The economics of energy transition….

From an interview with the new CEO of Drax (the largest biomass electricity producer in the UK):

Drax received about £730 million in subsidies last year for its three biomass units, through schemes that pay it between £95 and £110 for every megawatt-hour (MWh) of electricity they generate. That makes it viable despite high running costs of £75/MWh, well above market prices of about £50/MWh…

Mr Gardiner drives a Tesla, bought two and a half years ago to be green even though it cannot get him all the way from his London home to Drax without stopping to recharge.

He criticises nuclear, describing the contract agreed for Hinkley Point at £92.50/MWh as very expensive. Sorry, how much is Drax getting again? “Similar, right, that’s why I want to bring the cost down because it needs to be cheaper.” In fact, Drax’s contract is even higher than Hinkley’s. So it is more expensive than a contract that he said is too expensive? He hesitates. “That’s a fair, er…” he begins, before trailing off for a second then adding: “Anyway, so I think nuclear is expensive.” He moves swiftly on to other concerns about nuclear clean-up and the government’s plans to invest directly in future plants, which he warns could “distort the market”.

Oil as a declining industry…

Like all good Op-Eds (and blogs) this one in the FT started yesterday with a big headline and with some punchy quotes:

The time to stop investing is not today. But that point is coming. The industry needs to be clear that its future is one of long-term decline — whilst returning increasing sums of cash to investors. There is a possibility that the industry over-invests as we reach that point of peak demand, leaving an oversupply that persists for a long time. Fighting for market share in a declining market would be even worse.

Everything in life is relative (well if you are a post-modernist anyway) and the authors are not saying to stop investing tomorrow or that oil is dead: merely ex-growth as an industry.  The message is about E&P companies not having a good record at investing in alternative energy sources so encouraging them to return the cash to fund managers (who do apparently?).

We think oil companies can have a positive part to play in our future world of energy — as a cash generating engine that can be used to power the transition when the time comes, and we urge the industry to make a clear commitment to this future.

You can dismiss it as another view that will simply ensure that prices are higher in the future, I guess the question then becomes how far and how high? Or you can take the views seriously as the representatives of one of the UK’s largest fund managers and realise that it is part of a wider secular shift in thinking about business models for E&P companies that require less CapEx and less redundant capacity. I think it just shows how much pressure CFOs/Directors are under to return cash to shareholders all the time and how much harder it is for smaller E&P companies with good project ideas to raise money.

Regardless or your view this is becoming a popular one amongst the actual owners of some companies so it is worth not writing off indiscriminately. The investment narrative isn’t all “growth at any cost”, or future production volumes, which is a marked shift from previous periods where statements like “all the easy oil has gone” doiminated.

In a good interview here Spencer Dale, BP Chief Economist highlighted that

Because of natural decline, there is going to be a huge need for investments to keep supply at pace with demand, even if oil demand were to peak relatively soon.

“For a company like BP, that has a key role in our strategy. Continue to invest in oil, because the world will need that investment, but make sure to invest only in low cost, advantaged oil to make sure that we are robust for this more competitive environment that we think is going to emerge over the next ten to fifteen years.”

That strikes me a very different dynamic to previous eras and will have a huge impact on E&P project developments which are also consistent with the shareholder wishes highlighted above.

To be fair to Ocean Installer…

I was a bit hasty in drafting some things re: Ocean Installer in trying to make a comparison with Bibby. To be clear Ocean Installer have contracted work further out than a season and some of this is higher value installation work.

My broader point around if contractors of this size can ever earn true economic profits outside of Norway remains as does my point around how much additional funding it is rational to put in. But the drafting was sloppy to the point of inaccuracy which wasn’t the intention.

Anecdote is not the singular of data…

“As regards the scope of political economy, no question is more important, or in a way more difficult, than its true relation to practical problems. Does it treat of the actual or of the ideal? Is it a positive science concerned exclusively with the investigation of uniformities, or is it an art having for its object the determination of practical rules of action?”

John Neville Keynes, 1890, Chapter 2

Music journalists know a lot about music… if you want some good summer listening I would advise taking them seriously. However, as a general rule, their knowledge of finance and economics is less sound… ‘Greatest Hits’ have for example included complete confidence that EMAS Chiyoda would be recapitalised right before they went bankrupt… or that the scheme from Nautilus to put ancient DSVs in lay-up wasn’t stark raving mad because the Sapphire couldn’t get work either… I digress…

On a logical basis it is very hard to argue that a majority of companies in an industry can consistently be under margin pressure and and that they will exist indefinitely regardless of cash flow losses. It might make a good album cover but as economic reasoning it leaves a lot to be desired.

