Farstad restructuring… owe the bank 1m you are in trouble, owe the bank (NOK) 10bn and the bank is in trouble…

News that the Siem deal had fallen over and led to the banks staying their position didn’t come as a huge surprise. I got the Aker/Solstad deal: maybe Aker came in too early but Solstad is defined by its subsea fleet which differentiates it from almost all the other large Norwegian owners. The dominant logic in the industry, and one I find hard to disagree with, is that the subsea fleet will recover and the good times will eventually come again. But AHTS/PSV is a whole different story: there were 121 North Sea PSVs in layup last week (more than 2 x the number last year) and 58 AHTS.

I don’t know enough about the funds Siem was raising or investing from but if I was long Subsea 7 and Siem Offshore (and clearly far be it from me to question his investment judgement) I would want extraordinarily good terms before going long on the Farstad fleet with only 6 subsea vessels out of 55. It looks dire for Farstad: of the 27 AHTS only 6 had any decent contract coverage at Q3 16. 5 are 15 or more years old but more concerning is that the large 2013/14 built, 24 000 bhp, units are in lay-up or have no work. It has always been an article of faith in offshore that newer units will find work, but that clearly isn’t the case now. The PSV fleet is just as bad with decent contract coverage for only five. I would classify only 3 of the the subsea fleet as proper subsea vessels, and the others as PSVs with a crane suitable really for wind farm work.

For the industry as a whole the best thing that could happen would be unfortunately for Farstad to vanish into the ether. A great company that simply went too long on ships in a cyclical industry. Like the Italian banks though I think there are a few more acts to play here as the secured lenders work out what they are going to do. One of the really interesting pieces of information that would have come out of this was the % cut the senior banks were prepared to take. Unlike many of the Norwegian restructuring the bonds are of minor importance here (and this really highlights how conservative Farstad was), of the ~NOK 11.6bn debt only NOK 1.4bn is in bonds. In the Siem plan the bondholders became equity holders and clearly that will happen in any plan and at a dilution rate I suspect that leaves them with nothing effectively.

But NOK ~ 10.2bn (USD ~1.2bn) is still real money. Here we have the age old problem that if you owe the bank a million you are in trouble but if you owe the bank a billion they are in trouble. The four largest banks listed in the 2015 year end were DNB (NOK ~1.6bn), Danske (NOK ~1.6bn), GIEK (NOK~1.5bn), and Nordea (NOK ~1.3bn). Nordea is interesting because in its latest results (Q3/16) the entire bank included loan losses of only EUR 135m,  (NOK 1.2bn), 53% of these already from oil and gas related loans. So although the banks prefer to report numbers like Exposure at Default, which for Nordea shows that of EUR 516bn of loans only 1.4% is at risk, and of these 42% is oil and gas related, the point is writing off everything in Farstad would have doubled the Q3 loan losses for Nordea and that is a material number for the bank. There is clearly no systemic risk to Nordea (and I have merely picked on them here) but the number, just from one company, admittedly a fairly large and niche one, is important and not simply a rounding error on a massive loan book.

Nordea appears to be a very well run bank and  banks take risks that don’t always payoff and charge a margin for it; although the over the years banks have become more dependent on fee income than margin income, and this incentivises bankers on long-life asset deals like this to load up the loans at the start and worry about the credit quality later. Essentially commercial banks have become investment banks for long-term loans with all the agency and moral hazard problems this presents. Anyone in shipping who has dealt with banks over the last 10 years always comments on the pressure to get sold multi-product deals and the associated fees: 5 product deals which included interest swaps, forex hedges etc were the gold standard as loan margins remained ultra slim… anyhow I digress…

Thus the work-out teams from all the banks are trying desperately hard here to pretend that their “secured” position is really more than worthless exposure to vessels with a high operating cost and minimal chance of asset price recovery with so many similar vessels available for sale. Even worse the size of the fleet is large enough to move the sale and purchase market prices down even further (if possible). Selling the subsea vessels won’t help as I would guess they will barely cover their liabilities if lucky.

So the best rational thing, for the industry, is the least likely and rational strategy for the banks. For as long as this happens the supply side of the industry will not correct itself. I accept the demand side has probably plateaued, at least in the short-term, but the supply side has a lot of pain to come. The PSV Opportunity (I and II) investment, backed by Standard Drilling (an equity play on structural recovery), saw 3 x Norwegian built PSVs come back to the North Sea from Asia and can economically at current day rates. While these PSVs are older (2005/06 built) in operational terms they can do everything a 2015 built vessel can and they arrived in the North Sea for ~USD 4m per vessel. The disparity between the book/bank values and the distress sale price seems far too wide to pretend the industry is recovering. Applying those type of sale values to the Farstad fleet would end up with huge losses for the banks and with the 2009 built PSV Rem Star being sold recently for fish farm work that is all but assured.

