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.

Tidewater, European banks, and zombie companies…

You walk outside, you risk your life. You take a drink of water, you risk your life. Nowadays you breath and you risk your life. You don’t have a choice. The only thing you can choose is what you’re risking it for.

Hershel (The Walking Dead)

Tidewater announed their restructuring today… as is widely reported they have written off USD 1.6bn of debt and reduced operating lease expenses by USD 73m. US Chap 11 isn’t perfect, and having nearly been on the receiving end once I find it amazing that US courts will claim jurisdiction essentially on the basis of a US domestic dollar bank account and Delaware address (which clearly isn’t the case here), but it is remarkably efficient from a macroeconomic perspective.

Last week The Economist published an article on Zombie companies noting:

there is a growing belief that the persistence of zombie firms—companies that keep operating despite a poor financial performance—may explain the weak productivity performance of developed economies in recent years.

An inability to kill off failing companies seems to have two main effects. First, the existence of the zombies drives down the average productivity level of businesses. Second, capital and labour are wrongly allocated to such firms. That stops money and workers shifting to more efficient businesses, making it harder for the latter to compete. In a sense, therefore, the corporate zombies are eating healthy firms.

… [the] analysis builds on the work of an OECD paper* published earlier this year which found that, within industries, a higher share of capital invested in zombie firms was associated with lower investment and employment growth at healthier businesses.

A fair summation of European shipping and offshore at the moment if ever I read one.

The contrast with the European shipping and offshore firms, where the banks have constantly tried to pretend that insolvent companies are viable by allowing them to pay interest only and deferring the principal payments, and the willingness of US firms to restructure and move on is clear. Part of it is structural as US banks have a smaller percentage exposure to these troubled assets but that doesn’t change the outcome. Quite how long auditors are going to allow this to continue when there are clear market based transactions with demonstrable asset values is anyone’s guess but eventually these loans will default. I agree with short-term measures, the equivalent of a liquidity rather than a solvency crisis for firms, when it really is that but with depreciating assets eventually the bullet payment is due and years into these situations the arguements for writedowns on a scale not yet seen is becoming more apparent.

The Nordic banks have been through this before during the Nordic Banking Crisis (1988-1993) having overextended themselves in real estate loans, in this case the credit bubble was driven by deregulation, like offshore shipping with a high oil price, the boom was procyclical.

Nordic Banking and Real Estate 1988-1993

Nordic Banking Crisis Data.png

As can be seen a reduction in asset values leads to a dramatic reduction in the amount of bank credit. The same thing will happen in shipping in offshore, despite it being a much smaller part of the overall bank loan books, and this reduction in credit is likely to permanently impair asset values. Economists have called this process the financial accelerator and it is clearly interacting between the banks and zombie offshore and shipping companies.

The sceptic in me thinks only a combination of liquidations, writedowns, and scrapping is going to return these sectors to an economically viable level. But the actions of the various stakeholders, individually rational but collectively irrational, the collective action problem I have mentioned here before, makes this unlikely. A future of low profitability and structural overcapacity in Europe beckons while restructured American companies with clean balance sheets look to be able to move ahead with a cost base that matches the operational environment.

Great Exepectations and Asset Values in The New Offshore…

“Suffering has been stronger than all other teaching, and has taught me to understand what your heart used to be. I have been bent and broken, but – I hope – into a better shape.”

Charles Dickens, Great Expectations

Further evidence of the narrative turning to shale:

When the facts change … ” Hall wrote to investors in his Stamford, Connecticut, hedge fund, Astenbeck Capital Management LLC, in a July 3 letter obtained by Bloomberg News. “Not only did sentiment plumb new depths but fundamentals appear to have materially worsened.”

U.S. shale drilling is expanding “at a surprisingly fast rate, thus raising the odds for significant oversupply in 2018, even if OPEC maintains its production cuts.”

“When the facts change … ” Hall wrote to investor… “Not only did sentiment plumb new depths but fundamentals appear to have materially worsened.”

