Economic progress, in capitalist society, means turmoil.
I don’t want to say I told you so, not more than once anyway, but in an article in the FT yesterday Ed Morse from Citibank called what I have been saying for some time:
They way the market has responded is a reminder not to underestimate shale. The unconventional oil revolution looks unstoppable. US shale production looks likely to rise by more than 5m barrels a day by 2022. Shale costs have fallen 35 per cent since 2014 and are beginning to rise again. But shale cost inflation is limited to well completion, not drilling, and productivity gains look to be rising even faster. Estimated ultimate recovery levels have doubled over the last few years and such bottlenecks as delivering fracking sands are being overcome. And don’t ignore either deep water or oil sands, which could each contribute more than 1m b/d of growth by 2022. Deep and difficult water costs have fallen 20-25 per cent and appear to have another 20-25 per cent to go.
Read the whole thing if you can. The article also highlights that shale may not be subject to the volume constraints the offshore industry has always assumed.
In a tribute to their forecasting accuracy, and with all the resources of Citibank on offer, the team have managed to “forecast” a price variation of somewhere between USD 20-25 per barrel (a c. 50% of the current price) and note the peak price should max out at 65, but may reach 70… I hope these quotes are for general distribution and the banks clients get a more accurate view… I digress….
I have mentioned productivity before, one of my favourite quotes is Krugman’s line “productivity may not be everything, but in the long run it’s nearly everything” (okay he was talking about East Asia but actually the growth models used for modelling are pretty similar). But there is something deeper going on here. Last week a giant in the economics world passed away: William Baumol. Baumol literally wrote my undergrad economics textbook, as a discipline Microeconomics (the study of firms) has advanced significantly in the last 25 years in a really positive way that diverges from the obsession with perfect competition, and much of it due to his insights, many of which infuse this blog (I hope).
The first major insight Baumol had has shaped our worldview literally and is directly applicable in viewing offshore versus shale. In the 1960’s Baumol noticed that musicians weren’t any more productive than they were 100 years ago. A string quartet still takes four people just as it did 100 years before. Manufacturing is subject to increasing returns to scale, unit costs drop as production increases (up to a certain point), but that isn’t true in service organisations where there are limits to productivity increases and wages are fixed in a nominal sense (especially in the short-run). Bamoul cost disease or the Bamoul effect, is a world of progressive decline in real prices for manufactured goods, subject to standardisation and mass production, and therefore productivity improvements, these become cheaper, while goods with a high service element or input remain at that level.
Notice in the above Morse references offshore cost drops not productivity improvements. A DSV still has a safe manning certificate of 12 just like it did last week, and last year (while shale well output has increased 20% for the same inputs), what has happened in offshore is there has been a transfer of wealth from vessel owners and banks to E&P companies. The equity has in effect been wiped-out in this transfer. It’s not that offshore has got more efficient, it is that it has distributed the losses throughout the supply chain. That is unsustainable.
Offshore has not been subject to any standardisation, in fact it is by design an industry with a high human service element and input basis. Rigs and vessels, while following similar designs, are essentially custom built (or maybe one of a series of 3 or 4), field development is bespoke, installation methodology is unique, risers are one-off’s etc. By design the offshore industry is a high service output and not subject to productivity improvements. Cost disease isn’t meant to be pejorative in this case, rather a statement of fact. Everyone in offshore has tales of outrageous waste (I once found a TV repairman from Aberdeen on a vessel in Malaysia), but this was a sympton not a cause of an industry where getting first oil topped all other considerations. The world has changed.
Compare that with shale. Shale is a manufacturing process at the start of its technological journey. I don’t know how quickly companies will continue to improve shale productivity, but I do know large rig companies, like Nabors, with huge assets and R&D arms, have teams of people working every day to work out how to get a little bit better and deliver a little more and over time they will improve, industrialise the process across the fleet and drive unit costs down. It will be very hard for offshore to match this.
Bamoul’s other great contribution, that is also relevant to offshore, was to realise that large firms don’t actually compete by trying to drive prices down all the time (which was close to heresy in the economics community when he suggested this), they compete on innovation and productivity.
I won’t go into the full argument here but it involves a theory of how the economy grows as well as firms that is based on constant innovation. This process is underpinning the service firms driving the shale revolution, a constant fear that if they do not seek to drive this productivity they will lose market share, firms in this situation don’t sit still and move to static efficiency, the concentrate on innovation.
Offshore has an unattractive development cycle compared to shale: you need to get some seismic data, hire a rig for exploration and assessment, raise money (if you are a small company), get a different rig back to drill the wells, and then put the subsea kit in. It’s risky and expensive, and the pay-off cycle is long with break points at which you can lose all previous investment. Fields/tie-backs that used to be developed for 5-15 000 bpd output look severely at risk. It is very easy to see offshore turning into an industry where large fields, with high flow rates, are developed and smaller fields become a rarity (until technology improves). Large fields, with very low lift costs and high volumes can offset the huge investment in one-off design that this requires. Such an outcome would see a vastly different supply chain to the current one.