A loss to the secured lenders could realistically look like this if they were forced sellers tomorrow:

Farstad Fleet
Price per vessel (USD)/ Total Proceeds
AHTS 27 8,000,000 216,000,000
PSV 22 5,000,000 110,000,000
Subsea
Saga/Scotia/Swift 3 7,000,000 21,000,000
Samson 1 50,000,000 50,000,000
Sleipner 1 50,000,000 50,000,000
Sentinel 1 50,000,000 50,000,000
Superior
 Sales proceeds (USD) 497,000,000
Exchange Rate 8.71
NOK 4,328,870,000
Current secured portion (10,600,000,000)
Loss to secured lenders 59% (6,271,130,000)

This is clearly meant to be an example rather than a serious valuation and it assumes Superior is not delivered and pre-delivery commitments are written off, no sale expenses, and no opex until sale. But I use it to highlight that when a market becomes as illiquid as the current OSV market asset prices collapse to levels previously thought unreachable and certainly well outside the norms of bank risk models. But from an equity story I find it really hard to see why someone would buy in at a level significantly above this as the new book value of the assets (and I have been exceedingly generous on the subsea vessel valuations) as Farstad is essentially an operations company not a service company.

I don’t think the banks are here yet, or even close to accepting sale prices like this. The inexorable process grinds on here: all the other security holders have lost everything and now the banks are facing their position. There is a straight trade-off between committing more (even waiving payments essentially prefers other creditors) or admitting now there is no future. The reason Farstad, Havila, and EMAS are so interesting is that not all the large companies can survive (or the small obviously). Sooner or later a rational group of financial of investors will pull out of this game. The survivors will make more but someone, probably more than one, has to fall before the supply side of the industry recovers.

Having a guess at how much working capital would be required is tricky. Farstad again highlights the extraordinary opex requirements of these vessels, in more ordinary times these would be integral to credit modelling, approximately 17% of the asset base is expended is vessel opex annually at Farstad (vessel opex/ vessel book value). Cut the asset value by half and you are well over 34% per annum. On a per day/per vessel at USD 13.9k looks expensive, but I have no reason to believe Farstad was especially inefficient in this regard. Banks could see CDOs at 30 cents in the dollar and you could hold them and wait for a rebound but with a vessel the opex, even in layup, is a killer.

The Siem solution effectively valued the company at NOK 1bn. Without knowing the size of the bank write down agreed its hard to see what the new Enterprise Value would have been. Finding an equity investor willing to take on a risk like this will be a daunting project but without it the banks are going to have to look at marking their loans to some sort of realistic recovery rate, and simply assuming a market recovery in 2018 and being made whole isn’t viable; which means the nuclear scenario will clearly be in play here. Meanwhile long-term contracts get harder to win as people (rightly) worry about the trading prospects of the Group. Siem might just be driving one of the great deals, realising the position of the banks the offer has just become extremely aggressive, but it takes a brave investor to follow through on this and I suspect we are looking at a solution that protects any investment, something more akin to super-senior than pure equity which was outlined in the first announcement.

The logical industrial strategy here is for the subsea vessels to be sold, the PSVs that aren’t strong regionally to be sold/scrapped, and a recapitalised Farstad to return to its roots and be a major player in AHTS as the industry inevitably consolidates. At some point in the future one would think a rational market would entail vessel owners offering open book type contracts for long term E&P rates, and the spot market being defined by very high rates that reflect the risk. Spot market vessels would need to be all equity financed because the correlation between a severe downturn in the oil price and asset prices is stronger than anyone thought possible prior to 2015. But the reason we all love offshore is while it maybe rational in the long run it is anything but in the short… and in the long run we are all dead as the Great Man may have quipped.

Having burned through the equity holders in 2014 and the bond holders in 2015/16 it would appear 2017 is the year when the banks will be the ones to face the economic reality. This will be healthy long term but this is likely to be a tortuous and long process as the losses here go straight to tier 1 capital and the banks will resist to the last. The good news is that this really does mark the industry lows and it will be recovery from here… but maybe not for Farstad.

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