“Preparing for the recovery”… Whatever…

The IEA has recently published it’s new World Energy Review and if you have been reading this blog this comment will come as no surprise:

One notable trend concerns the relationship between oil prices and upstream costs. In the past, there has been a roughly linear relationship between upstream costs and oil prices. When price spiked, so did costs, and vice versa. What we are noting now is a decoupling. While prices have more than doubled since 2016, global upstream costs have remained substantially flat and for 2018 we estimate those increasing very modestly, by just 3%. Companies appear to have learned to do more with less.

Too many business models in the offshore supply chain are simply ignoring this. If you are going long on Borr Drilling shares (for example), as anything other than a momentum trade, then you need to look at data driven forecasts like this, which in statistical terms are called a structural break. Look at the cost deflator in the graph above! In an industry with high fixed costs (both original and operating) that is a straight financial gain for E&P companies and with the volatility in the oil prices they will not give that up easily… and in a world of oversupply they won’t have to.

The future will be different. Some vast market snapback where the Deamnd Fairy appears, and everyone brave enough to have paid OpEx in the offshore supply chain has found a clever get rich quick scheme, is an extremely unlikely event.

More data points like this should make you think as well:

IEA Source.png

Yes, I get the volume in absolute terms is growing, but it is change at the margin that defines industry profitability.

There is still too much liquidity and too many business plans talking as if a return to 2013/14 is a certainty when in reality such a scenario would be an outlier.

Greece, Solstad Farstad, and other restructurings…

The recent Greek debt deal is proof that when no other option exists lenders will sometimes do the right thing. Greece it should be remembered was a banking crisis as well as a sovereign debt crisis, and although the Greek banks are recovering five years after the first major ructions they are still on life support from the ECB. This should provide both some degree of hope and reality for Solsatd Farstad when they announce where they are on the latest restructuring this week. I understand that as part of the process the Farstad name will be dropped in October/ November and the Farstad’s will sell out and not be associated with the company.

The banks and investors now seem to be aware of the scale of the problem here and realize that a booming market isn’t coming and isn’t going to save anyone. The high-end AHTS have even had disappointing day rates relative to expectations (hopes?) and the Q2 numbers will simply not bank enough for a long idle winter to give anyone real comfort. And all the while the Deep Sea Supply fleet festers like a cancer on what healthy tissue remains in the body. Now only an agreement with the banks can  provide any long term solution.

Offshore companies remind me of banks in a funding sense, hence why I mention Greece, as the debt dynamics and issues are broadly similar. Offshore vessel operators fund themselves in charter markets that are significantly shorter than the economic life of the assets they buy. Charter periods dropped from 5-8 years in the early 2000s to complete spot market/ at risk vessels by 2013/14. That is complete market risk funding the purchase of a 25 year asset.

Banks also borrow-short and lend-long, in simplistic terms they borrow money as deposits and lend them to businesses for significantly longer periods of time, and while the deposits can be drawn down as requested the loans cannot. There is in effect a funding mismatch called “maturity transformation” which creates value.

This same sort of duration mis-match between the vessels owned and the charter market created huge value for offshore vessel and rig companies in a booming market. Vessel owners committed to 25 year assets, with 10 year loans on 12-15 year repayment profiles, and funded this in some cases purely in the spot market. In trading terms it was a carry-trade with the high yield short term market being funded by a long term lending market. This was a totally procyclical financial phenomenon that meant the short-term market had a pricing premium compared to the long term cost to anyone who took the risk to commit assets to the short-term market. Now, just like a banking crisis, there has been a freeze in the short-end of the market and this is impacting their ability to meet long term commitments. As Paul Krugman stated “if you borrow short and lend long you are a hedge fund and should be regulated like one”, and that is in effect the embedded funding profile of many offshore operators prior to 2014.

That model is now dead, although not completely, but I think this is the most important, and maybe the least discussed, part of the industry change. And there will be change, not through any grand initiative, but eventually as the market recovers and banks lend on offshore assets again they will force the counterparty to have a longer term contract, and gradually the time/duration risk will be more equitably split than it currently is in an oversupplied market. But I think that is going to take a long time.

