Brazil, The New Offshore, and Contractor Profitability…

“My salad days, When I was green in judgment, cold in blood, To say as I said then!”

Cleopatra – Act 1, Anthony and Cleopatra

Bassoe Offshore had a very good and insightful article on Brazil this week. The key thing for me was the sheer drop in volume of rigs working in Brazil:

As we noted earlier this year, the number of drilling rigs in Brazil has gone from over 80 to under 30 during the past five years.  Currently, 26 rigs are on contract (all for Petrobras), but only about 20 are on full dayrate and drilling due to Petrobras’ reduced effective demand.  By the end of 2018 – assuming no new contracts or contract extensions – Petrobras will have 14 rigs working for them.  By 2021, this number becomes three. 

We estimate that Petrobras has a minimum requirement of around 20 rigs to sustain production through 2021.

Rigs are obviously the leading indicator of future subsea work and it’s worth putting some context on this as Bassoe Offshore did in April:

If you were an offshore rig owner back in 2010–2014, Brazil was the land of opportunity.  Petrobras offered long term contracts with solid dayrates.  Everyone wanted to be there.  Rigs were built; demand seemed insatiable. 

Petrobras even initiated Sete Brazil, a company with plans to build 29 Brazilian-content, deepwater semisubs and drillships, which was slated to be Brazil’s path to global prominence in rig construction and a boost to the country’s industry and economy.

And in order to keep production going from all the well work these rigs would be doing Petrobras went just as long on flexlay capacity. The strategy here was slightly different: Petrobras choose the two most capable subsea contractors in the world and signed them up for a vast investment campaign to buy specialist Pipe-Lay Support Vessels (PLSVs) and contract them for a period of c. 30% of their expected economic life. Technip, who always seem to call these things correctly, decided to share the risk 50/50 with DOF Subsea for four vessels, while Subsea 7 decided to build and own its three vessels.

There is a constant commentary about how high the margins are on these contracts, and it is true that during the firm period they look good, outstanding even, but there is a very real risk that some of these vessels will be re-delivered. A company that had 80 rigs working and went long on flex-lay capability with 7 vessels is unlikely to need that number in the future when it has c. 20 rigs working. For a whole pile of reasons the drop in demand is unlikely to be linear, but you only need to be directionally correct here to understand the scale of the issue.

Brazil also has proper emerging market risk characteristics in it’s local cabotage regulations that favour local tonnage as Subsea 7 found out this year when the Seven Mar had its charter terminated early,effectively for convenience, and therefore had to reduce backlog by USD 106m. So clearly the economic reason you get a good margin is because there is actually a fair bit of risk in building such a specific asset for such a unique (and having worked on a Petrobras contract I use the word in its most expressive sense) customer: the downside here is in 7 years you get a ship back quayside in Brazil that costs USD 15k per day to run and is only good for laying pipe in 3000m of water. All of a sudden that healthy margin for the last seven years doesn’t look quite so attractive, and this is a very real possibility here for at least 3 or 4 of these vessels.

This fact clearly had a massive impact of the ability of DOF Subsea to get an IPO away and is one of a number of huge strategic issues DOF Subsea has. The DOF Subsea investors were hoping to remove some of the risk of vessel redelivery, and the price the investors were offering to do this just wasn’t enough, or in sufficient volume, for a deal to be agreed. Given the binary nature of the payoff involved it is no surprise a mid-point on the two positons could not be reached: Because a downside scenario is that Petrobras halves the number of contract PLSVs it wants and Subsea 7 comes in with a low bid and the Technip/DOF Susbea JV has its entire fleet redelivered. It may not be likely but it cannot be ruled out either.

The greater IOC involvement in Brazil may also change what has been one of the great comparative anomolies of the market: the complete lack of a spot market (which made sense when Petrobras was the only customer). Should PB and the IOCs decide to bid flexlay work on a project-by-project basis the revenues for the purpose built PLSVs will be much less secure and the valuation assigned to them will be significantly lower to reflect this income volatility. These investments rightly required a very healthy margin.

I always find it amusing to read statements like “the investors think this is an even better investment” and then read the latest accounts and come across comments like this:

In the 2nd quarter the Group has seen improvement in both numbers and activity compared to 1st quarter, however the general market conditions within our industry are challenging, especially in the Atlantic region and the North America region…

During the quarter, the Group has seen a low utilisation of the vessels Skandi Constructor, Skandi Neptune, Skandi Achiever and the JV vessel Skandi Niteroi… In the Subsea/IMR project segment the idle time between projects has increased, however the Group saw an increased project activity toward the end of the quarter.

Ah… the famous greenshots of recovery… at the end of every quarter everyone always sees activity picking up… not quite enough to make it into the current results… but jam tomorrow…

Which led to these numbers:

DOF Subsea Q217

So you might believe it’s a “real out performer”, but in a financial sense it’s a very hard case to make. All the key indicators are going South.

DOF Subsea is an extremely hard investment case to make (to highlight just the three most obvious examples):

  1. Is it a contractor or a contractors’ contractor? A falling out with FMC Technip would devastate the business yet it is hard to see where the clear division of capabilities and competencies at the lower end between the two is? Are DOF Subsea really going to put the Achiever to work against the Technip North Sea DSVs? Even if you really believe they will do this how many jobs would they have to win off Technip before Mons got a call asking what was going on?
  2. The pay-off from the Brazil PLSV project is highly uncertain but it is almost certain that the current margins will drop from their current levels
  3. DOF Subsea has all the costs of being an international EPIC contractor with none of the associated scale benefits. The scale benefits of being international require large diameter pipelay and its associated margins, a move into this area is financially impossible given their current constraints and would clearly precipitate a major ruction with FMC Technip

I think DOF Subsea is just the wrong size to compete as a global contractor and I mark it as likely to underperform significantly in the future. I see a world where FMC Technip, Subsea 7, McDermott, and maybe Saipem, become almost unassailable as the profitable global SURF contractors for mid-sized field development up. Each with a very strong base in one geographic region, with an asset base that can trade internationally enough to gain scale economies from other international operations, and with the balance sheets to invest in capabilities that will standardise and drive SURF costs down. DOF Subsea, despite having a lot of nice ships and clever people, is by an order of magnitude behind these companies.

These Tier 1 contractors will make disproportionate margins to the rest of the supply chain where overcapacity is rampant and balance sheets are weak. These Tier 1 contractors will need to own only core enabling assets and simply contract in all commodity tonnage, which will remain oversupplied for years. Tier 1 margins will improve as they need proportionately less CapEx, or operational leverage, now the OSV fleet has more options. It is not all salad days as apart from MDR the Tier 1’s have some issues from the boom years, but on a project level, for larger SURF work, they are creating a very strong competitive position. You will able to have a strong regional presence/competitors, but the gap between the few global SURF contractors and the “also rans” is going to become very wide indeed as backlog declines going into 2018.

