Ponzi finance and asset values…

When the present phase of the stock market is written, we believe it will be referred to as ‘the era of projected inflation’ … the period when enthusiasm for future profits obscured actual earnings to an excessive degree. We are on the way towards the age of reason of several years ago when stocks had to show substantial earnings power, reasonable book value, and dividend returns comparable to the cost of carry.

Barr, Cohen, and Co, October 21, 1929

Rainbow’s End: The Great Crash of 1929, Maury Klein

The financial instability hypothesis, therefore, is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated…

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell  assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.

Hyman Minsky

Ponzi finance is happening in the rig market. And it is certainly the form of finance that McDermott got from Goldman’s (yielding over 14% today and essentially locking MDR out any future financing). This never ends well.

When this goes wrong it goes really wrong because unlike equity people thought they were getting their money back for 100c in the dollar. Banks in particular. When these rig and asset deals go wrong, and the banks shut down the loans books, and indeed contract the asset side of the balance sheet to compensate for the lost equity, things will really get tough in the financing market and force restructurings and supply side contraction.

A very small number of companies have been buying “assets” at inflated prices, cheered on by self-serving analysts, at rates that bear no relationship to their ability to generate cash. Some banks appear to be  lending against these nominal asset values when the underlying entities do not have suffient order book, yet alone cash flow, to pay them back. This is the classic dying throws of a credit boom and we know how this script ends. When someone asks you how do these moments of clear financial irrationality occur you are looking at one. No one wants to admit the madness or remove the punch-bowl.

Charle’s Ponzi’s original idea was actually legal and profitable… just not at the scale he wanted:

Ponzi emigrated to the United Sates in November 1903 moving from city to city working different jobs and serving prison sentences at least twice before settling into Boston in 1917. Employed as a typist and answering foreign mail, in August 1919 Ponzi discovered his path to the wealth he had always envisioned for himself. He was going to trade in postal reply coupons. What Ponzi identified was a flaw in the coupon system that he could use to his advantage. He realized the value of the International Reply Coupon (IRC) had been set at fixed exchange rates that had not changed since 1919, creating a market in which he could parlay the IRCs into profit if he exchanged coupons from countries with deflated valuations into the higher valued US dollars ostensibly buying low and selling high.

The flaw in Ponzi’s coupon scheme was that he probably could have earned a 400 percent profit on individual coupon redemptions but in absolute terms, the net would be infinitesimal. To amass the millions of dollars Ponzi alleged, an enormous amount of coupons would have to be traded. Two important reports were about to emerge that would ultimately lead to panic and a run on Securities Exchange Company. First, after examining Ponzi’s operation, financial analyst Clarence Barron reported that to be making the money that he was, 160,000,000 IRCs would have to be in circulation when, in fact, only about 27,000 were. Second, the United States Post Office announced that IRCs were not being purchased in large lots (Zukoff, 2006). Therefore, Ponzi could not hold the millions dollars of liquid assets he claimed. Charles Ponzi was arrested on August 12, 1920.

 

The same could almost be argued for the rig and asset deals going on… If you could sell these assets for 520 days a year at twice the market rate you could make a fortune. It’s the execution of this that is causing problems not the math…

But when loans are made, or rolled-over, to companies with no hope of paying them back eventually things stop. You can feel the credit noose tightening in the market now and the equity market is closed no matter how good the summer season. Expect the effects throughout the market to get progressively worse. 

I made this note today to remind me when I look back that some of the credit deals being announced for rig companies are literally insane. People who should know better who are simply not prepared to accept their original thesis of a recovery in rig market was correct and continue, again all the evidence to the contrary, to do anything other than continue to go long on something that cannot be true. Credit committee’s becoming equity investors by accepting that markets have to change before they can be paid back for a few hundred basis points above LIBOR. Nuts.

McKinsey came out with this recently for those who want a dose of big data rationality:

As non-national-oil-company operators shift focus to deepwater fields because of increasing break-even costs of shallow-water fields, jack-up demand should grow 1 percent per year through 2035. Following this trend, utilization will recover to above 80 percent by 2023, driven by a large number of retirements and continued deferment of the order book. The chronic jack-up oversupply appears set to end, as extensive retirements of older and lower-spec rigs in the near future are expected to lead to a 9 percent decline in the overall jack-up fleet by 2035.

