The oil market…

I am not an oil forecaster, if merely use of the word isn’t a misnomer, but I am interested in the psychological effects the market has on the physical and pricing of offshore services. Only last week Goldman called $80 oil, coincidentally when they called oil going to $20 in 2016 (when it was $36), it marked the low point in the market, now it seems this maybe the high as the price dropped yesterday.

To put these daily fluctuations into perspective there is a good article here on the swings in the oil price since 1973 until 2014. The story of shale gets a passing mention but remains to be written.

I have also noticed a lot of commentary mocking the market analysts from investment banks for their inability to predict accurately the turns in the market. I would note firstly if you think analysts at an investment bank have a job to do beyond helping the firm sell securities then you are wrong. IB analysts fall under the remit of marketing and that is their job, not to provide independent, and free, research to the community at large.

And even if they are trying to be accurate, say a firm with a limited corporate finance arm, one should remember Alfred Cowles. Cowles was the inheritor, and investment advisor, to a large Chicago newspaper fortune, as well as being a statistician and economist. In 1929 he was long on stocks and lost a great deal of money and set out to find the answer to a question made famous when asked by the Queen to LSE academics in 2008, namely “Why did nobody notice it?” (as in the Global Financial Crisis). Specifically, Cowles wondered why the big Wall Street brokerages didn’t see the crash of 1929 coming? Did they know any more than their customers? (I mean The Great Vampire Squid was keen on Ceona when anyone with a modicum of pipelay knowledge knew the Amazon lay system was a busted flush?)

In a famous paper “Can Stock Market Forecasters Forecast?”, published in Econometrica in 1944,  Cowles proved that they can’t. I urge you to read the whole article (aside from anything the language is beautiful), for example Cowles found:

Cowles.png

The answer would be exactly the same for the oil market today if replicated I would wager. This comes up time again in mututal fund research and other areas of finance, where essentially the outcome is random and cannot be predicted with accuracy (a statistical theory known as “Random Walk“). In case you think technology has improved things this paper was published recently “Do Banks Have an Edge” … and the answer is no… you would be better off buying a portfolio of treasuries than going to all the effort of taking a complex mix of loans and securities that banks do. And that is when the bank is acting as a principal not even trying to sell the stuff!

So when you read that someone is calling the oil market, or whatever, you need to treat it with the scepticism it deserves, and not be surprised when it is wrong.

A new industrial revolution…

Pessimism has been the usual response to the Industrial Revolution.

Robert Allen

Tell me there isn’t a new industrial revolution happening in the US at the moment (from The Houston Chronicle)?

U.S. oil production surged to a 46-year record in October.

The Energy Department said the nation’s output of crude oil jumped 1.8 percent to 9.64 million barrels a day. Morgan Stanley said shale drillers pumped at the fastest rate in nearly three years.

And they did it with half the rigs they had in the boom times

I have said many times here I don’t think offshore oil and gas production is going away… but when was the last time someone showed you a project that could be constructed with 50% less boat days? I have seen day rates go down 50%, but that just means once the equity of a boat owner has been lost the bank is taking a hit. I have seen project costs reduced markedly, and some of this is down to standardisation and better scheduling, but much of it is just down to better procurement in an industry plagued with overcapacity. Vessels are running into productivity improvement limits and this has a bearing on costs, which cannot easily be reduced, whereas shale seems to be at the beginning of its technological and productivity journey (see also this post)).

On a volume basis offshore has advantages but the pace of technological improvement here, as the US turns oil and gas production into a manufacturing process, cannot be underestimated. This is turning into a positive feedback loop of increasing profits feeding increasing investment and further productivity improvements for E&P companies investing in shale.

There is a link between these sorts of productivity improvements and declining investment in offshore, especially the high cost UKCS/ Norway. Another good article here on declining investment in the Barents region from the most recent Norwegian licensing round:

“It’s a warning and a cause for reflection,” said Stale Kyllingstad, chief executive officer of IKM Gruppen AS, one of the biggest suppliers to Norway’s oil industry. “The Norwegian shelf isn’t as popular anymore. It’s a concern.” An historic three-year slump in the industry has seen Exxon and BP Plc relinquish their role as field operators in western Europe’s biggest producer. The landscape is changing in the aging North Sea basin in Norway and the UK as companies search for higher margins in projects such as liquefied natural-gas or US shale. Smaller, more specialised companies, some backed by private equity, are stepping in.

The fact is of the 11 companies who bid only 1, Statoil, has both the balance sheet and the technical capability to develop multiple fields in the region, and of a scale and complexity comparable to Africa and the Gulf of Mexico sanctioned projects, and it can’t do everything. The lack of super-major support, and their massive concomittant increases in shale investment is an important market signal.

Long gone are the days when ExxonMobil used to take its PSVs up to the Barents in April so they would be early in case weather conditions were favourable early. I still don’t think the offshore industry is being real about how an increase in the oil price and E&P investment will play out.

Business Sense versus Economic Sense… UDS and Say’s law …

A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest the value should vanish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is the purchase of some product or other. Thus, the mere circumstance of the creation of one product immediately opens a vent for other products.

