2017… watch financial markets not just the oil price.

bloomberg-oil-4-jan-2017A wise New Zealand philosopher once said “the future looks a lot like the past… only different”;  which pretty much sums up my thoughts for 2017 regarding Offshore and SURF. I accept sentiment in the market is increasingly positive but without wishing to sound permanently negative here are some of the issues I see coming up this year.

On the plus side… Offshore and SURF in particular enter 2017 in a far more positive note than 2016 with the price of oil having stabilised after doubling from its lows. The psychological impact on the industry has been hugely positive. Staff leaving are now actually replaced, and in many instances, the general feeling is that we are on the path to some sort of recovery. Tendering activity looks like it is increasing but rates are still at rock bottom levels.

But for the offshore /SURF industry while 2017 may mark the start of the recovery of the demand side of the industry the supply side still has some significant adjustments to make and therefore it is not just the price of oil that is important it is also the profitability of the contractors and the state of the financial markets that underpin the assets and infrastructure.

Offshore is an asset-intensive business and therefore a business dependent on credit in the modern economy. The offshore/SURF industry went into the downturn after a massive increase in capital allocation to the sector that led to an enormous new building programme, and much of the capital was in the form of debt. Previous downturns in the oil price have not coincided with such a large proportionate increase in tonnage. The industry remains over-capitalised and overbuilt and this adjustment period is likely to prove extremely painful with debt corrections being far more painful than equity corrections (compare the minimal fallout from the dotcom bubble with the US housing crisis). There are too many owners and investors who have not accepted the economic reality of what this means for asset prices with high operational costs.

Even ignoring the AHTS/PSV fleets the subsea side of the OSV fleet looks well overbuilt. There has not been such a glut of North Sea class DSVs since 1999. If the Ultradeep and Vard vessels deliver with the build quality as high as the spec then all of sudden the Bibby and Nor fleets start to look like second rate tonnage. The Bibby Polaris was built in 1999 and is still a very capable ship but I can confidently say it will never find a bank to provide a mortgage style facility against such an old specialist vessel again. Similarly pipelay, as recently as 2008 the North Sea rigid reeled market was effectively a duopoly, now there are at least four credible systems and a couple on the margin. Large OCVs? 250t crane? Coming out of the 2007/08 downturn you couldn’t magic one up. Now the Boa Deep C and Sub C look headed for lay-up and certainly don’t look that special with plenty of vessels of that spec being offered for nearly OPEX only on a day rate. Flex-lay system in Asia? Take your pick and have a free portable SAT system to go with it… Ex-Brazil tonnage… I could go on…

The other big change I see slowly percolating down into the industry psyche this year will be the realisation that there has been a structural change in the financial markets that underpin the industry. It’s not just the Norwegian high-yield market that has disappeared but bank lending to asset-backed transactions will be fundamentally different as well going forward, and just as when banks go on strike in the mortgage market and house prices drop, the inevitable is going to happen to vessel and asset prices in the offshore industry. Hopefully, it leads to more scrapping at the older end of the age profile which will help restore balance.

Banks, in particular, will be slow to return to the party I feel. The severity of the downturn in asset prices has blown out their Value-At-Risk (“VAR”) models so beloved of financial regulators and internal risk managers. The new standard deviation parameters are likely to materially increase the pricing offered to new transactions which will again lower the price of these assets and force sellers to recognise equity losses (either on paper or psychologically the effect is the same).

This change will favour larger players with bigger balance sheets as a recovery takes place as they will be able to put in place fleet loan facilities and cash flow facilities that will not be available to smaller companies and raise equity in public markets. It is inevitable that the recovery becomes dominated by larger and better-capitalised companies. The industry as a whole will require more equity to grow, and more I suspect will come from retained earnings, which will limit capacity increases in any sustained upturn. After a long period of low volatility returns equity investors will re-price seeking higher rewards for the obvious (and now historically documented) risks. I fear smaller vessel operators who put 10 (at the peak) -25% down on a vessel and financed the rest of a $100m vessel on the back of a 5 year charter, or used the project finance market and took the margin, are consigned now to the archives. These markets will return but the risk profile will more closely align to the economic life of the asset than we have previously seen. I haven’t done the calculations but if you estimated that all spot market vessels would need 60% equity going forward, on a 20% reduction in their book value, on tighter LTVs, and all vessels over 15 years would need to be fully equity financed, then the amount of extra capital required by the industry is in the billions and the effect on the vessel S&P market would be profound and chilling. Profit has a habit of erasing bad memories, but financial institutions and investors are famous for never making the same mistake twice, and any thawing out of the banking side will take an extended period of time. Bank Directors will view offshore as just another cyclical shipping business and allocate capital accordingly.

But this still feels some way off that with distressed investors working on individual asset deals rather than anything with an industrial strategy angle, beyond the Aker/Solstad deal in subsea, and some of the moves Seacor has been making in supply. Whereas the recently closed PSV III deal (purchase price for 2 x UT 755 at 11.7m) shows that distress asset prices are still well below what owners in layup situations hope to achieve but more in line with a risk reward profile that equity investors may need going forward. Nor bonds trading in the 30’s only reinforce this picture.

So 2017 is looking better than 2016 without a doubt but we are not looking at a 2008 quick recovery here. Asset prices are going to be weak for a prolonged period. 2017 marks the start of the deep structural changes in the supply side which will define the new industry structure going forward.

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