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.

DOF Subsea IPO looks like a market bellweather of what financial investors believe…

Successful investing is anticipating the anticipations of others.

John Maynard Keynes

I was always sceptical of the DOF Subsea IPO, any subsea company raising capital at the moment would need an exceptional value story and this never offered that. I saw it as insiders selling out aware of how the future could look, so news that it was canned doesn’t come as a huge surprise. First Reserve wanted out but not at any price, and so the IPO was pulled. Let’s be clear this wasn’t a casual conversation, bankers will have had sounding out conversations with key investors who either gave a steadfast refusal, or said they would only buy it really cheap. The investment narrative is moving to shale in financial hubs at the moment, no one is paying full price for assets at the moment, and as the numbers make clear this is an asset business. The DOF Subsea Q1 numbers also make really clear that talk of a recovery at the moment just isn’t substantive.

DOF Subsea is a good company, and they are strong in Brazil and Norway which strategically is as good as it gets in macro terms for offshore, but they simply cannot be immune to the enormous retraction in demand the industry is experiencing. DOF Subsea also has the DOF problem which they blithely dismiss but which no one can get past: are they a contractors’ contractor or a contractor? As the industry consolidates it is increasingly hard to see someone being able to be both. It is also hard to believe that when all the flexlay vessels come off contract with Petrobras they will be employed at anything like the current rate creating a huge residual value issue on entry for stockholders (unless they were relying on the greater fool theory).

A quick look at at the Q1 results shows why the IPO was always going to be tricky:

DOF Subsea Utilisation Q1 2017

Despite what the Ops guys try and tell you about the boat stuff being black magic voodoo knowledge that simple people can’t understand subsea (and offshore supply) is a utilisation business, just like a hotel. Even at the top end of projects the value added by the marine delivery assets outstrips all the other costs of the SURF installations and therefore the performance of the vessels dictates the cost base and obviously the financial results of offshore contractors. Offshore contractors have high fixed costs on a depreciating asset base, vessel days are “disposable inventory” that if not sold have a set cost. Given DOF Subsea only have 1 chartered vessel so fleet utilisation shown above is clearly declining massively. This dropped straight to the bottom line:

DOF Subsea Q1 2017 EBITDA

It is a really simple business model: when the ships work you make money. DOF Subsea has a load of liquidity and has no immediate issues, but if anything goes wrong in Brazil then there is a massive problem. Petrobras are too long on flexlay capability and are unlikely to simply get rid of Subsea 7 only.

Despite the name and it’s ambitions DOF Subsea is still essentially a supply company:

DOF Subsea EBITDA Segment

Project accounting is notoriously complicated but in short in the six months from Oct 16 to Mar 17 DOF Subsea turned over NOK 1.5bn in subsea project delivery and made only NOK 96m EBITDA (as a rough cash proxy). The cash conversion rate is down substantially from 2016, whereas chartering vessels, by far the vast majority of EBITDA on a smaller number of vessels, drops with remarkable efficiency to EBITDA (c.80%).

I am always perplexed then to read comments like this:

DOF Subsea AS (“DOF Subsea”) and its shareholders have decided to start reviewing the opportunity for DOF Subsea to apply for a listing on Oslo Stock Exchange.
Proceeds from the primary issuance will provide flexibility for DOF Subsea to decisively pursue further organic and strategic growth opportunities and enhance the Company’s competitive position ahead of an anticipated market recovery.
You would think announcing numbers like the above you would want a better explanation before just casually dropping in a market recovery story/theory. Maybe even a data point or two? But no… straight in with this:
The Board of Directors is disappointed with the financial numbers for 1st quarter of 2017, especially with the performance in the North America region and the high number of vessels facing idle time between projects and downtime due to maintenance.
The real problem would appear to be believing that subsea vessels now have different economic drivers to offshore supply vessels. Maybe DOF would be better of just combining with DOF Subsea and accepting its all about scale now? Subsea vessels used to command a premium but not for the foreseeable future, a point bizzarely HugeStadSea have implicity accepted. I note that no ROV information is provided at all. Everyone in the ROV space is complaining about pricing pressure and with 69 systems DOF Subsea are a big player, you can read into that blank what you want.
At some point not everyone can benefit from this increasingly distant, and potentially mythical, recovery. With the amount of tonnage delivered a demand side recovery will also not translate directly into a supply side boom.  Investors paying full price for assets that were ordered for a different era are a rare breed at the moment as it is hard to argue that asset values have not been permanently impaired. Whether this is structural or cyclical downturn is for individual investors to decide (I saw an email last Friday from  the senior management at one offshore company stressing again the fervent hope that the market would turn eventually), clearly in this case investors decided they needed to see a different set of numbers.

Productivity breakeven reduction versus over supply driven cost reduction

Great graph from Rystad today showing how productivity improvements are driving a reduction in tight oil and offshore. I do however think it worth noting that this is a productivity driven cost reduction whereas in offshore it would appear that much of the cost reduction simply reflects equity that has been wiped out and contractors supplying assets at OpEx levels or below. My thoughts on Baumol productivity remain valid.

It is interesting though that offshore deepwater costs seem to move in a linear fashion with demand, as does offshore midwater. The reasons for the decline in offshore shelf breakeven costs would be interesting to explore.

DeepSea Supply, bank behaviour, credit, and the Great Depression

Contagion is a significant increase in comovements of prices and quantities across markets, conditional on a crisis occurring in one market or group of markets.

