A total failure of governance… McDermott and the cost of money at the margin…

If you want to know what the cost of raising funds for a corporation in trouble following a failed acquisition is the recent disclosures from McDermott provide a good guide. Crucial to the continued ability of the firm to stay within its banking covenants and remain a going concern in the Q3 2018 results was the $300m in 12% preference shares sold by McDermott to Goldman Sachs and Company (and affiliated funds). From the sale McDermott received $289m, meaning Goldman banked $11m in fees… to start with… The kicker is that Goldman and its funds (likely credit opportunity funds managed by the bank) also ended up owning warrants to purchase 3.75% of MDR at .01 per share… at the time of pixel those options are worth ~$51.5m (at an MDR share price of c. $7.61).

If you don’t believe MDR is in real financial trouble you need to ask yourself why the best course of action for management was to engage in a financing that cost shareholders ~$62m to “borrow”/ strengthen their balance sheet (sic) to the tune of $300m. The $289m the company got has an interest cost of $36m per year (excluding tax effects) and cost the shareholders 3.75% of their company. No wonder the shares dropped ~40% when the news was announced (already well down on the pre-acquisition price): investors knew they were losing a lot more than 3.75% of the value of the company. Not only that the increased working capital lines ($230m) required that this capital went in. MDR had maxed its borrowing capacity just a few short months after the takeover. In short: it was a financial disaster.

This isn’t a rage against the Great Vampire Squid, because if you need to get your hands on $300m quickly, and you are running out of cash, then for a good reason money tends to be expensive. The real question is how MDR got here, and so quickly, since acquiring CBI?

In my view the short answer is: a total failure of governance from the MDR Board that allowed management to buy a much bigger business they knew literally nothing about. The famed “One McDermott Way” was about installing cheap pipe and jackets in the Middle East and Africa not building on-shore low-margin refining plants. It is about as relevant as an orange juice manufacturer buying Tesla because they are going to apply the lessons learned in de-pipping oranges to extending the battery life of electric-powered vehicles.

The failure of this deal will I believe lead to the end of the MDR offshore contracting business as an independent entity. The reason is nothing more than a failure to ask a basic and honest question about where the skills of the company reside? And for the Board to realise that for MDR management the worst option of being acquired was probably the best option for the shareholders.

This presentation given to shareholders in August indicates that shareholders already had a serious case of post-acquisition regret, and reading between the lines here management are clearly under huge pressure despite the upbeat tone of their communications. The 40% decline their investment post-August is likely to have induced a sense of humour failure amongst even their most loyal of followers. Someone senior is going to have to carry the can soon and that does not make for a harmonious exec. I can’t think of another M&A deal that has locked in  such a loss of value so quickly.

McDermott got into this because in late 2017 their viability as an independent company looked shaky. Management had a very good offshore crises through a mix of skill and luck: their low-cost Middle Eastern model, not applicable when the Norwegians and French were in competition to build a more expensive OSV than the company before them, was more shallow-water focused than Brazil/UDW, and they didn’t have a complex about working old assets to death. McDermott picked up some cheap assets like the 105 when the opportunity presented itself, but management didn’t blow money on value dilutive acquisitions either or go to long on assets or debt. MDR management had steered the company back from the brink to create a genuinely competitive company with an ideal geographic footprint and asset base for the new offshore environment. I was a real admirer of the company.

But then GE started sounding out Subsea 7 (and being turned down), and the MDR footprint would have been perfect for Subsea 7 (BHGE would clearly have made a hash of MDR). There are very few companies the size of MDR that remain independent in an environment where consolidation is the market mantra: they had very little net debt, were big enough to buy and move the needle for a large company in revenue terms, but small enough to acquire in financing to terms. And there is some real intellectual and engineering skills in the core DNA of the McDermott business, no matter how complex the offshore problem, someone in McDermott knows the answer.

