Anecdote is not the singular of data…

“As regards the scope of political economy, no question is more important, or in a way more difficult, than its true relation to practical problems. Does it treat of the actual or of the ideal? Is it a positive science concerned exclusively with the investigation of uniformities, or is it an art having for its object the determination of practical rules of action?”

John Neville Keynes, 1890, Chapter 2

Music journalists know a lot about music… if you want some good summer listening I would advise taking them seriously. However, as a general rule, their knowledge of finance and economics is less sound… ‘Greatest Hits’ have for example included complete confidence that EMAS Chiyoda would be recapitalised right before they went bankrupt… or that the scheme from Nautilus to put ancient DSVs in lay-up wasn’t stark raving mad because the Sapphire couldn’t get work either… I digress…

On a logical basis it is very hard to argue that a majority of companies in an industry can consistently be under margin pressure and and that they will exist indefinitely regardless of cash flow losses. It might make a good album cover but as economic reasoning it leaves a lot to be desired.

Let me be very clear here: if the total number of firms in an industry are operating at below cash break-even only one of three things (or a combination of) are possible:

  1. Some firms exit the industry. Capacity is withdrawn and the margins of the remaining firms rise to breakeven (a supply side correction).
  2. The market recovers or grows (a demand side correction).
  3. An external source injects funds into the loss making companies or they sell assets (a funding correction).

There are no other options. I write this not because I want people to lose their jobs, or because I hate my old company, or because I didn’t like the Back Street Boys as much as the next music journalist in Westhill, I write it because it is an axiomatic law of economics. To write that firms, backed by private equity companies, who have a very high cost of capital, will simply carry on funding these businesses indefinitely is simply delusional.

A deus ex machina event where a central bank provides unlimited liquidity to an industry only happens in the banking sector generally (in the energy space even Thatcher made the banks deliver in general on their BP underwriting commitment). Subsea appears to flushed out the dumb liquidity money, convinced of a quick turnaround, and being turning toward the committed industrial money now.

The real problem for both York and HitecVision, or indeed any private equity investor in  the industry isn’t getting in it’s getting out (as Alchemy are demonstrating). Both have ample funds to deploy if they really believe the market is coming back and this is just a short-term liquidity issue, but who do they sell these companies to eventually? It was very different selling an investment story to the market in 2013 when all the graphs were hockey sticks but now anyone with no long-term backlog (i.e. more than a season) will struggle to get investors (even current ones). The DOF Subsea IPO, even with their long-term Brazil work, failed and the market is (rightly) more sceptical now. Every year the market fails to reover in the snap-back hoped for each incremental funding round gets riskier and theoretically more expensive.

Private equity firms have a range of strategies but they generally involve leverage. Pure equity investment in loss making companies in the hope of building scale or waiting for the market to develop is actually a venture capital strategy. Without the use of leverage the returns need to be very high to cover the cost of funding, and if the market doesn’t grow then this isn’t possible because you need to compete on price to win market share and by definition firms struggle to earn economic profits, yet alone excess profits, that would allow a private equity investor to profit from the equity invested. For private equity investors now each funding round becomes a competition to last longer than someone else until the market recovers. In simple terms without a demand side boom where asset values are bid up significantly above their current levels the funding costs of this strategy become financially irrational.

In this vein HitecVision are trying to exit OMP by turning it into an Ocean Yield copy. The GP/LP structure will be ditched if possible and the investment in the MR tankers shows the strategy of being a specialist subsea/offshore vessel company is dead. Like the contracting companies it isn’t a viable economic model given the vintage year the funds all started.

Bibby Offshore may have backlog but it is losing money at a cash flow level. The backlog (and I use the 2013 definition here where it implies a contractual commitment) it does have beyond this year consists solely of a contract with Fairfield for decom work. This contract is break-even at best and contains extraordinary risks around Waiting-On-Weather and other delivery risks that are pushed onto the delivery contractor. It is a millstone not a selling point.

