Bibby bond restructuring…

Photo: The Bibby Topaz idle in Aberdeen Harbour yesterday.

The Bibby restructuring is a big deal. In 2003 Bibby purchased the Aquamarine and on the back of an offshore oil boom attempted to build an international EPIC contractor. One of the major themes of this blog is excessive leverage and as I have consistently argued, since around this time last year, the debt load Bibby Offshore was always going to require a financial restructuring. It was obvious at this point last year when they were clearly on course for their £52m operating loss, and it has just got progressively worse this year and frankly they have left it far too long before taking any action.

The proposed Bibby bondholder led restructuring  as I understand it is:

  • Bibby Offshore gets a capital injection of GBP 40m
  • Bondholders take a 50% haircut on the debt and take 50% of the business (presumably this means they subscribe to 50% of the new equity i.e. £20m)

I don’t think this is a starter for a number of reasons but I also think it shows how little, if the rumours are true of a small US/London fund buying in, they actually know what they have brought. But this is surely the opening gambit here that promises to be quite a public conglagration for an organisation that values secrecy for all but the most optimistic news. However, with the next interest payment scheduled for Dec 14 it also promises to move quickly from here.

The key to this is cash. Here is the BOHL cash flow statement from the most recent results (Q2 2017):

BOHL Q2 CF 2017.pngBOHL had sales of £37m over the first six months of the year (a 30% drop on 2016) and it cost them in cash terms £60m to get those sales. That is a totally unsustainable business model. BOHL is on target for less than £80m in sales in 2017, down from £155m in 2016, while at the same time its administration expenses rose by nearly £2m! (I actually had to double check that before I wrote it). They are actually on target to spend a full 20% more in admin this year than last year when their sales were nearly 50% higher (excluding one-offs). Let that sink in. This for a business that lost £52m at operating profit last year, something management and the directors must have been well aware of from at least June 16.

So on the current run rate the bondholder proposal requires that £40m of operating expenditure just to do £80m in sales. Sooner or later businesses like this run into a cash constraint. The cash flow statement above makes clear: the problem isn’t the interest payments (a mere £6.9m), although they don’t help, this is an operational problem not a financial problem. This is not a stable platform on which you can base a recovery story.

I also struggle to see why the bondholders would only want 50% of the business when in a few weeks, when Bibby Offshore defaults on the December interest payment, they will own 100% of the business? The bond is secured on the assets and a share pledge as security: If BOHL cannot make the interest payments the bondholders own the company. I can only think this is some clever ruse to flush out the fact that Bibby Line Group don’t have £20m for their 50%, and even if they did wouldn’t do it as an equity injection because the bondholders would have to paid £87.5m before the equity had any value?

To be clear here is the cash position of Bibby Line Group in their most recent accounts:

BLG Cash 2016

BLG isn’t spending 100% of its available cash to bailout the bondholders here even if they wanted to. And the only previous offering from BLG was an unapproved facility that would have diluted the bondholders security interest (and potentially led to a legal claim for doing so). There is therefore no reason to believe there is any willingness at BLG level to support Bibby Offshore and every financial reason to see they cannot. Bibby Offshore is simply too big for Bibby Line Group to save. I actually partly wonder if this offer isn’t a shot across the bow of management by the bondholders to make sure they don’t use the Barclays facility as outlined (not that I thought Barclays would ever agree to it) as it simply adds more debt to a business that so transparently needs less and delays the inevitable.

I was surprised the auditors signed off the asset values at the last accounts (2016) but there is a problem now for Group because the BOHL assets are 20% of the total Group asset base and DSVs values have fallen percipitously in the last year. I see these asset values as the core problem moving forward because they disconnection between the cash they can earn and the values owners wish them to present is just so large, but the cash required to trade to a time when the owners believe the values will have come back is beyond them to supply.

The proposal as outlined above would actually value Bibby Offshore at £127.5m – 40m equity + 87.5 debt- post restructuring for assets (DSVs and ROVs) that would be worth c. £50m on a very good day on the open market today. That debt load alone is more than 1 x Last Twelve Months Revenue! No one can seriously expect that money to be paid back, and it is backed by a 1999  build and 2003 build DSV that will never get debt against them again, so this is a business that will be effectively equity financed forever. If someone came to you today and said they wanted to raise £130m to buy Sapphire and Polaris and invest it in a business losing £2m per month (pre finance costs) you would think they were nuts, and in investment the rule is to ignore sunk costs.

In order to make those numbers work you would need some heroic assumptions about DSV day rates, currently between £95-130k, in the North Sea to fundamentally have a different view on the value of the asset base, and believe that a start-up US operation can suddenly change course in the face of continued market pressure (despite having the best DSV in the region last year and getting less than four weeks work). Somewhere, in an exceptionally nice office, someone must be starting to wonder at the enormity of what they have brought into. Because with the bonds trading as high as .37 of face value last week institutions have effectively been paying ~.7 for a claim of £87.5 in debt that they also have to fund with £20m for a 50% share of the equity (I am assuming). Or at an average cost of .35 Bibby Offshore was valued at £61.3m (i.e. total debt 35% of 175m) but then you need to put in another 65% /£40m just to keep trading? And that is simply to fund operating losses until the market returns? Its just not serious. There is no meaningful backlog here and it is 100% dependent on the market turning and customers continuing to use a contractor who would be known to be on life support financially.

To suggest that the Polaris and Sapphire could support secured debts more than 2 x their current asset value at the moment is again I think a heroic assumption.

