More evidence this is the offshore “recovery”…

I was going to write this anyway today and then looked at the oil price as I was leaving work… down 2.7% at the time of pixel… The graph above comes from the Dallas Fed blog which makes this salient point and helps explain why:

Given current market prices, U.S. shale production will continue growing this year. Indeed, a recent report by the International Energy Agency highlighted that shale production is likely to be a major driver over the next five years. This does not rule out the possibility of major oil price movements, but it does point to a strong tendency that oil prices will be range bound in the near future.

Read the whole thing. Shale has structurally changed the oil industry and fundamentally changed any realistic scenarios for an “offshore recovery”.

Contrast that with the investment boom in shale: If you want to see how the whole ecosystem of companies and innovation are working in a harmony to make US shale more efficient, deepen the capital base, and thereby work in a virtuous circle then this article from the Houston Chronicle that showcases a GEBH project to turn flared gas into power in the region is a great anecdote:

Baker Hughes is using the Permian Basin in West Texas to debut a fleet of new turbines that use excess natural gas from a drilling site to power hydraulic fracturing equipment — reducing flaring, carbon dioxide emissions, people and equipment in remote locations…

Baker Hughes estimates 500 hydraulic fracturing fleets are deployed in shale basins across the United States and Canada. Most of them are powered by trailer-mounted diesel engines. Each fleet consumes more than 7 million gallons of diesel per year, emits an average of 70,000 metric tons of carbon dioxide and require 700,000 tanker truck loads of diesel supplied to remote sites, according to Baker Hughes.

“Electric frack enables the switch from diesel-driven to electrical-driven pumps powered by modular gas turbine generating units,” Simonelli said. “This alleviates several limiting factors for the operator and the pressure pumping company such as diesel truck logistics, excess gas handling, carbon emissions and the reliability of the pressure pumping operation.”

More capital, greater efficiency, and capital deepening. It is a virtuous circle that increases productivity and economic returns and is the signal for firms to invest more. It is a completely different investment dynamic to the one driving offshore projects at the moment.

Shale productivity.png

The above graph from the IEA makess a point I have made any times here: there is no real cost pressure in shale beyond labour (which will drop in the long run). Shale is all about productivity and cost improvement driven by mass production, something the US economy has as an almost intrinsic quality. The cost improvements in offshore are solely the result of over-capitalised assets earning less than their economic rate of return (i.e. oversupply) and is clearly not sustainable in the long run.

That is why firms with a low cost of capital are vacating fields like the North Sea to firms with a higher cost of capital: one requires steady investment and scale, the other investment is a punt on a shortage and price inflation. [A post for another day will be on how on earth some of these larger investors actually get out of the North Sea.]

This IEA data also tells you why this is the offshore reocvery:

IEA 2019 investment mix.png

The IEA is also forecasting overall spending to increase just 6%. So offshore just isn’t getting investment at the margin that will drive fleet utilisation and expansion. In company accounts this is showing up as depreciation significantly outpacing investment and is a constant across the industry. The economics of offshore are such that profitability is dictated by marginal demand (i.e. that one extra day of utilisation at a higher rate) and this graph shows the industry built a fleet for a far higher level and the only realistic prospect here is for structurally lower profitability. Given the high capital costs of the assets this is going to take a long time for the oversupply to work out.

For manufacturers (i.e. subsea trees) the recession is generally over, although not for Weatherford, but if it floats nothing but a wall of oversupply and below economic pricing and therefore sub economic returns is the logical consequence of this industry structure and market dynamic.

The hope of a massive demand boom kept banks from foreclosing and led hedge funds and other alternative capital providers putting money into assets that were (and are) losing cash but seen as “valuable” in the future. Slowly it is becoming apparent there is no credible path to anything other than liquidation for many companies still in business.

Rates will slowly rise, and so will utilisation levels, but only to economic levels i.e. covering their cost of capital in a perfectly competitive market. Absent a demand boom liquidity slowly, and then quickly, vanishes. And that is finally starting to happen now. For example the McDermott 10.25% 2024 bonds, already very expensive, were trading at well below par today implying a 13.5% yield, in effect locking them out of the unsecured credit market completely (and in reality all credit markets). A restructuring beckons. MDR will not be the only one by any stretch. Many rig companies will do a Chap 22 and a wave of supply companies in Europe and Asia are uneconomic and simply cannot survive under realistic financial assumptions.

Slowly the overcapacity in the industry will work its way out to more economically sustainable day rates with higher utilisation levels in a smaller global offshore rig and vessel fleet. But it won’t be a return to 2013, it will be a return to a far lower profitability level despite the smaller fleet, higher prices, and less time and utilisation risk taken smaller companies. There will be a complete wipe-out, almost without exception, of investors who backed offshore “recovery” theses of asset backed companies and an inability of these companies to access funding almost at any price levels. Theories about assets recovering to values implied by book value will be realised for what they are: a fantasy no serious person could believe.

