Increasing US oil production… Just like the man said…

[P]rogress in science is not a simple line leading to the truth. It is more progress away from less adequate conceptions of, and interactions with, the world.

Thomas Kuhn, The Structure of Scientific Revolutions

Some excellent data from the EIA this week confirmed that US production, even with the known Permian constraint issues, is powering ahead and is excess of previous forecast levels. My hypothesis, hardly controversial, is that there is a strong negative correlation between these graphs and offshore vessel values.

This is playing out almost exactly as Spencer Dale predicted in 2015. This is a generational change in oil production that is clearly going to impact on any “offshore recovery” theory… some of which are starting to sound a little desperate and absurd. I have referenced the Spencer Dale article before and if you are looking for a unifying theory of why any offshore recovery is likely to be delayed and anemic I think it is still the most relevant and lucid explanation.

You can obviously make money from shale…

From the Conoco Phillips Q3 2018 results today… a $600m turnaround in the Lower 48 (shale) on this time last year… and yes CP is investing more in Lower 48 than earnings… mainly I suspect because the return on capital looks so good…

COP dates

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It is quite amazing you can see an article titled this:

Red Flags on U.S. Fracking Disappointing Financial Performance Continues

And then get a table like this:

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My views on this here…With the onshore rig count near an all time it actually looks like good financial performance is encouraging even greater investment… something the offshore community should understand well.

#capitaldeepening #productivity

Shale versus offshore: SLB version

In 1984, a cellphone weighed two pounds, was nothing but a telephone, and cost $10,277 in today’s $. Today, a smartphone is also a camera, radio, television set, alarm clock, newspaper, photo album, voice recorder, map, and compass, and cost as little as $99…

Human Progress

A lot of press being made about the Schlumberger comments regarding shale reaching its production limits. Coincidentally(?) The Economist has a leader and an article on the same this week. I don’t have the technical knowledge to get into the Parent/Child well productivity debate  but I note this is not the first time the death of shale productivity has been forecast (particularly eagerly by the offshore community for obvious reasons).

What was less reported was this nugget from the same SLB results:

Offshore Angola, Sand Management Services deployed a combination of technologies for Total E&P Angola to save more than $100 million and gain an estimated 1 million BOE of incremental production in the Kaombo deepwater development. Combining the OptiPac* openhole Alternate Path‡ gravel-pack service with OSMP* OptiPac service mechanical packers enabled the customer to achieve target production with six wells instead of the planned eight. This combination of technologies enabled effective zonal isolation of complex stacked reservoirs in one field, while in another field the water shutoff capability of the technology enabled accelerated production. [Emphasis added]

SLB appears to have developed a technology that has reduced the number of wells by 25%? That will signficantly lower the cost of the development but at the cost of rig and vessel days as well as lower subsea well orders if applicable in other developments.

This is the future of offshore. More work onshore and less offshore proportionately where the costs and risks are significantly higher. Productivity increases like this, not based on selling high capital equipment below cost, will be important for the industry.

I am also not convinced shale productivity is decreasing. The declining demand (and margins) faced by SLB and HAL could well be the result of larger E&P companies internalizing costs and driving them down as they seek to “mass produce” shale oil. We shall see… The BHGE rig count was at levels not seen since 2015 last week.

There is actually a much bigger change going on in the supply chain. In the old offshore geographically dispersed fields and rigs made using contractors like Schlumberger the logical option from both a cost and skills point-of-view. But when you are committed to a region like the Permian (or Bakken etc) you have critical mass and it makes sense to internalise those skills and capabilities.

Shale has dropped significantly in cost terms and a plateau of some sort should be expected. But shale is a mass production technology and the slow relentless grind of an annual 1 or 2% productivity input is still a real issue for offshore where each development is to a certain extent custom designed and therefore subject to limited economies of scale. That is true for the rigs and vessels throughout the supply chain as much as it is for the field lay-out and wells. Offshore needs companies like SLB to produce innovations as described above but the future of offshore is having less assets do more for similar outcomes.

Unconventional verus offshore demand at the margin…

Economic growth occurs whenever people take resources and rearrange them in ways that are more valuable. A useful metaphor for production in an economy comes from the kitchen. To create valuable final products, we mix inexpensive ingredients together according to a recipe. The cooking one can do is limited by the supply of ingredients, and most cooking in the economy produces undesirable side effects. If economic growth could be achieved only by doing more and more of the same kind of cooking, we would eventually run out of raw materials and suffer from unacceptable levels of pollution and nuisance. Human history teaches us, however, that economic growth springs from better recipes, not just from more cooking. New recipes generally produce fewer unpleasant side effects and generate more economic value per unit of raw material…

Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has underestimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. The difficulty is the same one we have with compounding. Possibilities do not add up. They multiply.