All this points to the fact that someone started building a position in Bibby over the summer before the Q2 results came out, and when they did in September they have started to panic. Bibby Offshore is performing materially worse in financial terms than in 2016 with significantly lower DSV utilisation at significantly lower rates because they are doing more air diving work. The DSV utilisation was 29% in 2017 versus 77% in 2016: a number that must have made bond investors more than a little nervous.

The other big mistake people seem to have made is not to understand that the frothy days of 2013/14 were driven by CAPEX not OPEX and until small scale shallow water construction returns there will be excess capacity in DSVs. There are almost no plans for this work, much of which used to be driven by small-cap E&P companies and their sources of financing are almost completely closed.

This is an absolute mess. Bibby Offshore has waited far too long to start discussions, making the June interest payment was absurd, and it would appear the bondholders are now being asked to put in more money than the assets are worth to keep a company trading with more debt than revenue. Its totally unsustainable. Clearly the EY led accelerated M&A effort has failed, as the equity has no value, and the company is in the process of being handed over to the bondholders, it’s just not everyone realises that yet.

The only viable model for the business would be a debt writedown to c. £30-40m and ~£20m equity injection and all that would be left was a 2 x DSV North Sea operation. The problem with this is it wouldn’t leave you with the right assets, there is no exit strategy for the investors, there is no guarantee the payout would be higher than a liquidation scenario, and it entails significant market risk. It would also appear to be hostile to management who have been increasingly shrill lately about their range of opportunities and have simply ignored economic, market, and finanial reality.

I am not saying a deal won’t be done: London is awash with dumb liquidity at the moment. I suspect someone got into this because they looked at the asset values in BOHL accounts and saw the discrepancy between those and the bond price and simply brought in without realising how inflated the vessel values were. Should this be the case the scale of the mess here is likely causing them to follow a “double-down” scenario that is simply illogical in financial terms, but it seems unlikely the other bondholders won’t request updated valuations before putting new money in and that is when the wheels will start to come off this completely as no shipbroker will issue a certificate to (notoriously litigious) investor groups that isn’t realistic. Sooner or later the grown-ups at credit committee will begin to take charge…

It is worth comparing the USD 15m Nor raised in November last year to support their liquidity for a year. That USD 15m represented what they hoped was 10-15% of the final asset value. Assuming the £40m is correct (and at less than 2017 annualised cash burn it must be a good approximation) Bibby is looking for 100% of the DSV value (on a good day) and still have another £87.5m owing?! Really? This can’t be serious.

I repeat my call that if Bibby Line Group wanted to be consistent to the values it espouses that it should guarantee all non-Director staff their contractual notice period. Such a meaningful gesture would be well received by those approaching the Christmas period with such massive uncertainty.

Bibby Line Group unlikely to be riding to the rescue of The Black Knight (sheep)…

With apologies to Monty Python fans.

Black knight.jpg

The FT today had a great story last week about how hard the convenience store industry is:

The pressure on British corner shops has been highlighted by store chain Nisa, which revealed sales growth lagging the broader grocery market. The wholesaler on Friday reported that like-for-like sales increased 0.8 per cent in the six months to October 1, lower than the rate of inflation and the sector as a whole. However, overall revenues grew faster as it attracted new store owners. Kantar Worldpanel has reported that supermarket sales jumped 3.6 per cent in the 12 weeks to September 10.

This coincided with Bibby Line Group getting an extension to publishing their 2016 accounts until 30 Nov 2017. I also noticed that while BOHL has filed its 2016 accounts Bibby Offshore Limited (the UK business) hasn’t, a move I struggle to see as an oversight. Bibby Line Group is of course significantly exposed to the convenience store industry through it’s ownership of Costcutter and it is simply impossible to believe they have traded better than the market on average.

I understand that Bibby Line Group is set to report a substantial loss for the 2016 year and clearly the Bibby Offshore situation is related to their late filing of accounts.  A quick recap of Bibby Line Group’s 2015 KPI’s highlights why their support for Bibby Offshore has been verbal rather than financial:

BLG KPIs.png

Source: BLG 2015 Annual Accounts

In 2015 BLG managed to generate a mere £9m operating profit from £1.4bn in sales. That is a lot of effort for a rounding error. And that wasn’t a one-off as their graphic makes plain. In case you are wondering how a profit before tax was generated the Group P&L makes clear:

BLG consolidated P&L 2015.png

Basically £40m from asset and company sales. Without that BLG would have recorded an £11m loss before tax. 

I am not going to get into consolidated accounting here but the crucial thing for anyone expecting a rescue of Bibby Offshore from Bibby Line Group needs to see BLGs 2015 cash position and make a realistic assessment if it can be any bigger now than then?BLG Cash 2015

BLG had a mere £12m cash at the end of 2015 and as you can see from the KPIs above the business trajectory was not improving. Frankly it’s barely enough to pay for some expensive lawyers in Bishopsgate to tell you what to do. It is certainly nowhere near enough to buy a serious seat at the creditors table when you have a subsidiary that owes £175m and is burning through extraordinary amounts of cash (even assuming you had the inclination to do so). It is certainly not enough to risk a £10m guarantee to Barclays. 

