The Emporers New Clothes… Seadrill Redux…

As a quick update to my last post on Seadrill (in which I was making a semi-serious point). I had a quick flick through the Seadrill 6k so you don’t have to… But first a little background… this post I wrote in April last year “Seadrill restructuring… secular or cyclical industry change?” seems to have aged well. In particular I noted:

[According to their restructuring plan in] 2019 Seadrill needs to grow revenue 65% to lose $415m of cash after turning over $2bn. In 2020 Seadrill then needs to grow 40% again, and only then do they generate $25m after meeting all their obligations. A rounding error. A few thousand short on day rates or a few percentage points in utilisation adrift and they will lose some real money.

Have another look at their business plan they had released in April last year:

Seadrill forecast P&L 2018.png

How is that “forecast” on revenue going? Seadrill did $302m in Q1 2019, which if they keep at that level is a rounding error above 2018. But it is more than 30% less where they thought they would be only a year ago. It’s not that long ago to be like $600m (of only $1.9bn) out… just saying… it’s more than a minor forecasting error… (go back and look at my post they were already downgraded and had been based on numbers supplied by a reputable IB with an analyst who currently has a Buy rating on SDRL).

Now just be to clear Seadrill was also forecasting they would generate $721m in EBITDA (a proxy for cash flow and an ability to service their debt). We have now passed the Q1, where they generated $72m, and guided $60m for Q2. So if we annualise that (which is generous as they got an unexpected $12m in Q1) they are on target for (max) $250m; around 1/3 of what they thought.

The $7.2bn of debt remains of course and was the (only?) accurate part of the forecast. Immovable and a testament to the willingness of humans to believe something that cannot possibly be true.

The numbers are clearly a disaster. The business plan above is a fantasy and Seadrill is heading for Chapter 22. Relatively quickly.

If you’re interested here’s how bad it is:

Seadrill actually did less revenue last quarter than the one the year before:

Seadrill Revenues Q1 2019.png

But had the same number of rigs working:

SDRL rigs working Q1 2019.png

And therefore the obvious… day rates have dropped…

SDRL Day Rates Q1 2019.png

And that is your microcosm for the whole industry offshore and subsea. Excess capacity means that even if you can find new work it is at lower rates.

Also, and I keep banging on about this, what are they going to do when Petrobras starts handing back the PLSVs this year? DOF’s are in lay-up, and there is no spot market for PLSVs. The equity in that JV is likely zero. Even if Petrobras does start re-tendering for PLSVs (unlikely given the drop in the number of floaters working) all that beckons is a price war with DOF to get them working. Anything above running costs will be a victory if the vessel market is a guide.

It goes without saying that in a price deflationary environment it is only a question of how long the banks can pretend they will be made whole here. SDRL isn’t going to get to $1.9bn in revenue this year and it certainly isn’t getting to $2.6bn the year after unless they change their reporting figures to the Argentinian Peso.

When I have more time I will explain my point on this more… but in the meantime be reassured the 23% drop the other day was  not an anomoly. The real question is why it took so long (and yes I do have a theory:). The investment bankers dream of someone buying Seadrill almost as much as Seadrill’s lending banks, but I find it highly unlikely (but not impossible) someone will make good $7bn in debt, and putting to stones together doesn’t mean they will float.

But the core point is that this is part of a deep structural change in the oil production market where offshore is not the marginal producer of choice any more. Previously that meant short-term oil price effects had a large (extremely pro-cyclical) effects on an industry with a very long-run supply curve, and this was combined with a credit bubble between 2009-2014. If my theory is right, and it has held up well for the past few years, then the much predicted,  but never appearing, demand-side boom will remain the Unicorn it has been for the past few years: a chimera that only appears in investment bank and shipbroker slide-decks.

That marginal producer is the now that shale industry a point Spencer Dale made a very long time ago now:

An important consequence of these characteristics is that the short-run responsiveness of shale oil to price changes will be far greater than that for conventional oil. As prices fall, investment and drilling activity will decline and production will soon follow. But as prices recover, investment and production can be increased relatively quickly. The US shale revolution has, in effect, introduced a kink in the (short-run) oil supply curve, which should act to dampen price volatility. As prices fall, the supply of shale oil will decline, mitigating the fall in oil prices. Likewise, as prices recover, shale oil will increase, limiting any spike in oil prices. Shale oil acts as a form of shock absorber for the global oil market.

Ignoring this fact lets you produce a “Key Financials” slide that bears no obvious relationship to how the market is really going to evolve. There is a lot of pain to come for the offshore industry as the need for banks to make painful writeoffs starts to permeate through the system and finally even more painfully capacity will be permanently removed from the market. This is an industry that needs significantly less capital and capacity to generate economic profits. And as I say: this is the recovery.

Change at the margin… shale versus offshore…

Shelf Drilling US.png

The map above and the statement above are taken from the Shelf Drilling prospectus. According to management, as can be clearly seen, there has been a structural change in the market and it simply isn’t coming back. 28 jack ups gone. Forever.

