Increasing US oil production… Just like the man said…

[P]rogress in science is not a simple line leading to the truth. It is more progress away from less adequate conceptions of, and interactions with, the world.

Thomas Kuhn, The Structure of Scientific Revolutions

Some excellent data from the EIA this week confirmed that US production, even with the known Permian constraint issues, is powering ahead and is excess of previous forecast levels. My hypothesis, hardly controversial, is that there is a strong negative correlation between these graphs and offshore vessel values.

This is playing out almost exactly as Spencer Dale predicted in 2015. This is a generational change in oil production that is clearly going to impact on any “offshore recovery” theory… some of which are starting to sound a little desperate and absurd. I have referenced the Spencer Dale article before and if you are looking for a unifying theory of why any offshore recovery is likely to be delayed and anemic I think it is still the most relevant and lucid explanation.

Random weekend energy thoughts… Productivity, costs, and DSV asset values…

Permian shale and tight production in the third quarter was 338,000 barrels per day, representing an increase of 150,000 barrels per day. Let me say it again: this is up 80% relative to the same quarter last year. As many of you will realize, that’s the equivalent of adding a midsized Permian pure play E&P company in a matter of months.

Pat Yarrington, CFO, Chevron, on the Q3 2018 results call

John Howe from UT2 posted the photo above on Friday and kindly allowed me to reproduce the it. The Seawell cost £35m in 1987 and according to the Bank of England Inflation Calculator the same vessel would cost ~£94m in 2018 in real terms. In 1987 the USD/UK exchange rate was ~1.5 so the Seawell cost $53m and inflation adjusted around $132m (at current exchange rates).

Compare that with the most recent numbers we have for a new Dive Support Vessel (“DSV”) of a similar spec: the Vard 801 ex Haldane that was contracted at $165m (sold for $105m).  That price is roughly 25% above the cost of the Seawell in real terms. You get a better crane and lower fuel consumption but in productive terms you can still only dive to 300m (and no riser tower) and I doubt the crane and the lower fuel consumption are worth paying 25% more in capital terms.

These prices don’t reflect how much the MV Seawell pushed the technological boundary when she was built when and recognised as one of the most sophisticated vessels in the world. The major £60m/$75m upgrade she received in 2014 highlights again the myth that old tonnage will naturally be scrapped as an iron cast law is wrong, but more importantly highlights the technical specification of the vessel has always been above even a high-end construction class DSV (clearly visible in the photo the riser tower must have been seen a major technological innovation in 1987) and yet it is more economic to upgrade than build new for a core North Sea well intervention and dive asset. Helix has invested in an asset that brings the benefits of low-cost from a different cost era to a new more uncertain environment.

The reasons for price inflation in OSVs are well-known and I have discussed this before (here): offshore vessels are custom designed and have a high labour content which is not subject to the same produtivity improvements and lower overall cost reduction that manufactured goods have (Baumol Cost Disease). The DP system and engine might have come down in real terms, but the dive systems certainly haven’t. Even getting hulls built in Eastern Europe and finished in Norway has not reduced the cost of new OSVs in real terms (you only have to look at Vard’s financial numbers to see the answer isn’t in shipbuilding being a structurally more profitable industry).

That sort of structural cost inflation, a hallmark of the great offshore boom of 2003-2014, was fine when there was no substitute product for offshore oil. Very few OSVs were built in a series (apart from some PSV and AHTS). But the majority of the vessels were one-off or customised designs with enormous amounts of time from ship designers, naval architects, class auditors (i.e. labour) before you even got to the fit-out stage. Structural inflation became built into the industry with day-rates in charters etc expected to go up even as assets aged and depreciated in real economic terms because demand was outpacing the ability of yards to supply the tonnage as needed.

The same cost explosion happened in pipelay but did allow buyers to access deeper water projects. Between 2003-2014 an enormous number of deepwater rigid-reel pipelay vessels were built (in a relative sense) with each new vessel having even more top tension etc. than the last; but the parameters were essentially the same: they were just seeking to push the boundary of the same engineering constraints. The result was (again) a vast increase in real costs but one that was partially offset by advances in new pipe and riser technology that allowed uneconomic fields to be developed. Now Airborne and Magma are working on solutions that could make many of these assets redundant. Only time will tell if those offshore companies who have made vast investments in pipelay vessels will have to sell them at marginal cost to compete with composite pipe if the solution gets large-scale operator acceptance (i.e. Petrobras). However, if composite pipe and risers get accepted by E&P companies on a commercial scale those deepwater lay assets are worth substantially less than book value would imply (I actually think the most likely scenario is a gradual erosion of the fleet as it is not replaced).

