Bibby Offshore restructuring… End of an era…

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

DOF Subsea, Bibby Offshore, and The Pecking Order Theory…

We always plan too much and think too little.

Joesph Schumpeter

We were succeeding. When you looked at specifics, this became a war of attrition. We were winning.

General William Westmoreland on US involvement in Vietnam

DOF AS/ Subsea reported numbers yesterday that were frankly terrible. All those who keep telling you the market is getting better seem blithely ignorant of the constantly decreasing financial performance of nearly all the companies in the sector. It’s like Comical Ali or General Westmoreland constantly assuring everyone that victory is just around the corner, if not in fact delivered. Tendering, like the Viet Cong, never ceases to stop appearing in increasing numbers, and it will bring victory…

I have another theory why tendering is increasing: there are a lot of engineers who are worried about their jobs. In a completely rational strategy they are increasing the number of parties who receive tendering documents, spending more time assessing them, and making the tenders ever more complex. Turkeys don’t vote for Christmas. More people appear to be spending increasing amounts of time and money on the same tenders and it is making industry margins even thinner, and allowing management to claim that completely unproductive work is actually a sign of an industry returning to health.

But back to the numbers… this is the same DOF Subsea that as recently as Q1 and Q2 this year was hoping to get an IPO away. It’s a good reminder, as if anyone needed one, that when insiders are selling out you should be wary of what you are buying. I call it the Feltex Carpets or Dick Smith theory. Economists have however developed a far more robust theory about how firms decide on their capital structure: The Pecking Order Theory. It’s based on the information asymmetry that exists between the insiders of the firm (shareholders and management) and the outsiders (investors and funders). Basically it’s a deeply cynical view (which probably means it is right) that managers and owners use internally generated funds first, then use debt and only issue equity as a last resort.

In a classic paper Myers and Majluf (1984) argue managers and owners issue equity only when they believe it is overpriced. It is very hard not believe that early in 2017 the insiders at DOF Subsea (i.e. the private equity owners) looked at the vessel schedules and the likely win/loss ratio of the tender pipeline (not the amount of tendering), and decided that if they could dump some stock they would. Luckily investors are aware of the asymmetric information problem and “they discount the firm’s new and existing risky securities when new issues are announced“. Or in other words they just refuse to buy at the asking price which is what happened in the DOF Subsea case.

You should always be wary of financial presentations that start with highlights that don’t include any financials (like the latest DOF Subsea one). Just to be clear the DOF Subsea revenue was down 11% on the same period as last year and EBITDA was down 6%. Luckily, they are doing more tendering.

DOF also helpfully provided this chart of the business:

DOF Business Model.png

Basically without the long term chartering business, which is really just a risk diversification move by Technip, there is no business: the 10% EBITDA on the projects side wouldn’t cover the economic costs and frankly potentially the cash costs either. This is a business where unrealised gains from derivatives (probably interest rate and/or currency swaps) were 6 x the operating loss for the period of NOK (41m).  Year to date DOF Subsea has had to turnover NOK 2.8bn to get a mere NOK 45m in profit. It is pretty clear from the above that actually the projects business, with 17 very expensive fixed costs assets, is not an economic entity; and as I have said before you need a very good return on the vessels on long-term charter in Brazil because as the above graphic makes clear if their contracts aren’t renewed (and no one believes they will be on anything like the current terms) then the value of the vessels will drop like a stone if you believe at some point a vessel is only worth what it can earn in cash terms. The number of other activities you can perform with a 650t vertical lay system is actually pretty small which lowers resale value regardless of how much it cost to build. In which case the value of the business is probably much smaller than the current shareholders would be willing to admit to themselves. Time is not a friend to the investors in this deal because everyday they hold this company future investors get one day closer to finding out what happens in Brazil.

DOF Subsea is a pretty good projects house and the EBITDA margin is just a reflection of market overcapacity. If you were going to invest new money in a subsea projects business you would need therefore to look at that as a realistc EBITDA margin you could earn for the foreseeable future until further supply capacity leaves the market or there is a significant increase in demand. Bear that in mind if you were, for example, looking at injecting funds into a company about to default on its bonds…

The Pecking Order Theory is also helpful in explaining (some of) the shennanigans involved in the Bibby Offshore attempted refinancing at the moment. The insider shareholders in this case also saw the writing the on the wall and in January 2016 took a cheeky £20m off the table in the form of a dividend (after a c.£40m dividend recap that was flagged in the prospectus). In the next 12 months Bibby Offshore lost £52m at the operating profit level, and it must have been known to the Directors by June 16 that without some sort of miracle the business would require a restructuring (which to be clear is an event of default as defined by the ratings agencies even if consensual). It was certainly apparent to any responsible Director by Oct 16.

