Group think and conventional wisdom…

“It will be convenient to have a name for the ideas which are esteemed at any time for their acceptability, and it should be a term that emphasizes this predictability. I shall refer to these ideas henceforth as the conventional wisdom.”

J.K. Galbraith, The Affluent Society

 

“All that we imagine to be factual is already theory: what “we know” of our surroundings is our interpretation of them”

Friedrich Hayek

 

We find broad- based and significant evidence for the anchoring hypothesis; consensus forecasts are biased towards the values of previous months’ data releases, which in some cases results in sizable predictable forecast errors.

Sean D. Campbell and Steven A. Sharpe, Anchoring Bias in Consensus Forecasts and its Effect on Market Prices

Great quote in the $FT yesterday that reveals how hard it has been in the oil and gas industry for professional analysts to read the single biggest influencing factor that is reshaping the supply chain: rising CapEx productivity and its ongoing continued pressure. Money quote:

Mr Malek said that with the notable exception of ExxonMobil, most energy majors had shown they were capable of growing output quickly even when investing less than it used to.

“We all thought production was going to fall off a cliff from Big Oil when they started slashing spending in 2014,” said Mr Malek. “But it hasn’t. The majority of them are coming out on the front foot in terms of production.” [Emphasis added].

#groupthink 

An outlook where E&P companies can substantially reduce CapEx and maintain output is not one in a lot of forecast models. Forecasts are rooted in a liner input/out paradigm that leads to a new peak oil doomsday scenario. But the data is coming in: E&P companies are serious about reducing CapEx long term and especially relative to output, and collectively the analyst community didn’t realise it. The meme was all “when the rebound comes…” as night follows day…

The BP example I showed was not an aberration. For a whole host of practical and institutional reasons it is hard to model something like 40% increase in productivity in capital expenditure. But the productivity of E&P CapEx, along with the marginal investment dollar spend,  has enormous explanatory power and implications for the offshore and onshore supply chain.

Aside from behavioural constraints (partly an availability heuristc and partly an anchoring bias) the core reason analysts are out though is because their models are grounded in history. Analysts have used either a basic regression model, which over time would have shown a very high correlation between Capex and Output Production, or they simply divided production output by CapEx spend historically and rolled it forward. When they built a financial model they assumed these historic relationships, strong up until 2014, worked in the future… But these are linear models: y if the world hasn’t changed. The problem is when x doesn’t = anymore and really we have a multivariate world and that becomes a very different modelling proposition (both because the world has changed and a more challenging modelling assignment). We are in a period of a  structural break with previous eras in offshore oil and gas.

These regressions don’t explain the future so cannot be used for forecasting. No matter how many times you cut it and reshape the data the historical relationship won’t produce a relationship that validly predicts the future. At a operational level at E&P companies this is easier to see: e.g. aggressive tendering, projects bid but not taken forward if they haven’t reached a threshold, the procurement guys wants another 10k a day off the rig. There is a lag delay before it shows up in the models or is accepted as the conventional wisdom.

SLB Forecast.png

Source: Schlumberger

Over the last 10 years, but with an acceleration in the last five, an industrial and energy revolution (and I do not use the term lightly) has taken place in America. To model it would actually be an exponential equation (a really complicated one at that), and even then subject to such output errors that wouldn’t achieve what (most) analysts needed in terms of useful ranges and outputs. But the errors, in statitics the epsilon, is actually where all the good information, the guide to the future, is buried.

But when the past isn’t a good guide to the future, as is clearly the case in the oil and gas market at the moment, understanding what drives forecasts and what they are set up to achieve is ever more important. How predictive are the models really?

A lot of investment has gone into offshore as the market has declined. A lot of it not because people really believe in the industry but because they believe they will make money when the industry reverts to previous price and utilisation levels, a mean reversion investment thesis often driven on the production rationale cited in the quote. Investors such as these have really being buying a derivative to expose themselves, often in a very leveraged way, to a rising oil price, assuming or hoping, frankly at times in the face of overhwelming contrary evidence, that the historic relationship between the oil price and these assets would return.

