Common knowledge in offshore and shale…

“With every grant of complete security to one group the insecurity of the rest necessarily increases.”

Friedrich Hayek

Common knowledge is something that we all believe everyone else believes. 

We don’t have to believe it ourselves, and it doesn’t even have to be public knowledge. But whether or not you personally believe something to be true, if you believe that everyone else believes something to be true, then the rational behavior is for you to act AS IF you believe it, too. Or at least that’s the rational behavior if you want to make money.

Common knowledge is rarer than you think, at least for most investment theses. That is, there’s almost always a bear case and a bull case for a stock or a sector or a geography, and god knows there are plenty of forums for bulls and bears to argue their respective cases.

What can change this normal state of affairs … what can create common knowledge out of competing opinions … are the words of a Missionary. In game theory terms, the Missionary is someone who can speak to everyone AND who everyone takes seriously. Or at least each of us believes that everyone else hears the Missionary’s words and takes them seriously.

When a Missionary takes sides in a bull vs. bear argument, then depending on the unexpectedness of the words and the prestige of the Missionary, more or less powerful common knowledge is created. Sometimes the original Missionary’s words are talked down by a competing Missionary, and the common knowledge is dissipated. Often, however, the original Missionary’s words are repeated by other, lesser Missionaries, and the common knowledge is amplified.

When powerful common knowledge is created in favor of either the bull or bear story, then the other side’s story is broken. And broken stories take a looooong time to heal, if they ever do. Again, it’s not that the bulls or the bears on the wrong side of the common knowledge are convinced that they were wrong. It’s not that the bulls or the bears on the wrong side of the common knowledge necessarily believe the Missionary’s statements. But the bulls or the bears on the wrong side of the common knowledge believe that everyone ELSE believes the Missionary’s statements, includingeveryone who used to be on their side. And so the bulls or the bears on the wrong side of the common knowledge get out of their position. They sell if they’re long. They cover if they’re short.

Ben Hunt, Epsilon Theory

Oil and offshore has a lot of missionaries. In cyclical industries separating out industry firm effects from market effects is nigh on impossible. Be on the right side of a bull market and you make enough money to be a missionary respected by the crowd.

I thought of this when I read this extract from Saudi America in the Guardian. I won’t be buying the book (KirkusReviews panned it here) but the parts on Aubrey McLendon of Cheasapeake fame are interesting. However, what is really interesting is that in 2016 when the research for the book was being done there was a strong strain of  the “shale isn’t economic” narrative:

Because so few fracking companies actually make money, the most vital ingredient in fracking isn’t chemicals, but capital, with companies relying on Wall Street’s willingness to fund them. If it weren’t for historically low interest rates, it’s not clear there would even have been a fracking boom at all…

You can make an argument that the Federal Reserve is entirely responsible for the fracking boom,” one private-equity titan told me. That view is echoed by Amir Azar, a fellow at Columbia University’s Center on Global EnergyPolicy…

John Hempton, who runs the Australia-based hedge fund Bronte Capital, recalls having debates with his partner as the boom was just getting going. “The oil and gas are real,” his partner would say. “Yes,” Hempton would respond, “but the economics don’t work.”…

In a report released in the fall of 2016, credit rating agency Moody’s called the corporate casualties “catastrophic”. “When all the data is in, including 2016 bankruptcies, it may very well turn out that this oil and gas industry crisis has created a segment-wide bust of historic proportions,” said David Keisman, a Moody’s senior vice-president.

Many of the offshore “recovery plays” were financed when this was the investment narrative. The “common knowledge” was that there was going to be an offshore recovery, it was simply a case of when not if. The staggering increase in shale productivity was not part of the common knowledge and didn’t form part of the narrative. Go long on assets said the common knowledge… they are cheap… this is a funding issue only… what could go wrong? As the oil price inevitably rose demand for offshore assets would quickly recover right?

As the graph at the top of this article highlights, just as the common knowledge was being formed that allowed a range of offshore companies to raise more capital to get them through to the inevitable recovery, and clearly the demise of shale would occur by simple economics alone, in fact the shale industry was just cranking up.