Over the course of 2019, floating-rig demand will drop slightly because of unstable oil prices, but growth—to the tune of 6 percent per annum between 2019 and 2027, then 2 percent per annum until 2035—is expected to follow. Key growth regions will be Africa, Brazil, and the Gulf of Mexico. We anticipate that supply will remain relatively stable through 2026, leading utilization to recover to 80 percent by 2026 and long-term floater-supply growth to reach about 13 percent by 2035. [Emphasis added].

Most rig companies will be bankrupt long before those recovery times at current day rates.

When all these guys stop running around congratulating themselves for buying rigs at 70% of their build cost, when day rates have gone down by 50% and utilisation the same, and actually have to pay for them, chaos is going to ensue in the financing market. The start of which is clearly visible now.

Presenting the results, Van Eden gave a plain spoken account of how Anglo had come to rack up such losses. ‘There was no substance behind the borrowers,’ he said. ‘They had nothing but the collateral (property assets) they were providing. There was no equity in the system. They took all the equity out of deals and replenished it in new deals. It was one big leveraged play. It was one big Ponzi scheme’.

Anglo Republic: Inside the Bank that Broke Ireland, Simon Carswell

[This blog is largely becoming a storage post for what I hope will be a PhD in economic history that argues the offshore boom was largely the conjunction of a commodity boom but also, and importantly, a credit boom combined with structural industry change. The consequences a credit boom are well understood for asset heavy industry backed by high debt and it is not a comforting picture for anyone long in assets at the moment.]

Bully for Brontosaurus…

“I am truly convinced that both the shipping and the offshore markets will recover.”

Mads Syversen, CEO Arctic Securities (26 Jan 2016)

Arctic and ABG Merger valuation.png

From the Solstad Farstad merger prospectus (9 May 2017) highglighting the extreme optimism of the investment bankers putting the deal together. It should be noted the asset market was under huge stress at the time (the bankers of course were paid in cash on completion).

The Golden Bough

In point of fact magicians appear to have often developed into chiefs and kings.

 James George Frazer, “The Golden Bough” (1890)

The Emporer

Courtier T.L. — Amid all the people starving, missionaries and nurses clamoring, students rioting, and police cracking heads, His Serene Majesty went to Eritrea, where he was received by his grandson, Fleet Commander Eskinder Desta, with whom he intended to make an official cruise on the flagship Ethiopia. They could only manage to start one engine, however, and the cruise had to be called off. His Highness then moved to the French ship Protet, where he was received on board by Hiele, the well-known admiral from Marseille. The next day, in the port of Massawa, His Most Ineffable Highness raised himself for the occasion to the rank of Grand Admiral of the Imperial Fleet, and made seven cadets officers, thereby increasing our naval power. Also he summoned the wretched notables from the north who had been accused by the missionaries and nurses of speculation and stealing from the starving, and he conferred high distinctions on them to prove that they were innocent and to curb the foreign gossip and slander.

 Ryszard Kapuscinski, “The Emperor” (1978)

Mons Aase, DOF Subsea CEO, said: “The appointment of Mr. Riise is an important step towards realizing our vision of being a world-class integrated offshore company, delivering marine services and subsea solutions responsibly, balancing risk and opportunity in a sustainable way, together, every day. I look forward to working closely with our new CCO and I welcome Steinar to DOF Subsea.” (15 October, 2018)

“Our business will probably die over the next 10 yrs because the demand for oil probably will start peaking – we think in 2028-2029.”

Ian Taylor, Vittol Chairman, June 8, 2019

“If you get lucky for a long period of time, you think the rules don’t apply to you… These guys thought they could walk on water. They weren’t smart, they were lucky”.

Maarten Van Eden, Anglo Irish Bank CFO, in Anglo Republic: The Bank that Broke Ireland

(Anglo Irish bank initially assessed its downside losses in the credit crunch at less than €2bn. Over €45bn later they had nearly bankrupted the Irish state by lending on illiquid property assets reliant on a booming Irish economy and a global credit boom).

 

Have a look at the graph in the header, particularly 2016/17, and then the Solstad liabilities for 2016/17, just as they were “buying” Farstad and DeepSea Supply:

Solstad liabilities 2016_17.png

(I saying “buying” because it was then second major rescue attempt after Aker made a spectacular error in timing with REM. It was a deal pushed by the bankers who didn’t want to deal with consequences of Farstad and Deepsea Supply).

