Private equity and offshore: Bibby/York Offshore, DOF Subsea, and Ocean Installer and “stuck in the middle”..

Realism provides only amoral observation, while Absurdism rejects even the possibility of debate.

FRANCES BABBAGE, Augusto Boal

 

The firm stuck in the middle is almost guaranteed low profitability. It either loses the high-volume customers who demand low prices or must bid away its profits to get this business away from low-cost firms. Yet it also loses high-margin businesses — the cream — to the firms who are focused on high-margin targets or have achieved differentiation overall. The firm stuck in the middle also probably suffers from a blurred corporate culture and a conflicting set of organizational arrangements and motivation system.”

Porter, Competitive Strategy, p. 41-42

 

“Alice laughed: “There’s no use trying,” she said; “one can’t believe impossible things.” “I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

Bibby/York Offshore, DOF Subsea, and Ocean Installer are all tied into the same economic dynamic in the offshore market: the improvement in the market is coming in IRM spend (marginally), large-deepwater projects, and  step-outs associated with existing deepwater infrastructure, not the markets that made these firms viable economic entities (although the DOF Subsea question is just as much about leverage and overcommitting to assets). These companies highlight that although offshore spending may increase in 2018 over 2017, though DNB notes risk to the downside, a recovery will not benefit everyone equally: asset choice and strategy that recognise different market segments are important to identify.

I have read the Bibby Offshore “Cleansing Document” that was sent out as part of the takeover/recapitalisation notice. A cleansing document is required when investors, who are classed as “outsiders”, gain confidential information as part of deal and therefore become “insiders”, who learn confidential information, and must make all the investors aware of what they know. It’s an extraordinary presentation, a business plan so outrageous that it can’t be taken seriously. The document obviously has its origins in the EY attempted distress M&A transaction, that couldn’t be funded, and when you read this you can see why. Worringly the new investors must accept something similar or they are involved in a gigantic scheme to knowingly lose money.

The most obvious affront to intelligence is the 2017 growth rate for revenue pegged at 52%!!! Seriously, in this market someone is telling you they are going to grow at 52% and they actually have enough chutzpah to put it to paper… words don’t often fail me. Not only that they then double down and state it will rise 50% again the year after. I can tell you there is a 0 (zero)% chance of that happening. There is more chance of drydocking the Sapphire on the moon to save money. It’s not just the fact that IMR spend, the core Bibby/York offering, is set to grow at 3.3%, or the fact that total market spend is due to grow at 6.7%, that is just a common sense point: if the market grows at 6.7% and you are growing at 53% then 46% of your growth is coming from winning market share. Does anyone really think Bibby’s competitors are just going to wake up one day and allow them to be the only company in the entire industry that can grow that fast and let them take all that market share? Really?

Fictional Revenue and EBITDA Forecast

Lewis Carrol

Source: Lewis Carroll

To be clear the previous best year of growth was 2013-2014 when Bibby chartered in tonnage, in the greatest North Sea DSV boom ever, and it grew a measly 46%… seriously you can’t make this up.

North Sea Outlook

The fact is this forecast shows the core Bibby/York IRM market declining after 2019 and all the growth is coming in windfarm work. A portion of the windfarm work is likely to be bundled with installation workscopes, and that leaves Subsea 7 and Boskalis well positioned with their topflight installation capacity. And I have said many times the lack of oil and gas construction work (the light grey bar EPCI) will leave a surplus of DSVs as there are no multi-month construction projects to soak up capacity. There is an even more absurd graph later on designed to show a market shortfall in a few years that ignores latent capacity in meeting supply challenges.

Bibby/York will turnover £85m if they are lucky for 2017. In this market, if they have an amazing year next year they will turnover £95-100m, and if they have a bad year they will come in at £70-75m. And the risk is on the downside here because the first six months of 2017 included ROVs in Asia that were sold, most of which were working. But in offshore contracting in general some jobs will go your way and some won’t, so everyone in the industry budgets a modest increase and some get lucky. But what definitely won’t happen is putting 15 Red on at the casino and winning 30 times in a row, and talk of £130m in revenue is more unrealistic mathematically than that.

Even more the Sapphire now looks to be going into layup! So not only is turnover going up 53% but DSV capacity is going back 33%. It’s a miracle I tell you! That’s not profitability that is top-line!

The US office is of course a giant millstone and is put in the presentation as a “Diversification” play rather than as a cost centre – and certainly no spefic financiakl data on the office is offered. The US must be costing Bibby/York c.USD 250k per month in cash terms and now has no boat to bid. That puts them Bibby against DOF Subsea and OI for any significant project except they don’t have a boat? Zero chance. Literally less than zero. Only someone who really didn’t understand, or didn’t want to, the reality of the current market would sanction such move. Operating margins of similar competitors, following exactly that strategy are less than 10%, which means you will be losing cash forever. Nuts. Not needed and not wanted in an oversupplied market, it is simply a matter of time before that office is closed.

But I don’t want to get into it in a micro level because it degrades the wider point: in this market businesses don’t grow organically at 53%. It is a preposterous statement and needs to be treated as such on that basis only.

Not only that, Bibby claim they will make an EBITDA of ~£12m on the 2 x DSVs in the North Sea, and a staggering c.£11m using vessels of opportunity. So not only are they betting they will take enormous amounts of market share off their competitors they are also planning to do it at margins way above anyone else in the industry. And this from a management team, with exactly the same asset base, who presided over a revenue decline of 56% in 2016 and is on target for a 45% decline in 2017. The first few people who got this presentation must have phoned up and asked if the printer had had a typesetting error, not believing that intelligent people would send them this.

The only certainty of this plan is that it will fail. Statements around its release confirm the company ~50 days of work for 2018 yet they are planning 78% utilisation (up from 53% in 2017), yet if the first quarter work isn’t booked in now it won’t happen in a meaningful sense.  And once you are chasing you tail to that extent a dreadful dynamic sets it because you have committed to the cost and the revenue miss means you know early in the year you are facing a massive cash flow deficit. The fixed cost base is so high in the operation that a miss on the revenue side produces catastrophic financial results; just like a budget airline, the inventory is effectively disposable (i.e. after a possible days sale has passed) yet the cost base is committed. This of course explains how the model was created I suspect: a revenue number that magically covered the costs was devised, how real management believed that number to be at the time will be crucial by March (only 12 weeks away) when the plan is revealed as a fantasy. I’m not saying it’s deliberate, humans are strange, it took Hiroo Onoda until 1974 to surrender, so if you want to you can believe a lot of things, and unless you believe the revenue number then the whole economic model falls apart.

