Further evidence on the shale narrative and rational decisions…

The FT noted yesterday:

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

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

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

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

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

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

Diverging results point to the future of offshore… procyclicality reverses…

Colin, for example, has recently persuaded himself that the propensity to consume in terms of money is constant at all phases of the credit cycle.  He works out a figure for it and proposes to predict by using the result, regardless of the fact that his own investigations clearly show that it is not constant, in addition to the strong a priori reasons for regarding it as most unlikely that it can be so.

The point needs emphasising because the art of thinking in terms of models is a difficult–largely because it is an unaccustomed–practice. The pseudo-analogy with the physical sciences leads directly counter to the habit of mind which is most important for an economist proper to acquire…

One has to be constantly on guard against treating the material as constant and homogeneous in the same way that the material of the other sciences, in spite of its complexity, is constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple’s motives, on whether it is worth while falling to the ground, and whether the ground wanted the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth.

Keynes to Harrod, 1938

 

A, having one hundred pounds stock in trade, though pretty much in debt, gives it out to be worth three hundred pounds, on account of many privileges and advantages to which he is entitled. B, relying on A’s great wisdom and integrity, sues to be admitted partner on those terms, and accordingly buys three hundred pounds into the partnership.The trade being afterwords given out or discovered to be very improving, C comes in at fivehundred pounds; and afterwards D, at one thousand one hundred pounds. And the capital is then completed to two thousand pounds. If the partnership had gone no further than A and B, then A had got and B had lost one hundred pounds. If it had stopped at C, then A had got and C had lost two hundred pounds; and B had been where he was before: but D also coming in, A gains four hundred pounds, and B two hundred pounds; and C neither gains nor loses: but D loses six hundred pounds. Indeed, if A could show that the said capital was intrinsicallyworth four thousand and four hundred pounds, there would be no harm done to D; and B and C would have been obliged to him. But if the capital at first was worth but one hundred pounds, and increasedonly by subsequent partnership, it must then be acknowl-edged that B and C have been imposed on in their turns, and that unfortunate thoughtless D paid the piper.
A Adamson (1787) A History of Commerce (referring to the South Sea Bubble)

The Bank of England has defined procyclicality as follows:

  • First, in the short term, as the tendency to invest in a way that exacerbates market movements and contributes to asset price volatility, which can in turn contribute to asset price feedback loops. Asset price volatility has the potential to affect participants across financial markets, as well as to have longer-term macroeconomic effects; and
  • Second, in the medium term, as a tendency to invest in line with asset price and economic cycles, so that willingness to bear risk diminishes in periods of stress and increases in upturns.

Everyone is offshore recognises these traits: as the oil price rose and E&P companies started reporting record results offshore contractors had record profits. Contractors and E&P comapnies both began an investment boom, highly correlated, and on the back of this banks extended vast quantities of credit to both parties, when even the banks started getting nervous the high-yield market willingly obliged with even more credit to offshore contractors. And then the price of oil crashed an a dramatically different investment environment began.

What is procyclical on the way up with a debt boom always falls harder on the way down as a countercyclical reaction, and now the E&P companies are used to a capital light approach this is the new norm for offshore. The problem in macroeconomic terms, as I constantly repeat here, is that debt is an obligation fixed in constant numbers and as the second point above makes clear that in periods of stress for offshore contracting, such as now, the willingness to bear risk is low. Contractors with high leverage levels that required the industry to be substantially bigger cannot survive financially with new lower demand levels.

I mention this because the end of the asset bubble has truly been marked this week by the diverging results between the E&P companies and some of the large contractors. All the supermajors are now clearly a viable entities at USD 50 a barrel whereas the same cannot be said for offshore rig and vessel contractors who still face large over capacity issues.

This chart from Saipem nicely highlights the problem the offshore industry has:

Saipem backlog H1 2017 €mn

Saipem backlog Hi 2017.png

Not only has backlog in offshore Engineering and Construction dropped 13% but Saipem are working through it pretty quickly with new business at c.66% of revenues. The implication clearly being that there is a business here just 1/3 smaller than the current one. You can see why Subsea 7 worked so hard to buy the EMAS Chiyoda backlog because they added only $141m organically in Q2 with almost no new deepwater projects announced in the quarter.

It is not that industry conditions are “challenging” but clearly the industry is undergoing a secular shift to being a much smaller part of the investment profile for E&P companies and therefore a much smaller industry as the market is permanently contracting as this profile of Shell capex shows:

Shell Capex 2017

A billion here, a billion there, and pretty soon you are talking real money. The FT had a good article this week that highlighted how “Big Oil” are adapating to lower costs, and its all bad for the offshore supply chain:

The first six months of this year saw 15 large conventional upstream oil and gas projects given the green light, with reserves of about 8bn barrels of oil and oil equivalent, according to WoodMac. This compared with 12 projects approved in the whole of 2016, containing about 8.8bn barrels. However, activity remains far below the average 40 new developments approved annually between 2007 and 2013 and, with crude prices yo-yoing around $50 per barrel, analysts say the economics of conventional projects remain precarious.

