Diverging results point to the future of offshore… procyclicality reverses…

Colin, for example, has recently persuaded himself that the propensity to consume in terms of money is constant at all phases of the credit cycle.  He works out a figure for it and proposes to predict by using the result, regardless of the fact that his own investigations clearly show that it is not constant, in addition to the strong a priori reasons for regarding it as most unlikely that it can be so.

The point needs emphasising because the art of thinking in terms of models is a difficult–largely because it is an unaccustomed–practice. The pseudo-analogy with the physical sciences leads directly counter to the habit of mind which is most important for an economist proper to acquire…

One has to be constantly on guard against treating the material as constant and homogeneous in the same way that the material of the other sciences, in spite of its complexity, is constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple’s motives, on whether it is worth while falling to the ground, and whether the ground wanted the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth.

Keynes to Harrod, 1938

 

A, having one hundred pounds stock in trade, though pretty much in debt, gives it out to be worth three hundred pounds, on account of many privileges and advantages to which he is entitled. B, relying on A’s great wisdom and integrity, sues to be admitted partner on those terms, and accordingly buys three hundred pounds into the partnership.The trade being afterwords given out or discovered to be very improving, C comes in at fivehundred pounds; and afterwards D, at one thousand one hundred pounds. And the capital is then completed to two thousand pounds. If the partnership had gone no further than A and B, then A had got and B had lost one hundred pounds. If it had stopped at C, then A had got and C had lost two hundred pounds; and B had been where he was before: but D also coming in, A gains four hundred pounds, and B two hundred pounds; and C neither gains nor loses: but D loses six hundred pounds. Indeed, if A could show that the said capital was intrinsicallyworth four thousand and four hundred pounds, there would be no harm done to D; and B and C would have been obliged to him. But if the capital at first was worth but one hundred pounds, and increasedonly by subsequent partnership, it must then be acknowl-edged that B and C have been imposed on in their turns, and that unfortunate thoughtless D paid the piper.
A Adamson (1787) A History of Commerce (referring to the South Sea Bubble)

The Bank of England has defined procyclicality as follows:

  • First, in the short term, as the tendency to invest in a way that exacerbates market movements and contributes to asset price volatility, which can in turn contribute to asset price feedback loops. Asset price volatility has the potential to affect participants across financial markets, as well as to have longer-term macroeconomic effects; and
  • Second, in the medium term, as a tendency to invest in line with asset price and economic cycles, so that willingness to bear risk diminishes in periods of stress and increases in upturns.

Everyone is offshore recognises these traits: as the oil price rose and E&P companies started reporting record results offshore contractors had record profits. Contractors and E&P comapnies both began an investment boom, highly correlated, and on the back of this banks extended vast quantities of credit to both parties, when even the banks started getting nervous the high-yield market willingly obliged with even more credit to offshore contractors. And then the price of oil crashed an a dramatically different investment environment began.

What is procyclical on the way up with a debt boom always falls harder on the way down as a countercyclical reaction, and now the E&P companies are used to a capital light approach this is the new norm for offshore. The problem in macroeconomic terms, as I constantly repeat here, is that debt is an obligation fixed in constant numbers and as the second point above makes clear that in periods of stress for offshore contracting, such as now, the willingness to bear risk is low. Contractors with high leverage levels that required the industry to be substantially bigger cannot survive financially with new lower demand levels.

I mention this because the end of the asset bubble has truly been marked this week by the diverging results between the E&P companies and some of the large contractors. All the supermajors are now clearly a viable entities at USD 50 a barrel whereas the same cannot be said for offshore rig and vessel contractors who still face large over capacity issues.

This chart from Saipem nicely highlights the problem the offshore industry has:

Saipem backlog H1 2017 €mn

Saipem backlog Hi 2017.png

Not only has backlog in offshore Engineering and Construction dropped 13% but Saipem are working through it pretty quickly with new business at c.66% of revenues. The implication clearly being that there is a business here just 1/3 smaller than the current one. You can see why Subsea 7 worked so hard to buy the EMAS Chiyoda backlog because they added only $141m organically in Q2 with almost no new deepwater projects announced in the quarter.

It is not that industry conditions are “challenging” but clearly the industry is undergoing a secular shift to being a much smaller part of the investment profile for E&P companies and therefore a much smaller industry as the market is permanently contracting as this profile of Shell capex shows:

Shell Capex 2017

A billion here, a billion there, and pretty soon you are talking real money. The FT had a good article this week that highlighted how “Big Oil” are adapating to lower costs, and its all bad for the offshore supply chain:

The first six months of this year saw 15 large conventional upstream oil and gas projects given the green light, with reserves of about 8bn barrels of oil and oil equivalent, according to WoodMac. This compared with 12 projects approved in the whole of 2016, containing about 8.8bn barrels. However, activity remains far below the average 40 new developments approved annually between 2007 and 2013 and, with crude prices yo-yoing around $50 per barrel, analysts say the economics of conventional projects remain precarious.

Not all of these are offshore but the offshore supply chain built capacity for this demand and in fact more because utilisation was already slipping in 2014. And this statistic should terrify the offshore industry:

WoodMac says that half of all greenfield conventional projects awaiting a green light would not achieve a 15 per cent return on investment at long-term oil prices of $60 per barrel, raising “serious doubt” over their prospects for development. By this measure, there is twice as much undeveloped US shale oil capable of making money at $60 per barrel than there is conventional resources.

The backlog (or lack of) is the most worrying aspect for the financing of the whole industry. E&P companies have laid off so many engineers and slowed down so many FIDs that even if the price of oil jumped to $100 tomorrow (and no one believes that) it would take years to ramp up project delivery capacity anyway. Saipem and Subsea 7 are not exceptions they are large companies that highlight likely future work indicates that asset values at current levels may not be an anamoly for vessel and rig owners but the “new normal” as part of “lower for longer”.

