Follow the money… it’s all in the numbers…

“We no longer believe because it is absurd: it is absurd because we must believe.”

 Julio Cortázar, Around the Day in Eighty Worlds

At some point companies are going to have to stop reporting poor financial results and say things are looking good from a tendering perspective to retain credibility (or will they maybe their shareholders want to believe as well?). This week Solstad seemed to pull this trick, while the most brazen appears to be Subsea 7 who while annoucing that their order book had dropped significantly, stated that:

[We have] [c]ause to believe in an improvement in SURF project award activity within 12 months

Early engagement activity increasing

This despite the fact that 1 year ago they had $6.1bn in backlog and they currently only have $5.1bn. Subsea 7 is more exposed to EPIC projects and I believe these will form a bigger percentage part of the market going forward, but it’s still a bold call.

For Solstad the alternative explanation, announced by Bourbon, is that there is no recovery. Or as Siem Offshore stated this week:

we believe there will still be an oversupply of AHTS vessels and PSVs and expect the market to remain challenging for several years. The charter rates and margins still remain below what is sustainable. (Emphasis added).

Part of me thinks the offshore industry just isn’t used to an environment where the forward supply curve price isn’t fundamentally different from the current price. It is worth noting that on an inflation weighted basis the oil price peaked in 1979 and then dropped in real terms for 19 years to reach an all-time low in 1998, before stagnating for a couple of years, before the inexorable rise that we all regard as the new normal, began.

The major reason for the steady decline was both supply and demand based. New sources of supply came on, technology advanced, and high prices encouraged substitution. Clearly it isn’t an iron law that prices will keep rising over the long run as if it is an immutable economic law, yet it is taken as a given by certain sectors of the offshore community.

Solstad announced results this week that seemed to defy all logic. I don’t know how much money Aker have, but they have played the OSV market stunningly badly since the downturn began, and one would think sooner or later they will get sick of throwing more money away on vessel OpEx. Aker jumped into Solstad way to early, and yet for some inexplicable reason, (other than blind faith in a vessel recovery?) when more than 100 North Sea class PSVs were in lay-up in January, agreed to effectively bail Farstad out and combine with DeepSea Supply. Now Solstad came out with this predictable bullet point from their results presentation:

Majority of revenue and EBITDA from CSV segment

Really what a surprise! You just can’t make this up. What is working for them in this downturn is their high-end CSV fleet and then Solstad jump headlong into the most overbuilt commodity shipping in the offshore industry, Madness. The rest of the presentation is an exercise in mental dislocation from industry reality: DESSC’s cost leading business model is praised… but that doesn’t help at the moment when ships are going out for less than their economic value? It’s also not scaleable or transferable in an acquisition of  other vessels (or companies) because it relies on all vessels in the fleet being similar? And can you really have a low cost business model in this sector anyway? Its a boat + crew? What special insight does DESSC have in making this low cost? Apparently a strategic driver for saving Farstad’s banks is their AHTS experience? Great… Farstad are the most skilled company in a market segment that is structurally unprofitable? If the shareholders are like Aker and like owning companies that are the most competent at what they do regardless of whether they make money or not then this is a very good investment idea. I suspect it’s niche though because investors like that are rare.

It is all well and good highlighting that Farstad and DESSC are non-recourse subsidiaries of Solstad wth the implication being if it all goes wrong then they can be jettisoned. But of course JF took his holding in Solstad not the subsidiary which shows you where he thinks the value is. The Solstad supply fleet will simply not be big enough to generate economies of scale that outweigh the negative industry structure or induce pricing power in any region. It is also debatable what the minimum efficient scale is in offshore supply? This was a transaction driven by the desperation of Farstad’s bankers and recognition by DESSC that trying to do a rights issue without a different investment story would have been extraordinarily dilutive given the cash would have been used for OpEx only. Quite how it was sold to Solstdad/ Aker is anyone’s guess.

A good comparison is Gulfmark which is going into a voluntary Chapter 11. Gulfmark will emerge with a clean balance and 72 vessels in the supply sector. If you want to look at a company with the potential to consolidate the PSV sector it is right there with a simple operational structure and balance sheet focused on one sector that investors can understand and measure. It is very rare  for companies to consolidate an industry that come from one of the high cost markets and then work out how to be cheap internationally – it usually works in reverse. US companies like Seacor and Gulfmark are going to be well placed to drive proper industry consolidation in a way that may not be possible for a company coming from a relatively high cost environment. Yet this industry feels a long way from the bottom when NAO Offshore with a mere 10 vessels, and 30% of the fleet in lay-up, all working at nowhere near their cost base, can say blithely:

Nordic American Offshore closed a follow-on offering March 1, 2017, strengthening the Company by about $48.8 million in cash. The main objectives of the offering were to strengthen NAO financially and position NAO for further expansion...

NAO sees opportunities to grow the Company… 

(Emphasis added).

I sometimes wonder if when Norwegian schoolchildren are young they are indoctrinated with a special ship class in which the answer to every question is “ship”. I imagine an immaculate schoolroom (paid for with petrodollars of course), a very small class, and 20 children with their eyes closed humming and intoning gently “skip… skip…. skip…” And the teacher asking “What is the meaning of life?”… and the gentle reply coming back immediately “Skip”… “What is 2 + 2?” … “Skip, Skip + Skip Skip”… “E=MC2?” “Skip”….

