Subsea 7 and Conoco Phillips… industry bellwethers…

[N]othing can have value without being an object of utility.

Karl Marx

[I couldn’t agree more with the philosophy outlined in the Conoco Phillips graphic in the header].

A stark contrast in the fortunes of two companies reporting numbers yesterday and it doesn’t take a genius to work out that an E&P company (Conoco Phillips) is benefitting from a higher oil price while an offshore contractor (Subsea 7) is suffering from lower committed offshore spending. But I think it’s worth delving into a little deeper because the scale of the changes taking place in investment terms I think provide a note of guidance for how the future of the industry will look.

CP makes an excellent E&P company to use as an example. In 2015 CP announced they were giving up deepwater exploration but not deepwater production. All economic change occurs at the margin, the change in preferences of different actors in the economy melding into demand and supply curves which intersect at equilibrium points: in this case the decision to invest in deepwater production, or not, depending on market conditions. CP looks to be a hard task master in this regard: based on the statements and actions they have taken if CP decides to invest in offshore production others will as well.

I start with CP because E&P demand for offshore services is obviously crucial. Firstly, and this is not an original thought, the entire tone of this presentation (Q3 2017) is geared to financial returns to shareholders (you should actually read the whole thing to sense this) at the expense of production growth. Just as Shell, and other E&P companies have done, there is a signalling effect that this is a company that will not turn an oil price rise into a feast of mega-growth projects:

CP Priorities

The whole focus is being able to pay dividends even at a $40 per barrel price, gone are the 2013 days of boasting about reserve replacement ratios in excess of 170%. CP helpfully shows that this focus has helped them outperform their peer group: Executive level pay generally includes a link to performance against a defined peer group, if other E&P managers start losing bonuses by not being as disciplined on returning money to shareholders as CP, and their share price appreciation is less, their strategy will change extremely quickly. But in reality all the big companies reporting now are making “credible commitments” to return any excess cash to shareholders and focus on demand increases through short cycle production. Just as it would take years to turn investment decisions into projects now so much offshore engieering capability has been turned off, so too it will take a long time to change this investment narrative and performance incentive system in E&P companies that drive offshore demand. Any perceived linear link between an increase in the oil price and an increase in offshore demand is wrong in my view.

COP Works.png

Secondly: CapEx: for the 2018-2020 period CP is guiding sustaining CapEx at $3.5bn per annum and $2.0bn for expansion. Of the $2.0bn expansion $1.2bn is short-cycle unconventional and only $0.5bn for conventional/offshore and $0.3bn for exploration (split evenly between conventionals and short-cycle). To put that in context in 2012, when the offshore industry was going long on boats and rigs based on future demand, CP guided 2013 CapEx at USD $15.8bn! Of that 10% alone ($1.6bn) was for the North Sea and Alaska (i.e. offshore), 26% ($4.2bn) was for short-cycle, 15% ($2.4bn) for offshore Angola and GoM, and another 14% ($2.1bn).

Graphically it works like this: To keep production constant CP will spend $3.5bn

2018-2020 Flat Production.png

The green is entirely offshore. But to increase production:

COP Growth Production.png

The green in the second graph is almost all historic commitments. That is the future of offshore in a microcosm for the largest independent E&P company in the world and historically a major investor in deepwater offshore. The point is, for those bored of the minutiae, that CP have knocked ~$9.5bn off theirCapEx (60%) in 5 years (they have also divested assets so its not a straight relative comparison) and that the portion devoted to offshore is really related to legacy investments only now, not new fields or developments.

Third: productivity. I keep saying this but the productivity improvements look real to me the economist, as opposed to some of the geologists I know, who argue shale is bound fail:

CP Shale Productivity.png

The last line: >50% more wells per rig line! It’s all about productivity and scale and large companies investing in R&D are extracting more for less on a continuous basis from their shale wells. This is becoming a self-reinforcing cycle where they invest, improve, and re-invest. As I say here often: Spencer Dale is right.

