Heart of darkness…

Colonel Kurtz: Did they say why, Willard, why they want to terminate my command?
Capt. Benjamin Willard: I was sent on a classified mission, sir.
Colonel Kurtz: It’s no longer classified, is it? Did they tell you?
Capt. Benjamin Willard: They told me that you had gone totally insane, and that your methods were unsound.
Colonel Kurtz: Are my methods unsound?
Capt. Benjamin Willard: I don’t see any method at all, sir.
Colonel Kurtz: I expected someone like you. What did you expect? Are you an assassin?
Capt. Benjamin Willard: I’m a soldier.
Colonel Kurtz: You’re neither. You’re an errand boy, sent by grocery clerks, to collect a bill.
Someone needs to collect the bill here. It isn’t the only one that needs to be paid.

“Preparing for the recovery”… Whatever…

The IEA has recently published it’s new World Energy Review and if you have been reading this blog this comment will come as no surprise:

One notable trend concerns the relationship between oil prices and upstream costs. In the past, there has been a roughly linear relationship between upstream costs and oil prices. When price spiked, so did costs, and vice versa. What we are noting now is a decoupling. While prices have more than doubled since 2016, global upstream costs have remained substantially flat and for 2018 we estimate those increasing very modestly, by just 3%. Companies appear to have learned to do more with less.

Too many business models in the offshore supply chain are simply ignoring this. If you are going long on Borr Drilling shares (for example), as anything other than a momentum trade, then you need to look at data driven forecasts like this, which in statistical terms are called a structural break. Look at the cost deflator in the graph above! In an industry with high fixed costs (both original and operating) that is a straight financial gain for E&P companies and with the volatility in the oil prices they will not give that up easily… and in a world of oversupply they won’t have to.

The future will be different. Some vast market snapback where the Deamnd Fairy appears, and everyone brave enough to have paid OpEx in the offshore supply chain has found a clever get rich quick scheme, is an extremely unlikely event.

More data points like this should make you think as well:

IEA Source.png

Yes, I get the volume in absolute terms is growing, but it is change at the margin that defines industry profitability.

There is still too much liquidity and too many business plans talking as if a return to 2013/14 is a certainty when in reality such a scenario would be an outlier.

The new trading game… and the deal of the downturn…

It is my belief that no man ever understands quite his own artful dodges to escape from the grim shadow of self-knowledge. The question is not how to get cured, but how to live.

Joseph Conrad

 

La fatal pietra sovra me si chiuse. / “The fatal stone now closes over me”)

Morir! Si pura e bella / “To die! So pure and lovely!”)

Aida

Solstad Farstad announced it’s 4th extension to its Solship/ Deep Sea Supply problem last week. The Q1 2018 results also noted that they had breached the covenants for the Farstad  entity as well and were therefore seeking a waiver for this part of the Group. Solstad state they expect the Farstad part to fall into compliance in the 2nd half of 2018, this is significant because if this doesn’t happen then two of the three legs of the merger have effectively broken and the entire industrial logic for this merger will have fallen apart less than a year after closing. That this has occured so rapidly after the merger is a large credibility blow to all those involved putting the deal together.  All the major stakeholders, except for the Deep Sea Supply shareholders, bet all on a market recovery that had no basis in reality, and now, unsurprisingly, it hasn’t happened they are bereft of ideas. It is no wonder the Chairman has been recently replaced.

I think Solstad are actually aware of the scale of the problem now, the new Chairman who not only has a strong financial background but as Chairman of the Norwegian National Opera and Ballet surely apprecites drama and tragedy, seems to be playing for serioius time? The Q1 2018 report is significantly more downbeat than the annual report released only a few weeks earlier and the financial risks section highlights how serious the problems are.

It is very hard to underplay what a mess this is from an industrial perspective, with a Group holding company responsible for two insolvent trading companies (of three trading entities) and yet the scale of all three put together was the core rationale of the deal? In a bizarre twist of logic Solstad claim the merger cost synergy targets remain in place despite the fact they must be close to simply handing back the Deep Sea/ Solship 3 fleet to the banks and yet remain liable for the running costs of the company, despite it being a massive economic drag on the group? Surely if they do this they need to explain what synergy number cannot now be achieved? This is just one example that highlights in reality getting out of this deal will be far harder than it was to get into. What will the new Solstad look like? The banks will be seeking to get out as soon as possible from all but the aquaculture business, and the relationship to Hemen/ Fredriksen just another complication from an industrial perspective the company doesn’t need.

