What will recovery looks like?

I came across the chart above the other day while starting to think how to write a post the other day about how 2018 will look (I have been really busy on an FLNG project so have not had much time lately), the reason I like it is I think it sums the two eras we are dealing with: Before Crash (2014 and earlier) and the After Drop. The chart is for Ocean Rig Q3 2017 and is just a very simple illustration of the scale of the drop in day rates the entire industry is facing.

Quite simply ORIG was banging out rigs at $500-600k per day and now they are going out at ~$150-170k, when they can get work. I am no rig expert (I think the best commentary is at Bassoe for rigs) but it’s no different in the vessel market where discounts of a similar percentage (~70%) have been common since 2014. Not only that but whereas before the utilisation was near 100% now it is patchy at best.

It’s all well and good talking about a recovery, and clearly as the oil price increases work for offshore will come back, but the scale of a comeback here needs to be kept in context, and the best way to do that is to look at historic utilisation and day rates. It is also well worthwhile remembering the subsea value chain and being honest that if the rig market is struggling with such onerous day rate decreases to make projects “economic” for the E&P companies then even these projects are a long way off hitting those with vessel exposure, and will they even be economic for offshore contractors?

The definition of economic on this blog is economic profit not simply surviving. That means consistently earning returns the actual cost of capital. I think the industry will be better from a demand perspective in 2018 the question is really at what price point the surplus capacity soaks up demand? Unfortunately I can’t see anyway that a marginal increase in work doesn’t simply encourages some companies to stay in the market and keep profits weak for everyone else. Individually economically rational, but collectively destructive. Nothing will make the E&P companies happier than to watch the contracting industry burn through their equity while projects are de-risked for them with the resulting cost reductions.

The North Sea PSV market is a classic case where as soon as day rates pick up someone buys another distress sale PSV for around what it costs to operate at cash breakeven and lures investors with the unrealistic proposition that if asset values recover to previous levels they will make supernormal profits. If anyone other than the project promoters and the operating company make money then I will be very surprised and the situation is being replicated across a range of asset classes. The Seadrill restructuring plan for example requires a heroic belief in day rate increases and utilisation:

Seadrill RP day rates.png

It is a very rare market where both the quantity and price of work increases at the same time so aggressively when there is so much excess capacity. You can argue that the industry is at an unaturally low levels but I struggle to see the commissioning of rigs and projects on a scale to make these numbers realistic.

In 2017 the problem for the offshore industry was over confidence in demand. Move too early and you lost money, and because there is so much distress money looking at the sector, people feel they have to do something or lose out regardless of how unrealistic the plan (i.e. the Nor liquidity issue). But the market dropped lower than people thought, maintenance demand was more elastic than presumed, and new Capex virtually dried up. The problem in 2018 is going to that same level of supply for only marginal increases in work. Good for workers as job losses abate but offering no respite in profit terms and asset valuations.

New FID’s will take years to flow through to offshore execution. Literally two seasons for most of them under a best case scenario by the time the engineering and financing has been arranged. So you need to last until 2020 under best case scenarios. Also not every asset class will benefit from a straight increase in the oil price as E&P companies are being far more selective about the types of fields they develop. All the data I have seen point to large scale, high flow, developments being the focus for development: that will favour large contractors with bigger balance sheet and a more complex asset base.

Vendor financing is becoming a big issue. For example Premier and Rockhopper are trying to finance the Sealion development with nearly 100% vendor financing – paid on installments following first oil. In earlier years these companies would have gone to the capital markets for financing and paid cash. It is another sign of the broken financing market that this vendor financing is being considered large scale: contracting companies have limited ability to assess downhole risk, and if these deals ever go really wrong then this will be very messy as the creditors fight it out. There is also a limit to the number of deals contracting companies can absorb like this.

A common thread in this (that I will talk more about later) is that in addition to the price of oil needing to be high financial markets need to recover as well to help companies take advantage of the opportunities, and we appear to be a long way off that happening. E&P companies are concentrating on paying down debt and prioritising dividends, and when you can sell 100% of your output, and your shareholders have been scared by the volatility in your price level, then you have less incentive to spend to keep market share that other types of companies (i.e. supermarkets) might worry about. The longer E&P companies want to be cash rich, or distribute it, then the harder it will be for offshore.

Smaller E&P companies that focus on offshore need to be able to raise debt and equity for the industry to improve – these were called marginal producers for a reason and they created marginal demand for the offshore contractors. Until some degree of access comes back for these companies then the global fleet is simply too big as the supermajors refocus on shale.

Don’t get me wrong offshore isn’t going away, and for the vessels not in lay-up 2018 is likely to be busier than 2017. But I think it will be utilisation, not day rates, where the majority of the pick-up will be felt, and a vessel doesn’t pay for itself with 4-5 months work (unless you buy it super cheap), a fact that won’t help financial markets open up for offshore as the same banks are behind the pull-back in the vessel and offshore market as were often behind the offshore E&P companies.

Not every business model is going to work here and not every asset will have value as the market recovers. I think we will only see the bottom when the banks start accepting the scale of the losses they will have to take, there some indications of this: DZ Bank has appointed Goldman to sell DVB, DNB looks to be setting up a “bad bank” etc. But there are a host of deals across the sector: Seadrill, Mermaid (Australia), SolstadFarstad, Eidesvik ad infinitum where the banks are just delaying repayment and hoping for a miracle. Much like the Euro crisis this will just create zombie companies and banks from which the industry will struggle break free of.

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