This is the link point to Subsea 7, and all the other subsea contractors frankly. Subsea 7 have performed better than most other contractors throughout the downturn (not McDermott), but the issue is backlog and the pace of future work delivery: as CP seeks to please the stockmarket by avoiding all but the most promising of offshore investments (if any), SS7 and others must show huge declines in their order backlogs which de-risk a hugely expensive and specific asset base. I have said before I think you almost need to value subsea contracting companies like a bank: they fund long-term assets with a series of shorter duration contracts of uncertain redemption value, yes they have a much higher equity cushion, but they need it as they are borrowing short from a market to fund long term assets. Certainly smaller contractors are susceptible to “runs”.

In the last quarter SS7 had revenue of ~$1bn but it took in orders of only .5 of that (book-to-bill ratio) in new orders which left it with a backlog of $5.3bn (against liabilies of $2.4bn). At Q4 2013, when companies like CP were spending all their CapEx, SS7 had backlog of $11.8bn (against $3.8bn of liabilities).

Now SS7 is a well managed company and as can be seen they have reduced debt as the downturn continued, continued to return chartered tonnage,  and they have over $1.2bn in cash, so there are no problems in the short-term. But if you were owed money by SS7 I would rather be owed a higher amount backed by nearly 3x backlog than owed a smaller amount by 2x (a declining) backlog. The problem is the pace at which all the contracting companies are eating through their backlog of contracted work that was at a significantly higher margin than the work they are bidding for now. The actual booked backlog number is the only certainty guiding real expectations of future profitability.

It is a function of the SS7 business model that they have an extremely long position in very specialist assets that sap meaningful amounts of money from companies if they are not working as the graph from the FMC Technip results makes clear:

Technip margin erosion.png

The single largest fact in Technip’s declining subsea margin is lower fleet utilization. If Technip and SS7 are expecting poor utilization in 2018 then it is locked in for the rest of the supply chain.

The fact is the huge offshore CapEx pull back and reallocation by the E&P companies is continuing unabated. Offshore allocations may not be declining in real terms any more but E&P companies are making clear to their shareholders that it isn’t going to materially increase either. The offshore fleet built for 2014 isn’t getting a reprieve from the Oil Price Fairy, the gift from that fairytale should it come true for the E&P companies will be given to shareholders, who after the volatility they have suffered in recent years feel they are owed higher risk weighted returns. E&P companies are locking in systems and processes that ensure their procurement in the supply chain will systematically lower their per unit production costs for years to come and ensuring that other asset owners get lower returns for their investments is a core part of that.

And it’s not only backlog the SURF business now is declining year-on-year of you look at the Q3 2017 SS7 results:

Q3 2017 BU performance.png

~$50m is a meaningful decline in revenue (6.3%) for SURF alone and the decline in i-tech shows that the maintenance market hasn’t come back either. Both CapEx and OpEx work remain under huge margin pressure and in the maintenance market the smaller ROV companies with vessel alliances are all mutually killing any chance of anyone making money until a significant amount of capacity leaves the market. The point of reinforcing this is that it is clear that the E&P companies do not view higher prices the start of a relaxation of cost controls: this is the new environment for offshore contractors.

Subsea maintenance costs involving vessels are time and capital intensive. Internally E&P companies are weighing up whether to invest in maintenance CapEx for offshore assets or new CapEx on short cycle wells. At the margin many like CP are choosing short cycle over offshore and hence the demand curve for offshore is likely to have shifted permanently down and price alone is simply not clearing the market.

I have only used SS7 as they are the purest subsea player in the market. I definitely think it is one of the better managed companies in the industry buut it is impossible to fight industry effects this big when demand is falling, and therefore the size of the market is shrinking, and you have such a high fixed cost base. Not everyone can take market share.

