Unconventional verus offshore demand at the margin…

Economic growth occurs whenever people take resources and rearrange them in ways that are more valuable. A useful metaphor for production in an economy comes from the kitchen. To create valuable final products, we mix inexpensive ingredients together according to a recipe. The cooking one can do is limited by the supply of ingredients, and most cooking in the economy produces undesirable side effects. If economic growth could be achieved only by doing more and more of the same kind of cooking, we would eventually run out of raw materials and suffer from unacceptable levels of pollution and nuisance. Human history teaches us, however, that economic growth springs from better recipes, not just from more cooking. New recipes generally produce fewer unpleasant side effects and generate more economic value per unit of raw material…

Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has underestimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. The difficulty is the same one we have with compounding. Possibilities do not add up. They multiply.

Paul Romer (Nobel Prize winner in Economics 2018)

Good article in the $FT today on Shell’s attitude to US shale production:

Growing oil and gas production from shale fields will act as a “balance” for deepwater projects, the new head of Royal Dutch Shell’s US business said, as the energy major strives for flexibility in the transition to cleaner fuels. Gretchen Watkins said drilling far beneath oceans in the US Gulf of Mexico, Brazil and Nigeria secured revenues for the longer-term, but tapping shale reserves in the US, Canada and Argentina enabled nimble decision-making.

“The role that [the shale business] plays in Shell’s portfolio is one of being a good balance for deepwater,” Ms Watkins said in her first interview since she joined the Anglo-Dutch major in May…

Shell is allocating between $2bn and $3bn every year to the shale business, which is about 10 per cent of the company’s annual capital expenditure until 2020 and half of its expected spending on deepwater projects. [Emphasis added].

Notice the importance of investing in the energy transition as well. For oil companies this is important and not merely rhetoric. Recycling cash generated from higher margin oil into products that will ensure the survival of the firm longer term even if at a lower return level is currently in vogue for large E&P companies. 5 years ago a large proportion of that shale budget would have gone to offshore, and 100% of the energy transition budget would have gone to upstream.

The graph at the top from Wood MacKenzie is an illustration of this and the corollary to the declining offshore rig numbers I mentioned here. Offshore is an industry in the middle of a period of huge structural change as it’s core users open up a vast new production frontier unimaginable only a short period before. The only certainty associated with this is lower structural profits for the industry than existed ex ante.

Note also the split that the – are making between high CapEx deepwater projects and shale. Shell’s deal yesterday with Noreco was a classic case of getting out of a sizable business squarely in the middle of these: capital-intensive and not scalable (but still a great business). PE style companies will run these assets for cash and seem less concerned about the decom liabilities.

You can also see this play out in terms of generating future supply and the importance of unconventional in this waterfall:

Shale production growth

As you can see from the graph above even under best case assumptions shale is set to take around 45% of new production growth. When the majority of the offshore fleet was being built if you had drawn a graph like this people would have thought you were mad – and you would have been – it just highlights the enormous increase in productivity in shale. All this adds up to a lack of demand momentum for more marginal offshore projects. The E&P companies that are investing, like Noreco, have less scale and resources and a higher cost of capital which will flow through the supply chain in terms of higher margin requirements to get investment approval. This means a smaller quantity of approved projects as higher return requirements means a smaller number of possible projects.

Don’t believe the scare stories about reserves! The market has a way of adjusting (although I am not arguing it is a perfect mechanism!):

Running Out of Oil.png

Common knowledge in offshore and shale…

“With every grant of complete security to one group the insecurity of the rest necessarily increases.”

Friedrich Hayek

Common knowledge is something that we all believe everyone else believes. 

We don’t have to believe it ourselves, and it doesn’t even have to be public knowledge. But whether or not you personally believe something to be true, if you believe that everyone else believes something to be true, then the rational behavior is for you to act AS IF you believe it, too. Or at least that’s the rational behavior if you want to make money.

Common knowledge is rarer than you think, at least for most investment theses. That is, there’s almost always a bear case and a bull case for a stock or a sector or a geography, and god knows there are plenty of forums for bulls and bears to argue their respective cases.

What can change this normal state of affairs … what can create common knowledge out of competing opinions … are the words of a Missionary. In game theory terms, the Missionary is someone who can speak to everyone AND who everyone takes seriously. Or at least each of us believes that everyone else hears the Missionary’s words and takes them seriously.

When a Missionary takes sides in a bull vs. bear argument, then depending on the unexpectedness of the words and the prestige of the Missionary, more or less powerful common knowledge is created. Sometimes the original Missionary’s words are talked down by a competing Missionary, and the common knowledge is dissipated. Often, however, the original Missionary’s words are repeated by other, lesser Missionaries, and the common knowledge is amplified.

