Business Sense versus Economic Sense… UDS and Say’s law …

A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest the value should vanish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is the purchase of some product or other. Thus, the mere circumstance of the creation of one product immediately opens a vent for other products.

Jean-Baptiste Say, Traité d’économie politique, (1802)

[Say’s law: Supply creates its own demand as Keynes described it. ]

 

Men err in their productions, there is no deficiency of demand.

David Ricardo in a letter to Thomas Malthus commenting on Say’s law (c. 1820).

 

More than one press appearence lately of the UDS Lichtenstein (ex Marmaid Ausana) in transit to the Middle East for Sat diving work in Iran apparently. I am a huge supporter of any new business, and taking over assets that others can’t work is a time tested model in cyclical industries. The question is: who is the winner here and who is going to make money? As anyone who has run a dive vessel in Iran, or tendered for work there, can explain the rates make India look attractive. A plethora of choice from around the region and customers who only care about price, and perhaps the size of the backhander, mean that even a 30 year old PSV with a portable Sat system can struggle to make money… Thus a newbuild 130m+ DSV is not a natural candidate for the region.

But there can be a real difference between business sense and economic sense: if you can convince a Chinese yard to build you a ship without having to pay for it I think it is a great business model, and UDS are well connected in certain regions to get DSVs working, I am just not sure of the longevity. I haven’t seen the deal UDS have agreed but if it is similar to others floating around then UDS will only be paying for the vessel when it is actually working, and even then a proportion of profit the job generates not a fixed fee. In Iran that is likely to be the square root of a very small number, and if it’s linked to actual payment then even that is a long way off.

UDS therefore is likely to be making money. How much it is impossible to say with certainty but it is possible to have a good guess…The beauty of this business model is its splits the oversupplied capital element away from the necessary cost of operating the service. It’s like a good bank/bad bank with Chinese yards operating as central bank. Cash costs are covered by the profitable service companies while asset owners hope The Money Illusion and the miracle of demand saves them. The Money Illusion is just that and this demand chart shows why demand is unlikely to help DSV owners:

Global E&P Capex

Near stagnant shallow water Capex for years meaning an oversupplied maintenance market.

One of the reasons new DSVs struggle to trade at a premium to old DSVs is the lack of functional benefits from a new vessel for the customer. 30 years ago people were diving at 300m below sea level and we still are now (in fact I have been told Tehcnip and Subsea 7 now call all dives over 200m “special” and need higher approval). Sure the newer vessels may use a bit less fuel on DP, carry a few more people, have a better gym etc, but for the customer, especially in a place like Iran, no one actually cares. The fact is an old banger can do pretty much what a new build Chinese all-singing all dancing DSV can do.

In brutal terms going long on a $150m doesn’t command any pricing premium, or only marginally so, it may just help you secure the work. When people are operating at cash breakeven only that may be a blessing for the company who operates the vessel but that extra capacity is curse for the industry.

Not only are customers cheap in every region outside the North Sea, they can afford to be! Environmental conditions are far more benign which means for a lot of jobs you can use a PSV with a modular system or one of the many $50m build cost Asian focused DSVs… they might not be quite as “productive” or “efficient” as a North Sea class but the owner just reduces the day-rate to the customer to reflect this.

What makes this important is this: for as long as UDS can convince (yard) shipowners that they are the best people to manage unpaid for DSVs, or their own, then they should make money. For the yards and DSV industry it’s a difference story…

In normal times people like to make a return on their capital. The reason you invest is obviously because you want to be paid back. Economists have a really easy way to calculate this: economic profit (which is completely different to accounting profit) and is derived by simply allowing for the cost of the capital in the investment. In crude terms SS7’s cost of capital today is ~12%. Assume a new DSV, with no backlog, all equity financed (a realistic assumption as what bank would lend on this (ignore fleet loans)?). So the “market capital cost” per annum of a new DSV for a recognised industrial player is c. $18m per annum ($150m * 12%); at 270 days utilisation the vessel needs to make $67k per working day just to pay the capital provider. No Opex, no divers, no maintenance, just finance. No one in Iran gets more than $85-90 in total, and it may well be substantially less.

