A well intervention/lay-vessel or a DSV?

I’ve missed something with this… is it a Dive Support Vessel or a lay-vessel? News that UDS is building a new vessel left me confused:

The Salt 310 design vessel will be capable of well intervention, flex lay and rigid pipe lay operations in 3,000 m of water.

The vessel will be fitted with first-of-its-kind ‘3 in 1’ tower designed by Huisman in the Netherlands. It will also be fitted with a Huisman 600-1,000 tonne crane which can work in depths of up to 3,000 m and a 650 m hydrogen saturation diving system along with two integrated hydrogen refineries.

Either it’s the worlds most advanced DSV, capable of diving at an incredible 650m (no info on the Hs at that depth), and therefore it will need to travel and be a global asset as those jobs are so rare, or it’s a deepwater well intervention and lay vessel? In either mode of operation it will be overcapitalised, with one part of its functionality redundant? But it would still require dive techs etc even in pipelay mode and vice versa? I am perplexed… Questions abound… A 1000t crane is a monster… Who does 1000t lifts? How often? How much does this crane cost? How many days does it have to work to pay for itself? How much strengthening of the deck was required for the payload? This vessel will clearly be an astonishing technical achievement.

The economics on the other hand look more challenging: If you made the assumption that the dive system was worth $100m, not unreasonable comparing a CSV to a DSV price, then the dive system is depreciating at 11k per day (365 over 25 years), regardless of whether it is being used, and excluding OpEx (about 15% of a working DSV day rate in Asia). The lay system/well intervention system, at say $150m, would be depreciating at $17k per day (365 over 25 years), again excluding running costs. And I have a feeling this j-lay/ flexlay system is closer to $200m, with the tower giving you the well intervention capability for free (with another expensive Lego set).  This effectively adds that to the cost of diving or lay each day depending on what you aren’t doing? And that is without OpEx? I am struggling to see how that is economically efficient.  An economic value calculation would substantially increase those numbers. On a more realistic assumption of 270 days utilisation, given schedule gaps and transit, those numbers rise by a quarter.

Are UDS planning on being a EPCI contractor for rigid lay? There is no spot market for rigid lay vessels? Or do they have a charter for this vessel? Surely for a core delivery asset, such as this, a charterer would be intimately involved?

I could be wrong but this reminds me of the CSS Derwent. It could do almost everything possible (in the right region and water depth), and nothing economically efficiently. At a cost of USD 110m it ended up in Angola once Hallin folded, where I doubt the collective value of offshore shipping assets is USD 110m, and certainly caused a massive loss for the yard (STX).

CSS-Hallin Derwent

In an industry which requires standardisation and cost reduction I struggle to see this as the future. I have voiced concerns before about the willingness of the offshore industry to do something because it can, not because it is economically viable, hidden in a boom market it is a real issue now. But the great thing about capitalism is it’s not my money, and I don’t know everything.

Don’t get me wrong, I have huge admiration for UDS. They are delivering and ordering, by an order of magnitude, a DSV fleet bigger than Subsea 7, a company with a market cap of USD 4.8bn! It is an astonishing organisational and financing achievement, and when  the history of this period is written this will be one of the more interesting stories. By any rough calculation UDS must have ordered, and/or taken delivery, of ~$1bn in vessels.

This is all happening at a time when very good DSVs are underutilised or going into lay-up (Toisa Pegasus) and there is massive over capacity in the lay fleet. If I owned a DSV I’d be dreading seeing UDS pop-up in my LinkedIn feed, as they start delivering these vessels it will almost be call for an asset impairment review everytime. This is turning into a countercylical bet so large it will deserve a place in financial history whichever way it goes.

 

McDermott buys Chicago Bridge and Iron…

“Chicago Bridge and Iron is not based in Chicago, doesn’t make bridges, and uses no iron”.

Anonymous

 

We argue that mergers and merger waves can occur when managers prefer that their firms remain independent rather than be acquired. We assume that managers can reduce their chance of being acquired by acquiring another firm and hence increasing the size of their own firm. We show that if managers value private benefits of control sufficiently, they may engage in unprofitable defensive acquisitions.

Gorton, Kahl, and Rosen, 2005

 

If you want to have a look at what signals the insiders in offshore SURF are sending, and that major shareholders are supporting, look no further than McDermott (“MDR”) acquiring Chicago Bridge and Iron (“CBI”). MDR, which had $435m cash on hand at Q3, generated $155m EBITDA in the quarter, and is widely regarded as a very well run company, brought a declining onshore construction and fabrication house (with a small technology arm). No wonder the shares dropped 9% in aftermarket trading while CBI rose.

