Bully for Brontosaurus…

“I am truly convinced that both the shipping and the offshore markets will recover.”

Mads Syversen, CEO Arctic Securities (26 Jan 2016)

Arctic and ABG Merger valuation.png

From the Solstad Farstad merger prospectus (9 May 2017) highglighting the extreme optimism of the investment bankers putting the deal together. It should be noted the asset market was under huge stress at the time (the bankers of course were paid in cash on completion).

The Golden Bough

In point of fact magicians appear to have often developed into chiefs and kings.

 James George Frazer, “The Golden Bough” (1890)

The Emporer

Courtier T.L. — Amid all the people starving, missionaries and nurses clamoring, students rioting, and police cracking heads, His Serene Majesty went to Eritrea, where he was received by his grandson, Fleet Commander Eskinder Desta, with whom he intended to make an official cruise on the flagship Ethiopia. They could only manage to start one engine, however, and the cruise had to be called off. His Highness then moved to the French ship Protet, where he was received on board by Hiele, the well-known admiral from Marseille. The next day, in the port of Massawa, His Most Ineffable Highness raised himself for the occasion to the rank of Grand Admiral of the Imperial Fleet, and made seven cadets officers, thereby increasing our naval power. Also he summoned the wretched notables from the north who had been accused by the missionaries and nurses of speculation and stealing from the starving, and he conferred high distinctions on them to prove that they were innocent and to curb the foreign gossip and slander.

 Ryszard Kapuscinski, “The Emperor” (1978)

Mons Aase, DOF Subsea CEO, said: “The appointment of Mr. Riise is an important step towards realizing our vision of being a world-class integrated offshore company, delivering marine services and subsea solutions responsibly, balancing risk and opportunity in a sustainable way, together, every day. I look forward to working closely with our new CCO and I welcome Steinar to DOF Subsea.” (15 October, 2018)

“Our business will probably die over the next 10 yrs because the demand for oil probably will start peaking – we think in 2028-2029.”

Ian Taylor, Vittol Chairman, June 8, 2019

“If you get lucky for a long period of time, you think the rules don’t apply to you… These guys thought they could walk on water. They weren’t smart, they were lucky”.

Maarten Van Eden, Anglo Irish Bank CFO, in Anglo Republic: The Bank that Broke Ireland

(Anglo Irish bank initially assessed its downside losses in the credit crunch at less than €2bn. Over €45bn later they had nearly bankrupted the Irish state by lending on illiquid property assets reliant on a booming Irish economy and a global credit boom).

 

Have a look at the graph in the header, particularly 2016/17, and then the Solstad liabilities for 2016/17, just as they were “buying” Farstad and DeepSea Supply:

Solstad liabilities 2016_17.png

(I saying “buying” because it was then second major rescue attempt after Aker made a spectacular error in timing with REM. It was a deal pushed by the bankers who didn’t want to deal with consequences of Farstad and Deepsea Supply).

That would be just the time the rig count in the Permain was to explode:

BH rig count June 2019.jpg

And here are the latest Solstad Q1 2019 liability figues:

Solstad Q1 2019 Liabilities.png

Roughly NOK 2bn higher! The assets are older, the market isn’t much better, and they owe NOK 2bn more! (Don’t get me started on look at the assets side of the balance sheet: it was well known the Farstad/DESS were worth significantly less than book value).

If you believed Solstad had a future in anything like its current form you would be asked to believe the impossible: that despite the most extraordinary structural shift the oil and gas industry, despite owning depreciating assets barely covering actual running costs, despite no indication of oversupply ending (and in fact every indication that funding a mutually assured destructive battle will continue with NAO planning to raise money), you would be asked to believe Solstad could actually pay that money back… And of course they can’t: the numbers on paper, the amounts the banks and creditors claim they are due, are indeed a fantasy. A wish, with no basis in economic substance despite their accounting clarity.

Solstad made an operating profit of NOK 162 918 000 in Q1 2019 on NOK 33bn of balance sheet and asset risk. If someone had lost the petty cash tin they would have been in a loss. It’s totally unsustainable.

It may have been reasonable to believe that NOK 30bn of debt could be supported by offshore demand when the US graph was at 2014 levels but it is no longer credible now. Too much of the investment and maintenance expenditure flowing through the global energy industry is just going to other places. This is a structural shift in the industry not a temporary drop in demand like 2009.

