Offshore and shipping recovery cycles…

Clarksons reported results yesterday and offered the view that that shipping cycles seem to be turning. The interesting thing is the scale of the retrenchment in the traditional shipping sector that has been required to being the market back to equilibrium (if they are right). Traditonal shipping had a boom driven mainly by Chinese raw material imports (and to a lesser extent exports which were less bulky):

Clarksea Index.png

Chinese import and export growth:

Which looks somewhat similar to the oil price and investment boom:

It is worth noting that if Clarksons are right it has taken 8 years since the slump for normality and equilibrium to start to emerge. The scale of the pullback is severe with tonnage delivered down from 2047 vessels in 2013 to 217 in 2016 (a 90% reduction) and only 266 orders for 2017. Shipyards are down from 305 to 50 (an 83% reduction). It shouldn’t be a surprise because the assets are built for a 20-25 year economic life, the offshore subsea fleet is smaller (~600 vessels), but each one had a high build cost, whereas offshore supply with its larger fleet and more commodity like structure looks set to suffer a similar pull back.

The other really interesting data point Clarksons highlight is the decreasing loan exposure banks have to the sector (which I am assuming covers offshore as well):

Global ship finance lending volumes

Source: Clarksons, 2017

Lending volumes from the top 25 banks, surely more than a representative sample and clearly the most important by size with DNB Nor having 5x greater exposure than KDB, is down 25%, over $100bn,  over a six year period. More than any other factor this is surely helping the sector rebalance but it will keep a check on asset prices for years, especially as getting a loan for a ship older than 8-10 years is nigh on impossible.

The historical reasons for the shipping boom are analogous to the oil price boom that drive offshore: As China boomed so did commodity shipping, this quote should be well understood by anyone in  offshore this quote should be well understood by anyone in  offshore:

Less than a decade ago, just before the global financial crisis, the largest of the commodities-carrying bulk ships cost some $150 million and commanded as much as $200,000 a day on charter markets. Today, a similarly modern capesize class ship is worth $30 million and a vessel owner can expect to earn just $9,000 a day in a business where the prices for iron ore, coal and other industrial goods have deteriorated.

Ships that were increasing in value (as day rates rose) were used as collateral to borrow more money from banks to buy more ships in a self referencing cycle. Which is exactly what happened in offshore, and when even the banks got nervous the high yield bond market was tapped. What could possibly go wrong?

Banks hold the key to the restoration of normality. Like normal shipping offshore will require dramatically more equity and lower leverage levels going forward. Capital will be significantly more expensive. Banks, especially those in the graph above, that continue to take large losses on their portfolios, will be very reluctant to materially increase exposure and will continue to wind the loan books down with concommitment reduction in asset prices. This will go on for years as the above graph makes clear. Yes some smaller newer banks (e.g. Merchant and Maritime) and specialist lenders will fill the void, but rationally they will charge much higher rates (as they will have a higher funding cost to reflect the risk) and will require more equity. As retained earnings are lower this will take longer to build up.

Many of the new shipping projects at the moment are 100% equity financed and until asset values stabilise even newer players are likely to avoid offshore. Slowly, over years when combined with scrapping, the offshore fleet will rebalance, but it will be a long way off. Offshore would appear to be closer to the start of its journey than the end (a point Clarkson appear to agree with in their research). Nearly all distress investors who moved in 2016 looks to have moved too early (e.g. Standard Drilling, Nor Offshore) and faces a capital loss on the positions taken as opposed to industrial companies buying one-off assets (e.g. McDermott), With high running costs and demand stagnant its hard to see 2017 being any different. 

As the author of the above quote notes:

A sizable part of the portfolio of nonperforming shipping loans cannot be expected to bring market pricing much higher than the scrap price of the ships collateralized, however. In this case, shipping banks can take a deep breath and mark them to scrap value, and then make certain those ships are dismantled and removed from the market. Under this scenario, the immediate accounting losses would be mitigated over time by a more balanced market which theoretically will push freight rates and the value of the remaining ships higher.

Whatever path they take, European banks will be shaken by the unfolding of their shipping loan portfolios. Their capital structures will be affected, and given the freight market and banking regulatory headwinds, their appetite for ship finance will be diminished. The shipping industry likely will never be the same.

The same can be said for offshore I suspect.

