“Short-cycle production” could be about to get an economic test…

The dots clearly show that oil prices and oil production are uncorrelated…

Caldara, Dario, Michele Cavallo, and Matteo Iacoviello

Board of Governers of the Federal Reserve System, 2016

The number of US oil rigs went down by 5 last week to 744 rigs, while the number of US gas rigs increased by 4 to 190 rigs. In terms of the large basins, the Permian rig count increased by 6 to 386 rigs, while both the Eagle Ford and Bakken rig counts declined by 3 each to 68 and 49 rigs respectively. 

Baker Hughes Rig Count, Sep 25, 2017

 

The multi-billion dollar question is: Can shale handle an increse in demand? Closely related: Is shale in a boom that is unsustainable and not generating sufficient cash to reward investors for the massive risk they have taken? Because if the latter is correct the former must be answered in the negative. The above quote is slightly mischevious and merely highlights economic research that supply factors have historically had a far bigger impact on the oil market than demand factors  (whether this is true going forward is not for today).

The NY Fed today reports that it is supply shortages now that are driving the price (and I have no idea about the construction of the model but the reduction in the residual leads me to believe it is broadly accurate), so this is a supply driven event not a demand driven event:

Oil Price Decomp 25 Sep 2017.png

If, as Spencer Dale argues (speech here), we are in the midst of a technical revolution then this is what we would expect. Hostoric levels of inventories should come down because supply is more flexible, these short-term kinks in demand caused by natural or geopolitical events should merely spur an increase in the rig count or a change in OPEC quotas. Other senior BP staff today were on message:

“Rebalancing is already on the way,” Janet Kong, Eastern Hemisphere Chief Executive Officer of integrated supply and trading at BP, said in an interview in Singapore. But OPEC needs “definitely to cut beyond the first quarter [2018]” to bring inventories down and back to historically normal levels, she said…

“If they extend the cuts, yes it’s possible” to achieve $60 a barrel next year, she said. “But it’s hard for me to see that prices will be sustainably higher,” she added.

Or is Permania simply the result of the Federal Reserve flooding the market with liquidity that is allowing an unsustainable production methodology to continue unabated storing up yet another boom and bust cycle? Bloomberg this week published this article on Permania, where the incipient signs of a bubble are showing in labour and infrastructure shortages and the outrageous cost overruns:

Experienced workers are harder and harder to find, and training newbies adds to expenses. The quality of work can suffer, too, erasing efficiency gains. Pruett said Elevation Resources recently had a fracking job that was supposed to take seven days but lasted nine because unschooled roughnecks caused some equipment malfunctions.

By this point, “we’ve given up all of our profit margin,” he said, referring to the industry. “We’re over-capitalized, we’re over-drilling and, if prices don’t rise, we might be facing a double dip in drilling.”

If I was being cynical about offshore production I would note that he was two days over with a rig crew while in the same calender week Seadrill and Oceanrig had collectively disposed of billions of investment capital and will still have the inventory for years. This guy is literally two days out of forecast and he is worried about being over-capitalized (and also that wiped his profit margin? Hardly redolent of a boom?) Offshore drilling companies are like 10 years and 100 rigs out of kilter… Anyway moving swiftly on…

Bloomberg also published this opinion on Anadarko noting:

Late on Wednesday, Anadarko Petroleum Corp., which closed at $44.81 a share, announced plans to buy back up to $2.5 billion of its stock; which is interesting, because almost exactly a year ago, it sold about $2 billion of new stock — at $54.50 apiece.

(That’s pretty clever, they sold stock at $54.5 and are buying it back at $44.8, like Glencore never buy off these people when they are selling, at heart they are traders. More importantly most research suggest companies nearly always overpay when buying stock back so if the oil price keeps creeping up they are going to look very smart indeed.)

But the real point of the story is that capital is slowing up to the E&P sector, well equity anyway no mention of high-yield:

Equity US E&P Sep 2017

Meaning that maybe people are getting sick of being promised “jam tomorrow”. However I can’t help contrasting this with productivity data, Rystad on Friday produced this:

Rystad Shale Improvement Sep 17

So despite the anecdotal evidence on cost increases in the first Bloomberg article the productivity trend is all one way.  And the stats seem clear that a large part of deepwater is at a structural cost disadvantage to shale:

ANZ cost structure 2017

Frac sand used to be c.50% of the consummables of shale, but surprise:

Average sand volumes for each foot of a well drilled fell slightly last quarter for the first time in a year, said exploration and production consultancy Rystad Energy. Volumes are expected to drop a further 2.5 percent per foot in the current quarter over last, Rystad forecast…

Companies including Unimin Corp, U.S. Silica Holdings Inc (SLCA.N), and Hi Crush Partners LP (HCLP.N) are spending hundreds of millions of dollars on new mines to address an expected increase in demand.

