Overdiscounting… the future of offshore…

The qualities most useful to ourselves are, first of all, superior reasons and understanding, by which we are capable of discerning the remote consequences of all our actions; and, secondly, self-command, by which we are enabled to abstain from present pleasure or to endure present pain in order to obtain a greater pleasure in some future time.

Adam Smith, 1759

 

For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence.

John Maynard Keynes, 1936

 

The slide above taken from Transocean highlights how competitve offshore has become on a per barrel recovered basis. I’ll ignore the fact that the cost estimates for shale appear high because it isn’t my point: the real point is that to compete in the modern environment offshore oil production will have to be significantly more profitable on a per barrel recoverable basis because there is significant evidence managers underestimate (“overdiscount“) future financial returns the further away they are. Shale returns, while lower, are produced in a much shorter time period than offshore and behavioral finance shows strong evidence that managers prefer these sorts of returns at lower levels when compared to higher returns further away.

In  2011 Andrew Haldane, Executive Director, Financial Stability at the Bank of England, and Richard Davis, and Economist at the Bank of England spoke at a Bank for International Settlements conference and noted:

[r]ecently, in 2011 PriceWaterhouseCoopers conducted a survey of FTSE-100 and 250 executives, the majority of which chose a low return option sooner (£250,000 tomorrow) rather than a high return later (£450,000 in 3 years). This suggested annual discount rates of over 20%. Recently, Matthew Rose, CEO of Burlington Northern Santa Fe (America’s second biggest rail company), expressed frustration at the focus on quarterly earnings when locomotives lasted for 20 years and tracks for 30 to 40 years. Echoes, here, of “quarterly capitalism”.

In 2013 McKinsey & Co and CPPIB surveyed 1000 Board members and found:

  • 63% of respondents said the pressure to generate strong short-term results had increased over the previous five years.
  • 79% felt especially pressured to demonstrate strong financial performance over a period of just two years or less.
  • 44% said they use a time horizon of less than three years in setting strategy.
  • 73% said they should use a time horizon of more than three years.
  • 86% declared that using a longer time horizon to make business decisions would positively affect corporate performance in a number of ways, including strengthening financial returns and increasing innovation.
  • 46% of respondents said that the pressure to deliver strong short-term financial performance stemmed from their boards—they expected their companies to generate greater earnings in the near term.

The implications for offshore investment (decision tree here) versus the certainty of a short payoff from shale investment are obvious. It has been well known in economics for years that managers overdiscount future returns: in behavioural economics it falls under time preference problems. Humans are neurologically wired with a preference for immediacy that affects economic behaviour. As Haldane and Davis make clear:

This evidence – anecdotal, survey, quantitative – is broadly consistent with popular perceptions. Capital market myopia is real.

As early as 1972 Mervyn King, who would later become Governor of the Bank of England, noted that managers in the UK overdiscounted returns from long term investments. This stream of literature dried up as the Efficient Market Hypothesis took over as the vogue theory but it doesn’t change an actual reality.

The fact is that in competition for marginal oil investment dollars there are institutional and behavioural factors pushing for short-term solutions. This article in the Financial Times notes that Shell is under pressure as the CFO hasn’t outlined when the promised $25bn share buyback will start. Do you think the CFO at Shell is pushing for a new Appomattox because it has lower economic costs (but high CapEx) or will she simply seek to favour short pay-off, lower margin, projects?

Managers pushing offshore projects in E&P companies are running into senior managers who represent exactly those type of Board members surveyed by McKinsey and CPPIB. These managers aren’t wilfully myopic, the shareholders are pushing them to be, but they are more focused on immediate payoffs and overdiscounting the costs of the offshore projects. Again this quote from Haldane and Davis seems apposite:

Graham, Harvey and Rajgopal (2005) surveyed 401 executives. They found three striking results. First, managers would reject a positive-NPV project if that lowered earnings below quarterly consensus expectations. Second, over 75% of the sample would give up economic value in order to smooth earnings. Third, managers said that this was driven by the desire to satisfy investors.