Bibby Offshore cannot realistically make an interest payment in December, and management have qualified the accounts such that it is not a going concern without a refinancing. And now  the insiders (Bibby Line Group and management) have decided they want outsiders to put money in. They don’t think the equity is overvalued (they know it is valueless);  the insiders think the debt overvalued is and there is too much of it. All the talk of a supportive shareholder reveals it for the sophistry it is: the insiders don’t believe enough to contribute financially. BLG aren’t putting in any of the £60m they have taken out not just because they don’t have it but also because they know the business better than anyone and The Pecking Order Theory makes clear they want someone elses money here.

One deal that is on the table is some “Super Senior” financing (i.e. paid before anyone else) provided by the distressed debt desk at Deutsche Bank. Now Deutsche are arguably the best desk at this in the City, but if you need this sort of financing it is pretty much the end of the road. If EY have resorted to the distress desk at Deutsche as an alternative it shows that no long term investor is interested. This form of financing is more suited for a company in bankruptcy (where it is called debtor-in-possession financing) than for one imminently approaching it. The Deutsche plan would be to lend fully secured against the Polaris and the Sapphire and give Bibby enough money to make until next summer when DSV day rates miraculously improve and the business can service this new debt and bonds. But don’t the bond holders own those boats I hear you ask? Yes. And I am not close enough to this to know exactly the specifics but the security agent is only likely to hand over the ownership papers to the vessels if the bond holders agree to this (I guess); and (I guess) Deutsche would only advance the funds in conjunction with a writedown of their claim. Unbelievably management will argue they are they best people to trade the business out of this mess.

The real tension here appears to be how much equity the bondholders take, and how consensual the handover is, as the business undertakes a debt-for-equity swap. The bondholders can hold out for 100% of the equity as their only other asset apart from the DSVs (and a couple of ROVs) is the shares of Bibby Offshore, but in  order to follow through on this they have to push the company into administration and a liquidation scenario is completely possible at that point as customers and suppliers refuse to trade. The Bibby/Management/EY plan envisages a far more generous structure whereby any money Bibby Line Group put in is also fully secured and they retain majority control so they can consolidate Bibby Offshore in their Group accounts (20% of net assets). The problem with this is of course that BLG don’t have anywhere near enough money to put in proportionately.

A nightmare scenario for the bondholders is taking over a company in such circumstances where agency conflicts abound and in a practical sense now it is a hostile takeover with management having acted until the last possible moment to realise the rights of the debt holders. It is arguable for all of this year Bibby Offshore should have been run with the creditors interests at the forefront of all decisions and it is clear that this has not happened.

In case you’re wondering what is in it for Deutsche: it’s the fees. They are looking at advancing c. £20-30m on the vessels and it would have to be cleared before the bondholders get paid. They would get a 7 figure upfront fee and an interest rate of c. 15%, and if a default occurred they would sell the assets in a fire sale to get their money as quickly as possible. Which is why you can’t get much money from such deals because the bank needs to be conservative here (and I think this deal will die on broker valuations given the likely fire sale prices of Polaris and Sapphire). The problem is of course that debt got Bibby into this mess and it is very unlikely to be the cure to get them out of it. I don’t think the Deutsche proposal has passed credit committee and even though they would make an eye-watering fee on the this the risk is clear: becoming the proud owner of 2 x North Sea class DSVs (and as their offices are some way from the Thames they wouldn’t even add to the famed Deutsche art collection).

With no significant work booked for next year the Bibby plan relies 100% on day rates increasing significantly above current levels. And therein lies the real problem for the bondholders and any potential distress desk coming in on this: at some point the only solution to a market in oversupply is for some capacity to go. How can Bibby credibly claim to make a better margin than DOF Subsea? At the moment Boskalis look almost certain to enter the market in a big way and other companies are also looking to enter the market. Not only does Bibby need tens of millions of pounds under its current cost structure just to make it until next summer there is actually no certainty that this magical scenario of higher rates will allow them to come close to settling the outstanding debt obligations they are generating to get there.

