A bank run in offshore…

DOF shares dropped 33% yesterday as the market woke up to the painfully obvious fact that it need a major financial restructuring. In breach of loan agreements at least one bank appears to be accepting reality.

I have said here before, indeed it was the basis of my EMAS predecitions, that you need to think of offshore operators as funding themselves like a bank: they borrow short and lend long. They take mismatched duration risk, or maturity transformation in the vernacular. Offshore operators “borrow” short-term in the contracting market with contracts that are far shorter than the assets they need to fulfill the contracts, and then they use this facility to invest in assets of a longer duration that cannot be redeemed early if the short-end of the market changes. In construction they are a confidence play that requires the customer to believe they will be solvent and deliver the contract next year. With these numbers DOF can’t promise that.

DOF is in short experiencing a bank run. This little paragraph highlights that going into the summer some banks are losing patience (waking up to?) [with] rolling over loans they know will not be paid back at an economic rate and have had enough:

DOF banks 2019.png

DOF has breached the covenants in its loan agreements and the equity is now worth nothing. Another restructuring begins.

Just like in the financial crisis the liquidity crisis starts between financial institutions refusing to roll-over obligations. The summer is coming and some banks have seen that day rates and utilisation levels are not occurring at an economic rate and the internal risk police (and financial regulators) appear to have called time.

My own view is that Solstad and DOF cannot survive. Certainly there is the possibility that someone like DNB Bank back a ‘national champion’ and commbines them (and that will surely be DOF). Or maybe Solstad is allowed to die? But the market isn’t big enough for both now and the industrial logic of having two major Norwegian OSV operators slowly draining cash waiting for the never appearing recovery has moved from the tenuous to the non-existent. It might seem like a big deal in the industry but in economic terms it’s two over leveraged micro caps going out off business at the end of a commodity boom. Move on.

The folly of the offshore strategy of going long on specialised assets with a contract life significantly shorter than their economic value is now painfully obvious; the Skandi Vittoria and Skandi Nitteroi were purpose built in 2010/2011 and were redelivered in 2018 and are now in lay-up. There is no spot market for PLSVs as everyone knows and so DOF either goes really long on flexlay contracting capacity (which I doubt Technip will accept) by building up a really expensive engineering team that will takes years to win work that has a long lead time (and therefore required vast sums of working capital) … or … Or what?

No one needs those vessels. Ever. There used to be 80 floaters driving flexlay demand in Brazil and now there are less than 20. Subsea 7 skipped a bargain and went for the new build Vega and everyone else has excess flexlay capacity. The value of having a short-put on a specialised asset has been gained by Petrobras at the expense of DOF shareholders and creditors.

Those two relatively new vessels are actually worthless at much beyond conversion value but probably have a book value of over $100m. For Seadrill (through Seabras), Subsea 7, and Technip the reality of what lies ahead when their contracts finish is all to obvious.

The only thing that isn’t like a bank run is the customers are staying (at the moment). But that’s because they are getting supplied long duration assets well below their economic cost aided by real banks that would rather push the day of reckoning out than realise real losses now. For Solstad and DOF to be viable economic entities senior (and junior) creditors will have to write-off billions of NOK.

No wonder the banks are reducing their loan books and expsoure to the sector. And if no one lends then asset values drop (one of the major flaws in the Standard Drilling business model for another day).  How exactly you seperate a liquidity crisis from a solvency crises becomes a moot point, but we are about to see more than one practical example.

 

When group think and economic incentives collide …

I’m never sure with this whether it’s a collective case of Norwegian thinking that refuses to accept the scale of the change taking place in the offshore industry or simply the desire to try and get investment banking fees? Maybe a little of both.

Either way it’s clear the market has realised Seadrill is headed for restructuring way before the analyst community…

Seadrill yesterday:

Down 23%. Analysts yesterday morning:

Look at the price targets! And it’s not like anyone didn’t see it coming (Seadrill over 6 months):

There is a liquidity squeeze coming in offshore as all these crazy asset play deals, that were nothing more than momentum trades, have no momentum. The fact is Seadrill is performing miles behind the restructuring plan of only a few months again. Yet again the promised summer hasn’t come and financial markets know it.