I recently spoke to a senior E&P financier in Houston who is convinced “the man from Oaklahoma” is right but only because he thinks overcapacity will keep prices low: c. 50% of fracing costs come from sand, which isn’t subject to productivity improvements, and he is picking that low prices eventually catch up with the prices being paid for land. I still think that the more large E&P companies focus on improving efficiency will ensure this remains a robust source of production given their productivity improvements as Chevron’s results showed:

Chevron Permian Productivity 2017

Large oil came to the North Sea and turned it into a leading technical development centre for the rest of the world. Brazil would not be possible without the skills and competencies (e.g. HPHT) developed by the supermajors in the North Sea and I think once these same companies start focusing their R&D efforts on shale productivity will continue to increase and this will be at the expense of offshore.

It is now very clear that the supermajors, who count for the majority of complex deepwater developments that are the users of high-end vessel capacity, are very comfortable with current economic conditions. They have no incentive to binge on CapEx because even if prices go up rapidly that just means they can pay for it with current cash flow.

That means the ‘Demand Fairy’ isn’t saving anyone here and that asset values are probably a fair reflection of their economic earning potential. Now the process between banks and offshore contractors has become one of counter-cyclicality where the asset price-feedback loop is working in reverse: banks will not lend on offshore assets because no one knows (or wants to believe) the current values and therefore there are no transactions beyond absolute distress sales. This model has been well understood by economists modelling contracting credit and asset values:

Asset Prices and Credit Contracttion

Getting banks to allocate capital to offshore in the future will be very hard given the risk models used and historical losses. Offshore assets will clearly be subject to the self referencing model above.

I remain convinced that European banks and investors are doing a poor job compared to US investors about accepting the scale of their loss and the need for the industry to have significantly less capital and asset value than it does now. Too many investors thought this downturn was like 2007/08, when there was a quick rebound, and while this smoothed asset prices somewhat on the way down this cash was used mainly for liquidity, it is now running dry and not more will be available (e.e. Nor Offshore) at anything other than penal terms given the uncertainty. Until backlog is meaningfully added across the industry asset values should, in a rational world, remain extremely depressed and I believe they will.

Backlog is essential for re-financing…

“Just because you don’t understand it doesn’t mean it isn’t so.”
― Lemony SnicketThe Blank Book

The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

— Adam Smith (1776)

Subsea 7 purchased the remnants of EMAS Chiyoda last week in a tale that highlights how not getting your timing right can be an expensive mistake in subsea. Chiyoda have probably decided to stick to stuff they know something about this time.

Contrary to my earlier remarks I think the Subsea 7 is an okay defensive deal. The Gulf of Mexico is a growth deepwater market (one of the few) and the weakest one for Subsea 7, and in addition they bolster their position in the Middle East. Backlog for Subsea 7 was virtually static in the last quarter which highlights why they need to take such aggressive steps to prop it up, the downside is they have added to their fixed cost base at a time of declining demand and project margins. There is an outside risk as I have said before that the backlog was poorly tendered and there are integration risks associated with the delivery, but Subsea 7 is one of the world’s best engineering companies and probably consider this manageable.

But it was backlog that drove this more than any other consideration I would argue…

Another deal, Project Astra, is kicking around the distressed debt houses at the moment and this is a deal that comes with pipeline more than backlog: the refinancing of Bibby Offshore.  I think Bibby have left it extremely late to raise capital like this in what is actually a pretty complicated transaction. If executed as planned it will involve a substantial writedown of debt by the bondholders in addition to a liquidity issue. The real question is surely why an interest payment was made on June 15 almost simultaneously along with an IM seeking capital? Surely a business in control of this wouldn’t be paying bondholders interest while trying to organise a liquidity issue?

The answer is that far from Bibby Line Group (“BLG”) being a supportive shareholder they are actually the major problem here as this process starts the recognition that their equity value in Bibby Offshore Holdings Limited is worthless. BLG had every reason to try and believe, against all the available evidence in the market, that this was going to be a quiet year. After losing £52m at operating profit in 2016, having no visible backlog, and clearly no firm commitments for work, they instead sanctioned the Bibby Offshore ploughing forward into what is effectively a financial catastrophe. The BLG Portfolio Director is a chartered accountant and frankly should have known better: management wrapped up in the situation cannot pretend to be objective but that is what a Board, and financially literate Chairman, is for.

Instead, and clearly given the asymmetric nature of the payoff to BLG as shareholders, they sanctioned what can only best be described as bizarre financial decisions, all driven to try and protect the BLG shareholders against the interest of the creditors, which frankly from Sep/Oct 16 should have been the primary concern of the Directors. However, they are only human and when their employer is the shareholder it has placed the majority of the Executive Board in an invidious and conflicted situation.

Unless you are a full EPIC contractor subsea contracting is essentially a regional business and to justify the head-office an integration costs you need to add significant scale and value in the regions you are in. Bibby Offshore HQ offers none of this and new investors participating are merely prolonging this charade, like the Nor Offshore liquidity investors they will be buying something the literally do not understand.

