Illiquid or insolvent? Bagehot and lenders of last resort to the offshore industry…

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.


Irving Fisher

The Singapore Government think they have found a case of market failure:

SINGAPORE – Offshore marine services firm Pacific Radiance has been granted S$85 million in loans under two Government-backed financing schemes.

I’d suggest the Singaporean Government brush-up on the difference between a shift in the demand curve and a shift along the demand curve To non-economists the difference may look semantic but to every stage 1 student it is drilled into them that a shift along the demand curve occurs when price changes and then the quantity demanded responds, a shift in the demand curve means a fundamental change in demand. It is the difference between a change in the quantity demanded versus a change in demand, which are self-evidently two completely different things.

I would argue, and have on this blog consistently, that we are seeing a complete reconfiguration of the offshore supply chain, think Woodside moving to electronic Dutch Auctions for commodity supply vessels, rather than a short-term fluctuation in demand as the result of temporarily low oil prices.

Quite why the Singaporean Government feels it knows better than the market is beyond me here? I should note at this point I am not an unadulterated free-marketeer, my favourite paper at University in NZ at the height of Rogernomics and its successors in a supply-side revolution, was “State-Led Development in South-East Asian Tiger Nations: Singapore, Hong Kong, Taiwan, and South Korea”. In the debate between the World Bank and the activists I took my lead from Robert Wade (also from NZ) and others who saw active government involvement in the economies as an essential part of the process that drove these economies to outperform and pull their people out of poverty. I was a believer, I agree still to a certain extent, with Alice Amsden who argued the governments’ of the region actively set out to “get the market price wrong”.

But I also grew up in New Zealand, which terrified of rising oil prices in the 1970’s had launched Think Big, and by the time the Motonui synthetic “gas-to-gasoline” plant was finished the tax payer footed the bill for every single litre manufactured. It was in short an economic disaster. Trusting a Government ministry to out-judge the energy market is a dangerously expensive passtime.

I should also note that Stanley Fischer, in an unbiased review of South East Asian development policies following the East Asian Crisis noted:

As to Asian industrial policy… some degree of government involvement can in principle be successful, and that it was successful in practice, too, in some Asian economies by allowing new industries to overcome coordination failures and exploit economies of scale. I also believe the potential for such interventions to go wrong is very high, both because the government may make the wrong decisions, and also because they are conducive to corruption. In most cases the best approach is for a country to create a supportive business environment, including policies and institutions that encourage innovation, investment and exports in general, and to leave allocative investment decisions to the private sector.

So when I read that Pacific Radiance has secured loans from two entities affiliated with the Singaporean Government I have to question what is going on?

Firstly, there is a moral hazard element here as the shareholders and the banks appear to benefit from an overly generous dose of leverage on average assets. The Straits Times notes:

The Government will take on 70 per cent of the risk share for both the IFS and BL loans, which were rolled out last November to help local offshore and marine companies weather the current prolonged industry downturn by gaining access to working capital and financing.

These are loans largely owned by DBS and UOB. I don’t undertand how if this is an economic transaction these banks need this level of support? This is an assymetric payoff where the Government takes most of the risk and the banks pick up most of the upside.

Secondly, the sanity: this money is going on OpEx:

The loans … will help support the group’s working capital needs over the medium term, said Pacific Radiance in a statement on Thursday.

Really? Does the Government of Singapore believe that a short-term market dislocation has occured that will see USD 5-10k per day per vessel of OpEx recovered when the market comes back? Pacific Radiance has USD 605m of liabilities over a fleet of 60 vessels and JVs with a further 60 in Indonesia. Like Deepsea Supply, and a host of others pretending the vessels are worth anything like this is a fantasy. But another problem isn’t just the size of the debt, and the quality of the assets underpinning it, but the income being generated to service it:

PAC RAD Sales Q1 2017

Sales are dropping like a stone, and as a general rule depreciating assets that earn less than you thought are worth less. The loan doesn’t solve the fundamental problem: Pacific Radiance have borrowed too much money relative to the revenue these assets can now earn and are likely to in the forseeable future. As you can see over the same period comparison as above Pacific Radiance is consuming cash at an alarming rate:

PAC RAD Cash Flow Q1 2017

Most worrying is the amounts due from related companies which would have to be seen as doubtful, but the business is also using large amounts of cash in operations and this loan is simply going to go in and then go out on that operational expenditure. Loan covenants on fixed assets were simply not designed to cope with turnover dropping 24% quarter-on-quarter: there was too much leverage in the offshore sector to support this. The banks need to come to the party here for this to be a viable firm.

