Shale watch and American Exceptionalism…

A good article in the FT today (behind a paywall) showing how US shale producers are tapping capital markets as the oil price rises.  This reinforces again the scale of industrial transformation taking place in the US:

Companies in the sector have raised just under $60bn in bond sales so far this year, already a 28 per cent jump from 2016, according to Dealogic. Over the past three weeks, Whiting Petroleum, Continental Resources and Endeavor Energy Resources have each raised $1bn in debt. The bond sales have helped finance increased activity in US shale reserves. The number of rigs drilling the horizontal wells used for shale oil production has more than doubled from its low of 248 in May last year to 652 last week, according to Baker Hughes, the oilfield services group controlled by General Electric.

As the graphic above the title makes clear there is a clearly going to be another year of shale oil output increases in the US. It is a story of capital markets keeping pace, and helping drive, innovation in production. This is now a mass production story and is an economic model at which the US economy excels that economic historians refer to as “American Exceptionalism’ (see here and here if you are interested). American Exceptionalism is based on rich resource endowments and a large domestic market that allow it to produce extraordinary economies of scale. This becomes a virtuous circle, or a “positive feedback loop”, that constantly reduces unit costs and increases output per unit:

Salter Cycle.png

For all those naysayers of shale these charts from the recent Chevron Q3 results make clear that this is no ephemeral phenomena:

Production Efficiency is Increasing:

Chevron Permian Production Q3.png

As are financial returns:

Chevron Permian Returns Q3 2017.png

That is why Chevron, along with BP, Shell, and a host of of E&P companies are increasing their capital allocation to shale. In Chevron’s case 75% of CapEx spend is going on “short-cycle/ brownfield” or the existing commitments to Gorgon/ Wheatsone. Again I emphasise not only the changing nature of the CapEx but the size of the drop from 2014:

Chevron C&E.png

$20bn here and there and pretty soon you are talking real money.

It is clear the US economy can mobilise vast sums of capital to reach companies that are innovating and driving down unit costs.

Offshore is still competitive on a cost basis as this Woodmac graph from Chevron shows:

Woodmac cost base.png

But I have a feeling the shale costs are held as constant in this model without a productivity improvement factored in. A 5% compound productivity improvement over 10 years, not unrealistic in a manufacturing industry and way below current trends, would see a 62% reduction in constant costs. Offshore is simply unable at the moment to offer that sort of productivity increase. Large deepwater fields clearly have the potential to provide a baseload of high-flow, low-lift cost fields, but marginal developments compared to shale look likely to increase in economic difficulty. I know the offshore industry is making a major commitment to standardisation, it needs to, its future without the ability to drop unit costs or raise output per dollar invested will be very hard as only those fields so large as to justify one-off design will be viable against the US (and global) shale industry, or when it runs into volume constraints.

DOF Subsea, Bibby Offshore, and The Pecking Order Theory…

We always plan too much and think too little.

Joesph Schumpeter

We were succeeding. When you looked at specifics, this became a war of attrition. We were winning.

General William Westmoreland on US involvement in Vietnam

DOF AS/ Subsea reported numbers yesterday that were frankly terrible. All those who keep telling you the market is getting better seem blithely ignorant of the constantly decreasing financial performance of nearly all the companies in the sector. It’s like Comical Ali or General Westmoreland constantly assuring everyone that victory is just around the corner, if not in fact delivered. Tendering, like the Viet Cong, never ceases to stop appearing in increasing numbers, and it will bring victory…

I have another theory why tendering is increasing: there are a lot of engineers who are worried about their jobs. In a completely rational strategy they are increasing the number of parties who receive tendering documents, spending more time assessing them, and making the tenders ever more complex. Turkeys don’t vote for Christmas. More people appear to be spending increasing amounts of time and money on the same tenders and it is making industry margins even thinner, and allowing management to claim that completely unproductive work is actually a sign of an industry returning to health.

But back to the numbers… this is the same DOF Subsea that as recently as Q1 and Q2 this year was hoping to get an IPO away. It’s a good reminder, as if anyone needed one, that when insiders are selling out you should be wary of what you are buying. I call it the Feltex Carpets or Dick Smith theory. Economists have however developed a far more robust theory about how firms decide on their capital structure: The Pecking Order Theory. It’s based on the information asymmetry that exists between the insiders of the firm (shareholders and management) and the outsiders (investors and funders). Basically it’s a deeply cynical view (which probably means it is right) that managers and owners use internally generated funds first, then use debt and only issue equity as a last resort.

In a classic paper Myers and Majluf (1984) argue managers and owners issue equity only when they believe it is overpriced. It is very hard not believe that early in 2017 the insiders at DOF Subsea (i.e. the private equity owners) looked at the vessel schedules and the likely win/loss ratio of the tender pipeline (not the amount of tendering), and decided that if they could dump some stock they would. Luckily investors are aware of the asymmetric information problem and “they discount the firm’s new and existing risky securities when new issues are announced“. Or in other words they just refuse to buy at the asking price which is what happened in the DOF Subsea case.

You should always be wary of financial presentations that start with highlights that don’t include any financials (like the latest DOF Subsea one). Just to be clear the DOF Subsea revenue was down 11% on the same period as last year and EBITDA was down 6%. Luckily, they are doing more tendering.

