Greece, Solstad Farstad, and other restructurings…

The recent Greek debt deal is proof that when no other option exists lenders will sometimes do the right thing. Greece it should be remembered was a banking crisis as well as a sovereign debt crisis, and although the Greek banks are recovering five years after the first major ructions they are still on life support from the ECB. This should provide both some degree of hope and reality for Solsatd Farstad when they announce where they are on the latest restructuring this week. I understand that as part of the process the Farstad name will be dropped in October/ November and the Farstad’s will sell out and not be associated with the company.

The banks and investors now seem to be aware of the scale of the problem here and realize that a booming market isn’t coming and isn’t going to save anyone. The high-end AHTS have even had disappointing day rates relative to expectations (hopes?) and the Q2 numbers will simply not bank enough for a long idle winter to give anyone real comfort. And all the while the Deep Sea Supply fleet festers like a cancer on what healthy tissue remains in the body. Now only an agreement with the banks can  provide any long term solution.

Offshore companies remind me of banks in a funding sense, hence why I mention Greece, as the debt dynamics and issues are broadly similar. Offshore vessel operators fund themselves in charter markets that are significantly shorter than the economic life of the assets they buy. Charter periods dropped from 5-8 years in the early 2000s to complete spot market/ at risk vessels by 2013/14. That is complete market risk funding the purchase of a 25 year asset.

Banks also borrow-short and lend-long, in simplistic terms they borrow money as deposits and lend them to businesses for significantly longer periods of time, and while the deposits can be drawn down as requested the loans cannot. There is in effect a funding mismatch called “maturity transformation” which creates value.

This same sort of duration mis-match between the vessels owned and the charter market created huge value for offshore vessel and rig companies in a booming market. Vessel owners committed to 25 year assets, with 10 year loans on 12-15 year repayment profiles, and funded this in some cases purely in the spot market. In trading terms it was a carry-trade with the high yield short term market being funded by a long term lending market. This was a totally procyclical financial phenomenon that meant the short-term market had a pricing premium compared to the long term cost to anyone who took the risk to commit assets to the short-term market. Now, just like a banking crisis, there has been a freeze in the short-end of the market and this is impacting their ability to meet long term commitments. As Paul Krugman stated “if you borrow short and lend long you are a hedge fund and should be regulated like one”, and that is in effect the embedded funding profile of many offshore operators prior to 2014.

That model is now dead, although not completely, but I think this is the most important, and maybe the least discussed, part of the industry change. And there will be change, not through any grand initiative, but eventually as the market recovers and banks lend on offshore assets again they will force the counterparty to have a longer term contract, and gradually the time/duration risk will be more equitably split than it currently is in an oversupplied market. But I think that is going to take a long time.

It will also mean for smaller E&P operators, marginal producers, their costs could increase significantly for assets on the spot market… and they should! Building assets in the tens-to-hundreds of millions and relying on the spot market to clear them just isn’t rational, as is currently being shown. Being able to call up a jack-up PSV, AHTS, CSV or whatever at a moment’s notce and get it delivered in a few hours or days is currently proving to be a terrible business model for asset owners. Longer term the industry should move to larger operators with a series of longer contracts that roll off in a time efficient way rather than everyone thinking they can clear excess capacity in a short-term market. Larger E&P companies will commit to longer contracts and get a much lower margin as a result. Those providing short term assets will have to charge a substantial premium for this given the risk involved but it will be a smaller, risker part of the market, with substantial amounts of equity to cushion the cyclicality required. It is this factor that I think will drive consolidation far more than any cost savings: how much idle time can your business model handle?

The solution is therefore going to look like banking resolutions in Europe. Traditionally that has meant either a) bankruptcy/insolvency (and there is still more of this to come), or; b) a good bank/ bad bank split (e.g. Novo Banco). Solstad I think could eventually go this way: Solship 3/ Deep Sea Supply was an early attempt at this but failed. More radical solutions are needed now but the final solution will end up more like this. In order to compete with Standard Drilling and others in the North Sea the banks behind Solstad would need to equitise their entire expsoure to the PSV fleet and the most likely new “bad bank” starts here. The “bad bank” they already own, Deep Sea Supply, needs to be cauterised. All the banks have with these assets anyway is a claim to some future value when the market recovers and they want someone else to pay the OpEx to get there. It might have worked in 2016 but the investment narrative has changed since then.

These are moves that take months not weeks and not all the stakeholders are in the same place. A cold winter with lots of tied up vessels is likely to bring these groups closer together. Resolution is some way off. Eventually, when all the other options have been exhausted, the banks are likely to do the right thing here.

Offshore contractors face ‘bank run’ scenarios

lewek-constellation

I was struck by how much EMAS (and other offshore contractors with poor balance sheet strength) need to be viewed as facing a ‘bank run’ like scenario after reading this BIS article on the collapse of Continental Illinois. The key question is can a ‘funding run’ be stopped for both contractors (and banks). The Lewek Constellation (above) is an amazing operational asset, but it needs a vast flow of future profitable project work to keep it going (and proper deepwater construction work not infield), and the question at the  moment when looking at the financial strength of EZRA/EMAS/ EMAS Chiyoda is who would award them a complex multi-year construction project?