Now UDS don’t need to pay that because the yard unfortunately had a customer credit event and got left with a vessel. Mermaid wrote of over $20m so the yard is probably exposed for $130m, and it maybe more because rumours abound of a fisaco with the dive system which will have been expensive to fix. But there is no doubt UDS have added great value to the yard by providing them with the technical expertise to finish this vessel. UDS just needs to cover their costs and the yard can get something which they probably feel is better than nothing, but it doesn’t mean this work is “economic”. The subsidy here is being paid for by the yard’s equity holders, effectively the Chinese taxpayer, who are involved in an extremely expensive job creation scheme… but times were different… who am I to criticise anyone for going long on OSVs in 2013?

The UDS new-builds are a somewhat different story. If a private equity firm were financing a new build DSV their cost of capital would be ~30% (in this environment probably a lot higher); so at 270 days utilisation that would be c. $167k per working day as a cost of capital. That is after paying for divers, maintenance, and OpEx, a market level of return commensurate to the level of risk of starting a new build DSV company would require that just for the vessels, ignore the working capital of the company. Each new build DSV needs to generate $167k per working day to make an economic profit for the investors. Rates have never been that high in the region, which maybe why economics is a “dismal science“, but it also explains why no one has built $100m+ DSVs for Asia: no one will pay for it!

Rates have been higher in the North Sea but never anything like that consistently and cannot realistically be expected to grow to even half that economic level.  There is also simply no realistic chance of any of the UDS vessels being a core part of the North Sea fleet where rates could traditionally support a capital cost appropriate to the investment in such a specialised asset. SS7 and Technip simply do not procure 25 year assets by chartering off companies like UDS, and frankly they could get a better or cheaper product in Korea or the Netherlands if they built now.  And even if the Chinese built the most amazing DSVs ever (a big if) no one in the North Sea would believe it and pay for it. Given the high profile problems of chartering North Sea DSVs it simply isn’t credible to have any scenario where any of these DSVs come North of the Mediterranean.

I haven’t even dealt with the most important problem: There isn’t enough work in the North Sea. People relax constraints in the region when they need to but at the moment they don’t. The UDS vessels when completed will not be North Sea tonnage… and the only market I think it’s harder to sell a DSV into than Iran is China…

The UDS startegy seems pretty clear at this point: to try and flag the vessels locally and take advantage of local cabotage regulations (like OSS did in Indonesia with the Crest Odyssey) to ensure some local regulatory support for utilisation. The problem with this strategy seems to be it doesn’t have a meaningful impact on day rates. Asian markets with strong flag state rules have never paid top dollar before and it is hard to see these vessels changing the situation. On a boring technical note it is normally impossible to get a mortgage over the vessel as arresting it can be difficult. It’s probably worth a punt for utilisation but it isn’t going to change the profitability of this and makes the capital commitment enduring for anything other than a token price.

I think UDS has great business sense don’t get me wrong. Owe the bank $1m and you are in trouble… owe the bank $100m and they are in trouble. UDS looks set to owe yard c. $450-600m, depending on how many vessels they take delivery of. UDS has great business sense because the yards have a problem way bigger than any of the shareholders in UDS and in an economic sense the yards are never going to make money from this.

All of which brings me to Jean-Baptiste Say, who in 1802 ennuciated a theory that dominated economics for over 120 years. Say’s law was actually the macroeconomy but that wasn’t invented until Keynes. Say looked at the incredible industrial development of the early 19th century cotton industy and thought the economy as a whole must work like that. Without people building something there would be nothing to sell, and therefore there could be no recessions. To anyone working in oil services Say’s further writings looks close prophetic:

Sales cannot be said to be dull because money is scarce, but because other products are so. … To use a more hackneyed phrase, people have bought less, because they have made less profit.

But this was a world away from when Keynes wrote The General Theory at the start of The Great Depression. Until this time Say’s law was the dominant theory of what Keynes later termed “aggregate demand”. We now know that at a macroeconomic level there can be a chronic demand problem, it took WWII for the world economy to recover from The Great Depression, and it is impossible to overstate the importance of the new view in 1936 when Keynes published The General Theory which intellectually overturned Say’s law. Say had confused what happens with companies for what happens to the economy as a whole.

