The wrong side of history…

“Until an hour before the Devil fell, God thought him beautiful in Heaven.” …

The Crucible, Arthur Miller

 

On the IHS Markit projection, by 2023 the Permian is likely to be producing an additional 3m b/d of oil, along with an extra 15 bcf of gas. For the US economy this news is positive. America will have a secure source of supply that, through its production, distribution and consumption, will generate significant economic activity across the country.

The volumes involved will further reduce the unit of production, probably to below $25 a barrel. The study estimates the total investment needed to deliver the new supplies will be some $300bn. For the global oil market the effect will be dramatic. The US will become a significant exporter. The IHS Markit paper suggests that by 2023 the country will be exporting around 4m barrels a day. That will absorb much of the expected growth in demand. [Emphasis added].

Nick Butler, Financial Times, June 25, 2018

 

For one thing, customers have an unfortunate habit of asking about the financial future. Now, if you do someone the single honor of asking him a difficult question, you may be assured that you will get a detailed answer. Rarely will it be the most difficult of all answers – “I don’t know.”

Where are the Customers’ Yachts? 

Fred Schwed

In case you missed it another major pipeline looks certain to go ahead in the Permian by 2020 (in addition of course to the Exxon Mobil 1m b/d). If the 30″ version is selected then 675k barrels a day will be added in export capacity to the port at Corpus Christi, where a major upgrade is also taking place that will allow significantly larger tankers into the region:

Oil export capacity from the Corpus Christi area is expected to rise to 3.3 million bpd by 2021 from 1.3 million bpd this year, keeping its rank as the top oil export port, according to energy research firm Wood Mackenzie.

In fact if you believe Pioneer Natural Resources (on S&P Platts) then Permian pipeline capacity will double by 2020 (to 3.5m b/d) and the US production will reach 15m b/d by 2028. The graphic at the top of the page highlights that top Permian wells are profitable at $22 per barrel. There is a good point on the interview where the CEO of Pioneer points out in 2015 the dominant narrative was shale would go bankrupt and in fact there has been a rebound.

This continuous process of capital deepening, infratsructure upgrades, and productivity improvements has driven the recovery of the US shale industry and has devastated the offshore industry. There is a link: it is not all inventory and reserve rundown. Offshore used to have to run at very high utilisation in order to work and without it the economic model is broken. No other economy in the world excels at this kind of constant, small-scale, mass production improvement like the American economy. Once a product can be mass produced at scale the ability of the US economy to drive down per unit production costs is unmatched.

At the moment there is a boom in the Permian and Eagle Ford basins: wages are high and there are delays and bottlenecks (I read a story last week of a power company demanding 40k to put in one power pole) but this capital deepening will alleviate some of these issues in the short-term. Trucks will be replaced with pipelines etc, a new generation of high spec rigs in the  offing. Deliver, review, improve. Always with a focus on productivity and efficiency. Shale is a process of horsepower and capital and those are two attributes the US economy is preternaturally endowed with. Each incremental pipeline becomes less important in a relative sense so the investment bar is lower. Slowly but surely unit costs get lower every year. It is a relentless and predictable process.

That is the competition for offshore for capital at the margin: an industry improving its efficiency and cost curve with every month that passes. And the solutions to constraint problems in the Permian are on a timescale measured in months while investments in offshore take years to realise.  Offshore offers huge advatages over shale in terms of high volume flow rates and low per barrel lift costs but it is a long term CapEx high industry and not suited to production of marginal volumes. There is every likelihood it is used as a baseload output in years to come while shale supplies marginal demand. This is a massive secular change for offshore and will fundamentally alter the demand curve to a lower level. The clear evidence of this seems to be causing a degree of cognitive dissonance in the offshore industry where any other outcome that a return to the past is discounted.

To just focus the mind: if offshore were to improve productivty by 3% per annum for three years- which is considerably slower than the productivity improvement in shale – day rates for offshore assets in 3 years would need to be at c.92% of current levels per unit of output (i.e. a 8% reduction [1/1.03^3]). Not all of this is going to be possible in offshore execution terms given the aset base, some of this will come from equipment suppliers who are manufacturers and subject to scale economies reducing costs, but this is the challenge for offshore bounded by Bamoul constraints. There are limits to the volumes that can be produced by shale but they have constantly exceeded market expectations and they have eaten a meaningful share of global oil output and this will not change only increase.