Expect DOF Subsea to remain privately held for a good while longer if the investors really believe it’s undergoing a current period of out-performance that no one else is clever enough to see.

“Short-cycle production” could be about to get an economic test…

The dots clearly show that oil prices and oil production are uncorrelated…

Caldara, Dario, Michele Cavallo, and Matteo Iacoviello

Board of Governers of the Federal Reserve System, 2016

The number of US oil rigs went down by 5 last week to 744 rigs, while the number of US gas rigs increased by 4 to 190 rigs. In terms of the large basins, the Permian rig count increased by 6 to 386 rigs, while both the Eagle Ford and Bakken rig counts declined by 3 each to 68 and 49 rigs respectively. 

Baker Hughes Rig Count, Sep 25, 2017

 

The multi-billion dollar question is: Can shale handle an increse in demand? Closely related: Is shale in a boom that is unsustainable and not generating sufficient cash to reward investors for the massive risk they have taken? Because if the latter is correct the former must be answered in the negative. The above quote is slightly mischevious and merely highlights economic research that supply factors have historically had a far bigger impact on the oil market than demand factors  (whether this is true going forward is not for today).

The NY Fed today reports that it is supply shortages now that are driving the price (and I have no idea about the construction of the model but the reduction in the residual leads me to believe it is broadly accurate), so this is a supply driven event not a demand driven event:

Oil Price Decomp 25 Sep 2017.png

If, as Spencer Dale argues (speech here), we are in the midst of a technical revolution then this is what we would expect. Hostoric levels of inventories should come down because supply is more flexible, these short-term kinks in demand caused by natural or geopolitical events should merely spur an increase in the rig count or a change in OPEC quotas. Other senior BP staff today were on message:

“Rebalancing is already on the way,” Janet Kong, Eastern Hemisphere Chief Executive Officer of integrated supply and trading at BP, said in an interview in Singapore. But OPEC needs “definitely to cut beyond the first quarter [2018]” to bring inventories down and back to historically normal levels, she said…

“If they extend the cuts, yes it’s possible” to achieve $60 a barrel next year, she said. “But it’s hard for me to see that prices will be sustainably higher,” she added.

Or is Permania simply the result of the Federal Reserve flooding the market with liquidity that is allowing an unsustainable production methodology to continue unabated storing up yet another boom and bust cycle? Bloomberg this week published this article on Permania, where the incipient signs of a bubble are showing in labour and infrastructure shortages and the outrageous cost overruns:

Experienced workers are harder and harder to find, and training newbies adds to expenses. The quality of work can suffer, too, erasing efficiency gains. Pruett said Elevation Resources recently had a fracking job that was supposed to take seven days but lasted nine because unschooled roughnecks caused some equipment malfunctions.

By this point, “we’ve given up all of our profit margin,” he said, referring to the industry. “We’re over-capitalized, we’re over-drilling and, if prices don’t rise, we might be facing a double dip in drilling.”

If I was being cynical about offshore production I would note that he was two days over with a rig crew while in the same calender week Seadrill and Oceanrig had collectively disposed of billions of investment capital and will still have the inventory for years. This guy is literally two days out of forecast and he is worried about being over-capitalized (and also that wiped his profit margin? Hardly redolent of a boom?) Offshore drilling companies are like 10 years and 100 rigs out of kilter… Anyway moving swiftly on…

Bloomberg also published this opinion on Anadarko noting:

Late on Wednesday, Anadarko Petroleum Corp., which closed at $44.81 a share, announced plans to buy back up to $2.5 billion of its stock; which is interesting, because almost exactly a year ago, it sold about $2 billion of new stock — at $54.50 apiece.

(That’s pretty clever, they sold stock at $54.5 and are buying it back at $44.8, like Glencore never buy off these people when they are selling, at heart they are traders. More importantly most research suggest companies nearly always overpay when buying stock back so if the oil price keeps creeping up they are going to look very smart indeed.)

But the real point of the story is that capital is slowing up to the E&P sector, well equity anyway no mention of high-yield:

Equity US E&P Sep 2017

Meaning that maybe people are getting sick of being promised “jam tomorrow”. However I can’t help contrasting this with productivity data, Rystad on Friday produced this:

Rystad Shale Improvement Sep 17

So despite the anecdotal evidence on cost increases in the first Bloomberg article the productivity trend is all one way.  And the stats seem clear that a large part of deepwater is at a structural cost disadvantage to shale:

ANZ cost structure 2017

Frac sand used to be c.50% of the consummables of shale, but surprise:

Average sand volumes for each foot of a well drilled fell slightly last quarter for the first time in a year, said exploration and production consultancy Rystad Energy. Volumes are expected to drop a further 2.5 percent per foot in the current quarter over last, Rystad forecast…

Companies including Unimin Corp, U.S. Silica Holdings Inc (SLCA.N), and Hi Crush Partners LP (HCLP.N) are spending hundreds of millions of dollars on new mines to address an expected increase in demand.

On Thursday, supplier Smart Sand SND.O reported it shipped less frack sand in the second quarter than it did in the first. Rival Fairmount Santrol Holdings Inc (FMSA.N) forecast flat to slightly higher volumes this quarter over last.

In the last six weeks, shares of U.S. Silica and Hi Crush are both off about 30 percent. Smart Sand is off about 43 percent since June 30…

Some shale producers add chemical diverters, compounds that spread the slurry evenly in a well, and can reduce the amount of sand required. Anadarko Petroleum Corp (APC.N) and Continental Resources Inc (CLR.N) are reducing the distance between fractures to boost oil production. The tighter spacing allows them to extract more crude with less sand.

Technological innovation and scale: Less sand used and increased investment going on that will reduce the unit costs of sand for E&P producers. This is the sort of production that brought you the Model T in the first place and the American economy excels at. Bet against if you want: just remember the widowmaker trade.

Shale is a mass production technique: eventually it will push the cost of production down as it refines the processes associated with it. To be competitive offshore must emulate these constantly increasing cost efficiencies. I have said before that shale won’t be the death of offshore but it will make a new offshore: a bifurcation between more efficient fields, low lift costs, and economies of scale in production that make the “one-off” nature of the infratsructure cost efficient, and smaller, short-cycle E&P of shale (and some onshore conventional).

Offshore is going to be here for a long time, it is simply too important in volume terms not to be. But what a price increase is not going to see is a vast increase in the sanctioning of new offshore projects in the short-term. These will be gradual and provide a strong base of supply, as there longer investment cycle represents, while kinks in short-term demand will be pushed towards short cycle production. Backlog, or lack thereof, remains the single biggest threat to all offshore contractors.

