Brazil, The New Offshore, and Contractor Profitability…

“My salad days, When I was green in judgment, cold in blood, To say as I said then!”

Cleopatra – Act 1, Anthony and Cleopatra

Bassoe Offshore had a very good and insightful article on Brazil this week. The key thing for me was the sheer drop in volume of rigs working in Brazil:

As we noted earlier this year, the number of drilling rigs in Brazil has gone from over 80 to under 30 during the past five years.  Currently, 26 rigs are on contract (all for Petrobras), but only about 20 are on full dayrate and drilling due to Petrobras’ reduced effective demand.  By the end of 2018 – assuming no new contracts or contract extensions – Petrobras will have 14 rigs working for them.  By 2021, this number becomes three. 

We estimate that Petrobras has a minimum requirement of around 20 rigs to sustain production through 2021.

Rigs are obviously the leading indicator of future subsea work and it’s worth putting some context on this as Bassoe Offshore did in April:

If you were an offshore rig owner back in 2010–2014, Brazil was the land of opportunity.  Petrobras offered long term contracts with solid dayrates.  Everyone wanted to be there.  Rigs were built; demand seemed insatiable. 

Petrobras even initiated Sete Brazil, a company with plans to build 29 Brazilian-content, deepwater semisubs and drillships, which was slated to be Brazil’s path to global prominence in rig construction and a boost to the country’s industry and economy.

And in order to keep production going from all the well work these rigs would be doing Petrobras went just as long on flexlay capacity. The strategy here was slightly different: Petrobras choose the two most capable subsea contractors in the world and signed them up for a vast investment campaign to buy specialist Pipe-Lay Support Vessels (PLSVs) and contract them for a period of c. 30% of their expected economic life. Technip, who always seem to call these things correctly, decided to share the risk 50/50 with DOF Subsea for four vessels, while Subsea 7 decided to build and own its three vessels.

There is a constant commentary about how high the margins are on these contracts, and it is true that during the firm period they look good, outstanding even, but there is a very real risk that some of these vessels will be re-delivered. A company that had 80 rigs working and went long on flex-lay capability with 7 vessels is unlikely to need that number in the future when it has c. 20 rigs working. For a whole pile of reasons the drop in demand is unlikely to be linear, but you only need to be directionally correct here to understand the scale of the issue.

Brazil also has proper emerging market risk characteristics in it’s local cabotage regulations that favour local tonnage as Subsea 7 found out this year when the Seven Mar had its charter terminated early,effectively for convenience, and therefore had to reduce backlog by USD 106m. So clearly the economic reason you get a good margin is because there is actually a fair bit of risk in building such a specific asset for such a unique (and having worked on a Petrobras contract I use the word in its most expressive sense) customer: the downside here is in 7 years you get a ship back quayside in Brazil that costs USD 15k per day to run and is only good for laying pipe in 3000m of water. All of a sudden that healthy margin for the last seven years doesn’t look quite so attractive, and this is a very real possibility here for at least 3 or 4 of these vessels.

This fact clearly had a massive impact of the ability of DOF Subsea to get an IPO away and is one of a number of huge strategic issues DOF Subsea has. The DOF Subsea investors were hoping to remove some of the risk of vessel redelivery, and the price the investors were offering to do this just wasn’t enough, or in sufficient volume, for a deal to be agreed. Given the binary nature of the payoff involved it is no surprise a mid-point on the two positons could not be reached: Because a downside scenario is that Petrobras halves the number of contract PLSVs it wants and Subsea 7 comes in with a low bid and the Technip/DOF Susbea JV has its entire fleet redelivered. It may not be likely but it cannot be ruled out either.

The greater IOC involvement in Brazil may also change what has been one of the great comparative anomolies of the market: the complete lack of a spot market (which made sense when Petrobras was the only customer). Should PB and the IOCs decide to bid flexlay work on a project-by-project basis the revenues for the purpose built PLSVs will be much less secure and the valuation assigned to them will be significantly lower to reflect this income volatility. These investments rightly required a very healthy margin.

I always find it amusing to read statements like “the investors think this is an even better investment” and then read the latest accounts and come across comments like this:

In the 2nd quarter the Group has seen improvement in both numbers and activity compared to 1st quarter, however the general market conditions within our industry are challenging, especially in the Atlantic region and the North America region…

During the quarter, the Group has seen a low utilisation of the vessels Skandi Constructor, Skandi Neptune, Skandi Achiever and the JV vessel Skandi Niteroi… In the Subsea/IMR project segment the idle time between projects has increased, however the Group saw an increased project activity toward the end of the quarter.

Ah… the famous greenshots of recovery… at the end of every quarter everyone always sees activity picking up… not quite enough to make it into the current results… but jam tomorrow…

Which led to these numbers:

DOF Subsea Q217

So you might believe it’s a “real out performer”, but in a financial sense it’s a very hard case to make. All the key indicators are going South.