As the graphic below shows this is a supply side revolution as demand for the underlying commodity has increased consistently since 2006:

Global Oil Demand 2006 to 2018F

IMG_0611.jpg

So the only possible explanation for the continuing drop in the utilisation of offshore assets is that the demand has fallen for their use relative to the global demand for the underlying commodity they help produce.  I accept that may look tautological but we just need to clear that point out early.

I have been on before about how I don’t think a quick recovery is likely for the offshore market for those long on offshore delivery assets only (the tier one SURF contractors are different as their returns are driven by engineering as well as asset leverage). I can’t see how an industry like the shale can develop in parallel with a “snap back” in offshore, particularly when the larger E&P companies have been consistent and vocal about limiting CapEx.

The reason jack-up companies are like offshore supply companies, and not SURF contractors, is that they take no project risk. An oil company doesn’t handover well risk to a drilling contractor (as Macondo showed). Shallow water drilling contractors are the AHTS and PSV of drilling: you get a day rate and that is the only value we expect you to provide. It is an asset return and utilisation gig completely different from SURF contracting. And yet against this background there is a bubble developing in the jack-up market seemingly unsupported by any fundamental demand side recovery. I am not alone here: McKinsey forecast jack-up demand to rise 2% per annum to 2030 (about a 10% growth in market size over the next five years).

Bassoe on the other hand are forecasting that day rates will double in the jack-up market in five years, which equates to a 15% compound average growth rate.  I realise this narrative is one everyone wants to hear, you can almost hear the sighs of relief in New York and London as the hedge funds say “finally someone has found a way to make money in offshore and profit from the downturn”. And as the bankers stuff their best hedge fund clients full of these jack-up companies stock this is the meme they need as well. At least in this day and age the investors have better yachts than the bankers.

Yet the entire jack-up market thesis seems to rest on the accepted market narrative of scrapping and therefore higher utilisation. As Bassoe state:

If 85% jackup utilization seems relatively certain, then a doubling of dayrates is too.

Certain is a strong word about the future… As if the entire E&P supply chain will benignly accept day rates increasing 15% Y-O-Y from every single market participant without worrying about it…

Ensco is a good place to look because it also considers itself a leader in premium jack-ups. Ensco has exactly the same business model as Borr and Shelf (indeed it is focusing on exactly the same market segment in jack-ups): raise a ton of money, go long on premium assets and wait for the market to recover… Ensco’s recently filed 10K shows how well this jack-up recovery is going:

Ensco q1 2018.png

Oh hold on it doesn’t show that at all! Instead it shows the jack-up business revenue declined 17% Q1 18 versus Q1 17. Awkward… So like everyone else here is the crunch of the “market must come back” narrative: Scrapping.

Ensco jackup fleet forecast.png

The problem with this argument is the scale of the scrapping required in the red bars (not to mention the assumptions on China). If that slows and/or the market growth doesn’t quite come then the obvious downside is that there are too many jack-ups for the amount of work around. Somewhere between 2% and 15% compound per annum leaves a lot of room for error.

When your revenue figures drop 17% on the previous year management in most normal companies, but especially those with a very high fixed cost base and a disposable inventory base (i.e. days for sale), tells the sales reps to cut the price and win market share. And that is exactly what will happen here. In fact far more accurate than forecasting the market is an iron law of economics that in an industry with excess capacity and high fixed costs firms will compete on price for market share. Investors going long on jack-ups are making a very complicated bet that the market growth will outpace scrapping in a way it hasn’t done in the past despite E&P companies being under huge pressure to keep per unit production costs low.

On the point of the age of the jack-up fleet: this is clearly valid to a degree. But as anyone who has negotiated with an NOC in places in South East Asia and Africa can tell you all this talk of new and safe over price is Hocus Pocus. Otherwise in the greatest down market around none of these units would be working or getting new work and that clearly isn’t the case.

In fact in many manufacturing businesses old machines, fully depreciated and therefore providing only positive cash flow to the P&L, are highly prized if they are reliable. There is no evidence that this will not happen in offshore and plenty of counter-examples showing that oil companies will take cheaper older assets. The best example is Standard Drilling: bringing 15 year old PSVs back to the North Sea that were originally DPI, and getting decent summer utilisation (day rates are another issue but for obvious reasons). Eventually as the munificence of an industry declines the bean-counters overpower the engineers and this is what I believe will happen here, there is plenty of evidence of it happening in offshore at the moment. Every single contracts manager in offshore has had a ridiculous conversation with an E&P company along the lines of: “we want a brand new DP III DSV, 120m x 23, 200t crane, SPS compliant, and build year no later than 2014 and it’s a global standard… and we want to pay 30k a day”… and then they go for the 30k a day option which is nothing like the tender spec.

