Bully for Brontosaurus…

“I am truly convinced that both the shipping and the offshore markets will recover.”

Mads Syversen, CEO Arctic Securities (26 Jan 2016)

Arctic and ABG Merger valuation.png

From the Solstad Farstad merger prospectus (9 May 2017) highglighting the extreme optimism of the investment bankers putting the deal together. It should be noted the asset market was under huge stress at the time (the bankers of course were paid in cash on completion).

The Golden Bough

In point of fact magicians appear to have often developed into chiefs and kings.

 James George Frazer, “The Golden Bough” (1890)

The Emporer

Courtier T.L. — Amid all the people starving, missionaries and nurses clamoring, students rioting, and police cracking heads, His Serene Majesty went to Eritrea, where he was received by his grandson, Fleet Commander Eskinder Desta, with whom he intended to make an official cruise on the flagship Ethiopia. They could only manage to start one engine, however, and the cruise had to be called off. His Highness then moved to the French ship Protet, where he was received on board by Hiele, the well-known admiral from Marseille. The next day, in the port of Massawa, His Most Ineffable Highness raised himself for the occasion to the rank of Grand Admiral of the Imperial Fleet, and made seven cadets officers, thereby increasing our naval power. Also he summoned the wretched notables from the north who had been accused by the missionaries and nurses of speculation and stealing from the starving, and he conferred high distinctions on them to prove that they were innocent and to curb the foreign gossip and slander.

 Ryszard Kapuscinski, “The Emperor” (1978)

Mons Aase, DOF Subsea CEO, said: “The appointment of Mr. Riise is an important step towards realizing our vision of being a world-class integrated offshore company, delivering marine services and subsea solutions responsibly, balancing risk and opportunity in a sustainable way, together, every day. I look forward to working closely with our new CCO and I welcome Steinar to DOF Subsea.” (15 October, 2018)

“Our business will probably die over the next 10 yrs because the demand for oil probably will start peaking – we think in 2028-2029.”

Ian Taylor, Vittol Chairman, June 8, 2019

“If you get lucky for a long period of time, you think the rules don’t apply to you… These guys thought they could walk on water. They weren’t smart, they were lucky”.

Maarten Van Eden, Anglo Irish Bank CFO, in Anglo Republic: The Bank that Broke Ireland

(Anglo Irish bank initially assessed its downside losses in the credit crunch at less than €2bn. Over €45bn later they had nearly bankrupted the Irish state by lending on illiquid property assets reliant on a booming Irish economy and a global credit boom).

 

Have a look at the graph in the header, particularly 2016/17, and then the Solstad liabilities for 2016/17, just as they were “buying” Farstad and DeepSea Supply:

Solstad liabilities 2016_17.png

(I saying “buying” because it was then second major rescue attempt after Aker made a spectacular error in timing with REM. It was a deal pushed by the bankers who didn’t want to deal with consequences of Farstad and Deepsea Supply).

That would be just the time the rig count in the Permain was to explode:

BH rig count June 2019.jpg

And here are the latest Solstad Q1 2019 liability figues:

Solstad Q1 2019 Liabilities.png

Roughly NOK 2bn higher! The assets are older, the market isn’t much better, and they owe NOK 2bn more! (Don’t get me started on look at the assets side of the balance sheet: it was well known the Farstad/DESS were worth significantly less than book value).

If you believed Solstad had a future in anything like its current form you would be asked to believe the impossible: that despite the most extraordinary structural shift the oil and gas industry, despite owning depreciating assets barely covering actual running costs, despite no indication of oversupply ending (and in fact every indication that funding a mutually assured destructive battle will continue with NAO planning to raise money), you would be asked to believe Solstad could actually pay that money back… And of course they can’t: the numbers on paper, the amounts the banks and creditors claim they are due, are indeed a fantasy. A wish, with no basis in economic substance despite their accounting clarity.

Solstad made an operating profit of NOK 162 918 000 in Q1 2019 on NOK 33bn of balance sheet and asset risk. If someone had lost the petty cash tin they would have been in a loss. It’s totally unsustainable.

It may have been reasonable to believe that NOK 30bn of debt could be supported by offshore demand when the US graph was at 2014 levels but it is no longer credible now. Too much of the investment and maintenance expenditure flowing through the global energy industry is just going to other places. This is a structural shift in the industry not a temporary drop in demand like 2009.

I am not picking on Solstad here, they are just the most obvious example as their resolution seems (reasonably) imminent. Without exception all these crazy asset play deals that relied on the market coming back will fail.

When I was at university I first read the palaeontologist Stephen J Gould who introduced me to the difference between Lamarckian and Darwinian evolution (Bully for Brontasaurus). If you can’t bothered clicking through to the links the easiest way to think about this (in a purely demonstrative example) is that Lamarckian evolution argues that giraffes evolved by gradually growing longer necks and reaching for higher leaves on trees that others couldn’t reach – which is wrong. One of the many brilliant things about Darwin was that he realised that it was the randomness in evolution that caused the process – giraffes that just happened to have the long neck gene prospered and had more baby giraffes and passed the gene on. The race of giraffes that prospered was the result of random selection that ended up adapting best to their environment. They got lucky not smart.