When powerful common knowledge is created in favor of either the bull or bear story, then the other side’s story is broken. And broken stories take a looooong time to heal, if they ever do. Again, it’s not that the bulls or the bears on the wrong side of the common knowledge are convinced that they were wrong. It’s not that the bulls or the bears on the wrong side of the common knowledge necessarily believe the Missionary’s statements. But the bulls or the bears on the wrong side of the common knowledge believe that everyone ELSE believes the Missionary’s statements, includingeveryone who used to be on their side. And so the bulls or the bears on the wrong side of the common knowledge get out of their position. They sell if they’re long. They cover if they’re short.

Ben Hunt, Epsilon Theory

Oil and offshore has a lot of missionaries. In cyclical industries separating out industry firm effects from market effects is nigh on impossible. Be on the right side of a bull market and you make enough money to be a missionary respected by the crowd.

I thought of this when I read this extract from Saudi America in the Guardian. I won’t be buying the book (KirkusReviews panned it here) but the parts on Aubrey McLendon of Cheasapeake fame are interesting. However, what is really interesting is that in 2016 when the research for the book was being done there was a strong strain of  the “shale isn’t economic” narrative:

Because so few fracking companies actually make money, the most vital ingredient in fracking isn’t chemicals, but capital, with companies relying on Wall Street’s willingness to fund them. If it weren’t for historically low interest rates, it’s not clear there would even have been a fracking boom at all…

You can make an argument that the Federal Reserve is entirely responsible for the fracking boom,” one private-equity titan told me. That view is echoed by Amir Azar, a fellow at Columbia University’s Center on Global EnergyPolicy…

John Hempton, who runs the Australia-based hedge fund Bronte Capital, recalls having debates with his partner as the boom was just getting going. “The oil and gas are real,” his partner would say. “Yes,” Hempton would respond, “but the economics don’t work.”…

In a report released in the fall of 2016, credit rating agency Moody’s called the corporate casualties “catastrophic”. “When all the data is in, including 2016 bankruptcies, it may very well turn out that this oil and gas industry crisis has created a segment-wide bust of historic proportions,” said David Keisman, a Moody’s senior vice-president.

Many of the offshore “recovery plays” were financed when this was the investment narrative. The “common knowledge” was that there was going to be an offshore recovery, it was simply a case of when not if. The staggering increase in shale productivity was not part of the common knowledge and didn’t form part of the narrative. Go long on assets said the common knowledge… they are cheap… this is a funding issue only… what could go wrong? As the oil price inevitably rose demand for offshore assets would quickly recover right?

As the graph at the top of this article highlights, just as the common knowledge was being formed that allowed a range of offshore companies to raise more capital to get them through to the inevitable recovery, and clearly the demise of shale would occur by simple economics alone, in fact the shale industry was just cranking up.

The results of most of the offshore companies for the supposedly busy summer season show that at best a slight EBITDA positive is the most that can be hoped for. Rig, jack-up, and vessel rates remain extremely depressed and most companies are struggling to even cover interest payments. A few larger SURF contractors are covering their cost of capital but most companies are simply doing more for less. Companies might be covering their cash costs but there is a massive issue still with oversupply, and judging from the comments everyone continues to tender for work they have no hope of getting as everyone is doing more tendering. The cash flow is rapidly approaching for a number of companies and Q2 results have shown the market is unlikely to save them.

The missionaries for the shale industry are currently in the ascendant in creating a new common knowledge. The new common knowledge for offshore will be extremely interesting.

(P.S. If I was the publishers I’d rush the paperback edition of the book out).

Shale doesn’t have a cash flow issue …and the limits of expansion…

Yesterday the $WSJ had this article on the economics and cash flows of the shale industry. The overall point is logical that if cost increases continue the cost of capital may go up for shale producers and point to it reaching the economic limits of its expansion. I agree with the general thrust of the article in that if the industry isn’t as profitable as forecast the cost of capital will increase, but this comment is being taken out of context by some:

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Of course they didn’t… they are investing for even higher production next year… the comment “within their means” is pejorative and not a reflection of economic reality. That is a sign of confidence from the firms and their financial backers that their output can be sold at a profitable price. The price signal from both the oil and the capital markets is strong.

I also received a comment yesterday with a link to this comment. I don’t think this is a big deal to anyone with a basic understanding of finance because they get this… but then again I have lost count of the number of people who repeat back to me that no one makes money from shale.

I wonder if this isn’t becoming part of the great “Gotcha” narrative that aims to prove that shale isn’t a viable production methodology? Like the CEO of Shell is going to wake up next Tuesday and say “after reading the article in the WSJ we are going to stop investing in shale. Thank goodness I read that or I would never have realised we will never make money from it!” As if those investing literally tens of billions had no idea of the cash flow profile of their assets?

