Backlog, boats, and oligopolies…

“[E]conomists usually assume that people know how the economy works. This is a bit strange since economists don’t even know how the economy works”. …

Xavier Gabaix

There was a lot of talk about Subsea 7 ordering a new pipelay vessel last week, and given the engineering quality at Subsea 7 I am sure it will be an efficient, if not technically brilliant, asset. I don’t have a counter-opinion on this: Subsea 7 shareholders expect them to be a market leader and this means buying assets, particularly when yard prices are likely to be advantageous.  The plan would seem to try and push the technical window of pipelay even further and make it harder for smaller tier two contractors to offer a competitive product with such technical features as heated pipe-in-pipe.

As a replacement for the erstwhile Navica it will ensure a leading edge capability. The Navica was built in 1999 so Subsea 7 had 16 good years out of her and  for a number of years Technip and Subsea 7 offered the only realistic reel lay in the North Sea, and I would say the vessel made real money for the shareholders from 2004 onwards (especially when considering the huge number of DSV days she generated) until 2014. Subsea 7 depreciates vessels between 10-25 years and I wonder what the figure is for pipelay assets?  If the pace of innovation in the pipe technology is such that you need a new vessel as a platform every few years then the economics would dictate a slow diffusion of pipe technology (I don’t think it’s likely).

At USD~300m it is not a massive purchase for Subsea 7 either. In 2017, in the midst of the worst industry crisis ever, Subsea 7 made a special dividend of USD 191m, and this vessel is 3 years away from the take-out payment (and could probably be pushed back if needed). The interesting thing is given the delivery time how Subsea 7 see the market coming back… because its not in the backlog. In 2013 Subsea 7 published their backlog as USD 11.8bn:

Subsea 7 Backlog Q4 13

Strangely, for the last few quarters the bar graph has been dropped in favour of the pie graph and the number is materially smaller:

Subsea 7 Backlog June 2017.png

That USD 4.4bn also includes ~USD 1.4bn for the PLSVs in Brazil. Now to be fair when Subsea 7 had backlog of USD 11bn it had six vessels under construction and was targeting CapEx of ~USD 1bn, 60% on new builds and 25% on replacement CapEx. As the order book at Subsea 7 has dropped so has CapEx pretty much proportionately. It is also interesting that they can cut maintenance CapEx back so much with guidance for total CapEx this year guided in at USD 180-220m. Yes, it’s a lot less than Depreciation, but as the industry contracts this is going to become more normal, the asset base has to shrink to reflect the total macro demand.

However, I think you can get a sense of Subsea 7 managements’ confidence in the future from this graph in their 2016 annual report:

Subsea 7 Outlook Feb 17

2014-2018 look like lean years with the tap opening up in 2018. The sceptic in me always looks at the variability of the grey box (USD/bbl 40-60) and thinks the longer market sentiment remains negative the less likely this segment is likely to fulfill its potential, because the baseload of offshore projects at USD 40 is depressingly small. But if Subsea 7 shareholders expect their company to be a market leader, and if the market is moving to longer tie-ins with heated pipe, then that is the direction the company must go. What is interesting, and will be impossible to tell for outsiders initially, is how they price this in the market? If they only have 10 years to get a return on the investment the project day rate will have to be substantially higher than if it’s a 20 year investment.

You can make a bear case for Subsea 7 being too long on pipelay capacity in Brazil and for it going too early with this vessel if the recovery doesn’t come, otherwise they have arguably handled and read the downturn better than anyone. But I guess what the management really don’t want is a company that doesn’t have the asset base if the market comes back and this is only balanced against the very high cost base vessels have if they don’t work.  Again in the latest SS7 presentation they showed this market data which would give the Management/Board the confidence to invest:

Subsea market outlook Sep 2017

Subsea 7 have the liquidity to make it through to a forecast upturn and other shareholders will have the confidence they are following on the back of Siem Industries,  who have been remarkably honest about the problems they face at Siem Offshore and their commodity tonnage.

I think it likely that at the top end of SURF FMC Technip, Saipem, Subsea 7 and McDermott pull away from the other companies and create a small pool of competitors who bid for projects offshore globally that only they can realistically do given the technical sophitication and asset base required for delivery. A large number of the tier two installation contractors are no more (Swiber, EMAS Chiyoda, SeaTrucks), so the bigger contractors should gain market share on some of the more basic installations and offer a host of technical capabilities that will make it impossible for smaller companies to compete on the larger projects.

