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.

The narrative in capital allocation moves to shale…

I use the term narrative to mean a simple story or easily expressed explanation of events that many people want to bring up in conversation or on news or social media because it can be used to stimulate the concerns or emotions of others, and/or because it appears to advance self-interest. To be stimulating, it usually has some human interest either direct or implied. As I (and many others) use the term, a narrative is a gem for conversation, and may take the form of an extraordinary or heroic tale or even a joke. It is not generally a researched story, and may have glaring holes, as in “urban legends.” The form of the narrative varies through time and across tellings, but maintains a core contagious element, in the forms that are successful in spreading. Why an element is contagious, when it may even “go viral,” may be hard to understand, unless we reflect carefully on the reason people like to spread the narrative. Mutations in narratives spring up randomly, just as in organisms in evolutionary biology, and when they are contagious, the mutated narratives generate seemingly unpredictable changes in the economy.

Shiller, 2017

News that BP had started production at Quad 204 (Schiehallion) led curmudgeonly FT columnist Lombard to note  yesterday:

If anything, then, Monday’s news is more of a last hurrah for BP in the North Sea, and for the UK Continental Shelf more broadly. With the strongest capital flows — and investor buzz — focused on unconventional US resources, traditional offshore oil can seem as fashionable as a set of free “crystal” tumblers from a 1970s petrol station. With a big shield logo.

I have mentioned here before that behavioural finance is starting to examine the narrative in economics (see initial quote), and at the moment this is the narrative in London and other capital markets. This ties in nicely with an excellent piece from Rystad earlier in the week looking at the future of the North Sea and the Gulf of Mexico (I recommend reading the whole thing). For service companies Rystad notes:

After such a deep cut in this market it will take some time before the industry experiences a full recovery. Even with oil prices of $90/bbl to $100/bbl for the next decade, the market will not be back to 2014 levels before 2024.

The link for me is that offshore is going to bifurcate into huge developments (Quad 204, Mariner, Bressay, Mad Dog 2) and “the rest”. The rest are unfortunately going to be much smaller in number and less frequent. Rystad specifically mentions the lack of tie-back and tie-in projects in these regions. These projects are the investments that really compete with shale: 8-12 000 bpd that were ignored by larger E&P companies. The larger developments with high flow rates, and multi-decade economic plans, are vital for security of volume and a core underpinning of E&P profitability, and they are very economic, playing to super-major strengths of vast capital requirements combined with astounding engineering capability; but smaller developments in the USD 50-200m range are at a real risk of grinding to a slow halt for all except the companies currently committed to this space.

The North Sea, and to a lesser extent GoM, always had a significant number of smaller players (think Ithaca Energy (recently sold to Dalek) or Enquest), that raised (relatively) small sums of money and then sought to regenerate an exisiting area or develop smaller finds. Access to financing for that market simply doesn’t exist at the moment on anything like the scale it did before. Those Finance Directors who used to traipse around fund managers in London, Vancouver, New York etc with a deck of slides explaining their proposed developments are simply not getting a hearing. Not only that the tried and tested business model of developing a few fields and selling out with a takeover premium when they had built sufficient scale isn’t credible any more as potential acquirers focus on more on tight oil. Now those fund managers are meeting with guys who have a deck of slides that start with a shale rig, emphasise the relatively low upfront capital (as opposed to the higher OpEx) and their ability to rein in variable costs should price declines occur. The meme in financial markets now is all about shale, and rightly or wrongly, influential columns such as the one above help set this “dominant logic”.

Inside the big E&P companies managers, who are cognizent of the fact they must deal with analysts in the financial community and the investor base who follow the same narrative, are adapting and spending more time to examining potential shale investments. Offshore is getting less airtime. When was the last time you hard someone say “all the easy oil is gone” – which was taken as fact only 5 years ago. From this myriad of individual meetings and actions the macro picture of slowing capital flows into offshore and increased investment in shale is being driven, and it will be very hard to reverse without some exogenous event.