But now there is a competitor to offshore production: shale. And it is clearly taking investment at the margin from offshore oil and gas. And shale production is an industry subject to vast economies of scale and productivity improvements. The latest Chevron results make clear that they have built a vast, and economically viable, shale business that added 150k barrels per day of production at an 80% growth rate year-on-year:

Chevron Q3 2018 Permian .png

To put that in perspective when Siccar Point gets the Cambo field up and going they will be at 15k per day and it will have taken them years (and the point is they are a quality firm with Blackstone/Bluewater as investors ensuring the do not face a financing constraint).

What makes shale economic is the vast economies of scale and scope available to companies like Chevron. E&P companies producing shale are adding vast amounts of production volume every year and theories that they are not making money doing this are starting to sound like Moon photo hoax stories. E&P companies throw money and technology at a known geological formation and it delivers oil. The more money they invest the lower the unit costs become and the greater the economics of learning and innovation they can apply at even greater scale.

Offshore has a place but it needs to match the productivity benefits offered by shale because it is at a disadvantage in terms of capital flexibility and time to payback.The cost reductions in offshore that have been driven by excess capacity and an investment boom hangover, these are not sustainable and replicable advantages. In offshore everything, from the rig to well design and subsea production system, has traditionally been custom designed (or had a significant amount of rework per development). When people talk of “advantaged” offshore oil now it generally means either a) a field close to existing infrastructure, or, b) a find so big it is worth the enormous development cost. Either of those factors allow a productivity benefit that allows these fields to compete with onshore investment. But to pretend all known or unknown offshore reserves are equal in this regard is ignoring the evidence that offshore will be a far more selective investment for E&P companies and capital markets.

One of the reasons I don’t take seriously graphs like this:

IMG_1067.JPG

…and their accompanying “supply shortage” scare stories is that the market and price mechanism have a remarkably good track record at delivering supply at an economically viable price (since like the dawn of capitalism in Mesopotamia). Modelling the sort of productivity and output benefits that E&P majors are coming up with at the moment is an issue fraught with risk because 1 or 2% compounded over a long period of time is a very large number.

As an immediate contra you get this today for example:

(Reuters) – The oil market’s two-year bull run is running into one of its biggest tests in months, facing a tidal wave of supply and growing worries about economic weakness sapping demand worldwide.

Which brings us back to DSVs in the North Sea, their asset values, and the question of whether you would commission a new one at current prices?

Last week the OGA published an excellent report on wells in the UK and its grim for the future of UK subsea, but especially for the core brownfield and greenfield projects in shallow water that DSVs specialised in. And without a CapEx boom there won’t be a utilisation boom:

OGA wells summary 2-18.png

Future drilling is expected to pick-up  mildly, although it is unfunded, but look at this:

EA well spud.png

Development Drilling.png

So the only area in the UKCS that isn’t in long-term decline is West-of Shetland which is not a DSV area. CNS and SNS were the great DSV development and maintenance areas and the decline in activity in those areas are a structural phenomena that looks unlikely to change. Any pickup is rig work is years away from translating into a Capex boom that would change the profitability of the UKCS DSV and small project fleet.

DSV driven projects have become economic in the North Sea because they are being sold well below their economic cost. Such a situation is unsustainable in the long run (particularly as the offshore assets have a very high running cost). The UKCS isn’t getting a productivity boom like shale to cover the increased costs of specialist assets like DSVs and rigs: E&P companies are merely taking advantage of a supply overhang from an investment boom. That is no sustainable for either party.

So while the period 2003-2014 was “The Great Offshore Boom” the period 2015-2025 is likely to be “The Great Rebalancing” where supply and demand both contract to meet at an equilibrium point. Supply will have to contract because at the moment it is helping to make projects economic by selling DSVs below their true economic worth, and the number of projects will have to contract eventually because that situation won’t last. E&P companies will need to pay higher rates and that will simply make less projects viable. You can clearly see from the historic drilling data that a project boom in shallow water must be a long time coming given the lags between drilling and final investment decisions.

