The New North Sea…

[Pictured above a sneak preview of the new (TBC) York Capital/Bibby/ Cecon OSV]

Subsea 7 came out with weak results last week and specific comments were made regarding the weakness of the North Sea market. I have been saying here for well over a year that this UKCS in particular will produce structurally lower profits for offshore contracting companies going forward: you simply cannot fight a contraction in market demand this big.

In Norway spending has remained more consistent, largely due to Statoil. But it is worth noting how committed they are to keeping costs down:

Statoil Cost reduction Q1 2018.png

A 10% increase in production is balanced with a 50% reduction in CapEx and a 25% reduction in per unit costs. Part of that is paid for by the supply chain… actually all of it. What I mean is only part of it is paid for by productivity improvements and lower operational costs… the rest is a direct hit to equity for service companies.

But as a major offshore player this presentation from Statoil highlights how efficient they have become in the new environment (and how offshore will compete going forward):

Statoil drilling efficiency.png

Cutting the number of days per well by 45% not only vastly reduces the costs for rigs it clearly reduces the number of PSV runs required to support the rig for example. The net result is that offshore is more than competitive with shale/tight oil:

Statoil break even.png

In fact Statoil is claiming its breakeven for offshore is USD 21 ppb on a volume weighted basis. It’s just a timing and economic commitment issue on a project basis to get there, but the future of offshore in demand terms is secure: it is an efficient end economically viable form of production. Especially when your supply chain has invested billions in assets that they are unable to recover the full economic value from. Demand is clearly not going any lower, and is in fact rising, just nowhere near the level required to make the entire offshore even cash breakeven.

Statoil has also changed its contracting mode which is probably part of the reason Subsea 7 is suffering from margin erosion in the North Sea. Statoil has clearly made a conscious decision to break workscopes into smaller pieces and keep Reach and Ocean Installer viable by doing this (and helping DeepOcean but it is clearly less vital economically for them). Part of this maybe long term planning to keep a decent base of contractor infrastructure for projects, but part of it maybe rational because previously for organising relatively minor workscopes larger contractors were simply making too much margin. A good way to reduce costs is to manage more internally in some circumstances, and especially in a declining market. I doubt you can be a viable tier 2 size contractor in the North Sea now without a relationship with Statoil to be honest, it just too big and too consistent in spend terms relative to the overall market size (Boskalis is clearly a tier 1 if you include its renewables business).

I still struggle to see Ocean Installer as a viable standalone concept. At the town hall recently the CEO stated that Hitecvision were in for another two years as they needed three of years of positive cash flow to get a decent price in a sale. But what is a buyer getting? They have no fixed charters on vessels (not that you need them) and no proprietary equipment or IP? All they have is track record and a Statoil relationship. In a volatile market even investors with as much money as Hitecvision must want to invest in businesses with a realistic chance of outperforming in the market?

The UKCS is a different story. Putting the Seven Navica into lay-up is an operational reflection of a point I have made here before: there is a dearth of UKCS CapEx projects. Demand is coming back in the IRM market overall but the diving market remains chronically oversupplied and this is likely to lead to much lower profits in a structural sense regardless of a cyclical upswing.

As I have said before Bibby, surely to be renamed soon if York cannot sell the business, remains by far in the weakest position now. Bibby appear to have won more than 70 days work for the Sapphire but that is just the wrong number. Bibby are caught in a Faustian pact where they need to keep the vessel operating to stop Boskalis getting market share, but they have no pricing power, and are not selling enough days to cover the cost of economic ownership on an annual basis. The embedded cost structure of the business overrides the excellent work on the ground the operational and sales staff do.

Boskalis with a large balance sheet are clearly using this year to get out and build some presence and market share. The operating losses from the Boka DSVs won’t please anyone, but would have been expected by all but the most optimistic, and all that is happening is they are building a pipeline for next year. Coming from Germany and the Netherlands, areas more cost-focused, gives them an advantage, as does their deep experience and asset base in renewables. Boskalis know full well the fragile financial structure of Bibby and this is merely a waiting game for them.

The problem for Bibby owner’s York Capital (or their principals if the music journalist from Aberdeen is to be believed)  is the lack of potential buyers beyond DeepOcean or Oceaneering. I spoke to someone last week who worked on the restructuring and told me it was a mad rush in the end as EY were £50m cash out in their forecast models of the business (which makes the June 17 interest payment comprehensible). This makes sense in terms of how York got into this it doesn’t help them get out, and frankly raises more (uninmportant) questions, because it was obvious to all in the offshore community Bibby was going to be out of cash by Nov/ Dec 17 but not to the major owner of the bonds? Bizzare.

Internally staff don’t believe the business is in anything other than “available for sale mode” because the cost cutting hasn’t come, the fate of the Business Excellence Dept is seen as a talisman for the wider firm, and there is no question of money being spent on the needed rebranding by year end unless required. A temporary CFO from a turnaround firm continues without any hint of a permanent solution being found for a business that continues to have major structural financial issues.