York clearly got into this late in 2016 and early 2017 not believing the scale of the decrease going on in the business in revenue terms, and without clearly understanding how the competitive space was directly supported by the construction market. Instead of pulling out they have doubled down and appear set to pump more in working capital into the business than the assets are worth (one of which is going into lay-up for goodness sake). York appear to have confused a liquidity problem with a solvency one.

The funds this come from are large but this is till going to be a painful episode for York while doing nothing to solve the long-term solvency issues at Bibby who now only have a 6 month liquidity runway based on current expenditure. At an Enterprise Value of £115m it values a business with one DSV on lay-up and a cost centre with no work, and an operation with a 1999 DSV and one chartered asset, losing substantial amounts of money and with historic liabilities, way above a the operation Boskalis are building with 2 x 2011 DSVs at a blended capital cost of ~USD 80m. Good luck with that.

I still wouldn’t rule out a Swiber scenario here where as York get close to the drawdown/ scheme of arrangement date they get lawyers to examine MAC clauses (e.g. Boskalis buying the Nor vessels), or simply not pay and worry about getting sued by the administrator. They must know now this is a terrible financial idea.

DOF Subsea on the other hand have the opposite issue: First Reserve looked to reduce their position earlier in the year via an IPO and couldn’t. Now DOF are slowly diluting First Reserve out in  the latest capital raise… there is no more money coming from First Reserve for DOF Subsea. I get the fact that some technical reasons are in  play here: it is difficult for late-life private equity funds to buy inter-related holdings, but they always seem to manage it on the up but never on the down.

DOF Subsea might be big but the problem is clear:

DOF Subsea Debt repayent profile Q3 2017

 

DOF Subsea EBITA Q3 2017

DOF Subsea isn’t generating enough cash to pay the scheduled debt repayments. And in these circumstances it is no surprise that the private equity fund is reluctant to put more equity in. DOF Subsea could sell its crown-jewels, the flexlay assets, to Technip but that would involve a price at nothing like book value; or maybe DOF/Mogsters’ bail them out but that will further dilute First Reserve. Either way First Reserve, some of the smartest energy PE money in history on a performance basis, have decided if you can’t get someone else to buy your equity then dilution is a better option.

Ocean Installer is a riddle wrapped in a mystery. OI has some chartered tonnage and some smart people. But it is subscale in nearly everything and I doubt it was even cash flow positive in the boom years as they were “investing” so much in growing capacity. The company had takeover talks with McDermott, that failed on price, and seems to exist solely because Statoil is worried about having an installation duopoly in Norway. It can’t continue like this forever. Rumours abound that Hi Tec have now installed staff in the Aberdeen office and are seriously looking at how to cut the burn rate.

There is nothing in OI that you couldn’t recreate for less in todays market, and that unfortunately means the equity is worth zero. Hi Tec, whose standard business model of taking Norwegian companies and opening a foriegn office, expanding both the quantum and size of the acquisition multiple (admittedly a fantastic idea in the boom), will not work here. Now it’s hunker down and build a substantial business of scale or exit. All the larger players have to do is sit this out, no one needs to pay an acquisition premium, buying work at a marginal loss, which will eventually reduce industry capacity, is a far more rational option.

Not all of these companies can survive as they are simply too similar and chasing the same projects that are also now being chased by the larger SURF contractors. Clearly DOF Subsea is in the best position as OI and Bibby/York have a very high cost of capital and owners with unrealistic value assumptions.

All these firms suffer from two problems:

  1. In strategic terms they are “stuck in the middle”. In 1980 Michael Porter wrote his famous text (“Competitive Strategy“) positing that a company chooses to be either low cost or value added; firms that didn’t  were “stuck in the middle” and destined to low profitability forever. In subsea the deepwater contractors are the value-add and the contractors without a vessel, or the regional companies with local tonnage,  are the low cost. Bibby/York, DOF Subsea, OI are stuck in the middle – not deepwater/rigid reel to add value and with too high a cost base to compete with the regional low cost operators – given their funding requirements this will not carry on indefinitelyPorter stuck in the middle
  2. The projects that made these companies profitable (if OI ever was) have suffered the largest fall in demand of all the market segments. Small scale field development, with flexibles as the core component, just aren’t big enough to move the needle for the the larger companies and the smaller E&P companies can’t raise the cash. All the FID stats show these developments to be almost non-existent. These were projects commissioned at the margin to satisfy high oil prices and therefore are the first to fall off as the price drops. That is why these companies have suffered disproportionately in the downturn: they have lost market size and market share (Bibby Offshore revenue has dropped by 77% since 2014 where as Subsea has (only!) dropped 45%

The subsea/SURF market is an industry that private equity/ alternative asset managers struggle with: a market with genuine advantages to industrial players with economies of scale, scope and knowledge. In an age of seemingly endless debt and leverage these equity providers are not used to coming across industries where their organisational advantages of capital and speed cannot work. But for the next few years, as the industry requires less capital not more, the smart money here will be on the industrial companies. It wasn’t the distressed debt investors in Nor Offshore who made money on the liquidity bond (issued this time last year), it was Boskalis when the reckoning came for more liquidity. That is a parable of this market.

 

The scale of the challenge…

Deliveroo lost £129m in 2016 – more than its revenue. It does not have a business model – basket case. Investors will lose everything.

Luke Johnson, Risk Capital Partners

There’s still too many DSVs in the North Sea, even with an upturn, but that’s my guess. Perhaps the scrappage and departure of the Sapphire will reset the NS market to something sustainable for when the market recovers, but I have my doubts.

I’m interested to hear your prediction beyond year 1, where there’s the shuffling of cards (market share), year 2 where the slush fund is running low and we possibly come full circle again?

