Shale, mental models, strategic change, renewal, and railways…

“In other words the problem that is usually being visualised is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them………However, it is still competition within a rigid pattern of invariant conditions, methods of production and forms of industrial organization in particular, that practically monopolizes attention. But in capitalist reality as distinguished from the textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization….”

(Schumpeter, 1943, p. 84.)

On a day when the oil price dropped to its lowest point in seven months Bloomberg reported that:

There’s yet another concern growing as oil prices continue to erode: A record U.S. fracklog.

There were 5,946 drilled-but-uncompleted wells in the nation’s oilfields at the end of May, the most in at least three years, according to estimates by the U.S. Energy Information Administration. In the last month alone, explorers drilled 125 more wells in the Permian Basin than they would open. That represents about 96,000 barrels a day of output hovering over the market.

Yesterday Energen, a US shale E&P company, reported numbers yesterday with increasing productivity of “Gen 3” fracking:

Energen Wells with Gen 3 Fracs Outperforming

In central Midland Basin, cumulative production of 5 new Wolfcamp A and B wells averaging ≈15% above the high‐end, 1.3 MMBOE EUR type curve for a 10,000’ lateral (77% oil) at 75 days. Cumulative production of 2 new Wolfcamp A and B wells with 80 days of production history in Delaware Basin averaging ≈80% above the high‐end, 2.0 MMBOE EUR type curve for a 10,000’ lateral (61% oil).

If you don’t understand the implication of the text above for offshore they have a handy graph that makes it abundantly clear:

Energen 3G Frac Performance.png

This is simply a productivity game now as I have said before.  Yesterday I mentioned the DOF Subsea potential IPO, it’s worth noting that investors could choose between a company that took a bigger asset impairment charge than they made in EBITDA in the subsea projects division, or a company like Energen. When deciding to allocate capital it starts to become an easy decision.

There is a technical and industrial revolution taking place on the plains of the US. Ignoring this won’t make it go away. The Industrial Revolution didn’t happen overnight: steam engines were invented, coal production capacity increased, canals were built, railways invented etc, a series of interlinked innovations occured in a linear and dependent fashion. No one woke up one day and experienced them all. Productivity is a never ending journey. In the Cotton Revolution Kay invented the “Flying Shuttle” (1733), Hargreaves the “Spinning Jenny” (1765), Arkwright the “Water Frame“, (1769), the Crompton Mule (1779) was a combination of the Spinning Jenny and the Water Frame, and Boulton and Watt (1781) invented the condenser steam engine for use in a mill (ad infinitum).

The same thing is happening in shale. Shale won’t come up with a rig that kills deepwater productivity and lower lift costs overnight, but a series of systemic and interdependent innovations that advance the productivity of the sector as a whole is a certainty. That red line above will become steeper and move to the right with irregular monotony now until new technological constraints are reached.

For those of us, and I include myself in this camp, new to the shale productivity revolution Energen included another chart:

EGN Frac Design Evolution.png

And after this will be 4G and 5G… just like mobile phone evolution. Each generation will offer greater productivity than the one before. The image at the top of the page highlights the advances multi-well pad technology has already made to shale.

I am still not convinced everyone in offshore has understood the scale of the change occurring in the industry. I still think some people, particularly banks and those with fixed obligations, are using the 2007/08 years as a frame of reference when a short and sharp drop in demand was followed by a boom. I don’t see that happening this time. Telling people it will change one day isn’t a strategy it’s a hope.

Mental models I think are crucial here. One extraordinarily interesting paper is from Barr, Stimpert, and Huff (1992) who looked at the cognitive change managers underwent to successfully renew an organisation in light of externally driven change. (This is actually the paper that made me want to become a management consultant, a decision I quickly regretted I hasten to add). These researchers basically found two almost identical railroads operating in the same state and compared what happened to them in a longitudinal study spanning 25 years. The mental models of managers were examined by content analysing the annual reports and in particular the comments to shareholders. It is a rare example of a perfect natural control group so rare in social sciences and it’s a brilliant piece of research. The key findings were essentially the managers who were outward focused and changed their strategy accordingly survived while the railroad that went bankrupt always blamed industry factors beyond management control. The analogy to offshore at the moment needs little development.

Barr, Stimpert, & Huff (1992): COGNITIVE CHANGE, STRATEGIC ACTION, AND ORGANIZATIONAL RENEWAL

Barr Stimpert and Huff

BSH found four things mattered, 3 of which are directly related to offshore at the moment:

  1. Renewal requires a change in mental models
  2. A munificient environment may confirm outdated mental models
  3. Changes in the environment may not be noticed because they are not central to existing models
  4. Delays in the succession of mental models may be due to the time required for learning.

I’d argue there was another factor present in offshore that is the commitment to fixed assets and the associated liability structure makes it impossible to change the core business model even if the need for change is realised. Very little can be done outside a restructuring event in that case, although it is likely to actively influence management mental models.

Offshore will survive and prosper as an industry but it won’t be a reincarnation of the 2013/14 offshore. A new and different industry with a vastly different capital structure and strategic option set will appear I would suggest.

DOF Subsea IPO looks like a market bellweather of what financial investors believe…

Successful investing is anticipating the anticipations of others.