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

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

A Primer on Financial Contagion

Massimo Sbracia and Marcello Pericoli

 

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

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

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

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

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

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

Main elements in this context are the following:

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

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

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

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

(v) Introduction of cash sweep mechanism.

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

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

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

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

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

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

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

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

DESS Repayment profile

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Follow the money… it’s all in the numbers…

“We no longer believe because it is absurd: it is absurd because we must believe.”

 Julio Cortázar, Around the Day in Eighty Worlds

At some point companies are going to have to stop reporting poor financial results and say things are looking good from a tendering perspective to retain credibility (or will they maybe their shareholders want to believe as well?). This week Solstad seemed to pull this trick, while the most brazen appears to be Subsea 7 who while annoucing that their order book had dropped significantly, stated that:

[We have] [c]ause to believe in an improvement in SURF project award activity within 12 months

Early engagement activity increasing

This despite the fact that 1 year ago they had $6.1bn in backlog and they currently only have $5.1bn. Subsea 7 is more exposed to EPIC projects and I believe these will form a bigger percentage part of the market going forward, but it’s still a bold call.

For Solstad the alternative explanation, announced by Bourbon, is that there is no recovery. Or as Siem Offshore stated this week:

we believe there will still be an oversupply of AHTS vessels and PSVs and expect the market to remain challenging for several years. The charter rates and margins still remain below what is sustainable. (Emphasis added).

Part of me thinks the offshore industry just isn’t used to an environment where the forward supply curve price isn’t fundamentally different from the current price. It is worth noting that on an inflation weighted basis the oil price peaked in 1979 and then dropped in real terms for 19 years to reach an all-time low in 1998, before stagnating for a couple of years, before the inexorable rise that we all regard as the new normal, began.

The major reason for the steady decline was both supply and demand based. New sources of supply came on, technology advanced, and high prices encouraged substitution. Clearly it isn’t an iron law that prices will keep rising over the long run as if it is an immutable economic law, yet it is taken as a given by certain sectors of the offshore community.

Solstad announced results this week that seemed to defy all logic. I don’t know how much money Aker have, but they have played the OSV market stunningly badly since the downturn began, and one would think sooner or later they will get sick of throwing more money away on vessel OpEx. Aker jumped into Solstad way to early, and yet for some inexplicable reason, (other than blind faith in a vessel recovery?) when more than 100 North Sea class PSVs were in lay-up in January, agreed to effectively bail Farstad out and combine with DeepSea Supply. Now Solstad came out with this predictable bullet point from their results presentation:

Majority of revenue and EBITDA from CSV segment

Really what a surprise! You just can’t make this up. What is working for them in this downturn is their high-end CSV fleet and then Solstad jump headlong into the most overbuilt commodity shipping in the offshore industry, Madness. The rest of the presentation is an exercise in mental dislocation from industry reality: DESSC’s cost leading business model is praised… but that doesn’t help at the moment when ships are going out for less than their economic value? It’s also not scaleable or transferable in an acquisition of  other vessels (or companies) because it relies on all vessels in the fleet being similar? And can you really have a low cost business model in this sector anyway? Its a boat + crew? What special insight does DESSC have in making this low cost? Apparently a strategic driver for saving Farstad’s banks is their AHTS experience? Great… Farstad are the most skilled company in a market segment that is structurally unprofitable? If the shareholders are like Aker and like owning companies that are the most competent at what they do regardless of whether they make money or not then this is a very good investment idea. I suspect it’s niche though because investors like that are rare.

It is all well and good highlighting that Farstad and DESSC are non-recourse subsidiaries of Solstad wth the implication being if it all goes wrong then they can be jettisoned. But of course JF took his holding in Solstad not the subsidiary which shows you where he thinks the value is. The Solstad supply fleet will simply not be big enough to generate economies of scale that outweigh the negative industry structure or induce pricing power in any region. It is also debatable what the minimum efficient scale is in offshore supply? This was a transaction driven by the desperation of Farstad’s bankers and recognition by DESSC that trying to do a rights issue without a different investment story would have been extraordinarily dilutive given the cash would have been used for OpEx only. Quite how it was sold to Solstdad/ Aker is anyone’s guess.