The reason is this: North Sea E&P companies are competing against shale for scarce capital resources and they need to drive costs out of the supply chain constantly. Offshore has dropped its costs in a large part because the equity in many assets and companies has been wiped out, that is not sustainable, but what is really unlikely to happen here is a whole pile of asset managers wake up simultaneously at E&P companies over the next three years and tell people to wholesale scrap units knowing it will increase their per barrel recovery costs while watching shale producers test new productivity levels.

There may well be a gradual process on a unit-by-unit basis, a cost benefit analysis as the result of some pre-survey work or a reports from a offshore crew that the unit isn’t safe, but not suddenly 30 or 40 units a year, and if does happen too quickly and prices rise then the E&P companies will revert to older units to cap costs. Fleet replacement will be a gradual process and some operators will be so keen to save money that they will let some older units be upgraded because it will have a lower long term day rate than a newer unit because they get that to continue to have capital allocated they need to drive their costs down.

The investment bubble in jack-ups is centred on Borr Drilling and Shelf Drilling. These companies have no ability or intention to pay dividends for the next few years. Credit to them: raising that sort of money is not easy and if the market is open you should take the money. Their strategy, in an industry that patently needs less capital to help rebalance, is to add more and wait for a recovery. Place everything on 18 red at the casino. Wait for higher prices and utilisation than everyone else despite doing exactly the same thing (just better). And that’s fine it’s private money, and it might work. But economic theory I would argue suggests it is extremely unlikely, and it will be a statistical outlier if it does. Five years ago the US shale industry was producing minimal amounts and the dominant thought was they required $100 oil to work so think how different the world will be by the time these companies have any hope of returning cash to investors?

Forecasts are hardly ever right, not for lack of effort but the inability to take into account the sheer number of random variables, the epsilon, in any social process. Forecasts that a segment of the offshore market will double given the headwinds raging against it should probably be viewed as bold, a starting point for debate rather than a base case for investments. Having picked 9 of the last 0 housing crashes you should also realise that while my arguments will eventually be proven right the timing of them can be wildly inaccurate as well.

The scale of shale…

Exxon Mobil signed a JV on Tuesday with Plains All American Pipeline LP to build a pipeline that will ease it’s offtake problems in the Permian. Permian has been trading at a discount to WTI of up to USD 27 per barrel due to export constraints from the region so there is a real incentive to come up with a permanent solution.

The thing that struck me was the scale of the pipeline: 1 million barrels capacity per day. That single pipeline will carry as much as the entire output of the UKCS! ~1% of global oil demand being carried in one pipeline. There are a lot more of these pipelines being built as well and they are constructed relatively cheaply and very quickly.

I repeat again that I really struggle to see how a multi-year boom in oil prices can happen now on the same scale as previous cycles. The ability of shale to act as a marginal producer and the ability of E&P companies to develop the infratsructure much more quickly than before seem to act as cap on the price that hasn’t existed before. They could be famous last words but the scale of the investments and infrastructure being committed to Lower 48 counts is part of a genuine supply side revolution in the current oil market.

Shale and offshore… the competition for marginal investment dollars…

Last week the Baker Hughes rig count for the US came in and again it was up. In the graph above Woodmac are highlighting it that Lower 48 US shale production may crack 12m barrels a day.  As recently as 2013, when offshore was starting to go really long on ships, US shale production was ~3.0m per day. It has in short been an industrial phenomena, one as I have noted here before no other economy in  the world could have marshalled as it has required enrmous flexibility in capital markets and the ability to turn a service industry into a manufacturing process.

The narrative has changed as well. Shale has consistently outperformed even optmistic forecasts:

US-Shale-Production-Outlook-Revised-Upward-Repeatedly-20160210-v2.png

As recently as 2016 even BP’s renowned research team were only predicting a fraction of actual demand. Shale now represents an enormous portion of workd output and it’s economic model of short-cycle low-margin is the antithesis offshore but this flexibility around spending commitment is clearly very valuable to E&P companies in an era of price volatility.

So I get as the price declined in 2014/15 you could maybe make a reasonable case for a quick rebound in offshore? 2016 at a stretch, although I think the market signals for offshore were already clear byt then, but I have to say it strikes me as hard now for people ignore the scale of this change and to argue there will be some demand driven boom coming in offshore. E&P companies have stated repeatedly they are sticking to forecast offshore CapEx numbers and they seem to be sticking this.