John Maynard Keynes

I was always sceptical of the DOF Subsea IPO, any subsea company raising capital at the moment would need an exceptional value story and this never offered that. I saw it as insiders selling out aware of how the future could look, so news that it was canned doesn’t come as a huge surprise. First Reserve wanted out but not at any price, and so the IPO was pulled. Let’s be clear this wasn’t a casual conversation, bankers will have had sounding out conversations with key investors who either gave a steadfast refusal, or said they would only buy it really cheap. The investment narrative is moving to shale in financial hubs at the moment, no one is paying full price for assets at the moment, and as the numbers make clear this is an asset business. The DOF Subsea Q1 numbers also make really clear that talk of a recovery at the moment just isn’t substantive.

DOF Subsea is a good company, and they are strong in Brazil and Norway which strategically is as good as it gets in macro terms for offshore, but they simply cannot be immune to the enormous retraction in demand the industry is experiencing. DOF Subsea also has the DOF problem which they blithely dismiss but which no one can get past: are they a contractors’ contractor or a contractor? As the industry consolidates it is increasingly hard to see someone being able to be both. It is also hard to believe that when all the flexlay vessels come off contract with Petrobras they will be employed at anything like the current rate creating a huge residual value issue on entry for stockholders (unless they were relying on the greater fool theory).

A quick look at at the Q1 results shows why the IPO was always going to be tricky:

DOF Subsea Utilisation Q1 2017

Despite what the Ops guys try and tell you about the boat stuff being black magic voodoo knowledge that simple people can’t understand subsea (and offshore supply) is a utilisation business, just like a hotel. Even at the top end of projects the value added by the marine delivery assets outstrips all the other costs of the SURF installations and therefore the performance of the vessels dictates the cost base and obviously the financial results of offshore contractors. Offshore contractors have high fixed costs on a depreciating asset base, vessel days are “disposable inventory” that if not sold have a set cost. Given DOF Subsea only have 1 chartered vessel so fleet utilisation shown above is clearly declining massively. This dropped straight to the bottom line:

DOF Subsea Q1 2017 EBITDA

It is a really simple business model: when the ships work you make money. DOF Subsea has a load of liquidity and has no immediate issues, but if anything goes wrong in Brazil then there is a massive problem. Petrobras are too long on flexlay capability and are unlikely to simply get rid of Subsea 7 only.

Despite the name and it’s ambitions DOF Subsea is still essentially a supply company:

DOF Subsea EBITDA Segment

Project accounting is notoriously complicated but in short in the six months from Oct 16 to Mar 17 DOF Subsea turned over NOK 1.5bn in subsea project delivery and made only NOK 96m EBITDA (as a rough cash proxy). The cash conversion rate is down substantially from 2016, whereas chartering vessels, by far the vast majority of EBITDA on a smaller number of vessels, drops with remarkable efficiency to EBITDA (c.80%).

I am always perplexed then to read comments like this:

DOF Subsea AS (“DOF Subsea”) and its shareholders have decided to start reviewing the opportunity for DOF Subsea to apply for a listing on Oslo Stock Exchange.
Proceeds from the primary issuance will provide flexibility for DOF Subsea to decisively pursue further organic and strategic growth opportunities and enhance the Company’s competitive position ahead of an anticipated market recovery.
You would think announcing numbers like the above you would want a better explanation before just casually dropping in a market recovery story/theory. Maybe even a data point or two? But no… straight in with this:
The Board of Directors is disappointed with the financial numbers for 1st quarter of 2017, especially with the performance in the North America region and the high number of vessels facing idle time between projects and downtime due to maintenance.
The real problem would appear to be believing that subsea vessels now have different economic drivers to offshore supply vessels. Maybe DOF would be better of just combining with DOF Subsea and accepting its all about scale now? Subsea vessels used to command a premium but not for the foreseeable future, a point bizzarely HugeStadSea have implicity accepted. I note that no ROV information is provided at all. Everyone in the ROV space is complaining about pricing pressure and with 69 systems DOF Subsea are a big player, you can read into that blank what you want.
At some point not everyone can benefit from this increasingly distant, and potentially mythical, recovery. With the amount of tonnage delivered a demand side recovery will also not translate directly into a supply side boom.  Investors paying full price for assets that were ordered for a different era are a rare breed at the moment as it is hard to argue that asset values have not been permanently impaired. Whether this is structural or cyclical downturn is for individual investors to decide (I saw an email last Friday from  the senior management at one offshore company stressing again the fervent hope that the market would turn eventually), clearly in this case investors decided they needed to see a different set of numbers.

Productivity breakeven reduction versus over supply driven cost reduction

Great graph from Rystad today showing how productivity improvements are driving a reduction in tight oil and offshore. I do however think it worth noting that this is a productivity driven cost reduction whereas in offshore it would appear that much of the cost reduction simply reflects equity that has been wiped out and contractors supplying assets at OpEx levels or below. My thoughts on Baumol productivity remain valid.

It is interesting though that offshore deepwater costs seem to move in a linear fashion with demand, as does offshore midwater. The reasons for the decline in offshore shelf breakeven costs would be interesting to explore.

i-Day for Bibby Offshore…

According to the bond prospectus Bibby Offshore (“BO”) is scheduled to handover interest of £6.56m to the creditors on June 15. Based on the last financials if they make this payment it will be the last before a default or restructuring event (next payment due Dec 15 2017).

In January BO claimed that they were close to finalising an agreement with the revolver bank (Barclays) to open up the facility with a contribution from Bibby Line Group. Given BO lost £52m in operating profit in 2016 that always looked unlikely and in the most recent financials that prospect has been quietly dropped in place of a much smaller facility from Group. Given that BO appears to be going back c. £100k per day, excluding interest costs, the c.£9m would only buy BO 90 days time. £30m isn’t a lot of cash for a business that must need a minimum of £10-15m in working capital and had a net current asset movement of -£22m in the last quarter.