The results of most of the offshore companies for the supposedly busy summer season show that at best a slight EBITDA positive is the most that can be hoped for. Rig, jack-up, and vessel rates remain extremely depressed and most companies are struggling to even cover interest payments. A few larger SURF contractors are covering their cost of capital but most companies are simply doing more for less. Companies might be covering their cash costs but there is a massive issue still with oversupply, and judging from the comments everyone continues to tender for work they have no hope of getting as everyone is doing more tendering. The cash flow is rapidly approaching for a number of companies and Q2 results have shown the market is unlikely to save them.

The missionaries for the shale industry are currently in the ascendant in creating a new common knowledge. The new common knowledge for offshore will be extremely interesting.

(P.S. If I was the publishers I’d rush the paperback edition of the book out).

Group think and conventional wisdom…

“It will be convenient to have a name for the ideas which are esteemed at any time for their acceptability, and it should be a term that emphasizes this predictability. I shall refer to these ideas henceforth as the conventional wisdom.”

J.K. Galbraith, The Affluent Society

 

“All that we imagine to be factual is already theory: what “we know” of our surroundings is our interpretation of them”

Friedrich Hayek

 

We find broad- based and significant evidence for the anchoring hypothesis; consensus forecasts are biased towards the values of previous months’ data releases, which in some cases results in sizable predictable forecast errors.

Sean D. Campbell and Steven A. Sharpe, Anchoring Bias in Consensus Forecasts and its Effect on Market Prices

Great quote in the $FT yesterday that reveals how hard it has been in the oil and gas industry for professional analysts to read the single biggest influencing factor that is reshaping the supply chain: rising CapEx productivity and its ongoing continued pressure. Money quote:

Mr Malek said that with the notable exception of ExxonMobil, most energy majors had shown they were capable of growing output quickly even when investing less than it used to.

“We all thought production was going to fall off a cliff from Big Oil when they started slashing spending in 2014,” said Mr Malek. “But it hasn’t. The majority of them are coming out on the front foot in terms of production.” [Emphasis added].

#groupthink 

An outlook where E&P companies can substantially reduce CapEx and maintain output is not one in a lot of forecast models. Forecasts are rooted in a liner input/out paradigm that leads to a new peak oil doomsday scenario. But the data is coming in: E&P companies are serious about reducing CapEx long term and especially relative to output, and collectively the analyst community didn’t realise it. The meme was all “when the rebound comes…” as night follows day…

The BP example I showed was not an aberration. For a whole host of practical and institutional reasons it is hard to model something like 40% increase in productivity in capital expenditure. But the productivity of E&P CapEx, along with the marginal investment dollar spend,  has enormous explanatory power and implications for the offshore and onshore supply chain.

Aside from behavioural constraints (partly an availability heuristc and partly an anchoring bias) the core reason analysts are out though is because their models are grounded in history. Analysts have used either a basic regression model, which over time would have shown a very high correlation between Capex and Output Production, or they simply divided production output by CapEx spend historically and rolled it forward. When they built a financial model they assumed these historic relationships, strong up until 2014, worked in the future… But these are linear models: y if the world hasn’t changed. The problem is when x doesn’t = anymore and really we have a multivariate world and that becomes a very different modelling proposition (both because the world has changed and a more challenging modelling assignment). We are in a period of a  structural break with previous eras in offshore oil and gas.

These regressions don’t explain the future so cannot be used for forecasting. No matter how many times you cut it and reshape the data the historical relationship won’t produce a relationship that validly predicts the future. At a operational level at E&P companies this is easier to see: e.g. aggressive tendering, projects bid but not taken forward if they haven’t reached a threshold, the procurement guys wants another 10k a day off the rig. There is a lag delay before it shows up in the models or is accepted as the conventional wisdom.

SLB Forecast.png

Source: Schlumberger

Over the last 10 years, but with an acceleration in the last five, an industrial and energy revolution (and I do not use the term lightly) has taken place in America. To model it would actually be an exponential equation (a really complicated one at that), and even then subject to such output errors that wouldn’t achieve what (most) analysts needed in terms of useful ranges and outputs. But the errors, in statitics the epsilon, is actually where all the good information, the guide to the future, is buried.

But when the past isn’t a good guide to the future, as is clearly the case in the oil and gas market at the moment, understanding what drives forecasts and what they are set up to achieve is ever more important. How predictive are the models really?

