Ponzi finance and asset values…

When the present phase of the stock market is written, we believe it will be referred to as ‘the era of projected inflation’ … the period when enthusiasm for future profits obscured actual earnings to an excessive degree. We are on the way towards the age of reason of several years ago when stocks had to show substantial earnings power, reasonable book value, and dividend returns comparable to the cost of carry.

Barr, Cohen, and Co, October 21, 1929

Rainbow’s End: The Great Crash of 1929, Maury Klein

The financial instability hypothesis, therefore, is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated…

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell  assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.

Hyman Minsky

Ponzi finance is happening in the rig market. And it is certainly the form of finance that McDermott got from Goldman’s (yielding over 14% today and essentially locking MDR out any future financing). This never ends well.

When this goes wrong it goes really wrong because unlike equity people thought they were getting their money back for 100c in the dollar. Banks in particular. When these rig and asset deals go wrong, and the banks shut down the loans books, and indeed contract the asset side of the balance sheet to compensate for the lost equity, things will really get tough in the financing market and force restructurings and supply side contraction.

A very small number of companies have been buying “assets” at inflated prices, cheered on by self-serving analysts, at rates that bear no relationship to their ability to generate cash. Some banks appear to be  lending against these nominal asset values when the underlying entities do not have suffient order book, yet alone cash flow, to pay them back. This is the classic dying throws of a credit boom and we know how this script ends. When someone asks you how do these moments of clear financial irrationality occur you are looking at one. No one wants to admit the madness or remove the punch-bowl.

Charle’s Ponzi’s original idea was actually legal and profitable… just not at the scale he wanted:

Ponzi emigrated to the United Sates in November 1903 moving from city to city working different jobs and serving prison sentences at least twice before settling into Boston in 1917. Employed as a typist and answering foreign mail, in August 1919 Ponzi discovered his path to the wealth he had always envisioned for himself. He was going to trade in postal reply coupons. What Ponzi identified was a flaw in the coupon system that he could use to his advantage. He realized the value of the International Reply Coupon (IRC) had been set at fixed exchange rates that had not changed since 1919, creating a market in which he could parlay the IRCs into profit if he exchanged coupons from countries with deflated valuations into the higher valued US dollars ostensibly buying low and selling high.

The flaw in Ponzi’s coupon scheme was that he probably could have earned a 400 percent profit on individual coupon redemptions but in absolute terms, the net would be infinitesimal. To amass the millions of dollars Ponzi alleged, an enormous amount of coupons would have to be traded. Two important reports were about to emerge that would ultimately lead to panic and a run on Securities Exchange Company. First, after examining Ponzi’s operation, financial analyst Clarence Barron reported that to be making the money that he was, 160,000,000 IRCs would have to be in circulation when, in fact, only about 27,000 were. Second, the United States Post Office announced that IRCs were not being purchased in large lots (Zukoff, 2006). Therefore, Ponzi could not hold the millions dollars of liquid assets he claimed. Charles Ponzi was arrested on August 12, 1920.

 

The same could almost be argued for the rig and asset deals going on… If you could sell these assets for 520 days a year at twice the market rate you could make a fortune. It’s the execution of this that is causing problems not the math…

But when loans are made, or rolled-over, to companies with no hope of paying them back eventually things stop. You can feel the credit noose tightening in the market now and the equity market is closed no matter how good the summer season. Expect the effects throughout the market to get progressively worse. 

I made this note today to remind me when I look back that some of the credit deals being announced for rig companies are literally insane. People who should know better who are simply not prepared to accept their original thesis of a recovery in rig market was correct and continue, again all the evidence to the contrary, to do anything other than continue to go long on something that cannot be true. Credit committee’s becoming equity investors by accepting that markets have to change before they can be paid back for a few hundred basis points above LIBOR. Nuts.

