A money creation theory of offshore asset recovery…

The reason we are less enthused by companies which rely on tangible assets such as buildings or manufacturing plants [Ed: or rigs/jackups/ships?] is that anyone with a big enough budget can easily replicate (and compete with) their business. Indeed, they are often able to become better than the original simply by installing the latest technology in their new factory. Banks are also quite keen to lend against the collateral of tangible assets under the often illusory view that this gives them greater security, meaning that such assets can also be financed easily with debt, or as we call it, ‘other people’s money’. Debt is provided to such companies both cheaply, and with seeming abandon at certain times in the economic cycle, with often perilous results.

Smithson Investment Trust, Owners Manual

High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich…

Akerlof and Shiller, Animal Spirits

…the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Keynes, Chap 2: The State of Long Term Expectations, in The General Theory

While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together…

Some of the other and usually minor factors often derive some importance when combined with one or both of the two dominant factors.

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.

Irving Fisher, The Debt Deflationary Theory of Great Depressions

… the modern debt-deflation process encompasses falling asset prices, debt repayment difficulties, a reluctance to lend, a financial crisis, the impact on the banks, and the inter-dependency of the financial system…

Wolfson, Cambridge Journal of Economics

Financial illiteracy is a recipe for debt, default and depression, whose effects appear to feedback on each another in a vicious spiral.

These individual costs are amplified when they are aggregated up to the macro level. How people’s expectations evolve – their degree of optimism or pessimism, exuberance or depression – is crucial for determining their individual decisions. It has long been recognised that these expectations can be shaped importantly by others’ expectations. For example, “popular narratives” can emerge which shape collective expectations among the public – optimism or pessimism, exuberance or depression – and which can then drive aggregate economic fluctuations…

At a macroeconomic level, the work of George Akerlof and Robert Shiller has looked at the popular narratives which emerge during periods of boom and bust.  Using words extracted from newspapers, they find the prevailing popular narratives about the economy have played a significant role in accounting for the heights of the peaks and depths of the troughs during macro-economic booms and busts. Public expectations, embedded in the stories they tell, are a key macro-economic driver.

Andrew Haldane, Bank of England, Folk Wisdom

Last week the Deputy Governor of the Reserve Bank of Australia gave a speech titled “Money – Born of Credit?”, in this speech he outlined an important, yet underappreciated fact, of modern economies: deposits in bank accounts are caused by loans. A lot of people think that by putting money in their bank account they are giving the bank the ability to make a loan, but actually in a systemic sense it is the other way around: the money in your account is the result of banks making loans that end up as deposits in your account. In case you think this is some bizarre, and wrong, economic tangent, the Bank of England has an explanatory article “Money creation in the modern economy” which states:

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The Chief Economist of Standard and Poor’s summed it up in this article:

Banks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit “creation”–credit is created literally out of thin air (or with the stroke of a keyboard). The loan is not created out of reserves. And the loan is not created out of deposits: Loans create deposits, not the other way around.

This ability of privately owned banks to have the power of money creation is not often discussed. To many economists, although generally not those working at banks, this is a privilege where the ability to ‘privatize the profits and socialise the risk, is most flagrant and should perhaps be regulated more. The ‘Exorbitant Privilege‘ of the private sector. There is significant evidence that financial and banking crises have indeed become more common since the move to deregulate the financial system and credit creation that became especially strong post the end of the Bretton Woods era (post 1973).

If you are still reading at this point you may be wondering where I am going with this? The answer is that the implications for an industry like offshore, an asset-backed industry where values were sustained by huge amounts of bank leverage, are important for understanding what a “recovery” will look like. The psychology and ‘animal spirits’ of the commercial banks is likely to matter more than any single factor in dictating when an asset price recovery will be. Given that the loan books are closed to all but tier 1 borrowers, and contracting overall in offshore sector exposure, this would appear to be some way off.

