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).

Capital reallocation and oil prices…

The above graph comes from Ocean Rig in their latest results where despite coming in with numbers well below expectations they are doing a lot of tendering. At the same time ICIS published this chart…

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It is my (strongly held) view that these two data points are in fact correlated.

I saw an offshore company this week post a link to the oil price as if this was proof they had a viable business model. Despite the rise in the oil price in the last year there has been only a marginal improvement in conditions for most companies with offshore asset exposure.  There is sufficient evidence around now that the shape and level of the demand curve for offshore services, particularly at the margin, is in fact determined by the marginal rate of substitution of shale for offshore by E&P companies. That is a very different demand curve to one that moved almost in perfect correlation to the oil price in past periods.

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Source: BH Rig Count, IEA Oil Price, TT

This week two large transactions took place in the pipeline space. The commonality in both is new money comping into pipeline assets that E&P companies own. Over time the E&P companies hope they make more money producing oil than transporting it. But they have found some investors who for a lower rate of return are happy just carrying the stuff. More capital is raised and the cycle continues. On Friday as well Exxon Mobil was confirmed as the anchor customer for a new $2bn Permian Highway pipe. These are serious amounts of capital with the Apache and Oxy deals alone valued combined at over $6bn and shale producers confirming they are raising Capex.

When I people talk of an offshore “recovery” as a certainty I often wonder what they mean and what they think will happen to shale in the US? There strike me as only three outcomes:

  1. At some point everyone realises that shale technology doesn’t work in an economic sense and that this investment boom has all been a tremendous waste of money. Everyone stops investing in shale and goes back to using offshore projects as the new source of supply. I regard this as unlikely in the extreme.
  2. Technology in shale extraction reaches a peak and unit costs struggle to drop below current levels. In particular sand and water as inputs (which are not subject to dramatic productivity improvements but are a major cost) rise in cost terms and lower overall profitability at marginal levels of production. This would lead to a gradual reduction in investment as a proportion of total E&P CapEx and a rebalancing to offshore. Possible.
  3. Capital deepening and investment combined with technology improvements cause a virtuous cycle in which per unit costs are reduced consistently over many years. Such a scenario, and one I think is by far the most likely, would place consistent deflationary pressure on the production price of oil and would lead to shale expanding market share and taking a larger absolute share of E&P CapEx budgets on a global basis. This process has been the hallmark of the US mass production economy and has been repliacted in many industries from automobiles to semiconductors. Offshore would still be competitive but would be under constant deflationary pressure and given the long life of the assets and the supply demand balance would gradually converge at a “normal” profit level where the cost of capital was covered by profits.

I don’t know what the upper limit of shale expansion in terms of production capacity. I guess we are there or near-abouts there at the moment, but I also don’t really see what will make it stop apart from the limits or organizational ability and manpower?

It is worth noting that a lot of shale has been sold for significantly less than the highly visible WTI price (delivery Midland  not Cushing):

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And Bakken production is at a record:

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Each area creates its own little ecosystem which deepens the capital base and either lowers the unit costs or takes in used marginal capital (i.e. depreciated rigs) and works them to death. The infrastructure created by the temporary move away from the Permian may just create other marginal areas of production.

I think “the recovery”, defined here as offshore taking production and CapEx share off shale, looks something like this model from HSBC:

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I suspect it’s about 2021 under this scenario that the price signal starts kicking in to E&P companies that at the margin there are more attractive investment opportunities to hit the green light on. That’s a long way off and is completely dependent on some stability in the market until then, but under a fixed set of assumptions seems reasonable. Note however the continued growth of shale which must take potential volume from offshore at the margin.

The offshore industry needs to get to grips with the challenges this presents (I have some more posts on this on the Shale tag). Mass production is deflationary, indeed that is it’s purpose. Shale is deflationary in the sense of adding supply to the world market but also deflationary in terms of consistently lowering unit costs via improving the efficiency of the extraction process and the technology. Offshore was competitive because it opened up a vast new source of supply, but it has not been deflationary on a cost basis (until the crash caused its assets to be offered at below their economic cost).