The overall article is interesting only in that it points to what appears to be the current “productive efficiency” of shale, not its demise. The point of the article isn’t that you can’t make money from shale it is that at the margin now it is becoming less profitable and that may affect the pricing of capital. Bear in mind before you read the rest of this post the scale of the increase in absolute oil production shown in the graph above and the amount of capital required to finance this.

For those not versed in accounting cash flow negative might seem like a big deal but it’s not. A casflow statement is made up of Cash From Operations [CFO] (+/-) Cash flows from investing [CFI](+/-) Cash flows from financing [CFF]. It balances with the cash at bank at the start of the period and at the end. Free Cash Flow to the firm is simply the sum of the first two… You would expect the number to be negative in a capital-intensive industry, like shale oil extraction, when you are seeking to grow output volumes significantly, particularly when a number of firms are new entrants into the industry and not financing from retained earnings. You are spending capital to get future revenue and you need to borrow or raise equity to do this. Collectively as all the firms in the industry deepen the capital base for ever higher production they are using more cash than they are generating currently. (I am aware that there are a number of definitions of Free Cash Flow but this appears to be the Factset one and the generally accepted one of FCFF).

If you buy an offshore drilling rig for $1bn and get 100m in operating cash flow for year 1 then your (highly simplified and representative) cash flow statement reads: CFO +100m: CFI -$1bn. That is your “Free Cash Flow” [FCF] is -$900m. It is balanced (all going well) by CFF +900. You own an oil rig that lasts for 20 years but in year 1 you were down $900m in FCF. You can buy as many rigs as you want and be FCF negative (like Seadrill) for as long as you can keep CFF >= CFO+ CFI  i.e. you have access to debt or equity markets. That is all that is happening in shale collectively.

If these were operating cash flow negative then there would be a massive issue. But as this research from the Dallas Federal Reserve (March 2018) makes clear there is no problem with operating cash:

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Or indeed with profitably drilling wells at the current oil price (i.e. including financing):

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For as long as investors believe that in the future the oil price attainable by these E&P companies is sufficient to return capital, and funding markets remain open, then spending more on Operating Income + CapEx combined is no problem. There is rollover risk in the debt but that is a seperate risk and appears to be pretty minimal at the moment.

Pioneer is an embodiment of this: in the first six months of 2018 it generated ~$1.5bn from operations (i.e. selling oil and gas) [CFO], spent ~$1bn on investments (actually nearly $2bn but it sold some stuff as well) [CFI], and then paid back debt of $450m and purchased ~$50m of shares. But some smaller companies who have come in recently will have spent far more on CapEx than they will earn in CFO.

When I have talked about the ‘virtuous cycle’ of capital deepening in prior posts this is part of that network effect of decreasing risks and increasing returns for all involved in the ecosystem. E.g. if Trafigura build an export facility for 2m b/per day it lowers the risk for every E&P company (and their financiers) that they can sell more oil profitably. So more investment comes into the sector in an ever-expanding circle, lower costs, replacing labour with capital. That is what appears to be happening here. The limits of this process are there and are hinted at in the WSJ:

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Permian production will be up 19-24% according to Pioneer so it’s not all bad. Costs are increasing as the Permian reaches the constraints of labour and capital as has been well documented. Some of these will disappear with new pipelines and other capital deepening, e.g. a replacement of capital over labour as excess surplus is currently trucked or railed out, but some will continue given the huge increase in absolute production volumes. It is no surprise that with such a huge percentage increase in production that at the margin each incremental barrel becomes more expensive in the short-run, but then the capital deepening effect will kick in and the long-run cost curve will decline, as always in mass-production, and then the unit costs drop again… ad infinitum

Pioneer are saying with that statement is that their marginal output on capital is declining slightly this year as cost increases have not kept pace with productivity improvements. That isn’t surprising because the sheer volume of output increased has consistently surprised on the upside. If the project costs increase 10% and this isn’t covered with higher prices and/or productivity improvements then investors will change their price of capital to reflect diminished expectations.

US-Shale-Production-Outlook-Revised-Upward-Repeatedly-20160210-v2

But this production capacity isn’t going away. The rigs have been built. The pipelines have been, or are being, built; the same goes for export terminals etc. The capital base of the industry has increased massively and is facing some teething problems. But in a little 4 over years the US tight oil industry has driven US production up to over 11m b/ per day in 2018, over 6m b/ per day of that from shale up from ~4m b/ per day in 2017.

What should really worry those in the offshore community is that this is an industry that increased production 50% in a calendar year before hitting the limits of economic growth, and it did this while increasing productivity and lowering unit costs. Someone isn’t waking up next Tuesday and realising it has all been a massive mistake and turning the tap of funding or production off. The US shale industry is a deep and entrenched part of the energy mix now. Current forecasts might be out by a few hundred thousand barrels a day but they are not going to be out by millions. This production is real and permanent with profound implications.