Not to put too finer point on it but the Q1 2018 results for Solstad Farstad really made clear that the company is insolvent, by that I mean in the accounting sense where the ability of the asset base to generate enough economic value to pay their liabilities is clearly compromised. Solstad don’t have a liquidity problem immediately but they will soon having gone back NOK 400m in Q1… unless they have a stonking Q2, and there is no reason to believe they will. An upcoming (round 2) restructuring appears imminent because its financing costs are killing it. The comparison with the efficiency of the American Chapter 11 system which has allowed  Tidewater, Gulfmark, Harvey etc. to emerge and take market share is such a contrast to the European system it merely adds another nail in the coffin here.

Like Siem Offshore, and so many other offshore vessel companies, Solstad can pay for everything up to finance costs, and then it falls into a pit of actual cash outflow. Welcome to the new normal. Eventually, in an industry with depreciating assets that need replacing, this model doesn’t work.

One amazing financial revelation of the Q1 2018 results is the fact that Solstad depreciate vessels over 20 years to 50% of original cost! If anyone thinks a 20 year old AHTS is worth 50% of the new build price they either know nothing about the industry or enjoy a healthy portion of magic mushrooms. These values are apparently adjusted by broker values but this policy must massively overstate the book equity in the company relative to current market values. The policy itself seems a remnant of a bygone era when a demand boom meant assets depreciated less slowly than book value implied. The only thing making those creditor claims look economically realistic appears to be a policy that has consistently over valued the asset base above its long-term economic value.

As an argument for how some audit firms are too close to their clients Solstad Farstad makes a strong case given the EY statements regarding the financial positon of the Group. On the 18.04.18 Solstad Farstad published their 2017, and inaugural, accounts for the combined entity which EY accepted as fairly representing the positon at year end 2017. A mere 2 weeks later, literally just before the Easter holidays, the first deferral of the Solship 3 “investment” was made, something that would have been blatantly obvious to all concerned closing the accounts, and this allowed all the long term debt to be recorded as just that. In effect, as became clear at the Q1 2018 accounts, coming only a few weeks after the Solship deferral and was clearly obvious in Q4 2017, Solstad Farstad had a massive problem and a covenant breach,  therefore a major portion (NOK 11bn) needed to be reclassified as short-term as the lenders could theoretically call this in immediately. This looks stage managed in the extreme. One would think this was such a significant post balance sheet date event that it must be reported…

This is just another sympton of how out of control the whole situation is. What is clearly happening in the background here is that Solstdad Farstad needs to hand back the entire Deep Sea Supply to the banks, something everyone in the industry knows, but the banks don’t want it. It also means all this talk of a recovery in large AHTS is hokum. A few good weeks over summer doesn’t make an asset economic over 52 weeks. Without this mirage of scale of the merger is a busted flush and someone then needs to go back to the market and explain that the stated industrial strategy and planned synergies as outlined in the original merger document, less than one full financial year before this became apparent, are totally unrealistic and have in fact threatened the very existence of the entity. Without new equity, which would require a substantial writedown in bank debts, Solstad will simply limp along as a zombie company with the banks extracting what they can over time and the equity remaining worthless at best. It will be like a bank in run off with the asset base eventually eroding away to nothing.

Solstad (and it will be just Solstad going forward) is probably only viable as a Norwegian area (re: Equinor sponsored) PSV and AHTS operator, with an option on some Brazilian tonnage. The CSV operation is still potenitally considerably overvalued: it is an aging fleet that will never realise book value because no bank will lend against assets that old and and without long term contracts going forward. The Australian/Asian operations need to go immediately and the laid up Brazilian assets (i.e. the majority of the Brazilian fleet) need to go as well. Siem Offshore appear to be pulling out of Australia and Solstad cannot be far behind them on any rational basis. The aquaculture business will surely revert to Hemen/Seatankers/Fredriksen or be sold.