In addition to the obvious and valid questions as to the structural market characteristics Bibby Offshore is involved in Bondholders, now presented with what is in effect an emergency liquidity issue or administration, must be wondering inter alia:

  • Why the ex-COO has been sent on an ex-pat package to Houston to build-up the business when they are facing an imminent liquidity crisis? (Fully loaded this must be close to USD 500k per annum including house, airfares etc? Madness).
  • Why they should pump liquidity into a North American operation that has no competitive advantage, no backlog, and having had the best DSV in the GoM this year has managed to win less than 40 days work?
  • Why the BOHL is holding the value of the DSVs on the balance sheet at over GBP 100m when it is clear that their fair value is worth considerably less? It would be interesting to see the disclaimers brokers have provided for this valuation because should the capital raised be insufficient to carry BOHL though to profitability the delta between those values and realised values are likely to be very sore points of contention by those who put money in this. The Nor Offshore and Vard vessels provide ample proof that these assets are effectively unsellable in the current market and if the have to sold down in Asia/Africa/GOM those two DSVs would be lucky to get USD 25m and substantially less for a quick sale
  • Why there is a Director of Innovation and Small Pools Initiative when the core UK diving business is going backwards massively in cash flow terms? Why in fact are there 3 separate Boards for such a small company? Has legal structure been confused with operational structure?
  • Why the CEO’s wife is running a “Business Excellence” Department when the overhead is well over GBP 20m per annum? It might sound like a minor deal but as the lay-offs have increased it has clearly become a huge issue for staff working inside the business and it is like a cancer on morale

These extra costs are in the millions a year and add to the air of unreality of the whole proposal.

DeepOcean was another company with a lot of IRM type work but managed a successful refinancing. Management and staff all took a pay cut and built up a huge backlog in renewables and IRM work prior to seeking a refinancing. Potential investors there face execution risk on project delivery but can model with some certainty the top-line. The same just isn’t true at Bibby although the cost base can be shown with a  great deal of accuracy and there management have taken no pay cuts and the cost cutting doesn’t seem to have reflected the seriousness of the downturn.

No one should blame the management but rather a supine and ineffective Board that have allowed this situation to develop. None of the potential investors I have spoken to look like putting money in. It makes much more sense to try and “pre-pack” the business from administration than go through the complexity of a renegotiating with the bondholders and getting a byzantine capital structure in place in which they do not share all of the upside.

The reason all these issues collide of course is a classic agent-principal conflict: In a market where activity has declined so markedly to raise money to invest in developing new markets is verging on the absurd. Bibby Offshore is losing money in Norway and the US, has a minor ROV operation in Singapore which is unprofitable most of the time, and has seen a significant decline in the core UK diving business. The logical strategy is therefore to strip it back to basics, but that means the people negotiating the fundraising would be out of a job and therefore the strategy they have devised, not surprisingly, is more of the same and hope the market turns. This has suited the shareholder for the reasons outlined above.

Like so many companies grappling with The New Offshore Bibby is a very different company to the one that raised cash in 2014. Back then there were 4 North Sea class DSVs all working at very high rates in addition to the CSVs (and two DSVs were chartered adding extra leverage). Now not even 2 DSVs are close to break-even utilisation and the CSV time charter costs are well above any expected revenue. Returning the Olympic CSVs will cut the cash burn but merely reinforces the fact that the business no longer has an asset base that offers any realistic prospect of the bondholders being made whole (the drop in the bond price in the last few weeks confirming they now realise this).

It is in-short a mess, and one the BLG Portfolio Director and NED more than others should be placing their hand in the air to take responsibility for. It was obvious when the £52m operating loss was announced that a restructuring was needed, particularly in light of what was happening in Norway, and leaving it this late to raise funds. To pretend a fundamental structural change is not required, is simply irresponsible.

I had five years at Bibby Offshore, 4 of those were the most rewarding of my professional career to date. It gives me no pleasure to write this but I can’t help feeling the path that has been taken here risks seeing people not getting paid one month while on the BLG website will be a big article about how they sponsored a mountain walk to Kenya and highlighting their credentials as a good corporate citizen. But it is also true by the end I did have an issue with the strategy, which when you are notionally in charge of it becomes a big issue. The company shareholders insisted on a 50% of net profit dividend strategy, which in a capital-intensive industry when you were growing that quickly meant there was constant working capital pressure yet alone expansion capital. Yet every year at the strategy planning meetings we were expected to present ambitious growth plans where capital was no object, except it always was. Over the years the farce built up that when multiplied by easy credit has not worked out well. What this translated to at the Bibby Offshore level was a management team who wanted to build another Technip without anything like the resources needed to realistically accomplish this.

I used to constantly try and explain the benefits of “plain vanilla equity” but it was simply not what the shareholders wanted and it was clear at Group that they were already concerned about the size of Bibby Offshore in relation to the overall holding company. This culture of unrealistic planning has formed the basis of which constantly missing numbers hasn’t sent the right warning signal to the Board about the scale of the impending losses in the business despite it being blatantly obvious to ex-employees.

What the BLG shareholders wanted was to do everything on borrowed money, which is fine if it’s your business. But this attitude led to the Olympic charters and fatefully the bond, which in itself was a dividend recap taking GBP 37m out, and it of course left the business woefully undercapitalised in all but the best of conditions.

Bibby Offshore as a company would have had the best chance of surviving this downturn if it had approached the bondholders early about the scale of the problem, stopped making interest payments and saving the cash, had a meaningful contribution from the shareholders at a place in the capital structure that was risk capital, and approached Olympic about massively reducing the charter rates while extending the period of commitment (this would have been complex but the banks were realising 2 years ago they needed deals like this as Deepsea Supply showed). These are the hallmarks of all the successful restructurings that have been done. Instead for the benefit of the shareholders they took a massive gamble that the market would comeback and had a spreadsheet showing it was theoretically possible in the face of common sense. The consequences of this are now coming home.

Bondholders of course only have themselves to blame, The Bibby bond was a covenant light issue and was essentially bullet redemption on depreciating fixed assets, a risk all financial investors know deep down is just gambling. Confident in the mistaken view that BLG would step in the bonds have held up unnaturally in pricing for an eon while the company continued to burn through cash at a rate that should have worried any serious investor. They have now been presented with a nuclear scenario where they must put something in or face potentially nearly a total write-off of their investment, a quick look at the Nor bonds and asset situation only strengthening Bibby’s hand.