A lot of investment has gone into offshore as the market has declined. A lot of it not because people really believe in the industry but because they believe they will make money when the industry reverts to previous price and utilisation levels, a mean reversion investment thesis often driven on the production rationale cited in the quote. Investors such as these have really being buying a derivative to expose themselves, often in a very leveraged way, to a rising oil price, assuming or hoping, frankly at times in the face of overhwelming contrary evidence, that the historic relationship between the oil price and these assets would return.

These investors are exposed to basis risk: when the underlying on which the derivative is based changes its relationship in its interaction with the derivative. These investors thought they were buying assets exposed in a linear fashion to a rising oil price, but actually the structure of the industry has changed and now they just own exposure to an underutilised asset that is imperfectly hedged (and often with a very high cost of carry). Shale has changed the marginal supply curve of the oil industry and the demand curves for oil field services fundamentally. Models utilising prior relationships simply cannot conceptually or logically explain this and certainly offer zero predictive power.

The future I would argue is about the narrative. Linking what people say and actions taken and mapping out how this might affect the future. To create the future and be a part of it you cannot rely on past hisotrical drivers you need to understand the forces driving it. Less certain statistically but paradoxically more likely to be right.

Oil supply shortage? Really?

“We’re able to do, I would say, 40% more per dollar of activity than we did 4 or 5 years ago at $100 oil”

Bob Dudley on BP’s Q2 2018 results.

When you are told there might be a supply shortage you need to understand how much model risk there is in these sort of forecasts. The IEA graph in the header, a variant on the new peak oil theme, being used as the rationale for why a “recovery” for offshore may be just around the corner, doesn’t show the output implications of the cost deflator.

Bob Dudley is saying that BP are getting 1.4x output for each dollar 4-5 years after the “great oil price crash” of 2014. That ~$500bn of expenditure in 2018 buys you what ~$700bn did 4 years ago (roughly what was being produced in 2013?).

This just isn’t consistent with a some sort of “snapback recovery” for offshore that people try and credibly speak of (and that some business models are based). Mean reversion only works as a theory when the underlying mechanics haven’t changed. The offshore supply chain needs to be realistic about the implications of this sort of comment that is clearly being translated into E&P company CapEx plans. Whether the offshore industry believes it or not this is the new narrative and reality in E&P companies and capital is being allocated accordingly.

 

Time for plan B…

A somewhat ambitiously titled article in the FT seemed to have something for everyone: looking for any excuse to claim the impending supply shortage? Check.  And for the sceptics? Check. To save you reading ‘The Big Read’ I’ll give you a quick synopsis: the reporter spoke to a load of people (mainly analysts) who said there will be a supply crunch but didn’t know when, and then spoke to another bunch of people (who actually make the investments) and they said they don’t think there will be.

The fact is that oil will be a substantial part of the energy mix for a very long time. How we extract it and the relative costs of doing so are far more interesting questions. The E&P companies will be substantial businesses for a long time to come no matter how alarmist some warnings maybe.

But the article does mention the mythical $100 per barrel… just not a timeframe… in fact if you are looking for comfort for when this supply crunch will occur the only person prepared to put a timescale on it is ex-BP CEO Tony Heywood, and you are unlikely to get much comfort from this:

“I don’t think the supermajors really believe the long-term story of peak demand,” Mr Hayward told the Financial Times last week. “Looking at the trajectory, we’re more likely to have a supply crunch in the early 2020s.”

If you really believed in the supply crunch I can’t work out why you wouldn’t sell your house and just go long on Exxon Mobil? According to this article on Bloomberg they are staying as a pure oil and gas supermajor and being punished by the stockmarket for it. Buy their undervalued shares and when the supply crunch comes all their reserves are worth the market price and they have production capacity? And in  the meantime you collect the dividend?

The alternative in the offshore world appears to be buying investments in highly speculative asset companies with no order book that are relying entirely on a macro recovery for their plans to work. At this point in the cycle, and without some clear indication of when any of these plans can return actual cash to the investors, the only thing certain is that they supply side still has a lot of adjustment to go. The big contractors are starting to pull away from the small operators because a) they do the large developments currently in vogue, b) scale has economic advantages in an era of low utilisation, and c) why use a small company where your prepaid engineering work is effectively an unsecured creditor? Expect the flight to quality to continue in the project market.

