The bull case for oil… but does it really matter for offshore anyway?

I’m basically an iconoclast by nature and therefore I want to believe things like this:

Burgrabben “Crude Oil: Are you ready for triple digit prices”

And it’s a smart piece of work with loads of really interesting data points. But it is also a variation of “shale can’t possibly work” which I have heard now many times, with a million different reasons, all generally based on shale/tight oil reaching a technical frontier. Subsequently over the years this has been shown to wrong as productivity constantly improves. But if you want the bull case it’s been written for you…

I think it is very hard to believe though that major investors and E&P companies have got this so wrong? A lot of large companies seem to have some fairly explicit forecasts about their production levels and would look very stupid backtracking on the scale some of the shale pessimists seem to think will happen. Surely before the supermajors make major acquisitions they talk to a shale engineer and say “you know like if we buy these wells this will work right?” And maybe more than one and get some opinions? And then some really smart engineers in-house put their names to this? The fact a small number of people seem to think, not for the first time, they have caught out everyone else with something they hadn’t thought of strikes me as a low probability event. I get this goes against everything I say about investment bubbles at times… it’s just this time…

There is also a large section on a “supply gap” with other assets and that maybe true… the market will respond to higher prices just not as quickly as some people hope. I will leave it at that. For the record I have no view on the oil price, in the short run I think it’s a random walk as I always say, and in the long run, the very long run, I believe in technology. But it’s a risky and cyclical business and in a rational world you need a high rate of return to cover for this. Clearly an industry operating at a price level below that of marginal production costs will see a rise in price for a commodity like oil which has an inelastic demand curve.

My major point here is that even if the oil price recovers demand conditions for the offshore industry are extremely unlikely to return to the 2013 type years. Shale only needed to take 5% of global production to drop utilisation rates for offshore assets and change the industry economics over a very short time span. The offshore industry used to need very high utilisation levels and day rates to make the economics work and I find it hard to see a scenario where this will return quickly. Even this report acknowledges the cycle times in offshore and is clear about the increasing role of shale in an absolute sense. The fact remains a larger portion E&P capital expenditure for the next few years is focused on shale/tight oil in an environment where CapEx budgets have been cut. Unless someone can explain to you how they expect a bounce-back in demand that deals with that fact then it isn’t a sensible explanation.

Saipem’s most recent results had a good graphic example of this:

Saipem Q1 2018 backlog.png

Backlog down another 13%… yet Saipem still went long on a USD 275m asset that will keep capacity in the rigid-reel SURF market and force them to lower prices to gain market share. And in fact that asset went to the worst possible competitor for everyone else in the market because Saipem have the resources and technical skills to maximise the value of the Constellation.

Focusing less on the daily change in the spot price of oil and more on the marginal drivers of demand for offshore utilisation would strike me as a better way of gauging industry profitability going forward.

State of the nation…a slow trip towards equilibrium…

Loads of news happening that seems to sum up to me the state of where the offshore and subsea industry is at the moment. Dare I say it but we appear to be approaching a sort of equilibrium point where demand and supply are converging around more stable levels.

The FT reported on Monday that:

The US shale oil revolution has reached a landmark moment, with the sector’s top companies for the first time earning enough cash to cover the cost of new wells…

From the time the first shale oil test wells were drilled in the US in 2008-09, the industry’s capital expenditure has exceeded its cash from operations, with producers only able to stay in business by attracting hundreds of billions of dollars in financing from bond and share sales and bank loans. From 2008 to 2017, US exploration and production companies raised $293bn from bond sales, according to Dealogic.

That is what should happen to a marginal producer: they must become profitable at a cash flow (and economic) level so there is an incentive for them to supply the next barrel of oil required. The great hope for some in offshore that shale was an ephemeral phenomenon can be firmly put aside.  To put that bond number into perspective the UKCS spent £14bn offshore in 2014, its best year ever! Efficient US capital markets have channelled the funds into an industry where the long term prize was clear.  And as I constantly say here it wasn’t just a capital story it is a productivity story:

Scott Sheffield, chairman of Pioneer Natural Resources, said its wells in the Permian Basin of Texas and New Mexico were now 300 per cent more productive than four years ago, driving down the oil price needed for them to make a profit.