That would be just the time the rig count in the Permain was to explode:

BH rig count June 2019.jpg

And here are the latest Solstad Q1 2019 liability figues:

Solstad Q1 2019 Liabilities.png

Roughly NOK 2bn higher! The assets are older, the market isn’t much better, and they owe NOK 2bn more! (Don’t get me started on look at the assets side of the balance sheet: it was well known the Farstad/DESS were worth significantly less than book value).

If you believed Solstad had a future in anything like its current form you would be asked to believe the impossible: that despite the most extraordinary structural shift the oil and gas industry, despite owning depreciating assets barely covering actual running costs, despite no indication of oversupply ending (and in fact every indication that funding a mutually assured destructive battle will continue with NAO planning to raise money), you would be asked to believe Solstad could actually pay that money back… And of course they can’t: the numbers on paper, the amounts the banks and creditors claim they are due, are indeed a fantasy. A wish, with no basis in economic substance despite their accounting clarity.

Solstad made an operating profit of NOK 162 918 000 in Q1 2019 on NOK 33bn of balance sheet and asset risk. If someone had lost the petty cash tin they would have been in a loss. It’s totally unsustainable.

It may have been reasonable to believe that NOK 30bn of debt could be supported by offshore demand when the US graph was at 2014 levels but it is no longer credible now. Too much of the investment and maintenance expenditure flowing through the global energy industry is just going to other places. This is a structural shift in the industry not a temporary drop in demand like 2009.

I am not picking on Solstad here, they are just the most obvious example as their resolution seems (reasonably) imminent. Without exception all these crazy asset play deals that relied on the market coming back will fail.

When I was at university I first read the palaeontologist Stephen J Gould who introduced me to the difference between Lamarckian and Darwinian evolution (Bully for Brontasaurus). If you can’t bothered clicking through to the links the easiest way to think about this (in a purely demonstrative example) is that Lamarckian evolution argues that giraffes evolved by gradually growing longer necks and reaching for higher leaves on trees that others couldn’t reach – which is wrong. One of the many brilliant things about Darwin was that he realised that it was the randomness in evolution that caused the process – giraffes that just happened to have the long neck gene prospered and had more baby giraffes and passed the gene on. The race of giraffes that prospered was the result of random selection that ended up adapting best to their environment. They got lucky not smart.

Offshore is full of companies that may have been lucky on the way up but are totally inappropriate financial and operational structures to survive in the modern energy era. Evolution is a brutal, mechanical, and forward acting process. It is irreversible and path dependent. In economics the randomness of the evolutionary process is well understood with most research showing industry effects are stronger than firm effects. By dint of randomness the genes of many of the asset heavy offshore companies companies, but especially those with debt held constant at 2015/16 levels, are fundamentally unsuited to their new environment.

In case you are wondering where I am going with this (and want to stop reading now) I have two points:

  • A lot of the offshore supply chain confused managerial brilliance on the ride up to 2014 with good luck, a high oil price, and a credit bubble. Seemingly being lucky enough to have been running small fishing vessels when North Sea oil was found was rarely posited as an explanation for the growth of many West Coast Norwegian offshore firms, but it is in reality true. A random act of economic circumstance that threw them into a rising commodity and credit bubble. A newer, far less wealthy, future beckons for many of the small coastal towns that supported this boom.
  • The randomness of US geology colliding with the most efficient capital markets in the world, the largest energy consuming nation, and technological circumstance has caused a complete change in the structure in the underlying oil market. The profound implication for North Sea producers, and the supply chain underpinning them, is a transition to be an ever more marginal part of the global supply chain. That will mean less dollars in flow to them and that however long companies try to fight this will be in vain because we are dealing with a profound structural change not a temporary reduction in demand.

What the offshore industry is faced with now is a fundamental regime change – in its broadest sense both statistically (which I have argued before) and sociologically. The economic models of debt fuelled boats and rigs with smaller contractors are over in principal. It’s just the messy and awkward stage of getting to the other side that beckons now.

For pure SURF contracting and drilling consolidation is the answer and will occur. Financial markets will squeeze all but the largest companies from taking asset risk. DOF Subsea’s business model of buying ships Technip wasn’t sure about long-term will look like the short term aberration to economic rationality it was. For offshore supply the industry will be structurally less profitable forever. Asia shows the future of offshore is a vast array of smaller contractors, operating on minimal margin and taking vast risks, and yet the E&P companies are happy with this outcome because they get competitive prices. There is no reason to believe this model will not work in Europe as well. Where procurement is regional there are no advantages to being a global operator as the unit onshore costs are such a small proportion of the offshore/asset costs.