On Thursday, supplier Smart Sand SND.O reported it shipped less frack sand in the second quarter than it did in the first. Rival Fairmount Santrol Holdings Inc (FMSA.N) forecast flat to slightly higher volumes this quarter over last.

In the last six weeks, shares of U.S. Silica and Hi Crush are both off about 30 percent. Smart Sand is off about 43 percent since June 30…

Some shale producers add chemical diverters, compounds that spread the slurry evenly in a well, and can reduce the amount of sand required. Anadarko Petroleum Corp (APC.N) and Continental Resources Inc (CLR.N) are reducing the distance between fractures to boost oil production. The tighter spacing allows them to extract more crude with less sand.

Technological innovation and scale: Less sand used and increased investment going on that will reduce the unit costs of sand for E&P producers. This is the sort of production that brought you the Model T in the first place and the American economy excels at. Bet against if you want: just remember the widowmaker trade.

Shale is a mass production technique: eventually it will push the cost of production down as it refines the processes associated with it. To be competitive offshore must emulate these constantly increasing cost efficiencies. I have said before that shale won’t be the death of offshore but it will make a new offshore: a bifurcation between more efficient fields, low lift costs, and economies of scale in production that make the “one-off” nature of the infratsructure cost efficient, and smaller, short-cycle E&P of shale (and some onshore conventional).

Offshore is going to be here for a long time, it is simply too important in volume terms not to be. But what a price increase is not going to see is a vast increase in the sanctioning of new offshore projects in the short-term. These will be gradual and provide a strong base of supply, as there longer investment cycle represents, while kinks in short-term demand will be pushed towards short cycle production. Backlog, or lack thereof, remains the single biggest threat to all offshore contractors.

Or this thesis is wrong and I, and to be fair people far cleverer (and more credible) than me, are spectacularly wrong, and a new boom for offshore awaits in the not too distant future…

Friday morning cheer for the bulls… and safe thoughts for those in Houston…

“Give me a one-handed Economist. All my economists say ‘on the one hand…’, then ‘but on the other…”

Harry Truman

 

As I am off on holiday to Spain I thought I would spread some cheer for the weekend…The Bull case for oil was made by the Federal Reserve Bank of San Francisco yesterday looking at oil demand in China and combining it with The Varian Rule (which I hadn’t heard of either):

A simple way to forecast the future is to look at what rich people have today; middle-income people will have something equivalent in 10 years, and poor people will have it in an additional decade.

The economists from the Federal Reserve conclude what every offshore bull hopes for, even if it is in a delightfully non-commital and unspecified in timeframe:

In particular, if both domestic and foreign oil producers are reluctant to invest now in exploration and development, they may be unable to expand quickly to meet a sharp increase in Chinese demand. If global supply cannot expand fast enough, oil prices will have to rise to balance the market, as they did in the early 2000s.

On the other hand DNB came out with this graph this week:

DNB Offshore Spend 2017e

The point about being “unable” to expand is a good one. Even if the price spiked now the supply chain has laid off so many people in the short term all that will happen is there would be an explosion in wage costs not asset utilisation (and therefore day rates) as projects would take time to wind up. For the supply chain there is no easy solution to the current problems apart from slow deleveraging and the occassional exogenous shock maybe?

To all my friends in Houston I hope all is well and you are hunkered down safely. For the record no one obviously wants an increase in demand generated in such a way.

Hornbeck Hurricane map.png

Source: Hornbeck

Electric vehicles and oil…

The Economist has a good series of articles on electric vehicles this week. For some Monday cheer for oil bulls I note this quote:

And then there is oil. Roughly two-thirds of oil consumption in America is on the roads, and a fair amount of the rest uses up the by-products of refining crude oil to make petrol and diesel. The oil industry is divided about when to expect peak demand; Royal Dutch Shell says that it could be little more than a decade away. The prospect will weigh on prices long before then. Because nobody wants to be left with useless oil in the ground, there will be a dearth of new investment, especially in new, high-cost areas such as the Arctic. By contrast, producers such as Saudi Arabia, with vast reserves that can be tapped cheaply, will be under pressure to get pumping before it is too late: the Middle East will still matter, but a lot less than it did. Although there will still be a market for natural gas, which will help generate power for all those electric cars, volatile oil prices will strain countries that depend on hydrocarbon revenues to fill the national coffers. When volumes fall, the adjustment will be fraught, particularly where the struggle for power has long been about controlling oil wealth. In countries such as Angola and Nigeria where oil has often been a curse, the diffusion of economic clout may bring immense benefits.

