Aug 21, 2007|
Offshore services: Will history repeat itself?
They say history repeats itself. Nothing fits this adage better than a cyclical business. Thanks to high oil prices, exploration and production activities have grown manifold over the past two years, driving up the rates for offshore assets like rigs and offshore support vessels (OSVs) to unprecendeted levels. While the consensus remains that the strong rates are here to stay, we believe it would be foolhardy for investors to become complacent and ignore the lessons learnt from the past.
What history has to say – The boom and bust in oil prices in the 1970-1980s
The boom: In 1972, the price of crude oil was around US$ 3 per barrel and, by the end of 1974, it had quadrupled to over US$ 12. The Yom Kippur War started with an attack on Israel by Syria and Egypt in 1973. The US and many countries in the western world showed strong support for Israel. As a result, several Arab exporting nations imposed an embargo on the countries supporting Israel. Arab nations curtailed production by 5 m barrels per day (mbpd). About 1 mbpd of the cut was made up by increased production in other countries. The net loss of 4 mbpd extended through March of 1974 and represented 7% of world production. The primary oil weapon for Arab countries was the excise tax - a price increase per barrel levied by a cartel experimenting with a new and aggressive pricing policy throughout the 1970s. Each time a new disruption occurred in world oil markets, from pipeline breaks to the Iranian revolution, OPEC used the event to ratchet up the price and then maintain it. OPEC's pricing became more aggressive after it implemented a formal quota system among members in 1978 to support prices. OPEC's Long-Term Price Policy Committee saw the ultimate target as just under the price of synthetic oil - the only possible substitute, as they saw it - or near US$ 60 per barrel.
The bust: OPEC was wrong, of course! One substitute turned out to be conservation and alternative fuels. Another was cheating on quotas by OPEC members unable to control their domestic budgets or comply with their quotas due to spending pressures at home. Most important, high oil prices stirred substantial exploration in relatively high-cost areas outside the Middle East, such as the North Sea, Alaska and Mexico. Non-OPEC production rose from 3.8 mbpd to 7 mbpd between 1981 and 1992. After a failed attempt to ratchet the price upward after the start of the Iran–Iraq War in 1980, the OPEC price began to retreat. The myth of resource scarcity and the inevitable upward spiral of oil prices kicked off an unprecedented boom in oil exploration in the US. The domestic rig count rose from 1,242 in January 1973 to a peak of 4,530 in December 1981. On the downside, the rig count fell to 663 in July 1986, an 85% decline.
What is the current situation?
A compounded 1.8% growth in oil consumption in the past ten years has outpaced the reserves growth of 1.6%. Strong economic growth in emerging economies (especially India and China), has led to global spare oil production capacity touching a three-decade low at 2 mbpd in 2006. This has led to a spike in oil prices. Lured by high oil prices, exploration and production companies have lined up huge investments over the next few years.
Rig and vessels count does not tell the entire story of oil and gas exploration and development. After a well is drilled it is either classified as an oil well, natural gas well or dry hole. The percentage of wells completed as oil or gas wells is frequently used as a measure of success. Since the percentage completion rates are much lower for the more risky exploratory wells, a shift in emphasis away from development would result in lower overall completion rates. When a well is drilled, the fact that oil or gas is found does not mean that the well will be completed as a producing well. The determining factor is economics. If the well can produce enough oil or gas to cover the additional cost of completion and the ongoing production costs, it will be put into production. Otherwise, it is a dry hole even if crude oil or natural gas is found. The conclusion is that if crude prices are increasing, we can expect a higher percentage of successful wells. Conversely if prices are declining, the opposite is true.
Will the boom in offshore business continue? Watch out for oil prices
The demand for offshore assets is closely linked to oil prices. When the prices are high, oil companies will invest more into exploration and production activities. Wells which were hitherto unviable suddenly start making investment sense to the oil companies. According to some estimates, the investments in oil exploration and production activities are unlikely to reverse unless the crude falls below US$ 45 per barrel.
The other important factor to note is the replacement demand among the offshore assets - a sizeable portion of current assets were acquired during the boom in oil prices in the 1970s and 1980s. Although, it seems unlikely to us that owners would want to scrap these assets when the hire rates are so high. Like in the 1970s and 1980s, high oil prices may prompt economies to bring down their fuel consumption and look for other substitutes. While the offshore story might continue for years to come, we would urge investors to exercise caution while investing in offshore companies especially putting money in leveraged companies (lured by high day rates, many offshore companies have leveraged their balance sheets extensively to acquire new vessels).
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