I am not picking on Solstad here, they are just the most obvious example as their resolution seems (reasonably) imminent. Without exception all these crazy asset play deals that relied on the market coming back will fail.

When I was at university I first read the palaeontologist Stephen J Gould who introduced me to the difference between Lamarckian and Darwinian evolution (Bully for Brontasaurus). If you can’t bothered clicking through to the links the easiest way to think about this (in a purely demonstrative example) is that Lamarckian evolution argues that giraffes evolved by gradually growing longer necks and reaching for higher leaves on trees that others couldn’t reach – which is wrong. One of the many brilliant things about Darwin was that he realised that it was the randomness in evolution that caused the process – giraffes that just happened to have the long neck gene prospered and had more baby giraffes and passed the gene on. The race of giraffes that prospered was the result of random selection that ended up adapting best to their environment. They got lucky not smart.

Offshore is full of companies that may have been lucky on the way up but are totally inappropriate financial and operational structures to survive in the modern energy era. Evolution is a brutal, mechanical, and forward acting process. It is irreversible and path dependent. In economics the randomness of the evolutionary process is well understood with most research showing industry effects are stronger than firm effects. By dint of randomness the genes of many of the asset heavy offshore companies companies, but especially those with debt held constant at 2015/16 levels, are fundamentally unsuited to their new environment.

In case you are wondering where I am going with this (and want to stop reading now) I have two points:

  • A lot of the offshore supply chain confused managerial brilliance on the ride up to 2014 with good luck, a high oil price, and a credit bubble. Seemingly being lucky enough to have been running small fishing vessels when North Sea oil was found was rarely posited as an explanation for the growth of many West Coast Norwegian offshore firms, but it is in reality true. A random act of economic circumstance that threw them into a rising commodity and credit bubble. A newer, far less wealthy, future beckons for many of the small coastal towns that supported this boom.
  • The randomness of US geology colliding with the most efficient capital markets in the world, the largest energy consuming nation, and technological circumstance has caused a complete change in the structure in the underlying oil market. The profound implication for North Sea producers, and the supply chain underpinning them, is a transition to be an ever more marginal part of the global supply chain. That will mean less dollars in flow to them and that however long companies try to fight this will be in vain because we are dealing with a profound structural change not a temporary reduction in demand.

What the offshore industry is faced with now is a fundamental regime change – in its broadest sense both statistically (which I have argued before) and sociologically. The economic models of debt fuelled boats and rigs with smaller contractors are over in principal. It’s just the messy and awkward stage of getting to the other side that beckons now.

For pure SURF contracting and drilling consolidation is the answer and will occur. Financial markets will squeeze all but the largest companies from taking asset risk. DOF Subsea’s business model of buying ships Technip wasn’t sure about long-term will look like the short term aberration to economic rationality it was. For offshore supply the industry will be structurally less profitable forever. Asia shows the future of offshore is a vast array of smaller contractors, operating on minimal margin and taking vast risks, and yet the E&P companies are happy with this outcome because they get competitive prices. There is no reason to believe this model will not work in Europe as well. Where procurement is regional there are no advantages to being a global operator as the unit onshore costs are such a small proportion of the offshore/asset costs.

Although it feels unique to many in offshore it isn’t. If you only read one book about a collapse of ancien regime make sure it is Ryszard Kapuscinski’s “The Emperor” (1978)  on the collapsing Ethiopian empire. By interviewing a large number of the courtiers Kapuscinski gets you into the collective mind of an institution unable to face the reality of circumstance. The inability of Haile Selassie to realise that his random luck was totally unsuited to adaptation in the modern world is deeply reminiscent of the management in offshore, and to a certain extent the banks behind it (I’ll write more on the Stiglitz- Grossman paradox which answers why this may occur later).

Slowly the power and the capital of marginal oil production is being shifted to the Lower 48. Make no mistake the replacement of low capital cost Super Majors for high cost of capital (often PE backed) E&P companies in the North Sea marks the slow withdrawal of capital long-term from the area. Note not removal: just slower investment, higher cost hurdles, more pressure on cost etc. That will require a structurally smaller supply chain.