Jean-Baptiste Say, Traité d’économie politique, (1802)

[Say’s law: Supply creates its own demand as Keynes described it. ]

 

Men err in their productions, there is no deficiency of demand.

David Ricardo in a letter to Thomas Malthus commenting on Say’s law (c. 1820).

 

More than one press appearence lately of the UDS Lichtenstein (ex Marmaid Ausana) in transit to the Middle East for Sat diving work in Iran apparently. I am a huge supporter of any new business, and taking over assets that others can’t work is a time tested model in cyclical industries. The question is: who is the winner here and who is going to make money? As anyone who has run a dive vessel in Iran, or tendered for work there, can explain the rates make India look attractive. A plethora of choice from around the region and customers who only care about price, and perhaps the size of the backhander, mean that even a 30 year old PSV with a portable Sat system can struggle to make money… Thus a newbuild 130m+ DSV is not a natural candidate for the region.

But there can be a real difference between business sense and economic sense: if you can convince a Chinese yard to build you a ship without having to pay for it I think it is a great business model, and UDS are well connected in certain regions to get DSVs working, I am just not sure of the longevity. I haven’t seen the deal UDS have agreed but if it is similar to others floating around then UDS will only be paying for the vessel when it is actually working, and even then a proportion of profit the job generates not a fixed fee. In Iran that is likely to be the square root of a very small number, and if it’s linked to actual payment then even that is a long way off.

UDS therefore is likely to be making money. How much it is impossible to say with certainty but it is possible to have a good guess…The beauty of this business model is its splits the oversupplied capital element away from the necessary cost of operating the service. It’s like a good bank/bad bank with Chinese yards operating as central bank. Cash costs are covered by the profitable service companies while asset owners hope The Money Illusion and the miracle of demand saves them. The Money Illusion is just that and this demand chart shows why demand is unlikely to help DSV owners:

Global E&P Capex

Near stagnant shallow water Capex for years meaning an oversupplied maintenance market.

One of the reasons new DSVs struggle to trade at a premium to old DSVs is the lack of functional benefits from a new vessel for the customer. 30 years ago people were diving at 300m below sea level and we still are now (in fact I have been told Tehcnip and Subsea 7 now call all dives over 200m “special” and need higher approval). Sure the newer vessels may use a bit less fuel on DP, carry a few more people, have a better gym etc, but for the customer, especially in a place like Iran, no one actually cares. The fact is an old banger can do pretty much what a new build Chinese all-singing all dancing DSV can do.

In brutal terms going long on a $150m doesn’t command any pricing premium, or only marginally so, it may just help you secure the work. When people are operating at cash breakeven only that may be a blessing for the company who operates the vessel but that extra capacity is curse for the industry.

Not only are customers cheap in every region outside the North Sea, they can afford to be! Environmental conditions are far more benign which means for a lot of jobs you can use a PSV with a modular system or one of the many $50m build cost Asian focused DSVs… they might not be quite as “productive” or “efficient” as a North Sea class but the owner just reduces the day-rate to the customer to reflect this.

What makes this important is this: for as long as UDS can convince (yard) shipowners that they are the best people to manage unpaid for DSVs, or their own, then they should make money. For the yards and DSV industry it’s a difference story…

In normal times people like to make a return on their capital. The reason you invest is obviously because you want to be paid back. Economists have a really easy way to calculate this: economic profit (which is completely different to accounting profit) and is derived by simply allowing for the cost of the capital in the investment. In crude terms SS7’s cost of capital today is ~12%. Assume a new DSV, with no backlog, all equity financed (a realistic assumption as what bank would lend on this (ignore fleet loans)?). So the “market capital cost” per annum of a new DSV for a recognised industrial player is c. $18m per annum ($150m * 12%); at 270 days utilisation the vessel needs to make $67k per working day just to pay the capital provider. No Opex, no divers, no maintenance, just finance. No one in Iran gets more than $85-90 in total, and it may well be substantially less.

Now UDS don’t need to pay that because the yard unfortunately had a customer credit event and got left with a vessel. Mermaid wrote of over $20m so the yard is probably exposed for $130m, and it maybe more because rumours abound of a fisaco with the dive system which will have been expensive to fix. But there is no doubt UDS have added great value to the yard by providing them with the technical expertise to finish this vessel. UDS just needs to cover their costs and the yard can get something which they probably feel is better than nothing, but it doesn’t mean this work is “economic”. The subsidy here is being paid for by the yard’s equity holders, effectively the Chinese taxpayer, who are involved in an extremely expensive job creation scheme… but times were different… who am I to criticise anyone for going long on OSVs in 2013?

The UDS new-builds are a somewhat different story. If a private equity firm were financing a new build DSV their cost of capital would be ~30% (in this environment probably a lot higher); so at 270 days utilisation that would be c. $167k per working day as a cost of capital. That is after paying for divers, maintenance, and OpEx, a market level of return commensurate to the level of risk of starting a new build DSV company would require that just for the vessels, ignore the working capital of the company. Each new build DSV needs to generate $167k per working day to make an economic profit for the investors. Rates have never been that high in the region, which maybe why economics is a “dismal science“, but it also explains why no one has built $100m+ DSVs for Asia: no one will pay for it!

