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.

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.

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.

Reach(ing) for the absurd… Structure-Conduct-Performance

Situations emerge in the process of creative destruction in which many firms may have to perish that nevertheless would be able to live on vigorously and usefully if they could weather a particular storm.

Joseph A. Schumpeter

I have been busy lately and therefore not had as much time to write as I would like. I am working on a longer post about how much a North Sea DSV is worth (following the Nor and Bibby results), and another post on DeepSea Supply. But the constant theme in the market at the moment seems to be that no matter how bad the numbers are to claim an increase in tendering activity, as if all will be well if we just hold on a little longer, and it is this that has forced me to write…

The most logical explanation, borne out by the numbers at the moment, is that tendering is increasing because those putting out the tenders have realised there is a marginal benefit in doing so: they get cheaper prices and do not face diminishing returns from the increasing tender costs. Such an explanation fits easily with everyone reporting declining margins (Maersk, Bibby, Reach, Bourbon, DeepOcean, Solstad etc.,) across the entire supply chain while unanimously claiming to be tendering more. I get contracting lags tenders, and at some point this will mean that tenders will increase prior to work, but it simply isn’t happening at the moment: the schedules are still being cut and work delayed as all those reporting weaker numbers tell you, with no sense of apparent irony, at the same time as they report increased tendering activity.

I still feel that many people in the industry haven’t yet come to grips with the scale of change in the supply change that will be necessary for the market to balance and the structural nature of that change. Until investors who don’t understand this have been flushed out, and it would appear that this will only happen when they have faced mutliple capital injections at ever decreasing rates of return, the entire supply chain will suffer with profitability and utilisation issues.

Reach Subsea reported results and commentary this week in exactly this vein. The ROV industry in particular reminds me of my first job in NZ when a couple of weeks into it someone flew down from Germany to have a strategy meeting with us. “We are going to grow twice as fast as the market” he stated, when I asked “Isn’t everyone else saying this at their planning day as well, so what are we going to do differently” I realised my career at this company was off to a bad start. (I also realised that marketing wasn’t for me. Although the hilarity did ensue when the said individual returned later in the year (1997) to demand higher returns as the Asian currency crisis was having a poor effect on his P&L. When I pointed out 65% of NZ’s trade balance came from APEC countries I was pleased to have a UK passport.

Collectively it is axiomatic that the sum of all firms in the industry can only be equal to the market size and the overall market growth rate. Yet everyone in the ROV space at the moment claims to be growing market share or holding up despite new companies launching and no one making any money.

ROV systems are preferable to own over an offshore vessel only because they don’t have the running costs and you can put them in a warehouse until a recovery appears. But the ROV industry has very low barriers to entry, are in huge oversupply, and the industry is dominated by 5 very well capitalised and global companies. I have lost count of the number of companies striking a deal with a vessel owner to put the system on for free while they take the risk and cost of tendering on. It is not an original business model.

This graph from the market leader, Oceaneering, makes it clear the scale of the large companies:

ROV Market 2017

Source: MS Presentation, May 2017, IHS Data

And the largest company in the market (OII) has poor utilisation and a day rate reduction of 25% since 2014:

OII fleet utilisation.png

The question is really why you would want to go long on this market? Reach to be clear has 6 systems while OII has 282. Four competitors control more than 50% of the market. This is a market that has declined significantly in the last couple of years and seen a small number of new competitors (i.e. M2) come in and buy assets below depreciated value from previously bankrupt companies. If you speak to anyone in the market at the ROV companies they will tell you they are giving away the ROV for free and trying to make money off the personnel and mobilisations. It is a totally unsustainable business model.

The only economically rational strategy here is for a massive consolidation amongst the larger industry players, starting with the grey quarter in the graph who don’t even get their own colour. There is no differentiation in the end product to the customer and no ability for ROV contractors to add value in all but a few extreme circumstances. The longer investors support companies like this the longer the entire industry will operate at below a profitability level required to get CapEx to equal depreciation and ROE to equal the cost of capital.

Reach to be clear reported revenue down more than 50% on the same period last year but at the same time like everyone else reported increased tendering. Reach are krill that will eventually be eaten by a blue whale (hence the photo). I understand that smaller contractors face risks where one vessel is in proportion a larger part of their business, but that just reinforces the economic necessity of having the assets controlled by a larger firm, because the cost base doesn’t vary by the same amount and the lack the scale and scope required to market and develop such assets.