Let me be very clear here: if the total number of firms in an industry are operating at below cash break-even only one of three things (or a combination of) are possible:

  1. Some firms exit the industry. Capacity is withdrawn and the margins of the remaining firms rise to breakeven (a supply side correction).
  2. The market recovers or grows (a demand side correction).
  3. An external source injects funds into the loss making companies or they sell assets (a funding correction).

There are no other options. I write this not because I want people to lose their jobs, or because I hate my old company, or because I didn’t like the Back Street Boys as much as the next music journalist in Westhill, I write it because it is an axiomatic law of economics. To write that firms, backed by private equity companies, who have a very high cost of capital, will simply carry on funding these businesses indefinitely is simply delusional.

A deus ex machina event where a central bank provides unlimited liquidity to an industry only happens in the banking sector generally (in the energy space even Thatcher made the banks deliver in general on their BP underwriting commitment). Subsea appears to flushed out the dumb liquidity money, convinced of a quick turnaround, and being turning toward the committed industrial money now.

The real problem for both York and HitecVision, or indeed any private equity investor in  the industry isn’t getting in it’s getting out (as Alchemy are demonstrating). Both have ample funds to deploy if they really believe the market is coming back and this is just a short-term liquidity issue, but who do they sell these companies to eventually? It was very different selling an investment story to the market in 2013 when all the graphs were hockey sticks but now anyone with no long-term backlog (i.e. more than a season) will struggle to get investors (even current ones). The DOF Subsea IPO, even with their long-term Brazil work, failed and the market is (rightly) more sceptical now. Every year the market fails to reover in the snap-back hoped for each incremental funding round gets riskier and theoretically more expensive.

Private equity firms have a range of strategies but they generally involve leverage. Pure equity investment in loss making companies in the hope of building scale or waiting for the market to develop is actually a venture capital strategy. Without the use of leverage the returns need to be very high to cover the cost of funding, and if the market doesn’t grow then this isn’t possible because you need to compete on price to win market share and by definition firms struggle to earn economic profits, yet alone excess profits, that would allow a private equity investor to profit from the equity invested. For private equity investors now each funding round becomes a competition to last longer than someone else until the market recovers. In simple terms without a demand side boom where asset values are bid up significantly above their current levels the funding costs of this strategy become financially irrational.

In this vein HitecVision are trying to exit OMP by turning it into an Ocean Yield copy. The GP/LP structure will be ditched if possible and the investment in the MR tankers shows the strategy of being a specialist subsea/offshore vessel company is dead. Like the contracting companies it isn’t a viable economic model given the vintage year the funds all started.

Bibby Offshore may have backlog but it is losing money at a cash flow level. The backlog (and I use the 2013 definition here where it implies a contractual commitment) it does have beyond this year consists solely of a contract with Fairfield for decom work. This contract is break-even at best and contains extraordinary risks around Waiting-On-Weather and other delivery risks that are pushed onto the delivery contractor. It is a millstone not a selling point.

Aside from the cost base another major issue for Bibby is the Polaris. Polaris will be 20 years old next year and in need of a 4th special survery: only the clinically insane would take that cost and on if they didn’t already own it (i.e. buy the company beforehand). Not only that but at 10 years the vessel is within sight of the end of her working life. Any semi-knowledgeable buyer would value her not as a perpetuity but as a fixed-life annuity with an explicit model period and this has a massive impact on the value of the firm. In simple terms I mean that the vessel within 5-10 years needs to generate enough cash to pay for a replacement asset (to keep company revenues and margins stable) that costs new USD ~165m and for a spot market operator might need to be paid for with a very high equity cheque (say ~$80m). Sure a buyer can capture some of this value, but not much and they don’t need to give this away.

In order to fund her replacement capital value the Polaris needs to bank ~USD 22k per day on top of her earnings. Good luck with that. When I talk about lower secular profits in  the industry and the slow dimishment of the capital base that is it in a microcosm: an expensive specialist asset that will be worked to death, above cash flow breakeven in a good year, with no hope of generating enough value in the current economic regime to pay for a replacement. This is how the capital base of the industry will shrink in many cases, not the quick flash of scrapping, but the slow gradual erosion of economic value.