McKinsey came out with this recently for those who want a dose of big data rationality:

As non-national-oil-company operators shift focus to deepwater fields because of increasing break-even costs of shallow-water fields, jack-up demand should grow 1 percent per year through 2035. Following this trend, utilization will recover to above 80 percent by 2023, driven by a large number of retirements and continued deferment of the order book. The chronic jack-up oversupply appears set to end, as extensive retirements of older and lower-spec rigs in the near future are expected to lead to a 9 percent decline in the overall jack-up fleet by 2035.

Over the course of 2019, floating-rig demand will drop slightly because of unstable oil prices, but growth—to the tune of 6 percent per annum between 2019 and 2027, then 2 percent per annum until 2035—is expected to follow. Key growth regions will be Africa, Brazil, and the Gulf of Mexico. We anticipate that supply will remain relatively stable through 2026, leading utilization to recover to 80 percent by 2026 and long-term floater-supply growth to reach about 13 percent by 2035. [Emphasis added].

Most rig companies will be bankrupt long before those recovery times at current day rates.

When all these guys stop running around congratulating themselves for buying rigs at 70% of their build cost, when day rates have gone down by 50% and utilisation the same, and actually have to pay for them, chaos is going to ensue in the financing market. The start of which is clearly visible now.

Presenting the results, Van Eden gave a plain spoken account of how Anglo had come to rack up such losses. ‘There was no substance behind the borrowers,’ he said. ‘They had nothing but the collateral (property assets) they were providing. There was no equity in the system. They took all the equity out of deals and replenished it in new deals. It was one big leveraged play. It was one big Ponzi scheme’.

Anglo Republic: Inside the Bank that Broke Ireland, Simon Carswell

[This blog is largely becoming a storage post for what I hope will be a PhD in economic history that argues the offshore boom was largely the conjunction of a commodity boom but also, and importantly, a credit boom combined with structural industry change. The consequences a credit boom are well understood for asset heavy industry backed by high debt and it is not a comforting picture for anyone long in assets at the moment.]

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.

Random weekend energy thoughts… Productivity, costs, and DSV asset values…

Permian shale and tight production in the third quarter was 338,000 barrels per day, representing an increase of 150,000 barrels per day. Let me say it again: this is up 80% relative to the same quarter last year. As many of you will realize, that’s the equivalent of adding a midsized Permian pure play E&P company in a matter of months.

Pat Yarrington, CFO, Chevron, on the Q3 2018 results call

John Howe from UT2 posted the photo above on Friday and kindly allowed me to reproduce the it. The Seawell cost £35m in 1987 and according to the Bank of England Inflation Calculator the same vessel would cost ~£94m in 2018 in real terms. In 1987 the USD/UK exchange rate was ~1.5 so the Seawell cost $53m and inflation adjusted around $132m (at current exchange rates).

Compare that with the most recent numbers we have for a new Dive Support Vessel (“DSV”) of a similar spec: the Vard 801 ex Haldane that was contracted at $165m (sold for $105m).  That price is roughly 25% above the cost of the Seawell in real terms. You get a better crane and lower fuel consumption but in productive terms you can still only dive to 300m (and no riser tower) and I doubt the crane and the lower fuel consumption are worth paying 25% more in capital terms.

These prices don’t reflect how much the MV Seawell pushed the technological boundary when she was built when and recognised as one of the most sophisticated vessels in the world. The major £60m/$75m upgrade she received in 2014 highlights again the myth that old tonnage will naturally be scrapped as an iron cast law is wrong, but more importantly highlights the technical specification of the vessel has always been above even a high-end construction class DSV (clearly visible in the photo the riser tower must have been seen a major technological innovation in 1987) and yet it is more economic to upgrade than build new for a core North Sea well intervention and dive asset. Helix has invested in an asset that brings the benefits of low-cost from a different cost era to a new more uncertain environment.

The reasons for price inflation in OSVs are well-known and I have discussed this before (here): offshore vessels are custom designed and have a high labour content which is not subject to the same produtivity improvements and lower overall cost reduction that manufactured goods have (Baumol Cost Disease). The DP system and engine might have come down in real terms, but the dive systems certainly haven’t. Even getting hulls built in Eastern Europe and finished in Norway has not reduced the cost of new OSVs in real terms (you only have to look at Vard’s financial numbers to see the answer isn’t in shipbuilding being a structurally more profitable industry).