Offshore is full of companies that may have been lucky on the way up but are totally inappropriate financial and operational structures to survive in the modern energy era. Evolution is a brutal, mechanical, and forward acting process. It is irreversible and path dependent. In economics the randomness of the evolutionary process is well understood with most research showing industry effects are stronger than firm effects. By dint of randomness the genes of many of the asset heavy offshore companies companies, but especially those with debt held constant at 2015/16 levels, are fundamentally unsuited to their new environment.

In case you are wondering where I am going with this (and want to stop reading now) I have two points:

  • A lot of the offshore supply chain confused managerial brilliance on the ride up to 2014 with good luck, a high oil price, and a credit bubble. Seemingly being lucky enough to have been running small fishing vessels when North Sea oil was found was rarely posited as an explanation for the growth of many West Coast Norwegian offshore firms, but it is in reality true. A random act of economic circumstance that threw them into a rising commodity and credit bubble. A newer, far less wealthy, future beckons for many of the small coastal towns that supported this boom.
  • The randomness of US geology colliding with the most efficient capital markets in the world, the largest energy consuming nation, and technological circumstance has caused a complete change in the structure in the underlying oil market. The profound implication for North Sea producers, and the supply chain underpinning them, is a transition to be an ever more marginal part of the global supply chain. That will mean less dollars in flow to them and that however long companies try to fight this will be in vain because we are dealing with a profound structural change not a temporary reduction in demand.

What the offshore industry is faced with now is a fundamental regime change – in its broadest sense both statistically (which I have argued before) and sociologically. The economic models of debt fuelled boats and rigs with smaller contractors are over in principal. It’s just the messy and awkward stage of getting to the other side that beckons now.

For pure SURF contracting and drilling consolidation is the answer and will occur. Financial markets will squeeze all but the largest companies from taking asset risk. DOF Subsea’s business model of buying ships Technip wasn’t sure about long-term will look like the short term aberration to economic rationality it was. For offshore supply the industry will be structurally less profitable forever. Asia shows the future of offshore is a vast array of smaller contractors, operating on minimal margin and taking vast risks, and yet the E&P companies are happy with this outcome because they get competitive prices. There is no reason to believe this model will not work in Europe as well. Where procurement is regional there are no advantages to being a global operator as the unit onshore costs are such a small proportion of the offshore/asset costs.

Although it feels unique to many in offshore it isn’t. If you only read one book about a collapse of ancien regime make sure it is Ryszard Kapuscinski’s “The Emperor” (1978)  on the collapsing Ethiopian empire. By interviewing a large number of the courtiers Kapuscinski gets you into the collective mind of an institution unable to face the reality of circumstance. The inability of Haile Selassie to realise that his random luck was totally unsuited to adaptation in the modern world is deeply reminiscent of the management in offshore, and to a certain extent the banks behind it (I’ll write more on the Stiglitz- Grossman paradox which answers why this may occur later).

Slowly the power and the capital of marginal oil production is being shifted to the Lower 48. Make no mistake the replacement of low capital cost Super Majors for high cost of capital (often PE backed) E&P companies in the North Sea marks the slow withdrawal of capital long-term from the area. Note not removal: just slower investment, higher cost hurdles, more pressure on cost etc. That will require a structurally smaller supply chain.

Old capital structures, and especially debt obligations, written in the good times will be completely re-written. Over the next couple of years the Nordic banks are going to write off billions dollars (that isn’t a misprint) as the hope thesis of recovery loses credibility. They will shut down credit to all but the most worth borrowers and sellable assets (if you think that is happening now you aren’t watching the crazy deals going on in the rig market). Equity across the industry will rise and leverage will substantially decline.  Smaller operators will vanish driven the same process reducing biodiversity on earth now: a less munificent environment. I believe when these banks have to start really taking write-offs, and Solstad and DOF are important here because they are close in time and significant in value, bank loan books will in effect close for all but the largest companies. In the rig market where are few companies have been responsible for nearly all the deals and private bubble has built up in the assets this will be contrasted with a nuclear winter of credit. And if banks aren’t lending then asset values fall dramatically.

How much is the Skandi Nitteroi really worth? There is no spot market for PLSVs, Petrobras have no tenders for flexlay? No one else capable using it needs one and Seadras are getting theirs redelivered? Banks are going to take the hit here and then the industry will really feel it.