Quite why Solstad is therefore publishing two week extensions when this problem will take months to sort out is anyone’s guess. But a whole pile more deferrals are coming unless some rabbit is pulled from a hat. The Q2 results are likely to lead only to the creditors starting to get real about the scale of the problem.

To be clear this isn’t only a Solstad issue, although the merger was clearly a folly on an epic scale: in the the same week Bourbon Offshore announced that they were suspending debt repayments (again). Miclyn Express Offshore, Pacific Radiance and EMAS (again) cannot find sustainable financial positions. Siem Offshore recently reached agreement to defer payments on debt

It defies the laws of economics and common sense to believe that any one firm can outperform any others in this market in a meaningful financial sense when they all offer assets that are identical in function and form to their (identical) customer base. Siem Offshore now isn’t paying it’s lenders back in full until 2022 and lowered (again) payments by 30%. It will simply reduce day rates to get utilisation and it shows the banks know they have no leverage here. Deferring all borrowers across the industry indefinitely however will ensure they never get paid paper claims. Eventually winners will have to be picked and it will clearly be those burning the least cash.

I have followed the Solstdad situation more closely than any other simply because a) from an industrial and financial perspective it was clearly such a bad idea; and, b) their public prognostications have been so divergent from any actual data points in the market, and so far removed from realism, it makes a fascinating sociological experiment. Those of you who have read The March of Folly will know what I mean.

The funny thing about all the banks delaying the bullet payments outstanding (to Siem Offshore, MMA, Pacific Radiance, Solstad, ad infinitum) is that each bank knows in truth their own bank would never lend on the other side of the deal. The Siem deal recognises this. The banks in these deals are locked into the boats and companies they have backed because the bullet payment will never be made unless they sell it at a huge discount to a distress debt investor. The banks are stuck in these deals but they are not getting into any more, but in this self-perpetuating cycle it also locks in low asset prices and day rates. Breaking this self-reinforcing circle will only occur when the mythical demand fairy appears.

All offshore supply companies, and by that I mean OSV operators who do not engage in engineering and execution, are price takers in the current market: there is no ability to add value, they are in effect trading firms wholly depedendent on the market price and demand levels for a commodity asset, with no ability to take anything other than what they are offered. This isn’t what the original funders signed up for, isn’t the skill set of the majority of management, and is significantly more risky given the risk/reward basis that rational investors should be comfortable with. Eventually funders will realise this and new equity will stop flowing into the industry under the promise that all you have to do is burn cash and wait. Pacific Radiance and EMAS are two good examples where clearly due diligence has revealed the downside of this strategy.

Anyone investing in this market should realise they are betting against the greatest shipping trader of the age: John Fredriksen. When the chips are counted from this downturm the greatest deal in offshore will not be an acquisition at the bottom of the market it will almost certainly be a divestment: and it will be the story of how JF managed to put only $20m in to rid himself of a bankrupt entity, with some really low market tonnage, that surely his major bankers would have demanded substantially more support for had it not been folded into Solstad? Now Deep Sea Supply is inextricably tied to Solstad and it is a management and funding issue of this company not a Seatankers/Hemen problem.

If you are buying AHTS’s and PSV’s you need to ask yourself what you know that JF doesn’t? And what your industrial angle is that is better than Seatankers?

Anyone who tells you scale and consolidation will save all needs only to look at how many high-end AHTS Solstdad Farstad have, and after a year of operation all it brought them was a covenant breach. Scale without pricing power is meaningless, the costs of the vessel operations are so high relative to the onshore costs that saving a few dollars a day on SG&A costs is just a rounding error. A new industry narrative is required for the lender to be kept happy but each becomes more tenuous than the last.