DOF Subsea is an extremely hard investment case to make (to highlight just the three most obvious examples):

  1. Is it a contractor or a contractors’ contractor? A falling out with FMC Technip would devastate the business yet it is hard to see where the clear division of capabilities and competencies at the lower end between the two is? Are DOF Subsea really going to put the Achiever to work against the Technip North Sea DSVs? Even if you really believe they will do this how many jobs would they have to win off Technip before Mons got a call asking what was going on?
  2. The pay-off from the Brazil PLSV project is highly uncertain but it is almost certain that the current margins will drop from their current levels
  3. DOF Subsea has all the costs of being an international EPIC contractor with none of the associated scale benefits. The scale benefits of being international require large diameter pipelay and its associated margins, a move into this area is financially impossible given their current constraints and would clearly precipitate a major ruction with FMC Technip

I think DOF Subsea is just the wrong size to compete as a global contractor and I mark it as likely to underperform significantly in the future. I see a world where FMC Technip, Subsea 7, McDermott, and maybe Saipem, become almost unassailable as the profitable global SURF contractors for mid-sized field development up. Each with a very strong base in one geographic region, with an asset base that can trade internationally enough to gain scale economies from other international operations, and with the balance sheets to invest in capabilities that will standardise and drive SURF costs down. DOF Subsea, despite having a lot of nice ships and clever people, is by an order of magnitude behind these companies.

These Tier 1 contractors will make disproportionate margins to the rest of the supply chain where overcapacity is rampant and balance sheets are weak. These Tier 1 contractors will need to own only core enabling assets and simply contract in all commodity tonnage, which will remain oversupplied for years. Tier 1 margins will improve as they need proportionately less CapEx, or operational leverage, now the OSV fleet has more options. It is not all salad days as apart from MDR the Tier 1’s have some issues from the boom years, but on a project level, for larger SURF work, they are creating a very strong competitive position. You will able to have a strong regional presence/competitors, but the gap between the few global SURF contractors and the “also rans” is going to become very wide indeed as backlog declines going into 2018.

Expect DOF Subsea to remain privately held for a good while longer if the investors really believe it’s undergoing a current period of out-performance that no one else is clever enough to see.

Productivity in the long run…

I go on about it a lot but productivity is the core of economic growth and undertsanding its importance is crucial to having a reasonable chance of understanding how an industry may evolve. Brad De Long makes this clear when discussing the iPhone X;

Consider the 256 GB memory iPhone X: Implemented in vacuum tubes in 1957, the transistors in an iPhoneX alone would have:

  • cost 150 trillion of today’s dollars: one and a half times today’s global annual product

  • taken up a hundred-story square building 300 meters high, and 3 kilometers long and wide

  • drawn 150 terawatts of power—30 times the world’s current generating capacity

Renewable also energy seems to be in a marked phase of marked productivity improvement:

better_energy_01.jpg

I am not predicting the end of oil already: it is simply too efficient on an output basis. but in the long run everything is a productivity game, the supply curve in oil is just a very long run curve that requires technology to fundamentally change it. And for offshore it isn’t doing that much at the moment. The risk here is that large E&P companies reduce their focus on CapEx for offshore, which becomes self-fulfilling because it prompts infrastructure investments that make renewables even more efficient. Most commentators believe this productivity surge has a long way to go with maybe a 20-30% further cost reduction by 2030.

And big institutions have the investment narrative that says this is hot with Blackrock Infratsructure (who admittedly have their own agenda to raise money) backing a shift in energy sources:

During a recent interview, Jim Barry, a managing director of BlackRock and global head of the investment firm’s Infrastructure and Investment Group, recently declared that “coal is dead.” While he acknowledged that coal will still be part of many countries’ energy portfolios, Barry said any investor who is seeking returns from coal beyond 10 years from now is “gambling very significantly.”…

And largely due to the cheap cost of renewables, Barry and BlackRock are sanguine about these technologies’ future. Barry was also optimistic during the interview on the outlook for electric cars, due to their improved range and the declining cost of battery storage. While talk of “peak oil” has been underway for years, Barry views the oil markets through a different lens, insisting that “peak demand,” not just supply, is a dynamic that investors should not ignore. As consumers embrace electric vehicles, the demand for oil will continue to decline – with the end result a cloudy future for conventional energy companies with large oil reserves on their books.

Don’t for a second underestimate the fact that senior managers at large E&P companies see investors like this as their boss and seek to deliver messages that please them.

I think some of the big mergers will help integrated solutions deliver productivity to make oil more competitive. But production productivity, and not just demand, will be crucial for the future of offshore production. The core of productivity improvements is generally mass production of all components in the supply chain by a small number of vast tier one suppliers and a network of subcontractors (who make minimal margins), and this is almost antithetical to the entire make-up of offshore. Change is coming.

Backlog, boats, and oligopolies…

“[E]conomists usually assume that people know how the economy works. This is a bit strange since economists don’t even know how the economy works”. …

Xavier Gabaix

There was a lot of talk about Subsea 7 ordering a new pipelay vessel last week, and given the engineering quality at Subsea 7 I am sure it will be an efficient, if not technically brilliant, asset. I don’t have a counter-opinion on this: Subsea 7 shareholders expect them to be a market leader and this means buying assets, particularly when yard prices are likely to be advantageous.  The plan would seem to try and push the technical window of pipelay even further and make it harder for smaller tier two contractors to offer a competitive product with such technical features as heated pipe-in-pipe.