Talk last weekend of James Fisher buying the company for £1 missed the obvious point: why would James Fisher Plc want to owe the bondholders £175m + other fixed commitments (ROVs, offices etc)? Bibby and James Fisher go way back to the Ministry of Defence RORO PFI deal, but this was never on the cards.

The North Sea DSV market became the ultimate boom market symbol of the last oil upswing, the ultimate procyclical market where a short-term increase in day rates with a long-lead time, pushed up asset prices and leverage levels that were simply unable to cope with a slowdown. Harkand, owned by Oaktree really didn’t take that long to fold once day-rates slid. Vard are now sitting on an extremely expensive reminder of how illiquid the high-end DSV market is (although surely a DOF solution beckons?)

Now more than any other segment this is a niche market in crisis. Last week the Harkand/Nor bondholders took their latest dose of pain by informing suppliers that they will try and preserve funds by putting the vessels in lay-up. As I wrote here, and here,  this was always a strategy of hope over reality and the only real surprise is how long it took the bondholders to accept this.

The last BO financials held the value of the Bibby Sapphire and Bibby Polaris at £107m, which equated nicely to the bonds trading at .60-.65 par. If the owners of these bonds really believe they could realise £100m for those two assets then they clearly haven’t been following the market or have any knowledge of it (which to be fair for a bondholder with a small position is understandable). The Nor bondholders recently wrote their vessels down to USD 58m, and they are considerably newer and higher spec than either of the Bibby vessels, although they appear to be extremely poorly maintained, and sitting in Blyth for 18 months without the dive system having worked will ensure a major refurb regardless of lay-up procedures. But just as importantly they can’t get anyone to buy them! Or even charter them! The “market”, for all but the most distressed transactions at concomitant prices, is non-existent.

But first let’s back up to a different time when the Bibby bond was sold and see that uses of the funds:

Bibby Sources and Uses

So BO actually didn’t get that much money to start with. BO borrowed £175m and only had £36m to invest to pay it back. Now the business was “underleveraged” in a sense before the issue, but only on turnover numbers, it still owed StanChart nearly £100m on vessels with no forward order book. The majority of the revenue is “spot” market, i,e. no commitment, and when you have such high running costs which the Olympic charters entailed,  you need minimal debt in a downturn to survive. Still the stated plan was to expand the business, not silly in a time of market growth, but all the risk was taken in debt capital not equity. Everything needed to work perfectly.

The problem, as so often with offshore at the moment, was excessive leverage and insufficient equity. For 7.5%, at the same time Unicredit was paying 7.3% (admittedly on a EUR issue) the bondholders agreed to lend Bibby Offshore money, secured only on two depreciating assets, one of which was built in 1999 and by 2021 (when the bullet payment was due) would be at best 75% of the way through its economic life, for seven years with no amortising payments. I make no judgements at all, the prospectus lists every possible risk, both sides agreed a transaction and signed and the money changed hands. The utlimate risk was clear: a downturn in the maket would create significant challenges for this company with two of the older assets in the market (Deep Explorer and Seven Kestrel had been announced) that were not being paid down to reflect depreciated value. You can make a claim to go interest only on a house because if maintained they do increase in value (sometimes) in a real and nominal sense, it is very hard to argue that with a ship that has a finite life.

This was a classic case of using debt for what should have been equity risk and why the offshore sector is struggling with a balance sheet recession at the moment. The plan, clearly outlined in the prospectus, was to borrow money to charter ships to make even more money.

As you can see from the table above £100m went to Standard Chartered who had amortising mortgages on the vessels and were traded for interest only bonds at a higher interest rate. StanChart is a fairly conservative bank and the loans were probably around the 8 year tenor leaving the bank exposed to minimal capital risk at the end of the loan so BO actually cranked up the risk even more because instead of paying the vessels off it simply had the equivalent of an interest only mortgage. In the Minsky framework BO had moved from hedge financing (cash flows cover interest and principal) to speculative financing (cash flows cover interest only).

A quick look at the Bibby Line Group (“BLG”) financials reveal that Bibby Offshore is simply too big for Group to save. Yes BLG will be annoyed they may not have access to the capital markets they thought, but when your turnover £1.7bn for £40-50m profit then you are not bailing the bondholders out for £175m. The majority of the turnover is all from Costcutter that produces almost no margin. Group had long been concerned BO had grown too big for the overall portfolio for exactly this sort of reason, but debt is the heroin of the financial system and extraordinarily hard to turn down when thrust forwards on such seemingly attractive terms. Chartering ships when not amortising your own is the ultimate leverage strategy.

I realise the market was completely different when the bonds were issued but this just highlights how both sides willingly got into a deal they both realised was extremely risky. Since then revenue has more than halved at BO and it is hard to argue they are worse operationally (although the prospectus lists two COOs, which for a company of this size looks somewhat overmanaged, and sending a manager (ex-COO) to the US on an ex-pat package when you are weeks away from running out of money looks optimistic in the extreme). However, a structural solution will be required to bring the balance sheet into line with the new reality, and as the equity is worthless, a restructuring is a certainty. The major reason I think BLG is agreeing to the revolver (apart from the fact it ranks above the bonds so is in effect risk-free) is to gain a seat at the restructuring table.

Which brings us back to the vessel values and the bondholder options that are clearly inextricably linked. In the current market there is simply no way the Polaris will remain in the North Sea in an open sale process and even Sapphire is doubtful, in which case the comparable sale price is against Asian tonnage as this is as much cash as each asset could reasonably earn for the foreseeable future. That number is so far south of £100m I’d suggest any bondholder expecting that pull up a chair and grab a strong coffee before being rational about how much less.

