It’s grim up North… And the labour theory of value…

It’s Grim Up North.  The Justified Ancients of Mu Mu

Ricardo, Marx, and Mill believed that prices were determined by how much people had, in the past, invested. And that blinded them to any understanding of the workings of the market.

Friedrich Hayek

[I am not really a Hayek fan (in case anyone is interested). But he was a very smart guy who understood social and economic change processes better than most. Beyond that you get diminishing returns. As an aside I have been too busy to blog much lately, which is a shame as some really interesting things have been happening, but it doesn’t seem to have affected my visitor numbers much, which just goes to show maybe my silence is more valuable.]

The Oil and Gas UK 2018 Economic Report is out. For the North Sea supply chain there is no good news. There is clearly a limited offshore industry recovery underway as we head towards the end of summer. However, the market is plagued by overcapacity, and while service firms without offshore assets are starting to see some positive gains, if you are long on floating assets chances are you still have a  problem, it is only the severity that varies.

The UKCS is what a declining basin looks like: fewer wells of all types being drilled and dramatically lower capital expenditure. There is no silver lining here: an asset base built to deliver 2013/14 activity levels simply has too many assets for the vastly reduced flow of funds going through the supply chain. The report makes clear that the base of installed infrastructure will decline and there will be a relentless focus on cost optimisation to achieve this.

UK Capital Investment 2018.png

The volume of work may be increasing marginally but the overall value may even down on 2017 at the lower end of the 2018 forecast (purple box). Clearly £10bn being removed from the oil and gas supply chain, c. 60% down on 2014, is a structural change.

And the OpEx numbers unsurprisingly show a similar trend:

UKCS OpEx 2018.png

Party like it’s 2012 says Oil and Gas UK. Unfortunately a lot more boats and rigs were built since then.

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An unsurprisingly the pressure on per barrel costs seems to have reached the limits of downward pressure.

This should make supply chain managers seriously consider what their investment plans are for assets specific to the region and the likelihood of assets having to work internationally to be economic. It should also make people reassess what stuff is actually worth in a market that has reduced in size by that quantum and from which there is no realistic path to 2014 activity levels.

Technip paid $105m for the Vard 801, about $55m/45% discount to the build cost. Such a deal seems realistic to me. Some of the deals I have seen in offshore remind me of The Labour Theory of Value: if you dig a massive hole that costs a lot it must therefore be worth a lot. In reality with so much less cash floating around for assets that will service the UKCS an asset is worth the cash it can generate over its life, and the fact that it is substantially less than its replacement cost is just another clear example of how the industry will reduce its invested capital  as production levels in the basin decline. Like airlines offshore assets have a high marginal cost to operate and disposable inventory which is why you can lose so much money on them.

Boskalis appears to have paid an average of c. $60m for the two Nor vessels which equates to a similar discount on an age weighted basis. Quite where this leaves Bibby needing to replace the 20 year old Polaris and 14 year old Sapphire is anyone’s guess. But it is not a comfortable position to be in as the clear number four by size (in terms of resource access) to have competitors funding their newest assets on this basis. Yes, the shareholders may have paid an equivalent discount given the company value they brought in at, but if you want to sell the business eventually then you need a realistic economic plan that the asset base can self-fund itself, and at these sort of prices that is a long way off. Without an increase in the volume and value of construction work 4 DSV companies looks to be too many and this will be true for multiple asset classes.

As a mild comparison I came across this article on $Bloomberg regarding Permian basin mid-stream investment:

Operations in the Permian that gather oil and gas, and process fuel into propane and other liquids, have drawn almost $14 billion in investment since the start of 2017, with $9.2 billion of that coming from private companies..

That is just one part of the value chain. I get you it’s not a great comparison, but the idea is simply the ability to raise capital and deploy it in oil production, and it is clear that for Permian projects that is relatively easy at the moment. The sheer scale of the opportunities in the US at the moment is ensuring it gets attention and resources that belie a strictly “rational” basis of evaluation.

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That is what a growth basin looks like. The narrative is all positive. Once short-term infrastructure challenges are resolved that stock of drilled but uncompleted will be turned into production wells.