But a far more rational industry and market will emerge. The only thing that could change the dynamic outlined above is a massive demand boom, and the graphs above show you why that isn’t going to happen.

IEA global upstream investment 2019.png

Shale productivity and swing production…

“We have just started to get into the manufacturing and harvest mode of the shale revolution,”

Concho Chief Executive Officer Tim Leach

I keep going on about productivity because as Krugman says, it’s not everything, but it’s nearly everything. This article from Bloomberg highlights how Encana is pushing the technical boundaries of shale further with a new Cube process (pictured above).

Basically, you do a whole pile of layers at the same time. I have no idea if it will be successful or not, but these companies will learn a lot from this and not all this knowledge will be wasted even if the process itself is a failure. Economists talk of dynamic capabilities, where companies build a knowledge base, in a path dependent manner,  by trying to do new things; and this is a classic case. This article from 1994 is as relevant now to this as it was to the semiconductor industry which led to the original observations (remember Moore’s Law).

Which is why Encana can show this:

Encana Productivity

On a per dollar basis no one in offshore is showing those sort of gains. A large part of the cost reductions have come as equity in assets has been wiped out through oversupply. This is a genuine ‘learning-by-doing’ productivity gain. I have consistently said that once the US economy starts to turn this into a manufacturing industry there will be a consistent reduction in per unit costs, it is the raison d’etre of American capitalism (which to be clear I don’t think is an amazingly astute observation).

I mentioned the other day I believe shale production was a genuine swing producer and looked for some data on this. And I found it:

The simulations show that the U.S. supply response is much larger now due to the shale revolution. Given a price rise to $80 per barrel, U.S. oil production could rise by 0.5 million barrels per day in 6 months, 1.2 million in 1 year, 2 million in 2 years, and 3 million in 5 years. Nonetheless, it takes many months before a substantial portion of the full supply response is online, longer than the 30 to 90 days typically associated with the role of “swing producer” such as Saudi Arabia.

The thing is this research used well data from 2010-2015, so if you look at the productivity gains over the last two years then shale is even more responsive. A comparison with offshore, given cycle times and unit costs are so different, would be interesting, but methodologically challenging I think. The point is shale is undeniably a swing producer and with a much lower capital commitment (i.e. low CapEx/ high OpEx) than the industry has had before and gives E&P companies an optionality that offshore doesn’t (but not the high flow/low lift costs advanatges of offshore).

This is where the US economy is so good. Look at this data from Precision Drilling Corp:

PDC Productivity

These cummulative gains are huge. Day-in, day-out, this is an economy, and in this case an energy production system, focused on driving down unit costs. I get you can run into limits, but we appear to be someway off them here. As I say, I think it takes a brave person to bet against this, and from an investors point-of-view such productivity gains are enormously attractive.

New ship Saturday…

Yet again UDS seemed to have pulled off an amazing feat, right after becoming the greatest DSV owner and charterer in the world, with a record 4 out of 4 (or maybe 5) DSVs on long term charter, they appear to have Technip, McDermott, and Subsea 7 quaking with fear as they look at helping a company enter the deepwater lay market:

UDS Lay vessel.png

This is a serious ship. Roughly the same capability as the Seven Borealis.

Seven Borealis

Although the Seven Borealis  can only lay to 3000m, not the 3800m UDS are looking at. As depth is really a function of tension capacity then I guess they will have a significantly bigger top tension system than the Seven Borealis as well?

I can see why you would go to UDS if you wanted to build a pipelay vessel significantly more capable than any that the world’s top subsea contractors run. Sure UDS may never have built a vessel of such complexity, and actually haven’t even delivered one ship they started building, but they have ambition and you need that to build a ship like this. Not for this customer the years of accumulated technical capability, knowledge building, and intellectual competency, there is nothing an ex-diver can’t solve.

UDS is building vessels the DSVs in China. The closest the Chinese have come (that I know of) to such a vessel is HYSY 201:

HAI-YANG-SHI-YOU-201.jpg

But that only has 4000t system? No wonder this new mystery customer, who I assume is completely independent of the other customers that have chartered their other vessels, wants to up the ante. The HYSY 201 cost ~$500m though, which is quite a lot of money to everyone in the subsea industry, apart from UDS.