As behavioural economics teaches us humans are “boundedly rational” not the perfectly rational homo economicus so beloved of the efficient markets crowd. What this means is that potential investors can only process so much information, if you combine this with the fact that institutional investors “herd” (i.e. invest where their competitors do), you can see the current investment vogue is short cycle shale which makes even getting funding hard even for compelling offshore investments. Those who have heard the word “Permania” used to describe the boom in Permian basin will relate to this quote from the IMF on investment herding:

[p]rocyclicality in asset allocation can make swings in financial asset value and economic activity more intense. From an individual investor’s point of view, procyclical behavior can be rational, especially if short-term constraints become binding or if the investor can exit earlier than others. However, the collective actions of many investors may lead to increased volatility of asset prices and instability of the financial system..

Eventually the shale mania will wain as people overpay for land and productivity improvements slow. The problem for offshore is the amount of OpEx people will have to burn to get to this point and the consistently increasing productivity of shale.

Big players in the North Sea region like Apache, Taqa, and Sinopec will conitnue to develop offshore fields but they are not doing as many projects. The threshold rate for investment will be higher, because experience has taught us that you can get 5 years of low oil prices and many of these projects only have economic lives of 5-10 years (risk models are great at solving previous issues). These companies have less access to capital markets than their shale competitors because the high-yield desk has the same meme as the equity investors, higher equity costs and more risk averse bank funding raise project return requirements even more. Even state -backed companies like Taqa must vie for funding internally. Outside of the North Sea and GoM these developments are likely to remain dominated by National Oil Companies who may not rank projects on a strictly economic basis but will take the expected spot price of oil into account in their investment decisions. But as Rystad makes clear the North Sea and GoM volume increases will all be driven by a smaller number of larger projects.

This affects contractors differently. As Rystad notes EPIC work will decline proportionately less than other work.  For DSVs and ROV operators and vessel owners) this is grim . Until construction work, that uses far more DSV and ROV days than maintenance work, improves the supply side of the industry will take the adjustments both in day rates and utilisation levels. The supply chain is going to change into a few large integrated contractors in these regions with a vast choice of assets to service their needs and they are likely to reduce their comitted charter tonnage . These large contractors will make an economic return but part of it will be done by ensuring the smaller companies in the supply chain make only enough economic profit to survive and the equity value (if any) in these companies and assets looks set to be depressed for an extended period. Consolidation on a scale only dreamed of at the moment amongst vessel owners looks certain.

Demand will not return for smaller projects until the market price for oil stabilises at a substantially higher price than now, and does so for long-enough to give potential funders confidence that the upturn isn’t temporary. The uplift will likely be less severe because shale has introduced a “kink” in the supply curve. Projects take time to pass through engineering, funding etc before meaningful offshore work occurs. This is a long-term issue: Demand may have stabilised at current levels but recovery for the supply chain that is based on the realistic prospect of higher days rates and utillisation looks some way off.  For an asset base built to supply a 2013/14 demand curve the outcome looks uncomfortably obvious.

 

 

Shell and Bourbon: a tale of two cities

“In short,” said Sydney, “this is a desperate time, when desperate games are played for desperate stakes.” 

A Tale of Two Cities

Despite oil prices remaining above US$50 a barrel during the 1st quarter of 2017, activity is yet to recover in the Shallow water offshore and Deepwater offshore sectors”

Jacques de Chateauvieux, Chairman and Chief Executive Officer of BOURBON Corporation.

I am absolutely not going to turn this blog into one that goes through the financial results every quarter (and even less so one that follows the oil price), but I do think now is an interesting time because on a volume basis they make up a large percentage of the total offshore CapEx so their spending plans are important. The most important forward number the contracting community needs to focus on is backlog, for the simple reason that in volume terms it drives the number of days utilisation. Shell reported today as did Bourbon, and I believe that they support the view I have taken here and here with BP: we are looking at a structural change in the offshore contracting industry and the likelihood of a supply crunch saviour is unlikely at best.

The massive supply crunch that the IEA forecasts doesn’t appear to be showing up in the physical market (with oil down nearly 5% today although I believe daily prices are a close to a random variable) or the futures market. This IEA forecast is starting to look chimerical:

Global oil supply may struggle to match demand after 2020, when the pinch of a two-year decline in investment in new production could leave spare capacity at a 14-year low and send prices sharply higher, the International Energy Agency said on Monday.

