in the same way that the material of the other sciences, in spite of its complexity, is constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple’s motives, on whether it is worth while falling to the ground, and whether the ground wanted the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth.

Keynes to Harrod, 1938

 

A, having one hundred pounds stock in trade, though pretty much in debt, gives it out to be worth three hundred pounds, on account of many privileges and advantages to which he is entitled. B, relying on A’s great wisdom and integrity, sues to be admitted partner on those terms, and accordingly buys three hundred pounds into the partnership.The trade being afterwords given out or discovered to be very improving, C comes in at fivehundred pounds; and afterwards D, at one thousand one hundred pounds. And the capital is then completed to two thousand pounds. If the partnership had gone no further than A and B, then A had got and B had lost one hundred pounds. If it had stopped at C, then A had got and C had lost two hundred pounds; and B had been where he was before: but D also coming in, A gains four hundred pounds, and B two hundred pounds; and C neither gains nor loses: but D loses six hundred pounds. Indeed, if A could show that the said capital was intrinsicallyworth four thousand and four hundred pounds, there would be no harm done to D; and B and C would have been obliged to him. But if the capital at first was worth but one hundred pounds, and increasedonly by subsequent partnership, it must then be acknowl-edged that B and C have been imposed on in their turns, and that unfortunate thoughtless D paid the piper.
A Adamson (1787) A History of Commerce (referring to the South Sea Bubble)

The Bank of England has defined procyclicality as follows:

  • First, in the short term, as the tendency to invest in a way that exacerbates market movements and contributes to asset price volatility, which can in turn contribute to asset price feedback loops. Asset price volatility has the potential to affect participants across financial markets, as well as to have longer-term macroeconomic effects; and
  • Second, in the medium term, as a tendency to invest in line with asset price and economic cycles, so that willingness to bear risk diminishes in periods of stress and increases in upturns.

Everyone is offshore recognises these traits: as the oil price rose and E&P companies started reporting record results offshore contractors had record profits. Contractors and E&P comapnies both began an investment boom, highly correlated, and on the back of this banks extended vast quantities of credit to both parties, when even the banks started getting nervous the high-yield market willingly obliged with even more credit to offshore contractors. And then the price of oil crashed an a dramatically different investment environment began.

What is procyclical on the way up with a debt boom always falls harder on the way down as a countercyclical reaction, and now the E&P companies are used to a capital light approach this is the new norm for offshore. The problem in macroeconomic terms, as I constantly repeat here, is that debt is an obligation fixed in constant numbers and as the second point above makes clear that in periods of stress for offshore contracting, such as now, the willingness to bear risk is low. Contractors with high leverage levels that required the industry to be substantially bigger cannot survive financially with new lower demand levels.

I mention this because the end of the asset bubble has truly been marked this week by the diverging results between the E&P companies and some of the large contractors. All the supermajors are now clearly a viable entities at USD 50 a barrel whereas the same cannot be said for offshore rig and vessel contractors who still face large over capacity issues.

This chart from Saipem nicely highlights the problem the offshore industry has:

Saipem backlog H1 2017 €mn

Saipem backlog Hi 2017.png

Not only has backlog in offshore Engineering and Construction dropped 13% but Saipem are working through it pretty quickly with new business at c.66% of revenues. The implication clearly being that there is a business here just 1/3 smaller than the current one. You can see why Subsea 7 worked so hard to buy the EMAS Chiyoda backlog because they added only $141m organically in Q2 with almost no new deepwater projects announced in the quarter.

It is not that industry conditions are “challenging” but clearly the industry is undergoing a secular shift to being a much smaller part of the investment profile for E&P companies and therefore a much smaller industry as the market is permanently contracting as this profile of Shell capex shows:

Shell Capex 2017

A billion here, a billion there, and pretty soon you are talking real money. The FT had a good article this week that highlighted how “Big Oil” are adapating to lower costs, and its all bad for the offshore supply chain:

The first six months of this year saw 15 large conventional upstream oil and gas projects given the green light, with reserves of about 8bn barrels of oil and oil equivalent, according to WoodMac. This compared with 12 projects approved in the whole of 2016, containing about 8.8bn barrels. However, activity remains far below the average 40 new developments approved annually between 2007 and 2013 and, with crude prices yo-yoing around $50 per barrel, analysts say the economics of conventional projects remain precarious.