I am reminded of UDS when I think of Say’s law: they might make money out of this, but whether this is economically rational for the whole economy is another story.  Say was wrong in micro and macroeconomics: supply doesn’t create demand.

All the UDS vessels will do is create extra capacity from sellers who are forced to accept lower than opex from anyone with an external financing constraint. The UDS vessels, and the Magic Orient, and the Keppel Everest, and the Vard 801, and the Toisa new build etc will simply wipe out the equity slowly of all those who stay at the table playing poker.

Sooner or later the funders of this enormous gamble will come out. Unwittingly China Yard Inc. is clearly going to be a dominant equity holder, they might think they have a fixed obligation at this point, but just as Keppel and others are finding out: at this level of leverage debt quickly becomes equity. For existing DSV operators in markets where these vessels turn up they are nothing short of an economic disaster. 2018 is going to be another poor year to be long DSV capacity.

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.

DSV market runs out of ‘Greater Fools’… Keppel version…

It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it for “keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence.

— John Maynard Keynes

If something cannot go on forever, it will stop.” (Stein’s Law)

— Herbert Stein

The greater fool investment theory is acribed to the Great Man, who in a famous passage noted that the stock market worked like a beauty parade and that picking a winner was not about backing one’s own judgement:

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

(Keynes, General Theory of Employment, Interest and Money, 1936)

This led to the ‘greater fool’ theory as it has been observed that assets trade not on an intrinsic value (i.e. the cash they can be assumed to generate) but on the basis of what people believe others will pay for them at some point in the future. The boom in DSV building is running into the wall of cash requirements and a shortage of fools willing to invest in them.

If the market scuttlebut is true, and I believe it is, somewhere in 31 Shipyard Road, if it hasn’t happened already, a terrible realisation is taking place: New Orient Marine Pte Ltd, a subsidiary of  Marine Construction Services Ltd (Luxembourg), has a financing issue with the new ICE Class DSV, and in reality isn’t going to take delivery as planned. SOR reported last week that they were seeking a charterer at rates of USD 80-100k a day, a number that if true is so absurd it is beyond satire. The vessel as you can see from the Keppel Q1 presentation is due to be delivered at some time this year.

You can write the script here I suspect: New Orient will be a thinly capitalised company that had sufficient funds to make the progress payments only. Unable to get work for the vessel they have now have no takeout financing, and will be unable to take delivery from Keppel. A frantic search is therefore underway to find someone, anyone, to try and take the vessel off their hands.

At the time the order was signed in 2015 (when the market was cooling significantly), Keppel issued this press release with the comment:

Mr Knut Reinertz, Director of Maritime Construction Services, said, “There is a demand for modern ice-class multi-purpose vessels in the market and we believe this new state-of-the art vessel we are building with Keppel Singmarine is ideally suited to meet this need.

The problem I have with this statement is that how much demand there was/is? And how you split the risk? And even more importantly what is the supply side looking like? MCS/MRTS have used the Toisa Paladin in the region and it has never been on a 365 basis, and they certainly never had the forward order book to justify going long on a vessel of this complexity and cost. So they were either completely mad, or wildly optimistic as to their prospects to resell or recharter the vessel prior to delivery (and they aren’t the only people doing this in the DSV space). Unfortunately the timing is spectacularly bad. I don’t know what the payment profile was for this asset but I can guess it was something like 5% down with 10% later, and if Keppel were lucky, another 10% further on. But apart from that I don’t see them getting any more for this.

I actually believe this vessel, with a reported build costs of USD 200m, or SGD 265m, is valueless. I say this not to be controversial but a cold examination of the market and the asset.

