Overdiscounting… the future of offshore…

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

Adam Smith, 1759

 

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

John Maynard Keynes, 1936

 

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

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

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

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

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

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

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

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

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

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

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

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

 

Sunny Sunday afternoon reading…

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

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

[on Permian growth:]

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

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

Shale productivity…

Woodmac ask:

Woodmac Shale Prod

Whereas others highlight increasing efficiency from opening wells:

Shale prod open well.JPG

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

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

Shale cost forecast.png

With this comment:

Shale breakeven level words.png

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

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

$60 is the new $100…

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

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

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

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

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

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

Data and theory…

Above is the BH rig count ending Friday last week. Look at the change in rig numbers a year ago…

When the facts fit the theory (here and here for example) it might be time to accept the logic?

There is definitely a strong “recovery” in some parts of the oil and gas industry… it’s just in offshore the supply side is stronger than what appears to be a very weak demand side recovery?

Offshore project approvals Q1 2018.png

Source: Ensco.

State of the nation…a slow trip towards equilibrium…

Loads of news happening that seems to sum up to me the state of where the offshore and subsea industry is at the moment. Dare I say it but we appear to be approaching a sort of equilibrium point where demand and supply are converging around more stable levels.

The FT reported on Monday that:

The US shale oil revolution has reached a landmark moment, with the sector’s top companies for the first time earning enough cash to cover the cost of new wells…

From the time the first shale oil test wells were drilled in the US in 2008-09, the industry’s capital expenditure has exceeded its cash from operations, with producers only able to stay in business by attracting hundreds of billions of dollars in financing from bond and share sales and bank loans. From 2008 to 2017, US exploration and production companies raised $293bn from bond sales, according to Dealogic.

That is what should happen to a marginal producer: they must become profitable at a cash flow (and economic) level so there is an incentive for them to supply the next barrel of oil required. The great hope for some in offshore that shale was an ephemeral phenomenon can be firmly put aside.  To put that bond number into perspective the UKCS spent £14bn offshore in 2014, its best year ever! Efficient US capital markets have channelled the funds into an industry where the long term prize was clear.  And as I constantly say here it wasn’t just a capital story it is a productivity story:

Scott Sheffield, chairman of Pioneer Natural Resources, said its wells in the Permian Basin of Texas and New Mexico were now 300 per cent more productive than four years ago, driving down the oil price needed for them to make a profit.

“In 2014 our break-even price in the Permian Basin was probably $55 or $60 a barrel,” he told the Columbia Global Energy Summit last week. “I would never have thought that the Permian Basin could drive down the break-even price to the low $20s. And we did it.”

So it is hardly surprising that today Heerema announced they are pulling out of pipe-lay, converting the Aegir to a heavy lift vessel that will also work on renewables, and laying off 350 people. The Aegir was only added to the fleet in 2013, yet a mere 5 years later the market has changed so much that a premium asset must now be re-engineered as a completely different economic proposition. I have statistical issues with microcosms but this struck me as one.

Heerema have called it right in my opinion: the deepwater lay market, and pipe-lay in general, is now totally over supplied. Some companies and assets will have to leave the industry in order for it to rebalance. Heerema simply doesn’t have the  financial resources or integrated solution of the “Big Three” (TechnipFMC, Subsea 7, Saipem).  Heerema were annoyed when EMAS seemed to copy many of the unique features of the Aegir for the Constellation (which is of course now in the Saipem fleet), but the economist in me says that only reflects how high returns have to be in this industry to reflect the risks. Saipem have arguably appropriated some of the value from the Aegir and Heerem’s IP…. although the trade-off was an asset built in TriYards Vietnam so maybe it will all even out… Quite what move Allseas makes next remains to be seen but they must be starting to feel lonely.

Maintenance spend will increase as higher prices make it economic to refurbish older wells or those shut in now. But the installed base on which future demand predictions were made will be permanently smaller. Prices for E&P companies will eventually have to rise to recognise that someone building a $600-700m construction vessel, with no forward order book, is a very risky business model and investors need to be compensated for this. Especially when the downside can be at least a 50% discount to build cost in a managed sale.