Back in January BOHL claimed that Barclays were extending the RCF, then in May it became they would have to cash collatoralise this for a smaller amount, and still, 10 months later this facility, the core of the going concern assumption appears not to have been executed. This paragraph from the BOHL June 17 accounts make clear how how conditional this facility is:

BOHL Barclays RCF.png

It is therefore verging on absurd I think to suggest that BLG would then cash collatoralise a Barclays Revolver Credit Facility for c. £8.1m that would allow Bibby Offshore to make the next interest payment in December. This long awaited guarantee (that was reduced from an initial £30m to £8m), which would benefit the equity owners at the expense of the bondholders and would appear to be suspect at least,  appears to have been the only basis for the going concern assumption in the last BOHL accounts. This is a facility that has been in negotiation since January and is still subject to BLG Board approval! Unless BLG has had a cash infusion from somewhere in the ether in 2016 their ability to follow through and approve the Barclays RCF does not appear credible.

It also seems pretty obvious from the BLG accounts that the £20m dividend taken from Bibby Offshore in 2015 was used to pay loan notes and bank facilities owed at the Group level. The key to all this is the investment in subsidiaries:

BLG Investments 2015

Somewhere in that £153.8m is the equity value of Costcutter and Bibby Offshore (and Woodland Burial which bizzarely may be material for 2016). There is an enormous impairment charge coming one suspects, even more enormous if Bibby Offshore is not refinanced soon. The only reasonable assumption for the late filing of the BLG accounts is:

  1. BLG are in a disagreement with the auditor as to the value of BOHL and therefore more time is needed to resolve this
  2. BLG have cannot prepapre the accounts because the values of investments are so uncertain
  3. BLG are trying to hide something until the last possible moment

I have stated before I believe, as does the market given current bond price levels, that the equity value in BOHL is zero. Accounts must reflect all events up to the signing date and if the equity value is zero then BLG looks likely to have to restate its 2016 accounts to reflect this, at the very least it will be a significant post-balance sheet date event that will require disclosure, but the net effect is the same. I don’t know the exact value of the investment in Bibby Offshore but it is surely north of £50m? A writedown of this scale would fundamentally transform the BLG financial position. It would also look extraordinary for BLG to support Bibby Offshore when the entity has no book equity (you could make an argument for option value maybe)? I don’t think BLG ever really believed how bad things were getting at BOHL, and never had any intention of actually having to approve the Barclays facility: BLG thought announcing it would buy them some time and a seat at the creditors table. Now as the denouement approaches the fallacy of this strategy is becoming all too apparent.

Because I have either missed something really obvious, and you should never completely rule that out (I missed Bibby selling the ROVs in Asia and getting USD 7-10m in my August prediction), or you are being asked to believe that (a) high profile hedge fund(s) are paying .28-.36 of the bond, which values Bibby Offshore at c. £55-60m, for a company losing money at operating profit at the rate of 100k per day for assets that you could liquidate for substantially less (the Sapphire and Polaris would be lucky to recover USD 30m in a fire sale and it might cost you USD 5-10m to get that). These assets are held in the BOHL accounts at £78m so if a hedge fund has brought in hoping to sell them for that I suspect someone is getting a much smaller bonus this Christmas than they were hoping for. As a general rule, and I admit I should know, buying assets for 60 and selling them for 30 is not a great investment proposition.

The idea just seems so fantastical to me I really can’t believe anyone would sanction such an investment but I was assured that this was apparently an asset play this morning by a shipbroker! Surely someone running institutional money can’t really believe that a 1999 build DSV and a 2003 build DSV, both well and truely of the previuous generation of DSVS, without ever having the hope of a mortgage again, could really be flipped for a profit in this market (or even the next one if it ever recovers)? If true, when the hedge funds involved realise they have been sold a total pup, and the consultants they employ make them aware of the cash burn rate to even stay at the table, you can expect the end to be brutally quick here. These investors would literally have got involved in an asset play without understanding the assets? But the only other option is to be paying £60m for a company that requires £10-15m more just to trade through to the next summer season, has minimal backlog, and a hugely loss making US office? It’s almost as nonsensical as buying the company for Sapphire and Polaris.

The strategy may make sense for an industrial buyer, who could strip out some of the costs as synergies and take a 15 year view on the assets, but it makes no sense for an investor who has to run the company as a standalone unit and needs an exit strategy.

Yet even more nonsensical still the Bibby Offshore back-up plan is apparently the parent company presented above as a “supportive shareholder”? The only way this shareholder could really appear to support the company would be to move out of the way,

I suspect EY are not just involved with Bibby Offshore, but also BLG, who to be clear are unlikely to have the going concern issue that BOHL clearly does, but may well have covenant and other issues associated with material balance sheet writedowns. The contrast between the Norwegian restructurings, most of which were EBITDA positive, and where the shareholders have contributed substantial new equity, could not be clearer.

The 2016 BLG accounts, published almost in 2018, promise to an interesting read.


[Disclosure of interest: I consult for companies in the subsea and alternative investment industry but I have no financial interest in Bibby Offshore Holdings Limited, the Bibby Offshore Bonds, nor am I advising any party who I believe to be trading in the bonds. These are my own views and I have not been paid or asked by anyone to write this blog post.]

Leverage… banking is a risky business… DVB edition

First, “equity” is an accounting construct. In Vickers’s phrasing, a bank’s equity is “the difference between the estimated value of its loan assets and other exposures on the one hand, and its contractual obligations to depositors and bondholders on the other. In short, it is a residual, the difference between two typically big numbers.” A small difference between two large numbers is highly sensitive to even small changes in those big numbers — assets and liabilities — and so it is in the nature of equity to be poorly measured and unstable.