Firstly, and most importantly, the vessel is being classed by Bureau Veritas. That wasn’t a joke, I’m serious. You can read the BV press release and documentation here. Those who have worked for a saturation diving company will appreciate the significance of this, while others may wonder where I am going with it? Saturation diving isn’t rocket science, but not everyone can do it either, you need a certain number of systems, and processes, and high quality people to be there to create a certain institutional knowledge base to do it safely and efficiently (particularly North Sea/ ICE work). Small things can cost you a lot of money and this is a classic example where cutting corners, is I believe, going to render this hull worthless. For those still here, there is no other DSV in the world classed by BV, it is just not a classification society recognised to give a vessel SAT notation. The only reason you would use them, and not DNV or Lloyds (and maybe ABS at a push), is to save money, and anyone looking at buying this vessel at anything close to its construction cost would know the original purchaser did this to be cheap. Very cheap.

Secondly, the chambers and other equipment are not NORSOK compliant. I don’t even think a BV system could be NORSOK compliant without a vast amount of bridging documentation and ancillary work (I am happy to be proven wrong on this). The only market in the world where you can get day rates that would cover that build cost is Norway, and they already have two NORSOK DSVs for a total market of 550-600 DSV days on a good year.

Thirdly, the dive system is a Lexmar, and has had known installation problems throughout the build. No one spends USD 200m on a dive vessel with a Lexmar system. Again it was done to be cheap and it will in all likelihood render the vessel unsellable.

Although I am a paid consultant I have therefore done Keppel a favour and compiled a list of all the possible buyers for this asset (who says consultants ask for your watch and then tell you the time?):

 

 

 

Unfortunately, as you can see, it’s quite a small list. But the number of people needing a USD 200m DSV at the moment is 0. The largest owner of high class DSVs is rapidly beoming Yard Inc. Lichtenstein is still in Shenzhen, Vard has the Haldane, and now Keppel has the New Orient DSV. And that is without getting into idle tonnage and the DSVs still to be delivered. If you speak to people associated with these assets they all assure you that they are close to selling them, yet if these vessels are not used in the North Sea they are only worth the Asian/African DSV price, where you are competing with modular systems on a PSV, and all the North Sea contractors have too much tonnage, as the Nor vessels prove. Find me a CFO from one of the big 6 who could take one of these DSVs at anything like book value, and who is willing to go to the stockmarket, with backlog collapsing, and say he has paid anything less than a steal for one of these? No one outside of these companies could get the vessel into a region where they could hope to recover that sort of cost – and even then not in the current market.

New Orient Marine Pte Ltd , are in turn linked with MRTS, a Russian owned contractor focused on the Sakhalin region (although I think they have done other work in the Caspian).  It’s worthwhile having a look at their fleet to see the sophistication of vessel they are normally used to dealing with here and the risk Keppel took in this contract given this. MCS have hired DSVs on a time charter basis, but have never owned a DSV; you therefore have to admire their… courage?… in striking out to build one of the most advanced DSVs in the world.

Clearly they were hoping to sell something well above it’s intrinsic value by being bold. The payoff was an asymetric one to MCS though, who stood to benefit enormously while Keppel are going to be stuck with this eccentric design for a long time prior to reality setting in I suspect. Keppel are a big company with a multi-billion market cap so this isn’t a “farmburner” for them, but they could realistically have to writeoff USD 150-200m here which is going to be very painful all the same. The Chinese yards have decided to play for time, the Tasik DSV was yard financed and  UDS are the potential saviour for the Lichtenstein. Not everyone can be saved here because there is just insufficient demand until the DSVs return to construction work not maintenance, and that looks a long way off.

EZRA fate depends on more than debt write off… it would need significant capital

“Don’t cry because it’s over, smile because it happened.” 

– Dr Suess

An update on the EZRA situation in the Straits Times this morning deals with one part of the EZRA problem:

Much of the company’s fate now hinges on the willingness of its creditors, including bondholders, to write off – whether partially or in full – its massive debt.

Which is true as I have said many times before here, but this would be nowhere near enough. What EZRA would need in addition to a massive debt writedown is a gargantuan injection of equity to fund the company through until profitability. I don’t what the exact number would be, but it is in the tens of millions, and I suspect that number is scaring the banks now. It would also need a completely new leadership team, but I will treat that as a given.