A Primer on Financial Contagion

Massimo Sbracia and Marcello Pericoli

 

“No one has seen a worse offshore market than what we’re going through now,” Kristin Holth, head of shipping, offshore and logistics at DNB ASA, said in an interview at the Nor-Shipping conference… “It hasn’t been a regular downturn. In many ways, we’ve seen the collapse of an industry.”

I am a bit late getting to this but the DeepSea Supply (“DESS”) Q1 results when combined with the Solstad merger information memorandum are extremely interesting… they beg the question: would you pay USD 600m for some Asian built PSVs and AHTSs when 16 of them are in lay-up? Some of these are not flash tonnage: the six year old 6800bhp vessels built at ABG and the UT 755 PSVs built in Cochin look extremely vulnerable. To put that figure in perspective it is USD 28.5m for every working vessel (with 16 of the 37 in lay-up) and even on a average basis it is still USD 16.2m. In the current market most of those vessels would strugggle to go for more than USD 8m, collectively they would make asset values even lower than that they are such a large fleet.

It is an absurd figure… but of course the banks behind DESS, who are owed that much, don’t have a choice now, they lent in a different era. The reason balance sheet recessions are so severe is that debt obligations remain constant long after the equity is wiped out. If enough debtors default this travels to the banking system. And one of the problems offshore has at the moment is a lack of lending from the banking system: it is no different to the housing market, if banks will not lend then asset prices decline, and on depreciating assets such as vessels, I would argue the impairment is likely to be permanent for certain assets (Asian built commodity tonnage being part of that for sure). The problem for the offshore supply industry is when will the banks start to lend? Because for a long time I think risk officers at banks will insist this tonnage stays off the balance sheet once they have closed their positions. Risk models hate volatility and these assets have it in large quantities.

In the DESS case the banks and Solstad have branded DESS a low cost operator, not low cost enough to come close to break-even in this downturn, but apparently this is the future. It is really hard not to think that the closer they get to this merger Solstad can’t be wondering if there was anyway of getting rid of this company… If it was a horse you would shoot it.

Sooner or later someone is going to have get some of the banks behind these assets to start getting real. Part of the business of banking is what economists call maturity transformation: banks borrow deposits off people and then re-lend them out for projects with a much longer contractual requirement, it is a a very risk business model, particularly when done on very thin layers of capital. They are a lot like a hedge fund in other words, in the industry vernacular banks “borrow short and lend long”.  The Nordic banks involved in both Farstad and DESS are effectively becoming hedge funds in another way: thinking they can play the market. These banks are the prime movers in failing to liquidate assets to discover their true floor price.

In order for the HugeStadSea merger to go ahead the DESS banks must make the following concessions:

Main elements in this context are the following:

(i) Reduction of amortization to 10 % of the original repayment schedule until 31 December 2021;

(ii) Pre-approval to sell certain vessels at prices below allocated mortgaged debt (only applicable under the combined fleet facility);

(iii) Minimum value clause set to 100 % and suspended until 1 January 2020;

(iv) Removal of financial covenants related to value adjusted equity, and

(v) Introduction of cash sweep mechanism.

Point (i) makes clear the assets cannot generate sufficient cash flow in the current market to pay them back more than a token amount. One of the troubles is the 10% is for the entire 37 vessels not the 26 working so even this looks optimisitic.

Point (iv) means the banks will just pretend that even though you are insolvent you are a going concern while (v) just makes sure they collect any surplus cash.

Does anyone in this industry believe that a Chinese built UT 755 will in 4 years time, having made no payments for 25% of its economic life, be able to keep the bank whole on this loan? It is just absurd.

Solstad are going to need an enormous rights issue fairly early on (not just because of DESS I hasten to add, Farstad is arguably more of a basket case). According to the announcement JF/Hemmen put in NOK 200m (c. USD 23m) into Solstad shares (approximately 3.8% of the loans outstanding or c. 180 days of EBIT losses). So in crude terms the DESS gift to Solstad’s high class CSV fleet (with some supply vessels as well to be fair)  is a commodity fleet of 37 vessels, with 16 laid up, constant debt obligations of USD 600m, and a proportionate capital increase against this of 4%. Potentially there are some cost savings but these seem contrived in the extreme (when you cash flow losses are this high you can’t meaningfully talk of measurable synergies as opposed to normal cost cutting)… but I don’t think anyone would buy the shares based on those anyway.

When people saw the US housing crisis emerge they realised it wasn’t just NINJA loans and MBS that was the problem, it was also second mortgages to pay for current consumption. Shipping banks also make the same mistake as this paragraph outlining DNBs exposure to DESS makes clear:

The facility amount under the DNB Facility is USD 140,640,000 repayable in quarterly instalments until 31December 2021…The DNB Facility is secured by, inter alia, first priority mortgages over the financed vessels… Additionally, the lenders under the DNB Facility will… receive (silent) second priority mortgages over the vessels in the NIBC Facility (described below) and the Fleet Loan Facility

How much would you pay for the second mortgage on a Chinese AHTS at the moment? If you give me a number in anything other than Turkish Lira, and a small one at that, please PM me your details so my Nigerian banking associates can request your account details as we have a Euromillions win we wish to deposit there.

