Situations emerge in the process of creative destruction in which many firms may have to perish that nevertheless would be able to live on vigorously and usefully if they could weather a particular storm.
Joseph A. Schumpeter
I have been busy lately and therefore not had as much time to write as I would like. I am working on a longer post about how much a North Sea DSV is worth (following the Nor and Bibby results), and another post on DeepSea Supply. But the constant theme in the market at the moment seems to be that no matter how bad the numbers are to claim an increase in tendering activity, as if all will be well if we just hold on a little longer, and it is this that has forced me to write…
The most logical explanation, borne out by the numbers at the moment, is that tendering is increasing because those putting out the tenders have realised there is a marginal benefit in doing so: they get cheaper prices and do not face diminishing returns from the increasing tender costs. Such an explanation fits easily with everyone reporting declining margins (Maersk, Bibby, Reach, Bourbon, DeepOcean, Solstad etc.,) across the entire supply chain while unanimously claiming to be tendering more. I get contracting lags tenders, and at some point this will mean that tenders will increase prior to work, but it simply isn’t happening at the moment: the schedules are still being cut and work delayed as all those reporting weaker numbers tell you, with no sense of apparent irony, at the same time as they report increased tendering activity.
I still feel that many people in the industry haven’t yet come to grips with the scale of change in the supply change that will be necessary for the market to balance and the structural nature of that change. Until investors who don’t understand this have been flushed out, and it would appear that this will only happen when they have faced mutliple capital injections at ever decreasing rates of return, the entire supply chain will suffer with profitability and utilisation issues.
Reach Subsea reported results and commentary this week in exactly this vein. The ROV industry in particular reminds me of my first job in NZ when a couple of weeks into it someone flew down from Germany to have a strategy meeting with us. “We are going to grow twice as fast as the market” he stated, when I asked “Isn’t everyone else saying this at their planning day as well, so what are we going to do differently” I realised my career at this company was off to a bad start. (I also realised that marketing wasn’t for me. Although the hilarity did ensue when the said individual returned later in the year (1997) to demand higher returns as the Asian currency crisis was having a poor effect on his P&L. When I pointed out 65% of NZ’s trade balance came from APEC countries I was pleased to have a UK passport.
Collectively it is axiomatic that the sum of all firms in the industry can only be equal to the market size and the overall market growth rate. Yet everyone in the ROV space at the moment claims to be growing market share or holding up despite new companies launching and no one making any money.
ROV systems are preferable to own over an offshore vessel only because they don’t have the running costs and you can put them in a warehouse until a recovery appears. But the ROV industry has very low barriers to entry, are in huge oversupply, and the industry is dominated by 5 very well capitalised and global companies. I have lost count of the number of companies striking a deal with a vessel owner to put the system on for free while they take the risk and cost of tendering on. It is not an original business model.
This graph from the market leader, Oceaneering, makes it clear the scale of the large companies:
Source: MS Presentation, May 2017, IHS Data
And the largest company in the market (OII) has poor utilisation and a day rate reduction of 25% since 2014:
The question is really why you would want to go long on this market? Reach to be clear has 6 systems while OII has 282. Four competitors control more than 50% of the market. This is a market that has declined significantly in the last couple of years and seen a small number of new competitors (i.e. M2) come in and buy assets below depreciated value from previously bankrupt companies. If you speak to anyone in the market at the ROV companies they will tell you they are giving away the ROV for free and trying to make money off the personnel and mobilisations. It is a totally unsustainable business model.
The only economically rational strategy here is for a massive consolidation amongst the larger industry players, starting with the grey quarter in the graph who don’t even get their own colour. There is no differentiation in the end product to the customer and no ability for ROV contractors to add value in all but a few extreme circumstances. The longer investors support companies like this the longer the entire industry will operate at below a profitability level required to get CapEx to equal depreciation and ROE to equal the cost of capital.
Reach to be clear reported revenue down more than 50% on the same period last year but at the same time like everyone else reported increased tendering. Reach are krill that will eventually be eaten by a blue whale (hence the photo). I understand that smaller contractors face risks where one vessel is in proportion a larger part of their business, but that just reinforces the economic necessity of having the assets controlled by a larger firm, because the cost base doesn’t vary by the same amount and the lack the scale and scope required to market and develop such assets.
I also noted in the Reach private placement memo this note about their strategy:
8.9 The Group’s strategy
The strategy of the Group in a five-year perspective, could be outlined as follows:
8.9.1 Strategy in the OPEX-market (fields in operation)
- Target IMR frame agreements
- Export of North Sea technology and standards to selected major deepwater areas in the world (emphasis added)
- Provide new services in the segment
- Bid for seasonal contracts in key regions (FTSS: Really?)