Investors generally are not betting on a sharp rise in the price of crude oil any time soon, but the contraction in global spending in 2015 and 2016 and growing global demand means the world could well face a “supply crunch” if new projects are not soon given the go-ahead, the IEA said in its five-year “Oil 2017” market analysis and forecast report

Firstly the Shell numbers: unsurprisingly there was a massive growth in profit as the oil price went straight to the bootom line. Like BP its all about the CapEx and the dividends:

Shell Dividends

Despite a massive drop in earnings Shell sells stuff and borrows more to pay shareholders the same. And like BP it will massively cut back CapEx compared to historic periods:

Shell Capex.png

The cut from 2013 to 2016 is nigh on 50% for upstream, It is also worth looking at the drop in Europe. Yes, Shell sold a large proportion of the portfolio to Chryosoar, but from a market perspective it will take the new company some time to develop and execute its plans, and there is more chance than not that they take more time to develop as a new management team and shareholder base come to grips with the scale of what they have purchased and match their asset to their strategic plans. Some quick wins maybe, huge CapEx developments… Unlikely. For European contractors that is bad news.

Shell also made plain in their strategy presentation last year that:

Capital investment will be in the range of $25-$30 billion each year to 2020, as we improve capital efficiency and ensure a more predictable development funnel for new projects. Investment for 2016 is expected to be $29 billion, excluding the purchase price of BG, some 35% lower than the pro-forma Shell-plus-BG level in 2014. In the prevailing low oil price environment we will continue to drive capital spending down towards the bottom end of this range; or even lower if needed. In a higher oil price future we intend to cap our spending at the top end of the range.

As I said I believe their shareholders have made clear the dividend is sacrosanct and the management get it. This is what economists call a time consistency issue, and in this case the incentive to keep the commitment is the same as the incentive to make the commitment. In other words, they are likely to keep this promise because everyone is incentivised just to take the money if oil prices suddenly shoot up.

Shell also noted geographically their commitment to deepwater:

Brazil and the Gulf of Mexico represent the best real estate in global deep water. We are developing competitive projects here based on this advantaged acreage. Shell’s deep-water production could double, to some 900 thousand barrels of oil equivalent per day (kboed) in 2020, compared with 450 kboed in 2015.

The fact is that operating costs are lower in these regions compared to the North Sea: e.g. PSV runs have lower spec vessels, cheaper fuel, cheaper crews, and lower CapEx. It’s all about driving unit production costs down now, just like a manufacturing business every process will be examined and reviewed and an attempt made to lower the cost.

To that end Shell have approved the Kaiskias development for a 40 000 bpd field (them picture here). Like BP on Mad Dog Phase 2 Shell got a near 50% reduction in development costs and replicated previous design knowledge. These companies are using large offshore projects as the baseload for their production needs and building shale capability as the marginal production that flexs as market needs dictate.

And shale is flexible:  the Baker Hughes rig count hit 697 rigs last week, up 9 on the last week, but up an astonishing 365 year-on-year (91%). It’s just the right growth rate, not so high cost goes mad, but high enough to substantially affect the market price and keep investment incoming. Goldilocks growth. Right now those rig and service companies are adding more capacity, training more people, learning how they can extract more per well, and lower the running cost. Every day they learn more and apply more in a self referential cycle that is the hallmark of standardisation and lowering unit costs. Bet against it at your peril.

The other side of this production revolution could been seen as Bourbon also reported today. Revenue down 28% year-on-year! Bourbon is so big it is a bellweather for those exposed to assets without the project execution capability that others have. The contrast with Shell couldn’t be more obvious. Poor utilisation and management highlighting only they had negotiated with ICBC to taper lease payments. There is no light at the moment for subsea – which is consistent with what GE said this week. The common theme here is that subsea is structurally unattractive compared to other development opportunities. High upfront exploration and appraisal costs relative to flow rates make it harder to attract upfront funding and capacity utilisation at below economic levels for vessel operators still not lowering costs enough to bring the market into equilibrium.