“In 2014 our break-even price in the Permian Basin was probably $55 or $60 a barrel,” he told the Columbia Global Energy Summit last week. “I would never have thought that the Permian Basin could drive down the break-even price to the low $20s. And we did it.”

So it is hardly surprising that today Heerema announced they are pulling out of pipe-lay, converting the Aegir to a heavy lift vessel that will also work on renewables, and laying off 350 people. The Aegir was only added to the fleet in 2013, yet a mere 5 years later the market has changed so much that a premium asset must now be re-engineered as a completely different economic proposition. I have statistical issues with microcosms but this struck me as one.

Heerema have called it right in my opinion: the deepwater lay market, and pipe-lay in general, is now totally over supplied. Some companies and assets will have to leave the industry in order for it to rebalance. Heerema simply doesn’t have the  financial resources or integrated solution of the “Big Three” (TechnipFMC, Subsea 7, Saipem).  Heerema were annoyed when EMAS seemed to copy many of the unique features of the Aegir for the Constellation (which is of course now in the Saipem fleet), but the economist in me says that only reflects how high returns have to be in this industry to reflect the risks. Saipem have arguably appropriated some of the value from the Aegir and Heerem’s IP…. although the trade-off was an asset built in TriYards Vietnam so maybe it will all even out… Quite what move Allseas makes next remains to be seen but they must be starting to feel lonely.

Maintenance spend will increase as higher prices make it economic to refurbish older wells or those shut in now. But the installed base on which future demand predictions were made will be permanently smaller. Prices for E&P companies will eventually have to rise to recognise that someone building a $600-700m construction vessel, with no forward order book, is a very risky business model and investors need to be compensated for this. Especially when the downside can be at least a 50% discount to build cost in a managed sale.

But this time as the oil price has crept up E&P companies have failed to shine as in previous eras of rising prices as they are burdended with excessive debts and sceptical investors who want to share more of the upside in a boom. There is a very good article from Bloomberg here:

At fault, a toxic troika that combines gushing supply with fears that long-term demand will flat-line as electric vehicles and renewable energies grow, and climate change policies proliferate. And while cash flow for oil’s majors in 2018 is likely to be the highest in 12 years, investors are largely unmoved…

Oil executives acknowledge that it’s too soon to win back investors. Shell CEO Ben van Beurden has openly talked about a “credibility and track record gap” between the major oil companies and its shareholder base.

“We need to show a little bit longer we mean what we say in terms of capital discipline,” he told reporters last week. “This newfound religion and confidence is, to say the least, fragile.”…

“The investment community still is not sure we’re going to handle these higher prices with discipline,” BP Plc Chief Executive Officer Bob Dudley said Tuesday. “Then there’s a section of the investment community that wonders why we’re not investing more in batteries and cars and renewables.”

E&P versus market.JPG

You can see above that higher oil prices haven’t meant much for E&P companies. One central issue is CapEx spend where large companies are making a promise to investors not to spend on mega projects in an era of rising prices. Smaller companies, offshore companies, are struggling to get finance at all. If you want it set out explicitly here it is:

Big Oil’s first quarter results are “a chance at redemption” after a poor fourth quarter of 2017, Biraj Borkhataria, a London-based analyst at RBC Capital Markets wrote in a note. Investors will reward companies whose cash generation rises at the same rate as oil prices in the period, and no new plans to raise capital spending, he said.

Get that…? An increase in oil price goes out in debt reduction, dividends, and stock buy-back not offshore projects to increase supply. No to hitting the supply chain with massive orders that cause a spike in prices as the spot oil price increases.  E&P companies are going to make money in an  era of rising oil prices from higher prices, not from taking the money from rising prices and putting it into more production to take advantage of potentially higher prices in the future. It is a very different investment dynamic. It might change in the future, but it will take a long time to be felt in the offshore supply chain, and there is no guarantee it will.

And by the way it doesn’t matter if you believe the “toxic troika” theory or not… the people who buy the shares in E&P companies, and therefore ultimately fund large projects, do. And collectively they are making it harder for these projects to be funded by insisting on higher cash payments from E&P companies. So perception has become reality.