I am reading Anglo Republic, a book about the collapse of Anglo Irish Bank, at the moment. Again the inability of management (and Treasury, and the goverment) to see the scale of the losses has a strong parallel with offshore. And like offshore initially everyone believed the Irish propery market would come back, that liquidity not solvency was the problem, that this was temporary blip. The crisis was a slow burner for this reason. But when it really came, just like all asset heavy industries, it starts with the refusal of credit institutions to renew liquidity lines because they know it’s a solvency problem. And that is why Solstad and and DOF are significant. They are the BNP Paribas of the next phase. But you know what… my next book is this, and it will have the same story of excessive optimism, leverage, an event (literally a revolution in this case), and default. If there are only really seven major plots in literature there is surely smaller set in economic history? So we know what is coming here.

This needs to happen in an economic sense. The cost to produce offshore will have to rise to reflect the enormous risk the supply chain take in supplying these hugely unique assets on a contract basis. But for this to happen there needs to be a major reduction in supply and it needs to happen while competing against shale for E&P production share. And it cannot happen while the industry continues to attract liquidity from those who buy assets solely on the basis of their perceived discount to 2016 asset values in the hope of a ‘recovery’ to previous profitability levels.

Which brings us on to what will happen to Solstad? It is in the interests of both the major equity investors (Aker/ Fredrikson) and the banks to play for time here. I fully expect a postponement of the 20 June deadline. Next summer, the bankers will tell themselves, the rates will be high and we will be fine (just like the Irish bankers and countless others before). But some of the smaller syndicate banks clearly get the picture here, the business is effectively trading while insolvent, regulators will also eventually lose patience, and the passage of time will not be kind. The solution everyone wants: to put no more money in and get all their money back isn’t going to happen.

Normally in situations like this, where the duration of the assets is long and illiquid, like a failed bank, a ‘bad bank’ and a ‘good bank’ are created. One runs down (as DVB Bank is doing with offshore) and the good one trades and is sold (as DVB Bank have done with aircraft finance). That would see the Solstad of old split off into a CSV fleet maybe or a Solstad North Sea while the old Asian/Brazil DESS was liquidated and the Farstad AHTS business also liquidated. But that will require the banks writing off c. NOK 20bn (maybe more) and I don’t think they are there yet.

After Solstad comes DOF. And in all likelihood following them will be some smaller tier 2 contractors, and certainly some rig companies, who realize that in an economic sense this just cannot continue. No matter how hard they keep reaching for the greener leaves higher up.

The address that never was…

“Not all barrels are created equally,” she said. “60 per cent of our cash flows are not coming from our upstream business. There shouldn’t be a correlation with our reserves or capital expenditure in upstream. It’s not tied to that.”

Jessica Uhl, CFO Shell

 

Money is not the value for which goods are exchanged, but the value by which they are exchanged.

John Law, Money and Trade (1705)

 

Roughly a year ago this week I gave an address at the OSJ Conference where I was pretty gloomy about the future for offshore. I was invited back this year but unfortunately a change of work circumstances mean it is no longer really the thing for me to do. Having said that I don’t think it is a bad time for a State of the Union speech.

You can guess where this is going…

Last year we had a mini-rally in offshore mid-year. Some of the more outlandish ideas raised more money and invested more capital in an industry already suffering an excess of capital and the share prices of all these public investments are seriously underwater. The banks also continued to pretend things could only get better, when in fact they were clearly getting worse. Solstad and Pacific Radiance are the two most prominent examples of this philosophy but there are a slew more in offshore supply and drilling.

And all the while shale simply grows in scale and scope. I am actually bored now with the really complicated theories about how and why the shale revolution will die. The offshore optimists who touted this theory have been comprehensively wrong in the past and will continue to be so in my opinion.

A few data points show the scale of the infrastructure being used to grow the shale fields:

That folks is your offshore recovery: prices above breakeven at best and lower utilisation as the prices are just high enough to keep zombie companies in business. Welcome to the new normal.

Shale growth may be slowing down,  but it will still grow over 1 million barrels a day in 2019. This slide from Exxon Mobil is reflective of the huge amounts of capital going into Lower 48 production and the continuous productivity immproveents creating the virtuous feedback loop:

IMG_0405.JPG

So you can believe some really complicated story about this “offshore recovery” and how it has to happen because reserves are low, or demand will outstrip supply, or shale production isn’t economic, or you can look at what is happening in the US now and accept the logical conclusion: this is the offshore recovery.

Just like the steel industry in the US when it was hit with Asian competition so offshore now has a serious competitor for production investment at the margin. Offshore production isn’t going away but nor is there a boom in store. Projects at the margin are being delayed or cancelled and never coming back. The fleet built for 2014 is still too large by an order of magnitude and operating well below economic break-even. Only a massive increase from the demand fairy can save the current industry structure and that isn’t happening. There are too many boats and rigs with too many operators and this year will bring the start of the slow rationalisation needed. We will end the year with less companies and less tonnage and still the job will remain incomplete.

The most likely scenario at this point is years of oversupply with grindingly poor margins, struggles to get to economic profitability, and a gradual reduction in the fleet as ever so slowly those with less commitment and cash drop out of the race to stay alive. Eventually prices will have to rise to pay for new investment in the offshore supply chain but that looks years away and most firms don’t have the liquidity to wait. Raising new money is getting near impossible for all but the most serious candidates: hedge funds who piled in last year are underwater and look unlikely to wade back in unless the terms are extraordinary, and long-term investors are rightly terrified at the losses the Alternative fraternity have suffered calling the recovery far too early.

