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.

How much more recovery can the industry handle?

Results from HugeStadSea for Q4 were predictably dire. I like the line “project to spin off non core fleet initiated – no transaction concluded so far“. That would be like the entire DeepSea Supply fleet they merged with a year ago? This is rapidly turning into a huge embarrassment for the companies, directors, and advisers involved in this: it was obvious at the time it was a terrible idea, and it is even more obvious, and cash depleting, today.

To be clear: SolstadFarstad made NOK 741m from operating its vessels in the quarter, and paid interest of NOK 1.1bn (and made a debt repayment of NOK 1.4bn). A giant restructuring beckons here when a) someone figures out how to break it to the banks and bondholders that they need to take a 30-50% haircut on their debt; and, b) the investment bankers and lawyers are sure the company has enough money to make it worthwhile to tell the balance sheet banks and bondholders this.

I recently spoke with a shipbroker who assured me that Reach had chartered the Normand Vision for their most recent job for between NOK 275-325k a day. That included 50% Oceaneering ROV crew and Proserv survey, Reach supplied the rest of crew. SolstadFarstad are desperate for other offers of work and longer term work could be had potentially cheaper. That’s for work in 2018. So much for the Vision being a strategic asset for OI… Banks looking at those sorts of numbers must realise the game is up.

Siem Offshore also came out with a loss and said:

Although we expect an uptick in the activity level during the summer period, we believe that the market rates will remain volatile and generally low in 2018.

Despite indications of increased activity, the timing of a significant sustainable improvement in utilization and rates is uncertain and this situation will continue to put financial pressure on owners and lenders.

And DOF, where the real takeaway is the business is substantially smaller in revenue terms than 2016, but with just as many assets and as much debt:

DOF Subsea Q4 17

And in case you think that is because DOF is a supply heavy company look at the DOF Subsea results:

DOF Subsea Q4 2017

I get that the recovery may in 2018… but why is backlog down then? When the DOF Subsea IPO  was pulled an offshore publication and consulting business, with a strong track record in music, announced it as a sign of confidence from the shareholders… I hope no one brought DSVs based on their advice?

I don’t have a magic solution, but I would say that reports of a general market recovery seem somewhat premature. Some segments of the offshore market are doing well and growing again, but those that are asset heavy, and leverage high, are unlikely to see a recovery for the foreseeable future.

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

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

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

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

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

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

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

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

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

Tidewater scale and scope.png

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

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

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

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

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

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

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

 

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