My only point on this is when you read about 90 units being scrapped since 2014 and 31 this year alone that is good in terms of helping restore the demand supply balance. But a market that used to have 40 jack-ups at it’s peak is never coming back and could conceivably go to zero. 1/3 of the scrappings just reflected a decline in the size of the market. And Mexico isn’t looking good either. Strangely none of the waterfall charts that show scrapping add back in an allowance for the accepted end state of the US Gulf? So of the 285 jackups on contract 10% of that number have had their market permanently removed and must surely impact on any credible scenario of market recovery?

Yes many in the GoM will have been the ones scrapped and will have been the older and less capable units, certainly not premium. But the point is there has been a structural change due to shale that has removed an geographical segment of the jack-up market and those need to be accounted for in a simplistic scrapping scenario. It also mean that if the market is “certain” to double in five years then other areas actually need to grow proportionately more to pick up the slack?

There has been a structural change in the Gulf market. Shallow water is out and large fields are in. Many of the offshore guys have probably gone onshore for the same money and the expense of laying off-take infrastructure in shallow water just isn’t worth it for companies now. This is a unique feature of the Gulf, although in Mexico they also appear to have largely exhausted the shallow water fields, but a factor with utilisation and supply/demand balances for the entire global fleet.

For those hoping for some Mexican respite this article from the FT last week will not be good news quoting the almost certain-to-be new finance minister:

“We certainly want more and more foreign, not just Mexican, investment and we’re going to open the door to everything,” Carlos Urzúa told the FT.  “The only exception is that there’s going to be a halt to oil tenders, ” said Mr Urzúa, an economics professor and published poet with a doctorate from the University of Wisconsin-Madison. “But apart from that, anywhere they want to invest, let them invest.” [Emphais added].

The growth in the GoM is all deep water high-flow rate, high CapEx projects. None of those can be serviced by jack-ups and given the international scope of companies like Rowan and Ensco some units are clearly destined for international markets.

This is just a small example of how small change at the margin affects the overall picture of demand for offshore assets. In 2014 the US was 14% of the jack-up market according to the figures above and recovery boom in the years ahead when the market has contracted meaningfully will be a rare feat if it occurs.

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.

More of the same…?

There are two reasons why the world has lost confidence in forecasts. First: the record is awful. Remember the predictions of oil at $200 a barrel or the view that nuclear energy would be so cheap that no one would bother to meter its use?

The second reason is that events, especially around technology, are moving so rapidly that it is difficult to keep up with what is happening already, never mind what could come next. Artificial intelligence, energy storage and, at a very different level, the spread of religious fundamentalism are all potential game changers in the energy market. Yet predictions of how and when their influence will be felt are no more than guesses.

Nick Butler

Professor and chair of the Kings Policy Institute at Kings College London

GS oil price 18 June 19.JPG

Goldman Sachs, 18 June, 2018

In our Lower 48 business we co-developed a pad optimisation mathematical model with a Silicon valley start-up. This is the first time it has been applied in the Oil and Gas industry. When initially deployed on 180 wells and five pads, it reduced emissions by 74%, increased production by 20%, and reduced costs by 22%.

Lamar Mackay, BP Upstream CEO

 

The graph at the top is the IEA’s forecast for the oil price in 2019. I don’t get caught up on forecasts because for obvious statistical reasons they have a low probability of being correct, but they interesting in that they reflect the current “dominant logic” or investment narrative.

Brent crude averaged $54 per barrel in 2017 so obviously a near 30% price increase is good news for the beleagured offshore industry. But I am struggling to see a breakout here which isn’t just more of the same where a little incremental revenue gets added each year? At the moment volume also appears to be increasing more than value in the offshore industry (i..e companies are doing more for less).

There is optimism in the jack-up market though… investors are throwing money at jack-up companies that are promising not to return money in dividends (or indeed any form of capital repayment) and build market share in a highly fragmented industry. I struggle to see how these companies can in effect be adding capital to an industry when the majority of their customers are trying to reduce capital intensity? It is an odd dynamic where they are buying jack-ups for 30% less than cost despite the fact that in the old days utilisation used to be between 90-100% and now it is accepted it is much lower. A jack-up with only 8 months work is worth more than 30% less than one with 12 months work given the high fixed costs and the same day rate… and yet day rates are still under pressure and still the deliveries keep coming.

More later when I have more time but I think this is becoming an irrational market if demand stays at these sorts of levels. The ability of E&P companies to force time risk back to asset owners marks a fundamentally different industry in terms of structural profitability potential to one that existed in the past. I get scrapping reduces net units in the market but with the fleet utilisation of around 50% there is a lot to go and the option costs of these companies without significant work is very high in cash terms…

Anyway these forecasts are important in that about now E&P companies are starting to set budgets for 2019 plans. Based on the sort of forecasts you can expect only a marginal increase in spending and in offshore that isn’t what a lot of business plans want or need.

Random Friday afternoon thought… Borr and McKinsey….

They both can’t be right can they?