More evidence this is the offshore “recovery”…

I was going to write this anyway today and then looked at the oil price as I was leaving work… down 2.7% at the time of pixel… The graph above comes from the Dallas Fed blog which makes this salient point and helps explain why:

Given current market prices, U.S. shale production will continue growing this year. Indeed, a recent report by the International Energy Agency highlighted that shale production is likely to be a major driver over the next five years. This does not rule out the possibility of major oil price movements, but it does point to a strong tendency that oil prices will be range bound in the near future.

Read the whole thing. Shale has structurally changed the oil industry and fundamentally changed any realistic scenarios for an “offshore recovery”.

Contrast that with the investment boom in shale: If you want to see how the whole ecosystem of companies and innovation are working in a harmony to make US shale more efficient, deepen the capital base, and thereby work in a virtuous circle then this article from the Houston Chronicle that showcases a GEBH project to turn flared gas into power in the region is a great anecdote:

Baker Hughes is using the Permian Basin in West Texas to debut a fleet of new turbines that use excess natural gas from a drilling site to power hydraulic fracturing equipment — reducing flaring, carbon dioxide emissions, people and equipment in remote locations…

Baker Hughes estimates 500 hydraulic fracturing fleets are deployed in shale basins across the United States and Canada. Most of them are powered by trailer-mounted diesel engines. Each fleet consumes more than 7 million gallons of diesel per year, emits an average of 70,000 metric tons of carbon dioxide and require 700,000 tanker truck loads of diesel supplied to remote sites, according to Baker Hughes.

“Electric frack enables the switch from diesel-driven to electrical-driven pumps powered by modular gas turbine generating units,” Simonelli said. “This alleviates several limiting factors for the operator and the pressure pumping company such as diesel truck logistics, excess gas handling, carbon emissions and the reliability of the pressure pumping operation.”

More capital, greater efficiency, and capital deepening. It is a virtuous circle that increases productivity and economic returns and is the signal for firms to invest more. It is a completely different investment dynamic to the one driving offshore projects at the moment.

Shale productivity.png

The above graph from the IEA makess a point I have made any times here: there is no real cost pressure in shale beyond labour (which will drop in the long run). Shale is all about productivity and cost improvement driven by mass production, something the US economy has as an almost intrinsic quality. The cost improvements in offshore are solely the result of over-capitalised assets earning less than their economic rate of return (i.e. oversupply) and is clearly not sustainable in the long run.

That is why firms with a low cost of capital are vacating fields like the North Sea to firms with a higher cost of capital: one requires steady investment and scale, the other investment is a punt on a shortage and price inflation. [A post for another day will be on how on earth some of these larger investors actually get out of the North Sea.]

This IEA data also tells you why this is the offshore reocvery:

IEA 2019 investment mix.png

The IEA is also forecasting overall spending to increase just 6%. So offshore just isn’t getting investment at the margin that will drive fleet utilisation and expansion. In company accounts this is showing up as depreciation significantly outpacing investment and is a constant across the industry. The economics of offshore are such that profitability is dictated by marginal demand (i.e. that one extra day of utilisation at a higher rate) and this graph shows the industry built a fleet for a far higher level and the only realistic prospect here is for structurally lower profitability. Given the high capital costs of the assets this is going to take a long time for the oversupply to work out.

For manufacturers (i.e. subsea trees) the recession is generally over, although not for Weatherford, but if it floats nothing but a wall of oversupply and below economic pricing and therefore sub economic returns is the logical consequence of this industry structure and market dynamic.

The hope of a massive demand boom kept banks from foreclosing and led hedge funds and other alternative capital providers putting money into assets that were (and are) losing cash but seen as “valuable” in the future. Slowly it is becoming apparent there is no credible path to anything other than liquidation for many companies still in business.

Rates will slowly rise, and so will utilisation levels, but only to economic levels i.e. covering their cost of capital in a perfectly competitive market. Absent a demand boom liquidity slowly, and then quickly, vanishes. And that is finally starting to happen now. For example the McDermott 10.25% 2024 bonds, already very expensive, were trading at well below par today implying a 13.5% yield, in effect locking them out of the unsecured credit market completely (and in reality all credit markets). A restructuring beckons. MDR will not be the only one by any stretch. Many rig companies will do a Chap 22 and a wave of supply companies in Europe and Asia are uneconomic and simply cannot survive under realistic financial assumptions.