Rates have been higher in the North Sea but never anything like that consistently and cannot realistically be expected to grow to even half that economic level.  There is also simply no realistic chance of any of the UDS vessels being a core part of the North Sea fleet where rates could traditionally support a capital cost appropriate to the investment in such a specialised asset. SS7 and Technip simply do not procure 25 year assets by chartering off companies like UDS, and frankly they could get a better or cheaper product in Korea or the Netherlands if they built now.  And even if the Chinese built the most amazing DSVs ever (a big if) no one in the North Sea would believe it and pay for it. Given the high profile problems of chartering North Sea DSVs it simply isn’t credible to have any scenario where any of these DSVs come North of the Mediterranean.

I haven’t even dealt with the most important problem: There isn’t enough work in the North Sea. People relax constraints in the region when they need to but at the moment they don’t. The UDS vessels when completed will not be North Sea tonnage… and the only market I think it’s harder to sell a DSV into than Iran is China…

The UDS startegy seems pretty clear at this point: to try and flag the vessels locally and take advantage of local cabotage regulations (like OSS did in Indonesia with the Crest Odyssey) to ensure some local regulatory support for utilisation. The problem with this strategy seems to be it doesn’t have a meaningful impact on day rates. Asian markets with strong flag state rules have never paid top dollar before and it is hard to see these vessels changing the situation. On a boring technical note it is normally impossible to get a mortgage over the vessel as arresting it can be difficult. It’s probably worth a punt for utilisation but it isn’t going to change the profitability of this and makes the capital commitment enduring for anything other than a token price.

I think UDS has great business sense don’t get me wrong. Owe the bank $1m and you are in trouble… owe the bank $100m and they are in trouble. UDS looks set to owe yard c. $450-600m, depending on how many vessels they take delivery of. UDS has great business sense because the yards have a problem way bigger than any of the shareholders in UDS and in an economic sense the yards are never going to make money from this.

All of which brings me to Jean-Baptiste Say, who in 1802 ennuciated a theory that dominated economics for over 120 years. Say’s law was actually the macroeconomy but that wasn’t invented until Keynes. Say looked at the incredible industrial development of the early 19th century cotton industy and thought the economy as a whole must work like that. Without people building something there would be nothing to sell, and therefore there could be no recessions. To anyone working in oil services Say’s further writings looks close prophetic:

Sales cannot be said to be dull because money is scarce, but because other products are so. … To use a more hackneyed phrase, people have bought less, because they have made less profit.

But this was a world away from when Keynes wrote The General Theory at the start of The Great Depression. Until this time Say’s law was the dominant theory of what Keynes later termed “aggregate demand”. We now know that at a macroeconomic level there can be a chronic demand problem, it took WWII for the world economy to recover from The Great Depression, and it is impossible to overstate the importance of the new view in 1936 when Keynes published The General Theory which intellectually overturned Say’s law. Say had confused what happens with companies for what happens to the economy as a whole.

I am reminded of UDS when I think of Say’s law: they might make money out of this, but whether this is economically rational for the whole economy is another story.  Say was wrong in micro and macroeconomics: supply doesn’t create demand.

All the UDS vessels will do is create extra capacity from sellers who are forced to accept lower than opex from anyone with an external financing constraint. The UDS vessels, and the Magic Orient, and the Keppel Everest, and the Vard 801, and the Toisa new build etc will simply wipe out the equity slowly of all those who stay at the table playing poker.

Sooner or later the funders of this enormous gamble will come out. Unwittingly China Yard Inc. is clearly going to be a dominant equity holder, they might think they have a fixed obligation at this point, but just as Keppel and others are finding out: at this level of leverage debt quickly becomes equity. For existing DSV operators in markets where these vessels turn up they are nothing short of an economic disaster. 2018 is going to be another poor year to be long DSV capacity.

I was wrong about Bitcoin: it is an asset class not money…

These curious capabilities make Bitcoins a combination of a commodity and a fiat currency (creating the coins is referred to as “mining” and they have value only because people accept them). But boosters inflated a Bitcoin bubble. Shortly after the currency launched, articles spread around the internet arguing that Bitcoins would protect wealth from hyperinflation and that early adopters would make a fortune. The dollar price of a Bitcoin currency unit climbed from a few cents in 2010 to a peak of nearly $30 in June 2011 (see chart), according to data compiled by Mt Gox, a popular online Bitcoin exchange. Inevitably, the currency then crashed back down, bottoming out at $2 in November 2011.

The Economist on Bitcoin in 2012 when the price was USD 12 per coin

 

This commodity [gold] is a material to be almost indestructible, and one of which therefore the accumulated stocks are very large in proportion to the annual fresh supply. Gold tends, therefore, to have a remarkably steady value.