At some point in 2017 MDR management and the Giant Vampire Squid decided on a plan to buy CB&I and their shareholders really did think Christmas had come early that December 17th. To avoid being acquired McDermott opted for a type of ‘Pac Man’ defence: it went on to acquire a larger company. You can see the balance sheet of CB&I was substantially larger than MDR:

CBI Balance sheet:

CBI BS .png

MDR Balance Sheet:

MDR BS.png

Crudely MDR had $3.2 bn in assets and almost no debt while CB&I had $6bn in assets but $5.6bn in debt.

The reason MDR could do this was the debt and CB&I losses. CB&I was losing, and had been for a considerable period of time, vast amounts of money in its core business. A pretty crucial question would therefore be “could the One McDermott Way” transform this situation? A secondary question if the answer was yes was how much due diligence should be undertaken to prove this?

This isn’t hindsight talking. Here are the last four years financial performance of CBI:

CBI losses 2014-2017.png

Can any of you, even those without financial training, see something that might worry you about buying this company? (I’ll give you a clue it’s in the last line and it’s a material number). As Bloomberg noted at the time:

MDR Stamp.png

Bridge to Nowhere.png

Boom!

The problem with buying a larger company as a defence is its asymmetric returns: it is a leveraged bet on management and financial skill and if it goes wrong the value in the acquiring company is wiped out. And that unfortunately is what has happened here.

In case you were wondering the merger between MDR and CB&I consumed ~$300m in fees, slightly more in cash than McDermott later managed to raise from Goldman (and paid in cash of course), a symmetry in irony I am sure the bankers enjoyed.

McDermott CBI fees.png

And yet for the $300m in fees the due diligence didn’t uncover the cost overruns in the projects, and despite having three of the most illustrious banks on Wall Street: Goldman, Sachs, & Co, (lead adviser), Moelis & Co (advising on the financing only), Greenhill & Co (advising the Board of MDR) no one managed to ask: really, can we do this? And if they did, get the right answer!

But after the fees comes the interest bill… in cash and kind now… the hangover so to speak, and this one is mind-numbingly painful:

MDR Capital Structure

MDR Cap Structure.png

MDR are paying an interest bill (per annum) of: ~$90m for the Senior Loan, ~$138m for the notes, $36m for the preference shares (not included here), and the Amazon lease payments which must be ~$30m for a $345m vessel: ~$294m in total per year (say one Amazon per year at current build costs?). MDR only made an operating profit of $324m in 2017.  In addition, the three CB&I projects they have taken a hit on will consume $425m in cash in 2019! So by the end of 2019 MDR will have spent ~$1bn in cash on deal fees, interest, and project costs. As someone nearly said “a billion here, and a billion there, and pretty soon you’re talking real money“.

All this talk of “synergies” is hokum. Everyone involved in projects knows that the pipeline fabricator in Dubai isn’t getting cheaper steel because MDR are losing money building an LNG train in Freeport. But the interest and fees are real cash. Maybe they will sell the non-core businesses and bring the debt pile down but it brings execution risk and no certainty the debt reduction will be proportionate. These asset sales have the feeling of looking for change down the back of the sofa as they were never announced as part of the original deal and the tanks business is a complex carve out that will involve vast consultants fees and by MDR’s own admission take at least nine month… on the other hand interest, like rust, never sleeps…

The fact is the reason the on-shore business of CB&I is structurally unprofitable is because despite the contract size and complexity there are a large number of equally competent (more so actually) companies who bid all the margin away. That’s no different to subsea but MDR had a genuine competitive advantage in that business and CB&I didn’t in on-shore (as their financials showed).

In really simple terms now McDermott must make a smaller offshore business, in very competitive market that consumes vast amounts of capital to grow; pay for a larger unprofitable onshore operation where management lack skills and knowledge. The odds of success must be seen as low? The square root of zero I would suggest. McDermott will be starved of CapEx as the CFO uses any cash he can to pay for the interest and charter commitments while trying to compete against onshore behemoths much larger in scale. Maintaining market share in offshore will be impressive, forget about growing it. And all this to feed a beast in a low margin onshore business that competes against giants like Fluor.

If the Board of McDermott took shareholder value seriously they would try to get Subsea 7 management back to the table and sell them the offshore business for a price close to what Subsea 7 were offering last year. The world has changed but the price for a trophy asset might still be good. What happens to the rump CB&I would be sold at auction, for probably not much, but such is reality. Such a scenario would yield more than letting this state of affairs continue.