Further evidence on the shale narrative and rational decisions…

The FT noted yesterday:

Kosmos, which had a market capitalisation of $2.5bn in New York on Tuesday, has earned a reputation as one of the most successful international exploration companies after a string of big discoveries off the coast of west Africa. Andrew Inglis, Kosmos chief executive, said the company wanted to widen its shareholder base beyond the US, where offshore exploration has been eclipsed by onshore shale oil and gas production in investors’ affections. “The US shareholder base has become very focused on shale and we believe there is a better understanding in the UK market of the opportunities that exist in conventional offshore exploration,”

It is not a good sign for offshore that the deepest and most liquid capital market in the world doesn’t seem to recognise the value in offshore. This is a further sign that the investment narrative is moving to shale. Ultimately even large E&P companies feel responsible to their shareholders, if the largest capital market in the world starts preferring companies that invest in shale then companies will alter their capital investment plans to relfect this, there is an element of marketing in this not just based on strict economic evaluation of the potential investments available.

If you want further proof that financial decisions aren’t always rational and markets the human interaction that is part of this look no further than this fascinating paper (from Matt Levine) “Decision Fatigue and Heuristic Analyst Forecasts” where it is found:

We study whether decision fatigue affects analysts’ judgments. Analysts cover multiple firms and often issue several forecasts in a single day. We find that forecast accuracy declines over the course of a day as the number of forecasts the analyst has already issued increases. Also consistent with decision fatigue, we find that the more forecasts an analyst issues, the higher the likelihood the analyst resorts to more heuristic decisions by herding more closely with the consensus forecast and also by self-herding (i.e., reissuing their own previous outstanding forecasts). Finally, we find that the stock market understands these effects and discounts for analyst decision fatigue.

Did you get that? Act on investment banking notes if they come out early in the morning! I love the findng the market understands this. The authors note that analysts may start the day by looking at companies they have the best information about but ask why they would do this?

The link here is just that financial decisions are not always purely rational and are based on herding, narrative, and other behavioural instincts. Managers who believe they will be rewarded by the stock market for moving their investment profile to shale will do this regardless of how attractive other investment opportunities may be on a strictly “rational” basis. Not every decision, but as I always say economic change happens at the margin.

A supply rich market…

The above graph comes from the New York Federal Reserve who publish the weekly (and free!) Oil Price Dynamics report. I have no wish to obsess over the daily price, which is obviously important in certain professions, but in offshore the trend is more crucial. And as can be seen from 2012 supply factors began to dominate the market (the methodology basically collects a range of factors and then the sum of demand+supply+residual=price). It sounds intuitively to be a better methodology than daily explanations of what could clearly be spurious reasons by commentators on minor movements and seems to reflect the complexity of the market. The timing of supply dominance is clearly the result of the US Shale industry.

IA-Energy-Shale-Oil-2007-2017

This is in an environment where major E&P company capital expenditure is continuing to decline. DNB forecast E&P capex to drop another 18% in 2017 compared to 2016 and of this a higher proportion will be focused onshore. The drop in prices recently could not have come at a worse time for offshore as CFOs of the E&P companies finalise budgets for next year.

The narrative and numbers are moving towards shale in an unmistakable shift. A quick look at ExxonMobil’s performance in the Permian shows why:

XOM AP Q1 17

The heading in this Conoco Phillips slide says it all:

CP Shale 17Q1.png

These are not original thoughts but merely set out to reinforce the view that if your story is for a market recovery next year it needs to be a really good story. It was good to see Kraken start in the North Sea but it is a statistical oddity not the norm.

Shale, mental models, strategic change, renewal, and railways…

“In other words the problem that is usually being visualised is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them………However, it is still competition within a rigid pattern of invariant conditions, methods of production and forms of industrial organization in particular, that practically monopolizes attention. But in capitalist reality as distinguished from the textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization….”

(Schumpeter, 1943, p. 84.)

