Chinese subsea vessels…

Last month COOEC successfully delivered a high spec DSV and IMR further adding capacity to an already depressed market. The only effect is that companies like who used to charter DSVs and IMR vessels in the region have now lost completely the chance for this work and these vessels will be offered at rock bottom rates when they are quiet domestically.

Given that it is cheaper, and will be for some time to charter vessels rather than own them, one wonders why construction on these vessels was started long after this became clear?

A good article here highlights the scale of the subsidies for Chinese shipbuilders and the effect this has had on the industry:

Chinese shipyards.png

Given the conclusion:

[t]his calculation implies that a frequent assertion that China developed shipbuilding to benefit from low freight rates for its trade seems to be unsubstantiated. Indeed, the benefits of subsidies to shipping are minimal. Perhaps instead, the Chinese government is aspiring to externalities for sectors such as steel and defense, or even national pride …

[t]he results of my study suggest that Chinese subsidies dramatically altered the geography of production and countries’ market shares. Although price (and thus consumer) gains are small in the short run, they may grow in the long run as the operating fleet becomes larger.

It is hard not to see this as a move to ensure China moves up the value chain in the production chain for high spec vessels. Not good news for residual values long term I would suggest.

Debt is the problem…

Pacific Radiance announced it was restructuring last week and Harvey Gulf this week. I have talked about the Pacific Radiance situation before and this latest deal just reveals how desperate the banks are to keep some option value alive here. They basically write off $100m and get $120m of new money as working capital… I guess in their situation it’s logical… but it just locks in another cycle of burning newly raised money in Opex and ensures that day rates in Asia will remain depressed.

Eventually, as it is starting to happen in the ROV game, this will end. A good slide here from Tidewater this week highlights the efficiency of US capital markets and the state of denial that exists in Europe and Asia at the lending banks:

OSV net debt.png

The US firms all firmly on the left (well when Hornbeck Chap 11’s anyway) and the Europeans stuck firmly to the right. There is a very limited number of ways this will play out. SolstadFarstad is coming back in early June with it’s DeepSea solution (the photo above was at Karmoy this week, Solstad’s home port) when another excruciating round of write-downs and negotiations will be presented. But nothing sums up the sheer impossibility of SolstadFarstad being a world leading OSV company that than the slide above, and the Herculean financial challenges all the leading European companies face. It is simply not sustainable.

What is an offshore construction vessel worth?

There is an article from Subsea World News here that is sure to have bank risk officers and CFOs choking over their coffee… VesselValues new OCV is launching a new analytics tool for the sector. The ten most valuable vessels in the OCV sector are apparently:

  • Normand Maximus $189m;
  • Fortitude $99 million;
  • Deep Explorer $97 million;
  • Siem Helix 2 $96 million;
  • Seven Kestrel $95 million;
  • Siem Helix 1 $95 million;
  • Island Venture $94 million;
  • Viking Neptun $92 million;
  • Far Sentinel $90 million;
  • Far Sleipner $89 million;

Firstly, look at the depreciation this would imply? As an example the Maximus was delivered in 2016 at a contract price of USD $367m. So in less than 2 years the vessel has dropped about 48% in value. Similarly the two new DSVs the Seven Kestrel and Deep Explorer appear to be worth about 67% of value for a little over two years depreciation.

Secondly, the methodology. I broadly agree with using an economic fundamentals approach to valuation. And I definitely agree that in a future of lower SURF project margins that these assets have a lower price than would have been implied when the vessels were ordered. I have doubts that you can seperate out completely the value of a reel-lay ship like Maximus from the value of the projects it works on but you need to start somewhere. It is clear that SURF projects will have a lower structural margin going forward and logically this must be reflected in a vessel’s value so I agree with the overall idea of what is being said.

There is a spot market for DSVs on the other hand so their value must reflect this as well as the SURF projects market where larger contractors traditionally cross-subsidised their investment in these assets. A 33% reduction in value in two years might well reflect an ongoing structural change in the North Sea DSV market and is consistent with the Nor/Boskalis transactions on an ongoing basis. This adds weight to the fact York have overpaid significantly for Bibby, who would be unable to add any future capacity to the DSV market in the pricing model this would imply and not even be earning enough to justify a replacement asset. Given the Polaris will need a fourth special survey next year, and is operating at below economic value at current market rates, even justifying the cost of the drydock in cash terms on a rational basis is difficult.

Depreciation levels like this imply clearly that the industry needs less capital in it and a supply side reduction to adjust to normal levels. Technip and Subsea 7 are big enough to trade through this and will realise the reality of similar figures internally even if they don’t take a writedown to reflect this. Boskalis looks to have purchased at fair value not bargain value to enter the North Sea DSV market. SolstadFarstad on the hand have major financial issues and Saipem locked into a charter rate for the next 8 years at way above market rates, but with earnings dependent on the current market, will have to admit that while the Maximus might be a project enabler it will also be a significant drag on operational earnings. The VesselsValue number seems to be a fair reflection of what that overall number might look like.