Although it feels unique to many in offshore it isn’t. If you only read one book about a collapse of ancien regime make sure it is Ryszard Kapuscinski’s “The Emperor” (1978)  on the collapsing Ethiopian empire. By interviewing a large number of the courtiers Kapuscinski gets you into the collective mind of an institution unable to face the reality of circumstance. The inability of Haile Selassie to realise that his random luck was totally unsuited to adaptation in the modern world is deeply reminiscent of the management in offshore, and to a certain extent the banks behind it (I’ll write more on the Stiglitz- Grossman paradox which answers why this may occur later).

Slowly the power and the capital of marginal oil production is being shifted to the Lower 48. Make no mistake the replacement of low capital cost Super Majors for high cost of capital (often PE backed) E&P companies in the North Sea marks the slow withdrawal of capital long-term from the area. Note not removal: just slower investment, higher cost hurdles, more pressure on cost etc. That will require a structurally smaller supply chain.

Old capital structures, and especially debt obligations, written in the good times will be completely re-written. Over the next couple of years the Nordic banks are going to write off billions dollars (that isn’t a misprint) as the hope thesis of recovery loses credibility. They will shut down credit to all but the most worth borrowers and sellable assets (if you think that is happening now you aren’t watching the crazy deals going on in the rig market). Equity across the industry will rise and leverage will substantially decline.  Smaller operators will vanish driven the same process reducing biodiversity on earth now: a less munificent environment. I believe when these banks have to start really taking write-offs, and Solstad and DOF are important here because they are close in time and significant in value, bank loan books will in effect close for all but the largest companies. In the rig market where are few companies have been responsible for nearly all the deals and private bubble has built up in the assets this will be contrasted with a nuclear winter of credit. And if banks aren’t lending then asset values fall dramatically.

How much is the Skandi Nitteroi really worth? There is no spot market for PLSVs, Petrobras have no tenders for flexlay? No one else capable using it needs one and Seadras are getting theirs redelivered? Banks are going to take the hit here and then the industry will really feel it.

I am reading Anglo Republic, a book about the collapse of Anglo Irish Bank, at the moment. Again the inability of management (and Treasury, and the goverment) to see the scale of the losses has a strong parallel with offshore. And like offshore initially everyone believed the Irish propery market would come back, that liquidity not solvency was the problem, that this was temporary blip. The crisis was a slow burner for this reason. But when it really came, just like all asset heavy industries, it starts with the refusal of credit institutions to renew liquidity lines because they know it’s a solvency problem. And that is why Solstad and and DOF are significant. They are the BNP Paribas of the next phase. But you know what… my next book is this, and it will have the same story of excessive optimism, leverage, an event (literally a revolution in this case), and default. If there are only really seven major plots in literature there is surely smaller set in economic history? So we know what is coming here.

This needs to happen in an economic sense. The cost to produce offshore will have to rise to reflect the enormous risk the supply chain take in supplying these hugely unique assets on a contract basis. But for this to happen there needs to be a major reduction in supply and it needs to happen while competing against shale for E&P production share. And it cannot happen while the industry continues to attract liquidity from those who buy assets solely on the basis of their perceived discount to 2016 asset values in the hope of a ‘recovery’ to previous profitability levels.

Which brings us on to what will happen to Solstad? It is in the interests of both the major equity investors (Aker/ Fredrikson) and the banks to play for time here. I fully expect a postponement of the 20 June deadline. Next summer, the bankers will tell themselves, the rates will be high and we will be fine (just like the Irish bankers and countless others before). But some of the smaller syndicate banks clearly get the picture here, the business is effectively trading while insolvent, regulators will also eventually lose patience, and the passage of time will not be kind. The solution everyone wants: to put no more money in and get all their money back isn’t going to happen.

Normally in situations like this, where the duration of the assets is long and illiquid, like a failed bank, a ‘bad bank’ and a ‘good bank’ are created. One runs down (as DVB Bank is doing with offshore) and the good one trades and is sold (as DVB Bank have done with aircraft finance). That would see the Solstad of old split off into a CSV fleet maybe or a Solstad North Sea while the old Asian/Brazil DESS was liquidated and the Farstad AHTS business also liquidated. But that will require the banks writing off c. NOK 20bn (maybe more) and I don’t think they are there yet.