Not all of these are offshore but the offshore supply chain built capacity for this demand and in fact more because utilisation was already slipping in 2014. And this statistic should terrify the offshore industry:

WoodMac says that half of all greenfield conventional projects awaiting a green light would not achieve a 15 per cent return on investment at long-term oil prices of $60 per barrel, raising “serious doubt” over their prospects for development. By this measure, there is twice as much undeveloped US shale oil capable of making money at $60 per barrel than there is conventional resources.

The backlog (or lack of) is the most worrying aspect for the financing of the whole industry. E&P companies have laid off so many engineers and slowed down so many FIDs that even if the price of oil jumped to $100 tomorrow (and no one believes that) it would take years to ramp up project delivery capacity anyway. Saipem and Subsea 7 are not exceptions they are large companies that highlight likely future work indicates that asset values at current levels may not be an anamoly for vessel and rig owners but the “new normal” as part of “lower for longer”.

I recently spoke to a senior E&P financier in Houston who is convinced “the man from Oaklahoma” is right but only because he thinks overcapacity will keep prices low: c. 50% of fracing costs come from sand, which isn’t subject to productivity improvements, and he is picking that low prices eventually catch up with the prices being paid for land. I still think that the more large E&P companies focus on improving efficiency will ensure this remains a robust source of production given their productivity improvements as Chevron’s results showed:

Chevron Permian Productivity 2017

Large oil came to the North Sea and turned it into a leading technical development centre for the rest of the world. Brazil would not be possible without the skills and competencies (e.g. HPHT) developed by the supermajors in the North Sea and I think once these same companies start focusing their R&D efforts on shale productivity will continue to increase and this will be at the expense of offshore.

It is now very clear that the supermajors, who count for the majority of complex deepwater developments that are the users of high-end vessel capacity, are very comfortable with current economic conditions. They have no incentive to binge on CapEx because even if prices go up rapidly that just means they can pay for it with current cash flow.

That means the ‘Demand Fairy’ isn’t saving anyone here and that asset values are probably a fair reflection of their economic earning potential. Now the process between banks and offshore contractors has become one of counter-cyclicality where the asset price-feedback loop is working in reverse: banks will not lend on offshore assets because no one knows (or wants to believe) the current values and therefore there are no transactions beyond absolute distress sales. This model has been well understood by economists modelling contracting credit and asset values:

Asset Prices and Credit Contracttion

Getting banks to allocate capital to offshore in the future will be very hard given the risk models used and historical losses. Offshore assets will clearly be subject to the self referencing model above.

I remain convinced that European banks and investors are doing a poor job compared to US investors about accepting the scale of their loss and the need for the industry to have significantly less capital and asset value than it does now. Too many investors thought this downturn was like 2007/08, when there was a quick rebound, and while this smoothed asset prices somewhat on the way down this cash was used mainly for liquidity, it is now running dry and not more will be available (e.e. Nor Offshore) at anything other than penal terms given the uncertainty. Until backlog is meaningfully added across the industry asset values should, in a rational world, remain extremely depressed and I believe they will.

Hasty generalisations and shale…

The being without an opinion is so painful to human nature that most people will leap to a hasty opinion rather than undergo it.

Walter Bagehot

John Dizzard in the FT this week spoke to a man from Oaklahoma and decided that the whole shale sector was just the result of market liquidity pumping money into the small debt financed E&P companies. Dizard suggests capital markets are “subsidising” the sector. This appears to have been a hasty generalisation… The data point appears to be based on Drilled-But-Uncompleted wells:

As one Oklahoma oil and gas man I know says: “There is still unlimited capital, and as long as that is true, you can grow anything. If the companies had been forced to live within their cash flow, then their production would go down. Then they would have run into a death spiral where nobody would want to invest in them.” The shale companies struggling with sub-$40 or sub-$50 oil prices were also able to live off the excess inventory of drilled-but-uncompleted (DUC) wells that had built up during the boom years.

As our Oklahoman says: “There were thousands of DUCs that had not been taken account of. The companies could just complete and connect those to offset the declines in production from older wells.”

The problem is I don’t see this:

DUC 17

Source: EIA, Baker Hughes, Jeffries

First of all we had the meme that shale was too expensive on a per unit basis, and now we have the meme that actually it is only possible because high-yield investors don’t understand what they are buying and funding. Admittedly HY doesn’t always get it right, as offshore bonds currently show, but to suggest that shale is solely the result of a capital misallocation is surely mistaken?

US capital markets are probably the most efficient in the world at adapting. The various restructurings happening in offshore (Paragon, Tidewater etc) highlight that banks and investors take the writedowns and move on. They are also efficient at funding companies for long periods prior to cash flow break even (Uber being the most notorious example). Shale is here to say it is only a question of how big it is.