As the article rightly points out the banks exposure is to the high-end vessels like the Lewek Constellation. An engineering marvel it may be, a liquid asset that could be sold at anything like book value, it is not. I often talk here about asset specificity, which the offshore industry and their financial providers spectacularly mispriced in the last boom, but the Lewek Constellation is also an example of a complementary asset: the return on the asset increases the marginal return to another (or its owner). In the hands of a contractor wanting to do deepwater pipelay it’s a very valuable asset, but the reverse is also true, without the right owner such a specific asset is actually close to valueless. Intuitively we know this to be right about the Lewek Constellation, there is nothing else that can be done with that vessel without enormously expensive modifications. Banks should have had a much lower loan-to-value ratio on the vessel, in effect it was a project that was entirely equity risk should it go wrong, because even to hold it at port costs ~USD 15k per day, and it will take months to sell at a fraction of its build cost (unless Subsea 7 are silly enough to buy it) as the Ceona Amazon did.

There was a straight asymmetric payoff for EZRA shareholders here where they put up a fraction of the value of such a complex asset and received all the benefits if it worked and the banks were left holding an unsellable asset with high running costs if it didn’t. It is also clear, and this should be a warning to anyone thinking of funding this, that EZRA massively underestimated how long it would take the vessel to get decent utilisation, and therefore how much capital would be required to fund the roll-out of the Lewek Constellation. A new contractor could realistically only hope to win one or two jobs a year with such a new specialised asset, the EZRA equity holders would have had to accept dramatically lower utilisation than anyone else, and therefore lower immediate payouts (dividends), for the prospect of a higher value firm in the future (if you were following MM theory). But that is equity risk and it is clearly a big number when funding a deepwater pipelay asset to challenge the world’s industry leaders.

But the banks behind EZRA have a choice: accept the loss now, or risk putting millions more in working capital into the venture in the hope that the asset values will increase enough, and the company can repay even more money in the future. Both are really bad options in the current market. Any new equity investor not already exposed to this company would demand market prices for the assets, which doesn’t help the banks at all, but to take an equity position (whatever for the semantic legal definition the capital injection took) to dig themselves out of a very deep hole is a real problem for banks. Equity risk has to be reserved at almost a 1:1 ratio under capital adequacy provisions at the moment, and for good reason: no one can tell when this market is coming back, and indeed if it will ever come back like before.

And even if the market turns a reconstituted EZRA would be competing against Technip, Subsea 7, McDermott, and maybe, longer-term, Saipem (for another blog day). This new company would require sufficient capital to convince the Board of any potential customers that they were the right partner for a large, strategically important, complex offshore field development that would cost in the tens-to-hundreds of millions of dollars. I don’t see anyone taking them up on such a remarkably unattractive offer, in this market, with a surplus of good assets and contractor capacity, you would be mad to willingly choose EZRA as your offshore development partner. All engineering and procurement work for long-term projects is effectively contractor specific and exposes potential E&P customers to becoming unsecured creditors should the new EZRA fail, so it would need a fortress-like balance sheet to convince people they will be here next year, or the year after, but would you hand over a key strategic project to a contractor who has just come out of Chap 11 and defaulted on a large number of people throughout the supply chain? I just don’t see it.

In addition, it would appear that the Norwegian arm is to be liquidated and contracting on this scale only works as a global operation. There is simply no industrial logic for a recapitalised EZRA.

If the banks want a lesson in how expensive a strategy of providing working capital in a depressed offshore market can be they need look no further than Nor Offshore and their two DSVs parked at Blyth. Having raised USD 15m last November, and making a big deal about how much financial flexibility this gave them, they now look certain to have to raise funds again at the end of this year as the entire amount will have been spent on working capital without any work being generated in 2017 (remarkably like 2016 for them).