I still think there are too many business plans floating around which have as a core assumption. This from Ocean Rig:

Ocean Rig Recovery.png

“[F]or the market upturn” (emphasis added)… like it’s a given? I get it’s off a low base but I think we all know when people talk about that sort of recovery they mean a deep cyclical one that flows to rig and vessel operators who will make a ton of money.

But let’s look at the scale in terms of shift at the margin in incremental output:

Long term offshore.png

The last time the oil price dropped and offshore boomed back,whichever cycle you were talking about but especially the quick 2008/09 rebound, that yellow portion of incremental investmnent simply didn’t exist on the graph in a meaningful sense (and since this graph was done shale is more important). A business plan that simply ignores this reality an insists on a change in market conditions as it’s defining principal is simply logically inconsistent to my mind. Clearly offshore is an important part of the energy mix going forward, but in 2009 it was really the only alternative to traditional onshore production and that clearly isn’t the case now.

Offshore used to have very high utilisation rates, that is what made small companies in an extremely capital intensive industry viable, but it is clear that the scale of investment in shale is having a profound impact on utilisation levels and this is changing the entire economic structure of the industry. This point is a prelude to a further few posts that have this logic as there core.

Overdiscounting… the future of offshore…

The qualities most useful to ourselves are, first of all, superior reasons and understanding, by which we are capable of discerning the remote consequences of all our actions; and, secondly, self-command, by which we are enabled to abstain from present pleasure or to endure present pain in order to obtain a greater pleasure in some future time.

Adam Smith, 1759

 

For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence.

John Maynard Keynes, 1936

 

The slide above taken from Transocean highlights how competitve offshore has become on a per barrel recovered basis. I’ll ignore the fact that the cost estimates for shale appear high because it isn’t my point: the real point is that to compete in the modern environment offshore oil production will have to be significantly more profitable on a per barrel recoverable basis because there is significant evidence managers underestimate (“overdiscount“) future financial returns the further away they are. Shale returns, while lower, are produced in a much shorter time period than offshore and behavioral finance shows strong evidence that managers prefer these sorts of returns at lower levels when compared to higher returns further away.

In  2011 Andrew Haldane, Executive Director, Financial Stability at the Bank of England, and Richard Davis, and Economist at the Bank of England spoke at a Bank for International Settlements conference and noted:

[r]ecently, in 2011 PriceWaterhouseCoopers conducted a survey of FTSE-100 and 250 executives, the majority of which chose a low return option sooner (£250,000 tomorrow) rather than a high return later (£450,000 in 3 years). This suggested annual discount rates of over 20%. Recently, Matthew Rose, CEO of Burlington Northern Santa Fe (America’s second biggest rail company), expressed frustration at the focus on quarterly earnings when locomotives lasted for 20 years and tracks for 30 to 40 years. Echoes, here, of “quarterly capitalism”.

In 2013 McKinsey & Co and CPPIB surveyed 1000 Board members and found:

  • 63% of respondents said the pressure to generate strong short-term results had increased over the previous five years.
  • 79% felt especially pressured to demonstrate strong financial performance over a period of just two years or less.
  • 44% said they use a time horizon of less than three years in setting strategy.
  • 73% said they should use a time horizon of more than three years.
  • 86% declared that using a longer time horizon to make business decisions would positively affect corporate performance in a number of ways, including strengthening financial returns and increasing innovation.
  • 46% of respondents said that the pressure to deliver strong short-term financial performance stemmed from their boards—they expected their companies to generate greater earnings in the near term.

The implications for offshore investment (decision tree here) versus the certainty of a short payoff from shale investment are obvious. It has been well known in economics for years that managers overdiscount future returns: in behavioural economics it falls under time preference problems. Humans are neurologically wired with a preference for immediacy that affects economic behaviour. As Haldane and Davis make clear:

This evidence – anecdotal, survey, quantitative – is broadly consistent with popular perceptions. Capital market myopia is real.

As early as 1972 Mervyn King, who would later become Governor of the Bank of England, noted that managers in the UK overdiscounted returns from long term investments. This stream of literature dried up as the Efficient Market Hypothesis took over as the vogue theory but it doesn’t change an actual reality.

The fact is that in competition for marginal oil investment dollars there are institutional and behavioural factors pushing for short-term solutions. This article in the Financial Times notes that Shell is under pressure as the CFO hasn’t outlined when the promised $25bn share buyback will start. Do you think the CFO at Shell is pushing for a new Appomattox because it has lower economic costs (but high CapEx) or will she simply seek to favour short pay-off, lower margin, projects?