Email from senior exec at a North Sea contractor

The scale of the challenge the new owners of Bibby Offshore have is revealed in the Q3 financials that were released on the same day as the takeover:

BOHL Q3 Highlights

A quiet November/December and they will lose more than revenues. Or actually in Total Comprehensive Income they have managed this trick:

Q3 2017 Financial Results.png

Now it isn’t a fair comparison because the charters on the Ares and Olympic Bibby are well above market rate and will substantially change the performance of the business when they have ended (one has). But the point is it is not the bond alone that killed Bibby: it was going long on expensive vessels with a neglible equity cushion and a complete rigidity in the business model therefore to reduce costs when the market changed. But then again the Polaris and Sapphire were valued at USD 220m! in 2014 and they still look way to high on the books. Non cash charges are fine if you don’t have liquidity issue but they are very real in measuring economic return.

What I like (sic), and they aren’t the only people guilty of this (I have named others doing it as well) is the Orwellian use of English (although it’s more Catch 22). On summarising these results, which entailed handing the business over to the creditors, the following sentence appears (emphasis added):

The recapitalisation of the business together with the improving market outlook, reflected in the growing summer campaign, means the Group is well placed to weather the current market conditions and to capitalise on new opportunities.

A mere four lines later, 4!, just 4, comes this:

Despite the seasonal increase in activities the pressure on margins has not eased, impacting total revenue. Revenue also reflects the mix of work, which includes further air diving projects in shallower waters, which command lower day rates.

They have less than 50 days for next years booked and over 1000 days of inventory.

Seriously! Make it stop. Please make it stop…

Bibby has a really simple business model: you sell boats days and some associated engineering. One of the two variables has to change: days or the price. If one of those is declining, or you have to reduce the other in price in order to sell more days, then it is sophistry of the highest order to claim an improving market outlook. I was just waiting for the quote “and we are doing record amounts of tendering”.

As the analysis below will make clear the emergency rights issue that a “leading bondholder” has underwritten gives the business, at current cash burn rates, around six months working capital as the best case assumption. This is not a war chest for acquisitions this, is simply survival money while options are assessed and some quick wins on the cost side are made. I don’t have any inside knowledge at all of what will happen here, the thoughts below I believe to be directionally correct, but the one thing I definitely know for certain is this: the money going in will not be willingly frittered away in OpEx while the business simply waits for the market to return. However, the winter months are ruinuously expensive for boat owners with without work…

The cash flow makes clear Bibby had burned through £10.5m in cash in what should have been the best quarter of the year for 2017:

Q3 2017 cash flow.png

The closing cash balance at Sep 30 gives the game away: Bibby had drawn down on the revolver and that is simply insufficient for working capital purposes. It is very hard to see how the November payroll could have been made on those numbers as another 6 weeks of losses (by the time the creditors rescued the business) must have meant an actual cash positon of less than £2m. But what is really apparent is how much worse the business is performing than last year: £58m in operating losses YTD versus £26.8m last year! If it was a horse you would have shot it!

Those losses were driven not only by the Olympic Vessel charters entered into at the top of the market but by the Sapphire utilisation at 3%. Fully crewed and maintained in port waiting to win the BP Trinidad work that went to Nor (a move I accept I said would never happen), and a US office that inexcusably had 19 people in it until August and is now on it’s third ex-pat manager as the company struggles to define its market position now it is not proceeding with a Jones Act vessel. The fact is Bibby have taken the Hotel du Vin to a market where customers resent the prices at the local Holiday Inn, and you can offer all the upgrades you want, but it just won’t work without a base level of demand that isn’t there. The US business model is broken  and that is an intractable issue for the new owners.

The £50m the emergency rights offering puts in will need to cover a variety of new expenses: consultants (and there will be a lot), transaction expenses (tier 1 law firms etc), working capital banking facilities (say £5-10m) etc. This is unlikely to be the only injection made to keep the firm solvent if the new owners are serious about keeping the business going.

The big outstanding commitments relate to vessel costs and things like offices (Atmosphere 1, Houston, ROV hanger) all of which were entered into at the top of the market. Olympic are no doubt nervous because their charter on the Olympic Bibby goes into Q2 next year at a rate of c. $35k per day (c. $1m per month). I suspect the Scheme of Arrangement the bondholders are using here will allow them to take the assets to the Newco and leave residual commitments to Oldco Bibby should they want. The communications have promised trade suppliers will be paid, and that is certain, but when the new corporate structure emerges a conversation will be held about how much shareholder support will be provided to the BOL/BOHL (the answer is likely to be none i.e. these are the entitites that will be liquidated) and all the contracts will be moot. All the smaller trade creditors who are nescessary for trading will clearly be fine but I am not sure about Olympic and property commitments at all (and it would have the nice effect of getting rid of the Trinidad tax issue).

But this is the easy part in a way. There will clearly be an urgent and deep effort to slash costs in a way there hasn’t been before. Engineers, Bus Dev, people that add real economic value can expect this to be a better place to work. But there are 5 PAs in Aberdeen for business on target for £80m turnover and a Risk and Business Continuity Department that has about 5 people per vessel! All good people to be sure but just not sustainable in any shape or form. I suspect when these consultants walk into the Houston office and get presented with a spreadsheet with $9 trillion of possible tenders and zero purchase orders for 2018, 11 people, a boat at 3% utilisation (according to the Q3 report), and an expensive ex-pat ex-COO, there is going to be a quick call back to the UK about WTF is going on? Some of these things are a direct reflection on current management which will only increase tension with the new owners.

The real problem though is how you get your £115m back…

Let’s assume you need to sell out at 8x EBITDA (Acteon went for 10x in the boom but they were lighter CapEx and had more booked revenue); that means you need to get EBITDA to about £14m from its current level. The scale of this challenge becomes clear if you have a look at BOHL bond prospectus, which for all of us in offshore was a different era:

BOHL Prospectus EBITDA

Basically the “new Bibby” needs to look something like old Bibby between 2011 and 2012. which handily we get some stats on:

BOHL prospectus operational data.png

In 2011 Bibby were delivering their biggest ever construction project: Ithaca Athena hence the reason other project revenue is so high (that and mob fees were high) and it is also woth noting that the Topaz worked much of the year on that project. Now the fact is companies like Ithaca, Premier, Enquest have given up development for debt repayment so these projects just aren’t there, and with Technip and Subsea 7 in hunger mode no one is winning small development projects outside that duopoly. But DSV rates in 2017, prior to the Boskalis entry, were about 2011 levels at the end of 2016 but utilisation is way down.  Bibby administration costs were on £10.4m for the 2011 year whereas this year they are on target to be 70% higher at £17.5m.