Not all of these are offshore but the offshore supply chain built capacity for this demand and in fact more because utilisation was already slipping in 2014. And this statistic should terrify the offshore industry:

WoodMac says that half of all greenfield conventional projects awaiting a green light would not achieve a 15 per cent return on investment at long-term oil prices of $60 per barrel, raising “serious doubt” over their prospects for development. By this measure, there is twice as much undeveloped US shale oil capable of making money at $60 per barrel than there is conventional resources.

The backlog (or lack of) is the most worrying aspect for the financing of the whole industry. E&P companies have laid off so many engineers and slowed down so many FIDs that even if the price of oil jumped to $100 tomorrow (and no one believes that) it would take years to ramp up project delivery capacity anyway. Saipem and Subsea 7 are not exceptions they are large companies that highlight likely future work indicates that asset values at current levels may not be an anamoly for vessel and rig owners but the “new normal” as part of “lower for longer”.

I recently spoke to a senior E&P financier in Houston who is convinced “the man from Oaklahoma” is right but only because he thinks overcapacity will keep prices low: c. 50% of fracing costs come from sand, which isn’t subject to productivity improvements, and he is picking that low prices eventually catch up with the prices being paid for land. I still think that the more large E&P companies focus on improving efficiency will ensure this remains a robust source of production given their productivity improvements as Chevron’s results showed:

Chevron Permian Productivity 2017

Large oil came to the North Sea and turned it into a leading technical development centre for the rest of the world. Brazil would not be possible without the skills and competencies (e.g. HPHT) developed by the supermajors in the North Sea and I think once these same companies start focusing their R&D efforts on shale productivity will continue to increase and this will be at the expense of offshore.

It is now very clear that the supermajors, who count for the majority of complex deepwater developments that are the users of high-end vessel capacity, are very comfortable with current economic conditions. They have no incentive to binge on CapEx because even if prices go up rapidly that just means they can pay for it with current cash flow.

That means the ‘Demand Fairy’ isn’t saving anyone here and that asset values are probably a fair reflection of their economic earning potential. Now the process between banks and offshore contractors has become one of counter-cyclicality where the asset price-feedback loop is working in reverse: banks will not lend on offshore assets because no one knows (or wants to believe) the current values and therefore there are no transactions beyond absolute distress sales. This model has been well understood by economists modelling contracting credit and asset values:

Asset Prices and Credit Contracttion

Getting banks to allocate capital to offshore in the future will be very hard given the risk models used and historical losses. Offshore assets will clearly be subject to the self referencing model above.

I remain convinced that European banks and investors are doing a poor job compared to US investors about accepting the scale of their loss and the need for the industry to have significantly less capital and asset value than it does now. Too many investors thought this downturn was like 2007/08, when there was a quick rebound, and while this smoothed asset prices somewhat on the way down this cash was used mainly for liquidity, it is now running dry and not more will be available (e.e. Nor Offshore) at anything other than penal terms given the uncertainty. Until backlog is meaningfully added across the industry asset values should, in a rational world, remain extremely depressed and I believe they will.

The New Offshore… it looks a lot like Italian and Spanish banking…

The oldest bank in the world, Banca Monte dei Paschi di Siena SpA, founded in 1472, came under government control today. The bank, founded as the “Mount of Piety”, has been through numerous capital raisings and life support packages since 2008/09, and finally, even the Italian government and the ECB could no longer pretend it was solvent. I have lost count over the years of the number of times the ECB has declared the banks solvent (only last December the MdP fundraising was announced as “precautionary”), but shareholders who have previously be forgiving have had enough as has the Bank of Italy. There are some clearly analogous lessons for offshore in this.

European banks and offshore oil and gas contractors share many of the same issues. For years now central banks around the world have kept the price of the core commodity that banks trade in (money) low, interest rates at the Zero Lower Bound (“ZLB”) has become the new normal and banks struggle to the margin they used to between the money they borrow and the money the lend.