It will also mean for smaller E&P operators, marginal producers, their costs could increase significantly for assets on the spot market… and they should! Building assets in the tens-to-hundreds of millions and relying on the spot market to clear them just isn’t rational, as is currently being shown. Being able to call up a jack-up PSV, AHTS, CSV or whatever at a moment’s notce and get it delivered in a few hours or days is currently proving to be a terrible business model for asset owners. Longer term the industry should move to larger operators with a series of longer contracts that roll off in a time efficient way rather than everyone thinking they can clear excess capacity in a short-term market. Larger E&P companies will commit to longer contracts and get a much lower margin as a result. Those providing short term assets will have to charge a substantial premium for this given the risk involved but it will be a smaller, risker part of the market, with substantial amounts of equity to cushion the cyclicality required. It is this factor that I think will drive consolidation far more than any cost savings: how much idle time can your business model handle?

The solution is therefore going to look like banking resolutions in Europe. Traditionally that has meant either a) bankruptcy/insolvency (and there is still more of this to come), or; b) a good bank/ bad bank split (e.g. Novo Banco). Solstad I think could eventually go this way: Solship 3/ Deep Sea Supply was an early attempt at this but failed. More radical solutions are needed now but the final solution will end up more like this. In order to compete with Standard Drilling and others in the North Sea the banks behind Solstad would need to equitise their entire expsoure to the PSV fleet and the most likely new “bad bank” starts here. The “bad bank” they already own, Deep Sea Supply, needs to be cauterised. All the banks have with these assets anyway is a claim to some future value when the market recovers and they want someone else to pay the OpEx to get there. It might have worked in 2016 but the investment narrative has changed since then.

These are moves that take months not weeks and not all the stakeholders are in the same place. A cold winter with lots of tied up vessels is likely to bring these groups closer together. Resolution is some way off. Eventually, when all the other options have been exhausted, the banks are likely to do the right thing here.

Investment will be sufficient…

I think this is very big news for offshore energy:

“Over the next 10 years, we see that supply will continue to keep up with demand growth,” said Espen Erlingsen, an analyst at Oslo-based consultant Rystad. “The surge in North American shale activity and start up of new fields are the main drivers for this growth.”…

The upshot is that it costs less to expand global oil production today than it did back in 2014. Rystad said industry spending in recent years will deliver the necessary 7 percent growth in global oil production to just over 103 million barrels a day by the end of the decade. That trend will continue over the next 10 years if oil remains between $60 and $70 a barrel, it said.

For as long as the downturn in offshore has been going on the Demand Fairy of recovery has been posited on the seemingly axiomatic logic that insufficient investment now would bring a boom in demand in later years and only offshore could supply this capacity. Indeed almost every restructuring presentation or positive talking up on the sector seemed to have a variation on this theme, it was the meme that made a quick recovery believable to those determined to try.

Rystad appear to have re-run their models with the structural break I referred to earlier, where altering the volume of output to the value of input, produces much higher output levels than previously assumed. Rystad aren’t saying there won’t be growth, but it will not be exponential driven by a supply shortage, in the next three years anyway, and maybe not for the next ten years. ‘Lower for longer’ might not be strictly accurate for the oil price but it is likely to be for rig and vessel rates. And magically supply will equal demand. Just as the shale pessimists always had a mind numbingly boggling theory about how it could never work in the long run, so the offshore bulls have always stuck to their theory that the market was being irrational in the short-term and would eventually see sense. The longer the downturn has gone on the more unsustainable that argument has become.

Interestingly offshore global investment (not defined) rises from $164bn in 2018 and 31% of total spend ($345bn/39% in 2014!) to $189bn and 32% of total investment spend in 2020 (a compound growth of ~7%). Shale goes from 12% in 2016 to 24% in 2020. Total upstream CapEx drops from $890bn to $584bn from 2014 to 2020 in the Rystad forecast. If that is correct (even directionally) it is a severely deflationary market environment with huge implications for asset values and solvency going forward.

The IEA says spending dropped about $338 billion, or 44 percent, between 2014 and 2017.

The shale revolution is real and here to stay and it is completely unrealistic for the offshore supply chain not to accept the scale of change required to adapt to this new environment. If you see a “recovery play” that doesn’t explain how it works within this macro context, or how this is wrong, then it isn’t realistic. Expect to hear the phrase “we are doing a lot more tendering” instead of an intelligent response.

The oil market was previously very cyclical because there was no short-cycle marginal prodcuer who could respond quickly to changes in demand. Investment was hugely cyclical because of this. Supply was met with a series of large and lumpy projects planned years in advance and oil companies erred on the side of caution in doing so. Marginal production was supplied by smaller tier two producers who were predominantly offshore. The price change-to-output response time was slow but could be brutal as the downturn in oil price in 2009 showed where a host of small high cost producers went bankrupt. [Read Spencer Dale!].