But admin costs while part of the problem aren’t the core of it: the decline in revenue, and therefore the scale of the business is:

BOHL Pros P&L.png

If Bibby does £80m in 2017, and that is a very big if at this point, the business will be 70% smaller in revenue terms than 2014. Subsea 7 by contrast has seen revenue drop from c.  $6.8bn (2014) to c. $3.8bn for 2017, which is only a drop of 45%. I have said it before that the smaller firms have not only lost market size but market share as the market has contracted and that is unsustainble. You can see the effect that scale has because despite having seen its turnover drop by such a large amount, even with such high fixed costs, Subsea 7 kept its fleet utilisation at 78%, and then generated $250m in EBITDA and even Net Income came in at $111m. One business model is sustainable and one isn’t.

If you look at the types of projects heading for FID at the moment they are disproportionately complex and expensive projects that mean this trend is likely to continue. Its not just a Bibby problem: OI, DOF Subsea etc all suffer from the fact that they were marginal capacity working on smaller projects that added marginal production. Production and capacity at the margin is expensive and therefore it is no surprise these business models suffer disproportionately in a downturn. [What I mean by marginal capacity/production is that these were the extra units added as the existing industry and companies hit their production frontiers. This new capacity/production is added but at a higher per unit cost as suppliers etc push up prices to reflect increasing demand].

I guess the positive side of this is it shows how much operational leverage the business has: fixed costs are so high that a small addition to the day rate and/or the number of days worked and the results drop straight to the bottom line. The downside is it looks like 2013 and 2014 were an aberration in terms of day rate and utilisation and that actually the industry was in a nice little equilibrium in 2011 with day rates that made projects work for E&P companies and kept everyone in profit, and maybe that is as good as the industry can hope to get back to (before the Harkand/Nor/Boskalis DSVs arrived but with the DiscoveryKestrel and Oriella.

A major structural change has also occured in the market: in 2011 you could not get your hands on a CSV with a 250t crane for almost any money. Rates for these vessels was c. £130-150k and this was purely a supply shortage. Therefore you simply added a mark-up on those boats for all work undertaken. I doubt any other class of vessel has been so over built now and they are all in lay up (the Boa vessels) or doing windfarm work for €20k per day (Olympic). The other project revenue flatters the margins made on non-DSV projects because anyone who had access to a vessel in those days just placed a large mark up on the vessel (a number that was already high).

Now everyone (Reach, M2, Bibby Offshore, James Fisher) is a “boatless” contractor. This de-risks the fixed costs but obviously at the reduction of margin. In Asia there used to be a number of “boatless contractors”, running around organising bid bonds and all the other associated issues that come with trying to fix a schedule. One of the many problems is that because everyone can do it the profitability on it is very low and you actually take quite a bit of project risk to get this margin because you often go lump sum and the vessel operator gets paid every day.

And the elephant in the room is now Boskalis. It is pointless here to go on about the advantages an industrial player has in this game. There are 100 reasons why Boskalis is better positioned that the “New Bibby” going forward, and the first 20 are signficant. A much lower cost of capital for one, existing marine, crane, and other departments spread over a much larger fleet (lower unit costs), a serious position in renewables with full cable lay equipment etc.  When day rates were much higher everyone used to measure the cost of ancillary departments (i.e. crane) by looking at the cost to the vessel being out of service and the price was just increased, but that obviously isn’t the case now where these costs are material and need to be spread over a big fleet. Sometimes commitment signals count in economic situations and the fact is that Boskalis likely to be here in 20 years and the same just isn’t true of the New Bibby.

This really makes me question whether it is possible to have an economic model that is based solely on being a DSV operator, particularly a smaller one? For every other competitor to the “New Bibby” diving is an ancillary, but important, service to a broader offering. Boskalis probably only need to get 100-150 days per annum of pur SAT work to be cash flow positive on an asset basis if they use the rest of the time to back up the renewables fleet. Subsea 7 and Technip can cross subsidise limited construction work by keeping utilisation up in the IRM market at low day rates. If these operators commit enough capacity to a market in that situation where their breakeven cost is significantly lower the overall industry rates will be low. These three companies all know that the “New Bibby” will live or die by the North Sea SAT DSV rates, and all they need to do is keep these low for a period and the entire edifice is at risk.

Bibby worked from 2004-2012 because it was the “Healthy Dwarf” of the North Sea in SAT diving. The excess cash from this business was used to fund ROVs and develop other areas. But Singapore never worked beyond ROVs and neither did other ideas. It was an opportunistic business with a really good local market position that allowed it to try different things when the market was booming. But it patently does not have a magic formula that would allow it to grow in other markets or some sort of magic ingredient that is scaleable.The “land grab” was in fact made by DOF Subsea, Ocean Installer, and others who had access to what Bibby desperately needed: adequate equity/ CapEx ability in an extremely capital intensive industry.

When there have been four SAT dive companies in the North Sea only 3 have really made money: Bibby helped drive Harkand out of business, Bluestream didn’t last more than a season, ISS chartering the Polaris just allowed them to fill a six month charter in a peak period. It is very hard to see how Boskalis isn’t going to be a lot more than a “healthy dwarf”, and likely the first non-RMT unionised major contractor, and that really doesn’t leave a lot of space for anyone else.

If you look at the Bibby 2012 P&L above it also makes it clear that even when times are good, and Bibby dived over 900 days that year, and after tax it only made £13.3m, a rate of return on the asset base of 7.8%. The ROE (40%)looks high because of the leverage… which brings up the issue of risk: in this business model you go extremely long on some very specific assets, which have a huge volatility in value (as Boskalis can affirm), and match these against a series contracts that are short in duration and have almost no visibility, and must be competitively won… and that’s before you even get into execution risk. I know private equity firms love EBITDA (and the £55m Bibby did in 2014 is proof of that) but it is a really inappropriate number for an industry with such high CapEx requirements because the depreciation amount on the fixed asset base is a crucial number in how much real economic value is being created.