Old capital structures, and especially debt obligations, written in the good times will be completely re-written. Over the next couple of years the Nordic banks are going to write off billions dollars (that isn’t a misprint) as the hope thesis of recovery loses credibility. They will shut down credit to all but the most worth borrowers and sellable assets (if you think that is happening now you aren’t watching the crazy deals going on in the rig market). Equity across the industry will rise and leverage will substantially decline.  Smaller operators will vanish driven the same process reducing biodiversity on earth now: a less munificent environment. I believe when these banks have to start really taking write-offs, and Solstad and DOF are important here because they are close in time and significant in value, bank loan books will in effect close for all but the largest companies. In the rig market where are few companies have been responsible for nearly all the deals and private bubble has built up in the assets this will be contrasted with a nuclear winter of credit. And if banks aren’t lending then asset values fall dramatically.

How much is the Skandi Nitteroi really worth? There is no spot market for PLSVs, Petrobras have no tenders for flexlay? No one else capable using it needs one and Seadras are getting theirs redelivered? Banks are going to take the hit here and then the industry will really feel it.

I am reading Anglo Republic, a book about the collapse of Anglo Irish Bank, at the moment. Again the inability of management (and Treasury, and the goverment) to see the scale of the losses has a strong parallel with offshore. And like offshore initially everyone believed the Irish propery market would come back, that liquidity not solvency was the problem, that this was temporary blip. The crisis was a slow burner for this reason. But when it really came, just like all asset heavy industries, it starts with the refusal of credit institutions to renew liquidity lines because they know it’s a solvency problem. And that is why Solstad and and DOF are significant. They are the BNP Paribas of the next phase. But you know what… my next book is this, and it will have the same story of excessive optimism, leverage, an event (literally a revolution in this case), and default. If there are only really seven major plots in literature there is surely smaller set in economic history? So we know what is coming here.

This needs to happen in an economic sense. The cost to produce offshore will have to rise to reflect the enormous risk the supply chain take in supplying these hugely unique assets on a contract basis. But for this to happen there needs to be a major reduction in supply and it needs to happen while competing against shale for E&P production share. And it cannot happen while the industry continues to attract liquidity from those who buy assets solely on the basis of their perceived discount to 2016 asset values in the hope of a ‘recovery’ to previous profitability levels.

Which brings us on to what will happen to Solstad? It is in the interests of both the major equity investors (Aker/ Fredrikson) and the banks to play for time here. I fully expect a postponement of the 20 June deadline. Next summer, the bankers will tell themselves, the rates will be high and we will be fine (just like the Irish bankers and countless others before). But some of the smaller syndicate banks clearly get the picture here, the business is effectively trading while insolvent, regulators will also eventually lose patience, and the passage of time will not be kind. The solution everyone wants: to put no more money in and get all their money back isn’t going to happen.

Normally in situations like this, where the duration of the assets is long and illiquid, like a failed bank, a ‘bad bank’ and a ‘good bank’ are created. One runs down (as DVB Bank is doing with offshore) and the good one trades and is sold (as DVB Bank have done with aircraft finance). That would see the Solstad of old split off into a CSV fleet maybe or a Solstad North Sea while the old Asian/Brazil DESS was liquidated and the Farstad AHTS business also liquidated. But that will require the banks writing off c. NOK 20bn (maybe more) and I don’t think they are there yet.

After Solstad comes DOF. And in all likelihood following them will be some smaller tier 2 contractors, and certainly some rig companies, who realize that in an economic sense this just cannot continue. No matter how hard they keep reaching for the greener leaves higher up.

A money creation theory of offshore asset recovery…

The reason we are less enthused by companies which rely on tangible assets such as buildings or manufacturing plants [Ed: or rigs/jackups/ships?] is that anyone with a big enough budget can easily replicate (and compete with) their business. Indeed, they are often able to become better than the original simply by installing the latest technology in their new factory. Banks are also quite keen to lend against the collateral of tangible assets under the often illusory view that this gives them greater security, meaning that such assets can also be financed easily with debt, or as we call it, ‘other people’s money’. Debt is provided to such companies both cheaply, and with seeming abandon at certain times in the economic cycle, with often perilous results.

Smithson Investment Trust, Owners Manual

High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich…

Akerlof and Shiller, Animal Spirits

…the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Keynes, Chap 2: The State of Long Term Expectations, in The General Theory

While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together…

Some of the other and usually minor factors often derive some importance when combined with one or both of the two dominant factors.

