Bully for Brontosaurus…

“I am truly convinced that both the shipping and the offshore markets will recover.”

Mads Syversen, CEO Arctic Securities (26 Jan 2016)

Arctic and ABG Merger valuation.png

From the Solstad Farstad merger prospectus (9 May 2017) highglighting the extreme optimism of the investment bankers putting the deal together. It should be noted the asset market was under huge stress at the time (the bankers of course were paid in cash on completion).

The Golden Bough

In point of fact magicians appear to have often developed into chiefs and kings.

 James George Frazer, “The Golden Bough” (1890)

The Emporer

Courtier T.L. — Amid all the people starving, missionaries and nurses clamoring, students rioting, and police cracking heads, His Serene Majesty went to Eritrea, where he was received by his grandson, Fleet Commander Eskinder Desta, with whom he intended to make an official cruise on the flagship Ethiopia. They could only manage to start one engine, however, and the cruise had to be called off. His Highness then moved to the French ship Protet, where he was received on board by Hiele, the well-known admiral from Marseille. The next day, in the port of Massawa, His Most Ineffable Highness raised himself for the occasion to the rank of Grand Admiral of the Imperial Fleet, and made seven cadets officers, thereby increasing our naval power. Also he summoned the wretched notables from the north who had been accused by the missionaries and nurses of speculation and stealing from the starving, and he conferred high distinctions on them to prove that they were innocent and to curb the foreign gossip and slander.

 Ryszard Kapuscinski, “The Emperor” (1978)

Mons Aase, DOF Subsea CEO, said: “The appointment of Mr. Riise is an important step towards realizing our vision of being a world-class integrated offshore company, delivering marine services and subsea solutions responsibly, balancing risk and opportunity in a sustainable way, together, every day. I look forward to working closely with our new CCO and I welcome Steinar to DOF Subsea.” (15 October, 2018)

“Our business will probably die over the next 10 yrs because the demand for oil probably will start peaking – we think in 2028-2029.”

Ian Taylor, Vittol Chairman, June 8, 2019

“If you get lucky for a long period of time, you think the rules don’t apply to you… These guys thought they could walk on water. They weren’t smart, they were lucky”.

Maarten Van Eden, Anglo Irish Bank CFO, in Anglo Republic: The Bank that Broke Ireland

(Anglo Irish bank initially assessed its downside losses in the credit crunch at less than €2bn. Over €45bn later they had nearly bankrupted the Irish state by lending on illiquid property assets reliant on a booming Irish economy and a global credit boom).

 

Have a look at the graph in the header, particularly 2016/17, and then the Solstad liabilities for 2016/17, just as they were “buying” Farstad and DeepSea Supply:

Solstad liabilities 2016_17.png

(I saying “buying” because it was then second major rescue attempt after Aker made a spectacular error in timing with REM. It was a deal pushed by the bankers who didn’t want to deal with consequences of Farstad and Deepsea Supply).

That would be just the time the rig count in the Permain was to explode:

BH rig count June 2019.jpg

And here are the latest Solstad Q1 2019 liability figues:

Solstad Q1 2019 Liabilities.png

Roughly NOK 2bn higher! The assets are older, the market isn’t much better, and they owe NOK 2bn more! (Don’t get me started on look at the assets side of the balance sheet: it was well known the Farstad/DESS were worth significantly less than book value).

If you believed Solstad had a future in anything like its current form you would be asked to believe the impossible: that despite the most extraordinary structural shift the oil and gas industry, despite owning depreciating assets barely covering actual running costs, despite no indication of oversupply ending (and in fact every indication that funding a mutually assured destructive battle will continue with NAO planning to raise money), you would be asked to believe Solstad could actually pay that money back… And of course they can’t: the numbers on paper, the amounts the banks and creditors claim they are due, are indeed a fantasy. A wish, with no basis in economic substance despite their accounting clarity.