The last people I know who went to build a vessel like from scratch were Petrofac. There is a reason this picture is a computer graphic:

Petrofac JSD 6000.jpg

To do this Petrofac hired some of the top guys from Saipem, a whole team, with years of deepwater engineering experience… And when the downturn hit Petrofac took a number of write offs, and even with a market capitalisation in the billions, didn’t finish the ship. To be fair though, they hadn’t engaged UDS.

But I think the reason you go to UDS “to explore the costs”, you know instead of like a shipyard and designer who would actually build it, is because they appear to have perfected the art of not paying for ships. So if you go to them and ask for a price on an asset like this chances are you get the answer: the ship is free! It’s amazing the yard just pays for it. Which is cheap I accept but ultimately the joy-killing economist in me wonders if this is sustainable?

Coincidentally I am exploring the costs of building a ship. I have just as much experience in building a deepwater lay vessel as UDS. On Dec 25th 2017, with some assistance from my Chief Engineer (Guy, aged 9), we completed this advanced offshore support vessel, the Ocean Explorer,  from scratch!

Ocean Explorer.jpg

Ocean Explorer Lego.jpg

Not only that I had take-out financing for the vessel in place which is more than UDS can claim at this stage!

Now having watched Elon Musk launch a car on a rocket into space (largely it would appear to detract some appalling financial results, although far be it for me to suggest a parallel here) we (that is myself and my Chief Engineer) have designed a ship: It will be 9000m  x 2000m, a semi-sub at one end to drill for oil, a massive (the biggest in the universe) crane to lay the SPS,  j-lay, s-lay, c-lay, xyzzy lay in the middle, and two (Flastekk maybe?) sat systems at the other end in case we forgot something, and to make it versatile. Instead of launching a car into space we are having a docking station for the space shuttle in order to beat the Elon Musk of Singapore. It is also hybrid being both solar powered and running on clean burning nuclear fusion. Not only that the whole boat works on blockchain and is being paid for with bitcoin. The vessel is also a world first having won a contract forever as the first support vessel for Ghawar field. We are also committing to build a new ship every week forever.

I expect to bask in the adulation on LinkedIn forever once I announce this news, and it will feel like all the hard work was deserved at that point. I am slightly worried about the business model as my Chief Engineer asked “Won’t we have to get more money in for the boat than we paid for it?”. When I have an answer for that trifling problem I will post the answer.

Another IEA supply warning…

Prediction is very difficult, especially about the future.

Neils Bohr

The International Energy Agency once again warned today that we face an oil supply crunch if investment levels remain at current levels and their “forecast” for increased energy demand remains accurate:

There are still not enough signs of investment beginning to return, and that raises the risk of tightening of the market in the next five years and a risk to the stability of oil prices,” Neil Atkinson, head of the IEA’s oil markets and industry division, said at a conference in Bahrain. “There is at least a possibility of going back to the situation we had 10 years ago where oil prices were very, very high at a time when demand was growing.”

Atkinson warned that the market’s spare capacity—largely concentrated in Saudi Arabia—will dwindle as demand keeps rising at a time when supply remains stagnant. The market will tighten and OPEC will have to abandon its production limits in order to satisfy demand. After that, rising consumption could whittle away at the latent surplus capacity. At that point, the market will hit a supply crunch, which would likely result in higher volatility and higher prices.

As an aside here is a list of OPEC member states. Does anyone really believe they can hold a production limiting agreement indefinitely?

If correct it is good news for offshore with a likely investment boom coming… but not until the 2020’s apparently. For oil companies that are cash flow positive even with high debt that might seem manageable, if you have vessels in lay-up or underutilised it is going to look like a long way off.

Like all forecasts understanding the context they come from is as important as the forecast itself. It is fair to say there is some fairly pointed criticism about the accuracy of these forecasts, FT Alphaville recently published this (guest) piece that noted this about IEA data:

  1. They are not forecasts, they are scenarios and named accordingly.
  2. The IEA publishes more than one scenario. Each one represents a different assumption about *policy* [again, the clue is in the title: Current Policies Scenario, New Policy Scenario, and 450 Scenario].
  3. Almost no-one, anywhere, ever seems to pay any attention to either 1) or 2). It’s very common to see “forecasts” or “projections” attributed to the IEA without even specifying *which* IEA scenario they’re talking about.
  4. The IEA’s scenarios have been consistently terrible at illustrating how well clean energy, might play out in almost any scenario. And terrible in the same way.