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 Debt Deflationary Theory of Great Depressions

… the modern debt-deflation process encompasses falling asset prices, debt repayment difficulties, a reluctance to lend, a financial crisis, the impact on the banks, and the inter-dependency of the financial system…

Wolfson, Cambridge Journal of Economics

Financial illiteracy is a recipe for debt, default and depression, whose effects appear to feedback on each another in a vicious spiral.

These individual costs are amplified when they are aggregated up to the macro level. How people’s expectations evolve – their degree of optimism or pessimism, exuberance or depression – is crucial for determining their individual decisions. It has long been recognised that these expectations can be shaped importantly by others’ expectations. For example, “popular narratives” can emerge which shape collective expectations among the public – optimism or pessimism, exuberance or depression – and which can then drive aggregate economic fluctuations…

At a macroeconomic level, the work of George Akerlof and Robert Shiller has looked at the popular narratives which emerge during periods of boom and bust.  Using words extracted from newspapers, they find the prevailing popular narratives about the economy have played a significant role in accounting for the heights of the peaks and depths of the troughs during macro-economic booms and busts. Public expectations, embedded in the stories they tell, are a key macro-economic driver.

Andrew Haldane, Bank of England, Folk Wisdom

Last week the Deputy Governor of the Reserve Bank of Australia gave a speech titled “Money – Born of Credit?”, in this speech he outlined an important, yet underappreciated fact, of modern economies: deposits in bank accounts are caused by loans. A lot of people think that by putting money in their bank account they are giving the bank the ability to make a loan, but actually in a systemic sense it is the other way around: the money in your account is the result of banks making loans that end up as deposits in your account. In case you think this is some bizarre, and wrong, economic tangent, the Bank of England has an explanatory article “Money creation in the modern economy” which states:

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The Chief Economist of Standard and Poor’s summed it up in this article:

Banks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit “creation”–credit is created literally out of thin air (or with the stroke of a keyboard). The loan is not created out of reserves. And the loan is not created out of deposits: Loans create deposits, not the other way around.

This ability of privately owned banks to have the power of money creation is not often discussed. To many economists, although generally not those working at banks, this is a privilege where the ability to ‘privatize the profits and socialise the risk, is most flagrant and should perhaps be regulated more. The ‘Exorbitant Privilege‘ of the private sector. There is significant evidence that financial and banking crises have indeed become more common since the move to deregulate the financial system and credit creation that became especially strong post the end of the Bretton Woods era (post 1973).

If you are still reading at this point you may be wondering where I am going with this? The answer is that the implications for an industry like offshore, an asset-backed industry where values were sustained by huge amounts of bank leverage, are important for understanding what a “recovery” will look like. The psychology and ‘animal spirits’ of the commercial banks is likely to matter more than any single factor in dictating when an asset price recovery will be. Given that the loan books are closed to all but tier 1 borrowers, and contracting overall in offshore sector exposure, this would appear to be some way off.

Part of “the boom” in offshore since 2000, barring a short and sharp downturn in 2008/09, was the increasing value of rigs and offshore support vessels, but important too was the willingness of banks to lend against 2P reserves (Reserve Based Lending). This was a pro-cyclical boom where because everyone believed the offshore assets and reserves were worth more than their book value banks were willing to lend significant amounts of money against them. There was a positive and logical narrative of a resource-contrained oil world to unlock the animal spirits, it wasn’t irrational per se. As these assets changed hands banks created deposits in company accounts, they literally created “money” out of thin air by believing that the assets were worth more than they were previously. It is no different to a housing boom, and the more money the banks pumped in, the more everyone believed their assets were worth more (as the deposits grew). Ergo a pro-cyclical credit boom combined with an oil price boom. The demand for oil, and its price, has recovered, and this will affect the amount of offshore work undertaken, but the negative effects of an asset price boom will take longer to recover.

Right now the banks aren’t creating any new money for the offshore sector, collectively they are actually destroying it. When banks refuse to lend on ships or rigs no deposits flow through the system. Money from outside the system stops flowing into the offshore sector from the banks. Values and transactions are supported by the economic earning potential of current assets and the amount of equity and debt raised externally by funds. None of these “creates” money as banks do. These funds are “inside” money.