The weak link here in the North Sea DSV market is clearly Bibby Offshore (surely soon to be branded as Rever Offshore?). As the most marginal player it is the most at risk as marginal demand shrinks. Bibby, like other DSV operators on the UKCS, serves an E&P community that is facing declining productivity relative to shale (and therefore a higher cost of capital), in a declining basin, where the cost of their DSVs is not reducing proportionately or offering increased productivity terms to cover this gap. Both Technip and Boskalis were able to buy assets at below economic cost to reduce this structural gap but the York led recapitalisation of Bibby still seems to significantly over value the Polaris and the Sapphire – particularly given implied DSV values with the Technip purchase of the Vard 801 (TBN: Deep Discovery).

DSVs made the UKCS viable and built the core infrastructure, but they did it in a rising price environment where the market was based on a fear of a lack of supply. One reason no new North Sea class DSVs were built between 1999 the Bibby Sapphire conversion in 2005 is because the price of oil declined in real terms but the price of a DSV increased meaningfully in real terms. A new generation of West of Shetland projects may keep the North Sea alive for a while longer but this work will be ROV led. A number of brownfield developments and maintenance work may keep certain “advantaged” fields going for years that will require a declining number of DSVs.

North Sea class DSV sales prices for DSVs are adjusting to their actual economic value it would appear not just reflecting a short-term market aberration.

#structural_change #this_time_it_is_different #supplymustequaldemand

A money creation theory of offshore asset recovery…

The reason we are less enthused by companies which rely on tangible assets such as buildings or manufacturing plants [Ed: or rigs/jackups/ships?] is that anyone with a big enough budget can easily replicate (and compete with) their business. Indeed, they are often able to become better than the original simply by installing the latest technology in their new factory. Banks are also quite keen to lend against the collateral of tangible assets under the often illusory view that this gives them greater security, meaning that such assets can also be financed easily with debt, or as we call it, ‘other people’s money’. Debt is provided to such companies both cheaply, and with seeming abandon at certain times in the economic cycle, with often perilous results.

Smithson Investment Trust, Owners Manual

High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich…

Akerlof and Shiller, Animal Spirits

…the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Keynes, Chap 2: The State of Long Term Expectations, in The General Theory

While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together…

Some of the other and usually minor factors often derive some importance when combined with one or both of the two dominant factors.

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.

Irving Fisher, The Debt Deflationary Theory of Great Depressions

… the modern debt-deflation process encompasses falling asset prices, debt repayment difficulties, a reluctance to lend, a financial crisis, the impact on the banks, and the inter-dependency of the financial system…

Wolfson, Cambridge Journal of Economics

Financial illiteracy is a recipe for debt, default and depression, whose effects appear to feedback on each another in a vicious spiral.

These individual costs are amplified when they are aggregated up to the macro level. How people’s expectations evolve – their degree of optimism or pessimism, exuberance or depression – is crucial for determining their individual decisions. It has long been recognised that these expectations can be shaped importantly by others’ expectations. For example, “popular narratives” can emerge which shape collective expectations among the public – optimism or pessimism, exuberance or depression – and which can then drive aggregate economic fluctuations…

At a macroeconomic level, the work of George Akerlof and Robert Shiller has looked at the popular narratives which emerge during periods of boom and bust.  Using words extracted from newspapers, they find the prevailing popular narratives about the economy have played a significant role in accounting for the heights of the peaks and depths of the troughs during macro-economic booms and busts. Public expectations, embedded in the stories they tell, are a key macro-economic driver.

Andrew Haldane, Bank of England, Folk Wisdom

Last week the Deputy Governor of the Reserve Bank of Australia gave a speech titled “Money – Born of Credit?”, in this speech he outlined an important, yet underappreciated fact, of modern economies: deposits in bank accounts are caused by loans. A lot of people think that by putting money in their bank account they are giving the bank the ability to make a loan, but actually in a systemic sense it is the other way around: the money in your account is the result of banks making loans that end up as deposits in your account. In case you think this is some bizarre, and wrong, economic tangent, the Bank of England has an explanatory article “Money creation in the modern economy” which states:

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The Chief Economist of Standard and Poor’s summed it up in this article:

Banks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit “creation”–credit is created literally out of thin air (or with the stroke of a keyboard). The loan is not created out of reserves. And the loan is not created out of deposits: Loans create deposits, not the other way around.

This ability of privately owned banks to have the power of money creation is not often discussed. To many economists, although generally not those working at banks, this is a privilege where the ability to ‘privatize the profits and socialise the risk, is most flagrant and should perhaps be regulated more. The ‘Exorbitant Privilege‘ of the private sector. There is significant evidence that financial and banking crises have indeed become more common since the move to deregulate the financial system and credit creation that became especially strong post the end of the Bretton Woods era (post 1973).