When there was no shale this wasn’t an option as the question was “Do you want oil or not?”. The question is a whole lot more complex now and involves and assessment of certainty, risk, payoff potential and timing, and the pricing uncertainty of a volatile commodity over the long run. All this points to the fact the the financial and institutional barriers to new offshore projects are much higher than simple “rational” expectation models of future payoffs would suggest.

 

McDermott and Subsea 7…

Okay so I was too hasty in this post on Monday… When you’re wrong, you’re wrong…

MDR’s rejection of Subsea 7, and some good Q1 numbers,  seems to have sent the stock price down below the Subsea 7 offer and another ~35m shares traded yesterday (25/04). MDR only has 286m shares on offer and over 140m have changed hands in 3 days (up from a daily (30 day average) on Monday of 10m).

You need to be a holder of record on April 4 to vote in the CB&I merger, so anyone buying now I don’t think can vote? Being the US they can definitely sue for review but that looks harder for an offer subject to due diligence. And they can definitely press management to enter discussions, but the share price drop seems to reflect that maybe this is a train that cannot be stopped no matter how good the underlying logic of the counter bid?

Subsea 7 surely know what they are doing here? I have to think deep down they are backing shareholders to vote against the combination next week and enter talks with them. Subsea 7 must surely have sounded out the larger shareholders (Norges Bank and the Government Pension Fund of Norway being two of the top 20)? Subsea 7 are a deal machine and have enough experience to know all these things and my working assumption is that they simply didn’t just float this proposal out there hoping MDR would change their mind as late as 2 weeks before the final vote. The McDermott CB&I deal was so obviously an acquisition to stay independent and they must have picked up on this? This bid from Subsea 7 is must be part of a plan where they must be confident they have the numbers, or a good chance of getting them, or would not waste their time… ?

There is a certain logic in leaving it late to launch a bid as MDR management clearly didn’t want one and Subsea 7 could have faced months of useless negotiations or it was spend driving the price up of a trophy asset and other companies coming in… I spoke to a Saipem shareholder today who told me they have been sounded out about backing a bid should it turn into a sale process…

Was I suffering from a confirmation bias due to my dislike of vertical mergers?

But maybe Occam’s Razor applies here and I am over thinking this…? Maybe this was just a last minute attempt to be invited to a party where the invitation never arrived? In which case disregard my post of yesterday as well. This bid from Subsea 7 appears destined to be the start of a move of tactical genius or a total damp squib…

Blackrock as the 12% shareholder is worth watching here… they have a history of selling shares in offshore contractors at the perfect time (and being cleared of any wrong doing for the sake of good order).

This will be fascinating to watch for a few days to see how this pans out.

A supply contraction and rising oil prices…

The comments above are from Schlumberger’s results last week. Note the comments about the only possible sources of short-term supply increase. I think SLB are ignoring increased maintenance spending to bring shut-in wells back but this is probably not a major number.

It is worth noting that this era of rising oil prices, if they remain, is driven by OPEC trying to limit supply to drive the price up for macroeconomic reasons, and is therefore different to the 2008 -2014 increase where the dominant narrative was to increase supply for a booming economy. The narrative counts.

Here is another reason any “recovery”, or boom 5.0, or whatever, in oil prices will be:

Crude Shipments

So any recovery will be just like before only different. Some change will be cyclical and just like the past but some has clearly been secular. Business plans that assume a general “recovery” as being disingenuous.

I ran a very hot half marathon today (Southampton). Anyone who enjoys this blog and feels it has some economic value please make a contribution to the Hospice North Shore (NZ) (an amazing place that took amazing care of my Mum at the end and to whom I am forever in their debt) or the Motor Neurone Disease Association UK.

Thanks in advance.