Nor are desperately hoping that their combined bid with Oceaneering for the BP Trinidad work will come to them. I don’t see it. Bibby have the Bibby Sapphire in the Gulf, know the worksite etc. DOF have the DOF Achiever in the region as well. Would BP really bring a new DSV, with a new crew, that hasn’t dived in a year, and put it into a complex and tidal worksite? I rate their chances at less than 5% (and on a rational basis 0%). Unless Oceaneering has a remarkable relationship with someone at BP I don’t see it happening: at the end of the day a DSV puts people on the seabed and someone at BP would be accepting that if anything went wrong from a safety perspective they had taken a very risky option. And given the market BP would not save any money in doing something so risky. BP need the work done and they need it done safely.  Sure BP, try and get the price down, but who would risk their job to take such a decision? Safety first in everything we do right?

And even if Nor/Oceaneering won the work it’s a 20-25 day transit, 400k on fuel (which BP won’t pay for), and then sea trials, bell run trials etc. Madness. The Nor bondholders will be going backwards in cash flow terms given current day rates at OpEx only, just to get the boat moved. So they will be raising money at the end of the year, or selling the vessels for a lot less than they had hoped, when they raised the USD 15m last year. It is literally locked in because they have no other work and no hope of recovering their liquidity position given the market and their position in it.

Such a situation is magnified a hundred times for the banks involved in EZRA. Someone senior would have to agree to in effect provide enough working capital for at least 24 months to prove they were going to make it through, potentially offer refund guarantees against procurement and engineering etc. As Nor has shown there is no guarantee that conditions will improve in time if you simply sit back and watch. And Nor is bidding on short-cycle projects, most of the construction projects EZRA would have to tender take years to come to fruition and the tendering costs, which require vast engineering resources, are extremely expensive (particularly when you are starting with a pipeline of nothing). As I have said before as well there is no proof that EZRA was actually any good at contracting: the BHP project in Trinidad I believe was a significant loss maker, I have had many people tell me the engineering coming out of Singapore was substandard, and I spoke to someone about the work performed in the Med and they couldn’t have been more critical of the work standard. EZRA is a busted flush.

Investors, or potential investors, should remember my favourite maxim of The Great One: markets can remain irrational longer than you can remain solvent (and I am not even sure they are being irrational at the moment). People keep coming up with really complex theories about EZRA and yet I see it really simply: find me a rational investor who would pump hundreds of millions of dollars into a new subsea contracting company at the moment, in an oversupplied and fiercely competitive market, with an uncertain future, and the industry as whole operating at negative economic value? Until you can find this mythical institution there will be no EZRA. The working capital costs of offshore contracting are so high that only a fool backs a business model with no clear path to decent utilisation.

The solution here is clearly for the banks to approach another contractor with a deal that would preserve asset value while taking capacity out the market. Maybe the banks swap the assets for a stake in Ocean Installer? Let Subsea 7 take the specialist vessels for nothing and some warrants? Save face somehow through financial engineering. Because the truth is the assets really are worth collectively hundreds of millions less than book value in the new environment and no one wants to be exposed to the OpEx of them. Pumping a company with a poor industrial strategy and futile market position full of working capital is the last thing the industry needs, and frankly won’t help the organisations that do it in the long-run.

 

The oil market narrative…

Robert Schiller gave this lecture earlier on the year on the power of the narrative in economics and it concerns:

 the epidemiology of narratives relevant to economic fluctuations. The human brain has always been highly tuned towards narratives, whether factual or not, to justify ongoing actions, even such basic actions as spending and investing. Stories motivate and connect activities to deeply felt values and needs. Narratives “go viral” and spread far, even worldwide, with economic impact.

It’s wide ranging and I would recommend all 57 pages. Schiller argues that epidemological models from biology maybe a good basis for integrating narratives into economics. Evolutionary economics has been hugely influenced by biologicals models of change and there is no reason to believe behavioural economics cannot be just as influenced.

Given the action in the oil market I regard this as a good a theory of market price developments as any other. Deep down clearly the market fundamentals count i.e. the basic where demand will meet supply. But up until a few weeks ago the dominant logic in the oil industry was clearly just how rapid price rises would be, and yet how quickly this has changed in the past week after the IEA claimed we were underinvesting massively.

