“Preparing for the recovery”… Whatever…

The IEA has recently published it’s new World Energy Review and if you have been reading this blog this comment will come as no surprise:

One notable trend concerns the relationship between oil prices and upstream costs. In the past, there has been a roughly linear relationship between upstream costs and oil prices. When price spiked, so did costs, and vice versa. What we are noting now is a decoupling. While prices have more than doubled since 2016, global upstream costs have remained substantially flat and for 2018 we estimate those increasing very modestly, by just 3%. Companies appear to have learned to do more with less.

Too many business models in the offshore supply chain are simply ignoring this. If you are going long on Borr Drilling shares (for example), as anything other than a momentum trade, then you need to look at data driven forecasts like this, which in statistical terms are called a structural break. Look at the cost deflator in the graph above! In an industry with high fixed costs (both original and operating) that is a straight financial gain for E&P companies and with the volatility in the oil prices they will not give that up easily… and in a world of oversupply they won’t have to.

The future will be different. Some vast market snapback where the Deamnd Fairy appears, and everyone brave enough to have paid OpEx in the offshore supply chain has found a clever get rich quick scheme, is an extremely unlikely event.

More data points like this should make you think as well:

IEA Source.png

Yes, I get the volume in absolute terms is growing, but it is change at the margin that defines industry profitability.

There is still too much liquidity and too many business plans talking as if a return to 2013/14 is a certainty when in reality such a scenario would be an outlier.

SOCAL, Saudi Arabia, and Bitcoin… If you thought the oil industry had booms…

I meant to note this two days ago but the photo on the top is the signing ceremony on 29 May1933 between SOCALm (Standard Oil Company of California) and Saudi Arabia to manage the Kingdom’s oil concession. Clearly a historic event in the development of the oil industry.

As a contrast… I couldn’t help noticing this story about Bitcoin and it’s energy usage. In Chelan County, renowned for cheap electricity and:

an area famous for apples, wheat and conservative politics [it] has been transformed into a kind of cyber-boomtown, with Bitcoin mining operations that range from large-scale, state-of-the-art warehouses to repurposed cargo containers to backyard sheds. By the end of this year, according to some estimates, the Mid-Columbia Basin could account for as much as 30 percent of the global output of new Bitcoin and large shares of other digital currencies, such as Litecoin and Ethereum.

There is a boom going on:

In a normal year, demand for electric power in Chelan County grows by perhaps 4 megawatts ­­— enough for around 2,250 homes — as new residents arrive and as businesses start or expand. But since January 2017, as Bitcoin enthusiasts bid up the price of the currency, eager miners have requested a staggering 210 megawatts for mines they want to build in Chelan County. That’s nearly as much as the county and its 73,000 residents were already using…

 The scale of some new requests is mind-boggling. Until recently, the largest mines in Chelan County used five megawatts or less. In the past six months, by contrast, miners have requested loads of 50 megawatts and, in several cases, 100 megawatts. By comparison, a fruit warehouse uses around 2.5 megawatts.

However, the acquisition of resources has not gone quite as smoothly:

China electricity.png

I am pretty sure the crypto-miners from China are thinking about crypto-sceptics (like me), from the comfort of their private jet, sure that we are the people who just don’t get it.  In future years maybe someone will dig up a photo of the dam master and the Chinese miner signing a supply agreement… but I have my doubts…

What will a deepwater recovery look like for contractors?

In the five years since the 1996 bill became law, telecommunications companies poured more than $500 billion into laying fiber optic cable, adding new switches, and building wireless networks. So much long-distance capacity was added in North America, for example, that no more than two percent is currently being used. With the fixed costs of these new networks so high and the marginal costs of sending signals over them so low, it is not a surprise that competition has forced prices down to the point where many firms have lost the ability to service their debts. No wonder we have seen so many bankruptcies and layoffs.

Brookings Institute, 2002

McKinsey Energy Inisghts has a good article on how a recovery in the offshore energy might play out. The article makes the point I have made here that large deepwater projects, especially in Brazil and the Gulf of Mexico, are likely to economically attractive going forward but smaller, and shallower projects are in trouble.

First let’s appreciate the scale of the downturn the offshore contracting and supply industry is dealing with:

Global upstream investment has suffered dramatic cuts in the recent low oil price environment. Upstream oil and gas capex was halved from ~$800 billion in 2014 to ~$400 billion in 2016, and global exploration and appraisal spending fell by 40% to $11.2 billion during the same period…

Spending cuts are expected to cause a 50-60% decrease in oil volumes coming online from new projects in the next three to five years, compared to the 2010-14 average. As with brownfield projects, the greenfield pipeline for the next few years has been significantly reduced due to the lack of investment since 2014, especially for shallow water developments. [Emphasis added].