Or this thesis is wrong and I, and to be fair people far cleverer (and more credible) than me, are spectacularly wrong, and a new boom for offshore awaits in the not too distant future…

DSV valuations in an uncertain world: Love isn’t all you need… Credible commitment is more important…

“Residual valuation in shipping and offshore scares the shit out of me”

Investment Banker in a recent conversation

 

“Alice laughed: “There’s no use trying,” she said; “one can’t believe impossible things.” “I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

 

The FT recently published this Short View about how the bottom may have been reached for rig companies and that there may be upside from here. The first thing I noted was how high rig utilisation was, the OSV fleet would kill for that level, and yet still the fleet is struggling to maintain profitability (graph not in the electronic edition but currently about 65%). The degree of operational leverage is a sign of how broken the risk model is for the offshore sector as a whole. A correction will be needed going forward for new investment in kit going forward and the obvious point to meet is in contract length. Banks simply are not going to lend $500m on a rig that will be going on a three year contract. Multi- operator, longer-term, contracts will be the norm to get to 7G rigs I suspect (no one needs to make a 6G rig ever again I suspect). The article states:

No wonder. Daily rental rates for even the most sophisticated deepwater rigs have tumbled 70 per cent, back to prices not seen since 2004. Miserly capital spending by the major oil companies, down more than half to $40bn in the two years to 2016, has not helped. Adding to this lack of investment from its customers is a bubble of new builds, which is only slowly deflating.

Understandably, the market is showing little faith in the underlying value of these rig operators. US and Norwegian operators trade at just 20 per cent of their stated book values. The market value of US-listed Atwood Oceanics suggests its rigs are worth no more than its constituent steel, according to Fearnley Securities.

What the article doesn’t make clear, but every OSV investor understands, is that in order to access more than the value of the steel rigs and OSVs have very high running costs. The market is making a logical discount because if you cannot fund the OpEx until operating it above cash break even or a sale then steel is all you will get: it’s the liquidity discount to a solvency problem. That tension between future realisable value and the option value/cost of getting there is at the core of current valuation problems.

The OSV fleet is struggling with utilisation levels that are well under 50% for most asset classes and even some relatively new vessels (Seven Navica) are so unsellable (to E&P customers I don’t think Subsea 7 is a seller of the asset) they have been laid-up.  From a valuation perspective nothing intrigues me more than the North Sea DSV fleet: The global fleet is limited to between 18-24 vessels, depending on how your criteria, and with a limited number companies who can utilise the vessels, they provide a near perfect natural experiment for asset prices in an illiquid market.

North Sea class DSVs need to be valued from an Asset Specific perspective: in economic terms this means the value of the asset declines significantly when the DSV leaves the North Sea region. Economists define this risk as “Hold Up” risk. In both the BOHL and Harkand/Nor case this risk was passed to bondholders, owners of fixed debt obligations with no managerial involvement in the business and few contractual obligations as to how the business was run.

The question, as both companies face fundraising challenges, is what are the DSVs worth? Is there an “price” for the asset unique from the structure that allows it to operate?

In the last BOHL accounts (30 June 2017) the value of the Polaris and Sapphire is £74m. I am sure there is a reputable broker who has given them this number, on a willing buyer/ willing seller basis. The problem of course is that in a distress situation, and when you are going through cash at c.£1m per week and you have less than £7m left it is a distress capital raise, what is a willing seller? No one I know in the shipbroking community really believes they could get £74m for those vessels and indeed if they could they bondholders should jump at the chance of a near 40% recovery of par. A fire-sale would bring a figure a quantum below this.

Sapphire is the harder of the two assets to value: the vessel is in lay-up, has worked less than 20 days this year, and despite being the best DSV in the Gulf of Mexico hasn’t allowed BOHL to develop meaningful market share (which is why the Nor Da Vinci going to Trinidad needs to be kept in context). Let’s assume that 1/3 of the £74m is the Sapphire… How do you justify £24m for a vessel that cannot even earn its OpEx and indeed has so little work the best option is warm-stack? The running costs on these sort of vessels is close to £10k per day normally, over 10% of the capital value of the asset not including a dry dock allowance etc? Moving the vessel back to the North Sea would cost $500k including fuel.  The only answer is potential future residual value. If BOHL really believed the asset was worth £24m they should have approached the bondholders and agreed a proportionate writedown and sold the asset… but I think everyone knows that the asset is essentially unsellable in the current market, and certainly for nowhere near the number book value implies. Vard, Keppel, and China Merchants certainly do… The only recent DSV sale was the Swiber Atlantis that had a broker valuation of USD 40-44m in 2014 and went for c. USD 10m to NPCC and that was not an anomaly on recent transaction multiples. If the Sapphire isn’t purchased as part of a broader asset purchase she may not return to the North Sea and her value is extremely uncertain – see how little work the Swordfish has had.

Polaris has a different, but related, valuation problem. In order to access the North Sea day rate that would make the vessel worth say a £50m valuation you need a certain amount of infrastructure and that costs at c.£5-8m per annum (c.£14k -22k per day), and that is way above the margin one of two DSVs is making yet you are exposed to the running costs of £10k per day. Utilisation for the BOHL fleet has been between 29%-46% this year and the market is primarily spot with little forward commitment from the customer base. So an investor is being asked to go long on a £50m asset, with high OpEx and infrastructure requirements, and no backlog and a market upturn needed as well? In order to invest in a proposition like that you normally need increasing returns to scale not decreasing returns that a depreciable asset offers you.

This link between the asset specificity of DSV and the complementary nature of the infrastructure required to support it is the core valuation of these assets. Ignoring the costs of the support infrastructure from the ability of the asset to generate the work is like doing a DCF valuation of a company and then forgetting to subtract the debt obligation from the implied equity value: without the ability to trade in the North Sea the asset must compete in the rest-of-the-world market, and apart from a bigger crane and deck-space the vessels have no advantage.

It is this inability to see this, and refusal to accept that because of this there is no spot market for North Sea class DSVs, that has led to the Nor position in my humble opinion. The shareholders of the vessels are caught in the irreconcilable position of wanting the vessels to be valued at a “North Sea Price”, but unable or unwilling to commit to the expenditure to make this credible. It would of course be economic madness to do so, but it’s just as mad to pretend that without doing so the values might revert to the historically implied levels of depreciated book value.

The Nor owners issued a prospectus as part of the capital raising in Nov 2016 and made clear the running costs of the vessels were c. USD 370k per month per vessel for crewing and c. USD 90k per month for SAT system maintenance. In their last accounts they claimed the vessels value at c. USD 60m each. Given Nor raised USD 15m in Nov last year, and expected to have one vessel on a 365 contract ay US 15k per day by March, they are so far behind this they cannot catch-up at current market rates.

Again, these vessels, even at the book values registered, require more than 10% of their capital value annually just to keep the option alive of capturing that value. That is a very expensive option when the payoff is so uncertain. If you are out on your assumption of the final sale value by 10% then you have wasted an entire year’s option premium and on a discounted basis hugely diluted your potential returns (i.e. this is very risky). Supposedly 25 year assets you spend more than 2.5x their asset values to keep the residual value option alive.