I also noted in the Reach private placement memo this note about their strategy:

8.9 The Group’s strategy

The strategy of the Group in a five-year perspective, could be outlined as follows:

8.9.1 Strategy in the OPEX-market (fields in operation)

  • Target IMR frame agreements
  • Export of North Sea technology and standards to selected major deepwater areas in the world (emphasis added)
  • Provide new services in the segment
  • Bid for seasonal contracts in key regions  (FTSS: Really?)

8.9.2 Strategy in the CAPEX-market (fields under construction)

  • The goal is to be a preferred subcontractor to the major EPIC subsea contractors
  • Securing the right assets will be key (FTSS: They are everywhere and in huge quantity, no problem)
  • Gradually develop assets and resource base
  • Do smaller EPIC-contracts at own risk

8.9.3 International expansion (FTSS: And take market share off who? How?)

  • Develop the international market in parallel with the North Sea market when opportunities appear
  • Seek international partners in selected areas like Australia, Mexico, Brazil and West Africa
  • Develop a foothold in new deepwater areas

8.9.4 Asset base

  • Invest in new assets (FTSS: Why?! The industry has overcapacity)
  • Secure the right assets
  • Mix of owned and hired equipment

I don’t know when I have disagreed with something more. Firstly, if offshore is to grow as industry it needs to compete on cost and that means the North Sea becoming more like the rest of the world not the other way around. Taking the North Sea standard overseas is a proven failure. Bibby tried it in the Gulf of Mexico with disastrous results, and in Asia with a DSV, it was worth trying in Asia but it wasn’t needed or wanted. Technip did the same in Australia. Anyone who thinks they can take the North Sea standard out of the North Sea hasn’t been out of the region. The North Sea is like it is because a) the environmental conditions are more severe than anywhere else, and b) the regulatory environment. You can’t force E&P companies to add to their cost base when it adds no value in the current environment.

If Reach are looking to expand internationally in a declining market then someone else is losing market share. Call me sceptical but in this market that is simply unrealistic. That a company with 6 systems, could have the resources to do this and start to drive consolidation when they are 276 systems behind the market leader isn’t real.

OII and others have literally tens of spare systems, they make them, and are giving them away for free. OII and others are here for as long as there is an industry (and OII have a current market cap of USD 2.3bn). I am not saying Reach is a bad investment (I don’t give investment advice), although it does strike me that it is an asymetric payoff where either someone buys them at a takeover premium, or they slowly make a return at less than their cost of capital and eventually funding runs out. Quite why you would pay higher than NAV for some ROVs which are cheaper on the second hand market and some vessel commitments is beyond me though.

I could go on. I don’t want to do a hatchet job on Reach, that isn’t my point. My point is simply that this industry needs to be signficantly smaller on the supply side and that this requires letting some firms go under. The economic rationale is called the structure-conduct-performance paradigm and is a well known feature of industrial organisation analysis. Porter’s five forces model (that all MBA’s learn), is based on this intellectual strand and the simple expedient that industry effects can be stronger than firm effects (there is much more to this and it deserves a much bigger piece for another day, including the move in the 80’s to the Resource-Based view of the firm which argues that firm effects are stronger and markets not so deterministic:, but in a consolidating industry the evidence is clear). No matter how competent the management of Reach Subsea are, and they clearly are skilled operators, they cannot in the long run compete against market structures so entrenched and differing in scale. Path dependency counts.

The offshore supply chain is clearly going to evolve in a way that was very different from the past. In the pre-2014 environment the industry had large numbers of small subcontractors, like Reach, who made money because the big companies were too busy, and making too much money, to concentrate on the small stuff. That isn’t the case now where they are under pressure to supply assets with very high fixed costs at below breakeven to win work. In order to do that they using the supply chain for ROVs (and other equipment) to supply their kit at below cost and ensure both sides lose their equity. When there is no more for the supply chain to give they will internalise the costs and reduce unit costs where possible. There is no other way this will play out.

Financial investors like Standard Drilling (PSVs), Nor Offshore (DSVs), Reach (ROVs) have all brought in expecting this was some temporary downturn and thought prices would start rising, as per previous models, and then they would then be handsomely rewarded for their (sic) foresight. It is becoming apparent now that this is not the right narrative: this is a structural downturn (Rystad  put a demand return in 10 years!). Only last week I learnt Shell was making a major commitment to ROVs on platforms (again) to consistently reduce OpEx where previously they had used vessels. Examples like this are legion, and I believe in total these stories to be representative of a wider and deeper change where E&P companies will seek to drive down unit costs offshore and this favours consolidation in the industry. So far the numbers are with my theory.