Slowly the overcapacity in the industry will work its way out to more economically sustainable day rates with higher utilisation levels in a smaller global offshore rig and vessel fleet. But it won’t be a return to 2013, it will be a return to a far lower profitability level despite the smaller fleet, higher prices, and less time and utilisation risk taken smaller companies. There will be a complete wipe-out, almost without exception, of investors who backed offshore “recovery” theses of asset backed companies and an inability of these companies to access funding almost at any price levels. Theories about assets recovering to values implied by book value will be realised for what they are: a fantasy no serious person could believe.

But a far more rational industry and market will emerge. The only thing that could change the dynamic outlined above is a massive demand boom, and the graphs above show you why that isn’t going to happen.

IEA global upstream investment 2019.png

The address that never was…

“Not all barrels are created equally,” she said. “60 per cent of our cash flows are not coming from our upstream business. There shouldn’t be a correlation with our reserves or capital expenditure in upstream. It’s not tied to that.”

Jessica Uhl, CFO Shell

 

Money is not the value for which goods are exchanged, but the value by which they are exchanged.

John Law, Money and Trade (1705)

 

Roughly a year ago this week I gave an address at the OSJ Conference where I was pretty gloomy about the future for offshore. I was invited back this year but unfortunately a change of work circumstances mean it is no longer really the thing for me to do. Having said that I don’t think it is a bad time for a State of the Union speech.

You can guess where this is going…

Last year we had a mini-rally in offshore mid-year. Some of the more outlandish ideas raised more money and invested more capital in an industry already suffering an excess of capital and the share prices of all these public investments are seriously underwater. The banks also continued to pretend things could only get better, when in fact they were clearly getting worse. Solstad and Pacific Radiance are the two most prominent examples of this philosophy but there are a slew more in offshore supply and drilling.

And all the while shale simply grows in scale and scope. I am actually bored now with the really complicated theories about how and why the shale revolution will die. The offshore optimists who touted this theory have been comprehensively wrong in the past and will continue to be so in my opinion.

A few data points show the scale of the infrastructure being used to grow the shale fields:

That folks is your offshore recovery: prices above breakeven at best and lower utilisation as the prices are just high enough to keep zombie companies in business. Welcome to the new normal.

Shale growth may be slowing down,  but it will still grow over 1 million barrels a day in 2019. This slide from Exxon Mobil is reflective of the huge amounts of capital going into Lower 48 production and the continuous productivity immproveents creating the virtuous feedback loop:

IMG_0405.JPG

So you can believe some really complicated story about this “offshore recovery” and how it has to happen because reserves are low, or demand will outstrip supply, or shale production isn’t economic, or you can look at what is happening in the US now and accept the logical conclusion: this is the offshore recovery.

Just like the steel industry in the US when it was hit with Asian competition so offshore now has a serious competitor for production investment at the margin. Offshore production isn’t going away but nor is there a boom in store. Projects at the margin are being delayed or cancelled and never coming back. The fleet built for 2014 is still too large by an order of magnitude and operating well below economic break-even. Only a massive increase from the demand fairy can save the current industry structure and that isn’t happening. There are too many boats and rigs with too many operators and this year will bring the start of the slow rationalisation needed. We will end the year with less companies and less tonnage and still the job will remain incomplete.

The most likely scenario at this point is years of oversupply with grindingly poor margins, struggles to get to economic profitability, and a gradual reduction in the fleet as ever so slowly those with less commitment and cash drop out of the race to stay alive. Eventually prices will have to rise to pay for new investment in the offshore supply chain but that looks years away and most firms don’t have the liquidity to wait. Raising new money is getting near impossible for all but the most serious candidates: hedge funds who piled in last year are underwater and look unlikely to wade back in unless the terms are extraordinary, and long-term investors are rightly terrified at the losses the Alternative fraternity have suffered calling the recovery far too early.

The interesting thing is why? In this paper “The elasticity of demand with respect to product failures” by Werner Troesken (pdf) shows that while markets are selection mechanisms they don’t always choose the best products. People continued to buy snake oil in the US long after its efficacy could be argued for.  Maybe the offshore crowd waiting for the boom can comfort themselves with this fact?

However, I see however that in an era of mass production, and rapidly increasing efficiency and unit cost reductions in shale production. To avoid shale, to take your firm off the technological trajectory, would so limit the future  options of a large E&P company that it would not be a wise strategic decision. More marginal capital will be deployed not less. has It is far less risky to invest in a lower margin product like shale, with a shorter payback period, than those custom designed deepwater fields with economic lives vastly in excess of price forecast accuracy.