The problem is that in order to understand all this you have to buy (and read) the IEA report not just read the press releases and newsfeed stories commenting on the press releases. Javier Blas, ex-FT and now Chief Energy Reporter at Bloomberg, had a spat with the IEA in may this year after a Dutch academic showed how far out of line the IEA had been with solar predictions (since 2003). This led the IEA comment :

This misrepresents point of WEO (World Energy Outlook) scenarios. They don’t forecast future, but provide yearly picture of what will happen if nothing changes

Which is sort of like useless for such long-term scenarios unless nothing in the world changes (file that under unlikely) which is Blas’ point (I think). This does have the advantage of clarity though so you know exactly what the scenarios are based on. As if to underline it Blas published this today:

Evolution of Wind.png

It’s all about productivity… At the margin all energy products have a degree of substitutability and the renewable sources seem to have that advantage at the moment as they grow in scale.

Bloomberg had an excellent article earlier in the year highlighting how demand for oil could vary under different scenarios:

A Radically Different Future

And is if to highlight how much things can change we learnt today that shale production is apparently slowing but building up “Drilled but UnCompleted” inventory:

the buildup of DUCs is also bearish since it creates latent supply. Because the incremental cash cost to start pumping crude is low for a DUC, the payback period for an oil company is only a year or so. Even for wells not drilled, analysts at Citigroup estimate the break-even cost to drill and complete a well is just $29 a barrel on a production-weighted basis for the drillers they cover once the costs of acreage and sunk capital costs are excluded for the companies they cover.

No one can know the future so the most important thing any forecaster can do is simply make their assumptions (and preferably limitations) clear. The IEA forecasts need to be seen as relatively bullish from an organisation that makes a living from advocating policies that increase investment in traditional fossil fuels. Therefore whether its errors are cognitive or merely emotional biases the answer is likely to be somewhere between the two: but the word of God from an impartial agency with the wisdom of Solomon they are not.

For the offshore supply chain I do actually think we have hit the nadir, the point of this isn’t to say it can’t get any worse, and in maintenance spend terms things are likely to get better soon. But a boom case for the supply chain is hard to make because the ramp-up period will now be substantial as people and assets leave the industry and large E&P companies focus on other areas, and I don’t believe the 2013 days will ever return: nor should they the offshore industry can be more efficient than that. The one thing I do know is that if I was an offshore contractor I’d make sure I had a renewables strategy to go with my oil and gas one.

Productivity in the long run…

I go on about it a lot but productivity is the core of economic growth and undertsanding its importance is crucial to having a reasonable chance of understanding how an industry may evolve. Brad De Long makes this clear when discussing the iPhone X;

Consider the 256 GB memory iPhone X: Implemented in vacuum tubes in 1957, the transistors in an iPhoneX alone would have:

  • cost 150 trillion of today’s dollars: one and a half times today’s global annual product

  • taken up a hundred-story square building 300 meters high, and 3 kilometers long and wide

  • drawn 150 terawatts of power—30 times the world’s current generating capacity

Renewable also energy seems to be in a marked phase of marked productivity improvement:

better_energy_01.jpg

I am not predicting the end of oil already: it is simply too efficient on an output basis. but in the long run everything is a productivity game, the supply curve in oil is just a very long run curve that requires technology to fundamentally change it. And for offshore it isn’t doing that much at the moment. The risk here is that large E&P companies reduce their focus on CapEx for offshore, which becomes self-fulfilling because it prompts infrastructure investments that make renewables even more efficient. Most commentators believe this productivity surge has a long way to go with maybe a 20-30% further cost reduction by 2030.

And big institutions have the investment narrative that says this is hot with Blackrock Infratsructure (who admittedly have their own agenda to raise money) backing a shift in energy sources:

During a recent interview, Jim Barry, a managing director of BlackRock and global head of the investment firm’s Infrastructure and Investment Group, recently declared that “coal is dead.” While he acknowledged that coal will still be part of many countries’ energy portfolios, Barry said any investor who is seeking returns from coal beyond 10 years from now is “gambling very significantly.”…

And largely due to the cheap cost of renewables, Barry and BlackRock are sanguine about these technologies’ future. Barry was also optimistic during the interview on the outlook for electric cars, due to their improved range and the declining cost of battery storage. While talk of “peak oil” has been underway for years, Barry views the oil markets through a different lens, insisting that “peak demand,” not just supply, is a dynamic that investors should not ignore. As consumers embrace electric vehicles, the demand for oil will continue to decline – with the end result a cloudy future for conventional energy companies with large oil reserves on their books.

Don’t for a second underestimate the fact that senior managers at large E&P companies see investors like this as their boss and seek to deliver messages that please them.

I think some of the big mergers will help integrated solutions deliver productivity to make oil more competitive. But production productivity, and not just demand, will be crucial for the future of offshore production. The core of productivity improvements is generally mass production of all components in the supply chain by a small number of vast tier one suppliers and a network of subcontractors (who make minimal margins), and this is almost antithetical to the entire make-up of offshore. Change is coming.