From a downbeat McKinsey view on the jackup and floater market:

McKinsey jackup demand 1.0.png

From a recent Borr Drilling presentation:

Borr Jackups business.png

I know you can argue high-end jackups will recover etc… it’s just not a booming market if you have this much uncontracted capacity:

Borr fleet status.png

And maybe you would prefer less analysis like this from McKinsey:

After seeing rig activity stabilize during the first half of 2017, it resumed a declining trajectory in the second half of the year, hitting record low levels (estimated at about 300 units for jackup rigs and 140 for floaters). This will keep downward pressure on day-rates, with the few rigs that are finding new contracts, doing so at a sharp discount to the rates earned prior to the oil price decline (about 25 percent for jackups and about 75 percent for floaters from 2014 levels). This means lower margins for rig owners, even though they have reduced operating costs by around 70 percent since 2014.

Roll the dice!

 

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.

 

Seadrill restructuring… secular or cyclical industry change?

There is a cheeky 879 page document that outlines the Seadrill restructuring, agreed this week, if anyone is interested. My only real point of interest is that the business plan that was agreed finally in December 17 contained a significant reduction in day rates and forecast utilisation levels from the previously agreed plan of June 2017.

Seadrill VA Dec 17.png

It seems to sum up something I have said here before that the general consensus  said 2017 would be better than 20 16, and actually as the numbers come in it was not, and therefore 2018 will be another year with only weak growth for offshore. The longer this keeps up the harder it gets to mark the drop in demand in the offshore industry as a purely cyclical change that will reverse. The longer the rigs and jackups keep quiet the longer the boats will be under-utilised as well. Part of this I think is the realisation that the industry has relied in the past on very high levels of utilisation to remain profitable: fixed costs are so high that profit often wasn’t reached on any unit until it has worked 270-300+ days a year, so a future where these levels might not be reached permanently again is almost too much for many banks to accept or even contemplate.

A quick look at the forecast P&L for Seadrill shows that this is a business that requires a rapid recovery for this complex restructuring to work:

Seadrill forecast P&L 2018.png

In 2019 Seadrill needs to grow revenue 65% to lose $415m of cash after turning over $2bn. In 2020 Seadrill then needs to grow 40% again, and only then do they generate $25m after meeting all their obligations. A rounding error. A few thousand short on day rates or a few percentage points in utilisation adrift and they will lose some real money. Sure they start with a big cash pile, but they are still paying off .5 billion debt per annum and it goes up quickly. You don’t need to be a financial wizard to see that there is very little margin for error here. But the real dynamic here is the banks who would have to look at writing off billions if a plan along these lines cannot be agreed. And this is exactly the dynamic that drove the SolstadFarstad restructuring.

Here is a graphic example of “extend and pretend” or “delay and pray” that the Seadrill restructuring has come up with:

Seadrill extend and pretend.png

The banks are hoping that a collection of 32 assets, many  in lay-up, will recover in economic value enough to keep them whole in the next six years. I guess if you are in for this much it is a risk you have to take but is it really realistic?

McKinsey noted in their latest OFS outlook that:

[t]he offshore Baker Hughes rig count managed a tentative rise to 215 in January from a record low of 209 in September – barely reflecting the beginning of what many expect to be a more broad-based recovery in oil and gas project development in 2018 and 2019. Our data show that after showing signs of recovery in Q1–Q2 2017, rig demand actually decreased in the second half of the year (–3 percent for jack-ups, –13 percent for floaters since July 2017). Demand has now stabilized, although it remains more than 30 percent below levels seen in mid-2014. In the next bid round, we anticipate some improvement in rates as a result. [Emphasis added].

It doesn’t feel like a deep recovery that will lead to increased day rates. Certainly not on the scale that would lead to huge increases in day rates and utilisation. Borr Drilling recently used this data point:

Borr Activity Levels.png

Tender volumes might be rising… but surely if the price goes up some tenders will be withdrawn because the work will come in above budget? The longer oil stays rangebound at $70 surely the less likely, and longer, and these high utilisation and day rate scenarios become? Borr also have a whole presentation that essentially argues for a degree of mean reversion in day rates which is really just an argument that this is a cyclical downturn. For large portfolio investors Borr might make a sensible hedge in case it is true, but I don’t think it reflects the profound nature of the change going on in the industry at the moment.

The second Borr chart simply ignores the fact that in every other upturn mentioned shale was a non-existent market force, not the marginal producer of choice it is now. And look at the most recent 2011 recovery cycle: a very shallow recovery, and the fleet increased significantly since then. But the Borr presentation does highlight the scale of the upside if this is purely a cyclical downturn. My doubts are well known here.

The other unresolved issue in the restructuring is the fate of Seadrill/ Sapura JV flexlay vessels. In Europe everyone concentrates on the DOF/Technip and Subsea 7 vessels but the Sapura/Seadrill JV also own six PLSVs operating on long term contract. The huge drop in Brazilian floater and jack-up work directly imperils the long term demand for all the PLSVs in Brazil, and it is impossible to see Petrobras renewing such long-term and rich contracts for all these vessels.

Seadrill is going to be a very public bellwether of what an industry recovery looks like in the rig market and whether this is a cyclical or structural change in industry demand. The restructured Seadrill will have to hit the run rate very quickly this year or it will rapidly become apparent that, not for the first time in this downturn, projections of a broad industry recovery have been far too optimistic.