Ocean Installer also have limited work although it is installation work and firmly grounded in Norway. Like everyone else this is not a management failing but a reflection of market circumstances.

McDermott and OI could not reach a deal on  price previously. MDR realised they could just hire some engineers, get some vessels (and even continue to park them in an obscure Norwegian port if needed by Equinor), and recreate OI very quickly. All OI has worth selling is a Norwegian franchise the rest is fantasy. An ex-growth business with single customer risk and some chartered vessels has a value but nowhere near enough to make a venture capital strategy work in financial terms.

Now at both companies there are some extremely astute financial investors are doing the numbers and they must either send out letters to fund investors requiring a draw down to inject funds into these businesses, explaining why they think it is worth it, and putting their reputations on the line for the performance. It may have been worth a risk in 2016, and 17, but really again in 18? Really? [For those unaware of how PE works the money isn’t raised and put in a bank it is irrevocable undertaking to unconditionally provide the funds when the investment manager demands. Investors in big funds know when the money goes in generally and what it is being used for.] And again in 19? And the more they draw down now the higher the upturn has to be to recover. (In York’s case I think it’s more subtle as the investment exposure seems to have moved from the fund to Mr Dinan personally given the substantial person of interest filings).

But whatever. If they do this all the firms do this forever then they will all continue to lose money barring a significant increase in demand. And we know that this is not possible in the short-term from data supplied to the various regulatory agencies. And for the UK sector we know production starts to decline in two years (see graph). So in the UK two years just to keep the same available spend in the region the price of oil will have to go up or E&P companies will have to spend more proportionately on the service companies. This is not a structurally attractive market beset as it is with overcapacity.

Aside from the major tier 1 companies are a host of smaller companies like DOF Subsea, Maersk, Bourbon, and Swire, long on vessels and project teams, and with a rational comnmitment and ability to keep in the market until some smaller players leave. I repeat: this is a commitment issue and the companies with the highest cost of capital and the smallest balance sheets and reources will lose. These companies don’t need to win the tie-backs etc. that OI (and Bibby) are really aiming for: they just need to take enough small projects to ensure that the cost base OI and Bibby have to maintain for trying to get larger projects is uneconomic and expensive in short-term cash costs. It is a much lower bar to aim for but an achievable one.

So the private equity funded companies are left with option 3 as are the industrial companies. The problem is that the industrial companies have a Weighted Average Cost of Capital of ~8-15% and private equity companies who like to make a 2.5x money multiple have about a 25-30% (including portfolio losses) The magic of discounting means the nominal variance over time is considerably larger.

And for both OI and Bibby the fact is they face a very different market from when they started. Both companies went long on specialised tonnage when there was a shortage, taking real financial and operational risk, and growing in a growing market. That market looks likely never to return and the exit route for their private equity backers therefore becomes trying to convince other investors that they need to go long on specialist assets that operate in the spot the market with little visibility and backlog beyonnd the next six months. As someone who tried raising capital for one of these companies in downturns and booms I can tell you that is a very hard task.

So if you want some easy listening summer music I suggest you take advice from a music journalist. On the other hand if you want a serious strategic and financial plan that reflects the market please contact me.

The scale of shale…

Exxon Mobil signed a JV on Tuesday with Plains All American Pipeline LP to build a pipeline that will ease it’s offtake problems in the Permian. Permian has been trading at a discount to WTI of up to USD 27 per barrel due to export constraints from the region so there is a real incentive to come up with a permanent solution.

The thing that struck me was the scale of the pipeline: 1 million barrels capacity per day. That single pipeline will carry as much as the entire output of the UKCS! ~1% of global oil demand being carried in one pipeline. There are a lot more of these pipelines being built as well and they are constructed relatively cheaply and very quickly.

I repeat again that I really struggle to see how a multi-year boom in oil prices can happen now on the same scale as previous cycles. The ability of shale to act as a marginal producer and the ability of E&P companies to develop the infratsructure much more quickly than before seem to act as cap on the price that hasn’t existed before. They could be famous last words but the scale of the investments and infrastructure being committed to Lower 48 counts is part of a genuine supply side revolution in the current oil market.

Der Schrei der Natur …

It is very likely that the North Sea starts next summer without Ocean Installer, M2 Subsea, and Bibby Offshore. In fact I am going for probable rather than possible. Private equity owners are looking at having to inject real cash resources into these businesses and they are not happy given the prospects of getting it back.