What it means is that a well informed group of rational senior executives in the offshore industry, in a company with ample liquidity and investment capability, decided the best option for growth and shareholder returns were for them to diversify onshore in the US. I don’t think that rings of confidence for an offshore recovery. At the moment anyone with enough financial capacity to charter ships (at below economic cost) and hire engineers can win market share. It is obvious what that will do to financial returns and why therefore companies are looking at different sources of growth and not recycling cash flow generated from the industry back into it. Over the long term this is part of the story of how the offshore industry will lose the capital it needs to in order restore the market to equilibrium.

This is a defensive merger. MDR was simply too small not to be acquired as part of a major acquisition had it remained independent (part of the reason the shares have dropped is the loss of the “acquisition premium” in their value), but it also needed to pay in shares only to keep its operating flexibility in this market. MDR was just big enough to raise the needle signficantly for someone else, but not large enough to buy an industry leader or number two. MDR had the choice of going on a shopping spree of SURF companies, maybe Aker Solutions or someone, and then trying to compete with Susbea 7 or FTI, and slowly over time getting materially bigger, risk being acquired as the industry consolidates, or buying something big and leveraging up so as to make it to big and risky to be acquired. The short-term risk was someone like GEBH, having failed to acquire an installation capability with SS7, deciding MDR was large enough to swallow. I’d love to know if the Board instructed one of the banks to sound out other bidders instead of this? I suspect instead that Goldman Sachs, lead adviser to MDR, was brought in with a specific mandate to keep MDR independent and CBI was the company they settled on.

Clearly, and having sounded out the shareholders as well, MDR management have decided that the least risky option, or at least the deal that could be done, was onshore US, a business about which MDR management have limited exposure. Whether consciously or  not, the fact is MDR management couldn’t find enough value, on a risk weighted basis, to carry on investing in offshore.

MDR management decided to diversify, a so called “vertical merger“. Financial markets generally dislike verticals, which have a limited range of situations when they are likely to be profitable, preferring to believe shareholders are better at diversifying individually than company management. However, financial economists have spent a huge amount of time studying M&A, and from what I can ascertain all they really agree on is that returns are hugely dispersed around the mean i.e. sometimes it works and sometimes it doesn’t:

[o]n balance, one should conclude that M&A does pay. But the broad dispersion of findings around a zero return to buyers suggests that executives should approach this activity with caution.

 

I get why it was done I think: scale. Cynical theories abound in economic research:

What, then, is the motive for the widespread and persisting phenomenon of conglomerate mergers? In this study, a “managerial” motive for conglomerate merger is advanced and tested. Specifically, managers, as opposed to investors, are hypothesized to engage in conglomerate mergers to decrease their largely undiversifiable “employment risk” (i.e., risk oflosing job, professional reputation, etc.). Such risk-reduction activities are considered here as managerial perquisites in the context of the agency cost model. [Emphasis added]

In this case the argument is really that increased scale will help the offshore business as a standalone unit with lower unit costs being spread over a large company. If management can make it work, and they prove to have swooped on CBI in a moment of weakness, then everyone will be happy. That isn’t really my point with this: it is my agreement that offshore contracting/SURF still has excess capital at an industry level and I agree with MDR management that in the current environment deploying more, even at current price levels,  looks hard to justify.

So rather than hold out for an acquisition premium, or try and build up slowly, MDR management have made the company virtually impregnable to being acquired, for a few years anyway, and if they can turnaround CBI as they have done with MDR the risk will be worth it.  But I also think it sends a signal that management have far more confidence in the lighter CAPEX onshore market than they do about the offshore market, and even though they had the opportunity to buy a string of assets and companies at rock bottom prices MDR management (with the support of the Board and shareholders) decided it was less risky to buy an onshore construction business. That is consistent with the investment profile of many E&P companies who are cutting offshore investment in favour of onshore.

I think that this M&A decision tells you a lot about what those actually making the investment decisions in profitable offshore companies think about the market direction and the risk weighted returns available from it, for the forseeable future. MDR are backing themselves to apply the lessons learned in the downturn to another business rather than applying it to more businesses in the sector.

DOF Subsea, Bibby Offshore, and The Pecking Order Theory…

We always plan too much and think too little.

Joesph Schumpeter

We were succeeding. When you looked at specifics, this became a war of attrition. We were winning.