Not all offshore supply firms are going to survive, but quite understandably the banks want the failures to be someone elses. There is nothing written in stone that Solstad Farstad will survive. Every Solstad report talks of a willingness to participate in consolidation but the equity has no value and anyone taking it over would want the banks to write-off the billions of NOK. Given the post-merger performance of the Group it isn’t a serious proposition that anyone would take their shares in a consolidation play either. My money would be on a take-private deal where the Solstad backers hope to use it as a consolidation vehicle, but everyone is doing this at the moment and eventually some firms need to drop out and take a hit before this works for someone. But if you think some of the public firms valuations are high I bet some of the private fund accounting going on is even more aggressive…

For the industry to recover a few big firms, and their associated asset bases, are going to have to go and some losses way beyond those taken to date are going to have to realised by banks and increasingly equity investors. Even the most outrageous demand forecasts for next year don’t offer the sort of demand boom required to fundamentally alter vessel profitability. Unless this relationship below reverses the global OSV fleet has substantially less value than some recent deals presume:

McKInsey BH Q1 2018.png

Source: McKinsey.

Working out when  profits come again is highlighted by the Siem Offshore results which pointed out that owners are laying vessels up and bringing them out when day rates recover. Scrapping simply hasn’t happened at the levels that some were forecasting. Something has to give and at the moment it’s day rates and utilisation. For as long as the high-capital values of vessels relative to marginal day-rates make this worthwhile, or companies like Standard Drilling buy cheap and sell cheap, then this is just a straight trading game. The scale of any recovery in offshore work required to make the whole fleet even economically breakeven so far into the distance it is definitely a chimera.

You can’t stop time…

“In 1936 I suddenly saw that my previous work in different branches of economics had a common root. This insight was that the price system was really an instrument which enabled millions of people to adjust their effort to events of which they had no concrete knowledge.”

Friedrich Hayek

“They say I’m old-fashioned, and live in the past, but sometimes I think progress progresses too fast!”

Dr Seuss

In Singapore both EOL and Pacific Radiance are trying to freeze time to their advantage. I can’t see it working. Both parties seem to be using a judicial process to try and slow the reality of weak market conditions, and yet the longer this keeps on the worse the offers to finance these businesses seem to get.

EOL signed a “binding” term sheet with new investors in September 17… Then BTI/Point Hope came back and said they wanted new terms, and then again… and again. The only possible explanations were A) EMAS is performing even more poorly than was estimated last September when they first agreed a “binding” term sheet, or perhaps than in December 17 when they agreed a revised “binding” term sheet; or, B) the market hasn’t recovered so the new investors don’t want to put cash in. The parties were looking to sign another (“binding” I presume?) term sheet so asked the court for a moratoria that will allow them to keep operating while they tried to sort out a $50m investment. But then today BT accepted reality walked away. It bodes ill for Pacific Radiance.

At some point the creditor groups led  by DBS and OCBC must be forced to either recognise the market value of the assets or just accept what is needed in terms of the size of the write down, which is going to be very large if they liquidate the EMAS fleet now, or new working capital required and what it will be priced at. It is very hard to see anything viable coming out of EMAS whatever the price.

Pacific Radiance can’t even get the binding part of a term sheet: they just have a group of investors so keen to move forward they can only agree preliminary terms. News reports suggest that these are investors from outside the industry looking for a bargain. Good luck with that. The only operational plan appears to be for the company to carry on as before and spend a ton of new money on OpEx while waiting for the market to turn (and enter the nascent Asian wind market). That’s fine if you could actually get the money signed up to do this, but of course that hasn’t happened yet…

The Pacific Radiance restructuring involves USD 120m cash going in and the banks writing off $100m but getting $100m cash out immediately. Getting effectively .5 in the dollar on some aging offshore support vessels is a great deal in this market (see above)… almost too good to be true… The remaining USD 120m gets paid back over three years starting on January 1 2021. This is the ultimate bet on a market recovery in the most margin sensitive OSV market in  the world. Pacific Radiance generated a cash loss from operations of $4m in Q1 2018, so should the market not come back then you have a small amount of cash sitting behind USD 120m of fully secured bank debt. Given current OSV rates if investors are putting money into this project they are betting that this company can generate at least $40m per annum to pay the banks back before they have any prospect of their equity having any value in only 3 years time.

I will be really will be surprised if the Pacific Radiance deal goes ahead in this form. At this stage of the cycle if you are providing working capital finance to help the banks recover their asset value you should have some prospect of getting your money back first. A three year repayment profile just doesn’t reflect the economic realities of these vessels or the likely market moving forward no matter how much the banks behind this may choose to believe something else.