This is an environment that favours offshore field developments to supply a baseload of high volume/low lift cost supply while using shale for marginal demand. Some smaller field developments will of course happen, TechnipFMC has an good video here about how standardised they will be in shallow water for example, but it is harder not to see offshore developments being marked by larger projects or infield work.

This is a market heading for equilibrium, yes there will be rising oil prices, but no one, not even the E&P companies, feel like this is a boom. Yes, it is better for E&P companies than the offshore supply chain, although the onshore supply chain is booming in US onshore. A number of offshore contractors are making money, they are more than cash flow positive, but the order book is weak and few points utilisation either way is the difference between a breakeven and a loss. The supply side will still face a contraction, sensible M&A will occur, services will be more profitable than owning tonnage, and companies will make money. But returns in excess of the cost-of-capital look a long way off for the offshore industry given that the last boom showed how expensive the cost-of-capital should really be on a cyclically adjusted basis.

A supply contraction and rising oil prices…

The comments above are from Schlumberger’s results last week. Note the comments about the only possible sources of short-term supply increase. I think SLB are ignoring increased maintenance spending to bring shut-in wells back but this is probably not a major number.

It is worth noting that this era of rising oil prices, if they remain, is driven by OPEC trying to limit supply to drive the price up for macroeconomic reasons, and is therefore different to the 2008 -2014 increase where the dominant narrative was to increase supply for a booming economy. The narrative counts.

Here is another reason any “recovery”, or boom 5.0, or whatever, in oil prices will be:

Crude Shipments

So any recovery will be just like before only different. Some change will be cyclical and just like the past but some has clearly been secular. Business plans that assume a general “recovery” as being disingenuous.

I ran a very hot half marathon today (Southampton). Anyone who enjoys this blog and feels it has some economic value please make a contribution to the Hospice North Shore (NZ) (an amazing place that took amazing care of my Mum at the end and to whom I am forever in their debt) or the Motor Neurone Disease Association UK.

Thanks in advance.

A journey in graphs and capital intensity…

The above graph was taken from a JP Morgan report into the oil price this week. I wouldn’t read too much into the headline, as I have said before in the short-term I think the oil price is a random walk, but it gives you an idea of what a well researched analysis thinks the long term breakeven price is in the 50s. That isn’t my view but it reminded me of this graph from 2013:

Berenberg 2013.png

This is from a report in 2013 that Berenberg Bank published (using Infield as their source). Rystad had a similar one in 2013 (the article is very perceptive in retrospect):

Rystad 2013

The key for me is how far shale has dropped down the cost curve and the fact that this has been driven by productivity improvements while utilisation in the industry has been high (i.e. cost pressure was on the upside not the downside). I would argue a majority of the decrease in offshore costs has come about through over capacity and economic value (debt and equity) being wiped out. Given that many offshore assets are designed for 25 years of operational life this is a real issue.

I was interested to see the Noble/GE link this week with the aim of reducing drilling timing by c. 20%. But surely this points to the future where more planning and onshore data work will lead to less offshore execution time? I thought this was cool:

The Digital Rig solution combines data models from a digital replica of physical assets, known as a digital twin, along with advanced analytics to detect off-standard behavior, providing an early warning to operators to mitigate a problem before it strikes. Thanks to vessel-wide intelligence, personnel both on the vessel or onshore can gain a holistic view of an entire vessel’s health state and the real-time performance of each piece of equipment onboard.

Offshore is going to have to work out how to increase productivity to keep winning projects but a common theme is the need for less capital intensity:

Chevron Corp. is studding the ocean floor with heavy-duty pumping gear as part of an effort to make deepwater oil discoveries competitive with shale.

The idea is to force crude from newly drilled wells in the deepest parts of the Gulf of Mexico to flow through miles and miles of pipe to platforms built a decade or more ago, said Jay Johnson, Chevron’s executive vice president for upstream. By lopping off the billions it would cost to construct each new platform, offshore exploration begins to make economic sense again.

That methodology will use a lot less asset time than a traditional tie-back/FPSO or trunkline solution I am sure. A realistic view of the next offshore cycle requires a recalibration of many mental models I feel.