Corporate finance Borr Drilling style…

One of the more curious corporate finance transactions took place earlier this year when Borr Drilling, an enormously leveraged rig company when financial commitments are taken into account and using its revolver for working capital, then purchased 1.5m of its own shares at NOK 35.50. As can be seen above the shares have since declined 18% and are now worth NOK 29, which is signficantly below the price they last raised capital at ($4.6/ ~NOK 39).

In the scheme of things the loss isn’t that much money,  it’s really a question of whether for such a  (sic) “high-growth” company is depleting liquidity to buy back shares the best use of its capital? I noted at the time this was close to extraordinary for a company that needs to raise hundreds of millions of dollars (not a misprint) in capital over the next three years to remain a going concern ? In which case why are they doing it?

For what it’s worth my own view is I think the Management and the Directors of Borr understand how deeply in financial trouble they are: the market simply isn’t coming back to anything like what they and their original backers planned. Without a massive increase in demand the entire investment thesis is flawed and the company has no reason for existing in a very real sense. By embedding leverage in the shipyard delivery times as well as the bonds, and using a revolver for working capital, Borr requires the market to come back strongly and for them to activate a vast number of warm-stacked units in this hypothetical demand pickup… just for Borr to remain solvent, yet alone make an economic return. As an external observer reading the public anouncements it feels like a degree of panic is setting in.

As the Borr Drilling prospectusin early 2018 made clear this is a highly competitive business:

The profitability of the offshore drilling industry is largely determined by the balance between supply and demand for rigs. Offshore drilling contractors can mobilize rigs from one region of the world to another, or reactivate cold stacked rigs in order to meet demand in various markets.

The shallow water segment of the drilling industry is particularly competitive with no single contractor having a dominant market share. Competitive factors include price, rig availability, rig operating features, workforce experience, operating efficiency, condition of equipment, safety record, contractor experience in a specific area, reputation and customer relationships. [Emphasis added].

Particularly competitive” with “no single contractor having a dominant market share” tells you how absurd the plan here is, and how much alternative investors wanted to believe in an outcome they knew to be economically illogical. Market share and competitive factors are directly related to profitability. With no fast growing market this company is simply a financial time bomb. Yet as recently as September Borr’s Chairman stated:

“We have an ambition to return a significant part of cash back to shareholders quickly … if we don’t pay dividends in 2020, we have failed,” Troeim told Reuters.

I’ll bet my house that doesn’t happen. [Actually that isn’t strictly true because Troeim could clearly afford to take me up on that and my domestic happiness would be rapidly curtailed if I started playing in the futures market with matrimonial property… But you get where I am coming from].  But the dividend comment springs from the same belief that the current market is some mis-pricing anomaly rather than a deep structural change in the oil market.

Now for plan B. A rights issue that would heavily dilute shareholders is the most logical fundraising strategy here, but finding more hedge funds to by your stock when it keeps on going down 30% is not easy. I just cannot believe Schlumberger are going to carry on committing capital to this venture on a proportionate basis. Debt? really? With no backlog or even utilisation?

The idea that this slide seems to highlight ,that banks or other debt providers would lend against the unencumbered rigs when they have absolutely no work available, seems so very 2012, quaint almost:

Built to last .png

The title of this slide is surely begging irony? The whole Borr business plan relies on growth significantly faster than the market when the market has extreme overcapacity from well capitalised (and desperate) competitors, and financing this by borrowing against rigs with no work or backlog. What could go wrong? See more here.  Borr management have done a lot, struck deals, brought kit etc., but the possible economic value creation is a simply a vastly leveraged play on a never appearing demand boom. It is a microcosm of offshore investment sentiment and a stubborn willingness to accept the scale of change shale as wrought on the market. At some point the business case must be a logical inconsistency if shale keeps growing at current rates? I’d suggest that point was passed a while ago.