People keep telling me that DBS and OCBC have have taken large internal write-offs with their investments in these companies. I struggle to believe this as if this were really the case the banks would surely just equitise their investment fully, bring the new money in, and sell the shares when they started trading again, which in simplistic terms is what happened to the creditors in the Tidewater and Gulfmark. Both banks, as with all banks with lending to the sector, should be maximising their own position, but in doing so they are ensuring collectively the poor financial performance of the entire fleet they longer they keep the extensions up.

There is a fine line in these situations between judging when the market is being excessively negative in the short-term, and therefore put new money in, or just liquidate. I know the bankers are loo king at Pacific Radiance going how can USD 600m be worth so little? But the answer is the assets have a very high holding cost and breakeven point and they lent in the middle of a credit boom. Given current market prices it looks like the banks are holding out not just for the unlikely now but the impossible. In economic terms these banks own nothing more than a claim to some future value on a vessel if the market recovers, and for a load of reasons (some related to accounting regulations), they want others to front this cost. But the economic substance of their claim remains the same.

Both Pacific Radiance and EMAS are  locked in a problem of mutually assured destruction if they both get temporary funding for another season. The market is structurally smaller than it was five years ago and ergo the vessels are not worth as much, and at the moment cannot generate enough cash to cover more than OpEx (not even including dry docking). The market hasn’t come back and shows no sign of doing so in any substantial way. If both of these firms secure further cash to blow on operating at cash break even for another season or two they will simply ensure overcapacity remains and no one in the industry can make money and therefore no rational investor should put money into the industry until capacity is reduced.

This Tidewater presentation shows quite how oversupplied the market is: from 4.5 vessels per rig to 8 on a significantly lower rig base down 40% from the peak in 2014.

Tidewater Market Equilibrium.png

The other point to note is that turnover for Pacific Radiance dropped 16% on last year for Q1 2018. Price deflation in an asset industry, particularly one with debt, is the nuclear bomb of finance as debt remains constant in nominal dollars while real earnings to service it decline. I doubt Pacific Radiance lost market share so I think that is indicative of pricing pressure that customers are pushing on them. What is clearly not happening, as in every other sector of offshore, is that E&P companies are asking vessel owners to scrap older tonnage so they can pay a premium for newer kit. In fact they are just demanding, as they always have but particularly in Asia, the cheapest kit that meets a minimum acceptable standard. The “aging scrapping” myth will have to wait a while longer before becoming reality. Pacific Radiance might be right and the nadir of the market has arrived, but there is precious little sign of an upward trajectory from here, and plenty of signs from contracted day rates that market expectations are for at least another season of rates at this level.

To be fair the graph is contrasted with this:

Supply is tight.png

But “adjusted supply” is a forecast and a nebulous concept at best. And with a 16%% drop in revenue over last year even if the increased utilisation figure is true it just means productivity is dropping. There is no good news at the moment on the supply side.

If prolonged these constant judicial delays to economic reality risk doing further harm to the sector as they will actually discourage private sector investment. MMA raised private money on market terms to manage the downturn, yet it’s returns are being forced lower because it is effectively competing against firms being kept on life support by a seemingly never ending stream of judicial moratoria from its competitors. The more this happens the less other private investors will become to get involved because a never ending overcapacity situation becomes effectively a court annoited market.

There is a moral hazard problem here where these indefinite moratorium agreements encouragement management, and in some cases creditors, to negotiate in bad faith while the costs of this are paid for by private sector investors who have put new money into competitor companies. The BT/ EMAS position shows the folly of allowing parties unlimited time to negotiate as it worsens the economic pain for firms that have proactively sought solutions. At some point these parties need to be given a “hard stop” date at which time the courts will not allow moratoria to be rolled over.

Eventually the restructuring in Asia will begin in earnest because there are simply not enough chairs now the music has stopped (with apologies to Chuck Prince). EMAS surely looks likely to kick this off.

The current oil price…

“You cannot improve a signal if you do not know what it signals”.

