Market equilibrium…

The graph above comes from a recent Tidewater presentation. There is also this slide from the same presentation:

OSV Business Drivers.png

Now Tidewater is a global supply vessel company, rather than a subsea player, but the data cannot be ignored: it is the Jackups and Floaters that generate future demand for the industry. The subsea vessels may not be quite as dependent as the supply vessels on the ratios of JU/Floaters to vessels, but it will be close and directionally similar. There is simply not enough front end work being done for a realistic scenario where anything like the current fleet is saved. Any realistic scenario of market equilibrium involves and increase in demand and a large adjustment in supply.

Demand does appear to have hit rock bottom. However, market equilibrium, which I would define as a situation is which those operating vessels covered their cost of capital, appears to be a long way off.

I would urge you to read the whole of a conference call Hornbeck gave recently (courtesy of Seeking Alpha):

Todd Hornbeck:

Beyond a doubt in nearly every category 2017 was the most challenging year we ever have confronted in our 20-year history. We experienced the full force of the offshore meltdown in all of our core operating regions and across our vessel classes. In the Gulf of Mexico an average of 21 deepwater drilling units were working during the year. We started and finished the year with almost zero contract coverage for our vessels meaning there are financial results reflect a true market conditions with little residual noise from day rates contracted in better times…

So where are we today and what do we believe 2018 holds in store for us?

To begin with, we think that the conditions for recovery offshore will begin to gel and that the necessary elements for improvement in our core markets maybe taking shape. Improved oil prices reflecting a more balanced oil market, improved global economic conditions, and healthy global demand for oil cannot be ignored nor can the significant under investment in deepwater over the last several years by our customers. While we think weak market conditions shaped by a low offshore drilling rig activity at OSV overcapacity will continue in 2018. We also think this year could mark the beginning of the end of this downturn.

Current healthy production from the Gulf of Mexico is unsustainable absent new investment by our customers. Depletion is real. The same is true in Mexico and Brazil. Consider this in 2014 there were 114 floaters under contract across our three focus areas of operation in this hemisphere plus 45 jack-ups in Mexico. Today there are 57 floaters and 20 Mexican jack-ups under contract in our core markets. So the contracted rig counts have been cut in half…

That said, we still expect OSV demand in 2018 to resemble 2017 in which we saw only 21 floating drilling units working in the Gulf of Mexico on average. We can even make a case that the drilling rig count to fall into the teens. As a reminder, there were 39 active floating rigs working in the Gulf of Mexico in 2015… [emphasis added]

James Harp (CFO):

In fact, our effective day rates thus far in 2018 are down substantially for both our OSVs and MPSVs…

Hornbeck is a Gulf of Mexico focused operator with both subsea and offshore vessels. The Gulf of Mexico is still regarded as one of the major investment growth areas in subsea, but it shows off what a low base this is, and how unevenly an industry “recovery” will be spread.

Basically what I am saying is  we are in a recovery phase (and you can agree with analysts who argue this), but as Todd Hornbeck states, it is off such a low base, and with such a vast amount of oversupply in vessels and rigs, that the industry will face low profitability for years. It is clear day rates in some markets and segments will be higher over the summer, some PSVs are being bid at £25k per day in June/July/August, but these rates need to be averaged over a year not a few months.

Any OSV/rig/subsea company strategy that doesn’t reflect the fact that the market will be significantly smaller than it has been previously, and the “recovery” level will be smaller than 2014, just isn’t realistic. Just buying boats and hoping for mean reversion seems to ignore the  data presented above. This time it will not be like the dip of 2009.

New ship Saturday…

Yet again UDS seemed to have pulled off an amazing feat, right after becoming the greatest DSV owner and charterer in the world, with a record 4 out of 4 (or maybe 5) DSVs on long term charter, they appear to have Technip, McDermott, and Subsea 7 quaking with fear as they look at helping a company enter the deepwater lay market:

UDS Lay vessel.png

This is a serious ship. Roughly the same capability as the Seven Borealis.

Seven Borealis

Although the Seven Borealis  can only lay to 3000m, not the 3800m UDS are looking at. As depth is really a function of tension capacity then I guess they will have a significantly bigger top tension system than the Seven Borealis as well?