“Banking Systems Remain Unsafe”

Martin Sandbu, FT Free Lunch

News that DZ Bank has had a final sense of humour failure with DVB doesn’t do justice to the scale of the problem:

after DVB posted a return on equity of minus 73 percent in the first half of the year, or a net loss of 547 million euros after breaking even a year earlier, plans to sell off its loan portfolios have gained traction…

[S]ources said DZ Bank was working with Boston Consulting Group to evaluate options for DVB, while the transport division has hired separate advisors to assess the value of its $12.5 billion ship loan portfolio.

I have talked about DVB before and the fact is the results that were released in August were probably worse than DZ Bank had wanted, but the scale of the problem in the shipping and offshore portfolio are that they have in effect bankrupted the bank and forced in into run down mode.  Here are the losses broken out:

DVB Losses by sector

Half a billion here, half a billion there, and pretty soon you are losing real money… It is also worth noting that the loss in offshore was 25% higher despite the loan book to shipping being 5x the size. Looking at the offshore portfolio I still don’t see this being the final write-down:

DVB lending by sector Aug 2017

Now the portfolio was marked down from €2.4bn to €2.1bn so maybe €50m has been disposed of. But there is no one involved in offshore, looking at the asset mix, who really believes that it could possibly be worth €2.1bn in aggregate. I don’t really want to get into a big discussion about whether banks should account for loans at fair value (i.e. what you would get if you disposed of the portfolio at the moment) or held-to-maturity (i.e. what you get if the customer honours the loan contract): You can make sensible arguments for both. Clearly in the short term if the customer is solvent it makes no sense, in an economic perspective, to hold the loan as an asset for a value less than you will receive, and it adds a huge degree of volatility to the earnings of banks if you do this, the reverse though it as it allows a huge degree of discretion for management that simply isn’t warranted by the facts.

You can see the scale of the DVB problem by looking at the tier 1 capital:

DVB Bank tier 1 aug 2017

For the uninitiated to get the number you basically take the book equity (less goodwill) and divide by risk weighted assets, and this gets to c.9%. But it’s a meaningless number in reality as the quote from John Vickers in my opening makes clear. A far more instructive number is the leverage ratio which divides the amount of equity in the business by the asset base (i.e. loans) and that is 2.9%, which in considered far below what a bank should have. In essence this number shows a 3% decline in the value of DVBs assets (loan contracts) would wipe out the equity: with $12.5bn in shipping and and €2.4bn in offshore loans you can be sure that in reality this has happened.

Which is why DZ Bank are pumping another €500m into DVB Bank.

There is a bigger economic question that I think cuts to the heart of what DVB is as a bank and why diversified bank lending works better than narrow bank lending: active versus passive management. For years researchers have known that active fund managers underperform passive fund managers when fees are taken into account. The entire DVB business model relied on them picking four industries and producing returns in those industries consistently, regardless of underlying market movements, despite the fact this is known to be statistically unlikely.

The problem everyone in offshore and shipping has is this: Who do you sell to when other big banks in the sector are making a virtue of closing their loan books to your industry? DNB is typical off all the big banks in the sector (as I have discussed before):

DNB rebalance

Offshore as an industry has an asset finance issue and not just a demand side issue. The road to recovery, however you define it, looks someway off.

Brazil, The New Offshore, and Contractor Profitability…

“My salad days, When I was green in judgment, cold in blood, To say as I said then!”

Cleopatra – Act 1, Anthony and Cleopatra

Bassoe Offshore had a very good and insightful article on Brazil this week. The key thing for me was the sheer drop in volume of rigs working in Brazil:

As we noted earlier this year, the number of drilling rigs in Brazil has gone from over 80 to under 30 during the past five years.  Currently, 26 rigs are on contract (all for Petrobras), but only about 20 are on full dayrate and drilling due to Petrobras’ reduced effective demand.  By the end of 2018 – assuming no new contracts or contract extensions – Petrobras will have 14 rigs working for them.  By 2021, this number becomes three. 

We estimate that Petrobras has a minimum requirement of around 20 rigs to sustain production through 2021.

Rigs are obviously the leading indicator of future subsea work and it’s worth putting some context on this as Bassoe Offshore did in April:

If you were an offshore rig owner back in 2010–2014, Brazil was the land of opportunity.  Petrobras offered long term contracts with solid dayrates.  Everyone wanted to be there.  Rigs were built; demand seemed insatiable. 

Petrobras even initiated Sete Brazil, a company with plans to build 29 Brazilian-content, deepwater semisubs and drillships, which was slated to be Brazil’s path to global prominence in rig construction and a boost to the country’s industry and economy.

And in order to keep production going from all the well work these rigs would be doing Petrobras went just as long on flexlay capacity. The strategy here was slightly different: Petrobras choose the two most capable subsea contractors in the world and signed them up for a vast investment campaign to buy specialist Pipe-Lay Support Vessels (PLSVs) and contract them for a period of c. 30% of their expected economic life. Technip, who always seem to call these things correctly, decided to share the risk 50/50 with DOF Subsea for four vessels, while Subsea 7 decided to build and own its three vessels.

There is a constant commentary about how high the margins are on these contracts, and it is true that during the firm period they look good, outstanding even, but there is a very real risk that some of these vessels will be re-delivered. A company that had 80 rigs working and went long on flex-lay capability with 7 vessels is unlikely to need that number in the future when it has c. 20 rigs working. For a whole pile of reasons the drop in demand is unlikely to be linear, but you only need to be directionally correct here to understand the scale of the issue.