The blow-up here is unlikely to be as dramatic and spectacular as something like EMAS because the perceived asset value is so high. But the scale of the amount of capital that needs to be raised, and the likely time period before it could be returned is so long, that each additional round of funding here is likely to be very expensive. Something “the market” seems to be belatedly waking up to. Borr Drilling is the ultimate measure of investment risk and sentiment in the alternative investment community in my opinion and serves as a useful barometer for how to perceive market risk.

I think Borr were trying to use the share buyback as a small signal to keep the share price high and to cut the dilution effect that will be imposed on the insiders who hold a large amount of the shares. I think the reactivation of 4 rigs speculatively was literally a gamblers last-roll as there have been no updates since about possible work for these units. A signalling event spectacularly mis-timed given the decline in the price of oil.

Share buybacks, particularly open-ended purchase programmes like the one Borr is engaged in, are extremely well-studied. There is evidence that managers can time the market (i.e. buy the shares cheap) and that smaller firms do this better than bigger firms… but you can also see “Share repurchases as a potential tool to mislead investors“, which is close to what I think happened here, although I temper this a view that offshore seems to have a number of people who see a declining oil price as contrary to some law of nature.

The fabulously optimistic Rystad Energy (more recently here and in direct contravention to DOF on AHTS, (who like actually own boats)) predict higher rates, proof that maybe you can build a great information business without having great information… a skill I grant you.  But there is no question now that most rational participants are coming to grips with the fact that the subsea and offshore market isn’t going to “recover” next year and that leaves Borr Drilling with an enormous funding hole to cover. Borr is the ultimate leveraged play on the “market recovery and scrapping” thesis, a momentum play that has lost inertia, and slowly the (hot) air seems to be draining from this balloon and the market sentiment in general.

 

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

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

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

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

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

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

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

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

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

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

Chevron Q3 2018 Permian .png

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

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

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

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

IMG_1067.JPG

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

As an immediate contra you get this today for example:

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

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

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

OGA wells summary 2-18.png

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

EA well spud.png

Development Drilling.png

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

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

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

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

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

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

#structural_change #this_time_it_is_different #supplymustequaldemand

My favourite scandal…

The quote above comes from the excellent Billion Dollar Whale. The culmination of some excellent investigative reporting that broke the original 1MBD scandal story in the WSJ and then later published in the book… [I am sure most people are aware but if you are not in one of the great ironies of the scandal the stolen funds were invested in The Wolf of Wall Street].

1MBD has everything: the sheer scale of the graft ($5bn), the arrogance and incompetence, the Saudis, the purchase of a yacht beyond luxury (cost $250m), a Times Square apartment, the entrenchment of the local elite and then a grovelling apology,  and the Malaysian election with Mahathir Mohamad coming from behind to win… And then it get’s interestingJust one of many outrageous uses of the money:

Nearly US$30 million (S$41.5 million) of funds stolen from scandal-hit 1Malaysia Development Berhad (1MDB) was used to buy jewellery for the prime minister’s wife, including a rare 22-carat pink diamond set in a necklace, according to latest filings by the United States Justice Department in a civil lawsuit.

And yet the 1MBD scandal just keeps on giving… and now it is getting serious because the US Dept of Justice clearly has Goldman Sachs & Co in its sights (the “unamed bank”. Goldman made $600m from selling three bond issues worth $6.5bn for 1MBD, fee rates that could be considered egregious … Ex-head of Goldman Asia, the colorful Tim Leissner, boasted of a PhD from The Univeristy of Somerset (where they could be purchased via mail for ~£2500) , as the FT acerbically noted “[w]hile an institution of that precise name does not appear to exist, one called Somerset University was fined in the UK in 1992 for selling unrecognised degrees” … Leissner appears to be co-operating… a current MD of Goldman is on leave and the current CEO was on the committee that approved the deals at the time.

Tim Liessner PHD.jpg

There are going to be documents galore here. Funds moved via US correspondent banks are subject to wire fraud regulations, a federal crime that brings the almost unlimited resources of the Department of Justice and the FBI, and encompasses communications made via email, phones etc in addition to just moving the funds. Once you are in that embrace it is very hard to leave and it seems certain now that there is a lot more to come…

Quite how much money the people of Malaysia get back remains to be seen.