General William Westmoreland on US involvement in Vietnam

DOF AS/ Subsea reported numbers yesterday that were frankly terrible. All those who keep telling you the market is getting better seem blithely ignorant of the constantly decreasing financial performance of nearly all the companies in the sector. It’s like Comical Ali or General Westmoreland constantly assuring everyone that victory is just around the corner, if not in fact delivered. Tendering, like the Viet Cong, never ceases to stop appearing in increasing numbers, and it will bring victory…

I have another theory why tendering is increasing: there are a lot of engineers who are worried about their jobs. In a completely rational strategy they are increasing the number of parties who receive tendering documents, spending more time assessing them, and making the tenders ever more complex. Turkeys don’t vote for Christmas. More people appear to be spending increasing amounts of time and money on the same tenders and it is making industry margins even thinner, and allowing management to claim that completely unproductive work is actually a sign of an industry returning to health.

But back to the numbers… this is the same DOF Subsea that as recently as Q1 and Q2 this year was hoping to get an IPO away. It’s a good reminder, as if anyone needed one, that when insiders are selling out you should be wary of what you are buying. I call it the Feltex Carpets or Dick Smith theory. Economists have however developed a far more robust theory about how firms decide on their capital structure: The Pecking Order Theory. It’s based on the information asymmetry that exists between the insiders of the firm (shareholders and management) and the outsiders (investors and funders). Basically it’s a deeply cynical view (which probably means it is right) that managers and owners use internally generated funds first, then use debt and only issue equity as a last resort.

In a classic paper Myers and Majluf (1984) argue managers and owners issue equity only when they believe it is overpriced. It is very hard not believe that early in 2017 the insiders at DOF Subsea (i.e. the private equity owners) looked at the vessel schedules and the likely win/loss ratio of the tender pipeline (not the amount of tendering), and decided that if they could dump some stock they would. Luckily investors are aware of the asymmetric information problem and “they discount the firm’s new and existing risky securities when new issues are announced“. Or in other words they just refuse to buy at the asking price which is what happened in the DOF Subsea case.

You should always be wary of financial presentations that start with highlights that don’t include any financials (like the latest DOF Subsea one). Just to be clear the DOF Subsea revenue was down 11% on the same period as last year and EBITDA was down 6%. Luckily, they are doing more tendering.

DOF also helpfully provided this chart of the business:

DOF Business Model.png

Basically without the long term chartering business, which is really just a risk diversification move by Technip, there is no business: the 10% EBITDA on the projects side wouldn’t cover the economic costs and frankly potentially the cash costs either. This is a business where unrealised gains from derivatives (probably interest rate and/or currency swaps) were 6 x the operating loss for the period of NOK (41m).  Year to date DOF Subsea has had to turnover NOK 2.8bn to get a mere NOK 45m in profit. It is pretty clear from the above that actually the projects business, with 17 very expensive fixed costs assets, is not an economic entity; and as I have said before you need a very good return on the vessels on long-term charter in Brazil because as the above graphic makes clear if their contracts aren’t renewed (and no one believes they will be on anything like the current terms) then the value of the vessels will drop like a stone if you believe at some point a vessel is only worth what it can earn in cash terms. The number of other activities you can perform with a 650t vertical lay system is actually pretty small which lowers resale value regardless of how much it cost to build. In which case the value of the business is probably much smaller than the current shareholders would be willing to admit to themselves. Time is not a friend to the investors in this deal because everyday they hold this company future investors get one day closer to finding out what happens in Brazil.

DOF Subsea is a pretty good projects house and the EBITDA margin is just a reflection of market overcapacity. If you were going to invest new money in a subsea projects business you would need therefore to look at that as a realistc EBITDA margin you could earn for the foreseeable future until further supply capacity leaves the market or there is a significant increase in demand. Bear that in mind if you were, for example, looking at injecting funds into a company about to default on its bonds…

The Pecking Order Theory is also helpful in explaining (some of) the shennanigans involved in the Bibby Offshore attempted refinancing at the moment. The insider shareholders in this case also saw the writing the on the wall and in January 2016 took a cheeky £20m off the table in the form of a dividend (after a c.£40m dividend recap that was flagged in the prospectus). In the next 12 months Bibby Offshore lost £52m at the operating profit level, and it must have been known to the Directors by June 16 that without some sort of miracle the business would require a restructuring (which to be clear is an event of default as defined by the ratings agencies even if consensual). It was certainly apparent to any responsible Director by Oct 16.

