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.

Hasty generalisations and shale…

The being without an opinion is so painful to human nature that most people will leap to a hasty opinion rather than undergo it.

Walter Bagehot

John Dizzard in the FT this week spoke to a man from Oaklahoma and decided that the whole shale sector was just the result of market liquidity pumping money into the small debt financed E&P companies. Dizard suggests capital markets are “subsidising” the sector. This appears to have been a hasty generalisation… The data point appears to be based on Drilled-But-Uncompleted wells:

As one Oklahoma oil and gas man I know says: “There is still unlimited capital, and as long as that is true, you can grow anything. If the companies had been forced to live within their cash flow, then their production would go down. Then they would have run into a death spiral where nobody would want to invest in them.” The shale companies struggling with sub-$40 or sub-$50 oil prices were also able to live off the excess inventory of drilled-but-uncompleted (DUC) wells that had built up during the boom years.

As our Oklahoman says: “There were thousands of DUCs that had not been taken account of. The companies could just complete and connect those to offset the declines in production from older wells.”

The problem is I don’t see this:

DUC 17

Source: EIA, Baker Hughes, Jeffries

First of all we had the meme that shale was too expensive on a per unit basis, and now we have the meme that actually it is only possible because high-yield investors don’t understand what they are buying and funding. Admittedly HY doesn’t always get it right, as offshore bonds currently show, but to suggest that shale is solely the result of a capital misallocation is surely mistaken?

US capital markets are probably the most efficient in the world at adapting. The various restructurings happening in offshore (Paragon, Tidewater etc) highlight that banks and investors take the writedowns and move on. They are also efficient at funding companies for long periods prior to cash flow break even (Uber being the most notorious example). Shale is here to say it is only a question of how big it is.

Fundamental change or short-term shock?

The most popular letter in the FT today compared the review of Crude Volatility by Robert McNally (a Bush adviser) by the FT Energy Correspondent, Anjli Raval, to The Price of Oil by Roberto F Aguilera and Marian Radetzki. Basically, McNally argues we are in for a wild ride on prices and supply while Aguilera and Radetzki come in for shale and technology and permanently low prices. The writer agrees with fracking our way to salvation and permanently lower prices.

I read the read the review and admit McNally lost me with this:

But industry attempts to tame the market in the past have either had minimal success or been defied. The arrival of US shale in recent years has rendered Opec unwilling or unable to control the market, McNally says. With Opec’s power ebbing, “we are going to be unpleasantly surprised by chronically unstable oil prices”.

Come again? Normally getting rid of a cartel stabilises prices and lets market forces determine supply and demand? I couldn’t be bothered to read the book based on the review because it all sounded a bit contrived: you cannot control a cartel with that many players (as Opec is finding out), and as the famous Hunt Brothers (oil men to the core) discovered you can’t control a complex market like silver (or oil I’m betting on).

I haven’t read Aguilera and Radetzki’s book either, but they have a lot of stuff on the web that makes their view clear (at Vox and Scientific American). As they say here:

Using simple and reasonable methodologies, we estimate that the shale revolution outside the US will yield an additional 20 million barrels per day (mbd) by 2035 – nearly equal to the rise in global oil production over the past 20 years.

And look how much the cost curve for shale has changed since they published this in 2016:

Cam Rystad

The cynic in me naturally errs to favour technology over political market determinism in as much as I get concerned about these things. I guess that makes me long shale in my views. I still think offshore will be a major part of the energy supply mix (as the above chart makes clear), but perhaps less a part of the overall portfolio than we hoped in the near distant past.