After Solstad comes DOF. And in all likelihood following them will be some smaller tier 2 contractors, and certainly some rig companies, who realize that in an economic sense this just cannot continue. No matter how hard they keep reaching for the greener leaves higher up.

Deflation, Shell, and Bourbon…

Shell gave a strategy update this week (the graphic above is from the presentation). More of the same really if you read this blog: more investment in shale and targeted and steady investment in offshore:

Shell 2025 outlook.png

And you can see the effect that over time Deep Water will be an increasingly smaller (but still important) part of production at Shell:

Shell 2025 Investment Tilt.png

But there is a clear tilt to shale and power. Yes they are spending more but the supply chain aren’t getting it:

Shell cost reduction to 2025.png

Shell Vendor Spend.png

For the offshore supply chain this is a very different world because a large number of the assets were acquired when that 2015 number was sloshing around the industry along with all the other money. Boats and rigs were ordered with 2015 dollars in mind and those days are long gone.

This is an age of deflation. Oil companies can, and have, sustainably changed the cost of production and met long-term demand expectations. The last offshore asset price bubble required both a demand boom and a credit boom. The demand boom has clearly gone and instead of the credit boom were are starting to see a credit contraction in a meaningful sense.

Slowly banks are realising that when the industry declines this much they don’t own and asset (loan), all they really own is a claim to the economic value an asset can produce. For all offshore assets that is much lower now than it was in 2015, and therefore those assets are not going to pay back anything like all the money they owe in an accounting sense. Slowly some banks stop rolling over credit, as has happened with DOF and Solstad among other firms, and the liquidity really starts to dry up.

The smaller banks are trying to force the larger banks to buy them out of these positions. This is clearly what is happening at DOF and Solstad. The larger banks in these deals will have to double down or accept large write-offs. In addition the number of hedge funds and other who have lost money on asset recovery plays is now so large that selling these deals is all but impossible (see Seadrill). Easy to get into but very hard to get out.

Bourbon creditors appear to have realised this.  A restructuring proposal has been sent to the Board for consideration. In reality the default is so large the creditors own the company. The creditors will write down billions of debt, Bourbon will reappear as a new financial entity, looking operationally a lot like the old, but like everyone else in the market believing their assets must be worth at least what they restructured them at. Capacity will be kept high and competition will ensure rates continue at below economic levels. It is a parable of the whole industry at the moment which shows no sign of abatement. Watching with interest DOF and Solstad because the larger Nordic banks stand to lose some real money here and yet the investment required to go on pretending would seem untouchable to any serious investor without write-offs in the billions of NOK from the banks. As offshore supply leads so will the rig companies as the head for their second round of restructurings (who inexplicably still seem to have access to bank financing).

But this is crazy world we live in. Much like the dotcom boom people are going to ask one day how they ever put money into a shipping company that excluded the cost of running a ship from it’s reported numbers:

  1. Positive EBITDA (adj.) of USD 617 thousands, excluding start-up cost, dry dock, special survey and maintenance (Q1 18 USD 400 thousands) from chartering out the 5 large –sized PSV’s. Including the ownership in Northern Supply AS (25.53%) the group netted a positive EBITDA (adj.) excluding start-up cost, dry dock, special survey and maintenance of USD 518 thousands (Q1 18 USD 200 thousands).

This isn’t going to happen quickly. Credit effects take significantly longer to work through than demand side effects. Once these banks have written off loans in a meaningful sense getting them to lend against these assets again will be nearly impossible.

And yet the cost pressure will continue:

Shell Cost pressure.png

The Emporers New Clothes… Seadrill Redux…

As a quick update to my last post on Seadrill (in which I was making a semi-serious point). I had a quick flick through the Seadrill 6k so you don’t have to… But first a little background… this post I wrote in April last year “Seadrill restructuring… secular or cyclical industry change?” seems to have aged well. In particular I noted:

[According to their restructuring plan in] 2019 Seadrill needs to grow revenue 65% to lose $415m of cash after turning over $2bn. In 2020 Seadrill then needs to grow 40% again, and only then do they generate $25m after meeting all their obligations. A rounding error. A few thousand short on day rates or a few percentage points in utilisation adrift and they will lose some real money.