Third, this seems completely contrary to what other major players in the market, like Bourbon are saying (and they are surviving without government assistance):

Mr Pang noted that the longer-term outlook for the industry has improved, as Opec and certain non-Opec producers have sustained oil production cuts until June this year and have also agreed to extend these cuts by another nine months. “This concerted effort by oil producers should enable supply and demand to balance in the medium term.”

The Singaporean Government is essentially making a bet on a private company that seems to have no other plan than simply hanging around waiting for the market to improve. To be honest that doesn’t strike me as a great plan, and if enough investors agreed with Mr Pang surely getting an equity rights issue away should be easy for the company to raise the money and wait for this miraculous occurrence? In fact of course with the Swiber AHTS going for 10% of book value the loan already looks doubtful.

The government of Singapore has now become the Lender of Last Resort to the offshore sector and therefore the Bagehot dictum applies “lend freely at a penal interest rate against collateral that would be good quality in normal times” (I have discussed this before) . The formula is help the illiquid but not the insolvent. Bagehot outlined this formula in 1873 after repeated shutdowns in the London money market put sound financial institutions at risk. The Bank of England had followed this dictum in 1866 when London had its own Lehman moment and the Bank of England allowed Overund, Gurney and Co., one of the largest institutions, to fail.

I haven’t done a full valuation of the Pacific Radiance fleet but a quick overview of the assets on the website makes it clear this is pure commodity tonnage and some of it very low end. Quite why anyone thinks this is going to recover to previous levels needs to be outlined explicitly I would have thought given the scale of the commitment that is in the process of being made. I don’t think in the current market this would qualify as high quality collateral in normal times. There also appears nothing penal in the loan at all.

Worringly for Singaporean tax payers, looking at Ezion and others, Bagehot also wrote:

‘either shut the Bank at once […] or lend freely, boldly, and so that the public will feel you mean to go on lending. To lend a great deal, and not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies’

I think Pacific Radiance had a solvency problem not just a liquidity issue, but the systemic problem is now the longer Singapore props up companies like this the longer the industry will take to recover. If Singaporean taxpayers decide to support Ezion and a host of others they need to be prepared to write some very big checks, and the US companies fresh from Chap 11, with clean balance sheets, will be in a far better place to compete.

During the last Global Financial Crisis Paul Tucker of the Bank of England stated the Bagehot dictum as ‘to avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at ‘high rates.’ These loans do nothing of the sort by backing poor quality collateral and providing uneconomic liquidity to a company with an unsolvable problem. People are not paying less for these vessels because there is a panic they are paying less because E&P companies are using them less and they cost a lot to run! These loans will only delay the pain and hinder other struggling firms. The banks should have been forced to realise the assets at current market values as the penal rates both Bagehot and Tucker outlined and the shareholders should have been completely wiped out.

As a comparison I do not think Mermaid Maritime Australia will be so lucky. I have experienced Australian banks first hand and I suspect the “Big Four” will be ruthless and simply shut the company down soon having given the company temporary respite to see if this was just a short-term dislocation. Unfortunately from an economic perspective this type of capacity reduction is exactly what is needed to rebalance the industry.

DeepSea Supply, bank behaviour, credit, and the Great Depression

Contagion is a significant increase in comovements of prices and quantities across markets, conditional on a crisis occurring in one market or group of markets.

A Primer on Financial Contagion

Massimo Sbracia and Marcello Pericoli


“No one has seen a worse offshore market than what we’re going through now,” Kristin Holth, head of shipping, offshore and logistics at DNB ASA, said in an interview at the Nor-Shipping conference… “It hasn’t been a regular downturn. In many ways, we’ve seen the collapse of an industry.”

I am a bit late getting to this but the DeepSea Supply (“DESS”) Q1 results when combined with the Solstad merger information memorandum are extremely interesting… they beg the question: would you pay USD 600m for some Asian built PSVs and AHTSs when 16 of them are in lay-up? Some of these are not flash tonnage: the six year old 6800bhp vessels built at ABG and the UT 755 PSVs built in Cochin look extremely vulnerable. To put that figure in perspective it is USD 28.5m for every working vessel (with 16 of the 37 in lay-up) and even on a average basis it is still USD 16.2m. In the current market most of those vessels would strugggle to go for more than USD 8m, collectively they would make asset values even lower than that they are such a large fleet.