And here is what I have been saying in words laid out graphically for you:

DESS Repayment profile

What the banks behind DESS and Solstad want you to believe is that in five years time a company with a collection of Asian built PSVs and AHTS, many over 10-14 years old, will be able to get another bank or group of bondholders to pay them USD 515m to settle their claim (c. USD 13.9m per vessel!). These same banks refuse loans to vessels older than 8 years! It’s just not serious,  but it shows how desperate the banks are not to take losses to the P&L here and pretend they don’t have the problem. Note the lead bank here is DNB who as Mr Holth has made clear do understand the scale of the problem. Mr Holth is extending five years further credit to an industry he believes has collapsed?

[Obviously the loan will be rolled over in 5 years or written down massively]. Quite why banks with the self-professed capital strength of DNB, Nordea and others involve themselves in such shenanigans is for another post. But these numbers are material and not even realistic: at USD 21m per annum of interest all of the 21 working vessels (at less than 100% utilisation) need to make USD 57.5k per day just to pay the interest bill (USD 2.7k per vessel) when most are working at OpEx breakeven if lucky.

To really drive home what a bad deal the merger is checkout this paragraph:

As per the date of this Information Memorandum, the SOFF Group does not have sufficient working capital for its present requirements in a twelve month perspective. Under its current financing facilities, there is a minimum liquidity requirement of NOK 400 million, and by March 2018, a shortage of approximately NOK 100 million is expected.

The document states the banks will relax this covenant but that isn’t really the issue. The issue is in more prudent times the banks thought they needed 400 and now that asset values have plummted they suddenly don’t. A “world leading” OSV company with 157 vessels doesn’t even have USD 48m in liquidity… please… You need to be flexible in these situations absolutely, but really, for this merger? I love the way the lawyers have forced them to write if they cannot agree this the banks may demand accelerated repayment, despite the fact everyone has gone to such extraordinary efforts to ensure that is exactly what doesn’t happen.

And I guess at base level that is what I don’t like about this merger: the owners should have played harder with the banks and forced them to realise that their values are nothing like the book values. Forcing people to keep book values high with low ammortisation payments just delays things and makes raising new equity even harder. We are starting to get into a philosophical debate about the nature of money here, that a loan contract is just a claim on future economic outcomes, and these ones are worth substantially less than when they were willingly entered into. Friedman was wrong (about a lot):

“Only government can take perfectly good paper, cover it with perfectly good ink, and make it worthless”

Shipowners and banks combined have also done an excellent job of doing the same. Particularly the OpEx demon…

If you wonder what the expression “zombie bank” is look no further than the offshore portfolios of these banks because they will never take this sort of exposure on balance sheet again and unless the Chinese banks do, who are much more likely to support new builds from Chinese yards, then the industry has an asset value problem.

There are plenty of historical precedents for these issues in the banking system. In innovative research Postel-Vinay looked at banks, housing, and second mortgages in Chicago during the Great Depression and found:

[a]s theory predicts, debt dilution, even in the presence of seniority rules, can be highly detrimental to both junior and senior lenders. The probability of default on first mortgages was likely to increase, and commercial banks were more likely to foreclose. Through foreclosure they would still be able to retrieve 50 per cent of the property value, but often after a protracted foreclosure process. This would have put further strain on banks during liquidity crises. This article is thus a timely reminder that second mortgages, or ‘piggyback loans’ as they are called today, can be hazardous to lenders and borrowers alike. It provides further empirical evidence that debt dilution can be detrimental to credit.

When those second mortgages on vessels turn out to be valueless this will cause an issue in the banks risk models. Then what economists call “interbank amplification” where banks withdraw money from certain asset sectors, and in this case reduce lending to similar asset classes, further lessening the available money supply available in total and reducing asset values (ad infinitum). Researchers at the Richmond Fed looked at this in the Great Depression:

Interbank networks amplified the contraction in lending during the Great Depression. Banking panics induced banks in the hinterland to withdraw interbank deposits from Federal Reserve member banks located in reserve and central reserve cities. These correspondent banks responded by curtailing lending to businesses. Between the peak in the summer of 1929 and the banking holiday in the winter of 1933, interbank amplification reduced aggregate lending in the U.S. economy by an estimated 15 percent.

I keep referencing the Great Depression here because one of the issues in recovery from it was asset values and the problems associated with a reduction in the monetary supply (and here I will concede Friedman was on to something). These two issues fed on one another in a self reinforcing circle and also led to a collapse in credit because no one had collateral that financial institutions would accept as worthy lending against. Taking macro models to micro industries has methodological issues, but I think it is valid here (*methodologiocal reasoning too technical for this forum). Suffice to say the supply side of this recovery will follow a different dynamic to the demand side and those who watch the daily fluctuations in the oil price with hope are wasting their time.

One of the controversies of the Great Depression is did Andrew Mellon, arch tycoon in a Trumpian sense, really tell Hoover to “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.”? Mellon always denied it and it suited Hoover to claim it. In a macro sense it is clearly ill advised, but in offshore I can’t help feeling it would be good advice. At the moment we are slowly grinding through the inexorable oversupply where banks are propping up failed economic propositions though moves like this that potentially put companies out of business that may have survived. Such is the life of credit, but as I have said before until this clears out the entire industry will make suboptimal returns. 

Reach(ing) for the absurd… Structure-Conduct-Performance

Situations emerge in the process of creative destruction in which many firms may have to perish that nevertheless would be able to live on vigorously and usefully if they could weather a particular storm.