These investors are exposed to basis risk: when the underlying on which the derivative is based changes its relationship in its interaction with the derivative. These investors thought they were buying assets exposed in a linear fashion to a rising oil price, but actually the structure of the industry has changed and now they just own exposure to an underutilised asset that is imperfectly hedged (and often with a very high cost of carry). Shale has changed the marginal supply curve of the oil industry and the demand curves for oil field services fundamentally. Models utilising prior relationships simply cannot conceptually or logically explain this and certainly offer zero predictive power.

The future I would argue is about the narrative. Linking what people say and actions taken and mapping out how this might affect the future. To create the future and be a part of it you cannot rely on past hisotrical drivers you need to understand the forces driving it. Less certain statistically but paradoxically more likely to be right.

Oil prices, technology, volatility, and productivity…

Oil prices are unusually prone to volatility because both supply and demand are insensitive or “sticky” in responding to price changes in the short term, while storage is limited and costly.

Robert McNally, Rapidan Energy Group

 

Last week Citi’s lead oil analyst came out and said he thought oil prices might dip to $45 per barrel in 2019 and be in the $45-65 per barrel range by the end of 2019. This contrasts with Goldman Sachs ($70-80), Morgan Stanley ($85), and Bernstein ($100). I don’t have a view on the oil price, all this shows you is that intelligent, well-informed analysts, with almost endless resources, can vary in their forecasts by around ~50-100%. Read the whole story to understand how looking at exactly the same data set as all the other equally capable analysts Citi’s analyst reaches such a different conclusion.

What this really shows is model risk: a few percentage points difference in key input variables, even over a short space of time, can have a huge influence over the outcomes. And actually, there are in reality too many influences to model them all accurately: Will there be a supply outage in Libya? What will happen with Iranian oil? What will happen in Venezuela? And these are just a few of the big geopolitical questions alone. You need a forecast for many planning assumptions but in the short-run the oil price is a random walk.

A good example is this graph from the EIA showing the difference between their February prediction of US oil prediction and the current one:

IMG_0717

If you are wondering why your jack-up, rig, or vessel isn’t quite getting the utilisation or day rate you were looking for in that graph may lie the answer? It’s a bold Board that sanctions too many projects in this environment, and in fact the one that is, Exxon Mobil with the huge Guyana finds, is getting slammed by the stock market. Barclays, summing up the “market view” saying:

IMG_0718.JPG

Shale isn’t a swing producer as McNally makes clear, but it does have a much shorter-term impact on the market in way that nothing did prior to 2013. But it also isn’t a given that offshore will have a cost or volume advantage over offshore in 10 years time: companies need to hedge their bets if they are large portfolio corporations. McNally has published ‘Crude Volatility‘ which may make  my summer reading list.

The big area where I agree with Citi/Morse is on technology and productivity.  Morse obviously believes, as I do, that a few percentage points of recovery and technological improvement over the well lifecycle has the potential to radically alter physical oil output assumptions over the long-run. And that is before you get into the wonkish areas such as on what base you forecast the decline volume on.

Against this backdrop is a new wine in the old bottle of peak oil demand: lack of investment and the coming supply shortage. A whole host of energy consulting firms say underinvestment may cause a supply driven price rise: Rystad and Energy Aspects in this WSJ article:

IMG_0712.JPG

This despite the fact that gross investment doesn’t reflect the increased volume of supply gained from each incremental dollar at the moment (a point Morse makes), or the fact that oil companies don’t need the same level of reserves now (and investors don’t want them to pay for them).  Woodmac, who in the latest “gotcha” on why shale won’t work (sic), has now discovered shale well rates decline faster than thought… I’ll bet by 2040 the 800k a day production cited in the article is made irrelevant by productivity improvements in extraction and production techniques. But I guess again it shows how senstive large data models are to small input changes (and how desperate research firms are to have some uncertainty and upside to discuss with certain corporate clients where an element of group think appears to be pervading Board thinking).

“Preparing for the Recovery”

Preparing for the future.png Rystad also run’s strategy days for Maersk Supply and numerous other subsea and offshore companies…. “Hang in there guys the recovery is just around the corner when the supply crunch happens…”… (however remember The Dominant Logic is dangerous?)….

Meanwhile the capital deepening in the US shale industry continues apace. Have a look at the new pipelines going in:

IMG_0716.JPG

Once these are built the price discount will disappear, further raising E&P company profitability and some railway carriages and trucks they displace will still exist (‘unit trains’ with 100+ carriages carry >66 000 barrels). Some will be scrapped but the railway carriages are like offshore vessels: high fixed costs and commitments and low marginal costs. That is a short way of saying they will reduce their costs to compete… and the virtuous cycle will continue with the capital base even deeper.