Paul Romer (Nobel Prize winner in Economics 2018)

Good article in the $FT today on Shell’s attitude to US shale production:

Growing oil and gas production from shale fields will act as a “balance” for deepwater projects, the new head of Royal Dutch Shell’s US business said, as the energy major strives for flexibility in the transition to cleaner fuels. Gretchen Watkins said drilling far beneath oceans in the US Gulf of Mexico, Brazil and Nigeria secured revenues for the longer-term, but tapping shale reserves in the US, Canada and Argentina enabled nimble decision-making.

“The role that [the shale business] plays in Shell’s portfolio is one of being a good balance for deepwater,” Ms Watkins said in her first interview since she joined the Anglo-Dutch major in May…

Shell is allocating between $2bn and $3bn every year to the shale business, which is about 10 per cent of the company’s annual capital expenditure until 2020 and half of its expected spending on deepwater projects. [Emphasis added].

Notice the importance of investing in the energy transition as well. For oil companies this is important and not merely rhetoric. Recycling cash generated from higher margin oil into products that will ensure the survival of the firm longer term even if at a lower return level is currently in vogue for large E&P companies. 5 years ago a large proportion of that shale budget would have gone to offshore, and 100% of the energy transition budget would have gone to upstream.

The graph at the top from Wood MacKenzie is an illustration of this and the corollary to the declining offshore rig numbers I mentioned here. Offshore is an industry in the middle of a period of huge structural change as it’s core users open up a vast new production frontier unimaginable only a short period before. The only certainty associated with this is lower structural profits for the industry than existed ex ante.

Note also the split that the – are making between high CapEx deepwater projects and shale. Shell’s deal yesterday with Noreco was a classic case of getting out of a sizable business squarely in the middle of these: capital-intensive and not scalable (but still a great business). PE style companies will run these assets for cash and seem less concerned about the decom liabilities.

You can also see this play out in terms of generating future supply and the importance of unconventional in this waterfall:

Shale production growth

As you can see from the graph above even under best case assumptions shale is set to take around 45% of new production growth. When the majority of the offshore fleet was being built if you had drawn a graph like this people would have thought you were mad – and you would have been – it just highlights the enormous increase in productivity in shale. All this adds up to a lack of demand momentum for more marginal offshore projects. The E&P companies that are investing, like Noreco, have less scale and resources and a higher cost of capital which will flow through the supply chain in terms of higher margin requirements to get investment approval. This means a smaller quantity of approved projects as higher return requirements means a smaller number of possible projects.

Don’t believe the scare stories about reserves! The market has a way of adjusting (although I am not arguing it is a perfect mechanism!):

Running Out of Oil.png

Shale and structural change…

The graph above is from the IEA’s most recent energy report. No huge surprises for anyone reading this blog but the historical comparison is interesting. When someone tells you that offshore isn’t facing structural issues this graph would be a good data point to discuss. The IEA is also sounding more confident of shale becoming cash flow positive although as I have said I don’t think that is a big issue. My scepticism of plans that involve buying a load of ‘cheap’ offshore assets and waiting for ‘the inevitable’ recovery continues to grow…

Capping the price of oil… The Visible Hand of US managerialism…

It is impossible to understand where I am coming from on this blog it without grasping the implications of the graph above (also used here). The graph from the Federal Reserve Bank of Dallas earlier this year highlights the level at which it is profitable for E&P companies to drill new wells. Clearly this is well below the current oil price. The price signal is strong: drill more wells.

Shale oil production is not resource constrained. There is no shortage of rocks to frac or sand to feed the beast. Pioneer estimate there is in excess of 250 years supply in the Permian basin alone at significantly higher production rates than today. There might be a shortage of rocks to frac at an economically efficient price but that answers a different question. The limiting factor on shale is not resource availability but the technical and organisational constraints associated with its growth. The constraints shale faces in the US are organisational: raising capital, training people, building pipelines and new rigs, all the challenges of maximising a known process. Over time no economy in the world is more adept at solving these challenges than the US economy. Chandler called it The Visible Hand and he was right.

This is a massive change from the recent era of offshore domination. Shale is a mass production process where unit costs are constantly being driven down. Offshore was a custom process: each field development was a one-off, each rig and vessel (largely) were one-off’s, each tender was a one-off. The whole chain was geared to custom solutions and while it was efficient at high volumes it is not a deflationary process. The Brazilian pre-salt finds while enormous in size led to a cost explosion throughout the industry and not one it has fully recovered from. The Harsh Environment UDW rigs while significantly more capable than jack-ups did not reduce per barrel costs they just helped us access a scarce resource that we didn’t think we could get from anywhere else. We were happy to pay the price.

