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):

Subsea 7 vessel utilisation.png

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.

E&P versus offshore strategy plans… Not what you think?

Last week ExxonMobil released its analyst day presentation. It has a number of interesting things, but I wanted to highlight the fact that although it feels like E&P companies are back making real money, which they are, it may not feel like that to them. And as this article on Bloomberg makes clear investors in these companies want management to keep the lid on CapEx, which is one of the cash flows they really can control:

Exxon argues it has a formidable set of projects, pointing to such goodies as offshore Guyana discoveries, as well as the Permian basin. The problem is that investors have seen this story before, and quite recently, with the oil majors. And while Exxon’s reputation might once have enabled it to simply be trusted to deliver, that is no longer the case.

Here is a Bloomberg shot showing you what would have happened had you purchased 1000 ExxonMobil shares in 2013 and sold at the end of 2017 (about when plans were probably being agreed):

image.PNG

You were down fractionally in the share price and up overall marginally only after reinvesting dividends. So the Directors are probably not coming under massive pressure to throw more money at production when 4 years after the price slump the owners of the ExxonMobil are trading below their 2013 entry cost (or fund market value). This is very oversimplified, but I make the point only because it has become an article of faith amongst some in the offshore space that E&P companies are verging on the irrational by not increasing offshore project spend when it is far from clear they are, or that they face pressure to do so.

Which is why you end up with a slide like this from a company that has just made some huge offshore discoveries:

Disciplined value.png

ExxonMobil focuses on Brazil and Guyana in terms of offshore development. I think the larger E&P companies switching to larger developments only offshore continues to mark a real shift in the market because the smaller companies just don’t have access to the development funding they used to for smaller fields.

I thought this was interesting:

XOM Guyana.png

Versus shale:

XOM tight oit.png

ExxonMobil appears to be implying shale has a lower breakeven pricing at $35 to get to a great than 10% return? And as always productivity is increasing:

XOM productivity increase.png

The other thing that struck me about the presentation was just how many investment opportunities management have across the portfolio, and they are increasing CapEx across the forecast period from USD 24bn to USD 30bn, but it is clear that downstream and other activities are also important. Investors want growth but maybe some at lower volatility that a fluctuating oil price offers, and as this graph shows ExxonMobil will make money at USD 60 ppb oil, but not ridiculous amounts.

XOM Fundamental.png

Obviously XOM is a leveraged bet on the price of oil increasing. But at the moment the upstream managers probably feel they have a free option on the excess capacity in the offshore supply chain that means any rapid price increases can be met with shale and a slower commissioning pace of offshore fields. Also these larger discoveries allow greater flexibility to speed up infield developments at a lower cost and asset utilisation.

Bourbon Offshore recently released it’s Bourbon in Motion strategy which to my mind is one of the most honest assessments of the scale of the challenge facing offshore companies I have seen. I think Bourbon are well worth listening to because I cannot think of another company that has played the capital markets as well as they have in financing their operations. Here in 3 simple points is the problem every offshore company faces:

3 issues.png

And it was really nice to see it wasn’t followed by a slide which said “but we are doing lots of tendering”.

A little history is required: In 2008  Bourbon had €1.3bn in debt and was focusing almost exclusively offshore. The annual report for that year described the returns in the offshore business as “exceptional”, and like all good companies it took this as a price signal to invest and grow the business further. Bourbon did this, because as the financing market was so flush it could borrow a lot of money, by 2013 debt had increased by €1bn to reach €2.2bn and the Directors were so confident about the business they proposed a 34% increase in the dividend.

In 2013 and 2014, taking advantge of the exceptional sentiment in the market Bourbon sold, and then leased back, vessels worth €1.65bn to Standard Chartered and ICBC which also allowed them to write up the value of the rest of the fleet by €900m in value. It’s hard to overstate how good the timing of this transaction was, timed literally to perfection, as the vessel market peaked in value they got two banks to pay not only top dollar for the assets but lease them back at less than 11% per annum. I doubt if sold on the open market here these now commodity vessels would fetch a third of that.

I am not implying Bourbon knew this would happen, what I am saying is they worked out that perhaps this was as good as it was going to get in the industry and they should bank what they could and take some (more) money off the table for their shareholders. As a management team it made them look very smart.