DOF also helpfully provided this chart of the business:

DOF Business Model.png

Basically without the long term chartering business, which is really just a risk diversification move by Technip, there is no business: the 10% EBITDA on the projects side wouldn’t cover the economic costs and frankly potentially the cash costs either. This is a business where unrealised gains from derivatives (probably interest rate and/or currency swaps) were 6 x the operating loss for the period of NOK (41m).  Year to date DOF Subsea has had to turnover NOK 2.8bn to get a mere NOK 45m in profit. It is pretty clear from the above that actually the projects business, with 17 very expensive fixed costs assets, is not an economic entity; and as I have said before you need a very good return on the vessels on long-term charter in Brazil because as the above graphic makes clear if their contracts aren’t renewed (and no one believes they will be on anything like the current terms) then the value of the vessels will drop like a stone if you believe at some point a vessel is only worth what it can earn in cash terms. The number of other activities you can perform with a 650t vertical lay system is actually pretty small which lowers resale value regardless of how much it cost to build. In which case the value of the business is probably much smaller than the current shareholders would be willing to admit to themselves. Time is not a friend to the investors in this deal because everyday they hold this company future investors get one day closer to finding out what happens in Brazil.

DOF Subsea is a pretty good projects house and the EBITDA margin is just a reflection of market overcapacity. If you were going to invest new money in a subsea projects business you would need therefore to look at that as a realistc EBITDA margin you could earn for the foreseeable future until further supply capacity leaves the market or there is a significant increase in demand. Bear that in mind if you were, for example, looking at injecting funds into a company about to default on its bonds…

The Pecking Order Theory is also helpful in explaining (some of) the shennanigans involved in the Bibby Offshore attempted refinancing at the moment. The insider shareholders in this case also saw the writing the on the wall and in January 2016 took a cheeky £20m off the table in the form of a dividend (after a c.£40m dividend recap that was flagged in the prospectus). In the next 12 months Bibby Offshore lost £52m at the operating profit level, and it must have been known to the Directors by June 16 that without some sort of miracle the business would require a restructuring (which to be clear is an event of default as defined by the ratings agencies even if consensual). It was certainly apparent to any responsible Director by Oct 16.

Bibby Offshore cannot realistically make an interest payment in December, and management have qualified the accounts such that it is not a going concern without a refinancing. And now  the insiders (Bibby Line Group and management) have decided they want outsiders to put money in. They don’t think the equity is overvalued (they know it is valueless);  the insiders think the debt overvalued is and there is too much of it. All the talk of a supportive shareholder reveals it for the sophistry it is: the insiders don’t believe enough to contribute financially. BLG aren’t putting in any of the £60m they have taken out not just because they don’t have it but also because they know the business better than anyone and The Pecking Order Theory makes clear they want someone elses money here.

One deal that is on the table is some “Super Senior” financing (i.e. paid before anyone else) provided by the distressed debt desk at Deutsche Bank. Now Deutsche are arguably the best desk at this in the City, but if you need this sort of financing it is pretty much the end of the road. If EY have resorted to the distress desk at Deutsche as an alternative it shows that no long term investor is interested. This form of financing is more suited for a company in bankruptcy (where it is called debtor-in-possession financing) than for one imminently approaching it. The Deutsche plan would be to lend fully secured against the Polaris and the Sapphire and give Bibby enough money to make until next summer when DSV day rates miraculously improve and the business can service this new debt and bonds. But don’t the bond holders own those boats I hear you ask? Yes. And I am not close enough to this to know exactly the specifics but the security agent is only likely to hand over the ownership papers to the vessels if the bond holders agree to this (I guess); and (I guess) Deutsche would only advance the funds in conjunction with a writedown of their claim. Unbelievably management will argue they are they best people to trade the business out of this mess.

The real tension here appears to be how much equity the bondholders take, and how consensual the handover is, as the business undertakes a debt-for-equity swap. The bondholders can hold out for 100% of the equity as their only other asset apart from the DSVs (and a couple of ROVs) is the shares of Bibby Offshore, but in  order to follow through on this they have to push the company into administration and a liquidation scenario is completely possible at that point as customers and suppliers refuse to trade. The Bibby/Management/EY plan envisages a far more generous structure whereby any money Bibby Line Group put in is also fully secured and they retain majority control so they can consolidate Bibby Offshore in their Group accounts (20% of net assets). The problem with this is of course that BLG don’t have anywhere near enough money to put in proportionately.

A nightmare scenario for the bondholders is taking over a company in such circumstances where agency conflicts abound and in a practical sense now it is a hostile takeover with management having acted until the last possible moment to realise the rights of the debt holders. It is arguable for all of this year Bibby Offshore should have been run with the creditors interests at the forefront of all decisions and it is clear that this has not happened.

In case you’re wondering what is in it for Deutsche: it’s the fees. They are looking at advancing c. £20-30m on the vessels and it would have to be cleared before the bondholders get paid. They would get a 7 figure upfront fee and an interest rate of c. 15%, and if a default occurred they would sell the assets in a fire sale to get their money as quickly as possible. Which is why you can’t get much money from such deals because the bank needs to be conservative here (and I think this deal will die on broker valuations given the likely fire sale prices of Polaris and Sapphire). The problem is of course that debt got Bibby into this mess and it is very unlikely to be the cure to get them out of it. I don’t think the Deutsche proposal has passed credit committee and even though they would make an eye-watering fee on the this the risk is clear: becoming the proud owner of 2 x North Sea class DSVs (and as their offices are some way from the Thames they wouldn’t even add to the famed Deutsche art collection).