It is an absurd figure… but of course the banks behind DESS, who are owed that much, don’t have a choice now, they lent in a different era. The reason balance sheet recessions are so severe is that debt obligations remain constant long after the equity is wiped out. If enough debtors default this travels to the banking system. And one of the problems offshore has at the moment is a lack of lending from the banking system: it is no different to the housing market, if banks will not lend then asset prices decline, and on depreciating assets such as vessels, I would argue the impairment is likely to be permanent for certain assets (Asian built commodity tonnage being part of that for sure). The problem for the offshore supply industry is when will the banks start to lend? Because for a long time I think risk officers at banks will insist this tonnage stays off the balance sheet once they have closed their positions. Risk models hate volatility and these assets have it in large quantities.

In the DESS case the banks and Solstad have branded DESS a low cost operator, not low cost enough to come close to break-even in this downturn, but apparently this is the future. It is really hard not to think that the closer they get to this merger Solstad can’t be wondering if there was anyway of getting rid of this company… If it was a horse you would shoot it.

Sooner or later someone is going to have get some of the banks behind these assets to start getting real. Part of the business of banking is what economists call maturity transformation: banks borrow deposits off people and then re-lend them out for projects with a much longer contractual requirement, it is a a very risk business model, particularly when done on very thin layers of capital. They are a lot like a hedge fund in other words, in the industry vernacular banks “borrow short and lend long”.  The Nordic banks involved in both Farstad and DESS are effectively becoming hedge funds in another way: thinking they can play the market. These banks are the prime movers in failing to liquidate assets to discover their true floor price.

In order for the HugeStadSea merger to go ahead the DESS banks must make the following concessions:

Main elements in this context are the following:

(i) Reduction of amortization to 10 % of the original repayment schedule until 31 December 2021;

(ii) Pre-approval to sell certain vessels at prices below allocated mortgaged debt (only applicable under the combined fleet facility);

(iii) Minimum value clause set to 100 % and suspended until 1 January 2020;

(iv) Removal of financial covenants related to value adjusted equity, and

(v) Introduction of cash sweep mechanism.

Point (i) makes clear the assets cannot generate sufficient cash flow in the current market to pay them back more than a token amount. One of the troubles is the 10% is for the entire 37 vessels not the 26 working so even this looks optimisitic.

Point (iv) means the banks will just pretend that even though you are insolvent you are a going concern while (v) just makes sure they collect any surplus cash.

Does anyone in this industry believe that a Chinese built UT 755 will in 4 years time, having made no payments for 25% of its economic life, be able to keep the bank whole on this loan? It is just absurd.

Solstad are going to need an enormous rights issue fairly early on (not just because of DESS I hasten to add, Farstad is arguably more of a basket case). According to the announcement JF/Hemmen put in NOK 200m (c. USD 23m) into Solstad shares (approximately 3.8% of the loans outstanding or c. 180 days of EBIT losses). So in crude terms the DESS gift to Solstad’s high class CSV fleet (with some supply vessels as well to be fair)  is a commodity fleet of 37 vessels, with 16 laid up, constant debt obligations of USD 600m, and a proportionate capital increase against this of 4%. Potentially there are some cost savings but these seem contrived in the extreme (when you cash flow losses are this high you can’t meaningfully talk of measurable synergies as opposed to normal cost cutting)… but I don’t think anyone would buy the shares based on those anyway.

When people saw the US housing crisis emerge they realised it wasn’t just NINJA loans and MBS that was the problem, it was also second mortgages to pay for current consumption. Shipping banks also make the same mistake as this paragraph outlining DNBs exposure to DESS makes clear:

The facility amount under the DNB Facility is USD 140,640,000 repayable in quarterly instalments until 31December 2021…The DNB Facility is secured by, inter alia, first priority mortgages over the financed vessels… Additionally, the lenders under the DNB Facility will… receive (silent) second priority mortgages over the vessels in the NIBC Facility (described below) and the Fleet Loan Facility

How much would you pay for the second mortgage on a Chinese AHTS at the moment? If you give me a number in anything other than Turkish Lira, and a small one at that, please PM me your details so my Nigerian banking associates can request your account details as we have a Euromillions win we wish to deposit there.