Aside from the cost base another major issue for Bibby is the Polaris. Polaris will be 20 years old next year and in need of a 4th special survery: only the clinically insane would take that cost and on if they didn’t already own it (i.e. buy the company beforehand). Not only that but at 10 years the vessel is within sight of the end of her working life. Any semi-knowledgeable buyer would value her not as a perpetuity but as a fixed-life annuity with an explicit model period and this has a massive impact on the value of the firm. In simple terms I mean that the vessel within 5-10 years needs to generate enough cash to pay for a replacement asset (to keep company revenues and margins stable) that costs new USD ~165m and for a spot market operator might need to be paid for with a very high equity cheque (say ~$80m). Sure a buyer can capture some of this value, but not much and they don’t need to give this away.

In order to fund her replacement capital value the Polaris needs to bank ~USD 22k per day on top of her earnings. Good luck with that. When I talk about lower secular profits in  the industry and the slow dimishment of the capital base that is it in a microcosm: an expensive specialist asset that will be worked to death, above cash flow breakeven in a good year, with no hope of generating enough value in the current economic regime to pay for a replacement. This is how the capital base of the industry will shrink in many cases, not the quick flash of scrapping, but the slow gradual erosion of economic value.

Ocean Installer also have limited work although it is installation work and firmly grounded in Norway. Like everyone else this is not a management failing but a reflection of market circumstances.

McDermott and OI could not reach a deal on  price previously. MDR realised they could just hire some engineers, get some vessels (and even continue to park them in an obscure Norwegian port if needed by Equinor), and recreate OI very quickly. All OI has worth selling is a Norwegian franchise the rest is fantasy. An ex-growth business with single customer risk and some chartered vessels has a value but nowhere near enough to make a venture capital strategy work in financial terms.

Now at both companies there are some extremely astute financial investors are doing the numbers and they must either send out letters to fund investors requiring a draw down to inject funds into these businesses, explaining why they think it is worth it, and putting their reputations on the line for the performance. It may have been worth a risk in 2016, and 17, but really again in 18? Really? [For those unaware of how PE works the money isn’t raised and put in a bank it is irrevocable undertaking to unconditionally provide the funds when the investment manager demands. Investors in big funds know when the money goes in generally and what it is being used for.] And again in 19? And the more they draw down now the higher the upturn has to be to recover. (In York’s case I think it’s more subtle as the investment exposure seems to have moved from the fund to Mr Dinan personally given the substantial person of interest filings).

But whatever. If they do this all the firms do this forever then they will all continue to lose money barring a significant increase in demand. And we know that this is not possible in the short-term from data supplied to the various regulatory agencies. And for the UK sector we know production starts to decline in two years (see graph). So in the UK two years just to keep the same available spend in the region the price of oil will have to go up or E&P companies will have to spend more proportionately on the service companies. This is not a structurally attractive market beset as it is with overcapacity.

Aside from the major tier 1 companies are a host of smaller companies like DOF Subsea, Maersk, Bourbon, and Swire, long on vessels and project teams, and with a rational comnmitment and ability to keep in the market until some smaller players leave. I repeat: this is a commitment issue and the companies with the highest cost of capital and the smallest balance sheets and reources will lose. These companies don’t need to win the tie-backs etc. that OI (and Bibby) are really aiming for: they just need to take enough small projects to ensure that the cost base OI and Bibby have to maintain for trying to get larger projects is uneconomic and expensive in short-term cash costs. It is a much lower bar to aim for but an achievable one.

So the private equity funded companies are left with option 3 as are the industrial companies. The problem is that the industrial companies have a Weighted Average Cost of Capital of ~8-15% and private equity companies who like to make a 2.5x money multiple have about a 25-30% (including portfolio losses) The magic of discounting means the nominal variance over time is considerably larger.

And for both OI and Bibby the fact is they face a very different market from when they started. Both companies went long on specialised tonnage when there was a shortage, taking real financial and operational risk, and growing in a growing market. That market looks likely never to return and the exit route for their private equity backers therefore becomes trying to convince other investors that they need to go long on specialist assets that operate in the spot the market with little visibility and backlog beyonnd the next six months. As someone who tried raising capital for one of these companies in downturns and booms I can tell you that is a very hard task.

So if you want some easy listening summer music I suggest you take advice from a music journalist. On the other hand if you want a serious strategic and financial plan that reflects the market please contact me.

6 thoughts on “Anecdote is not the singular of data…

  1. “if you want a serious strategic and financial plan that reflects the market please contact me”

    You’ve preached the end of the world for 2nd tier contractors, and now you’re offering them your services..? I know a man who tried that some time ago.

    Liked by 1 person

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s