Now US shale producers are very responsive to price trends and production increases as price does. This is the major change to the market and it is such a significant change that this is why it is (rightly) called “the shale revolution”. It was a price-output feedback meachanism that simply didn’t exist before. Yes, shale might be more expensive, but it is an immediate dollar of revenue, lower risk and lower margin because of it, and that is what the marginal barrel, the next barrel of oil required for the market to balance, should be priced at. Oil as a spot market will be less cyclical going forward as the market responds more incrementally to price changes, a point that Rystad effectively make above.

In a more rational market, with smaller supply/demand imbalance the logical solution would be for larger vessel and rig companies to get into a series of longer term contracts with E&P companies for the provision of assets. This would reduce the cost of ownership (and finance) and therefore the day rate, and also reduce the risk of oversupply. Over time the market may well go this way and this will drive real consolidation, particularly in the offshore supply market, smaller operators of high-end OSVs will become a relic. But for the moment the E&P companies will simply take advantage of the over-supply to gain access to an asset at below it’s economic cost.

State of the nation…a slow trip towards equilibrium…

Loads of news happening that seems to sum up to me the state of where the offshore and subsea industry is at the moment. Dare I say it but we appear to be approaching a sort of equilibrium point where demand and supply are converging around more stable levels.

The FT reported on Monday that:

The US shale oil revolution has reached a landmark moment, with the sector’s top companies for the first time earning enough cash to cover the cost of new wells…

From the time the first shale oil test wells were drilled in the US in 2008-09, the industry’s capital expenditure has exceeded its cash from operations, with producers only able to stay in business by attracting hundreds of billions of dollars in financing from bond and share sales and bank loans. From 2008 to 2017, US exploration and production companies raised $293bn from bond sales, according to Dealogic.

That is what should happen to a marginal producer: they must become profitable at a cash flow (and economic) level so there is an incentive for them to supply the next barrel of oil required. The great hope for some in offshore that shale was an ephemeral phenomenon can be firmly put aside.  To put that bond number into perspective the UKCS spent £14bn offshore in 2014, its best year ever! Efficient US capital markets have channelled the funds into an industry where the long term prize was clear.  And as I constantly say here it wasn’t just a capital story it is a productivity story:

Scott Sheffield, chairman of Pioneer Natural Resources, said its wells in the Permian Basin of Texas and New Mexico were now 300 per cent more productive than four years ago, driving down the oil price needed for them to make a profit.

“In 2014 our break-even price in the Permian Basin was probably $55 or $60 a barrel,” he told the Columbia Global Energy Summit last week. “I would never have thought that the Permian Basin could drive down the break-even price to the low $20s. And we did it.”

So it is hardly surprising that today Heerema announced they are pulling out of pipe-lay, converting the Aegir to a heavy lift vessel that will also work on renewables, and laying off 350 people. The Aegir was only added to the fleet in 2013, yet a mere 5 years later the market has changed so much that a premium asset must now be re-engineered as a completely different economic proposition. I have statistical issues with microcosms but this struck me as one.

Heerema have called it right in my opinion: the deepwater lay market, and pipe-lay in general, is now totally over supplied. Some companies and assets will have to leave the industry in order for it to rebalance. Heerema simply doesn’t have the  financial resources or integrated solution of the “Big Three” (TechnipFMC, Subsea 7, Saipem).  Heerema were annoyed when EMAS seemed to copy many of the unique features of the Aegir for the Constellation (which is of course now in the Saipem fleet), but the economist in me says that only reflects how high returns have to be in this industry to reflect the risks. Saipem have arguably appropriated some of the value from the Aegir and Heerem’s IP…. although the trade-off was an asset built in TriYards Vietnam so maybe it will all even out… Quite what move Allseas makes next remains to be seen but they must be starting to feel lonely.

Maintenance spend will increase as higher prices make it economic to refurbish older wells or those shut in now. But the installed base on which future demand predictions were made will be permanently smaller. Prices for E&P companies will eventually have to rise to recognise that someone building a $600-700m construction vessel, with no forward order book, is a very risky business model and investors need to be compensated for this. Especially when the downside can be at least a 50% discount to build cost in a managed sale.