R.G. Hawtrey, The Gold Standard

The Economic Journal, Vol 29, 1919

I have been prety vocal in the past about Bitcoin as a bubble. Stories like this seem to reinforce that image in me:

Eugene Mutai’s Nairobi apartment is filled with the sound of money: That would be the hum of a phalanx of fans cooling the computers he’s programmed to mine cryptocurrencies around the clock…

“The entire ecosystem could be the biggest wealth-distribution system ever,” Mutai said as his 2-year old daughter, Xena, named after the warrior princess, played with a tablet, swiping from app to app. In the world of internet-based currencies traded without interference from banks or regulators, “big players can’t deny anyone from participating in the financial system.”

And sure enough the CEO of Credit Suisse also explained that:

[f]rom what we can identify, the only reason today to buy or sell bitcoin is to make money, which is the very definition of speculation and the very definition of a bubble

I am not sure I believe that big players are excluding people from the financial system… but it is certainly part of the marketing of Bitcoin. The FT also has a great article on a how people are being marketed the dream of riches via bitcoin (read the whole thing the promoters are “interesting” to say the least:

“Ninety-five per cent of people you’re going to talk to about cryptocurrency, they say to you it’s a bubble. Correct?” he said as the 30 or so men and women packed into a small, hot room on the fourth floor nodded in agreement. In fact, he declared, “the bubble will never burst…

Pro FX Options launched in 2016 and says it can turn people with “zero trading knowledge” into skilled traders. It claims its software can detect short-term trading trends and help ordinary people make consistent profits from binary options, where a bet is placed on whether a stock or currency pair will be higher or lower at a predetermined time in the future. “What we’ve done is really made it simple, simple for anybody from any walk of life to take advantage of it”

But I am erring more now to the fact that while the top prices may be “bubble like” in that they deviate from the mean significantly over time, that some cryptocurrencies, and Bitcoin in particular, look likely to be a permanent asset class. I don’t think the CEO of Credit Suisse is right, buying and selling for profit only is speculation, but that doesn’t make it a bubble.

Bitcoin isn’t a currency as defined by monetary economists in the classical sense, but it appears to have become an asset class, which seems likely to give it some enduring value. It just needs enough people to believe it worth something at it will have a floor of demand that should give it some value, even if intrinsically it generates no income. There are enough reports now that people are starting to treat it like gold, risk small stakes and hoping to profit wildly. All it needs is this number to keep growing faster than the Bitcoin system mines coins and the price will go up. Last week CME announced they would start a futures service for Bitcoin. It seems almost inconceivable that a global market this big will simply vanish, the price may go down as some buyers lose confidence, but there is surely enough market depth now that this is simply becoming a recognised asset class, albeit one with likely extreme volatility in demand/pricing.

The mistake I made was treating it as currency and as money. I am not the only one this attempt to value Bitcoin on a rational basis was :

based on the presumption that bitcoin’s core utility value is serving as a currency for the dark economy.

Bitcoin is clearly neither money nor a currency but it is becoming an asset class.

The reason I missed 9 of the last 0 housing recessions in NZ is simply because I was too rational in my analysis on the overall return not the capital gain: Asian buyers and peoples innate desire for a secure house has increased faster than the stock of housing and ergo the prices have boomed.

newzealand-house-prices-gdp-per-cap

Its all about the capital gain in NZ but that doesn’t make the gain any less real if you cash it in.

I’m not pretending Bitcoin is perfect: there are security issues, and the price will be volatile, to name just two. But there is a longevity in the prposition that simply didn’t exist with Dutch Tulips (a fashionable perishable item amongst a small domestic population) or the South Sea Company (effectively a financial engineering that overreached combined with fraud).  Some of the Initial Coin Offerings are clearly fraud and a bubble but the more I read the more I can see a case for investing in Bitcoin: the rate of supply will grow less slowly than the rate of demand.

Gold has no value beyond what someone is willing to pay and and 37% of its demand come from people who just hold for “investment purposes”. A fraction of those people worldwide who decided to invest in Bitcoin would likely make it a great investment.

Gold-Demand-by-Source

But I still would pay someone £1100 for a three day couse to learn how to trade the stuff. I may regret that later but that is a bubble.

Interest rates rise in the UK after 10 years…

Liquidity used to mean cash in hand; now it means access to credit.

Henry Kaufman

When you combine ignorance and leverage, you get some pretty interesting results.

Warren Buffett

Given this blog is partly a diary I wanted to note for future reference. This is a bit wonkish and unless you are interested in the wider economic issues I’d suggest you ignore this post. It’s something I want as a note to self.

Last week base rate was raised in the UK by a mere .25% to .5%. I think its been lost is how long and extreme these rates have been and the side-effects of such extraordinarly low rates. Base rate dropped from 5.75% in 2007, to .05% in 2009 and remained there for the best part of 8 years.

I have been interested in interest rates from a young age, as I have written before one of my defining economic memories was the wage and price freeze in New Zealand. My parents were civil servants with fixed salaries, that were frozen by the government in an attempt to control inflation in 1982, a Labour government was elected and interest rates rose again and mortgage rates peaked at  over 20% briefly in 1985, and my parents nearly lost their house.