With no significant work booked for next year the Bibby plan relies 100% on day rates increasing significantly above current levels. And therein lies the real problem for the bondholders and any potential distress desk coming in on this: at some point the only solution to a market in oversupply is for some capacity to go. How can Bibby credibly claim to make a better margin than DOF Subsea? At the moment Boskalis look almost certain to enter the market in a big way and other companies are also looking to enter the market. Not only does Bibby need tens of millions of pounds under its current cost structure just to make it until next summer there is actually no certainty that this magical scenario of higher rates will allow them to come close to settling the outstanding debt obligations they are generating to get there.

DOF Subsea made clear that while tendering activity is robust project work is dismal (and indeed they made a specific comment that amounted to a profit warning about it). At 7.0 x debt to last-twelve-months EBITDA DOF Subsea (and everyone else in the market) will be throwing everything into trying to win work… all the non-DSV work will compete with Bibby (no one really expects them to reactivate the SAT system on the Achiever) and they will keep margins at ~EBITDA breakeven in order ot get utilisation. As a committed industrial player that is a rational economic strategy. Subsea 7 and Technip are booking DSV days at less than £120k for 2018 to get utilisation in early and they can clearly keep this up virutally indefinitely. The dumb non-industrial money won’t last as long as those with an operational logic and an industrial strategy + balance sheet in this market.

The problem for the Bibby bondholders is that not only at current prices (.36) have they capitalised the firm at c. £63m, way above what it could hope to earn in an economic sense, it also needs £20-40m just to keep trading until next summer.  The major competitors have no cash flow issues (Boskalis has €1bn in the bank) and every reason to chase market share over profit. There is therefore no rational economic reason why under this scenario North Sea class day rates will rise, particularly if Boskalis enters, and every reason to believe they will stay at current levels. Any rational investor in Bibby Offshore would shut down everything apart from the UK business, but 2 x DSVs in the UK doesn’t justify anything like £60m in value…

The Nor bondholders tried super senior financing on their DSVs in Nov 2016 and it is clear, as they slowly run out of money and cannot raise anymore at anything like the 15% fully super senior they did last time, that when someone says you can’t lose on a North Sea class DSV, you can on some. It’s all down to asset specificity as I have said before. Deutsche and other distress desks will be well aware of the mistake the Nor bondholders made, and frankly if I was going to make a mistake on two DSVs I’d rather do it with the Nor vessels than the Bibby ones.

This will all be resolved soon. A bondholder meeting is scheduled for next week and everyone will lay out their plan. The problem is of course there isn’t one really and it should never been allowed to have get this close to Dec 14 when the interest payment is due. The Bibby plan is for it to continue as a lifestyle business where external investors allow the family and management to stay in control and fund it until the market returns. A few (27) redundancies are underway but in a microcosm of the cost and conflict issues that define the company the CEO’s wife, who runs the Business Excellence department, is staying , as is the Director of Small Pools and Innovation, while the Engineering Manager is made redundant (seriously).

The Bibby plan relies on a small number of bondholders, enough to block the majority, being so afraid of the great unknown they back them to carry on as before. This will just delay things until next summer because the cash burn is just so high that even £20-30m would be gone by this time next year without a wholesale change in market conditions. Handing back the Olympic Bibby cuts the cash burn, and may allow the business to come close to cash break even, although the US will make another substantial trading loss in 2018 as will Norway (and without the Ares why bother?); but doesn’t solve the core problem that the business itself is unprofitable at an operating profit level. Call it the slow-burn and pretend strategy. It was disastrous for Nor as eventually reality comes and the cash is gone. As plans go it is pretty terrible.

But the bondholders don’t have a good one either. The bondholders appears to have spectacularly misread the willingness and ability of Bibby Line Group to support Bibby Offshore as well as how badly the business would perform in 2017 versus 2016 (revenue -50%). Some of the funds involved in the bonds don’t need money from an institution like Deutsche, but unless they control the company they have to hold a bondholder vote every time they want to make any significant moves, and letting the company go into administration risks a total wipe-out of value. Stripping the company back to a smaller business locks-in a loss, continue funding it until the market returns is simply throwing good money after bad and it’s real cash. If they do take the business over they will have an awkward period where almost the entire senior management are changed out and they will be cash funding a business, with an unknown financial commitment, while their consultants re-do the numbers and tell them how much capital they will need to inject. I have done that as a management consultant and it is hugely destabilising while it goes on and makes normal operations almost impossible. If if takes consultants 6 weeks to produce an initial report (30 working days), and Bibby Offshore is losing c. 100k a day in the interim even an emergency facility of £3m + £1m for the consultants is real money given the limited upside sale potential. And then they are only in February with a real funding commitment until the mythical summer season that will save everyone… until it doesn’t…

There is a more complicated scenario here where the Bibby Offshore is restructured through a pre-pack insolvency that the current bondholders control. This will remove the historic liabilities incurred (i.e. property leases, Trinidad tax) and see a new company emerge free of its past shareholders and with a new capital structure. I think this the most likely but it will be a dramatically smaller business and will be run solely for sale ASAP. I also see no guarantee it will realise more value than a liquidation despite it being enormously risky given changing market conditions.