Worringly for people in offshore is this paper: “Depression babies” by Ulrike Malmendier and Stefan Nagel. If you want to understand how formative experiences can be in lifelong economic actions then this paper demonstrates that investors whose careers were built in recessions invest in fewer equities (i.e. risk capital) even in positive economic times. My rough analogy, which I have no intent to take further, is that E&P execs who lived the 2014 downturn are in no hurry to turn on the CapEx spigot to satisfy all those who tell the world is running out of energy (and as 3 above shows are consistently wrong). And they will be like this forever. Just as those in offshore sit around waiting for the next boom E&P company execs sit around trying to avoid the next investment driven crash.

I have said before loss-aversion theory greatly explains the behaviour of the banks who are crucial to the clean-up of the industry (particularly in Europe and Asia as American losses have been equitized). Every time they have delayed the losses pretending the comeback will happen. And offshore supply in particular was dominated by European and Asian banks. Sooner or later, when the cash flows from the offshore supply and rig asset base cannot make even token payments, and the banks loan books are revealed to be more like Italian regional banks, the real contraction will begin. John Law intimately understood the link between a banks assets and liabilities in a way that would do a modern risk officer proud.

I also mentioned the DSV market last year. I am not mentioning names but building a $150m DSV and selling the vessel for 100k per day for 150 days (at best per annum) is a fools errand in economic terms regardless of the outstanding organisational skills required to deliver it in physical terms. It is simply not possible in a market as competitive as as the Asian DSV market for one firm to outperform others over the long run.

The sale of the Toisa DSVs for between $20-34m shows the economic clearing price of such assets. Such a large gap between actual economic values of operational assets and the historical build costs of new assets can be met by the Chinese taxpayer forever, but eventually the unsustainable nature of this will catch-up with itself. I shall say no more. But Uber can lose money on running taxis for longer than I thought… eventually I will be right here too. Delivering cold Starbucks at $5 won’t keep Uber at a $60bn valuation and IRM work in Malaysia cannot pay for $150m DSVs.

Offshore will continue to be an important part of the energy mix. But the supply chain supporting it to be like that has a great deal of shrinkage to be an economic part of this mix.

A change of tack…

There are some big changes coming to this blog: I am joining an asset managment firm next year and will therefore not be commenting at all on individual companies from now on. The company I am joining is not an investor in offshore specifically, and I am certainly not joining to help them invest in the sector, but to avoid any appearence of conflict I will not discuss companies by name now. I will still continue to write about the energy transition, the growth of shale, and other energy topics that I find interesting but from a macro perspective only. I will also post notes on books and economic history… but for many subscribers you may want to think about cancelling because this will be a little esoteric.

I believe that the offshore oil supply chain still needs a large reduction in capital long-term to bring the risk-reward ratio of the industry into balance.  That may mean a higher oil prices but it will certainly bring a concommitant reduction in the supply of offshore assets. I also really believe that shale has transformed the offshore industry beyond recognition and has put the golden days of the past  (in terms of “excess” profitability) firmly into the realms of economic history. I await with interest to see how the private equity firms that have gone into the North Sea will exit as one of my other overriding questions of interest.

Shale will overshoot in investment terms there is no doubt. Whether the constraint will be resource related (i.e. water) or productivity related I don’t know… But I very much doubt the investment boom will slow in 2019 or 2020 and for many in the offshore supply chain that is still a funding bridge too far.

 

A total failure of governance… McDermott and the cost of money at the margin…

If you want to know what the cost of raising funds for a corporation in trouble following a failed acquisition is the recent disclosures from McDermott provide a good guide. Crucial to the continued ability of the firm to stay within its banking covenants and remain a going concern in the Q3 2018 results was the $300m in 12% preference shares sold by McDermott to Goldman Sachs and Company (and affiliated funds). From the sale McDermott received $289m, meaning Goldman banked $11m in fees… to start with… The kicker is that Goldman and its funds (likely credit opportunity funds managed by the bank) also ended up owning warrants to purchase 3.75% of MDR at .01 per share… at the time of pixel those options are worth ~$51.5m (at an MDR share price of c. $7.61).