Part of “the boom” in offshore since 2000, barring a short and sharp downturn in 2008/09, was the increasing value of rigs and offshore support vessels, but important too was the willingness of banks to lend against 2P reserves (Reserve Based Lending). This was a pro-cyclical boom where because everyone believed the offshore assets and reserves were worth more than their book value banks were willing to lend significant amounts of money against them. There was a positive and logical narrative of a resource-contrained oil world to unlock the animal spirits, it wasn’t irrational per se. As these assets changed hands banks created deposits in company accounts, they literally created “money” out of thin air by believing that the assets were worth more than they were previously. It is no different to a housing boom, and the more money the banks pumped in, the more everyone believed their assets were worth more (as the deposits grew). Ergo a pro-cyclical credit boom combined with an oil price boom. The demand for oil, and its price, has recovered, and this will affect the amount of offshore work undertaken, but the negative effects of an asset price boom will take longer to recover.

Right now the banks aren’t creating any new money for the offshore sector, collectively they are actually destroying it. When banks refuse to lend on ships or rigs no deposits flow through the system. Money from outside the system stops flowing into the offshore sector from the banks. Values and transactions are supported by the economic earning potential of current assets and the amount of equity and debt raised externally by funds. None of these “creates” money as banks do. These funds are “inside” money.

As an example last week Noble purchased a jack-up from a yard in Indonesia and was granted a loan by the yard selling the unit (a Gusto unit pcitured above). A piece of paper was exchanged and credit was created for the $60m loan of the total ~$94m price. Neither firm has any more money than they had prior to signing the loan contract. Credit isn’t the same as money… had a bank been involved (simplistically) it would have credited the yard with $60m, created a debt of $60m for Noble (a debit), and created an asset for $60m on its balance sheet. This money would have flowed from outside the offshore industry. The total value of the transaction would have been the same but the economic consequences, particularly for the liquidity of the yard, would have been very different. It is safe to say the reason this didn’t happen is because no bank would lend the money under similar terms. Relief rather than animal spirits seems a more likely emotion for this transaction.

It is not just the offshore contracting companies but also the E&P companies that are suffering from reduced bank credit and this is affecting the number of projects they can execute (despite a rise in the oil price). Premier is currently raising funds for the Sealion project, as part of this Drilquip has been given the contract for significant parts of the subsea scope, and they have provided this on a credit basis. In past times Premier would simply have borrowed the money from a bank and paid Drilquip. Now Drilquip has an asset in how much credit it has extended Premier but in the hierarchy of money that is lower than the cash it would previously have had, and it has to wait for Premier to sell the oil to pay it, and take credit risk and oil price risk in the meantime. Vendor financing is not the panacea for offshore because unlike banks vendors can create credit, but not money, and these are two fundamentally different things. There is a financial limit to how many customer Drilquip can serve like this. Collectively this lowers the universe of potential projects for E&P companies, and therefore the growth of the industry, that can be achieved. Credit creation is essential for an industry to grow beyond its ability to generate funds internally.

Another good example is the Pacific Radiance restructuring. Here the proposed solution, that I am enormously sceptical of, is that a new investor comes in allows the banks to restructure their loan contracts/ assets such that they can get paid SGD 100m in cash immediately while writing down the size of the loan. The equity and funds coming in are funds from the existing stock of money supply, they are not additional liquidity created by a belief in underlying asset values and represented by a paper loan contract and a growth in the loan book of the bank. While the new funds are adding to the total stock of money available to the offshore industry the bank involved is taking nearly as much off the table and you can be sure they won’t be lending it back to the sector. And thus the money stock and capital of the industry is reduced. Asset values remain low and the pain counter-cyclical process continues.

When you see companies announcing asset impairments and net losses that flow through to retained earnings this is often merely accounting of the banks withdrawing money from the sector and the economic cost of the asset base not being in tune with the amount of money available to the industry as a whole. It is also seen in share price reductions as the assets will never pay their owners the cash flows previously forecast.

In a modern economy this is normally the transmission mechanism from a credit bubble to a subsequent economic collapse: the ability of private sector banks, and only banks because of the system can create “money”, to amplify asset prices and cause sectoral booms on the way up and reduce the money stock and asset valuations on the way down. Why this happens is a complex topic and cannot be tackled in a blog, but it has clearly happened in offshore. Just as it has happened in housing booms, mining booms, ad infinitum previously. The dynamics are well known and are accentuated in industries which have had a lot of leverage. Much work was undertaken following the depression of agricultural prices in the 1930s, a commodity like oil which fluctuated wildly but the tangible backing of land allowed banks to supply significant leverage to the sector. Irving Fisher, quoted above, was famous for predicting that the US stock market had reached a “permanently high plateau” in 1929,  but his understanding of debt dyamics from studying banking and the US dustbowl depression transformed our understanding of the role of credit and banking.