But this time as the oil price has crept up E&P companies have failed to shine as in previous eras of rising prices as they are burdended with excessive debts and sceptical investors who want to share more of the upside in a boom. There is a very good article from Bloomberg here:

At fault, a toxic troika that combines gushing supply with fears that long-term demand will flat-line as electric vehicles and renewable energies grow, and climate change policies proliferate. And while cash flow for oil’s majors in 2018 is likely to be the highest in 12 years, investors are largely unmoved…

Oil executives acknowledge that it’s too soon to win back investors. Shell CEO Ben van Beurden has openly talked about a “credibility and track record gap” between the major oil companies and its shareholder base.

“We need to show a little bit longer we mean what we say in terms of capital discipline,” he told reporters last week. “This newfound religion and confidence is, to say the least, fragile.”…

“The investment community still is not sure we’re going to handle these higher prices with discipline,” BP Plc Chief Executive Officer Bob Dudley said Tuesday. “Then there’s a section of the investment community that wonders why we’re not investing more in batteries and cars and renewables.”

E&P versus market.JPG

You can see above that higher oil prices haven’t meant much for E&P companies. One central issue is CapEx spend where large companies are making a promise to investors not to spend on mega projects in an era of rising prices. Smaller companies, offshore companies, are struggling to get finance at all. If you want it set out explicitly here it is:

Big Oil’s first quarter results are “a chance at redemption” after a poor fourth quarter of 2017, Biraj Borkhataria, a London-based analyst at RBC Capital Markets wrote in a note. Investors will reward companies whose cash generation rises at the same rate as oil prices in the period, and no new plans to raise capital spending, he said.

Get that…? An increase in oil price goes out in debt reduction, dividends, and stock buy-back not offshore projects to increase supply. No to hitting the supply chain with massive orders that cause a spike in prices as the spot oil price increases.  E&P companies are going to make money in an  era of rising oil prices from higher prices, not from taking the money from rising prices and putting it into more production to take advantage of potentially higher prices in the future. It is a very different investment dynamic. It might change in the future, but it will take a long time to be felt in the offshore supply chain, and there is no guarantee it will.

And by the way it doesn’t matter if you believe the “toxic troika” theory or not… the people who buy the shares in E&P companies, and therefore ultimately fund large projects, do. And collectively they are making it harder for these projects to be funded by insisting on higher cash payments from E&P companies. So perception has become reality.

This is an environment that favours offshore field developments to supply a baseload of high volume/low lift cost supply while using shale for marginal demand. Some smaller field developments will of course happen, TechnipFMC has an good video here about how standardised they will be in shallow water for example, but it is harder not to see offshore developments being marked by larger projects or infield work.

This is a market heading for equilibrium, yes there will be rising oil prices, but no one, not even the E&P companies, feel like this is a boom. Yes, it is better for E&P companies than the offshore supply chain, although the onshore supply chain is booming in US onshore. A number of offshore contractors are making money, they are more than cash flow positive, but the order book is weak and few points utilisation either way is the difference between a breakeven and a loss. The supply side will still face a contraction, sensible M&A will occur, services will be more profitable than owning tonnage, and companies will make money. But returns in excess of the cost-of-capital look a long way off for the offshore industry given that the last boom showed how expensive the cost-of-capital should really be on a cyclically adjusted basis.

A really big boat, asset specificity, and Chinese finance….

The picture above is a purpose built vessel, a deepsea mining unit for Nautalis Minerals, currently being built in China at the Mawei yard. It is undoubtedly an amazing piece of engineering, enormous as can been seen: 227m x 40m . A few more shots here:

The problem of course is who is going to pay for it. This is a deal that has been kicking around the market for years, a complex vessel, with few other potential buyers, ordered in the boom times with no takeout financing. Surely, yet again, like the DSVs floating around at the moment the yard is going to be stuck with this?

The economics of this argues that a charter is not the right option for Nautalis here. The vessel is the perfect example of asset specificity where it has a higher value to Nautalis than any other owner, and logic would dictate that Nautalis should raise the capital to pay for it. But Nautalis may get lucky here that the yard knows this and will simply have to charter them the vessel to avoid a firesale for an asset that has few other natural buyers. Delivery date is approaching here and it will start to get interesting.

When you read about the Chinese credit bubble it isn’t all in real estate (although a fair proportion is). This asset is one of number where it seems fairly clear that the losses, or at least the risks in the case of this vessel, will be taken by a semi-private entity at some point, maybe moved to a state bank leasing arm. The question is how systemically important the number is overall for all the Chinese yards? Rumours in China abound that the UDS may end up with the Chinese Navy or Coastguard.