NZ Mortgage Interest Rates

NZ Interest rates

If you tell most people now that mortgages rates were 20% they would struggle to comprehend it. Yes inflation was much higher, but that’s my point: just how different the modern economy is. It changes so incrementally you can easily lose sight of the changes and also we are used to a lack of volatility in the economy.

The New Zealand Experiment, as it was later dubbed, included many measures that are standard economic perscriptions now, but they included being the first country in the world to grant the central bank autonomy to set interest rates taking into account inflation and monetary stability only.

The defining economic period for my professional career has been called “The Great Moderation”, the taming of business cycle volatility led to fairly consistent economic growth . The term is normally applied to the US where the name originated but was a fairly consistent pattern in the Western World. The downside was it created hubris amongst central bankers, who ignored the genius of Minsky and the financial imbalances building up in the economy, and led to the Global Financial Crisis… The apogee of this institutional arogance could well be this cringe-inducing speech Gordon Brown gave at Mansion House on the 20th of June 2007:

So I congratulate you Lord Mayor and the City of London on these remarkable achievements, an era that history will record as the beginning of a new golden age for the City of London.

And I believe the lesson we learn from the success of the City has ramifications far beyond the City itself – that we are leading because we are first in putting to work exactly that set of qualities that is needed for global success:

  • openness to the world and global reach,
  • pioneers of free trade and its leading defenders,
  • with a deep and abiding belief in open markets,
  • champions of diversity in ownership and talent, and of flexibility and adaptability to change, and
  • a basic faith that from wherever it comes and from whatever background, what matters is that the talent, ingenuity and potential of people is harnessed to drive performance.

And I believe it will be said of this age, the first decades of the 21st century, that out of the greatest restructuring of the global economy, perhaps even greater than the industrial revolution, a new world order was created.

In August 2007 the interbank market effectively froze while the Bank of England and the Federal Reserve were forced to inject massive liquidity into the system. The US housing market collapsed over the following summer and Lehman Brothers filed for bankruptcy on September 15 2008.

The three main reasons advanced for the Great Moderation are:

  • Good luck: The shocks that derailed growth and price stability in the 1970s and early 1980s failed to rear their ugly heads over the subsequent 20 years.
  • Structural change: Improved information technology, especially related to inventory management, and financial deregulation resulted in much smoother economic progress.
  • Better monetary policy: Former Federal Reserve Chairman Paul Volcker set a precedent of aggressively reining in inflation.

Unsurprisingly St Louis Fed officials think the last two reasons were more important.

And the rest is economic history as even the Queen realised. And Brown’s 2007 view of a new industrial revolution based on self-regulation of the finance and shadow banking industry turned into an enormous taxpayer funded rescue of that same industry. Although I will give Brown some credit for ensuring the UK didn’t join the Euro he really didn’t deserve to ever be PM after such an enormous lapse in judgement and is a prime example of what economists call regulatory capture.

Cometh the hour and cometh the man… Ben Bernanke, a great and assiduous scholar of the Great Depression is in the Fed along with the intellectual Mervyn King at the Bank of England, and reluctantly Mario Monti at the ECB. Recognising that banking failure was a great cause of prolonging the downturn they flooded the market with liquidity and a core part of doing this was keeping interest rates low, but not saisfied with that they enourmously expanded the money supply. While there is no doubt the measures undertaking to keep the payments infratsructure working and financial markets open stopped another great depression there was a flip side:

since the 2008 credit crisis, it has risen sharply: the level of global debt to gross domestic product is now 40 per cent — yes, 40 per cent — higher than it was in 2008. The world has responded to a crisis caused by excess leverage by piling on more, not less, debt.

Major Central Bank Balance Sheets (Assets)

Major CB BS

The resulting asset price inflation that can be seen post 2008 is obvious:

Asset price inflation.jpg

This isn’t really the place to go into it but there is a big debate in economics between those who argue the structure and function of the financial infratsructure is important, and therefore favour raising interest rates, and another camp of economists who view money as merely a signalling device and believe in the “neutrality of money”, and want to keep interest rates low until economies revover to an output level that relfects the long run trend (since the 2008 crisis all G8 economies have grown below this). Despite promoting Keynsian type measures it should be noted Keynes rejected the neutrality of money both in the short and the long run. It may surprise non-economic readers to know the core models most economists in use assume the neutrality of money yet most economists who work in financial markets don’t accept money neutrality either.

The problem is further complicated by the fact that the market itself is driving interest rates down, Bernanke argues there has been a savings “glut” with Asia pushing capital West to find a safe home. As Cabellero et al., note:

For the last few decades, with minor cyclical interruptions, the supply of safe assets has not kept up with global demand. The reason is straightforward: the collective growth rate of the advanced economies that produce safe assets has been lower than the world’s growth rate, which has been driven disproportionately by the high growth rate of high-saving emerging economies such as China. If demand for safe assets is proportional to global output, this shortage of safe assets is here to stay.