The interesting thing is why? In this paper “The elasticity of demand with respect to product failures” by Werner Troesken (pdf) shows that while markets are selection mechanisms they don’t always choose the best products. People continued to buy snake oil in the US long after its efficacy could be argued for.  Maybe the offshore crowd waiting for the boom can comfort themselves with this fact?

However, I see however that in an era of mass production, and rapidly increasing efficiency and unit cost reductions in shale production. To avoid shale, to take your firm off the technological trajectory, would so limit the future  options of a large E&P company that it would not be a wise strategic decision. More marginal capital will be deployed not less. has It is far less risky to invest in a lower margin product like shale, with a shorter payback period, than those custom designed deepwater fields with economic lives vastly in excess of price forecast accuracy.

Worringly for people in offshore is this paper: “Depression babies” by Ulrike Malmendier and Stefan Nagel. If you want to understand how formative experiences can be in lifelong economic actions then this paper demonstrates that investors whose careers were built in recessions invest in fewer equities (i.e. risk capital) even in positive economic times. My rough analogy, which I have no intent to take further, is that E&P execs who lived the 2014 downturn are in no hurry to turn on the CapEx spigot to satisfy all those who tell the world is running out of energy (and as 3 above shows are consistently wrong). And they will be like this forever. Just as those in offshore sit around waiting for the next boom E&P company execs sit around trying to avoid the next investment driven crash.

I have said before loss-aversion theory greatly explains the behaviour of the banks who are crucial to the clean-up of the industry (particularly in Europe and Asia as American losses have been equitized). Every time they have delayed the losses pretending the comeback will happen. And offshore supply in particular was dominated by European and Asian banks. Sooner or later, when the cash flows from the offshore supply and rig asset base cannot make even token payments, and the banks loan books are revealed to be more like Italian regional banks, the real contraction will begin. John Law intimately understood the link between a banks assets and liabilities in a way that would do a modern risk officer proud.

I also mentioned the DSV market last year. I am not mentioning names but building a $150m DSV and selling the vessel for 100k per day for 150 days (at best per annum) is a fools errand in economic terms regardless of the outstanding organisational skills required to deliver it in physical terms. It is simply not possible in a market as competitive as as the Asian DSV market for one firm to outperform others over the long run.

The sale of the Toisa DSVs for between $20-34m shows the economic clearing price of such assets. Such a large gap between actual economic values of operational assets and the historical build costs of new assets can be met by the Chinese taxpayer forever, but eventually the unsustainable nature of this will catch-up with itself. I shall say no more. But Uber can lose money on running taxis for longer than I thought… eventually I will be right here too. Delivering cold Starbucks at $5 won’t keep Uber at a $60bn valuation and IRM work in Malaysia cannot pay for $150m DSVs.

Offshore will continue to be an important part of the energy mix. But the supply chain supporting it to be like that has a great deal of shrinkage to be an economic part of this mix.

Common knowledge in offshore and shale…

“With every grant of complete security to one group the insecurity of the rest necessarily increases.”

Friedrich Hayek

Common knowledge is something that we all believe everyone else believes. 

We don’t have to believe it ourselves, and it doesn’t even have to be public knowledge. But whether or not you personally believe something to be true, if you believe that everyone else believes something to be true, then the rational behavior is for you to act AS IF you believe it, too. Or at least that’s the rational behavior if you want to make money.

Common knowledge is rarer than you think, at least for most investment theses. That is, there’s almost always a bear case and a bull case for a stock or a sector or a geography, and god knows there are plenty of forums for bulls and bears to argue their respective cases.

What can change this normal state of affairs … what can create common knowledge out of competing opinions … are the words of a Missionary. In game theory terms, the Missionary is someone who can speak to everyone AND who everyone takes seriously. Or at least each of us believes that everyone else hears the Missionary’s words and takes them seriously.

When a Missionary takes sides in a bull vs. bear argument, then depending on the unexpectedness of the words and the prestige of the Missionary, more or less powerful common knowledge is created. Sometimes the original Missionary’s words are talked down by a competing Missionary, and the common knowledge is dissipated. Often, however, the original Missionary’s words are repeated by other, lesser Missionaries, and the common knowledge is amplified.

When powerful common knowledge is created in favor of either the bull or bear story, then the other side’s story is broken. And broken stories take a looooong time to heal, if they ever do. Again, it’s not that the bulls or the bears on the wrong side of the common knowledge are convinced that they were wrong. It’s not that the bulls or the bears on the wrong side of the common knowledge necessarily believe the Missionary’s statements. But the bulls or the bears on the wrong side of the common knowledge believe that everyone ELSE believes the Missionary’s statements, includingeveryone who used to be on their side. And so the bulls or the bears on the wrong side of the common knowledge get out of their position. They sell if they’re long. They cover if they’re short.