London is awash with distress credit investors at the moment who are long on funds. Many are traders and hopeful of entering a position with a quick exit to someone else, and they may get this deal away with people like this. But it is a very hard sell because unlike DeepOcean there is no backlog only pipeline, and one is bankable and the other is not.

 

BOA and Volstad: End of a Norwegian era… More restructurings to come…

The best of men cannot suspend their fate: The good die early and the bad die late.

DANIEL DEFOE, Character of the late Dr. S. Annesley

Boa Offshore and Volstad Maritime are both involved in restructuring talks at the moment, both are bound by the same ties of market fate and financial commitments: excessive leverage, financial speculation, and a secular change in demand for the asset base that underpinned the bonds. On a wider scale these should be seen as examples of small Norwegian companies that rode an oil and credit wave that has now definitely ended and their place in the market will remain limited at best and in the Boa case is likely to be non-existent.

The excessive leverage isn’t simply a case of hindsight: again like the Bibby bonds these were depreciating assets backed by bonds that required no repayment during the life of the instrument. Capital assets that do not have to earn a return on their principal but rather rely on further refinancing are simply speculation by both parties to the transaction and are clearly indicative of a credit bubble. Such investments are what Minsky called Ponzi financing, it requires a suspension of belief from economic reality that such a situation can continue, and that interest payments can be met by constantly drawing on an increased capital value. In the offshore oil services world this wasn’t willfully disregardng the evidence but rather the industry belief that ever rising oil prices and demand side factors were immutable forces of nature. The failure to recognise that in the long-run this would cause some innovative firms to seek new solutions is one of the great enduring mental models that has led previous generations to believe fervently in ‘peak oil’.

The other similarity is the type of vessels both Boa and Volstad have backed: no other asset class in offshore has been as overbuilt as the large OCV (~250t crane, 1000m2+ back deck etc). Potential new investors in Volstad should look at how illiquid the Boa Deep C and Boa Sub C are: bondholders are looking at a liquidity issue because these assets are in all reality unsellable at any price at the moment. When the Volstad vessel charters finish their maximum upside is surely capped to the amount bondholders in comparable assets are willing to accept to supply vessels to Helix-Canyon… and that is surely lower than their current charters? And that would assume Helix need as many vessels, a bold asumption looking at their utilisation record. In the old offshore such assets were rare and expensive… now not so much…

Part of the clue to the lack of sales in the OSV market is not just in the demand side of the market it also lies in the behaviour of banks. Have a look at DVB (my previous thoughts on the bank here), lending to offshore was running at c. USD 2-3bn per annum in 2010 to 2014:

DVB lending by segment 2010-2014.png

Welcome to the world of The New Offshore and closed loan books as the DVB investor presentation (2017) shows:

DVB New Transport Business 2017

That isn’t DVB specific this is a relfection of all banks in the market and a total withdrawal of asset financing. No matter what the relationship bankers tell you to all but the most exceptional cases the loan book is closed for offshore assets in all banks (apart from US focused companies with a US revenue base and a US bank). And no one pays close to historical value for such specialised assets if you cannot get a loan, but this has become a self-referential cycle that will be very hard to break, and in reality will only be done so as part of an overall consolidation play by a player with a realistic financing structure relative to the market risk.

Volstad Maritime may have a viable business going forward (i.e. strategy and execution capability) based solely on the Helix-Canyon charters, but liquidity is a different issue. The fate of the Bibby Topaz remains a major area of interest as the vessel is part of a three boat high-yeild bond and the owners of the bond have in effect an option to take full control of the Topaz. The bond has a corporate guarantee from Volstad Maritime AS that adds to the complications. OTC bonds are a grey area but rumours abound of Alchemy (the core M2 investor), other funds, and industrial players all having positions in the bond. Bibby Offshore may well be delaying their restructuring announcement until the position of Volstad Maritime and the Topaz is clear (although if they can make it to September without legally overtrading handing back an Olympic vessel is also likely an announcement time). A seperation of the Helix chartered vessels could be a viable option but only if the corporate Volstad corporate guarantee can be squared with the bond owners (who also own the m/v Tau on charter to DeepOcean but must surely been seen as effectively worthless, and the Geco Bluefin (in lay-up?)).

The Boa bondholders and banks seem to be repeating the same mistake the Harkand/Nor bondholders have consistently made: confusing a permanent impairment in asset values for a temporary market dislocation. In fact the Boa OCV bond term sheet contains the following nugget:

the aggregate current market value of the vessels according to information provided by the Group prior to the date of this Term Sheet is NOK 810,000,000

No sane individual believes that you could get USD 95.7m for the Boa Deep C and Boa Sub C at the moment:  2 vessels that have to enter lay-up because there is no work for them and assets that no bank that would lend against. There is a nice gap in the documentation here where the advisers to Boa state they have not undertaken due diligence of any information supplied. Everyone here wants to believe something everyone knows not to be true.

The structure calls for the seperation of the various asset classes into their individual vessel type exposures and is in effect a wait-and-pray strategy. Bondholders pay a “Newco” management company a fee to manage the vessels and provision is made for a further liquidity issue. I sound like a broken record here but the longer everyone keeps providing further liquidity the further any supplyside recovery becomes. The Sub C and Deep C are very nice vessels but two vessels does not an operator make in the current market, all this set-up does is support latent capacity, like the North Sea PSV market, that keeps everyone bidding at OpEx levels only. Hope is not a strategy.

I don’t have any magic answers here beyond investors accepting the economic reality of their position which they are under no obligation to do. The Boa bondholders, like the Harkand bondholders, and others, figure they have lost so much what harm can one last roll of the dice do I suspect? For those of you who have seen the movie ‘A Beautiful Mind’ you may recognise this as a problem that is a case of Nash Equilibrium:

a solution to a non-cooperative game where players, knowing the playing strategies of their opponents, have no incentive to change their strategy

It drove Nash to a nervous breakdown (literally) and I have no intention therefore of taking this any further.