You don’t need to run a regression to understand what is happening here: investment is pouring into shale and ignoring offshore for all but the most certain bets. Until CapEx from the E&P companies comes back any hope of a “recovery” for those long on tonnage is a mirage. CapEx drives utilisation in a way IRM just cannot. At some point the offshore community is going to have to stop pretending the only possible solution here is a market “recovery”. There has been a fundamental and structural change in the market. Multi-year commitment to low CapEx is not what the global fleet was built for, it was built for 2013 when Shell Upstream alone chucked a cheeky USD 24bn at improving production, not a measly USD 12bn per annum capped.

I think this highlights what a massive mistake Solstad has made here by taking on Farstad and DeepSea. A supplier of high-end CSVs may have had an independent future, but exposing yourself to commodity tonnage, predominantly in structurally unattractive regions suffering declining investment, without enough scale to generate pricing power, is looking more and more like a poor move every day (not that it ever looked good). Minorities in Solstad must be livid.

Clearly those contractors who can deliver large offshore projects in deepwater have a viable business model if they don’t have too much tonnage. For the rest it will be years of sub-economic returns unless restructuring brings a new capital structure.

BP results, the future of offshore, and myopic loss aversion…

The myopic loss aversion explanation rests on two behavioral principles: loss aversion and mental accounting. Loss aversion re-fers to the fact that people tend to be more sensitive to decreases in their wealth than to increases.

Thaler, Tversky, Kahneman, and Schwartz (The Quarterly Journal of Economics, 1997

 

Let me start by saying, as I have many times before, I am a believer in offshore oil and gas production. My issue at the moment isn’t that it is going to go away, rather it is that too many vessels have been built, and that 2012-2014 was a peak bubble of activity. There will still be good money to be made offshore, I am just not sure it will be through owning vessels (and rigs) until a very painful, and in all likelihood prolonged, restructuring process has been completed.

I recently wrote my thoughts on economic research and dividend policy and why this may lead to an undersupply of offshore projects in the future. I am not conviced this will happen at all, but it seems to be the great hope for all involved in offshore. The BP results yesterday highlight what I was saying with one perfect graph:

BP Cash vs Capex 17Q1

For BP the dividend doesn’t change, CapEx, the driver of future production and profitability potential, is the moveable number. And in a large corporation it is surprisingly flexible in the short-term. (“A billion here, a billion there, pretty soon you are talking real money…”). I think this is typical of all the supermajors, their shareholders want dividends.  The data reveal that Shell and BP alone were responsible in Q1 2017 for £4.8bn of the total £12.5bn (38%!!) of total FTSE 100 dividends. BP and Shell shareholders, UK pension funds especially, want the money now not the hypothetical billions available from a shortage of capacity in a few years time.

Another way to look at it is this: the BP dividend was USD 10.0 cents per share in Q1 2017, and Q4 2016, but this is way more than the company is earning per share (bold Q1 2017, then Q4 2016, then Q1 2016):

BP EPS Q12017

BP is making up the numbers by increasing the debt and divestments in the portfolio. The last thing they want, and their shareholders I suspect, is a large and capital intensive bet on risky offshore projects. As if to reassure everyone this is the case the CFO gave look ahead guidance for CapEx at these levels until 2021.

There is a really good interview with Starlee Sykes, BP VP Global Projects, that is well worth a read – the cost on the Mad Dog phase 2 project was cut to USD 9bn (from USD 20bn). Several parts struck me but none more than this:

We looked for analogies to what we had done before and focused on the Atlantis project in the gulf, which came online in 2007, and its semisubmersible-platform design concept. Atlantis was, and is, viewed as a very economic, very good development. We decided to adopt this simpler design concept. Compared to the original Mad Dog 2 stacked-deck spar design, the semisubmersible is flexible for building future capacity, while fulfilling minimum technical requirements. That was the big idea around Mad Dog 2. Rather than designing for a future that may not happen, the principle was to build what we need at day one, and then allow for the expansion later. So, for example, we did not install all of the water-injection capacity that we needed on day one. It’s a more incremental approach.