Oil prices, speculators, and supply expansion…

An article from the FT here touches on an issue that has been discussed since there was an oil market:

Who trades oil is changing, however. Investors who bother little with details such as inventories and pipeline flows are replacing dwindling ranks of specialist commodities hedge funds. The shift could alter the way prices are formed…
Then who is driving oil positions higher? Newly prominent oil speculators are not necessarily reacting to news about supply and demand or utterances from Riyadh. Instead, they may be buying and selling oil based on moves in currencies, interest rates or the price of oil itself.

Namely, are speculators affecting the price of oil? You can see from the graph above that the exponential growth of Brent Ice futures contracts, which is cash settled and does not require physical product delivery, bears no relationship to the relative steady increase in the demand for oil. Some demand for these futures clearly reflects increasingly sophisticated financial risk management techniques, but some clearly represents purely speculative capital trading on price moves (often with large amounts of leverage).

There has been an entire industry in trying to ascertain the economic effects of speculators in oil markets. The IMF view is that they have no effect, but reputable economists at institutions such as the St Louis Fed disagree. A good summary is here.

My own (simplified) view, that accords to a well researched positions, is that speculators affect the volatility of the oil price but the not the final price over the long run.  Basic economic logic alone should dictate that if there is an increased amount of capital being invested in an asset class it will cause the price to rise, but when combined with leverage it adds huge volatility (quite simply if you have borrowed money to buy something and the price drops you tend to liquidate quickly to minimise loses). Which is why you see such huge swings in oil investment positions with a clear procyclical bias:

The big long.png

But the major point for those involved in service industries to my mind is that this is part of the explanation why there is not a linear relationship between the oil price and demand for oil field services. Directors at E&P companies make decisions about the long term price but ultimately the market for physically delivered product is more important when investing in production infrastructure, despite the large trading arms of the supermajors,  because they obviously do have deliver in the physical form eventually. They also benefit from miscalculating demand on the upisde through rising prices and a higher ROE on invested capital, so although they give up some amount of market share it’s a fairly small downside for erring on the side of caution.

Too many models that forecast the demand for oilfield services work are based on the forecast oil price rather than physical volume required. Too many management teams in offshore are using a rebound in the oil price as “proof” the “market” will eventually recover in demand terms when it is clear there is no linear relationship. As shale becomes the swing production method of choice offshore demand in particular should be relatively easy to forecast because in the new environment it will be supplying a baseload of physically demanded production while short-term changes in demand are managed by tight-oil. If someone in oil services tells you their business model is fine because the price of oil will rise I would suggest examining things a lot more carefully.

Investment banking analysts, groupthink, and the space shuttle disaster….

“a mode of thinking that people engage in when they are deeply involved in a cohesive in-group, when the members striving for unanimity override their motivation to realistically appraise alternative courses of action”

Janis, Victims of Groupthink, 1972

The quotes in the graphic above come from an MMA Australia equity placing last year. As a follow on to an earlier post I made regarding equity analysts at investment banks I read this article in the Financial Times Alphaville blog this week which makes essentially the same point:

The problem is that equity research has a famous bias towards positivity. Investment banks seek to do business with companies, which tend to dislike sell ratings. Stock markets spend most of their time rising. Fund managers don’t love to be told their decisions to invest in something is wrong…

So, it is very rare to see more than a quarter of analysts recommend their clients sell a stock

The distribution of ratings bears this out. Goldman Sachs aims to have 10 per cent to 15 per cents of stocks it covers rated as a sell. Morgan Stanley discloses 18 per cent of 3,200 stocks covered are rated underweight/sell. For UBS the global figure is 16 per cent. Investec has just 9 per cent of European and Hong Kong stocks on a sell rating.

How could the offshore analysts of some of the major maritime banks have been so positive when managers in the industry are saying things are very different? And in fact MMA’s latest financial results offer no hope of a market recovery?