I can see why you would go to UDS if you wanted to build a pipelay vessel significantly more capable than any that the world’s top subsea contractors run. Sure UDS may never have built a vessel of such complexity, and actually haven’t even delivered one ship they started building, but they have ambition and you need that to build a ship like this. Not for this customer the years of accumulated technical capability, knowledge building, and intellectual competency, there is nothing an ex-diver can’t solve.

UDS is building vessels the DSVs in China. The closest the Chinese have come (that I know of) to such a vessel is HYSY 201:

HAI-YANG-SHI-YOU-201.jpg

But that only has 4000t system? No wonder this new mystery customer, who I assume is completely independent of the other customers that have chartered their other vessels, wants to up the ante. The HYSY 201 cost ~$500m though, which is quite a lot of money to everyone in the subsea industry, apart from UDS.

The last people I know who went to build a vessel like from scratch were Petrofac. There is a reason this picture is a computer graphic:

Petrofac JSD 6000.jpg

To do this Petrofac hired some of the top guys from Saipem, a whole team, with years of deepwater engineering experience… And when the downturn hit Petrofac took a number of write offs, and even with a market capitalisation in the billions, didn’t finish the ship. To be fair though, they hadn’t engaged UDS.

But I think the reason you go to UDS “to explore the costs”, you know instead of like a shipyard and designer who would actually build it, is because they appear to have perfected the art of not paying for ships. So if you go to them and ask for a price on an asset like this chances are you get the answer: the ship is free! It’s amazing the yard just pays for it. Which is cheap I accept but ultimately the joy-killing economist in me wonders if this is sustainable?

Coincidentally I am exploring the costs of building a ship. I have just as much experience in building a deepwater lay vessel as UDS. On Dec 25th 2017, with some assistance from my Chief Engineer (Guy, aged 9), we completed this advanced offshore support vessel, the Ocean Explorer,  from scratch!

Ocean Explorer.jpg

Ocean Explorer Lego.jpg

Not only that I had take-out financing for the vessel in place which is more than UDS can claim at this stage!

Now having watched Elon Musk launch a car on a rocket into space (largely it would appear to detract some appalling financial results, although far be it for me to suggest a parallel here) we (that is myself and my Chief Engineer) have designed a ship: It will be 9000m  x 2000m, a semi-sub at one end to drill for oil, a massive (the biggest in the universe) crane to lay the SPS,  j-lay, s-lay, c-lay, xyzzy lay in the middle, and two (Flastekk maybe?) sat systems at the other end in case we forgot something, and to make it versatile. Instead of launching a car into space we are having a docking station for the space shuttle in order to beat the Elon Musk of Singapore. It is also hybrid being both solar powered and running on clean burning nuclear fusion. Not only that the whole boat works on blockchain and is being paid for with bitcoin. The vessel is also a world first having won a contract forever as the first support vessel for Ghawar field. We are also committing to build a new ship every week forever.

I expect to bask in the adulation on LinkedIn forever once I announce this news, and it will feel like all the hard work was deserved at that point. I am slightly worried about the business model as my Chief Engineer asked “Won’t we have to get more money in for the boat than we paid for it?”. When I have an answer for that trifling problem I will post the answer.

Zombie offshore companies… “Kill the zombie…”

“I’ve long said that capitalism without bankruptcy is like Christianity without Hell. But it’s hard to see any good news in this.”

Frank Borman

“In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor”.

Warren Buffet

The Bank for International Settlements defines a Zombie Company as a “firm whose interest bill exceeds earnings before interest and taxes”. The reason is obvious: a firm who is making less in profits than it is paying in interest is likely to be able to eke out an existence, but not generate sufficient profits to invest and grow and adapt to industry changes. A firm in such a position will create no economic value and merely exist while destroying profit margins for those also remaining in the industry.

The BIS make clear that zombie companies are an important part of the economic make-up of many economies. I am sure sector level data in Europe would show offshore comfortably represented in the data.