A total change of mindset for the industry where everything in offshore was bespoke and future proof. This is part of a slow path to standardisation where possible to reduce costs. Mad Dog Phase 2 can produce 140 000 bpd at peak capacity, far beyond anything tight oil can dream of. At that level, and with efficient lift costs, it’s well worthwhile dropping a cool USD 9bn. But as I have said before I see offshore bifurcating into developments like this with very high flow rates and very high CapEx commitments, normally at deepwater, (only the Norwegians seem to get lucky enough to find huge fields at shallow depths now), and a base of demand in Asia and the Middle East where NOC’s are more security supply focused where they will develop in shallow (often alone) as well as deeper water (where they will need a supermajor partner for technical expertise).

I fear for the shallow UKCS which is somewhat caught in the middle: SPS technology isn’t standardised and cannot feel the effects of scale and scope that tight oil has, yet these fields cannot provide the reserve capacity in a high cost environment. One of the reasons the Norwegian basin seems to do better than the UKCS is an understanding of Loss Aversion Theory, that in essence states that investors would rather not lose $5 than gain $5: in Norway tax incentives for drilling are heavily front ended loaded versus credits for production in the UK (making a massive generalisation of a very complex issue). A classic article on myopia and and loss aversion in risk taking is available here. Which is a lot like shareholders in E&P companies who have seen paper wealth vanish as the oil price drops.

To be effective shallow offshore fields will have to be subject to some form of standardisation around production equipment and SURF installation, and we are a long way from that at the moment because a core component of that is drop volume which drives the experience curve. And of course as the E&P companies cut CapEx, that is distinctly lacking.

The other problem offshore has at the moment is management focus and resource constraints. I have mentioned before the power of narrative in economics, as Shiller argues:

[w]e have to consider the possibility that sometimes the dominant reason why a recession is severe is related to the prevalence and vividness of certain stories, not the purely economic feedback or multipliers that economists love to model.

The industry meme at the moment is all about cost and tight oil. Changing that mindset in large organisations is hard – it can take at least 12 months if peoples bonuses have just been contractually set for exmaple and they are based on cost savings. A recovery for the offshore contracting industry is going to rely on changing this narrative somewhat.

I have discussed here mainly the demand side of the market which I believe will be structurally more unattractive for the next few years going forward. I still think for the supply side, the offshore contractors, there can be a bright future if positioned clearly: a tight fleet of core enabling assets (mainly lay capability) and a strong EPIC competency, and an ability to position the firm to respond to this structural change in the industry.

I am generally sceptical on alliances and integration between SPS and SURF because I think they add more  value to the contractor than customer, and as Exxon Mobil showed with the Liza award, an educated customer can drive the price down by splitting workscopes. But I am writing a fuller piece on this.

The oil market narrative…

Robert Schiller gave this lecture earlier on the year on the power of the narrative in economics and it concerns:

 the epidemiology of narratives relevant to economic fluctuations. The human brain has always been highly tuned towards narratives, whether factual or not, to justify ongoing actions, even such basic actions as spending and investing. Stories motivate and connect activities to deeply felt values and needs. Narratives “go viral” and spread far, even worldwide, with economic impact.

It’s wide ranging and I would recommend all 57 pages. Schiller argues that epidemological models from biology maybe a good basis for integrating narratives into economics. Evolutionary economics has been hugely influenced by biologicals models of change and there is no reason to believe behavioural economics cannot be just as influenced.

Given the action in the oil market I regard this as a good a theory of market price developments as any other. Deep down clearly the market fundamentals count i.e. the basic where demand will meet supply. But up until a few weeks ago the dominant logic in the oil industry was clearly just how rapid price rises would be, and yet how quickly this has changed in the past week after the IEA claimed we were underinvesting massively.

Reuters published an interesting story last week about how bullish oil companies were, indeed the market narrative was summed up by this analyst:

“The investor mindset is switching to growth again,” said Anish Kapadia, analyst at investment bank Tudor, Pickering, Holt& Co.

“Oil prices are above $50 a barrel, companies are generating cash and are starting to talk about growth again, we are at that point of the cycle.”