Brazil also has proper emerging market risk characteristics in it’s local cabotage regulations that favour local tonnage as Subsea 7 found out this year when the Seven Mar had its charter terminated early,effectively for convenience, and therefore had to reduce backlog by USD 106m. So clearly the economic reason you get a good margin is because there is actually a fair bit of risk in building such a specific asset for such a unique (and having worked on a Petrobras contract I use the word in its most expressive sense) customer: the downside here is in 7 years you get a ship back quayside in Brazil that costs USD 15k per day to run and is only good for laying pipe in 3000m of water. All of a sudden that healthy margin for the last seven years doesn’t look quite so attractive, and this is a very real possibility here for at least 3 or 4 of these vessels.

This fact clearly had a massive impact of the ability of DOF Subsea to get an IPO away and is one of a number of huge strategic issues DOF Subsea has. The DOF Subsea investors were hoping to remove some of the risk of vessel redelivery, and the price the investors were offering to do this just wasn’t enough, or in sufficient volume, for a deal to be agreed. Given the binary nature of the payoff involved it is no surprise a mid-point on the two positons could not be reached: Because a downside scenario is that Petrobras halves the number of contract PLSVs it wants and Subsea 7 comes in with a low bid and the Technip/DOF Susbea JV has its entire fleet redelivered. It may not be likely but it cannot be ruled out either.

The greater IOC involvement in Brazil may also change what has been one of the great comparative anomolies of the market: the complete lack of a spot market (which made sense when Petrobras was the only customer). Should PB and the IOCs decide to bid flexlay work on a project-by-project basis the revenues for the purpose built PLSVs will be much less secure and the valuation assigned to them will be significantly lower to reflect this income volatility. These investments rightly required a very healthy margin.

I always find it amusing to read statements like “the investors think this is an even better investment” and then read the latest accounts and come across comments like this:

In the 2nd quarter the Group has seen improvement in both numbers and activity compared to 1st quarter, however the general market conditions within our industry are challenging, especially in the Atlantic region and the North America region…

During the quarter, the Group has seen a low utilisation of the vessels Skandi Constructor, Skandi Neptune, Skandi Achiever and the JV vessel Skandi Niteroi… In the Subsea/IMR project segment the idle time between projects has increased, however the Group saw an increased project activity toward the end of the quarter.

Ah… the famous greenshots of recovery… at the end of every quarter everyone always sees activity picking up… not quite enough to make it into the current results… but jam tomorrow…

Which led to these numbers:

DOF Subsea Q217

So you might believe it’s a “real out performer”, but in a financial sense it’s a very hard case to make. All the key indicators are going South.

DOF Subsea is an extremely hard investment case to make (to highlight just the three most obvious examples):

  1. Is it a contractor or a contractors’ contractor? A falling out with FMC Technip would devastate the business yet it is hard to see where the clear division of capabilities and competencies at the lower end between the two is? Are DOF Subsea really going to put the Achiever to work against the Technip North Sea DSVs? Even if you really believe they will do this how many jobs would they have to win off Technip before Mons got a call asking what was going on?
  2. The pay-off from the Brazil PLSV project is highly uncertain but it is almost certain that the current margins will drop from their current levels
  3. DOF Subsea has all the costs of being an international EPIC contractor with none of the associated scale benefits. The scale benefits of being international require large diameter pipelay and its associated margins, a move into this area is financially impossible given their current constraints and would clearly precipitate a major ruction with FMC Technip

I think DOF Subsea is just the wrong size to compete as a global contractor and I mark it as likely to underperform significantly in the future. I see a world where FMC Technip, Subsea 7, McDermott, and maybe Saipem, become almost unassailable as the profitable global SURF contractors for mid-sized field development up. Each with a very strong base in one geographic region, with an asset base that can trade internationally enough to gain scale economies from other international operations, and with the balance sheets to invest in capabilities that will standardise and drive SURF costs down. DOF Subsea, despite having a lot of nice ships and clever people, is by an order of magnitude behind these companies.

These Tier 1 contractors will make disproportionate margins to the rest of the supply chain where overcapacity is rampant and balance sheets are weak. These Tier 1 contractors will need to own only core enabling assets and simply contract in all commodity tonnage, which will remain oversupplied for years. Tier 1 margins will improve as they need proportionately less CapEx, or operational leverage, now the OSV fleet has more options. It is not all salad days as apart from MDR the Tier 1’s have some issues from the boom years, but on a project level, for larger SURF work, they are creating a very strong competitive position. You will able to have a strong regional presence/competitors, but the gap between the few global SURF contractors and the “also rans” is going to become very wide indeed as backlog declines going into 2018.

Expect DOF Subsea to remain privately held for a good while longer if the investors really believe it’s undergoing a current period of out-performance that no one else is clever enough to see.

Back to the future… or maybe…

Dr. Emmett Brown: I’m sure in 1985 plutonium is in every corner drug store, but in 1955, its a little hard to come by! I’m sorry, but I’m afraid you’re stuck here..

Back to the Future


All that is solid melts into air.

Karl Marx

One of my enduring intellectual fascinations is whether things are actually changing any faster now than in previous epochs (the next book I have to read is Human Race: 10 Centuries of Change on Earth). I think I am an iconoclast by nature and I struggle with the fact things are completely new in a relative sense: Can we really say the internet was bigger than the printing press? I get change is “faster” now, but so is commication? Anyway I will read the book.