Ben Hunt, Epsilon Theory

Oil and offshore has a lot of missionaries. In cyclical industries separating out industry firm effects from market effects is nigh on impossible. Be on the right side of a bull market and you make enough money to be a missionary respected by the crowd.

I thought of this when I read this extract from Saudi America in the Guardian. I won’t be buying the book (KirkusReviews panned it here) but the parts on Aubrey McLendon of Cheasapeake fame are interesting. However, what is really interesting is that in 2016 when the research for the book was being done there was a strong strain of  the “shale isn’t economic” narrative:

Because so few fracking companies actually make money, the most vital ingredient in fracking isn’t chemicals, but capital, with companies relying on Wall Street’s willingness to fund them. If it weren’t for historically low interest rates, it’s not clear there would even have been a fracking boom at all…

You can make an argument that the Federal Reserve is entirely responsible for the fracking boom,” one private-equity titan told me. That view is echoed by Amir Azar, a fellow at Columbia University’s Center on Global EnergyPolicy…

John Hempton, who runs the Australia-based hedge fund Bronte Capital, recalls having debates with his partner as the boom was just getting going. “The oil and gas are real,” his partner would say. “Yes,” Hempton would respond, “but the economics don’t work.”…

In a report released in the fall of 2016, credit rating agency Moody’s called the corporate casualties “catastrophic”. “When all the data is in, including 2016 bankruptcies, it may very well turn out that this oil and gas industry crisis has created a segment-wide bust of historic proportions,” said David Keisman, a Moody’s senior vice-president.

Many of the offshore “recovery plays” were financed when this was the investment narrative. The “common knowledge” was that there was going to be an offshore recovery, it was simply a case of when not if. The staggering increase in shale productivity was not part of the common knowledge and didn’t form part of the narrative. Go long on assets said the common knowledge… they are cheap… this is a funding issue only… what could go wrong? As the oil price inevitably rose demand for offshore assets would quickly recover right?

As the graph at the top of this article highlights, just as the common knowledge was being formed that allowed a range of offshore companies to raise more capital to get them through to the inevitable recovery, and clearly the demise of shale would occur by simple economics alone, in fact the shale industry was just cranking up.

The results of most of the offshore companies for the supposedly busy summer season show that at best a slight EBITDA positive is the most that can be hoped for. Rig, jack-up, and vessel rates remain extremely depressed and most companies are struggling to even cover interest payments. A few larger SURF contractors are covering their cost of capital but most companies are simply doing more for less. Companies might be covering their cash costs but there is a massive issue still with oversupply, and judging from the comments everyone continues to tender for work they have no hope of getting as everyone is doing more tendering. The cash flow is rapidly approaching for a number of companies and Q2 results have shown the market is unlikely to save them.

The missionaries for the shale industry are currently in the ascendant in creating a new common knowledge. The new common knowledge for offshore will be extremely interesting.

(P.S. If I was the publishers I’d rush the paperback edition of the book out).

Dead man walking…

Hilton Barber: [at Matthew Poncelet’s appeals hearing] The death penalty. It’s nothin’ new; it’s been with us for centuries. We’ve buried people alive; lopped off their heads with an axe; burned them alive at a public square… gruesome spectacles. In this century, we kept searchin’ for more and more *humane* ways… of killin’ people that we didn’t like. We’ve shot ’em with firing squads; suffocated ’em, in the gas chamber. But now… Now we have developed a device that is the most humane of all. Lethal injection. We strap the guy up. We anesthetize him with shot number one; then we give him shot number two, and that implodes his lungs, and shot number three stops… his heart. We put ’em to death just like an old horse. His face just, goes to sleep, while, inside, his organs are going through armageddon. The muscles of his face would twist, and contort, and pull, but you see, shot number one relaxes all those muscles so we don’t have to see any horror show… We don’t have to taste the blood of revenge on our lips, while this, human being’s organs writhe, and twist, and contort… We just sit there, quietly. Nod our heads, and say: ‘Justice has been done.’

Dead Man Walking

Let’s just be clear: there is no chance of Viking Supply suriving as an economic entity. The question is around the method of demise not the ultimate question of it. For those aware of my history with the Odin Viking there are no surprises, and the irony of it’s association with “war, death divination, and magic” is not lost on me.

GOL Offshore was also put into liquidation last week. Again a subscale operator with no discernable point of difference from all the other assets and service providers out there.

This is how the industry in the supply side will rebalance. Small operators with commodity ships, no competitive advantage, and simply not enough asset value or liquidity to survive. But there are a lot more to come.  These size of these companies are small enough for the banks to write-off and are simply not worth saving. When the asset sales are done Viking Supply will effectively be in wind-down mode, the result of structural forces more than any other reason, but a necessary step to economic rationality. I don’t know what the minimum efficient scale is for a supply company but it’s a lot more than 15 vessels.