The New Offshore: Liquidity, Strategy, Execution. Nothing else matters.

Illiquid or insolvent? Bagehot and lenders of last resort to the offshore industry…

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.

 

Irving Fisher

The Singapore Government think they have found a case of market failure:

SINGAPORE – Offshore marine services firm Pacific Radiance has been granted S$85 million in loans under two Government-backed financing schemes.

I’d suggest the Singaporean Government brush-up on the difference between a shift in the demand curve and a shift along the demand curve To non-economists the difference may look semantic but to every stage 1 student it is drilled into them that a shift along the demand curve occurs when price changes and then the quantity demanded responds, a shift in the demand curve means a fundamental change in demand. It is the difference between a change in the quantity demanded versus a change in demand, which are self-evidently two completely different things.

I would argue, and have on this blog consistently, that we are seeing a complete reconfiguration of the offshore supply chain, think Woodside moving to electronic Dutch Auctions for commodity supply vessels, rather than a short-term fluctuation in demand as the result of temporarily low oil prices.

Quite why the Singaporean Government feels it knows better than the market is beyond me here? I should note at this point I am not an unadulterated free-marketeer, my favourite paper at University in NZ at the height of Rogernomics and its successors in a supply-side revolution, was “State-Led Development in South-East Asian Tiger Nations: Singapore, Hong Kong, Taiwan, and South Korea”. In the debate between the World Bank and the activists I took my lead from Robert Wade (also from NZ) and others who saw active government involvement in the economies as an essential part of the process that drove these economies to outperform and pull their people out of poverty. I was a believer, I agree still to a certain extent, with Alice Amsden who argued the governments’ of the region actively set out to “get the market price wrong”.

But I also grew up in New Zealand, which terrified of rising oil prices in the 1970’s had launched Think Big, and by the time the Motonui synthetic “gas-to-gasoline” plant was finished the tax payer footed the bill for every single litre manufactured. It was in short an economic disaster. Trusting a Government ministry to out-judge the energy market is a dangerously expensive passtime.

I should also note that Stanley Fischer, in an unbiased review of South East Asian development policies following the East Asian Crisis noted:

As to Asian industrial policy… some degree of government involvement can in principle be successful, and that it was successful in practice, too, in some Asian economies by allowing new industries to overcome coordination failures and exploit economies of scale. I also believe the potential for such interventions to go wrong is very high, both because the government may make the wrong decisions, and also because they are conducive to corruption. In most cases the best approach is for a country to create a supportive business environment, including policies and institutions that encourage innovation, investment and exports in general, and to leave allocative investment decisions to the private sector.

So when I read that Pacific Radiance has secured loans from two entities affiliated with the Singaporean Government I have to question what is going on?

Firstly, there is a moral hazard element here as the shareholders and the banks appear to benefit from an overly generous dose of leverage on average assets. The Straits Times notes:

The Government will take on 70 per cent of the risk share for both the IFS and BL loans, which were rolled out last November to help local offshore and marine companies weather the current prolonged industry downturn by gaining access to working capital and financing.

These are loans largely owned by DBS and UOB. I don’t undertand how if this is an economic transaction these banks need this level of support? This is an assymetric payoff where the Government takes most of the risk and the banks pick up most of the upside.

Secondly, the sanity: this money is going on OpEx:

The loans … will help support the group’s working capital needs over the medium term, said Pacific Radiance in a statement on Thursday.

Really? Does the Government of Singapore believe that a short-term market dislocation has occured that will see USD 5-10k per day per vessel of OpEx recovered when the market comes back? Pacific Radiance has USD 605m of liabilities over a fleet of 60 vessels and JVs with a further 60 in Indonesia. Like Deepsea Supply, and a host of others pretending the vessels are worth anything like this is a fantasy. But another problem isn’t just the size of the debt, and the quality of the assets underpinning it, but the income being generated to service it:

PAC RAD Sales Q1 2017

Sales are dropping like a stone, and as a general rule depreciating assets that earn less than you thought are worth less. The loan doesn’t solve the fundamental problem: Pacific Radiance have borrowed too much money relative to the revenue these assets can now earn and are likely to in the forseeable future. As you can see over the same period comparison as above Pacific Radiance is consuming cash at an alarming rate:

PAC RAD Cash Flow Q1 2017

Most worrying is the amounts due from related companies which would have to be seen as doubtful, but the business is also using large amounts of cash in operations and this loan is simply going to go in and then go out on that operational expenditure. Loan covenants on fixed assets were simply not designed to cope with turnover dropping 24% quarter-on-quarter: there was too much leverage in the offshore sector to support this. The banks need to come to the party here for this to be a viable firm.

Third, this seems completely contrary to what other major players in the market, like Bourbon are saying (and they are surviving without government assistance):

Mr Pang noted that the longer-term outlook for the industry has improved, as Opec and certain non-Opec producers have sustained oil production cuts until June this year and have also agreed to extend these cuts by another nine months. “This concerted effort by oil producers should enable supply and demand to balance in the medium term.”

The Singaporean Government is essentially making a bet on a private company that seems to have no other plan than simply hanging around waiting for the market to improve. To be honest that doesn’t strike me as a great plan, and if enough investors agreed with Mr Pang surely getting an equity rights issue away should be easy for the company to raise the money and wait for this miraculous occurrence? In fact of course with the Swiber AHTS going for 10% of book value the loan already looks doubtful.

The government of Singapore has now become the Lender of Last Resort to the offshore sector and therefore the Bagehot dictum applies “lend freely at a penal interest rate against collateral that would be good quality in normal times” (I have discussed this before) . The formula is help the illiquid but not the insolvent. Bagehot outlined this formula in 1873 after repeated shutdowns in the London money market put sound financial institutions at risk. The Bank of England had followed this dictum in 1866 when London had its own Lehman moment and the Bank of England allowed Overund, Gurney and Co., one of the largest institutions, to fail.