That sort of structural cost inflation, a hallmark of the great offshore boom of 2003-2014, was fine when there was no substitute product for offshore oil. Very few OSVs were built in a series (apart from some PSV and AHTS). But the majority of the vessels were one-off or customised designs with enormous amounts of time from ship designers, naval architects, class auditors (i.e. labour) before you even got to the fit-out stage. Structural inflation became built into the industry with day-rates in charters etc expected to go up even as assets aged and depreciated in real economic terms because demand was outpacing the ability of yards to supply the tonnage as needed.

The same cost explosion happened in pipelay but did allow buyers to access deeper water projects. Between 2003-2014 an enormous number of deepwater rigid-reel pipelay vessels were built (in a relative sense) with each new vessel having even more top tension etc. than the last; but the parameters were essentially the same: they were just seeking to push the boundary of the same engineering constraints. The result was (again) a vast increase in real costs but one that was partially offset by advances in new pipe and riser technology that allowed uneconomic fields to be developed. Now Airborne and Magma are working on solutions that could make many of these assets redundant. Only time will tell if those offshore companies who have made vast investments in pipelay vessels will have to sell them at marginal cost to compete with composite pipe if the solution gets large-scale operator acceptance (i.e. Petrobras). However, if composite pipe and risers get accepted by E&P companies on a commercial scale those deepwater lay assets are worth substantially less than book value would imply (I actually think the most likely scenario is a gradual erosion of the fleet as it is not replaced).

But now there is a competitor to offshore production: shale. And it is clearly taking investment at the margin from offshore oil and gas. And shale production is an industry subject to vast economies of scale and productivity improvements. The latest Chevron results make clear that they have built a vast, and economically viable, shale business that added 150k barrels per day of production at an 80% growth rate year-on-year:

Chevron Q3 2018 Permian .png

To put that in perspective when Siccar Point gets the Cambo field up and going they will be at 15k per day and it will have taken them years (and the point is they are a quality firm with Blackstone/Bluewater as investors ensuring the do not face a financing constraint).

What makes shale economic is the vast economies of scale and scope available to companies like Chevron. E&P companies producing shale are adding vast amounts of production volume every year and theories that they are not making money doing this are starting to sound like Moon photo hoax stories. E&P companies throw money and technology at a known geological formation and it delivers oil. The more money they invest the lower the unit costs become and the greater the economics of learning and innovation they can apply at even greater scale.

Offshore has a place but it needs to match the productivity benefits offered by shale because it is at a disadvantage in terms of capital flexibility and time to payback.The cost reductions in offshore that have been driven by excess capacity and an investment boom hangover, these are not sustainable and replicable advantages. In offshore everything, from the rig to well design and subsea production system, has traditionally been custom designed (or had a significant amount of rework per development). When people talk of “advantaged” offshore oil now it generally means either a) a field close to existing infrastructure, or, b) a find so big it is worth the enormous development cost. Either of those factors allow a productivity benefit that allows these fields to compete with onshore investment. But to pretend all known or unknown offshore reserves are equal in this regard is ignoring the evidence that offshore will be a far more selective investment for E&P companies and capital markets.

One of the reasons I don’t take seriously graphs like this:

IMG_1067.JPG

…and their accompanying “supply shortage” scare stories is that the market and price mechanism have a remarkably good track record at delivering supply at an economically viable price (since like the dawn of capitalism in Mesopotamia). Modelling the sort of productivity and output benefits that E&P majors are coming up with at the moment is an issue fraught with risk because 1 or 2% compounded over a long period of time is a very large number.

As an immediate contra you get this today for example:

(Reuters) – The oil market’s two-year bull run is running into one of its biggest tests in months, facing a tidal wave of supply and growing worries about economic weakness sapping demand worldwide.