My core problem with this, if anyone is still reading, is the structural reliance of debt in the economy without the safety of equity,. When the dotcom crash happened in 2000 it has minor effects on the rest of the conomy because it was equity financed. Credit recessions have more severe macro economic effects. The tax shield provided to debt over equity encourages share buybacks and leveraged finance over more cautious capital structures. I’m erring with the crowd who believe perpetually low interest rates are distorting the financial infratsructure.

And ultimately, as this seminal paper shows the economy has fundamentally changed as debt becomes a greater part of economic activity (see figure 1 at the top):

In the past four decades, the volume of private credit has grown dramatically relative to both output and monetary aggregates. The disconnect between private credit and (traditionally measured) monetary aggregates has resulted, in large part, from the shrinkage of bank reserves and the increasing reliance by financial institutions on non-monetary means of financing, such as bond issuance and inter-bank lending.

Private credit in advanced economies doubled relative to GDP between 1980 and 2009, increasing from 62% in 1980 to 118% in 2010. The data also demonstrate the breathtakingsurge of bank credit prior to the Global Financial Crisis in 2008. In a little more than 10 years, between the mid-1990s and 2008–09, the average bank credit to GDP ratio in advanced economies rose from a little under 80% of GDP in 1995 to more than 110% of GDP in 2007.

What has been driving this great leveraging?…

[m]ortgage borrowing has accelerated markedly in the advanced economies after WW2, a trend that is common to almost all individual economies. Mortgage lending to households accounts for the lion’s share of the rise in credit to GDP ratios in advanced economies since 1980…The main business of banks in the early 1900s consisted of making unsecured corporate loans. Today, however, the main business of banks is to extend mortgage credit, often financed with short term borrowings.

 

Fig 3 The Great Remortgaging

The counter-arguement from (the Nobel Laureate) Shiller and the SNB. Although anyone still reading who has been in offshore or shipping will appreciate this diagram from the SNB:

Excess credit

Ultimately for 8 years, a third of my professional life, the economy has been marked by low interest rates and prior to that it was the great moderation. Ironically within this I choose to work in sector with enormous volatility which just highlights the huge variance within the averages of a modern economy.

Back to the future… or maybe…

Dr. Emmett Brown: I’m sure in 1985 plutonium is in every corner drug store, but in 1955, its a little hard to come by! I’m sorry, but I’m afraid you’re stuck here..

Back to the Future

 

All that is solid melts into air.

Karl Marx

One of my enduring intellectual fascinations is whether things are actually changing any faster now than in previous epochs (the next book I have to read is Human Race: 10 Centuries of Change on Earth). I think I am an iconoclast by nature and I struggle with the fact things are completely new in a relative sense: Can we really say the internet was bigger than the printing press? I get change is “faster” now, but so is commication? Anyway I will read the book.

I arrived in London in 2000, right in the middle of the dot-com boom. Everyone claimed the couldn’t understand it (I was working for a management consultantcy), and I actually think a lot of people could understand it but didn’t want to admit the implications of it, but the historical examples were looking people in the face: Tom Standage published (an underrated book) The Victorian Internet, that made clear to anyone with a sense of history that the scale of change was precendented, and hardly unique to one generation. Some of the issues regarding open systems for software in the modern era are compared skillfully to debates regarding railway gauge width. It will come as no surprise to most that I think Standage makes a good argument that the Telegraph may have been more important than the internet.

Quite why each age is obsessed with its own sense of modernity is not something I want to tackle here, I have my own (deeply cynical I must concede) theories, but my I have always remembered the book “Hypercompetition” as a standout example of this self-conceited position. Hypercompetition describes a world where:

Business has also entered a new age of realities. It is essential to understand and take advantage of the dynamic motion and flux of our global markets and technological breakthroughs… [Hypercompetition] is a condition of rapidly escalating competition based on price-quality positioning, competition to create new know how and establish first mover advantage, competition to protect or invade established product or geographic markets, and competition based on deep pockets and the creation of even deeper pocketed alliances.

Seriously? That just sounds like industrial capitalism. Selling a steam engine to India in the 1890s may not have been as sexy as creating WeChat or Lyft, but it wasn’t that easy either, and within the confines of the environment in the time you had to move just as quickly and be just as innovative, or did you?

The original theory was publshed with some (controversial) research that indeed suggested when looking at  a broader group of companies than the S&P 500:

support for the argument that over time competitive advantage has become significantly harder to sustain and, further, that the phenomenon is limited neither to high-technology industries nor to manufacturing industries but is seen across a broad range of industries

But it wasn’t universally accepted: the core difference being the researchers who agreed with this notion only focused on firms that appear to have consistently generated higher economic returns not the total universe of firms. McNamara, Valler, and Devers note:

Some strategy scholars and practitioners contend that markets have become increasingly hyper- competitive in recent years. We examine this contention by analyzing industry and business performance patterns in a broad sample of firms… We find little support for the argument that markets have become more hypercompetitive. From the late 1970s to the late-1980s we observe decreased per- formance and market stability, consistent with increasing hypercompetition contentions. From the late 1980s to the mid-1990s, however, trends reverse and performance and market stability increase.