The Bibby Offshore refinancing is a mess and liquidation is clearly a very real possibility here. Getting to less than 28 days of an interest repayment before trying to finalise a refinancing is irresponsible in the extreme when it has been telegraphed for months and your plan is simply not to hand the company to the bondholders. The only thing I can definitely tell you is that if you brought Bibby bonds at .36 you are going to lose some real money here.

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.

DSV valuations in an uncertain world: Love isn’t all you need… Credible commitment is more important…

“Residual valuation in shipping and offshore scares the shit out of me”

Investment Banker in a recent conversation

 

“Alice laughed: “There’s no use trying,” she said; “one can’t believe impossible things.” “I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

 

The FT recently published this Short View about how the bottom may have been reached for rig companies and that there may be upside from here. The first thing I noted was how high rig utilisation was, the OSV fleet would kill for that level, and yet still the fleet is struggling to maintain profitability (graph not in the electronic edition but currently about 65%). The degree of operational leverage is a sign of how broken the risk model is for the offshore sector as a whole. A correction will be needed going forward for new investment in kit going forward and the obvious point to meet is in contract length. Banks simply are not going to lend $500m on a rig that will be going on a three year contract. Multi- operator, longer-term, contracts will be the norm to get to 7G rigs I suspect (no one needs to make a 6G rig ever again I suspect). The article states:

No wonder. Daily rental rates for even the most sophisticated deepwater rigs have tumbled 70 per cent, back to prices not seen since 2004. Miserly capital spending by the major oil companies, down more than half to $40bn in the two years to 2016, has not helped. Adding to this lack of investment from its customers is a bubble of new builds, which is only slowly deflating.

Understandably, the market is showing little faith in the underlying value of these rig operators. US and Norwegian operators trade at just 20 per cent of their stated book values. The market value of US-listed Atwood Oceanics suggests its rigs are worth no more than its constituent steel, according to Fearnley Securities.

What the article doesn’t make clear, but every OSV investor understands, is that in order to access more than the value of the steel rigs and OSVs have very high running costs. The market is making a logical discount because if you cannot fund the OpEx until operating it above cash break even or a sale then steel is all you will get: it’s the liquidity discount to a solvency problem. That tension between future realisable value and the option value/cost of getting there is at the core of current valuation problems.

The OSV fleet is struggling with utilisation levels that are well under 50% for most asset classes and even some relatively new vessels (Seven Navica) are so unsellable (to E&P customers I don’t think Subsea 7 is a seller of the asset) they have been laid-up.  From a valuation perspective nothing intrigues me more than the North Sea DSV fleet: The global fleet is limited to between 18-24 vessels, depending on how your criteria, and with a limited number companies who can utilise the vessels, they provide a near perfect natural experiment for asset prices in an illiquid market.

North Sea class DSVs need to be valued from an Asset Specific perspective: in economic terms this means the value of the asset declines significantly when the DSV leaves the North Sea region. Economists define this risk as “Hold Up” risk. In both the BOHL and Harkand/Nor case this risk was passed to bondholders, owners of fixed debt obligations with no managerial involvement in the business and few contractual obligations as to how the business was run.

The question, as both companies face fundraising challenges, is what are the DSVs worth? Is there an “price” for the asset unique from the structure that allows it to operate?

In the last BOHL accounts (30 June 2017) the value of the Polaris and Sapphire is £74m. I am sure there is a reputable broker who has given them this number, on a willing buyer/ willing seller basis. The problem of course is that in a distress situation, and when you are going through cash at c.£1m per week and you have less than £7m left it is a distress capital raise, what is a willing seller? No one I know in the shipbroking community really believes they could get £74m for those vessels and indeed if they could they bondholders should jump at the chance of a near 40% recovery of par. A fire-sale would bring a figure a quantum below this.

Sapphire is the harder of the two assets to value: the vessel is in lay-up, has worked less than 20 days this year, and despite being the best DSV in the Gulf of Mexico hasn’t allowed BOHL to develop meaningful market share (which is why the Nor Da Vinci going to Trinidad needs to be kept in context). Let’s assume that 1/3 of the £74m is the Sapphire… How do you justify £24m for a vessel that cannot even earn its OpEx and indeed has so little work the best option is warm-stack? The running costs on these sort of vessels is close to £10k per day normally, over 10% of the capital value of the asset not including a dry dock allowance etc? Moving the vessel back to the North Sea would cost $500k including fuel.  The only answer is potential future residual value. If BOHL really believed the asset was worth £24m they should have approached the bondholders and agreed a proportionate writedown and sold the asset… but I think everyone knows that the asset is essentially unsellable in the current market, and certainly for nowhere near the number book value implies. Vard, Keppel, and China Merchants certainly do… The only recent DSV sale was the Swiber Atlantis that had a broker valuation of USD 40-44m in 2014 and went for c. USD 10m to NPCC and that was not an anomaly on recent transaction multiples. If the Sapphire isn’t purchased as part of a broader asset purchase she may not return to the North Sea and her value is extremely uncertain – see how little work the Swordfish has had.

Polaris has a different, but related, valuation problem. In order to access the North Sea day rate that would make the vessel worth say a £50m valuation you need a certain amount of infrastructure and that costs at c.£5-8m per annum (c.£14k -22k per day), and that is way above the margin one of two DSVs is making yet you are exposed to the running costs of £10k per day. Utilisation for the BOHL fleet has been between 29%-46% this year and the market is primarily spot with little forward commitment from the customer base. So an investor is being asked to go long on a £50m asset, with high OpEx and infrastructure requirements, and no backlog and a market upturn needed as well? In order to invest in a proposition like that you normally need increasing returns to scale not decreasing returns that a depreciable asset offers you.