Zombie Firms.png

Conversable Economist has an excellent post (from where I got the majority of my links for this post) on Zombie Companies and their economic effects, which timed with a post I have been  meaning to right about 2018 which I was going to call “year of the zombie”. Zombie companies have been shown to exist in a number of different contexts: in the US Savings and Loans Crisis zombie firms paid too much in interest and backed projects that were too risky, raising the overall costs for all market players. Another example is Japan, where post the 1990 meltdown Hoshi and Kashyap found (in a directly analogous situation to offshore currently):

that subsidies have not only kept many money-losing “zombie” firms in business, but also have depressed the creation of new businesses in the sectors where the subsidized firms are most prevalent. For instance, they show that in the construction industry, job creation has dropped sharply, while job destruction has remained relatively low. Thus, because of a lack of restructuring, the mix of firms in the economy has been distorted with inefficient firms crowding out new, more productive firms.

In China zombie firms have been linked to State Owned Enterprises, and have been shown to have an outsize share of corporate debt despite weak fundamental factors (sound familiar?). The solution is clear:

The empirical results in this paper would support the arguments that accelerating that progress requires a more holistic and coordinated strategy, which should include debt restructuring to recognize losses, fostering operational restructuring, reducing implicit support, and liquidating zombies.”

The subsidies in offshore at the moment keeping zombie firms alive don’t come from central banks but from private banks, and sometimes poorly timed investments from hedge funds. Private banks are unwilling to treat the current offshore market as anything more than a market cycle change, as opposed to a secular change, and are therefore allowing a host of companies to delay principal payments on loans, and in most cases dramatically reduce interest payments as well, until a point when they hope the market has recovered and these companies can start making payments that would keep the banks from having to make material writedowns in their offshore portfolios.

Now to be clear the banks are (arguably) being economically rational here. Given the scale of their exposure a reasonable position is to try and hold on as the delta on liquidating now, versus assuming even a mild recovery, is massive because of the quantity of leverage in most of the offshore companies.

But for the industry as a whole this is a disaster. The biggest zombie company in offshore in Europe is SolstadFarstad, it’s ambition to be a world leading OSV company is so far from reality it may as well be a line from Game of Thrones, and a company effectively controlled by the banks who are unwilling to face the obvious.

A little context on the financial position of SolstadFarstad makes clear how serious things are:

  • Current interest bearing debt is NOK 28bn/$3.6bn. A large amount of this debt is US$ denominated and the NOK has depreciated significantly since 2014, as have vessel values. SolstadFarstad also takes in less absolute dollar revenues to hedge against this;
  • Market value equity: ~NOK 1.73bn/$ 220m;
  • As part of the merger agreement payments to reduce bank loans were reduced significanlty from Q2 (Farstad)/Q3 (Solstad) 2017. YTD 2017 SOFF spent NOK ~1.5bn on interest and bank repayments which amounted to more than 3 x the net cash flow from actually operating all those vessels. While these payments should reduce going forward it highlights how unsustainable the current capital structure is.

The market capitalisation is significantly less than the cash SOF had on the balance sheet at the end of Q3 2017 (NOK 2.1bn). Supporting that enormous debt load are a huge number of vessels of dubious value in lay up: 28 AHTS, many built in Asia and likely to be worth significantly less than book value if sold now, 22 PSVs of the same hertiage and value and 6 ageing subsea vessels. The two vessels on charter to OI cannot be generating any real value and sooner or later their shareholders will have had as much fun as they can handle with a loss making contracting business.

But change is coming because at some point this year SolstadFarstad management are in for an awkward conversation with the banks about handing back DeepSea Supply (the banks worst nightmare), or forcing the shareholders to dilute their interest in the high-end CSV fleet in order to save the banks exposure to the DeepSea fleet (the shareholders worst nightmare and involves a degree of cognitive dissonance from their PSV exposure). Theoretically DeepSea is a separate “non-recourse” subsidiary, whether the banks who control the rest of the debt SolstadFarstad have see it quite that way is another question? It would also represent an enormous loss of face to management now to admit a failure of this magnitude having not prepared the market in advance for this?