SS7 will be a survivor, and longer term given the technical skills and scale required to compete in this industry I think it likely in the long run they will earn economic profits i.e. profits in excess of their cost of capital, along with the larger SURF contractors excluding Saipem. But they will do this by being brutal with the rest of the supply chain that has gone long on assets and simply doesn’t have the operational capability and balance sheet to dictate similar terms. For everyone below tier one the winter chill is just beginning.

So what does this point to for the future of the industry?

  1. It is a safe bet with all the major E&P companies CapEx locked in for 2018 now and all the OpEx budgets done that demand isn’t going to be materially different from 2017. Slightly higher oil prices may lead to some minor increases in maintenance budgets but nothing that will structurally affect the market
  2. A smaller number of larger offshore projects of disproportionate size and importance fot the larger contractors and industry. Only the largest will have the technical skills and capability to deliver these (hence SS7 ordering a new pipelay vessel). These projects will have higher flow volume and lower lift costs and will be used by E&P majors to underpin base demand
  3. A huge bifurcation in contractor profitability between those capable of delivering projects above and the rest of the industry who will struggle to cover their cost of capital for years
  4. An ROV market that uses surplus vessels and excess equipment equipment that keeps margins at around OpEx for years as vessel owners seek this option for any utilisation
  5. E&P companies consistently seeking to standardise shale production, treat it as a manufacturing process that drives down per unit costs, and increase productivity. Any major offshore CapEx decision will be weighed against the production flexibility of shale
  6. Structurally lower margins in any reocvery cycle for the majority of SURF contractors

Affirming the consequent: Standard Drilling and vessel recovery…

A ship is at best an opportunity and at worst a liability.

Anon.

If you wanted to pick on one company to highlight how diminished expectations are of the offshore sector SDSD, down 66% for the year, would be a good candidate.

I think its great that if investors want a counter-cyclical investment vehicle they have one, but I just don’t think there is any industrial strategy here at all, and it is really hard to see how this can ever make money without some sort of extraordinary market movement. Depreciating 2007 and 2008 built PSVs, some of which required upgrades to DP II,  must be the ultimate “have faith in offshore” investment. Let’s have a look at the SDSD strategy:

Strategy.png

The thing is that Standard Drilling sold all the KFELs units prior to delivery, so maybe its been lost a little in the translation: but quite why buying assets in a booming market and selling them prior to delivery illustrates the success of buying minority shares in PSVs and putting them in lay-up in the worst downturn to hit the offshore vessel sector is beyond me? Just because I am good at rugby is unlikely to make me good at cricket (and the company isn’t called Jeff Wilson Drilling). The logical error is I believe called affirming the consequent.

It doesn’t mean you can’t make make money from this: but you are taking not only asset risk, on the vessel prices, but market risk on the stock price as well. So it’s not ideal (although you would think in this case they are highly correlated).

My broader point is that offshore supply is probably at the absolute nadir for demand. The PSVs working are supporting working operational infratsructure, or the few rigs working, and it probably cannot get any lower. But as Maersk Supply reported this week there remains an industry characterised by revenue at opex levels and huge oversupply. The SDSD are primarily older and/or in layup. The original plans to operate the vessels at cash break even, or above, and try and pay dividends. Even if one or two projects manage to achieve this there is no chance of this happening at a corporate level. Quoting historic vessel values I also think is a little absurd given the whole point of accepting the scale of the current downturn must mean they want revert to their previous implied value?

Look I don’t have an issue with this: SDSD has allowed the public a show of the price discovery mechansim that is identical to how many distressed funds viewed these types of investments. The fact is at this time last year, when the world seemed a different place, people thought the market couldn’t get any worse, and the plain fact is that it has. Substantially both at an asset value level and an operational level.

In specialty vessels Nor Offshore raised USD 15m almost to the day at this time last year. Now the reports are Fearnleys is basically trying to get them out completely as you can see from the SDSD share price graph that the cost of equity financing these vessels without visible backlog must have materially increased.