This link between the asset specificity of DSV and the complementary nature of the infrastructure required to support it is the core valuation of these assets. Ignoring the costs of the support infrastructure from the ability of the asset to generate the work is like doing a DCF valuation of a company and then forgetting to subtract the debt obligation from the implied equity value: without the ability to trade in the North Sea the asset must compete in the rest-of-the-world market, and apart from a bigger crane and deck-space the vessels have no advantage.

It is this inability to see this, and refusal to accept that because of this there is no spot market for North Sea class DSVs, that has led to the Nor position in my humble opinion. The shareholders of the vessels are caught in the irreconcilable position of wanting the vessels to be valued at a “North Sea Price”, but unable or unwilling to commit to the expenditure to make this credible. It would of course be economic madness to do so, but it’s just as mad to pretend that without doing so the values might revert to the historically implied levels of depreciated book value.

The Nor owners issued a prospectus as part of the capital raising in Nov 2016 and made clear the running costs of the vessels were c. USD 370k per month per vessel for crewing and c. USD 90k per month for SAT system maintenance. In their last accounts they claimed the vessels value at c. USD 60m each. Given Nor raised USD 15m in Nov last year, and expected to have one vessel on a 365 contract ay US 15k per day by March, they are so far behind this they cannot catch-up at current market rates.

Again, these vessels, even at the book values registered, require more than 10% of their capital value annually just to keep the option alive of capturing that value. That is a very expensive option when the payoff is so uncertain. If you are out on your assumption of the final sale value by 10% then you have wasted an entire year’s option premium and on a discounted basis hugely diluted your potential returns (i.e. this is very risky). Supposedly 25 year assets you spend more than 2.5x their asset values to keep the residual value option alive.

Three factors are crucial for the valuation of these assets:

  • The gap between the present earning potential and the possible future value is speculation. You can craft an extremely complicated investment thesis but it’s just a hypothesis. The “sellers” of these assets, unsurprisingly, believe they hold something of great future value the market simply doesn’t recognise at the moment. Sometimes this goes right, as it did for John Paulson in the subprime mortgage market (in this case a short position obviously) and other times it didn’t as owners of Mississippi Company shares found to their discomfort. We are back to the “Greater Fool Theory” of DSV valuation.One share.png
  • Debt: In the good old days you could finance these assets with debt so the equity check, certainly relative to the risk was small. In reality now, for all but the most blue-chip borrowers, bank loan books are closed for such specialist assets. And the problem is the blue-chip borrowers have (more than) enough DSVs. The Bibby and Nor DSVs are becoming old vessels: Polaris (1999) will never get a loan against it again I would venture and the Sapphire (2005) has the same problem. The Nor vessels are 2011 builds and are very close to the 8 year threshold of most shipping banks. As a general rule, like a house, if you can’t get a mortgage the vessel is worth less, substantially so in these cases because all diving companies are making less money so their ability to find equity for vessels is reduced. Banks and other lenders have worked out that the price volatility on these assets is huge and the only thing more unsellable that a new DSV is an old DSV. It will take a generation for internal risk models to reset.
  • You need a large amount of liquidity to signal that you have the commitment to see this through. At the moment neither Bibby or Nor have this. From easily obtainable public information any potential counterparty can see a far more rational strategy is to wait, the choice of substitutes is large and the problems of the seller greater than your potential upside.

Of course, the answer to liquidity concerns, as any central banker since Bagehot has realised, is to flood the market with liquidity. Bibby Line Group for example could remove their restrictions on the RCF and simply say they have approved it (quite why Barclays will agree to this arrangement is beyond me: the reputational risk for them foreclosing is huge). As the shareholder Bibby Line Group could tell the market what they are doing, in Mario Monti’s words, “whatever it takes”. Of course, Mario Monti can print “high powered money” which is not something Bibby Line Group can, and that credibility deficit is well understood by the market. A central bank cannot go bankrupt (and here) whereas a commitment from BLG to underwrite BOHL to the tune of £62m per annum would threaten the financial position of the parent.

I have a theory, untestable in a statistically significant sense but seemingly observable (e.g. Standard Drilling, the rig market in general), that excessive liquidity, especially among alternative asset managers and special situation funds, is destroying the price discovery mechanism in oil and gas (and probably other markets as well).  I accept that this maybe because I am excessively pessimistic, but when your entire gamble is on residual value in an oversupplied market, how can you not be? In offshore this is plain to see as the Nor buyers again work out how to value the assets for their second “super senior” or is that “super super senior” tranche, or however they plan to fund their ongoing operations. The Bibby question will have to be resolved imminently.

At some point potential investors will have the revolutionary notion that the assets should be valued under reasonable cash flow assumptions that reflect the huge increase in supply of the competitive asset base and lower demand volumes. Such a price is substantially lower than build cost, and therein lies the correction mechanism because new assets will not be built, in the North Sea DSV case for a considerable period of time. Both the Bibby and the Nor bondholders, possessors of theoretically fixed payment obligations secured on illiquid and specialised assets will be key to the market correction. Yes this value is likely to be substantially below implied book/depreciated value… but that is the price signal not to build any more! Economics is a brutal discipline as well as a dismal one (and clearly not one Chinese yards have encountered much).