Three factors are crucial for the valuation of these assets:

  • The gap between the present earning potential and the possible future value is speculation. You can craft an extremely complicated investment thesis but it’s just a hypothesis. The “sellers” of these assets, unsurprisingly, believe they hold something of great future value the market simply doesn’t recognise at the moment. Sometimes this goes right, as it did for John Paulson in the subprime mortgage market (in this case a short position obviously) and other times it didn’t as owners of Mississippi Company shares found to their discomfort. We are back to the “Greater Fool Theory” of DSV valuation.One share.png
  • Debt: In the good old days you could finance these assets with debt so the equity check, certainly relative to the risk was small. In reality now, for all but the most blue-chip borrowers, bank loan books are closed for such specialist assets. And the problem is the blue-chip borrowers have (more than) enough DSVs. The Bibby and Nor DSVs are becoming old vessels: Polaris (1999) will never get a loan against it again I would venture and the Sapphire (2005) has the same problem. The Nor vessels are 2011 builds and are very close to the 8 year threshold of most shipping banks. As a general rule, like a house, if you can’t get a mortgage the vessel is worth less, substantially so in these cases because all diving companies are making less money so their ability to find equity for vessels is reduced. Banks and other lenders have worked out that the price volatility on these assets is huge and the only thing more unsellable that a new DSV is an old DSV. It will take a generation for internal risk models to reset.
  • You need a large amount of liquidity to signal that you have the commitment to see this through. At the moment neither Bibby or Nor have this. From easily obtainable public information any potential counterparty can see a far more rational strategy is to wait, the choice of substitutes is large and the problems of the seller greater than your potential upside.

Of course, the answer to liquidity concerns, as any central banker since Bagehot has realised, is to flood the market with liquidity. Bibby Line Group for example could remove their restrictions on the RCF and simply say they have approved it (quite why Barclays will agree to this arrangement is beyond me: the reputational risk for them foreclosing is huge). As the shareholder Bibby Line Group could tell the market what they are doing, in Mario Monti’s words, “whatever it takes”. Of course, Mario Monti can print “high powered money” which is not something Bibby Line Group can, and that credibility deficit is well understood by the market. A central bank cannot go bankrupt (and here) whereas a commitment from BLG to underwrite BOHL to the tune of £62m per annum would threaten the financial position of the parent.

I have a theory, untestable in a statistically significant sense but seemingly observable (e.g. Standard Drilling, the rig market in general), that excessive liquidity, especially among alternative asset managers and special situation funds, is destroying the price discovery mechanism in oil and gas (and probably other markets as well).  I accept that this maybe because I am excessively pessimistic, but when your entire gamble is on residual value in an oversupplied market, how can you not be? In offshore this is plain to see as the Nor buyers again work out how to value the assets for their second “super senior” or is that “super super senior” tranche, or however they plan to fund their ongoing operations. The Bibby question will have to be resolved imminently.

At some point potential investors will have the revolutionary notion that the assets should be valued under reasonable cash flow assumptions that reflect the huge increase in supply of the competitive asset base and lower demand volumes. Such a price is substantially lower than build cost, and therein lies the correction mechanism because new assets will not be built, in the North Sea DSV case for a considerable period of time. Both the Bibby and the Nor bondholders, possessors of theoretically fixed payment obligations secured on illiquid and specialised assets will be key to the market correction. Yes this value is likely to be substantially below implied book/depreciated value… but that is the price signal not to build any more! Economics is a brutal discipline as well as a dismal one (and clearly not one Chinese yards have encountered much).

How these existing assets are financed will provide an insight into the current market “price discovery” mechanism. For Nor the percentage of the asset effectively that the new cash demands, and the fixed rate of return for further liquidity, will highlight a degree of market pessimism or optimism over the future residual value. If you have to supply another USD 15m to keep the two vessels in the spot charter market for another 12 or 15 months how much asset exposure do you need to make it work? Will the Nor vessels really be worth $60m in a few years if you have to spend USD 7.5 per annum to realize that? What IRR do you require on the $7.5m to take that risk? Somewhere between the pessimism of poor historic utilisation and declining structural conditions and the inherent liquidity and optimism of the distressed debt investors lies a deal.

The Bibby valuation is more binary: either the company raises capital that sees the assets tied to the frameworks of their infrastructure, and implicit cross-subsidisation of both, or the assets are exposed to the pure vessel sale and purchase market. The latter scenario will see a brutal price discovery mechanism as industrial buyers alone will be the bidders I suspect.

Shipbroker valuations work well for liquid markets. The brokers have a very good knowledge of what buyers and sellers are willing to pay and I believe they are accurate. I have severe doubts for illiquid markets, particularly those erring down, that brokers, like rating agencies, have the right economic incentives to provide a broad enough range of the possibilities.

Although the question regarding the North Sea DSVs wasn’t rhetorical it is clear what I think: unless you are prepared to commit to the North Sea in a credible manner a North Sea DSV is worth only what it can earn in the rest-of-the-world with maybe a small option premium in case the market booms and the very long run nature of the supply curve. The longer this doesn’t happen the less that option is valued at and the more expensive it is to keep.

 

[P.S. Around Bishopsgate there is a theory circulating that Blogs can have a disproportionate impact on DSV values a theory only the most paranoid and delusional could subscribe to. I have therefore chosen to ignore this at the present time. The substance of the message is more important than the form or location of its delivery.]

DSV economics and finance 101.

The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating.”
BNP Paribas press release, August 9,2007

 

I don’t want realism. I want magic!

TENNESSEE WILLIAMS, A Streetcar Named Desire

 

“Reality is that which, when you stop believing in it, doesn’t go away.”

Philip K Dick, I Hope I Shall Arrive Soon

 

Right now is the toughest DSV that has existed since a massive DSV rebuild programme began in earnest in 2000. At the moment Toisa are in restructuring talks, Bibby have not made money for at least two years, Harkand are no more, and a host of other smaller companies have gone bankrupt. The cause was that there was too little work at profitable rates.

Currently there is a vast inventory of North Sea class Dive Support vessels mounting up: 2 x Nor Offshore, 1 x Vard, 1 x Bibby Sapphire, various assets of Technip and Subsea 7, and various Toisa, for non-comprehensive list. In Asia the number of underutilised DSVs is so vast, and the competition so intense from PSVs with modular SAT systems, that the new normal is OpEx breakeven if you are lucky. Keppel have a USD 200m DSV that can’t be sold  and another Toisa DSV is in the production line in China . As in Europe intense price competition is stopping anyone of the dive companies making any money.

By any traditional measure of economic and financial analysis this is not a good time to launch a new DSV company, either as an owner, where the market is oversupplied and no owner can even get his book value back on the boats, or as a dive contractor where an excess of capacity is driving the price of work to its cost or less. It is worth noting that the new build Tasik DSV, with a 365 five year charter to Fugro, could not get takeout financing from the yard.