The basic problem the Harkand/Nor bondholders never understood, which the BO bondholders maybe about to, is that without a certain amount of operational infrastructure it doesn’t matter how high-spec the vessel is it isn’t a North Sea asset. If you want to dive in the North Sea you need a financial commitment in excesss of the extremely specialised assets and these have a high cash burn rate if they are under-utilised. Failure to make this commitment just renders the “North Sea class DSV” a ROW DSV with higher OpEx and no chance to get extra revenue. That is likely to make bondholders look to cut their losses quickly once they understand the complexity and commitment involved.

(Disclosure: I resigned as a Director of Bibby Offshore Holdings Ltd in December 2012. The bond issue was well after my time).

Illiquid or insolvent? Bagehot and lenders of last resort to the offshore industry…

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 Singapore Government think they have found a case of market failure:

SINGAPORE – Offshore marine services firm Pacific Radiance has been granted S$85 million in loans under two Government-backed financing schemes.

I’d suggest the Singaporean Government brush-up on the difference between a shift in the demand curve and a shift along the demand curve To non-economists the difference may look semantic but to every stage 1 student it is drilled into them that a shift along the demand curve occurs when price changes and then the quantity demanded responds, a shift in the demand curve means a fundamental change in demand. It is the difference between a change in the quantity demanded versus a change in demand, which are self-evidently two completely different things.

I would argue, and have on this blog consistently, that we are seeing a complete reconfiguration of the offshore supply chain, think Woodside moving to electronic Dutch Auctions for commodity supply vessels, rather than a short-term fluctuation in demand as the result of temporarily low oil prices.

Quite why the Singaporean Government feels it knows better than the market is beyond me here? I should note at this point I am not an unadulterated free-marketeer, my favourite paper at University in NZ at the height of Rogernomics and its successors in a supply-side revolution, was “State-Led Development in South-East Asian Tiger Nations: Singapore, Hong Kong, Taiwan, and South Korea”. In the debate between the World Bank and the activists I took my lead from Robert Wade (also from NZ) and others who saw active government involvement in the economies as an essential part of the process that drove these economies to outperform and pull their people out of poverty. I was a believer, I agree still to a certain extent, with Alice Amsden who argued the governments’ of the region actively set out to “get the market price wrong”.

But I also grew up in New Zealand, which terrified of rising oil prices in the 1970’s had launched Think Big, and by the time the Motonui synthetic “gas-to-gasoline” plant was finished the tax payer footed the bill for every single litre manufactured. It was in short an economic disaster. Trusting a Government ministry to out-judge the energy market is a dangerously expensive passtime.

I should also note that Stanley Fischer, in an unbiased review of South East Asian development policies following the East Asian Crisis noted:

As to Asian industrial policy… some degree of government involvement can in principle be successful, and that it was successful in practice, too, in some Asian economies by allowing new industries to overcome coordination failures and exploit economies of scale. I also believe the potential for such interventions to go wrong is very high, both because the government may make the wrong decisions, and also because they are conducive to corruption. In most cases the best approach is for a country to create a supportive business environment, including policies and institutions that encourage innovation, investment and exports in general, and to leave allocative investment decisions to the private sector.

So when I read that Pacific Radiance has secured loans from two entities affiliated with the Singaporean Government I have to question what is going on?

Firstly, there is a moral hazard element here as the shareholders and the banks appear to benefit from an overly generous dose of leverage on average assets. The Straits Times notes:

The Government will take on 70 per cent of the risk share for both the IFS and BL loans, which were rolled out last November to help local offshore and marine companies weather the current prolonged industry downturn by gaining access to working capital and financing.

These are loans largely owned by DBS and UOB. I don’t undertand how if this is an economic transaction these banks need this level of support? This is an assymetric payoff where the Government takes most of the risk and the banks pick up most of the upside.

Secondly, the sanity: this money is going on OpEx:

The loans … will help support the group’s working capital needs over the medium term, said Pacific Radiance in a statement on Thursday.

Really? Does the Government of Singapore believe that a short-term market dislocation has occured that will see USD 5-10k per day per vessel of OpEx recovered when the market comes back? Pacific Radiance has USD 605m of liabilities over a fleet of 60 vessels and JVs with a further 60 in Indonesia. Like Deepsea Supply, and a host of others pretending the vessels are worth anything like this is a fantasy. But another problem isn’t just the size of the debt, and the quality of the assets underpinning it, but the income being generated to service it:

PAC RAD Sales Q1 2017

Sales are dropping like a stone, and as a general rule depreciating assets that earn less than you thought are worth less. The loan doesn’t solve the fundamental problem: Pacific Radiance have borrowed too much money relative to the revenue these assets can now earn and are likely to in the forseeable future. As you can see over the same period comparison as above Pacific Radiance is consuming cash at an alarming rate:

PAC RAD Cash Flow Q1 2017

Most worrying is the amounts due from related companies which would have to be seen as doubtful, but the business is also using large amounts of cash in operations and this loan is simply going to go in and then go out on that operational expenditure. Loan covenants on fixed assets were simply not designed to cope with turnover dropping 24% quarter-on-quarter: there was too much leverage in the offshore sector to support this. The banks need to come to the party here for this to be a viable firm.

