More for less… Tier 2 contractors is where capacity will leave the market

I don’t get the ROV business. At the small end numerous small firms, often with private equity money, all with exactly the same strategy of getting cheap ROVs and finding  a (desperate) vessel operator to charter them the vessel for next to nothing on a profit share. They all have exactly the same business model and have no ability to differentiate on anything other than price, entry barriers are low, and buyers have a vast array of choice. It is a textbook example of an industry structure designed to produce poor profitability. Against this there are large international contractors who make minimal profit but clearly have enough capital and cash to have staying power. Surely, if demand remains at current levels something has to give?

Back in February Reach Subsea raised money, I didn’t get their logic, or that of people backing it, and I don’t get it now. However, unlike ROVOP, M2, and a host of others, they are publicly listed so you can get access to exactly how they are performing, and I would be really surprised if any of the other smaller companies are doing any differently given their business model and strategy are exactly the same. It is also worth noting that Oceaneering, the worlds biggest ROV company by some margin, has just reiterated its commitment not to pay dividends until the market improves. So with all the benefits of scale that Oceaneering has they still cannot return any cash to investors for all their free cash flow.

Now Reach Subsea are maybe great engineers and operations people, and they may have good relations with Statoil, but here in essence is the problem:

Reach key figures Q4 2018.png

Compared to 2016 in 2017 Reach sold 49% more ROV days, 63% more offshore personnel days, and 35% more vessel days and yet increased turnover by only 10%. It is the very definition of business facing decreasing returns to capital: For every unit of capital they throw at the market they get a decreasing amount of economic value back. (I won’t even get into the EBITDA and operating loss because they brought some equipment during the year and claim to be building up scale, but the turnover number tells you all you need to know).

This is interesting as well:

Reach Operating Profit Q4 2018.png

To get 360m in sales in 2017 cost 387m in direct expenses. Or look at it another way: it cost 387m to sell 360m. That is a totally unsustainable business model. I get they are working their way out of terminating some historic vessel charters but businesses that cannot make an operating profits are axiomatically dependent on external funding eventually. Like everyone else in the ROV space this business is simply keeping capacity going while waiting for other people to drop out of the market and wait for the magical demand fairy to appear and save everyone.

Despite this they are opening an office in Houston, which is a major expense for a company of this size, to offer exactly what everyone else in the market there does: cheap ROVs on vessels with no commitments. Like everyone else they are doing loads of tendering and are in advanced discussions with potential clients. I get the US has the best structural growth characteristics of any ROV market, but there are a lot of companies there doing exactly this,  and firms like Bibby had to pull out despite investing substantial amounts in kit and infrastructure.

I therefore find it amazing that you can get comments like this:

Reach q4 comment 1.png

And then get this:

Reach Q4 comment 2.png

What attractive growth opportunities? The installation market is forecast to be flat next year and the IRM will grow modestly but nowhere near enough to soak up excess capacity. But despite this the obvious answer is to go to Houston, well behind ROVOP, M2 … ad infinitum

But clearly some people disagree because despite everything I have written above look at the Reach share price:

Reach Share Price 06042018.png

Up 42% in the last 12 months. 20% since November. Not only that the company according to Bloomberg is trading 1.6x book value which implies that the asset base can generate signficant value (Tobin’s Q) above its cost. For a company where the operating losses were NOK -17m and the Depreciation charge was NOK 27m that is verging on the astonishing, and definitely on the irrational.

You can say the stockmarket is meant to anticipate forward earnings and I agree, but there is nothing structural in the market that would lead you to believe 2018 is going to be very different from 2017 (as the graph from Oceaneering in the header makes clear). I get Reach have announced over 100 days work recently, but without any information on day rates and margin levels can you believe it is value accretive?

