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.

Productivity breakeven reduction versus over supply driven cost reduction

Great graph from Rystad today showing how productivity improvements are driving a reduction in tight oil and offshore. I do however think it worth noting that this is a productivity driven cost reduction whereas in offshore it would appear that much of the cost reduction simply reflects equity that has been wiped out and contractors supplying assets at OpEx levels or below. My thoughts on Baumol productivity remain valid.

It is interesting though that offshore deepwater costs seem to move in a linear fashion with demand, as does offshore midwater. The reasons for the decline in offshore shelf breakeven costs would be interesting to explore.

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.

 

 

Fundamental change or short-term shock?

The most popular letter in the FT today compared the review of Crude Volatility by Robert McNally (a Bush adviser) by the FT Energy Correspondent, Anjli Raval, to The Price of Oil by Roberto F Aguilera and Marian Radetzki. Basically, McNally argues we are in for a wild ride on prices and supply while Aguilera and Radetzki come in for shale and technology and permanently low prices. The writer agrees with fracking our way to salvation and permanently lower prices.

I read the read the review and admit McNally lost me with this:

But industry attempts to tame the market in the past have either had minimal success or been defied. The arrival of US shale in recent years has rendered Opec unwilling or unable to control the market, McNally says. With Opec’s power ebbing, “we are going to be unpleasantly surprised by chronically unstable oil prices”.

Come again? Normally getting rid of a cartel stabilises prices and lets market forces determine supply and demand? I couldn’t be bothered to read the book based on the review because it all sounded a bit contrived: you cannot control a cartel with that many players (as Opec is finding out), and as the famous Hunt Brothers (oil men to the core) discovered you can’t control a complex market like silver (or oil I’m betting on).

I haven’t read Aguilera and Radetzki’s book either, but they have a lot of stuff on the web that makes their view clear (at Vox and Scientific American). As they say here:

Using simple and reasonable methodologies, we estimate that the shale revolution outside the US will yield an additional 20 million barrels per day (mbd) by 2035 – nearly equal to the rise in global oil production over the past 20 years.

And look how much the cost curve for shale has changed since they published this in 2016:

Cam Rystad

The cynic in me naturally errs to favour technology over political market determinism in as much as I get concerned about these things. I guess that makes me long shale in my views. I still think offshore will be a major part of the energy supply mix (as the above chart makes clear), but perhaps less a part of the overall portfolio than we hoped in the near distant past.

“Short cycle” E&P production, offshore demand, and future industry structure…

“Productivity isn’t everything, but in the long run it is almost everything.” 

Paul Krugman

There was an excellent article in the Telegraph this week on the economics of shale (“short-cycle”) investment that is so important for the future of offshore demand. This comes at the same time the IEA is raising concerns that lack of current investment could lead to a “sharp increase” in prices and effectively says shale is not the solution. I back the economics of marginal supply over future concerns that large mega-projects are not occurring.

I note the IEA itself says:

The demand and supply trends point to a tight global oil market, with spare production capacity in 2022 falling to a 14-year low.

In the next few years, oil supply is growing in the United States, Canada, Brazil and elsewhere but this growth could stall by 2020 if the record two-year investment slump of 2015 and 2016 is not reversed. While investments in the US shale play are picking up strongly, early indications of global spending for 2017 are not encouraging.

[emphasis added]

I have to admit to being slightly perplexed having read the IEA release on this report (and not the whole report) because I am not sure I get why a tightening of supply would lead to increased volatility in prices? Surely it would mean a gradual increase in investment to meet the tightening supply? Or maybe a period of underinvestment would lead to rising prices (but would surely be a signal for investment)? It may be true that large mega-projects are not replacing the previous number of similar projects, but that is exactly the point shale producers make, their production is more marginally driven.

Dr Fatih Birol, the IEA’s Executive Director. “But this is no time for complacency. We don’t see a peak in oil demand any time soon. And unless investments globally rebound sharply, a new period of price volatility looms on the horizon.”

I understand the IEA may want low prices for consumers permanently but that isn’t rational for E&P companies who need a return on capital? Volatility would surely come as a result of large changes in the supply or demand in an industry with a relatively long-run supply curve for larger increases in marginal demand? Volatility in prices is the result of one side of the market being unable to respond to the other and there is limited evidence of that at the moment.