And here is what I have been saying in words laid out graphically for you:

DESS Repayment profile

What the banks behind DESS and Solstad want you to believe is that in five years time a company with a collection of Asian built PSVs and AHTS, many over 10-14 years old, will be able to get another bank or group of bondholders to pay them USD 515m to settle their claim (c. USD 13.9m per vessel!). These same banks refuse loans to vessels older than 8 years! It’s just not serious,  but it shows how desperate the banks are not to take losses to the P&L here and pretend they don’t have the problem. Note the lead bank here is DNB who as Mr Holth has made clear do understand the scale of the problem. Mr Holth is extending five years further credit to an industry he believes has collapsed?

[Obviously the loan will be rolled over in 5 years or written down massively]. Quite why banks with the self-professed capital strength of DNB, Nordea and others involve themselves in such shenanigans is for another post. But these numbers are material and not even realistic: at USD 21m per annum of interest all of the 21 working vessels (at less than 100% utilisation) need to make USD 57.5k per day just to pay the interest bill (USD 2.7k per vessel) when most are working at OpEx breakeven if lucky.

To really drive home what a bad deal the merger is checkout this paragraph:

As per the date of this Information Memorandum, the SOFF Group does not have sufficient working capital for its present requirements in a twelve month perspective. Under its current financing facilities, there is a minimum liquidity requirement of NOK 400 million, and by March 2018, a shortage of approximately NOK 100 million is expected.

The document states the banks will relax this covenant but that isn’t really the issue. The issue is in more prudent times the banks thought they needed 400 and now that asset values have plummted they suddenly don’t. A “world leading” OSV company with 157 vessels doesn’t even have USD 48m in liquidity… please… You need to be flexible in these situations absolutely, but really, for this merger? I love the way the lawyers have forced them to write if they cannot agree this the banks may demand accelerated repayment, despite the fact everyone has gone to such extraordinary efforts to ensure that is exactly what doesn’t happen.

And I guess at base level that is what I don’t like about this merger: the owners should have played harder with the banks and forced them to realise that their values are nothing like the book values. Forcing people to keep book values high with low ammortisation payments just delays things and makes raising new equity even harder. We are starting to get into a philosophical debate about the nature of money here, that a loan contract is just a claim on future economic outcomes, and these ones are worth substantially less than when they were willingly entered into. Friedman was wrong (about a lot):

“Only government can take perfectly good paper, cover it with perfectly good ink, and make it worthless”

Shipowners and banks combined have also done an excellent job of doing the same. Particularly the OpEx demon…

If you wonder what the expression “zombie bank” is look no further than the offshore portfolios of these banks because they will never take this sort of exposure on balance sheet again and unless the Chinese banks do, who are much more likely to support new builds from Chinese yards, then the industry has an asset value problem.

There are plenty of historical precedents for these issues in the banking system. In innovative research Postel-Vinay looked at banks, housing, and second mortgages in Chicago during the Great Depression and found:

[a]s theory predicts, debt dilution, even in the presence of seniority rules, can be highly detrimental to both junior and senior lenders. The probability of default on first mortgages was likely to increase, and commercial banks were more likely to foreclose. Through foreclosure they would still be able to retrieve 50 per cent of the property value, but often after a protracted foreclosure process. This would have put further strain on banks during liquidity crises. This article is thus a timely reminder that second mortgages, or ‘piggyback loans’ as they are called today, can be hazardous to lenders and borrowers alike. It provides further empirical evidence that debt dilution can be detrimental to credit.

When those second mortgages on vessels turn out to be valueless this will cause an issue in the banks risk models. Then what economists call “interbank amplification” where banks withdraw money from certain asset sectors, and in this case reduce lending to similar asset classes, further lessening the available money supply available in total and reducing asset values (ad infinitum). Researchers at the Richmond Fed looked at this in the Great Depression:

Interbank networks amplified the contraction in lending during the Great Depression. Banking panics induced banks in the hinterland to withdraw interbank deposits from Federal Reserve member banks located in reserve and central reserve cities. These correspondent banks responded by curtailing lending to businesses. Between the peak in the summer of 1929 and the banking holiday in the winter of 1933, interbank amplification reduced aggregate lending in the U.S. economy by an estimated 15 percent.