Joseph A. Schumpeter

I have been busy lately and therefore not had as much time to write as I would like. I am working on a longer post about how much a North Sea DSV is worth (following the Nor and Bibby results), and another post on DeepSea Supply. But the constant theme in the market at the moment seems to be that no matter how bad the numbers are to claim an increase in tendering activity, as if all will be well if we just hold on a little longer, and it is this that has forced me to write…

The most logical explanation, borne out by the numbers at the moment, is that tendering is increasing because those putting out the tenders have realised there is a marginal benefit in doing so: they get cheaper prices and do not face diminishing returns from the increasing tender costs. Such an explanation fits easily with everyone reporting declining margins (Maersk, Bibby, Reach, Bourbon, DeepOcean, Solstad etc.,) across the entire supply chain while unanimously claiming to be tendering more. I get contracting lags tenders, and at some point this will mean that tenders will increase prior to work, but it simply isn’t happening at the moment: the schedules are still being cut and work delayed as all those reporting weaker numbers tell you, with no sense of apparent irony, at the same time as they report increased tendering activity.

I still feel that many people in the industry haven’t yet come to grips with the scale of change in the supply change that will be necessary for the market to balance and the structural nature of that change. Until investors who don’t understand this have been flushed out, and it would appear that this will only happen when they have faced mutliple capital injections at ever decreasing rates of return, the entire supply chain will suffer with profitability and utilisation issues.

Reach Subsea reported results and commentary this week in exactly this vein. The ROV industry in particular reminds me of my first job in NZ when a couple of weeks into it someone flew down from Germany to have a strategy meeting with us. “We are going to grow twice as fast as the market” he stated, when I asked “Isn’t everyone else saying this at their planning day as well, so what are we going to do differently” I realised my career at this company was off to a bad start. (I also realised that marketing wasn’t for me. Although the hilarity did ensue when the said individual returned later in the year (1997) to demand higher returns as the Asian currency crisis was having a poor effect on his P&L. When I pointed out 65% of NZ’s trade balance came from APEC countries I was pleased to have a UK passport.

Collectively it is axiomatic that the sum of all firms in the industry can only be equal to the market size and the overall market growth rate. Yet everyone in the ROV space at the moment claims to be growing market share or holding up despite new companies launching and no one making any money.

ROV systems are preferable to own over an offshore vessel only because they don’t have the running costs and you can put them in a warehouse until a recovery appears. But the ROV industry has very low barriers to entry, are in huge oversupply, and the industry is dominated by 5 very well capitalised and global companies. I have lost count of the number of companies striking a deal with a vessel owner to put the system on for free while they take the risk and cost of tendering on. It is not an original business model.

This graph from the market leader, Oceaneering, makes it clear the scale of the large companies:

ROV Market 2017

Source: MS Presentation, May 2017, IHS Data

And the largest company in the market (OII) has poor utilisation and a day rate reduction of 25% since 2014:

OII fleet utilisation.png

The question is really why you would want to go long on this market? Reach to be clear has 6 systems while OII has 282. Four competitors control more than 50% of the market. This is a market that has declined significantly in the last couple of years and seen a small number of new competitors (i.e. M2) come in and buy assets below depreciated value from previously bankrupt companies. If you speak to anyone in the market at the ROV companies they will tell you they are giving away the ROV for free and trying to make money off the personnel and mobilisations. It is a totally unsustainable business model.

The only economically rational strategy here is for a massive consolidation amongst the larger industry players, starting with the grey quarter in the graph who don’t even get their own colour. There is no differentiation in the end product to the customer and no ability for ROV contractors to add value in all but a few extreme circumstances. The longer investors support companies like this the longer the entire industry will operate at below a profitability level required to get CapEx to equal depreciation and ROE to equal the cost of capital.

Reach to be clear reported revenue down more than 50% on the same period last year but at the same time like everyone else reported increased tendering. Reach are krill that will eventually be eaten by a blue whale (hence the photo). I understand that smaller contractors face risks where one vessel is in proportion a larger part of their business, but that just reinforces the economic necessity of having the assets controlled by a larger firm, because the cost base doesn’t vary by the same amount and the lack the scale and scope required to market and develop such assets.

I also noted in the Reach private placement memo this note about their strategy:

8.9 The Group’s strategy

The strategy of the Group in a five-year perspective, could be outlined as follows:

8.9.1 Strategy in the OPEX-market (fields in operation)

  • Target IMR frame agreements
  • Export of North Sea technology and standards to selected major deepwater areas in the world (emphasis added)
  • Provide new services in the segment
  • Bid for seasonal contracts in key regions  (FTSS: Really?)

8.9.2 Strategy in the CAPEX-market (fields under construction)

  • The goal is to be a preferred subcontractor to the major EPIC subsea contractors
  • Securing the right assets will be key (FTSS: They are everywhere and in huge quantity, no problem)
  • Gradually develop assets and resource base
  • Do smaller EPIC-contracts at own risk

8.9.3 International expansion (FTSS: And take market share off who? How?)

  • Develop the international market in parallel with the North Sea market when opportunities appear
  • Seek international partners in selected areas like Australia, Mexico, Brazil and West Africa
  • Develop a foothold in new deepwater areas

8.9.4 Asset base

  • Invest in new assets (FTSS: Why?! The industry has overcapacity)
  • Secure the right assets
  • Mix of owned and hired equipment

I don’t know when I have disagreed with something more. Firstly, if offshore is to grow as industry it needs to compete on cost and that means the North Sea becoming more like the rest of the world not the other way around. Taking the North Sea standard overseas is a proven failure. Bibby tried it in the Gulf of Mexico with disastrous results, and in Asia with a DSV, it was worth trying in Asia but it wasn’t needed or wanted. Technip did the same in Australia. Anyone who thinks they can take the North Sea standard out of the North Sea hasn’t been out of the region. The North Sea is like it is because a) the environmental conditions are more severe than anywhere else, and b) the regulatory environment. You can’t force E&P companies to add to their cost base when it adds no value in the current environment.

