The slow fade to obscurity and Gell-Mann amnesia…

Dum loquimur, fugerit invida ætas: carpe diem, quam minimum credula postero.

(While we speak, envious time will have fled; seize today, trust as little as possible in tomorrow.)

Horace

For this will to deceive that is in things luminous may manifest itself likewise in retrospect and so by sleight of some fixed part of a journey already accomplished may also post men to fraudulent destinies.

Cormac McCarthy, Blood Meridian 

Amid the seeming confusion of our mysterious world, individuals are so nicely adjusted to a system, and systems to one another, and to a whole, that by stepping aside for a moment man exposes himself to a fearful risk of losing his place forever.

Nathaniel Hawthorne

Media carries with it a credibility that is totally undeserved. You have all experienced this, in what I call the Murray Gell-Mann Amnesia effect. (I call it by this name because I once discussed it with Murray Gell-Mann, and by dropping a famous name I imply greater importance to myself, and to the effect, than it would otherwise have.)

Briefly stated, the Gell-Mann Amnesia effect works as follows. You open the newspaper to an article on some subject you know well. In Murray’s case, physics. In mine, show business. You read the article and see the journalist has absolutely no understanding of either the facts or the issues. Often, the article is so wrong it actually presents the story backward-reversing cause and effect. I call these the “wet streets cause rain” stories. Paper’s full of them.

In any case, you read with exasperation or amusement the multiple errors in a story-and then turn the page to national or international affairs, and read with renewed interest as if the rest of the newspaper was somehow more accurate about far-off Palestine than it was about the story you just read. You turn the page, and forget what you know.

That is the Gell-Mann Amnesia effect. I’d point out it does not operate in other arenas of life. In ordinary life, if somebody consistently exaggerates or lies to you, you soon discount everything they say. In court, there is the legal doctrine of falsus in uno, falsus in omnibus, which means untruthful in one part, untruthful in all.

But when it comes to the media, we believe against evidence that it is probably worth our time to read other parts of the paper. When, in fact, it almost certainly isn’t. The only possible explanation for our behavior is amnesia.

Michael Crichton

Fearnley Securities resumes OSV coverage as slow pickup starts to take shape…Analyst Gustaf Amle places buy ratings on Tidewater and Standard Drilling at a time market is experiencing a slow recovery…

Tradewinds

Energy companies and investors are focused on profits and reluctant to boost spending even after crude prices surged to four-year highs, a senior Goldman Sachs banker said on Thursday…

But this time round, the barriers for investments are high, with investors seeking returns of as much as 15 to 20 percent from multi-billion dollar oil and gas projects, Fry said.

“In the near term the focus is on returns as opposed to growth for the sake of growth,”

Big Oil still reluctant to open spending taps: Goldman

I haven’t written much lately a) because I have been busy with an LNG project I am working on, and b) because it’s a bit like Groundhog Day at the moment: a bunch of offshore companies come out with bad results and tell you it’s grim out there and then a bunch of Norwegian investment banks and consultants write reports about what a good time it is to invest. In the same way the relentless expansion of shale continues apace so to does the inevitable decline in value of the offshore fleet and the capital intensity required to maintain it.

Offshore supply is so grim, with such vast oversupply, it is not even worth the effort to rebut some of the more outlandish claims being made. But if you buy Standard Drilling shares expecting the World Wide Supply Vessels to reocver anything like 60% of their historical value I wish you luck, the money would probably be better spent on lottery tickets, but good luck. If you have relied on one of these above-mentioned reports it is likely you are suffering from Gell-Mann amnesia, forgetting the false positives these self-same analysts saw before (this time it’s different…)

On the contracting/subsea side in the North Sea a denouement slowly approaches regarding capacity and the number of firms. I am interested in the North Sea not only because I worked in that market but also as a quite specialised market, with a small number of players and potential assets, it is as close to a natural experiment in economics as you are likely to get. So when you see a load of small firms losing cash, charging rates below what it would cost them to replace capital equipment, and competing against diversified and well capitalised multi-national corporations, the most likely scenario is that sooner or later their private equity owners decide they are not worth putting money into and they are shut down.