Solstad made an operating profit of NOK 162 918 000 in Q1 2019 on NOK 33bn of balance sheet and asset risk. If someone had lost the petty cash tin they would have been in a loss. It’s totally unsustainable.

It may have been reasonable to believe that NOK 30bn of debt could be supported by offshore demand when the US graph was at 2014 levels but it is no longer credible now. Too much of the investment and maintenance expenditure flowing through the global energy industry is just going to other places. This is a structural shift in the industry not a temporary drop in demand like 2009.

I am not picking on Solstad here, they are just the most obvious example as their resolution seems (reasonably) imminent. Without exception all these crazy asset play deals that relied on the market coming back will fail.

When I was at university I first read the palaeontologist Stephen J Gould who introduced me to the difference between Lamarckian and Darwinian evolution (Bully for Brontasaurus). If you can’t bothered clicking through to the links the easiest way to think about this (in a purely demonstrative example) is that Lamarckian evolution argues that giraffes evolved by gradually growing longer necks and reaching for higher leaves on trees that others couldn’t reach – which is wrong. One of the many brilliant things about Darwin was that he realised that it was the randomness in evolution that caused the process – giraffes that just happened to have the long neck gene prospered and had more baby giraffes and passed the gene on. The race of giraffes that prospered was the result of random selection that ended up adapting best to their environment. They got lucky not smart.

Offshore is full of companies that may have been lucky on the way up but are totally inappropriate financial and operational structures to survive in the modern energy era. Evolution is a brutal, mechanical, and forward acting process. It is irreversible and path dependent. In economics the randomness of the evolutionary process is well understood with most research showing industry effects are stronger than firm effects. By dint of randomness the genes of many of the asset heavy offshore companies companies, but especially those with debt held constant at 2015/16 levels, are fundamentally unsuited to their new environment.

In case you are wondering where I am going with this (and want to stop reading now) I have two points:

  • A lot of the offshore supply chain confused managerial brilliance on the ride up to 2014 with good luck, a high oil price, and a credit bubble. Seemingly being lucky enough to have been running small fishing vessels when North Sea oil was found was rarely posited as an explanation for the growth of many West Coast Norwegian offshore firms, but it is in reality true. A random act of economic circumstance that threw them into a rising commodity and credit bubble. A newer, far less wealthy, future beckons for many of the small coastal towns that supported this boom.
  • The randomness of US geology colliding with the most efficient capital markets in the world, the largest energy consuming nation, and technological circumstance has caused a complete change in the structure in the underlying oil market. The profound implication for North Sea producers, and the supply chain underpinning them, is a transition to be an ever more marginal part of the global supply chain. That will mean less dollars in flow to them and that however long companies try to fight this will be in vain because we are dealing with a profound structural change not a temporary reduction in demand.

What the offshore industry is faced with now is a fundamental regime change – in its broadest sense both statistically (which I have argued before) and sociologically. The economic models of debt fuelled boats and rigs with smaller contractors are over in principal. It’s just the messy and awkward stage of getting to the other side that beckons now.

For pure SURF contracting and drilling consolidation is the answer and will occur. Financial markets will squeeze all but the largest companies from taking asset risk. DOF Subsea’s business model of buying ships Technip wasn’t sure about long-term will look like the short term aberration to economic rationality it was. For offshore supply the industry will be structurally less profitable forever. Asia shows the future of offshore is a vast array of smaller contractors, operating on minimal margin and taking vast risks, and yet the E&P companies are happy with this outcome because they get competitive prices. There is no reason to believe this model will not work in Europe as well. Where procurement is regional there are no advantages to being a global operator as the unit onshore costs are such a small proportion of the offshore/asset costs.

Although it feels unique to many in offshore it isn’t. If you only read one book about a collapse of ancien regime make sure it is Ryszard Kapuscinski’s “The Emperor” (1978)  on the collapsing Ethiopian empire. By interviewing a large number of the courtiers Kapuscinski gets you into the collective mind of an institution unable to face the reality of circumstance. The inability of Haile Selassie to realise that his random luck was totally unsuited to adaptation in the modern world is deeply reminiscent of the management in offshore, and to a certain extent the banks behind it (I’ll write more on the Stiglitz- Grossman paradox which answers why this may occur later).