I’ve used this graph before (it comes from this great article) it highlights that the 1980s and 1990s had generally deflationary oil prices based on tight-monetary policy and weaker economic growth expectations. Ex-Asia the second part of that equation is a given today and US$ strength means oils isn’t cheap in developing countries. As the last couple of weeks have reminded us there is no natural law that requires the oil price to be in a constant upward trajectory.

Inflation adjusted WTI price.png

 

Absolute versus relative…. shale and conventional competition at the margin…

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“An uptick of 30% from the abnormally low levels in 2017 might seem encouraging, but E&P players are currently facing a low reserve replacement ratio, on average of less than 10%. This is worrisome considering the impact on global oil supply in long term,” says Espen Erlingsen, Head of Upstream Research at Rystad Energy.

I think this is simply a badly worded comment from Rystad where they mean E&P added less than 10% to overall reserves from  conventional sources. In a relative sense I think Rystad are arguing that reserve replacement has been low (i.e. relative to total reserves). The comment is hard to square with the graphic at the top from the EIA and this comment which makes clear in an absolute sense there is no problem:

In 2017, a group of the world’s largest publicly traded oil and natural gas producers added more hydrocarbons to their resource base than in any year since 2013, according to the annual reports of 83 exploration and production companies. Collectively, these companies added a net 8.2 billion barrels of oil equivalent (BOE) to their proved reserves during 2017, which totaled 277 billion BOE at the end of the year. Exploration and development (E&D) spending in 2017 increased 11% from 2016 levels but remained 47% lower than 2013 levels.

Of the 83 companies, 18 held more than 80% of the 277 billion BOE in proved reserves at the end of 2017. [Emphasis added].

Rystad seem to be measuring “conventional” resources only which in this world strikes me as an irrelevant metric. Shale and Conventional may not be perfect substitutes  (some refineries for instance cannot process light crude in the short-run) but they are close. Either way we don’t appear to be facing an imminent supply shortage caused by under-investment in early stage E&P activity. And in fact the EIA says:

First-quarter 2018 capital expenditures for this set of companies were 16% higher than in first-quarter 2017, suggesting that many of these companies have increased their E&D budgets, which will likely contribute to further organic proved reserves additions in 2018.

Clearly they are measuring two different things, but I still don’t get the Rystad conclusion? The EIA uses proven and economically achievable reserves  on net discoveries and is surely a more relevant metric? Of course it doesn’t support a “Preparing for the Recovery” thesis at all.

If you want a graphic illustration why European offshore companies have been the most exposed to the downturn in offshore CapEx look at the first chart:

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On a rolling three year average investment in Europe, which is predominantly offshore, has dropped to around 30% of previous levels. A far greater proportion than any other region and the reason is obviously that it is a high cost area of marginal production.

You can really see the productivity improvement in the second graph: Capex peaked at over $30 per BOE in 2014 and is heading down for $15 per BOE. The supply chain having gone long on fixed assets hoping to profit from a production boom has just over capitalised and allowed the E&P companies to massively reduce development spend in a downturn.

What the EIA and the Rystad combined show is the profound changes taking place in the production of oil and gas. The data show (partially and indirectly) the marginal investment curves for shale versus offshore/onshore conventional. Rystad show that conventional oil and gas replacement is dropping as a proportion of the energy mix. The EIA data shows the drop in marginal production areas: the huge drop in European CapEx, almost exclusively offshore and extremely expensive on a per BOE equivalent, shows that at the marginal capital is being redeployed in other production techniques.

But what the data emphatically does not show is anything to worry about long-term from a supply perspective.

Oil prices, technology, volatility, and productivity…

Oil prices are unusually prone to volatility because both supply and demand are insensitive or “sticky” in responding to price changes in the short term, while storage is limited and costly.

Robert McNally, Rapidan Energy Group

 

Last week Citi’s lead oil analyst came out and said he thought oil prices might dip to $45 per barrel in 2019 and be in the $45-65 per barrel range by the end of 2019. This contrasts with Goldman Sachs ($70-80), Morgan Stanley ($85), and Bernstein ($100). I don’t have a view on the oil price, all this shows you is that intelligent, well-informed analysts, with almost endless resources, can vary in their forecasts by around ~50-100%. Read the whole story to understand how looking at exactly the same data set as all the other equally capable analysts Citi’s analyst reaches such a different conclusion.