As a replacement for the erstwhile Navica it will ensure a leading edge capability. The Navica was built in 1999 so Subsea 7 had 16 good years out of her and  for a number of years Technip and Subsea 7 offered the only realistic reel lay in the North Sea, and I would say the vessel made real money for the shareholders from 2004 onwards (especially when considering the huge number of DSV days she generated) until 2014. Subsea 7 depreciates vessels between 10-25 years and I wonder what the figure is for pipelay assets?  If the pace of innovation in the pipe technology is such that you need a new vessel as a platform every few years then the economics would dictate a slow diffusion of pipe technology (I don’t think it’s likely).

At USD~300m it is not a massive purchase for Subsea 7 either. In 2017, in the midst of the worst industry crisis ever, Subsea 7 made a special dividend of USD 191m, and this vessel is 3 years away from the take-out payment (and could probably be pushed back if needed). The interesting thing is given the delivery time how Subsea 7 see the market coming back… because its not in the backlog. In 2013 Subsea 7 published their backlog as USD 11.8bn:

Subsea 7 Backlog Q4 13

Strangely, for the last few quarters the bar graph has been dropped in favour of the pie graph and the number is materially smaller:

Subsea 7 Backlog June 2017.png

That USD 4.4bn also includes ~USD 1.4bn for the PLSVs in Brazil. Now to be fair when Subsea 7 had backlog of USD 11bn it had six vessels under construction and was targeting CapEx of ~USD 1bn, 60% on new builds and 25% on replacement CapEx. As the order book at Subsea 7 has dropped so has CapEx pretty much proportionately. It is also interesting that they can cut maintenance CapEx back so much with guidance for total CapEx this year guided in at USD 180-220m. Yes, it’s a lot less than Depreciation, but as the industry contracts this is going to become more normal, the asset base has to shrink to reflect the total macro demand.

However, I think you can get a sense of Subsea 7 managements’ confidence in the future from this graph in their 2016 annual report:

Subsea 7 Outlook Feb 17

2014-2018 look like lean years with the tap opening up in 2018. The sceptic in me always looks at the variability of the grey box (USD/bbl 40-60) and thinks the longer market sentiment remains negative the less likely this segment is likely to fulfill its potential, because the baseload of offshore projects at USD 40 is depressingly small. But if Subsea 7 shareholders expect their company to be a market leader, and if the market is moving to longer tie-ins with heated pipe, then that is the direction the company must go. What is interesting, and will be impossible to tell for outsiders initially, is how they price this in the market? If they only have 10 years to get a return on the investment the project day rate will have to be substantially higher than if it’s a 20 year investment.

You can make a bear case for Subsea 7 being too long on pipelay capacity in Brazil and for it going too early with this vessel if the recovery doesn’t come, otherwise they have arguably handled and read the downturn better than anyone. But I guess what the management really don’t want is a company that doesn’t have the asset base if the market comes back and this is only balanced against the very high cost base vessels have if they don’t work.  Again in the latest SS7 presentation they showed this market data which would give the Management/Board the confidence to invest:

Subsea market outlook Sep 2017

Subsea 7 have the liquidity to make it through to a forecast upturn and other shareholders will have the confidence they are following on the back of Siem Industries,  who have been remarkably honest about the problems they face at Siem Offshore and their commodity tonnage.

I think it likely that at the top end of SURF FMC Technip, Saipem, Subsea 7 and McDermott pull away from the other companies and create a small pool of competitors who bid for projects offshore globally that only they can realistically do given the technical sophitication and asset base required for delivery. A large number of the tier two installation contractors are no more (Swiber, EMAS Chiyoda, SeaTrucks), so the bigger contractors should gain market share on some of the more basic installations and offer a host of technical capabilities that will make it impossible for smaller companies to compete on the larger projects.

Therefore the question is whether a small number of firms bid each other out of profits or whether they create economic value? I think you can make a bull case for Subsea 7, and the other large integrated SURF contractors, based on theories of market power and argue that this is a case where if they can push the technical and asset window enough they will generate significant economic profits, and this vessel order needs to be seen in that light. This isn’t true for every segment in the subsea market and is unique to the financial strength and product breadth the large integrated contractors have.

Markets with a small number of selling firms who are in a strong position are known as oligopolies. These market structures have fascinated economists for years because of the potential for collusion and price setting (as well as the failure of the firm profits to decline over time as classical theory would suggest). But two theories, based on French mathemeticians (who looked at a spring water duopoly) allow some insight into how the SURF companies will behave in the future: Bertrand competition, which argues that companies in this position would sell on price; or Cournot competition, which argues that companies in this position maximise sales and ultimately profitability.

In a much longer post (for another day and likely of limited interest) I will argue that this likely oligopoly of large SURF contractors will compete on a Cournot model, and therefore these firms are likely to make significant economic profits, despite the capital intensity of the industry. Cournot models are defined by:

  • [M]ore than one firm and all firms produce a homogeneous product, i.e. there is no product differentiation;
  • Firms do not cooperate, i.e. there is no collusion;
  • Firms have market power, i.e. each firm’s output decision affects the good’s price;
  • The number of firms is fixed;
  • Firms compete in quantities, and choose quantities simultaneously;
  • The firms are economically rational and act strategically, usually seeking to maximize profit given their competitors’ decisions.