Frankly if you are long floating assets you simply cannot disregard comments like this from one of the biggest CapEx spenders in the world:

“We’re becoming more efficient at how we deploy capital,” Mr Gilvary says. He adds that BP and other energy groups are ploughing a middle road: raising oil production by using technology to sweat more barrels out of existing fields, while also funnelling smaller amounts of capital into so-called short-cycle projects such as US shale.

BP of course continue to deliver mega-projects where they think they have ‘advantaged’ oil. They just expect to pay less for it:

BP Unit costs.png

Reintroducing cost inflation into the industry will be harder than any previous cyclical upturn is my bet.

Value free options as a signal for future market demand…

One of the reasons both the shipping and offshore industries got themselves into financial problems was excessive leverage. One way to create leverage without an offsetting liquidity position is to sign up for an asset without takeout financing (i.e. at delivery financing). It’s risky because if anything goes wrong with the takeout financing you lose your deposit and potentially more.

So I was surprised when I saw Odfjell Drilling a USD 220m deposit to buy a rig from Samsung having got a term sheet for a USD 325M loan that required a 4 year contract from an operator as a condition of drawdown… Because what Odfjell have is a 2 year firm plus 1 + 1 year options from Aker BP… Which is clearly very different from a risk perspective. Odfjell Drilling are in the uncomfortable position that if anything goes wrong with the provision of the loan they prepaid the yard USD 220m and have limited options to get it back.

I can’t see the upside for the bank here? Yes the market is strong in this niche, but not so strong that an operator is prepared to commit for four years, only two. 24 months isn’t long and if anything goes wrong they will be hugely exposed here with their counterparty having made minimal payments relative to the value of the unit and not really big enough to honour the loan from the rest of  their resources. For a few hundred basis points above LIBOR that strikes me as an asymmetric payoff in Odfjell’s favour (and whereas in a longer deal the credit approver may have moved on to a new job in this deal they could well still be there if it blows up). Clearly on the mitigating side is a great operator, with a good credit history, and quality shareholders. What’s $300m between friends?

The options for the follow on work are “free” options as far as I read them: i.e. Odjfell gave away call options on their asset for nothing. And Odjfell did this (assuming they are rational and competent negotiators) because the customer wouldn’t pay. So I get the market looks strong but not so strong that an E&P company has to pay anything to guarantee the price of USD 550m rig for two years in two years time (and in options pricing time is one of the most valuable components). The customer will have the right to get other rigs if the market drops and it is capped if the demand goes up. If someone tells you the market is about to boom it isn’t being priced in the options market.

Options in finance and economics are price signals about demand and expectations for demand at the margin. People take risk, or offload, without having to buy the underlying asset. In a volatile environment an option has higher value. When an option is agreed it is meant to be a value neutral position, priced at an equilibrium point where both sides  believe the option is fairly valued. In this deal Aker BP are offloading long term pricing risk to Odfjell for free.

There are numerous examples at the moment in offshore where the asset owner gives away a call option on their pricing and utilisation security. This tells you a great deal unbiasedly about how both sides really view the market going forward. Asset owners giving free call options on vessels and rigs to their customers is an unambiguously bad sign. Economic theory would suggest that these options are “free” because they are valueless.

I can’t help feeling that this is the wrong model for offshore. Surely the best solution to lock-in low long-term rig prices would be for the company with the balance sheet and need for the asset to give a long term charter to allow the rig operator to use less equity and lower the day rate? If people are not that confident then let the unit rot in a shipyard where the current owner has a comparative advantage in storage costs?

At some point, and I think we have reached it generally in offshore, building highly specialised assets that cost in the hundreds of millions and taking spot market risk just won’t be viable for all but a very small number of providers who will price this at very high marginal levels. The problem is until the inventory of such assets drops we are a long way of reaching that degree of rationality. Offshore will remain a highly contestable market and therefore subject to low profitability.

The rig market will feel any upswing first and clearly the ‘animal spirits’ have returned. I offer no judgement, if the shareholders want this they are the ones taking the risk, and it could pay-off spectacularly. But it points to one of what I believe to be the secular changes in the offshore market: who pays for time? Specifically idle time? The Ocean Rig/DNB data below make clear the risk and cost sit with the asset owners.