U.S. shale drilling is expanding “at a surprisingly fast rate, thus raising the odds for significant oversupply in 2018, even if OPEC maintains its production cuts.”

Reuters notes:

“The market is in trouble and looks very vulnerable to lower numbers,” PVM brokerage said in a note.

I can’t help wondering if some of the private equity money that flooded the North Sea when the price declined in 2015/16 isn’t getting a little worried. The investors behind Siccar Point and Chrysoar for exmaple are some of the largest private equity funds in the world, and the transactions were de-risked by paying a contingent amount on prices following the transaction, but prices are lower than the dominant narrative was at closing and they surely weren’t based on a mid 40s oil price but rather a long-term appreciation trend? Both are very different as well with Siccar Point exposed to Clair Ridge and some new deepwater projects where as Chrysoar is more exposed to the legacy Shell assets. But even still the only viable exit is another massive private sale or preferably a listing and both these companies offer very poor growth prospects in a high cost environment in what are officially declining basins. For North Sea contractors the implications for future demand are serious given how well the new players like Ineos have been at driving down OpEx in other markets. And E&P company spending obviously drives spending for offshore contractors and therefore asset values…

I have gone on about this before but I think the downturn in 2008/09 has a lot to answer for when a short price dip was followed by a very healthy five year boom, but shale simply wasn’t such a big deal and OSV supply was more limited. Just as in offshore fields so in offshore support vessels: those who piled into the Harkand/Nor bonds were typical: Justin Patterson of Intermarket (www.intermarket.us) proudly announced he was a holder of record of the Nor/Harkand bonds in November 2016. Constrained in the number of opportunities in the sector they could buy into they were not interested in understanding the assets or the market, they would just buy and hold… what could go wrong?

The investment is of course now worthless. The Nor investors are discovering either you have a North Sea diving operation or the vessels are only worth what someone in Asia will pay, and that is an order of magnitude less than the implied depreciated value of a North Sea class DSV. There is no magic solution here and as I don’t believe the Demand Fairy will save people here. With a load of sellers of similar assets who would be willing to sell or charter for $1 cheaper than the Nor investors, whatever the price, they need a good story to tell here if they want to convince anyone there is value in their investment.

Surely at some point auditors are going to insist on more cash-flow based assessments of vessel values and that is likely to cause chaos in such investments because they all rely on the Greater Fool Theory at the moment? The Harkand/Nor DSVs are an egregious example of where the valuation of USD 58m per vessel for their last set of accounts simply bears no relation to any realistic sale price the assets may fetch, it may help people like Intermarket show a positive Fair Market Value in their accounts but it isn’t a real number. Similarly Bibby held their DSVs combined at over GBP 100m in the last accounts… collectively this means that 4 North Sea class DSVs that cannot be operated at even cash flow break even are worth in excess of USD 240m, despite no credible reports of an uptick in day rates and other comparable vessels such as the Vard Haldane for sale? Something will have to give and it won’t be economic reality or the “cash flow constraint” as Minsky recoognised.

Expectations of future cash flows are the main driving force of offshore asset transactions at the moment (as opposed to “valuations”) not concerns over lack of supply (so 2014) or the ease of selling the asset to someone else (so 2013). Barring a major change in demand therefore expect asset values to have been permanently impaired and wait for the auditors to start calling time as liquidity needs continue to strain companies that have made it this far despite the hoped for Great Expectations of the 2015/16 investment class.

BOA and Volstad: End of a Norwegian era… More restructurings to come…

The best of men cannot suspend their fate: The good die early and the bad die late.

DANIEL DEFOE, Character of the late Dr. S. Annesley

Boa Offshore and Volstad Maritime are both involved in restructuring talks at the moment, both are bound by the same ties of market fate and financial commitments: excessive leverage, financial speculation, and a secular change in demand for the asset base that underpinned the bonds. On a wider scale these should be seen as examples of small Norwegian companies that rode an oil and credit wave that has now definitely ended and their place in the market will remain limited at best and in the Boa case is likely to be non-existent.