Bibby Offshore cannot realistically make an interest payment in December, and management have qualified the accounts such that it is not a going concern without a refinancing. And now  the insiders (Bibby Line Group and management) have decided they want outsiders to put money in. They don’t think the equity is overvalued (they know it is valueless);  the insiders think the debt overvalued is and there is too much of it. All the talk of a supportive shareholder reveals it for the sophistry it is: the insiders don’t believe enough to contribute financially. BLG aren’t putting in any of the £60m they have taken out not just because they don’t have it but also because they know the business better than anyone and The Pecking Order Theory makes clear they want someone elses money here.

One deal that is on the table is some “Super Senior” financing (i.e. paid before anyone else) provided by the distressed debt desk at Deutsche Bank. Now Deutsche are arguably the best desk at this in the City, but if you need this sort of financing it is pretty much the end of the road. If EY have resorted to the distress desk at Deutsche as an alternative it shows that no long term investor is interested. This form of financing is more suited for a company in bankruptcy (where it is called debtor-in-possession financing) than for one imminently approaching it. The Deutsche plan would be to lend fully secured against the Polaris and the Sapphire and give Bibby enough money to make until next summer when DSV day rates miraculously improve and the business can service this new debt and bonds. But don’t the bond holders own those boats I hear you ask? Yes. And I am not close enough to this to know exactly the specifics but the security agent is only likely to hand over the ownership papers to the vessels if the bond holders agree to this (I guess); and (I guess) Deutsche would only advance the funds in conjunction with a writedown of their claim. Unbelievably management will argue they are they best people to trade the business out of this mess.

The real tension here appears to be how much equity the bondholders take, and how consensual the handover is, as the business undertakes a debt-for-equity swap. The bondholders can hold out for 100% of the equity as their only other asset apart from the DSVs (and a couple of ROVs) is the shares of Bibby Offshore, but in  order to follow through on this they have to push the company into administration and a liquidation scenario is completely possible at that point as customers and suppliers refuse to trade. The Bibby/Management/EY plan envisages a far more generous structure whereby any money Bibby Line Group put in is also fully secured and they retain majority control so they can consolidate Bibby Offshore in their Group accounts (20% of net assets). The problem with this is of course that BLG don’t have anywhere near enough money to put in proportionately.

A nightmare scenario for the bondholders is taking over a company in such circumstances where agency conflicts abound and in a practical sense now it is a hostile takeover with management having acted until the last possible moment to realise the rights of the debt holders. It is arguable for all of this year Bibby Offshore should have been run with the creditors interests at the forefront of all decisions and it is clear that this has not happened.

In case you’re wondering what is in it for Deutsche: it’s the fees. They are looking at advancing c. £20-30m on the vessels and it would have to be cleared before the bondholders get paid. They would get a 7 figure upfront fee and an interest rate of c. 15%, and if a default occurred they would sell the assets in a fire sale to get their money as quickly as possible. Which is why you can’t get much money from such deals because the bank needs to be conservative here (and I think this deal will die on broker valuations given the likely fire sale prices of Polaris and Sapphire). The problem is of course that debt got Bibby into this mess and it is very unlikely to be the cure to get them out of it. I don’t think the Deutsche proposal has passed credit committee and even though they would make an eye-watering fee on the this the risk is clear: becoming the proud owner of 2 x North Sea class DSVs (and as their offices are some way from the Thames they wouldn’t even add to the famed Deutsche art collection).

With no significant work booked for next year the Bibby plan relies 100% on day rates increasing significantly above current levels. And therein lies the real problem for the bondholders and any potential distress desk coming in on this: at some point the only solution to a market in oversupply is for some capacity to go. How can Bibby credibly claim to make a better margin than DOF Subsea? At the moment Boskalis look almost certain to enter the market in a big way and other companies are also looking to enter the market. Not only does Bibby need tens of millions of pounds under its current cost structure just to make it until next summer there is actually no certainty that this magical scenario of higher rates will allow them to come close to settling the outstanding debt obligations they are generating to get there.

DOF Subsea made clear that while tendering activity is robust project work is dismal (and indeed they made a specific comment that amounted to a profit warning about it). At 7.0 x debt to last-twelve-months EBITDA DOF Subsea (and everyone else in the market) will be throwing everything into trying to win work… all the non-DSV work will compete with Bibby (no one really expects them to reactivate the SAT system on the Achiever) and they will keep margins at ~EBITDA breakeven in order ot get utilisation. As a committed industrial player that is a rational economic strategy. Subsea 7 and Technip are booking DSV days at less than £120k for 2018 to get utilisation in early and they can clearly keep this up virutally indefinitely. The dumb non-industrial money won’t last as long as those with an operational logic and an industrial strategy + balance sheet in this market.