Reuters published an interesting story last week about how bullish oil companies were, indeed the market narrative was summed up by this analyst:

“The investor mindset is switching to growth again,” said Anish Kapadia, analyst at investment bank Tudor, Pickering, Holt& Co.

“Oil prices are above $50 a barrel, companies are generating cash and are starting to talk about growth again, we are at that point of the cycle.”

But they also dumped in this casual data point:

Even as prices LCOc1CLc1 hold near $50 per barrel, the firms – Royal Dutch Shell Plc (RDSa.L), Exxon Mobil Corp (XOM.N), Chevron Corp (CVX.N), BP Plc (BP.L), Total SA (TOTF.PA), Statoil ASA (STL.OL) and Eni SpA (ENI.MI) – plan to grow output by a combined 15 percent in the next five years…

The seven companies will add almost 3 million barrels per day to their combined output in the next five years effectively generating production the size of another major like Chevron. [Emphasis added].

The FT this morning had an article about Leonardo Maugeir, who used to head strategy for ENI,  and his views who has written this article:

In January, my similar field-by-field analysis indicated that world oil production capacity and actual production were still growing—while prospects for demand growth were not sufficiently high to absorb the excess supply. In particular, actual oil production (which includes crude oil and other liquids such as condensates, NGLs, and more according to the standard definition used by most statistics) was almost 99.5 million barrels per day (mbd)—leaving a voluntary and involuntary spare capacity (the result of local civil wars and other geopolitical factors) of more than 4 mbd.

Frankly any sane person is going to be bored-to-death by potential supply/demand imbalances of 1-2m barrels a day (or 4m or whatever, life is too short), and the models underpinning these are so complicated they can only ever be directionally correct, but the core point here is how they are shaping the narrative. The narrative seems to have turned to the downside, to the potential of shale as a marginal production source of choice, and the potential for oversupply in the industry. Too many people in the industry still just refer to “when the next boom comes”, but having predicted 9 of the last 0 house price crashes in New Zealand I realise that such predictions offer little value. Is there really going to be another boom? What will it look like? And when really will it come?

But the value, and the interest, in oil, seems to be the euphoric highs and lows (and the investment returns that mimic this), driven partly by the narrative.  I wonder if it’s a function of the sheer scale of the capital investments that have previously been required to make a meaningful increase in production? I wonder if shale won’t modify this somewhat?

I’m a long run guy. Maybe in the long-term shale, with much smaller capital commitments per well, will make the oil industry less cyclical as marginal production can be more efficiently brought in and out of use? Everything in life is relative (in an economic sense). Modern economic growth is usually dated from c. 1500 (which the Great Man ascribed to the price revolution), maybe the importance of oil from the beginning of the 19th century was just a blip in the economic cycle of the post 1890 long globalisation age, in which case we have just been through a Cambrian Explosion of innovation and now the oil extraction industry settles down to maturity with less price volatility and more constant productivity improvements one would expect from a more mature industry? Maybe shale is the productivity revolution that matches supply and demand after a 40 year lag when oil prices really took off in real terms? Productivity improvements are not linear but erratic. The dominant narrative until just a few years ago was that “all the easy oil is gone”, now that just isn’t true again.

oilprice1869.gif

Maybe I am actually a random walk guy? As always I back technology and productivity improvements over long-run resource scarcity and supply issues given relatively free markets. I therefore err on the side of lower oil prices for some time, especially given oversupply in the servive sector.

 

Markets can remain “irrational” longer than you can remain solvent…

This cheery news came in from Hornbeck today (shares down only 2% so let’s not start the EMH debate now):

The Company projects that, even with the current depressed operating levels, cash generated from operations together with cash on hand should be sufficient to fund its operations and commitments at least through the end of its current guidance period ending December 31, 2018.  However, the Company does not currently expect to have sufficient liquidity to repay its three tranches of funded unsecured debt outstanding that mature in fiscal years 2019, 2020 and 2021, respectively, as they come due, absent a refinancing or restructuring of such debt.