Another minor sign: more changing of the guard in the tier two contractors with Bibby Offshore now parting company with their CEO today. This looks stage managed coming almost 6 months to day after York Capital took control (6 months is a standard BOHL executive notice period). Although there are clearly some specific circumstances in play here the driving force at Bibby Offshore is the same as at the other tier two contractors: the cash crunch (see here). As business plans are developed for next year, and the poor summer season continues, Boards are facing up to the fact they will need new funding for next year.

Just as the Board of Ocean Installer demanded a plan that saw HitecVision sever the cash umbilical this year, so Bibby Offshore had to go through the farce of a “recapitalisation” late last year (which was more Rabelais than reason). It was frankly an embarrasment (and here) although it has led to a severe dispute between York (who fell for it) and its authors EY.

Now in 2018 York are having to do it again with Bibby who have no path to cash flow profitability. Bibby Offshore is very vulnerable: In financial terms they are likely to consume £10-15m in cash this calender year, then start next year needing to put Polaris through a 4th special survey (£2-3m?) and Sapphire through an intermediate (£1m?). At current run rate they may need £10m more in cash before next April. It’s grim.

I don’t believe a sale of the business is realistic now it has this trading history behind it (see here). A potential buyer is now gets a business locked in a battle with Boskalis at the low-end and TechnipFMC and Subsea 7 at the top-end. Without a sustained improvement in market conditions, which now will not come at the earliest until summer 2019, the shareholders face another hefty cash call. And all to fund more of the same: a subscale business battling giants and losing cash with an increasingly aging asset base. It’s a hard pitchbook for investment bankers to write. There is no upside here in terms of expansion potential or margin expansion. And it’s very risky. Why not leave your money in the bank?

It’s sad for me to see but the honest truth is it was Bibby Line Group that killed the business: a 50% dividend policy in a capital intensive business like offshore simply cannot work long-term. The GBP 175m bond, the only real money Bibby Offshore ever had, was used to pay off SCB (USD 110m) and then a dividend recap to group of ~£35m. There were never funds to grow the business when the market boomed and no equity as a cushion when the market tanked. We are in the final stages of a tragic denouement now.

York are in a terrible position now with no realistic course of recovering their investment and no logical argument to keep putting money in. A dispute with EY over the “missing £50m” is apparently causing some tension between the two firms. The story as I have heard it (from a person directly involved in the deal) was that EY had their numbers wrong and had miscalculated the financial runway Bibby had. York realised too late and “had” to follow through not seeing how bad the current downside could be. On current performance the bondholders would be better off with the EY liquidation assumptions than current exit strategies would imply.

Quite how a self-professed set of financial geniuses and a Big 4 missed the obvious fact that a firm losing £1m in cash a week would run out of money quickly is being kept quiet for obvious reasons (see here June 2017). York blame EY but really it was obvious to any outside observer with a basic knowledge of offshore economics that this would happen and it’s just embarrassing for both parties.

The new management have strong experience with Songa and are in all likelihood extremely capable and talented individuals. They are unfortunately not alchemists and the fact is that the North Sea DSV and small projects market has not had a rebound of the scale needed to help firms of this size and it suffers from chronic overcapacity. Until the CapEx market comes back, and we know from field development plans it cannot in the short-term for the UKCS, then this situation will not change. It is a commitment battle and the firm with the highest cost of capital and smallest balance sheet will lose.

Throughout the supply chain this continues: Olympic Subsea came out with numbers last week and it shows again that this continues to be a broad, deep, structural market contraction. Have a look at the cash flow because at the moment nothing else matters:

Olympic Cash Flow Q1 2018.png

Olympic spent more on financial repayments in Q1 2018 than they received net from operating the vessels. And despite talk of a market improvement they have 3 CSVs for fairly close delivery available by the end of August. Olympic look like the will make it to their 2020 runway with the cash they have on hand, but then what? This summer isn’t going to save them only slow the cash burn.

For those without the cash the decisions are starting to get ominiously close.The North Sea summer next year is likely to have  a very different economic ecosystem from the one currently exists.

 

 

Value free options as a signal for future market demand…

One of the reasons both the shipping and offshore industries got themselves into financial problems was excessive leverage. One way to create leverage without an offsetting liquidity position is to sign up for an asset without takeout financing (i.e. at delivery financing). It’s risky because if anything goes wrong with the takeout financing you lose your deposit and potentially more.