Not that the market seems fooled:

SOFF 0202

(I don’t want to say I told you so).

SolstadFarstad is in a poor position anyway, the company was created because no one had a better idea than doing nothing, which is always poor strategic logic for a major merger. What logic there was involved putting together a mind numbingly complex financial merger and hoping it might lead to a positive industrial solution, which was always a little strained. But it suited all parties to pretend that they could delay things a little longer by creating a monstrous zombie: Aker got to pretend they hadn’t jumped too early and therefore got a bad deal, Hemen/Fredrikson got to put in less than they would have had to had DeepSea remained independent, the banks got to pretend their assets were worth more than they were (and that they weren’t going to have to kill the PSVs to save the Solstad), and the Solstad family got to pretend they still had a company that was a viable economic entity. A year later and the folly has been shown.

Clearly internally it is recongised this has become a disaster as well. In late December HugeStadSea announced they had doubled merger savings to 800mn NOK. The cynic in  me says this was done because financial markets capitalise these and management wanted to make some good news from nothing; it doesn’t speak volumes they were that badly miscalculated at that start given these were all vessel types and geographic regions Solstad management understood. But I think what it actually reflects is that utilisation has been signifcantly weaker than the base case they were working too. Now Sverre Farstad has resigned from the Solstad board apparently unhappy with merger progress. I am guessing he is still less unhappy though than having seen Farstad go bankrupt which was the only other alternative? I guess this reveals massive internal Board conflict and I also imagine the auditors are going to be get extremely uncomfortable signing vessel values off here, a 10% reduction in vessel value would be fatal in an accounting sense for the company.

The market is moving as well. In Asia companies like EMAS, Pacific Radiance, Mermaid, and a host of others have all come to a deal with the banks that they can delay interest and principal payments. Miclyn Express is in discussions to do the same. This is the very definition of zombie companies, existing precariously on operating cash flows but at a level that is not even close to economic profitability, while keeping supply in the market to ensure no one else can make money either. Individually logical in each situation but collectively ruinuous (a collective action problem). These companies have assets that directly compete with the SolstadFarstad supply fleet, with significantly deeper local infratsructure in Asia (not Brazil), and in some cases better assets; there is no chance of SolstadFarstad creating meaningful “world class OSV company” in their midst with the low grade PSV and AHTS fleet.

Even more worrying is the American situation where the Chapter 11 process (and psyche) recognises explicitly the danger of zombie companies. Gulfmark and others have led the way to have clean, debt free, balance sheets to cope in an era of reduced demand. These companies look certain to have a look at the high-end non-Norwegian market.

SolstadFarstad says it wants to be a world leading OSV company that takes part in industry consolidation but: a) it cannot afford to buy anyone because it shares are worthless and would therefore have to pay cash, and b) it has no cash and cannot raise equity while it owes the banks NOK 28bn, and c) no one is going to buy a company where they have to pay the banks back arguably more than the assets are worth. SOF is stuck in complete limbo at best. Not only that as part of the merger it agreed to start repaying the banks very quickly after 2021. 36 months doesn’t seem very far away now and without some sort of magic increase in day rates, out of all proportion to the amount of likely subsea work (see above), then all the accelerated payment terms from 2022 will do is force the event. But still is can continue its zombie like existence until then…

In contrast if you want to look at those doing smart deals look no further than Secor/COSCO deal. 8 new PSVs for under $3m per vessel and those don’t start delivering for at least another 18 months. Not only that they are only $20m new… start working out what your  10 year old PSV is really worth on a comparative basis. There is positivity in the market… just not if you are effectively owned by the bank.

One of my themes here, highlighted by the graph at the top, is that there has been a structural change in the market and not a temporary price driven change in demand. Sooner or later, and it looks likely to be later, the banks are going to have to kill off some of these companies for the industry as a whole to flourish, or even just to start to undertake a normal capital replacement cycle. Banks, stuffed full with offshore don’t want to back any replacement deals for all but the biggest players, and banks that don’t have any exposure don’t want to lend to the sector. In an economy driven by credit this is a major issue.