I keep referencing the Great Depression here because one of the issues in recovery from it was asset values and the problems associated with a reduction in the monetary supply (and here I will concede Friedman was on to something). These two issues fed on one another in a self reinforcing circle and also led to a collapse in credit because no one had collateral that financial institutions would accept as worthy lending against. Taking macro models to micro industries has methodological issues, but I think it is valid here (*methodologiocal reasoning too technical for this forum). Suffice to say the supply side of this recovery will follow a different dynamic to the demand side and those who watch the daily fluctuations in the oil price with hope are wasting their time.

One of the controversies of the Great Depression is did Andrew Mellon, arch tycoon in a Trumpian sense, really tell Hoover to “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.”? Mellon always denied it and it suited Hoover to claim it. In a macro sense it is clearly ill advised, but in offshore I can’t help feeling it would be good advice. At the moment we are slowly grinding through the inexorable oversupply where banks are propping up failed economic propositions though moves like this that potentially put companies out of business that may have survived. Such is the life of credit, but as I have said before until this clears out the entire industry will make suboptimal returns. 

2017… watch financial markets not just the oil price.

bloomberg-oil-4-jan-2017A wise New Zealand philosopher once said “the future looks a lot like the past… only different”;  which pretty much sums up my thoughts for 2017 regarding Offshore and SURF. I accept sentiment in the market is increasingly positive but without wishing to sound permanently negative here are some of the issues I see coming up this year.

On the plus side… Offshore and SURF in particular enter 2017 in a far more positive note than 2016 with the price of oil having stabilised after doubling from its lows. The psychological impact on the industry has been hugely positive. Staff leaving are now actually replaced, and in many instances, the general feeling is that we are on the path to some sort of recovery. Tendering activity looks like it is increasing but rates are still at rock bottom levels.

But for the offshore /SURF industry while 2017 may mark the start of the recovery of the demand side of the industry the supply side still has some significant adjustments to make and therefore it is not just the price of oil that is important it is also the profitability of the contractors and the state of the financial markets that underpin the assets and infrastructure.

Offshore is an asset-intensive business and therefore a business dependent on credit in the modern economy. The offshore/SURF industry went into the downturn after a massive increase in capital allocation to the sector that led to an enormous new building programme, and much of the capital was in the form of debt. Previous downturns in the oil price have not coincided with such a large proportionate increase in tonnage. The industry remains over-capitalised and overbuilt and this adjustment period is likely to prove extremely painful with debt corrections being far more painful than equity corrections (compare the minimal fallout from the dotcom bubble with the US housing crisis). There are too many owners and investors who have not accepted the economic reality of what this means for asset prices with high operational costs.

Even ignoring the AHTS/PSV fleets the subsea side of the OSV fleet looks well overbuilt. There has not been such a glut of North Sea class DSVs since 1999. If the Ultradeep and Vard vessels deliver with the build quality as high as the spec then all of sudden the Bibby and Nor fleets start to look like second rate tonnage. The Bibby Polaris was built in 1999 and is still a very capable ship but I can confidently say it will never find a bank to provide a mortgage style facility against such an old specialist vessel again. Similarly pipelay, as recently as 2008 the North Sea rigid reeled market was effectively a duopoly, now there are at least four credible systems and a couple on the margin. Large OCVs? 250t crane? Coming out of the 2007/08 downturn you couldn’t magic one up. Now the Boa Deep C and Sub C look headed for lay-up and certainly don’t look that special with plenty of vessels of that spec being offered for nearly OPEX only on a day rate. Flex-lay system in Asia? Take your pick and have a free portable SAT system to go with it… Ex-Brazil tonnage… I could go on…

The other big change I see slowly percolating down into the industry psyche this year will be the realisation that there has been a structural change in the financial markets that underpin the industry. It’s not just the Norwegian high-yield market that has disappeared but bank lending to asset-backed transactions will be fundamentally different as well going forward, and just as when banks go on strike in the mortgage market and house prices drop, the inevitable is going to happen to vessel and asset prices in the offshore industry. Hopefully, it leads to more scrapping at the older end of the age profile which will help restore balance.

Banks, in particular, will be slow to return to the party I feel. The severity of the downturn in asset prices has blown out their Value-At-Risk (“VAR”) models so beloved of financial regulators and internal risk managers. The new standard deviation parameters are likely to materially increase the pricing offered to new transactions which will again lower the price of these assets and force sellers to recognise equity losses (either on paper or psychologically the effect is the same).

