It’s grim up North… And the labour theory of value…

It’s Grim Up North.  The Justified Ancients of Mu Mu

Ricardo, Marx, and Mill believed that prices were determined by how much people had, in the past, invested. And that blinded them to any understanding of the workings of the market.

Friedrich Hayek

[I am not really a Hayek fan (in case anyone is interested). But he was a very smart guy who understood social and economic change processes better than most. Beyond that you get diminishing returns. As an aside I have been too busy to blog much lately, which is a shame as some really interesting things have been happening, but it doesn’t seem to have affected my visitor numbers much, which just goes to show maybe my silence is more valuable.]

The Oil and Gas UK 2018 Economic Report is out. For the North Sea supply chain there is no good news. There is clearly a limited offshore industry recovery underway as we head towards the end of summer. However, the market is plagued by overcapacity, and while service firms without offshore assets are starting to see some positive gains, if you are long on floating assets chances are you still have a  problem, it is only the severity that varies.

The UKCS is what a declining basin looks like: fewer wells of all types being drilled and dramatically lower capital expenditure. There is no silver lining here: an asset base built to deliver 2013/14 activity levels simply has too many assets for the vastly reduced flow of funds going through the supply chain. The report makes clear that the base of installed infrastructure will decline and there will be a relentless focus on cost optimisation to achieve this.

UK Capital Investment 2018.png

The volume of work may be increasing marginally but the overall value may even down on 2017 at the lower end of the 2018 forecast (purple box). Clearly £10bn being removed from the oil and gas supply chain, c. 60% down on 2014, is a structural change.

And the OpEx numbers unsurprisingly show a similar trend:

UKCS OpEx 2018.png

Party like it’s 2012 says Oil and Gas UK. Unfortunately a lot more boats and rigs were built since then.

Unit Operating Costs 2018.png

An unsurprisingly the pressure on per barrel costs seems to have reached the limits of downward pressure.

This should make supply chain managers seriously consider what their investment plans are for assets specific to the region and the likelihood of assets having to work internationally to be economic. It should also make people reassess what stuff is actually worth in a market that has reduced in size by that quantum and from which there is no realistic path to 2014 activity levels.

Technip paid $105m for the Vard 801, about $55m/45% discount to the build cost. Such a deal seems realistic to me. Some of the deals I have seen in offshore remind me of The Labour Theory of Value: if you dig a massive hole that costs a lot it must therefore be worth a lot. In reality with so much less cash floating around for assets that will service the UKCS an asset is worth the cash it can generate over its life, and the fact that it is substantially less than its replacement cost is just another clear example of how the industry will reduce its invested capital  as production levels in the basin decline. Like airlines offshore assets have a high marginal cost to operate and disposable inventory which is why you can lose so much money on them.

Boskalis appears to have paid an average of c. $60m for the two Nor vessels which equates to a similar discount on an age weighted basis. Quite where this leaves Bibby needing to replace the 20 year old Polaris and 14 year old Sapphire is anyone’s guess. But it is not a comfortable position to be in as the clear number four by size (in terms of resource access) to have competitors funding their newest assets on this basis. Yes, the shareholders may have paid an equivalent discount given the company value they brought in at, but if you want to sell the business eventually then you need a realistic economic plan that the asset base can self-fund itself, and at these sort of prices that is a long way off. Without an increase in the volume and value of construction work 4 DSV companies looks to be too many and this will be true for multiple asset classes.

As a mild comparison I came across this article on $Bloomberg regarding Permian basin mid-stream investment:

Operations in the Permian that gather oil and gas, and process fuel into propane and other liquids, have drawn almost $14 billion in investment since the start of 2017, with $9.2 billion of that coming from private companies..

That is just one part of the value chain. I get you it’s not a great comparison, but the idea is simply the ability to raise capital and deploy it in oil production, and it is clear that for Permian projects that is relatively easy at the moment. The sheer scale of the opportunities in the US at the moment is ensuring it gets attention and resources that belie a strictly “rational” basis of evaluation.

IMG_0957.JPG

That is what a growth basin looks like. The narrative is all positive. Once short-term infrastructure challenges are resolved that stock of drilled but uncompleted will be turned into production wells.

Oil and Gas UK go to great pains to explain the economic potential of the UKCS. But finance isn’t strictly rational and I still feel they need to be realistic about the cycle time tradeoff offshore entails. Shale, as we have seen, has an enormously flexible cost base relative to offshore and that has value.

The comments I make below are part of a bigger piece that I keep wanting to write but a) don’t have the time; and, b) probably doesn’t work for a blog format. But I think the impact of the private equity companies taking over North Sea assets needs to be realistically assessed.