The problem for the Bibby bondholders is that not only at current prices (.36) have they capitalised the firm at c. £63m, way above what it could hope to earn in an economic sense, it also needs £20-40m just to keep trading until next summer.  The major competitors have no cash flow issues (Boskalis has €1bn in the bank) and every reason to chase market share over profit. There is therefore no rational economic reason why under this scenario North Sea class day rates will rise, particularly if Boskalis enters, and every reason to believe they will stay at current levels. Any rational investor in Bibby Offshore would shut down everything apart from the UK business, but 2 x DSVs in the UK doesn’t justify anything like £60m in value…

The Nor bondholders tried super senior financing on their DSVs in Nov 2016 and it is clear, as they slowly run out of money and cannot raise anymore at anything like the 15% fully super senior they did last time, that when someone says you can’t lose on a North Sea class DSV, you can on some. It’s all down to asset specificity as I have said before. Deutsche and other distress desks will be well aware of the mistake the Nor bondholders made, and frankly if I was going to make a mistake on two DSVs I’d rather do it with the Nor vessels than the Bibby ones.

This will all be resolved soon. A bondholder meeting is scheduled for next week and everyone will lay out their plan. The problem is of course there isn’t one really and it should never been allowed to have get this close to Dec 14 when the interest payment is due. The Bibby plan is for it to continue as a lifestyle business where external investors allow the family and management to stay in control and fund it until the market returns. A few (27) redundancies are underway but in a microcosm of the cost and conflict issues that define the company the CEO’s wife, who runs the Business Excellence department, is staying , as is the Director of Small Pools and Innovation, while the Engineering Manager is made redundant (seriously).

The Bibby plan relies on a small number of bondholders, enough to block the majority, being so afraid of the great unknown they back them to carry on as before. This will just delay things until next summer because the cash burn is just so high that even £20-30m would be gone by this time next year without a wholesale change in market conditions. Handing back the Olympic Bibby cuts the cash burn, and may allow the business to come close to cash break even, although the US will make another substantial trading loss in 2018 as will Norway (and without the Ares why bother?); but doesn’t solve the core problem that the business itself is unprofitable at an operating profit level. Call it the slow-burn and pretend strategy. It was disastrous for Nor as eventually reality comes and the cash is gone. As plans go it is pretty terrible.

But the bondholders don’t have a good one either. The bondholders appears to have spectacularly misread the willingness and ability of Bibby Line Group to support Bibby Offshore as well as how badly the business would perform in 2017 versus 2016 (revenue -50%). Some of the funds involved in the bonds don’t need money from an institution like Deutsche, but unless they control the company they have to hold a bondholder vote every time they want to make any significant moves, and letting the company go into administration risks a total wipe-out of value. Stripping the company back to a smaller business locks-in a loss, continue funding it until the market returns is simply throwing good money after bad and it’s real cash. If they do take the business over they will have an awkward period where almost the entire senior management are changed out and they will be cash funding a business, with an unknown financial commitment, while their consultants re-do the numbers and tell them how much capital they will need to inject. I have done that as a management consultant and it is hugely destabilising while it goes on and makes normal operations almost impossible. If if takes consultants 6 weeks to produce an initial report (30 working days), and Bibby Offshore is losing c. 100k a day in the interim even an emergency facility of £3m + £1m for the consultants is real money given the limited upside sale potential. And then they are only in February with a real funding commitment until the mythical summer season that will save everyone… until it doesn’t…

There is a more complicated scenario here where the Bibby Offshore is restructured through a pre-pack insolvency that the current bondholders control. This will remove the historic liabilities incurred (i.e. property leases, Trinidad tax) and see a new company emerge free of its past shareholders and with a new capital structure. I think this the most likely but it will be a dramatically smaller business and will be run solely for sale ASAP. I also see no guarantee it will realise more value than a liquidation despite it being enormously risky given changing market conditions.

The Bibby Offshore refinancing is a mess and liquidation is clearly a very real possibility here. Getting to less than 28 days of an interest repayment before trying to finalise a refinancing is irresponsible in the extreme when it has been telegraphed for months and your plan is simply not to hand the company to the bondholders. The only thing I can definitely tell you is that if you brought Bibby bonds at .36 you are going to lose some real money here.