What really matters for offshore at the moment is the competition for marginal investment dollars. Does an E&P company choose to invest onshore or offshore? The big advantages of shale are potential productivity increases and lower upfront cash costs despite a lower margin (i.e. low CapEx high OpEx), this flexibility has a number of distinct advantages in  an era when forecasts are so divergent. It is worth noting that Shell, Exxon Mobile and Chevron all underperformed the stock market last week despite oil prices having risen signficantly over the last year. Shareholders want their money back in an era of uncertainty, not mega-projects that offer future pay-offs.

In an era when the volatility of oil prices is clearly increasing you can be sure that tight oil will be favoured over long cycle production at the margin. The ability to take margin risk over commitment risk is a key part of the investment making decision process.  The graph above shows how volatile oil prices has been, in particular since 2003. It is irrational to go long on fixed commitments in a age of increasing volatility: just as it is illogical to take on a massive mortgage on a rig or vessel in the current market it is illogical to go long on too many 20 year deepwater developments, and the two symptons are obviously related to the same cause. For a baseload of demand that is logical, but that only works for the larger players with significant market share, at the margin assets and projects become harder to finance.

The other issue driving investment towards shale, in a time of capital discipline, is path dependence. Path dependence is a process where each step forward can only be achieved with the prior steps preceeding it. Deepwater followed shallow water as an extension of the skills developed there.

The productivity benefits of shale are such that larger E&P companies must fear if they miss this technology cycle catching up on the “path” may be too hard or expensive given the dependent steps they will have to get there. History matters.

Offshore will remain an important part of the energy mix. But the price rise of the past 12 months has led to only marginal increases in work and a firm commitment from E&P companies to control CapEx in a manner that breaks with the past. Price rises not increases in long term production projects are the short term adjustment mechanism at the moment. In a era of price volatility and extraordinary technical change the future could look a lot like the present.

“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.

Anecdote is not the singular of data…

“As regards the scope of political economy, no question is more important, or in a way more difficult, than its true relation to practical problems. Does it treat of the actual or of the ideal? Is it a positive science concerned exclusively with the investigation of uniformities, or is it an art having for its object the determination of practical rules of action?”

John Neville Keynes, 1890, Chapter 2

Music journalists know a lot about music… if you want some good summer listening I would advise taking them seriously. However, as a general rule, their knowledge of finance and economics is less sound… ‘Greatest Hits’ have for example included complete confidence that EMAS Chiyoda would be recapitalised right before they went bankrupt… or that the scheme from Nautilus to put ancient DSVs in lay-up wasn’t stark raving mad because the Sapphire couldn’t get work either… I digress…

On a logical basis it is very hard to argue that a majority of companies in an industry can consistently be under margin pressure and and that they will exist indefinitely regardless of cash flow losses. It might make a good album cover but as economic reasoning it leaves a lot to be desired.

Let me be very clear here: if the total number of firms in an industry are operating at below cash break-even only one of three things (or a combination of) are possible:

  1. Some firms exit the industry. Capacity is withdrawn and the margins of the remaining firms rise to breakeven (a supply side correction).
  2. The market recovers or grows (a demand side correction).
  3. An external source injects funds into the loss making companies or they sell assets (a funding correction).

There are no other options. I write this not because I want people to lose their jobs, or because I hate my old company, or because I didn’t like the Back Street Boys as much as the next music journalist in Westhill, I write it because it is an axiomatic law of economics. To write that firms, backed by private equity companies, who have a very high cost of capital, will simply carry on funding these businesses indefinitely is simply delusional.

A deus ex machina event where a central bank provides unlimited liquidity to an industry only happens in the banking sector generally (in the energy space even Thatcher made the banks deliver in general on their BP underwriting commitment). Subsea appears to flushed out the dumb liquidity money, convinced of a quick turnaround, and being turning toward the committed industrial money now.

