Deepwater to fund shale and renewables…

From a great article in the $FT today:

For the Anglo-Dutch major, drilling far beneath oceans is essential for raising the funds for investments that will steer it through an uncertain energy transition.

“The responsibility deepwater has is to generate the cash that is going to pay for shales and for renewables,” said Wael Sawan, Shell’s head of deepwater exploration and production. “From 2020 we start to pay the bills for the organisation,” added Mr Sawan…

The company is banking on this new profit centre — alongside conventional fossil fuels, integrated gas and its refining arm — to cover the dividend, finance debt and pay for the investments that will future-proof Shell.

Likely to have made some shareholders in companies like Seadrill (shares down 23% in the last month) and Tidewater (shares down 27% in a fortnight) choke on their cornflakes this morning…,

The never appearing subsea CapEx boom…

The graph above highlights why comments about the impending offshore capex boom, long prophesied as a certainty by true believers, maybe a long time coming… What the graph shows effectively is that the Energy Select Sector ETF (a proxy for all S&P 500 E&P companies) has significantly underperformed in percentage terms the price increase in WTI (oil) throughout 2018. Not only that the rebased price volatility of oil is high.

E&P shareholders have been saying loudly they want money back from E&P companies not a capex driven option on a future supply shortage. The easiest way for E&P companies to give shareholders comfort at this point, and hopefully boost the share price, is to reduce their forward commitments to long-lived expensive projects (deepwater) and focus on shorter payback projects (shale) to supply volume. From the $FT:

Investors have been pushing executives to cut costs, reign in investments in the type of oil megaprojects that might take decades to pay back, and focus on generating cash, either for dividends or share buybacks. Bernstein Research said this week that companies were responding, noting that those who had raised capital expenditure in the second quarter had been taught a lesson.

“Investors punished E&Ps that raised guidance by 230 basis points on average,” said Bob Brackett at Bernstein.

You read comments all the time about how it is a “certainty” that high oil prices and reserve rundown must, as if some metaphysical law, lead to increased offshore activity. It simply isn’t true. The shareholders don’t want it for a whole host of good reasons: the energy transition, the benefits of higher prices and reduced supply, price volatility when making long commitments etc. This week Equinor reduced CapEx forecasts $1bn for 2019 (from $11bn to $10bn), Total confirmed theirs at the lower limit, and Conoco Phillips did the same. All the E&P companies are making similar noises. You can come up with some really complex reasons for this or just accept the CEO’s are being consistent externally and internally: they are rationing capex reasoning the upside of doing so is better than the downside.

There has been change in perceptions and market sentiment since the last energy rebound in 2008/09:

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If E&P companies are not going to get share price appreciation through sentiment they will have to do it the old fashioned way through dividends and share buy-backs; and cutting back CapEx is the single most important lever they control to do this.

Yes subsea project approvals are increasing (from WoodMac <50m boe):

WM Subsea FID.png

But in order for there to a “boom”, one that would influence day rates and utilisation levels across the offshore and subsea asset base, marginal operators have to be able, and willing, to spend and that simply isn’t the case. There is a flight to larger projects, with larger operators, who are ruthless about driving down price. So yes, spend levels are increasing, but check out the size of the absolute decline from the North Sea (from the $FT):

Investments in new North Sea projects have hit £3bn in 2018, the highest level since 2015, after two oil and gas projects received regulatory approval from authorities on Monday…

Capital investments in new North Sea fields were less than £500m in both 2016 and 2017, down from £4.6bn in 2015, but were much higher before the downturn, reaching as much as £17bn in 2011.

£17bn to to less than £500m!!! Seriously… just complete a structural change in the market and the supply chain needs to reduce massively in size and capacity to reflect a drop like that. And a recovery at £3bn is still less than 20% of the 2011 which the fleet delivered (and 30% down on 2015): volumes might be up but the drop in value is just too extreme for anything other than the major players to hold out here. It goes without saying a vastly larger number of businesses are viable with £17bn flowing through the market than £500m. The North Sea might be an extreme example by global levels but it’s illustrative of a worldwide trend.