Floating Rigs Awarded.png

Offshore used to work because relatively small companies took huge relative financial risks on assets because the market was so strong they got the day rates and utilisation to cover these risks. But even in the boom years many assets only broke-even in a economic sense between day 270-300 calendaer days. More than 330 were golden years and less than 280 a worry.

Now the E&P companies don’t have to take this risk and they aren’t. Yet the offshore industry isn’t getting the day rates to cover for this idle time and it’s a material number. It is in fact the most important economic number for most owners because the profit rates on a day worked are well below the cost of one idle day (and that is regardless of asset class).

Solstad Farstad announced a couple of PSV deals at 4 months firm plus 4 months options. Working a vessel for four months year, making it avilable for another four where you can’t market it (another free call option), and maybe getting some work for another 4, is a very risky business model. For that to be sustainable the four working months would have to be at an extraordinary day rate, which currently of course they are not.

I think this is a sign of structurally lower profits in the industry for some considerable time. I also think the options market is where the first signals of long-term confidence may be seen. If Aker BP was really worried about rates increasing in 2 years time, and Odfjell was seeing the same thing, they could agree a cost for those options (that would also probably make the bank happy). Until you see such deals it’s all just talk.

Shale and offshore… the competition for marginal investment dollars…

Last week the Baker Hughes rig count for the US came in and again it was up. In the graph above Woodmac are highlighting it that Lower 48 US shale production may crack 12m barrels a day.  As recently as 2013, when offshore was starting to go really long on ships, US shale production was ~3.0m per day. It has in short been an industrial phenomena, one as I have noted here before no other economy in  the world could have marshalled as it has required enrmous flexibility in capital markets and the ability to turn a service industry into a manufacturing process.

The narrative has changed as well. Shale has consistently outperformed even optmistic forecasts:

US-Shale-Production-Outlook-Revised-Upward-Repeatedly-20160210-v2.png

As recently as 2016 even BP’s renowned research team were only predicting a fraction of actual demand. Shale now represents an enormous portion of workd output and it’s economic model of short-cycle low-margin is the antithesis offshore but this flexibility around spending commitment is clearly very valuable to E&P companies in an era of price volatility.

So I get as the price declined in 2014/15 you could maybe make a reasonable case for a quick rebound in offshore? 2016 at a stretch, although I think the market signals for offshore were already clear byt then, but I have to say it strikes me as hard now for people ignore the scale of this change and to argue there will be some demand driven boom coming in offshore. E&P companies have stated repeatedly they are sticking to forecast offshore CapEx numbers and they seem to be sticking this.

I still think there are too many business plans floating around which have as a core assumption. This from Ocean Rig:

Ocean Rig Recovery.png

“[F]or the market upturn” (emphasis added)… like it’s a given? I get it’s off a low base but I think we all know when people talk about that sort of recovery they mean a deep cyclical one that flows to rig and vessel operators who will make a ton of money.

But let’s look at the scale in terms of shift at the margin in incremental output:

Long term offshore.png

The last time the oil price dropped and offshore boomed back,whichever cycle you were talking about but especially the quick 2008/09 rebound, that yellow portion of incremental investmnent simply didn’t exist on the graph in a meaningful sense (and since this graph was done shale is more important). A business plan that simply ignores this reality an insists on a change in market conditions as it’s defining principal is simply logically inconsistent to my mind. Clearly offshore is an important part of the energy mix going forward, but in 2009 it was really the only alternative to traditional onshore production and that clearly isn’t the case now.

Offshore used to have very high utilisation rates, that is what made small companies in an extremely capital intensive industry viable, but it is clear that the scale of investment in shale is having a profound impact on utilisation levels and this is changing the entire economic structure of the industry. This point is a prelude to a further few posts that have this logic as there core.

The New North Sea…

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

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

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

Statoil Cost reduction Q1 2018.png

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

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

Statoil drilling efficiency.png

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

Statoil break even.png

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

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

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

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

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

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

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

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

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

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

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

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

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

Subsea 7 cost reductions.png

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

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

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

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

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