I get people can make a lot of money on counter-cyclical bets. That is the essence of the investment proposition: having the ability to make a bet like that. But the dynamics of any upturn in the North Sea, with vastly more tonnage than the last upswing, would seem to err more to there being too much tonnage and that will only lead to lower day rates. And there are far more North Sea class DSVs that can be drafted in to keep rates down than were previously available: Technip for example could just re-commision the Achiever as an IRM vessel, and at some point Vard are going to have to sell the 801.

So in answer to the question of what I see happening for the next few years I think there will be three serious players in the North Sea SAT market and a fourth company that maybe viable if the market booms. But that will be a struggle. Even if the price of oil doubled overnight the ramp up in logistical terms required in the North Sea would be immense before a serious impact in CapEx spend would be felt. Smaller companies would have to access financing, hire engineers, consultants, approve drilling, arrange interconnection agreements etc… all this before small scale subsea development CapEx came back at a meaningful level to affect the overall fleet demand and profitability. An increase in IRM spend just won’t cut it. The worst case scenario is someone like DeepOcean taking a DSV and using it as a split ROV/DSV for 6 months a year as IRM spend increases. At that point the Bibby business model is well an truly dead. But in the interim Subsea 7, Technip, and Boskalis can rapidly add capacity if the IRM market improves, in a way that simply wasn’t possible in the past and in a manner that is simply too credible and likely to ignore.

I am a long term believer in subsea and the meaningful amounts of production it will be responsible for going forward. But in the past when it was the marginal producer of choice for the oil market the whole industry was profitable, almost without exception, and that simply will not be the case going forward where the process of economic natural selection will far more brutal and will favour larger players.

Bibby Offshore restructuring… End of an era…

Bibby Offshore Holdings Limited announced today it reached a comprehensive agreement on the recapitalisation of its balance sheet with noteholders who hold 80% of the £175 million 7.5% senior secured notes due 15 June 2021 issued by its subsidiary Bibby Offshore Services Plc .
The terms of the recapitalisation will result in the group having a substantially debt-free balance sheet with an equity injection of £50 million to enable it to consolidate and expand its position within the offshore inspection, repairs and maintenance and construction markets. At completion of the transaction, Bibby Line Group Limited (BLG) will transfer its entire ownership in Bibby Offshore to the group’s noteholders.

It is mildly ironic that after the Nor and Bibby bondholders spent so long seeking a resolution to their problems that both solutions were announced within hours of each other. On a first pass I would rather be a Boskalis shareholder than a Bibby bondholder.

Let’s be really clear this was no ordinary refinancing: this was in effect a relatively hostile takeover by the bondholders after the financial situation became untenable. Bibby Line Group exit with 0% having clearly been unable and unwilling to put any money in. After taking out £60m since 2014 they may consider this a good deal, but it will be painful for the Group accounts next year.

Bibby Offshore can keep using the name for another 12 months and the Directors have warranted not to frustrate the handover or pay the December interest payment (amongst other things). As at the close of the last quarter Bibby Offshore had a mere £3.1m cash in the bank, so the last point was academic in a way, but it avoids the need for a disruptive administration process. It seems pretty obvious to outside observers that it took the bondholders to make BLG aware of the gravity of the situation. Smaller companies in Aberdeen supplying goods on credit were taking an enormous risk here.

The restructuring values Bibby Offshore at £115m: basically the outstanding £175m bond (valued at .37) + 50m in new cash. Transaction and other expenses need to be taken from the £50m going in. Therefore for £115m bondholders are now the proud owners of the Bibby Polaris, Bibby Sapphire, a risk share charter on the Bibby Topaz, and all the associated IP, master service agreements, etc of the company that make it a business. This is a company that will now undergo a fundamental operating restructure as the announcement makes clear:

Within the next 7 days, Bibby Offshore will appoint an independent consultant on behalf of the noteholders to support management on the ongoing cash flow management and transition of the business to the new shareholders.

That means a group of restructuring consultants (in all likelihood from Alix Partners or Alvarez and Marsal) who will come in and do a restructuring plan that will be loosely based on zero-based budgeting. This is a brutal process and will aim to significantly reduce the costs so the business is at least cash flow breakeven by June (or they will be through a significant portion of the £50m on current trading levels). Given this hasn’t been the case for well over 2 years now you can imagine the scale of what is about to go on here (even accepting that vessel charters have been part of the issue). I’d imagine Small Pools, Business Excellence, and ex-pat managers in Houston look to be first on the list of costs to be reduced but there is a real question about what the business model is and what position the company will hold in the market that needs to be addressed.

For staff this is still the best outcome even if it provides huge uncertainty in the short-term: with only £3.1m in the bank without this agreement there would have been an administration process begun in the next few days. The revolver expired in the next couple of days and that would have brought the nuclear scenario. This was not a deal made in strength but in effect a shareholder being faced with insolvency having a gun held to their head and told to handover the keys.

The consultants’ budgeting process will highlight the fundamental issue the new owners of the business have: What is the competitive and market position of the business? A high end North Sea contractor trying to compete in the US market which is the most price sensitive in the world? Cut the costs back to a “Bibby lite-2007”, with 80 people in Waterloo Quay, shut all other offices, and trade with 2 x DSVs and Sapphire in lay-up or sold, and you will never recover your £115m. But keep trading as you are with an uncompetitive US and Norwegian office and you have to burn vast amounts of cash to make it through until the market changes. There are no economies of scale or scope through these regions and therefore no need for an expensive corporate staff and administrative overhead.

The fleet strategy will also need to be sorted out. Sapphire is in warm stack and Polaris (1999 build) cannot keep going forever. Both vessels are to old for mortgages and will be equity funded for the rest of their lives and there is a valuation implication in that (i.e. lower).  The Topaz is only on a risk sharing charter and frankly without that vessel it is arguable if there is a “Bibby Offshore” at all.