Longer term I don’t really get though how European companies, burdened with bank debt that the banks are reluctant to write-off, are going to compete with the likes of Tidewater and Gulfmark? SolstadFarstad must be the most worried of all the European companies given their commodity tonnage exposure. Sitting on a bunch of Asian built AHTS and PSVs from DeepSea Supply with inflexible European banks and no Chap 11 possibility must seem like a Sisyphean challenge at this point in the cycle.

But in the Tidewater’s case all the investors had an incentive to save the operational company to maximise value, whereas in the SDSD case the asset manager is paid regardless and isn’t making the returns required to back the assets.

Bassoe noted this week that they expect nearly 340 rigs to leave the market permanently. If you assume that supply vessels now are serving the base load of work on production assets and maintenance associated with them, and that a meaningful part of the E&P rig fleet that drove demand  will be scrapped, you need a real good story to explain a recovery play in offshore supply. There is more pain to come for investors before the market stabilises I feel.

 

I was wrong about Bitcoin: it is an asset class not money…

These curious capabilities make Bitcoins a combination of a commodity and a fiat currency (creating the coins is referred to as “mining” and they have value only because people accept them). But boosters inflated a Bitcoin bubble. Shortly after the currency launched, articles spread around the internet arguing that Bitcoins would protect wealth from hyperinflation and that early adopters would make a fortune. The dollar price of a Bitcoin currency unit climbed from a few cents in 2010 to a peak of nearly $30 in June 2011 (see chart), according to data compiled by Mt Gox, a popular online Bitcoin exchange. Inevitably, the currency then crashed back down, bottoming out at $2 in November 2011.

The Economist on Bitcoin in 2012 when the price was USD 12 per coin

 

This commodity [gold] is a material to be almost indestructible, and one of which therefore the accumulated stocks are very large in proportion to the annual fresh supply. Gold tends, therefore, to have a remarkably steady value.

R.G. Hawtrey, The Gold Standard

The Economic Journal, Vol 29, 1919

I have been prety vocal in the past about Bitcoin as a bubble. Stories like this seem to reinforce that image in me:

Eugene Mutai’s Nairobi apartment is filled with the sound of money: That would be the hum of a phalanx of fans cooling the computers he’s programmed to mine cryptocurrencies around the clock…

“The entire ecosystem could be the biggest wealth-distribution system ever,” Mutai said as his 2-year old daughter, Xena, named after the warrior princess, played with a tablet, swiping from app to app. In the world of internet-based currencies traded without interference from banks or regulators, “big players can’t deny anyone from participating in the financial system.”

And sure enough the CEO of Credit Suisse also explained that:

[f]rom what we can identify, the only reason today to buy or sell bitcoin is to make money, which is the very definition of speculation and the very definition of a bubble

I am not sure I believe that big players are excluding people from the financial system… but it is certainly part of the marketing of Bitcoin. The FT also has a great article on a how people are being marketed the dream of riches via bitcoin (read the whole thing the promoters are “interesting” to say the least:

“Ninety-five per cent of people you’re going to talk to about cryptocurrency, they say to you it’s a bubble. Correct?” he said as the 30 or so men and women packed into a small, hot room on the fourth floor nodded in agreement. In fact, he declared, “the bubble will never burst…

Pro FX Options launched in 2016 and says it can turn people with “zero trading knowledge” into skilled traders. It claims its software can detect short-term trading trends and help ordinary people make consistent profits from binary options, where a bet is placed on whether a stock or currency pair will be higher or lower at a predetermined time in the future. “What we’ve done is really made it simple, simple for anybody from any walk of life to take advantage of it”

But I am erring more now to the fact that while the top prices may be “bubble like” in that they deviate from the mean significantly over time, that some cryptocurrencies, and Bitcoin in particular, look likely to be a permanent asset class. I don’t think the CEO of Credit Suisse is right, buying and selling for profit only is speculation, but that doesn’t make it a bubble.