I love the 80’s. My entire music collection probably consists of Greatest Hits of 80’s. It might be heartbreaking for us now to accept but economically and competitively they were harder times – from a macroeconomic perspective particularly. I remember when my parents nearly lost their house in the 1980s when mortgage interest rates when up to 18% and the government attempted to ban inflation with a “price freeze” (seriously). Imagine that now? It is one of the events that actually led to NZ becoming the first country in the world to make their central bank (relatively) independent (in 1989).

A decade that started with the Iranian hostage crisis and finished with Tianaman Square was a tough time competitively, and a large part of that is because many companies simply didn’t have the pricing power they now do. A less global, more domestically focused economy, without Chinese competition, was actually a harder time to be a manager. One of favourite theories involves cross-ownership: as asset managers have got so large (and indexing enhances this), and therefore have so many cross shareholdings, they discourage competition amongst their investments. Azar, Schmalz, and Tecu find:

[i]n the US airline industry, taking common ownership into account implies increases in market concentration that are ten times larger than what is “presumed likely to enhance market power” by antitrust authorities….We conclude that a hidden social cost – reduced product market competition – accompanies the private benefits of diversification and good governance.

Basically ticket prices are 3-5% higher than they would be if the airlines had seperate owners. As well as common ownership the increasing size of banks and the scale if the M&A they can now underwrite is also driving industrial consolodation on a scale that simply wasn’t possible in the 1970s and 1980s.

From about the time Hypercompetition was published (1995) economists began to realise that modern economic change, in first world countries, was characterised actually by a proportionately smaller number of larger firms with market power, higher profits, and greater stability. As these researchers in 2016 make clear:

[a]bout a decade ago a stream of research emerged looking at changing persistence over time and finding a monotonic trend toward a new “age of temporary advantage”… We find that the trend reversed itself and the beginning of the 21st century has been characterized by increasing persistence of superior performance… our results appear not to be a consequence of a compositional shift in the economy of industries toward those with lower levels of competition nor of increased conservatism by newly listed firms. Instead the phenomenon appears to occur primarily within industries by seasoned firms. 

Hence my interest was piqued by this excellent article on Bloomberg yesterday that posits:

modern capitalism produces and probably requires a lot of creative destruction. But this isn’t a relentless, ever-accelerating process. It goes in waves. For about 15 years now we’ve been in a lull, and it’s not at all clear when or how it will end.

The core of this sort of analysis is survivorship bias: just looking at how many big companies are still in business or part of various indexes. Standard Oil, for example, has consistently remained one of the largest industrial corporations in America (now under the guise of ExxonMobil) for over 100 years and ATT was the second largest US company in 1917. A few Facebook and Google new entrants does not change the basic makeup of the modern economy but they do show up in the profit figures:

ROIC 90th percentile.png

Basically a small number of firms are pulling away in profit terms of the others and entrenching themselves as modern monopolies according the Council of Economic Advisers:

Market Concentration.png

The evidence seems clear: there hasn’t been a better, or easier,  time to be a big company since pre-Roosevelt days.

 

What matters more firm or industry?

So for Reach Subsea it all comes down to Q3 and Q4 this year… having raised money in February, the company came in came in with some significant losses in profit and cash flow but is fully confident its all coming right in the next two quarters. I don’t know they people from Reach, all of whom look to be very talented individuals, but I am interested in the company because I can’t think of a more structurally unattractive industry to be in than ROVs at the moment, and all the people I know in the ROV game tell me how hard it is currently with everything going out for free virtually bar personnel.

Reach has a host of competitors: i.e. M2, ROVOP, Bibby, and then the larger competitors. This is a fragmented industry and this is because the entry costs are low and the gains from scaling up the business so small given the fixed cost nature of per unit output. All the smaller companies in particular are simply finding desperate vessel owners and putting an ROV on their boat: it is not an original strategy and not one that strikes me as having great longevity once the market balances more. Every single company with ROVs is trying to hire a few project engineers and say they offer a full service not just taking hire revenue… it’s brutal and E&P companies/contractors/vessel owners are driving very hard pricing and contractual terms.

This chart from Oceaneering shows the scale of competition Reach and the other small companies are up against:

OII Vessel Fleet 31 Mar 2017.png

That is from an asset base of 282 units and strong stable revenue drill support market – although with low margins.

Last week Bibby gave up the game in Asia and sold its ROVs to Shelf for a few million. The transaction will likely reduce their revenue and cash generation potential and will make investors even more cognizant of the fact that the depleting asset base will not make paying the bond investors back possible. But as the noose of an interest bill of £35k per day tightens few options were left. The numbers I have heard suggest a sale way below book value of the asset base and that is common across the industry and the reason for that is like vessels the ROVs cannot generate the amount of cash required to pretend historic values reflect current economic values (~USD 7.5m).