The largest companies in the supply industry have either large parent companies (Maersk, Swire, etc) or so much asset value post-restrcturing there will always be some logic to put money into to see the next year (Tidewater). For those without a cheap local cost base and contacts or without the advanatges of financial scale a grim existence beckons.

The real question is do the Viking Supply results presage the Q2 results for other operators or have they lost significant market share in the AHTS space? I think you can take it as a given that this comment reflects the general industry conditions:

The offshore supply market was very disappointing throughout the first half year, and the very weak market has caused both fixture rates and utilization to remain on unsatisfactory levels.

The real question isn’t who is selling the shares of companies like Viking, Solstad, and Standard Drilling but who on earth is buying them? The banks were desperate for Viking to survive but even they have abandoned hope now. Expect more banks and investors to do the same in offshore supply.

Tidewater and Gulfmark… big but not big enough…

The Tidewater-Gulfmark combination is a classic M&A play in a market awash with overcapacity: two companies merge and cut costs, integrate, get the savings, and everyone goes home for tea and biscuits. In a market that has declined so substantially the deal clearly makes financial sense: if you can run the same number of boats with 1/2 the management team you should take the money and run. But how much money are they (the shareholders) actually really taking here?

The Tidewater-Gulfmark acquisition is predicated on two types of synergies:

  1. Cost savings of around ~$30m per annum from 2020 onwards. That is based on the combined spending of both companies and they seem fairly certain on it. But the combined company will have  245 vessels, so that is about $336 per boat per day (based on a 365 year). In other words it isn’t going to fundamentally alter the economics of the (combined) company or their ability to take market share on cost. Bear in mind that Tidewater alone spends $245m per annum on direct vessel operating costs.
  2. Revenue synergies. Always beware of this number as it is nebulous to calculate and even harder to achieve in practice. These are meant to be achieved when a combined entity can sell more but that isn’t the case here. What little logic you can deduce from management is transparently thin, this is far more a market recovery play based on higher utilisation and day rates. This makes logical sense as well: all that has happened here is one management team are being removed and the number of boats increased. Nothing has changed the ability of the combined entity to sell more days something this confusing slide seems designed to obsfucate.

Offshore leverage.png

The higher day rates strike me as extremely optimistic given Siem Offshore recently announced that North Sea rates has been capped by vessel reactivations. But Tidewater are full of optimism:

In a market recovery, utilization should improve to approximately 85% for active vessels, including 82 Tier 1 vessels and 91 non-Tier 1 vessels.

With an increase in offshore drilling activity, the combined company should also be able to quickly reactivate 20 currently-idle Tier 1 vessels.

The combination of higher active vessel utilization and additional active vessels could yield in excess of $100 million in additional annual vessel operating margin.

With potentially higher average day rates in a recovering market, the impact on vessel operating margin could also be significant.

To give you a sense of the sensitivity of operating margins to higher industry-wide average day rates, if we were to assume overall active utilization of 85% and 20 incremental working vessels over and above the two companies’ respective active fleets during the 12 months ended March 31, 2018, and also assume no OpEx inflation, each $1,000 day of rate increase on the Tier 1 vessels could result in an annual incremental vessel operating margin of approximately$45 million.

I think someone then had too much coffee:

This analysis also assumes $500 day increase in average day rate for the active non-Tier 1 vessels.

If we were to assume somewhat stronger market conditions, a $5,000 a day increase in average day rates on the Tier 1 vessels (and a $2,500 per day increase in average day rates on the non-Tier 1 vessels), would put the combined company on a path towards more than $450 million of annual vessel operating margin, or about 50% of the company’s combined vessel operating margin at the last industry peak in 2014.

Yes, and we would also need to assume then that the shale revolution hadn’t happened, the Chinese shipyards hadn’t overbuilt with “at least a hundred” vessels waiting to be delivered (something acknowledged on the call), and that vast quantities of drill rigs weren’t idle.

To put those utilisation figures in context here is Tidewater’s utilisation from their latest quarterly filing:

Tidewater Utilization 2018.png

Yes, it’s a Q1 number but 85% utilisation is 311 days per annum, a boom number if ever there was one for supply vessels, and it is a massive increase year-on-year that would basically entail the vessels working fulltime from 1 February to 30 November. There is no indication in the backlog of any buildup of this size. Management are asking you to believe a realistic scenario is that not only do they add more vessels to their fleet from layup but they do it on the back of large percentage increase in day rates. There is no indication in the rig market that the kind of order backlog required for this sort of demand side boost is coming to fruition.

Management also highlight how tough the market is in Asia. These are global assets (within reason) and regional increase in day rates will be met with increased supply. As a follow up on my note on vessel operators now being traders. I noticed that Kim Heng, ostensibly a shipyard (of ther Swiber AHTS fame), had purchased another two cheap AHTS coterminously selling one to Vietnam and getting a charter for another in Malaysia (at rock bottom rates one can assume).