How these existing assets are financed will provide an insight into the current market “price discovery” mechanism. For Nor the percentage of the asset effectively that the new cash demands, and the fixed rate of return for further liquidity, will highlight a degree of market pessimism or optimism over the future residual value. If you have to supply another USD 15m to keep the two vessels in the spot charter market for another 12 or 15 months how much asset exposure do you need to make it work? Will the Nor vessels really be worth $60m in a few years if you have to spend USD 7.5 per annum to realize that? What IRR do you require on the $7.5m to take that risk? Somewhere between the pessimism of poor historic utilisation and declining structural conditions and the inherent liquidity and optimism of the distressed debt investors lies a deal.

The Bibby valuation is more binary: either the company raises capital that sees the assets tied to the frameworks of their infrastructure, and implicit cross-subsidisation of both, or the assets are exposed to the pure vessel sale and purchase market. The latter scenario will see a brutal price discovery mechanism as industrial buyers alone will be the bidders I suspect.

Shipbroker valuations work well for liquid markets. The brokers have a very good knowledge of what buyers and sellers are willing to pay and I believe they are accurate. I have severe doubts for illiquid markets, particularly those erring down, that brokers, like rating agencies, have the right economic incentives to provide a broad enough range of the possibilities.

Although the question regarding the North Sea DSVs wasn’t rhetorical it is clear what I think: unless you are prepared to commit to the North Sea in a credible manner a North Sea DSV is worth only what it can earn in the rest-of-the-world with maybe a small option premium in case the market booms and the very long run nature of the supply curve. The longer this doesn’t happen the less that option is valued at and the more expensive it is to keep.

 

[P.S. Around Bishopsgate there is a theory circulating that Blogs can have a disproportionate impact on DSV values a theory only the most paranoid and delusional could subscribe to. I have therefore chosen to ignore this at the present time. The substance of the message is more important than the form or location of its delivery.]

Tidewater, European banks, and zombie companies…

You walk outside, you risk your life. You take a drink of water, you risk your life. Nowadays you breath and you risk your life. You don’t have a choice. The only thing you can choose is what you’re risking it for.

Hershel (The Walking Dead)

Tidewater announed their restructuring today… as is widely reported they have written off USD 1.6bn of debt and reduced operating lease expenses by USD 73m. US Chap 11 isn’t perfect, and having nearly been on the receiving end once I find it amazing that US courts will claim jurisdiction essentially on the basis of a US domestic dollar bank account and Delaware address (which clearly isn’t the case here), but it is remarkably efficient from a macroeconomic perspective.

Last week The Economist published an article on Zombie companies noting:

there is a growing belief that the persistence of zombie firms—companies that keep operating despite a poor financial performance—may explain the weak productivity performance of developed economies in recent years.

An inability to kill off failing companies seems to have two main effects. First, the existence of the zombies drives down the average productivity level of businesses. Second, capital and labour are wrongly allocated to such firms. That stops money and workers shifting to more efficient businesses, making it harder for the latter to compete. In a sense, therefore, the corporate zombies are eating healthy firms.

… [the] analysis builds on the work of an OECD paper* published earlier this year which found that, within industries, a higher share of capital invested in zombie firms was associated with lower investment and employment growth at healthier businesses.

A fair summation of European shipping and offshore at the moment if ever I read one.

The contrast with the European shipping and offshore firms, where the banks have constantly tried to pretend that insolvent companies are viable by allowing them to pay interest only and deferring the principal payments, and the willingness of US firms to restructure and move on is clear. Part of it is structural as US banks have a smaller percentage exposure to these troubled assets but that doesn’t change the outcome. Quite how long auditors are going to allow this to continue when there are clear market based transactions with demonstrable asset values is anyone’s guess but eventually these loans will default. I agree with short-term measures, the equivalent of a liquidity rather than a solvency crisis for firms, when it really is that but with depreciating assets eventually the bullet payment is due and years into these situations the arguements for writedowns on a scale not yet seen is becoming more apparent.

The Nordic banks have been through this before during the Nordic Banking Crisis (1988-1993) having overextended themselves in real estate loans, in this case the credit bubble was driven by deregulation, like offshore shipping with a high oil price, the boom was procyclical.

Nordic Banking and Real Estate 1988-1993

Nordic Banking Crisis Data.png

As can be seen a reduction in asset values leads to a dramatic reduction in the amount of bank credit. The same thing will happen in shipping in offshore, despite it being a much smaller part of the overall bank loan books, and this reduction in credit is likely to permanently impair asset values. Economists have called this process the financial accelerator and it is clearly interacting between the banks and zombie offshore and shipping companies.

The sceptic in me thinks only a combination of liquidations, writedowns, and scrapping is going to return these sectors to an economically viable level. But the actions of the various stakeholders, individually rational but collectively irrational, the collective action problem I have mentioned here before, makes this unlikely. A future of low profitability and structural overcapacity in Europe beckons while restructured American companies with clean balance sheets look to be able to move ahead with a cost base that matches the operational environment.

