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.

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.