Slowly the power and the capital of marginal oil production is being shifted to the Lower 48. Make no mistake the replacement of low capital cost Super Majors for high cost of capital (often PE backed) E&P companies in the North Sea marks the slow withdrawal of capital long-term from the area. Note not removal: just slower investment, higher cost hurdles, more pressure on cost etc. That will require a structurally smaller supply chain.

Old capital structures, and especially debt obligations, written in the good times will be completely re-written. Over the next couple of years the Nordic banks are going to write off billions dollars (that isn’t a misprint) as the hope thesis of recovery loses credibility. They will shut down credit to all but the most worth borrowers and sellable assets (if you think that is happening now you aren’t watching the crazy deals going on in the rig market). Equity across the industry will rise and leverage will substantially decline.  Smaller operators will vanish driven the same process reducing biodiversity on earth now: a less munificent environment. I believe when these banks have to start really taking write-offs, and Solstad and DOF are important here because they are close in time and significant in value, bank loan books will in effect close for all but the largest companies. In the rig market where are few companies have been responsible for nearly all the deals and private bubble has built up in the assets this will be contrasted with a nuclear winter of credit. And if banks aren’t lending then asset values fall dramatically.

How much is the Skandi Nitteroi really worth? There is no spot market for PLSVs, Petrobras have no tenders for flexlay? No one else capable using it needs one and Seadras are getting theirs redelivered? Banks are going to take the hit here and then the industry will really feel it.

I am reading Anglo Republic, a book about the collapse of Anglo Irish Bank, at the moment. Again the inability of management (and Treasury, and the goverment) to see the scale of the losses has a strong parallel with offshore. And like offshore initially everyone believed the Irish propery market would come back, that liquidity not solvency was the problem, that this was temporary blip. The crisis was a slow burner for this reason. But when it really came, just like all asset heavy industries, it starts with the refusal of credit institutions to renew liquidity lines because they know it’s a solvency problem. And that is why Solstad and and DOF are significant. They are the BNP Paribas of the next phase. But you know what… my next book is this, and it will have the same story of excessive optimism, leverage, an event (literally a revolution in this case), and default. If there are only really seven major plots in literature there is surely smaller set in economic history? So we know what is coming here.

This needs to happen in an economic sense. The cost to produce offshore will have to rise to reflect the enormous risk the supply chain take in supplying these hugely unique assets on a contract basis. But for this to happen there needs to be a major reduction in supply and it needs to happen while competing against shale for E&P production share. And it cannot happen while the industry continues to attract liquidity from those who buy assets solely on the basis of their perceived discount to 2016 asset values in the hope of a ‘recovery’ to previous profitability levels.

Which brings us on to what will happen to Solstad? It is in the interests of both the major equity investors (Aker/ Fredrikson) and the banks to play for time here. I fully expect a postponement of the 20 June deadline. Next summer, the bankers will tell themselves, the rates will be high and we will be fine (just like the Irish bankers and countless others before). But some of the smaller syndicate banks clearly get the picture here, the business is effectively trading while insolvent, regulators will also eventually lose patience, and the passage of time will not be kind. The solution everyone wants: to put no more money in and get all their money back isn’t going to happen.

Normally in situations like this, where the duration of the assets is long and illiquid, like a failed bank, a ‘bad bank’ and a ‘good bank’ are created. One runs down (as DVB Bank is doing with offshore) and the good one trades and is sold (as DVB Bank have done with aircraft finance). That would see the Solstad of old split off into a CSV fleet maybe or a Solstad North Sea while the old Asian/Brazil DESS was liquidated and the Farstad AHTS business also liquidated. But that will require the banks writing off c. NOK 20bn (maybe more) and I don’t think they are there yet.