Part of the answer I think lies in the psychology of groupthink (a classic article on it is here which applies this logic to the Challenger disaster). Another part of the answer lies in behavioural economics where analysts exhibit a positive confirmation bias, in which they look, and notice, information that accords with their preconceived ideas. This bias comes about understandably because analysts are employed by firms seeking to do business with companies they write reports about (and to be clear analysts who a nicer to managers get preferential treatment). People who want unbiased advice should probably pay for it from someone who owes them a duty of care is my takeaway… but hey I’m biased…

The oil market…

I am not an oil forecaster, if merely use of the word isn’t a misnomer, but I am interested in the psychological effects the market has on the physical and pricing of offshore services. Only last week Goldman called $80 oil, coincidentally when they called oil going to $20 in 2016 (when it was $36), it marked the low point in the market, now it seems this maybe the high as the price dropped yesterday.

To put these daily fluctuations into perspective there is a good article here on the swings in the oil price since 1973 until 2014. The story of shale gets a passing mention but remains to be written.

I have also noticed a lot of commentary mocking the market analysts from investment banks for their inability to predict accurately the turns in the market. I would note firstly if you think analysts at an investment bank have a job to do beyond helping the firm sell securities then you are wrong. IB analysts fall under the remit of marketing and that is their job, not to provide independent, and free, research to the community at large.

And even if they are trying to be accurate, say a firm with a limited corporate finance arm, one should remember Alfred Cowles. Cowles was the inheritor, and investment advisor, to a large Chicago newspaper fortune, as well as being a statistician and economist. In 1929 he was long on stocks and lost a great deal of money and set out to find the answer to a question made famous when asked by the Queen to LSE academics in 2008, namely “Why did nobody notice it?” (as in the Global Financial Crisis). Specifically, Cowles wondered why the big Wall Street brokerages didn’t see the crash of 1929 coming? Did they know any more than their customers? (I mean The Great Vampire Squid was keen on Ceona when anyone with a modicum of pipelay knowledge knew the Amazon lay system was a busted flush?)

In a famous paper “Can Stock Market Forecasters Forecast?”, published in Econometrica in 1944,  Cowles proved that they can’t. I urge you to read the whole article (aside from anything the language is beautiful), for example Cowles found:

Cowles.png

The answer would be exactly the same for the oil market today if replicated I would wager. This comes up time again in mututal fund research and other areas of finance, where essentially the outcome is random and cannot be predicted with accuracy (a statistical theory known as “Random Walk“). In case you think technology has improved things this paper was published recently “Do Banks Have an Edge” … and the answer is no… you would be better off buying a portfolio of treasuries than going to all the effort of taking a complex mix of loans and securities that banks do. And that is when the bank is acting as a principal not even trying to sell the stuff!

So when you read that someone is calling the oil market, or whatever, you need to treat it with the scepticism it deserves, and not be surprised when it is wrong.

McDermott buys Chicago Bridge and Iron…

“Chicago Bridge and Iron is not based in Chicago, doesn’t make bridges, and uses no iron”.

Anonymous

 

We argue that mergers and merger waves can occur when managers prefer that their firms remain independent rather than be acquired. We assume that managers can reduce their chance of being acquired by acquiring another firm and hence increasing the size of their own firm. We show that if managers value private benefits of control sufficiently, they may engage in unprofitable defensive acquisitions.

Gorton, Kahl, and Rosen, 2005

 

If you want to have a look at what signals the insiders in offshore SURF are sending, and that major shareholders are supporting, look no further than McDermott (“MDR”) acquiring Chicago Bridge and Iron (“CBI”). MDR, which had $435m cash on hand at Q3, generated $155m EBITDA in the quarter, and is widely regarded as a very well run company, brought a declining onshore construction and fabrication house (with a small technology arm). No wonder the shares dropped 9% in aftermarket trading while CBI rose.