It isn’t the only scenario: the investment industry is awash with liquidity, every PE house wants to be the hero that called the bottom of the market right before it boomed. This idea found its ultimate expression in Borr Drilling, but York Capital buying Bibby Offshore was based on a similar sentiment. The problem is that the price of oil has doubled and the amount of offshore work has remained relatively fixed. Next year (apparently?) the oasis in the desert will appear…

Despite the music journalist from Aberdeen claiming that the management reshuffle at Ocean Installer a few months back was just a small thing and all about focus, this week the ex-CEO left to join DOF Subsea. No one would have had more share options in OI than Steinar, and I bet DOF Subsea wasn’t buying any out: when insiders know the shares are worthless you can bet they are. Even a PE house as big as Hitec Vision has to admit sometimes they cannot keeping pumping money into such a marginal venture as OI with such clearly limited upside for an exit? McDermott and OI couldn’t agree on price and unless another bidder can be conjured up to pay more for a business than you could build it from scratch then it’s days are surely numbered?

OI is a subscale business with a few chartered vessels and is exposed to their charter rates rising if the market booms. The downside is limited to zero for equity and but the upside effectively capped. It is no one’s fault it is just a subscale firm in a remarkably unattractive industry from a structural perspective. Eventually, just as with M2, the grown-ups take charge and face reality. As my shore-based offshore engineering guru reminded me: only a well-timed exit from the Normand Vision kept the business open as long as it has been in all likelihood.

But in the long-run OI has no competitive advantage and will be lucky to earn a cost of capital beyond Reach or other such comparable firms, certainly not one to move the needle on a PE portfolio for Hitec. Is there a market in Norway big enough to keep OI as a Reach competitor? I doubt that despite it being a favoured Equinor outcome.

DOF Subsea revealed in it’s most recent numbers that it only makes a ~9% EBITDA margin on projects (excluding the long-term pre-crash Brazil boats).

DOF pre-post.png

That one graphic shows you the scale of the change in the industry: contracts signed pre-2014: profitable, business post that? Uneconomic. No firm in the market will be making much more than DOF Subsea in IMR  and that is loss making in an economic sense: a signal to the market that there is severe excess capacity in contracting.

The Chief Strategy Officer of Maersk Supply recently went public and admitted even an oil boom won’t save them (a relatively frank admission for a company seeking a buyer whose only interest must be seeing MSS as a leveraged play on an oil boom!). For Maersk Supply the future is charity projects (waste collection), decom (E&P forced waste collection), deepsea mining, and a crane so clever it will make windfarms more than a zero sum game for the vessel provider. The chances of that being as profitable as helping an oil company get to “first oil” are zero. But still with a big corporate parent Maersk remain there supplying capacity at below economic cost and ensuring “the great recovery” remains an elusive Loch Ness styled creature.

A slow descent into obscurity would seem the best case scenario for OI while the worst case is clearly a suddent stop in funding when the investors realise 2019 will just be another drain on cash. Something the ex CEO and CFO have acknowledged in their career choices…

I fear the same thing for Bibby. Clearly York are delaying spending on the re-branding (required by their acquisition) because they were hoping to sell the business before the year was out. The financial results released make it clear how hard that will be. Not only did they overpay to get into the business they then, despite Bibby having spent £6m on advisers, had to pump in £15m more in working capital. When you have to put 30% more investment into working capital don’t believe the line about customers paying slowly: it was a simple, yet dramatic, complete misundertsanding about how much cash the business could generate and would therefore need. If you really believed Polaris, Sapphire, and the ROV fleet were worth 80m you would take the money and run…

Like OI the most likely, but not the only scenario, is that Bibby is simply ground down by Technip, Subsea 7, and Boskalis. At the moment North Sea DSV day rates are such that they do not come close to covering the funded purchase of a new DSV (likely to be USD 170m), and yet Bibby have a relatively old fleet. The 1999 built Polaris for example only has 10 years life left in her: on a DCF valuation model that means she has a finite life and not a capitalised value. In all probability Polaris simply cannot earn enough money in the next ten years to pay for the deposit on a new-build to replace herself (particularly given the dearth of bank financing). When I talk of capital leaving the industry this is a classic case of how this will happen. Boats can be chartered now but then the value accrues to the owner, a situation Volstad are only too aware of and will take advantage of when the Topaz charter comes up for renewal.