After Solstad comes DOF. And in all likelihood following them will be some smaller tier 2 contractors, and certainly some rig companies, who realize that in an economic sense this just cannot continue. No matter how hard they keep reaching for the greener leaves higher up.

The address that never was…

“Not all barrels are created equally,” she said. “60 per cent of our cash flows are not coming from our upstream business. There shouldn’t be a correlation with our reserves or capital expenditure in upstream. It’s not tied to that.”

Jessica Uhl, CFO Shell

 

Money is not the value for which goods are exchanged, but the value by which they are exchanged.

John Law, Money and Trade (1705)

 

Roughly a year ago this week I gave an address at the OSJ Conference where I was pretty gloomy about the future for offshore. I was invited back this year but unfortunately a change of work circumstances mean it is no longer really the thing for me to do. Having said that I don’t think it is a bad time for a State of the Union speech.

You can guess where this is going…

Last year we had a mini-rally in offshore mid-year. Some of the more outlandish ideas raised more money and invested more capital in an industry already suffering an excess of capital and the share prices of all these public investments are seriously underwater. The banks also continued to pretend things could only get better, when in fact they were clearly getting worse. Solstad and Pacific Radiance are the two most prominent examples of this philosophy but there are a slew more in offshore supply and drilling.

And all the while shale simply grows in scale and scope. I am actually bored now with the really complicated theories about how and why the shale revolution will die. The offshore optimists who touted this theory have been comprehensively wrong in the past and will continue to be so in my opinion.

A few data points show the scale of the infrastructure being used to grow the shale fields:

That folks is your offshore recovery: prices above breakeven at best and lower utilisation as the prices are just high enough to keep zombie companies in business. Welcome to the new normal.

Shale growth may be slowing down,  but it will still grow over 1 million barrels a day in 2019. This slide from Exxon Mobil is reflective of the huge amounts of capital going into Lower 48 production and the continuous productivity immproveents creating the virtuous feedback loop:

IMG_0405.JPG

So you can believe some really complicated story about this “offshore recovery” and how it has to happen because reserves are low, or demand will outstrip supply, or shale production isn’t economic, or you can look at what is happening in the US now and accept the logical conclusion: this is the offshore recovery.

Just like the steel industry in the US when it was hit with Asian competition so offshore now has a serious competitor for production investment at the margin. Offshore production isn’t going away but nor is there a boom in store. Projects at the margin are being delayed or cancelled and never coming back. The fleet built for 2014 is still too large by an order of magnitude and operating well below economic break-even. Only a massive increase from the demand fairy can save the current industry structure and that isn’t happening. There are too many boats and rigs with too many operators and this year will bring the start of the slow rationalisation needed. We will end the year with less companies and less tonnage and still the job will remain incomplete.

The most likely scenario at this point is years of oversupply with grindingly poor margins, struggles to get to economic profitability, and a gradual reduction in the fleet as ever so slowly those with less commitment and cash drop out of the race to stay alive. Eventually prices will have to rise to pay for new investment in the offshore supply chain but that looks years away and most firms don’t have the liquidity to wait. Raising new money is getting near impossible for all but the most serious candidates: hedge funds who piled in last year are underwater and look unlikely to wade back in unless the terms are extraordinary, and long-term investors are rightly terrified at the losses the Alternative fraternity have suffered calling the recovery far too early.

The interesting thing is why? In this paper “The elasticity of demand with respect to product failures” by Werner Troesken (pdf) shows that while markets are selection mechanisms they don’t always choose the best products. People continued to buy snake oil in the US long after its efficacy could be argued for.  Maybe the offshore crowd waiting for the boom can comfort themselves with this fact?

However, I see however that in an era of mass production, and rapidly increasing efficiency and unit cost reductions in shale production. To avoid shale, to take your firm off the technological trajectory, would so limit the future  options of a large E&P company that it would not be a wise strategic decision. More marginal capital will be deployed not less. has It is far less risky to invest in a lower margin product like shale, with a shorter payback period, than those custom designed deepwater fields with economic lives vastly in excess of price forecast accuracy.