But this time as the oil price has crept up E&P companies have failed to shine as in previous eras of rising prices as they are burdended with excessive debts and sceptical investors who want to share more of the upside in a boom. There is a very good article from Bloomberg here:

At fault, a toxic troika that combines gushing supply with fears that long-term demand will flat-line as electric vehicles and renewable energies grow, and climate change policies proliferate. And while cash flow for oil’s majors in 2018 is likely to be the highest in 12 years, investors are largely unmoved…

Oil executives acknowledge that it’s too soon to win back investors. Shell CEO Ben van Beurden has openly talked about a “credibility and track record gap” between the major oil companies and its shareholder base.

“We need to show a little bit longer we mean what we say in terms of capital discipline,” he told reporters last week. “This newfound religion and confidence is, to say the least, fragile.”…

“The investment community still is not sure we’re going to handle these higher prices with discipline,” BP Plc Chief Executive Officer Bob Dudley said Tuesday. “Then there’s a section of the investment community that wonders why we’re not investing more in batteries and cars and renewables.”

E&P versus market.JPG

You can see above that higher oil prices haven’t meant much for E&P companies. One central issue is CapEx spend where large companies are making a promise to investors not to spend on mega projects in an era of rising prices. Smaller companies, offshore companies, are struggling to get finance at all. If you want it set out explicitly here it is:

Big Oil’s first quarter results are “a chance at redemption” after a poor fourth quarter of 2017, Biraj Borkhataria, a London-based analyst at RBC Capital Markets wrote in a note. Investors will reward companies whose cash generation rises at the same rate as oil prices in the period, and no new plans to raise capital spending, he said.

Get that…? An increase in oil price goes out in debt reduction, dividends, and stock buy-back not offshore projects to increase supply. No to hitting the supply chain with massive orders that cause a spike in prices as the spot oil price increases.  E&P companies are going to make money in an  era of rising oil prices from higher prices, not from taking the money from rising prices and putting it into more production to take advantage of potentially higher prices in the future. It is a very different investment dynamic. It might change in the future, but it will take a long time to be felt in the offshore supply chain, and there is no guarantee it will.

And by the way it doesn’t matter if you believe the “toxic troika” theory or not… the people who buy the shares in E&P companies, and therefore ultimately fund large projects, do. And collectively they are making it harder for these projects to be funded by insisting on higher cash payments from E&P companies. So perception has become reality.

This is an environment that favours offshore field developments to supply a baseload of high volume/low lift cost supply while using shale for marginal demand. Some smaller field developments will of course happen, TechnipFMC has an good video here about how standardised they will be in shallow water for example, but it is harder not to see offshore developments being marked by larger projects or infield work.

This is a market heading for equilibrium, yes there will be rising oil prices, but no one, not even the E&P companies, feel like this is a boom. Yes, it is better for E&P companies than the offshore supply chain, although the onshore supply chain is booming in US onshore. A number of offshore contractors are making money, they are more than cash flow positive, but the order book is weak and few points utilisation either way is the difference between a breakeven and a loss. The supply side will still face a contraction, sensible M&A will occur, services will be more profitable than owning tonnage, and companies will make money. But returns in excess of the cost-of-capital look a long way off for the offshore industry given that the last boom showed how expensive the cost-of-capital should really be on a cyclically adjusted basis.

Bergen… a world leader in fracking advancement… who knew?

From the WaPo today:

Even better, scientists in Norway may have found a good way to store the captured carbon. At a conference in Vienna last summer, a team from the University of Bergen unveiled a promising advance in high-pressure oil and gas extraction. Rather than “fracking” underground rock formations to free trapped fuels, the scientists successfully injected carbon dioxide into core samples to force out trapped oil, leaving the carbon dioxide locked in its place. The new process “increased recoverable oil by an order of magnitude compared with fracking, and at the same time reduced the carbon footprint by associated CO2 storage,” the team summed up.

Fracking has been a game-changer for the U.S. economy, offering cheaper, cleaner fuel and the prospect of energy independence. But this process could be even better, if the Norwegian experiment can be proved in field tests. No more chemically contaminated water, no more fractured rocks and related earthquakes. Furthermore, by creating a lucrative market for large supplies of carbon dioxide, the new technology could drive rapid commercialization of “memzyme” scrubbers.

The full paper is here if anyone is interested.

My only real point with this, without wishing to sound repetitive, is that productivity improvements for shale seem to have significant further potential. Obviously ideas like this take a significant amount of time to come to fruition, but the will, resources, and capital to push the technical frontier for shale are clear. I imagine some tense moments in the bars of Bergen as the University staff explain to the boat owners and crew their idea and its potential implications for an “offshore recovery”…