It is a very different world now. It is all well and good for the $FT to claim “Shell hails bounceback towards deepwater drilling” but the story carries a more modest message:

“Deepwater can compete if not demonstrate higher returns because of fundamental cost reduction,” he said. “Break-even prices in deepwater — we are now talking $30 per barrel.”…

“It’s great to have both in the portfolio and we are growing our shales business . . . but in terms of sheer cash flow delivery our deepwater has significantly more cash flow potential,” said Mr Brown.

We are into deepwater at $30 a barrel Shell are saying, but we like the competitive tension of shale and we will keep our options open. The upside is in other words capped.

I think the price of oil is therefore capped in the long-run, and I stress that because an industry run with minimal stocks and a highly interconnected supply chain is always going to have short-run volatility, at the rate at which the US shale industry can organise and finance itself and supply marginal production. Eventually the oil price will be capped at what these producers can profitably supply to the market because over time they will continue to grow production significantly. This is an industry with very low barriers to entry and a wealth of subcontractors who can supply kit, and while the offshore rig count has had a fairly minimal improvement globally over the last year there is an almost .9 correlation to the oil price and the US land rig count:

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There is a good article here as well about how in the long-run refineries can process various types of sweet/sour and light/heavy. Again there will be a short-run transition for some refineries who cannot handle light sweet crude but the processes are known and it is simply a cost-optmisation exercise between cheaper light-sweet crude versus more expensive heavy-Brent (for example).

This is clearly a long transition but it strikes me as an inevitable one. US shale production will over time increase as the capital intensity and investment deepens. The huge capital and organisational requirements this will entail ensures this is not an overnight process, but it is a continuous process and one where the inertia now seems unstoppable. This is why I strongly believe that the offshore industry demand curve has lost its correlation with the oil price and a far more complex demand line needs to be plotted for companies.

Offshore’s golden age post 2000 simply didn’t have this competitive supply source, and certainly not one with a major deflationary bias, to compete with. Every strong recovery in global demand led to a straight linear investment in offshore as the only marginal source of supply… ‘there is no easy oil’ people used to say as cost inflation took hold of the offshore industry. But now there is and not only that it appears to be getting cheaper to access it as well.

Shale doesn’t have a cash flow issue …and the limits of expansion…

Yesterday the $WSJ had this article on the economics and cash flows of the shale industry. The overall point is logical that if cost increases continue the cost of capital may go up for shale producers and point to it reaching the economic limits of its expansion. I agree with the general thrust of the article in that if the industry isn’t as profitable as forecast the cost of capital will increase, but this comment is being taken out of context by some:

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Of course they didn’t… they are investing for even higher production next year… the comment “within their means” is pejorative and not a reflection of economic reality. That is a sign of confidence from the firms and their financial backers that their output can be sold at a profitable price. The price signal from both the oil and the capital markets is strong.

I also received a comment yesterday with a link to this comment. I don’t think this is a big deal to anyone with a basic understanding of finance because they get this… but then again I have lost count of the number of people who repeat back to me that no one makes money from shale.

I wonder if this isn’t becoming part of the great “Gotcha” narrative that aims to prove that shale isn’t a viable production methodology? Like the CEO of Shell is going to wake up next Tuesday and say “after reading the article in the WSJ we are going to stop investing in shale. Thank goodness I read that or I would never have realised we will never make money from it!” As if those investing literally tens of billions had no idea of the cash flow profile of their assets?

The overall article is interesting only in that it points to what appears to be the current “productive efficiency” of shale, not its demise. The point of the article isn’t that you can’t make money from shale it is that at the margin now it is becoming less profitable and that may affect the pricing of capital. Bear in mind before you read the rest of this post the scale of the increase in absolute oil production shown in the graph above and the amount of capital required to finance this.

For those not versed in accounting cash flow negative might seem like a big deal but it’s not. A casflow statement is made up of Cash From Operations [CFO] (+/-) Cash flows from investing [CFI](+/-) Cash flows from financing [CFF]. It balances with the cash at bank at the start of the period and at the end. Free Cash Flow to the firm is simply the sum of the first two… You would expect the number to be negative in a capital-intensive industry, like shale oil extraction, when you are seeking to grow output volumes significantly, particularly when a number of firms are new entrants into the industry and not financing from retained earnings. You are spending capital to get future revenue and you need to borrow or raise equity to do this. Collectively as all the firms in the industry deepen the capital base for ever higher production they are using more cash than they are generating currently. (I am aware that there are a number of definitions of Free Cash Flow but this appears to be the Factset one and the generally accepted one of FCFF).

If you buy an offshore drilling rig for $1bn and get 100m in operating cash flow for year 1 then your (highly simplified and representative) cash flow statement reads: CFO +100m: CFI -$1bn. That is your “Free Cash Flow” [FCF] is -$900m. It is balanced (all going well) by CFF +900. You own an oil rig that lasts for 20 years but in year 1 you were down $900m in FCF. You can buy as many rigs as you want and be FCF negative (like Seadrill) for as long as you can keep CFF >= CFO+ CFI  i.e. you have access to debt or equity markets. That is all that is happening in shale collectively.