The real problem for both York and HitecVision, or indeed any private equity investor in  the industry isn’t getting in it’s getting out (as Alchemy are demonstrating). Both have ample funds to deploy if they really believe the market is coming back and this is just a short-term liquidity issue, but who do they sell these companies to eventually? It was very different selling an investment story to the market in 2013 when all the graphs were hockey sticks but now anyone with no long-term backlog (i.e. more than a season) will struggle to get investors (even current ones). The DOF Subsea IPO, even with their long-term Brazil work, failed and the market is (rightly) more sceptical now. Every year the market fails to reover in the snap-back hoped for each incremental funding round gets riskier and theoretically more expensive.

Private equity firms have a range of strategies but they generally involve leverage. Pure equity investment in loss making companies in the hope of building scale or waiting for the market to develop is actually a venture capital strategy. Without the use of leverage the returns need to be very high to cover the cost of funding, and if the market doesn’t grow then this isn’t possible because you need to compete on price to win market share and by definition firms struggle to earn economic profits, yet alone excess profits, that would allow a private equity investor to profit from the equity invested. For private equity investors now each funding round becomes a competition to last longer than someone else until the market recovers. In simple terms without a demand side boom where asset values are bid up significantly above their current levels the funding costs of this strategy become financially irrational.

In this vein HitecVision are trying to exit OMP by turning it into an Ocean Yield copy. The GP/LP structure will be ditched if possible and the investment in the MR tankers shows the strategy of being a specialist subsea/offshore vessel company is dead. Like the contracting companies it isn’t a viable economic model given the vintage year the funds all started.

Bibby Offshore may have backlog but it is losing money at a cash flow level. The backlog (and I use the 2013 definition here where it implies a contractual commitment) it does have beyond this year consists solely of a contract with Fairfield for decom work. This contract is break-even at best and contains extraordinary risks around Waiting-On-Weather and other delivery risks that are pushed onto the delivery contractor. It is a millstone not a selling point.

Aside from the cost base another major issue for Bibby is the Polaris. Polaris will be 20 years old next year and in need of a 4th special survery: only the clinically insane would take that cost and on if they didn’t already own it (i.e. buy the company beforehand). Not only that but at 10 years the vessel is within sight of the end of her working life. Any semi-knowledgeable buyer would value her not as a perpetuity but as a fixed-life annuity with an explicit model period and this has a massive impact on the value of the firm. In simple terms I mean that the vessel within 5-10 years needs to generate enough cash to pay for a replacement asset (to keep company revenues and margins stable) that costs new USD ~165m and for a spot market operator might need to be paid for with a very high equity cheque (say ~$80m). Sure a buyer can capture some of this value, but not much and they don’t need to give this away.

In order to fund her replacement capital value the Polaris needs to bank ~USD 22k per day on top of her earnings. Good luck with that. When I talk about lower secular profits in  the industry and the slow dimishment of the capital base that is it in a microcosm: an expensive specialist asset that will be worked to death, above cash flow breakeven in a good year, with no hope of generating enough value in the current economic regime to pay for a replacement. This is how the capital base of the industry will shrink in many cases, not the quick flash of scrapping, but the slow gradual erosion of economic value.

Ocean Installer also have limited work although it is installation work and firmly grounded in Norway. Like everyone else this is not a management failing but a reflection of market circumstances.

McDermott and OI could not reach a deal on  price previously. MDR realised they could just hire some engineers, get some vessels (and even continue to park them in an obscure Norwegian port if needed by Equinor), and recreate OI very quickly. All OI has worth selling is a Norwegian franchise the rest is fantasy. An ex-growth business with single customer risk and some chartered vessels has a value but nowhere near enough to make a venture capital strategy work in financial terms.

Now at both companies there are some extremely astute financial investors are doing the numbers and they must either send out letters to fund investors requiring a draw down to inject funds into these businesses, explaining why they think it is worth it, and putting their reputations on the line for the performance. It may have been worth a risk in 2016, and 17, but really again in 18? Really? [For those unaware of how PE works the money isn’t raised and put in a bank it is irrevocable undertaking to unconditionally provide the funds when the investment manager demands. Investors in big funds know when the money goes in generally and what it is being used for.] And again in 19? And the more they draw down now the higher the upturn has to be to recover. (In York’s case I think it’s more subtle as the investment exposure seems to have moved from the fund to Mr Dinan personally given the substantial person of interest filings).