I don’t believe recent price rises in oil will do anything for this. E&P budgets are set once a year, the project cycle takes a long time to wind up, company managers are being bonused on dividends not production, short cycle production is being prioritised etc. So while price rises are good, and will lead to an increase in work, the scale of the oversupply will ensure the market will take an even longer time to remove the zombie companies. At the moment a large number of banks are pretending that if you make no payments on an asset with a working life of 20-25 years, for 5 years (i.e. 20-25% of the assets economic life), they will not lose a substantial amount of money on the loan or need to write the asset down more than a token level. It is just not real and one day auditors might even start asking questions…

I don’t have a magic solution here, just groundhog day for vessel owners for a lot longer to come. What will be interesting this year is watching to see the scale of the charges some of the banks will have to make, a sign of the vessel market at the bottom will be when they start to get rid of these loans or assets on a reasonable scale.

Kill the zombies for the good of the industry, however painful that may be.

A market recovery? Not in the data…

Danish Ship Finance have just published their latest report. As usual it is thorough and measured, and frankly not uplifting if you are long on vessels or rigs. The graph above really covers a lot of things I have blogged about here, it’s all well and good coming up with graphs showing how offshore MUST get more investment, as if it were a divine economic law, but that isn’t what companies are ACTUALLY planning on spending.

Another great graph is this one:

DSV Charter Rates DSF.png

What the commentary in the report omits, and I think is very important, is the fact that the divers costs, which are c. £50k for a 15 man team, have not dropped. So for the vessel owner the rate hasn’t dropped 50% it has actually dropped 67% because the labour cost of the dive crew is fixed (again I have blogged about the Baumol effect here). This is probably more pronounced on DSVs than any other asset class but it is a real problem for offshore because the industry isn’t getting more productive (just cheaper which is different). Removing 67% of the revenue for any business is bad, in an industry that had binged on debt, as can be seen, it is beyond a disaster.

DSF also note that while spending on Subsea Production Systems is rising this because smaller step out developments are being done, which require less vessel days, than larger greenfield developments. Again I have discussed this before here.

DSF SPS.png

Finally, it highlights again the scale of the pullback in offshore and why any recovery will not be a repeat of the past. The speed at which contractors are working through backlog is a real concern. Subsea 7 won work recently on the Johan Castberg field that was valued at c. USD 2.0 – 5.0m per well, a 75% decline from the peak. So even an increase in the volume of work awarded will not help the industry recover to previous levels.

Big Three Backlog.png

Subsea Contract Awards.png

This matters because offshore used so much leverage to purchase assets in the past. Now the companies revenues and profits are materially smaller and they are struggling to pay the banks back leading to a credit crisis in the industry. Debt is a fixed obligation that must be paid back for firms to have value and that is much harder to do when the industry is in a deflationary cycle. This is no different to a banking crisis without a central bank.  It is this credit crisis that when combined with the demand crisis makes this so serious. DVB Bank, a specialist lender to the sector, went bankrupt! Indeed I have discussed this many times and it is one my one recurring theme.

Last year probably was the low point in terms of demand. But as the first graph makes clear there is not a wave of investment coming here, just a long slow increase in spending.

Read the whole thing. Many business plans simply don’t reflect this reality yet. Not everyone will survive. 2018 promises to be another tough year for asset heavy companies.

The drawdown on offshore… My views on shale and offshore…

A friend asked me this week what my view on the graph above was (courtesy of Sparebank1  Markets) given my views on shale? I have been pretty consistent here that shale isn’t going to displace offshore, but it doesn’t need to in order to have a major impact on the economics offshore: It just has to take demand at the margin.

There are many graphs floating around like the one above. The Seadrill restructuring presentation contains this:

Seadrill offshore gap.png

Oceaneering had this graph recently:

Oceaneering Deepwater Demand.png

Ocean Rig has this one (while I agree with the headline the logic and data supporting this don’t make sense to me as the sanctioning replacement ratio has been historically over 100% for meaningful periods so a drawdown as firms pay down debt in a low price environment is logical):

Ocean Rig Industry Demand.png

You get the idea.