A quiet winter and a couple of dry-docks later in June 2019 and it is going to be hard to convince an investor to put another £15m because the customers just keep paying slowly (sic). A bidding competition to renew the Topaz charter would in effect render the business worthless.

There are other scenarios for these firms. I sometimes think optimism is a mineral in Lofoten. A veritable army of Norwegian investment bankers are no doubt trudging around with pitchbooks and research reports showing that if you just pay them a transaction fee in cash these contracting companies will bring you untold wealth (next year). But the most likely scenario is that a dramatic reduction in demand is followed by a large reduction in supply and at the moment only the first of these outcomes has occured as the previous cyclical nature of the industry has encouraged hope for a demand led revival. “It’s not the despair, Laura. I can take the despair. It’s the hope I can’t stand” as John Cleese famously remarked.

But it is starting to feel like the end of the road… Solstad has become a national embarrasment, OI a vanity project, and Bibby simply a mistake (to name just three examples). Eventually, when all the other possibilities have been exhausted mean reversion and cash needs will begin dictate economic reality.

One of the most bullish offshore data firms recently published this forecast:

IMG_0992

Just remember as a general rule: the larger the orange bar at the bottom (particularly in a relative sense) the less your offshore asset is worth.

[Graph in the header from this Seadrill presentation. Not a graph I suspect that will appear in one from Borr Drilling soon].

The New North Sea…

[Pictured above a sneak preview of the new (TBC) York Capital/Bibby/ Cecon OSV]

Subsea 7 came out with weak results last week and specific comments were made regarding the weakness of the North Sea market. I have been saying here for well over a year that this UKCS in particular will produce structurally lower profits for offshore contracting companies going forward: you simply cannot fight a contraction in market demand this big.

In Norway spending has remained more consistent, largely due to Statoil. But it is worth noting how committed they are to keeping costs down:

Statoil Cost reduction Q1 2018.png

A 10% increase in production is balanced with a 50% reduction in CapEx and a 25% reduction in per unit costs. Part of that is paid for by the supply chain… actually all of it. What I mean is only part of it is paid for by productivity improvements and lower operational costs… the rest is a direct hit to equity for service companies.

But as a major offshore player this presentation from Statoil highlights how efficient they have become in the new environment (and how offshore will compete going forward):

Statoil drilling efficiency.png

Cutting the number of days per well by 45% not only vastly reduces the costs for rigs it clearly reduces the number of PSV runs required to support the rig for example. The net result is that offshore is more than competitive with shale/tight oil:

Statoil break even.png

In fact Statoil is claiming its breakeven for offshore is USD 21 ppb on a volume weighted basis. It’s just a timing and economic commitment issue on a project basis to get there, but the future of offshore in demand terms is secure: it is an efficient end economically viable form of production. Especially when your supply chain has invested billions in assets that they are unable to recover the full economic value from. Demand is clearly not going any lower, and is in fact rising, just nowhere near the level required to make the entire offshore even cash breakeven.

Statoil has also changed its contracting mode which is probably part of the reason Subsea 7 is suffering from margin erosion in the North Sea. Statoil has clearly made a conscious decision to break workscopes into smaller pieces and keep Reach and Ocean Installer viable by doing this (and helping DeepOcean but it is clearly less vital economically for them). Part of this maybe long term planning to keep a decent base of contractor infrastructure for projects, but part of it maybe rational because previously for organising relatively minor workscopes larger contractors were simply making too much margin. A good way to reduce costs is to manage more internally in some circumstances, and especially in a declining market. I doubt you can be a viable tier 2 size contractor in the North Sea now without a relationship with Statoil to be honest, it just too big and too consistent in spend terms relative to the overall market size (Boskalis is clearly a tier 1 if you include its renewables business).