I arrived in London in 2000, right in the middle of the dot-com boom. Everyone claimed the couldn’t understand it (I was working for a management consultantcy), and I actually think a lot of people could understand it but didn’t want to admit the implications of it, but the historical examples were looking people in the face: Tom Standage published (an underrated book) The Victorian Internet, that made clear to anyone with a sense of history that the scale of change was precendented, and hardly unique to one generation. Some of the issues regarding open systems for software in the modern era are compared skillfully to debates regarding railway gauge width. It will come as no surprise to most that I think Standage makes a good argument that the Telegraph may have been more important than the internet.

Quite why each age is obsessed with its own sense of modernity is not something I want to tackle here, I have my own (deeply cynical I must concede) theories, but my I have always remembered the book “Hypercompetition” as a standout example of this self-conceited position. Hypercompetition describes a world where:

Business has also entered a new age of realities. It is essential to understand and take advantage of the dynamic motion and flux of our global markets and technological breakthroughs… [Hypercompetition] is a condition of rapidly escalating competition based on price-quality positioning, competition to create new know how and establish first mover advantage, competition to protect or invade established product or geographic markets, and competition based on deep pockets and the creation of even deeper pocketed alliances.

Seriously? That just sounds like industrial capitalism. Selling a steam engine to India in the 1890s may not have been as sexy as creating WeChat or Lyft, but it wasn’t that easy either, and within the confines of the environment in the time you had to move just as quickly and be just as innovative, or did you?

The original theory was publshed with some (controversial) research that indeed suggested when looking at  a broader group of companies than the S&P 500:

support for the argument that over time competitive advantage has become significantly harder to sustain and, further, that the phenomenon is limited neither to high-technology industries nor to manufacturing industries but is seen across a broad range of industries

But it wasn’t universally accepted: the core difference being the researchers who agreed with this notion only focused on firms that appear to have consistently generated higher economic returns not the total universe of firms. McNamara, Valler, and Devers note:

Some strategy scholars and practitioners contend that markets have become increasingly hyper- competitive in recent years. We examine this contention by analyzing industry and business performance patterns in a broad sample of firms… We find little support for the argument that markets have become more hypercompetitive. From the late 1970s to the late-1980s we observe decreased per- formance and market stability, consistent with increasing hypercompetition contentions. From the late 1980s to the mid-1990s, however, trends reverse and performance and market stability increase.

I love the 80’s. My entire music collection probably consists of Greatest Hits of 80’s. It might be heartbreaking for us now to accept but economically and competitively they were harder times – from a macroeconomic perspective particularly. I remember when my parents nearly lost their house in the 1980s when mortgage interest rates when up to 18% and the government attempted to ban inflation with a “price freeze” (seriously). Imagine that now? It is one of the events that actually led to NZ becoming the first country in the world to make their central bank (relatively) independent (in 1989).

A decade that started with the Iranian hostage crisis and finished with Tianaman Square was a tough time competitively, and a large part of that is because many companies simply didn’t have the pricing power they now do. A less global, more domestically focused economy, without Chinese competition, was actually a harder time to be a manager. One of favourite theories involves cross-ownership: as asset managers have got so large (and indexing enhances this), and therefore have so many cross shareholdings, they discourage competition amongst their investments. Azar, Schmalz, and Tecu find:

[i]n the US airline industry, taking common ownership into account implies increases in market concentration that are ten times larger than what is “presumed likely to enhance market power” by antitrust authorities….We conclude that a hidden social cost – reduced product market competition – accompanies the private benefits of diversification and good governance.

Basically ticket prices are 3-5% higher than they would be if the airlines had seperate owners. As well as common ownership the increasing size of banks and the scale if the M&A they can now underwrite is also driving industrial consolodation on a scale that simply wasn’t possible in the 1970s and 1980s.

From about the time Hypercompetition was published (1995) economists began to realise that modern economic change, in first world countries, was characterised actually by a proportionately smaller number of larger firms with market power, higher profits, and greater stability. As these researchers in 2016 make clear:

[a]bout a decade ago a stream of research emerged looking at changing persistence over time and finding a monotonic trend toward a new “age of temporary advantage”… We find that the trend reversed itself and the beginning of the 21st century has been characterized by increasing persistence of superior performance… our results appear not to be a consequence of a compositional shift in the economy of industries toward those with lower levels of competition nor of increased conservatism by newly listed firms. Instead the phenomenon appears to occur primarily within industries by seasoned firms. 

Hence my interest was piqued by this excellent article on Bloomberg yesterday that posits:

modern capitalism produces and probably requires a lot of creative destruction. But this isn’t a relentless, ever-accelerating process. It goes in waves. For about 15 years now we’ve been in a lull, and it’s not at all clear when or how it will end.

The core of this sort of analysis is survivorship bias: just looking at how many big companies are still in business or part of various indexes. Standard Oil, for example, has consistently remained one of the largest industrial corporations in America (now under the guise of ExxonMobil) for over 100 years and ATT was the second largest US company in 1917. A few Facebook and Google new entrants does not change the basic makeup of the modern economy but they do show up in the profit figures:

ROIC 90th percentile.png

Basically a small number of firms are pulling away in profit terms of the others and entrenching themselves as modern monopolies according the Council of Economic Advisers:

Market Concentration.png

The evidence seems clear: there hasn’t been a better, or easier,  time to be a big company since pre-Roosevelt days.