Schlumberger recently put the scale of shale production into perspective:

2017 Oil Supply

So to be clear: all tight oil had to do was add ~5% to the global supply and it has turned the entire offshore industry into a financial mess. Now it isn’t a strict causation, offshore has suffered a severe financial bubble based on oversupply as well as a demand crisis driven by the speed of change in the shale industry, but still it shows how finely balanced things were.

And indeed if you look at all the stories of hope and recovery that aim to recreate the world cast in a 2013 shadow they all profess unrealistically high utilisation and day rates at their core. The reason is obvious: the industry from 2007 was built on very high day rate levels and utilisation figues and any small change in those realities, given the very high fixed cost base, causes financial chaos.

A few percentage points in utilisation and day rates is all it takes to massively swing profitability in such a high fixed cost industry. Economic change happens at the margins.

Look at this chart from HugeStadSea which sums up the dominant thinking in the market (Q2 2017):

HSS Market Assumptions

Back to a cheeky 90% utilisation from 60%. Nice… what could go wrong?

Seadrill has the same:

Seadrill RP day rates

Everyone has the same story. But the problem is unless everyone is at very high utiilisation then day rates won’t pick up as the economic incentive for anyone with idle tonnage is to bid it cheap. Rowan in their latest results stated that they believed the market had to hit 85% utilisation before day rates improved.

So shale has an importance on the economics of offshore far beyond it’s output in the physical market displacing offshore oil as a source of supply. Shale only needs to reduce the utilisation of the offshore fleet by a few percentage points and that fundamentally changes the economics of rig and vessel companies. Seadrill, Solstad, Bibby, Technip DOF, in fact EVERYONE in the industry, is a completely different financial proposition at 51% utilisation compared to 91% with concomittant increases (or decreases) in day rates.

You also get an idea how large the investment in shale has been (Source: Schlumberger) since 2008:

Shale CapEx.png

25% investment since 2008 has gone into tight oil and it has seen productivity improvements like this (although the presentation highlights these rates are slowing):

Shale productivity.png

So I repeat again that that shale will not displace offshore as a source of supply. But it doesn’t need to in order to completely upset the economic structure of the offshore industry by lowering the amount of marginal demand generated where offshore service companies made profits above their fixed costs. By that I mean if your rig/vessel covered its costs and overheads on 85% utilisation and profits came after that (i.e. at 86% utilisation and above you started to be profitable), and the impact of tight oil is such that you only ever get to 85% for ever, then shale will have managed to removed excess profitability from the industry by ensuring a drop in demand at the margin. All shale needs to do is meaningfully alter the global fleet utilisation, and win a significant amount of E&P CapEx share, both goals shale has achieved, to have a massive impact on the offshore industry.

In economic terms this is what looks likely to happen:

fig612

The Demand (for offshore services) = the extra unit of revenue firms get for selling (Marginal Revenue) which matches the point where the extra costs of supply (Marginal Cost + Average Total Costs) balance. So yes, there will be more work, and assets may well be busier than they are now, but it could be just enough to keep everyone in the industry cash flow positive but making zero economic profit. I am not saying there won’t be accounting profits, that all firms will all be loss making, and all shares will go to zero, but I am saying firms will find it very hard to earn returns above their cost of capital.

The one prediction I will make is that any business model in this industry that just relies on an increase in day rates and utilisation is doomed unless it has a massive cash pile (because getting there is going to take a very long time) or you are buying assets at distress prices. But most of the distress investors have moved far too early and there is so much money floating around from these funds I think the distress funds are killing the price discovery mechanism in this market.

It is clear that the quantative deployment of capital in large E&P companies will have a significant portion focued on tight oil as well as offshore. A few percentage points, that could go either way in many companies, collectively have a huge impact on the global offshore fleet utilisation (and therefore dayrates) and that is the core impact shale has.

Rystad on the future of offshore NW Europe…

Really good article and graph from Rystad Energy on the future of NW Europe and the size of reserves and output of the region but highlighting the challenges to production through a lack of exploration activity. It is very hard to disagree with this conclusion:

Northwest Europe, as one of the leading offshore regions globally and with OECD exposure, should therefore expect to see continued capital and resource allocation as along as the projects are competitive. Given the wide array of commercially very robust projects in the region, the expectations are towards a new development boom. However, poor exploration results over the last four years have not filled the project portfolio, potentially creating declining activity past 2020. [Emphasis added].