So when Bourbon tell you things are grim I think it comes with a degree of credibility few can match. Particularly when backed by some solid data:

The worst crisis ever

Which we all know by now. As I have said here repeatedly understanding that CapEx expenditure is what drives utilisation at the margin, and therefore overall fleet profitability, is crucial. And the reason I used ExxonMobil above was to show that this CapEx number, which I call “The Demand Fairy”, is unlikely to miraculously change in the short-term.

Offshore will still be an important part of the energy mix, but the growth of shale, as the left hand graph below makes clear, is having a huge impact on vessel utilisation and therefore industry profitability:

Bourbon Offshore production.png

The region reserved for shale is an area 3 or 4 years ago most people investing in offshore would have believed their assets would be servicing. And when you rely on 75-80% utilisation just to break even that in effect changes the whole economics of the industry, because if it knocks even 10% utilisation back across the fleet everyone is struggling to break even on their assets.

The right hand graph shows the enormous drop in CapEx. The fact that more projects are being sanctioned but the spend is lower just highlights what company results are showing: the volume of work has increased slightly this year but the value being paid for it has not (or reduced in some cases). This is likely to be a structural feature of the industry going forward that previous margin levels will simply not recover.

Like everyone else Bourbon is making a play to drive down the cost of operation of its commodity assets and add more value to the value of its subsea assets through moving up the value chain. Across the industry an entire species of contractor that used to make a good living by supporting larger contractors now aims to do more projects directly with E&P companies. Bourbon, like others, will likely win some market share, but they will do this by competing on price and driving industry margins down overall. For Bourbon it will still feel like more revenue than running the vessel alone, and in the long run it maybe, but grow to big and the larger contractors will be unlikely to charter your vessels. That slow increase in the blue bar on the graph is a result of all this extra capacity coming to market on the contractor side and why good Bus Dev staff in the industry are still remarkably employable.

It’s a post for another day the problem for offshore demand in shallow water, where projects could be done by flexibles and a vessel-of-opportunity, is that the smaller companies who used to do these projects simply have no access to the capital markets. Capital markets prefer smaller projects to be shale-based now where the cash-flow cycle is shorter. Think of the last time an Ithaca Athena development was commissioned on the UKCS?

Obviously the E&P companies are doing better than the offshore supply chain, the point is that they are not doing so much better that things are likely to change immediately. Bourbon seems to realise the future may look a lot like the present on the demand side and adjusting its business model accordingly.

(Hat-tip: SE).

 

Rigs and vessels… traders become operators…

Yet again another great commentary from Bassoe on the Borr acquisition of Paragon. I like this bit:

In the beginning, some may have considered Borr to be an asset play with no intention of becoming a long-term, established contractor.  The company could stack its rigs efficiently, wait for a rise in rig values, and sell everything for a profit.  In and out.

As time went on, Borr continued adding assets.   And although jackup values rose (primarily as a result of Borr’s transactions), the prospect of Borr selling off rigs at higher prices faded as they eventually became too big for any of the established drilling contractors to acquire them.

Whether this was the plan the from the beginning or something that just happened over time, the quick sale and profit option became less tenable.   So what could have started as a pure asset-flipping maneuver turned into a deliberate quest to become a fully-fledged drilling contractor. [Emphasis added.]

That has happened to a lot of people in the industry. Standard Drilling now aim for medium term capital appreciation, which is a significant change in their original position. The Nor bondholders had to sell out to an operational company in less than a year after their 2016 capital raise. York can’t really believe the Bibby DSVs or their Rever Offshore assets will ever appreciate? Will the Boa Deep C and Sub C ever return to active service? What on earth will someone pay for the Lewek Constellation? etc…

Without some fundamental change in the demand side of the market the asset recovery story should really be dead-and-buried now under a welter of evidence and transactions. You need to be long delivery capability and short assets to profit from “The New Offshore”. Backlog, liquidity, and capability. Everything else is noise.

Industry consolidation and market power… Is consolidation really the solution?