Oil and Gas UK go to great pains to explain the economic potential of the UKCS. But finance isn’t strictly rational and I still feel they need to be realistic about the cycle time tradeoff offshore entails. Shale, as we have seen, has an enormously flexible cost base relative to offshore and that has value.

The comments I make below are part of a bigger piece that I keep wanting to write but a) don’t have the time; and, b) probably doesn’t work for a blog format. But I think the impact of the private equity companies taking over North Sea assets needs to be realistically assessed.

Don’t get me wrong here I am a massive supporter of them. In terms of the volume of cash, and the ability to buy and invest at the bottom of the cycle, the North Sea would clearly have been worse off without private equity. But the results are in and there has not been a development boom… there has been a focus on the best economic assets that may make the fields last longer, but that is a different test. There may clearly have been an investment boom relative to what there would have been without private equity money, but again that is a slightly different point.

Private equity firms have a much higher cost of capital than traditional E&P companies and at the margin that will limit the number of projects they fund. The focus on lowering costs and returning cash as quickly as possible, often to compensate for how hard it will be for the owners to exit such sizeable positions, also adds to the change in the investment and spend dynamic (on the downside obviously). I am genuinely interested to see how these large multi-billion dollar investments are exited given how much trouble the super-majors are having at getting out.

Private equity may well be the future of the North Sea but that has huge implications for the supply chain. It is also worthwhile pointing out that while the smaller companies maybe able to sweat old assets they have a limit for larger projects. Quad 204 is a classic project where it is hard to see even one of the largest PE backed companies having the technical skills and risk appetite to take on such a vast project.

The majority of the larger deals also involved significant vendor financing from the sellers. Shell had to lend Chrysaor $400m of the $3bn initial consideration. This happened not through generosity, or a desire to maintain economic exposure to the assets, but because debt finance from the capital markets or banks was simply unavailable even to such large and sophisticated buyers. Siccar Point went to the Norwegian high-yield market in January borrowing $100m at 9% for five years. The fact is finance is scarce, and when available expensive, and this is impacting the ability of E&P projects to get financed. Enquest has had to do a deeply discounted rights issue, and borrow off BP, to complete Sullam Voe.

The E&P majors are helping to finance their own exit because it is the only way they can get out. The turnaround from that to an investment boom that could raise asset values in the supply chain is a long one.

In order to make money in this environment the E&P companies, particularly those backed by private equity, are focusing on driving down costs and limiting Capex with a ruthless efficiency and commitment few in the supply chain believed possible long-term. Where offshore assets are concerned the oversupply situation only assists with this. I met one of the private equity investors last week and I can assure you there is no pressure to replace old assets, safety first definitely, economics and finance second just as definitely.

The reality for the supply chain is this is a market where it will be very hard to make money for a very long time, and in reality the glory days of 2012-2014 look extremely unlikely to return. The Oil and Gas UK report gives some important data in explaining why.

Productivity and capital reduction in offshore …

“Bank executives, believers in sound money to a man when other sectors of the economy were in trouble, became less keen on monetary purity when it came to their own survival…”

Philip Coggan, Paper Promises

From the $FT on Monday:

This has helped boost UK oil and gas output from 1.42m barrels of oil equivalent per day in 2014 to 1.63m boepd in 2017, a 14.8 per cent increase…
But the industry has now managed to lower costs from an average of £19.40 a barrel in 2014 to an estimated £11.80 a barrel this year, according to the UK Oil and Gas Authority, while total expenditure on investment and exploration has fallen from £15bn to £5bn over the same period.

Let’s be clear about what this sort E&P company productivity means in terms of market and price deflation for the offshore supply chain over a four year period: OpEx -39% and CapEx down 66%%! £10bn has been taken from a market of £15bn in revenue terms for the supply chain supporting “investment and exploration”! It is an extraordinary number for an industry supported by a large amount of leverage in the supply chain and represents a fundamental structural shift.

Yes the CapEx number is variable by year, and Clair Ridge and other fields had massive expenditure last year, but this is the future of offshore in the UKCS. The gross figure is probably a good proportionate proxy for all those in market, with the most oversupplied segments perhaps taking a bigger hit, but if you are a UK focused business this is the scale of the reduction in the market. And this in an environment when the oil price rose 44%! As anyone close to the E&P companies will tell you cost pressure is still relentless. A near 13% decline in the price of Brent over the last few weeks only adding to CFO determination to keep OpEx in check.