“Short-cycle production” could be about to get an economic test…

The dots clearly show that oil prices and oil production are uncorrelated…

Caldara, Dario, Michele Cavallo, and Matteo Iacoviello

Board of Governers of the Federal Reserve System, 2016

The number of US oil rigs went down by 5 last week to 744 rigs, while the number of US gas rigs increased by 4 to 190 rigs. In terms of the large basins, the Permian rig count increased by 6 to 386 rigs, while both the Eagle Ford and Bakken rig counts declined by 3 each to 68 and 49 rigs respectively. 

Baker Hughes Rig Count, Sep 25, 2017


The multi-billion dollar question is: Can shale handle an increse in demand? Closely related: Is shale in a boom that is unsustainable and not generating sufficient cash to reward investors for the massive risk they have taken? Because if the latter is correct the former must be answered in the negative. The above quote is slightly mischevious and merely highlights economic research that supply factors have historically had a far bigger impact on the oil market than demand factors  (whether this is true going forward is not for today).

The NY Fed today reports that it is supply shortages now that are driving the price (and I have no idea about the construction of the model but the reduction in the residual leads me to believe it is broadly accurate), so this is a supply driven event not a demand driven event:

Oil Price Decomp 25 Sep 2017.png

If, as Spencer Dale argues (speech here), we are in the midst of a technical revolution then this is what we would expect. Hostoric levels of inventories should come down because supply is more flexible, these short-term kinks in demand caused by natural or geopolitical events should merely spur an increase in the rig count or a change in OPEC quotas. Other senior BP staff today were on message:

“Rebalancing is already on the way,” Janet Kong, Eastern Hemisphere Chief Executive Officer of integrated supply and trading at BP, said in an interview in Singapore. But OPEC needs “definitely to cut beyond the first quarter [2018]” to bring inventories down and back to historically normal levels, she said…

“If they extend the cuts, yes it’s possible” to achieve $60 a barrel next year, she said. “But it’s hard for me to see that prices will be sustainably higher,” she added.

Or is Permania simply the result of the Federal Reserve flooding the market with liquidity that is allowing an unsustainable production methodology to continue unabated storing up yet another boom and bust cycle? Bloomberg this week published this article on Permania, where the incipient signs of a bubble are showing in labour and infrastructure shortages and the outrageous cost overruns:

Experienced workers are harder and harder to find, and training newbies adds to expenses. The quality of work can suffer, too, erasing efficiency gains. Pruett said Elevation Resources recently had a fracking job that was supposed to take seven days but lasted nine because unschooled roughnecks caused some equipment malfunctions.

By this point, “we’ve given up all of our profit margin,” he said, referring to the industry. “We’re over-capitalized, we’re over-drilling and, if prices don’t rise, we might be facing a double dip in drilling.”

If I was being cynical about offshore production I would note that he was two days over with a rig crew while in the same calender week Seadrill and Oceanrig had collectively disposed of billions of investment capital and will still have the inventory for years. This guy is literally two days out of forecast and he is worried about being over-capitalized (and also that wiped his profit margin? Hardly redolent of a boom?) Offshore drilling companies are like 10 years and 100 rigs out of kilter… Anyway moving swiftly on…

Bloomberg also published this opinion on Anadarko noting:

Late on Wednesday, Anadarko Petroleum Corp., which closed at $44.81 a share, announced plans to buy back up to $2.5 billion of its stock; which is interesting, because almost exactly a year ago, it sold about $2 billion of new stock — at $54.50 apiece.

(That’s pretty clever, they sold stock at $54.5 and are buying it back at $44.8, like Glencore never buy off these people when they are selling, at heart they are traders. More importantly most research suggest companies nearly always overpay when buying stock back so if the oil price keeps creeping up they are going to look very smart indeed.)

But the real point of the story is that capital is slowing up to the E&P sector, well equity anyway no mention of high-yield:

Equity US E&P Sep 2017

Meaning that maybe people are getting sick of being promised “jam tomorrow”. However I can’t help contrasting this with productivity data, Rystad on Friday produced this:

Rystad Shale Improvement Sep 17

So despite the anecdotal evidence on cost increases in the first Bloomberg article the productivity trend is all one way.  And the stats seem clear that a large part of deepwater is at a structural cost disadvantage to shale:

ANZ cost structure 2017

Frac sand used to be c.50% of the consummables of shale, but surprise:

Average sand volumes for each foot of a well drilled fell slightly last quarter for the first time in a year, said exploration and production consultancy Rystad Energy. Volumes are expected to drop a further 2.5 percent per foot in the current quarter over last, Rystad forecast…

Companies including Unimin Corp, U.S. Silica Holdings Inc (SLCA.N), and Hi Crush Partners LP (HCLP.N) are spending hundreds of millions of dollars on new mines to address an expected increase in demand.

On Thursday, supplier Smart Sand SND.O reported it shipped less frack sand in the second quarter than it did in the first. Rival Fairmount Santrol Holdings Inc (FMSA.N) forecast flat to slightly higher volumes this quarter over last.

In the last six weeks, shares of U.S. Silica and Hi Crush are both off about 30 percent. Smart Sand is off about 43 percent since June 30…

Some shale producers add chemical diverters, compounds that spread the slurry evenly in a well, and can reduce the amount of sand required. Anadarko Petroleum Corp (APC.N) and Continental Resources Inc (CLR.N) are reducing the distance between fractures to boost oil production. The tighter spacing allows them to extract more crude with less sand.

Technological innovation and scale: Less sand used and increased investment going on that will reduce the unit costs of sand for E&P producers. This is the sort of production that brought you the Model T in the first place and the American economy excels at. Bet against if you want: just remember the widowmaker trade.