As an example last week Noble purchased a jack-up from a yard in Indonesia and was granted a loan by the yard selling the unit (a Gusto unit pcitured above). A piece of paper was exchanged and credit was created for the $60m loan of the total ~$94m price. Neither firm has any more money than they had prior to signing the loan contract. Credit isn’t the same as money… had a bank been involved (simplistically) it would have credited the yard with $60m, created a debt of $60m for Noble (a debit), and created an asset for $60m on its balance sheet. This money would have flowed from outside the offshore industry. The total value of the transaction would have been the same but the economic consequences, particularly for the liquidity of the yard, would have been very different. It is safe to say the reason this didn’t happen is because no bank would lend the money under similar terms. Relief rather than animal spirits seems a more likely emotion for this transaction.

It is not just the offshore contracting companies but also the E&P companies that are suffering from reduced bank credit and this is affecting the number of projects they can execute (despite a rise in the oil price). Premier is currently raising funds for the Sealion project, as part of this Drilquip has been given the contract for significant parts of the subsea scope, and they have provided this on a credit basis. In past times Premier would simply have borrowed the money from a bank and paid Drilquip. Now Drilquip has an asset in how much credit it has extended Premier but in the hierarchy of money that is lower than the cash it would previously have had, and it has to wait for Premier to sell the oil to pay it, and take credit risk and oil price risk in the meantime. Vendor financing is not the panacea for offshore because unlike banks vendors can create credit, but not money, and these are two fundamentally different things. There is a financial limit to how many customer Drilquip can serve like this. Collectively this lowers the universe of potential projects for E&P companies, and therefore the growth of the industry, that can be achieved. Credit creation is essential for an industry to grow beyond its ability to generate funds internally.

Another good example is the Pacific Radiance restructuring. Here the proposed solution, that I am enormously sceptical of, is that a new investor comes in allows the banks to restructure their loan contracts/ assets such that they can get paid SGD 100m in cash immediately while writing down the size of the loan. The equity and funds coming in are funds from the existing stock of money supply, they are not additional liquidity created by a belief in underlying asset values and represented by a paper loan contract and a growth in the loan book of the bank. While the new funds are adding to the total stock of money available to the offshore industry the bank involved is taking nearly as much off the table and you can be sure they won’t be lending it back to the sector. And thus the money stock and capital of the industry is reduced. Asset values remain low and the pain counter-cyclical process continues.

When you see companies announcing asset impairments and net losses that flow through to retained earnings this is often merely accounting of the banks withdrawing money from the sector and the economic cost of the asset base not being in tune with the amount of money available to the industry as a whole. It is also seen in share price reductions as the assets will never pay their owners the cash flows previously forecast.

In a modern economy this is normally the transmission mechanism from a credit bubble to a subsequent economic collapse: the ability of private sector banks, and only banks because of the system can create “money”, to amplify asset prices and cause sectoral booms on the way up and reduce the money stock and asset valuations on the way down. Why this happens is a complex topic and cannot be tackled in a blog, but it has clearly happened in offshore. Just as it has happened in housing booms, mining booms, ad infinitum previously. The dynamics are well known and are accentuated in industries which have had a lot of leverage. Much work was undertaken following the depression of agricultural prices in the 1930s, a commodity like oil which fluctuated wildly but the tangible backing of land allowed banks to supply significant leverage to the sector. Irving Fisher, quoted above, was famous for predicting that the US stock market had reached a “permanently high plateau” in 1929,  but his understanding of debt dyamics from studying banking and the US dustbowl depression transformed our understanding of the role of credit and banking.

[This explanation crucially differentiates between inside-money and outside-money. I am making a distinction between money generated inside the offshore sector and outside. By inside money I mean E&P company from expenditure, credit created amongst firms in the industry, and retained earnings. Outside money is primarily bank credit and private equity and debt funds. But whereas private equity and debt funds must raise money from the existing money stock only bank created money raises the volume of money].

In offshore the credit dynamics have been combined with the highly cyclical oil industry and allows optimists to believe a “recovery” is just possible. But a recovery scenario that is credible needs to differentiate between an industrial recovery, driven by the amount of E&P projects commissioned, and an asset price recovery, which is essentially a monetary phenomenon.