If Reach are looking to expand internationally in a declining market then someone else is losing market share. Call me sceptical but in this market that is simply unrealistic. That a company with 6 systems, could have the resources to do this and start to drive consolidation when they are 276 systems behind the market leader isn’t real.

OII and others have literally tens of spare systems, they make them, and are giving them away for free. OII and others are here for as long as there is an industry (and OII have a current market cap of USD 2.3bn). I am not saying Reach is a bad investment (I don’t give investment advice), although it does strike me that it is an asymetric payoff where either someone buys them at a takeover premium, or they slowly make a return at less than their cost of capital and eventually funding runs out. Quite why you would pay higher than NAV for some ROVs which are cheaper on the second hand market and some vessel commitments is beyond me though.

I could go on. I don’t want to do a hatchet job on Reach, that isn’t my point. My point is simply that this industry needs to be signficantly smaller on the supply side and that this requires letting some firms go under. The economic rationale is called the structure-conduct-performance paradigm and is a well known feature of industrial organisation analysis. Porter’s five forces model (that all MBA’s learn), is based on this intellectual strand and the simple expedient that industry effects can be stronger than firm effects (there is much more to this and it deserves a much bigger piece for another day, including the move in the 80’s to the Resource-Based view of the firm which argues that firm effects are stronger and markets not so deterministic:, but in a consolidating industry the evidence is clear). No matter how competent the management of Reach Subsea are, and they clearly are skilled operators, they cannot in the long run compete against market structures so entrenched and differing in scale. Path dependency counts.

The offshore supply chain is clearly going to evolve in a way that was very different from the past. In the pre-2014 environment the industry had large numbers of small subcontractors, like Reach, who made money because the big companies were too busy, and making too much money, to concentrate on the small stuff. That isn’t the case now where they are under pressure to supply assets with very high fixed costs at below breakeven to win work. In order to do that they using the supply chain for ROVs (and other equipment) to supply their kit at below cost and ensure both sides lose their equity. When there is no more for the supply chain to give they will internalise the costs and reduce unit costs where possible. There is no other way this will play out.

Financial investors like Standard Drilling (PSVs), Nor Offshore (DSVs), Reach (ROVs) have all brought in expecting this was some temporary downturn and thought prices would start rising, as per previous models, and then they would then be handsomely rewarded for their (sic) foresight. It is becoming apparent now that this is not the right narrative: this is a structural downturn (Rystad  put a demand return in 10 years!). Only last week I learnt Shell was making a major commitment to ROVs on platforms (again) to consistently reduce OpEx where previously they had used vessels. Examples like this are legion, and I believe in total these stories to be representative of a wider and deeper change where E&P companies will seek to drive down unit costs offshore and this favours consolidation in the industry. So far the numbers are with my theory.

The beauty of capitalism is that you can place bets with money that help determine the outcome. I could be wrong and some huge, totally unexpected, market recovery could take place. The investors in the Nor vessels have so far been way off in their judgement, and I believe Standard Drilling have as well. Let’s see with Reach. But as long as there are investors for companies like this out there, and demand remains at current levels, expect to read plenty more stories about increased tendering while digesting appalling financial results.

The narrative in capital allocation moves to shale…

I use the term narrative to mean a simple story or easily expressed explanation of events that many people want to bring up in conversation or on news or social media because it can be used to stimulate the concerns or emotions of others, and/or because it appears to advance self-interest. To be stimulating, it usually has some human interest either direct or implied. As I (and many others) use the term, a narrative is a gem for conversation, and may take the form of an extraordinary or heroic tale or even a joke. It is not generally a researched story, and may have glaring holes, as in “urban legends.” The form of the narrative varies through time and across tellings, but maintains a core contagious element, in the forms that are successful in spreading. Why an element is contagious, when it may even “go viral,” may be hard to understand, unless we reflect carefully on the reason people like to spread the narrative. Mutations in narratives spring up randomly, just as in organisms in evolutionary biology, and when they are contagious, the mutated narratives generate seemingly unpredictable changes in the economy.

Shiller, 2017

News that BP had started production at Quad 204 (Schiehallion) led curmudgeonly FT columnist Lombard to note  yesterday:

If anything, then, Monday’s news is more of a last hurrah for BP in the North Sea, and for the UK Continental Shelf more broadly. With the strongest capital flows — and investor buzz — focused on unconventional US resources, traditional offshore oil can seem as fashionable as a set of free “crystal” tumblers from a 1970s petrol station. With a big shield logo.