But whatever. If they do this all the firms do this forever then they will all continue to lose money barring a significant increase in demand. And we know that this is not possible in the short-term from data supplied to the various regulatory agencies. And for the UK sector we know production starts to decline in two years (see graph). So in the UK two years just to keep the same available spend in the region the price of oil will have to go up or E&P companies will have to spend more proportionately on the service companies. This is not a structurally attractive market beset as it is with overcapacity.

Aside from the major tier 1 companies are a host of smaller companies like DOF Subsea, Maersk, Bourbon, and Swire, long on vessels and project teams, and with a rational comnmitment and ability to keep in the market until some smaller players leave. I repeat: this is a commitment issue and the companies with the highest cost of capital and the smallest balance sheets and reources will lose. These companies don’t need to win the tie-backs etc. that OI (and Bibby) are really aiming for: they just need to take enough small projects to ensure that the cost base OI and Bibby have to maintain for trying to get larger projects is uneconomic and expensive in short-term cash costs. It is a much lower bar to aim for but an achievable one.

So the private equity funded companies are left with option 3 as are the industrial companies. The problem is that the industrial companies have a Weighted Average Cost of Capital of ~8-15% and private equity companies who like to make a 2.5x money multiple have about a 25-30% (including portfolio losses) The magic of discounting means the nominal variance over time is considerably larger.

And for both OI and Bibby the fact is they face a very different market from when they started. Both companies went long on specialised tonnage when there was a shortage, taking real financial and operational risk, and growing in a growing market. That market looks likely never to return and the exit route for their private equity backers therefore becomes trying to convince other investors that they need to go long on specialist assets that operate in the spot the market with little visibility and backlog beyonnd the next six months. As someone who tried raising capital for one of these companies in downturns and booms I can tell you that is a very hard task.

So if you want some easy listening summer music I suggest you take advice from a music journalist. On the other hand if you want a serious strategic and financial plan that reflects the market please contact me.

Shale and offshore… the competition for marginal investment dollars…

Last week the Baker Hughes rig count for the US came in and again it was up. In the graph above Woodmac are highlighting it that Lower 48 US shale production may crack 12m barrels a day.  As recently as 2013, when offshore was starting to go really long on ships, US shale production was ~3.0m per day. It has in short been an industrial phenomena, one as I have noted here before no other economy in  the world could have marshalled as it has required enrmous flexibility in capital markets and the ability to turn a service industry into a manufacturing process.

The narrative has changed as well. Shale has consistently outperformed even optmistic forecasts:

US-Shale-Production-Outlook-Revised-Upward-Repeatedly-20160210-v2.png

As recently as 2016 even BP’s renowned research team were only predicting a fraction of actual demand. Shale now represents an enormous portion of workd output and it’s economic model of short-cycle low-margin is the antithesis offshore but this flexibility around spending commitment is clearly very valuable to E&P companies in an era of price volatility.

So I get as the price declined in 2014/15 you could maybe make a reasonable case for a quick rebound in offshore? 2016 at a stretch, although I think the market signals for offshore were already clear byt then, but I have to say it strikes me as hard now for people ignore the scale of this change and to argue there will be some demand driven boom coming in offshore. E&P companies have stated repeatedly they are sticking to forecast offshore CapEx numbers and they seem to be sticking this.

I still think there are too many business plans floating around which have as a core assumption. This from Ocean Rig:

Ocean Rig Recovery.png

“[F]or the market upturn” (emphasis added)… like it’s a given? I get it’s off a low base but I think we all know when people talk about that sort of recovery they mean a deep cyclical one that flows to rig and vessel operators who will make a ton of money.

But let’s look at the scale in terms of shift at the margin in incremental output:

Long term offshore.png

The last time the oil price dropped and offshore boomed back,whichever cycle you were talking about but especially the quick 2008/09 rebound, that yellow portion of incremental investmnent simply didn’t exist on the graph in a meaningful sense (and since this graph was done shale is more important). A business plan that simply ignores this reality an insists on a change in market conditions as it’s defining principal is simply logically inconsistent to my mind. Clearly offshore is an important part of the energy mix going forward, but in 2009 it was really the only alternative to traditional onshore production and that clearly isn’t the case now.

