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.

Backlog is essential for re-financing…

“Just because you don’t understand it doesn’t mean it isn’t so.”
― Lemony SnicketThe Blank Book

The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

— Adam Smith (1776)

Subsea 7 purchased the remnants of EMAS Chiyoda last week in a tale that highlights how not getting your timing right can be an expensive mistake in subsea. Chiyoda have probably decided to stick to stuff they know something about this time.

Contrary to my earlier remarks I think the Subsea 7 is an okay defensive deal. The Gulf of Mexico is a growth deepwater market (one of the few) and the weakest one for Subsea 7, and in addition they bolster their position in the Middle East. Backlog for Subsea 7 was virtually static in the last quarter which highlights why they need to take such aggressive steps to prop it up, the downside is they have added to their fixed cost base at a time of declining demand and project margins. There is an outside risk as I have said before that the backlog was poorly tendered and there are integration risks associated with the delivery, but Subsea 7 is one of the world’s best engineering companies and probably consider this manageable.

But it was backlog that drove this more than any other consideration I would argue…

Another deal, Project Astra, is kicking around the distressed debt houses at the moment and this is a deal that comes with pipeline more than backlog: the refinancing of Bibby Offshore.  I think Bibby have left it extremely late to raise capital like this in what is actually a pretty complicated transaction. If executed as planned it will involve a substantial writedown of debt by the bondholders in addition to a liquidity issue. The real question is surely why an interest payment was made on June 15 almost simultaneously along with an IM seeking capital? Surely a business in control of this wouldn’t be paying bondholders interest while trying to organise a liquidity issue?

The answer is that far from Bibby Line Group (“BLG”) being a supportive shareholder they are actually the major problem here as this process starts the recognition that their equity value in Bibby Offshore Holdings Limited is worthless. BLG had every reason to try and believe, against all the available evidence in the market, that this was going to be a quiet year. After losing £52m at operating profit in 2016, having no visible backlog, and clearly no firm commitments for work, they instead sanctioned the Bibby Offshore ploughing forward into what is effectively a financial catastrophe. The BLG Portfolio Director is a chartered accountant and frankly should have known better: management wrapped up in the situation cannot pretend to be objective but that is what a Board, and financially literate Chairman, is for.

Instead, and clearly given the asymmetric nature of the payoff to BLG as shareholders, they sanctioned what can only best be described as bizarre financial decisions, all driven to try and protect the BLG shareholders against the interest of the creditors, which frankly from Sep/Oct 16 should have been the primary concern of the Directors. However, they are only human and when their employer is the shareholder it has placed the majority of the Executive Board in an invidious and conflicted situation.

Unless you are a full EPIC contractor subsea contracting is essentially a regional business and to justify the head-office an integration costs you need to add significant scale and value in the regions you are in. Bibby Offshore HQ offers none of this and new investors participating are merely prolonging this charade, like the Nor Offshore liquidity investors they will be buying something the literally do not understand.

In addition to the obvious and valid questions as to the structural market characteristics Bibby Offshore is involved in Bondholders, now presented with what is in effect an emergency liquidity issue or administration, must be wondering inter alia:

  • Why the ex-COO has been sent on an ex-pat package to Houston to build-up the business when they are facing an imminent liquidity crisis? (Fully loaded this must be close to USD 500k per annum including house, airfares etc? Madness).
  • Why they should pump liquidity into a North American operation that has no competitive advantage, no backlog, and having had the best DSV in the GoM this year has managed to win less than 40 days work?
  • Why the BOHL is holding the value of the DSVs on the balance sheet at over GBP 100m when it is clear that their fair value is worth considerably less? It would be interesting to see the disclaimers brokers have provided for this valuation because should the capital raised be insufficient to carry BOHL though to profitability the delta between those values and realised values are likely to be very sore points of contention by those who put money in this. The Nor Offshore and Vard vessels provide ample proof that these assets are effectively unsellable in the current market and if the have to sold down in Asia/Africa/GOM those two DSVs would be lucky to get USD 25m and substantially less for a quick sale
  • Why there is a Director of Innovation and Small Pools Initiative when the core UK diving business is going backwards massively in cash flow terms? Why in fact are there 3 separate Boards for such a small company? Has legal structure been confused with operational structure?
  • Why the CEO’s wife is running a “Business Excellence” Department when the overhead is well over GBP 20m per annum? It might sound like a minor deal but as the lay-offs have increased it has clearly become a huge issue for staff working inside the business and it is like a cancer on morale

These extra costs are in the millions a year and add to the air of unreality of the whole proposal.