The Boskalis shareholders got a much newer DSV for $60m (£45m at todays exchange rate) and have chartered another one for a rate I believe that is c. $7.5k per day bareboat. The new Bibby will have to compete with a company with a much lower implied asset cost and breakeven level. Boskalis now has sister ships that they can interchange on projects and tenders and appear to have done this for an implied CapEx of c. $40-45m per vessel. Balance sheet strength prevails during consolidation and this will be no exception.

Bibby Offshore now looks exactly like Harkand before it folded. Harkand had 2 x the Nor vessels in the UK and the Swordfish in Houston for their ex-Veolia acquisition. Oaktree funded Harkand 3 times, and it only broke even a couple of quarters, before finally giving up. In the scheme of operating North Sea class DSVs £50m is not a  lot of money given the direct operating costs and associated infrastructure (tendering, marine, overhead etc). The new shareholders will require a firm constiution and plan to carry through this through for any length of time given that the order book is nearly empty and vessel commitments remain until Q2 2018.

One option maybe to seek higher value services such as well intervention with some talented ex- Helix staff floating around though the barriers to entry are high though and it will require further capex. The Bibby investments in renewables capacity (i.e. the carousel) look prehistoric compared to the DeepOcean and Boskalis fleet. Simply bashing up against three substantially bigger companies offering DSV days doesn’t strike me a great strategy and certainly not a sustainable one.

There is no other reasonable expectation now than for Boskalis and the “new Bibby” to fight it out for utilization by dropping the day rates they bid at (and Technip and Subsea 7 have shown they play this game as well). There is no guarantee the market is big enough for four companies at current activity levels. The “new” Bibby Offshore is a hugely leveraged play (both operationally and financially) on an oil price recovery that will force a declining basin back to higher production levels with small scale developments and higher maintenance requirements. It looks like a big ask at this point, but the team leading this investment have the financial firepower and competence to see this through if they choose; but it will not look even remotely close to the current Bibby Offshore.

Something rare happened today: the entire picture of how this market will look for the next 5 to 7 years was made public with just two announcements. It is going to be a much better market to be an E&P or renewables company in than a contractor for a good while yet.

 

Boskalis takes the Nor vessels…

In a widely telegraphed move Boskalis has now taken both of the Nor DSVs and this would appear to be the start of the end game for the restructuring of the North Sea DSV market. I remain convinced Boskalis had preliminary discussions about buying Bibby but gave up on price and complexity. This transaction is clean for them and allows them to organically grow a business in line with their culture and values and will clearly be a significant IRM/ light construction player over the years.

A number of implications flow from this:

  1. Rates in the North Sea for DSV will remain under pressure. These vessels did not work in the North Sea last year and if you accept my broad categorization of the North Sea fleet, then these vessels c. 20-25% more capacity to the market for high-end SAT work (depending on how you calculate the lay-up tonnage SS7 reactivated etc and if you include the Skandi Achiever). While the amount of IRM work will increase in 2018 it will not go up in proportion to overall potential capacity
  2. Boskalis will win work with these assets and they will do it initially on price and schedule (a derivative of price in the summer months to some extent)
  3. A refinancing of Bibby Offshore from anyone outside the current Bondholder group is DOA at current price levels. Only the mad or committed back themselves to compete indefinitely against companies with the balance sheet strength of Boskalis, SS7, and Technip in a market where rates are only marginally above cash break even and low growth is forecast
  4. Bibby Offshore looks suspiciously like the Harkand of old with two North Sea class DSVs and an overspecified US unit struggling for utilisation while being owned by a distressed debt investor. The upgraded Swordfish was probably a better proportionate asset than the Sapphire. The ~£70m that Bibby is holding firm on the asset values of the Sapphire and Polaris would appear to be a fantasy
  5. If you are building a North Sea spec DSV in Asia the vessel is worth USD 60m at best. It doesn’t matter how much it cost to build the most you could claim it is worth is what Boskalis just paid. In reality it is probably worth less as the number of companies willing and able to pay USD 60m is an ever decreasing pool and that price reflects an operator who can get North Sea rates
  6. It is a reminder that such complex assets take months to sell and the running costs of such assets must be subtracted from any realistic asset value calculation. Nor put the cost of running the vessels in their public documents at c. USD 500k per month per vessel. There is a very small pool of buyers and that diminishes with each round of distressed purchase
  7. Trying to seperate out the asset value from the infrastructure required to run a North Sea class DSV is a mistake. Without a credible contractor to run the asset in the region they will trade only at Rest of the World prices (i.e. much lower)
  8. The Sapphire looks almost certain never to return to the North Sea now
  9. The  business model of purchasing DSVs for USD150-200m and then operating in the spot market for periods of a few days to a few weeks looks broken. Banks will insist on signficant forward cover to finance assets or only those players with strong balance sheets can compete. The days of small upstart offshore companies with a few good ideas and small contracts have vanished (and that is not just in the DSV space). Such a market looked reasonable when everyone was making a 60% gross margin off DSVs but the both the reduction and the volatility of the associated cash flows have changed the market forever
  10. The North Sea diving market for IRM is now dominated by firms for whom it is not a core activity and they will therefore price accordingly (lower). Boskalis, SS7, and Technip are all construction/renewables/dredging focused firms. They have a business model that doesn’t rely on diving being profitable in its own right which means they can sustain low margins for long periods of time. The same is simply not true for Bibby Offshore. Any new entrants into the SAT dive market will view it as an “add-on” service and will bargain a lower utilisation and day rates that were historically the norm. This will affect vessel values that will not recover to anything like 2014 levels and in reality will be lower than implied depreciated values from that period forever
  11. The Nor bondholders got lucky here that Boskalis decided not to muck around on a 20 year investment and pay a decent premium for convience and transaction success. There were no other bidders at anything like these levels and Nor was out of money in February. This was a binary pay-off model where without this transaction they would have been required to inject new money that would have devastated the value of the investors in these boats
  12. I think USD 60m isn’t a fire-sale but a reasonable price at which you could expect to earn a reasonable economic return on the asset over an economic cycle. Boskalis has to commit to a certain amount of infrastructure and fixed cost to achieve this but it can spread this over its existing overhead better than anyone else and therefore do this at a lower per unit cost than others

Boskalis have played a good hand well here.