I have mentioned here before that behavioural finance is starting to examine the narrative in economics (see initial quote), and at the moment this is the narrative in London and other capital markets. This ties in nicely with an excellent piece from Rystad earlier in the week looking at the future of the North Sea and the Gulf of Mexico (I recommend reading the whole thing). For service companies Rystad notes:

After such a deep cut in this market it will take some time before the industry experiences a full recovery. Even with oil prices of $90/bbl to $100/bbl for the next decade, the market will not be back to 2014 levels before 2024.

The link for me is that offshore is going to bifurcate into huge developments (Quad 204, Mariner, Bressay, Mad Dog 2) and “the rest”. The rest are unfortunately going to be much smaller in number and less frequent. Rystad specifically mentions the lack of tie-back and tie-in projects in these regions. These projects are the investments that really compete with shale: 8-12 000 bpd that were ignored by larger E&P companies. The larger developments with high flow rates, and multi-decade economic plans, are vital for security of volume and a core underpinning of E&P profitability, and they are very economic, playing to super-major strengths of vast capital requirements combined with astounding engineering capability; but smaller developments in the USD 50-200m range are at a real risk of grinding to a slow halt for all except the companies currently committed to this space.

The North Sea, and to a lesser extent GoM, always had a significant number of smaller players (think Ithaca Energy (recently sold to Dalek) or Enquest), that raised (relatively) small sums of money and then sought to regenerate an exisiting area or develop smaller finds. Access to financing for that market simply doesn’t exist at the moment on anything like the scale it did before. Those Finance Directors who used to traipse around fund managers in London, Vancouver, New York etc with a deck of slides explaining their proposed developments are simply not getting a hearing. Not only that the tried and tested business model of developing a few fields and selling out with a takeover premium when they had built sufficient scale isn’t credible any more as potential acquirers focus on more on tight oil. Now those fund managers are meeting with guys who have a deck of slides that start with a shale rig, emphasise the relatively low upfront capital (as opposed to the higher OpEx) and their ability to rein in variable costs should price declines occur. The meme in financial markets now is all about shale, and rightly or wrongly, influential columns such as the one above help set this “dominant logic”.

Inside the big E&P companies managers, who are cognizent of the fact they must deal with analysts in the financial community and the investor base who follow the same narrative, are adapting and spending more time to examining potential shale investments. Offshore is getting less airtime. When was the last time you hard someone say “all the easy oil is gone” – which was taken as fact only 5 years ago. From this myriad of individual meetings and actions the macro picture of slowing capital flows into offshore and increased investment in shale is being driven, and it will be very hard to reverse without some exogenous event.

As behavioural economics teaches us humans are “boundedly rational” not the perfectly rational homo economicus so beloved of the efficient markets crowd. What this means is that potential investors can only process so much information, if you combine this with the fact that institutional investors “herd” (i.e. invest where their competitors do), you can see the current investment vogue is short cycle shale which makes even getting funding hard even for compelling offshore investments. Those who have heard the word “Permania” used to describe the boom in Permian basin will relate to this quote from the IMF on investment herding:

[p]rocyclicality in asset allocation can make swings in financial asset value and economic activity more intense. From an individual investor’s point of view, procyclical behavior can be rational, especially if short-term constraints become binding or if the investor can exit earlier than others. However, the collective actions of many investors may lead to increased volatility of asset prices and instability of the financial system..

Eventually the shale mania will wain as people overpay for land and productivity improvements slow. The problem for offshore is the amount of OpEx people will have to burn to get to this point and the consistently increasing productivity of shale.

Big players in the North Sea region like Apache, Taqa, and Sinopec will conitnue to develop offshore fields but they are not doing as many projects. The threshold rate for investment will be higher, because experience has taught us that you can get 5 years of low oil prices and many of these projects only have economic lives of 5-10 years (risk models are great at solving previous issues). These companies have less access to capital markets than their shale competitors because the high-yield desk has the same meme as the equity investors, higher equity costs and more risk averse bank funding raise project return requirements even more. Even state -backed companies like Taqa must vie for funding internally. Outside of the North Sea and GoM these developments are likely to remain dominated by National Oil Companies who may not rank projects on a strictly economic basis but will take the expected spot price of oil into account in their investment decisions. But as Rystad makes clear the North Sea and GoM volume increases will all be driven by a smaller number of larger projects.

This affects contractors differently. As Rystad notes EPIC work will decline proportionately less than other work.  For DSVs and ROV operators and vessel owners) this is grim . Until construction work, that uses far more DSV and ROV days than maintenance work, improves the supply side of the industry will take the adjustments both in day rates and utilisation levels. The supply chain is going to change into a few large integrated contractors in these regions with a vast choice of assets to service their needs and they are likely to reduce their comitted charter tonnage . These large contractors will make an economic return but part of it will be done by ensuring the smaller companies in the supply chain make only enough economic profit to survive and the equity value (if any) in these companies and assets looks set to be depressed for an extended period. Consolidation on a scale only dreamed of at the moment amongst vessel owners looks certain.

Demand will not return for smaller projects until the market price for oil stabilises at a substantially higher price than now, and does so for long-enough to give potential funders confidence that the upturn isn’t temporary. The uplift will likely be less severe because shale has introduced a “kink” in the supply curve. Projects take time to pass through engineering, funding etc before meaningful offshore work occurs. This is a long-term issue: Demand may have stabilised at current levels but recovery for the supply chain that is based on the realistic prospect of higher days rates and utillisation looks some way off.  For an asset base built to supply a 2013/14 demand curve the outcome looks uncomfortably obvious.