The longer all the ROV companies remain in business and keep capacity high it guarantees that margins will be breakeven-to-low in the best case for everyone in the game. This is an industry that built capacity for 349 tree installations in 2014 and is coping with 243 in 2018 (a 44% decrease), and at the moment the new investors piling in are simply providing a subsidy for the E&P companies who take rates at below economic levels.

It is only a question of which tier 2 companies leave the market if The Demand Fairy doesn’t make a rapid deus ex machina appearence soon. This is an industry with too much capacity and capital relative to demand and the equity market here is sending the wrong price signal about allocating more capital.

Oil prices, speculators, and supply expansion…

An article from the FT here touches on an issue that has been discussed since there was an oil market:

Who trades oil is changing, however. Investors who bother little with details such as inventories and pipeline flows are replacing dwindling ranks of specialist commodities hedge funds. The shift could alter the way prices are formed…
Then who is driving oil positions higher? Newly prominent oil speculators are not necessarily reacting to news about supply and demand or utterances from Riyadh. Instead, they may be buying and selling oil based on moves in currencies, interest rates or the price of oil itself.

Namely, are speculators affecting the price of oil? You can see from the graph above that the exponential growth of Brent Ice futures contracts, which is cash settled and does not require physical product delivery, bears no relationship to the relative steady increase in the demand for oil. Some demand for these futures clearly reflects increasingly sophisticated financial risk management techniques, but some clearly represents purely speculative capital trading on price moves (often with large amounts of leverage).

There has been an entire industry in trying to ascertain the economic effects of speculators in oil markets. The IMF view is that they have no effect, but reputable economists at institutions such as the St Louis Fed disagree. A good summary is here.

My own (simplified) view, that accords to a well researched positions, is that speculators affect the volatility of the oil price but the not the final price over the long run.  Basic economic logic alone should dictate that if there is an increased amount of capital being invested in an asset class it will cause the price to rise, but when combined with leverage it adds huge volatility (quite simply if you have borrowed money to buy something and the price drops you tend to liquidate quickly to minimise loses). Which is why you see such huge swings in oil investment positions with a clear procyclical bias:

The big long.png

But the major point for those involved in service industries to my mind is that this is part of the explanation why there is not a linear relationship between the oil price and demand for oil field services. Directors at E&P companies make decisions about the long term price but ultimately the market for physically delivered product is more important when investing in production infrastructure, despite the large trading arms of the supermajors,  because they obviously do have deliver in the physical form eventually. They also benefit from miscalculating demand on the upisde through rising prices and a higher ROE on invested capital, so although they give up some amount of market share it’s a fairly small downside for erring on the side of caution.

Too many models that forecast the demand for oilfield services work are based on the forecast oil price rather than physical volume required. Too many management teams in offshore are using a rebound in the oil price as “proof” the “market” will eventually recover in demand terms when it is clear there is no linear relationship. As shale becomes the swing production method of choice offshore demand in particular should be relatively easy to forecast because in the new environment it will be supplying a baseload of physically demanded production while short-term changes in demand are managed by tight-oil. If someone in oil services tells you their business model is fine because the price of oil will rise I would suggest examining things a lot more carefully.

The shale productivity revolution in context…

“[W]e can see the computer age everywhere but in the productivity statistics”

Robert Solow

 

A great article in the FT today (behind paywall) on the boom in shale being driven by productivity increases (a near facsimile earlier version appears here). Readers of this blog will notice a consistent theme, as Krugman said, “productivity may not be everything, but in the long run it’s nearly everything”. The importance of this is that the US is turning shale into a manufacturing industry, small incremental improvements day-in, day-out, that cummulatively dramatically lower overall per unit costs:

In 2015, shale oil producers on average used 3,300 tons of sand per well, according to Petronerds, a consultancy. By last year, that had almost doubled to 6,100 tons per well. Delivering that much sand to the well site can require 250 truck movements. Other techniques for shale production have also been refined to increase the amount of oil that can be extracted. Modern rigs can drill faster, further, and more accurately than their predecessors. The process of hydraulic fracturing is being split up into more “stages”, allowing effort to be focused more precisely on oil-bearing rocks.