Have another look at their business plan they had released in April last year:

Seadrill forecast P&L 2018.png

How is that “forecast” on revenue going? Seadrill did $302m in Q1 2019, which if they keep at that level is a rounding error above 2018. But it is more than 30% less where they thought they would be only a year ago. It’s not that long ago to be like $600m (of only $1.9bn) out… just saying… it’s more than a minor forecasting error… (go back and look at my post they were already downgraded and had been based on numbers supplied by a reputable IB with an analyst who currently has a Buy rating on SDRL).

Now just be to clear Seadrill was also forecasting they would generate $721m in EBITDA (a proxy for cash flow and an ability to service their debt). We have now passed the Q1, where they generated $72m, and guided $60m for Q2. So if we annualise that (which is generous as they got an unexpected $12m in Q1) they are on target for (max) $250m; around 1/3 of what they thought.

The $7.2bn of debt remains of course and was the (only?) accurate part of the forecast. Immovable and a testament to the willingness of humans to believe something that cannot possibly be true.

The numbers are clearly a disaster. The business plan above is a fantasy and Seadrill is heading for Chapter 22. Relatively quickly.

If you’re interested here’s how bad it is:

Seadrill actually did less revenue last quarter than the one the year before:

Seadrill Revenues Q1 2019.png

But had the same number of rigs working:

SDRL rigs working Q1 2019.png

And therefore the obvious… day rates have dropped…

SDRL Day Rates Q1 2019.png

And that is your microcosm for the whole industry offshore and subsea. Excess capacity means that even if you can find new work it is at lower rates.

Also, and I keep banging on about this, what are they going to do when Petrobras starts handing back the PLSVs this year? DOF’s are in lay-up, and there is no spot market for PLSVs. The equity in that JV is likely zero. Even if Petrobras does start re-tendering for PLSVs (unlikely given the drop in the number of floaters working) all that beckons is a price war with DOF to get them working. Anything above running costs will be a victory if the vessel market is a guide.

It goes without saying that in a price deflationary environment it is only a question of how long the banks can pretend they will be made whole here. SDRL isn’t going to get to $1.9bn in revenue this year and it certainly isn’t getting to $2.6bn the year after unless they change their reporting figures to the Argentinian Peso.

When I have more time I will explain my point on this more… but in the meantime be reassured the 23% drop the other day was  not an anomoly. The real question is why it took so long (and yes I do have a theory:). The investment bankers dream of someone buying Seadrill almost as much as Seadrill’s lending banks, but I find it highly unlikely (but not impossible) someone will make good $7bn in debt, and putting to stones together doesn’t mean they will float.

But the core point is that this is part of a deep structural change in the oil production market where offshore is not the marginal producer of choice any more. Previously that meant short-term oil price effects had a large (extremely pro-cyclical) effects on an industry with a very long-run supply curve, and this was combined with a credit bubble between 2009-2014. If my theory is right, and it has held up well for the past few years, then the much predicted,  but never appearing, demand-side boom will remain the Unicorn it has been for the past few years: a chimera that only appears in investment bank and shipbroker slide-decks.

That marginal producer is the now that shale industry a point Spencer Dale made a very long time ago now:

An important consequence of these characteristics is that the short-run responsiveness of shale oil to price changes will be far greater than that for conventional oil. As prices fall, investment and drilling activity will decline and production will soon follow. But as prices recover, investment and production can be increased relatively quickly. The US shale revolution has, in effect, introduced a kink in the (short-run) oil supply curve, which should act to dampen price volatility. As prices fall, the supply of shale oil will decline, mitigating the fall in oil prices. Likewise, as prices recover, shale oil will increase, limiting any spike in oil prices. Shale oil acts as a form of shock absorber for the global oil market.

Ignoring this fact lets you produce a “Key Financials” slide that bears no obvious relationship to how the market is really going to evolve. There is a lot of pain to come for the offshore industry as the need for banks to make painful writeoffs starts to permeate through the system and finally even more painfully capacity will be permanently removed from the market. This is an industry that needs significantly less capital and capacity to generate economic profits. And as I say: this is the recovery.

A bank run in offshore…

DOF shares dropped 33% yesterday as the market woke up to the painfully obvious fact that it need a major financial restructuring. In breach of loan agreements at least one bank appears to be accepting reality.

I have said here before, indeed it was the basis of my EMAS predecitions, that you need to think of offshore operators as funding themselves like a bank: they borrow short and lend long. They take mismatched duration risk, or maturity transformation in the vernacular. Offshore operators “borrow” short-term in the contracting market with contracts that are far shorter than the assets they need to fulfill the contracts, and then they use this facility to invest in assets of a longer duration that cannot be redeemed early if the short-end of the market changes. In construction they are a confidence play that requires the customer to believe they will be solvent and deliver the contract next year. With these numbers DOF can’t promise that.