The high-end SURF market is a clear case of this: a relatively small number of firms (n=4 maybe n=7 in some cases) and specialised asset base, well known to competitors and easily monitored, allows firms to understand well what there rivals are doing. For game theorists it is a market made in heaven where the signalling intentions of all parties are obvious. From an E&P perspective, when you cut through the enginering voodoo language, the product is homogenous: it takes oil from a well to a transfer point. Firms will not irrationally bid down project margins constantly as they are aware of the competitive effect of doing this (which is different from when EMAS Chiyoda and other pretenders were in existence), and in reality the high-end SURF firms are well aware what projects suit their asset base and are “must win” projects. The network of alliances, and integrated solutions from the seabed, cannot be easily replicated but are not so different in technical terms that competitors cannot make intelligent judgements about a competitors cost base.

Each firms output decision will affect price because the large step increase in investment required for new capacity will make these companies more cautious is a more depressed market. The quantity theory of output is likely the least intuitive part of the theory for subsea but in essence firms will limit the supply of new vessels and concentrate on utilisation. The big four SURF contractors will only add vessel capacity when it generates profits well above capital costs – which simply hasn’t been true in the past. Over time as the new build wave subsides the firms will choose to limit the supply and focus on cash which will drive up rates (above marginal cost). This is different from a bank enforced asset freeze I have mentioned before as these companies are large enough to access asset funding.

For the tier 2 companies and vessel owners below my depressing tone of poor margins and over capacity will continue for some time I guess. But technical innovation and high CapEx, with mildly increasing demand, should allow the top SURF contractors to exercise a degree of non-collusive pricing power that will generate real economic profits in the not too distant future. These firms will take market share in the more commoditised (and shallow) field development market and face limited competition for high-end field development work which is a growing segment of the market (hence Subsea 7’s move into the Gulf of Mexico in a big way with the EMASC assets).

So despite a generally depressed industry it is easy to imagine the high-end SURF firms prospering to a certain extent. Brazil is the country however that hangs over Subsea 7 and to a lesser extent FMC Technip (and I wonder if it really sank the DOF Subsea IPO): too much flexlay capacity. It’s very hard to see how much capacity Petrobras is going to give back, but a look at tree awards suggests a degree of discomfort for the vessel owners.With one dominant customer the downside is clearly and intense period of price competition between FMC Technip and Subsea 7 in Brazil to keep their assets working. This is a classic example of Betrand competition where two firms who offer an identical product, and cannot collude, find the buyer chooses everything from the firm with the lowest price. Such a statement seems vaguely tautological but in economic terms it is more about a formal proof that two firms can push industry margins down to zero economic profits as efficiently as a large number of firms competing.

Note: For Saipem I am talking SURF only. At a corporate level I don’t see any respite for them).

(P.S. The header pictire is of a “Kinked” demand curve which is core to the oligopoly model.)

 

 

What matters more firm or industry?

So for Reach Subsea it all comes down to Q3 and Q4 this year… having raised money in February, the company came in came in with some significant losses in profit and cash flow but is fully confident its all coming right in the next two quarters. I don’t know they people from Reach, all of whom look to be very talented individuals, but I am interested in the company because I can’t think of a more structurally unattractive industry to be in than ROVs at the moment, and all the people I know in the ROV game tell me how hard it is currently with everything going out for free virtually bar personnel.

Reach has a host of competitors: i.e. M2, ROVOP, Bibby, and then the larger competitors. This is a fragmented industry and this is because the entry costs are low and the gains from scaling up the business so small given the fixed cost nature of per unit output. All the smaller companies in particular are simply finding desperate vessel owners and putting an ROV on their boat: it is not an original strategy and not one that strikes me as having great longevity once the market balances more. Every single company with ROVs is trying to hire a few project engineers and say they offer a full service not just taking hire revenue… it’s brutal and E&P companies/contractors/vessel owners are driving very hard pricing and contractual terms.

This chart from Oceaneering shows the scale of competition Reach and the other small companies are up against:

OII Vessel Fleet 31 Mar 2017.png

That is from an asset base of 282 units and strong stable revenue drill support market – although with low margins.

Last week Bibby gave up the game in Asia and sold its ROVs to Shelf for a few million. The transaction will likely reduce their revenue and cash generation potential and will make investors even more cognizant of the fact that the depleting asset base will not make paying the bond investors back possible. But as the noose of an interest bill of £35k per day tightens few options were left. The numbers I have heard suggest a sale way below book value of the asset base and that is common across the industry and the reason for that is like vessels the ROVs cannot generate the amount of cash required to pretend historic values reflect current economic values (~USD 7.5m).

I use Oceaneering as a proxy for the industry simply because with 28% of the total ROV fleet they are clearly representative of the market as a whole. Reach is simply the only listed entity of the pure play ROV companies and it therefore makes it easy to get information but the comments I make about them are appropriate for any of the smaller companies. Oceaneering has also announced it is going to focus on vessel based units and has put 18 units on long-term contract with Heerema and Maersk, and this surely is the future? Consolidation of the contractor base will see larger procurement orders from larger companies, or worse a host of smaller companies on both the vessel and the ROV side stay and operate at a subeconomic level because the exit costs would see them realise nothing?