I haven’t done a full valuation of the Pacific Radiance fleet but a quick overview of the assets on the website makes it clear this is pure commodity tonnage and some of it very low end. Quite why anyone thinks this is going to recover to previous levels needs to be outlined explicitly I would have thought given the scale of the commitment that is in the process of being made. I don’t think in the current market this would qualify as high quality collateral in normal times. There also appears nothing penal in the loan at all.

Worringly for Singaporean tax payers, looking at Ezion and others, Bagehot also wrote:

‘either shut the Bank at once […] or lend freely, boldly, and so that the public will feel you mean to go on lending. To lend a great deal, and not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies’

I think Pacific Radiance had a solvency problem not just a liquidity issue, but the systemic problem is now the longer Singapore props up companies like this the longer the industry will take to recover. If Singaporean taxpayers decide to support Ezion and a host of others they need to be prepared to write some very big checks, and the US companies fresh from Chap 11, with clean balance sheets, will be in a far better place to compete.

During the last Global Financial Crisis Paul Tucker of the Bank of England stated the Bagehot dictum as ‘to avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at ‘high rates.’ These loans do nothing of the sort by backing poor quality collateral and providing uneconomic liquidity to a company with an unsolvable problem. People are not paying less for these vessels because there is a panic they are paying less because E&P companies are using them less and they cost a lot to run! These loans will only delay the pain and hinder other struggling firms. The banks should have been forced to realise the assets at current market values as the penal rates both Bagehot and Tucker outlined and the shareholders should have been completely wiped out.

As a comparison I do not think Mermaid Maritime Australia will be so lucky. I have experienced Australian banks first hand and I suspect the “Big Four” will be ruthless and simply shut the company down soon having given the company temporary respite to see if this was just a short-term dislocation. Unfortunately from an economic perspective this type of capacity reduction is exactly what is needed to rebalance the industry.

Follow the money… it’s all in the numbers…

“We no longer believe because it is absurd: it is absurd because we must believe.”

 Julio Cortázar, Around the Day in Eighty Worlds

At some point companies are going to have to stop reporting poor financial results and say things are looking good from a tendering perspective to retain credibility (or will they maybe their shareholders want to believe as well?). This week Solstad seemed to pull this trick, while the most brazen appears to be Subsea 7 who while annoucing that their order book had dropped significantly, stated that:

[We have] [c]ause to believe in an improvement in SURF project award activity within 12 months

Early engagement activity increasing

This despite the fact that 1 year ago they had $6.1bn in backlog and they currently only have $5.1bn. Subsea 7 is more exposed to EPIC projects and I believe these will form a bigger percentage part of the market going forward, but it’s still a bold call.

For Solstad the alternative explanation, announced by Bourbon, is that there is no recovery. Or as Siem Offshore stated this week:

we believe there will still be an oversupply of AHTS vessels and PSVs and expect the market to remain challenging for several years. The charter rates and margins still remain below what is sustainable. (Emphasis added).

Part of me thinks the offshore industry just isn’t used to an environment where the forward supply curve price isn’t fundamentally different from the current price. It is worth noting that on an inflation weighted basis the oil price peaked in 1979 and then dropped in real terms for 19 years to reach an all-time low in 1998, before stagnating for a couple of years, before the inexorable rise that we all regard as the new normal, began.

The major reason for the steady decline was both supply and demand based. New sources of supply came on, technology advanced, and high prices encouraged substitution. Clearly it isn’t an iron law that prices will keep rising over the long run as if it is an immutable economic law, yet it is taken as a given by certain sectors of the offshore community.

Solstad announced results this week that seemed to defy all logic. I don’t know how much money Aker have, but they have played the OSV market stunningly badly since the downturn began, and one would think sooner or later they will get sick of throwing more money away on vessel OpEx. Aker jumped into Solstad way to early, and yet for some inexplicable reason, (other than blind faith in a vessel recovery?) when more than 100 North Sea class PSVs were in lay-up in January, agreed to effectively bail Farstad out and combine with DeepSea Supply. Now Solstad came out with this predictable bullet point from their results presentation:

Majority of revenue and EBITDA from CSV segment

Really what a surprise! You just can’t make this up. What is working for them in this downturn is their high-end CSV fleet and then Solstad jump headlong into the most overbuilt commodity shipping in the offshore industry, Madness. The rest of the presentation is an exercise in mental dislocation from industry reality: DESSC’s cost leading business model is praised… but that doesn’t help at the moment when ships are going out for less than their economic value? It’s also not scaleable or transferable in an acquisition of  other vessels (or companies) because it relies on all vessels in the fleet being similar? And can you really have a low cost business model in this sector anyway? Its a boat + crew? What special insight does DESSC have in making this low cost? Apparently a strategic driver for saving Farstad’s banks is their AHTS experience? Great… Farstad are the most skilled company in a market segment that is structurally unprofitable? If the shareholders are like Aker and like owning companies that are the most competent at what they do regardless of whether they make money or not then this is a very good investment idea. I suspect it’s niche though because investors like that are rare.

It is all well and good highlighting that Farstad and DESSC are non-recourse subsidiaries of Solstad wth the implication being if it all goes wrong then they can be jettisoned. But of course JF took his holding in Solstad not the subsidiary which shows you where he thinks the value is. The Solstad supply fleet will simply not be big enough to generate economies of scale that outweigh the negative industry structure or induce pricing power in any region. It is also debatable what the minimum efficient scale is in offshore supply? This was a transaction driven by the desperation of Farstad’s bankers and recognition by DESSC that trying to do a rights issue without a different investment story would have been extraordinarily dilutive given the cash would have been used for OpEx only. Quite how it was sold to Solstdad/ Aker is anyone’s guess.