Reach(ing) for the absurd… Structure-Conduct-Performance

Situations emerge in the process of creative destruction in which many firms may have to perish that nevertheless would be able to live on vigorously and usefully if they could weather a particular storm.

Joseph A. Schumpeter

I have been busy lately and therefore not had as much time to write as I would like. I am working on a longer post about how much a North Sea DSV is worth (following the Nor and Bibby results), and another post on DeepSea Supply. But the constant theme in the market at the moment seems to be that no matter how bad the numbers are to claim an increase in tendering activity, as if all will be well if we just hold on a little longer, and it is this that has forced me to write…

The most logical explanation, borne out by the numbers at the moment, is that tendering is increasing because those putting out the tenders have realised there is a marginal benefit in doing so: they get cheaper prices and do not face diminishing returns from the increasing tender costs. Such an explanation fits easily with everyone reporting declining margins (Maersk, Bibby, Reach, Bourbon, DeepOcean, Solstad etc.,) across the entire supply chain while unanimously claiming to be tendering more. I get contracting lags tenders, and at some point this will mean that tenders will increase prior to work, but it simply isn’t happening at the moment: the schedules are still being cut and work delayed as all those reporting weaker numbers tell you, with no sense of apparent irony, at the same time as they report increased tendering activity.

I still feel that many people in the industry haven’t yet come to grips with the scale of change in the supply change that will be necessary for the market to balance and the structural nature of that change. Until investors who don’t understand this have been flushed out, and it would appear that this will only happen when they have faced mutliple capital injections at ever decreasing rates of return, the entire supply chain will suffer with profitability and utilisation issues.

Reach Subsea reported results and commentary this week in exactly this vein. The ROV industry in particular reminds me of my first job in NZ when a couple of weeks into it someone flew down from Germany to have a strategy meeting with us. “We are going to grow twice as fast as the market” he stated, when I asked “Isn’t everyone else saying this at their planning day as well, so what are we going to do differently” I realised my career at this company was off to a bad start. (I also realised that marketing wasn’t for me. Although the hilarity did ensue when the said individual returned later in the year (1997) to demand higher returns as the Asian currency crisis was having a poor effect on his P&L. When I pointed out 65% of NZ’s trade balance came from APEC countries I was pleased to have a UK passport.

Collectively it is axiomatic that the sum of all firms in the industry can only be equal to the market size and the overall market growth rate. Yet everyone in the ROV space at the moment claims to be growing market share or holding up despite new companies launching and no one making any money.

ROV systems are preferable to own over an offshore vessel only because they don’t have the running costs and you can put them in a warehouse until a recovery appears. But the ROV industry has very low barriers to entry, are in huge oversupply, and the industry is dominated by 5 very well capitalised and global companies. I have lost count of the number of companies striking a deal with a vessel owner to put the system on for free while they take the risk and cost of tendering on. It is not an original business model.

This graph from the market leader, Oceaneering, makes it clear the scale of the large companies:

ROV Market 2017

Source: MS Presentation, May 2017, IHS Data

And the largest company in the market (OII) has poor utilisation and a day rate reduction of 25% since 2014:

OII fleet utilisation.png

The question is really why you would want to go long on this market? Reach to be clear has 6 systems while OII has 282. Four competitors control more than 50% of the market. This is a market that has declined significantly in the last couple of years and seen a small number of new competitors (i.e. M2) come in and buy assets below depreciated value from previously bankrupt companies. If you speak to anyone in the market at the ROV companies they will tell you they are giving away the ROV for free and trying to make money off the personnel and mobilisations. It is a totally unsustainable business model.

The only economically rational strategy here is for a massive consolidation amongst the larger industry players, starting with the grey quarter in the graph who don’t even get their own colour. There is no differentiation in the end product to the customer and no ability for ROV contractors to add value in all but a few extreme circumstances. The longer investors support companies like this the longer the entire industry will operate at below a profitability level required to get CapEx to equal depreciation and ROE to equal the cost of capital.

Reach to be clear reported revenue down more than 50% on the same period last year but at the same time like everyone else reported increased tendering. Reach are krill that will eventually be eaten by a blue whale (hence the photo). I understand that smaller contractors face risks where one vessel is in proportion a larger part of their business, but that just reinforces the economic necessity of having the assets controlled by a larger firm, because the cost base doesn’t vary by the same amount and the lack the scale and scope required to market and develop such assets.

I also noted in the Reach private placement memo this note about their strategy:

8.9 The Group’s strategy

The strategy of the Group in a five-year perspective, could be outlined as follows:

8.9.1 Strategy in the OPEX-market (fields in operation)

  • Target IMR frame agreements
  • Export of North Sea technology and standards to selected major deepwater areas in the world (emphasis added)
  • Provide new services in the segment
  • Bid for seasonal contracts in key regions  (FTSS: Really?)

8.9.2 Strategy in the CAPEX-market (fields under construction)

  • The goal is to be a preferred subcontractor to the major EPIC subsea contractors
  • Securing the right assets will be key (FTSS: They are everywhere and in huge quantity, no problem)
  • Gradually develop assets and resource base
  • Do smaller EPIC-contracts at own risk

8.9.3 International expansion (FTSS: And take market share off who? How?)

  • Develop the international market in parallel with the North Sea market when opportunities appear
  • Seek international partners in selected areas like Australia, Mexico, Brazil and West Africa
  • Develop a foothold in new deepwater areas

8.9.4 Asset base

  • Invest in new assets (FTSS: Why?! The industry has overcapacity)
  • Secure the right assets
  • Mix of owned and hired equipment

I don’t know when I have disagreed with something more. Firstly, if offshore is to grow as industry it needs to compete on cost and that means the North Sea becoming more like the rest of the world not the other way around. Taking the North Sea standard overseas is a proven failure. Bibby tried it in the Gulf of Mexico with disastrous results, and in Asia with a DSV, it was worth trying in Asia but it wasn’t needed or wanted. Technip did the same in Australia. Anyone who thinks they can take the North Sea standard out of the North Sea hasn’t been out of the region. The North Sea is like it is because a) the environmental conditions are more severe than anywhere else, and b) the regulatory environment. You can’t force E&P companies to add to their cost base when it adds no value in the current environment.