This change will favour larger players with bigger balance sheets as a recovery takes place as they will be able to put in place fleet loan facilities and cash flow facilities that will not be available to smaller companies and raise equity in public markets. It is inevitable that the recovery becomes dominated by larger and better-capitalised companies. The industry as a whole will require more equity to grow, and more I suspect will come from retained earnings, which will limit capacity increases in any sustained upturn. After a long period of low volatility returns equity investors will re-price seeking higher rewards for the obvious (and now historically documented) risks. I fear smaller vessel operators who put 10 (at the peak) -25% down on a vessel and financed the rest of a $100m vessel on the back of a 5 year charter, or used the project finance market and took the margin, are consigned now to the archives. These markets will return but the risk profile will more closely align to the economic life of the asset than we have previously seen. I haven’t done the calculations but if you estimated that all spot market vessels would need 60% equity going forward, on a 20% reduction in their book value, on tighter LTVs, and all vessels over 15 years would need to be fully equity financed, then the amount of extra capital required by the industry is in the billions and the effect on the vessel S&P market would be profound and chilling. Profit has a habit of erasing bad memories, but financial institutions and investors are famous for never making the same mistake twice, and any thawing out of the banking side will take an extended period of time. Bank Directors will view offshore as just another cyclical shipping business and allocate capital accordingly.

But this still feels some way off that with distressed investors working on individual asset deals rather than anything with an industrial strategy angle, beyond the Aker/Solstad deal in subsea, and some of the moves Seacor has been making in supply. Whereas the recently closed PSV III deal (purchase price for 2 x UT 755 at 11.7m) shows that distress asset prices are still well below what owners in layup situations hope to achieve but more in line with a risk reward profile that equity investors may need going forward. Nor bonds trading in the 30’s only reinforce this picture.

So 2017 is looking better than 2016 without a doubt but we are not looking at a 2008 quick recovery here. Asset prices are going to be weak for a prolonged period. 2017 marks the start of the deep structural changes in the supply side which will define the new industry structure going forward.

Farstad restructuring… owe the bank 1m you are in trouble, owe the bank (NOK) 10bn and the bank is in trouble…

News that the Siem deal had fallen over and led to the banks staying their position didn’t come as a huge surprise. I got the Aker/Solstad deal: maybe Aker came in too early but Solstad is defined by its subsea fleet which differentiates it from almost all the other large Norwegian owners. The dominant logic in the industry, and one I find hard to disagree with, is that the subsea fleet will recover and the good times will eventually come again. But AHTS/PSV is a whole different story: there were 121 North Sea PSVs in layup last week (more than 2 x the number last year) and 58 AHTS.

I don’t know enough about the funds Siem was raising or investing from but if I was long Subsea 7 and Siem Offshore (and clearly far be it from me to question his investment judgement) I would want extraordinarily good terms before going long on the Farstad fleet with only 6 subsea vessels out of 55. It looks dire for Farstad: of the 27 AHTS only 6 had any decent contract coverage at Q3 16. 5 are 15 or more years old but more concerning is that the large 2013/14 built, 24 000 bhp, units are in lay-up or have no work. It has always been an article of faith in offshore that newer units will find work, but that clearly isn’t the case now. The PSV fleet is just as bad with decent contract coverage for only five. I would classify only 3 of the the subsea fleet as proper subsea vessels, and the others as PSVs with a crane suitable really for wind farm work.

For the industry as a whole the best thing that could happen would be unfortunately for Farstad to vanish into the ether. A great company that simply went too long on ships in a cyclical industry. Like the Italian banks though I think there are a few more acts to play here as the secured lenders work out what they are going to do. One of the really interesting pieces of information that would have come out of this was the % cut the senior banks were prepared to take. Unlike many of the Norwegian restructuring the bonds are of minor importance here (and this really highlights how conservative Farstad was), of the ~NOK 11.6bn debt only NOK 1.4bn is in bonds. In the Siem plan the bondholders became equity holders and clearly that will happen in any plan and at a dilution rate I suspect that leaves them with nothing effectively.