If you don’t believe MDR is in real financial trouble you need to ask yourself why the best course of action for management was to engage in a financing that cost shareholders ~$62m to “borrow”/ strengthen their balance sheet (sic) to the tune of $300m. The $289m the company got has an interest cost of $36m per year (excluding tax effects) and cost the shareholders 3.75% of their company. No wonder the shares dropped ~40% when the news was announced (already well down on the pre-acquisition price): investors knew they were losing a lot more than 3.75% of the value of the company. Not only that the increased working capital lines ($230m) required that this capital went in. MDR had maxed its borrowing capacity just a few short months after the takeover. In short: it was a financial disaster.

This isn’t a rage against the Great Vampire Squid, because if you need to get your hands on $300m quickly, and you are running out of cash, then for a good reason money tends to be expensive. The real question is how MDR got here, and so quickly, since acquiring CBI?

In my view the short answer is: a total failure of governance from the MDR Board that allowed management to buy a much bigger business they knew literally nothing about. The famed “One McDermott Way” was about installing cheap pipe and jackets in the Middle East and Africa not building on-shore low-margin refining plants. It is about as relevant as an orange juice manufacturer buying Tesla because they are going to apply the lessons learned in de-pipping oranges to extending the battery life of electric-powered vehicles.

The failure of this deal will I believe lead to the end of the MDR offshore contracting business as an independent entity. The reason is nothing more than a failure to ask a basic and honest question about where the skills of the company reside? And for the Board to realise that for MDR management the worst option of being acquired was probably the best option for the shareholders.

This presentation given to shareholders in August indicates that shareholders already had a serious case of post-acquisition regret, and reading between the lines here management are clearly under huge pressure despite the upbeat tone of their communications. The 40% decline their investment post-August is likely to have induced a sense of humour failure amongst even their most loyal of followers. Someone senior is going to have to carry the can soon and that does not make for a harmonious exec. I can’t think of another M&A deal that has locked in  such a loss of value so quickly.

McDermott got into this because in late 2017 their viability as an independent company looked shaky. Management had a very good offshore crises through a mix of skill and luck: their low-cost Middle Eastern model, not applicable when the Norwegians and French were in competition to build a more expensive OSV than the company before them, was more shallow-water focused than Brazil/UDW, and they didn’t have a complex about working old assets to death. McDermott picked up some cheap assets like the 105 when the opportunity presented itself, but management didn’t blow money on value dilutive acquisitions either or go to long on assets or debt. MDR management had steered the company back from the brink to create a genuinely competitive company with an ideal geographic footprint and asset base for the new offshore environment. I was a real admirer of the company.

But then GE started sounding out Subsea 7 (and being turned down), and the MDR footprint would have been perfect for Subsea 7 (BHGE would clearly have made a hash of MDR). There are very few companies the size of MDR that remain independent in an environment where consolidation is the market mantra: they had very little net debt, were big enough to buy and move the needle for a large company in revenue terms, but small enough to acquire in financing to terms. And there is some real intellectual and engineering skills in the core DNA of the McDermott business, no matter how complex the offshore problem, someone in McDermott knows the answer.

At some point in 2017 MDR management and the Giant Vampire Squid decided on a plan to buy CB&I and their shareholders really did think Christmas had come early that December 17th. To avoid being acquired McDermott opted for a type of ‘Pac Man’ defence: it went on to acquire a larger company. You can see the balance sheet of CB&I was substantially larger than MDR:

CBI Balance sheet:

CBI BS .png

MDR Balance Sheet:

MDR BS.png

Crudely MDR had $3.2 bn in assets and almost no debt while CB&I had $6bn in assets but $5.6bn in debt.

The reason MDR could do this was the debt and CB&I losses. CB&I was losing, and had been for a considerable period of time, vast amounts of money in its core business. A pretty crucial question would therefore be “could the One McDermott Way” transform this situation? A secondary question if the answer was yes was how much due diligence should be undertaken to prove this?

This isn’t hindsight talking. Here are the last four years financial performance of CBI:

CBI losses 2014-2017.png

Can any of you, even those without financial training, see something that might worry you about buying this company? (I’ll give you a clue it’s in the last line and it’s a material number). As Bloomberg noted at the time:

MDR Stamp.png

Bridge to Nowhere.png

Boom!

The problem with buying a larger company as a defence is its asymmetric returns: it is a leveraged bet on management and financial skill and if it goes wrong the value in the acquiring company is wiped out. And that unfortunately is what has happened here.