A good comparison is Gulfmark which is going into a voluntary Chapter 11. Gulfmark will emerge with a clean balance and 72 vessels in the supply sector. If you want to look at a company with the potential to consolidate the PSV sector it is right there with a simple operational structure and balance sheet focused on one sector that investors can understand and measure. It is very rare  for companies to consolidate an industry that come from one of the high cost markets and then work out how to be cheap internationally – it usually works in reverse. US companies like Seacor and Gulfmark are going to be well placed to drive proper industry consolidation in a way that may not be possible for a company coming from a relatively high cost environment. Yet this industry feels a long way from the bottom when NAO Offshore with a mere 10 vessels, and 30% of the fleet in lay-up, all working at nowhere near their cost base, can say blithely:

Nordic American Offshore closed a follow-on offering March 1, 2017, strengthening the Company by about $48.8 million in cash. The main objectives of the offering were to strengthen NAO financially and position NAO for further expansion...

NAO sees opportunities to grow the Company… 

(Emphasis added).

I sometimes wonder if when Norwegian schoolchildren are young they are indoctrinated with a special ship class in which the answer to every question is “ship”. I imagine an immaculate schoolroom (paid for with petrodollars of course), a very small class, and 20 children with their eyes closed humming and intoning gently “skip… skip…. skip…” And the teacher asking “What is the meaning of life?”… and the gentle reply coming back immediately “Skip”… “What is 2 + 2?” … “Skip, Skip + Skip Skip”… “E=MC2?” “Skip”….

I am just not sure the answer to the current problems are more ships… I have a nagging suspicion it’s less ships. A lot less. Consolidation isn’t the only answer here a quantative reduction in vessel numbers is an yes smaller operators need to go.

DOF came in with revenue 23% below Q1 last year which makes it hard to point to any recovery. DOF also announced this week that they may list DOF Subsea as First Reserve would appear to want out. First Reserve have been in DOF Subsea a long-time, and it’s natural they would want to exit at sometime. But you should always ask why inside and knowledgable investors are selling now, at what some are calling the bottom of the cycle; maybe it isn’t the bottom? DOF Subsea project margins were 2.0%! Yes the DOF PLSVs in Brazil are now up an running, but as we all know Petrobras has far too much PLSV capacity and so I suspect First Reserve is trading off a very low point in the cycle against the cost of waiting which brings you a day closer to the possibility of a vessel being redelivered from Brazil.

DOS Subsea specialise in light IRM and small scale projects and out of the North Sea market (where you need a North Sea class DSV) owning a vessel is a disadvantage not an advantage (which isn’t true at the top end EPIC SURF contracting where you need a specialist lay vessel) for some projects as costs become purely variable. Every single asset DOF Subsea have can be chartered in from another company if you are project management house. There used to be a number of project companies that delivered projects but didn’t own vessels, that didn’t last as the market tightened from 2006 onwards and you simply couldn’t charter a vessel (I am trying to think of the Singapore/Perth company Technip brought?). But now that isn’t the case and so not only is there loads of delivery capacity in vessel owners and charterers, but small project management houses can, and will, bid and compete for jobs, which will lower industry profits structurally. The best strategy going forward is to have a fleet much smaller than your delivery schedule requires but still some core tonnage, companies that didn’t splurge in the last boom are clearly better positioned here.

Whatever the reason for First Reserve selling it is a fact that one of the most successful investors in the energy industry is lightening their exposure to the offshore sector. If you buy DOF Subsea shares you need to ask what you know that First Reserve don’t? Interestingly First Reserve hasn’t invested in an offshore exploration company since 2011 (Barra), but has invested in 7 tight oil plays since 2011, a pattern that seems to mirror capital flows in the industry. One wonders if Technip weren’t encouraged to try and by DOF Subsea and a lack of interest led to this way of getting out?

The obvious reason that First Reserve might well be selling is that they think the poor financial results are likely to continue for sometime and they see no easy answer to an industry awash with capacity and declining levels of investment and simply don’t want to fund working capital with an uncertain payback cycle. DOF Subsea has excellent project delivery capability but it simply too long on ships and unlike other contractors these are an essential part of their strategy going forward and they have no ability to given chartered tonnage back as the industry continues to contract.

DOF Subsea also have 67 ROVs. The quiet underperformer in the industry at the moment is the ROV space. Everyone at the moment is giving the ROVs away at costs + crew only. In the old days ROVs were so profitable because you used to able to hide a mark-up on the vessel in the contract amount and they looked very profitable. Now the vessel is given away for free as is the ROV and only the engineering generates some margin. There is clearly going to be some consolidation here and I believe it will be very hard for the smaller companies to raise additional funding without profitable backlog as it becomes clear that there will not be a recovery in 2017. A lot of companies in the ROV market have raised money yet offer the same thing as the industry leaders who have very strong liquidity positions and can play this game far longer than speculative investors. Reach is a well managed company, and can give vessels back eventually, M2 got it’s ROVs cheap, but both are going up against companies like DOF and Oceaneering and eventually, surely, investors are going to realise that without some sort of increase in demand the structure will favour the larger companies who have more equity to dilute to see them through to the final stages of consolidation. There is an argument that smaller nimbler ROV companies can respond better to IRM workscopes than larger companies, particularly at the moment with oversupply in the vessel market; we are about to find out if they can win sufficient market share to be viable.

Obviously there are different views about when the industry is going to recover and how it will look. That is legitimate as no one can know ex ante what will happen ex post but it is becoming apparent that 2017 isn’t going to be the recovery year people hoped and that more people are going to have to raise money to get through this. The Nor DSVs will need to start fundraising in August at the current burn rate, as will others, the dilution that the new money makes on the old money for these secondary fundraisings will be a clue I believe as to how close we are to pricing the bottom. The investors in Nor represented a group who thought there would be a quick bounce back in 2017 in the price of oil and subsea asset values, there are bound to be fewer the next time around and surely they will charge a higher price for their capital, and in many ways this is microcosm of the industry.