Subsea 7 and Conoco Phillips… industry bellwethers…

[N]othing can have value without being an object of utility.

Karl Marx

[I couldn’t agree more with the philosophy outlined in the Conoco Phillips graphic in the header].

A stark contrast in the fortunes of two companies reporting numbers yesterday and it doesn’t take a genius to work out that an E&P company (Conoco Phillips) is benefitting from a higher oil price while an offshore contractor (Subsea 7) is suffering from lower committed offshore spending. But I think it’s worth delving into a little deeper because the scale of the changes taking place in investment terms I think provide a note of guidance for how the future of the industry will look.

CP makes an excellent E&P company to use as an example. In 2015 CP announced they were giving up deepwater exploration but not deepwater production. All economic change occurs at the margin, the change in preferences of different actors in the economy melding into demand and supply curves which intersect at equilibrium points: in this case the decision to invest in deepwater production, or not, depending on market conditions. CP looks to be a hard task master in this regard: based on the statements and actions they have taken if CP decides to invest in offshore production others will as well.

I start with CP because E&P demand for offshore services is obviously crucial. Firstly, and this is not an original thought, the entire tone of this presentation (Q3 2017) is geared to financial returns to shareholders (you should actually read the whole thing to sense this) at the expense of production growth. Just as Shell, and other E&P companies have done, there is a signalling effect that this is a company that will not turn an oil price rise into a feast of mega-growth projects:

CP Priorities

The whole focus is being able to pay dividends even at a $40 per barrel price, gone are the 2013 days of boasting about reserve replacement ratios in excess of 170%. CP helpfully shows that this focus has helped them outperform their peer group: Executive level pay generally includes a link to performance against a defined peer group, if other E&P managers start losing bonuses by not being as disciplined on returning money to shareholders as CP, and their share price appreciation is less, their strategy will change extremely quickly. But in reality all the big companies reporting now are making “credible commitments” to return any excess cash to shareholders and focus on demand increases through short cycle production. Just as it would take years to turn investment decisions into projects now so much offshore engieering capability has been turned off, so too it will take a long time to change this investment narrative and performance incentive system in E&P companies that drive offshore demand. Any perceived linear link between an increase in the oil price and an increase in offshore demand is wrong in my view.

COP Works.png

Secondly: CapEx: for the 2018-2020 period CP is guiding sustaining CapEx at $3.5bn per annum and $2.0bn for expansion. Of the $2.0bn expansion $1.2bn is short-cycle unconventional and only $0.5bn for conventional/offshore and $0.3bn for exploration (split evenly between conventionals and short-cycle). To put that in context in 2012, when the offshore industry was going long on boats and rigs based on future demand, CP guided 2013 CapEx at USD $15.8bn! Of that 10% alone ($1.6bn) was for the North Sea and Alaska (i.e. offshore), 26% ($4.2bn) was for short-cycle, 15% ($2.4bn) for offshore Angola and GoM, and another 14% ($2.1bn).

Graphically it works like this: To keep production constant CP will spend $3.5bn

2018-2020 Flat Production.png

The green is entirely offshore. But to increase production:

COP Growth Production.png

The green in the second graph is almost all historic commitments. That is the future of offshore in a microcosm for the largest independent E&P company in the world and historically a major investor in deepwater offshore. The point is, for those bored of the minutiae, that CP have knocked ~$9.5bn off theirCapEx (60%) in 5 years (they have also divested assets so its not a straight relative comparison) and that the portion devoted to offshore is really related to legacy investments only now, not new fields or developments.

Third: productivity. I keep saying this but the productivity improvements look real to me the economist, as opposed to some of the geologists I know, who argue shale is bound fail:

CP Shale Productivity.png

The last line: >50% more wells per rig line! It’s all about productivity and scale and large companies investing in R&D are extracting more for less on a continuous basis from their shale wells. This is becoming a self-reinforcing cycle where they invest, improve, and re-invest. As I say here often: Spencer Dale is right.

This is the link point to Subsea 7, and all the other subsea contractors frankly. Subsea 7 have performed better than most other contractors throughout the downturn (not McDermott), but the issue is backlog and the pace of future work delivery: as CP seeks to please the stockmarket by avoiding all but the most promising of offshore investments (if any), SS7 and others must show huge declines in their order backlogs which de-risk a hugely expensive and specific asset base. I have said before I think you almost need to value subsea contracting companies like a bank: they fund long-term assets with a series of shorter duration contracts of uncertain redemption value, yes they have a much higher equity cushion, but they need it as they are borrowing short from a market to fund long term assets. Certainly smaller contractors are susceptible to “runs”.