 

 

How much is the Lewek Constellation worth? Somewhere between USD 43m and USD 370m (I’m closer to the former)…

“His services are like so many white elephants, of which nobody can make use, and yet that drain one’s gratitude, if indeed one does not feel bankrupt.”

G. E. Jewbury’s Letters, 1892

The EMAS Chiyoda restructuring plan nears execution. The most interesting aspect to me is what the Lewek Constellation is valued at and how the banks get this problem off their hands (i.e. how much of a loss do they have to take?) Outside of Saipem, SS7, Technip, McDermott, and Heerema (maybe) it is very hard to see who the realistic buyers would be? There is no spot market for these assets because you need a huge engineering capability (and cost base) on the beach to run one of these assets. And the real problem is that all these potential buyers have added substantial new tonnage in deepwater pipelay very recently. (My previous thoughts on asset specificity and transaction costs are here). Without a dramatic improvement in the market it’s hard to see why anyone would want this asset?

Or not? In the Chapter 11 reorg Subsea 7 and Chiyoda are essentially providing a USD 90m Debtor-In-Possession  facility that sees them take over 5 EMAS Chiyoda entities emerge that have 15 projects with c.1bn in backlog. Subsea 7 obviously decided this was the easiest way to get the work, and when you drop c.USD 1bn in backlog in a year it’s easy to see why you want to be inventive. The big SURF scopes are Cape Three Points and Chevron Tahiti Vertical Expansion. Given how far the engineering had advanced and the fact the contracts had been awarded it is easy to see why Subsea 7 would want to take some risk getting this work.

Some context: back in 2013, the build year of the Lewek Constellation, Clarkson published this graph:

Clarkson Subsea Trees Nov 25 2013

Now Clarkson’s are no different to anyone. I could have picked any number of information providers, the commonly held view was only how much growth there would be, and how much kit you needed to access it. Shale was not in vogue and starting it’s extraordinary journey.  Although as an aside, because I don’t want to delve into shale productivity here (but you can read some of my thoughts here and here), the US rig count was higher than it currently is.  But the point is clearly that boards, managers, and financing institutions all thought the market would evolve something like that graph. On such a basis the investment decision was made for the Lewek Constellation and DNB and a syndicate of banks advanced USD 503m in two facilities and got two Panamian mortgages and a credit agreement in return. Of that USD 370m in capital is outstanding under facuility A (and the 100m from facility B is effectively written off) in the Chap 11.

The market has obviously changed somewhat:

Subsea Tree Awards 2000-2019e

The single best indicator of future demand for heavy installation vessels is subsea tree awards. Now it is clear that demand has dropped and will remain depressed for a long time at around 2003/2004 levels. Strip out Brazil, where Petrobras has extensive spare PLSV capacity for flexlay, and you are within a margin of error of 2003 numbers. Yes, more proportionately will be in deep water, but the subsea lay fleet was built for 2013/14 not 2003 and no amount of deferred consideration can change that.

Let’s be clear the Lewek Constellation is a capable vessel, but I wrote here about competition: a significant number of competing vessels have been built in recent years and this is all about competition at the margin. These types of vessels don’t work to their maximum potential every day, they work on a broad range of smaller jobs and then make real money on a couple of jobs of a year where the competition is less and pricing is based not only on vessel capability but about engineering value added by the contractor. None of them is differentiated enough to win a project in its own right.

So a market transaction has been reached whereby Newco (owned by Subsea 7) will charter the vessel for USD 4.3m per annum and the cost of the dry dock (c. 2018) is split 50/50 at ~USD 5m each. That is, in the current environment Subsea 7/Newco judges that it is economic to add marginal (extra) lay capacity at bareboat rate per year of USD 4.3m, plus drydock accrual and operating expenses,  and the bank/owner has agreed it is economic to charter their asset at this rate. That is a market-based economic transaction between a “willing-buyer/ willing-seller” for the capital value of the asset and it reflects some backlog that a qualified purchaser can deliver with it. Subsea 7/Newco has an option to purchase the asset for USD 370m during the first 2 years of the charter agreement and this is then used a “floor” going forward or broker valuations less USD 20m. The extension options rise dramatically (see below).

Now if you add 3% per annum to the charter rate, add in dry dock costs, assume 10m salvage value in 20 years, and discount this back by the DNB WACC (10.4% today) you get an implied vessel value of ~ USD 43m.  I would argue that is a fair value for the vessel, which is pretty much in line with the discount MDR paid for the Amazon and NPCC paid for Atlantis (I mentioned this yesterday).  [I used the 3% growth in the annual day rate to reflect an industry with excess capacity and therefore growth roughly inline or above a CPI measure, obviously the mortgage banks would regard this number as unacceptably low. However, I think the discount rate at DNB WACC (rather than funding costs or liquidity spreads perhaps) given the project risk is far too low. Obviously different inputs will lead to different results.] For the sake of a comparison in order to get the vessel value to anything like USD 370m you have to increase the charter rate 25% per annum for the entire assumed 20 year period! The charter rate is also linked to a LIBOR adjustment, something that is very rare, and highlights how senstive the banks are to a valuation projection here.