8.9.2 Strategy in the CAPEX-market (fields under construction)
- The goal is to be a preferred subcontractor to the major EPIC subsea contractors
- Securing the right assets will be key (FTSS: They are everywhere and in huge quantity, no problem)
- Gradually develop assets and resource base
- Do smaller EPIC-contracts at own risk
8.9.3 International expansion (FTSS: And take market share off who? How?)
- Develop the international market in parallel with the North Sea market when opportunities appear
- Seek international partners in selected areas like Australia, Mexico, Brazil and West Africa
- Develop a foothold in new deepwater areas
8.9.4 Asset base
- Invest in new assets (FTSS: Why?! The industry has overcapacity)
- Secure the right assets
- Mix of owned and hired equipment
I don’t know when I have disagreed with something more. Firstly, if offshore is to grow as industry it needs to compete on cost and that means the North Sea becoming more like the rest of the world not the other way around. Taking the North Sea standard overseas is a proven failure. Bibby tried it in the Gulf of Mexico with disastrous results, and in Asia with a DSV, it was worth trying in Asia but it wasn’t needed or wanted. Technip did the same in Australia. Anyone who thinks they can take the North Sea standard out of the North Sea hasn’t been out of the region. The North Sea is like it is because a) the environmental conditions are more severe than anywhere else, and b) the regulatory environment. You can’t force E&P companies to add to their cost base when it adds no value in the current environment.
If Reach are looking to expand internationally in a declining market then someone else is losing market share. Call me sceptical but in this market that is simply unrealistic. That a company with 6 systems, could have the resources to do this and start to drive consolidation when they are 276 systems behind the market leader isn’t real.
OII and others have literally tens of spare systems, they make them, and are giving them away for free. OII and others are here for as long as there is an industry (and OII have a current market cap of USD 2.3bn). I am not saying Reach is a bad investment (I don’t give investment advice), although it does strike me that it is an asymetric payoff where either someone buys them at a takeover premium, or they slowly make a return at less than their cost of capital and eventually funding runs out. Quite why you would pay higher than NAV for some ROVs which are cheaper on the second hand market and some vessel commitments is beyond me though.
I could go on. I don’t want to do a hatchet job on Reach, that isn’t my point. My point is simply that this industry needs to be signficantly smaller on the supply side and that this requires letting some firms go under. The economic rationale is called the structure-conduct-performance paradigm and is a well known feature of industrial organisation analysis. Porter’s five forces model (that all MBA’s learn), is based on this intellectual strand and the simple expedient that industry effects can be stronger than firm effects (there is much more to this and it deserves a much bigger piece for another day, including the move in the 80’s to the Resource-Based view of the firm which argues that firm effects are stronger and markets not so deterministic:, but in a consolidating industry the evidence is clear). No matter how competent the management of Reach Subsea are, and they clearly are skilled operators, they cannot in the long run compete against market structures so entrenched and differing in scale. Path dependency counts.
The offshore supply chain is clearly going to evolve in a way that was very different from the past. In the pre-2014 environment the industry had large numbers of small subcontractors, like Reach, who made money because the big companies were too busy, and making too much money, to concentrate on the small stuff. That isn’t the case now where they are under pressure to supply assets with very high fixed costs at below breakeven to win work. In order to do that they using the supply chain for ROVs (and other equipment) to supply their kit at below cost and ensure both sides lose their equity. When there is no more for the supply chain to give they will internalise the costs and reduce unit costs where possible. There is no other way this will play out.
Financial investors like Standard Drilling (PSVs), Nor Offshore (DSVs), Reach (ROVs) have all brought in expecting this was some temporary downturn and thought prices would start rising, as per previous models, and then they would then be handsomely rewarded for their (sic) foresight. It is becoming apparent now that this is not the right narrative: this is a structural downturn (Rystad put a demand return in 10 years!). Only last week I learnt Shell was making a major commitment to ROVs on platforms (again) to consistently reduce OpEx where previously they had used vessels. Examples like this are legion, and I believe in total these stories to be representative of a wider and deeper change where E&P companies will seek to drive down unit costs offshore and this favours consolidation in the industry. So far the numbers are with my theory.
The beauty of capitalism is that you can place bets with money that help determine the outcome. I could be wrong and some huge, totally unexpected, market recovery could take place. The investors in the Nor vessels have so far been way off in their judgement, and I believe Standard Drilling have as well. Let’s see with Reach. But as long as there are investors for companies like this out there, and demand remains at current levels, expect to read plenty more stories about increased tendering while digesting appalling financial results.