Rystad make a good point about resource availability and is something I have mentioned here under the #shalenarrative. E&P companies don’t always make capital allocation decisions on a strictly rational basis. The one area I think Rystad could help clarify (given their database) it looks intuitively to me like the bigger E&P companies are divesting smaller offshore areas in favour of larger projects. Statoil announced an increased stake in Roncador (Brazil) today and all the West of Shetland work is harsh environment/ high capex/high flow rate investments.

As an example Subsea 7/ Aker Solutions have won the Skogul tie-back to North Alvheim. These are large contracts, technically complex (pipe-in-pipe) with umbilicals, risers etc. Again it highlights to me that the project work that is going ahead favours larger contractors. In this case case the Aker BP/Aker solutions link was vital: but that is the point that all are large companies and Aker has been actively continuing exploratory and production drilling. It is the smaller E&P companies who have pulled this work back disproportionately.  Those who think there will be a linear increase in offshore work with a rise in the oil price I fear will be disappointed.

 

The Economics of Constraints and (Really) Deepsea Diving…

It’s a poor sort of memory that only works backwards.

Lewis Carroll, Alice in Wonderland

In historical events what is most obvious is the prohibition against eating the fruit from the tree of knowledge.

Leo Tolstoy, War and Peace

One of my frustrations with offshore/SURF is that despite the mathematics of engineering and economics being the same, both are really optimisation problems, there is precious little of the latter influencing the former in offshore. A classic case of this came in Frontrunner today where there was an attempt at a serious discussion about diving below 300m. Now I accept that this is technically possible, lots of things are technically possible, for a billion dollars you can probably get NASA to take you on holiday to the moon, but because not that many people want/are able to spend a billion dollars on such a holiday there are very few companies offering this as an economic choice. If money is not a constraint then you have few constraints, but in economics and business money is always a constraint.

Diving at up to 600m is definitely technically possible, but it would be economic lunacy. Don’t get me wrong if I was an equipment supplier I would want to believe it was possible as well, but that doesn’t make it viable. There are so many realistic economic and organisational constraints on this I can’t be bothered going into them all, but here are a few, all of which are complete showstoppers:

  1. There is no market: the list of marginal field developments that could be made viable between 300-600m of water if a DSV could be used is minimal, even on a global basis. Most shelves drop off completely below 300m and there simply no proof that there are suitable reserves that could be tapped by this technology
  2. In order to service this (non) market you would have to build a 600m capable DSV completely at risk (which is admittedly what UDS claims to be doing), budget $160-185m, then prove the technology and procedures, which will be months of testing and practice dives etc, and only then be ready to sell it, all the while burning vast amounts of risk capital. Then you would need to get a bunch of global oil companies to change their entire HSE approval process, which will take years, and get this to coincide with a project approval process. This strikes me as an enormous barrier because even if you could prove this worked there is no demonstrable evidence of the long-term health effects on the divers and you risk creating an abestos like residual legal claim on the oil companies (as the diving contractor may be bankrupt) for approving this. And then, and only then, years after building a 25 year asset and burning through working capital you might, just might, win a project competitively tendered against an ROV solution. That is without going into IMCA, class, various regulatory agencies etc. All this for a project whose financial upside must by definition be capped at what a comparable ROV service could deliver the project for. So a venture capital investor has no possible way of making a returns in the 100s of % to cover the risk. Literally nuts.
  3. ROVs are currently oversupplied and operating below their capital cost, and are likely to for an extended period, so not only would this harebrained plan have to compete for work against the above constraints it would have to with competitors who will be selling at below economic cost

If you speak to divers who go below 250m they will tell you the joints hurt and they really notice the pressure. It is not a popular depth to dive at. Subsea 7 and Technip now have special dive procedures in place for anything over 200m and there is enormous resistance to diving over this depth level even if you could prove what it costs. Changing this organisational inertia for marginal benefits only just don’t represent a viable economic time/cost trade-off.