The beauty of capitalism is that you can place bets with money that help determine the outcome. I could be wrong and some huge, totally unexpected, market recovery could take place. The investors in the Nor vessels have so far been way off in their judgement, and I believe Standard Drilling have as well. Let’s see with Reach. But as long as there are investors for companies like this out there, and demand remains at current levels, expect to read plenty more stories about increased tendering while digesting appalling financial results.

More Uber madness… Devil take the hindmost…

The additional rise above the true capital will only be imaginary; one added to one, by any stretch of vulgar arithmetic will never make three and a half, consequently all fictitious value must be a loss to some person or other first or last. The only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost

A participant in the South Sea Bubble quoted in “The South Sea Bubble”, John Carswell, 

 

I’ve decided to keep a vague running tab on Uber. It’s an investment bubble, I don’t know quite how its’s going to pop… but it’s going to. My previous thoughts are here. In his Nobel award lecture “Speculative asset bubbles” Robert Shiller defines and investment bubble as:

[a] situation in which news of price increases spurs investor enthusiasm which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase and bringing in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawnto it partly through envy of others’ successes and partly through a gambler’s excitement.

Nothing seems to sum up the investment psychology of Uber more. Having watched the extraordinary returns others have made in companies such as Facebook, and seen a group of tier 1 VC’s get involved, the next round gets fund managers involved (at USD 40bn), and then gets a sovereign wealth fund involved to keep the valuation at USD 62.5bn. I quite like the irony of getting the Saudi’s to put in USD 3.5bn into an unprofitable Uber while convincing them to sell shares in Saudi Aramco… kind of like bait and switch only better… a new modern version of Petrodollar recycling but without the adverse consequences?

This week Uber announced the were gearing up for a flying taxi service:

Uber Technologies Inc. disclosed the initial steps of its air-travel vision this week, announcing five partner companies with various specialties aimed at making the sci-fi staple affordable and common. The initial testing is expected in 2020 in Dallas and Dubai, two car-clogged cities where aviation interests wield great influence.

“If you’re not planting the seeds for five, 10 years out, you have no company in five to 10 years,” Jeff Holden, Uber’s chief product officer, said.

The cynic in me see’s this a) as the equivalent of vapourware and b) a desperate attempt to show there may be some inherent value in a company that is clearly going backwards massively in terms at c. USD 2bn a year in cash terms. Uber are trying to fire the “gamblers excitement” that Shiller refers to (“don’t worry this taxi thing is just a smokescreen for our real route to profitability … autonomous drones…”)

But this line really tested my intellectual patience:

“There are a lot of compelling elements to this vision,” said Brian Wynne, president and CEO of the Association for Unmanned Vehicle Systems International, who attended the Uber event in Dallas this week where the plans were unveiled… 

“Whether this becomes a niche service … and how quickly it scales is anybody’s guess,” he said. “But they’ve got the demand.”

Don’t you need a price to gauge (potential) demand? I’ve got a lot of demand for a new Concorde from London to NYC at £500 per ticket… at £500 000 per ticket much less. It’s just all hype an no substance.

It’s not just me either… FT Alphaville (hardly the doyen of left-wing communism) came to the conclusion that:

[u]ltimately Uber’s success comes down to convincing the world that it has made a progressive leap by allocating cheap human resources towards the job of waiting around at the beck and call of an increasingly powerful elite.

From an aggregate economic allocation and welfare point of view that’s an obviously nuts proposition. What it amounts to is a transfer of labour from high productivity sectors to ultra low productivity sectors on the assumption that if this workforce is given autonomy over their non-productive time they can deploy it more efficiently in the market than if it was being allocated by a scaled-up specialist operator.

Since that, by definition, inhibits specialisation or skill acquisition in labour markets, all it really encourages is the purposeful unscaling of the economy and thus the entrenchment of a suppressed, underpaid, servant class with no prospect to ever benefit from a consumer surplus.