DeepOcean was another company with a lot of IRM type work but managed a successful refinancing. Management and staff all took a pay cut and built up a huge backlog in renewables and IRM work prior to seeking a refinancing. Potential investors there face execution risk on project delivery but can model with some certainty the top-line. The same just isn’t true at Bibby although the cost base can be shown with a  great deal of accuracy and there management have taken no pay cuts and the cost cutting doesn’t seem to have reflected the seriousness of the downturn.

No one should blame the management but rather a supine and ineffective Board that have allowed this situation to develop. None of the potential investors I have spoken to look like putting money in. It makes much more sense to try and “pre-pack” the business from administration than go through the complexity of a renegotiating with the bondholders and getting a byzantine capital structure in place in which they do not share all of the upside.

The reason all these issues collide of course is a classic agent-principal conflict: In a market where activity has declined so markedly to raise money to invest in developing new markets is verging on the absurd. Bibby Offshore is losing money in Norway and the US, has a minor ROV operation in Singapore which is unprofitable most of the time, and has seen a significant decline in the core UK diving business. The logical strategy is therefore to strip it back to basics, but that means the people negotiating the fundraising would be out of a job and therefore the strategy they have devised, not surprisingly, is more of the same and hope the market turns. This has suited the shareholder for the reasons outlined above.

Like so many companies grappling with The New Offshore Bibby is a very different company to the one that raised cash in 2014. Back then there were 4 North Sea class DSVs all working at very high rates in addition to the CSVs (and two DSVs were chartered adding extra leverage). Now not even 2 DSVs are close to break-even utilisation and the CSV time charter costs are well above any expected revenue. Returning the Olympic CSVs will cut the cash burn but merely reinforces the fact that the business no longer has an asset base that offers any realistic prospect of the bondholders being made whole (the drop in the bond price in the last few weeks confirming they now realise this).

It is in-short a mess, and one the BLG Portfolio Director and NED more than others should be placing their hand in the air to take responsibility for. It was obvious when the £52m operating loss was announced that a restructuring was needed, particularly in light of what was happening in Norway, and leaving it this late to raise funds. To pretend a fundamental structural change is not required, is simply irresponsible.

I had five years at Bibby Offshore, 4 of those were the most rewarding of my professional career to date. It gives me no pleasure to write this but I can’t help feeling the path that has been taken here risks seeing people not getting paid one month while on the BLG website will be a big article about how they sponsored a mountain walk to Kenya and highlighting their credentials as a good corporate citizen. But it is also true by the end I did have an issue with the strategy, which when you are notionally in charge of it becomes a big issue. The company shareholders insisted on a 50% of net profit dividend strategy, which in a capital-intensive industry when you were growing that quickly meant there was constant working capital pressure yet alone expansion capital. Yet every year at the strategy planning meetings we were expected to present ambitious growth plans where capital was no object, except it always was. Over the years the farce built up that when multiplied by easy credit has not worked out well. What this translated to at the Bibby Offshore level was a management team who wanted to build another Technip without anything like the resources needed to realistically accomplish this.

I used to constantly try and explain the benefits of “plain vanilla equity” but it was simply not what the shareholders wanted and it was clear at Group that they were already concerned about the size of Bibby Offshore in relation to the overall holding company. This culture of unrealistic planning has formed the basis of which constantly missing numbers hasn’t sent the right warning signal to the Board about the scale of the impending losses in the business despite it being blatantly obvious to ex-employees.

What the BLG shareholders wanted was to do everything on borrowed money, which is fine if it’s your business. But this attitude led to the Olympic charters and fatefully the bond, which in itself was a dividend recap taking GBP 37m out, and it of course left the business woefully undercapitalised in all but the best of conditions.

Bibby Offshore as a company would have had the best chance of surviving this downturn if it had approached the bondholders early about the scale of the problem, stopped making interest payments and saving the cash, had a meaningful contribution from the shareholders at a place in the capital structure that was risk capital, and approached Olympic about massively reducing the charter rates while extending the period of commitment (this would have been complex but the banks were realising 2 years ago they needed deals like this as Deepsea Supply showed). These are the hallmarks of all the successful restructurings that have been done. Instead for the benefit of the shareholders they took a massive gamble that the market would comeback and had a spreadsheet showing it was theoretically possible in the face of common sense. The consequences of this are now coming home.