Innovations using the latest computing and communications technology, including remote operations, are also starting to be used more widely. Schlumberger, the oilfield services group, says that in 2014, 13 per cent of jobs it worked on at US onshore wells were supported by technical experts watching from its Houston campus. By 2017, that was up to 31 per cent.

This coincided with the IEA forecasting that the US will become the world’s largest oil producer by 2023 (graph above). [It is well worth having a look at the 13 slides at the bottom of the page of the IEA link]. Investment remains depressed in all but tight oil and the comment at the bottom of this slide regarding offshore is telling:

IEA Upstream Spending.png

The IEA is worried:

that despite falling costs, additional investment will be needed to spur supply growth after 2020. The oil industry has yet to recover from an unprecedented two-year drop in investment in 2015-2016, and the IEA sees little-to-no increase in upstream spending outside of the United States in 2017 and 2018.

“The United States is set to put its stamp on global oil markets for the next five years,” said Dr. Fatih Birol, the IEA’s Executive Director. “But as we’ve highlighted repeatedly, the weak global investment picture remains a source of concern. More investments will be needed to make up for declining oil fields – the world needs to replace 3 mb/d of declines each year, the equivalent of the North Sea – while also meeting robust demand growth.”

The real questions here revolve around how much capacity is being replaced annually, and it is simply not true that 3mb/d are not being replaced at the moment. The producutivity improvements in shale above are part of the solution. Other questions are what sort of price increases would crimp demand? etc. There appears to be no change in investor expectations that they want E&P companies, certainly large ones, to reduce debt and increase shareholder payouts, and therefore capital projects will remain subdued. There is also a strong feeling in the investment community that reserves can be run down.

Without wishing to sound like a broken record the “Demand Fairy” isn’t saving anyone in offshore. Offshore needs to re-engineer it’s business model to compete. The IEA is clear that this weakness will be felt from 2020 onwards, so even if you accept their reasoning, that is a long time to keep burning OpEx if your business model cannot even breakeven in the current climate.

I view shale as a technological revolution and believe that no economy is better suited to maximising its potential. Perez defines the major economic technical revolutions since 1770 into five categories, and the US is dominant in the last three:

Tech Rev 1770 -2000s.png

Revolution is an overused word. But according to Perez’s definition, that I agree with, the shale industry is a Technological Revolution (TR):

Tech Rev Definition.png

This to me is the most interesting part of economic history, because while there are nuances the broad economic development of industrial patterns are really well understood. A classic article here compares the development of the computer industry to electric dynamo. Like shale it is a story of how US capital markets funded ambitious companies, vast economies of scale, manufacturing efficiency gains, and the slow initial diffusion of producitivity gains (think tight-oil 2007).

How long can this positive productivity feedback loop, where innovations throughout the system positively affect other inputs, continue? A long time I suspect. Shale may not be subject to the same volume effects as the PC industry but it still makes an interesting comparison (Allen):

Computers deflator.png

(For those who can’t remember logarithmic maths from school all the left hand bar of the top graph means is “this is a really big number… so big we have a formula to make it shorter”. And the bottom graph just means that even though the price dropped really quickly a lot of new features were added as well). This is a hallmark of the US economy and a manufacturing industry based on constant productivity improvements.

An earlier, and slightly different technical revolution, can be seen with the invention of Corliss Steam Engine,  which allowed America to break free from the constraints of water power in the 19th century (Rosenberg and Trajtenberg). Like shale this was an energy revolution, one that changed the structure of the US economy and allowed manufacturing and urbanization to begin in earnest. Corliss Steam Engine.png

Everytime I write about shale I want to write something about the incredible economic period of the 1930s: How US mass production techniques, a revolution in both managerial skill and capital formation, led to the creation of the economy that created Victory Ships and transformed the Ford factory at Willow Run (YouTube watch this, seriously) into the manufacturer of the B-24 (“the Liberator“), innovations that arguably changed the course of the WWII, and ultimately the post-war global economy. There are surprisingly (and disappointingly) few journal and web references to this, and all are about the mathematics of productivity, when this is really a story to be told at the company level. However, economic development is path dependent and these processes and learnings today are being applied in the shale basins every day, even if unwittingly. (For a broader read about what an incredible period the 1930s was in microeconomic terms this the best I have turned up so far).