DOF is in short experiencing a bank run. This little paragraph highlights that going into the summer some banks are losing patience (waking up to?) [with] rolling over loans they know will not be paid back at an economic rate and have had enough:

DOF banks 2019.png

DOF has breached the covenants in its loan agreements and the equity is now worth nothing. Another restructuring begins.

Just like in the financial crisis the liquidity crisis starts between financial institutions refusing to roll-over obligations. The summer is coming and some banks have seen that day rates and utilisation levels are not occurring at an economic rate and the internal risk police (and financial regulators) appear to have called time.

My own view is that Solstad and DOF cannot survive. Certainly there is the possibility that someone like DNB Bank back a ‘national champion’ and commbines them (and that will surely be DOF). Or maybe Solstad is allowed to die? But the market isn’t big enough for both now and the industrial logic of having two major Norwegian OSV operators slowly draining cash waiting for the never appearing recovery has moved from the tenuous to the non-existent. It might seem like a big deal in the industry but in economic terms it’s two over leveraged micro caps going out off business at the end of a commodity boom. Move on.

The folly of the offshore strategy of going long on specialised assets with a contract life significantly shorter than their economic value is now painfully obvious; the Skandi Vittoria and Skandi Nitteroi were purpose built in 2010/2011 and were redelivered in 2018 and are now in lay-up. There is no spot market for PLSVs as everyone knows and so DOF either goes really long on flexlay contracting capacity (which I doubt Technip will accept) by building up a really expensive engineering team that will takes years to win work that has a long lead time (and therefore required vast sums of working capital) … or … Or what?

No one needs those vessels. Ever. There used to be 80 floaters driving flexlay demand in Brazil and now there are less than 20. Subsea 7 skipped a bargain and went for the new build Vega and everyone else has excess flexlay capacity. The value of having a short-put on a specialised asset has been gained by Petrobras at the expense of DOF shareholders and creditors.

Those two relatively new vessels are actually worthless at much beyond conversion value but probably have a book value of over $100m. For Seadrill (through Seabras), Subsea 7, and Technip the reality of what lies ahead when their contracts finish is all to obvious.

The only thing that isn’t like a bank run is the customers are staying (at the moment). But that’s because they are getting supplied long duration assets well below their economic cost aided by real banks that would rather push the day of reckoning out than realise real losses now. For Solstad and DOF to be viable economic entities senior (and junior) creditors will have to write-off billions of NOK.

No wonder the banks are reducing their loan books and expsoure to the sector. And if no one lends then asset values drop (one of the major flaws in the Standard Drilling business model for another day).  How exactly you seperate a liquidity crisis from a solvency crises becomes a moot point, but we are about to see more than one practical example.

 

When group think and economic incentives collide …

I’m never sure with this whether it’s a collective case of Norwegian thinking that refuses to accept the scale of the change taking place in the offshore industry or simply the desire to try and get investment banking fees? Maybe a little of both.

Either way it’s clear the market has realised Seadrill is headed for restructuring way before the analyst community…

Seadrill yesterday:

Down 23%. Analysts yesterday morning:

Look at the price targets! And it’s not like anyone didn’t see it coming (Seadrill over 6 months):

There is a liquidity squeeze coming in offshore as all these crazy asset play deals, that were nothing more than momentum trades, have no momentum. The fact is Seadrill is performing miles behind the restructuring plan of only a few months again. Yet again the promised summer hasn’t come and financial markets know it.

More evidence this is the offshore “recovery”…

I was going to write this anyway today and then looked at the oil price as I was leaving work… down 2.7% at the time of pixel… The graph above comes from the Dallas Fed blog which makes this salient point and helps explain why:

Given current market prices, U.S. shale production will continue growing this year. Indeed, a recent report by the International Energy Agency highlighted that shale production is likely to be a major driver over the next five years. This does not rule out the possibility of major oil price movements, but it does point to a strong tendency that oil prices will be range bound in the near future.

Read the whole thing. Shale has structurally changed the oil industry and fundamentally changed any realistic scenarios for an “offshore recovery”.