In case you were wondering the merger between MDR and CB&I consumed ~$300m in fees, slightly more in cash than McDermott later managed to raise from Goldman (and paid in cash of course), a symmetry in irony I am sure the bankers enjoyed.

McDermott CBI fees.png

And yet for the $300m in fees the due diligence didn’t uncover the cost overruns in the projects, and despite having three of the most illustrious banks on Wall Street: Goldman, Sachs, & Co, (lead adviser), Moelis & Co (advising on the financing only), Greenhill & Co (advising the Board of MDR) no one managed to ask: really, can we do this? And if they did, get the right answer!

But after the fees comes the interest bill… in cash and kind now… the hangover so to speak, and this one is mind-numbingly painful:

MDR Capital Structure

MDR Cap Structure.png

MDR are paying an interest bill (per annum) of: ~$90m for the Senior Loan, ~$138m for the notes, $36m for the preference shares (not included here), and the Amazon lease payments which must be ~$30m for a $345m vessel: ~$294m in total per year (say one Amazon per year at current build costs?). MDR only made an operating profit of $324m in 2017.  In addition, the three CB&I projects they have taken a hit on will consume $425m in cash in 2019! So by the end of 2019 MDR will have spent ~$1bn in cash on deal fees, interest, and project costs. As someone nearly said “a billion here, and a billion there, and pretty soon you’re talking real money“.

All this talk of “synergies” is hokum. Everyone involved in projects knows that the pipeline fabricator in Dubai isn’t getting cheaper steel because MDR are losing money building an LNG train in Freeport. But the interest and fees are real cash. Maybe they will sell the non-core businesses and bring the debt pile down but it brings execution risk and no certainty the debt reduction will be proportionate. These asset sales have the feeling of looking for change down the back of the sofa as they were never announced as part of the original deal and the tanks business is a complex carve out that will involve vast consultants fees and by MDR’s own admission take at least nine month… on the other hand interest, like rust, never sleeps…

The fact is the reason the on-shore business of CB&I is structurally unprofitable is because despite the contract size and complexity there are a large number of equally competent (more so actually) companies who bid all the margin away. That’s no different to subsea but MDR had a genuine competitive advantage in that business and CB&I didn’t in on-shore (as their financials showed).

In really simple terms now McDermott must make a smaller offshore business, in very competitive market that consumes vast amounts of capital to grow; pay for a larger unprofitable onshore operation where management lack skills and knowledge. The odds of success must be seen as low? The square root of zero I would suggest. McDermott will be starved of CapEx as the CFO uses any cash he can to pay for the interest and charter commitments while trying to compete against onshore behemoths much larger in scale. Maintaining market share in offshore will be impressive, forget about growing it. And all this to feed a beast in a low margin onshore business that competes against giants like Fluor.

If the Board of McDermott took shareholder value seriously they would try to get Subsea 7 management back to the table and sell them the offshore business for a price close to what Subsea 7 were offering last year. The world has changed but the price for a trophy asset might still be good. What happens to the rump CB&I would be sold at auction, for probably not much, but such is reality. Such a scenario would yield more than letting this state of affairs continue.

Corporate finance Borr Drilling style…

One of the more curious corporate finance transactions took place earlier this year when Borr Drilling, an enormously leveraged rig company when financial commitments are taken into account and using its revolver for working capital, then purchased 1.5m of its own shares at NOK 35.50. As can be seen above the shares have since declined 18% and are now worth NOK 29, which is signficantly below the price they last raised capital at ($4.6/ ~NOK 39).

In the scheme of things the loss isn’t that much money,  it’s really a question of whether for such a  (sic) “high-growth” company is depleting liquidity to buy back shares the best use of its capital? I noted at the time this was close to extraordinary for a company that needs to raise hundreds of millions of dollars (not a misprint) in capital over the next three years to remain a going concern ? In which case why are they doing it?

For what it’s worth my own view is I think the Management and the Directors of Borr understand how deeply in financial trouble they are: the market simply isn’t coming back to anything like what they and their original backers planned. Without a massive increase in demand the entire investment thesis is flawed and the company has no reason for existing in a very real sense. By embedding leverage in the shipyard delivery times as well as the bonds, and using a revolver for working capital, Borr requires the market to come back strongly and for them to activate a vast number of warm-stacked units in this hypothetical demand pickup… just for Borr to remain solvent, yet alone make an economic return. As an external observer reading the public anouncements it feels like a degree of panic is setting in.