What this really shows is model risk: a few percentage points difference in key input variables, even over a short space of time, can have a huge influence over the outcomes. And actually, there are in reality too many influences to model them all accurately: Will there be a supply outage in Libya? What will happen with Iranian oil? What will happen in Venezuela? And these are just a few of the big geopolitical questions alone. You need a forecast for many planning assumptions but in the short-run the oil price is a random walk.

A good example is this graph from the EIA showing the difference between their February prediction of US oil prediction and the current one:

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If you are wondering why your jack-up, rig, or vessel isn’t quite getting the utilisation or day rate you were looking for in that graph may lie the answer? It’s a bold Board that sanctions too many projects in this environment, and in fact the one that is, Exxon Mobil with the huge Guyana finds, is getting slammed by the stock market. Barclays, summing up the “market view” saying:

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Shale isn’t a swing producer as McNally makes clear, but it does have a much shorter-term impact on the market in way that nothing did prior to 2013. But it also isn’t a given that offshore will have a cost or volume advantage over offshore in 10 years time: companies need to hedge their bets if they are large portfolio corporations. McNally has published ‘Crude Volatility‘ which may make  my summer reading list.

The big area where I agree with Citi/Morse is on technology and productivity.  Morse obviously believes, as I do, that a few percentage points of recovery and technological improvement over the well lifecycle has the potential to radically alter physical oil output assumptions over the long-run. And that is before you get into the wonkish areas such as on what base you forecast the decline volume on.

Against this backdrop is a new wine in the old bottle of peak oil demand: lack of investment and the coming supply shortage. A whole host of energy consulting firms say underinvestment may cause a supply driven price rise: Rystad and Energy Aspects in this WSJ article:

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This despite the fact that gross investment doesn’t reflect the increased volume of supply gained from each incremental dollar at the moment (a point Morse makes), or the fact that oil companies don’t need the same level of reserves now (and investors don’t want them to pay for them).  Woodmac, who in the latest “gotcha” on why shale won’t work (sic), has now discovered shale well rates decline faster than thought… I’ll bet by 2040 the 800k a day production cited in the article is made irrelevant by productivity improvements in extraction and production techniques. But I guess again it shows how senstive large data models are to small input changes (and how desperate research firms are to have some uncertainty and upside to discuss with certain corporate clients where an element of group think appears to be pervading Board thinking).

“Preparing for the Recovery”

Preparing for the future.png Rystad also run’s strategy days for Maersk Supply and numerous other subsea and offshore companies…. “Hang in there guys the recovery is just around the corner when the supply crunch happens…”… (however remember The Dominant Logic is dangerous?)….

Meanwhile the capital deepening in the US shale industry continues apace. Have a look at the new pipelines going in:

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Once these are built the price discount will disappear, further raising E&P company profitability and some railway carriages and trucks they displace will still exist (‘unit trains’ with 100+ carriages carry >66 000 barrels). Some will be scrapped but the railway carriages are like offshore vessels: high fixed costs and commitments and low marginal costs. That is a short way of saying they will reduce their costs to compete… and the virtuous cycle will continue with the capital base even deeper.

What really matters for offshore at the moment is the competition for marginal investment dollars. Does an E&P company choose to invest onshore or offshore? The big advantages of shale are potential productivity increases and lower upfront cash costs despite a lower margin (i.e. low CapEx high OpEx), this flexibility has a number of distinct advantages in  an era when forecasts are so divergent. It is worth noting that Shell, Exxon Mobile and Chevron all underperformed the stock market last week despite oil prices having risen signficantly over the last year. Shareholders want their money back in an era of uncertainty, not mega-projects that offer future pay-offs.

In an era when the volatility of oil prices is clearly increasing you can be sure that tight oil will be favoured over long cycle production at the margin. The ability to take margin risk over commitment risk is a key part of the investment making decision process.  The graph above shows how volatile oil prices has been, in particular since 2003. It is irrational to go long on fixed commitments in a age of increasing volatility: just as it is illogical to take on a massive mortgage on a rig or vessel in the current market it is illogical to go long on too many 20 year deepwater developments, and the two symptons are obviously related to the same cause. For a baseload of demand that is logical, but that only works for the larger players with significant market share, at the margin assets and projects become harder to finance.