The New Offshore… it looks a lot like Italian and Spanish banking…

The oldest bank in the world, Banca Monte dei Paschi di Siena SpA, founded in 1472, came under government control today. The bank, founded as the “Mount of Piety”, has been through numerous capital raisings and life support packages since 2008/09, and finally, even the Italian government and the ECB could no longer pretend it was solvent. I have lost count over the years of the number of times the ECB has declared the banks solvent (only last December the MdP fundraising was announced as “precautionary”), but shareholders who have previously be forgiving have had enough as has the Bank of Italy. There are some clearly analogous lessons for offshore in this.

European banks and offshore oil and gas contractors share many of the same issues. For years now central banks around the world have kept the price of the core commodity that banks trade in (money) low, interest rates at the Zero Lower Bound (“ZLB”) has become the new normal and banks struggle to the margin they used to between the money they borrow and the money the lend.

Another clear similarity between the banks and offshore contractors is excessive leverage. Banking is actually a pretty risky business (which is why banking crises and state bailouts are increasingly common), banks borrow short and lend long in a process known as maturity transformation. What this means in practice is that when you go into your friendly branch of DNB with your Kroners and deposit them you are lending the bank money and they are making a loan contract to pay you back a fixed number of Kroner. DNB then package up all the Kroner in the branch and turn it into a ship in the form of loan contract which they use to pay you back. The problem arises, as it did recently for DVB, when the value of the ship, or just as importantly the income from it, is worth less than the value of all the loan contracts the bank used in financing the ship. One or two doesn’t matter but if all the ships are worth less then the bank has a problem. This mismatch between the obligations that banks take on to finance assets that can vary hugely in value is the feature of nearly all banking crises, certainly in shipping as the German banks know well, but also the cause of the 2008/09 global financial crises. This is the fundamental instability mechanism in an economy that fractional reserve banking introduces.

Offshore has a similar instability mechanism and it too is a function of leverage. As the volume of work has dried up the fixed commitments owed to banks, bondholders, and other fixed rate security holders who were used to purchase vessels, assets, or finance takeovers has remained constant while the asset value has cratered and the revenue has done the same. Like a bank the asset side of the balance sheet is being severely strained at the moment as the revenues and profits simply cannot support historic commitments. It was this model of viewing the creditor run on Ezra/Emas as comparable to a bank run that made me sure there was no route to salvation for them. This transmission mechanism is destabilising all asset owners as banks are not lending on assets of uncertain value and the size of some of the writedowns is an issue for the banks. These sort of self-reinforcing loops are very hard to break.

Like the banking sector offshore is struggling with a the tail of a credit boom which is obviously related to the excessive leverage taken on. As has been shown many times over in research credit booms, in all contexts, take longer to recover from than other types of investment bubbles.

Historical analogies, no matter how interesting, are only good if they give us some insight into the future. In this case I think they are depressingly clear: since 2008/09 Spanish and Italian banks have created a structurally unprofitable industry that is unlikely to change with government intervention. Offshore contracting and European banks are both trapped in a low price commodity environment and burdened by historic asset commitments and the current economic value of said assets. European banks have overcapacity issues but shareholders and other stakeholders are committed to keeping this structure because of previously sunk costs and very high exit costs.

The banking crisis in Europe should be a lesson to offshore that impairments in asset values can be permanent. Mian and Sufi (read their book), after looking at the US housing crisis, propose shared risk mortgages where banks share in the capital value, such a suggestion seems prime for shipping and offshore gievn the extraordinary volatility in asset prices and the levels of leverage common in these asset transactions. The cynic in me says regulators would need to force this through, but I also believe eventually German taxypayers will tire of supporting the global shipping industry.

Another lesson to be drawn for offshore is that consolidation favours the large, there is a flight to quality. JP Morgan now has a market cap of roughly USD 336bn post crisis and would appear untouchable as the worlds largest bank (considerably larger than some central banks) after a series of well excuted post-crisis transactions. TechnipFMC has similarly become the largest offshore contractor through an astute merger (imagine if they had really brought CGG!) and if they can ever resolve the tax situation with Heerema will become untouchable as the largest and most capable offshore contractor.

Unfortunately for smaller players size counts. In a bank run people worry that the institution will not be there in the future so choose to withdraw savings because they are nothing but a loan to the bank. Similarly E&P companies who contract with smaller contractors are merely unsecured creditors if they fail despite the progress and procurement payments and therefore are at a considerable disadvantage in winning large contracts in a challenged environment even if they are substantially below the competition in price.

Another lesson is that there is no substitute for equity capital and the larger players have an advantage in raising this. Bank balance sheets have changed substantially since the financial crisis at it is clear that offshore companies that want to surivive will have a much higher componenet of equity in their capital structure. The quantum of this capital will be a major issue given the continued low profitability for all but the largest players in the industry,

But the clearest lesson to take unfortunately is that barring a major exogenous change the zombie banks, neither dead nor alive, can continue for a longer period of time than anyone would really like. Offshore is facing the same dilemma as 2018 looks to be quiet, relative to 2014, and OpEx continues to be a major problem for companies. There is no quick fix in sight unfortunately.

BOA and Volstad: End of a Norwegian era… More restructurings to come…

The best of men cannot suspend their fate: The good die early and the bad die late.

DANIEL DEFOE, Character of the late Dr. S. Annesley

Boa Offshore and Volstad Maritime are both involved in restructuring talks at the moment, both are bound by the same ties of market fate and financial commitments: excessive leverage, financial speculation, and a secular change in demand for the asset base that underpinned the bonds. On a wider scale these should be seen as examples of small Norwegian companies that rode an oil and credit wave that has now definitely ended and their place in the market will remain limited at best and in the Boa case is likely to be non-existent.