Not investing isn’t necessarily complacency it looks like rationality. E&P companies projects are fundamentally riskier when the variation in oil prices can be anywhere from USD 30 to USD 130 pboe, they need greater returns to cover that risk. The lesser investment could well lead to higher, more stable prices, on lower supply because that is the rational way to behave given past overinvestment cycles. E&P companies certainly don’t have to worry that the offshore supply chain could not assist in raising production very quickly, given the severe over capacity, a situation very different to past downturns.

Shale has become a manufacturing process like any other and subject to declining unit costs and experience curves as the Rystad Energy graph makes clear. For well over 150 years the US economy has been defined by an ability to reduce unit costs through productivity increases. Given the opportunity to make money in shale by continuing to do this I see no reason why this trend should not continue.

OGFJ_FEB17_1_wellhead_be

As a comparison:

US Steel Stocks versus Output

Offshore energy has advantages with larger reserve access and lower per unit costs. But the big disadvantage offshore has is that by its very nature it is non-standardised and it is very unlikely in the future this will change given the engineering challenges. The price reductions at the moment are the result of overcapacity and financial losses, not an increase in productivity, as is occurring in shale. This is not sustainable and prices for the supply chain will have to rise for the offshore supply chain to be viable again.

This ties in with the behavior that supermajors have been making in their investment programmes e.g. Chevron announced yesterday that offshore CAPEX would be USD ~12bn, a 30% drop from 2016, but still 67% of the total budget, which is down 12% YOY. Exxon has announced USD 25bn of CAPEX for 2017 with 1/3 for shale rising to 1/2 in a few years. The higher constant capital cost for shale, but shorter lead times, may mean marginal demand and supply are more easily balanced via pricing than has traditionally been the case in the past. E&P companies are not ignoring offshore but are using it for a large base of supply while having flexibility at the margin to change their capital and operating costs in a way offshore simply cannot offer.

The losses that have been sustained in the offshore supply chain by investors, and the growth of shale, point to a few constant themes to me here:

  1. There will need to be a “boom” to encourage new investment in offshore. When oil prices can be significantly below project forecasts for ~5 years then you need to make a higher return as an investor. That won’t be a boom it will be a return to a rational economic pricing level where supply and demand meet.
  2. A smaller number of offshore mega-projects could supply the base of new energy supply while shale picks up the more variable, and uncertain, demand.
  3. In order to ensure unit costs are lower the offshore supply chain is likely to be significantly more integrated into E&P companies than is currently the case. It is simply not viable to build USD 700m rigs and USD 100m vessels and have them on the spot market. Banks and financiers will insist on a better risk sharing mechanism (slowly and over time) or the capital required for these units (and therefore the day-rates that E&P companies pay) will become irrational and uncompetitive.  Brazil, so long an outlier for the lack of spot market, may, in fact, become a model for the sort of integration required to make offshore more competitive (in theory not fact as anyone who has worked for Petrobras can testify).
  4. This new industry structure will favour larger companies with a more diversified asset base.
  5. The real worry for basins such as the North Sea is that in size the projects are more akin to shale, but in economics closer to deep water, and therefore as a risk/return basis they look unattractive. That is not the end of the North Sea but it does mean all but the most attractive small fields are developed. It is very bad news for the supply chain which has built a fleet for far greater demand.
  6. Given current supply levels a “boom” offshore production is unlikely to flow through to the supply chain given current capacity levels.

Markets can remain “irrational” longer than you can remain solvent…

This cheery news came in from Hornbeck today (shares down only 2% so let’s not start the EMH debate now):

The Company projects that, even with the current depressed operating levels, cash generated from operations together with cash on hand should be sufficient to fund its operations and commitments at least through the end of its current guidance period ending December 31, 2018.  However, the Company does not currently expect to have sufficient liquidity to repay its three tranches of funded unsecured debt outstanding that mature in fiscal years 2019, 2020 and 2021, respectively, as they come due, absent a refinancing or restructuring of such debt.