I still struggle to see Ocean Installer as a viable standalone concept. At the town hall recently the CEO stated that Hitecvision were in for another two years as they needed three of years of positive cash flow to get a decent price in a sale. But what is a buyer getting? They have no fixed charters on vessels (not that you need them) and no proprietary equipment or IP? All they have is track record and a Statoil relationship. In a volatile market even investors with as much money as Hitecvision must want to invest in businesses with a realistic chance of outperforming in the market?

The UKCS is a different story. Putting the Seven Navica into lay-up is an operational reflection of a point I have made here before: there is a dearth of UKCS CapEx projects. Demand is coming back in the IRM market overall but the diving market remains chronically oversupplied and this is likely to lead to much lower profits in a structural sense regardless of a cyclical upswing.

As I have said before Bibby, surely to be renamed soon if York cannot sell the business, remains by far in the weakest position now. Bibby appear to have won more than 70 days work for the Sapphire but that is just the wrong number. Bibby are caught in a Faustian pact where they need to keep the vessel operating to stop Boskalis getting market share, but they have no pricing power, and are not selling enough days to cover the cost of economic ownership on an annual basis. The embedded cost structure of the business overrides the excellent work on the ground the operational and sales staff do.

Boskalis with a large balance sheet are clearly using this year to get out and build some presence and market share. The operating losses from the Boka DSVs won’t please anyone, but would have been expected by all but the most optimistic, and all that is happening is they are building a pipeline for next year. Coming from Germany and the Netherlands, areas more cost-focused, gives them an advantage, as does their deep experience and asset base in renewables. Boskalis know full well the fragile financial structure of Bibby and this is merely a waiting game for them.

The problem for Bibby owner’s York Capital (or their principals if the music journalist from Aberdeen is to be believed)  is the lack of potential buyers beyond DeepOcean or Oceaneering. I spoke to someone last week who worked on the restructuring and told me it was a mad rush in the end as EY were £50m cash out in their forecast models of the business (which makes the June 17 interest payment comprehensible). This makes sense in terms of how York got into this it doesn’t help them get out, and frankly raises more (uninmportant) questions, because it was obvious to all in the offshore community Bibby was going to be out of cash by Nov/ Dec 17 but not to the major owner of the bonds? Bizzare.

Internally staff don’t believe the business is in anything other than “available for sale mode” because the cost cutting hasn’t come, the fate of the Business Excellence Dept is seen as a talisman for the wider firm, and there is no question of money being spent on the needed rebranding by year end unless required. A temporary CFO from a turnaround firm continues without any hint of a permanent solution being found for a business that continues to have major structural financial issues.

Managers at Bibby now report complete a complete lack of strategic direction and stasis, it would appear that winning projects at merely cash flow break even, with the potential for downside, is making the business both hard to get rid of and the current shareholders nervous of where their commitments will end. Any rational financial buyer would wait for the Fairfield decom job to finish and the Polaris and Sapphire to be dry-docked before handing over actual cash, but there is a strong possibility the business will need another cash infusion to get it to this stage. And even then, with the market in the doldrums, all you are buying is a weak DSV day rate recovery story with no possibility to adding capacity in a world over-supplied with DSVs and diving companies. An EBITDA multiple based on 2 x DSVs would see a valuation that was a rounding error relative to the capital York have put into the business. All that beckons is a long drawn out fight with Boskalis who will only increase in strength every year…

On that note Boskalis look set to announce an alliance with Ocean Installer. In a practical sense I don’t get what this brings? Combining construction projects with DSVs from different companies is difficult: who pays if a pipe needs relaying and the DSV has to come back into the field for example? But the customers may like it and having a capped diving cost may appeal to Ocean Installer… it’s more control than most of their asset base at the moment.

