Increasing US oil production… Just like the man said…

[P]rogress in science is not a simple line leading to the truth. It is more progress away from less adequate conceptions of, and interactions with, the world.

Thomas Kuhn, The Structure of Scientific Revolutions

Some excellent data from the EIA this week confirmed that US production, even with the known Permian constraint issues, is powering ahead and is excess of previous forecast levels. My hypothesis, hardly controversial, is that there is a strong negative correlation between these graphs and offshore vessel values.

This is playing out almost exactly as Spencer Dale predicted in 2015. This is a generational change in oil production that is clearly going to impact on any “offshore recovery” theory… some of which are starting to sound a little desperate and absurd. I have referenced the Spencer Dale article before and if you are looking for a unifying theory of why any offshore recovery is likely to be delayed and anemic I think it is still the most relevant and lucid explanation.

Oil supply shortage? Really?

“We’re able to do, I would say, 40% more per dollar of activity than we did 4 or 5 years ago at $100 oil”

Bob Dudley on BP’s Q2 2018 results.

When you are told there might be a supply shortage you need to understand how much model risk there is in these sort of forecasts. The IEA graph in the header, a variant on the new peak oil theme, being used as the rationale for why a “recovery” for offshore may be just around the corner, doesn’t show the output implications of the cost deflator.

Bob Dudley is saying that BP are getting 1.4x output for each dollar 4-5 years after the “great oil price crash” of 2014. That ~$500bn of expenditure in 2018 buys you what ~$700bn did 4 years ago (roughly what was being produced in 2013?).

This just isn’t consistent with a some sort of “snapback recovery” for offshore that people try and credibly speak of (and that some business models are based). Mean reversion only works as a theory when the underlying mechanics haven’t changed. The offshore supply chain needs to be realistic about the implications of this sort of comment that is clearly being translated into E&P company CapEx plans. Whether the offshore industry believes it or not this is the new narrative and reality in E&P companies and capital is being allocated accordingly.

 

Time for plan B…

A somewhat ambitiously titled article in the FT seemed to have something for everyone: looking for any excuse to claim the impending supply shortage? Check.  And for the sceptics? Check. To save you reading ‘The Big Read’ I’ll give you a quick synopsis: the reporter spoke to a load of people (mainly analysts) who said there will be a supply crunch but didn’t know when, and then spoke to another bunch of people (who actually make the investments) and they said they don’t think there will be.

The fact is that oil will be a substantial part of the energy mix for a very long time. How we extract it and the relative costs of doing so are far more interesting questions. The E&P companies will be substantial businesses for a long time to come no matter how alarmist some warnings maybe.

But the article does mention the mythical $100 per barrel… just not a timeframe… in fact if you are looking for comfort for when this supply crunch will occur the only person prepared to put a timescale on it is ex-BP CEO Tony Heywood, and you are unlikely to get much comfort from this:

“I don’t think the supermajors really believe the long-term story of peak demand,” Mr Hayward told the Financial Times last week. “Looking at the trajectory, we’re more likely to have a supply crunch in the early 2020s.”

If you really believed in the supply crunch I can’t work out why you wouldn’t sell your house and just go long on Exxon Mobil? According to this article on Bloomberg they are staying as a pure oil and gas supermajor and being punished by the stockmarket for it. Buy their undervalued shares and when the supply crunch comes all their reserves are worth the market price and they have production capacity? And in  the meantime you collect the dividend?

The alternative in the offshore world appears to be buying investments in highly speculative asset companies with no order book that are relying entirely on a macro recovery for their plans to work. At this point in the cycle, and without some clear indication of when any of these plans can return actual cash to the investors, the only thing certain is that they supply side still has a lot of adjustment to go. The big contractors are starting to pull away from the small operators because a) they do the large developments currently in vogue, b) scale has economic advantages in an era of low utilisation, and c) why use a small company where your prepaid engineering work is effectively an unsecured creditor? Expect the flight to quality to continue in the project market.