E&P companies are spending increasing sums on shorter-cycle, potentially lower margin, projects because of the flexibility it offers in uncertain times. Subsea and offshore expenditure and volumes will be up in 2019 but not at the levels to keep some of the more speculative ventures alive.

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.

Shale doesn’t have a cash flow issue …and the limits of expansion…

Yesterday the $WSJ had this article on the economics and cash flows of the shale industry. The overall point is logical that if cost increases continue the cost of capital may go up for shale producers and point to it reaching the economic limits of its expansion. I agree with the general thrust of the article in that if the industry isn’t as profitable as forecast the cost of capital will increase, but this comment is being taken out of context by some:

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Of course they didn’t… they are investing for even higher production next year… the comment “within their means” is pejorative and not a reflection of economic reality. That is a sign of confidence from the firms and their financial backers that their output can be sold at a profitable price. The price signal from both the oil and the capital markets is strong.

I also received a comment yesterday with a link to this comment. I don’t think this is a big deal to anyone with a basic understanding of finance because they get this… but then again I have lost count of the number of people who repeat back to me that no one makes money from shale.

I wonder if this isn’t becoming part of the great “Gotcha” narrative that aims to prove that shale isn’t a viable production methodology? Like the CEO of Shell is going to wake up next Tuesday and say “after reading the article in the WSJ we are going to stop investing in shale. Thank goodness I read that or I would never have realised we will never make money from it!” As if those investing literally tens of billions had no idea of the cash flow profile of their assets?

The overall article is interesting only in that it points to what appears to be the current “productive efficiency” of shale, not its demise. The point of the article isn’t that you can’t make money from shale it is that at the margin now it is becoming less profitable and that may affect the pricing of capital. Bear in mind before you read the rest of this post the scale of the increase in absolute oil production shown in the graph above and the amount of capital required to finance this.

For those not versed in accounting cash flow negative might seem like a big deal but it’s not. A casflow statement is made up of Cash From Operations [CFO] (+/-) Cash flows from investing [CFI](+/-) Cash flows from financing [CFF]. It balances with the cash at bank at the start of the period and at the end. Free Cash Flow to the firm is simply the sum of the first two… You would expect the number to be negative in a capital-intensive industry, like shale oil extraction, when you are seeking to grow output volumes significantly, particularly when a number of firms are new entrants into the industry and not financing from retained earnings. You are spending capital to get future revenue and you need to borrow or raise equity to do this. Collectively as all the firms in the industry deepen the capital base for ever higher production they are using more cash than they are generating currently. (I am aware that there are a number of definitions of Free Cash Flow but this appears to be the Factset one and the generally accepted one of FCFF).

If you buy an offshore drilling rig for $1bn and get 100m in operating cash flow for year 1 then your (highly simplified and representative) cash flow statement reads: CFO +100m: CFI -$1bn. That is your “Free Cash Flow” [FCF] is -$900m. It is balanced (all going well) by CFF +900. You own an oil rig that lasts for 20 years but in year 1 you were down $900m in FCF. You can buy as many rigs as you want and be FCF negative (like Seadrill) for as long as you can keep CFF >= CFO+ CFI  i.e. you have access to debt or equity markets. That is all that is happening in shale collectively.

If these were operating cash flow negative then there would be a massive issue. But as this research from the Dallas Federal Reserve (March 2018) makes clear there is no problem with operating cash:

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Or indeed with profitably drilling wells at the current oil price (i.e. including financing):

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For as long as investors believe that in the future the oil price attainable by these E&P companies is sufficient to return capital, and funding markets remain open, then spending more on Operating Income + CapEx combined is no problem. There is rollover risk in the debt but that is a seperate risk and appears to be pretty minimal at the moment.