The longer the “offshore recovery” remains illusory the harder it will be for banks, CFOs, and auditors to ignore the reality of some sort of rational, economic value criteria, for offshore assets based on the cash flows the assets can actually generate.

HugeStadSea goes wrong…

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

SolstadFarstad merger prospectus, 2017

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Constellation goes to Saipem…

So Saipem has paid a headline figure of USD 275m to take out the Constellation, but based on this statement I don’t think the Italians handed over that money in cash as this statement makes clear:

The Constellation will be acquired for USD 275 million through the partial utilization of available liquidity. The 2018 Capex and Net debt guidance, as provided on March 6th 2018, did not include this investment. [Emphasis added].

As in they have partially paid for it with cash and got DNB to lend them a ton of money to take it out. A low interest rate and generous payment terms dramatically de-risk this for Saipem and with a bit of inflation could make the purchase price substantially less in real terms.

Yes the price discount doesn’t make it as cheap as McDermott taking out the Amazon, but the financing for that was arranged through Offshore Merchant Partners as a sale-and-leaseback, which is a long way of saying MDR were cash buyers. Boskalis also got a big discount as cash buyers at the high end for one Nor vessel and a short term charter on the other.

But as my original post made clear the banks have still lost a lot of money here, with 2 mortgages of USD 470m originally, but I still think they will be pleased with this. The original Subsea7 deal for the vessel had a purchase option at USD 370m, so the banks have obviously lowered their expectations since then, running costs of USD 15-20k per day tend to have that effect. I had heard the Chinese were trying to buy it for USD ~180m which would have felt really painful. Saipem on the other hand get a tie-back vessel at below the economic cost, stop anyone else getting the asset, and in all likelihood the deal includes a financial package at well below “market” rates (if there is such a thing for an asset like this).

 

Private equity, boatless contractors, and Carillion… The future is in the east…

The death of private equity has been predicted many times before and this recent article is no exception. What is also not in question is that more people than ever are throwing money at private equity and alternative asset providers and that thay are expecting less from them:

“The investors have accepted the idea of lower returns as OK,” said the head of a private equity group. “It used to be that investors would earn 20 per cent net internal rate of returns. Now they are happy with 14 per cent or 15 per cent net internal rate of returns.”

What is not in question as well is that with ever more private equity money looking for returns the risk meter is being dialled up, which in offshore may present opportunities on the services side of the business, but with vessels and rigs, private equity money  will end up leaving the industry I think. An inability to get debt, lack of asset price inflation, and no other buyers for exit will be the core reasons.

Saying the offshore vessel industry is in chronic oversupply is really the same thing as saying there is too much capital in the industry. To rebalance some of this capital will leave via scrapping vessels, but some will also leave as investors can no longer justify holding their positions that require new equity to keep funding operating losses, or they realise they hold something unsellable. The question for the private equity firms in offshore is how they get out of investments where they are long on vessels? First Reserve are clearly doing all they can to get out of DOF Subsea and they have been some of the smartest energy investors around.

At the other end of the spectrum are York Capital and Hitecvision. Both initially backed start-up contracting companies looking to go long on vessels, then the market turned and they changed strategy to be vessel light, and now York have doubled down by buying more vesssels via Bibby. Hitecvision on the other hand have renogtiated with Solstad to reduce their exposure, closed out on Reef Subsea, and have tried to sell OI to MDR but failed.

The link here is how do these companies get out from these investments? The deeply related question is do you need a boat to a contractor? I mean obviously you need a vessel to deliver work offshore, but do you need a vessel under your control 365 via ownership or a time charter to be a contractor? The answer of course is that it depends… but if Asia is any clue to how the North Sea will go, in a situation where construction vessels are commodities, then things will be increasingly difficult for these two investors even as the market picks up. In Asia the reason margins have been structurally lower than the North Sea for years is solely because there were more competitors, and there were more competitors because there was a bigger choice of vessels, and therefore a relatively larger number of project managers who would charter one for a one off project.

But it is clearly the case is that a “boatless” contractor is more a lifestyle business than a serious economic or investable proposition. Without a vessel barriers to entry are low and all the business is really is a project management house charging 10-15% on the PM & Engineering, and then, when the market is good, some margin on the vessel. Such a company has only intangible assets, no intellectual property, can borrow virtually nothing, and its growth options are limited to how many engineers and project resource it is committed to hire. This is what is called a constant returns to scale business: no matter how much capital you throw at it you get back a 10-15% operating profit on the output which increases marginally to scale as the business becomes huge. There is also a fair bit of risk as when the market is weak, like now, and you have to bid lump sum and it runs over, the cost of the vessel is way beyond any margin you made elsewhere. It is exactly the business model of Carillion.

Now that the vessel market for OSVs is oversupplied, once pricing on certain projects gets above a certain level, any number of project management houses are likely to enter the market. In the old days when this wasn’t the case the rewards for going long on chartered (or owned) vessels was immense: as days rates increased annually those on long terms charters got an uptick in the charter rate but still only made 10-15% margin on the PM & Engineering. Now, if you are lucky, you get a 10% markup on the vessel and some operators are askling for direct pricing of the vessel or direct procurement.