But they also dumped in this casual data point:

Even as prices LCOc1CLc1 hold near $50 per barrel, the firms – Royal Dutch Shell Plc (RDSa.L), Exxon Mobil Corp (XOM.N), Chevron Corp (CVX.N), BP Plc (BP.L), Total SA (TOTF.PA), Statoil ASA (STL.OL) and Eni SpA (ENI.MI) – plan to grow output by a combined 15 percent in the next five years…

The seven companies will add almost 3 million barrels per day to their combined output in the next five years effectively generating production the size of another major like Chevron. [Emphasis added].

The FT this morning had an article about Leonardo Maugeir, who used to head strategy for ENI,  and his views who has written this article:

In January, my similar field-by-field analysis indicated that world oil production capacity and actual production were still growing—while prospects for demand growth were not sufficiently high to absorb the excess supply. In particular, actual oil production (which includes crude oil and other liquids such as condensates, NGLs, and more according to the standard definition used by most statistics) was almost 99.5 million barrels per day (mbd)—leaving a voluntary and involuntary spare capacity (the result of local civil wars and other geopolitical factors) of more than 4 mbd.

Frankly any sane person is going to be bored-to-death by potential supply/demand imbalances of 1-2m barrels a day (or 4m or whatever, life is too short), and the models underpinning these are so complicated they can only ever be directionally correct, but the core point here is how they are shaping the narrative. The narrative seems to have turned to the downside, to the potential of shale as a marginal production source of choice, and the potential for oversupply in the industry. Too many people in the industry still just refer to “when the next boom comes”, but having predicted 9 of the last 0 house price crashes in New Zealand I realise that such predictions offer little value. Is there really going to be another boom? What will it look like? And when really will it come?

But the value, and the interest, in oil, seems to be the euphoric highs and lows (and the investment returns that mimic this), driven partly by the narrative.  I wonder if it’s a function of the sheer scale of the capital investments that have previously been required to make a meaningful increase in production? I wonder if shale won’t modify this somewhat?

I’m a long run guy. Maybe in the long-term shale, with much smaller capital commitments per well, will make the oil industry less cyclical as marginal production can be more efficiently brought in and out of use? Everything in life is relative (in an economic sense). Modern economic growth is usually dated from c. 1500 (which the Great Man ascribed to the price revolution), maybe the importance of oil from the beginning of the 19th century was just a blip in the economic cycle of the post 1890 long globalisation age, in which case we have just been through a Cambrian Explosion of innovation and now the oil extraction industry settles down to maturity with less price volatility and more constant productivity improvements one would expect from a more mature industry? Maybe shale is the productivity revolution that matches supply and demand after a 40 year lag when oil prices really took off in real terms? Productivity improvements are not linear but erratic. The dominant narrative until just a few years ago was that “all the easy oil is gone”, now that just isn’t true again.

oilprice1869.gif

Maybe I am actually a random walk guy? As always I back technology and productivity improvements over long-run resource scarcity and supply issues given relatively free markets. I therefore err on the side of lower oil prices for some time, especially given oversupply in the servive sector.

 

“This time it’s different…”

“The four most expensive words in the English language are, ‘This time it’s different.’”

Sir John Templeton

In investment theory a key part of recognising that a bubble is close to bursting is the logic that “this time it’s different”, the internet boom of 1999-2000 being the classic case. The core argument is actually regression to the mean: eventually all profits drop back to normal levels, but this time, they won’t.

In oil services, particularly offshore, there seems a view that this downturn is the same as others. Everyone wants to believe that next time will be the same. Somehow, magically, demand will equal supply, day rates will rocket, and everyone will go back to building USD 100m vessels with USD 20m equity, to put on the spot market and and that will be the new normal. I think the narrative is driven by the extremely mild (in hindsight, it didn’t feel like it at the time) dip in 2008/9, and the strong recovery in 2000, where people who had invested early, and took serious risk, made some exceptional returns (Integrated Subsea Services springs to mind). It might happen, but I doubt it.

For one thing the daily fascination with the oil price seems entirely inappropriate for offshore contractors. The industry is wallowing in a sty of capacity: it’s the supply side that important in the short-run here not the demand side. As everyone in the industry knows (deep down) the number of project staff laid-off will ensure it would take a long time for the E&P companies to ramp up projects even if they wanted to.