Subea 7 and Technip just need to keep their new DSVs working. They are building schedule at c. £120k per day and peak bookings at c.£150k per day and are winning the little project work there is. Although even the large companies are having to take substantially more operational and balance sheet risk to do this. The Hurricane Energy project, where Technip are effectively building on credit and getting paid on oil delivery, highlights that what little marginal construction work there is in the North Sea will go to companies with real balance sheet and field development integration skills. I have real doubts about this business model I will discuss another day: the solution to a debt crisis is rarely more leverage to a different part of the value chain.

But services are clearly holding up better than owning vessels. The contrast between the supply companies and the contracting companies continues the longer the downturn for vessels continues. The  old economic adage that organisation has a value is true. Technip and Subsea 7, along with McDermott and Saipem, have not needed to restructure as many vessel companies have. The worst years of the downturn were met with project margins booked in the best year of the upturn giving them time to restructure, hand back chartered ships, and reduce costs to cope with a new environment. There has been a natural portfolio diversification benefit the smaller companies and supply operators simply haven’t had.

Subsea 7 for example is a very different business to 2014 (investor presentation):

Subsea 7 cost reductions.png

Staff costs down 60% and a very decent effort at reducing vessel costs despite declining utilisation (and despite reducing vessel commitments by 12 vessels):

Subsea 7 vessel utilisation.png

In the past people in susbea used to say they were in the “asset business”. Without assets you couldn’t get projects. And that was true then. Now the returns in subsesa will come from adding intellectual value rather than being long on boats, and that is a very different business. In the North Sea it will lead to a clean out of those businesses who effectively existed only as entities that were willing to risk going very long on specific assets. I count Reach, OI, and Bibby in that group. Historically the returns to their asset base, or access to it, vastly exceeded all other economic value-added for these companies. The Norwegians went long on chartered vessels, Bibby chartered and purchased them, but it doesn’t matter in the end because service returns for such generic assets as OI and Reach run are minimal and easily repliacted, and the returns on DSVs are economically negative due to oversupply in Bibby’s case. Rigid reel pipe, full field development, long term embedded flexlay contracts in Brazil, all these provide sufficient economic return to ensure long term survival (very high organisational and commitment value), and a return that will exceed the cost of capital in an upturn. But for the smaller companies there isn’t a realistic prospect of replicating this now their returns from commoditised tonnage have been so dramatically lowered.

Outside of diving Bibby, OI, and Reach all do exactly the same thing: they charter ships only when they win work, after having dumped a ton of money tendering, and bid the same(ish) solution against each other. Bibby are even using an (ex) core OI asset for a break-even decommissioning job. In the end, regardless of the rhetoric, the compete on price doing this and it is a business model with low margins because it has low barriers to entry (i.e. a lot of people can do it). Eventually in a declining or very slowly growing market that leads to zero economic margin. And as subsea has shown in Asia what eventually happens is someone takes too much contractual risk with a vessel and gets wiped out in a bad contract. This is how the North Sea will rebalance for the marginal providers of  offshore contracting supply without a major increase in demand. That is as close to a microeconomic law as you can get. They simply do not have the scale in a less munificent market to compete.

Goiung forward balance sheets, intellectual capital, visible market commitment and financial resources will all be as important as the asset base of a company. Services will be important in economic terms, they will provide a positive economic return going forward, but not all services, and not in a volume likely to outweigh historic investments in offshore assets. There is a far more credible consolidation story for offshore contracting than for offshore supply with a smaller relative asset base spread over a global service provision set to tilt to regional purchasing by E&P companies.

For the North Sea as whole, a market that provided disproportionate structural profits due to the environmental requirements of the asset base and regulatory requirements, there is also the slow but gradual realisation that the supply chain will have to exist in a vastly less munificent environment than before. Scale will clearly be important here. A market that has contracted in size terms like the North Sea just doesn’t need as many marginal service companies, or assets, and that is the sad fact of life.