There is no better example of this business model than Cecon Contracting (“Cecon”). Now don’t get me wrong Cecon is a great little business, but it is a lifestyle business. By that I mean it is a collection of guys in a shed at Arundel (a lovely shed btw I have been to a few times and they do a nice lunch) who meet at the office, and annually, if they are lucky, do a project in Angola, Tunisia, or some other exotic location. It is a lot like a boys golf weekend with a lot of pre-meets at the pub for planning, followed by the actual trip.  But there is nothing replicable or scaleable about this, and there is no forward order to book so to speak of. There is therefore nothing of value to sell. It’s a great little business for the guys involved, I wish I owned it (although being from NZ I don’t play golf), but it will be a lifestyle business forever. It is worth noting that one of the two projects they did last year one was the seafastening calculations for their own (or really Revers’) partially built vessel to get to cold stack, a project that on the open market would rank in the few tens of thousands (and maybe pay for the golf weekend). But Cecon has no operational shipping assets to speak of in its current incarnation (whereas Rever appears to have an asset in warm stack in Malaysia… like a lot of other people).

The entire asset base according to the Cecon website is a tensioner and stinger. In 2013 when  no one had one you may have been able to profit from the lack of supply with this asset base on the back of a Maersk R class, but the fact Cecon are offering it out for hire now should tell you where the market is at.  The Cecon vessels, ordered by Cecon AS (the original Cecon that went bankrupt), are so far from completion that at current rates of progress they will serve as a replacement for the Polaris when she retires in 10 years

So talk of merging it with Bibby Offshore to “enhance capabilities”, from Bcon to Cecon, just aren’t serious. I haven’t seen the “merger” documents (obviously), but I am assuming the legal form is the Norwegian company buying the assets of the UK Bibby Offshore (maybe it’s the other way I don’t know why though?). The only reason for doing this are either tax (yawn), to engineer some sort of default on creditors of the Bibby Offshore UK company (potentially the T&T tax authorities and US offices), or to obsfucate the investment value in Bibby Offshore (or some combination of all three) as the investors in the transaction work out how to get out of this. Based on Cecon’s published projects for last year in 2014 and 2016 the boys didn’t go golfing at all, and in 2017 a small marginal development (flowline 1 mile, moorings, a buoy, and a riser and one of the larger jobs they have done historically) was the only project. In the low single millions given the client and location I expect. There is no “industrial logic” for such a combination. If you need to merge with 5 guys in a shed in Arundel, with an asset base that consists of a stinger and tensioner, to enhance your capabilities, then you have a big problem.

Hitec’s position with Ocean Installer (“OI”) is no less easy. When it was set-up the relationship with Solstad, and OI’s willingness and ability to go long on vessels, but also the flexible lay systems on these vessels which were also in short supply, was a differentiator. But in addition to the growth in vessel numbers since 2012 there has been a boom in the associated supply of ancillary equipment for vessels, and that includes lay equipment. Companies such as Aquatic and MDL supply systems that were unavailable only a few years ago, and can be mobbed cost effectively on chartered tonnage. I am not saying they are suitable for every job, but the problem is lay spreads used to be used to make a ton of money of some jobs and more marginal money of others, now the some of more marginal jobs have gone for those committed to lay spreads 365 and therefore it is just not as profitable to have lay capability. Hitec/OI took some real equity risk here, and as happens sometimes, it didn’t work out.

Hitec/OI, like DOF Subsea, is a clear tier 2 contractor in every market it operates in, where procurement is all done regionally, and there is no economic benefit to being in all the markets it operates. It needs to pull out of everywhere apart from Norway/UKCS where Statoils’ desire to not get fleeced by Subsea7 and Technip has led it to favour smaller contractors, and just charter its 2 remaining vessels out when not working for OI in the North Sea. Because in every other market it is basically a Cecon without the golf but with a corporate overhead (and Stavanger just doesn’t have the views of Arundel).

The OI problem is the Cecon problem simply of greater scale and potentially of greater losses over the years. The price any rational buyer for OI would pay is surely capped at the cost of assembling a similar group of people, chartering similar assets, and winning some backlog. The “vessel premium” for having gone long assets at the right time is gone and the replacement cost is well below the original assembly cost. Hitecvision’s apparent insistence that OI must stand on its own financially now marks the understanding that this investment is about limiting the loss here rather than a realistic proposition of making money on the deal. Hitecvision had a great business model, where they took smart Norwegian companies international and they picked up an increase in both the multiple on sale and the quantum it was based on, but there is nothing in OI that allows them to do this.

I wouldn’t be surprised to see some combination between OI and BeCon at some point. The problem for Hitec will be taking on the operating losses of BeCon but no doubt the respective owners can convince themselves that two loss-making donkeys can make a thoroughbred… for a short time anyway.

How much more recovery can the industry handle?

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

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

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

Siem Offshore also came out with a loss and said:

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

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

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

DOF Subsea Q4 17

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

DOF Subsea Q4 2017

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

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