But NOK ~ 10.2bn (USD ~1.2bn) is still real money. Here we have the age old problem that if you owe the bank a million you are in trouble but if you owe the bank a billion they are in trouble. The four largest banks listed in the 2015 year end were DNB (NOK ~1.6bn), Danske (NOK ~1.6bn), GIEK (NOK~1.5bn), and Nordea (NOK ~1.3bn). Nordea is interesting because in its latest results (Q3/16) the entire bank included loan losses of only EUR 135m,  (NOK 1.2bn), 53% of these already from oil and gas related loans. So although the banks prefer to report numbers like Exposure at Default, which for Nordea shows that of EUR 516bn of loans only 1.4% is at risk, and of these 42% is oil and gas related, the point is writing off everything in Farstad would have doubled the Q3 loan losses for Nordea and that is a material number for the bank. There is clearly no systemic risk to Nordea (and I have merely picked on them here) but the number, just from one company, admittedly a fairly large and niche one, is important and not simply a rounding error on a massive loan book.

Nordea appears to be a very well run bank and  banks take risks that don’t always payoff and charge a margin for it; although the over the years banks have become more dependent on fee income than margin income, and this incentivises bankers on long-life asset deals like this to load up the loans at the start and worry about the credit quality later. Essentially commercial banks have become investment banks for long-term loans with all the agency and moral hazard problems this presents. Anyone in shipping who has dealt with banks over the last 10 years always comments on the pressure to get sold multi-product deals and the associated fees: 5 product deals which included interest swaps, forex hedges etc were the gold standard as loan margins remained ultra slim… anyhow I digress…

Thus the work-out teams from all the banks are trying desperately hard here to pretend that their “secured” position is really more than worthless exposure to vessels with a high operating cost and minimal chance of asset price recovery with so many similar vessels available for sale. Even worse the size of the fleet is large enough to move the sale and purchase market prices down even further (if possible). Selling the subsea vessels won’t help as I would guess they will barely cover their liabilities if lucky.

So the best rational thing, for the industry, is the least likely and rational strategy for the banks. For as long as this happens the supply side of the industry will not correct itself. I accept the demand side has probably plateaued, at least in the short-term, but the supply side has a lot of pain to come. The PSV Opportunity (I and II) investment, backed by Standard Drilling (an equity play on structural recovery), saw 3 x Norwegian built PSVs come back to the North Sea from Asia and can economically at current day rates. While these PSVs are older (2005/06 built) in operational terms they can do everything a 2015 built vessel can and they arrived in the North Sea for ~USD 4m per vessel. The disparity between the book/bank values and the distress sale price seems far too wide to pretend the industry is recovering. Applying those type of sale values to the Farstad fleet would end up with huge losses for the banks and with the 2009 built PSV Rem Star being sold recently for fish farm work that is all but assured.

A loss to the secured lenders could realistically look like this if they were forced sellers tomorrow:

Farstad Fleet
Price per vessel (USD)/ Total Proceeds
AHTS 27 8,000,000 216,000,000
PSV 22 5,000,000 110,000,000
Saga/Scotia/Swift 3 7,000,000 21,000,000
Samson 1 50,000,000 50,000,000
Sleipner 1 50,000,000 50,000,000
Sentinel 1 50,000,000 50,000,000
 Sales proceeds (USD) 497,000,000
Exchange Rate 8.71
NOK 4,328,870,000
Current secured portion (10,600,000,000)
Loss to secured lenders 59% (6,271,130,000)

This is clearly meant to be an example rather than a serious valuation and it assumes Superior is not delivered and pre-delivery commitments are written off, no sale expenses, and no opex until sale. But I use it to highlight that when a market becomes as illiquid as the current OSV market asset prices collapse to levels previously thought unreachable and certainly well outside the norms of bank risk models. But from an equity story I find it really hard to see why someone would buy in at a level significantly above this as the new book value of the assets (and I have been exceedingly generous on the subsea vessel valuations) as Farstad is essentially an operations company not a service company.

I don’t think the banks are here yet, or even close to accepting sale prices like this. The inexorable process grinds on here: all the other security holders have lost everything and now the banks are facing their position. There is a straight trade-off between committing more (even waiving payments essentially prefers other creditors) or admitting now there is no future. The reason Farstad, Havila, and EMAS are so interesting is that not all the large companies can survive (or the small obviously). Sooner or later a rational group of financial of investors will pull out of this game. The survivors will make more but someone, probably more than one, has to fall before the supply side of the industry recovers.

Having a guess at how much working capital would be required is tricky. Farstad again highlights the extraordinary opex requirements of these vessels, in more ordinary times these would be integral to credit modelling, approximately 17% of the asset base is expended is vessel opex annually at Farstad (vessel opex/ vessel book value). Cut the asset value by half and you are well over 34% per annum. On a per day/per vessel at USD 13.9k looks expensive, but I have no reason to believe Farstad was especially inefficient in this regard. Banks could see CDOs at 30 cents in the dollar and you could hold them and wait for a rebound but with a vessel the opex, even in layup, is a killer.