Worringly for people in offshore is this paper: “Depression babies” by Ulrike Malmendier and Stefan Nagel. If you want to understand how formative experiences can be in lifelong economic actions then this paper demonstrates that investors whose careers were built in recessions invest in fewer equities (i.e. risk capital) even in positive economic times. My rough analogy, which I have no intent to take further, is that E&P execs who lived the 2014 downturn are in no hurry to turn on the CapEx spigot to satisfy all those who tell the world is running out of energy (and as 3 above shows are consistently wrong). And they will be like this forever. Just as those in offshore sit around waiting for the next boom E&P company execs sit around trying to avoid the next investment driven crash.

I have said before loss-aversion theory greatly explains the behaviour of the banks who are crucial to the clean-up of the industry (particularly in Europe and Asia as American losses have been equitized). Every time they have delayed the losses pretending the comeback will happen. And offshore supply in particular was dominated by European and Asian banks. Sooner or later, when the cash flows from the offshore supply and rig asset base cannot make even token payments, and the banks loan books are revealed to be more like Italian regional banks, the real contraction will begin. John Law intimately understood the link between a banks assets and liabilities in a way that would do a modern risk officer proud.

I also mentioned the DSV market last year. I am not mentioning names but building a $150m DSV and selling the vessel for 100k per day for 150 days (at best per annum) is a fools errand in economic terms regardless of the outstanding organisational skills required to deliver it in physical terms. It is simply not possible in a market as competitive as as the Asian DSV market for one firm to outperform others over the long run.

The sale of the Toisa DSVs for between $20-34m shows the economic clearing price of such assets. Such a large gap between actual economic values of operational assets and the historical build costs of new assets can be met by the Chinese taxpayer forever, but eventually the unsustainable nature of this will catch-up with itself. I shall say no more. But Uber can lose money on running taxis for longer than I thought… eventually I will be right here too. Delivering cold Starbucks at $5 won’t keep Uber at a $60bn valuation and IRM work in Malaysia cannot pay for $150m DSVs.

Offshore will continue to be an important part of the energy mix. But the supply chain supporting it to be like that has a great deal of shrinkage to be an economic part of this mix.

Common knowledge in offshore and shale…

“With every grant of complete security to one group the insecurity of the rest necessarily increases.”

Friedrich Hayek

Common knowledge is something that we all believe everyone else believes. 

We don’t have to believe it ourselves, and it doesn’t even have to be public knowledge. But whether or not you personally believe something to be true, if you believe that everyone else believes something to be true, then the rational behavior is for you to act AS IF you believe it, too. Or at least that’s the rational behavior if you want to make money.

Common knowledge is rarer than you think, at least for most investment theses. That is, there’s almost always a bear case and a bull case for a stock or a sector or a geography, and god knows there are plenty of forums for bulls and bears to argue their respective cases.

What can change this normal state of affairs … what can create common knowledge out of competing opinions … are the words of a Missionary. In game theory terms, the Missionary is someone who can speak to everyone AND who everyone takes seriously. Or at least each of us believes that everyone else hears the Missionary’s words and takes them seriously.

When a Missionary takes sides in a bull vs. bear argument, then depending on the unexpectedness of the words and the prestige of the Missionary, more or less powerful common knowledge is created. Sometimes the original Missionary’s words are talked down by a competing Missionary, and the common knowledge is dissipated. Often, however, the original Missionary’s words are repeated by other, lesser Missionaries, and the common knowledge is amplified.

When powerful common knowledge is created in favor of either the bull or bear story, then the other side’s story is broken. And broken stories take a looooong time to heal, if they ever do. Again, it’s not that the bulls or the bears on the wrong side of the common knowledge are convinced that they were wrong. It’s not that the bulls or the bears on the wrong side of the common knowledge necessarily believe the Missionary’s statements. But the bulls or the bears on the wrong side of the common knowledge believe that everyone ELSE believes the Missionary’s statements, includingeveryone who used to be on their side. And so the bulls or the bears on the wrong side of the common knowledge get out of their position. They sell if they’re long. They cover if they’re short.