Bondholders of course only have themselves to blame, The Bibby bond was a covenant light issue and was essentially bullet redemption on depreciating fixed assets, a risk all financial investors know deep down is just gambling. Confident in the mistaken view that BLG would step in the bonds have held up unnaturally in pricing for an eon while the company continued to burn through cash at a rate that should have worried any serious investor. They have now been presented with a nuclear scenario where they must put something in or face potentially nearly a total write-off of their investment, a quick look at the Nor bonds and asset situation only strengthening Bibby’s hand.

London is awash with distress credit investors at the moment who are long on funds. Many are traders and hopeful of entering a position with a quick exit to someone else, and they may get this deal away with people like this. But it is a very hard sell because unlike DeepOcean there is no backlog only pipeline, and one is bankable and the other is not.

 

BOA and Volstad: End of a Norwegian era… More restructurings to come…

The best of men cannot suspend their fate: The good die early and the bad die late.

DANIEL DEFOE, Character of the late Dr. S. Annesley

Boa Offshore and Volstad Maritime are both involved in restructuring talks at the moment, both are bound by the same ties of market fate and financial commitments: excessive leverage, financial speculation, and a secular change in demand for the asset base that underpinned the bonds. On a wider scale these should be seen as examples of small Norwegian companies that rode an oil and credit wave that has now definitely ended and their place in the market will remain limited at best and in the Boa case is likely to be non-existent.

The excessive leverage isn’t simply a case of hindsight: again like the Bibby bonds these were depreciating assets backed by bonds that required no repayment during the life of the instrument. Capital assets that do not have to earn a return on their principal but rather rely on further refinancing are simply speculation by both parties to the transaction and are clearly indicative of a credit bubble. Such investments are what Minsky called Ponzi financing, it requires a suspension of belief from economic reality that such a situation can continue, and that interest payments can be met by constantly drawing on an increased capital value. In the offshore oil services world this wasn’t willfully disregardng the evidence but rather the industry belief that ever rising oil prices and demand side factors were immutable forces of nature. The failure to recognise that in the long-run this would cause some innovative firms to seek new solutions is one of the great enduring mental models that has led previous generations to believe fervently in ‘peak oil’.

The other similarity is the type of vessels both Boa and Volstad have backed: no other asset class in offshore has been as overbuilt as the large OCV (~250t crane, 1000m2+ back deck etc). Potential new investors in Volstad should look at how illiquid the Boa Deep C and Boa Sub C are: bondholders are looking at a liquidity issue because these assets are in all reality unsellable at any price at the moment. When the Volstad vessel charters finish their maximum upside is surely capped to the amount bondholders in comparable assets are willing to accept to supply vessels to Helix-Canyon… and that is surely lower than their current charters? And that would assume Helix need as many vessels, a bold asumption looking at their utilisation record. In the old offshore such assets were rare and expensive… now not so much…

Part of the clue to the lack of sales in the OSV market is not just in the demand side of the market it also lies in the behaviour of banks. Have a look at DVB (my previous thoughts on the bank here), lending to offshore was running at c. USD 2-3bn per annum in 2010 to 2014:

DVB lending by segment 2010-2014.png

Welcome to the world of The New Offshore and closed loan books as the DVB investor presentation (2017) shows:

DVB New Transport Business 2017

That isn’t DVB specific this is a relfection of all banks in the market and a total withdrawal of asset financing. No matter what the relationship bankers tell you to all but the most exceptional cases the loan book is closed for offshore assets in all banks (apart from US focused companies with a US revenue base and a US bank). And no one pays close to historical value for such specialised assets if you cannot get a loan, but this has become a self-referential cycle that will be very hard to break, and in reality will only be done so as part of an overall consolidation play by a player with a realistic financing structure relative to the market risk.

Volstad Maritime may have a viable business going forward (i.e. strategy and execution capability) based solely on the Helix-Canyon charters, but liquidity is a different issue. The fate of the Bibby Topaz remains a major area of interest as the vessel is part of a three boat high-yeild bond and the owners of the bond have in effect an option to take full control of the Topaz. The bond has a corporate guarantee from Volstad Maritime AS that adds to the complications. OTC bonds are a grey area but rumours abound of Alchemy (the core M2 investor), other funds, and industrial players all having positions in the bond. Bibby Offshore may well be delaying their restructuring announcement until the position of Volstad Maritime and the Topaz is clear (although if they can make it to September without legally overtrading handing back an Olympic vessel is also likely an announcement time). A seperation of the Helix chartered vessels could be a viable option but only if the corporate Volstad corporate guarantee can be squared with the bond owners (who also own the m/v Tau on charter to DeepOcean but must surely been seen as effectively worthless, and the Geco Bluefin (in lay-up?)).