I find the ROV industry interesting from the point-of-view of firm versus industry effects: In 1985 Richard Schmalensee published a seminal paper “Do Markets Matter?” Schmalensee was trying to ascertain if strategy was simply a matter of picking markets with strong structural characteristics, the focus of the famous “Porter’s Five Forces Analysis”, or if firms had innate features that allowed them to generate returns regardless of poor markets? A later line of enquiry that became known as ‘The Resource-Based View of the Firm (RBV)” and was made famous in management circles by the book “Competing for the Future” where the idea of Core Competencies entered the business vernacular (its digestibility masking the deep academic heritage of the ideas).

For what it’s worth I don’t think the debate on firm versus industry has been completely solved but it points to the likelihood of certain events. As always with economics you can find good arguments for both sides: Rumelt (“How much does industry matter?“) argued pace Schlmalensee that industry effects were outweighed by firm effects, McGahan and Porter (“How much does industry matter really?“) argued that actually the relationship is complex but with a weighting to firm effects being stronger, but more so in service firms whereas Wenerfelt and Montgomery (“Tobin’s q and the Importance of Focus in Firm Performance“) agree industry effects are strong but some firms defy them and outperform. I could go on…

This article seems to suggest why you can find evidence of both firm effects and industry effects:

In other words, only for a few dominant value creators (leaders) and destroyers (losers) do firm-specific assets seem to matter significantly more than industry factors. For most other firms, i.e., for those that are not notable leaders or losers in their industry, however, the industry effect turns out to be more important for performance than firm-specific factors

It’s not everything either… size does matter: profits are positively correlated to size in broad cross-sectional research.

I read it that you are either a statistical outlier or the fact is the industry effects will dominate your likely financial performance. The clues to being an outlier, originally called strategic rent factors by economists, but made far more palatable by the consultants who created entire teams that specialised in “core competencies”, are now well accepted. To be a positive outlier Peteraf outlines:

four conditions must be met for a firm to enjoy sustained above-normal returns. Resource heterogeneity creates Ricardian or monopoly rents. Ex post limits to competition prevent the rents from being competed away. Imperfect factor mobility ensures that valuable factors remain with the firm and that the rents are shared. Ex ante limits to competition keep costs from offsetting the rents.

In diagrammatical form it looks like this:

Cornerstone of competitive advantage.png

Note economists call profits above breakeven “economic rents”. I should obviously point out that while it’s easy to look back with hindsight about this creating these rents is considerably more difficult and represents the dividing line between economics and management.

The diagram in simply says:

  1. Heterogeneity: Firms must be different and the profits must come from limiting the supply of factors (monopoly) or an inability to increase those factors that drive profits in the short run (Ricardian)
  2. Ex post limits: Essentially the imperfect imitability and substitution from the ‘Porters’ Five Forces’… not everyone can copy what your firm does or replace your product service with a substitute
  3. Imperfect mobility: A competitor can’t just go and buy your superior skills on the market. For example anyone could approach Airbus suppliers but could they really build a plane?
  4. Ex-ante limits: Not everyone decides to do the same thing before it becomes profitable.

Prahalad and Hamel became famous because the summed this up with three factors they said made something a “Core Competency” if it:

  1. Provides potential access to a wide variety of markets.
  2. Should make a significant contribution to the perceived customer benefits of the end product.
  3. Difficult to imitate by competitors.

So to bring all this back to the ROV market I think you can argue that a wide base of economic research says this is structurally a very unattractive market: low barriers to entry, easy substituability and imitability, high customer bargaining power, and intense competiton. And I look at most of the small ROV firms, not just Reach, and I see no core competencies or economic factors that would give rise to economic rents (i.e. profits above break-even) and a lot of red ink still being spilled. I see lots of good relationships, smart people, and great technical skills; what I don’t see is a lot of differentiation on anything other than price.

All of which leads me to believe none of the smaller ROV firms satisfy any of the conditions that would allow them to be statistical outliers against industry trends. They are all offering to put cheap ROVs on vessels and work at marginal cost only hoping someone else goes out of business first which makes them a hostage to industry forces only. I can’t see anything other than a wave of consolidation as the larger companies, who can manage their ROVs cost base better by cross-subsidising it while times are poor, taking the smaller companies who eventually struggle to fund OpEx. Sooner or later there needs to be a reduction in the number of operating ROVs to restore the industry to “normal”/breakeven profitability and the smaller companies simply lack commitment that the larger companies have.

I could be wrong… I have been before… I miscalculated for example how good a deal Subsea7 had struck on the EMAS Chiyoda assets … and I think we are in for a better market in some segments in 18 than 17, but continued cost pressure will favour well capitalised substantial companies in this industry not start-ups/growth companies I feel in this market segment… but getting there could be financially painful.

Generational change coming in North Sea DSV market…

I was told DeepOcean has hired Jerry Starling to set up a diving department: this marks the start of the new competitive landscape that looks set to shape up the North Sea saturation diving market. DeepOcean have the perfect competitive position to break into diving with a large backlog of work from windfarms (increasingly at depths that make SAT diving profitable), excellent relations with an IRM customer base, and a very good operations department skilled at running complex vessels like the Maersk Connector. Clients know and like them and diving is just a fill-in service.