A limited industrial recovery is underway. It is limited by the availability of bank credit and the huge debts built up in the previous boom by the E&P companies, and their insistence that shareholders need dividends that reflect the volatility risk of the oil and gas industry. It is also limited because of the significant market share US shale has taken from offshore. But the volume of offshore project work is increasing. This is positive for those service firms who had limited asset exposure, and particularly for the Tier 1 offshore contractors, as much of the work being undertaken is deepwater projects that are large in scope.

But an asset recovery is still a long way off. There are too many assets for the volume of work in the short-run and in the long run it will be very hard to get banks to advance meaningful volumes of credit to the industry. Companies can write loan contracts with each other that represent a value, but banks monetise that immediately by providing liquid funds and therefore raising the animal spirits in the industry, whereas shipyards lending money to drilling companies need them to generate the funds before they can get paid. The velocity and quantity of money within the industry become much smaller. Patience and animal spirits make poor bedfellows.

Bank risk models for a long time will highlight offshore as a) volatile, and b) risky given that a bad deal can see even the senior lenders wiped out completely. Like all of us banks fight the last crisis as they understand it best. Until banks start lending again the flow of funds into the offshore industry will mean the stock of assets that were created in more meaningful times are worth less. In a modern economy credit creation is the sign that animal spirits are returning because it raises the return to equity (and high yield) providers.

In the boom days leading up to 2014 money and credit were plentiful. The net result was a vast amount of money being “created” for the offshore sector and a lot of deposits being created in accounts by virtue of the loans banks were creating to companies in the offshore sector based on their asset value. Now the animal spirits are no more and a feeling of caution prevails. The amount of money entering the sector via higher oil prices and private equity and debt firms is much smaller than was previously created by the banking sector. Over time this should lead to a more rational industry structure… but a repeat f 2014 days is likely to be so far away that the market at least has forgotten it…

As The Great Man said:

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady…[but]…We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

Financial crises comparisons…

This article from Gillian Tett on whether we have learnt the lessons from previous financial crises contains this quote:

But whatever their statistical size, crises share two things. First, the pre-crisis period is marked by hubris, greed, opacity — and a tunnel vision among financiers that makes it impossible for them to assess risks. Second, when the crisis hits, there is a sudden loss of trust, among investors, governments, institutions or all three. If you want to understand financial crises, then, it pays to remember that the roots of the word “credit” comes from the Latin “credere”, meaning “to believe”: finance does not work without faith. The irony, though, is that too much trust creates bubbles that (almost) inevitably burst.

My hypothesis is that offshore energy has suffered both from the bursting of a credit bubble (that saw for example its largest specialist lender DVB Bank go effectively bankrupt), as well as a structural change in the demand for offshore oil brought on by shale. The interrelationship between these two events is at the core of my thinking.

But the above paragraph is clearly a good summation of the 2000-2014 offshore boom. As in a banking crisis offshore asset owners had high embedded leverage on long term financing contracts funded with a series of smaller and shorter duration contracts with E&P companies. The asset owners, like banks, were committed to a long-term collection of highly illiquid assets that relied on a buoyant short-term contracting market. Like all booms there was clearly “hubris, greed, and opacity”.

When this delicate balance changed the enitre funding model of the industry was called into question and the lack of rebound on the demand side has led to severe overcapacity issues that – understandably – have left stakeholders reluctant to address. This quote also seems apt:

But shattered trust is hard to restore — particularly when governments or bankers try to sweep problems under the carpet, say with creative accounting tricks. “You can put rotten meat in the freezer to stop it smelling — but its still rotten,” one Japanese official joked to me as he watched American attempts to reassure the markets, turning to some of the same tricks the Tokyo government had once tried — and failed — to use a decade before.

A really big boat, asset specificity, and Chinese finance….

The picture above is a purpose built vessel, a deepsea mining unit for Nautalis Minerals, currently being built in China at the Mawei yard. It is undoubtedly an amazing piece of engineering, enormous as can been seen: 227m x 40m . A few more shots here:

The problem of course is who is going to pay for it. This is a deal that has been kicking around the market for years, a complex vessel, with few other potential buyers, ordered in the boom times with no takeout financing. Surely, yet again, like the DSVs floating around at the moment the yard is going to be stuck with this?