Don’t get me wrong here I am a massive supporter of them. In terms of the volume of cash, and the ability to buy and invest at the bottom of the cycle, the North Sea would clearly have been worse off without private equity. But the results are in and there has not been a development boom… there has been a focus on the best economic assets that may make the fields last longer, but that is a different test. There may clearly have been an investment boom relative to what there would have been without private equity money, but again that is a slightly different point.

Private equity firms have a much higher cost of capital than traditional E&P companies and at the margin that will limit the number of projects they fund. The focus on lowering costs and returning cash as quickly as possible, often to compensate for how hard it will be for the owners to exit such sizeable positions, also adds to the change in the investment and spend dynamic (on the downside obviously). I am genuinely interested to see how these large multi-billion dollar investments are exited given how much trouble the super-majors are having at getting out.

Private equity may well be the future of the North Sea but that has huge implications for the supply chain. It is also worthwhile pointing out that while the smaller companies maybe able to sweat old assets they have a limit for larger projects. Quad 204 is a classic project where it is hard to see even one of the largest PE backed companies having the technical skills and risk appetite to take on such a vast project.

The majority of the larger deals also involved significant vendor financing from the sellers. Shell had to lend Chrysaor $400m of the $3bn initial consideration. This happened not through generosity, or a desire to maintain economic exposure to the assets, but because debt finance from the capital markets or banks was simply unavailable even to such large and sophisticated buyers. Siccar Point went to the Norwegian high-yield market in January borrowing $100m at 9% for five years. The fact is finance is scarce, and when available expensive, and this is impacting the ability of E&P projects to get financed. Enquest has had to do a deeply discounted rights issue, and borrow off BP, to complete Sullam Voe.

The E&P majors are helping to finance their own exit because it is the only way they can get out. The turnaround from that to an investment boom that could raise asset values in the supply chain is a long one.

In order to make money in this environment the E&P companies, particularly those backed by private equity, are focusing on driving down costs and limiting Capex with a ruthless efficiency and commitment few in the supply chain believed possible long-term. Where offshore assets are concerned the oversupply situation only assists with this. I met one of the private equity investors last week and I can assure you there is no pressure to replace old assets, safety first definitely, economics and finance second just as definitely.

The reality for the supply chain is this is a market where it will be very hard to make money for a very long time, and in reality the glory days of 2012-2014 look extremely unlikely to return. The Oil and Gas UK report gives some important data in explaining why.

Chinese subsea vessels…

Last month COOEC successfully delivered a high spec DSV and IMR further adding capacity to an already depressed market. The only effect is that companies like who used to charter DSVs and IMR vessels in the region have now lost completely the chance for this work and these vessels will be offered at rock bottom rates when they are quiet domestically.

Given that it is cheaper, and will be for some time to charter vessels rather than own them, one wonders why construction on these vessels was started long after this became clear?

A good article here highlights the scale of the subsidies for Chinese shipbuilders and the effect this has had on the industry:

Chinese shipyards.png

Given the conclusion:

[t]his calculation implies that a frequent assertion that China developed shipbuilding to benefit from low freight rates for its trade seems to be unsubstantiated. Indeed, the benefits of subsidies to shipping are minimal. Perhaps instead, the Chinese government is aspiring to externalities for sectors such as steel and defense, or even national pride …

[t]he results of my study suggest that Chinese subsidies dramatically altered the geography of production and countries’ market shares. Although price (and thus consumer) gains are small in the short run, they may grow in the long run as the operating fleet becomes larger.

It is hard not to see this as a move to ensure China moves up the value chain in the production chain for high spec vessels. Not good news for residual values long term I would suggest.

MPV Everest and DSV business models….

So it appears the Russians have paid equity and have fully taken delivery of the MPV Everest. Well done Keppel on getting paid the full contract value for such specialised tonnage in this market. I was wrong to cast aspersions on the soundness of the contract. And well done MCS for following through and taking full asset risk on this. I am not sure anyone esle can claim such a credit across most offshore asset classes?

The vessel looks close to signing some short-term work in Asia and will have the dive system commissioned as part of this. But…

The problem is the day rate… particularly as this is a vessel that looks set to operate at not that much more than cash breakeven on the first job and it has an empty schedule beyond that. The fact is the entirely speculative strategy of building high-quality DSV assets and thinking they would get a premium day rate, while displacing older tonnage, is having an extremely expensive initial experiment and proving its instigators both wrong and right…

Right in the fact there is a premium, but wrong in total economic terms because it is nowhere near enough for people to cover their cost of capital or hope to recover the builkd cost. The Everest was always a rescue job, having been built for a terminated contract, but others are not. UDS is rumoured to be getting USD 50k a day from McDermott for the Qatar job, but sitting in Singapore waiting for someone else’s boat to break is a high-risk strategy and unlikely to be profitable in the long run. The Everest looks like commanding a 10-15% premium to competitor vessels in the spot market but would need a ~400% premium to have any hope of recovering the build cost. This reflects the overspecification of the vessel, the fact it cannot command ice/polar rates, and the oversupply in the DSV market.