The excessive leverage isn’t simply a case of hindsight: again like the Bibby bonds these were depreciating assets backed by bonds that required no repayment during the life of the instrument. Capital assets that do not have to earn a return on their principal but rather rely on further refinancing are simply speculation by both parties to the transaction and are clearly indicative of a credit bubble. Such investments are what Minsky called Ponzi financing, it requires a suspension of belief from economic reality that such a situation can continue, and that interest payments can be met by constantly drawing on an increased capital value. In the offshore oil services world this wasn’t willfully disregardng the evidence but rather the industry belief that ever rising oil prices and demand side factors were immutable forces of nature. The failure to recognise that in the long-run this would cause some innovative firms to seek new solutions is one of the great enduring mental models that has led previous generations to believe fervently in ‘peak oil’.

The other similarity is the type of vessels both Boa and Volstad have backed: no other asset class in offshore has been as overbuilt as the large OCV (~250t crane, 1000m2+ back deck etc). Potential new investors in Volstad should look at how illiquid the Boa Deep C and Boa Sub C are: bondholders are looking at a liquidity issue because these assets are in all reality unsellable at any price at the moment. When the Volstad vessel charters finish their maximum upside is surely capped to the amount bondholders in comparable assets are willing to accept to supply vessels to Helix-Canyon… and that is surely lower than their current charters? And that would assume Helix need as many vessels, a bold asumption looking at their utilisation record. In the old offshore such assets were rare and expensive… now not so much…

Part of the clue to the lack of sales in the OSV market is not just in the demand side of the market it also lies in the behaviour of banks. Have a look at DVB (my previous thoughts on the bank here), lending to offshore was running at c. USD 2-3bn per annum in 2010 to 2014:

DVB lending by segment 2010-2014.png

Welcome to the world of The New Offshore and closed loan books as the DVB investor presentation (2017) shows:

DVB New Transport Business 2017

That isn’t DVB specific this is a relfection of all banks in the market and a total withdrawal of asset financing. No matter what the relationship bankers tell you to all but the most exceptional cases the loan book is closed for offshore assets in all banks (apart from US focused companies with a US revenue base and a US bank). And no one pays close to historical value for such specialised assets if you cannot get a loan, but this has become a self-referential cycle that will be very hard to break, and in reality will only be done so as part of an overall consolidation play by a player with a realistic financing structure relative to the market risk.

Volstad Maritime may have a viable business going forward (i.e. strategy and execution capability) based solely on the Helix-Canyon charters, but liquidity is a different issue. The fate of the Bibby Topaz remains a major area of interest as the vessel is part of a three boat high-yeild bond and the owners of the bond have in effect an option to take full control of the Topaz. The bond has a corporate guarantee from Volstad Maritime AS that adds to the complications. OTC bonds are a grey area but rumours abound of Alchemy (the core M2 investor), other funds, and industrial players all having positions in the bond. Bibby Offshore may well be delaying their restructuring announcement until the position of Volstad Maritime and the Topaz is clear (although if they can make it to September without legally overtrading handing back an Olympic vessel is also likely an announcement time). A seperation of the Helix chartered vessels could be a viable option but only if the corporate Volstad corporate guarantee can be squared with the bond owners (who also own the m/v Tau on charter to DeepOcean but must surely been seen as effectively worthless, and the Geco Bluefin (in lay-up?)).

The Boa bondholders and banks seem to be repeating the same mistake the Harkand/Nor bondholders have consistently made: confusing a permanent impairment in asset values for a temporary market dislocation. In fact the Boa OCV bond term sheet contains the following nugget:

the aggregate current market value of the vessels according to information provided by the Group prior to the date of this Term Sheet is NOK 810,000,000

No sane individual believes that you could get USD 95.7m for the Boa Deep C and Boa Sub C at the moment:  2 vessels that have to enter lay-up because there is no work for them and assets that no bank that would lend against. There is a nice gap in the documentation here where the advisers to Boa state they have not undertaken due diligence of any information supplied. Everyone here wants to believe something everyone knows not to be true.