The core logic of the WSJ article is surely right: A rise in the costs of shale relative to output signals the limit of the economic efficiency and therefore the diminishing returns to capital may make it more expensive for shale E&P firms to fund new projects. Shale and offshore compete for E&P company CapEx and if the cost of funding shale projects rises (on a productivity measured basis) that should increase relative demand for offshore as a substitute. But the Free Cash Flow from an offshore project is massively negative in the short-run and over time has higher yields, whereas the reduced CapEx commitment, despite its lower margin, is one of the chief attractions of shale. Cash for investment is not the issue.

I think it sits uncomfortably with forecasters who claim that day rates for jack-ups will double within two years, or other such notions, and it does not seem to be incorporated in the strategic planning assumptions of a large number of offshore companies or investors where the logical outcomes of such data sit uncomfortably. The offshore industry built a fleet to handle 2013 demand when shale was producing ~2.5m barrels a day, it is now producing 6m and is growing faster than the overall oil market growth and forecast to do so until 2021 at least.

Hard strategic questions arise for the offshore industry: how do we compete in an industry which faces potentially declining market share for our underlying product at the margin? How do we compete in an industry when a competitor with a different business model has taken 10% of global market share in the space of 5 years and we buy 25 year assets funded on short-term contracts? What level of asset base shrinkage does the offshore industry require to be competitive? How many firms will have to liquidate given this necessary shrinkage? What will the surviving firms look like? How much can they realistically expect to make? What are our assets worth?

There are a lot more questions based around this logic. But if you are simply expecting a day-rate increase and a demand side boom based on shale magically running out of cash at some future point I think you are going to be very disappointed.

Oil prices, technology, volatility, and productivity…

Oil prices are unusually prone to volatility because both supply and demand are insensitive or “sticky” in responding to price changes in the short term, while storage is limited and costly.

Robert McNally, Rapidan Energy Group

 

Last week Citi’s lead oil analyst came out and said he thought oil prices might dip to $45 per barrel in 2019 and be in the $45-65 per barrel range by the end of 2019. This contrasts with Goldman Sachs ($70-80), Morgan Stanley ($85), and Bernstein ($100). I don’t have a view on the oil price, all this shows you is that intelligent, well-informed analysts, with almost endless resources, can vary in their forecasts by around ~50-100%. Read the whole story to understand how looking at exactly the same data set as all the other equally capable analysts Citi’s analyst reaches such a different conclusion.

What this really shows is model risk: a few percentage points difference in key input variables, even over a short space of time, can have a huge influence over the outcomes. And actually, there are in reality too many influences to model them all accurately: Will there be a supply outage in Libya? What will happen with Iranian oil? What will happen in Venezuela? And these are just a few of the big geopolitical questions alone. You need a forecast for many planning assumptions but in the short-run the oil price is a random walk.

A good example is this graph from the EIA showing the difference between their February prediction of US oil prediction and the current one:

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If you are wondering why your jack-up, rig, or vessel isn’t quite getting the utilisation or day rate you were looking for in that graph may lie the answer? It’s a bold Board that sanctions too many projects in this environment, and in fact the one that is, Exxon Mobil with the huge Guyana finds, is getting slammed by the stock market. Barclays, summing up the “market view” saying:

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Shale isn’t a swing producer as McNally makes clear, but it does have a much shorter-term impact on the market in way that nothing did prior to 2013. But it also isn’t a given that offshore will have a cost or volume advantage over offshore in 10 years time: companies need to hedge their bets if they are large portfolio corporations. McNally has published ‘Crude Volatility‘ which may make  my summer reading list.

The big area where I agree with Citi/Morse is on technology and productivity.  Morse obviously believes, as I do, that a few percentage points of recovery and technological improvement over the well lifecycle has the potential to radically alter physical oil output assumptions over the long-run. And that is before you get into the wonkish areas such as on what base you forecast the decline volume on.

Against this backdrop is a new wine in the old bottle of peak oil demand: lack of investment and the coming supply shortage. A whole host of energy consulting firms say underinvestment may cause a supply driven price rise: Rystad and Energy Aspects in this WSJ article:

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This despite the fact that gross investment doesn’t reflect the increased volume of supply gained from each incremental dollar at the moment (a point Morse makes), or the fact that oil companies don’t need the same level of reserves now (and investors don’t want them to pay for them).  Woodmac, who in the latest “gotcha” on why shale won’t work (sic), has now discovered shale well rates decline faster than thought… I’ll bet by 2040 the 800k a day production cited in the article is made irrelevant by productivity improvements in extraction and production techniques. But I guess again it shows how senstive large data models are to small input changes (and how desperate research firms are to have some uncertainty and upside to discuss with certain corporate clients where an element of group think appears to be pervading Board thinking).