The oil production industry is clearly undergoing a structural shift with the impact of shale. It won’t be the end of deepwater and offshore, but it seems unlikely to return as before. I wrote before about the changing economics of shale and the extraordinary drop down the cost curve that has affected that industry. My core point is that when you can drive standardisation you get massive efficiencies that can transform the cost curve, and therefore, the underlying economics of an industry.

In that vein, inspired by this piece from the FT (which is broadly dismissive of electric vehicles), I read this from the Grantham Institute. The report focuses on the Solar Photovoltaic and Electric Vehicle cost reductions that come from scale improvements in the manufacturing process and producitivity of the units (particularly battery efficiency for electric cars). Under their model oil demand peaks in 2020:

E[lectric] V[ehicle]s account for approximately 35% of the road transport market by 2035 – BP put this figure at just 6% in its 2017 energy outlook. By 2050, EVs account for over two-thirds of the road transport market. This growth trajectory sees EVs displace approximately two million barrels of oil per day (mbd) in 2025 and 25mbd in 2050. To put these figures in context, the recent 2014-15 oil price collapse was the result of a two mbd (2%) shift in the supply-demand balance.

Now there are a number of caveats in the research and I also get that they have an agenda. So of course does BP. No one is lying here,  it’s just that humans are “boundedly rational“; they can only process so much, and what they do therefore is referenced in cognitive analogies and models. The arguments form part of a “dominant logic” of analysis and decision making. Both are statiscally sophisticated models with regression analysis at the core and therefore one is reminded of the Great Man’s warning (to Koopman’s) on the problems with this sort of analysis:

Many thanks for sending me your article. I enjoyed it very much. I am sure these matters need discussing in that sort of way. There is one point, to which in practice I attach a great importance, you do not allude to. In many of these statistical researches, in order to get enough observations they have to be scattered over a lengthy period of time; and for a lengthy period of time it very seldom remains true that the environment is sufficiently stable. That is the dilemma of many of these enquiries, which they do not seem to me to face. Either they are dependent on too few observations, or they cannot rely on the stability of the environment. It is only rarely that this dilemma can be avoided.

Letter from J. M. Keynes to T. Koopmans, May 29, 1941

The point is I guess that somewhere between BP and the Grantham Institute we are likely, barring a major technological development, to see the outcome. But directionally the Grantham Institute research seems to be right side of change, and that is important when you see this graph:

Global Oil by Sector

In the long run I favour productivity and technical improvement over most other drivers in the economy. You can pass an inflection point where the whole economics of an industry changes. Shale has had it, and solar and EV might have it as well. But a core point is it requires standardisation and scale combined with technology improvements, and my worry for offshore is it has none of these except the potential of marginal improvements.

As I have argued offshore energy isn’t going to go away: in volume terms it too much of an important part of the supply chain for that. But is it going to be on the scale and have the importance it did before? BP and the other oil companies are right to keep investing, that is their business and their shareholders believe that, it’s capitalism, and a very efficient market mechanism. These productivity improvements are marginal at the moment, and car replacement cycles are long, competition is never stagnant etc. But it is hard to see a dramatic fall in the price of oil extraction productivity given it’s maturity (blended across production sources), and the same cannot be said for electric vehicle productivity. I accept that I have said that about shale, and there appears to be much further to run down the productivity curve, but subsea production is subject to dimishing returns, high capital utilisation, and asset productivity limits. Subsea is very efficient at scale but it is not easy to transform the limits of that scale, which isn’t true for manufacturing electric batteries and their potential capacity increases and price decreases (in real terms), and also to a lesser degree shale, which is limited by a high-service/labour input element.

There are issues with this negative theory: production that ends is harder to track and much less visible, I think I am biased by being amazed how quickly Tesla seems to to be growing, resource constraints could be found in battery manufacture etc. But it feels to me like we are passing a stage where after having been dependent on one source of energy for so long, admittedly a remarkable one on a calorie/output efficiency basis, other technologies are catching-up.

I don’t have a crystal ball, but going long on 25 year assets like drilling rigs and vessels, on the logic that it will always bounce back, because it did before, unless it’s part of a portfolio investment, strikes me as more risky than at anytime in the past 25 years. Whatever the industry will looked like in five years from now I doubt offshore will look like it did in 2013 ever again.