Frankly if you are long floating assets you simply cannot disregard comments like this from one of the biggest CapEx spenders in the world:

“We’re becoming more efficient at how we deploy capital,” Mr Gilvary says. He adds that BP and other energy groups are ploughing a middle road: raising oil production by using technology to sweat more barrels out of existing fields, while also funnelling smaller amounts of capital into so-called short-cycle projects such as US shale.

BP of course continue to deliver mega-projects where they think they have ‘advantaged’ oil. They just expect to pay less for it:

BP Unit costs.png

Reintroducing cost inflation into the industry will be harder than any previous cyclical upturn is my bet.

Oil as a declining industry…

Like all good Op-Eds (and blogs) this one in the FT started yesterday with a big headline and with some punchy quotes:

The time to stop investing is not today. But that point is coming. The industry needs to be clear that its future is one of long-term decline — whilst returning increasing sums of cash to investors. There is a possibility that the industry over-invests as we reach that point of peak demand, leaving an oversupply that persists for a long time. Fighting for market share in a declining market would be even worse.

Everything in life is relative (well if you are a post-modernist anyway) and the authors are not saying to stop investing tomorrow or that oil is dead: merely ex-growth as an industry.  The message is about E&P companies not having a good record at investing in alternative energy sources so encouraging them to return the cash to fund managers (who do apparently?).

We think oil companies can have a positive part to play in our future world of energy — as a cash generating engine that can be used to power the transition when the time comes, and we urge the industry to make a clear commitment to this future.

You can dismiss it as another view that will simply ensure that prices are higher in the future, I guess the question then becomes how far and how high? Or you can take the views seriously as the representatives of one of the UK’s largest fund managers and realise that it is part of a wider secular shift in thinking about business models for E&P companies that require less CapEx and less redundant capacity. I think it just shows how much pressure CFOs/Directors are under to return cash to shareholders all the time and how much harder it is for smaller E&P companies with good project ideas to raise money.

Regardless or your view this is becoming a popular one amongst the actual owners of some companies so it is worth not writing off indiscriminately. The investment narrative isn’t all “growth at any cost”, or future production volumes, which is a marked shift from previous periods where statements like “all the easy oil has gone” doiminated.

In a good interview here Spencer Dale, BP Chief Economist highlighted that

Because of natural decline, there is going to be a huge need for investments to keep supply at pace with demand, even if oil demand were to peak relatively soon.

“For a company like BP, that has a key role in our strategy. Continue to invest in oil, because the world will need that investment, but make sure to invest only in low cost, advantaged oil to make sure that we are robust for this more competitive environment that we think is going to emerge over the next ten to fifteen years.”

That strikes me a very different dynamic to previous eras and will have a huge impact on E&P project developments which are also consistent with the shareholder wishes highlighted above.

What gets measured gets managed…

Chevron and BP released data this week highlighting their continuing focus on reducing production costs and productivity improvements. To set the tone in their Annual Report for 2017 for BP made this comment to the above graph:

Dated Brent crude oil prices averaged $54.19 per barrel in 2017 – the first annual increase since 2012 but roughly half the average of over $110 seen in 2011-13.

Which just goes to show that while the offshore industry is using an oil price USD 60-70 to show increasing confidence it may not feel like that to an E&P company who spent billions on projects with significantly higher price assumptions a few years ago:

BP Upstream 2017.png

 

This Chevron slide highlights why the Demand Fairy hasn’t appeared in  offshore despite a rise in prices:

Chevron category cost reductions.png

Spending on Subsea at Cheron is down nearly 70% since 2014! This is an absolute number so the fact that Chevron have completed some major projects influences this, but it also doesn’t change the fact of the scale downwards in subsea spending that a ‘Super Major’ has managed to make in a very short space of time. That drop in production costs comes solely from doing stuff internally cheaper but in reality by procuring from the supply chain at ever cheaper rates.