Bitcoin isn’t a currency as defined by monetary economists in the classical sense, but it appears to have become an asset class, which seems likely to give it some enduring value. It just needs enough people to believe it worth something at it will have a floor of demand that should give it some value, even if intrinsically it generates no income. There are enough reports now that people are starting to treat it like gold, risk small stakes and hoping to profit wildly. All it needs is this number to keep growing faster than the Bitcoin system mines coins and the price will go up. Last week CME announced they would start a futures service for Bitcoin. It seems almost inconceivable that a global market this big will simply vanish, the price may go down as some buyers lose confidence, but there is surely enough market depth now that this is simply becoming a recognised asset class, albeit one with likely extreme volatility in demand/pricing.

The mistake I made was treating it as currency and as money. I am not the only one this attempt to value Bitcoin on a rational basis was :

based on the presumption that bitcoin’s core utility value is serving as a currency for the dark economy.

Bitcoin is clearly neither money nor a currency but it is becoming an asset class.

The reason I missed 9 of the last 0 housing recessions in NZ is simply because I was too rational in my analysis on the overall return not the capital gain: Asian buyers and peoples innate desire for a secure house has increased faster than the stock of housing and ergo the prices have boomed.

newzealand-house-prices-gdp-per-cap

Its all about the capital gain in NZ but that doesn’t make the gain any less real if you cash it in.

I’m not pretending Bitcoin is perfect: there are security issues, and the price will be volatile, to name just two. But there is a longevity in the prposition that simply didn’t exist with Dutch Tulips (a fashionable perishable item amongst a small domestic population) or the South Sea Company (effectively a financial engineering that overreached combined with fraud).  Some of the Initial Coin Offerings are clearly fraud and a bubble but the more I read the more I can see a case for investing in Bitcoin: the rate of supply will grow less slowly than the rate of demand.

Gold has no value beyond what someone is willing to pay and and 37% of its demand come from people who just hold for “investment purposes”. A fraction of those people worldwide who decided to invest in Bitcoin would likely make it a great investment.

Gold-Demand-by-Source

But I still would pay someone £1100 for a three day couse to learn how to trade the stuff. I may regret that later but that is a bubble.

Interest rates rise in the UK after 10 years…

Liquidity used to mean cash in hand; now it means access to credit.

Henry Kaufman

When you combine ignorance and leverage, you get some pretty interesting results.

Warren Buffett

Given this blog is partly a diary I wanted to note for future reference. This is a bit wonkish and unless you are interested in the wider economic issues I’d suggest you ignore this post. It’s something I want as a note to self.

Last week base rate was raised in the UK by a mere .25% to .5%. I think its been lost is how long and extreme these rates have been and the side-effects of such extraordinarly low rates. Base rate dropped from 5.75% in 2007, to .05% in 2009 and remained there for the best part of 8 years.

I have been interested in interest rates from a young age, as I have written before one of my defining economic memories was the wage and price freeze in New Zealand. My parents were civil servants with fixed salaries, that were frozen by the government in an attempt to control inflation in 1982, a Labour government was elected and interest rates rose again and mortgage rates peaked at  over 20% briefly in 1985, and my parents nearly lost their house.

NZ Mortgage Interest Rates

NZ Interest rates

If you tell most people now that mortgages rates were 20% they would struggle to comprehend it. Yes inflation was much higher, but that’s my point: just how different the modern economy is. It changes so incrementally you can easily lose sight of the changes and also we are used to a lack of volatility in the economy.

The New Zealand Experiment, as it was later dubbed, included many measures that are standard economic perscriptions now, but they included being the first country in the world to grant the central bank autonomy to set interest rates taking into account inflation and monetary stability only.