So if you own a shallow water asset, like a DSV for example, this massive drop in demand is proportionately harder. Mckinsey say $654bn will need to be invested in currently unsanctioned projects by 2030, but that doesn’t come close to replacing the level of spending cut. Obviously a greater volume of work is being delivered for a greatly reduced price, which is one of their key points. Having predicted a supply gap in the oil market I also thought this prediction was interesting:

Projects that reached FID before 2014 – including mega-projects such as Lula and Golden Eagle – will cover 60% of the anticipated supply gap in 2020-21…

This is an industry with a long run supply curve. Talk of “inflection points” from some contractors just don’t seem to be backed by data.

Read the whole thing. I have a broader point than simply doing a cut and paste from McKinsey but it is based on this:

As a result of cost compression, deepwater breakeven levels are likely to continue being 20-25% lower than 2014, despite a situation where oil prices increase to $70/bbl in our base case. The wider margin created by lower costs should place deepwater investments firmly at the left side of the global oil cost curve, making these projects viable to close the supply gap.

McKinsey see the cost reductions in the offshore supply chain as permanent and structural. Not all relate to oversupply, but they are all based on spending less time offshore.

Although not as widely reported a bigger investment boom than the Dot Com investment bubble was the telecoms investment bubble that occurred at roughly the same time. The global, but particularly US, industry was overcapitalised as companies laid the “dark fibre” of the future internet. A vast number of firms went bankrupt and were subject to fraud (remember Bernie Ebbers and Worldcom?) before they even “lit” the fibre. It was a speculative mania in an industry that like offshore had very high fixed-costs and very low marginal-costs. But the thing is the telecoms companies made nothing from the boom, shareholders and bondholders were largely wiped out, the same thing happened in the English railway mania of the 1840s, and an earlier canal boom in the 1790s which ended in 1793 (and here). The winners from the telecoms investment boom have been companies like Netflix, Google, and Facebook which have used the networks paid for earlier at well below their true economic cost (and without the coordination issues of splitting the installation costs between themselves), similar arguments can be made for railways and canals. The net private losses were potentially an overall social gain.

So the question really is has the offshore industry just supplied a huge amount of latent capacity that will allow E&P companies to close the supply gap cost effectively while wiping out the equity of those who built the infratsructure behind it? I hope pre-2016 Seadrill shareholders (amongst others) enjoy their quality viewing, direct from the internet, and appreciate the irony.

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.

The shale productivity revolution in context…

“[W]e can see the computer age everywhere but in the productivity statistics”

Robert Solow


A great article in the FT today (behind paywall) on the boom in shale being driven by productivity increases (a near facsimile earlier version appears here). Readers of this blog will notice a consistent theme, as Krugman said, “productivity may not be everything, but in the long run it’s nearly everything”. The importance of this is that the US is turning shale into a manufacturing industry, small incremental improvements day-in, day-out, that cummulatively dramatically lower overall per unit costs:

In 2015, shale oil producers on average used 3,300 tons of sand per well, according to Petronerds, a consultancy. By last year, that had almost doubled to 6,100 tons per well. Delivering that much sand to the well site can require 250 truck movements. Other techniques for shale production have also been refined to increase the amount of oil that can be extracted. Modern rigs can drill faster, further, and more accurately than their predecessors. The process of hydraulic fracturing is being split up into more “stages”, allowing effort to be focused more precisely on oil-bearing rocks.

Innovations using the latest computing and communications technology, including remote operations, are also starting to be used more widely. Schlumberger, the oilfield services group, says that in 2014, 13 per cent of jobs it worked on at US onshore wells were supported by technical experts watching from its Houston campus. By 2017, that was up to 31 per cent.

This coincided with the IEA forecasting that the US will become the world’s largest oil producer by 2023 (graph above). [It is well worth having a look at the 13 slides at the bottom of the page of the IEA link]. Investment remains depressed in all but tight oil and the comment at the bottom of this slide regarding offshore is telling:

IEA Upstream Spending.png

The IEA is worried:

that despite falling costs, additional investment will be needed to spur supply growth after 2020. The oil industry has yet to recover from an unprecedented two-year drop in investment in 2015-2016, and the IEA sees little-to-no increase in upstream spending outside of the United States in 2017 and 2018.

“The United States is set to put its stamp on global oil markets for the next five years,” said Dr. Fatih Birol, the IEA’s Executive Director. “But as we’ve highlighted repeatedly, the weak global investment picture remains a source of concern. More investments will be needed to make up for declining oil fields – the world needs to replace 3 mb/d of declines each year, the equivalent of the North Sea – while also meeting robust demand growth.”

The real questions here revolve around how much capacity is being replaced annually, and it is simply not true that 3mb/d are not being replaced at the moment. The producutivity improvements in shale above are part of the solution. Other questions are what sort of price increases would crimp demand? etc. There appears to be no change in investor expectations that they want E&P companies, certainly large ones, to reduce debt and increase shareholder payouts, and therefore capital projects will remain subdued. There is also a strong feeling in the investment community that reserves can be run down.