If you take Bob Dudley’s assertion that you get 40% more volume for your value offshore the market is at £7bn in 2010 terms i.e. more than a 50% decline and a smaller installed base in the future to maintain. The sanctioning of Tolmount yesterday was good news but it doesn’t change the macro statistics: this is a rapidly shrinking basin in market expenditure terms. There is simply no linear relationship between the oil price and the demand for offshore services in  the North Sea now.

There is a reason the Vard 801 has not been taken out by Technip or Subsea 7 and that is clearly in this environment the UKCS is a very difficult place to make money.  It is not sensible to invest in fixed assets for a market facing such steep declines in size. For UK focused contractors there is simply no way to remove that volume of revenue from the market and under any realistic assumptions and expect the same number of firms to survive or profitability levels to return to past averages. The industry must contract to reflect this but the high perceived asset values of the vessels and rigs have slowed this contraction.

If you took on debt in the good times your market has shrunk rapidly but your creditors expect to be paid back from a market that was in percentage terms vastly bigger. If you don’t think offshore has any hot air left to come out then take a look at the accounts of Nordic American Offshore: a North Sea PSV ‘pure play’.

NAO in 2017 (or materially in any other year) decided not to impair the value of their PSVs because they think they will earn their value back. NAO has 10 PSVs, debt of $~140m, ~$12 in cash, and having largely spent the $47.5m raised in 2017. In 2017 it spent ~$22.5m in costs to get ~$18m in revenue and it made another loss (obviously) for H2 2018, resorting to sending non laid-up PSVs to Africa to work. There is no realistic future for this company as a standalone enterprise and no industrial logic for this company to exist at current market demand levels. The vessels are worth less than the bank debt and their market is in a steep contraction. These PSVs are on the books at over £30m each!!! Sooner or later the facts of this market contraction with their cash position will collide.

There is simply no place for these supply companies with 10-20 vessels. Sooner or later the banks will have to forclose here and simply get what they can for the vessels or they will have to write off some of their claims to encourage yet another round of investment in a loss making company whose assets are held at book value at significantly more than could be realised in a sale process. NAO fleet Value.png

That last comment above is based on using a 10 year average of PSV rates and utilisation levels. At some point the reality of needing new cash to pour into operating losses is going to collide with their “beliefs” as NAO don’t have enough cash to last until (if?) rates return to 10 year historic averages. It is very hard to see the upside for any potential investor here even if the banks wrote off 100% of their claims, something they are clearly unlikely to do.

Not that there is room at the survivors table for all the medium-sized companies either. Bankers for Maersk Supply Service have also been taking soundings for a buyer. They are seeking top dollar for a company unfortunate enough to order the Starfish class of vessels just before the market peaked, but even more unfortunate enough to have a parent able to honour the group guarantees to pay for the vessels on delivery. In 2017 they stopped posting financial results on the website but are well understood to be losing significant amounts of cash at an operating profit level.

Maersk Group are listing Maersk Drilling as they have been unable to find a buyer, but they were able to organise banks willing to back the company with debt facilities. It is very hard to see a similar situation arising with Maersk Supply where no realistic path to profitability can be plotted and creditors would remain exposed to large operating losses.

Maersk Supply has also been trying to build a contracting business when the market for projects in the UKCS has reduced by 66%. They have no competitive advantage and nothing to offer an oversupplied market. All that will happen here is they will burn OpEx trying to do this and eventually, when all the other options have failed, they will do the right thing and shut the contracting business down. While all the tier 1 (and 2) contractors have significant excess capacity there is no room in the market for a new tier 2 contractor whose sole purpose is to cross-subsidize utilisation from their vessel fleet. A JV with Maersk Drilling to work on decommissioning is unlikely to yeild anything of scale that someone with outside capital would find value in paying for.