The Siem solution effectively valued the company at NOK 1bn. Without knowing the size of the bank write down agreed its hard to see what the new Enterprise Value would have been. Finding an equity investor willing to take on a risk like this will be a daunting project but without it the banks are going to have to look at marking their loans to some sort of realistic recovery rate, and simply assuming a market recovery in 2018 and being made whole isn’t viable; which means the nuclear scenario will clearly be in play here. Meanwhile long-term contracts get harder to win as people (rightly) worry about the trading prospects of the Group. Siem might just be driving one of the great deals, realising the position of the banks the offer has just become extremely aggressive, but it takes a brave investor to follow through on this and I suspect we are looking at a solution that protects any investment, something more akin to super-senior than pure equity which was outlined in the first announcement.

The logical industrial strategy here is for the subsea vessels to be sold, the PSVs that aren’t strong regionally to be sold/scrapped, and a recapitalised Farstad to return to its roots and be a major player in AHTS as the industry inevitably consolidates. At some point in the future one would think a rational market would entail vessel owners offering open book type contracts for long term E&P rates, and the spot market being defined by very high rates that reflect the risk. Spot market vessels would need to be all equity financed because the correlation between a severe downturn in the oil price and asset prices is stronger than anyone thought possible prior to 2015. But the reason we all love offshore is while it maybe rational in the long run it is anything but in the short… and in the long run we are all dead as the Great Man may have quipped.

Having burned through the equity holders in 2014 and the bond holders in 2015/16 it would appear 2017 is the year when the banks will be the ones to face the economic reality. This will be healthy long term but this is likely to be a tortuous and long process as the losses here go straight to tier 1 capital and the banks will resist to the last. The good news is that this really does mark the industry lows and it will be recovery from here… but maybe not for Farstad.

Macro, gold, and private credit

Like most economic historians I get the gold standard was a bad idea and we shouldn’t go back to it. But I think the hankerings for it really reflect a deeper desire for some sort of control on the monetary base. As Bordo et al ., note:

We find that [financial and banking] crisis frequency since 1973 has been double that of the Bretton Woods and classical gold standard periods and is rivaled only by the crisis-ridden 1920s and 1930s. History thus confirms that there is something different and disturbing about our age.

The problem is credit. Specifically privately created credit and frankly clearly linked to housing and commercial property lending.


The Bretton Woods agreement controlled the capital account and acted as a brake on the pro-cyclicality of asset price inflation (unintentionally) by making it harder to fund these transactions from offshore borrowing. In some ways it linked the domestic asset base to a trading value of the currency. Now land values have gone crazy because capital is international and property has simply become an international asset class.

And as part of this change tThe banking system has been transformed:

The share of mortgage loans in banks’ total lending portfolios has roughly doubled over the course of the past century—from about 30% in 1900 to about 60% today. To a large extent the core business model of banks in advanced economies today resembles that of real estate funds: banks are borrowing (short) from the public and capital markets to invest (long) into assets linked to real estate.

The driving force in this has been lending to households as the article makes clear.

In the modern economy fractional reserve banking is a myth although it may have functioned like that under the gold standard. But now we understand that banks create money via deposits and there is no theoretical limit on money supply creation other than the monetary policy of the central bank, and there are questions as to the effectiveness of this given the openness of the modern international monetary system and banks ability to fund themselves in the wholesale market. In a modern economy, where home ownership is exalted above almost all other policy goals, combined with open bank funding on a international scale,  I struggle to see a limit on the creation of private credit to property and thus it is a system with a self-induced propensity to pro-cyclicality with a put option on the state. Anything less would imperil the banking system itself.

To me, the question isn’t whether we should be going back to the Gold Standard but really could the Bretton Woods agreement be improved and tried with Bancors? Like the Chicago Plan for domestic money, I am too cynical to believe an institutional mechanism that requires so much change is likely to occur, but it is clear that the link between credit and the macroeconomy is the crucial variable that needs to be understood better and be the driver of economic models. A fundamental model of understanding the modern macroeconomy needs to be the driver of credit, something Minsky well understood.

Offshore contractors face ‘bank run’ scenarios


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.