I sometimes think that all you need is an idea so outrageous sometimes it will get funding because people don’t want to say no. I half joke that I am thinking of registering the name http://www.chinaflng.com and then raising 10bn from investors and using it to buy a couple of broken VLCC’s for conversion purposes… and then worry about what to do… it’s a better idea than a $400 juicer…

Doug Evans, the company’s founder, would compare himself with Steve Jobs in his pursuit of juicing perfection. He declared that his juice press wields four tons of force—“enough to lift two Teslas,” he said. Google’s venture capital arm and other backers poured about $120 million into the startup. Juicero sells the machine for $400, plus the cost of individual juice packs delivered weekly. Tech blogs have dubbed it a “Keurig for juice.”

But after the product hit the market, some investors were surprised to discover a much cheaper alternative: You can squeeze the Juicero bags with your bare hands. Two backers said the final device was bulkier than what was originally pitched and that they were puzzled to find that customers could achieve similar results without it. Bloomberg performed its own press test, pitting a Juicero machine against a reporter’s grip. The experiment found that squeezing the bag yields nearly the same amount of juice just as quickly—and in some cases, faster—than using the device.

On second thoughts I am going to go with this… It will be an FLNG company that uses blockchain and has a cloud computing element to it with a big data social media engine driving it’s utilisation…. any maybe a really good juicer in the galley… please leave VC details in the comments section…

One day over a beer remind me to tell you the story of guy who walked into my office and wanted to build a fake tropical island in an abandoned Zeppelin factory, and then tried to shoot the messanger…

My Uber rant and the Gold Standard…

If a man has good corn or wood, or boards, or pigs, to sell, or can make better chairs or knives, crucibles or church organs, than anybody else, you will find a broad hard-beaten road to his house, though it be in the woods.

– Ralph Waldo Emerson
“I landed in this country with $2.50 in cash and $1 million in hopes, and those hopes never left me”
Charles Ponzi

As someone who has predicted 9 of the last 0 housing crashes in NZ I like to think I know an investment bubble when I see one… and nothing gets me more confused than the valuation of Uber at a cheeky USD 69bn. I should point out a clear conflict of interest here: I own a taxi license: Auckland Coop 466 is mine, a legacy and one I am reluctant to give up mainly for historical reasons (my father left it to me rather than economic reasons).

But Uber does my head in… I don’t think I am a Luddite, but it’s just so transparently not what it says it is: namely I don’t see any innovation just regulatory arbitrage and the collision of money and politics. The main thing they seemed to have achieved is to avoid the classification of a smartphone as a taxi meter, and therefore any of the regulatory costs that come with that. Taxis have always been defined by the meter, which enabled them fairly and transparently to show people how they were charging, combined with a host of regulations (including safety) they pushed the costs up far above what anyone with a private license and car could offer their services at. It was seen as collectively better for society to ensure that you knew a safe and regulated car was turning up, that was insured etc. Uber drivers also don’t get the same levels of insurance as licensed hire cars, nor undergo the same sort of licensing checks.

In other words, Uber’s costs are cheaper not because they have invented a better mousetrap but because they operate in an environment where the smartphone that catches the mouse is not called a mousetrap (with apologies to Emerson) even though it catches mice. I am not sure any of the reductions in regulations and insurance are in the long-term interests of consumers, but I may be biased, but then again I also know someone who lost their private hire license after a stroke and considered driving for Uber instead as he only needed a normal drivers license without a health check.

The constant need of Uber to fight it out in court, where they seem to be losing a number of battles such as Denmark, Brazil, and cities like Prague, show this isn’t minority view. And maybe that is what grates the most, the whole corporate mien of Uber. I read this today from INET (please read the whole thing):

In one of these countries live members of what Temin calls the “FTE sector” (named for finance, technology, and electronics, the industries which largely support its growth). These are the 20 percent of Americans who enjoy college educations, have good jobs, and sleep soundly knowing that they have not only enough money to meet life’s challenges, but also social networks to bolster their success…

Politicians increasingly influenced by the FTE sector turned from public-spirited universalism to free-market individualism. As money-driven politics accelerated (a phenomenon explained by the Investment Theory of Politics, as Temin explains), leaders of the FTE sector became increasingly emboldened to ignore the needs of members of the low-wage sector, or even to actively work against them.