The excessive leverage isn’t simply a case of hindsight: again like the Bibby bonds these were depreciating assets backed by bonds that required no repayment during the life of the instrument. Capital assets that do not have to earn a return on their principal but rather rely on further refinancing are simply speculation by both parties to the transaction and are clearly indicative of a credit bubble. Such investments are what Minsky called Ponzi financing, it requires a suspension of belief from economic reality that such a situation can continue, and that interest payments can be met by constantly drawing on an increased capital value. In the offshore oil services world this wasn’t willfully disregardng the evidence but rather the industry belief that ever rising oil prices and demand side factors were immutable forces of nature. The failure to recognise that in the long-run this would cause some innovative firms to seek new solutions is one of the great enduring mental models that has led previous generations to believe fervently in ‘peak oil’.

The other similarity is the type of vessels both Boa and Volstad have backed: no other asset class in offshore has been as overbuilt as the large OCV (~250t crane, 1000m2+ back deck etc). Potential new investors in Volstad should look at how illiquid the Boa Deep C and Boa Sub C are: bondholders are looking at a liquidity issue because these assets are in all reality unsellable at any price at the moment. When the Volstad vessel charters finish their maximum upside is surely capped to the amount bondholders in comparable assets are willing to accept to supply vessels to Helix-Canyon… and that is surely lower than their current charters? And that would assume Helix need as many vessels, a bold asumption looking at their utilisation record. In the old offshore such assets were rare and expensive… now not so much…

Part of the clue to the lack of sales in the OSV market is not just in the demand side of the market it also lies in the behaviour of banks. Have a look at DVB (my previous thoughts on the bank here), lending to offshore was running at c. USD 2-3bn per annum in 2010 to 2014:

DVB lending by segment 2010-2014.png

Welcome to the world of The New Offshore and closed loan books as the DVB investor presentation (2017) shows:

DVB New Transport Business 2017

That isn’t DVB specific this is a relfection of all banks in the market and a total withdrawal of asset financing. No matter what the relationship bankers tell you to all but the most exceptional cases the loan book is closed for offshore assets in all banks (apart from US focused companies with a US revenue base and a US bank). And no one pays close to historical value for such specialised assets if you cannot get a loan, but this has become a self-referential cycle that will be very hard to break, and in reality will only be done so as part of an overall consolidation play by a player with a realistic financing structure relative to the market risk.

Volstad Maritime may have a viable business going forward (i.e. strategy and execution capability) based solely on the Helix-Canyon charters, but liquidity is a different issue. The fate of the Bibby Topaz remains a major area of interest as the vessel is part of a three boat high-yeild bond and the owners of the bond have in effect an option to take full control of the Topaz. The bond has a corporate guarantee from Volstad Maritime AS that adds to the complications. OTC bonds are a grey area but rumours abound of Alchemy (the core M2 investor), other funds, and industrial players all having positions in the bond. Bibby Offshore may well be delaying their restructuring announcement until the position of Volstad Maritime and the Topaz is clear (although if they can make it to September without legally overtrading handing back an Olympic vessel is also likely an announcement time). A seperation of the Helix chartered vessels could be a viable option but only if the corporate Volstad corporate guarantee can be squared with the bond owners (who also own the m/v Tau on charter to DeepOcean but must surely been seen as effectively worthless, and the Geco Bluefin (in lay-up?)).

The Boa bondholders and banks seem to be repeating the same mistake the Harkand/Nor bondholders have consistently made: confusing a permanent impairment in asset values for a temporary market dislocation. In fact the Boa OCV bond term sheet contains the following nugget:

the aggregate current market value of the vessels according to information provided by the Group prior to the date of this Term Sheet is NOK 810,000,000

No sane individual believes that you could get USD 95.7m for the Boa Deep C and Boa Sub C at the moment:  2 vessels that have to enter lay-up because there is no work for them and assets that no bank that would lend against. There is a nice gap in the documentation here where the advisers to Boa state they have not undertaken due diligence of any information supplied. Everyone here wants to believe something everyone knows not to be true.

The structure calls for the seperation of the various asset classes into their individual vessel type exposures and is in effect a wait-and-pray strategy. Bondholders pay a “Newco” management company a fee to manage the vessels and provision is made for a further liquidity issue. I sound like a broken record here but the longer everyone keeps providing further liquidity the further any supplyside recovery becomes. The Sub C and Deep C are very nice vessels but two vessels does not an operator make in the current market, all this set-up does is support latent capacity, like the North Sea PSV market, that keeps everyone bidding at OpEx levels only. Hope is not a strategy.

I don’t have any magic answers here beyond investors accepting the economic reality of their position which they are under no obligation to do. The Boa bondholders, like the Harkand bondholders, and others, figure they have lost so much what harm can one last roll of the dice do I suspect? For those of you who have seen the movie ‘A Beautiful Mind’ you may recognise this as a problem that is a case of Nash Equilibrium:

a solution to a non-cooperative game where players, knowing the playing strategies of their opponents, have no incentive to change their strategy

It drove Nash to a nervous breakdown (literally) and I have no intention therefore of taking this any further.

The New Offshore: Liquidity, Strategy, Execution. Nothing else matters.