Managers at Bibby now report complete a complete lack of strategic direction and stasis, it would appear that winning projects at merely cash flow break even, with the potential for downside, is making the business both hard to get rid of and the current shareholders nervous of where their commitments will end. Any rational financial buyer would wait for the Fairfield decom job to finish and the Polaris and Sapphire to be dry-docked before handing over actual cash, but there is a strong possibility the business will need another cash infusion to get it to this stage. And even then, with the market in the doldrums, all you are buying is a weak DSV day rate recovery story with no possibility to adding capacity in a world over-supplied with DSVs and diving companies. An EBITDA multiple based on 2 x DSVs would see a valuation that was a rounding error relative to the capital York have put into the business. All that beckons is a long drawn out fight with Boskalis who will only increase in strength every year…

On that note Boskalis look set to announce an alliance with Ocean Installer. In a practical sense I don’t get what this brings? Combining construction projects with DSVs from different companies is difficult: who pays if a pipe needs relaying and the DSV has to come back into the field for example? But the customers may like it and having a capped diving cost may appeal to Ocean Installer… it’s more control than most of their asset base at the moment.

Subea 7 and Technip just need to keep their new DSVs working. They are building schedule at c. £120k per day and peak bookings at c.£150k per day and are winning the little project work there is. Although even the large companies are having to take substantially more operational and balance sheet risk to do this. The Hurricane Energy project, where Technip are effectively building on credit and getting paid on oil delivery, highlights that what little marginal construction work there is in the North Sea will go to companies with real balance sheet and field development integration skills. I have real doubts about this business model I will discuss another day: the solution to a debt crisis is rarely more leverage to a different part of the value chain.

But services are clearly holding up better than owning vessels. The contrast between the supply companies and the contracting companies continues the longer the downturn for vessels continues. The  old economic adage that organisation has a value is true. Technip and Subsea 7, along with McDermott and Saipem, have not needed to restructure as many vessel companies have. The worst years of the downturn were met with project margins booked in the best year of the upturn giving them time to restructure, hand back chartered ships, and reduce costs to cope with a new environment. There has been a natural portfolio diversification benefit the smaller companies and supply operators simply haven’t had.

Subsea 7 for example is a very different business to 2014 (investor presentation):

Subsea 7 cost reductions.png

Staff costs down 60% and a very decent effort at reducing vessel costs despite declining utilisation (and despite reducing vessel commitments by 12 vessels):

Subsea 7 vessel utilisation.png

In the past people in susbea used to say they were in the “asset business”. Without assets you couldn’t get projects. And that was true then. Now the returns in subsesa will come from adding intellectual value rather than being long on boats, and that is a very different business. In the North Sea it will lead to a clean out of those businesses who effectively existed only as entities that were willing to risk going very long on specific assets. I count Reach, OI, and Bibby in that group. Historically the returns to their asset base, or access to it, vastly exceeded all other economic value-added for these companies. The Norwegians went long on chartered vessels, Bibby chartered and purchased them, but it doesn’t matter in the end because service returns for such generic assets as OI and Reach run are minimal and easily repliacted, and the returns on DSVs are economically negative due to oversupply in Bibby’s case. Rigid reel pipe, full field development, long term embedded flexlay contracts in Brazil, all these provide sufficient economic return to ensure long term survival (very high organisational and commitment value), and a return that will exceed the cost of capital in an upturn. But for the smaller companies there isn’t a realistic prospect of replicating this now their returns from commoditised tonnage have been so dramatically lowered.

Outside of diving Bibby, OI, and Reach all do exactly the same thing: they charter ships only when they win work, after having dumped a ton of money tendering, and bid the same(ish) solution against each other. Bibby are even using an (ex) core OI asset for a break-even decommissioning job. In the end, regardless of the rhetoric, the compete on price doing this and it is a business model with low margins because it has low barriers to entry (i.e. a lot of people can do it). Eventually in a declining or very slowly growing market that leads to zero economic margin. And as subsea has shown in Asia what eventually happens is someone takes too much contractual risk with a vessel and gets wiped out in a bad contract. This is how the North Sea will rebalance for the marginal providers of  offshore contracting supply without a major increase in demand. That is as close to a microeconomic law as you can get. They simply do not have the scale in a less munificent market to compete.

Goiung forward balance sheets, intellectual capital, visible market commitment and financial resources will all be as important as the asset base of a company. Services will be important in economic terms, they will provide a positive economic return going forward, but not all services, and not in a volume likely to outweigh historic investments in offshore assets. There is a far more credible consolidation story for offshore contracting than for offshore supply with a smaller relative asset base spread over a global service provision set to tilt to regional purchasing by E&P companies.

For the North Sea as whole, a market that provided disproportionate structural profits due to the environmental requirements of the asset base and regulatory requirements, there is also the slow but gradual realisation that the supply chain will have to exist in a vastly less munificent environment than before. Scale will clearly be important here. A market that has contracted in size terms like the North Sea just doesn’t need as many marginal service companies, or assets, and that is the sad fact of life.

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