The structure calls for the seperation of the various asset classes into their individual vessel type exposures and is in effect a wait-and-pray strategy. Bondholders pay a “Newco” management company a fee to manage the vessels and provision is made for a further liquidity issue. I sound like a broken record here but the longer everyone keeps providing further liquidity the further any supplyside recovery becomes. The Sub C and Deep C are very nice vessels but two vessels does not an operator make in the current market, all this set-up does is support latent capacity, like the North Sea PSV market, that keeps everyone bidding at OpEx levels only. Hope is not a strategy.

I don’t have any magic answers here beyond investors accepting the economic reality of their position which they are under no obligation to do. The Boa bondholders, like the Harkand bondholders, and others, figure they have lost so much what harm can one last roll of the dice do I suspect? For those of you who have seen the movie ‘A Beautiful Mind’ you may recognise this as a problem that is a case of Nash Equilibrium:

a solution to a non-cooperative game where players, knowing the playing strategies of their opponents, have no incentive to change their strategy

It drove Nash to a nervous breakdown (literally) and I have no intention therefore of taking this any further.

The New Offshore: Liquidity, Strategy, Execution. Nothing else matters.

Shale, mental models, strategic change, renewal, and railways…

“In other words the problem that is usually being visualised is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them………However, it is still competition within a rigid pattern of invariant conditions, methods of production and forms of industrial organization in particular, that practically monopolizes attention. But in capitalist reality as distinguished from the textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization….”

(Schumpeter, 1943, p. 84.)

On a day when the oil price dropped to its lowest point in seven months Bloomberg reported that:

There’s yet another concern growing as oil prices continue to erode: A record U.S. fracklog.

There were 5,946 drilled-but-uncompleted wells in the nation’s oilfields at the end of May, the most in at least three years, according to estimates by the U.S. Energy Information Administration. In the last month alone, explorers drilled 125 more wells in the Permian Basin than they would open. That represents about 96,000 barrels a day of output hovering over the market.

Yesterday Energen, a US shale E&P company, reported numbers yesterday with increasing productivity of “Gen 3” fracking:

Energen Wells with Gen 3 Fracs Outperforming

In central Midland Basin, cumulative production of 5 new Wolfcamp A and B wells averaging ≈15% above the high‐end, 1.3 MMBOE EUR type curve for a 10,000’ lateral (77% oil) at 75 days. Cumulative production of 2 new Wolfcamp A and B wells with 80 days of production history in Delaware Basin averaging ≈80% above the high‐end, 2.0 MMBOE EUR type curve for a 10,000’ lateral (61% oil).

If you don’t understand the implication of the text above for offshore they have a handy graph that makes it abundantly clear:

Energen 3G Frac Performance.png

This is simply a productivity game now as I have said before.  Yesterday I mentioned the DOF Subsea potential IPO, it’s worth noting that investors could choose between a company that took a bigger asset impairment charge than they made in EBITDA in the subsea projects division, or a company like Energen. When deciding to allocate capital it starts to become an easy decision.

There is a technical and industrial revolution taking place on the plains of the US. Ignoring this won’t make it go away. The Industrial Revolution didn’t happen overnight: steam engines were invented, coal production capacity increased, canals were built, railways invented etc, a series of interlinked innovations occured in a linear and dependent fashion. No one woke up one day and experienced them all. Productivity is a never ending journey. In the Cotton Revolution Kay invented the “Flying Shuttle” (1733), Hargreaves the “Spinning Jenny” (1765), Arkwright the “Water Frame“, (1769), the Crompton Mule (1779) was a combination of the Spinning Jenny and the Water Frame, and Boulton and Watt (1781) invented the condenser steam engine for use in a mill (ad infinitum).