The defining economic period for my professional career has been called “The Great Moderation”, the taming of business cycle volatility led to fairly consistent economic growth . The term is normally applied to the US where the name originated but was a fairly consistent pattern in the Western World. The downside was it created hubris amongst central bankers, who ignored the genius of Minsky and the financial imbalances building up in the economy, and led to the Global Financial Crisis… The apogee of this institutional arogance could well be this cringe-inducing speech Gordon Brown gave at Mansion House on the 20th of June 2007:

So I congratulate you Lord Mayor and the City of London on these remarkable achievements, an era that history will record as the beginning of a new golden age for the City of London.

And I believe the lesson we learn from the success of the City has ramifications far beyond the City itself – that we are leading because we are first in putting to work exactly that set of qualities that is needed for global success:

  • openness to the world and global reach,
  • pioneers of free trade and its leading defenders,
  • with a deep and abiding belief in open markets,
  • champions of diversity in ownership and talent, and of flexibility and adaptability to change, and
  • a basic faith that from wherever it comes and from whatever background, what matters is that the talent, ingenuity and potential of people is harnessed to drive performance.

And I believe it will be said of this age, the first decades of the 21st century, that out of the greatest restructuring of the global economy, perhaps even greater than the industrial revolution, a new world order was created.

In August 2007 the interbank market effectively froze while the Bank of England and the Federal Reserve were forced to inject massive liquidity into the system. The US housing market collapsed over the following summer and Lehman Brothers filed for bankruptcy on September 15 2008.

The three main reasons advanced for the Great Moderation are:

  • Good luck: The shocks that derailed growth and price stability in the 1970s and early 1980s failed to rear their ugly heads over the subsequent 20 years.
  • Structural change: Improved information technology, especially related to inventory management, and financial deregulation resulted in much smoother economic progress.
  • Better monetary policy: Former Federal Reserve Chairman Paul Volcker set a precedent of aggressively reining in inflation.

Unsurprisingly St Louis Fed officials think the last two reasons were more important.

And the rest is economic history as even the Queen realised. And Brown’s 2007 view of a new industrial revolution based on self-regulation of the finance and shadow banking industry turned into an enormous taxpayer funded rescue of that same industry. Although I will give Brown some credit for ensuring the UK didn’t join the Euro he really didn’t deserve to ever be PM after such an enormous lapse in judgement and is a prime example of what economists call regulatory capture.

Cometh the hour and cometh the man… Ben Bernanke, a great and assiduous scholar of the Great Depression is in the Fed along with the intellectual Mervyn King at the Bank of England, and reluctantly Mario Monti at the ECB. Recognising that banking failure was a great cause of prolonging the downturn they flooded the market with liquidity and a core part of doing this was keeping interest rates low, but not saisfied with that they enourmously expanded the money supply. While there is no doubt the measures undertaking to keep the payments infratsructure working and financial markets open stopped another great depression there was a flip side:

since the 2008 credit crisis, it has risen sharply: the level of global debt to gross domestic product is now 40 per cent — yes, 40 per cent — higher than it was in 2008. The world has responded to a crisis caused by excess leverage by piling on more, not less, debt.

Major Central Bank Balance Sheets (Assets)

Major CB BS

The resulting asset price inflation that can be seen post 2008 is obvious:

Asset price inflation.jpg

This isn’t really the place to go into it but there is a big debate in economics between those who argue the structure and function of the financial infratsructure is important, and therefore favour raising interest rates, and another camp of economists who view money as merely a signalling device and believe in the “neutrality of money”, and want to keep interest rates low until economies revover to an output level that relfects the long run trend (since the 2008 crisis all G8 economies have grown below this). Despite promoting Keynsian type measures it should be noted Keynes rejected the neutrality of money both in the short and the long run. It may surprise non-economic readers to know the core models most economists in use assume the neutrality of money yet most economists who work in financial markets don’t accept money neutrality either.

The problem is further complicated by the fact that the market itself is driving interest rates down, Bernanke argues there has been a savings “glut” with Asia pushing capital West to find a safe home. As Cabellero et al., note:

For the last few decades, with minor cyclical interruptions, the supply of safe assets has not kept up with global demand. The reason is straightforward: the collective growth rate of the advanced economies that produce safe assets has been lower than the world’s growth rate, which has been driven disproportionately by the high growth rate of high-saving emerging economies such as China. If demand for safe assets is proportional to global output, this shortage of safe assets is here to stay.