The other issue driving investment towards shale, in a time of capital discipline, is path dependence. Path dependence is a process where each step forward can only be achieved with the prior steps preceeding it. Deepwater followed shallow water as an extension of the skills developed there.

The productivity benefits of shale are such that larger E&P companies must fear if they miss this technology cycle catching up on the “path” may be too hard or expensive given the dependent steps they will have to get there. History matters.

Offshore will remain an important part of the energy mix. But the price rise of the past 12 months has led to only marginal increases in work and a firm commitment from E&P companies to control CapEx in a manner that breaks with the past. Price rises not increases in long term production projects are the short term adjustment mechanism at the moment. In a era of price volatility and extraordinary technical change the future could look a lot like the present.

“Preparing for the recovery”… Whatever…

The IEA has recently published it’s new World Energy Review and if you have been reading this blog this comment will come as no surprise:

One notable trend concerns the relationship between oil prices and upstream costs. In the past, there has been a roughly linear relationship between upstream costs and oil prices. When price spiked, so did costs, and vice versa. What we are noting now is a decoupling. While prices have more than doubled since 2016, global upstream costs have remained substantially flat and for 2018 we estimate those increasing very modestly, by just 3%. Companies appear to have learned to do more with less.

Too many business models in the offshore supply chain are simply ignoring this. If you are going long on Borr Drilling shares (for example), as anything other than a momentum trade, then you need to look at data driven forecasts like this, which in statistical terms are called a structural break. Look at the cost deflator in the graph above! In an industry with high fixed costs (both original and operating) that is a straight financial gain for E&P companies and with the volatility in the oil prices they will not give that up easily… and in a world of oversupply they won’t have to.

The future will be different. Some vast market snapback where the Deamnd Fairy appears, and everyone brave enough to have paid OpEx in the offshore supply chain has found a clever get rich quick scheme, is an extremely unlikely event.

More data points like this should make you think as well:

IEA Source.png

Yes, I get the volume in absolute terms is growing, but it is change at the margin that defines industry profitability.

There is still too much liquidity and too many business plans talking as if a return to 2013/14 is a certainty when in reality such a scenario would be an outlier.

The current oil price…

“You cannot improve a signal if you do not know what it signals”.

Fredrich Hayek

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The oil price is hitting new highs but I don’t think this is going to have a dramatic effect on offshore for the next couple of years if at all. This is a supply constraint, particularly in relation to the Iran sanctions, and therefore this needs to resolved through the price mechanism in the short-term as all other swing producers are maxed out in terms of capacity as Libya and Venezeula also encounter problems.

This is a completely different investment narrative to the 2008-2014 boom. Then the rising price was viewed by the market as a reponse to rising Asian demand and the costs of developing new marginal sources of supply. The core of the rising price story was a demand driven boom.

No rational E&P company increases investments in 10-20 year fields in response to a price fluctuation with clear geo-political roots that could all be resolved in a relatively short period of time. By the time the field is built and delivered the political situation could have been resolved and then  the extra capacity will just lower the price. I could be wrong but I find it incomprehensible that Iran can be kept out of the international oil market forever. For these sort of changes in supply the changes in supply and demand need to be met with the pricing mechanism.  Some short-term changes in operating expenditure to boost production may become viable but not a wholesale commissioning of new fields.

As the Brookings Institute notes Trump seems to be pushing for regime change as the goal in Iran and the Saudis may have promised air cover with 2m b/d (and the strong administration links to Israel will also be coming into play here). This is a short term issue and maybe if the price gets too high here, and no one really believes the Saudi Arabia can come up with that sort of number in the short-term, then that will cause a change in policy. But I doubt it… Price will be the relief valve for what extra production OPEC cannot cover in the short-term.

As I have mentioned here before I think the link between the oil price and the demand for offshore services has altered fundamentally. Simply claiming now that a supply driven change will automatically be positive for offshore in a substative way is I think wrong and does not account for the difference between a demand driven expansion and a supply constricted shortage.