Ben Hunt, Epsilon Theory

Oil and offshore has a lot of missionaries. In cyclical industries separating out industry firm effects from market effects is nigh on impossible. Be on the right side of a bull market and you make enough money to be a missionary respected by the crowd.

I thought of this when I read this extract from Saudi America in the Guardian. I won’t be buying the book (KirkusReviews panned it here) but the parts on Aubrey McLendon of Cheasapeake fame are interesting. However, what is really interesting is that in 2016 when the research for the book was being done there was a strong strain of  the “shale isn’t economic” narrative:

Because so few fracking companies actually make money, the most vital ingredient in fracking isn’t chemicals, but capital, with companies relying on Wall Street’s willingness to fund them. If it weren’t for historically low interest rates, it’s not clear there would even have been a fracking boom at all…

You can make an argument that the Federal Reserve is entirely responsible for the fracking boom,” one private-equity titan told me. That view is echoed by Amir Azar, a fellow at Columbia University’s Center on Global EnergyPolicy…

John Hempton, who runs the Australia-based hedge fund Bronte Capital, recalls having debates with his partner as the boom was just getting going. “The oil and gas are real,” his partner would say. “Yes,” Hempton would respond, “but the economics don’t work.”…

In a report released in the fall of 2016, credit rating agency Moody’s called the corporate casualties “catastrophic”. “When all the data is in, including 2016 bankruptcies, it may very well turn out that this oil and gas industry crisis has created a segment-wide bust of historic proportions,” said David Keisman, a Moody’s senior vice-president.

Many of the offshore “recovery plays” were financed when this was the investment narrative. The “common knowledge” was that there was going to be an offshore recovery, it was simply a case of when not if. The staggering increase in shale productivity was not part of the common knowledge and didn’t form part of the narrative. Go long on assets said the common knowledge… they are cheap… this is a funding issue only… what could go wrong? As the oil price inevitably rose demand for offshore assets would quickly recover right?

As the graph at the top of this article highlights, just as the common knowledge was being formed that allowed a range of offshore companies to raise more capital to get them through to the inevitable recovery, and clearly the demise of shale would occur by simple economics alone, in fact the shale industry was just cranking up.

The results of most of the offshore companies for the supposedly busy summer season show that at best a slight EBITDA positive is the most that can be hoped for. Rig, jack-up, and vessel rates remain extremely depressed and most companies are struggling to even cover interest payments. A few larger SURF contractors are covering their cost of capital but most companies are simply doing more for less. Companies might be covering their cash costs but there is a massive issue still with oversupply, and judging from the comments everyone continues to tender for work they have no hope of getting as everyone is doing more tendering. The cash flow is rapidly approaching for a number of companies and Q2 results have shown the market is unlikely to save them.

The missionaries for the shale industry are currently in the ascendant in creating a new common knowledge. The new common knowledge for offshore will be extremely interesting.

(P.S. If I was the publishers I’d rush the paperback edition of the book out).

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 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.

Value free options as a signal for future market demand…

One of the reasons both the shipping and offshore industries got themselves into financial problems was excessive leverage. One way to create leverage without an offsetting liquidity position is to sign up for an asset without takeout financing (i.e. at delivery financing). It’s risky because if anything goes wrong with the takeout financing you lose your deposit and potentially more.

So I was surprised when I saw Odfjell Drilling a USD 220m deposit to buy a rig from Samsung having got a term sheet for a USD 325M loan that required a 4 year contract from an operator as a condition of drawdown… Because what Odfjell have is a 2 year firm plus 1 + 1 year options from Aker BP… Which is clearly very different from a risk perspective. Odfjell Drilling are in the uncomfortable position that if anything goes wrong with the provision of the loan they prepaid the yard USD 220m and have limited options to get it back.