DOF Subsea made clear that while tendering activity is robust project work is dismal (and indeed they made a specific comment that amounted to a profit warning about it). At 7.0 x debt to last-twelve-months EBITDA DOF Subsea (and everyone else in the market) will be throwing everything into trying to win work… all the non-DSV work will compete with Bibby (no one really expects them to reactivate the SAT system on the Achiever) and they will keep margins at ~EBITDA breakeven in order ot get utilisation. As a committed industrial player that is a rational economic strategy. Subsea 7 and Technip are booking DSV days at less than £120k for 2018 to get utilisation in early and they can clearly keep this up virutally indefinitely. The dumb non-industrial money won’t last as long as those with an operational logic and an industrial strategy + balance sheet in this market.

The problem for the Bibby bondholders is that not only at current prices (.36) have they capitalised the firm at c. £63m, way above what it could hope to earn in an economic sense, it also needs £20-40m just to keep trading until next summer.  The major competitors have no cash flow issues (Boskalis has €1bn in the bank) and every reason to chase market share over profit. There is therefore no rational economic reason why under this scenario North Sea class day rates will rise, particularly if Boskalis enters, and every reason to believe they will stay at current levels. Any rational investor in Bibby Offshore would shut down everything apart from the UK business, but 2 x DSVs in the UK doesn’t justify anything like £60m in value…

The Nor bondholders tried super senior financing on their DSVs in Nov 2016 and it is clear, as they slowly run out of money and cannot raise anymore at anything like the 15% fully super senior they did last time, that when someone says you can’t lose on a North Sea class DSV, you can on some. It’s all down to asset specificity as I have said before. Deutsche and other distress desks will be well aware of the mistake the Nor bondholders made, and frankly if I was going to make a mistake on two DSVs I’d rather do it with the Nor vessels than the Bibby ones.

This will all be resolved soon. A bondholder meeting is scheduled for next week and everyone will lay out their plan. The problem is of course there isn’t one really and it should never been allowed to have get this close to Dec 14 when the interest payment is due. The Bibby plan is for it to continue as a lifestyle business where external investors allow the family and management to stay in control and fund it until the market returns. A few (27) redundancies are underway but in a microcosm of the cost and conflict issues that define the company the CEO’s wife, who runs the Business Excellence department, is staying , as is the Director of Small Pools and Innovation, while the Engineering Manager is made redundant (seriously).

The Bibby plan relies on a small number of bondholders, enough to block the majority, being so afraid of the great unknown they back them to carry on as before. This will just delay things until next summer because the cash burn is just so high that even £20-30m would be gone by this time next year without a wholesale change in market conditions. Handing back the Olympic Bibby cuts the cash burn, and may allow the business to come close to cash break even, although the US will make another substantial trading loss in 2018 as will Norway (and without the Ares why bother?); but doesn’t solve the core problem that the business itself is unprofitable at an operating profit level. Call it the slow-burn and pretend strategy. It was disastrous for Nor as eventually reality comes and the cash is gone. As plans go it is pretty terrible.

But the bondholders don’t have a good one either. The bondholders appears to have spectacularly misread the willingness and ability of Bibby Line Group to support Bibby Offshore as well as how badly the business would perform in 2017 versus 2016 (revenue -50%). Some of the funds involved in the bonds don’t need money from an institution like Deutsche, but unless they control the company they have to hold a bondholder vote every time they want to make any significant moves, and letting the company go into administration risks a total wipe-out of value. Stripping the company back to a smaller business locks-in a loss, continue funding it until the market returns is simply throwing good money after bad and it’s real cash. If they do take the business over they will have an awkward period where almost the entire senior management are changed out and they will be cash funding a business, with an unknown financial commitment, while their consultants re-do the numbers and tell them how much capital they will need to inject. I have done that as a management consultant and it is hugely destabilising while it goes on and makes normal operations almost impossible. If if takes consultants 6 weeks to produce an initial report (30 working days), and Bibby Offshore is losing c. 100k a day in the interim even an emergency facility of £3m + £1m for the consultants is real money given the limited upside sale potential. And then they are only in February with a real funding commitment until the mythical summer season that will save everyone… until it doesn’t…

There is a more complicated scenario here where the Bibby Offshore is restructured through a pre-pack insolvency that the current bondholders control. This will remove the historic liabilities incurred (i.e. property leases, Trinidad tax) and see a new company emerge free of its past shareholders and with a new capital structure. I think this the most likely but it will be a dramatically smaller business and will be run solely for sale ASAP. I also see no guarantee it will realise more value than a liquidation despite it being enormously risky given changing market conditions.