Third, this seems completely contrary to what other major players in the market, like Bourbon are saying (and they are surviving without government assistance):

Mr Pang noted that the longer-term outlook for the industry has improved, as Opec and certain non-Opec producers have sustained oil production cuts until June this year and have also agreed to extend these cuts by another nine months. “This concerted effort by oil producers should enable supply and demand to balance in the medium term.”

The Singaporean Government is essentially making a bet on a private company that seems to have no other plan than simply hanging around waiting for the market to improve. To be honest that doesn’t strike me as a great plan, and if enough investors agreed with Mr Pang surely getting an equity rights issue away should be easy for the company to raise the money and wait for this miraculous occurrence? In fact of course with the Swiber AHTS going for 10% of book value the loan already looks doubtful.

The government of Singapore has now become the Lender of Last Resort to the offshore sector and therefore the Bagehot dictum applies “lend freely at a penal interest rate against collateral that would be good quality in normal times” (I have discussed this before) . The formula is help the illiquid but not the insolvent. Bagehot outlined this formula in 1873 after repeated shutdowns in the London money market put sound financial institutions at risk. The Bank of England had followed this dictum in 1866 when London had its own Lehman moment and the Bank of England allowed Overund, Gurney and Co., one of the largest institutions, to fail.

I haven’t done a full valuation of the Pacific Radiance fleet but a quick overview of the assets on the website makes it clear this is pure commodity tonnage and some of it very low end. Quite why anyone thinks this is going to recover to previous levels needs to be outlined explicitly I would have thought given the scale of the commitment that is in the process of being made. I don’t think in the current market this would qualify as high quality collateral in normal times. There also appears nothing penal in the loan at all.

Worringly for Singaporean tax payers, looking at Ezion and others, Bagehot also wrote:

‘either shut the Bank at once […] or lend freely, boldly, and so that the public will feel you mean to go on lending. To lend a great deal, and not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies’

I think Pacific Radiance had a solvency problem not just a liquidity issue, but the systemic problem is now the longer Singapore props up companies like this the longer the industry will take to recover. If Singaporean taxpayers decide to support Ezion and a host of others they need to be prepared to write some very big checks, and the US companies fresh from Chap 11, with clean balance sheets, will be in a far better place to compete.

During the last Global Financial Crisis Paul Tucker of the Bank of England stated the Bagehot dictum as ‘to avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at ‘high rates.’ These loans do nothing of the sort by backing poor quality collateral and providing uneconomic liquidity to a company with an unsolvable problem. People are not paying less for these vessels because there is a panic they are paying less because E&P companies are using them less and they cost a lot to run! These loans will only delay the pain and hinder other struggling firms. The banks should have been forced to realise the assets at current market values as the penal rates both Bagehot and Tucker outlined and the shareholders should have been completely wiped out.

As a comparison I do not think Mermaid Maritime Australia will be so lucky. I have experienced Australian banks first hand and I suspect the “Big Four” will be ruthless and simply shut the company down soon having given the company temporary respite to see if this was just a short-term dislocation. Unfortunately from an economic perspective this type of capacity reduction is exactly what is needed to rebalance the industry.

Shale, productivity, and American exceptionalism…

‘You see, Tom,’ said Mr Deane, at last, throwing himself backward, ‘the world goes on at a smarter pace now than it did when I was a young fellow. Why, sir, forty years ago, when I was much such a strapping youngster as you, a man expected to pull between the shafts the best part of his life, before he got the whip in his hand. The looms went slowish, and fashions didn’t alter quite so fast – I’d a best suit that lasted me six years. Everything was on a lower scale, sir – in point of expenditure, I mean. It’s this steam, you see, that has made the difference – it drives on every wheel double pace and the wheel of Fortune along with’ em…….

George Eliot, The Mill on the Floss

Jeffries came out with a good research note this week that covers many of the themes I have discussed in the past year on shale productivity noting (click on the shale tag if you are interested):

U.S. activity recovery has been very broad based, which suggests a systematic move up the learning curve. Nearly 50 incremental operators have added rigs across all major US unconventional oil basins since the end of February when current oil price volatility began. Further, US onshore total (ex-CBM)/oil-directed well permits increased by 29%/43% in May vs. April…  Perhaps surprisingly relative to our sense of investor expectations, only ~32%/8% of 2017/18 oil production for 38 US E&Ps tracked by Bloomberg is hedged. Although we think capital raises in 2016 and oil industry expectation of oil price increases spurred activity recovery, in this evidence of continued growth we suspect we are seeing greater comfort in sustained progress along the US unconventional learning curve and in turn greater comfort in a business model that can subsist in a $40-45/bbl WTI oil world.

In hindsight the years between 2001-2014 simply looked too good for offshore, a steadily increasing oil price and a limited ability to increase production from land-based resources led to an investment boom to access the offshore oil. Rigs, vessels, ROVs and associated kit were all hit with a huge increase in demand and there followed an enormous increase in the fleet. Like all investment bubbles there is normally a very good rationale in the beginning for their appearence, but the longer they continue the greater the risk they overshoot. It is probably impossible to spot a bubble before it bursts, although there a clear indicators that normally come through the credit channel of the economy. But deep down everyone in industry felt uncomfortable about specialist vessels selling for far more than implied book value, 25 year assets earning enough in cash flow terms to pay off in 7 or 8 etc, people building USD 100m vessels for the spot market… There was a good reason, the hockey stick graphs in the presentations all went north, but surely it couldn’t go on for ever (I claim no foresight here).