A lot of offshore supply equilibrium models show increasing day rates and utilisation levels and use scrapping as the balancing factor. They need to because the only variables you can use are day rates, utilisation, and fleet size, and the easiest way to boost the first two is to lower the third. But as the Kim Heng deal makes clear scrapping is coming extremely reluctantly, and in a large number of markets (especially Asia and Africa) well connected local players with low quality tonnage can consistently take work. I doubt Kim Heng purchased the vessels becaise they expected to scrap them at 20 years of age. They will run them until they literally rust away or fall apart and need a day rate substantially below the prices paid per vessel implied by this deal ($12-13m  per vessel). For as long as these “long tail” companies remain realistic competition then the upside in this industry is capped at the current prices implied in “distressed” sales. [I am going to write a whole post when I get the time on “The Scrapping Myth”].

Tidewater management acknowledge what I think will be the most powerful determinant of profitability in offshore supply going forward: the industry structure. After the merger there will still be 400 companies worldwide with 5 vessels on average and Tidewater will control only 10% of the market:

Vessel count.png

There is substantial evidence that you need more than 20% market share to exert pricing power and you need a far smaller competitor set than 400. None of these companies will be strong enough in any region to have any pricing power and all will have enough local and regional competition to ensure that there is limited upside. There is substantial redundant capacity via companies that have enough capital to reinstate it as rates pick up. Maybe this is only a first step but it would take years of mega M&A given the long tail of the industry to create even a few companies with pricing power and the asset base is so homogenised that you only need a couple of credible competitors with sufficient supply to ensure profitability is at cash breakeven levels. The fact that the operating costs, including dry docking, are so far below new build costs will I think encourage marginal tonnage to hang around for a long time and there are no signs E&P companies are forcing scrapping. Indonesia, India, and Malaysia have all been markets dominated by aging tonnage financed all with equity, and Standard Drilling is leading the charge to bring this model to the North Sea. But it kills resale values and inhibits bank lending to all but the largest companies because of the volatility in asset prices.

Industry debt levels.png

Unless The Demand Fairy appears every European supply company is going to struggle to compete with those with equity finance. From NAO to the right (bottom graph) all these companies look like financial zombies.

Over time the long tail of the offshore supply industry is going to struggle with getting access to capital which I think will be a far stronger driver of supply reduction than M&A. One area where I totally agree with Tidewater management is the ability of larger companies to have superior access to finaning. Larger companies will pull away from the smaller as they also will have access to credit and the ability to handle the cost of idle days (a key factor in OSV profitability). If you only own 5-20 boats then you will simply become unbankable because the residual value of your assets will wipe out your book equity (if it hasn’t already) and each idle day is simply too expensive relative to the upside of a working day for banks to lend money on. Even then companies really need to aim at a much higher number, but there will always be the odd Kim Heng waiting to capture any excess margin. Private equity companies will eventually leave the industry as they realise that these depreciating assets do not offer the IRR return required to keep investing and disress investors realised that current prices aren’t “distress” prices at all but “market” prices given current and likely demand levels.

It is easy to sit on the sidelines and throw stones. Management in the industry, particularly for a company the size of Tidewater, have to act within the constraints of what they are given in terms of an external environment and cannot simply decide to exit. In an option set with few good choices this is in all likelihood the best. Ultimately supply needs to reduce to ensure the supply demand balance is reallocated in the vessel operators favour, or at least falls into balance, and this looks to be some way off. Management and investors in more marginal companies can decide to exit and without The Demand Fairy appearing more will have too.

Debt is the problem…

Pacific Radiance announced it was restructuring last week and Harvey Gulf this week. I have talked about the Pacific Radiance situation before and this latest deal just reveals how desperate the banks are to keep some option value alive here. They basically write off $100m and get $120m of new money as working capital… I guess in their situation it’s logical… but it just locks in another cycle of burning newly raised money in Opex and ensures that day rates in Asia will remain depressed.

Eventually, as it is starting to happen in the ROV game, this will end. A good slide here from Tidewater this week highlights the efficiency of US capital markets and the state of denial that exists in Europe and Asia at the lending banks:

OSV net debt.png

The US firms all firmly on the left (well when Hornbeck Chap 11’s anyway) and the Europeans stuck firmly to the right. There is a very limited number of ways this will play out. SolstadFarstad is coming back in early June with it’s DeepSea solution (the photo above was at Karmoy this week, Solstad’s home port) when another excruciating round of write-downs and negotiations will be presented. But nothing sums up the sheer impossibility of SolstadFarstad being a world leading OSV company that than the slide above, and the Herculean financial challenges all the leading European companies face. It is simply not sustainable.

The Nemean lion of debt in offshore supply…

The slaying Nemean lion was the first of the twelve labours of Heracles. The lion had an indestructible skin and it’s claws were sharper than mortals swords. I sometimes feel that the first task in getting some normality into the offshore supply market is to find a Heracles who can begin to slay the debt mountain built up in good times…

In Singapore Otto Marine and Pacific Radiance appear all but certain to enter some sort of administrative process as their debt burden divorces from the economic reality of their asset base. The best guide to what they need to achieve, and the enormity of the task, come from the recent MMA Australia capital raising. I think MMA is a company that understood the scale of this downturn, and reacted accordingly, but they still have a tough path to follow, but at least they have an achievable plan.