[This explanation crucially differentiates between inside-money and outside-money. I am making a distinction between money generated inside the offshore sector and outside. By inside money I mean E&P company from expenditure, credit created amongst firms in the industry, and retained earnings. Outside money is primarily bank credit and private equity and debt funds. But whereas private equity and debt funds must raise money from the existing money stock only bank created money raises the volume of money].

In offshore the credit dynamics have been combined with the highly cyclical oil industry and allows optimists to believe a “recovery” is just possible. But a recovery scenario that is credible needs to differentiate between an industrial recovery, driven by the amount of E&P projects commissioned, and an asset price recovery, which is essentially a monetary phenomenon.

A limited industrial recovery is underway. It is limited by the availability of bank credit and the huge debts built up in the previous boom by the E&P companies, and their insistence that shareholders need dividends that reflect the volatility risk of the oil and gas industry. It is also limited because of the significant market share US shale has taken from offshore. But the volume of offshore project work is increasing. This is positive for those service firms who had limited asset exposure, and particularly for the Tier 1 offshore contractors, as much of the work being undertaken is deepwater projects that are large in scope.

But an asset recovery is still a long way off. There are too many assets for the volume of work in the short-run and in the long run it will be very hard to get banks to advance meaningful volumes of credit to the industry. Companies can write loan contracts with each other that represent a value, but banks monetise that immediately by providing liquid funds and therefore raising the animal spirits in the industry, whereas shipyards lending money to drilling companies need them to generate the funds before they can get paid. The velocity and quantity of money within the industry become much smaller. Patience and animal spirits make poor bedfellows.

Bank risk models for a long time will highlight offshore as a) volatile, and b) risky given that a bad deal can see even the senior lenders wiped out completely. Like all of us banks fight the last crisis as they understand it best. Until banks start lending again the flow of funds into the offshore industry will mean the stock of assets that were created in more meaningful times are worth less. In a modern economy credit creation is the sign that animal spirits are returning because it raises the return to equity (and high yield) providers.

In the boom days leading up to 2014 money and credit were plentiful. The net result was a vast amount of money being “created” for the offshore sector and a lot of deposits being created in accounts by virtue of the loans banks were creating to companies in the offshore sector based on their asset value. Now the animal spirits are no more and a feeling of caution prevails. The amount of money entering the sector via higher oil prices and private equity and debt firms is much smaller than was previously created by the banking sector. Over time this should lead to a more rational industry structure… but a repeat f 2014 days is likely to be so far away that the market at least has forgotten it…

As The Great Man said:

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady…[but]…We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

Market forecasts as structural breaks….[Wonkish]

Not for everyone this post but important if you are involved in strategic planning. The above chart is from the latest Subsea 7 Q1 numbers. The problem I have with these charts is what statisticians call “structural breaks“. Basically if the underlying data has changed then you need to change your forecast methodology. As I have argued here and here (although it’s a general themse of this blog) I think there is sufficient evidence that large E&P companies are commissioning less offshore projects when they become economically viable in the past on NPV basis. I am not sure that all the forecast models reflect this.

This break in the historical patterns has really important forecasting implications because when you see whichever market forecast  it has made an assumption, whether formally through a regression model or on a project-by-project basis, that x number of projects will be commissioned at y price of oil (outside of short term data which logs actual approvals). If there has been a stuctural change in the demand side then y (commissioned offshore projects) will be lower, and on a lower trajectory to x (the oil price) permanently, than past cycles.

E&P companies are not perfectly rational. As the oil price gets to $60 there is no set programme that triggers a project. For sure the longer the price stays high it increases the probability of projects being commissioned but it is a probability and the time scale of has changed I would argue. I think it is why demand has surprised many on the downside because there has been a change in the forecast relationship between offshore projects and the spot price of oil.