Contrast that with the investment boom in shale: If you want to see how the whole ecosystem of companies and innovation are working in a harmony to make US shale more efficient, deepen the capital base, and thereby work in a virtuous circle then this article from the Houston Chronicle that showcases a GEBH project to turn flared gas into power in the region is a great anecdote:

Baker Hughes is using the Permian Basin in West Texas to debut a fleet of new turbines that use excess natural gas from a drilling site to power hydraulic fracturing equipment — reducing flaring, carbon dioxide emissions, people and equipment in remote locations…

Baker Hughes estimates 500 hydraulic fracturing fleets are deployed in shale basins across the United States and Canada. Most of them are powered by trailer-mounted diesel engines. Each fleet consumes more than 7 million gallons of diesel per year, emits an average of 70,000 metric tons of carbon dioxide and require 700,000 tanker truck loads of diesel supplied to remote sites, according to Baker Hughes.

“Electric frack enables the switch from diesel-driven to electrical-driven pumps powered by modular gas turbine generating units,” Simonelli said. “This alleviates several limiting factors for the operator and the pressure pumping company such as diesel truck logistics, excess gas handling, carbon emissions and the reliability of the pressure pumping operation.”

More capital, greater efficiency, and capital deepening. It is a virtuous circle that increases productivity and economic returns and is the signal for firms to invest more. It is a completely different investment dynamic to the one driving offshore projects at the moment.

Shale productivity.png

The above graph from the IEA makess a point I have made any times here: there is no real cost pressure in shale beyond labour (which will drop in the long run). Shale is all about productivity and cost improvement driven by mass production, something the US economy has as an almost intrinsic quality. The cost improvements in offshore are solely the result of over-capitalised assets earning less than their economic rate of return (i.e. oversupply) and is clearly not sustainable in the long run.

That is why firms with a low cost of capital are vacating fields like the North Sea to firms with a higher cost of capital: one requires steady investment and scale, the other investment is a punt on a shortage and price inflation. [A post for another day will be on how on earth some of these larger investors actually get out of the North Sea.]

This IEA data also tells you why this is the offshore reocvery:

IEA 2019 investment mix.png

The IEA is also forecasting overall spending to increase just 6%. So offshore just isn’t getting investment at the margin that will drive fleet utilisation and expansion. In company accounts this is showing up as depreciation significantly outpacing investment and is a constant across the industry. The economics of offshore are such that profitability is dictated by marginal demand (i.e. that one extra day of utilisation at a higher rate) and this graph shows the industry built a fleet for a far higher level and the only realistic prospect here is for structurally lower profitability. Given the high capital costs of the assets this is going to take a long time for the oversupply to work out.

For manufacturers (i.e. subsea trees) the recession is generally over, although not for Weatherford, but if it floats nothing but a wall of oversupply and below economic pricing and therefore sub economic returns is the logical consequence of this industry structure and market dynamic.

The hope of a massive demand boom kept banks from foreclosing and led hedge funds and other alternative capital providers putting money into assets that were (and are) losing cash but seen as “valuable” in the future. Slowly it is becoming apparent there is no credible path to anything other than liquidation for many companies still in business.

Rates will slowly rise, and so will utilisation levels, but only to economic levels i.e. covering their cost of capital in a perfectly competitive market. Absent a demand boom liquidity slowly, and then quickly, vanishes. And that is finally starting to happen now. For example the McDermott 10.25% 2024 bonds, already very expensive, were trading at well below par today implying a 13.5% yield, in effect locking them out of the unsecured credit market completely (and in reality all credit markets). A restructuring beckons. MDR will not be the only one by any stretch. Many rig companies will do a Chap 22 and a wave of supply companies in Europe and Asia are uneconomic and simply cannot survive under realistic financial assumptions.

Slowly the overcapacity in the industry will work its way out to more economically sustainable day rates with higher utilisation levels in a smaller global offshore rig and vessel fleet. But it won’t be a return to 2013, it will be a return to a far lower profitability level despite the smaller fleet, higher prices, and less time and utilisation risk taken smaller companies. There will be a complete wipe-out, almost without exception, of investors who backed offshore “recovery” theses of asset backed companies and an inability of these companies to access funding almost at any price levels. Theories about assets recovering to values implied by book value will be realised for what they are: a fantasy no serious person could believe.

But a far more rational industry and market will emerge. The only thing that could change the dynamic outlined above is a massive demand boom, and the graphs above show you why that isn’t going to happen.

IEA global upstream investment 2019.png