Therefore the question is whether a small number of firms bid each other out of profits or whether they create economic value? I think you can make a bull case for Subsea 7, and the other large integrated SURF contractors, based on theories of market power and argue that this is a case where if they can push the technical and asset window enough they will generate significant economic profits, and this vessel order needs to be seen in that light. This isn’t true for every segment in the subsea market and is unique to the financial strength and product breadth the large integrated contractors have.

Markets with a small number of selling firms who are in a strong position are known as oligopolies. These market structures have fascinated economists for years because of the potential for collusion and price setting (as well as the failure of the firm profits to decline over time as classical theory would suggest). But two theories, based on French mathemeticians (who looked at a spring water duopoly) allow some insight into how the SURF companies will behave in the future: Bertrand competition, which argues that companies in this position would sell on price; or Cournot competition, which argues that companies in this position maximise sales and ultimately profitability.

In a much longer post (for another day and likely of limited interest) I will argue that this likely oligopoly of large SURF contractors will compete on a Cournot model, and therefore these firms are likely to make significant economic profits, despite the capital intensity of the industry. Cournot models are defined by:

  • [M]ore than one firm and all firms produce a homogeneous product, i.e. there is no product differentiation;
  • Firms do not cooperate, i.e. there is no collusion;
  • Firms have market power, i.e. each firm’s output decision affects the good’s price;
  • The number of firms is fixed;
  • Firms compete in quantities, and choose quantities simultaneously;
  • The firms are economically rational and act strategically, usually seeking to maximize profit given their competitors’ decisions.

The high-end SURF market is a clear case of this: a relatively small number of firms (n=4 maybe n=7 in some cases) and specialised asset base, well known to competitors and easily monitored, allows firms to understand well what there rivals are doing. For game theorists it is a market made in heaven where the signalling intentions of all parties are obvious. From an E&P perspective, when you cut through the enginering voodoo language, the product is homogenous: it takes oil from a well to a transfer point. Firms will not irrationally bid down project margins constantly as they are aware of the competitive effect of doing this (which is different from when EMAS Chiyoda and other pretenders were in existence), and in reality the high-end SURF firms are well aware what projects suit their asset base and are “must win” projects. The network of alliances, and integrated solutions from the seabed, cannot be easily replicated but are not so different in technical terms that competitors cannot make intelligent judgements about a competitors cost base.

Each firms output decision will affect price because the large step increase in investment required for new capacity will make these companies more cautious is a more depressed market. The quantity theory of output is likely the least intuitive part of the theory for subsea but in essence firms will limit the supply of new vessels and concentrate on utilisation. The big four SURF contractors will only add vessel capacity when it generates profits well above capital costs – which simply hasn’t been true in the past. Over time as the new build wave subsides the firms will choose to limit the supply and focus on cash which will drive up rates (above marginal cost). This is different from a bank enforced asset freeze I have mentioned before as these companies are large enough to access asset funding.

For the tier 2 companies and vessel owners below my depressing tone of poor margins and over capacity will continue for some time I guess. But technical innovation and high CapEx, with mildly increasing demand, should allow the top SURF contractors to exercise a degree of non-collusive pricing power that will generate real economic profits in the not too distant future. These firms will take market share in the more commoditised (and shallow) field development market and face limited competition for high-end field development work which is a growing segment of the market (hence Subsea 7’s move into the Gulf of Mexico in a big way with the EMASC assets).

So despite a generally depressed industry it is easy to imagine the high-end SURF firms prospering to a certain extent. Brazil is the country however that hangs over Subsea 7 and to a lesser extent FMC Technip (and I wonder if it really sank the DOF Subsea IPO): too much flexlay capacity. It’s very hard to see how much capacity Petrobras is going to give back, but a look at tree awards suggests a degree of discomfort for the vessel owners.With one dominant customer the downside is clearly and intense period of price competition between FMC Technip and Subsea 7 in Brazil to keep their assets working. This is a classic example of Betrand competition where two firms who offer an identical product, and cannot collude, find the buyer chooses everything from the firm with the lowest price. Such a statement seems vaguely tautological but in economic terms it is more about a formal proof that two firms can push industry margins down to zero economic profits as efficiently as a large number of firms competing.

Note: For Saipem I am talking SURF only. At a corporate level I don’t see any respite for them).

(P.S. The header pictire is of a “Kinked” demand curve which is core to the oligopoly model.)

 

 

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