Maersk Supply is at the upper end of the adjustment band of companies that are unlikely to survive without some sort of dramatic and unforecast change in market circumstances. Protected in better times by a massive corporate parent, and with a similar proptionate cost base, it is now exposed as a massive cash drag as its owner tries to protect its investment grade credit rating. MSS offers insignificant scale in the market, ongoing cash losses, and a very high cost base reminiscent of better times in a geographic location where this is hard to change. Maersk Supply simply isn’t a viable standalone business at the moment without a massive equity injection.

AP Moller-Maersk have vowed to do whatever it takes to protect their investment grade credit rating, at some point the material losses being generated in MSS will force their hand here. As more disparate parts of APMM are divested the trading performance of MSS will become something that will need to be cauterised.

The future of offshore supply can be seen in Asia where small nimble  companies with very low costs make money on wafer thin margins. Traders. Vessels are worked to death and meet minimum local standards but nothing more. If Standard Drilling/ Fletcher can bring ex-DP I vessels to the North Sea to compete against NAO then welcome to the future of the North Sea supply market because that is how you drive OpEx down 40%.

NAO and Maersk Supply, like a lot of other companies in the industry, found investors over the last couple of years (one external and one internal) who believed that the market would return to previous levels and it was worth funding the interim period. At each round of fundraising this becomes an ever more unlikely outcome and the costs of this rise. Slowly but surely some companies will be unable to convince potential investors that they will be the one who makes it through to the (mythical?) recovery. This slow grinding down of capacity and capital is how the industry looks set to rebalance.

The scale of shale…

Exxon Mobil signed a JV on Tuesday with Plains All American Pipeline LP to build a pipeline that will ease it’s offtake problems in the Permian. Permian has been trading at a discount to WTI of up to USD 27 per barrel due to export constraints from the region so there is a real incentive to come up with a permanent solution.

The thing that struck me was the scale of the pipeline: 1 million barrels capacity per day. That single pipeline will carry as much as the entire output of the UKCS! ~1% of global oil demand being carried in one pipeline. There are a lot more of these pipelines being built as well and they are constructed relatively cheaply and very quickly.

I repeat again that I really struggle to see how a multi-year boom in oil prices can happen now on the same scale as previous cycles. The ability of shale to act as a marginal producer and the ability of E&P companies to develop the infratsructure much more quickly than before seem to act as cap on the price that hasn’t existed before. They could be famous last words but the scale of the investments and infrastructure being committed to Lower 48 counts is part of a genuine supply side revolution in the current oil market.

The UKCS versus Norway…

The latest Oil and Gas UK Business Outlook report has just been published. Having had a quick read I would have to say you can easily see why those contractors with a strong presence in Norway are outperforming those with a UKCS focus only (see below). This blog runs on the fairly simple, and painfully proven philosophy, that CapEx drives overall fleet utilisation and that if it is quiet then all vessels play in the maintenance market. Everything else is just noise.

Here are the UK numbers:

UKCS O&G 2018 Capex.png

It is the peak-to-trough number that is so hard for the supply chain. They built enough assets to service ~£15bn in 2014 and then it drops to ~£6bn, a 60% drop. More work is being done now (i.e. value increasing slower than volume) but the top line is just painful to see. Failure to see the upside potential in 2020 would see a market significantly smaller than 2017, and there simply isn’t the time to speed up developments quicker than this should the oil price suddenly change.

Whereas in Norway:

Historical figures for 2006-2016 and forecast for 2017-2022

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Source: Norwegian Petroleum Directorate

The peak-to-trough decline in Norway is only ~40%, and the increase from 2018 to 2019 is around 16%, It is just on a different scale to the UK.

You get an idea of the lag time involved from idea to execution with this graph:

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Oil and Gas UK state that 25 fields are under discussion, although only 12 are under serious discussion to move ahead this year. And while that is potentially £5bn it will take a long time to flow through to the offshore asset fleet. And the OpEx spend is saving no one…

UKCS forecast Operating expenditure:

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Even on the best case assumption the OpEx market is down 25% from 2014. I guess it’s a reasonable proxy for IRM work. Again volume is up re: value but it’s just not enough for companies with high-fixed costs.

The other harsh reality is that all the West of Shetland developments that dominate the overall spending are a small number of large projects that favour large contractors. Clearly the increase in the oil price is improving sentiment, and opening up some IRM spend, but it will not lead to a general revival across the asset fleet. This time it is different.