The same thing is happening in shale. Shale won’t come up with a rig that kills deepwater productivity and lower lift costs overnight, but a series of systemic and interdependent innovations that advance the productivity of the sector as a whole is a certainty. That red line above will become steeper and move to the right with irregular monotony now until new technological constraints are reached.

For those of us, and I include myself in this camp, new to the shale productivity revolution Energen included another chart:

EGN Frac Design Evolution.png

And after this will be 4G and 5G… just like mobile phone evolution. Each generation will offer greater productivity than the one before. The image at the top of the page highlights the advances multi-well pad technology has already made to shale.

I am still not convinced everyone in offshore has understood the scale of the change occurring in the industry. I still think some people, particularly banks and those with fixed obligations, are using the 2007/08 years as a frame of reference when a short and sharp drop in demand was followed by a boom. I don’t see that happening this time. Telling people it will change one day isn’t a strategy it’s a hope.

Mental models I think are crucial here. One extraordinarily interesting paper is from Barr, Stimpert, and Huff (1992) who looked at the cognitive change managers underwent to successfully renew an organisation in light of externally driven change. (This is actually the paper that made me want to become a management consultant, a decision I quickly regretted I hasten to add). These researchers basically found two almost identical railroads operating in the same state and compared what happened to them in a longitudinal study spanning 25 years. The mental models of managers were examined by content analysing the annual reports and in particular the comments to shareholders. It is a rare example of a perfect natural control group so rare in social sciences and it’s a brilliant piece of research. The key findings were essentially the managers who were outward focused and changed their strategy accordingly survived while the railroad that went bankrupt always blamed industry factors beyond management control. The analogy to offshore at the moment needs little development.

Barr, Stimpert, & Huff (1992): COGNITIVE CHANGE, STRATEGIC ACTION, AND ORGANIZATIONAL RENEWAL

Barr Stimpert and Huff

BSH found four things mattered, 3 of which are directly related to offshore at the moment:

  1. Renewal requires a change in mental models
  2. A munificient environment may confirm outdated mental models
  3. Changes in the environment may not be noticed because they are not central to existing models
  4. Delays in the succession of mental models may be due to the time required for learning.

I’d argue there was another factor present in offshore that is the commitment to fixed assets and the associated liability structure makes it impossible to change the core business model even if the need for change is realised. Very little can be done outside a restructuring event in that case, although it is likely to actively influence management mental models.

Offshore will survive and prosper as an industry but it won’t be a reincarnation of the 2013/14 offshore. A new and different industry with a vastly different capital structure and strategic option set will appear I would suggest.

DOF Subsea IPO looks like a market bellweather of what financial investors believe…

Successful investing is anticipating the anticipations of others.

John Maynard Keynes

I was always sceptical of the DOF Subsea IPO, any subsea company raising capital at the moment would need an exceptional value story and this never offered that. I saw it as insiders selling out aware of how the future could look, so news that it was canned doesn’t come as a huge surprise. First Reserve wanted out but not at any price, and so the IPO was pulled. Let’s be clear this wasn’t a casual conversation, bankers will have had sounding out conversations with key investors who either gave a steadfast refusal, or said they would only buy it really cheap. The investment narrative is moving to shale in financial hubs at the moment, no one is paying full price for assets at the moment, and as the numbers make clear this is an asset business. The DOF Subsea Q1 numbers also make really clear that talk of a recovery at the moment just isn’t substantive.

DOF Subsea is a good company, and they are strong in Brazil and Norway which strategically is as good as it gets in macro terms for offshore, but they simply cannot be immune to the enormous retraction in demand the industry is experiencing. DOF Subsea also has the DOF problem which they blithely dismiss but which no one can get past: are they a contractors’ contractor or a contractor? As the industry consolidates it is increasingly hard to see someone being able to be both. It is also hard to believe that when all the flexlay vessels come off contract with Petrobras they will be employed at anything like the current rate creating a huge residual value issue on entry for stockholders (unless they were relying on the greater fool theory).