If Reach are looking to expand internationally in a declining market then someone else is losing market share. Call me sceptical but in this market that is simply unrealistic. That a company with 6 systems, could have the resources to do this and start to drive consolidation when they are 276 systems behind the market leader isn’t real.

OII and others have literally tens of spare systems, they make them, and are giving them away for free. OII and others are here for as long as there is an industry (and OII have a current market cap of USD 2.3bn). I am not saying Reach is a bad investment (I don’t give investment advice), although it does strike me that it is an asymetric payoff where either someone buys them at a takeover premium, or they slowly make a return at less than their cost of capital and eventually funding runs out. Quite why you would pay higher than NAV for some ROVs which are cheaper on the second hand market and some vessel commitments is beyond me though.

I could go on. I don’t want to do a hatchet job on Reach, that isn’t my point. My point is simply that this industry needs to be signficantly smaller on the supply side and that this requires letting some firms go under. The economic rationale is called the structure-conduct-performance paradigm and is a well known feature of industrial organisation analysis. Porter’s five forces model (that all MBA’s learn), is based on this intellectual strand and the simple expedient that industry effects can be stronger than firm effects (there is much more to this and it deserves a much bigger piece for another day, including the move in the 80’s to the Resource-Based view of the firm which argues that firm effects are stronger and markets not so deterministic:, but in a consolidating industry the evidence is clear). No matter how competent the management of Reach Subsea are, and they clearly are skilled operators, they cannot in the long run compete against market structures so entrenched and differing in scale. Path dependency counts.

The offshore supply chain is clearly going to evolve in a way that was very different from the past. In the pre-2014 environment the industry had large numbers of small subcontractors, like Reach, who made money because the big companies were too busy, and making too much money, to concentrate on the small stuff. That isn’t the case now where they are under pressure to supply assets with very high fixed costs at below breakeven to win work. In order to do that they using the supply chain for ROVs (and other equipment) to supply their kit at below cost and ensure both sides lose their equity. When there is no more for the supply chain to give they will internalise the costs and reduce unit costs where possible. There is no other way this will play out.

Financial investors like Standard Drilling (PSVs), Nor Offshore (DSVs), Reach (ROVs) have all brought in expecting this was some temporary downturn and thought prices would start rising, as per previous models, and then they would then be handsomely rewarded for their (sic) foresight. It is becoming apparent now that this is not the right narrative: this is a structural downturn (Rystad  put a demand return in 10 years!). Only last week I learnt Shell was making a major commitment to ROVs on platforms (again) to consistently reduce OpEx where previously they had used vessels. Examples like this are legion, and I believe in total these stories to be representative of a wider and deeper change where E&P companies will seek to drive down unit costs offshore and this favours consolidation in the industry. So far the numbers are with my theory.

The beauty of capitalism is that you can place bets with money that help determine the outcome. I could be wrong and some huge, totally unexpected, market recovery could take place. The investors in the Nor vessels have so far been way off in their judgement, and I believe Standard Drilling have as well. Let’s see with Reach. But as long as there are investors for companies like this out there, and demand remains at current levels, expect to read plenty more stories about increased tendering while digesting appalling financial results.

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.

 

Bourbon results offer no comfort or light

Bourbon released numbers this week that were bad, this isn’t an equity research site so I don’t intend to drill through them. Bourbon is a well-managed company and there is little it can do given the oversupply. But I can’t look at these stats without feeling like the HugeStadSea merger was too early. And quite how NAO, with 10 PSVs, raised money at USD 15m per vessel when the industry is at this level also looks like a triumph of hope over data. Subsea looks just as bad.

First, I think the graph below (from the Bourbon presentation) is telling and worrying for offshore. One of my constant themes is productivity. Shale is generating increasing productivity (i.e. constantly reducing unit costs) from all this investment, offshore fundamentally isn’t. The cost reductions from offshore are the result of financial losses, not more outputs from unit inputs.

Capital Investment Forecast: Shale versus Offshore

Capital Outlook

Clearly, the capital increase is good for vessel owners, but as this graph shows, the fleet was built for much better times.

Global E&P Spending

Global E&P Spending

And as the Bourbon numbers show, demand isn’t going to save offshore because the supply side of the market is too overbuilt.

Stacked vessels

The subsea fleet globally looks just as bad. Rates are only just above OPEX if you are lucky and nowhere near enough to cover financing or drydocking costs. The hard five-year dry-dock is the real killer from a cash flow perspective.

In order for this market to normalise not only vessels, but also capital, needs to leave the industry. I was, therefore, surprised that NAO raised USD 47m to keep going. NAO have 10 vessels, and are clearly subscale by any relevant industry size measure, are operating well below cash breakeven including financing costs (USD 11 500 per day), and still, they plow on. I understand it’s rational if you think the market is coming back (and the family/management put real money into this capital raise), but if everyone thinks like this then the market will never normalise. And when Fletcher/Standard Drilling can keep bringing PSVs back into the market at USD 8-10m, that do pretty much the same thing as your 2016 build, and 1/3 of the fleet can be recommissioned, the scale of a spending increase needed to credibly restore financial health to operators looks a long way off. Someone is going to have to start accepting capital losses or the industry as a whole will keep burning through new infusions of cash on OPEX. ( I know PSV rates, in particular, have increased this week but this looks like a short-run demand as summer comes and vessels come out of lay-up than a recovery.)

Specialty tonnage, such as DSVs, are in a worse position because as Nor/Harkand are showing people are reluctant to cold-stack due to the uncertainty of re-commissioning costs. Project work simply isn’t returning to at anything like the levels needed to get vessels and engineers working. Subsea construction work significantly lacks rig work, and companies are delaying maintenance longer than people ever thought possible.

Rig Demand

I think restructuring, consolidation, and capital raising are clearly the answer don’t get me wrong. I just think some falling knives have been caught recently (the Nor/Harkand bondholders being the best example) and the industry seems reluctant to admit the scale of the upcoming challenge. And again I am perplexed why the Solstad shareholders allowed themselves to dilute their OSV fleet with greater exposure to supply, when the dynamics are clearly so bad? The subsea and offshore industries appear to be facing structurally lower profits for a long time, and more restructurings, or a second round for some, seem far more likely than an uptick this year and next.