Into this maelstrom is coming Ultradeep Solutions (“UDS”),Flash Tekk Engineering, and a Chinese yard…

The distinction between the North Sea fleet and the rest of the world is important as everyone knows in the market the North Sea environmental conditions demand a higher specification vessel and therefore day rates have always been higher. The ROW has never chartered tonnage of the same cost because they don’t need too, older vessels traded out of the North Sea and finished their days in Asia or Africa for lower rates but trading on the higher spec and build quality.

UDS is building North Sea standard tonnage when both Harkand and Bibby, pure IRM and diving companies, could not operate similar, less expensive tonnage, profitably. That is a statement of fact. In order to operate in the North Sea you need a certain amount of infrastructure that I estimate at a minimum costs c. £5-8m per annum for two vessels, to cover things like bidding, HSE, business development, plus the vessel running costs (detailed below). Or you could just charter the vessels to someone willing to pay. There is no middle ground here. Nor Offshore recently tried and got zero utilisation, it is not a product anyone wants, or needs, to buy.

The problem is there are no charterers, and companies like Bibby, who despite their capital structure still offer a very good product, cannot even break even on the vessels: this should be a word of warning for companies seeking to enter. No owner wants to accept there has been a structural change in demand in the North Sea as it means writing off tens of millions of dollars on asset values. Like the financial crisis, which began nearly ten years ago today, everyone owning a DSV claims their assets are impossible to value fairly, what they mean is the price they would get isn’t one they are prepared to accept (cognitively even if they had to take it financially). Just like the financial crisis securities the vessels are used as collateral, when the risks of ownership of these assets cannot easily be assessed, as with DSVs now, their price falls and they become in effect untradeable at any price.

Anyone raising money for a high-end DSV at the moment needs to explain how even if they paid the yard delivered price only why they wouldn’t then go down the road to Vard and offer 10% less for theirs, then the Nor bondholders and offer them 20% less, and then Keppel and offer them 50% less, and then start the whole cycle again. These are extremely illiquid assets with very high holding costs and the option value doesn’t look great. Yes maybe, a big maybe, these Chinese built vessels are operationally better, but does that add anything for the client or a way to charge more? No.

At the moment the Nor Da Vinci is steaming to Trinidad for c. 35 days work for BP, and it takes 25 (ish) days in transit time to get there. This vessel is a near sister ship of the Ausana that UDS have taken on. Unless you believe that every single dive contractor/DSV owner in the world has forgotten to bid for certain jobs then you need to accept the market is suffering from chronic oversupply at the high end.  Nor raised USD 15m in Nov last year, ostensibly to keep the vessels trading in the North Sea, they are not taking the vessel to Trinidad because the crane wants to go sunbathing, it is the only work they can get. Nor will need to do a liquidity issue soon and decide where to position the vessels again this November. Every single job UDS go for will have people just as desperate as them to win work for years to come. The last Nor propospectus also made clear that crewing costs, on a near identical vessel to the Ausana, at safe manning level only, were USD 350k per vessel per month + c. 100k for the dive techs and maintenance. These are very expensive assets to hold an option on.

I don’t want to spend a lot of time on  UDS, I admire anyone setting up a company and making a go of it, but its really simple for me: either we are going to see the company raise literally hundreds of millions of dollars to pay for some DSVs and working capital, in a market when asset values are dropping and no one is making  break-even money, or the yard is going to have to subsidise the vessels and the working capital question becomes interesting. Because someone still needs to pickup the tab for the OpEx which is around USD 10k per vessel per day. 30k per day is c. USD 1m a month with some corporate overhead included and unexpected expenses included. That size of fundraising is institutional money and will leave a documentary trail. I can’t find anything yet which leads me to believe they are undercapitalised (I am happy to be proven wrong here). Raising that sort of money without any backlog at all will I believe be impossible in current financial markets. The return required for hedge funds and other alternative investors to get behind this simply cannot be demonstrated.

It is just not possible in this market, where extremely good operating companies are struggling for work for someone to know of jobs that everyone else forgot about. It’s just not possible in this market to deliver dive vessels tens of millions in cost more than local competitive vessels and claim that you are the only person who can make money and all that is stopping everyone else is negativity.

The fact of the matter is unless those UDS vessels work at North Sea rates, and UDS commits to the sort of infrastructure required to do this or finds a charterer, the vessels will never make money in an economic sense. And even then UDS would have to explain what they are going to do that Harkand and Bibby didn’t or can’t?  No one builds USD 150m dive vessels for Asia because people won’t pay for them. That doesn’t mean UDS won’t make money, owe the bank 1m you are in trouble, owe the bank 100m and they are. The yard has a problem here and needs these vessels to work if they are finished off as DSVs. But even if UDS come up with the vast amount of working capital required it doesn’t make the vessels economic units and that will be bad for the industry as whole.

We will see. I could be wrong… But sooner or later the cash flow constraint is going to bite here because the numbers are so big. If I was a supplier I’d really be hoping my contract was with the yard.

The New Offshore… it looks a lot like Italian and Spanish banking…

The oldest bank in the world, Banca Monte dei Paschi di Siena SpA, founded in 1472, came under government control today. The bank, founded as the “Mount of Piety”, has been through numerous capital raisings and life support packages since 2008/09, and finally, even the Italian government and the ECB could no longer pretend it was solvent. I have lost count over the years of the number of times the ECB has declared the banks solvent (only last December the MdP fundraising was announced as “precautionary”), but shareholders who have previously be forgiving have had enough as has the Bank of Italy. There are some clearly analogous lessons for offshore in this.

European banks and offshore oil and gas contractors share many of the same issues. For years now central banks around the world have kept the price of the core commodity that banks trade in (money) low, interest rates at the Zero Lower Bound (“ZLB”) has become the new normal and banks struggle to the margin they used to between the money they borrow and the money the lend.

Another clear similarity between the banks and offshore contractors is excessive leverage. Banking is actually a pretty risky business (which is why banking crises and state bailouts are increasingly common), banks borrow short and lend long in a process known as maturity transformation. What this means in practice is that when you go into your friendly branch of DNB with your Kroners and deposit them you are lending the bank money and they are making a loan contract to pay you back a fixed number of Kroner. DNB then package up all the Kroner in the branch and turn it into a ship in the form of loan contract which they use to pay you back. The problem arises, as it did recently for DVB, when the value of the ship, or just as importantly the income from it, is worth less than the value of all the loan contracts the bank used in financing the ship. One or two doesn’t matter but if all the ships are worth less then the bank has a problem. This mismatch between the obligations that banks take on to finance assets that can vary hugely in value is the feature of nearly all banking crises, certainly in shipping as the German banks know well, but also the cause of the 2008/09 global financial crises. This is the fundamental instability mechanism in an economy that fractional reserve banking introduces.