When looking at the impact of increasing energy costs from the 1970s researchers found:

… rather striking features. In particular, it appears (i) that the oil price increases in the 1970s were followed by a large and persistent increase in energy-saving and (ii) that there is a marked medium-run negative co-movement between energy-saving and capital/labor-saving. These observations suggest that our economy directs its R&D efforts to save on inputs that are scarce, or expensive, and away from others. We thus interpret our findings as aggregate evidence of directed technical change”

What that means is that following the price shocks of the 1970s people worked at ways on increasing energy efficiency and finding ways of using oil more efficiently, but it takes a long-time for things to change and the technilogical progress to follow. The long boom in the oil price, and therefore offshore energy, sowed the seeds of the shale revolution as the high cost led to technical innovation. Economic systems are adaptive in the long run.

Shale is in its formative years. I have no idea, and nor does anyone, what the future potential is. We do know the US indepedents have history:

US Wildcat Productivity

Source: Juan Blanco and Houshang Kheradmand, 2011, from Wene (2005). (The 1989 change relates to advances in seismic technology).

The oil price needs to be viewed in the very long run in terms of how long it takes complex production technologies time to adapt. However, given time they do.

But shale is a manufacturing process and no economy in the world is more adept at harnessing the power of potential in this area than the US.  Broadly speaking this “American Exceptionalism” in manufacturing is defined in four attributes:

  1. Stadardized products
  2. Assembly line production
  3. Long production runs
  4. Resource-using technologies

These qualities might look tautological now but they have a long history and weren’t always that obvious with the roots steeped in the antebellum US Civil War economy. At the US display at the Crystal Palace exhibition in 1851 the “American System” of manufacturing (for small arms) was displayed: interchangeable, high quality precision parts then assembled en masse. In 1853 the English went to the US to investigate and ended up purchasing some of the small arms machinery they went to see. At this stage this was unique to this area of the US economy and was completely different from the cotton revolution on which the UK manufacturing was based (for another post). One of the great controversies of modern economic history was solved when James and Skinner demonstrated that higher wages were the result of more skilled workers with this machinery.

This system was a lineal antecedent of the system that became American Manufacturing and was Rosenberg argues a quirk of the procurement process of the Army Ordance Department who realised the scale of the task they were trying to achieve. The number of companies involved was limited but in particular The Remington Firearm also became the Remington Typewriter (whose economic importance in its own right is the QWERTY debate) and thus this system was transferred to other areas of the economy. It took time but it really was that niche in the beginning (the typical manufacturing firm had 10 employees or less c. 1840-50).

At the time businessmen were aware though that the American economy was on the verge of something profound in terms of economic transformation:

US Commodity Output

US Commodity Production History

It is important to sidetrack for a minute here an seperate out this industry level change from what economists call General Purpose Technology, such as the steam engine or microprocessor, that effect the whole economy. We are talking innovation within an industry and it led to dramatic declines in cost as output rose:

US Oil Industry Cost Reductions 1865-1884

Prices per barrel NOM

Chandler, Schumpeter and others have used this to put the corporation at the heart of economic change. Markets are created and developed by corporate entrepreneurs. This was the age of the ‘Robber Barons”, yet monopolies are supposed to raise prices and restrict innovation, and this is the opposite of what happened. Standard Oil, predeccessor to ExxonMobil was at the heart of this with Rockerfeller as its larger-than-life founder and creator. As Chandler described in The Visible Hand:

The market remained the generator of demand for goods and services, but modern business enterprise took over the functions of coordinating flows of goods and services through existing processes of production and distribution, and of allocating funds and personnel for future production and distribution. As modern business enterprise acquired functions hitherto carried out by the market, it became the most powerful institution in the American economy and its managers the most influential group of economic decision makers. The rise of modern business enterprise in the United States, therefore, brought with it managerial capitalism. (Chandler 1977, p. 1.)

 

This lineage is important: out in plains of America right now shale companies are working out how to drill each well a little bit better and cheaper, how to move the rig a little faster, use a little less sand, and find a little more oil, and they are doing this constantly. Behind them stand the rig companies who are seeking to add more productivity to their customers wells, to a host of suppliers you have never heard of (i.e. Hi Crush Partners, a $1.2bn sand supplier) that are all learning a small incremental amount each day about how to improve the fracing process. Make no mistakes about the profundity of this change.

This growth is also at the perfect rate, 3-7 rigs each week (out of 889 as of last week) joining the fray across the whole industry mean finance directors don’t panic, rig crews can be swapped around, learnings from one rig shared with another crew etc. This is non inflationary growth that allows the supply chain to add capacity in a cost efficient manner without adding “kinks” that add cost pressure. I am no expert in this area but already brief research shows that the new standard for mud pump (faster drilling) is moving from 5000hp to 7500hp… this is something the American companies excel at: greater productivity and the virtuous cycle of lower costs that only scale can bring. The more rigs they build the better each generation wil become and the greater the scale and cost reduction each unit will bring. You bet against this at your peril. Yes there is likely to be be short-term inflationary pressures at certain points, there are concerns about the price being paid for land in the Permania craze at the moment, but these would not appear to threaten the overall direction of change here.

Innovation and Incremental Improvement in the Shale Manufacturing Process

Shale innovation.png

Source: Anterro Resources, Oct 2016

I think one of the reasons that productivity in shale has been underestimated is the hedonic adjustment in the quality of shale equipment that has in effect changed the production possibility frontier used in most forecast models of shale potential. [Hedonic adjustment is when economists have to cope with technical and product change in their output models by making adjustments for longevity and quality of the products. It is notoriously unrealiable and hard to calculate, particularly when the industry is at such a nascent stage of development. The UK Government added liquid soap to the CPI measure in 2014 replacing bars of soap: they offer different price points and benefits and aren’t strictly comparable, but they reflected the change in how the market worked so the change was made. Try doing this to rig output when new rigs offer completely different production possibilities, many of which are unproven.] As Solow quipped (on the IT revolution) “[p]roductivity shows up everywhere but the statistics”.