My only point on this has been that when a wall of oversupply meets a very weak market then economic returns will be substantially below economic costs. Continuing to deliver high quality tonnage to undercapitalised operators and chartering parties will just prolong any downturn for the existing fleet owners. But if initial indications are anything to go by MCS are in this for the long run, they have been burning c.10-15k per day Opex with Fox since delivery and purchased some second hand ROVs (from M2 I understand); and having put USD 200m into the vessel are unlikely to walk away quickly. Unfortunately the most logical, and likely, reaction from competing owners is simply to drop prices even more.

MPV Everest for sale…

If you had been paid the contracted SGD 265m for the MPV Everest I am not sure it would appear on LinkedIn as in the recent photo above? I love this statement:

MPV Everest can carry out subsea repair and construction activities at 3000 metres of water depth, well intervention, diving support services with an 18-men twin-bell system, fire-fighting and emergency rescue operations, as well as towing and the provision of supplies in Arctic terrain.

Having a DSV that can operate at 3000m is like having an aeroplane that can also fly to the moon, interesting but dramatically over-specified, given that divers are limited to 300m (and more commonly 200m now)? Yes, I get the crane and ROVs can be used at that depth… but why hire a DSV then? And quite why you would need an 18 man SAT system for the provision of supplies to the Arctic is beyond me?

Incidentially, if I had paid SGD 265m for a vessel I also would want it to be slightly better looking? Personal taste I guess…

But then again I am pretty sure no one has paid more than the progress payments for this vessel yet… If they get half the contract value I will be impressed (see here).

These types of assets that were ordered in the boom to do everything seem the most exposed in value terms while the market remains chronically oversupplied. If Keppel cannot get rid of this, and there are a very limited number of buyers, before the UDS vessels start arriving next year then all that beckons is a race to the bottom in day rates as supply  continues to outpace even a modest recovery in demand.

Looks a lot like this:

White Elephant

I still remain surprised at the lack of public comment on this from Keppel. The relevant SGX continuous disclosure requirements would appear clear:

SGX Cont Disc.png

Not getting paid for a SGD 265m asset, that is in all reality worth significantly less, would appear to “materially affect the price or value”? Nine figure write-offs, even for a company the size of Keppel, tend to have that effect?

Who knows? Maybe PWC as auditors for Vard and Keppel could ask them to park the DSVs at the same location? That way they could save money as once a year an audit junior could go out, inspect the DSVs, confirm they were there and in good condition, hadn’t worked for a another year, but were still worth nearly exactly what someone had agreed to pay for them before they went bankrupt, and despite day rates for comparable vessel dropping somewhere between 40-60%?

Given it is now April this vessel will have no regular work, of any of substance, in  the 2018 calender year as the schedules are now effectively secured. Combined with the fact that this is by an order of magnitude the most expensive DSV in Asia (in cost terms) things are not looking good for Keppel here. The strategy of building the most expensive DSV in the world and seeing if it will force companies to upgrade their tonnage is getting a  pure natural experiment here before more similar vessels arrive. Serious buyers can be very patient here… the sellers? Maybe not so much.

Random DSV write-off Friday …

The map above, in the yellow circle, shows the MPV Everest parked right outside Keppel in Singapore (this morning)… which is an odd place to park a SGD 265m vessel you have “delivered”. I mean you have literally delivered it, but normally in shipping terms it means to someone who has paid for it. Sooner or later Keppel is going to have to front up and admit they haven’t been paid for this. I am surprised that as a listed company they haven’t had to already, but they will also need to come up with a realistic impairment value here which will be interesting?

Because according to AIS the two UDS DSVs (Lichtenstein and Picasso) are also in lay-up effectively in Singapore. With three more being built having 0% utilisation on the first two in the fleet must be a minor concern?

Jumeirah Offshore ST.jpg

And now into the mix comes the Jumeirah Offshore DSV being built at Huangpu… At least the yard here is being honest and admitting that the buyers have defaulted. But in the next breath you are told they will only sell at 100% of book value… And the vessel is c. 80% complete apparently: just enough to have purchased all the expensive long lead items but not enough to recover their value. This is a nice vessel on paper, 24 man Drass system, ST design, 250t crane, and a fairly generous power capacity etc.

In fact it is possibly as nice as the Vard DSV, speaking of unsold DSVs (although without the build quality one suspects), that will also only be sold at book value. So when looking at the size of the financial write down that these yards will have to take why not look there given Vard have just published their accounts? It is not completely clear how much value Vard are acribing to the vessel as they hold it in inventory with another vessel, but amazingly the write-off for all their vessels is only NOK 54m, or around $7m!