“Preparing for the Recovery”

Preparing for the future.png Rystad also run’s strategy days for Maersk Supply and numerous other subsea and offshore companies…. “Hang in there guys the recovery is just around the corner when the supply crunch happens…”… (however remember The Dominant Logic is dangerous?)….

Meanwhile the capital deepening in the US shale industry continues apace. Have a look at the new pipelines going in:

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Once these are built the price discount will disappear, further raising E&P company profitability and some railway carriages and trucks they displace will still exist (‘unit trains’ with 100+ carriages carry >66 000 barrels). Some will be scrapped but the railway carriages are like offshore vessels: high fixed costs and commitments and low marginal costs. That is a short way of saying they will reduce their costs to compete… and the virtuous cycle will continue with the capital base even deeper.

What really matters for offshore at the moment is the competition for marginal investment dollars. Does an E&P company choose to invest onshore or offshore? The big advantages of shale are potential productivity increases and lower upfront cash costs despite a lower margin (i.e. low CapEx high OpEx), this flexibility has a number of distinct advantages in  an era when forecasts are so divergent. It is worth noting that Shell, Exxon Mobile and Chevron all underperformed the stock market last week despite oil prices having risen signficantly over the last year. Shareholders want their money back in an era of uncertainty, not mega-projects that offer future pay-offs.

In an era when the volatility of oil prices is clearly increasing you can be sure that tight oil will be favoured over long cycle production at the margin. The ability to take margin risk over commitment risk is a key part of the investment making decision process.  The graph above shows how volatile oil prices has been, in particular since 2003. It is irrational to go long on fixed commitments in a age of increasing volatility: just as it is illogical to take on a massive mortgage on a rig or vessel in the current market it is illogical to go long on too many 20 year deepwater developments, and the two symptons are obviously related to the same cause. For a baseload of demand that is logical, but that only works for the larger players with significant market share, at the margin assets and projects become harder to finance.

The other issue driving investment towards shale, in a time of capital discipline, is path dependence. Path dependence is a process where each step forward can only be achieved with the prior steps preceeding it. Deepwater followed shallow water as an extension of the skills developed there.

The productivity benefits of shale are such that larger E&P companies must fear if they miss this technology cycle catching up on the “path” may be too hard or expensive given the dependent steps they will have to get there. History matters.

Offshore will remain an important part of the energy mix. But the price rise of the past 12 months has led to only marginal increases in work and a firm commitment from E&P companies to control CapEx in a manner that breaks with the past. Price rises not increases in long term production projects are the short term adjustment mechanism at the moment. In a era of price volatility and extraordinary technical change the future could look a lot like the present.

The wrong side of history…

“Until an hour before the Devil fell, God thought him beautiful in Heaven.” …

The Crucible, Arthur Miller

 

On the IHS Markit projection, by 2023 the Permian is likely to be producing an additional 3m b/d of oil, along with an extra 15 bcf of gas. For the US economy this news is positive. America will have a secure source of supply that, through its production, distribution and consumption, will generate significant economic activity across the country.

The volumes involved will further reduce the unit of production, probably to below $25 a barrel. The study estimates the total investment needed to deliver the new supplies will be some $300bn. For the global oil market the effect will be dramatic. The US will become a significant exporter. The IHS Markit paper suggests that by 2023 the country will be exporting around 4m barrels a day. That will absorb much of the expected growth in demand. [Emphasis added].

Nick Butler, Financial Times, June 25, 2018

 

For one thing, customers have an unfortunate habit of asking about the financial future. Now, if you do someone the single honor of asking him a difficult question, you may be assured that you will get a detailed answer. Rarely will it be the most difficult of all answers – “I don’t know.”

Where are the Customers’ Yachts? 

Fred Schwed

In case you missed it another major pipeline looks certain to go ahead in the Permian by 2020 (in addition of course to the Exxon Mobil 1m b/d). If the 30″ version is selected then 675k barrels a day will be added in export capacity to the port at Corpus Christi, where a major upgrade is also taking place that will allow significantly larger tankers into the region:

Oil export capacity from the Corpus Christi area is expected to rise to 3.3 million bpd by 2021 from 1.3 million bpd this year, keeping its rank as the top oil export port, according to energy research firm Wood Mackenzie.

In fact if you believe Pioneer Natural Resources (on S&P Platts) then Permian pipeline capacity will double by 2020 (to 3.5m b/d) and the US production will reach 15m b/d by 2028. The graphic at the top of the page highlights that top Permian wells are profitable at $22 per barrel. There is a good point on the interview where the CEO of Pioneer points out in 2015 the dominant narrative was shale would go bankrupt and in fact there has been a rebound.