The economics of this argues that a charter is not the right option for Nautalis here. The vessel is the perfect example of asset specificity where it has a higher value to Nautalis than any other owner, and logic would dictate that Nautalis should raise the capital to pay for it. But Nautalis may get lucky here that the yard knows this and will simply have to charter them the vessel to avoid a firesale for an asset that has few other natural buyers. Delivery date is approaching here and it will start to get interesting.

When you read about the Chinese credit bubble it isn’t all in real estate (although a fair proportion is). This asset is one of number where it seems fairly clear that the losses, or at least the risks in the case of this vessel, will be taken by a semi-private entity at some point, maybe moved to a state bank leasing arm. The question is how systemically important the number is overall for all the Chinese yards? Rumours in China abound that the UDS may end up with the Chinese Navy or Coastguard.

At some point, as the German banks discovered, lending money to make ships that people can’t pay for, even as great short term job creation scheme, has an enormous economic cost.

There is a good article here summarising the Chinese push to become far more active in ship finance as part of a broader strategic plan. I have no idea what the bad loan capacity is for China Inc. as a whole in shipping, in offshore the Chinese lease houses appear to have paid top dollar for some average assets, but so did everyone in the boom and staying power will be important the longer demand stays depressed. In general shipping they may have missed the worst and be coming in at a good time.

Regardless, quite what happens to this vessel will make an interesting case study of how these issues get dealt with. Ship building is a relatively low margin industry that takes massive risks to get orders in the door, often with tacit or explicit state support, but when it goes wrong the potential losses seem so much larger than the upside ever offered. Hopefully the number of speculative new builds for such specific assets, without take-out financing, will drop going forward because it is so economically inefficient. But I doubt it.

The French Revolution and Venezuela…

As a follow on from my post on Venezuela a really interesting, and short, article at FT Alphaville (free) comparing Venezuela’s proposed “Petro” and the Assignats of the French Revolution. Maduro is well on his way to becoming a modern Robispierre, with exile or a similar fate awaiting him. Tony Yates highlights that nothing in Venezuela, not the revolutionary tendencies, or the economic solutions of the revolution’s leaders, have changed over time much over time as real options dry-up.

A more in-depth paper here for anyone really interested.

The Nemean lion of debt in offshore supply…

The slaying Nemean lion was the first of the twelve labours of Heracles. The lion had an indestructible skin and it’s claws were sharper than mortals swords. I sometimes feel that the first task in getting some normality into the offshore supply market is to find a Heracles who can begin to slay the debt mountain built up in good times…

In Singapore Otto Marine and Pacific Radiance appear all but certain to enter some sort of administrative process as their debt burden divorces from the economic reality of their asset base. The best guide to what they need to achieve, and the enormity of the task, come from the recent MMA Australia capital raising. I think MMA is a company that understood the scale of this downturn, and reacted accordingly, but they still have a tough path to follow, but at least they have an achievable plan.

The MMA plan involved raising AUD 97m new equity (AUD $92 cash after AUD$ 5m in fees, which is steep for a secondary issue and shows that this wasn’t easy) compared to bank borrowings of AUD $ 295m i.e. 33% of the debt of the company, or over 100% of the equity value (at AUD 88m) was raised in new capital in one transaction in November 17. In order to do this the lending banks involved had to agree to make no significant dent in the debt profile before 2021, reduce the interest rate, and extend the repayments. “Extend and pretend” as it is known in the jargon. All this for a company that in the six months ending 31 Dec 2017 saw a revenue decline of 22% over the same time last year (AUD $119m to AUD $92m) and generated an EBITDA of only $7.6m (which excluding newly raised cash would give a Debt/EBITDA of 14.3x when 7x is considered high).  I’d also argue the institutions agreed to put the money in when the consensus view (not mine) was that 2018 would be a better year, raising money now looks harder. (Investment bankers can sometimes come in for some stick but this, in my opinion,  was a really good deal for the company and the banks earned their money here).

The fact that MMA’s Australian banks have far less exposure to offshore supply than the Singaporean banks made them more pragmatic (while still unrealistic), but this shows what needs to be achieved to bring in new, institutional quantities, of money to back a plan. As a portfolio move from large investors, making a small bet on a recovery in oil prices leading to linear increase in offshore demand, I guess that is sensible. I don’t think it will work for the reason this slide that Tidewater recently presented shows:

TDW OSV S&D.png

There is too much latent capacity in an industry where the assets, particularly the MMA ones, are international in operational scope. By the time the banks need to start being repaid these 20-25 years assets will be 3 years older, 7 since the downturn, yet expected to bear an unmarked down principal repayment schedule. It’s just not realistic and requires everyone else but you to scrap their assets. It maybe worth a punt as an institutional shareholder… but I doubt that few really understand the economics of aging supply vessels.