The shale industry is at the start of a dramatic decline in cost and potentially a vast increase in output per unit of capital employed. Everyone in offshore should be examining their business model.

DeepSea Supply, bank behaviour, credit, and the Great Depression

Contagion is a significant increase in comovements of prices and quantities across markets, conditional on a crisis occurring in one market or group of markets.

A Primer on Financial Contagion

Massimo Sbracia and Marcello Pericoli

 

“No one has seen a worse offshore market than what we’re going through now,” Kristin Holth, head of shipping, offshore and logistics at DNB ASA, said in an interview at the Nor-Shipping conference… “It hasn’t been a regular downturn. In many ways, we’ve seen the collapse of an industry.”

I am a bit late getting to this but the DeepSea Supply (“DESS”) Q1 results when combined with the Solstad merger information memorandum are extremely interesting… they beg the question: would you pay USD 600m for some Asian built PSVs and AHTSs when 16 of them are in lay-up? Some of these are not flash tonnage: the six year old 6800bhp vessels built at ABG and the UT 755 PSVs built in Cochin look extremely vulnerable. To put that figure in perspective it is USD 28.5m for every working vessel (with 16 of the 37 in lay-up) and even on a average basis it is still USD 16.2m. In the current market most of those vessels would strugggle to go for more than USD 8m, collectively they would make asset values even lower than that they are such a large fleet.

It is an absurd figure… but of course the banks behind DESS, who are owed that much, don’t have a choice now, they lent in a different era. The reason balance sheet recessions are so severe is that debt obligations remain constant long after the equity is wiped out. If enough debtors default this travels to the banking system. And one of the problems offshore has at the moment is a lack of lending from the banking system: it is no different to the housing market, if banks will not lend then asset prices decline, and on depreciating assets such as vessels, I would argue the impairment is likely to be permanent for certain assets (Asian built commodity tonnage being part of that for sure). The problem for the offshore supply industry is when will the banks start to lend? Because for a long time I think risk officers at banks will insist this tonnage stays off the balance sheet once they have closed their positions. Risk models hate volatility and these assets have it in large quantities.

In the DESS case the banks and Solstad have branded DESS a low cost operator, not low cost enough to come close to break-even in this downturn, but apparently this is the future. It is really hard not to think that the closer they get to this merger Solstad can’t be wondering if there was anyway of getting rid of this company… If it was a horse you would shoot it.

Sooner or later someone is going to have get some of the banks behind these assets to start getting real. Part of the business of banking is what economists call maturity transformation: banks borrow deposits off people and then re-lend them out for projects with a much longer contractual requirement, it is a a very risk business model, particularly when done on very thin layers of capital. They are a lot like a hedge fund in other words, in the industry vernacular banks “borrow short and lend long”.  The Nordic banks involved in both Farstad and DESS are effectively becoming hedge funds in another way: thinking they can play the market. These banks are the prime movers in failing to liquidate assets to discover their true floor price.

In order for the HugeStadSea merger to go ahead the DESS banks must make the following concessions:

Main elements in this context are the following:

(i) Reduction of amortization to 10 % of the original repayment schedule until 31 December 2021;

(ii) Pre-approval to sell certain vessels at prices below allocated mortgaged debt (only applicable under the combined fleet facility);

(iii) Minimum value clause set to 100 % and suspended until 1 January 2020;

(iv) Removal of financial covenants related to value adjusted equity, and

(v) Introduction of cash sweep mechanism.

Point (i) makes clear the assets cannot generate sufficient cash flow in the current market to pay them back more than a token amount. One of the troubles is the 10% is for the entire 37 vessels not the 26 working so even this looks optimisitic.

Point (iv) means the banks will just pretend that even though you are insolvent you are a going concern while (v) just makes sure they collect any surplus cash.

Does anyone in this industry believe that a Chinese built UT 755 will in 4 years time, having made no payments for 25% of its economic life, be able to keep the bank whole on this loan? It is just absurd.

Solstad are going to need an enormous rights issue fairly early on (not just because of DESS I hasten to add, Farstad is arguably more of a basket case). According to the announcement JF/Hemmen put in NOK 200m (c. USD 23m) into Solstad shares (approximately 3.8% of the loans outstanding or c. 180 days of EBIT losses). So in crude terms the DESS gift to Solstad’s high class CSV fleet (with some supply vessels as well to be fair)  is a commodity fleet of 37 vessels, with 16 laid up, constant debt obligations of USD 600m, and a proportionate capital increase against this of 4%. Potentially there are some cost savings but these seem contrived in the extreme (when you cash flow losses are this high you can’t meaningfully talk of measurable synergies as opposed to normal cost cutting)… but I don’t think anyone would buy the shares based on those anyway.

When people saw the US housing crisis emerge they realised it wasn’t just NINJA loans and MBS that was the problem, it was also second mortgages to pay for current consumption. Shipping banks also make the same mistake as this paragraph outlining DNBs exposure to DESS makes clear:

The facility amount under the DNB Facility is USD 140,640,000 repayable in quarterly instalments until 31December 2021…The DNB Facility is secured by, inter alia, first priority mortgages over the financed vessels… Additionally, the lenders under the DNB Facility will… receive (silent) second priority mortgages over the vessels in the NIBC Facility (described below) and the Fleet Loan Facility

How much would you pay for the second mortgage on a Chinese AHTS at the moment? If you give me a number in anything other than Turkish Lira, and a small one at that, please PM me your details so my Nigerian banking associates can request your account details as we have a Euromillions win we wish to deposit there.