The Bibby Offshore refinancing is a mess and liquidation is clearly a very real possibility here. Getting to less than 28 days of an interest repayment before trying to finalise a refinancing is irresponsible in the extreme when it has been telegraphed for months and your plan is simply not to hand the company to the bondholders. The only thing I can definitely tell you is that if you brought Bibby bonds at .36 you are going to lose some real money here.

Subsea 7 and Conoco Phillips… industry bellwethers…

[N]othing can have value without being an object of utility.

Karl Marx

[I couldn’t agree more with the philosophy outlined in the Conoco Phillips graphic in the header].

A stark contrast in the fortunes of two companies reporting numbers yesterday and it doesn’t take a genius to work out that an E&P company (Conoco Phillips) is benefitting from a higher oil price while an offshore contractor (Subsea 7) is suffering from lower committed offshore spending. But I think it’s worth delving into a little deeper because the scale of the changes taking place in investment terms I think provide a note of guidance for how the future of the industry will look.

CP makes an excellent E&P company to use as an example. In 2015 CP announced they were giving up deepwater exploration but not deepwater production. All economic change occurs at the margin, the change in preferences of different actors in the economy melding into demand and supply curves which intersect at equilibrium points: in this case the decision to invest in deepwater production, or not, depending on market conditions. CP looks to be a hard task master in this regard: based on the statements and actions they have taken if CP decides to invest in offshore production others will as well.

I start with CP because E&P demand for offshore services is obviously crucial. Firstly, and this is not an original thought, the entire tone of this presentation (Q3 2017) is geared to financial returns to shareholders (you should actually read the whole thing to sense this) at the expense of production growth. Just as Shell, and other E&P companies have done, there is a signalling effect that this is a company that will not turn an oil price rise into a feast of mega-growth projects:

CP Priorities

The whole focus is being able to pay dividends even at a $40 per barrel price, gone are the 2013 days of boasting about reserve replacement ratios in excess of 170%. CP helpfully shows that this focus has helped them outperform their peer group: Executive level pay generally includes a link to performance against a defined peer group, if other E&P managers start losing bonuses by not being as disciplined on returning money to shareholders as CP, and their share price appreciation is less, their strategy will change extremely quickly. But in reality all the big companies reporting now are making “credible commitments” to return any excess cash to shareholders and focus on demand increases through short cycle production. Just as it would take years to turn investment decisions into projects now so much offshore engieering capability has been turned off, so too it will take a long time to change this investment narrative and performance incentive system in E&P companies that drive offshore demand. Any perceived linear link between an increase in the oil price and an increase in offshore demand is wrong in my view.

COP Works.png

Secondly: CapEx: for the 2018-2020 period CP is guiding sustaining CapEx at $3.5bn per annum and $2.0bn for expansion. Of the $2.0bn expansion $1.2bn is short-cycle unconventional and only $0.5bn for conventional/offshore and $0.3bn for exploration (split evenly between conventionals and short-cycle). To put that in context in 2012, when the offshore industry was going long on boats and rigs based on future demand, CP guided 2013 CapEx at USD $15.8bn! Of that 10% alone ($1.6bn) was for the North Sea and Alaska (i.e. offshore), 26% ($4.2bn) was for short-cycle, 15% ($2.4bn) for offshore Angola and GoM, and another 14% ($2.1bn).

Graphically it works like this: To keep production constant CP will spend $3.5bn

2018-2020 Flat Production.png

The green is entirely offshore. But to increase production:

COP Growth Production.png

The green in the second graph is almost all historic commitments. That is the future of offshore in a microcosm for the largest independent E&P company in the world and historically a major investor in deepwater offshore. The point is, for those bored of the minutiae, that CP have knocked ~$9.5bn off theirCapEx (60%) in 5 years (they have also divested assets so its not a straight relative comparison) and that the portion devoted to offshore is really related to legacy investments only now, not new fields or developments.