This purchase option number strikes me as a fantasy and reflects the fact that DNB recorded a capital value of USD 370m outstanding in the Chap 11 filing. If you look at the forward order book for subsea trees or announced projects in three years, and all the excess capacity on the vessels, who really believes Subsea 7 is going to pay USD 60 000 per day in 4 years time (USD 21.9m per annum) rising to USD 80 000 per day (USD 29m per annum) in 5 years time? You might do under the assumptions in the first graph but not in the second. It is a chimera to help the banks out and allow everyone to play for time. The initial charter rate implies a 1.16% interest rate on the capital outstanding, so DNB don’t really believe the USD 370m figure, but it highlights the size of the economic subsidy required now for everyone to pretend they haven’t lost as much money as they say.

I was a big fan of Subsea 7 just handing the asset back and forcing the banks into a lengthy period of nervousness and reality, but it would have meant Subsea having to tender for the work. I believe that the Lewek Constellation is such a specific asset that it is actually effectively valueless in the current market. The best thing for the industry was for the asset to fade into obscurity; in this market, and after Ceona, no one would risk a start-up and few other companies would have agreed to help DNB. Clearly Subsea 7 have a strong cash and liquidity position, need the work, and this gives them an option if the market really did take off again. However, surely the most likely scenario from the banks point-of-view, under any objective reading of the market, is that in two years Subsea 7 come back and tell them to start getting real about the price and the asset value? There is a very Norwegian behind the scenes solution going on here with DNB obviously desperate not to have to recognise the vessel at a fire sale price now, or expose itself to the OpEx, and in all likelihood was involved in soliciting Subsea 7 as part of the financing shop around discussed in the documents.

If the Bibby bondholders are looking at these transactions closely they must be getting nervous now. With the bonds trading in the mid-60s the implied valuation of the Polaris and Sapphire is c.GBP 105m, a number that looks as egregious as the USD 370m purchase option for the Lewek Constellation.

The big risk for Subsea 7 isn’t the committed expenditure, which amounts to USD 4.3m for charter per annum (+ the undefined LIBOR spread), + vessel OpEx (probably the same), and c. USD 5m for the dry-dock, it is that they appear to have agreed to deliver the EMAS Chiyoda contracts for the same lump sum price and contractual terms. The few projects EMAS Chiyoda delivered were a disaster in engineering terms, and that isn’t just Angostura, I have spoken to people who have managed other jobs with them. If Subsea 7 haven’t had enough time to due diligence the project engineering and costing properly, which is notoriously hard in lump sum jobs, they are going to have a big problem. Although the contracts appear to be novated to Newco, who exposure in one set of documents appears capped at USD 90m (that may be a placeholder), such a situation is likely to involve other Subsea 7 tonnage and exposure through the supply chain. Subsea 7 are one of the world’s great engineering houses but in 2013 a painful conference call to discuss Guara Lula (which they had bid themselves) led to these comments:

[w]e moved into the offshore phase of the project in the second quarter, with the Seven Polaris and the Seven Oceans being deployed on location. We are experiencing more weather downtime than originally planned due to severe weather conditions in the Santos Basin during the Brazilian winter. We have suffered equipment damage and the resulting downtime on the Polaris due to this bad weather. We expect these conditions to continue until the season is over. Although we are contractually covered for time spent by the prime vessel waiting on weather, we incur additional costs, both offshore and onshore, which are not covered. In addition, we have taken a more cautious approach in evaluating what can be achieved offshore during periods of calm weather, in view of the complexity of the facts involved…

Second, the stretched supply chain is resulting in delays from international and local suppliers….

[t]here was a delayed start to pipeline fabrication at the Ubu spool-base largely due to customs clearance issues. Initial productivity at Ubu has also taken longer to ramp up than expected…

A re-evaluation of the offshore risks based on experience to date, and the extended timeline of the project, has resulted in us increasing the estimate full-life project loss by between $250 and $300 million.

Final losses were USD 355m and that was on vessels and a project they tendered internally. Subsea 7 don’t know this vessel at all, and the engineers and tendering staff had all been instructed to win these tenders at all costs having spoken to people involved in tendering at that stage for EMAS. It may not happen, and they may have done sufficient due diligence, but when you agree to go basically lump sum you are taking execution risk on a tender and asset outside of your management system. Don’t complain later you couldn’t have forseen it, but backlog looks like it is going down so fast they may feel they have few options.

At some point the industry (contractors and financing institutions) are going to have to accept that if all this tonnage remains in operation, and the operating costs are included, then it will have a structural profitability issue without a dramatic change in demand that just isn’t occuring. Yes the Lewek Constellation is a flexible asset, and it can save a variety of vessels working in the field, but those vessels exist now, amongst the current contractors. If an E&P company really wants this specific vessel because of its advantages let them buy it? It only looks more “efficient” in the field compared to other vessels because it isn’t being compared to the historic investments currently solvent contractors have made in a fleet of vessels that collectively perform the same function.

Maybe Subea 7 are looking to retire some older tonnage later on and the easiest way to get over a difficult discussion with the banks was to kick the problem into touch? But at some point the discussion will have to come and I would have thought the banks auditors would have forced it now because in a default situation the value of the vessel is very clear: about USD 43m on a standard capitalised valuation framework. Convincing the auditor that in 36 months you will get a 6x uplift in the day rate when the market forecast is for negligible growth and stable supply strikes me as unlikely in the extreme.

The amount of offshore work may have hit its bottom level and some good contracts are being awarded, but as Eidesvik reminded us today more restructurings are coming, Solutions like this which simply push the eventual reduction in asset values further into the distance will only ensure continued weak profitability for vessel owners (and banks).