At some point, as the German banks discovered, lending money to make ships that people can’t pay for, even as great short term job creation scheme, has an enormous economic cost.

There is a good article here summarising the Chinese push to become far more active in ship finance as part of a broader strategic plan. I have no idea what the bad loan capacity is for China Inc. as a whole in shipping, in offshore the Chinese lease houses appear to have paid top dollar for some average assets, but so did everyone in the boom and staying power will be important the longer demand stays depressed. In general shipping they may have missed the worst and be coming in at a good time.

Regardless, quite what happens to this vessel will make an interesting case study of how these issues get dealt with. Ship building is a relatively low margin industry that takes massive risks to get orders in the door, often with tacit or explicit state support, but when it goes wrong the potential losses seem so much larger than the upside ever offered. Hopefully the number of speculative new builds for such specific assets, without take-out financing, will drop going forward because it is so economically inefficient. But I doubt it.

More for less… Tier 2 contractors is where capacity will leave the market

I don’t get the ROV business. At the small end numerous small firms, often with private equity money, all with exactly the same strategy of getting cheap ROVs and finding  a (desperate) vessel operator to charter them the vessel for next to nothing on a profit share. They all have exactly the same business model and have no ability to differentiate on anything other than price, entry barriers are low, and buyers have a vast array of choice. It is a textbook example of an industry structure designed to produce poor profitability. Against this there are large international contractors who make minimal profit but clearly have enough capital and cash to have staying power. Surely, if demand remains at current levels something has to give?

Back in February Reach Subsea raised money, I didn’t get their logic, or that of people backing it, and I don’t get it now. However, unlike ROVOP, M2, and a host of others, they are publicly listed so you can get access to exactly how they are performing, and I would be really surprised if any of the other smaller companies are doing any differently given their business model and strategy are exactly the same. It is also worth noting that Oceaneering, the worlds biggest ROV company by some margin, has just reiterated its commitment not to pay dividends until the market improves. So with all the benefits of scale that Oceaneering has they still cannot return any cash to investors for all their free cash flow.

Now Reach Subsea are maybe great engineers and operations people, and they may have good relations with Statoil, but here in essence is the problem:

Reach key figures Q4 2018.png

Compared to 2016 in 2017 Reach sold 49% more ROV days, 63% more offshore personnel days, and 35% more vessel days and yet increased turnover by only 10%. It is the very definition of business facing decreasing returns to capital: For every unit of capital they throw at the market they get a decreasing amount of economic value back. (I won’t even get into the EBITDA and operating loss because they brought some equipment during the year and claim to be building up scale, but the turnover number tells you all you need to know).

This is interesting as well:

Reach Operating Profit Q4 2018.png

To get 360m in sales in 2017 cost 387m in direct expenses. Or look at it another way: it cost 387m to sell 360m. That is a totally unsustainable business model. I get they are working their way out of terminating some historic vessel charters but businesses that cannot make an operating profits are axiomatically dependent on external funding eventually. Like everyone else in the ROV space this business is simply keeping capacity going while waiting for other people to drop out of the market and wait for the magical demand fairy to appear and save everyone.

Despite this they are opening an office in Houston, which is a major expense for a company of this size, to offer exactly what everyone else in the market there does: cheap ROVs on vessels with no commitments. Like everyone else they are doing loads of tendering and are in advanced discussions with potential clients. I get the US has the best structural growth characteristics of any ROV market, but there are a lot of companies there doing exactly this,  and firms like Bibby had to pull out despite investing substantial amounts in kit and infrastructure.

I therefore find it amazing that you can get comments like this:

Reach q4 comment 1.png

And then get this:

Reach Q4 comment 2.png

What attractive growth opportunities? The installation market is forecast to be flat next year and the IRM will grow modestly but nowhere near enough to soak up excess capacity. But despite this the obvious answer is to go to Houston, well behind ROVOP, M2 … ad infinitum

But clearly some people disagree because despite everything I have written above look at the Reach share price:

Reach Share Price 06042018.png

Up 42% in the last 12 months. 20% since November. Not only that the company according to Bloomberg is trading 1.6x book value which implies that the asset base can generate signficant value (Tobin’s Q) above its cost. For a company where the operating losses were NOK -17m and the Depreciation charge was NOK 27m that is verging on the astonishing, and definitely on the irrational.