Offshore has a similar instability mechanism and it too is a function of leverage. As the volume of work has dried up the fixed commitments owed to banks, bondholders, and other fixed rate security holders who were used to purchase vessels, assets, or finance takeovers has remained constant while the asset value has cratered and the revenue has done the same. Like a bank the asset side of the balance sheet is being severely strained at the moment as the revenues and profits simply cannot support historic commitments. It was this model of viewing the creditor run on Ezra/Emas as comparable to a bank run that made me sure there was no route to salvation for them. This transmission mechanism is destabilising all asset owners as banks are not lending on assets of uncertain value and the size of some of the writedowns is an issue for the banks. These sort of self-reinforcing loops are very hard to break.

Like the banking sector offshore is struggling with a the tail of a credit boom which is obviously related to the excessive leverage taken on. As has been shown many times over in research credit booms, in all contexts, take longer to recover from than other types of investment bubbles.

Historical analogies, no matter how interesting, are only good if they give us some insight into the future. In this case I think they are depressingly clear: since 2008/09 Spanish and Italian banks have created a structurally unprofitable industry that is unlikely to change with government intervention. Offshore contracting and European banks are both trapped in a low price commodity environment and burdened by historic asset commitments and the current economic value of said assets. European banks have overcapacity issues but shareholders and other stakeholders are committed to keeping this structure because of previously sunk costs and very high exit costs.

The banking crisis in Europe should be a lesson to offshore that impairments in asset values can be permanent. Mian and Sufi (read their book), after looking at the US housing crisis, propose shared risk mortgages where banks share in the capital value, such a suggestion seems prime for shipping and offshore gievn the extraordinary volatility in asset prices and the levels of leverage common in these asset transactions. The cynic in me says regulators would need to force this through, but I also believe eventually German taxypayers will tire of supporting the global shipping industry.

Another lesson to be drawn for offshore is that consolidation favours the large, there is a flight to quality. JP Morgan now has a market cap of roughly USD 336bn post crisis and would appear untouchable as the worlds largest bank (considerably larger than some central banks) after a series of well excuted post-crisis transactions. TechnipFMC has similarly become the largest offshore contractor through an astute merger (imagine if they had really brought CGG!) and if they can ever resolve the tax situation with Heerema will become untouchable as the largest and most capable offshore contractor.

Unfortunately for smaller players size counts. In a bank run people worry that the institution will not be there in the future so choose to withdraw savings because they are nothing but a loan to the bank. Similarly E&P companies who contract with smaller contractors are merely unsecured creditors if they fail despite the progress and procurement payments and therefore are at a considerable disadvantage in winning large contracts in a challenged environment even if they are substantially below the competition in price.

Another lesson is that there is no substitute for equity capital and the larger players have an advantage in raising this. Bank balance sheets have changed substantially since the financial crisis at it is clear that offshore companies that want to surivive will have a much higher componenet of equity in their capital structure. The quantum of this capital will be a major issue given the continued low profitability for all but the largest players in the industry,

But the clearest lesson to take unfortunately is that barring a major exogenous change the zombie banks, neither dead nor alive, can continue for a longer period of time than anyone would really like. Offshore is facing the same dilemma as 2018 looks to be quiet, relative to 2014, and OpEx continues to be a major problem for companies. There is no quick fix in sight unfortunately.

The narrative in capital allocation moves to shale…

I use the term narrative to mean a simple story or easily expressed explanation of events that many people want to bring up in conversation or on news or social media because it can be used to stimulate the concerns or emotions of others, and/or because it appears to advance self-interest. To be stimulating, it usually has some human interest either direct or implied. As I (and many others) use the term, a narrative is a gem for conversation, and may take the form of an extraordinary or heroic tale or even a joke. It is not generally a researched story, and may have glaring holes, as in “urban legends.” The form of the narrative varies through time and across tellings, but maintains a core contagious element, in the forms that are successful in spreading. Why an element is contagious, when it may even “go viral,” may be hard to understand, unless we reflect carefully on the reason people like to spread the narrative. Mutations in narratives spring up randomly, just as in organisms in evolutionary biology, and when they are contagious, the mutated narratives generate seemingly unpredictable changes in the economy.

Shiller, 2017

News that BP had started production at Quad 204 (Schiehallion) led curmudgeonly FT columnist Lombard to note  yesterday:

If anything, then, Monday’s news is more of a last hurrah for BP in the North Sea, and for the UK Continental Shelf more broadly. With the strongest capital flows — and investor buzz — focused on unconventional US resources, traditional offshore oil can seem as fashionable as a set of free “crystal” tumblers from a 1970s petrol station. With a big shield logo.

I have mentioned here before that behavioural finance is starting to examine the narrative in economics (see initial quote), and at the moment this is the narrative in London and other capital markets. This ties in nicely with an excellent piece from Rystad earlier in the week looking at the future of the North Sea and the Gulf of Mexico (I recommend reading the whole thing). For service companies Rystad notes:

After such a deep cut in this market it will take some time before the industry experiences a full recovery. Even with oil prices of $90/bbl to $100/bbl for the next decade, the market will not be back to 2014 levels before 2024.

The link for me is that offshore is going to bifurcate into huge developments (Quad 204, Mariner, Bressay, Mad Dog 2) and “the rest”. The rest are unfortunately going to be much smaller in number and less frequent. Rystad specifically mentions the lack of tie-back and tie-in projects in these regions. These projects are the investments that really compete with shale: 8-12 000 bpd that were ignored by larger E&P companies. The larger developments with high flow rates, and multi-decade economic plans, are vital for security of volume and a core underpinning of E&P profitability, and they are very economic, playing to super-major strengths of vast capital requirements combined with astounding engineering capability; but smaller developments in the USD 50-200m range are at a real risk of grinding to a slow halt for all except the companies currently committed to this space.

The North Sea, and to a lesser extent GoM, always had a significant number of smaller players (think Ithaca Energy (recently sold to Dalek) or Enquest), that raised (relatively) small sums of money and then sought to regenerate an exisiting area or develop smaller finds. Access to financing for that market simply doesn’t exist at the moment on anything like the scale it did before. Those Finance Directors who used to traipse around fund managers in London, Vancouver, New York etc with a deck of slides explaining their proposed developments are simply not getting a hearing. Not only that the tried and tested business model of developing a few fields and selling out with a takeover premium when they had built sufficient scale isn’t credible any more as potential acquirers focus on more on tight oil. Now those fund managers are meeting with guys who have a deck of slides that start with a shale rig, emphasise the relatively low upfront capital (as opposed to the higher OpEx) and their ability to rein in variable costs should price declines occur. The meme in financial markets now is all about shale, and rightly or wrongly, influential columns such as the one above help set this “dominant logic”.

Inside the big E&P companies managers, who are cognizent of the fact they must deal with analysts in the financial community and the investor base who follow the same narrative, are adapting and spending more time to examining potential shale investments. Offshore is getting less airtime. When was the last time you hard someone say “all the easy oil is gone” – which was taken as fact only 5 years ago. From this myriad of individual meetings and actions the macro picture of slowing capital flows into offshore and increased investment in shale is being driven, and it will be very hard to reverse without some exogenous event.