Great Exepectations and Asset Values in The New Offshore…

“Suffering has been stronger than all other teaching, and has taught me to understand what your heart used to be. I have been bent and broken, but – I hope – into a better shape.”

Charles Dickens, Great Expectations

Further evidence of the narrative turning to shale:

When the facts change … ” Hall wrote to investors in his Stamford, Connecticut, hedge fund, Astenbeck Capital Management LLC, in a July 3 letter obtained by Bloomberg News. “Not only did sentiment plumb new depths but fundamentals appear to have materially worsened.”

U.S. shale drilling is expanding “at a surprisingly fast rate, thus raising the odds for significant oversupply in 2018, even if OPEC maintains its production cuts.”

“When the facts change … ” Hall wrote to investor… “Not only did sentiment plumb new depths but fundamentals appear to have materially worsened.”

U.S. shale drilling is expanding “at a surprisingly fast rate, thus raising the odds for significant oversupply in 2018, even if OPEC maintains its production cuts.”

Reuters notes:

“The market is in trouble and looks very vulnerable to lower numbers,” PVM brokerage said in a note.

I can’t help wondering if some of the private equity money that flooded the North Sea when the price declined in 2015/16 isn’t getting a little worried. The investors behind Siccar Point and Chrysoar for exmaple are some of the largest private equity funds in the world, and the transactions were de-risked by paying a contingent amount on prices following the transaction, but prices are lower than the dominant narrative was at closing and they surely weren’t based on a mid 40s oil price but rather a long-term appreciation trend? Both are very different as well with Siccar Point exposed to Clair Ridge and some new deepwater projects where as Chrysoar is more exposed to the legacy Shell assets. But even still the only viable exit is another massive private sale or preferably a listing and both these companies offer very poor growth prospects in a high cost environment in what are officially declining basins. For North Sea contractors the implications for future demand are serious given how well the new players like Ineos have been at driving down OpEx in other markets. And E&P company spending obviously drives spending for offshore contractors and therefore asset values…

I have gone on about this before but I think the downturn in 2008/09 has a lot to answer for when a short price dip was followed by a very healthy five year boom, but shale simply wasn’t such a big deal and OSV supply was more limited. Just as in offshore fields so in offshore support vessels: those who piled into the Harkand/Nor bonds were typical: Justin Patterson of Intermarket (www.intermarket.us) proudly announced he was a holder of record of the Nor/Harkand bonds in November 2016. Constrained in the number of opportunities in the sector they could buy into they were not interested in understanding the assets or the market, they would just buy and hold… what could go wrong?

The investment is of course now worthless. The Nor investors are discovering either you have a North Sea diving operation or the vessels are only worth what someone in Asia will pay, and that is an order of magnitude less than the implied depreciated value of a North Sea class DSV. There is no magic solution here and as I don’t believe the Demand Fairy will save people here. With a load of sellers of similar assets who would be willing to sell or charter for $1 cheaper than the Nor investors, whatever the price, they need a good story to tell here if they want to convince anyone there is value in their investment.

Surely at some point auditors are going to insist on more cash-flow based assessments of vessel values and that is likely to cause chaos in such investments because they all rely on the Greater Fool Theory at the moment? The Harkand/Nor DSVs are an egregious example of where the valuation of USD 58m per vessel for their last set of accounts simply bears no relation to any realistic sale price the assets may fetch, it may help people like Intermarket show a positive Fair Market Value in their accounts but it isn’t a real number. Similarly Bibby held their DSVs combined at over GBP 100m in the last accounts… collectively this means that 4 North Sea class DSVs that cannot be operated at even cash flow break even are worth in excess of USD 240m, despite no credible reports of an uptick in day rates and other comparable vessels such as the Vard Haldane for sale? Something will have to give and it won’t be economic reality or the “cash flow constraint” as Minsky recoognised.

Expectations of future cash flows are the main driving force of offshore asset transactions at the moment (as opposed to “valuations”) not concerns over lack of supply (so 2014) or the ease of selling the asset to someone else (so 2013). Barring a major change in demand therefore expect asset values to have been permanently impaired and wait for the auditors to start calling time as liquidity needs continue to strain companies that have made it this far despite the hoped for Great Expectations of the 2015/16 investment class.

A supply rich market…

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

IA-Energy-Shale-Oil-2007-2017

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

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

XOM AP Q1 17

The heading in this Conoco Phillips slide says it all:

CP Shale 17Q1.png

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

The New Offshore…

Another great graph from Rystad on Friday highlighting increased productivity in shale:

Rystad Av IP30

Offshore isn’t going away as this graph makes clear:

IEA Energy Mix June 2017

But it is going to be different, and the “Demand Fairy” isn’t going to make it like 2014 quickly:

IEA Capex

Change at the margin of an extra 1 or 2% of shale as a share of the energy mix will have a major effect on offshore utilisation and day and day rates. Offshore needs to deal with overcapacity on the supply side and the increasing productivity of shale which will only continue.

Liquidity. Strategy. Execution. Nothing else matters. The New Offshore.

 

 

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.