That is on the back of poor numbers from DOF yesterday, in which a restructuring/refinancing of DOF Subsea is clearly an issue, and yet another month of no work for the Nor vessels, to pick just a couple of examples… I could go on. I know Europeans like to look down on the American fleets, and technically they are clearly not as good as the European tonnage,  but by virtue of market size they represent a bellweather of the industry, and the fact is it is across the board. I still feel Aker/ DSS caught a falling knife in supply rather than using capital to solve a structural issue. The price at which Hornbeck (and Tidewater) solve their financing will be interesting. Quite why Solstad didn’t leave these scale companies to sort out supply and stick to OSV/CSVs, where you can hopefully build some value into service delivery and therefore boost Enterprise Value, is beyond me.

Is there a bull case? Am I being too negative? I came across this graph from Surplus Energy Economics (a great blog I have just discovered and while I don’t agree with everything it’s very well written), from this article:

Average Annual Oil Price (constant 2015 dollars)

oil-price-trend-since-1965

It’s all the bulls in offshore have got left. The arugument is that this is a temporary dislocation in demand for offshore energy and maintenance services and that shale will hit the limits of its production and energy prices will return to their long-term averages and we can all go back to beer and skittles and the demand/supply imbalance will disappear.

The problem with trends is getting caught in the middle of a bad period. I am a believer in offshore energy long-term, I just worry about the running costs of the vessels to get there, and there is a real risk of moving too early in these assets given the high carry cost. In some options time is your friend, not in OSV/CSVs… The potential equity “funding gap”, between when the red line causes day rates and utilisation to increase, is the key question facing the industry and investors.

If you brought an OSV in 1994 and sold it in 2001 it wasn’t a great investment generally. 1985 to 1999 was generally a poor time to be in oil services as an investor. Alternatively, you could be like Bibby Offshore and by a North Sea class DSV for USD 10m in 2003, just before a boom in day rates, and make extremely high risk weighted returns. The core issue (as always) is when demand comes back to signficantly increase utilisation and day rates. The offshore industry is going into this downturn with a number of vessels beyond comprehension in any previous decline and with a new competitor at the margin in shale.

Financial return depends on the the numerator (cash flow) and the denominator  (discount rate) when assessing returns (CF/DR). Its not enough that day rates bounce back its the money injected in the interim. A really clever financial model could be made showing the equity gap for offshore vessel operators between now and a market recovery, but it depends on the gradient of the red slope as much as the current running cost. But as no one knows when demand will come back its not just the numerator that is important its the denominator to reflect the risk of this happening. Discounting is a brutal game, invest a dollar now with no payback, at only a 15% return (and frankly I would want more for buying such expensive options), and you calculating on only a .65 return in the dollar in three years to break even, on depreciating assets in an oversupplied market that is a bold call. A 30% IRR (common to alternative investors) is equivalent to a .45 return on the dollar in three years. A discount hurdle in day rates that just seems extremely unlikely to be met given the oversupply.

One of the areas I disagree with Surplus Energy is the view that shale cannot reduce the absolute cost of production. As I have written before shale demonstrably has. Anyone who bets against the ingenuity of US engineers to drive down economies of scale and scope, and find capital market support to do it, is making a very big call, and not one backed by many examples. Small shale wells appear susceptible to standardisation that will push the cost curve down again. I don’t see Moore’s law kicking in but the fact is the shale industry is relatively immature and suffered huge bottlenecks in the last boom. Yes, shale is using the best acreage at the moment, so productivity numbers are boosted, but the supply chain is in its infancy in terms of driving down unit costs. However, whether enough acreage can be brought on quickly enough is the defining question.

I am a long-term believer in offshore. Deepwater projects  by there nature are one-off projects that are hard to standardize. They require huge investments in project specific engineering and fabrication (i.e. a much higher CAPEX) but they can offer much higher, and more consistent, flow rates (i.e. substantially lower OPEX/unit) and therefore they will be part of the energy mix going forward. These sorts of projects offer huge scope for contractors to add value and therefore earn above average rates of return. Infield projects are going to be far more challenging: launch it at the wrong time and your entire 5-7 year operational period could be one of low prices. That will significantly raise the hurdle rate for these projects.

[Headline is from the Great Man].