Managers pushing offshore projects in E&P companies are running into senior managers who represent exactly those type of Board members surveyed by McKinsey and CPPIB. These managers aren’t wilfully myopic, the shareholders are pushing them to be, but they are more focused on immediate payoffs and overdiscounting the costs of the offshore projects. Again this quote from Haldane and Davis seems apposite:

Graham, Harvey and Rajgopal (2005) surveyed 401 executives. They found three striking results. First, managers would reject a positive-NPV project if that lowered earnings below quarterly consensus expectations. Second, over 75% of the sample would give up economic value in order to smooth earnings. Third, managers said that this was driven by the desire to satisfy investors.

When there was no shale this wasn’t an option as the question was “Do you want oil or not?”. The question is a whole lot more complex now and involves and assessment of certainty, risk, payoff potential and timing, and the pricing uncertainty of a volatile commodity over the long run. All this points to the fact the the financial and institutional barriers to new offshore projects are much higher than simple “rational” expectation models of future payoffs would suggest.

 

Sunny Sunday afternoon reading…

Very interesting podocast/transcript with Scott Sheffield, Chairman and ex-CEO of Pioneer Natural Rescources…

Pioneer is listed as number one, lowest breakeven, $19 — $20 breakeven price. And so, anything about $20, you start getting your money back. So, you really need something to get a 10%, 15% return. You need something probably in the mid 30s, long term. And the company has come out recently over the last 12 months saying it’s going to a million barrels a day plus and it could easily do that at $45 oil price flat for the next 10, 20 years…

[on Permian growth:]

And I think this year will probably be more in the 1.3 million barrels a day from year end 2017 to year end 2018, we’ll grow about 1.3 million barrels a day. And roughly about 800,000 will be from the Permian. We had about 800,000 from the Permian last year, of oil. Probably they have another 800,000, it can be a little bit higher. There are some issues I’ll talk about later with you, the backwardation, the constraints, pipeline constraints, people constraints, but I’m predicting another 800,000 long term in our discussion. Long term, Permian basin will get up to somewhere — seven million barrels a day, it could go higher. But at least seven in the next 10 years from the 3.2 that you mentioned earlier….

A long way to go. We’re only drilling three benches. There’s about 12 benches of that 4000 feet of Shale and people are only focused on three of those benches. So, we’ve got another nine benches of Shale formation to drill as we play out the Permian basin over the next several years..

Shale productivity…

Woodmac ask:

Woodmac Shale Prod

Whereas others highlight increasing efficiency from opening wells:

Shale prod open well.JPG

The two data points clearly aren’t in conflict they just highlight how complex productivity issues are. Productivity is just a input/output ratio and there is ample evidence of declining tight-oil rig costs for example as manufacturers move down the experience curve  which would simply change the inputs in the numerator.

My only view on this is that the sheer scale of the investment going into shale will see productivity improvements but they might not always be constant. To see how far the general consensus has lagged actual productivity improvements this graph from a reputable investment bank in January 2018 that shows where they thought the breakeven level would be:

Shale cost forecast.png

With this comment:

Shale breakeven level words.png

Shale is now cash flow breakeven at $25 a barrel. The CapEx number doesn’t make this a clean comparison with the graph above but focus on cash flow breakeven because that is all the investors providing the finance seem to worry about.

What isn’t going to happen here is that E&P companies are going to wake up one day and reverse the multi-billion investments they have in shale. Whether future productivity improvments follow some exponential Moore’s Law, or a more likely non linear process, remains to be seen. But the chance of there being some sudden realization that shale production is subject to rapidly diminishing economic returns strikes me a low probability event.

$60 is the new $100…

There is a boom in oil… it’s just not in Aberdeen or Stavanger…

“$60 is like the new $100,” said Dallas Fed economist Michael Plante in a mid-April interview.

Breakeven costs are now as little as $25 per barrel, according to the Dallas Fed’s most recent survey, so energy companies here no longer need $100 oil to make lots of money…

“It is a full-fledged boom,” says Dale Redman, chief executive of Propetro, a Midland, Texas, firm that supplies heavyduty horsepower to drill sites, where energy companies coax crude from the ground with sand and water.

He has tripled his workforce since early 2016, drawing workers from towns and cities hundreds of miles away. Over half of his 1,200 employees make more than $100,000. “What it has done is raised wages for all these folks. But housing and the cost of living has gone up as well.”

Eventually labour costs will rise, and as they are proportionally more expensive than offshore labour costs due to capital intensity, offshore will become more attractive in investment terms. But that will be offset by a productivity improvement. Never underestimate the ability of the US economy to be an efficient mass producer at scale.