So although I don’t understand the individual impact of every innovation listed on this slide I understand where they came from and the process driving this:

Nabors Rig.png

Once upon a time a PSV went for the low-to-mid USD 20ks a day. At the time of writing the BHGE rig count hit 800, the revolution therefore continues…

End of an era… goodbye to Orelia…

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

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

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

The French Revolution and Venezuela…

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

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

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

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

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

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

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

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

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

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

This time it’s different….

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

Industry consolidation and market power… Is consolidation really the solution?

Last week the creation of a new offshore company was announced: Telford Offshore. I presume financially related to Telford International. The company has purchased the four Jascon vessels for USD 215m and looks to be setting up a UAE/ Africa subsea construction and IMR business. I know one of the guys there and wish them all the best of luck, they are a strong team and seem likely to make it work having both financial backing, local connections, and managerial skill.

From an industry perspective though it is a microcosm of why I think industry profitability will elude those long on vessels for a prolonged period of time without a significant change on the demand side. Telford isn’t taking capacity out of the market, it is merely recapitalising assets at a lower valuation level, and giving them the working capoital to operate, and it will compete with other existing companies for work in the region. That excess capacity competes on price is as close to an iron law as you can get in economics and something everyone in the offshore industry knows intuitively to be true at the moment.

The talk in the industry at the moment is all about consolidation and how that will save everyone… but I don’t see it? Consolidation is only beneficial if it generates maket power and therefore some ability to charge higher prices to E&P companies: A bigger company in-and-of-itself is of no economic benefit unless it can generate economies of scale or scope i.e. a) lower unit costs, or, b) lower integration costs of supplying a range services . At the moment, in both subsea and supply, there is no evidence that this is the case.

The large subsea companies are currently all reporting book-to-bill numbers of less than 1 (apart from maybe McDermott), that means they are burning through work faster than they are replacing it, and this is consistent with the macro numbers. This is happening because the market is contracting in both volume, and especially, value terms. Simply adding another UAE/ West African contractor to the mix will only prolong this problem in the region. Not that it is unique to the region, as the industry grew up until 2014 a host of tier 2 construction companies grew their geographic footprint and asset base as well. Now they are committed to those regions because they have no economic option but to stay. Over time, as all the companies compete against each other for minimal profits, not everyone will be able to afford to replace their asset base, that is how capital will leave the industry and how it will rebalance on the supply side; but when you have gone long on very specific 25 year construction assets it takes a long while!

It is a fundamental tenent of ecoomics that industry profits, outside of firm specific events, is a function of industry concentration. Every person who has done a ‘Porter’s Five Forces’ analysis is actually using a microeconomic model that has a deep intellectual heritage in examining if the structure of markets drives profitabilty. More recent research has highlighted firm specific factors in determining profitability, but market power, firm concentration, normally the result of consolidation, is always crucial. That is why competition authorities focus on market power when looking at whether they should allow transactions that heighten market power to progress: because scale allows firms to drive pricing power.

A normal threshold for competition authorities to get concerned about market power is ~40% market share level for any one company, and often they like to see 3 or more companies in total, below this level it is understood that consumers have options and companies will compete on price to a certain extent. While Technip and Subsea 7 dominate the market for subsea installations they have nothing like that level of market share. Any large project could theoretically go to Saipem, McDermott as well at a minimum, and below large projects an E&P company is spoilt for choice. In other words there is no pricing power at all for offshore contractors, and as all they have all committed to assets with high fixed costs, and low relative marginal costs, vessel days are essentially “disposable inventory” that must be sold or paid for anyway (just like a low-cost airline) and have no other uses.