Third: productivity. I keep saying this but the productivity improvements look real to me the economist, as opposed to some of the geologists I know, who argue shale is bound fail:

CP Shale Productivity.png

The last line: >50% more wells per rig line! It’s all about productivity and scale and large companies investing in R&D are extracting more for less on a continuous basis from their shale wells. This is becoming a self-reinforcing cycle where they invest, improve, and re-invest. As I say here often: Spencer Dale is right.

This is the link point to Subsea 7, and all the other subsea contractors frankly. Subsea 7 have performed better than most other contractors throughout the downturn (not McDermott), but the issue is backlog and the pace of future work delivery: as CP seeks to please the stockmarket by avoiding all but the most promising of offshore investments (if any), SS7 and others must show huge declines in their order backlogs which de-risk a hugely expensive and specific asset base. I have said before I think you almost need to value subsea contracting companies like a bank: they fund long-term assets with a series of shorter duration contracts of uncertain redemption value, yes they have a much higher equity cushion, but they need it as they are borrowing short from a market to fund long term assets. Certainly smaller contractors are susceptible to “runs”.

In the last quarter SS7 had revenue of ~$1bn but it took in orders of only .5 of that (book-to-bill ratio) in new orders which left it with a backlog of $5.3bn (against liabilies of $2.4bn). At Q4 2013, when companies like CP were spending all their CapEx, SS7 had backlog of $11.8bn (against $3.8bn of liabilities).

Now SS7 is a well managed company and as can be seen they have reduced debt as the downturn continued, continued to return chartered tonnage,  and they have over $1.2bn in cash, so there are no problems in the short-term. But if you were owed money by SS7 I would rather be owed a higher amount backed by nearly 3x backlog than owed a smaller amount by 2x (a declining) backlog. The problem is the pace at which all the contracting companies are eating through their backlog of contracted work that was at a significantly higher margin than the work they are bidding for now. The actual booked backlog number is the only certainty guiding real expectations of future profitability.

It is a function of the SS7 business model that they have an extremely long position in very specialist assets that sap meaningful amounts of money from companies if they are not working as the graph from the FMC Technip results makes clear:

Technip margin erosion.png

The single largest fact in Technip’s declining subsea margin is lower fleet utilization. If Technip and SS7 are expecting poor utilization in 2018 then it is locked in for the rest of the supply chain.

The fact is the huge offshore CapEx pull back and reallocation by the E&P companies is continuing unabated. Offshore allocations may not be declining in real terms any more but E&P companies are making clear to their shareholders that it isn’t going to materially increase either. The offshore fleet built for 2014 isn’t getting a reprieve from the Oil Price Fairy, the gift from that fairytale should it come true for the E&P companies will be given to shareholders, who after the volatility they have suffered in recent years feel they are owed higher risk weighted returns. E&P companies are locking in systems and processes that ensure their procurement in the supply chain will systematically lower their per unit production costs for years to come and ensuring that other asset owners get lower returns for their investments is a core part of that.

And it’s not only backlog the SURF business now is declining year-on-year of you look at the Q3 2017 SS7 results:

Q3 2017 BU performance.png

~$50m is a meaningful decline in revenue (6.3%) for SURF alone and the decline in i-tech shows that the maintenance market hasn’t come back either. Both CapEx and OpEx work remain under huge margin pressure and in the maintenance market the smaller ROV companies with vessel alliances are all mutually killing any chance of anyone making money until a significant amount of capacity leaves the market. The point of reinforcing this is that it is clear that the E&P companies do not view higher prices the start of a relaxation of cost controls: this is the new environment for offshore contractors.

Subsea maintenance costs involving vessels are time and capital intensive. Internally E&P companies are weighing up whether to invest in maintenance CapEx for offshore assets or new CapEx on short cycle wells. At the margin many like CP are choosing short cycle over offshore and hence the demand curve for offshore is likely to have shifted permanently down and price alone is simply not clearing the market.

I have only used SS7 as they are the purest subsea player in the market. I definitely think it is one of the better managed companies in the industry buut it is impossible to fight industry effects this big when demand is falling, and therefore the size of the market is shrinking, and you have such a high fixed cost base. Not everyone can take market share.