On a day when the oil price dropped to its lowest point in seven months Bloomberg reported that:

There’s yet another concern growing as oil prices continue to erode: A record U.S. fracklog.

There were 5,946 drilled-but-uncompleted wells in the nation’s oilfields at the end of May, the most in at least three years, according to estimates by the U.S. Energy Information Administration. In the last month alone, explorers drilled 125 more wells in the Permian Basin than they would open. That represents about 96,000 barrels a day of output hovering over the market.

Yesterday Energen, a US shale E&P company, reported numbers yesterday with increasing productivity of “Gen 3” fracking:

Energen Wells with Gen 3 Fracs Outperforming

In central Midland Basin, cumulative production of 5 new Wolfcamp A and B wells averaging ≈15% above the high‐end, 1.3 MMBOE EUR type curve for a 10,000’ lateral (77% oil) at 75 days. Cumulative production of 2 new Wolfcamp A and B wells with 80 days of production history in Delaware Basin averaging ≈80% above the high‐end, 2.0 MMBOE EUR type curve for a 10,000’ lateral (61% oil).

If you don’t understand the implication of the text above for offshore they have a handy graph that makes it abundantly clear:

Energen 3G Frac Performance.png

This is simply a productivity game now as I have said before.  Yesterday I mentioned the DOF Subsea potential IPO, it’s worth noting that investors could choose between a company that took a bigger asset impairment charge than they made in EBITDA in the subsea projects division, or a company like Energen. When deciding to allocate capital it starts to become an easy decision.

There is a technical and industrial revolution taking place on the plains of the US. Ignoring this won’t make it go away. The Industrial Revolution didn’t happen overnight: steam engines were invented, coal production capacity increased, canals were built, railways invented etc, a series of interlinked innovations occured in a linear and dependent fashion. No one woke up one day and experienced them all. Productivity is a never ending journey. In the Cotton Revolution Kay invented the “Flying Shuttle” (1733), Hargreaves the “Spinning Jenny” (1765), Arkwright the “Water Frame“, (1769), the Crompton Mule (1779) was a combination of the Spinning Jenny and the Water Frame, and Boulton and Watt (1781) invented the condenser steam engine for use in a mill (ad infinitum).

The same thing is happening in shale. Shale won’t come up with a rig that kills deepwater productivity and lower lift costs overnight, but a series of systemic and interdependent innovations that advance the productivity of the sector as a whole is a certainty. That red line above will become steeper and move to the right with irregular monotony now until new technological constraints are reached.

For those of us, and I include myself in this camp, new to the shale productivity revolution Energen included another chart:

EGN Frac Design Evolution.png

And after this will be 4G and 5G… just like mobile phone evolution. Each generation will offer greater productivity than the one before. The image at the top of the page highlights the advances multi-well pad technology has already made to shale.

I am still not convinced everyone in offshore has understood the scale of the change occurring in the industry. I still think some people, particularly banks and those with fixed obligations, are using the 2007/08 years as a frame of reference when a short and sharp drop in demand was followed by a boom. I don’t see that happening this time. Telling people it will change one day isn’t a strategy it’s a hope.

Mental models I think are crucial here. One extraordinarily interesting paper is from Barr, Stimpert, and Huff (1992) who looked at the cognitive change managers underwent to successfully renew an organisation in light of externally driven change. (This is actually the paper that made me want to become a management consultant, a decision I quickly regretted I hasten to add). These researchers basically found two almost identical railroads operating in the same state and compared what happened to them in a longitudinal study spanning 25 years. The mental models of managers were examined by content analysing the annual reports and in particular the comments to shareholders. It is a rare example of a perfect natural control group so rare in social sciences and it’s a brilliant piece of research. The key findings were essentially the managers who were outward focused and changed their strategy accordingly survived while the railroad that went bankrupt always blamed industry factors beyond management control. The analogy to offshore at the moment needs little development.

Barr, Stimpert, & Huff (1992): COGNITIVE CHANGE, STRATEGIC ACTION, AND ORGANIZATIONAL RENEWAL

Barr Stimpert and Huff

BSH found four things mattered, 3 of which are directly related to offshore at the moment:

  1. Renewal requires a change in mental models
  2. A munificient environment may confirm outdated mental models
  3. Changes in the environment may not be noticed because they are not central to existing models
  4. Delays in the succession of mental models may be due to the time required for learning.

I’d argue there was another factor present in offshore that is the commitment to fixed assets and the associated liability structure makes it impossible to change the core business model even if the need for change is realised. Very little can be done outside a restructuring event in that case, although it is likely to actively influence management mental models.