You can say the stockmarket is meant to anticipate forward earnings and I agree, but there is nothing structural in the market that would lead you to believe 2018 is going to be very different from 2017 (as the graph from Oceaneering in the header makes clear). I get Reach have announced over 100 days work recently, but without any information on day rates and margin levels can you believe it is value accretive?

The longer all the ROV companies remain in business and keep capacity high it guarantees that margins will be breakeven-to-low in the best case for everyone in the game. This is an industry that built capacity for 349 tree installations in 2014 and is coping with 243 in 2018 (a 44% decrease), and at the moment the new investors piling in are simply providing a subsidy for the E&P companies who take rates at below economic levels.

It is only a question of which tier 2 companies leave the market if The Demand Fairy doesn’t make a rapid deus ex machina appearence soon. This is an industry with too much capacity and capital relative to demand and the equity market here is sending the wrong price signal about allocating more capital.

HugeStadSea goes wrong…

If completed, the Combination is expected to provide Solstad Offshore, Farstad and Deep Sea with an industrial platform to sustain the current downturn in the offshore supply vessel (“OSV”) market and be well positioned to exploit a market recovery. The Board of Directors of the three companies consider this to be a necessary structural measure that will enable the Merged Group to achieve significant synergies through more efficient operations and a lower cost base. The Combination will influence the SOFF Group’s financial position as total assets and liabilities as well as earning will increase substantially.

SolstadFarstad merger prospectus, 2017

This was always going to happen… nice timing though… just a few days before Easter, with everyone looking the other way, and only a short time before the Annual Report was due (with its extensive disclosures required), SolstadFarstad has come clean and admitted that Solship Invest 3 AS, more familiarly known as Deep Sea Supply, is in effect insolvent, being unable to discharge its debts as they fall due and remain a credible going concern:

As previously announced, Solstad Farstad ASA’s independent subsidiary, Solship Invest 3 AS and its subsidiaries are in discussions with its financial creditors aiming to achieve an agreement regarding the Solship Invest 3 AS capital structure.

As part of such discussions, Solship Invest 3 AS and its subsidiaries have today entered into an agreement with its major financial creditors to postpone instalment and interest payments until 4 May 2018.

I am not a lawyer but normally getting into agreements and discussions like this triggers the cross-default provisions of debts, including the bonds which look set for a default… and this would make all of the c. NOK 28bn debt become classed as short-term (i.e. payable immediately). Maybe they saw this coming and omitted those clauses when the loans were reorganised, but its a key provision, and I struggle to see it getting through compliance and lawyers without this? But it strikes me as a crucial question. The significance of this for those wondering where I am going with this is that it would be hard to argue SolstadFarstad is actually a going concern at that point. Maybe for a short while, but getting the 2017 accounts signed off like that I think would be tricky (ask EMAS/EZRA).

Investors, having been told  how well the merger is going, may want to have a think if they have been kept as informed as they would like here? There is nothing in this statement on 19 Dec 2017 for example to reflect clearly how serious things were at Deep Sea Supply. Indeed this statement appears to be destined for future historians to recall a management team blithly unaware of their precarious position:

With the reduced cost base we will be more competitive and with our high quality vessels and operations, we will be in a very good position when the market recovers.

The PR team may have liked that statement but surely more cautious lawyers would have wanted to add the rider “apart from Deep Sea Supply which is rapidly going bankrupt and the vessels are worth considerably less than their outstanding mortgages. We anticipate in the next 12 weeks defaulting on our obligations here until a permanent solution is found.” To make the above statement, when 1/3 of merger didn’t have a realistic financial path to get to this mythical recovery is extraordinary.

But the real and immediate problem the December 19 press release highlights is that in an operational sense Deep Sea Supply has been integrated into the operations of HugeStadSea:

The merger was formally in place in June 2017 and based on the experiences from the first six months in operation as one company, Solstad Farstad ASA is now increasing the targeted annualized savings to NOK 700 – 800 mill.

By the end of 2017 the cost reductions relating to measures already implemented represents annualized savings of approximately NOK 400 mill…

new organization structure implemented and the administration expenses have been reduced by combining offices globally and centralization of functions.