Last week the creation of a new offshore company was announced: Telford Offshore. I presume financially related to Telford International. The company has purchased the four Jascon vessels for USD 215m and looks to be setting up a UAE/ Africa subsea construction and IMR business. I know one of the guys there and wish them all the best of luck, they are a strong team and seem likely to make it work having both financial backing, local connections, and managerial skill.

From an industry perspective though it is a microcosm of why I think industry profitability will elude those long on vessels for a prolonged period of time without a significant change on the demand side. Telford isn’t taking capacity out of the market, it is merely recapitalising assets at a lower valuation level, and giving them the working capoital to operate, and it will compete with other existing companies for work in the region. That excess capacity competes on price is as close to an iron law as you can get in economics and something everyone in the offshore industry knows intuitively to be true at the moment.

The talk in the industry at the moment is all about consolidation and how that will save everyone… but I don’t see it? Consolidation is only beneficial if it generates maket power and therefore some ability to charge higher prices to E&P companies: A bigger company in-and-of-itself is of no economic benefit unless it can generate economies of scale or scope i.e. a) lower unit costs, or, b) lower integration costs of supplying a range services . At the moment, in both subsea and supply, there is no evidence that this is the case.

The large subsea companies are currently all reporting book-to-bill numbers of less than 1 (apart from maybe McDermott), that means they are burning through work faster than they are replacing it, and this is consistent with the macro numbers. This is happening because the market is contracting in both volume, and especially, value terms. Simply adding another UAE/ West African contractor to the mix will only prolong this problem in the region. Not that it is unique to the region, as the industry grew up until 2014 a host of tier 2 construction companies grew their geographic footprint and asset base as well. Now they are committed to those regions because they have no economic option but to stay. Over time, as all the companies compete against each other for minimal profits, not everyone will be able to afford to replace their asset base, that is how capital will leave the industry and how it will rebalance on the supply side; but when you have gone long on very specific 25 year construction assets it takes a long while!

It is a fundamental tenent of ecoomics that industry profits, outside of firm specific events, is a function of industry concentration. Every person who has done a ‘Porter’s Five Forces’ analysis is actually using a microeconomic model that has a deep intellectual heritage in examining if the structure of markets drives profitabilty. More recent research has highlighted firm specific factors in determining profitability, but market power, firm concentration, normally the result of consolidation, is always crucial. That is why competition authorities focus on market power when looking at whether they should allow transactions that heighten market power to progress: because scale allows firms to drive pricing power.

A normal threshold for competition authorities to get concerned about market power is ~40% market share level for any one company, and often they like to see 3 or more companies in total, below this level it is understood that consumers have options and companies will compete on price to a certain extent. While Technip and Subsea 7 dominate the market for subsea installations they have nothing like that level of market share. Any large project could theoretically go to Saipem, McDermott as well at a minimum, and below large projects an E&P company is spoilt for choice. In other words there is no pricing power at all for offshore contractors, and as all they have all committed to assets with high fixed costs, and low relative marginal costs, vessel days are essentially “disposable inventory” that must be sold or paid for anyway (just like a low-cost airline) and have no other uses.

The scale of consolidation that would have to occur in order to generate any pricing power for the contracting community defies any realistic prospect of execution for the next few years. It will happen, and slowly, but the scale of the change will be enormous, and as it nears its final stages expect the E&P companies to protest vigorously to competition authorities. Instead of the vessel companies and the subsea production system companies getting closer, eventually, the vessel companies will start to be acquired or merge. But until savings in replacement capital can be made, a while away given the huge new building programme we have had in the vessel fleet between 2010 and 2014, then it will not make sense for an acquisition premium/ nil premium merger to unlock these cost savings. One day it will be cheaper, for example, for Subsea 7 to buy the Saipem business than set out on a new build programme (through both cost savings and reduced CapEx)… but we are some way from that point and a long way from the institutions themselves accepting this.