Offshore will survive and prosper as an industry but it won’t be a reincarnation of the 2013/14 offshore. A new and different industry with a vastly different capital structure and strategic option set will appear I would suggest.

Shale, productivity, and American exceptionalism…

‘You see, Tom,’ said Mr Deane, at last, throwing himself backward, ‘the world goes on at a smarter pace now than it did when I was a young fellow. Why, sir, forty years ago, when I was much such a strapping youngster as you, a man expected to pull between the shafts the best part of his life, before he got the whip in his hand. The looms went slowish, and fashions didn’t alter quite so fast – I’d a best suit that lasted me six years. Everything was on a lower scale, sir – in point of expenditure, I mean. It’s this steam, you see, that has made the difference – it drives on every wheel double pace and the wheel of Fortune along with’ em…….

George Eliot, The Mill on the Floss

Jeffries came out with a good research note this week that covers many of the themes I have discussed in the past year on shale productivity noting (click on the shale tag if you are interested):

U.S. activity recovery has been very broad based, which suggests a systematic move up the learning curve. Nearly 50 incremental operators have added rigs across all major US unconventional oil basins since the end of February when current oil price volatility began. Further, US onshore total (ex-CBM)/oil-directed well permits increased by 29%/43% in May vs. April…  Perhaps surprisingly relative to our sense of investor expectations, only ~32%/8% of 2017/18 oil production for 38 US E&Ps tracked by Bloomberg is hedged. Although we think capital raises in 2016 and oil industry expectation of oil price increases spurred activity recovery, in this evidence of continued growth we suspect we are seeing greater comfort in sustained progress along the US unconventional learning curve and in turn greater comfort in a business model that can subsist in a $40-45/bbl WTI oil world.

In hindsight the years between 2001-2014 simply looked too good for offshore, a steadily increasing oil price and a limited ability to increase production from land-based resources led to an investment boom to access the offshore oil. Rigs, vessels, ROVs and associated kit were all hit with a huge increase in demand and there followed an enormous increase in the fleet. Like all investment bubbles there is normally a very good rationale in the beginning for their appearence, but the longer they continue the greater the risk they overshoot. It is probably impossible to spot a bubble before it bursts, although there a clear indicators that normally come through the credit channel of the economy. But deep down everyone in industry felt uncomfortable about specialist vessels selling for far more than implied book value, 25 year assets earning enough in cash flow terms to pay off in 7 or 8 etc, people building USD 100m vessels for the spot market… There was a good reason, the hockey stick graphs in the presentations all went north, but surely it couldn’t go on for ever (I claim no foresight here).

When looking at the impact of increasing energy costs from the 1970s researchers found:

… rather striking features. In particular, it appears (i) that the oil price increases in the 1970s were followed by a large and persistent increase in energy-saving and (ii) that there is a marked medium-run negative co-movement between energy-saving and capital/labor-saving. These observations suggest that our economy directs its R&D efforts to save on inputs that are scarce, or expensive, and away from others. We thus interpret our findings as aggregate evidence of directed technical change”

What that means is that following the price shocks of the 1970s people worked at ways on increasing energy efficiency and finding ways of using oil more efficiently, but it takes a long-time for things to change and the technilogical progress to follow. The long boom in the oil price, and therefore offshore energy, sowed the seeds of the shale revolution as the high cost led to technical innovation. Economic systems are adaptive in the long run.

Shale is in its formative years. I have no idea, and nor does anyone, what the future potential is. We do know the US indepedents have history:

US Wildcat Productivity

Source: Juan Blanco and Houshang Kheradmand, 2011, from Wene (2005). (The 1989 change relates to advances in seismic technology).

The oil price needs to be viewed in the very long run in terms of how long it takes complex production technologies time to adapt. However, given time they do.

But shale is a manufacturing process and no economy in the world is more adept at harnessing the power of potential in this area than the US.  Broadly speaking this “American Exceptionalism” in manufacturing is defined in four attributes:

  1. Stadardized products
  2. Assembly line production
  3. Long production runs
  4. Resource-using technologies

These qualities might look tautological now but they have a long history and weren’t always that obvious with the roots steeped in the antebellum US Civil War economy. At the US display at the Crystal Palace exhibition in 1851 the “American System” of manufacturing (for small arms) was displayed: interchangeable, high quality precision parts then assembled en masse. In 1853 the English went to the US to investigate and ended up purchasing some of the small arms machinery they went to see. At this stage this was unique to this area of the US economy and was completely different from the cotton revolution on which the UK manufacturing was based (for another post). One of the great controversies of modern economic history was solved when James and Skinner demonstrated that higher wages were the result of more skilled workers with this machinery.