The synergies laid out here can only be achieved by getting rid of each individual company’s systems and processes and integrating them as one, indeed that is the point of the merger? So how do you hand Deep SeaSupply back to the banks now? For months management consultants from Arkwright have been working with management and Aker to turn three disparate companies into one, now apparently, as an afterthought, the capital structure needs sorting as well along with disposing of “non core” fleet. Quite why you would get into a merger to create the largest world class OSV fleet while simulataneously combining it with a “non core” fleet at the same time (that wasn’t mentioned in the prospectus) is a question that seems to be studiously avoided?

Just as importantly going forward here management credibility is gone. Either you were creating a “world class OSV company” with the scale to compete, or you weren’t, in which case taking on the Asian built, and pure commodity tonnage of Deep Sea Supply was simply nuts.

Around 12 months after the merger announcement, and six momths after the legal consumation, when managers have had sufficient day rate and utilisation knowledge to build a semi-accurate financial forecast, they are back to the drawing board. If SolstadFarstad hand the Deep Sea fleet back to the banks they will have to either fire-sale the fleet or build up a new operational infrastructure to run the vessels independently of SolstadFarstad… does anyone really believe the banks will allow that to happen? The problem is the tension between the different banking syndicates: a strong European presence behind SolstadFarstad and Asian/Brazilian lenders to Deep Sea. This is likely to get messy.

Is Deep Sea Supply really ringfenced from SolStadFarstad? Will the lending banks be able to force SolStadFarstad to expose themselves more to the Deep SeaSupply vessels? As an independent company Deep Sea Supply would have been forced to undergo a rights issue, and if not supported by John Fredrikson/Hemen it would have in all likelihood have gone bankrupt, the few hundred million NOK Hemen putting into the merger barely touched the sides here. For the industry that would have been healthy, but for the banks a nuclear scenario. Now management face a highly embarrassing stand-off with the banks to force them to take the vessels back, or the equally highly embarrassing scenario of admitting that the shareholders were exposed to the Deep Sea Supply fleet all along, and that the assumptions underpinning this deal were wrong… Something easily foreseeable at the time to all but the wilfully blind.

The “project to spin off the non-core fleet”, which I have commented on before, is the Deep Sea Supply fleet that makes a mockery of the industrial logic of the merger. That was started in Q3 2017 according to their annoucements, only a few months later needs to be sold? What is the plan here? Or more accurately is there one?

There are no good options here. The only credible option for the management team and Board to survive unscathed would surely be the banks writing down their stake in Deep Sea Supply entirely and making a cash contribution to SolstadFarstad to recognise the time and costs involved in running it. You can mark that down as unlikely. But just as unlikely is a recovery in day rates where Deep Sea Supply can hope to cover its cash costs even in the short term

The Board of SolsatdFarstad and their bankers need to ask some searching questions here. The merger was a very bad idea that was then executed poorly.  It is therefore hard to argue SolstadFarstad have the right skills in place at a senior management and Board level? This wasn’t a function of a bad market, this was the result of bad decisions taken in a bad market. This constant mantra that scale will solve everything, when the company has no scale, needs to be challenged. The other issue is how disconnected management seem to be from basic market pricing signals, and moving the head office away from its current location should also be seriously considered along with a changing of the guard.

I said at the time this merger was the result of everyone wanting to believe something that couldn’t possibly be true and merely delaying for time, but eventually reality dawns as the cash constraint has become real. The banks need to write off billions of NOK here for this to work. Probably, like Gulfmark and Tidewater, the entire Deep Sea Supply/ Solstad/Farstad PSV and smaller AHTS fleet need to be equitised at a minimum, and some of the older vessels disposed of altogether. The stunning complexity of the original merger, where legal form trumped economic substance, needs to be reversed to a large degree, but this will not be easy as the shareholders in the rump SolstadFarstad will surely balk at being landed with trading their remaining economic interests for a clearly uneconomic business.

The inevitable large restructuring that will occur here arguably marks the start of the European fleets and banks catching up with their American counterparts, and to some degree matching the pace of the Asian supply fleets. The banks behind this need to start a series of writedowns that will be material and will affect asset values accross the sector. Reporting season will get interesting as everyone tries to pretend their vessels are worth more than Solstad’s and the accountants get worried about their exposure if they sign off on this.

A common fault of all the really bad investments in offshore since 2014 was people simply pretending the market is going to miraculously swing back into a state that was like 2013. It was clear late in 2016 this would not happen. The stronger that view has been has normally correlated with the (downside) financial impact on the companies in question, and there is no better case study than HugeStadSea.