The never appearing subsea CapEx boom…

The graph above highlights why comments about the impending offshore capex boom, long prophesied as a certainty by true believers, maybe a long time coming… What the graph shows effectively is that the Energy Select Sector ETF (a proxy for all S&P 500 E&P companies) has significantly underperformed in percentage terms the price increase in WTI (oil) throughout 2018. Not only that the rebased price volatility of oil is high.

E&P shareholders have been saying loudly they want money back from E&P companies not a capex driven option on a future supply shortage. The easiest way for E&P companies to give shareholders comfort at this point, and hopefully boost the share price, is to reduce their forward commitments to long-lived expensive projects (deepwater) and focus on shorter payback projects (shale) to supply volume. From the $FT:

Investors have been pushing executives to cut costs, reign in investments in the type of oil megaprojects that might take decades to pay back, and focus on generating cash, either for dividends or share buybacks. Bernstein Research said this week that companies were responding, noting that those who had raised capital expenditure in the second quarter had been taught a lesson.

“Investors punished E&Ps that raised guidance by 230 basis points on average,” said Bob Brackett at Bernstein.

You read comments all the time about how it is a “certainty” that high oil prices and reserve rundown must, as if some metaphysical law, lead to increased offshore activity. It simply isn’t true. The shareholders don’t want it for a whole host of good reasons: the energy transition, the benefits of higher prices and reduced supply, price volatility when making long commitments etc. This week Equinor reduced CapEx forecasts $1bn for 2019 (from $11bn to $10bn), Total confirmed theirs at the lower limit, and Conoco Phillips did the same. All the E&P companies are making similar noises. You can come up with some really complex reasons for this or just accept the CEO’s are being consistent externally and internally: they are rationing capex reasoning the upside of doing so is better than the downside.

There has been change in perceptions and market sentiment since the last energy rebound in 2008/09:

IMG_1064.JPG

If E&P companies are not going to get share price appreciation through sentiment they will have to do it the old fashioned way through dividends and share buy-backs; and cutting back CapEx is the single most important lever they control to do this.

Yes subsea project approvals are increasing (from WoodMac <50m boe):

WM Subsea FID.png

But in order for there to a “boom”, one that would influence day rates and utilisation levels across the offshore and subsea asset base, marginal operators have to be able, and willing, to spend and that simply isn’t the case. There is a flight to larger projects, with larger operators, who are ruthless about driving down price. So yes, spend levels are increasing, but check out the size of the absolute decline from the North Sea (from the $FT):

Investments in new North Sea projects have hit £3bn in 2018, the highest level since 2015, after two oil and gas projects received regulatory approval from authorities on Monday…

Capital investments in new North Sea fields were less than £500m in both 2016 and 2017, down from £4.6bn in 2015, but were much higher before the downturn, reaching as much as £17bn in 2011.

£17bn to to less than £500m!!! Seriously… just complete a structural change in the market and the supply chain needs to reduce massively in size and capacity to reflect a drop like that. And a recovery at £3bn is still less than 20% of the 2011 which the fleet delivered (and 30% down on 2015): volumes might be up but the drop in value is just too extreme for anything other than the major players to hold out here. It goes without saying a vastly larger number of businesses are viable with £17bn flowing through the market than £500m. The North Sea might be an extreme example by global levels but it’s illustrative of a worldwide trend.

E&P companies are spending increasing sums on shorter-cycle, potentially lower margin, projects because of the flexibility it offers in uncertain times. Subsea and offshore expenditure and volumes will be up in 2019 but not at the levels to keep some of the more speculative ventures alive.

If only it wasn’t a ship…

For those who want a little clarity re: my comments on Standard Drilling yesterday it really comes down to this paragraph in their most recent financial results:

Looking at the performance of the vessels there is a positive EBITDA (adj.) excluding start-up cost, dry dock, special survey and maintenance in Q2 18 of USD 0,4 million (Q2 1.7 negative USD 1,1 million) from chartering out the 5 large –sized PSV’s. Including the ownership in PSV Opportunity AS (25.53%) and in Northern PSV AS (25.53%) the group netted a positive EBITDA (adj.) excluding start-up cost, dry dock, special survey and maintenance of USD 0,2 million (Q2 17 negative USD 1,5 million).