This system was a lineal antecedent of the system that became American Manufacturing and was Rosenberg argues a quirk of the procurement process of the Army Ordance Department who realised the scale of the task they were trying to achieve. The number of companies involved was limited but in particular The Remington Firearm also became the Remington Typewriter (whose economic importance in its own right is the QWERTY debate) and thus this system was transferred to other areas of the economy. It took time but it really was that niche in the beginning (the typical manufacturing firm had 10 employees or less c. 1840-50).

At the time businessmen were aware though that the American economy was on the verge of something profound in terms of economic transformation:

US Commodity Output

US Commodity Production History

It is important to sidetrack for a minute here an seperate out this industry level change from what economists call General Purpose Technology, such as the steam engine or microprocessor, that effect the whole economy. We are talking innovation within an industry and it led to dramatic declines in cost as output rose:

US Oil Industry Cost Reductions 1865-1884

Prices per barrel NOM

Chandler, Schumpeter and others have used this to put the corporation at the heart of economic change. Markets are created and developed by corporate entrepreneurs. This was the age of the ‘Robber Barons”, yet monopolies are supposed to raise prices and restrict innovation, and this is the opposite of what happened. Standard Oil, predeccessor to ExxonMobil was at the heart of this with Rockerfeller as its larger-than-life founder and creator. As Chandler described in The Visible Hand:

The market remained the generator of demand for goods and services, but modern business enterprise took over the functions of coordinating flows of goods and services through existing processes of production and distribution, and of allocating funds and personnel for future production and distribution. As modern business enterprise acquired functions hitherto carried out by the market, it became the most powerful institution in the American economy and its managers the most influential group of economic decision makers. The rise of modern business enterprise in the United States, therefore, brought with it managerial capitalism. (Chandler 1977, p. 1.)

 

This lineage is important: out in plains of America right now shale companies are working out how to drill each well a little bit better and cheaper, how to move the rig a little faster, use a little less sand, and find a little more oil, and they are doing this constantly. Behind them stand the rig companies who are seeking to add more productivity to their customers wells, to a host of suppliers you have never heard of (i.e. Hi Crush Partners, a $1.2bn sand supplier) that are all learning a small incremental amount each day about how to improve the fracing process. Make no mistakes about the profundity of this change.

This growth is also at the perfect rate, 3-7 rigs each week (out of 889 as of last week) joining the fray across the whole industry mean finance directors don’t panic, rig crews can be swapped around, learnings from one rig shared with another crew etc. This is non inflationary growth that allows the supply chain to add capacity in a cost efficient manner without adding “kinks” that add cost pressure. I am no expert in this area but already brief research shows that the new standard for mud pump (faster drilling) is moving from 5000hp to 7500hp… this is something the American companies excel at: greater productivity and the virtuous cycle of lower costs that only scale can bring. The more rigs they build the better each generation wil become and the greater the scale and cost reduction each unit will bring. You bet against this at your peril. Yes there is likely to be be short-term inflationary pressures at certain points, there are concerns about the price being paid for land in the Permania craze at the moment, but these would not appear to threaten the overall direction of change here.

Innovation and Incremental Improvement in the Shale Manufacturing Process

Shale innovation.png

Source: Anterro Resources, Oct 2016

I think one of the reasons that productivity in shale has been underestimated is the hedonic adjustment in the quality of shale equipment that has in effect changed the production possibility frontier used in most forecast models of shale potential. [Hedonic adjustment is when economists have to cope with technical and product change in their output models by making adjustments for longevity and quality of the products. It is notoriously unrealiable and hard to calculate, particularly when the industry is at such a nascent stage of development. The UK Government added liquid soap to the CPI measure in 2014 replacing bars of soap: they offer different price points and benefits and aren’t strictly comparable, but they reflected the change in how the market worked so the change was made. Try doing this to rig output when new rigs offer completely different production possibilities, many of which are unproven.] As Solow quipped (on the IT revolution) “[p]roductivity shows up everywhere but the statistics”.

The shale industry is at the start of a dramatic decline in cost and potentially a vast increase in output per unit of capital employed. Everyone in offshore should be examining their business model.