In the last quarter SS7 had revenue of ~$1bn but it took in orders of only .5 of that (book-to-bill ratio) in new orders which left it with a backlog of $5.3bn (against liabilies of $2.4bn). At Q4 2013, when companies like CP were spending all their CapEx, SS7 had backlog of $11.8bn (against $3.8bn of liabilities).

Now SS7 is a well managed company and as can be seen they have reduced debt as the downturn continued, continued to return chartered tonnage,  and they have over $1.2bn in cash, so there are no problems in the short-term. But if you were owed money by SS7 I would rather be owed a higher amount backed by nearly 3x backlog than owed a smaller amount by 2x (a declining) backlog. The problem is the pace at which all the contracting companies are eating through their backlog of contracted work that was at a significantly higher margin than the work they are bidding for now. The actual booked backlog number is the only certainty guiding real expectations of future profitability.

It is a function of the SS7 business model that they have an extremely long position in very specialist assets that sap meaningful amounts of money from companies if they are not working as the graph from the FMC Technip results makes clear:

Technip margin erosion.png

The single largest fact in Technip’s declining subsea margin is lower fleet utilization. If Technip and SS7 are expecting poor utilization in 2018 then it is locked in for the rest of the supply chain.

The fact is the huge offshore CapEx pull back and reallocation by the E&P companies is continuing unabated. Offshore allocations may not be declining in real terms any more but E&P companies are making clear to their shareholders that it isn’t going to materially increase either. The offshore fleet built for 2014 isn’t getting a reprieve from the Oil Price Fairy, the gift from that fairytale should it come true for the E&P companies will be given to shareholders, who after the volatility they have suffered in recent years feel they are owed higher risk weighted returns. E&P companies are locking in systems and processes that ensure their procurement in the supply chain will systematically lower their per unit production costs for years to come and ensuring that other asset owners get lower returns for their investments is a core part of that.

And it’s not only backlog the SURF business now is declining year-on-year of you look at the Q3 2017 SS7 results:

Q3 2017 BU performance.png

~$50m is a meaningful decline in revenue (6.3%) for SURF alone and the decline in i-tech shows that the maintenance market hasn’t come back either. Both CapEx and OpEx work remain under huge margin pressure and in the maintenance market the smaller ROV companies with vessel alliances are all mutually killing any chance of anyone making money until a significant amount of capacity leaves the market. The point of reinforcing this is that it is clear that the E&P companies do not view higher prices the start of a relaxation of cost controls: this is the new environment for offshore contractors.

Subsea maintenance costs involving vessels are time and capital intensive. Internally E&P companies are weighing up whether to invest in maintenance CapEx for offshore assets or new CapEx on short cycle wells. At the margin many like CP are choosing short cycle over offshore and hence the demand curve for offshore is likely to have shifted permanently down and price alone is simply not clearing the market.

I have only used SS7 as they are the purest subsea player in the market. I definitely think it is one of the better managed companies in the industry buut it is impossible to fight industry effects this big when demand is falling, and therefore the size of the market is shrinking, and you have such a high fixed cost base. Not everyone can take market share.

SS7 will be a survivor, and longer term given the technical skills and scale required to compete in this industry I think it likely in the long run they will earn economic profits i.e. profits in excess of their cost of capital, along with the larger SURF contractors excluding Saipem. But they will do this by being brutal with the rest of the supply chain that has gone long on assets and simply doesn’t have the operational capability and balance sheet to dictate similar terms. For everyone below tier one the winter chill is just beginning.

So what does this point to for the future of the industry?

  1. It is a safe bet with all the major E&P companies CapEx locked in for 2018 now and all the OpEx budgets done that demand isn’t going to be materially different from 2017. Slightly higher oil prices may lead to some minor increases in maintenance budgets but nothing that will structurally affect the market
  2. A smaller number of larger offshore projects of disproportionate size and importance fot the larger contractors and industry. Only the largest will have the technical skills and capability to deliver these (hence SS7 ordering a new pipelay vessel). These projects will have higher flow volume and lower lift costs and will be used by E&P majors to underpin base demand
  3. A huge bifurcation in contractor profitability between those capable of delivering projects above and the rest of the industry who will struggle to cover their cost of capital for years
  4. An ROV market that uses surplus vessels and excess equipment equipment that keeps margins at around OpEx for years as vessel owners seek this option for any utilisation
  5. E&P companies consistently seeking to standardise shale production, treat it as a manufacturing process that drives down per unit costs, and increase productivity. Any major offshore CapEx decision will be weighed against the production flexibility of shale
  6. Structurally lower margins in any reocvery cycle for the majority of SURF contractors

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.