BP has also dropped its production costs significantly:

BP Unit production costs 2017.png

The blue “REM” by the way means the remuneration committee looks at this before allocating senior manager pay. In other words senior managers have a great deal of economic interest in ensuring this gets lowered constantly, as the dictum goes “what gets measured gets managed”. Interestingly in 2013 this wasn’t a metric, then it was all about operating cash flow and delivering production targets and projects. Now saving a few thousand a day on a rig or vessel, going offshore for less days, doing more work onshore if possible, all these will be looked at with a degree of rigour unknown in past times. This is a new and constant trend in the offshore industry and I doubt it will ever go away now.

The continuing impact of this for those involved in offshore is clear: there will be a relentless focus, despite an easing of spend for offshore, on driving costs down. These targets will be filtered down the organisation through objectives and goals to other managers who will be bonused against cost reductions. Pushing the supply chain to lower costs will be measured and therefore managed: the clear implication in a period of oversupply is continuing margin pressure.

The argument that offshore spending will have to increase as the Reserve Replacement Ratio is dropping is starting to look tenditious as well:

Chevron resources.png

Clearly it’s all about the shale at Chevron, but BP was fine as well:

BP RRR 2017

Chevron is making clear where future investment will go:

  1. Deepwater US

Deepwater US.png

2) Shale in the Permian (note the comments re: “factory” something I have discussed here before)

Permian.png

While BP is also making clear that offshore is important but will only be part of its investment in projects:

BP project mix 2021

Two companies doesn’t make an industry, but these were, and remain, significant investors in the offshore space. But it is clear they have changed in a structural way how much they will invest in offshore, and how the invest in offshore, and the amounts are significant to the offshore industry supply chain as a whole (especially as they don’t seem to be anomolies).

When I look at data like this,l and see business plans that rely solely on an “inflection point” in demand, or waiting it out for “the recovery”, I don’t think they are reflecting likely scenarios now. A base case for offshore is surely one without a dramatic change in demand conditions? The implications for many business models in the offshore space from that are profound nearly four years after the price decline began.

 

 

BP results, the future of offshore, and myopic loss aversion…

The myopic loss aversion explanation rests on two behavioral principles: loss aversion and mental accounting. Loss aversion re-fers to the fact that people tend to be more sensitive to decreases in their wealth than to increases.

Thaler, Tversky, Kahneman, and Schwartz (The Quarterly Journal of Economics, 1997

 

Let me start by saying, as I have many times before, I am a believer in offshore oil and gas production. My issue at the moment isn’t that it is going to go away, rather it is that too many vessels have been built, and that 2012-2014 was a peak bubble of activity. There will still be good money to be made offshore, I am just not sure it will be through owning vessels (and rigs) until a very painful, and in all likelihood prolonged, restructuring process has been completed.

I recently wrote my thoughts on economic research and dividend policy and why this may lead to an undersupply of offshore projects in the future. I am not conviced this will happen at all, but it seems to be the great hope for all involved in offshore. The BP results yesterday highlight what I was saying with one perfect graph:

BP Cash vs Capex 17Q1

For BP the dividend doesn’t change, CapEx, the driver of future production and profitability potential, is the moveable number. And in a large corporation it is surprisingly flexible in the short-term. (“A billion here, a billion there, pretty soon you are talking real money…”). I think this is typical of all the supermajors, their shareholders want dividends.  The data reveal that Shell and BP alone were responsible in Q1 2017 for £4.8bn of the total £12.5bn (38%!!) of total FTSE 100 dividends. BP and Shell shareholders, UK pension funds especially, want the money now not the hypothetical billions available from a shortage of capacity in a few years time.