And here is what I have been saying in words laid out graphically for you:

DESS Repayment profile

What the banks behind DESS and Solstad want you to believe is that in five years time a company with a collection of Asian built PSVs and AHTS, many over 10-14 years old, will be able to get another bank or group of bondholders to pay them USD 515m to settle their claim (c. USD 13.9m per vessel!). These same banks refuse loans to vessels older than 8 years! It’s just not serious,  but it shows how desperate the banks are not to take losses to the P&L here and pretend they don’t have the problem. Note the lead bank here is DNB who as Mr Holth has made clear do understand the scale of the problem. Mr Holth is extending five years further credit to an industry he believes has collapsed?

[Obviously the loan will be rolled over in 5 years or written down massively]. Quite why banks with the self-professed capital strength of DNB, Nordea and others involve themselves in such shenanigans is for another post. But these numbers are material and not even realistic: at USD 21m per annum of interest all of the 21 working vessels (at less than 100% utilisation) need to make USD 57.5k per day just to pay the interest bill (USD 2.7k per vessel) when most are working at OpEx breakeven if lucky.

To really drive home what a bad deal the merger is checkout this paragraph:

As per the date of this Information Memorandum, the SOFF Group does not have sufficient working capital for its present requirements in a twelve month perspective. Under its current financing facilities, there is a minimum liquidity requirement of NOK 400 million, and by March 2018, a shortage of approximately NOK 100 million is expected.

The document states the banks will relax this covenant but that isn’t really the issue. The issue is in more prudent times the banks thought they needed 400 and now that asset values have plummted they suddenly don’t. A “world leading” OSV company with 157 vessels doesn’t even have USD 48m in liquidity… please… You need to be flexible in these situations absolutely, but really, for this merger? I love the way the lawyers have forced them to write if they cannot agree this the banks may demand accelerated repayment, despite the fact everyone has gone to such extraordinary efforts to ensure that is exactly what doesn’t happen.

And I guess at base level that is what I don’t like about this merger: the owners should have played harder with the banks and forced them to realise that their values are nothing like the book values. Forcing people to keep book values high with low ammortisation payments just delays things and makes raising new equity even harder. We are starting to get into a philosophical debate about the nature of money here, that a loan contract is just a claim on future economic outcomes, and these ones are worth substantially less than when they were willingly entered into. Friedman was wrong (about a lot):

“Only government can take perfectly good paper, cover it with perfectly good ink, and make it worthless”

Shipowners and banks combined have also done an excellent job of doing the same. Particularly the OpEx demon…

If you wonder what the expression “zombie bank” is look no further than the offshore portfolios of these banks because they will never take this sort of exposure on balance sheet again and unless the Chinese banks do, who are much more likely to support new builds from Chinese yards, then the industry has an asset value problem.

There are plenty of historical precedents for these issues in the banking system. In innovative research Postel-Vinay looked at banks, housing, and second mortgages in Chicago during the Great Depression and found:

[a]s theory predicts, debt dilution, even in the presence of seniority rules, can be highly detrimental to both junior and senior lenders. The probability of default on first mortgages was likely to increase, and commercial banks were more likely to foreclose. Through foreclosure they would still be able to retrieve 50 per cent of the property value, but often after a protracted foreclosure process. This would have put further strain on banks during liquidity crises. This article is thus a timely reminder that second mortgages, or ‘piggyback loans’ as they are called today, can be hazardous to lenders and borrowers alike. It provides further empirical evidence that debt dilution can be detrimental to credit.

When those second mortgages on vessels turn out to be valueless this will cause an issue in the banks risk models. Then what economists call “interbank amplification” where banks withdraw money from certain asset sectors, and in this case reduce lending to similar asset classes, further lessening the available money supply available in total and reducing asset values (ad infinitum). Researchers at the Richmond Fed looked at this in the Great Depression:

Interbank networks amplified the contraction in lending during the Great Depression. Banking panics induced banks in the hinterland to withdraw interbank deposits from Federal Reserve member banks located in reserve and central reserve cities. These correspondent banks responded by curtailing lending to businesses. Between the peak in the summer of 1929 and the banking holiday in the winter of 1933, interbank amplification reduced aggregate lending in the U.S. economy by an estimated 15 percent.

I keep referencing the Great Depression here because one of the issues in recovery from it was asset values and the problems associated with a reduction in the monetary supply (and here I will concede Friedman was on to something). These two issues fed on one another in a self reinforcing circle and also led to a collapse in credit because no one had collateral that financial institutions would accept as worthy lending against. Taking macro models to micro industries has methodological issues, but I think it is valid here (*methodologiocal reasoning too technical for this forum). Suffice to say the supply side of this recovery will follow a different dynamic to the demand side and those who watch the daily fluctuations in the oil price with hope are wasting their time.

One of the controversies of the Great Depression is did Andrew Mellon, arch tycoon in a Trumpian sense, really tell Hoover to “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.”? Mellon always denied it and it suited Hoover to claim it. In a macro sense it is clearly ill advised, but in offshore I can’t help feeling it would be good advice. At the moment we are slowly grinding through the inexorable oversupply where banks are propping up failed economic propositions though moves like this that potentially put companies out of business that may have survived. Such is the life of credit, but as I have said before until this clears out the entire industry will make suboptimal returns.