Fredrich Hayek

Trump 1 July.JPG

The oil price is hitting new highs but I don’t think this is going to have a dramatic effect on offshore for the next couple of years if at all. This is a supply constraint, particularly in relation to the Iran sanctions, and therefore this needs to resolved through the price mechanism in the short-term as all other swing producers are maxed out in terms of capacity as Libya and Venezeula also encounter problems.

This is a completely different investment narrative to the 2008-2014 boom. Then the rising price was viewed by the market as a reponse to rising Asian demand and the costs of developing new marginal sources of supply. The core of the rising price story was a demand driven boom.

No rational E&P company increases investments in 10-20 year fields in response to a price fluctuation with clear geo-political roots that could all be resolved in a relatively short period of time. By the time the field is built and delivered the political situation could have been resolved and then  the extra capacity will just lower the price. I could be wrong but I find it incomprehensible that Iran can be kept out of the international oil market forever. For these sort of changes in supply the changes in supply and demand need to be met with the pricing mechanism.  Some short-term changes in operating expenditure to boost production may become viable but not a wholesale commissioning of new fields.

As the Brookings Institute notes Trump seems to be pushing for regime change as the goal in Iran and the Saudis may have promised air cover with 2m b/d (and the strong administration links to Israel will also be coming into play here). This is a short term issue and maybe if the price gets too high here, and no one really believes the Saudi Arabia can come up with that sort of number in the short-term, then that will cause a change in policy. But I doubt it… Price will be the relief valve for what extra production OPEC cannot cover in the short-term.

As I have mentioned here before I think the link between the oil price and the demand for offshore services has altered fundamentally. Simply claiming now that a supply driven change will automatically be positive for offshore in a substative way is I think wrong and does not account for the difference between a demand driven expansion and a supply constricted shortage.

Change at the margin… shale versus offshore…

Shelf Drilling US.png

The map above and the statement above are taken from the Shelf Drilling prospectus. According to management, as can be clearly seen, there has been a structural change in the market and it simply isn’t coming back. 28 jack ups gone. Forever.

My only point on this is when you read about 90 units being scrapped since 2014 and 31 this year alone that is good in terms of helping restore the demand supply balance. But a market that used to have 40 jack-ups at it’s peak is never coming back and could conceivably go to zero. 1/3 of the scrappings just reflected a decline in the size of the market. And Mexico isn’t looking good either. Strangely none of the waterfall charts that show scrapping add back in an allowance for the accepted end state of the US Gulf? So of the 285 jackups on contract 10% of that number have had their market permanently removed and must surely impact on any credible scenario of market recovery?

Yes many in the GoM will have been the ones scrapped and will have been the older and less capable units, certainly not premium. But the point is there has been a structural change due to shale that has removed an geographical segment of the jack-up market and those need to be accounted for in a simplistic scrapping scenario. It also mean that if the market is “certain” to double in five years then other areas actually need to grow proportionately more to pick up the slack?

There has been a structural change in the Gulf market. Shallow water is out and large fields are in. Many of the offshore guys have probably gone onshore for the same money and the expense of laying off-take infrastructure in shallow water just isn’t worth it for companies now. This is a unique feature of the Gulf, although in Mexico they also appear to have largely exhausted the shallow water fields, but a factor with utilisation and supply/demand balances for the entire global fleet.

For those hoping for some Mexican respite this article from the FT last week will not be good news quoting the almost certain-to-be new finance minister:

“We certainly want more and more foreign, not just Mexican, investment and we’re going to open the door to everything,” Carlos Urzúa told the FT.  “The only exception is that there’s going to be a halt to oil tenders, ” said Mr Urzúa, an economics professor and published poet with a doctorate from the University of Wisconsin-Madison. “But apart from that, anywhere they want to invest, let them invest.” [Emphais added].

The growth in the GoM is all deep water high-flow rate, high CapEx projects. None of those can be serviced by jack-ups and given the international scope of companies like Rowan and Ensco some units are clearly destined for international markets.

This is just a small example of how small change at the margin affects the overall picture of demand for offshore assets. In 2014 the US was 14% of the jack-up market according to the figures above and recovery boom in the years ahead when the market has contracted meaningfully will be a rare feat if it occurs.

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.

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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.