If you are still reading at this point you may be wondering where I am going with this? The answer is that the implications for an industry like offshore, an asset-backed industry where values were sustained by huge amounts of bank leverage, are important for understanding what a “recovery” will look like. The psychology and ‘animal spirits’ of the commercial banks is likely to matter more than any single factor in dictating when an asset price recovery will be. Given that the loan books are closed to all but tier 1 borrowers, and contracting overall in offshore sector exposure, this would appear to be some way off.

Part of “the boom” in offshore since 2000, barring a short and sharp downturn in 2008/09, was the increasing value of rigs and offshore support vessels, but important too was the willingness of banks to lend against 2P reserves (Reserve Based Lending). This was a pro-cyclical boom where because everyone believed the offshore assets and reserves were worth more than their book value banks were willing to lend significant amounts of money against them. There was a positive and logical narrative of a resource-contrained oil world to unlock the animal spirits, it wasn’t irrational per se. As these assets changed hands banks created deposits in company accounts, they literally created “money” out of thin air by believing that the assets were worth more than they were previously. It is no different to a housing boom, and the more money the banks pumped in, the more everyone believed their assets were worth more (as the deposits grew). Ergo a pro-cyclical credit boom combined with an oil price boom. The demand for oil, and its price, has recovered, and this will affect the amount of offshore work undertaken, but the negative effects of an asset price boom will take longer to recover.

Right now the banks aren’t creating any new money for the offshore sector, collectively they are actually destroying it. When banks refuse to lend on ships or rigs no deposits flow through the system. Money from outside the system stops flowing into the offshore sector from the banks. Values and transactions are supported by the economic earning potential of current assets and the amount of equity and debt raised externally by funds. None of these “creates” money as banks do. These funds are “inside” money.

As an example last week Noble purchased a jack-up from a yard in Indonesia and was granted a loan by the yard selling the unit (a Gusto unit pcitured above). A piece of paper was exchanged and credit was created for the $60m loan of the total ~$94m price. Neither firm has any more money than they had prior to signing the loan contract. Credit isn’t the same as money… had a bank been involved (simplistically) it would have credited the yard with $60m, created a debt of $60m for Noble (a debit), and created an asset for $60m on its balance sheet. This money would have flowed from outside the offshore industry. The total value of the transaction would have been the same but the economic consequences, particularly for the liquidity of the yard, would have been very different. It is safe to say the reason this didn’t happen is because no bank would lend the money under similar terms. Relief rather than animal spirits seems a more likely emotion for this transaction.

It is not just the offshore contracting companies but also the E&P companies that are suffering from reduced bank credit and this is affecting the number of projects they can execute (despite a rise in the oil price). Premier is currently raising funds for the Sealion project, as part of this Drilquip has been given the contract for significant parts of the subsea scope, and they have provided this on a credit basis. In past times Premier would simply have borrowed the money from a bank and paid Drilquip. Now Drilquip has an asset in how much credit it has extended Premier but in the hierarchy of money that is lower than the cash it would previously have had, and it has to wait for Premier to sell the oil to pay it, and take credit risk and oil price risk in the meantime. Vendor financing is not the panacea for offshore because unlike banks vendors can create credit, but not money, and these are two fundamentally different things. There is a financial limit to how many customer Drilquip can serve like this. Collectively this lowers the universe of potential projects for E&P companies, and therefore the growth of the industry, that can be achieved. Credit creation is essential for an industry to grow beyond its ability to generate funds internally.

Another good example is the Pacific Radiance restructuring. Here the proposed solution, that I am enormously sceptical of, is that a new investor comes in allows the banks to restructure their loan contracts/ assets such that they can get paid SGD 100m in cash immediately while writing down the size of the loan. The equity and funds coming in are funds from the existing stock of money supply, they are not additional liquidity created by a belief in underlying asset values and represented by a paper loan contract and a growth in the loan book of the bank. While the new funds are adding to the total stock of money available to the offshore industry the bank involved is taking nearly as much off the table and you can be sure they won’t be lending it back to the sector. And thus the money stock and capital of the industry is reduced. Asset values remain low and the pain counter-cyclical process continues.

When you see companies announcing asset impairments and net losses that flow through to retained earnings this is often merely accounting of the banks withdrawing money from the sector and the economic cost of the asset base not being in tune with the amount of money available to the industry as a whole. It is also seen in share price reductions as the assets will never pay their owners the cash flows previously forecast.

