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.

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.