A good comparison is Gulfmark which is going into a voluntary Chapter 11. Gulfmark will emerge with a clean balance and 72 vessels in the supply sector. If you want to look at a company with the potential to consolidate the PSV sector it is right there with a simple operational structure and balance sheet focused on one sector that investors can understand and measure. It is very rare  for companies to consolidate an industry that come from one of the high cost markets and then work out how to be cheap internationally – it usually works in reverse. US companies like Seacor and Gulfmark are going to be well placed to drive proper industry consolidation in a way that may not be possible for a company coming from a relatively high cost environment. Yet this industry feels a long way from the bottom when NAO Offshore with a mere 10 vessels, and 30% of the fleet in lay-up, all working at nowhere near their cost base, can say blithely:

Nordic American Offshore closed a follow-on offering March 1, 2017, strengthening the Company by about $48.8 million in cash. The main objectives of the offering were to strengthen NAO financially and position NAO for further expansion...

NAO sees opportunities to grow the Company… 

(Emphasis added).

I sometimes wonder if when Norwegian schoolchildren are young they are indoctrinated with a special ship class in which the answer to every question is “ship”. I imagine an immaculate schoolroom (paid for with petrodollars of course), a very small class, and 20 children with their eyes closed humming and intoning gently “skip… skip…. skip…” And the teacher asking “What is the meaning of life?”… and the gentle reply coming back immediately “Skip”… “What is 2 + 2?” … “Skip, Skip + Skip Skip”… “E=MC2?” “Skip”….

I am just not sure the answer to the current problems are more ships… I have a nagging suspicion it’s less ships. A lot less. Consolidation isn’t the only answer here a quantative reduction in vessel numbers is an yes smaller operators need to go.

DOF came in with revenue 23% below Q1 last year which makes it hard to point to any recovery. DOF also announced this week that they may list DOF Subsea as First Reserve would appear to want out. First Reserve have been in DOF Subsea a long-time, and it’s natural they would want to exit at sometime. But you should always ask why inside and knowledgable investors are selling now, at what some are calling the bottom of the cycle; maybe it isn’t the bottom? DOF Subsea project margins were 2.0%! Yes the DOF PLSVs in Brazil are now up an running, but as we all know Petrobras has far too much PLSV capacity and so I suspect First Reserve is trading off a very low point in the cycle against the cost of waiting which brings you a day closer to the possibility of a vessel being redelivered from Brazil.

DOS Subsea specialise in light IRM and small scale projects and out of the North Sea market (where you need a North Sea class DSV) owning a vessel is a disadvantage not an advantage (which isn’t true at the top end EPIC SURF contracting where you need a specialist lay vessel) for some projects as costs become purely variable. Every single asset DOF Subsea have can be chartered in from another company if you are project management house. There used to be a number of project companies that delivered projects but didn’t own vessels, that didn’t last as the market tightened from 2006 onwards and you simply couldn’t charter a vessel (I am trying to think of the Singapore/Perth company Technip brought?). But now that isn’t the case and so not only is there loads of delivery capacity in vessel owners and charterers, but small project management houses can, and will, bid and compete for jobs, which will lower industry profits structurally. The best strategy going forward is to have a fleet much smaller than your delivery schedule requires but still some core tonnage, companies that didn’t splurge in the last boom are clearly better positioned here.

Whatever the reason for First Reserve selling it is a fact that one of the most successful investors in the energy industry is lightening their exposure to the offshore sector. If you buy DOF Subsea shares you need to ask what you know that First Reserve don’t? Interestingly First Reserve hasn’t invested in an offshore exploration company since 2011 (Barra), but has invested in 7 tight oil plays since 2011, a pattern that seems to mirror capital flows in the industry. One wonders if Technip weren’t encouraged to try and by DOF Subsea and a lack of interest led to this way of getting out?

The obvious reason that First Reserve might well be selling is that they think the poor financial results are likely to continue for sometime and they see no easy answer to an industry awash with capacity and declining levels of investment and simply don’t want to fund working capital with an uncertain payback cycle. DOF Subsea has excellent project delivery capability but it simply too long on ships and unlike other contractors these are an essential part of their strategy going forward and they have no ability to given chartered tonnage back as the industry continues to contract.