The only thing that keeps these vessels (and others in the fleet like the currently in default Lewek Connector) is large lump sum jobs with a strong blended cost of high value, low capital intensity, project management fees to balance out OPEX of the vessels. At the moment large companies are all doing this at relatively low margins; where is the incentive to get an even cheaper price from EMAS Chiyoda and find mid project there has been a credit event? The offshore phase is the capstone of all the earlier custom engineering work that has been paid in stages along the way. No one ever got fired for buying IBM was an ad used with great effectiveness to convince mid-level procurement managers to go for the brand. In the current environment no one is going to get fired for buying Technip, Subsea7 and McDermott; but risking a multi-million dollar field development on EMAS Chiyoda is whole different story. Should a credit event occur all pre-funded engineering and procurement spent would in reality make the purchaser an unsecured creditor (and a lot of it would be vessel specific so no use anyway); not to mention performance bonds etc. There have been no significant news of awards for the Lewek Constellation recently and in reality there are unlikely to be.

Offshore contractors are in a pro cyclical industry and take long positions in assets with long funding and economic lives that are in a downturn illiquid to the point of having no saleable value (like now). These assets are funded with some equity but also a significant quantity of debt, with a funding profile less than economic life of the asset, from senior banks and more recently by increasing amounts of (often “issuer rated”) high-yield bonds, or off balance sheet financing from vessel charters. In operational terms an offshore contractors asset base has been funded by a series of offshore CAPEX projects significantly smaller in length and value than the underlying asset base. In banking this is called maturity transformation: banks lend long and borrow short; in offshore the contractor goes long on illiquid assets and funds them in the short-term project market. There is a clear analogy here with contractors serving the E&P companies by going long on highly specific illiquid assets and funding this with a series of short-run projects. Clearly the capital structure of the industry in a macro sense has not reflected this reality well as increasing margins led to ever increasing amounts of debt and rising asset values substituting for real equity (and Swiber and EZRA/EMAS were two of the best exponents at this form of financing). Minsky would have seen this coming a mile off

Net fee income is important for banks as the money they make on the asset base often only covers the funding costs with a small margin. This is true for offshore contractors as well, as discussed above, when that “fee income’ for engineering and project management dries up in poor market conditions the operational offshore asset base cannot even come close to covering its funding costs.

The Continental Illinois demonstrated how hard a bank run is to stop, as even with a Government guarantee, financially rational investors choose to leave in droves ensuring institutional failure. Just like a bank loan portfolio an asset like the Lewek Constellation will be worth nothing like its book value in the current market; it  may actually be “worth” close to zero given the high running costs and the lack of other uses. The same will apply to EMAS Chiyoda as a whole (and other offshore contractors): a run in confidence on their ability to be in business in 12 months time will become a self-fulfilling prophecy in all but the most exceptional cases because the financial gain from any price reduction that could be offered cannot compensate the risk of a large offshore project not being completed.

The pro cyclicality of operational offshore and financial assets  leads to huge volatility and as the Cerrado deal showed the OPEX costs may actually induce steeper depressions than problem loans from financial institutions. One thing is clear: at the moment many assets in an offshore construction/support vessel fleet are almost unsellable at any price and there is no Bagehot inspired institution willing to lend freely on any quality asset to stop a liquidity crisis becoming a solvency one. In fact as the current wave of restructuring among contractors at the moment indicates these are  solvency and liquidity issues combined. Like a banking crisis the offshore industry is awash in leverage and this will in all likelihood prolong the downturn and make a recovery harder.

What really needs to happen for EZRA/EMAS/EMAS Chiyoda is for all the creditors together  to undertake a massive debt-for-equity swap (if you have faith in the assets be the Bagehot: effectively lend freely on collateral that would be good in “ordinary” times – of course there isn’t much because the vessels are chartered); to try and get over the current downturn (if you believe it is just that or DCF some future recovery value anyway) and try and recover value in an orderly fashion accepting that the asset base may simply not be  worth what it was a couple of years ago. Like Continental Illinois though what is likely to happen is that regardless of extra support and measures that management can negotiate to slow the process everyone (funders in the broadest sense) just decide this is a situation they need to get out of as soon as possible.

It’s a bank run… there is no incentive for anyway to stay in and game theory suggests getting out first may be best individually even if staying in collectively would be better. For the offshore industry as a whole this is probably a good thing as EMAS Chiyoda doesn’t really solve any customer problems and was always (in hindsight) a symbol of an investment bubble. But this is going to hurt… I’d love to read the due diligence report Chiyoda and NYK got for this… the only possible solution is that they double down and fund this for a couple years but it would be bold move given current conditions.