But the real significance in economic terms of this is that it signals how the structure of the market no longer provides the profitability it used to. Quite simply a shortage of North Sea class DSVs, and the high fixed cost commitment to either a charter or ownership of one of these vessels, combined with the investment in location specific infrastructure that is expensive, provided a classic “barrier to entry” for North Sea diving that simply didn’t exist anywhere else. Over time these very high margins were noticed by vessel owners, who built new tonnage, and investors (like LDC and Oaktree) who added capacity, meaning even by 2014 margins were declining. Pretenders tried to imitate but either didn’t have the capital (Bluestream with the Toisa Paladin) or infratsructure (Mermaid/ KD Diving/ Mermaid Endurer).

While these very high margins made it sensible for these companies to invest in this business DeepOcean and to a lesser extent Boskalis were working away at the less sexy end of the market in trenching, ROVs, widfarm work under civils contracts. This work looked low margin in comparison but was completely countercyclical.

And then demand crashed and everyone got left with some very expensive vessels and not enough work as the IRM market declined more than people thought and the construction DSVs came down to take maintenance market share. First Harkand folded and now it appears almost certain Bibby Offshore will as well. Both have suffered for the same reason: if you pay c. $100-150m for a North Sea class dive vessel (or take on financial asset exposure to the same amount) you need 250-270 days utilisation to break even at around USD 150-180k per day. Since 2015 there has been nothing like that sort of utilisation, especially for the smaller players.

The market was bid down in 2016/ 2017  by reducing the day rates to effectively cash OpEx only with no return for the vessel. When you have the balance sheet of Subsea 7 and TechnipFMC this is sustainable for a while as effectively the equity portion of your balance sheet adjusts to reflect this. When you are highly leveraged with an undiversified business model, as both Harkand and Bibby Offshore were, that isn’t an option.

The loss is being taken on asset values, eventually DSVs will be mean reverting assets i.e. their value will be derived from the cash flow they generate and this implies a substantial reduction from the book value of some vessels. It is for this reason that I don’t think much has changed for the Nor bondholders: the two DSVs will only generate a minimal number of days work for the foreseeable future, with a high operating cost (including SAT maintenance), and as recent work has shown potentially long transit times. The capital value of such assets isn’t USD 60m and the really interesting thing will be how the next liquidity issue for the bonds is priced?

JS is close to The Contracts Department, who run the Nor vessels, but there has never been a better choice of DSVs. It would be hard to see DeepOcean going for two DSVs in one season so while this is better than nothing for the Nor bondholders it is very hard to see this being the “get out of jail card” they have been looking for. DeepOcean know the market well enough not to overpay for a vessel and it is highly likely they could get a risk based charter from Nor that would be lucky to be even cash flow even in one year. Given that the Atlantis needs serious crane work and a major thruster repair (at least) to get it working there would appear to be no way to avoid another cash call.

But it will be a different story for DeepOcean. They will gain a vessel on an extremely attractive charter and ease themselves into the SAT diving market with an OpEx margin and the vessel risk guaranteed. They will choose from Nor, Vard, Toisa, China Merchants (unlikely I agree), Keppel, and potentially the Topaz in terms of tonnage. DO will then drop a chartered vessel and try for maybe 180 days SAT diving in years 1 and 2, more if they get lucky. But the charter rate to support that, and therefore the capital value of the asset, isn’t USD 110m per vessel, or more for the Vard/ Keppel etc. DeepOcean’s shareholders don’t need to, and aren’t in the business of, helping distressed vessel sellers.

I have made my comments on McDermott and Bosklis before and see no need to repeat myself again. My view is that Boslalis with windfarm work are better placed than MDR to either buy Bibby Offshore or expand organically, as I am not close to McDermott I have no idea how aggressively they will chase this. But there is no doubt with substantial UK dredging, cable lay, and now Gardline Boskalis appear to have the most synergies for any deal.

The Bibby Offshore results were made public this week and I don’t want to say much. This blog was never meant to be anything other than my thoughts on how I had become involved in a credit bubble and other random thoughts.

My own view, as I have said many times before, is that Bibby Offshore will not survive this. The problems involved in a recapitalization are intractable and restructuring is more likely, with a trade sale of certain assets being the most likely outcome, and certainly in the bondholders’ best economic interests should a competitve auction be established. It gives me no pleasure to write this because my time at BOHL was an enormous learning experience and for the most part enjoyable.

I could write a long post but the basic reason is very simple: the company borrowed too much money and the current shareholders simply do not have the financial resources to reverse this course or indeed (just as importantly) the economic rationale to do so. The bondholders lent them too much money, lending bullet repayment on depreciating assets is madness, maybe therein lies a solution, but I doubt it because the MSAs, systems etc have more value to a player growing organically than negotiating a massive writedown and capital injection for the bondholders.

No one in this market puts equity into a business behind £175m of debt and poor cash flow generation. No one will invest a super senior tranche because this isn’t simply a liquidity problem. The entity that has been created and the operating model is inherently uneconomic and the scale of change required too big and too risky for a private equity provider to follow it through in a way that would allow the company to remain independent (in my opinion).

Talk of BOHL lasting until 2018 is simply a fantasy to my mind and doesn’t reflect (again) the seriousness of the situation. Being down to £7.2m at June 30, after having gone through £62m cash in the last 12 months, and allowing a slower run rate loss now vessels have been redelivered/ entered lay-up, implies the cash would be down to about £5-6m now (allowing the 46% DSV utilisation BOHL stated). Someone really needs to explain why the June interest payment was made.