This contrasts with Pacific Radiance where this week the bondholders refused to agree to accept a management driven voluntary debt restructuring and management seem to be relying on the industry reaching an “inflection point”. As soon as you hear that you know there is a terrible plan in offing that relies on the mythical demand fairy (friends with the Nemean lion I understand) to save them.

I would have voted against the resolutions this week as well had I been a bondholder, but mainly because of the absurdity of agreeing to a plan without the banks being involved or new money lined up. The bond was for SGD 100m… have a look at the debt below on the latest Pacific Radiance balance sheet (Q3 2017)… can anyone see a problem?

PR Balance Sheet Q3.png

Pacific Radiance has USD 630m in debts. Even writing off the bond would mean you are in a discussion with the banks here. I have no wish to take people through the math involved in what the bonds are worth becasue in reality all anyone owns here is an option on some future value, and if you are not the bank you don’t even have that. In order to bring the plan into line with MMA, Pacific Radiance would be looking at presenting an agreed plan with the banks, and ~USD 220m capital raise, an amount that is real money for a company that is still losing money at an operating level.

No one believes the vessels and the company are worth USD 710m. If the banks really thought they could get even .80c in the dollar here by selling to a hedge fund they would be out tomorrow. A large number of the Pacific Radiance vessels are well below the quality of the MMA vessels and in the real world it would seem reasonable for the banks to have to write down their debt significantly to attract new money. If vessels are sold independently of a company transaction, like MMA, then they go for .10c – .20c of book value, so it would make sense for the banks to be sensible here. However, I fear that so many have told shareholders they are over the oil and gas exposure that major losses here will be resisted despite economic reality. I suspect the write-off number here would need to be at ~50-60% of book value to make Pacific Radiance viable and get such a large quantity of new money, an amount that will have risk officers at some Singaporean banks terrified.

As I keep saying here the real problem is that if everyone keeps raising new money for operational expenditure, on ever lower capital value numbers, then the whole industry suffers as E&P companies continue to enjoy massive overcapacity on the supply side. Eventually without a major increase in demand a large number of vessels are going to have to leave the industry and this will happen when the  banks have no other options, and we are starting to get close to that point.

In reality the Pacific Radiance stakeholders need to sit around the table, have a nice cup of tea, and accept the scale of their losses. Then all the stakeholders can come up with a sensible business plan and the new money for operational expenditure can be found. But the banks here will be desperate to be like the MMA banks and get the new money in without suffering a serious writedown while trying and push the principal repayments out until a later date. I don’t see that happening here and the bondholders may as well sit around with all parties rather than be picked off indepdently. A major restructuring would appear the only realistic outcome here and if Pacific Radiance is to continue in anything like it’s present form there will be some very unhappy bankers.

What could possibly go wrong?… The $130m MBA….

For those with some knowledge of the financing of offshore assets over the last few years comes this amusing little story in the FT this morning:

Hedge funds are turning in increasing numbers to the business of buying planes and then leasing them to airlines, as the era of low interest rates pushes firms into more esoteric corners of finance in the hunt for higher returns.

A yield backed by an asset… Where have I heard that before?:

“People today are very focused on yield and it is driving investors to focus on aviation assets because you get yield and you have a hard asset — you have collateral,” said Marc Lasry, Avenue Capital’s co-founder.

As the article points out equity yields are dropping and a credit bubble follows:

The rising interest in buying and leasing aircraft has also triggered a surge in sales of debt tied to aircraft leases. Sales of bonds backed by aircraft leases jumped to $6.6bn in 2017 from $4.2bn in 2016, according to data from Finsight.

What is more, newer hedge fund entrants have focused on the higher yields available from leasing older, typically less fuel-efficient aircraft, but the rebound in oil prices is cutting their attraction for airlines.

This time it’s different….

I am writing a book on Nimrod/ the offshore bubble with the working title “The $130m MBA: The Nimrod Sea Assets Story”… a chapter on comparing the forthcoming airline crash would make a nice comparison I feel.