In a modern economy this is normally the transmission mechanism from a credit bubble to a subsequent economic collapse: the ability of private sector banks, and only banks because of the system can create “money”, to amplify asset prices and cause sectoral booms on the way up and reduce the money stock and asset valuations on the way down. Why this happens is a complex topic and cannot be tackled in a blog, but it has clearly happened in offshore. Just as it has happened in housing booms, mining booms, ad infinitum previously. The dynamics are well known and are accentuated in industries which have had a lot of leverage. Much work was undertaken following the depression of agricultural prices in the 1930s, a commodity like oil which fluctuated wildly but the tangible backing of land allowed banks to supply significant leverage to the sector. Irving Fisher, quoted above, was famous for predicting that the US stock market had reached a “permanently high plateau” in 1929,  but his understanding of debt dyamics from studying banking and the US dustbowl depression transformed our understanding of the role of credit and banking.

[This explanation crucially differentiates between inside-money and outside-money. I am making a distinction between money generated inside the offshore sector and outside. By inside money I mean E&P company from expenditure, credit created amongst firms in the industry, and retained earnings. Outside money is primarily bank credit and private equity and debt funds. But whereas private equity and debt funds must raise money from the existing money stock only bank created money raises the volume of money].

In offshore the credit dynamics have been combined with the highly cyclical oil industry and allows optimists to believe a “recovery” is just possible. But a recovery scenario that is credible needs to differentiate between an industrial recovery, driven by the amount of E&P projects commissioned, and an asset price recovery, which is essentially a monetary phenomenon.

A limited industrial recovery is underway. It is limited by the availability of bank credit and the huge debts built up in the previous boom by the E&P companies, and their insistence that shareholders need dividends that reflect the volatility risk of the oil and gas industry. It is also limited because of the significant market share US shale has taken from offshore. But the volume of offshore project work is increasing. This is positive for those service firms who had limited asset exposure, and particularly for the Tier 1 offshore contractors, as much of the work being undertaken is deepwater projects that are large in scope.

But an asset recovery is still a long way off. There are too many assets for the volume of work in the short-run and in the long run it will be very hard to get banks to advance meaningful volumes of credit to the industry. Companies can write loan contracts with each other that represent a value, but banks monetise that immediately by providing liquid funds and therefore raising the animal spirits in the industry, whereas shipyards lending money to drilling companies need them to generate the funds before they can get paid. The velocity and quantity of money within the industry become much smaller. Patience and animal spirits make poor bedfellows.

Bank risk models for a long time will highlight offshore as a) volatile, and b) risky given that a bad deal can see even the senior lenders wiped out completely. Like all of us banks fight the last crisis as they understand it best. Until banks start lending again the flow of funds into the offshore industry will mean the stock of assets that were created in more meaningful times are worth less. In a modern economy credit creation is the sign that animal spirits are returning because it raises the return to equity (and high yield) providers.

In the boom days leading up to 2014 money and credit were plentiful. The net result was a vast amount of money being “created” for the offshore sector and a lot of deposits being created in accounts by virtue of the loans banks were creating to companies in the offshore sector based on their asset value. Now the animal spirits are no more and a feeling of caution prevails. The amount of money entering the sector via higher oil prices and private equity and debt firms is much smaller than was previously created by the banking sector. Over time this should lead to a more rational industry structure… but a repeat f 2014 days is likely to be so far away that the market at least has forgotten it…

As The Great Man said:

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady…[but]…We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

Scrapping and UKCS North Sea demand…

Spirit Energy (67% owned by Centrica) awarded a 3 well / 6 month drilling contract this week to the Transocean Leader. The Transocean Leader was built-in 1987, 4500ft 3G semi, that had a major upgrade in 2012. I remember 1987, my first year of high school, the All Blacks won the inaugural Rugby World Cup with ‘The Iceman (Michael Jones)’, Fleetwood Mac and U2 were cool (or I thought they were), my sister listened to Whitney Houston (okay that isn’t strictly true more The Dead Kennedys). In other words it was a while ago. I’m not a rig expert, and like vessels there are a lot of nuances around what kit can at times do what job. I don’t want to get into those, and my point here isn’t to publish a post every time an old rig wins a job.