It is even worse in offshore supply. A measure for assessing market power in economics is the Herfindahl-Hirschman Index (also used widely by competition authorities) to assess if markets have concentration levels that would allow their participants to extract excess profits through concentration. I went to calculate this quickly (the math is not difficult) based on this data from Tidewater:

Tidewater scale and scope.png

The US Justice Dept gets concerned if the HHI number comes in at 1500-2500 and is likely to take action if the number is above 2500 and there is a 200 point movement based on anyone transaction. The supply industry has an HHI well below 1000. Bourbon, the largest company with a 6% market share, only has an HHI score of 36! All the named companies on this slide could merge and chances are the DOJ would wave the deals through because it wouldn’t think the enlarged mega company would still have any pricing power (this is a reductio ad absurdum here and clearly a real situation would be more complicated) and would therefore be able to extract excess rents.

Not only that entry costs/barrier in offshore supply are nothing which just dilutes any possible positive effects consolidation could bring: Standard Drilling can buy supply vessels for $12m and park them in a reconstructed North Sea operator and compete against SolstadFarstad and Tidewater? So how does merging all of the PSV assets that makeup HugeStadSea make any difference?

In offshore contracting it is not just construction assets like Telford, a host of ROV companies now don’t need to buy or charter vessels but merely pay on use allowing a host of small companies to enter the industry. ROVOP, M2, Reach, and a host of others have entered the industry and kept capacity (or potential capacity) high and margins low with vessel operators supplying vessels below economic cost while the ROV contractors make a margin on equipment they brought at 30c in the $1 and well below replacement CapEx levels. MEDS despite defaulting on a number have charters have been given the Swordfish to operate on charter!

The high capital values of these assets encourages investors to supply working capital to keep the assets working knowing they are competing against others who paid a higher capital value. It is a very hard dynamic to break and I don’t see a huge difference between offshore supply and subsea in economic structure which is why I deliberately merged the industries here.

Part of the reason consolidation doesn’t work is because the costs of the fixed assets, and the costs to run them, are so high in relation to the operational costs. The fixed costs of the vessels, and the non-reducible operating costs dominate expenditure, getting rid of a few back-office staff, who represent less than a few % of the day rate of a vessel just doesn’t make a big enough difference overall.

Another reason is the banks are still pretending they have value way above levels where deals such as Telford are priced at. No amount of consolidation to remove some minor backoffice costs can make up for the scale of capital loss they have in reality will solve this. If Standard Drilling is buying large Norwegian PSVs in distress for $12m, and SolstadFarstad has similar vessels on the books for $20m, then you can’t consolidate costs that would be capitalised at $8m per vessel no matter how many other companies you buy. The same goes for subsea only the numbers are bigger and more disproportionate.

So when someone tells you the answer is consolidation the real question is why?

 

That consolidation is the answer is simply an economic myth. Gales of Schumpterian creative destruction are the only real solution here barring some miraculous development on the demand side of the market.

The fallacy of composition and offshore equilibrium…

There is a really eloquent quote from the Hornbeck conference call that I didn’t want to get lost in my other post (courtesy of Seeking Alpha):

James Harp (CFO, Hornbeck Offshore):

The recent rise in commodity prices has led to a generally positive sentiment for the broader oilfield service industry including the offshore sector. But as Todd said we see little that leads us to believe that deep and ultradeepwater exploration will see a sharp rebound in activity in the immediate near-term.

While of course we are encouraged by equity analysts and larger oilfield service companies calling the bottom on this offshore cycle and it is certainly nice to hear major oil companies announcing more deepwater discoveries, FIDs, and FEED studies in our hemisphere. We are still a long way from reaching OSV market equilibrium. There is always a lag effect from when these types of macro sound bites actually result in increased demand for marine transportation and subsea services.

Investment research should be forward looking (my thoughts here), so it’s no surprise there might be a valuation gap between the current price and when cash flows into a company, but it is also true there have been a number of people claiming a market recovery when it doesn’t seem to be reflected in how owners feel? Both might be right: it is a recovery but off a low base and this recovery is miles away from an economic equilibrium. Also some sectors will do well, and others less so, this certainly won’t be a broad recovery.

Everytime a new offshore project, especially a major one, is announced people seem to try and use it to illustrate a turning point in the cycle, despite the fact that the macro numbers are clear: investment is way down from 2014 and the number of working rigs/ jackups etc is so low that anything other than a slow recovery is unlikely. This is the fallacy of composition: inferring the whole is true based on a small part of it being true.