Offshore used to have very high utilisation rates, that is what made small companies in an extremely capital intensive industry viable, but it is clear that the scale of investment in shale is having a profound impact on utilisation levels and this is changing the entire economic structure of the industry. This point is a prelude to a further few posts that have this logic as there core.

What is an offshore construction vessel worth?

There is an article from Subsea World News here that is sure to have bank risk officers and CFOs choking over their coffee… VesselValues new OCV is launching a new analytics tool for the sector. The ten most valuable vessels in the OCV sector are apparently:

  • Normand Maximus $189m;
  • Fortitude $99 million;
  • Deep Explorer $97 million;
  • Siem Helix 2 $96 million;
  • Seven Kestrel $95 million;
  • Siem Helix 1 $95 million;
  • Island Venture $94 million;
  • Viking Neptun $92 million;
  • Far Sentinel $90 million;
  • Far Sleipner $89 million;

Firstly, look at the depreciation this would imply? As an example the Maximus was delivered in 2016 at a contract price of USD $367m. So in less than 2 years the vessel has dropped about 48% in value. Similarly the two new DSVs the Seven Kestrel and Deep Explorer appear to be worth about 67% of value for a little over two years depreciation.

Secondly, the methodology. I broadly agree with using an economic fundamentals approach to valuation. And I definitely agree that in a future of lower SURF project margins that these assets have a lower price than would have been implied when the vessels were ordered. I have doubts that you can seperate out completely the value of a reel-lay ship like Maximus from the value of the projects it works on but you need to start somewhere. It is clear that SURF projects will have a lower structural margin going forward and logically this must be reflected in a vessel’s value so I agree with the overall idea of what is being said.

There is a spot market for DSVs on the other hand so their value must reflect this as well as the SURF projects market where larger contractors traditionally cross-subsidised their investment in these assets. A 33% reduction in value in two years might well reflect an ongoing structural change in the North Sea DSV market and is consistent with the Nor/Boskalis transactions on an ongoing basis. This adds weight to the fact York have overpaid significantly for Bibby, who would be unable to add any future capacity to the DSV market in the pricing model this would imply and not even be earning enough to justify a replacement asset. Given the Polaris will need a fourth special survey next year, and is operating at below economic value at current market rates, even justifying the cost of the drydock in cash terms on a rational basis is difficult.

Depreciation levels like this imply clearly that the industry needs less capital in it and a supply side reduction to adjust to normal levels. Technip and Subsea 7 are big enough to trade through this and will realise the reality of similar figures internally even if they don’t take a writedown to reflect this. Boskalis looks to have purchased at fair value not bargain value to enter the North Sea DSV market. SolstadFarstad on the hand have major financial issues and Saipem locked into a charter rate for the next 8 years at way above market rates, but with earnings dependent on the current market, will have to admit that while the Maximus might be a project enabler it will also be a significant drag on operational earnings. The VesselsValue number seems to be a fair reflection of what that overall number might look like.

The longer the “offshore recovery” remains illusory the harder it will be for banks, CFOs, and auditors to ignore the reality of some sort of rational, economic value criteria, for offshore assets based on the cash flows the assets can actually generate.

Market forecasts as structural breaks….[Wonkish]

Not for everyone this post but important if you are involved in strategic planning. The above chart is from the latest Subsea 7 Q1 numbers. The problem I have with these charts is what statisticians call “structural breaks“. Basically if the underlying data has changed then you need to change your forecast methodology. As I have argued here and here (although it’s a general themse of this blog) I think there is sufficient evidence that large E&P companies are commissioning less offshore projects when they become economically viable in the past on NPV basis. I am not sure that all the forecast models reflect this.

This break in the historical patterns has really important forecasting implications because when you see whichever market forecast  it has made an assumption, whether formally through a regression model or on a project-by-project basis, that x number of projects will be commissioned at y price of oil (outside of short term data which logs actual approvals). If there has been a stuctural change in the demand side then y (commissioned offshore projects) will be lower, and on a lower trajectory to x (the oil price) permanently, than past cycles.

E&P companies are not perfectly rational. As the oil price gets to $60 there is no set programme that triggers a project. For sure the longer the price stays high it increases the probability of projects being commissioned but it is a probability and the time scale of has changed I would argue. I think it is why demand has surprised many on the downside because there has been a change in the forecast relationship between offshore projects and the spot price of oil.