I can’t see the upside for the bank here? Yes the market is strong in this niche, but not so strong that an operator is prepared to commit for four years, only two. 24 months isn’t long and if anything goes wrong they will be hugely exposed here with their counterparty having made minimal payments relative to the value of the unit and not really big enough to honour the loan from the rest of  their resources. For a few hundred basis points above LIBOR that strikes me as an asymmetric payoff in Odfjell’s favour (and whereas in a longer deal the credit approver may have moved on to a new job in this deal they could well still be there if it blows up). Clearly on the mitigating side is a great operator, with a good credit history, and quality shareholders. What’s $300m between friends?

The options for the follow on work are “free” options as far as I read them: i.e. Odjfell gave away call options on their asset for nothing. And Odjfell did this (assuming they are rational and competent negotiators) because the customer wouldn’t pay. So I get the market looks strong but not so strong that an E&P company has to pay anything to guarantee the price of USD 550m rig for two years in two years time (and in options pricing time is one of the most valuable components). The customer will have the right to get other rigs if the market drops and it is capped if the demand goes up. If someone tells you the market is about to boom it isn’t being priced in the options market.

Options in finance and economics are price signals about demand and expectations for demand at the margin. People take risk, or offload, without having to buy the underlying asset. In a volatile environment an option has higher value. When an option is agreed it is meant to be a value neutral position, priced at an equilibrium point where both sides  believe the option is fairly valued. In this deal Aker BP are offloading long term pricing risk to Odfjell for free.

There are numerous examples at the moment in offshore where the asset owner gives away a call option on their pricing and utilisation security. This tells you a great deal unbiasedly about how both sides really view the market going forward. Asset owners giving free call options on vessels and rigs to their customers is an unambiguously bad sign. Economic theory would suggest that these options are “free” because they are valueless.

I can’t help feeling that this is the wrong model for offshore. Surely the best solution to lock-in low long-term rig prices would be for the company with the balance sheet and need for the asset to give a long term charter to allow the rig operator to use less equity and lower the day rate? If people are not that confident then let the unit rot in a shipyard where the current owner has a comparative advantage in storage costs?

At some point, and I think we have reached it generally in offshore, building highly specialised assets that cost in the hundreds of millions and taking spot market risk just won’t be viable for all but a very small number of providers who will price this at very high marginal levels. The problem is until the inventory of such assets drops we are a long way of reaching that degree of rationality. Offshore will remain a highly contestable market and therefore subject to low profitability.

The rig market will feel any upswing first and clearly the ‘animal spirits’ have returned. I offer no judgement, if the shareholders want this they are the ones taking the risk, and it could pay-off spectacularly. But it points to one of what I believe to be the secular changes in the offshore market: who pays for time? Specifically idle time? The Ocean Rig/DNB data below make clear the risk and cost sit with the asset owners.

Floating Rigs Awarded.png

Offshore used to work because relatively small companies took huge relative financial risks on assets because the market was so strong they got the day rates and utilisation to cover these risks. But even in the boom years many assets only broke-even in a economic sense between day 270-300 calendaer days. More than 330 were golden years and less than 280 a worry.

Now the E&P companies don’t have to take this risk and they aren’t. Yet the offshore industry isn’t getting the day rates to cover for this idle time and it’s a material number. It is in fact the most important economic number for most owners because the profit rates on a day worked are well below the cost of one idle day (and that is regardless of asset class).

Solstad Farstad announced a couple of PSV deals at 4 months firm plus 4 months options. Working a vessel for four months year, making it avilable for another four where you can’t market it (another free call option), and maybe getting some work for another 4, is a very risky business model. For that to be sustainable the four working months would have to be at an extraordinary day rate, which currently of course they are not.

I think this is a sign of structurally lower profits in the industry for some considerable time. I also think the options market is where the first signals of long-term confidence may be seen. If Aker BP was really worried about rates increasing in 2 years time, and Odfjell was seeing the same thing, they could agree a cost for those options (that would also probably make the bank happy). Until you see such deals it’s all just talk.