To put this in laymans terms: the company has calculated an adjusted cash flow and said “hey, if the costs of dry docks, survey, and maintenance were excluded from the running of these assets we would have made 0.x million”…Excluding maintenance????!…But then it wouldn’t be a ship would it?  It would be like a property which you purchased in a property crash and then held onto paying only land tax until the value recovered? But the whole point of why buying a ship in a downturn is really risky is because it has running costs so excluding those is just an offence to common sense. EBITDA is a flawed metric at the best of times, adjusted EBITDA is close to meaningless.

Also, as can be seen from PSV Opportunity I, the start-up, dry dock, survey costs etc are material so excluding them is also deliberate obsfucation:

PSV OP I Structure.png

Source: PSV Opportunity I Information Memorandum

If only they hadn’t purchased ships … but they did…

Offshore takeovers and the psychology of preferences…

Haile selassie.jpg

Courtier T.L. — Amid all the people starving, missionaries and nurses clamoring, students rioting, and police cracking heads, His Serene Majesty went to Eritrea, where he was received by his grandson, Fleet Commander Eskinder Desta, with whom he intended to make an official cruise on the flagship Ethiopia. They could only manage to start one engine, however, and the cruise had to be called off. His Highness then moved to the French ship Protet, where he was received on board by Hiele, the well-known admiral from Marseille. The next day, in the port of Massawa, His Most Ineffable Highness raised himself for the occasion to the rank of Grand Admiral of the Imperial Fleet, and made seven cadets officers, thereby increasing our naval power. Also he summoned the wretched notables from the north who had been accused by the missionaries and nurses of speculation and stealing from the starving, and he conferred high distinctions on them to prove that they were innocent and to curb the foreign gossip and slander.

Ryszard Kapuscinski, “The Emperor” (1978)

“It was surreal. When someone asked why he was doing the deal, here–now, he actually said, basically, ‘Because Americans are the dumbest investors around, and there’s lots of liquidity in this market.’”

From Kathryn Welling

 

An industry in decline has much in common with the decline of an Empire and the ancien regime. The changing of the guard, the Schumpterian competition that upsets the stability of the known order, is a constant in the evolution of social systems. Kapuscinski’s account of the fall of Haile Selassie’s empire is a classic account of a system unable to intepret information in the light of new objective realities with direct relevance to businesses facing structural changes. 

I think one needs to look at recent takeovers in offshore with a degree of cynicism that moves beyond the stated narrative of ‘confidence in the future’ based on rising oil prices, but also reflects the unwillingness of the participants to objectively view the risks being taken as the ancien regime of offshore faces a more competitive environment. One of the best comments I have read on the Tranocean/Ocean Rig deal is from Bassoe Offshore ‘Transocean Saves Ocean Rig from slow-moving train wreck‘. But the article only highlights the huge utilisation risks this deal (like so many others) creates: if the work doesn’t come at forecast levels Transocean will have gifted value to Ocean Rig who had few other options. A collection of rigs in cold-stack is not worth billions.

I would also add that I think the Transocean/Ocean Rig and Tidewater/Gulfmark takeovers bear striking similarities beyond the superficial of underutilised asset companies proffering a Common Knowledge of future confidence in future demand. The core similarity is that the shareholders of the selling entities were largely restructured debt holders and distressed debt investors seeking an exit from their investments. Behind the scenes these investors appear to have looked at the lack of forward demand, the high cash burn rate, and the willingness and ability of their competitors to burn cash with an identical strategy and asset base, and instructed an investment bank to get them out of their position. A peculiarity of the ORIG deal is the ability of the colourful Mr Economou to extract $130m over and above his proportionate economic interest in the company (the MSA break fee in the presentation), a situation that I imagine only encouraged the other shareholders to want to relinquish control (FT Alphaville has some interesting background on the him and here).