The MMA plan involved raising AUD 97m new equity (AUD $92 cash after AUD$ 5m in fees, which is steep for a secondary issue and shows that this wasn’t easy) compared to bank borrowings of AUD $ 295m i.e. 33% of the debt of the company, or over 100% of the equity value (at AUD 88m) was raised in new capital in one transaction in November 17. In order to do this the lending banks involved had to agree to make no significant dent in the debt profile before 2021, reduce the interest rate, and extend the repayments. “Extend and pretend” as it is known in the jargon. All this for a company that in the six months ending 31 Dec 2017 saw a revenue decline of 22% over the same time last year (AUD $119m to AUD $92m) and generated an EBITDA of only $7.6m (which excluding newly raised cash would give a Debt/EBITDA of 14.3x when 7x is considered high).  I’d also argue the institutions agreed to put the money in when the consensus view (not mine) was that 2018 would be a better year, raising money now looks harder. (Investment bankers can sometimes come in for some stick but this, in my opinion,  was a really good deal for the company and the banks earned their money here).

The fact that MMA’s Australian banks have far less exposure to offshore supply than the Singaporean banks made them more pragmatic (while still unrealistic), but this shows what needs to be achieved to bring in new, institutional quantities, of money to back a plan. As a portfolio move from large investors, making a small bet on a recovery in oil prices leading to linear increase in offshore demand, I guess that is sensible. I don’t think it will work for the reason this slide that Tidewater recently presented shows:

TDW OSV S&D.png

There is too much latent capacity in an industry where the assets, particularly the MMA ones, are international in operational scope. By the time the banks need to start being repaid these 20-25 years assets will be 3 years older, 7 since the downturn, yet expected to bear an unmarked down principal repayment schedule. It’s just not realistic and requires everyone else but you to scrap their assets. It maybe worth a punt as an institutional shareholder… but I doubt that few really understand the economics of aging supply vessels.

This contrasts with Pacific Radiance where this week the bondholders refused to agree to accept a management driven voluntary debt restructuring and management seem to be relying on the industry reaching an “inflection point”. As soon as you hear that you know there is a terrible plan in offing that relies on the mythical demand fairy (friends with the Nemean lion I understand) to save them.

I would have voted against the resolutions this week as well had I been a bondholder, but mainly because of the absurdity of agreeing to a plan without the banks being involved or new money lined up. The bond was for SGD 100m… have a look at the debt below on the latest Pacific Radiance balance sheet (Q3 2017)… can anyone see a problem?

PR Balance Sheet Q3.png

Pacific Radiance has USD 630m in debts. Even writing off the bond would mean you are in a discussion with the banks here. I have no wish to take people through the math involved in what the bonds are worth becasue in reality all anyone owns here is an option on some future value, and if you are not the bank you don’t even have that. In order to bring the plan into line with MMA, Pacific Radiance would be looking at presenting an agreed plan with the banks, and ~USD 220m capital raise, an amount that is real money for a company that is still losing money at an operating level.

No one believes the vessels and the company are worth USD 710m. If the banks really thought they could get even .80c in the dollar here by selling to a hedge fund they would be out tomorrow. A large number of the Pacific Radiance vessels are well below the quality of the MMA vessels and in the real world it would seem reasonable for the banks to have to write down their debt significantly to attract new money. If vessels are sold independently of a company transaction, like MMA, then they go for .10c – .20c of book value, so it would make sense for the banks to be sensible here. However, I fear that so many have told shareholders they are over the oil and gas exposure that major losses here will be resisted despite economic reality. I suspect the write-off number here would need to be at ~50-60% of book value to make Pacific Radiance viable and get such a large quantity of new money, an amount that will have risk officers at some Singaporean banks terrified.

As I keep saying here the real problem is that if everyone keeps raising new money for operational expenditure, on ever lower capital value numbers, then the whole industry suffers as E&P companies continue to enjoy massive overcapacity on the supply side. Eventually without a major increase in demand a large number of vessels are going to have to leave the industry and this will happen when the  banks have no other options, and we are starting to get close to that point.

In reality the Pacific Radiance stakeholders need to sit around the table, have a nice cup of tea, and accept the scale of their losses. Then all the stakeholders can come up with a sensible business plan and the new money for operational expenditure can be found. But the banks here will be desperate to be like the MMA banks and get the new money in without suffering a serious writedown while trying and push the principal repayments out until a later date. I don’t see that happening here and the bondholders may as well sit around with all parties rather than be picked off indepdently. A major restructuring would appear the only realistic outcome here and if Pacific Radiance is to continue in anything like it’s present form there will be some very unhappy bankers.