A quick look at at the Q1 results shows why the IPO was always going to be tricky:

DOF Subsea Utilisation Q1 2017

Despite what the Ops guys try and tell you about the boat stuff being black magic voodoo knowledge that simple people can’t understand subsea (and offshore supply) is a utilisation business, just like a hotel. Even at the top end of projects the value added by the marine delivery assets outstrips all the other costs of the SURF installations and therefore the performance of the vessels dictates the cost base and obviously the financial results of offshore contractors. Offshore contractors have high fixed costs on a depreciating asset base, vessel days are “disposable inventory” that if not sold have a set cost. Given DOF Subsea only have 1 chartered vessel so fleet utilisation shown above is clearly declining massively. This dropped straight to the bottom line:

DOF Subsea Q1 2017 EBITDA

It is a really simple business model: when the ships work you make money. DOF Subsea has a load of liquidity and has no immediate issues, but if anything goes wrong in Brazil then there is a massive problem. Petrobras are too long on flexlay capability and are unlikely to simply get rid of Subsea 7 only.

Despite the name and it’s ambitions DOF Subsea is still essentially a supply company:

DOF Subsea EBITDA Segment

Project accounting is notoriously complicated but in short in the six months from Oct 16 to Mar 17 DOF Subsea turned over NOK 1.5bn in subsea project delivery and made only NOK 96m EBITDA (as a rough cash proxy). The cash conversion rate is down substantially from 2016, whereas chartering vessels, by far the vast majority of EBITDA on a smaller number of vessels, drops with remarkable efficiency to EBITDA (c.80%).

I am always perplexed then to read comments like this:

DOF Subsea AS (“DOF Subsea”) and its shareholders have decided to start reviewing the opportunity for DOF Subsea to apply for a listing on Oslo Stock Exchange.
Proceeds from the primary issuance will provide flexibility for DOF Subsea to decisively pursue further organic and strategic growth opportunities and enhance the Company’s competitive position ahead of an anticipated market recovery.
You would think announcing numbers like the above you would want a better explanation before just casually dropping in a market recovery story/theory. Maybe even a data point or two? But no… straight in with this:
The Board of Directors is disappointed with the financial numbers for 1st quarter of 2017, especially with the performance in the North America region and the high number of vessels facing idle time between projects and downtime due to maintenance.
The real problem would appear to be believing that subsea vessels now have different economic drivers to offshore supply vessels. Maybe DOF would be better of just combining with DOF Subsea and accepting its all about scale now? Subsea vessels used to command a premium but not for the foreseeable future, a point bizzarely HugeStadSea have implicity accepted. I note that no ROV information is provided at all. Everyone in the ROV space is complaining about pricing pressure and with 69 systems DOF Subsea are a big player, you can read into that blank what you want.
At some point not everyone can benefit from this increasingly distant, and potentially mythical, recovery. With the amount of tonnage delivered a demand side recovery will also not translate directly into a supply side boom.  Investors paying full price for assets that were ordered for a different era are a rare breed at the moment as it is hard to argue that asset values have not been permanently impaired. Whether this is structural or cyclical downturn is for individual investors to decide (I saw an email last Friday from  the senior management at one offshore company stressing again the fervent hope that the market would turn eventually), clearly in this case investors decided they needed to see a different set of numbers.

Productivity breakeven reduction versus over supply driven cost reduction

Great graph from Rystad today showing how productivity improvements are driving a reduction in tight oil and offshore. I do however think it worth noting that this is a productivity driven cost reduction whereas in offshore it would appear that much of the cost reduction simply reflects equity that has been wiped out and contractors supplying assets at OpEx levels or below. My thoughts on Baumol productivity remain valid.

It is interesting though that offshore deepwater costs seem to move in a linear fashion with demand, as does offshore midwater. The reasons for the decline in offshore shelf breakeven costs would be interesting to explore.