The best guide to calling this appears to be those that have looked at previous investment bubbles. Charles Kindleberger, in his classic study of financial panics and manias stated the final stage of an investment bubble led to panic selling which would mark the bottom of the cycle:

‘Overtrading,’ ‘revulsion,’ ‘discredit’ have a musty, old-fashioned flavor; they convey a graphic picture of the decline in investor optimism.

Revulsion and discredit may lead to panic (or as the Germans put it, Torschlusspanik, ‘door-shut-panic’) as investors crowd to get through the door before it slams shut. The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets…

We still look a long way off this in offshore supply and subsea.

 

More Uber madness… Devil take the hindmost…

The additional rise above the true capital will only be imaginary; one added to one, by any stretch of vulgar arithmetic will never make three and a half, consequently all fictitious value must be a loss to some person or other first or last. The only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost

A participant in the South Sea Bubble quoted in “The South Sea Bubble”, John Carswell, 

 

I’ve decided to keep a vague running tab on Uber. It’s an investment bubble, I don’t know quite how its’s going to pop… but it’s going to. My previous thoughts are here. In his Nobel award lecture “Speculative asset bubbles” Robert Shiller defines and investment bubble as:

[a] situation in which news of price increases spurs investor enthusiasm which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase and bringing in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawnto it partly through envy of others’ successes and partly through a gambler’s excitement.

Nothing seems to sum up the investment psychology of Uber more. Having watched the extraordinary returns others have made in companies such as Facebook, and seen a group of tier 1 VC’s get involved, the next round gets fund managers involved (at USD 40bn), and then gets a sovereign wealth fund involved to keep the valuation at USD 62.5bn. I quite like the irony of getting the Saudi’s to put in USD 3.5bn into an unprofitable Uber while convincing them to sell shares in Saudi Aramco… kind of like bait and switch only better… a new modern version of Petrodollar recycling but without the adverse consequences?

This week Uber announced the were gearing up for a flying taxi service:

Uber Technologies Inc. disclosed the initial steps of its air-travel vision this week, announcing five partner companies with various specialties aimed at making the sci-fi staple affordable and common. The initial testing is expected in 2020 in Dallas and Dubai, two car-clogged cities where aviation interests wield great influence.

“If you’re not planting the seeds for five, 10 years out, you have no company in five to 10 years,” Jeff Holden, Uber’s chief product officer, said.

The cynic in me see’s this a) as the equivalent of vapourware and b) a desperate attempt to show there may be some inherent value in a company that is clearly going backwards massively in terms at c. USD 2bn a year in cash terms. Uber are trying to fire the “gamblers excitement” that Shiller refers to (“don’t worry this taxi thing is just a smokescreen for our real route to profitability … autonomous drones…”)

But this line really tested my intellectual patience:

“There are a lot of compelling elements to this vision,” said Brian Wynne, president and CEO of the Association for Unmanned Vehicle Systems International, who attended the Uber event in Dallas this week where the plans were unveiled… 

“Whether this becomes a niche service … and how quickly it scales is anybody’s guess,” he said. “But they’ve got the demand.”

Don’t you need a price to gauge (potential) demand? I’ve got a lot of demand for a new Concorde from London to NYC at £500 per ticket… at £500 000 per ticket much less. It’s just all hype an no substance.

It’s not just me either… FT Alphaville (hardly the doyen of left-wing communism) came to the conclusion that:

[u]ltimately Uber’s success comes down to convincing the world that it has made a progressive leap by allocating cheap human resources towards the job of waiting around at the beck and call of an increasingly powerful elite.

From an aggregate economic allocation and welfare point of view that’s an obviously nuts proposition. What it amounts to is a transfer of labour from high productivity sectors to ultra low productivity sectors on the assumption that if this workforce is given autonomy over their non-productive time they can deploy it more efficiently in the market than if it was being allocated by a scaled-up specialist operator.

Since that, by definition, inhibits specialisation or skill acquisition in labour markets, all it really encourages is the purposeful unscaling of the economy and thus the entrenchment of a suppressed, underpaid, servant class with no prospect to ever benefit from a consumer surplus.

I sometimes think that all you need is an idea so outrageous sometimes it will get funding because people don’t want to say no. I half joke that I am thinking of registering the name http://www.chinaflng.com and then raising 10bn from investors and using it to buy a couple of broken VLCC’s for conversion purposes… and then worry about what to do… it’s a better idea than a $400 juicer…

Doug Evans, the company’s founder, would compare himself with Steve Jobs in his pursuit of juicing perfection. He declared that his juice press wields four tons of force—“enough to lift two Teslas,” he said. Google’s venture capital arm and other backers poured about $120 million into the startup. Juicero sells the machine for $400, plus the cost of individual juice packs delivered weekly. Tech blogs have dubbed it a “Keurig for juice.”

But after the product hit the market, some investors were surprised to discover a much cheaper alternative: You can squeeze the Juicero bags with your bare hands. Two backers said the final device was bulkier than what was originally pitched and that they were puzzled to find that customers could achieve similar results without it. Bloomberg performed its own press test, pitting a Juicero machine against a reporter’s grip. The experiment found that squeezing the bag yields nearly the same amount of juice just as quickly—and in some cases, faster—than using the device.

On second thoughts I am going to go with this… It will be an FLNG company that uses blockchain and has a cloud computing element to it with a big data social media engine driving it’s utilisation…. any maybe a really good juicer in the galley… please leave VC details in the comments section…

One day over a beer remind me to tell you the story of guy who walked into my office and wanted to build a fake tropical island in an abandoned Zeppelin factory, and then tried to shoot the messanger…