The Boa bondholders and banks seem to be repeating the same mistake the Harkand/Nor bondholders have consistently made: confusing a permanent impairment in asset values for a temporary market dislocation. In fact the Boa OCV bond term sheet contains the following nugget:

the aggregate current market value of the vessels according to information provided by the Group prior to the date of this Term Sheet is NOK 810,000,000

No sane individual believes that you could get USD 95.7m for the Boa Deep C and Boa Sub C at the moment:  2 vessels that have to enter lay-up because there is no work for them and assets that no bank that would lend against. There is a nice gap in the documentation here where the advisers to Boa state they have not undertaken due diligence of any information supplied. Everyone here wants to believe something everyone knows not to be true.

The structure calls for the seperation of the various asset classes into their individual vessel type exposures and is in effect a wait-and-pray strategy. Bondholders pay a “Newco” management company a fee to manage the vessels and provision is made for a further liquidity issue. I sound like a broken record here but the longer everyone keeps providing further liquidity the further any supplyside recovery becomes. The Sub C and Deep C are very nice vessels but two vessels does not an operator make in the current market, all this set-up does is support latent capacity, like the North Sea PSV market, that keeps everyone bidding at OpEx levels only. Hope is not a strategy.

I don’t have any magic answers here beyond investors accepting the economic reality of their position which they are under no obligation to do. The Boa bondholders, like the Harkand bondholders, and others, figure they have lost so much what harm can one last roll of the dice do I suspect? For those of you who have seen the movie ‘A Beautiful Mind’ you may recognise this as a problem that is a case of Nash Equilibrium:

a solution to a non-cooperative game where players, knowing the playing strategies of their opponents, have no incentive to change their strategy

It drove Nash to a nervous breakdown (literally) and I have no intention therefore of taking this any further.

The New Offshore: Liquidity, Strategy, Execution. Nothing else matters.

A supply rich market…

The above graph comes from the New York Federal Reserve who publish the weekly (and free!) Oil Price Dynamics report. I have no wish to obsess over the daily price, which is obviously important in certain professions, but in offshore the trend is more crucial. And as can be seen from 2012 supply factors began to dominate the market (the methodology basically collects a range of factors and then the sum of demand+supply+residual=price). It sounds intuitively to be a better methodology than daily explanations of what could clearly be spurious reasons by commentators on minor movements and seems to reflect the complexity of the market. The timing of supply dominance is clearly the result of the US Shale industry.

IA-Energy-Shale-Oil-2007-2017

This is in an environment where major E&P company capital expenditure is continuing to decline. DNB forecast E&P capex to drop another 18% in 2017 compared to 2016 and of this a higher proportion will be focused onshore. The drop in prices recently could not have come at a worse time for offshore as CFOs of the E&P companies finalise budgets for next year.

The narrative and numbers are moving towards shale in an unmistakable shift. A quick look at ExxonMobil’s performance in the Permian shows why:

XOM AP Q1 17

The heading in this Conoco Phillips slide says it all:

CP Shale 17Q1.png

These are not original thoughts but merely set out to reinforce the view that if your story is for a market recovery next year it needs to be a really good story. It was good to see Kraken start in the North Sea but it is a statistical oddity not the norm.

The New Offshore…

Another great graph from Rystad on Friday highlighting increased productivity in shale:

Rystad Av IP30

Offshore isn’t going away as this graph makes clear:

IEA Energy Mix June 2017

But it is going to be different, and the “Demand Fairy” isn’t going to make it like 2014 quickly:

IEA Capex

Change at the margin of an extra 1 or 2% of shale as a share of the energy mix will have a major effect on offshore utilisation and day and day rates. Offshore needs to deal with overcapacity on the supply side and the increasing productivity of shale which will only continue.

Liquidity. Strategy. Execution. Nothing else matters. The New Offshore.

 

 

Shale, mental models, strategic change, renewal, and railways…

“In other words the problem that is usually being visualised is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them………However, it is still competition within a rigid pattern of invariant conditions, methods of production and forms of industrial organization in particular, that practically monopolizes attention. But in capitalist reality as distinguished from the textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization….”

(Schumpeter, 1943, p. 84.)

On a day when the oil price dropped to its lowest point in seven months Bloomberg reported that:

There’s yet another concern growing as oil prices continue to erode: A record U.S. fracklog.