My core problem with this, if anyone is still reading, is the structural reliance of debt in the economy without the safety of equity,. When the dotcom crash happened in 2000 it has minor effects on the rest of the conomy because it was equity financed. Credit recessions have more severe macro economic effects. The tax shield provided to debt over equity encourages share buybacks and leveraged finance over more cautious capital structures. I’m erring with the crowd who believe perpetually low interest rates are distorting the financial infratsructure.

And ultimately, as this seminal paper shows the economy has fundamentally changed as debt becomes a greater part of economic activity (see figure 1 at the top):

In the past four decades, the volume of private credit has grown dramatically relative to both output and monetary aggregates. The disconnect between private credit and (traditionally measured) monetary aggregates has resulted, in large part, from the shrinkage of bank reserves and the increasing reliance by financial institutions on non-monetary means of financing, such as bond issuance and inter-bank lending.

Private credit in advanced economies doubled relative to GDP between 1980 and 2009, increasing from 62% in 1980 to 118% in 2010. The data also demonstrate the breathtakingsurge of bank credit prior to the Global Financial Crisis in 2008. In a little more than 10 years, between the mid-1990s and 2008–09, the average bank credit to GDP ratio in advanced economies rose from a little under 80% of GDP in 1995 to more than 110% of GDP in 2007.

What has been driving this great leveraging?…

[m]ortgage borrowing has accelerated markedly in the advanced economies after WW2, a trend that is common to almost all individual economies. Mortgage lending to households accounts for the lion’s share of the rise in credit to GDP ratios in advanced economies since 1980…The main business of banks in the early 1900s consisted of making unsecured corporate loans. Today, however, the main business of banks is to extend mortgage credit, often financed with short term borrowings.

 

Fig 3 The Great Remortgaging

The counter-arguement from (the Nobel Laureate) Shiller and the SNB. Although anyone still reading who has been in offshore or shipping will appreciate this diagram from the SNB:

Excess credit

Ultimately for 8 years, a third of my professional life, the economy has been marked by low interest rates and prior to that it was the great moderation. Ironically within this I choose to work in sector with enormous volatility which just highlights the huge variance within the averages of a modern economy.

Structural and cyclical cost reduction and demand

A good article in the FT (behind the paywall sorry) but the core point is that the supply chain had better get used to a low cost procurement environment for a long time:

[C]uts have been made across the industry, pushing investment down to historic lows. The average number of new oil and gas developments given the go-ahead globally has fallen from 35 a year between 2010 and 2014 to just 12 since 2015, according to Patrick Pouyanné, Total chief executive. This number will have to increase, he said, if a supply crunch is to be avoided in the 2020s. He and other executives stress that reduced spending also reflects efficiency gains in the industry, allowing companies to do more for less…
Many of the savings stem from cuts forced on suppliers, such as rig operators, which were in no position to resist as business dried up after the oil price crash. But Bernard Looney, head of exploration and production for BP, insisted that two-thirds of reductions are structural, rather than cyclical, and would be sustainable. “It’s as much a story of how bad the past was as how good we have become,” he said. “We got the cost of Mad Dog 2 [a development in the Gulf of Mexico] down from $20bn to $8bn but frankly we should never have been at $20bn in the first place.”

The fact is for both rigs and vessels there is huge latent capacity and this will mean the supply chain is under pricing pressure for years. Offshore supply has structurally changed: it will become dominated by a few large players with massive fleets and low margins that mean scale is vital. Subsea contracting looks set to be dominated by a few large profitable contractors, in a flight to quality, while offshore support vessel owners who supply them will find it harder to make money due to long-lived over capacity. All this is a structural change in the industry and there is likely to be lower industry profitability regardless of how big a rebound is (when compared to 2010-2014).