That is on the back of poor numbers from DOF yesterday, in which a restructuring/refinancing of DOF Subsea is clearly an issue, and yet another month of no work for the Nor vessels, to pick just a couple of examples… I could go on. I know Europeans like to look down on the American fleets, and technically they are clearly not as good as the European tonnage,  but by virtue of market size they represent a bellweather of the industry, and the fact is it is across the board. I still feel Aker/ DSS caught a falling knife in supply rather than using capital to solve a structural issue. The price at which Hornbeck (and Tidewater) solve their financing will be interesting. Quite why Solstad didn’t leave these scale companies to sort out supply and stick to OSV/CSVs, where you can hopefully build some value into service delivery and therefore boost Enterprise Value, is beyond me.

Is there a bull case? Am I being too negative? I came across this graph from Surplus Energy Economics (a great blog I have just discovered and while I don’t agree with everything it’s very well written), from this article:

Average Annual Oil Price (constant 2015 dollars)

oil-price-trend-since-1965

It’s all the bulls in offshore have got left. The arugument is that this is a temporary dislocation in demand for offshore energy and maintenance services and that shale will hit the limits of its production and energy prices will return to their long-term averages and we can all go back to beer and skittles and the demand/supply imbalance will disappear.

The problem with trends is getting caught in the middle of a bad period. I am a believer in offshore energy long-term, I just worry about the running costs of the vessels to get there, and there is a real risk of moving too early in these assets given the high carry cost. In some options time is your friend, not in OSV/CSVs… The potential equity “funding gap”, between when the red line causes day rates and utilisation to increase, is the key question facing the industry and investors.

If you brought an OSV in 1994 and sold it in 2001 it wasn’t a great investment generally. 1985 to 1999 was generally a poor time to be in oil services as an investor. Alternatively, you could be like Bibby Offshore and by a North Sea class DSV for USD 10m in 2003, just before a boom in day rates, and make extremely high risk weighted returns. The core issue (as always) is when demand comes back to signficantly increase utilisation and day rates. The offshore industry is going into this downturn with a number of vessels beyond comprehension in any previous decline and with a new competitor at the margin in shale.

Financial return depends on the the numerator (cash flow) and the denominator  (discount rate) when assessing returns (CF/DR). Its not enough that day rates bounce back its the money injected in the interim. A really clever financial model could be made showing the equity gap for offshore vessel operators between now and a market recovery, but it depends on the gradient of the red slope as much as the current running cost. But as no one knows when demand will come back its not just the numerator that is important its the denominator to reflect the risk of this happening. Discounting is a brutal game, invest a dollar now with no payback, at only a 15% return (and frankly I would want more for buying such expensive options), and you calculating on only a .65 return in the dollar in three years to break even, on depreciating assets in an oversupplied market that is a bold call. A 30% IRR (common to alternative investors) is equivalent to a .45 return on the dollar in three years. A discount hurdle in day rates that just seems extremely unlikely to be met given the oversupply.

One of the areas I disagree with Surplus Energy is the view that shale cannot reduce the absolute cost of production. As I have written before shale demonstrably has. Anyone who bets against the ingenuity of US engineers to drive down economies of scale and scope, and find capital market support to do it, is making a very big call, and not one backed by many examples. Small shale wells appear susceptible to standardisation that will push the cost curve down again. I don’t see Moore’s law kicking in but the fact is the shale industry is relatively immature and suffered huge bottlenecks in the last boom. Yes, shale is using the best acreage at the moment, so productivity numbers are boosted, but the supply chain is in its infancy in terms of driving down unit costs. However, whether enough acreage can be brought on quickly enough is the defining question.

I am a long-term believer in offshore. Deepwater projects  by there nature are one-off projects that are hard to standardize. They require huge investments in project specific engineering and fabrication (i.e. a much higher CAPEX) but they can offer much higher, and more consistent, flow rates (i.e. substantially lower OPEX/unit) and therefore they will be part of the energy mix going forward. These sorts of projects offer huge scope for contractors to add value and therefore earn above average rates of return. Infield projects are going to be far more challenging: launch it at the wrong time and your entire 5-7 year operational period could be one of low prices. That will significantly raise the hurdle rate for these projects.

[Headline is from the Great Man].