Which brings us back to DSVs in the North Sea, their asset values, and the question of whether you would commission a new one at current prices?

Last week the OGA published an excellent report on wells in the UK and its grim for the future of UK subsea, but especially for the core brownfield and greenfield projects in shallow water that DSVs specialised in. And without a CapEx boom there won’t be a utilisation boom:

OGA wells summary 2-18.png

Future drilling is expected to pick-up  mildly, although it is unfunded, but look at this:

EA well spud.png

Development Drilling.png

So the only area in the UKCS that isn’t in long-term decline is West-of Shetland which is not a DSV area. CNS and SNS were the great DSV development and maintenance areas and the decline in activity in those areas are a structural phenomena that looks unlikely to change. Any pickup is rig work is years away from translating into a Capex boom that would change the profitability of the UKCS DSV and small project fleet.

DSV driven projects have become economic in the North Sea because they are being sold well below their economic cost. Such a situation is unsustainable in the long run (particularly as the offshore assets have a very high running cost). The UKCS isn’t getting a productivity boom like shale to cover the increased costs of specialist assets like DSVs and rigs: E&P companies are merely taking advantage of a supply overhang from an investment boom. That is no sustainable for either party.

So while the period 2003-2014 was “The Great Offshore Boom” the period 2015-2025 is likely to be “The Great Rebalancing” where supply and demand both contract to meet at an equilibrium point. Supply will have to contract because at the moment it is helping to make projects economic by selling DSVs below their true economic worth, and the number of projects will have to contract eventually because that situation won’t last. E&P companies will need to pay higher rates and that will simply make less projects viable. You can clearly see from the historic drilling data that a project boom in shallow water must be a long time coming given the lags between drilling and final investment decisions.

The weak link here in the North Sea DSV market is clearly Bibby Offshore (surely soon to be branded as Rever Offshore?). As the most marginal player it is the most at risk as marginal demand shrinks. Bibby, like other DSV operators on the UKCS, serves an E&P community that is facing declining productivity relative to shale (and therefore a higher cost of capital), in a declining basin, where the cost of their DSVs is not reducing proportionately or offering increased productivity terms to cover this gap. Both Technip and Boskalis were able to buy assets at below economic cost to reduce this structural gap but the York led recapitalisation of Bibby still seems to significantly over value the Polaris and the Sapphire – particularly given implied DSV values with the Technip purchase of the Vard 801 (TBN: Deep Discovery).

DSVs made the UKCS viable and built the core infrastructure, but they did it in a rising price environment where the market was based on a fear of a lack of supply. One reason no new North Sea class DSVs were built between 1999 the Bibby Sapphire conversion in 2005 is because the price of oil declined in real terms but the price of a DSV increased meaningfully in real terms. A new generation of West of Shetland projects may keep the North Sea alive for a while longer but this work will be ROV led. A number of brownfield developments and maintenance work may keep certain “advantaged” fields going for years that will require a declining number of DSVs.

North Sea class DSV sales prices for DSVs are adjusting to their actual economic value it would appear not just reflecting a short-term market aberration.

#structural_change #this_time_it_is_different #supplymustequaldemand

Unconventional verus offshore demand at the margin…

Economic growth occurs whenever people take resources and rearrange them in ways that are more valuable. A useful metaphor for production in an economy comes from the kitchen. To create valuable final products, we mix inexpensive ingredients together according to a recipe. The cooking one can do is limited by the supply of ingredients, and most cooking in the economy produces undesirable side effects. If economic growth could be achieved only by doing more and more of the same kind of cooking, we would eventually run out of raw materials and suffer from unacceptable levels of pollution and nuisance. Human history teaches us, however, that economic growth springs from better recipes, not just from more cooking. New recipes generally produce fewer unpleasant side effects and generate more economic value per unit of raw material…

Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has underestimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. The difficulty is the same one we have with compounding. Possibilities do not add up. They multiply.