 

Shale productivity and swing production…

“We have just started to get into the manufacturing and harvest mode of the shale revolution,”

Concho Chief Executive Officer Tim Leach

I keep going on about productivity because as Krugman says, it’s not everything, but it’s nearly everything. This article from Bloomberg highlights how Encana is pushing the technical boundaries of shale further with a new Cube process (pictured above).

Basically, you do a whole pile of layers at the same time. I have no idea if it will be successful or not, but these companies will learn a lot from this and not all this knowledge will be wasted even if the process itself is a failure. Economists talk of dynamic capabilities, where companies build a knowledge base, in a path dependent manner,  by trying to do new things; and this is a classic case. This article from 1994 is as relevant now to this as it was to the semiconductor industry which led to the original observations (remember Moore’s Law).

Which is why Encana can show this:

Encana Productivity

On a per dollar basis no one in offshore is showing those sort of gains. A large part of the cost reductions have come as equity in assets has been wiped out through oversupply. This is a genuine ‘learning-by-doing’ productivity gain. I have consistently said that once the US economy starts to turn this into a manufacturing industry there will be a consistent reduction in per unit costs, it is the raison d’etre of American capitalism (which to be clear I don’t think is an amazingly astute observation).

I mentioned the other day I believe shale production was a genuine swing producer and looked for some data on this. And I found it:

The simulations show that the U.S. supply response is much larger now due to the shale revolution. Given a price rise to $80 per barrel, U.S. oil production could rise by 0.5 million barrels per day in 6 months, 1.2 million in 1 year, 2 million in 2 years, and 3 million in 5 years. Nonetheless, it takes many months before a substantial portion of the full supply response is online, longer than the 30 to 90 days typically associated with the role of “swing producer” such as Saudi Arabia.

The thing is this research used well data from 2010-2015, so if you look at the productivity gains over the last two years then shale is even more responsive. A comparison with offshore, given cycle times and unit costs are so different, would be interesting, but methodologically challenging I think. The point is shale is undeniably a swing producer and with a much lower capital commitment (i.e. low CapEx/ high OpEx) than the industry has had before and gives E&P companies an optionality that offshore doesn’t (but not the high flow/low lift costs advanatges of offshore).

This is where the US economy is so good. Look at this data from Precision Drilling Corp:

PDC Productivity

These cummulative gains are huge. Day-in, day-out, this is an economy, and in this case an energy production system, focused on driving down unit costs. I get you can run into limits, but we appear to be someway off them here. As I say, I think it takes a brave person to bet against this, and from an investors point-of-view such productivity gains are enormously attractive.

Venezuela… a human tragedy…

Arguably an underdiscussed issue in the rise in the price of oil has been declining Venezuelan production (from c. 3.5m barrels a day to 1.75m). There is a great article ‘Hell of a Fiesta‘ in the latest New York Review of Books if you want a very readable account of how Venezuela got to this point. As always with these situations there is theft on an industrial scale, incompetence, idealology, political corruption, and just general stupidity:

Between 1999 and 2017 PDVSA earned $635 billion in cash and produced an additional $406 billion worth of oil, which it used to subsidize the internal market (gasoline in Venezuela is virtually free) and reward countries seen as politically sympathetic to the regime. What happened to the rest of this money? Jorge Giordani, a former minister of planning who left the government in 2014, estimates that $300 billion was simply stolen. Another portion was wasted on unfinished pharaonic projects (rail lines, bridges started but left incomplete), purchases of Russian military equipment, opaque and unaccountable multibillion-dollar public entities such as the Venezuelan Economic and Social Development Bank and the Fund for National Development, costly and unproductive expropriations, wasteful imports to compensate for the lack of internal production, purely sumptuary imports (500,000 automobiles in 2006 alone), and excessive growth in public employment. From 1998 to 2013, consumption grew by 60 percent but production barely increased.

Read the whole thing.

The drawdown on offshore… My views on shale and offshore…

A friend asked me this week what my view on the graph above was (courtesy of Sparebank1  Markets) given my views on shale? I have been pretty consistent here that shale isn’t going to displace offshore, but it doesn’t need to in order to have a major impact on the economics offshore: It just has to take demand at the margin.