It is impossible to see the OpEx being funded by the RCF, and indeed without serious hope of a new investor, willing to be behind the revolver of £13.1m and agreeing a deal with the bondholders, and no backlog, the RCF offers no solution and only prolongs things.  As soon as those figures were published in SOR every CFO in ABZ told his project staff not to contract with BOHL as the credit risk is simply too great… its like a bank run that becomes self fulfilling.

It must be an extremely worrying time for the staff involved an my heart goes out to them (having been in that position once I can genuinely understand). One thing the Bibby Family/ BLG could do to minimise this is ensure all staff are paid their contractual notice period as under any reasonable financial/ legal assumptions the BOHL simply doesn’t have the money for these to be honoured and the legal structure would prevent them from being treated as preferred creditors.

A North Sea DSV market without Bibby Offshore turns the clock back 15 years. Two large integrated contractors will control the oil and gas construction market and two will dominate the IRM and windfarm market. They will meet in the middle on some jobs. But the overall industry will not return to the supernormal profits of earlier years due to persistent overcapacity of DSV tonnage and lower entry costs. Boskalis and DeepOcean are also likely to bring a degree of civils cost control to the industry that keeps margin depressed: it is a microcosm of the whole industry to my mind.

Offshore and shipping recovery cycles…

Clarksons reported results yesterday and offered the view that that shipping cycles seem to be turning. The interesting thing is the scale of the retrenchment in the traditional shipping sector that has been required to being the market back to equilibrium (if they are right). Traditonal shipping had a boom driven mainly by Chinese raw material imports (and to a lesser extent exports which were less bulky):

Clarksea Index.png

Chinese import and export growth:

Which looks somewhat similar to the oil price and investment boom:

It is worth noting that if Clarksons are right it has taken 8 years since the slump for normality and equilibrium to start to emerge. The scale of the pullback is severe with tonnage delivered down from 2047 vessels in 2013 to 217 in 2016 (a 90% reduction) and only 266 orders for 2017. Shipyards are down from 305 to 50 (an 83% reduction). It shouldn’t be a surprise because the assets are built for a 20-25 year economic life, the offshore subsea fleet is smaller (~600 vessels), but each one had a high build cost, whereas offshore supply with its larger fleet and more commodity like structure looks set to suffer a similar pull back.

The other really interesting data point Clarksons highlight is the decreasing loan exposure banks have to the sector (which I am assuming covers offshore as well):

Global ship finance lending volumes

Source: Clarksons, 2017

Lending volumes from the top 25 banks, surely more than a representative sample and clearly the most important by size with DNB Nor having 5x greater exposure than KDB, is down 25%, over $100bn,  over a six year period. More than any other factor this is surely helping the sector rebalance but it will keep a check on asset prices for years, especially as getting a loan for a ship older than 8-10 years is nigh on impossible.

The historical reasons for the shipping boom are analogous to the oil price boom that drive offshore: As China boomed so did commodity shipping, this quote should be well understood by anyone in  offshore this quote should be well understood by anyone in  offshore:

Less than a decade ago, just before the global financial crisis, the largest of the commodities-carrying bulk ships cost some $150 million and commanded as much as $200,000 a day on charter markets. Today, a similarly modern capesize class ship is worth $30 million and a vessel owner can expect to earn just $9,000 a day in a business where the prices for iron ore, coal and other industrial goods have deteriorated.

Ships that were increasing in value (as day rates rose) were used as collateral to borrow more money from banks to buy more ships in a self referencing cycle. Which is exactly what happened in offshore, and when even the banks got nervous the high yield bond market was tapped. What could possibly go wrong?

Banks hold the key to the restoration of normality. Like normal shipping offshore will require dramatically more equity and lower leverage levels going forward. Capital will be significantly more expensive. Banks, especially those in the graph above, that continue to take large losses on their portfolios, will be very reluctant to materially increase exposure and will continue to wind the loan books down with concommitment reduction in asset prices. This will go on for years as the above graph makes clear. Yes some smaller newer banks (e.g. Merchant and Maritime) and specialist lenders will fill the void, but rationally they will charge much higher rates (as they will have a higher funding cost to reflect the risk) and will require more equity. As retained earnings are lower this will take longer to build up.

Many of the new shipping projects at the moment are 100% equity financed and until asset values stabilise even newer players are likely to avoid offshore. Slowly, over years when combined with scrapping, the offshore fleet will rebalance, but it will be a long way off. Offshore would appear to be closer to the start of its journey than the end (a point Clarkson appear to agree with in their research). Nearly all distress investors who moved in 2016 looks to have moved too early (e.g. Standard Drilling, Nor Offshore) and faces a capital loss on the positions taken as opposed to industrial companies buying one-off assets (e.g. McDermott), With high running costs and demand stagnant its hard to see 2017 being any different. 

As the author of the above quote notes:

A sizable part of the portfolio of nonperforming shipping loans cannot be expected to bring market pricing much higher than the scrap price of the ships collateralized, however. In this case, shipping banks can take a deep breath and mark them to scrap value, and then make certain those ships are dismantled and removed from the market. Under this scenario, the immediate accounting losses would be mitigated over time by a more balanced market which theoretically will push freight rates and the value of the remaining ships higher.

Whatever path they take, European banks will be shaken by the unfolding of their shipping loan portfolios. Their capital structures will be affected, and given the freight market and banking regulatory headwinds, their appetite for ship finance will be diminished. The shipping industry likely will never be the same.