As behavioural economics teaches us humans are “boundedly rational” not the perfectly rational homo economicus so beloved of the efficient markets crowd. What this means is that potential investors can only process so much information, if you combine this with the fact that institutional investors “herd” (i.e. invest where their competitors do), you can see the current investment vogue is short cycle shale which makes even getting funding hard even for compelling offshore investments. Those who have heard the word “Permania” used to describe the boom in Permian basin will relate to this quote from the IMF on investment herding:

[p]rocyclicality in asset allocation can make swings in financial asset value and economic activity more intense. From an individual investor’s point of view, procyclical behavior can be rational, especially if short-term constraints become binding or if the investor can exit earlier than others. However, the collective actions of many investors may lead to increased volatility of asset prices and instability of the financial system..

Eventually the shale mania will wain as people overpay for land and productivity improvements slow. The problem for offshore is the amount of OpEx people will have to burn to get to this point and the consistently increasing productivity of shale.

Big players in the North Sea region like Apache, Taqa, and Sinopec will conitnue to develop offshore fields but they are not doing as many projects. The threshold rate for investment will be higher, because experience has taught us that you can get 5 years of low oil prices and many of these projects only have economic lives of 5-10 years (risk models are great at solving previous issues). These companies have less access to capital markets than their shale competitors because the high-yield desk has the same meme as the equity investors, higher equity costs and more risk averse bank funding raise project return requirements even more. Even state -backed companies like Taqa must vie for funding internally. Outside of the North Sea and GoM these developments are likely to remain dominated by National Oil Companies who may not rank projects on a strictly economic basis but will take the expected spot price of oil into account in their investment decisions. But as Rystad makes clear the North Sea and GoM volume increases will all be driven by a smaller number of larger projects.

This affects contractors differently. As Rystad notes EPIC work will decline proportionately less than other work.  For DSVs and ROV operators and vessel owners) this is grim . Until construction work, that uses far more DSV and ROV days than maintenance work, improves the supply side of the industry will take the adjustments both in day rates and utilisation levels. The supply chain is going to change into a few large integrated contractors in these regions with a vast choice of assets to service their needs and they are likely to reduce their comitted charter tonnage . These large contractors will make an economic return but part of it will be done by ensuring the smaller companies in the supply chain make only enough economic profit to survive and the equity value (if any) in these companies and assets looks set to be depressed for an extended period. Consolidation on a scale only dreamed of at the moment amongst vessel owners looks certain.

Demand will not return for smaller projects until the market price for oil stabilises at a substantially higher price than now, and does so for long-enough to give potential funders confidence that the upturn isn’t temporary. The uplift will likely be less severe because shale has introduced a “kink” in the supply curve. Projects take time to pass through engineering, funding etc before meaningful offshore work occurs. This is a long-term issue: Demand may have stabilised at current levels but recovery for the supply chain that is based on the realistic prospect of higher days rates and utillisation looks some way off.  For an asset base built to supply a 2013/14 demand curve the outcome looks uncomfortably obvious.

 

 

How much is the Lewek Constellation worth? Somewhere between USD 43m and USD 370m (I’m closer to the former)…

“His services are like so many white elephants, of which nobody can make use, and yet that drain one’s gratitude, if indeed one does not feel bankrupt.”

G. E. Jewbury’s Letters, 1892

The EMAS Chiyoda restructuring plan nears execution. The most interesting aspect to me is what the Lewek Constellation is valued at and how the banks get this problem off their hands (i.e. how much of a loss do they have to take?) Outside of Saipem, SS7, Technip, McDermott, and Heerema (maybe) it is very hard to see who the realistic buyers would be? There is no spot market for these assets because you need a huge engineering capability (and cost base) on the beach to run one of these assets. And the real problem is that all these potential buyers have added substantial new tonnage in deepwater pipelay very recently. (My previous thoughts on asset specificity and transaction costs are here). Without a dramatic improvement in the market it’s hard to see why anyone would want this asset?

Or not? In the Chapter 11 reorg Subsea 7 and Chiyoda are essentially providing a USD 90m Debtor-In-Possession  facility that sees them take over 5 EMAS Chiyoda entities emerge that have 15 projects with c.1bn in backlog. Subsea 7 obviously decided this was the easiest way to get the work, and when you drop c.USD 1bn in backlog in a year it’s easy to see why you want to be inventive. The big SURF scopes are Cape Three Points and Chevron Tahiti Vertical Expansion. Given how far the engineering had advanced and the fact the contracts had been awarded it is easy to see why Subsea 7 would want to take some risk getting this work.

Some context: back in 2013, the build year of the Lewek Constellation, Clarkson published this graph:

Clarkson Subsea Trees Nov 25 2013

Now Clarkson’s are no different to anyone. I could have picked any number of information providers, the commonly held view was only how much growth there would be, and how much kit you needed to access it. Shale was not in vogue and starting it’s extraordinary journey.  Although as an aside, because I don’t want to delve into shale productivity here (but you can read some of my thoughts here and here), the US rig count was higher than it currently is.  But the point is clearly that boards, managers, and financing institutions all thought the market would evolve something like that graph. On such a basis the investment decision was made for the Lewek Constellation and DNB and a syndicate of banks advanced USD 503m in two facilities and got two Panamian mortgages and a credit agreement in return. Of that USD 370m in capital is outstanding under facuility A (and the 100m from facility B is effectively written off) in the Chap 11.

The market has obviously changed somewhat:

Subsea Tree Awards 2000-2019e

The single best indicator of future demand for heavy installation vessels is subsea tree awards. Now it is clear that demand has dropped and will remain depressed for a long time at around 2003/2004 levels. Strip out Brazil, where Petrobras has extensive spare PLSV capacity for flexlay, and you are within a margin of error of 2003 numbers. Yes, more proportionately will be in deep water, but the subsea lay fleet was built for 2013/14 not 2003 and no amount of deferred consideration can change that.

Let’s be clear the Lewek Constellation is a capable vessel, but I wrote here about competition: a significant number of competing vessels have been built in recent years and this is all about competition at the margin. These types of vessels don’t work to their maximum potential every day, they work on a broad range of smaller jobs and then make real money on a couple of jobs of a year where the competition is less and pricing is based not only on vessel capability but about engineering value added by the contractor. None of them is differentiated enough to win a project in its own right.

So a market transaction has been reached whereby Newco (owned by Subsea 7) will charter the vessel for USD 4.3m per annum and the cost of the dry dock (c. 2018) is split 50/50 at ~USD 5m each. That is, in the current environment Subsea 7/Newco judges that it is economic to add marginal (extra) lay capacity at bareboat rate per year of USD 4.3m, plus drydock accrual and operating expenses,  and the bank/owner has agreed it is economic to charter their asset at this rate. That is a market-based economic transaction between a “willing-buyer/ willing-seller” for the capital value of the asset and it reflects some backlog that a qualified purchaser can deliver with it. Subsea 7/Newco has an option to purchase the asset for USD 370m during the first 2 years of the charter agreement and this is then used a “floor” going forward or broker valuations less USD 20m. The extension options rise dramatically (see below).