If these were operating cash flow negative then there would be a massive issue. But as this research from the Dallas Federal Reserve (March 2018) makes clear there is no problem with operating cash:

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Or indeed with profitably drilling wells at the current oil price (i.e. including financing):

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For as long as investors believe that in the future the oil price attainable by these E&P companies is sufficient to return capital, and funding markets remain open, then spending more on Operating Income + CapEx combined is no problem. There is rollover risk in the debt but that is a seperate risk and appears to be pretty minimal at the moment.

Pioneer is an embodiment of this: in the first six months of 2018 it generated ~$1.5bn from operations (i.e. selling oil and gas) [CFO], spent ~$1bn on investments (actually nearly $2bn but it sold some stuff as well) [CFI], and then paid back debt of $450m and purchased ~$50m of shares. But some smaller companies who have come in recently will have spent far more on CapEx than they will earn in CFO.

When I have talked about the ‘virtuous cycle’ of capital deepening in prior posts this is part of that network effect of decreasing risks and increasing returns for all involved in the ecosystem. E.g. if Trafigura build an export facility for 2m b/per day it lowers the risk for every E&P company (and their financiers) that they can sell more oil profitably. So more investment comes into the sector in an ever-expanding circle, lower costs, replacing labour with capital. That is what appears to be happening here. The limits of this process are there and are hinted at in the WSJ:

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Permian production will be up 19-24% according to Pioneer so it’s not all bad. Costs are increasing as the Permian reaches the constraints of labour and capital as has been well documented. Some of these will disappear with new pipelines and other capital deepening, e.g. a replacement of capital over labour as excess surplus is currently trucked or railed out, but some will continue given the huge increase in absolute production volumes. It is no surprise that with such a huge percentage increase in production that at the margin each incremental barrel becomes more expensive in the short-run, but then the capital deepening effect will kick in and the long-run cost curve will decline, as always in mass-production, and then the unit costs drop again… ad infinitum

Pioneer are saying with that statement is that their marginal output on capital is declining slightly this year as cost increases have not kept pace with productivity improvements. That isn’t surprising because the sheer volume of output increased has consistently surprised on the upside. If the project costs increase 10% and this isn’t covered with higher prices and/or productivity improvements then investors will change their price of capital to reflect diminished expectations.

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

But this production capacity isn’t going away. The rigs have been built. The pipelines have been, or are being, built; the same goes for export terminals etc. The capital base of the industry has increased massively and is facing some teething problems. But in a little 4 over years the US tight oil industry has driven US production up to over 11m b/ per day in 2018, over 6m b/ per day of that from shale up from ~4m b/ per day in 2017.

What should really worry those in the offshore community is that this is an industry that increased production 50% in a calendar year before hitting the limits of economic growth, and it did this while increasing productivity and lowering unit costs. Someone isn’t waking up next Tuesday and realising it has all been a massive mistake and turning the tap of funding or production off. The US shale industry is a deep and entrenched part of the energy mix now. Current forecasts might be out by a few hundred thousand barrels a day but they are not going to be out by millions. This production is real and permanent with profound implications.

The core logic of the WSJ article is surely right: A rise in the costs of shale relative to output signals the limit of the economic efficiency and therefore the diminishing returns to capital may make it more expensive for shale E&P firms to fund new projects. Shale and offshore compete for E&P company CapEx and if the cost of funding shale projects rises (on a productivity measured basis) that should increase relative demand for offshore as a substitute. But the Free Cash Flow from an offshore project is massively negative in the short-run and over time has higher yields, whereas the reduced CapEx commitment, despite its lower margin, is one of the chief attractions of shale. Cash for investment is not the issue.

I think it sits uncomfortably with forecasters who claim that day rates for jack-ups will double within two years, or other such notions, and it does not seem to be incorporated in the strategic planning assumptions of a large number of offshore companies or investors where the logical outcomes of such data sit uncomfortably. The offshore industry built a fleet to handle 2013 demand when shale was producing ~2.5m barrels a day, it is now producing 6m and is growing faster than the overall oil market growth and forecast to do so until 2021 at least.

Hard strategic questions arise for the offshore industry: how do we compete in an industry which faces potentially declining market share for our underlying product at the margin? How do we compete in an industry when a competitor with a different business model has taken 10% of global market share in the space of 5 years and we buy 25 year assets funded on short-term contracts? What level of asset base shrinkage does the offshore industry require to be competitive? How many firms will have to liquidate given this necessary shrinkage? What will the surviving firms look like? How much can they realistically expect to make? What are our assets worth?

There are a lot more questions based around this logic. But if you are simply expecting a day-rate increase and a demand side boom based on shale magically running out of cash at some future point I think you are going to be very disappointed.