It is worth taking a recap on what the Common Knowledge was until quite recently (see here and here ) regarding the offshore industry (pushed by the Missionaries at the investment banks and other promoters). In 2017 and at the start of 2018 a credible story, as can be seen from the Seadrill restructuring presentation below, was for a sharp rebound in day rates and utilisation. The Seadrill restructuring was so complex and long that by late 2017 when it was actually due for completion, an update had to be issued and lo-and-behold the recovery was further off than first anticipated (if at all)…

Seadrill VA Dec 17.png

This presentation was by no means unique. Credible people will tell you that not only will day-rates double in three years (or less), but also that this will happen in addition to utilisation hitting 2014 levels. And this will all happen apparently in an environment where E&P companies are deliberately using shale as a competing investment to lower offshore costs…

It may happen, I don’t know the future, there is Knightian uncertainty, but on a probability weighted basis I would argue these sorts of outcomes are low probability events. The offshore industry will over time reach a new equilibrium in terms of demand and supply, in almost all other industries where there has been severe overcapacity issues before normalisation, it has led to lower structural profits on an ongoing basis.

Financial markets work on narratives and Common Knowledge as much fundamental valuation models rooted in the Efficient Market Hypothesis. Indeed these are the core of a financial bubble: a mis-alignment of current prices with long-term risk-weighted returns. What offshore industry particpants wanted to believe in 2017, against the face of significant evidence to the contrary, was that there would be a quick rebound in the demand for offshore drilling and subsea services. Despite the public pronouncements of the major E&P companies that CapEx was fixed and excess cash would be used to pay shareholders or reduce debt, despite the clear investment boom forming in shale, and despite stubbornly low day rates from their own contracting operations. People wanted to believe.

And so the investors rushed in. For Seadrill, for Borr Drilling, for Standard Drilling, for Solstad Farstad, and a myriad of others. While other investors through restructurings became reluctantly (pre-crash security holders) and willingly (post-crash distress debt investors) owners of these companies. Now, having realised that they own asset heavy companies, losing vast amounts of cash, with no possibility of bank lending to support asset values, and a slow growing market, they want out.

The meme for these deals is meant to be one of success… but really it isn’t. And just as the hard cash flow constraint is binding on the individual companies involved many of the hedge fund investors who get involved in these deals are required to produce quarterly performance reports. Charging 2/20 for an oil derived asset declining in the face of rising oil prices can cause questions, or even worse, redemptions.

So having rapidly opened the ‘black box’ of the companies they own the shareholders in both Gulfmark and ORIG realised that they were the proud owners of companies with no immediate respite from the market. The the most logical way to get out was to get shares in an even bigger entity where the shares are significantly more liquid and tradeable. That management of the acquired entities managed to get an acquisition premium is testament to the skills of the bankers involved no doubt, but also down to the fact that the acquiring companies wanted to be bigger, not because they really believe in a market recovery and pricing power (although the pricing power is valid), but because if or when they next raise capital it is better to be bigger in absolute value terms. Show me the incentive and I’ll show you the outcome…

In behavioural finance it is well known that humans overweight the possibility effect of unlikely high risk outcomes and underweight more likely certainty effects (the canonical reference is here):

POP 2018

What does this mean for offshore in general and Transocean/ORIG in particular? It means that the managers backing this deal are overweighting the possibility of a sudden and unexpected rise in offshore demand versus the more statistically likely chance of a gradual return to equilibrium of the market. It is exactly the same miscalculation that the management and shareholders of Borr Drilling appear to have made. The decline in share values recently indicates some shareholders in all these companies get the deal here. The risk of a slow recovery, and a vast increase in the stacking costs of the ORIG rigs is borne more significantly by Transocean shareholders who have borrowed ~$900m to fund the deal, while the upside is shared on a proportionate economic interest basis.

I have confidence in offshore as a production technique for the long-term. It will be a significant part of the energy mix for the foreseeable future. But a 2008 style recovery, given the importance of shale as a marginal producer and the increased offshore fleet size, looks to be an unlikely outcome that is still being heavily being bet on.