SS7 will be a survivor, and longer term given the technical skills and scale required to compete in this industry I think it likely in the long run they will earn economic profits i.e. profits in excess of their cost of capital, along with the larger SURF contractors excluding Saipem. But they will do this by being brutal with the rest of the supply chain that has gone long on assets and simply doesn’t have the operational capability and balance sheet to dictate similar terms. For everyone below tier one the winter chill is just beginning.

So what does this point to for the future of the industry?

  1. It is a safe bet with all the major E&P companies CapEx locked in for 2018 now and all the OpEx budgets done that demand isn’t going to be materially different from 2017. Slightly higher oil prices may lead to some minor increases in maintenance budgets but nothing that will structurally affect the market
  2. A smaller number of larger offshore projects of disproportionate size and importance fot the larger contractors and industry. Only the largest will have the technical skills and capability to deliver these (hence SS7 ordering a new pipelay vessel). These projects will have higher flow volume and lower lift costs and will be used by E&P majors to underpin base demand
  3. A huge bifurcation in contractor profitability between those capable of delivering projects above and the rest of the industry who will struggle to cover their cost of capital for years
  4. An ROV market that uses surplus vessels and excess equipment equipment that keeps margins at around OpEx for years as vessel owners seek this option for any utilisation
  5. E&P companies consistently seeking to standardise shale production, treat it as a manufacturing process that drives down per unit costs, and increase productivity. Any major offshore CapEx decision will be weighed against the production flexibility of shale
  6. Structurally lower margins in any reocvery cycle for the majority of SURF contractors

Affirming the consequent: Standard Drilling and vessel recovery…

A ship is at best an opportunity and at worst a liability.

Anon.

If you wanted to pick on one company to highlight how diminished expectations are of the offshore sector SDSD, down 66% for the year, would be a good candidate.

I think its great that if investors want a counter-cyclical investment vehicle they have one, but I just don’t think there is any industrial strategy here at all, and it is really hard to see how this can ever make money without some sort of extraordinary market movement. Depreciating 2007 and 2008 built PSVs, some of which required upgrades to DP II,  must be the ultimate “have faith in offshore” investment. Let’s have a look at the SDSD strategy:

Strategy.png

The thing is that Standard Drilling sold all the KFELs units prior to delivery, so maybe its been lost a little in the translation: but quite why buying assets in a booming market and selling them prior to delivery illustrates the success of buying minority shares in PSVs and putting them in lay-up in the worst downturn to hit the offshore vessel sector is beyond me? Just because I am good at rugby is unlikely to make me good at cricket (and the company isn’t called Jeff Wilson Drilling). The logical error is I believe called affirming the consequent.

It doesn’t mean you can’t make make money from this: but you are taking not only asset risk, on the vessel prices, but market risk on the stock price as well. So it’s not ideal (although you would think in this case they are highly correlated).

My broader point is that offshore supply is probably at the absolute nadir for demand. The PSVs working are supporting working operational infratsructure, or the few rigs working, and it probably cannot get any lower. But as Maersk Supply reported this week there remains an industry characterised by revenue at opex levels and huge oversupply. The SDSD are primarily older and/or in layup. The original plans to operate the vessels at cash break even, or above, and try and pay dividends. Even if one or two projects manage to achieve this there is no chance of this happening at a corporate level. Quoting historic vessel values I also think is a little absurd given the whole point of accepting the scale of the current downturn must mean they want revert to their previous implied value?

Look I don’t have an issue with this: SDSD has allowed the public a show of the price discovery mechansim that is identical to how many distressed funds viewed these types of investments. The fact is at this time last year, when the world seemed a different place, people thought the market couldn’t get any worse, and the plain fact is that it has. Substantially both at an asset value level and an operational level.

In specialty vessels Nor Offshore raised USD 15m almost to the day at this time last year. Now the reports are Fearnleys is basically trying to get them out completely as you can see from the SDSD share price graph that the cost of equity financing these vessels without visible backlog must have materially increased.

Longer term I don’t really get though how European companies, burdened with bank debt that the banks are reluctant to write-off, are going to compete with the likes of Tidewater and Gulfmark? SolstadFarstad must be the most worried of all the European companies given their commodity tonnage exposure. Sitting on a bunch of Asian built AHTS and PSVs from DeepSea Supply with inflexible European banks and no Chap 11 possibility must seem like a Sisyphean challenge at this point in the cycle.