Just what the world needs…. another dive support vessel…

Time is not a thing, thus nothing which is, and yet it remains constant in its passing away without being something temporal like the beings in time.

Heidegger -who revived the concept of Aletheia in philosophy

Congratulations to CCC (Underwater Engineering) UAE for delivering the DSV Said Aletheia. It’s a fine looking vessel, a single bell 12 man system that is perfect for the Middle East and built in China for probably a very attractive price.

Unfortunately for the owners it is arriving at a terrible time in the market and I use it to highlight one of the big problems for a market recovery that the subsea/offshore industry faces with it’s over capacity: the over segmentation that has resulted in the build programme.

This table from Kennedy Marr makes clear how large the fleet expansion has been:

KM DP Fleet Aug 17.png

In the old days (pre-2010) all vessels were multi-purpose to a certain extent. They might not operate optimally all the time but some work where they were over specified balanced out higher days rates for more specialised work. As the number of vessels grew so did the number of more specialised vessels.

In Asia and the Middle East this has seen a number of purpose built dive support vessels delivered for contracts that used to be important charters for contracting companies to win. The best example of this, if delivery occurs, is the Vard new-build for Kruez, that will go long-term to Shell Brunei. This vessel will displace older tonnage in the market and at the lower end modular systems but in such price sensitive markets the productivity benefits this vessel offers are unlikely to command a price premium. In other words it is going to keep prices low.

Here is the big problem for DSV owners (in all markets):

Global E&P Capex

Shallow water Capex is forecast to remain near stagnant for years at levels significantly below the period preceeding 2014. Shallow water fields are smaller, and often more marginal fields and they require vast amounts of DSV days to support pipelay and general construction. As the graph makes clear there has been a structural change in the market and even if the oil price recovers it will not flow into shallow water construction and ergo a portion of the market that existed prior to 2014 has gone.

There is no magic cure here and no deus ex machina that is simply going to allow the “maintenance fairy” to make all the problems go away. A DSV in field construction mode uses far more days than one involved in IRM work. Now all the DSVs are trading down from construction work into IRM and that isn’t going to change either. Logically asset values in the DSV sector have dropped significantly because there is no plausible story for how a DSV could deliver the cash flows you used to be able to believe it could. Markets are mean reverting eventually but the process is going to continue being extremely painful financially for a while yet.

Aletheia apparently means “the state of not being hidden; the state of being evident… it also means factuality or reality”. I find that highly apt for a new DSV delivering into the current market.

Friday morning cheer for the bulls… and safe thoughts for those in Houston…

“Give me a one-handed Economist. All my economists say ‘on the one hand…’, then ‘but on the other…”

Harry Truman

 

As I am off on holiday to Spain I thought I would spread some cheer for the weekend…The Bull case for oil was made by the Federal Reserve Bank of San Francisco yesterday looking at oil demand in China and combining it with The Varian Rule (which I hadn’t heard of either):

A simple way to forecast the future is to look at what rich people have today; middle-income people will have something equivalent in 10 years, and poor people will have it in an additional decade.

The economists from the Federal Reserve conclude what every offshore bull hopes for, even if it is in a delightfully non-commital and unspecified in timeframe:

In particular, if both domestic and foreign oil producers are reluctant to invest now in exploration and development, they may be unable to expand quickly to meet a sharp increase in Chinese demand. If global supply cannot expand fast enough, oil prices will have to rise to balance the market, as they did in the early 2000s.

On the other hand DNB came out with this graph this week:

DNB Offshore Spend 2017e

The point about being “unable” to expand is a good one. Even if the price spiked now the supply chain has laid off so many people in the short term all that will happen is there would be an explosion in wage costs not asset utilisation (and therefore day rates) as projects would take time to wind up. For the supply chain there is no easy solution to the current problems apart from slow deleveraging and the occassional exogenous shock maybe?

To all my friends in Houston I hope all is well and you are hunkered down safely. For the record no one obviously wants an increase in demand generated in such a way.

Hornbeck Hurricane map.png

Source: Hornbeck