Given the discounts going around in offshore at the moment for completed offshore vessels, and the price Boskalis recently paid for the Nor vessels, to pretend that the Vard 801 only lost a maximum of $7m on it’s build cost (Vard use realisable value) is really unbelievable. Preposterous in fact. Surely a discount of 50% to cost would be needed to actually sell the vessel in this market? The scale of the loss here is massive for Vard, not quite a solvency event but not that far off and hence their desperation to hold an unrealistic value, but this is really a case where it is hard to see how the auditor has been objective here? There is enough market intelligence to suggest that a North Sea Class DSV that cost c. $150m to build would need to be marked down more than 5% to sell in this market? Good news for Keppel because they are audited by PWC as well I guess?

The fact is there are a host of very high-end DSVs mounting up in yards now with no realistic buyers and yet somehow we are meant to believe these vessels are worth close to what they cost to build? This despite the fact that UDS has made a business out of offering to commercially market very similar vessels and apart from a small job in Iran, and short-lived contract with a company without an office or phone, has managed to get close to zero utilisation. I am going to share with you an extremely insightful piece of economic thinking: if a boat isn’t being paid to work then it it isn’t worth a lot of money (generally speaking).

And still they come… three more from UDS alone… will they really be finished or cancelled like the Toisa vessel in China?

Quite where all these vessels end up is a great unkown. Only a maximum of 2 could ever end up in the North Sea given current demand levels and replacement requirements, and more likely one, and just as likely Technip and Subsea 7 just decide to replicate their last DSV new builds with export financing and attractive delivery terms… in which case none are worth the North Sea premium.

That means these vessels are likely to end up in the Middle East and Asia where day rates have never supported North Sea class DSVs for a host of very good economic and environmental reasons. So either there are a whole pile of USD 150m DSVs sitting around idle, with no buyers, that are all worth nearly exactly what they cost indefinitely, or someone is going to start losing some real money soon, even if the auditors allow them to pretend they won’t for a while longer.

Changing of the North Sea guard in Leith…

Pictured this week are two stalwarts of the North Sea subsea market in Leith on their way to be scrapped.

The Seven Navica above has arguably gone earlier than envisaged when she was upgraded in 2014, but her replacement is a global asset for longer tiebacks and pipe-in-pipe projects and it reflects how much offshore development types have changed in a few short years. Not that long ago there were only two options for rigid-reel pipelay in the North Sea (excluding the s-lay Falcon) and that guaranteed Technip and Subsea 7 a substantial business where on they could integrate DSVs and rigid reel, which was the development methodology of choice. Now there are at least five options I can think of, flexibles technology has improved, and UKCS CapEx has shrunk so much the market doesn’t need dedicated assets but rather more flexible global ones.

Whereas this old girl below, caught on the same day, has more than paid for herself over the years and marks the end of what has been a very profitable investment for her owners. Rockwater shows you need to do a lot more than paint a DSV red to make money from it.

Rocky Scrap.JPG

End of an era… goodbye to Orelia…

The end of an era as the DSV Orelia is scrapped (above). I would wager she has been one of the most profitable offshore assets in an economic sense over her life. With a build cost much lower in real terms than new build tonnage, and in a market with a much lower number of competitors, this asset would have paid for her keep many times over.

As she goes it is worthwhile considering that the huge margins Orelia generated were a signal for other players to try and replicate this formula and build competitive assets and businesses. Such is the long run nature of the supply curve these new assets continue to arrive long after the margins have vanished, and despite some new-builds costing vastly more in a nominal and real sense, it is not clear, beyond being more fuel efficient, that they are superior economic assets. It is notable that Technip has sold off a large potion of her diving businesses and assets and is only really present in the North Sea now, which is a clear signal how profitable they think the SAT business will be in the coming years. The unwillingness of Technip to commit to specialised replacement tonnage for the North Sea market I also thinks signals their view, and mine, that there has been a structural change in the North Sea SAT diving market and anyone going long on it should have a very robust business case, because without a rebound in construction work, the market looks oversupplied for years. Soon the well Wellservicer will join her and a new generation of assets moves to the fore.

The latest rumour I heard regarding replacement tonnage was that the Vard new build had been sold to Middle Eastern interests (specifically Bahrain) who were going to charter the vessel back to Technip. Given that this is the third version of this story I have heard (although from two sources now) I treat it with a degree of scepticism (linked to JMT!): surely with TechnipFMC’s balance sheet the best option would be just to make Vard a take-it or leave-it cash offer? Vard have always insisted on a clean sale, maybe time and reality have intruded on this wish.