There are many graphs floating around like the one above. The Seadrill restructuring presentation contains this:

Seadrill offshore gap.png

Oceaneering had this graph recently:

Oceaneering Deepwater Demand.png

Ocean Rig has this one (while I agree with the headline the logic and data supporting this don’t make sense to me as the sanctioning replacement ratio has been historically over 100% for meaningful periods so a drawdown as firms pay down debt in a low price environment is logical):

Ocean Rig Industry Demand.png

You get the idea.

Schlumberger recently put the scale of shale production into perspective:

2017 Oil Supply

So to be clear: all tight oil had to do was add ~5% to the global supply and it has turned the entire offshore industry into a financial mess. Now it isn’t a strict causation, offshore has suffered a severe financial bubble based on oversupply as well as a demand crisis driven by the speed of change in the shale industry, but still it shows how finely balanced things were.

And indeed if you look at all the stories of hope and recovery that aim to recreate the world cast in a 2013 shadow they all profess unrealistically high utilisation and day rates at their core. The reason is obvious: the industry from 2007 was built on very high day rate levels and utilisation figues and any small change in those realities, given the very high fixed cost base, causes financial chaos.

A few percentage points in utilisation and day rates is all it takes to massively swing profitability in such a high fixed cost industry. Economic change happens at the margins.

Look at this chart from HugeStadSea which sums up the dominant thinking in the market (Q2 2017):

HSS Market Assumptions

Back to a cheeky 90% utilisation from 60%. Nice… what could go wrong?

Seadrill has the same:

Seadrill RP day rates

Everyone has the same story. But the problem is unless everyone is at very high utiilisation then day rates won’t pick up as the economic incentive for anyone with idle tonnage is to bid it cheap. Rowan in their latest results stated that they believed the market had to hit 85% utilisation before day rates improved.

So shale has an importance on the economics of offshore far beyond it’s output in the physical market displacing offshore oil as a source of supply. Shale only needs to reduce the utilisation of the offshore fleet by a few percentage points and that fundamentally changes the economics of rig and vessel companies. Seadrill, Solstad, Bibby, Technip DOF, in fact EVERYONE in the industry, is a completely different financial proposition at 51% utilisation compared to 91% with concomittant increases (or decreases) in day rates.

You also get an idea how large the investment in shale has been (Source: Schlumberger) since 2008:

Shale CapEx.png

25% investment since 2008 has gone into tight oil and it has seen productivity improvements like this (although the presentation highlights these rates are slowing):

Shale productivity.png

So I repeat again that that shale will not displace offshore as a source of supply. But it doesn’t need to in order to completely upset the economic structure of the offshore industry by lowering the amount of marginal demand generated where offshore service companies made profits above their fixed costs. By that I mean if your rig/vessel covered its costs and overheads on 85% utilisation and profits came after that (i.e. at 86% utilisation and above you started to be profitable), and the impact of tight oil is such that you only ever get to 85% for ever, then shale will have managed to removed excess profitability from the industry by ensuring a drop in demand at the margin. All shale needs to do is meaningfully alter the global fleet utilisation, and win a significant amount of E&P CapEx share, both goals shale has achieved, to have a massive impact on the offshore industry.

In economic terms this is what looks likely to happen:

fig612

The Demand (for offshore services) = the extra unit of revenue firms get for selling (Marginal Revenue) which matches the point where the extra costs of supply (Marginal Cost + Average Total Costs) balance. So yes, there will be more work, and assets may well be busier than they are now, but it could be just enough to keep everyone in the industry cash flow positive but making zero economic profit. I am not saying there won’t be accounting profits, that all firms will all be loss making, and all shares will go to zero, but I am saying firms will find it very hard to earn returns above their cost of capital.

The one prediction I will make is that any business model in this industry that just relies on an increase in day rates and utilisation is doomed unless it has a massive cash pile (because getting there is going to take a very long time) or you are buying assets at distress prices. But most of the distress investors have moved far too early and there is so much money floating around from these funds I think the distress funds are killing the price discovery mechanism in this market.

It is clear that the quantative deployment of capital in large E&P companies will have a significant portion focued on tight oil as well as offshore. A few percentage points, that could go either way in many companies, collectively have a huge impact on the global offshore fleet utilisation (and therefore dayrates) and that is the core impact shale has.