What it means is that a well informed group of rational senior executives in the offshore industry, in a company with ample liquidity and investment capability, decided the best option for growth and shareholder returns were for them to diversify onshore in the US. I don’t think that rings of confidence for an offshore recovery. At the moment anyone with enough financial capacity to charter ships (at below economic cost) and hire engineers can win market share. It is obvious what that will do to financial returns and why therefore companies are looking at different sources of growth and not recycling cash flow generated from the industry back into it. Over the long term this is part of the story of how the offshore industry will lose the capital it needs to in order restore the market to equilibrium.

This is a defensive merger. MDR was simply too small not to be acquired as part of a major acquisition had it remained independent (part of the reason the shares have dropped is the loss of the “acquisition premium” in their value), but it also needed to pay in shares only to keep its operating flexibility in this market. MDR was just big enough to raise the needle signficantly for someone else, but not large enough to buy an industry leader or number two. MDR had the choice of going on a shopping spree of SURF companies, maybe Aker Solutions or someone, and then trying to compete with Susbea 7 or FTI, and slowly over time getting materially bigger, risk being acquired as the industry consolidates, or buying something big and leveraging up so as to make it to big and risky to be acquired. The short-term risk was someone like GEBH, having failed to acquire an installation capability with SS7, deciding MDR was large enough to swallow. I’d love to know if the Board instructed one of the banks to sound out other bidders instead of this? I suspect instead that Goldman Sachs, lead adviser to MDR, was brought in with a specific mandate to keep MDR independent and CBI was the company they settled on.

Clearly, and having sounded out the shareholders as well, MDR management have decided that the least risky option, or at least the deal that could be done, was onshore US, a business about which MDR management have limited exposure. Whether consciously or  not, the fact is MDR management couldn’t find enough value, on a risk weighted basis, to carry on investing in offshore.

MDR management decided to diversify, a so called “vertical merger“. Financial markets generally dislike verticals, which have a limited range of situations when they are likely to be profitable, preferring to believe shareholders are better at diversifying individually than company management. However, financial economists have spent a huge amount of time studying M&A, and from what I can ascertain all they really agree on is that returns are hugely dispersed around the mean i.e. sometimes it works and sometimes it doesn’t:

[o]n balance, one should conclude that M&A does pay. But the broad dispersion of findings around a zero return to buyers suggests that executives should approach this activity with caution.

 

I get why it was done I think: scale. Cynical theories abound in economic research:

What, then, is the motive for the widespread and persisting phenomenon of conglomerate mergers? In this study, a “managerial” motive for conglomerate merger is advanced and tested. Specifically, managers, as opposed to investors, are hypothesized to engage in conglomerate mergers to decrease their largely undiversifiable “employment risk” (i.e., risk oflosing job, professional reputation, etc.). Such risk-reduction activities are considered here as managerial perquisites in the context of the agency cost model. [Emphasis added]

In this case the argument is really that increased scale will help the offshore business as a standalone unit with lower unit costs being spread over a large company. If management can make it work, and they prove to have swooped on CBI in a moment of weakness, then everyone will be happy. That isn’t really my point with this: it is my agreement that offshore contracting/SURF still has excess capital at an industry level and I agree with MDR management that in the current environment deploying more, even at current price levels,  looks hard to justify.

So rather than hold out for an acquisition premium, or try and build up slowly, MDR management have made the company virtually impregnable to being acquired, for a few years anyway, and if they can turnaround CBI as they have done with MDR the risk will be worth it.  But I also think it sends a signal that management have far more confidence in the lighter CAPEX onshore market than they do about the offshore market, and even though they had the opportunity to buy a string of assets and companies at rock bottom prices MDR management (with the support of the Board and shareholders) decided it was less risky to buy an onshore construction business. That is consistent with the investment profile of many E&P companies who are cutting offshore investment in favour of onshore.

I think that this M&A decision tells you a lot about what those actually making the investment decisions in profitable offshore companies think about the market direction and the risk weighted returns available from it, for the forseeable future. MDR are backing themselves to apply the lessons learned in the downturn to another business rather than applying it to more businesses in the sector.