This continuous process of capital deepening, infratsructure upgrades, and productivity improvements has driven the recovery of the US shale industry and has devastated the offshore industry. There is a link: it is not all inventory and reserve rundown. Offshore used to have to run at very high utilisation in order to work and without it the economic model is broken. No other economy in the world excels at this kind of constant, small-scale, mass production improvement like the American economy. Once a product can be mass produced at scale the ability of the US economy to drive down per unit production costs is unmatched.

At the moment there is a boom in the Permian and Eagle Ford basins: wages are high and there are delays and bottlenecks (I read a story last week of a power company demanding 40k to put in one power pole) but this capital deepening will alleviate some of these issues in the short-term. Trucks will be replaced with pipelines etc, a new generation of high spec rigs in the  offing. Deliver, review, improve. Always with a focus on productivity and efficiency. Shale is a process of horsepower and capital and those are two attributes the US economy is preternaturally endowed with. Each incremental pipeline becomes less important in a relative sense so the investment bar is lower. Slowly but surely unit costs get lower every year. It is a relentless and predictable process.

That is the competition for offshore for capital at the margin: an industry improving its efficiency and cost curve with every month that passes. And the solutions to constraint problems in the Permian are on a timescale measured in months while investments in offshore take years to realise.  Offshore offers huge advatages over shale in terms of high volume flow rates and low per barrel lift costs but it is a long term CapEx high industry and not suited to production of marginal volumes. There is every likelihood it is used as a baseload output in years to come while shale supplies marginal demand. This is a massive secular change for offshore and will fundamentally alter the demand curve to a lower level. The clear evidence of this seems to be causing a degree of cognitive dissonance in the offshore industry where any other outcome that a return to the past is discounted.

To just focus the mind: if offshore were to improve productivty by 3% per annum for three years- which is considerably slower than the productivity improvement in shale – day rates for offshore assets in 3 years would need to be at c.92% of current levels per unit of output (i.e. a 8% reduction [1/1.03^3]). Not all of this is going to be possible in offshore execution terms given the aset base, some of this will come from equipment suppliers who are manufacturers and subject to scale economies reducing costs, but this is the challenge for offshore bounded by Bamoul constraints. There are limits to the volumes that can be produced by shale but they have constantly exceeded market expectations and they have eaten a meaningful share of global oil output and this will not change only increase.

As the graphic below shows this is a supply side revolution as demand for the underlying commodity has increased consistently since 2006:

Global Oil Demand 2006 to 2018F

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So the only possible explanation for the continuing drop in the utilisation of offshore assets is that the demand has fallen for their use relative to the global demand for the underlying commodity they help produce.  I accept that may look tautological but we just need to clear that point out early.

I have been on before about how I don’t think a quick recovery is likely for the offshore market for those long on offshore delivery assets only (the tier one SURF contractors are different as their returns are driven by engineering as well as asset leverage). I can’t see how an industry like the shale can develop in parallel with a “snap back” in offshore, particularly when the larger E&P companies have been consistent and vocal about limiting CapEx.

The reason jack-up companies are like offshore supply companies, and not SURF contractors, is that they take no project risk. An oil company doesn’t handover well risk to a drilling contractor (as Macondo showed). Shallow water drilling contractors are the AHTS and PSV of drilling: you get a day rate and that is the only value we expect you to provide. It is an asset return and utilisation gig completely different from SURF contracting. And yet against this background there is a bubble developing in the jack-up market seemingly unsupported by any fundamental demand side recovery. I am not alone here: McKinsey forecast jack-up demand to rise 2% per annum to 2030 (about a 10% growth in market size over the next five years).

Bassoe on the other hand are forecasting that day rates will double in the jack-up market in five years, which equates to a 15% compound average growth rate.  I realise this narrative is one everyone wants to hear, you can almost hear the sighs of relief in New York and London as the hedge funds say “finally someone has found a way to make money in offshore and profit from the downturn”. And as the bankers stuff their best hedge fund clients full of these jack-up companies stock this is the meme they need as well. At least in this day and age the investors have better yachts than the bankers.

Yet the entire jack-up market thesis seems to rest on the accepted market narrative of scrapping and therefore higher utilisation. As Bassoe state:

If 85% jackup utilization seems relatively certain, then a doubling of dayrates is too.