I use Oceaneering as a proxy for the industry simply because with 28% of the total ROV fleet they are clearly representative of the market as a whole. Reach is simply the only listed entity of the pure play ROV companies and it therefore makes it easy to get information but the comments I make about them are appropriate for any of the smaller companies. Oceaneering has also announced it is going to focus on vessel based units and has put 18 units on long-term contract with Heerema and Maersk, and this surely is the future? Consolidation of the contractor base will see larger procurement orders from larger companies, or worse a host of smaller companies on both the vessel and the ROV side stay and operate at a subeconomic level because the exit costs would see them realise nothing?

I find the ROV industry interesting from the point-of-view of firm versus industry effects: In 1985 Richard Schmalensee published a seminal paper “Do Markets Matter?” Schmalensee was trying to ascertain if strategy was simply a matter of picking markets with strong structural characteristics, the focus of the famous “Porter’s Five Forces Analysis”, or if firms had innate features that allowed them to generate returns regardless of poor markets? A later line of enquiry that became known as ‘The Resource-Based View of the Firm (RBV)” and was made famous in management circles by the book “Competing for the Future” where the idea of Core Competencies entered the business vernacular (its digestibility masking the deep academic heritage of the ideas).

For what it’s worth I don’t think the debate on firm versus industry has been completely solved but it points to the likelihood of certain events. As always with economics you can find good arguments for both sides: Rumelt (“How much does industry matter?“) argued pace Schlmalensee that industry effects were outweighed by firm effects, McGahan and Porter (“How much does industry matter really?“) argued that actually the relationship is complex but with a weighting to firm effects being stronger, but more so in service firms whereas Wenerfelt and Montgomery (“Tobin’s q and the Importance of Focus in Firm Performance“) agree industry effects are strong but some firms defy them and outperform. I could go on…

This article seems to suggest why you can find evidence of both firm effects and industry effects:

In other words, only for a few dominant value creators (leaders) and destroyers (losers) do firm-specific assets seem to matter significantly more than industry factors. For most other firms, i.e., for those that are not notable leaders or losers in their industry, however, the industry effect turns out to be more important for performance than firm-specific factors

It’s not everything either… size does matter: profits are positively correlated to size in broad cross-sectional research.

I read it that you are either a statistical outlier or the fact is the industry effects will dominate your likely financial performance. The clues to being an outlier, originally called strategic rent factors by economists, but made far more palatable by the consultants who created entire teams that specialised in “core competencies”, are now well accepted. To be a positive outlier Peteraf outlines:

four conditions must be met for a firm to enjoy sustained above-normal returns. Resource heterogeneity creates Ricardian or monopoly rents. Ex post limits to competition prevent the rents from being competed away. Imperfect factor mobility ensures that valuable factors remain with the firm and that the rents are shared. Ex ante limits to competition keep costs from offsetting the rents.

In diagrammatical form it looks like this:

Cornerstone of competitive advantage.png

Note economists call profits above breakeven “economic rents”. I should obviously point out that while it’s easy to look back with hindsight about this creating these rents is considerably more difficult and represents the dividing line between economics and management.

The diagram in simply says:

  1. Heterogeneity: Firms must be different and the profits must come from limiting the supply of factors (monopoly) or an inability to increase those factors that drive profits in the short run (Ricardian)
  2. Ex post limits: Essentially the imperfect imitability and substitution from the ‘Porters’ Five Forces’… not everyone can copy what your firm does or replace your product service with a substitute
  3. Imperfect mobility: A competitor can’t just go and buy your superior skills on the market. For example anyone could approach Airbus suppliers but could they really build a plane?
  4. Ex-ante limits: Not everyone decides to do the same thing before it becomes profitable.

Prahalad and Hamel became famous because the summed this up with three factors they said made something a “Core Competency” if it:

  1. Provides potential access to a wide variety of markets.
  2. Should make a significant contribution to the perceived customer benefits of the end product.
  3. Difficult to imitate by competitors.

So to bring all this back to the ROV market I think you can argue that a wide base of economic research says this is structurally a very unattractive market: low barriers to entry, easy substituability and imitability, high customer bargaining power, and intense competiton. And I look at most of the small ROV firms, not just Reach, and I see no core competencies or economic factors that would give rise to economic rents (i.e. profits above break-even) and a lot of red ink still being spilled. I see lots of good relationships, smart people, and great technical skills; what I don’t see is a lot of differentiation on anything other than price.

All of which leads me to believe none of the smaller ROV firms satisfy any of the conditions that would allow them to be statistical outliers against industry trends. They are all offering to put cheap ROVs on vessels and work at marginal cost only hoping someone else goes out of business first which makes them a hostage to industry forces only. I can’t see anything other than a wave of consolidation as the larger companies, who can manage their ROVs cost base better by cross-subsidising it while times are poor, taking the smaller companies who eventually struggle to fund OpEx. Sooner or later there needs to be a reduction in the number of operating ROVs to restore the industry to “normal”/breakeven profitability and the smaller companies simply lack commitment that the larger companies have.

I could be wrong… I have been before… I miscalculated for example how good a deal Subsea7 had struck on the EMAS Chiyoda assets … and I think we are in for a better market in some segments in 18 than 17, but continued cost pressure will favour well capitalised substantial companies in this industry not start-ups/growth companies I feel in this market segment… but getting there could be financially painful.