Paul Romer (Nobel Prize winner in Economics 2018)

Good article in the $FT today on Shell’s attitude to US shale production:

Growing oil and gas production from shale fields will act as a “balance” for deepwater projects, the new head of Royal Dutch Shell’s US business said, as the energy major strives for flexibility in the transition to cleaner fuels. Gretchen Watkins said drilling far beneath oceans in the US Gulf of Mexico, Brazil and Nigeria secured revenues for the longer-term, but tapping shale reserves in the US, Canada and Argentina enabled nimble decision-making.

“The role that [the shale business] plays in Shell’s portfolio is one of being a good balance for deepwater,” Ms Watkins said in her first interview since she joined the Anglo-Dutch major in May…

Shell is allocating between $2bn and $3bn every year to the shale business, which is about 10 per cent of the company’s annual capital expenditure until 2020 and half of its expected spending on deepwater projects. [Emphasis added].

Notice the importance of investing in the energy transition as well. For oil companies this is important and not merely rhetoric. Recycling cash generated from higher margin oil into products that will ensure the survival of the firm longer term even if at a lower return level is currently in vogue for large E&P companies. 5 years ago a large proportion of that shale budget would have gone to offshore, and 100% of the energy transition budget would have gone to upstream.

The graph at the top from Wood MacKenzie is an illustration of this and the corollary to the declining offshore rig numbers I mentioned here. Offshore is an industry in the middle of a period of huge structural change as it’s core users open up a vast new production frontier unimaginable only a short period before. The only certainty associated with this is lower structural profits for the industry than existed ex ante.

Note also the split that the – are making between high CapEx deepwater projects and shale. Shell’s deal yesterday with Noreco was a classic case of getting out of a sizable business squarely in the middle of these: capital-intensive and not scalable (but still a great business). PE style companies will run these assets for cash and seem less concerned about the decom liabilities.

You can also see this play out in terms of generating future supply and the importance of unconventional in this waterfall:

Shale production growth

As you can see from the graph above even under best case assumptions shale is set to take around 45% of new production growth. When the majority of the offshore fleet was being built if you had drawn a graph like this people would have thought you were mad – and you would have been – it just highlights the enormous increase in productivity in shale. All this adds up to a lack of demand momentum for more marginal offshore projects. The E&P companies that are investing, like Noreco, have less scale and resources and a higher cost of capital which will flow through the supply chain in terms of higher margin requirements to get investment approval. This means a smaller quantity of approved projects as higher return requirements means a smaller number of possible projects.

Don’t believe the scare stories about reserves! The market has a way of adjusting (although I am not arguing it is a perfect mechanism!):

Running Out of Oil.png

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.

“Preparing for the recovery”… Whatever…

The IEA has recently published it’s new World Energy Review and if you have been reading this blog this comment will come as no surprise:

One notable trend concerns the relationship between oil prices and upstream costs. In the past, there has been a roughly linear relationship between upstream costs and oil prices. When price spiked, so did costs, and vice versa. What we are noting now is a decoupling. While prices have more than doubled since 2016, global upstream costs have remained substantially flat and for 2018 we estimate those increasing very modestly, by just 3%. Companies appear to have learned to do more with less.

Too many business models in the offshore supply chain are simply ignoring this. If you are going long on Borr Drilling shares (for example), as anything other than a momentum trade, then you need to look at data driven forecasts like this, which in statistical terms are called a structural break. Look at the cost deflator in the graph above! In an industry with high fixed costs (both original and operating) that is a straight financial gain for E&P companies and with the volatility in the oil prices they will not give that up easily… and in a world of oversupply they won’t have to.

The future will be different. Some vast market snapback where the Deamnd Fairy appears, and everyone brave enough to have paid OpEx in the offshore supply chain has found a clever get rich quick scheme, is an extremely unlikely event.

More data points like this should make you think as well:

IEA Source.png

Yes, I get the volume in absolute terms is growing, but it is change at the margin that defines industry profitability.

There is still too much liquidity and too many business plans talking as if a return to 2013/14 is a certainty when in reality such a scenario would be an outlier.