Another clear similarity between the banks and offshore contractors is excessive leverage. Banking is actually a pretty risky business (which is why banking crises and state bailouts are increasingly common), banks borrow short and lend long in a process known as maturity transformation. What this means in practice is that when you go into your friendly branch of DNB with your Kroners and deposit them you are lending the bank money and they are making a loan contract to pay you back a fixed number of Kroner. DNB then package up all the Kroner in the branch and turn it into a ship in the form of loan contract which they use to pay you back. The problem arises, as it did recently for DVB, when the value of the ship, or just as importantly the income from it, is worth less than the value of all the loan contracts the bank used in financing the ship. One or two doesn’t matter but if all the ships are worth less then the bank has a problem. This mismatch between the obligations that banks take on to finance assets that can vary hugely in value is the feature of nearly all banking crises, certainly in shipping as the German banks know well, but also the cause of the 2008/09 global financial crises. This is the fundamental instability mechanism in an economy that fractional reserve banking introduces.

Offshore has a similar instability mechanism and it too is a function of leverage. As the volume of work has dried up the fixed commitments owed to banks, bondholders, and other fixed rate security holders who were used to purchase vessels, assets, or finance takeovers has remained constant while the asset value has cratered and the revenue has done the same. Like a bank the asset side of the balance sheet is being severely strained at the moment as the revenues and profits simply cannot support historic commitments. It was this model of viewing the creditor run on Ezra/Emas as comparable to a bank run that made me sure there was no route to salvation for them. This transmission mechanism is destabilising all asset owners as banks are not lending on assets of uncertain value and the size of some of the writedowns is an issue for the banks. These sort of self-reinforcing loops are very hard to break.

Like the banking sector offshore is struggling with a the tail of a credit boom which is obviously related to the excessive leverage taken on. As has been shown many times over in research credit booms, in all contexts, take longer to recover from than other types of investment bubbles.

Historical analogies, no matter how interesting, are only good if they give us some insight into the future. In this case I think they are depressingly clear: since 2008/09 Spanish and Italian banks have created a structurally unprofitable industry that is unlikely to change with government intervention. Offshore contracting and European banks are both trapped in a low price commodity environment and burdened by historic asset commitments and the current economic value of said assets. European banks have overcapacity issues but shareholders and other stakeholders are committed to keeping this structure because of previously sunk costs and very high exit costs.

The banking crisis in Europe should be a lesson to offshore that impairments in asset values can be permanent. Mian and Sufi (read their book), after looking at the US housing crisis, propose shared risk mortgages where banks share in the capital value, such a suggestion seems prime for shipping and offshore gievn the extraordinary volatility in asset prices and the levels of leverage common in these asset transactions. The cynic in me says regulators would need to force this through, but I also believe eventually German taxypayers will tire of supporting the global shipping industry.

Another lesson to be drawn for offshore is that consolidation favours the large, there is a flight to quality. JP Morgan now has a market cap of roughly USD 336bn post crisis and would appear untouchable as the worlds largest bank (considerably larger than some central banks) after a series of well excuted post-crisis transactions. TechnipFMC has similarly become the largest offshore contractor through an astute merger (imagine if they had really brought CGG!) and if they can ever resolve the tax situation with Heerema will become untouchable as the largest and most capable offshore contractor.

Unfortunately for smaller players size counts. In a bank run people worry that the institution will not be there in the future so choose to withdraw savings because they are nothing but a loan to the bank. Similarly E&P companies who contract with smaller contractors are merely unsecured creditors if they fail despite the progress and procurement payments and therefore are at a considerable disadvantage in winning large contracts in a challenged environment even if they are substantially below the competition in price.

Another lesson is that there is no substitute for equity capital and the larger players have an advantage in raising this. Bank balance sheets have changed substantially since the financial crisis at it is clear that offshore companies that want to surivive will have a much higher componenet of equity in their capital structure. The quantum of this capital will be a major issue given the continued low profitability for all but the largest players in the industry,

But the clearest lesson to take unfortunately is that barring a major exogenous change the zombie banks, neither dead nor alive, can continue for a longer period of time than anyone would really like. Offshore is facing the same dilemma as 2018 looks to be quiet, relative to 2014, and OpEx continues to be a major problem for companies. There is no quick fix in sight unfortunately.

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…