But in the Tidewater’s case all the investors had an incentive to save the operational company to maximise value, whereas in the SDSD case the asset manager is paid regardless and isn’t making the returns required to back the assets.

Bassoe noted this week that they expect nearly 340 rigs to leave the market permanently. If you assume that supply vessels now are serving the base load of work on production assets and maintenance associated with them, and that a meaningful part of the E&P rig fleet that drove demand  will be scrapped, you need a real good story to explain a recovery play in offshore supply. There is more pain to come for investors before the market stabilises I feel.

 

Incremental Oil Production Growth… Shale versus Offshore …

Interesting graph from Oceaneering that shows the growth of incremental production. Like all these charts they need to be viewed as directionally correct only, but it makes clear the scale of the change that shale has wrought on the offshore industry.

That brown/ shale area would simply not have existed 4 years ago and ties in with my argument about shale becoming an important industry narrative which drives how actual investment decisions are made in companies. There are large questions about shale productivity (depletion rates etc), I am not  geologist or well engineer so can offer no insight into this from a technical perspective, but the economist in me is an inveterate technical optmist and I think the investment resources being signalled towards this form of E&P activity will lead to increased productivity and recovery in the future.

Many investors into offshore in prior to 2014 saw that brown area as one that offshore would have covered. Clearly offshore production will still remain an important part of the energy supply chain, but only niches within it will be profitable as opposed to the whole market uplift that drove the previous boom. Services over assets would be a good general rule. As would another point I have made previously that offshore developments are likely to be driven by a smaller number of mega developments.

GE and Subsea 7 …

The past few decades of leadership at GE has lessons for all companies. Stay focused on areas where you have differentiated skills (engineering, for GE) and avoid trends (financialisation). Set short-term expectations you can hit, but manage for the long-term. Take hard decisions. And hope for a little bit of good luck.

FT View, 21 October, 2017

There is a really easy explanation for why the BHGE and Subsea 7 talks broke off (aside from the fact that Kristian Siem probably likes owning and actively running a company with as many cool toys as Subsea 7)… Have a look at these results from BHGE last week:

BHGE 3Q 2017 Oil

BHGE basically turned over $3.4bn in oil field services and equipment and made no money on it (a 1% operating margin). Subsea 7 on the other hand has been a profit machine through the down turn:

SS7 5 year share price

Subsea 7 might be a much smaller company but it had operating income of $235m on $1bn of revenue. The only real worry Subsea 7 has is the size of the order book and Brazil exposure.  Subsea 7 really doesn’t need to expose it’s shareholders to the risks of a complex merger integration that isn’t going as quite as planned: Some commentary indicated the market was worse than when the merger was announced, not something anyone in the market I think really believes.  On those numbers Subsea 7 management would be taking over BHGE not the other way around.

The fact is that that the top end subsea execution companies have found a profitable niche. The OpEx is so high that competitors just didn’t last as the downturn hit, projects bid at the peak of the market got procurement at the bottom, a kind of natural hedge,  whereas the markets BHGE competes in might be bigger but they are structurally less profitable because more people can compete in them and the lower OpEx commitment means they just keep on doing so.

I still think the backlog is a huge issue. Financial markets are notoriously short-sighted and fickle, and I cannot see how the vast drop in demand in seismic and rig utilisation doesn’t eventually lead into dramatically lower offshore commitments. But I also accept that offshore oil isn’t going anywhere fast and it would appear Subsea 7, FMC Technip and a couple of others are pulling away. Saipem came out with some horrible numbers today with adjusted EBITDA in the offshore division down 17% YOY showing there is still pain to come. And everyone complains of weak order intake… But the larger companies appear to be generating more than sufficient cash to see off the weak and be in a great position for even a mild recovery.

I’m naturally scpetical that you can simply pick markets and keep acquiring companies on a “buy and build” strategy and this contrasts strongly with the very clear industrial strategy Subsea 7 has followed for a long time now. Exactly as the FT recommends GE should do whereas BHGE seems to be the combination of two companies facing ex ante growth limits who looked for a transaction to try and solve structural issues. Eventually you can probably cut enough cost to force it to work in a financial sense but industrial logic takes years to develop.

One thing is for sure: If BHGE are serious about getting involved in offshore execution only McDermott is big enough to move the financial needle and small enough to digest in a practical sense.

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.