Now if you add 3% per annum to the charter rate, add in dry dock costs, assume 10m salvage value in 20 years, and discount this back by the DNB WACC (10.4% today) you get an implied vessel value of ~ USD 43m.  I would argue that is a fair value for the vessel, which is pretty much in line with the discount MDR paid for the Amazon and NPCC paid for Atlantis (I mentioned this yesterday).  [I used the 3% growth in the annual day rate to reflect an industry with excess capacity and therefore growth roughly inline or above a CPI measure, obviously the mortgage banks would regard this number as unacceptably low. However, I think the discount rate at DNB WACC (rather than funding costs or liquidity spreads perhaps) given the project risk is far too low. Obviously different inputs will lead to different results.] For the sake of a comparison in order to get the vessel value to anything like USD 370m you have to increase the charter rate 25% per annum for the entire assumed 20 year period! The charter rate is also linked to a LIBOR adjustment, something that is very rare, and highlights how senstive the banks are to a valuation projection here.

This purchase option number strikes me as a fantasy and reflects the fact that DNB recorded a capital value of USD 370m outstanding in the Chap 11 filing. If you look at the forward order book for subsea trees or announced projects in three years, and all the excess capacity on the vessels, who really believes Subsea 7 is going to pay USD 60 000 per day in 4 years time (USD 21.9m per annum) rising to USD 80 000 per day (USD 29m per annum) in 5 years time? You might do under the assumptions in the first graph but not in the second. It is a chimera to help the banks out and allow everyone to play for time. The initial charter rate implies a 1.16% interest rate on the capital outstanding, so DNB don’t really believe the USD 370m figure, but it highlights the size of the economic subsidy required now for everyone to pretend they haven’t lost as much money as they say.

I was a big fan of Subsea 7 just handing the asset back and forcing the banks into a lengthy period of nervousness and reality, but it would have meant Subsea having to tender for the work. I believe that the Lewek Constellation is such a specific asset that it is actually effectively valueless in the current market. The best thing for the industry was for the asset to fade into obscurity; in this market, and after Ceona, no one would risk a start-up and few other companies would have agreed to help DNB. Clearly Subsea 7 have a strong cash and liquidity position, need the work, and this gives them an option if the market really did take off again. However, surely the most likely scenario from the banks point-of-view, under any objective reading of the market, is that in two years Subsea 7 come back and tell them to start getting real about the price and the asset value? There is a very Norwegian behind the scenes solution going on here with DNB obviously desperate not to have to recognise the vessel at a fire sale price now, or expose itself to the OpEx, and in all likelihood was involved in soliciting Subsea 7 as part of the financing shop around discussed in the documents.

If the Bibby bondholders are looking at these transactions closely they must be getting nervous now. With the bonds trading in the mid-60s the implied valuation of the Polaris and Sapphire is c.GBP 105m, a number that looks as egregious as the USD 370m purchase option for the Lewek Constellation.

The big risk for Subsea 7 isn’t the committed expenditure, which amounts to USD 4.3m for charter per annum (+ the undefined LIBOR spread), + vessel OpEx (probably the same), and c. USD 5m for the dry-dock, it is that they appear to have agreed to deliver the EMAS Chiyoda contracts for the same lump sum price and contractual terms. The few projects EMAS Chiyoda delivered were a disaster in engineering terms, and that isn’t just Angostura, I have spoken to people who have managed other jobs with them. If Subsea 7 haven’t had enough time to due diligence the project engineering and costing properly, which is notoriously hard in lump sum jobs, they are going to have a big problem. Although the contracts appear to be novated to Newco, who exposure in one set of documents appears capped at USD 90m (that may be a placeholder), such a situation is likely to involve other Subsea 7 tonnage and exposure through the supply chain. Subsea 7 are one of the world’s great engineering houses but in 2013 a painful conference call to discuss Guara Lula (which they had bid themselves) led to these comments:

[w]e moved into the offshore phase of the project in the second quarter, with the Seven Polaris and the Seven Oceans being deployed on location. We are experiencing more weather downtime than originally planned due to severe weather conditions in the Santos Basin during the Brazilian winter. We have suffered equipment damage and the resulting downtime on the Polaris due to this bad weather. We expect these conditions to continue until the season is over. Although we are contractually covered for time spent by the prime vessel waiting on weather, we incur additional costs, both offshore and onshore, which are not covered. In addition, we have taken a more cautious approach in evaluating what can be achieved offshore during periods of calm weather, in view of the complexity of the facts involved…

Second, the stretched supply chain is resulting in delays from international and local suppliers….

[t]here was a delayed start to pipeline fabrication at the Ubu spool-base largely due to customs clearance issues. Initial productivity at Ubu has also taken longer to ramp up than expected…

A re-evaluation of the offshore risks based on experience to date, and the extended timeline of the project, has resulted in us increasing the estimate full-life project loss by between $250 and $300 million.

Final losses were USD 355m and that was on vessels and a project they tendered internally. Subsea 7 don’t know this vessel at all, and the engineers and tendering staff had all been instructed to win these tenders at all costs having spoken to people involved in tendering at that stage for EMAS. It may not happen, and they may have done sufficient due diligence, but when you agree to go basically lump sum you are taking execution risk on a tender and asset outside of your management system. Don’t complain later you couldn’t have forseen it, but backlog looks like it is going down so fast they may feel they have few options.

At some point the industry (contractors and financing institutions) are going to have to accept that if all this tonnage remains in operation, and the operating costs are included, then it will have a structural profitability issue without a dramatic change in demand that just isn’t occuring. Yes the Lewek Constellation is a flexible asset, and it can save a variety of vessels working in the field, but those vessels exist now, amongst the current contractors. If an E&P company really wants this specific vessel because of its advantages let them buy it? It only looks more “efficient” in the field compared to other vessels because it isn’t being compared to the historic investments currently solvent contractors have made in a fleet of vessels that collectively perform the same function.

Maybe Subea 7 are looking to retire some older tonnage later on and the easiest way to get over a difficult discussion with the banks was to kick the problem into touch? But at some point the discussion will have to come and I would have thought the banks auditors would have forced it now because in a default situation the value of the vessel is very clear: about USD 43m on a standard capitalised valuation framework. Convincing the auditor that in 36 months you will get a 6x uplift in the day rate when the market forecast is for negligible growth and stable supply strikes me as unlikely in the extreme.

The amount of offshore work may have hit its bottom level and some good contracts are being awarded, but as Eidesvik reminded us today more restructurings are coming, Solutions like this which simply push the eventual reduction in asset values further into the distance will only ensure continued weak profitability for vessel owners (and banks).