DOF Subsea also have 67 ROVs. The quiet underperformer in the industry at the moment is the ROV space. Everyone at the moment is giving the ROVs away at costs + crew only. In the old days ROVs were so profitable because you used to able to hide a mark-up on the vessel in the contract amount and they looked very profitable. Now the vessel is given away for free as is the ROV and only the engineering generates some margin. There is clearly going to be some consolidation here and I believe it will be very hard for the smaller companies to raise additional funding without profitable backlog as it becomes clear that there will not be a recovery in 2017. A lot of companies in the ROV market have raised money yet offer the same thing as the industry leaders who have very strong liquidity positions and can play this game far longer than speculative investors. Reach is a well managed company, and can give vessels back eventually, M2 got it’s ROVs cheap, but both are going up against companies like DOF and Oceaneering and eventually, surely, investors are going to realise that without some sort of increase in demand the structure will favour the larger companies who have more equity to dilute to see them through to the final stages of consolidation. There is an argument that smaller nimbler ROV companies can respond better to IRM workscopes than larger companies, particularly at the moment with oversupply in the vessel market; we are about to find out if they can win sufficient market share to be viable.

Obviously there are different views about when the industry is going to recover and how it will look. That is legitimate as no one can know ex ante what will happen ex post but it is becoming apparent that 2017 isn’t going to be the recovery year people hoped and that more people are going to have to raise money to get through this. The Nor DSVs will need to start fundraising in August at the current burn rate, as will others, the dilution that the new money makes on the old money for these secondary fundraisings will be a clue I believe as to how close we are to pricing the bottom. The investors in Nor represented a group who thought there would be a quick bounce back in 2017 in the price of oil and subsea asset values, there are bound to be fewer the next time around and surely they will charge a higher price for their capital, and in many ways this is microcosm of the industry.

The best guide to calling this appears to be those that have looked at previous investment bubbles. Charles Kindleberger, in his classic study of financial panics and manias stated the final stage of an investment bubble led to panic selling which would mark the bottom of the cycle:

‘Overtrading,’ ‘revulsion,’ ‘discredit’ have a musty, old-fashioned flavor; they convey a graphic picture of the decline in investor optimism.

Revulsion and discredit may lead to panic (or as the Germans put it, Torschlusspanik, ‘door-shut-panic’) as investors crowd to get through the door before it slams shut. The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets…

We still look a long way off this in offshore supply and subsea.

 

Bourbon results offer no comfort or light

Bourbon released numbers this week that were bad, this isn’t an equity research site so I don’t intend to drill through them. Bourbon is a well-managed company and there is little it can do given the oversupply. But I can’t look at these stats without feeling like the HugeStadSea merger was too early. And quite how NAO, with 10 PSVs, raised money at USD 15m per vessel when the industry is at this level also looks like a triumph of hope over data. Subsea looks just as bad.

First, I think the graph below (from the Bourbon presentation) is telling and worrying for offshore. One of my constant themes is productivity. Shale is generating increasing productivity (i.e. constantly reducing unit costs) from all this investment, offshore fundamentally isn’t. The cost reductions from offshore are the result of financial losses, not more outputs from unit inputs.

Capital Investment Forecast: Shale versus Offshore

Capital Outlook

Clearly, the capital increase is good for vessel owners, but as this graph shows, the fleet was built for much better times.

Global E&P Spending

Global E&P Spending

And as the Bourbon numbers show, demand isn’t going to save offshore because the supply side of the market is too overbuilt.

Stacked vessels

The subsea fleet globally looks just as bad. Rates are only just above OPEX if you are lucky and nowhere near enough to cover financing or drydocking costs. The hard five-year dry-dock is the real killer from a cash flow perspective.

In order for this market to normalise not only vessels, but also capital, needs to leave the industry. I was, therefore, surprised that NAO raised USD 47m to keep going. NAO have 10 vessels, and are clearly subscale by any relevant industry size measure, are operating well below cash breakeven including financing costs (USD 11 500 per day), and still, they plow on. I understand it’s rational if you think the market is coming back (and the family/management put real money into this capital raise), but if everyone thinks like this then the market will never normalise. And when Fletcher/Standard Drilling can keep bringing PSVs back into the market at USD 8-10m, that do pretty much the same thing as your 2016 build, and 1/3 of the fleet can be recommissioned, the scale of a spending increase needed to credibly restore financial health to operators looks a long way off. Someone is going to have to start accepting capital losses or the industry as a whole will keep burning through new infusions of cash on OPEX. ( I know PSV rates, in particular, have increased this week but this looks like a short-run demand as summer comes and vessels come out of lay-up than a recovery.)

