Value free options as a signal for future market demand…

One of the reasons both the shipping and offshore industries got themselves into financial problems was excessive leverage. One way to create leverage without an offsetting liquidity position is to sign up for an asset without takeout financing (i.e. at delivery financing). It’s risky because if anything goes wrong with the takeout financing you lose your deposit and potentially more.

So I was surprised when I saw Odfjell Drilling a USD 220m deposit to buy a rig from Samsung having got a term sheet for a USD 325M loan that required a 4 year contract from an operator as a condition of drawdown… Because what Odfjell have is a 2 year firm plus 1 + 1 year options from Aker BP… Which is clearly very different from a risk perspective. Odfjell Drilling are in the uncomfortable position that if anything goes wrong with the provision of the loan they prepaid the yard USD 220m and have limited options to get it back.

I can’t see the upside for the bank here? Yes the market is strong in this niche, but not so strong that an operator is prepared to commit for four years, only two. 24 months isn’t long and if anything goes wrong they will be hugely exposed here with their counterparty having made minimal payments relative to the value of the unit and not really big enough to honour the loan from the rest of  their resources. For a few hundred basis points above LIBOR that strikes me as an asymmetric payoff in Odfjell’s favour (and whereas in a longer deal the credit approver may have moved on to a new job in this deal they could well still be there if it blows up). Clearly on the mitigating side is a great operator, with a good credit history, and quality shareholders. What’s $300m between friends?

The options for the follow on work are “free” options as far as I read them: i.e. Odjfell gave away call options on their asset for nothing. And Odjfell did this (assuming they are rational and competent negotiators) because the customer wouldn’t pay. So I get the market looks strong but not so strong that an E&P company has to pay anything to guarantee the price of USD 550m rig for two years in two years time (and in options pricing time is one of the most valuable components). The customer will have the right to get other rigs if the market drops and it is capped if the demand goes up. If someone tells you the market is about to boom it isn’t being priced in the options market.

Options in finance and economics are price signals about demand and expectations for demand at the margin. People take risk, or offload, without having to buy the underlying asset. In a volatile environment an option has higher value. When an option is agreed it is meant to be a value neutral position, priced at an equilibrium point where both sides  believe the option is fairly valued. In this deal Aker BP are offloading long term pricing risk to Odfjell for free.

There are numerous examples at the moment in offshore where the asset owner gives away a call option on their pricing and utilisation security. This tells you a great deal unbiasedly about how both sides really view the market going forward. Asset owners giving free call options on vessels and rigs to their customers is an unambiguously bad sign. Economic theory would suggest that these options are “free” because they are valueless.

I can’t help feeling that this is the wrong model for offshore. Surely the best solution to lock-in low long-term rig prices would be for the company with the balance sheet and need for the asset to give a long term charter to allow the rig operator to use less equity and lower the day rate? If people are not that confident then let the unit rot in a shipyard where the current owner has a comparative advantage in storage costs?

At some point, and I think we have reached it generally in offshore, building highly specialised assets that cost in the hundreds of millions and taking spot market risk just won’t be viable for all but a very small number of providers who will price this at very high marginal levels. The problem is until the inventory of such assets drops we are a long way of reaching that degree of rationality. Offshore will remain a highly contestable market and therefore subject to low profitability.

The rig market will feel any upswing first and clearly the ‘animal spirits’ have returned. I offer no judgement, if the shareholders want this they are the ones taking the risk, and it could pay-off spectacularly. But it points to one of what I believe to be the secular changes in the offshore market: who pays for time? Specifically idle time? The Ocean Rig/DNB data below make clear the risk and cost sit with the asset owners.

Floating Rigs Awarded.png

Offshore used to work because relatively small companies took huge relative financial risks on assets because the market was so strong they got the day rates and utilisation to cover these risks. But even in the boom years many assets only broke-even in a economic sense between day 270-300 calendaer days. More than 330 were golden years and less than 280 a worry.

Now the E&P companies don’t have to take this risk and they aren’t. Yet the offshore industry isn’t getting the day rates to cover for this idle time and it’s a material number. It is in fact the most important economic number for most owners because the profit rates on a day worked are well below the cost of one idle day (and that is regardless of asset class).

Solstad Farstad announced a couple of PSV deals at 4 months firm plus 4 months options. Working a vessel for four months year, making it avilable for another four where you can’t market it (another free call option), and maybe getting some work for another 4, is a very risky business model. For that to be sustainable the four working months would have to be at an extraordinary day rate, which currently of course they are not.

I think this is a sign of structurally lower profits in the industry for some considerable time. I also think the options market is where the first signals of long-term confidence may be seen. If Aker BP was really worried about rates increasing in 2 years time, and Odfjell was seeing the same thing, they could agree a cost for those options (that would also probably make the bank happy). Until you see such deals it’s all just talk.

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