The scale of consolidation that would have to occur in order to generate any pricing power for the contracting community defies any realistic prospect of execution for the next few years. It will happen, and slowly, but the scale of the change will be enormous, and as it nears its final stages expect the E&P companies to protest vigorously to competition authorities. Instead of the vessel companies and the subsea production system companies getting closer, eventually, the vessel companies will start to be acquired or merge. But until savings in replacement capital can be made, a while away given the huge new building programme we have had in the vessel fleet between 2010 and 2014, then it will not make sense for an acquisition premium/ nil premium merger to unlock these cost savings. One day it will be cheaper, for example, for Subsea 7 to buy the Saipem business than set out on a new build programme (through both cost savings and reduced CapEx)… but we are some way from that point and a long way from the institutions themselves accepting this.

It is even worse in offshore supply. A measure for assessing market power in economics is the Herfindahl-Hirschman Index (also used widely by competition authorities) to assess if markets have concentration levels that would allow their participants to extract excess profits through concentration. I went to calculate this quickly (the math is not difficult) based on this data from Tidewater:

Tidewater scale and scope.png

The US Justice Dept gets concerned if the HHI number comes in at 1500-2500 and is likely to take action if the number is above 2500 and there is a 200 point movement based on anyone transaction. The supply industry has an HHI well below 1000. Bourbon, the largest company with a 6% market share, only has an HHI score of 36! All the named companies on this slide could merge and chances are the DOJ would wave the deals through because it wouldn’t think the enlarged mega company would still have any pricing power (this is a reductio ad absurdum here and clearly a real situation would be more complicated) and would therefore be able to extract excess rents.

Not only that entry costs/barrier in offshore supply are nothing which just dilutes any possible positive effects consolidation could bring: Standard Drilling can buy supply vessels for $12m and park them in a reconstructed North Sea operator and compete against SolstadFarstad and Tidewater? So how does merging all of the PSV assets that makeup HugeStadSea make any difference?

In offshore contracting it is not just construction assets like Telford, a host of ROV companies now don’t need to buy or charter vessels but merely pay on use allowing a host of small companies to enter the industry. ROVOP, M2, Reach, and a host of others have entered the industry and kept capacity (or potential capacity) high and margins low with vessel operators supplying vessels below economic cost while the ROV contractors make a margin on equipment they brought at 30c in the $1 and well below replacement CapEx levels. MEDS despite defaulting on a number have charters have been given the Swordfish to operate on charter!

The high capital values of these assets encourages investors to supply working capital to keep the assets working knowing they are competing against others who paid a higher capital value. It is a very hard dynamic to break and I don’t see a huge difference between offshore supply and subsea in economic structure which is why I deliberately merged the industries here.

Part of the reason consolidation doesn’t work is because the costs of the fixed assets, and the costs to run them, are so high in relation to the operational costs. The fixed costs of the vessels, and the non-reducible operating costs dominate expenditure, getting rid of a few back-office staff, who represent less than a few % of the day rate of a vessel just doesn’t make a big enough difference overall.

Another reason is the banks are still pretending they have value way above levels where deals such as Telford are priced at. No amount of consolidation to remove some minor backoffice costs can make up for the scale of capital loss they have in reality will solve this. If Standard Drilling is buying large Norwegian PSVs in distress for $12m, and SolstadFarstad has similar vessels on the books for $20m, then you can’t consolidate costs that would be capitalised at $8m per vessel no matter how many other companies you buy. The same goes for subsea only the numbers are bigger and more disproportionate.

So when someone tells you the answer is consolidation the real question is why?

 

That consolidation is the answer is simply an economic myth. Gales of Schumpterian creative destruction are the only real solution here barring some miraculous development on the demand side of the market.