Without wishing to sound like a broken record the “Demand Fairy” isn’t saving anyone in offshore. Offshore needs to re-engineer it’s business model to compete. The IEA is clear that this weakness will be felt from 2020 onwards, so even if you accept their reasoning, that is a long time to keep burning OpEx if your business model cannot even breakeven in the current climate.

I view shale as a technological revolution and believe that no economy is better suited to maximising its potential. Perez defines the major economic technical revolutions since 1770 into five categories, and the US is dominant in the last three:

Tech Rev 1770 -2000s.png

Revolution is an overused word. But according to Perez’s definition, that I agree with, the shale industry is a Technological Revolution (TR):

Tech Rev Definition.png

This to me is the most interesting part of economic history, because while there are nuances the broad economic development of industrial patterns are really well understood. A classic article here compares the development of the computer industry to electric dynamo. Like shale it is a story of how US capital markets funded ambitious companies, vast economies of scale, manufacturing efficiency gains, and the slow initial diffusion of producitivity gains (think tight-oil 2007).

How long can this positive productivity feedback loop, where innovations throughout the system positively affect other inputs, continue? A long time I suspect. Shale may not be subject to the same volume effects as the PC industry but it still makes an interesting comparison (Allen):

Computers deflator.png

(For those who can’t remember logarithmic maths from school all the left hand bar of the top graph means is “this is a really big number… so big we have a formula to make it shorter”. And the bottom graph just means that even though the price dropped really quickly a lot of new features were added as well). This is a hallmark of the US economy and a manufacturing industry based on constant productivity improvements.

An earlier, and slightly different technical revolution, can be seen with the invention of Corliss Steam Engine,  which allowed America to break free from the constraints of water power in the 19th century (Rosenberg and Trajtenberg). Like shale this was an energy revolution, one that changed the structure of the US economy and allowed manufacturing and urbanization to begin in earnest. Corliss Steam Engine.png

Everytime I write about shale I want to write something about the incredible economic period of the 1930s: How US mass production techniques, a revolution in both managerial skill and capital formation, led to the creation of the economy that created Victory Ships and transformed the Ford factory at Willow Run (YouTube watch this, seriously) into the manufacturer of the B-24 (“the Liberator“), innovations that arguably changed the course of the WWII, and ultimately the post-war global economy. There are surprisingly (and disappointingly) few journal and web references to this, and all are about the mathematics of productivity, when this is really a story to be told at the company level. However, economic development is path dependent and these processes and learnings today are being applied in the shale basins every day, even if unwittingly. (For a broader read about what an incredible period the 1930s was in microeconomic terms this the best I have turned up so far).

So although I don’t understand the individual impact of every innovation listed on this slide I understand where they came from and the process driving this:

Nabors Rig.png

Once upon a time a PSV went for the low-to-mid USD 20ks a day. At the time of writing the BHGE rig count hit 800, the revolution therefore continues…

The French Revolution and Venezuela…

As a follow on from my post on Venezuela a really interesting, and short, article at FT Alphaville (free) comparing Venezuela’s proposed “Petro” and the Assignats of the French Revolution. Maduro is well on his way to becoming a modern Robispierre, with exile or a similar fate awaiting him. Tony Yates highlights that nothing in Venezuela, not the revolutionary tendencies, or the economic solutions of the revolution’s leaders, have changed over time much over time as real options dry-up.

A more in-depth paper here for anyone really interested.

What could possibly go wrong?… The $130m MBA….

For those with some knowledge of the financing of offshore assets over the last few years comes this amusing little story in the FT this morning:

Hedge funds are turning in increasing numbers to the business of buying planes and then leasing them to airlines, as the era of low interest rates pushes firms into more esoteric corners of finance in the hunt for higher returns.

A yield backed by an asset… Where have I heard that before?:

“People today are very focused on yield and it is driving investors to focus on aviation assets because you get yield and you have a hard asset — you have collateral,” said Marc Lasry, Avenue Capital’s co-founder.

As the article points out equity yields are dropping and a credit bubble follows:

The rising interest in buying and leasing aircraft has also triggered a surge in sales of debt tied to aircraft leases. Sales of bonds backed by aircraft leases jumped to $6.6bn in 2017 from $4.2bn in 2016, according to data from Finsight.

What is more, newer hedge fund entrants have focused on the higher yields available from leasing older, typically less fuel-efficient aircraft, but the rebound in oil prices is cutting their attraction for airlines.

This time it’s different….

I am writing a book on Nimrod/ the offshore bubble with the working title “The $130m MBA: The Nimrod Sea Assets Story”… a chapter on comparing the forthcoming airline crash would make a nice comparison I feel.