Certain is a strong word about the future… As if the entire E&P supply chain will benignly accept day rates increasing 15% Y-O-Y from every single market participant without worrying about it…

Ensco is a good place to look because it also considers itself a leader in premium jack-ups. Ensco has exactly the same business model as Borr and Shelf (indeed it is focusing on exactly the same market segment in jack-ups): raise a ton of money, go long on premium assets and wait for the market to recover… Ensco’s recently filed 10K shows how well this jack-up recovery is going:

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Oh hold on it doesn’t show that at all! Instead it shows the jack-up business revenue declined 17% Q1 18 versus Q1 17. Awkward… So like everyone else here is the crunch of the “market must come back” narrative: Scrapping.

Ensco jackup fleet forecast.png

The problem with this argument is the scale of the scrapping required in the red bars (not to mention the assumptions on China). If that slows and/or the market growth doesn’t quite come then the obvious downside is that there are too many jack-ups for the amount of work around. Somewhere between 2% and 15% compound per annum leaves a lot of room for error.

When your revenue figures drop 17% on the previous year management in most normal companies, but especially those with a very high fixed cost base and a disposable inventory base (i.e. days for sale), tells the sales reps to cut the price and win market share. And that is exactly what will happen here. In fact far more accurate than forecasting the market is an iron law of economics that in an industry with excess capacity and high fixed costs firms will compete on price for market share. Investors going long on jack-ups are making a very complicated bet that the market growth will outpace scrapping in a way it hasn’t done in the past despite E&P companies being under huge pressure to keep per unit production costs low.

On the point of the age of the jack-up fleet: this is clearly valid to a degree. But as anyone who has negotiated with an NOC in places in South East Asia and Africa can tell you all this talk of new and safe over price is Hocus Pocus. Otherwise in the greatest down market around none of these units would be working or getting new work and that clearly isn’t the case.

In fact in many manufacturing businesses old machines, fully depreciated and therefore providing only positive cash flow to the P&L, are highly prized if they are reliable. There is no evidence that this will not happen in offshore and plenty of counter-examples showing that oil companies will take cheaper older assets. The best example is Standard Drilling: bringing 15 year old PSVs back to the North Sea that were originally DPI, and getting decent summer utilisation (day rates are another issue but for obvious reasons). Eventually as the munificence of an industry declines the bean-counters overpower the engineers and this is what I believe will happen here, there is plenty of evidence of it happening in offshore at the moment. Every single contracts manager in offshore has had a ridiculous conversation with an E&P company along the lines of: “we want a brand new DP III DSV, 120m x 23, 200t crane, SPS compliant, and build year no later than 2014 and it’s a global standard… and we want to pay 30k a day”… and then they go for the 30k a day option which is nothing like the tender spec.

The reason is this: North Sea E&P companies are competing against shale for scarce capital resources and they need to drive costs out of the supply chain constantly. Offshore has dropped its costs in a large part because the equity in many assets and companies has been wiped out, that is not sustainable, but what is really unlikely to happen here is a whole pile of asset managers wake up simultaneously at E&P companies over the next three years and tell people to wholesale scrap units knowing it will increase their per barrel recovery costs while watching shale producers test new productivity levels.

There may well be a gradual process on a unit-by-unit basis, a cost benefit analysis as the result of some pre-survey work or a reports from a offshore crew that the unit isn’t safe, but not suddenly 30 or 40 units a year, and if does happen too quickly and prices rise then the E&P companies will revert to older units to cap costs. Fleet replacement will be a gradual process and some operators will be so keen to save money that they will let some older units be upgraded because it will have a lower long term day rate than a newer unit because they get that to continue to have capital allocated they need to drive their costs down.

The investment bubble in jack-ups is centred on Borr Drilling and Shelf Drilling. These companies have no ability or intention to pay dividends for the next few years. Credit to them: raising that sort of money is not easy and if the market is open you should take the money. Their strategy, in an industry that patently needs less capital to help rebalance, is to add more and wait for a recovery. Place everything on 18 red at the casino. Wait for higher prices and utilisation than everyone else despite doing exactly the same thing (just better). And that’s fine it’s private money, and it might work. But economic theory I would argue suggests it is extremely unlikely, and it will be a statistical outlier if it does. Five years ago the US shale industry was producing minimal amounts and the dominant thought was they required $100 oil to work so think how different the world will be by the time these companies have any hope of returning cash to investors?

Forecasts are hardly ever right, not for lack of effort but the inability to take into account the sheer number of random variables, the epsilon, in any social process. Forecasts that a segment of the offshore market will double given the headwinds raging against it should probably be viewed as bold, a starting point for debate rather than a base case for investments. Having picked 9 of the last 0 housing crashes you should also realise that while my arguments will eventually be proven right the timing of them can be wildly inaccurate as well.