Shale is a mass production technique: eventually it will push the cost of production down as it refines the processes associated with it. To be competitive offshore must emulate these constantly increasing cost efficiencies. I have said before that shale won’t be the death of offshore but it will make a new offshore: a bifurcation between more efficient fields, low lift costs, and economies of scale in production that make the “one-off” nature of the infratsructure cost efficient, and smaller, short-cycle E&P of shale (and some onshore conventional).

Offshore is going to be here for a long time, it is simply too important in volume terms not to be. But what a price increase is not going to see is a vast increase in the sanctioning of new offshore projects in the short-term. These will be gradual and provide a strong base of supply, as there longer investment cycle represents, while kinks in short-term demand will be pushed towards short cycle production. Backlog, or lack thereof, remains the single biggest threat to all offshore contractors.

Or this thesis is wrong and I, and to be fair people far cleverer (and more credible) than me, are spectacularly wrong, and a new boom for offshore awaits in the not too distant future…

Another IEA supply warning…

Prediction is very difficult, especially about the future.

Neils Bohr

The International Energy Agency once again warned today that we face an oil supply crunch if investment levels remain at current levels and their “forecast” for increased energy demand remains accurate:

There are still not enough signs of investment beginning to return, and that raises the risk of tightening of the market in the next five years and a risk to the stability of oil prices,” Neil Atkinson, head of the IEA’s oil markets and industry division, said at a conference in Bahrain. “There is at least a possibility of going back to the situation we had 10 years ago where oil prices were very, very high at a time when demand was growing.”

Atkinson warned that the market’s spare capacity—largely concentrated in Saudi Arabia—will dwindle as demand keeps rising at a time when supply remains stagnant. The market will tighten and OPEC will have to abandon its production limits in order to satisfy demand. After that, rising consumption could whittle away at the latent surplus capacity. At that point, the market will hit a supply crunch, which would likely result in higher volatility and higher prices.

As an aside here is a list of OPEC member states. Does anyone really believe they can hold a production limiting agreement indefinitely?

If correct it is good news for offshore with a likely investment boom coming… but not until the 2020’s apparently. For oil companies that are cash flow positive even with high debt that might seem manageable, if you have vessels in lay-up or underutilised it is going to look like a long way off.

Like all forecasts understanding the context they come from is as important as the forecast itself. It is fair to say there is some fairly pointed criticism about the accuracy of these forecasts, FT Alphaville recently published this (guest) piece that noted this about IEA data:

  1. They are not forecasts, they are scenarios and named accordingly.
  2. The IEA publishes more than one scenario. Each one represents a different assumption about *policy* [again, the clue is in the title: Current Policies Scenario, New Policy Scenario, and 450 Scenario].
  3. Almost no-one, anywhere, ever seems to pay any attention to either 1) or 2). It’s very common to see “forecasts” or “projections” attributed to the IEA without even specifying *which* IEA scenario they’re talking about.
  4. The IEA’s scenarios have been consistently terrible at illustrating how well clean energy, might play out in almost any scenario. And terrible in the same way.

The problem is that in order to understand all this you have to buy (and read) the IEA report not just read the press releases and newsfeed stories commenting on the press releases. Javier Blas, ex-FT and now Chief Energy Reporter at Bloomberg, had a spat with the IEA in may this year after a Dutch academic showed how far out of line the IEA had been with solar predictions (since 2003). This led the IEA comment :

This misrepresents point of WEO (World Energy Outlook) scenarios. They don’t forecast future, but provide yearly picture of what will happen if nothing changes

Which is sort of like useless for such long-term scenarios unless nothing in the world changes (file that under unlikely) which is Blas’ point (I think). This does have the advantage of clarity though so you know exactly what the scenarios are based on. As if to underline it Blas published this today:

Evolution of Wind.png

It’s all about productivity… At the margin all energy products have a degree of substitutability and the renewable sources seem to have that advantage at the moment as they grow in scale.

Bloomberg had an excellent article earlier in the year highlighting how demand for oil could vary under different scenarios:

A Radically Different Future

And is if to highlight how much things can change we learnt today that shale production is apparently slowing but building up “Drilled but UnCompleted” inventory:

the buildup of DUCs is also bearish since it creates latent supply. Because the incremental cash cost to start pumping crude is low for a DUC, the payback period for an oil company is only a year or so. Even for wells not drilled, analysts at Citigroup estimate the break-even cost to drill and complete a well is just $29 a barrel on a production-weighted basis for the drillers they cover once the costs of acreage and sunk capital costs are excluded for the companies they cover.

No one can know the future so the most important thing any forecaster can do is simply make their assumptions (and preferably limitations) clear. The IEA forecasts need to be seen as relatively bullish from an organisation that makes a living from advocating policies that increase investment in traditional fossil fuels. Therefore whether its errors are cognitive or merely emotional biases the answer is likely to be somewhere between the two: but the word of God from an impartial agency with the wisdom of Solomon they are not.

For the offshore supply chain I do actually think we have hit the nadir, the point of this isn’t to say it can’t get any worse, and in maintenance spend terms things are likely to get better soon. But a boom case for the supply chain is hard to make because the ramp-up period will now be substantial as people and assets leave the industry and large E&P companies focus on other areas, and I don’t believe the 2013 days will ever return: nor should they the offshore industry can be more efficient than that. The one thing I do know is that if I was an offshore contractor I’d make sure I had a renewables strategy to go with my oil and gas one.