Reserves Rise Rapidly…

I have writtent about reserve replacement ratio figures before (i.e. here). It has become part of the accepted meme in offshore for why there must be a recovery. The above IEA data just released categorically shows this isn’t really an issue at the moment and there are now numerous data points that for large companies in particular investors are happy for the reserves figures to drop below historical averages.

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I am writing a longer piece on momentum, herding, and the jack-up market where I think people are getting a little carried away. I note that this isn’t unique to the oil and gas segment with the FT having a good article on Norwegian this weekend. Like some jack-up companies today Norwegian took an outsized bet on a market coming about (low cost international with a new business model), unfortunately for them it just hasn’t. Norwegian benefited from aircraft manufacturers wanting to sell planes that allowed them to embed huge amounts of leverage in their financial structure that would not be possible in a “normal” market. As the Bernstein analyst says:

“If you’re a holder, you need to sell. If you can short the stock, short the stock.” A second analyst, who did not want to be named, is blunter: Norwegian could “go bust in the autumn”.

Stock markets are known to be irrational, momentum strategies in particular are known to exist at certain points in time but to be transitory in  nature. Norwegian serves as a warning to anyone following exactly the same strategy in oil and gas.

However, nothing excites markets more than forecasts of markets doubling in five years (a magical number in  finance which equates to a 15% compaound annual growth rate over five years (1.15^5*)) forgetting that earnings discounted that far out at a discount rate that reflects the risk could easily absorb any rational return calculations.

But back to my point here: if reserves are your argument for increased offshore activity I think you need a new one.

*Number updated for a typo in the original version.

The oil price meme…

As the oil price passes USD 80 there is a really interesting post (lengthy, but great) here from Epsilon Theory on memes:

If you get nothing else from Epsilon Theory, get this: we are ALL hard-wired — literally hard-wired through millions of years of neurological evolution — to respond positively to effective meme introduction. We are ALL programmed — literally programmed through tens of thousands of years of cultural evolution — to respond positively to effective meme introduction. It’s no exaggeration to say that our biological and cultural symbiosis with memes defines the modern human species. This is a feature, not a bug.

Eusocial animals (the “pure” form of what it means to be a social animal) swim in an ocean of constant intra-species communications. It’s why these species — the ant, the termite, the bee, and the human — are the most successful multicellular animal species on the planet. Eusocial animals have the ability to store, retrieve and broadcast information (yes, eusocial insects communally “remember” incredibly complex informational structures) in a way that non-eusocial animals simply can’t, and it allows the eusocial animal not only to survive its environment, but to master its environment. Any environment. Humans are essentially giant termites with opposable thumbs and fire, and that combination is particularly unstoppable. But it’s the termite-ness … it’s the swimming in an ocean of constant intra-species communication … that’s the most important of these qualities.

Right on cue this week the FT carried a piece from the research firm Energy Aspects:

While there has been breathless attention paid to prompt Brent prices climbing to $80 a barrel for the first time since 2014, what has received less attention is that the entire Brent forward curve is now trading above $60, including contracts for delivery as far out as December 2024.

This development is an important psychological milestone for the oil market. The market is, in effect, saying that “lower for longer” is dead. (Emphasis added).

Narratives and memes are getting a lot of focus in economics for the right reasons as the above authors realise.

The Bank for International Settlements this week came out with some research that suggested 30-35% of the movement in oil prices was down to demand and supply and the rest of the movement down to potentially financialisation, speculation and other factors.

Another of the big (related) reasons for the procyclicality of the oil price (which the BIS touch on) is the structutral nature of the trading firms in the oil market. When the price is going up CFOs/Risk Officers feel good because they are buying at 70 and selling at 75. So bid/ask spreads narrow, inventory goes up, leverage goes up, and risk is on… whereas on the way down the value of inventory is declining, leverage does down, the bid ask spreak widens, volumes drop… we’ve been here before. Where we haven’t been before is in an oil market where a marginal producer has potentially such a powerful impact on the market.

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…