Investment will be sufficient…

I think this is very big news for offshore energy:

“Over the next 10 years, we see that supply will continue to keep up with demand growth,” said Espen Erlingsen, an analyst at Oslo-based consultant Rystad. “The surge in North American shale activity and start up of new fields are the main drivers for this growth.”…

The upshot is that it costs less to expand global oil production today than it did back in 2014. Rystad said industry spending in recent years will deliver the necessary 7 percent growth in global oil production to just over 103 million barrels a day by the end of the decade. That trend will continue over the next 10 years if oil remains between $60 and $70 a barrel, it said.

For as long as the downturn in offshore has been going on the Demand Fairy of recovery has been posited on the seemingly axiomatic logic that insufficient investment now would bring a boom in demand in later years and only offshore could supply this capacity. Indeed almost every restructuring presentation or positive talking up on the sector seemed to have a variation on this theme, it was the meme that made a quick recovery believable to those determined to try.

Rystad appear to have re-run their models with the structural break I referred to earlier, where altering the volume of output to the value of input, produces much higher output levels than previously assumed. Rystad aren’t saying there won’t be growth, but it will not be exponential driven by a supply shortage, in the next three years anyway, and maybe not for the next ten years. ‘Lower for longer’ might not be strictly accurate for the oil price but it is likely to be for rig and vessel rates. And magically supply will equal demand. Just as the shale pessimists always had a mind numbingly boggling theory about how it could never work in the long run, so the offshore bulls have always stuck to their theory that the market was being irrational in the short-term and would eventually see sense. The longer the downturn has gone on the more unsustainable that argument has become.

Interestingly offshore global investment (not defined) rises from $164bn in 2018 and 31% of total spend ($345bn/39% in 2014!) to $189bn and 32% of total investment spend in 2020 (a compound growth of ~7%). Shale goes from 12% in 2016 to 24% in 2020. Total upstream CapEx drops from $890bn to $584bn from 2014 to 2020 in the Rystad forecast. If that is correct (even directionally) it is a severely deflationary market environment with huge implications for asset values and solvency going forward.

The IEA says spending dropped about $338 billion, or 44 percent, between 2014 and 2017.

The shale revolution is real and here to stay and it is completely unrealistic for the offshore supply chain not to accept the scale of change required to adapt to this new environment. If you see a “recovery play” that doesn’t explain how it works within this macro context, or how this is wrong, then it isn’t realistic. Expect to hear the phrase “we are doing a lot more tendering” instead of an intelligent response.

The oil market was previously very cyclical because there was no short-cycle marginal prodcuer who could respond quickly to changes in demand. Investment was hugely cyclical because of this. Supply was met with a series of large and lumpy projects planned years in advance and oil companies erred on the side of caution in doing so. Marginal production was supplied by smaller tier two producers who were predominantly offshore. The price change-to-output response time was slow but could be brutal as the downturn in oil price in 2009 showed where a host of small high cost producers went bankrupt. [Read Spencer Dale!].

Now US shale producers are very responsive to price trends and production increases as price does. This is the major change to the market and it is such a significant change that this is why it is (rightly) called “the shale revolution”. It was a price-output feedback meachanism that simply didn’t exist before. Yes, shale might be more expensive, but it is an immediate dollar of revenue, lower risk and lower margin because of it, and that is what the marginal barrel, the next barrel of oil required for the market to balance, should be priced at. Oil as a spot market will be less cyclical going forward as the market responds more incrementally to price changes, a point that Rystad effectively make above.

In a more rational market, with smaller supply/demand imbalance the logical solution would be for larger vessel and rig companies to get into a series of longer term contracts with E&P companies for the provision of assets. This would reduce the cost of ownership (and finance) and therefore the day rate, and also reduce the risk of oversupply. Over time the market may well go this way and this will drive real consolidation, particularly in the offshore supply market, smaller operators of high-end OSVs will become a relic. But for the moment the E&P companies will simply take advantage of the over-supply to gain access to an asset at below it’s economic cost.

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.

Market forecasts as structural breaks….[Wonkish]

Not for everyone this post but important if you are involved in strategic planning. The above chart is from the latest Subsea 7 Q1 numbers. The problem I have with these charts is what statisticians call “structural breaks“. Basically if the underlying data has changed then you need to change your forecast methodology. As I have argued here and here (although it’s a general themse of this blog) I think there is sufficient evidence that large E&P companies are commissioning less offshore projects when they become economically viable in the past on NPV basis. I am not sure that all the forecast models reflect this.

This break in the historical patterns has really important forecasting implications because when you see whichever market forecast  it has made an assumption, whether formally through a regression model or on a project-by-project basis, that x number of projects will be commissioned at y price of oil (outside of short term data which logs actual approvals). If there has been a stuctural change in the demand side then y (commissioned offshore projects) will be lower, and on a lower trajectory to x (the oil price) permanently, than past cycles.

E&P companies are not perfectly rational. As the oil price gets to $60 there is no set programme that triggers a project. For sure the longer the price stays high it increases the probability of projects being commissioned but it is a probability and the time scale of has changed I would argue. I think it is why demand has surprised many on the downside because there has been a change in the forecast relationship between offshore projects and the spot price of oil.