Specialty tonnage, such as DSVs, are in a worse position because as Nor/Harkand are showing people are reluctant to cold-stack due to the uncertainty of re-commissioning costs. Project work simply isn’t returning to at anything like the levels needed to get vessels and engineers working. Subsea construction work significantly lacks rig work, and companies are delaying maintenance longer than people ever thought possible.

Rig Demand

I think restructuring, consolidation, and capital raising are clearly the answer don’t get me wrong. I just think some falling knives have been caught recently (the Nor/Harkand bondholders being the best example) and the industry seems reluctant to admit the scale of the upcoming challenge. And again I am perplexed why the Solstad shareholders allowed themselves to dilute their OSV fleet with greater exposure to supply, when the dynamics are clearly so bad? The subsea and offshore industries appear to be facing structurally lower profits for a long time, and more restructurings, or a second round for some, seem far more likely than an uptick this year and next.

 

“Short cycle” E&P production, offshore demand, and future industry structure…

“Productivity isn’t everything, but in the long run it is almost everything.” 

Paul Krugman

There was an excellent article in the Telegraph this week on the economics of shale (“short-cycle”) investment that is so important for the future of offshore demand. This comes at the same time the IEA is raising concerns that lack of current investment could lead to a “sharp increase” in prices and effectively says shale is not the solution. I back the economics of marginal supply over future concerns that large mega-projects are not occurring.

I note the IEA itself says:

The demand and supply trends point to a tight global oil market, with spare production capacity in 2022 falling to a 14-year low.

In the next few years, oil supply is growing in the United States, Canada, Brazil and elsewhere but this growth could stall by 2020 if the record two-year investment slump of 2015 and 2016 is not reversed. While investments in the US shale play are picking up strongly, early indications of global spending for 2017 are not encouraging.

[emphasis added]

I have to admit to being slightly perplexed having read the IEA release on this report (and not the whole report) because I am not sure I get why a tightening of supply would lead to increased volatility in prices? Surely it would mean a gradual increase in investment to meet the tightening supply? Or maybe a period of underinvestment would lead to rising prices (but would surely be a signal for investment)? It may be true that large mega-projects are not replacing the previous number of similar projects, but that is exactly the point shale producers make, their production is more marginally driven.

Dr Fatih Birol, the IEA’s Executive Director. “But this is no time for complacency. We don’t see a peak in oil demand any time soon. And unless investments globally rebound sharply, a new period of price volatility looms on the horizon.”

I understand the IEA may want low prices for consumers permanently but that isn’t rational for E&P companies who need a return on capital? Volatility would surely come as a result of large changes in the supply or demand in an industry with a relatively long-run supply curve for larger increases in marginal demand? Volatility in prices is the result of one side of the market being unable to respond to the other and there is limited evidence of that at the moment.

Not investing isn’t necessarily complacency it looks like rationality. E&P companies projects are fundamentally riskier when the variation in oil prices can be anywhere from USD 30 to USD 130 pboe, they need greater returns to cover that risk. The lesser investment could well lead to higher, more stable prices, on lower supply because that is the rational way to behave given past overinvestment cycles. E&P companies certainly don’t have to worry that the offshore supply chain could not assist in raising production very quickly, given the severe over capacity, a situation very different to past downturns.

Shale has become a manufacturing process like any other and subject to declining unit costs and experience curves as the Rystad Energy graph makes clear. For well over 150 years the US economy has been defined by an ability to reduce unit costs through productivity increases. Given the opportunity to make money in shale by continuing to do this I see no reason why this trend should not continue.

OGFJ_FEB17_1_wellhead_be

As a comparison:

US Steel Stocks versus Output

Offshore energy has advantages with larger reserve access and lower per unit costs. But the big disadvantage offshore has is that by its very nature it is non-standardised and it is very unlikely in the future this will change given the engineering challenges. The price reductions at the moment are the result of overcapacity and financial losses, not an increase in productivity, as is occurring in shale. This is not sustainable and prices for the supply chain will have to rise for the offshore supply chain to be viable again.