This is just a classic case of someone trying or thinking of doing something because it is technically possible not because there is any economic rationale to it. The idea is so DOA from an economic perspective it doesn’t bear serious analysis.

SOR also make the following highly questionable claim:

Sources close to the scene, suggest BP’s huge west of Shetland Quad -204 redevelopment might have cost a third of the total bill if the project could have used divers. [Emphasis added].

Now the best estimate of the costs I have is £4.4bn ($5.7bn), but that includes drilling, fabrication, control modules, a FPSO etc. Traditionally the SURF installtion scope is 10-15% of the total project budget, so at best what I think SOR mean is they could have saved 1/3 of this… so maybe 5% of the total budget. But that is a pretty minimal saving in the scheme of things and exposes the installation to a lot more weather and other operational and contractual risks. For a 5% saving on the overall cost you would have exposed yourself to having a minimal choice of assets to complete the task and run the risk that all future OpEx operations would have to be done by divers (i.e. no ROV handles) and that needs to be factored in to the total economic cost.

[But if I am wrong I am happy for SOR to publish some more detailed information to correct my erroneous logic and I will happily publish a correction having been suitably educated].

But again the Quad 204 cost statement avoids the economics of this situation: if Quad 204 was going offshore in 2014, when every North Sea class DSV was operating at capacity the job would probably have cost more because DSV rates were at a premium. Re-bid the job now and you might get a different answer. Markets are dynamic not static. So there “might” have been a saving, but there is a much smaller North Sea class DSV fleet than ROV fleet that “might” have been busy, or it might not, and the saving would have been dependent on that. And surely the losing contractor would have gone back and offered to make such a substantial saving? But whatever the situation it would not have transformed the economics of a project the size of Quad 204 as suggested.

Interestingly the whole Frontrunner is relatively bullish on diving. Although, frankly any previous investors in vessels backing MEDS would be amazed if their ability to get hold of a vessel should be seen as a sign of confidence in  the market given the losses they have suffered on the Altus Invictus and Altus Extertus (disclosure of interest: I was a Director of one such company). I don’t think SAT diving is going to go away, that isn’t what I am arguing at all, but until significant CapEx projects involving DSVs return to the North Sea then the market on any reasonable basis remains over-supplied and day rates and utilisation levels will remain under huge pressure.

SOR has been at the forefront of reporting the creditors involved in the rescue of Bibby Offshore and I’d be interested to know if they have a consulting relationship with any of the bondholders who they have named? Either someone very close to the deal is speaking to them or they are working on this deal… And you would really have to believe in a degree of bullishness about diving that isn’t grounded in current market reality to buy into the Bibby deal at current value levels…. And frankly any financially rational actor would be more than a little nervous now Boskalis have the Nor vessels… contracts for small DSVs in Brazil won’t save the North Sea market…

I am wondering if a lack of clear economic thinking has permeated the deal for the investors, maybe they have been blinded by perceived benefits such as 600m diving, because when you have to get management to warrant that:

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

you clearly don’t have a great handle on the business or what you plan to do with it. This could well be a classic situation of the “Winners Curse” in M&A.

At the time I had worked with two seperate hedge funds who were also looking at the deal. We valued the business at ~.08 – .15 of the outstanding bonds (£14.0 – 26.5m) reflecting the new working capital required. Different people have different perceptions of value and therein will lie the answer to who makes money on this deal. A 2 x North Sea DSV operation, focused only on being a low cost operator, was the plan. In order to get to a bigger number you need to back a platform business to expand. No one outside of the large contractors has made diving work on a global basis as there are no economies of scale and procurement is all regional and follows different standards. So in order to recover £115m Enterprise Value York & Co., are backing a subscale, loss-making business, in an industry that is consolidating with large competitors, in a market with huge cost pressures. Traditionally that has been a poor route to value creation… but it is also true that counter cyclical investments generate huge returns. The hard part here is that because of the lead times for projects (which are well documentted), and Bibby’s own investment documents show, this is a market forecast to grow at CAGR c. 7%… roll the dice…