As the Borr Drilling prospectusin early 2018 made clear this is a highly competitive business:

The profitability of the offshore drilling industry is largely determined by the balance between supply and demand for rigs. Offshore drilling contractors can mobilize rigs from one region of the world to another, or reactivate cold stacked rigs in order to meet demand in various markets.

The shallow water segment of the drilling industry is particularly competitive with no single contractor having a dominant market share. Competitive factors include price, rig availability, rig operating features, workforce experience, operating efficiency, condition of equipment, safety record, contractor experience in a specific area, reputation and customer relationships. [Emphasis added].

Particularly competitive” with “no single contractor having a dominant market share” tells you how absurd the plan here is, and how much alternative investors wanted to believe in an outcome they knew to be economically illogical. Market share and competitive factors are directly related to profitability. With no fast growing market this company is simply a financial time bomb. Yet as recently as September Borr’s Chairman stated:

“We have an ambition to return a significant part of cash back to shareholders quickly … if we don’t pay dividends in 2020, we have failed,” Troeim told Reuters.

I’ll bet my house that doesn’t happen. [Actually that isn’t strictly true because Troeim could clearly afford to take me up on that and my domestic happiness would be rapidly curtailed if I started playing in the futures market with matrimonial property… But you get where I am coming from].  But the dividend comment springs from the same belief that the current market is some mis-pricing anomaly rather than a deep structural change in the oil market.

Now for plan B. A rights issue that would heavily dilute shareholders is the most logical fundraising strategy here, but finding more hedge funds to by your stock when it keeps on going down 30% is not easy. I just cannot believe Schlumberger are going to carry on committing capital to this venture on a proportionate basis. Debt? really? With no backlog or even utilisation?

The idea that this slide seems to highlight ,that banks or other debt providers would lend against the unencumbered rigs when they have absolutely no work available, seems so very 2012, quaint almost:

Built to last .png

The title of this slide is surely begging irony? The whole Borr business plan relies on growth significantly faster than the market when the market has extreme overcapacity from well capitalised (and desperate) competitors, and financing this by borrowing against rigs with no work or backlog. What could go wrong? See more here.  Borr management have done a lot, struck deals, brought kit etc., but the possible economic value creation is a simply a vastly leveraged play on a never appearing demand boom. It is a microcosm of offshore investment sentiment and a stubborn willingness to accept the scale of change shale as wrought on the market. At some point the business case must be a logical inconsistency if shale keeps growing at current rates? I’d suggest that point was passed a while ago.

The blow-up here is unlikely to be as dramatic and spectacular as something like EMAS because the perceived asset value is so high. But the scale of the amount of capital that needs to be raised, and the likely time period before it could be returned is so long, that each additional round of funding here is likely to be very expensive. Something “the market” seems to be belatedly waking up to. Borr Drilling is the ultimate measure of investment risk and sentiment in the alternative investment community in my opinion and serves as a useful barometer for how to perceive market risk.

I think Borr were trying to use the share buyback as a small signal to keep the share price high and to cut the dilution effect that will be imposed on the insiders who hold a large amount of the shares. I think the reactivation of 4 rigs speculatively was literally a gamblers last-roll as there have been no updates since about possible work for these units. A signalling event spectacularly mis-timed given the decline in the price of oil.

Share buybacks, particularly open-ended purchase programmes like the one Borr is engaged in, are extremely well-studied. There is evidence that managers can time the market (i.e. buy the shares cheap) and that smaller firms do this better than bigger firms… but you can also see “Share repurchases as a potential tool to mislead investors“, which is close to what I think happened here, although I temper this a view that offshore seems to have a number of people who see a declining oil price as contrary to some law of nature.

The fabulously optimistic Rystad Energy (more recently here and in direct contravention to DOF on AHTS, (who like actually own boats)) predict higher rates, proof that maybe you can build a great information business without having great information… a skill I grant you.  But there is no question now that most rational participants are coming to grips with the fact that the subsea and offshore market isn’t going to “recover” next year and that leaves Borr Drilling with an enormous funding hole to cover. Borr is the ultimate leveraged play on the “market recovery and scrapping” thesis, a momentum play that has lost inertia, and slowly the (hot) air seems to be draining from this balloon and the market sentiment in general.