Another way to look at it is this: the BP dividend was USD 10.0 cents per share in Q1 2017, and Q4 2016, but this is way more than the company is earning per share (bold Q1 2017, then Q4 2016, then Q1 2016):

BP EPS Q12017

BP is making up the numbers by increasing the debt and divestments in the portfolio. The last thing they want, and their shareholders I suspect, is a large and capital intensive bet on risky offshore projects. As if to reassure everyone this is the case the CFO gave look ahead guidance for CapEx at these levels until 2021.

There is a really good interview with Starlee Sykes, BP VP Global Projects, that is well worth a read – the cost on the Mad Dog phase 2 project was cut to USD 9bn (from USD 20bn). Several parts struck me but none more than this:

We looked for analogies to what we had done before and focused on the Atlantis project in the gulf, which came online in 2007, and its semisubmersible-platform design concept. Atlantis was, and is, viewed as a very economic, very good development. We decided to adopt this simpler design concept. Compared to the original Mad Dog 2 stacked-deck spar design, the semisubmersible is flexible for building future capacity, while fulfilling minimum technical requirements. That was the big idea around Mad Dog 2. Rather than designing for a future that may not happen, the principle was to build what we need at day one, and then allow for the expansion later. So, for example, we did not install all of the water-injection capacity that we needed on day one. It’s a more incremental approach.

A total change of mindset for the industry where everything in offshore was bespoke and future proof. This is part of a slow path to standardisation where possible to reduce costs. Mad Dog Phase 2 can produce 140 000 bpd at peak capacity, far beyond anything tight oil can dream of. At that level, and with efficient lift costs, it’s well worthwhile dropping a cool USD 9bn. But as I have said before I see offshore bifurcating into developments like this with very high flow rates and very high CapEx commitments, normally at deepwater, (only the Norwegians seem to get lucky enough to find huge fields at shallow depths now), and a base of demand in Asia and the Middle East where NOC’s are more security supply focused where they will develop in shallow (often alone) as well as deeper water (where they will need a supermajor partner for technical expertise).

I fear for the shallow UKCS which is somewhat caught in the middle: SPS technology isn’t standardised and cannot feel the effects of scale and scope that tight oil has, yet these fields cannot provide the reserve capacity in a high cost environment. One of the reasons the Norwegian basin seems to do better than the UKCS is an understanding of Loss Aversion Theory, that in essence states that investors would rather not lose $5 than gain $5: in Norway tax incentives for drilling are heavily front ended loaded versus credits for production in the UK (making a massive generalisation of a very complex issue). A classic article on myopia and and loss aversion in risk taking is available here. Which is a lot like shareholders in E&P companies who have seen paper wealth vanish as the oil price drops.

To be effective shallow offshore fields will have to be subject to some form of standardisation around production equipment and SURF installation, and we are a long way from that at the moment because a core component of that is drop volume which drives the experience curve. And of course as the E&P companies cut CapEx, that is distinctly lacking.

The other problem offshore has at the moment is management focus and resource constraints. I have mentioned before the power of narrative in economics, as Shiller argues:

[w]e have to consider the possibility that sometimes the dominant reason why a recession is severe is related to the prevalence and vividness of certain stories, not the purely economic feedback or multipliers that economists love to model.

The industry meme at the moment is all about cost and tight oil. Changing that mindset in large organisations is hard – it can take at least 12 months if peoples bonuses have just been contractually set for exmaple and they are based on cost savings. A recovery for the offshore contracting industry is going to rely on changing this narrative somewhat.

I have discussed here mainly the demand side of the market which I believe will be structurally more unattractive for the next few years going forward. I still think for the supply side, the offshore contractors, there can be a bright future if positioned clearly: a tight fleet of core enabling assets (mainly lay capability) and a strong EPIC competency, and an ability to position the firm to respond to this structural change in the industry.

I am generally sceptical on alliances and integration between SPS and SURF because I think they add more  value to the contractor than customer, and as Exxon Mobil showed with the Liza award, an educated customer can drive the price down by splitting workscopes. But I am writing a fuller piece on this.