Shale and offshore… the competition for marginal investment dollars…

Last week the Baker Hughes rig count for the US came in and again it was up. In the graph above Woodmac are highlighting it that Lower 48 US shale production may crack 12m barrels a day.  As recently as 2013, when offshore was starting to go really long on ships, US shale production was ~3.0m per day. It has in short been an industrial phenomena, one as I have noted here before no other economy in  the world could have marshalled as it has required enrmous flexibility in capital markets and the ability to turn a service industry into a manufacturing process.

The narrative has changed as well. Shale has consistently outperformed even optmistic forecasts:

US-Shale-Production-Outlook-Revised-Upward-Repeatedly-20160210-v2.png

As recently as 2016 even BP’s renowned research team were only predicting a fraction of actual demand. Shale now represents an enormous portion of workd output and it’s economic model of short-cycle low-margin is the antithesis offshore but this flexibility around spending commitment is clearly very valuable to E&P companies in an era of price volatility.

So I get as the price declined in 2014/15 you could maybe make a reasonable case for a quick rebound in offshore? 2016 at a stretch, although I think the market signals for offshore were already clear byt then, but I have to say it strikes me as hard now for people ignore the scale of this change and to argue there will be some demand driven boom coming in offshore. E&P companies have stated repeatedly they are sticking to forecast offshore CapEx numbers and they seem to be sticking this.

I still think there are too many business plans floating around which have as a core assumption. This from Ocean Rig:

Ocean Rig Recovery.png

“[F]or the market upturn” (emphasis added)… like it’s a given? I get it’s off a low base but I think we all know when people talk about that sort of recovery they mean a deep cyclical one that flows to rig and vessel operators who will make a ton of money.

But let’s look at the scale in terms of shift at the margin in incremental output:

Long term offshore.png

The last time the oil price dropped and offshore boomed back,whichever cycle you were talking about but especially the quick 2008/09 rebound, that yellow portion of incremental investmnent simply didn’t exist on the graph in a meaningful sense (and since this graph was done shale is more important). A business plan that simply ignores this reality an insists on a change in market conditions as it’s defining principal is simply logically inconsistent to my mind. Clearly offshore is an important part of the energy mix going forward, but in 2009 it was really the only alternative to traditional onshore production and that clearly isn’t the case now.

Offshore used to have very high utilisation rates, that is what made small companies in an extremely capital intensive industry viable, but it is clear that the scale of investment in shale is having a profound impact on utilisation levels and this is changing the entire economic structure of the industry. This point is a prelude to a further few posts that have this logic as there core.

The oil price meme…

As the oil price passes USD 80 there is a really interesting post (lengthy, but great) here from Epsilon Theory on memes:

If you get nothing else from Epsilon Theory, get this: we are ALL hard-wired — literally hard-wired through millions of years of neurological evolution — to respond positively to effective meme introduction. We are ALL programmed — literally programmed through tens of thousands of years of cultural evolution — to respond positively to effective meme introduction. It’s no exaggeration to say that our biological and cultural symbiosis with memes defines the modern human species. This is a feature, not a bug.

Eusocial animals (the “pure” form of what it means to be a social animal) swim in an ocean of constant intra-species communications. It’s why these species — the ant, the termite, the bee, and the human — are the most successful multicellular animal species on the planet. Eusocial animals have the ability to store, retrieve and broadcast information (yes, eusocial insects communally “remember” incredibly complex informational structures) in a way that non-eusocial animals simply can’t, and it allows the eusocial animal not only to survive its environment, but to master its environment. Any environment. Humans are essentially giant termites with opposable thumbs and fire, and that combination is particularly unstoppable. But it’s the termite-ness … it’s the swimming in an ocean of constant intra-species communication … that’s the most important of these qualities.

Right on cue this week the FT carried a piece from the research firm Energy Aspects:

While there has been breathless attention paid to prompt Brent prices climbing to $80 a barrel for the first time since 2014, what has received less attention is that the entire Brent forward curve is now trading above $60, including contracts for delivery as far out as December 2024.

This development is an important psychological milestone for the oil market. The market is, in effect, saying that “lower for longer” is dead. (Emphasis added).

Narratives and memes are getting a lot of focus in economics for the right reasons as the above authors realise.

The Bank for International Settlements this week came out with some research that suggested 30-35% of the movement in oil prices was down to demand and supply and the rest of the movement down to potentially financialisation, speculation and other factors.

Another of the big (related) reasons for the procyclicality of the oil price (which the BIS touch on) is the structutral nature of the trading firms in the oil market. When the price is going up CFOs/Risk Officers feel good because they are buying at 70 and selling at 75. So bid/ask spreads narrow, inventory goes up, leverage goes up, and risk is on… whereas on the way down the value of inventory is declining, leverage does down, the bid ask spreak widens, volumes drop… we’ve been here before. Where we haven’t been before is in an oil market where a marginal producer has potentially such a powerful impact on the market.