Data versus insight…

An interesting report from EY Norway on the OFS sector in 2017. I’d have to say some of the data left me somewhat perplexed. I think they need to go back to the drawing board with this because they appear to have taken pure numerical data without looking to see if it even makes sense:

Subsea Top 5.png

I could almost let them have this because I think they are trying to show the activity of companies in Norway and the scale of their operations, but mixing an on onshore manufacturer of subsea production systems with offshore vessel delivery contractors seems to lose any insight in the data for me.

We then delve into the bizarre in “offshore logistics”:

Top 5 logistics.png

In case no one noticed, because it isn’t mentioned in the accompanying commentary at all, the top 3 companies run helicopters and the bottom 2 vessels? An explanation of why they have been grouped together would be good? I find it very unlikely the industrial dynamics of these two services are similar? And clearly given the data the financial performance of the  helicopter companies is distorting the vessel data?

And then this the “production” segment, which includes:

companies active in production, supporting equipment and services, such as floating production storage and off loading (FPSO) units, facility management, waste management, communication and production operations.

Why? FPSOs and waste management? Communications? How on earth did someone think that was a logical mix of companies? If you are using an SIC coding system then you need to make modifications here because the results are not relevant:

Top 5 production.png

Last time I looked Inmarsat supplied phone services? APL is an intermodal freight company? How on earth would their margin and revenue development, unless you could separate out the OFS component, be relevant?

A basic lesson of data analysis is to check the output makes sense and if not re-think. Either EY need to change their categories here, or change the analysis, because the output is meaningless (even if some of the commentary is okay).

Increased production in the North Sea…

A good article in the FT this weekend on the resurgence in production in the North Sea and the influence of some of the private equity backed companies (behind a paywall):

Production from the North Sea has bucked the long-term decline and energy consultancy Wood Mackenzie expects it to average 1.9m barrels of oil equivalent (boe) a day in 2018, its highest since 2010. This is, in part, driven by new developments such as Catcher, as well as Dana Petroleum’s Western Isles and EnQuest’s Kraken.

The rise “highlights that while the UK North Sea is in decline, these smaller independents and new private equity players are helping drive a bit of a renaissance,” said Neivan Boroujerdi, an analyst at Wood Mackenzie.

Chrysaor’s Mr Kirk said: “If someone had said then [during the downturn] that UK production from the North Sea would increase for three straight years or more, nobody would have believed them. That kind of thing changes people’s perceptions.”

But the article misses a few things important for the contracting community (and context in general):

  1. As the graph above from Oil and Gas UK makes clear this increased production is the result of historic investment in 2012-2015 and has absolutely nothing to do with these new entrants who were not part of the decision making entities that drove this production increase
  2. There has been a massive drop in Capex that will eventually reduce production
  3. Enquest and Premier, two major “small producers”, are locked out of the capital markets until their debt burdens reduce transformationally and have no plans for significant North Sea developments. Kraken and Catcher simply will not be repeated by smaller players without a massive change in funding conditions for small E&P companies
  4. The FT highlights the reduced cost of per barrel production and unit development costs. These have been at the economic cost to a large amount of equity in the supply chain and really show no short-term likelihood of changing
  5. The new private equity backed companies (and I especially include Ineos in this) are ruthless about supply chain costs. This is healthy for the long-term future of the basis but brutal for those long on assets in an over supplied market

Look, I am as happy about an increase in production as anyone, and clearly it is good economic news, but there is a degree of unreality creeping into this: CapEx spending has dropped by an order of magnitude and is not likely to rebound to anything like it’s previous levels in the next few years. Some firms will do well as the amount of work increases, but for anyone long on vessels or rigs that just isn’t likely to be the case.

Subsea work takes years to work through from initial discovery and field approval decisions, and as this data point from Oil and Gas UK makes clear the outlook in this respect is poor:

UKOG Field approvals.png

One Penguin doesn’t make a summer.