My point is that this is a 31-year-old rig, that earlier this year had operational problems forcing it to return to a shipyard for repair before it could continue its contracted workscope, could comfortably win work with a significant UKCS (and international) operator. At 31 years old, and operating in the UK sector, it would be unreasonable to not to expect the odd issue, and indeed when that happened Dana and Transocean settled on a commercial deal to avoid contract termination. E&P operators may prefer new kit, find me an engineer who doesn’t, but the commercial guys like best priced kit in the current environment, and at the moment they are firmly in-charge of procurement.

For all the talk of scrapping being inevitable there are a lot of examples of older kit being contracted by big owners. Simply marking a build year and saying that everything older than that will be scrapped is proving to be an unrealistic forecast methodology across all asset classes (i.e. Fletcher Shipping with the Standard Drilling PSVs). Scrapping is likely to be far more selective around owner financial resources, work programmes forecast, and age, with the relationship between all three more important than any one variable.

In any other industry with cyclical demand equipment is often worked until likely maintenance costs exceed marginal profits. Fully depreciated equipment can have a major (positive) impact on the P&L for struggling companies. As industry demand rises older, less efficient, equipment is brought out to operate at a higher marginal cost. The oil industry is going the same way and while newer rigs and jack-ups may be preferred for drilling work that is clearly not the case in all situations. In plug-and-abandonment work in particular, which is less time-sensitive and more price-sensitive, there is absolutely no indication that new rigs are preferred unless their performance compensates for a cost differential (a very high bar to pass). There is also minimal-to-no evidence of newer rigs attracting anything like the sort of day rate that would allow them to cover their cost of capital versus new-build cost which is surely the first stage in a demand driven recovery?

There has been a lot of discussion lately about the new investors in the North Sea and how they are changing the economic makeup of the area, the UKCS in particular. For the supply chain one thing the new (operationally and/or financially) leveraged companies definitely bring is a relentless focus on pragmatism and cost control that simply was not as evident at larger E&P companies (who tend to excel at larger more complex developments). These might well be the right type of companies to extract the maximum resources from a mature basin, but for the supply chain the relentless focus on cost control over global and gold standards marks a significant change in procurement priorities. This is a long-term deflationary trend for the supply chain.

However, for the subsea and supply industries on the UKCS they better hope this works. The most recent stats from Oil and Gas UK show that CapEx work simply does not have the drilled inventory for a quick upturn in demand, and while the construction assets play in the maintenance market oversupply will continue. The decline in development wells, which drive tie-back activity and is leading indicator of small field developments, is what is causing huge problems for the tier-2 subsea contractors on the demand side. This isn’t going to change until drilling programmes increase in volume.

UKCS Statistics (2017)

Oil and Gas UK activity 2017.png

Source: Oil and Gas UK.

 

Financial crises comparisons…

This article from Gillian Tett on whether we have learnt the lessons from previous financial crises contains this quote:

But whatever their statistical size, crises share two things. First, the pre-crisis period is marked by hubris, greed, opacity — and a tunnel vision among financiers that makes it impossible for them to assess risks. Second, when the crisis hits, there is a sudden loss of trust, among investors, governments, institutions or all three. If you want to understand financial crises, then, it pays to remember that the roots of the word “credit” comes from the Latin “credere”, meaning “to believe”: finance does not work without faith. The irony, though, is that too much trust creates bubbles that (almost) inevitably burst.

My hypothesis is that offshore energy has suffered both from the bursting of a credit bubble (that saw for example its largest specialist lender DVB Bank go effectively bankrupt), as well as a structural change in the demand for offshore oil brought on by shale. The interrelationship between these two events is at the core of my thinking.

But the above paragraph is clearly a good summation of the 2000-2014 offshore boom. As in a banking crisis offshore asset owners had high embedded leverage on long term financing contracts funded with a series of smaller and shorter duration contracts with E&P companies. The asset owners, like banks, were committed to a long-term collection of highly illiquid assets that relied on a buoyant short-term contracting market. Like all booms there was clearly “hubris, greed, and opacity”.

When this delicate balance changed the enitre funding model of the industry was called into question and the lack of rebound on the demand side has led to severe overcapacity issues that – understandably – have left stakeholders reluctant to address. This quote also seems apt:

But shattered trust is hard to restore — particularly when governments or bankers try to sweep problems under the carpet, say with creative accounting tricks. “You can put rotten meat in the freezer to stop it smelling — but its still rotten,” one Japanese official joked to me as he watched American attempts to reassure the markets, turning to some of the same tricks the Tokyo government had once tried — and failed — to use a decade before.

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:

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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:

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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:

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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:

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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.