Pioneer is an embodiment of this: in the first six months of 2018 it generated ~$1.5bn from operations (i.e. selling oil and gas) [CFO], spent ~$1bn on investments (actually nearly $2bn but it sold some stuff as well) [CFI], and then paid back debt of $450m and purchased ~$50m of shares. But some smaller companies who have come in recently will have spent far more on CapEx than they will earn in CFO.

When I have talked about the ‘virtuous cycle’ of capital deepening in prior posts this is part of that network effect of decreasing risks and increasing returns for all involved in the ecosystem. E.g. if Trafigura build an export facility for 2m b/per day it lowers the risk for every E&P company (and their financiers) that they can sell more oil profitably. So more investment comes into the sector in an ever-expanding circle, lower costs, replacing labour with capital. That is what appears to be happening here. The limits of this process are there and are hinted at in the WSJ:

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Permian production will be up 19-24% according to Pioneer so it’s not all bad. Costs are increasing as the Permian reaches the constraints of labour and capital as has been well documented. Some of these will disappear with new pipelines and other capital deepening, e.g. a replacement of capital over labour as excess surplus is currently trucked or railed out, but some will continue given the huge increase in absolute production volumes. It is no surprise that with such a huge percentage increase in production that at the margin each incremental barrel becomes more expensive in the short-run, but then the capital deepening effect will kick in and the long-run cost curve will decline, as always in mass-production, and then the unit costs drop again… ad infinitum

Pioneer are saying with that statement is that their marginal output on capital is declining slightly this year as cost increases have not kept pace with productivity improvements. That isn’t surprising because the sheer volume of output increased has consistently surprised on the upside. If the project costs increase 10% and this isn’t covered with higher prices and/or productivity improvements then investors will change their price of capital to reflect diminished expectations.

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

But this production capacity isn’t going away. The rigs have been built. The pipelines have been, or are being, built; the same goes for export terminals etc. The capital base of the industry has increased massively and is facing some teething problems. But in a little 4 over years the US tight oil industry has driven US production up to over 11m b/ per day in 2018, over 6m b/ per day of that from shale up from ~4m b/ per day in 2017.

What should really worry those in the offshore community is that this is an industry that increased production 50% in a calendar year before hitting the limits of economic growth, and it did this while increasing productivity and lowering unit costs. Someone isn’t waking up next Tuesday and realising it has all been a massive mistake and turning the tap of funding or production off. The US shale industry is a deep and entrenched part of the energy mix now. Current forecasts might be out by a few hundred thousand barrels a day but they are not going to be out by millions. This production is real and permanent with profound implications.

The core logic of the WSJ article is surely right: A rise in the costs of shale relative to output signals the limit of the economic efficiency and therefore the diminishing returns to capital may make it more expensive for shale E&P firms to fund new projects. Shale and offshore compete for E&P company CapEx and if the cost of funding shale projects rises (on a productivity measured basis) that should increase relative demand for offshore as a substitute. But the Free Cash Flow from an offshore project is massively negative in the short-run and over time has higher yields, whereas the reduced CapEx commitment, despite its lower margin, is one of the chief attractions of shale. Cash for investment is not the issue.

I think it sits uncomfortably with forecasters who claim that day rates for jack-ups will double within two years, or other such notions, and it does not seem to be incorporated in the strategic planning assumptions of a large number of offshore companies or investors where the logical outcomes of such data sit uncomfortably. The offshore industry built a fleet to handle 2013 demand when shale was producing ~2.5m barrels a day, it is now producing 6m and is growing faster than the overall oil market growth and forecast to do so until 2021 at least.

Hard strategic questions arise for the offshore industry: how do we compete in an industry which faces potentially declining market share for our underlying product at the margin? How do we compete in an industry when a competitor with a different business model has taken 10% of global market share in the space of 5 years and we buy 25 year assets funded on short-term contracts? What level of asset base shrinkage does the offshore industry require to be competitive? How many firms will have to liquidate given this necessary shrinkage? What will the surviving firms look like? How much can they realistically expect to make? What are our assets worth?