When David Cameron was Prime Minister he claimed to be looking after the little guy. But the little guy was a tax paying guy from Essex who had done three years training to get “the knowledge” who then found his income dramatically cut by a fleet unregulated and unregistered drivers. Coincidentally his head of strategy, Steve Hilton, was married to Rachel Whetstone, who headed up Uber’s PR department in London… and behind closed doors… Which explains why a traditional group of self-employed business, traditional Tory voters were hung out to dry. It’s why Travis Kalnick can yell at an Uber driver… I could go on…

I get it: Uber is cheap, and in the new gig economy we all like cheap. But is it economic? For a thorough demolition of the business model read Naked Capitalism. I really like this part:

By contrast, in the hundred years since the first motorized taxi, there has been no evidence of significant scale economies in the urban car service industry. That explains why successful operators never expanded to other cities and why there was no natural tendency towards concentration in individual markets. Drivers, vehicles and fuel account for 85% of urban car service costs. None of these costs decline significantly as companies grow. As the P&L data above demonstrates, Uber has not discovered a magical new way to drive down unit costs.

The whole thing is worthy of a read. Nothing beats a good bit of iconoclasm when it’s grounded in fact.

I especially like the revelation that two investment banks passed on marketing the private company to their high-net-worth customers after reviewing a prospectus with no revenue or profitability data (at 290 pages!). Not all did: caveat emptor!

The words Ponzi scheme are used, and the Uber valuation clearly is one. Not because there is any fraud involved, but because the last people in depend on more people coming into ever show a profit. With a 2bn operating loss those people will get harder to find… eventually… The cynic would argue the investment banks have gone through the institutional money making small portfolio bets, then moved on to individuals who are much less astute…

I prefer the arbitrage comparison. Charles Ponzi’s original scheme  had the basis of sound economics (more so than Uber after reading the Naked Capitalism posts), if it worked; but it was also based on regulatory arbitrage and the slow adaptation of international systems to economic change. In 1906, in the classical Gold Standard era , by agreement at the Universal Postal Congress (held in Italy) , world postal organisations agreed to a system of International Reply Coupons to make it easy to send funds abroad: as exchange rates were fixed to a pre-agreed formula the prices for the coupons were pre-agreed and locked in as well. When in 1919, under the interwar gold standard (where there was some exchange rate flexibility), someone sent Ponzi an IRC from Spain that cost 30 centavos that could be exchanged for US 5c and Charles Ponzi realised there was a riskless profit to be made as the Spanish currency had recently devalued.

And Ponzi was right, but like Uber part of the economic problem rested with scale, and Ponzi simply couldn’t organise to purchase enough of these coupons to make the profits he had promised investors. The mistake, the fraud,  he then made was to claim he had a network of agents buying IRCs in various countries and that there was a viable business underpinning this that could go on indefinitely; he then hired a network of agents in the US, paid them more than the arbitrage profit levels to collect “investments”, and collected the money coming in paying out those who wanted to be cashed out with the money coming in. (One could also add the stupidity of investors was not realising that riskless profits would be traded away).

Uber does appear to be a business that takes advantage of regulatory arbitrage on a global scale and it obviously, based on five years of operating performance and financial results, requires massive scale if it is ever going to work at all.   I buy the argument that actually the industry structure and economics don’t work that Naked Capitalism make so eloquently so I won’t bother doing anything other than quoting some more of it:

If rapid growth could not drive major margin improvements between 2012 and 2016, there is no reason to believe that Uber will suddenly find billions in scale economies going forward. Fundamentally digital companies like Amazon, EBay, Google and Facebook had massive operating scale economies because the marginal cost of expanded operations was close to zero. Aggressive pricing fueled the growth that drove major margin improvements and also created major consumer welfare benefits.

What all the other big names like Google, Facebook and Amazon achieved were increasing returns to scale where fixed costs remain virtually unchanged even as revenue grew massively and hence dramatically lowered unit costs. Unless Uber could find some way of changing this equation they simply cannot trade forever on at the same price level as a company that does this as they require dramatically more cash (mainly in subsidies by the look of it). The next pricing round promises to be extremely interesting because if Naked Capitalism is right it’s not simply that it should be done at a lower number it’s clearly that there is no inherent economic value in the business at all… which is also like Ponzi…

I’d rather be lucky than smart…

and these people were clearly both…

For the past year, Google’s car project has been a talent sieve, thanks to leadership changes, strategy doubts, new startup dreams and rivals luring self-driving technology experts. Another force pushing people out? Money. A lot of it. 

Early staffers had an unusual compensation system that awarded supersized payouts based on the project’s value. By late 2015, the numbers were so big that several veteran members didn’t need the job security anymore, making them more open to other opportunities, according to people familiar with the situation. Two people called it “F-you money.”