I am just not sure the answer to the current problems are more ships… I have a nagging suspicion it’s less ships. A lot less. Consolidation isn’t the only answer here a quantative reduction in vessel numbers is an yes smaller operators need to go.

DOF came in with revenue 23% below Q1 last year which makes it hard to point to any recovery. DOF also announced this week that they may list DOF Subsea as First Reserve would appear to want out. First Reserve have been in DOF Subsea a long-time, and it’s natural they would want to exit at sometime. But you should always ask why inside and knowledgable investors are selling now, at what some are calling the bottom of the cycle; maybe it isn’t the bottom? DOF Subsea project margins were 2.0%! Yes the DOF PLSVs in Brazil are now up an running, but as we all know Petrobras has far too much PLSV capacity and so I suspect First Reserve is trading off a very low point in the cycle against the cost of waiting which brings you a day closer to the possibility of a vessel being redelivered from Brazil.

DOS Subsea specialise in light IRM and small scale projects and out of the North Sea market (where you need a North Sea class DSV) owning a vessel is a disadvantage not an advantage (which isn’t true at the top end EPIC SURF contracting where you need a specialist lay vessel) for some projects as costs become purely variable. Every single asset DOF Subsea have can be chartered in from another company if you are project management house. There used to be a number of project companies that delivered projects but didn’t own vessels, that didn’t last as the market tightened from 2006 onwards and you simply couldn’t charter a vessel (I am trying to think of the Singapore/Perth company Technip brought?). But now that isn’t the case and so not only is there loads of delivery capacity in vessel owners and charterers, but small project management houses can, and will, bid and compete for jobs, which will lower industry profits structurally. The best strategy going forward is to have a fleet much smaller than your delivery schedule requires but still some core tonnage, companies that didn’t splurge in the last boom are clearly better positioned here.

Whatever the reason for First Reserve selling it is a fact that one of the most successful investors in the energy industry is lightening their exposure to the offshore sector. If you buy DOF Subsea shares you need to ask what you know that First Reserve don’t? Interestingly First Reserve hasn’t invested in an offshore exploration company since 2011 (Barra), but has invested in 7 tight oil plays since 2011, a pattern that seems to mirror capital flows in the industry. One wonders if Technip weren’t encouraged to try and by DOF Subsea and a lack of interest led to this way of getting out?

The obvious reason that First Reserve might well be selling is that they think the poor financial results are likely to continue for sometime and they see no easy answer to an industry awash with capacity and declining levels of investment and simply don’t want to fund working capital with an uncertain payback cycle. DOF Subsea has excellent project delivery capability but it simply too long on ships and unlike other contractors these are an essential part of their strategy going forward and they have no ability to given chartered tonnage back as the industry continues to contract.

DOF Subsea also have 67 ROVs. The quiet underperformer in the industry at the moment is the ROV space. Everyone at the moment is giving the ROVs away at costs + crew only. In the old days ROVs were so profitable because you used to able to hide a mark-up on the vessel in the contract amount and they looked very profitable. Now the vessel is given away for free as is the ROV and only the engineering generates some margin. There is clearly going to be some consolidation here and I believe it will be very hard for the smaller companies to raise additional funding without profitable backlog as it becomes clear that there will not be a recovery in 2017. A lot of companies in the ROV market have raised money yet offer the same thing as the industry leaders who have very strong liquidity positions and can play this game far longer than speculative investors. Reach is a well managed company, and can give vessels back eventually, M2 got it’s ROVs cheap, but both are going up against companies like DOF and Oceaneering and eventually, surely, investors are going to realise that without some sort of increase in demand the structure will favour the larger companies who have more equity to dilute to see them through to the final stages of consolidation. There is an argument that smaller nimbler ROV companies can respond better to IRM workscopes than larger companies, particularly at the moment with oversupply in the vessel market; we are about to find out if they can win sufficient market share to be viable.

Obviously there are different views about when the industry is going to recover and how it will look. That is legitimate as no one can know ex ante what will happen ex post but it is becoming apparent that 2017 isn’t going to be the recovery year people hoped and that more people are going to have to raise money to get through this. The Nor DSVs will need to start fundraising in August at the current burn rate, as will others, the dilution that the new money makes on the old money for these secondary fundraisings will be a clue I believe as to how close we are to pricing the bottom. The investors in Nor represented a group who thought there would be a quick bounce back in 2017 in the price of oil and subsea asset values, there are bound to be fewer the next time around and surely they will charge a higher price for their capital, and in many ways this is microcosm of the industry.

The best guide to calling this appears to be those that have looked at previous investment bubbles. Charles Kindleberger, in his classic study of financial panics and manias stated the final stage of an investment bubble led to panic selling which would mark the bottom of the cycle:

‘Overtrading,’ ‘revulsion,’ ‘discredit’ have a musty, old-fashioned flavor; they convey a graphic picture of the decline in investor optimism.

Revulsion and discredit may lead to panic (or as the Germans put it, Torschlusspanik, ‘door-shut-panic’) as investors crowd to get through the door before it slams shut. The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets…

We still look a long way off this in offshore supply and subsea.

 

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