So I was surprised when I saw Odfjell Drilling a USD 220m deposit to buy a rig from Samsung having got a term sheet for a USD 325M loan that required a 4 year contract from an operator as a condition of drawdown… Because what Odfjell have is a 2 year firm plus 1 + 1 year options from Aker BP… Which is clearly very different from a risk perspective. Odfjell Drilling are in the uncomfortable position that if anything goes wrong with the provision of the loan they prepaid the yard USD 220m and have limited options to get it back.

I can’t see the upside for the bank here? Yes the market is strong in this niche, but not so strong that an operator is prepared to commit for four years, only two. 24 months isn’t long and if anything goes wrong they will be hugely exposed here with their counterparty having made minimal payments relative to the value of the unit and not really big enough to honour the loan from the rest of  their resources. For a few hundred basis points above LIBOR that strikes me as an asymmetric payoff in Odfjell’s favour (and whereas in a longer deal the credit approver may have moved on to a new job in this deal they could well still be there if it blows up). Clearly on the mitigating side is a great operator, with a good credit history, and quality shareholders. What’s $300m between friends?

The options for the follow on work are “free” options as far as I read them: i.e. Odjfell gave away call options on their asset for nothing. And Odjfell did this (assuming they are rational and competent negotiators) because the customer wouldn’t pay. So I get the market looks strong but not so strong that an E&P company has to pay anything to guarantee the price of USD 550m rig for two years in two years time (and in options pricing time is one of the most valuable components). The customer will have the right to get other rigs if the market drops and it is capped if the demand goes up. If someone tells you the market is about to boom it isn’t being priced in the options market.

Options in finance and economics are price signals about demand and expectations for demand at the margin. People take risk, or offload, without having to buy the underlying asset. In a volatile environment an option has higher value. When an option is agreed it is meant to be a value neutral position, priced at an equilibrium point where both sides  believe the option is fairly valued. In this deal Aker BP are offloading long term pricing risk to Odfjell for free.

There are numerous examples at the moment in offshore where the asset owner gives away a call option on their pricing and utilisation security. This tells you a great deal unbiasedly about how both sides really view the market going forward. Asset owners giving free call options on vessels and rigs to their customers is an unambiguously bad sign. Economic theory would suggest that these options are “free” because they are valueless.

I can’t help feeling that this is the wrong model for offshore. Surely the best solution to lock-in low long-term rig prices would be for the company with the balance sheet and need for the asset to give a long term charter to allow the rig operator to use less equity and lower the day rate? If people are not that confident then let the unit rot in a shipyard where the current owner has a comparative advantage in storage costs?

At some point, and I think we have reached it generally in offshore, building highly specialised assets that cost in the hundreds of millions and taking spot market risk just won’t be viable for all but a very small number of providers who will price this at very high marginal levels. The problem is until the inventory of such assets drops we are a long way of reaching that degree of rationality. Offshore will remain a highly contestable market and therefore subject to low profitability.

The rig market will feel any upswing first and clearly the ‘animal spirits’ have returned. I offer no judgement, if the shareholders want this they are the ones taking the risk, and it could pay-off spectacularly. But it points to one of what I believe to be the secular changes in the offshore market: who pays for time? Specifically idle time? The Ocean Rig/DNB data below make clear the risk and cost sit with the asset owners.

Floating Rigs Awarded.png

Offshore used to work because relatively small companies took huge relative financial risks on assets because the market was so strong they got the day rates and utilisation to cover these risks. But even in the boom years many assets only broke-even in a economic sense between day 270-300 calendaer days. More than 330 were golden years and less than 280 a worry.

Now the E&P companies don’t have to take this risk and they aren’t. Yet the offshore industry isn’t getting the day rates to cover for this idle time and it’s a material number. It is in fact the most important economic number for most owners because the profit rates on a day worked are well below the cost of one idle day (and that is regardless of asset class).

Solstad Farstad announced a couple of PSV deals at 4 months firm plus 4 months options. Working a vessel for four months year, making it avilable for another four where you can’t market it (another free call option), and maybe getting some work for another 4, is a very risky business model. For that to be sustainable the four working months would have to be at an extraordinary day rate, which currently of course they are not.

I think this is a sign of structurally lower profits in the industry for some considerable time. I also think the options market is where the first signals of long-term confidence may be seen. If Aker BP was really worried about rates increasing in 2 years time, and Odfjell was seeing the same thing, they could agree a cost for those options (that would also probably make the bank happy). Until you see such deals it’s all just talk.