There were 5,946 drilled-but-uncompleted wells in the nation’s oilfields at the end of May, the most in at least three years, according to estimates by the U.S. Energy Information Administration. In the last month alone, explorers drilled 125 more wells in the Permian Basin than they would open. That represents about 96,000 barrels a day of output hovering over the market.

Yesterday Energen, a US shale E&P company, reported numbers yesterday with increasing productivity of “Gen 3” fracking:

Energen Wells with Gen 3 Fracs Outperforming

In central Midland Basin, cumulative production of 5 new Wolfcamp A and B wells averaging ≈15% above the high‐end, 1.3 MMBOE EUR type curve for a 10,000’ lateral (77% oil) at 75 days. Cumulative production of 2 new Wolfcamp A and B wells with 80 days of production history in Delaware Basin averaging ≈80% above the high‐end, 2.0 MMBOE EUR type curve for a 10,000’ lateral (61% oil).

If you don’t understand the implication of the text above for offshore they have a handy graph that makes it abundantly clear:

Energen 3G Frac Performance.png

This is simply a productivity game now as I have said before.  Yesterday I mentioned the DOF Subsea potential IPO, it’s worth noting that investors could choose between a company that took a bigger asset impairment charge than they made in EBITDA in the subsea projects division, or a company like Energen. When deciding to allocate capital it starts to become an easy decision.

There is a technical and industrial revolution taking place on the plains of the US. Ignoring this won’t make it go away. The Industrial Revolution didn’t happen overnight: steam engines were invented, coal production capacity increased, canals were built, railways invented etc, a series of interlinked innovations occured in a linear and dependent fashion. No one woke up one day and experienced them all. Productivity is a never ending journey. In the Cotton Revolution Kay invented the “Flying Shuttle” (1733), Hargreaves the “Spinning Jenny” (1765), Arkwright the “Water Frame“, (1769), the Crompton Mule (1779) was a combination of the Spinning Jenny and the Water Frame, and Boulton and Watt (1781) invented the condenser steam engine for use in a mill (ad infinitum).

The same thing is happening in shale. Shale won’t come up with a rig that kills deepwater productivity and lower lift costs overnight, but a series of systemic and interdependent innovations that advance the productivity of the sector as a whole is a certainty. That red line above will become steeper and move to the right with irregular monotony now until new technological constraints are reached.

For those of us, and I include myself in this camp, new to the shale productivity revolution Energen included another chart:

EGN Frac Design Evolution.png

And after this will be 4G and 5G… just like mobile phone evolution. Each generation will offer greater productivity than the one before. The image at the top of the page highlights the advances multi-well pad technology has already made to shale.

I am still not convinced everyone in offshore has understood the scale of the change occurring in the industry. I still think some people, particularly banks and those with fixed obligations, are using the 2007/08 years as a frame of reference when a short and sharp drop in demand was followed by a boom. I don’t see that happening this time. Telling people it will change one day isn’t a strategy it’s a hope.

Mental models I think are crucial here. One extraordinarily interesting paper is from Barr, Stimpert, and Huff (1992) who looked at the cognitive change managers underwent to successfully renew an organisation in light of externally driven change. (This is actually the paper that made me want to become a management consultant, a decision I quickly regretted I hasten to add). These researchers basically found two almost identical railroads operating in the same state and compared what happened to them in a longitudinal study spanning 25 years. The mental models of managers were examined by content analysing the annual reports and in particular the comments to shareholders. It is a rare example of a perfect natural control group so rare in social sciences and it’s a brilliant piece of research. The key findings were essentially the managers who were outward focused and changed their strategy accordingly survived while the railroad that went bankrupt always blamed industry factors beyond management control. The analogy to offshore at the moment needs little development.

Barr, Stimpert, & Huff (1992): COGNITIVE CHANGE, STRATEGIC ACTION, AND ORGANIZATIONAL RENEWAL

Barr Stimpert and Huff

BSH found four things mattered, 3 of which are directly related to offshore at the moment:

  1. Renewal requires a change in mental models
  2. A munificient environment may confirm outdated mental models
  3. Changes in the environment may not be noticed because they are not central to existing models
  4. Delays in the succession of mental models may be due to the time required for learning.

I’d argue there was another factor present in offshore that is the commitment to fixed assets and the associated liability structure makes it impossible to change the core business model even if the need for change is realised. Very little can be done outside a restructuring event in that case, although it is likely to actively influence management mental models.

Offshore will survive and prosper as an industry but it won’t be a reincarnation of the 2013/14 offshore. A new and different industry with a vastly different capital structure and strategic option set will appear I would suggest.