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.

Market equilibrium…

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

OSV Business Drivers.png

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

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

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

Todd Hornbeck:

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

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

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

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

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

James Harp (CFO):

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

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

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

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

OSV reality…

Some great footage on Youtube here of vessels in lay up in Batam. Sometimes I think it is only by watching such scenes visually the scale of the drop in demand in offshore, and the concomitant oversupply, can be appreciated.

I heard a lot of talk at the OSJ conference last week that it isn’t as simple as putting companies out of business, as these assets will simply come back at a lower price and compete against you, or they may be worth more in the future, but really that just means their economic worth is less than you care to accept.

I’ll write more about this later but the obvious point is that unless something structural is done here the vast quantities of latent capacity make any sort of recovery in offshore supply unlikely. Not wishing to pick on any particular company here, but as a follow-up to this, it shows what a huge problem SolstadFarstad has with the commodity DeepSea fleet.

Zombie offshore companies… “Kill the zombie…”

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

Frank Borman

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

Warren Buffet

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

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

Zombie Firms.png

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

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

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

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

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

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

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

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

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

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

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

Not that the market seems fooled:

SOFF 0202

(I don’t want to say I told you so).

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

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

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

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

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

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

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

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

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

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