The same can be said for offshore I suspect.

The New Offshore… it looks a lot like Italian and Spanish banking…

The oldest bank in the world, Banca Monte dei Paschi di Siena SpA, founded in 1472, came under government control today. The bank, founded as the “Mount of Piety”, has been through numerous capital raisings and life support packages since 2008/09, and finally, even the Italian government and the ECB could no longer pretend it was solvent. I have lost count over the years of the number of times the ECB has declared the banks solvent (only last December the MdP fundraising was announced as “precautionary”), but shareholders who have previously be forgiving have had enough as has the Bank of Italy. There are some clearly analogous lessons for offshore in this.

European banks and offshore oil and gas contractors share many of the same issues. For years now central banks around the world have kept the price of the core commodity that banks trade in (money) low, interest rates at the Zero Lower Bound (“ZLB”) has become the new normal and banks struggle to the margin they used to between the money they borrow and the money the lend.

Another clear similarity between the banks and offshore contractors is excessive leverage. Banking is actually a pretty risky business (which is why banking crises and state bailouts are increasingly common), banks borrow short and lend long in a process known as maturity transformation. What this means in practice is that when you go into your friendly branch of DNB with your Kroners and deposit them you are lending the bank money and they are making a loan contract to pay you back a fixed number of Kroner. DNB then package up all the Kroner in the branch and turn it into a ship in the form of loan contract which they use to pay you back. The problem arises, as it did recently for DVB, when the value of the ship, or just as importantly the income from it, is worth less than the value of all the loan contracts the bank used in financing the ship. One or two doesn’t matter but if all the ships are worth less then the bank has a problem. This mismatch between the obligations that banks take on to finance assets that can vary hugely in value is the feature of nearly all banking crises, certainly in shipping as the German banks know well, but also the cause of the 2008/09 global financial crises. This is the fundamental instability mechanism in an economy that fractional reserve banking introduces.

Offshore has a similar instability mechanism and it too is a function of leverage. As the volume of work has dried up the fixed commitments owed to banks, bondholders, and other fixed rate security holders who were used to purchase vessels, assets, or finance takeovers has remained constant while the asset value has cratered and the revenue has done the same. Like a bank the asset side of the balance sheet is being severely strained at the moment as the revenues and profits simply cannot support historic commitments. It was this model of viewing the creditor run on Ezra/Emas as comparable to a bank run that made me sure there was no route to salvation for them. This transmission mechanism is destabilising all asset owners as banks are not lending on assets of uncertain value and the size of some of the writedowns is an issue for the banks. These sort of self-reinforcing loops are very hard to break.

Like the banking sector offshore is struggling with a the tail of a credit boom which is obviously related to the excessive leverage taken on. As has been shown many times over in research credit booms, in all contexts, take longer to recover from than other types of investment bubbles.

Historical analogies, no matter how interesting, are only good if they give us some insight into the future. In this case I think they are depressingly clear: since 2008/09 Spanish and Italian banks have created a structurally unprofitable industry that is unlikely to change with government intervention. Offshore contracting and European banks are both trapped in a low price commodity environment and burdened by historic asset commitments and the current economic value of said assets. European banks have overcapacity issues but shareholders and other stakeholders are committed to keeping this structure because of previously sunk costs and very high exit costs.

The banking crisis in Europe should be a lesson to offshore that impairments in asset values can be permanent. Mian and Sufi (read their book), after looking at the US housing crisis, propose shared risk mortgages where banks share in the capital value, such a suggestion seems prime for shipping and offshore gievn the extraordinary volatility in asset prices and the levels of leverage common in these asset transactions. The cynic in me says regulators would need to force this through, but I also believe eventually German taxypayers will tire of supporting the global shipping industry.

Another lesson to be drawn for offshore is that consolidation favours the large, there is a flight to quality. JP Morgan now has a market cap of roughly USD 336bn post crisis and would appear untouchable as the worlds largest bank (considerably larger than some central banks) after a series of well excuted post-crisis transactions. TechnipFMC has similarly become the largest offshore contractor through an astute merger (imagine if they had really brought CGG!) and if they can ever resolve the tax situation with Heerema will become untouchable as the largest and most capable offshore contractor.

Unfortunately for smaller players size counts. In a bank run people worry that the institution will not be there in the future so choose to withdraw savings because they are nothing but a loan to the bank. Similarly E&P companies who contract with smaller contractors are merely unsecured creditors if they fail despite the progress and procurement payments and therefore are at a considerable disadvantage in winning large contracts in a challenged environment even if they are substantially below the competition in price.

Another lesson is that there is no substitute for equity capital and the larger players have an advantage in raising this. Bank balance sheets have changed substantially since the financial crisis at it is clear that offshore companies that want to surivive will have a much higher componenet of equity in their capital structure. The quantum of this capital will be a major issue given the continued low profitability for all but the largest players in the industry,

But the clearest lesson to take unfortunately is that barring a major exogenous change the zombie banks, neither dead nor alive, can continue for a longer period of time than anyone would really like. Offshore is facing the same dilemma as 2018 looks to be quiet, relative to 2014, and OpEx continues to be a major problem for companies. There is no quick fix in sight unfortunately.