This ties in with the behavior that supermajors have been making in their investment programmes e.g. Chevron announced yesterday that offshore CAPEX would be USD ~12bn, a 30% drop from 2016, but still 67% of the total budget, which is down 12% YOY. Exxon has announced USD 25bn of CAPEX for 2017 with 1/3 for shale rising to 1/2 in a few years. The higher constant capital cost for shale, but shorter lead times, may mean marginal demand and supply are more easily balanced via pricing than has traditionally been the case in the past. E&P companies are not ignoring offshore but are using it for a large base of supply while having flexibility at the margin to change their capital and operating costs in a way offshore simply cannot offer.

The losses that have been sustained in the offshore supply chain by investors, and the growth of shale, point to a few constant themes to me here:

  1. There will need to be a “boom” to encourage new investment in offshore. When oil prices can be significantly below project forecasts for ~5 years then you need to make a higher return as an investor. That won’t be a boom it will be a return to a rational economic pricing level where supply and demand meet.
  2. A smaller number of offshore mega-projects could supply the base of new energy supply while shale picks up the more variable, and uncertain, demand.
  3. In order to ensure unit costs are lower the offshore supply chain is likely to be significantly more integrated into E&P companies than is currently the case. It is simply not viable to build USD 700m rigs and USD 100m vessels and have them on the spot market. Banks and financiers will insist on a better risk sharing mechanism (slowly and over time) or the capital required for these units (and therefore the day-rates that E&P companies pay) will become irrational and uncompetitive.  Brazil, so long an outlier for the lack of spot market, may, in fact, become a model for the sort of integration required to make offshore more competitive (in theory not fact as anyone who has worked for Petrobras can testify).
  4. This new industry structure will favour larger companies with a more diversified asset base.
  5. The real worry for basins such as the North Sea is that in size the projects are more akin to shale, but in economics closer to deep water, and therefore as a risk/return basis they look unattractive. That is not the end of the North Sea but it does mean all but the most attractive small fields are developed. It is very bad news for the supply chain which has built a fleet for far greater demand.
  6. Given current supply levels a “boom” offshore production is unlikely to flow through to the supply chain given current capacity levels.

HugeStadSea and Olympic

Two major pieces of restructuring news today with Solstad merging with Farstad and Deep Sea Supply and Olympic finalising its deal. The interesting thing is the contrast: Solstad goes long on offshore supply while Olympic goes for subsea. I get the Olympic deal but for what its worth I’m not sure about creating a bigger HugeStadSea.

The Solstad/Farstad/Deep Sea is about as complicated as it gets (full details here). However in simple terms Solstad currently has 20 PSVs (32%), 16 AHTS (25%), and 27 CSV/Subsea (43%) as opposed to the new merged fleet of 154 vessels has 66 PSVs (43%), 55 AHTS (36%), and 33 CSV/ subsea (21%). That doesn’t seem like a good deal to me. I get the financial metrics mean Solstad, with a (slightly) better debt profile and fleet profile, is taking a proportionately bigger share. But the economics seem simple to me: Supply and Subsea have similar daily running costs but unless you are a true beliver its hard to see asset price appreciation in supply whereas subsea has the potential for a service element that can add value beyond the steel in addition to the vessels holding their value better. Not many people would trade a fleet with 43% exposure to subsea and trade it for one with 21% in this market.

I don’t see how this business will have enough scale to lower unit costs to make the merger worthwhile? Procurement is still regional in the industry and while it will be a large company with 2100 supply vessels in the industry it won’t be big enough to have any effect on market pricing. Savings of NOK 500m across a fleet of 154 vessels with such high running costs look to have almost no effect. Put me in the sceptical camp. I would have passed on Farstad if I was either Deep Sea or Solstad but I accept different people are more confident in the long-term supply market, but exposing yourself to a similar cost base on commodity vessels when the upturn seems so uncertain is bold to say they least (which could well be one of the many reasons JF is a billionaire and I am not).

Olympic seem to have realised this and effectively cauterised the risk of the supply vessels (by handing them back to the bank and bondholders effectively) and offering upside only on the subsea fleet while providing only for basic running costs for the supply fleet (deal here). Significant new equity is injected (from the main shareholders), along with the ship and crew management companies, and the medium-term liquidity looks confirmed (barring a credit event I guess?). This strikes me as a far more investible proposition whereas the HugeStadSea looks more like assets looking for a transaction to buy them time and hope.