When the number of projects starts to rebound, and it will take a long time to re-employ the engineering capacity required to do this, there will be a cyclical upswing as overall demand for these assets increases. But this is unlikely to see the entire industry benefit as a smaller number of companies at the contracting end of the market will still be able to use their market power to charter in excess capacity at a low marginal cost.

Whereas pretty much al business models used to work in offshore  that is patently not the case now.

 

 

Incremental Oil Production Growth… Shale versus Offshore …

Interesting graph from Oceaneering that shows the growth of incremental production. Like all these charts they need to be viewed as directionally correct only, but it makes clear the scale of the change that shale has wrought on the offshore industry.

That brown/ shale area would simply not have existed 4 years ago and ties in with my argument about shale becoming an important industry narrative which drives how actual investment decisions are made in companies. There are large questions about shale productivity (depletion rates etc), I am not  geologist or well engineer so can offer no insight into this from a technical perspective, but the economist in me is an inveterate technical optmist and I think the investment resources being signalled towards this form of E&P activity will lead to increased productivity and recovery in the future.

Many investors into offshore in prior to 2014 saw that brown area as one that offshore would have covered. Clearly offshore production will still remain an important part of the energy supply chain, but only niches within it will be profitable as opposed to the whole market uplift that drove the previous boom. Services over assets would be a good general rule. As would another point I have made previously that offshore developments are likely to be driven by a smaller number of mega developments.

Just what the world needs…. another dive support vessel…

Time is not a thing, thus nothing which is, and yet it remains constant in its passing away without being something temporal like the beings in time.

Heidegger -who revived the concept of Aletheia in philosophy

Congratulations to CCC (Underwater Engineering) UAE for delivering the DSV Said Aletheia. It’s a fine looking vessel, a single bell 12 man system that is perfect for the Middle East and built in China for probably a very attractive price.

Unfortunately for the owners it is arriving at a terrible time in the market and I use it to highlight one of the big problems for a market recovery that the subsea/offshore industry faces with it’s over capacity: the over segmentation that has resulted in the build programme.

This table from Kennedy Marr makes clear how large the fleet expansion has been:

KM DP Fleet Aug 17.png

In the old days (pre-2010) all vessels were multi-purpose to a certain extent. They might not operate optimally all the time but some work where they were over specified balanced out higher days rates for more specialised work. As the number of vessels grew so did the number of more specialised vessels.

In Asia and the Middle East this has seen a number of purpose built dive support vessels delivered for contracts that used to be important charters for contracting companies to win. The best example of this, if delivery occurs, is the Vard new-build for Kruez, that will go long-term to Shell Brunei. This vessel will displace older tonnage in the market and at the lower end modular systems but in such price sensitive markets the productivity benefits this vessel offers are unlikely to command a price premium. In other words it is going to keep prices low.

Here is the big problem for DSV owners (in all markets):

Global E&P Capex

Shallow water Capex is forecast to remain near stagnant for years at levels significantly below the period preceeding 2014. Shallow water fields are smaller, and often more marginal fields and they require vast amounts of DSV days to support pipelay and general construction. As the graph makes clear there has been a structural change in the market and even if the oil price recovers it will not flow into shallow water construction and ergo a portion of the market that existed prior to 2014 has gone.

There is no magic cure here and no deus ex machina that is simply going to allow the “maintenance fairy” to make all the problems go away. A DSV in field construction mode uses far more days than one involved in IRM work. Now all the DSVs are trading down from construction work into IRM and that isn’t going to change either. Logically asset values in the DSV sector have dropped significantly because there is no plausible story for how a DSV could deliver the cash flows you used to be able to believe it could. Markets are mean reverting eventually but the process is going to continue being extremely painful financially for a while yet.

Aletheia apparently means “the state of not being hidden; the state of being evident… it also means factuality or reality”. I find that highly apt for a new DSV delivering into the current market.