There are a lot more questions based around this logic. But if you are simply expecting a day-rate increase and a demand side boom based on shale magically running out of cash at some future point I think you are going to be very disappointed.

Oil supply shortage? Really?

“We’re able to do, I would say, 40% more per dollar of activity than we did 4 or 5 years ago at $100 oil”

Bob Dudley on BP’s Q2 2018 results.

When you are told there might be a supply shortage you need to understand how much model risk there is in these sort of forecasts. The IEA graph in the header, a variant on the new peak oil theme, being used as the rationale for why a “recovery” for offshore may be just around the corner, doesn’t show the output implications of the cost deflator.

Bob Dudley is saying that BP are getting 1.4x output for each dollar 4-5 years after the “great oil price crash” of 2014. That ~$500bn of expenditure in 2018 buys you what ~$700bn did 4 years ago (roughly what was being produced in 2013?).

This just isn’t consistent with a some sort of “snapback recovery” for offshore that people try and credibly speak of (and that some business models are based). Mean reversion only works as a theory when the underlying mechanics haven’t changed. The offshore supply chain needs to be realistic about the implications of this sort of comment that is clearly being translated into E&P company CapEx plans. Whether the offshore industry believes it or not this is the new narrative and reality in E&P companies and capital is being allocated accordingly.

 

Time for plan B…

A somewhat ambitiously titled article in the FT seemed to have something for everyone: looking for any excuse to claim the impending supply shortage? Check.  And for the sceptics? Check. To save you reading ‘The Big Read’ I’ll give you a quick synopsis: the reporter spoke to a load of people (mainly analysts) who said there will be a supply crunch but didn’t know when, and then spoke to another bunch of people (who actually make the investments) and they said they don’t think there will be.

The fact is that oil will be a substantial part of the energy mix for a very long time. How we extract it and the relative costs of doing so are far more interesting questions. The E&P companies will be substantial businesses for a long time to come no matter how alarmist some warnings maybe.

But the article does mention the mythical $100 per barrel… just not a timeframe… in fact if you are looking for comfort for when this supply crunch will occur the only person prepared to put a timescale on it is ex-BP CEO Tony Heywood, and you are unlikely to get much comfort from this:

“I don’t think the supermajors really believe the long-term story of peak demand,” Mr Hayward told the Financial Times last week. “Looking at the trajectory, we’re more likely to have a supply crunch in the early 2020s.”

If you really believed in the supply crunch I can’t work out why you wouldn’t sell your house and just go long on Exxon Mobil? According to this article on Bloomberg they are staying as a pure oil and gas supermajor and being punished by the stockmarket for it. Buy their undervalued shares and when the supply crunch comes all their reserves are worth the market price and they have production capacity? And in  the meantime you collect the dividend?

The alternative in the offshore world appears to be buying investments in highly speculative asset companies with no order book that are relying entirely on a macro recovery for their plans to work. At this point in the cycle, and without some clear indication of when any of these plans can return actual cash to the investors, the only thing certain is that they supply side still has a lot of adjustment to go. The big contractors are starting to pull away from the small operators because a) they do the large developments currently in vogue, b) scale has economic advantages in an era of low utilisation, and c) why use a small company where your prepaid engineering work is effectively an unsecured creditor? Expect the flight to quality to continue in the project market.

Frankly if you are long floating assets you simply cannot disregard comments like this from one of the biggest CapEx spenders in the world:

“We’re becoming more efficient at how we deploy capital,” Mr Gilvary says. He adds that BP and other energy groups are ploughing a middle road: raising oil production by using technology to sweat more barrels out of existing fields, while also funnelling smaller amounts of capital into so-called short-cycle projects such as US shale.

BP of course continue to deliver mega-projects where they think they have ‘advantaged’ oil. They just expect to pay less for it:

BP Unit costs.png

Reintroducing cost inflation into the industry will be harder than any previous cyclical upturn is my bet.

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.