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.

Backlog, boats, and oligopolies…

“[E]conomists usually assume that people know how the economy works. This is a bit strange since economists don’t even know how the economy works”. …

Xavier Gabaix

There was a lot of talk about Subsea 7 ordering a new pipelay vessel last week, and given the engineering quality at Subsea 7 I am sure it will be an efficient, if not technically brilliant, asset. I don’t have a counter-opinion on this: Subsea 7 shareholders expect them to be a market leader and this means buying assets, particularly when yard prices are likely to be advantageous.  The plan would seem to try and push the technical window of pipelay even further and make it harder for smaller tier two contractors to offer a competitive product with such technical features as heated pipe-in-pipe.

As a replacement for the erstwhile Navica it will ensure a leading edge capability. The Navica was built in 1999 so Subsea 7 had 16 good years out of her and  for a number of years Technip and Subsea 7 offered the only realistic reel lay in the North Sea, and I would say the vessel made real money for the shareholders from 2004 onwards (especially when considering the huge number of DSV days she generated) until 2014. Subsea 7 depreciates vessels between 10-25 years and I wonder what the figure is for pipelay assets?  If the pace of innovation in the pipe technology is such that you need a new vessel as a platform every few years then the economics would dictate a slow diffusion of pipe technology (I don’t think it’s likely).

At USD~300m it is not a massive purchase for Subsea 7 either. In 2017, in the midst of the worst industry crisis ever, Subsea 7 made a special dividend of USD 191m, and this vessel is 3 years away from the take-out payment (and could probably be pushed back if needed). The interesting thing is given the delivery time how Subsea 7 see the market coming back… because its not in the backlog. In 2013 Subsea 7 published their backlog as USD 11.8bn:

Subsea 7 Backlog Q4 13

Strangely, for the last few quarters the bar graph has been dropped in favour of the pie graph and the number is materially smaller:

Subsea 7 Backlog June 2017.png

That USD 4.4bn also includes ~USD 1.4bn for the PLSVs in Brazil. Now to be fair when Subsea 7 had backlog of USD 11bn it had six vessels under construction and was targeting CapEx of ~USD 1bn, 60% on new builds and 25% on replacement CapEx. As the order book at Subsea 7 has dropped so has CapEx pretty much proportionately. It is also interesting that they can cut maintenance CapEx back so much with guidance for total CapEx this year guided in at USD 180-220m. Yes, it’s a lot less than Depreciation, but as the industry contracts this is going to become more normal, the asset base has to shrink to reflect the total macro demand.

However, I think you can get a sense of Subsea 7 managements’ confidence in the future from this graph in their 2016 annual report:

Subsea 7 Outlook Feb 17

2014-2018 look like lean years with the tap opening up in 2018. The sceptic in me always looks at the variability of the grey box (USD/bbl 40-60) and thinks the longer market sentiment remains negative the less likely this segment is likely to fulfill its potential, because the baseload of offshore projects at USD 40 is depressingly small. But if Subsea 7 shareholders expect their company to be a market leader, and if the market is moving to longer tie-ins with heated pipe, then that is the direction the company must go. What is interesting, and will be impossible to tell for outsiders initially, is how they price this in the market? If they only have 10 years to get a return on the investment the project day rate will have to be substantially higher than if it’s a 20 year investment.

You can make a bear case for Subsea 7 being too long on pipelay capacity in Brazil and for it going too early with this vessel if the recovery doesn’t come, otherwise they have arguably handled and read the downturn better than anyone. But I guess what the management really don’t want is a company that doesn’t have the asset base if the market comes back and this is only balanced against the very high cost base vessels have if they don’t work.  Again in the latest SS7 presentation they showed this market data which would give the Management/Board the confidence to invest:

Subsea market outlook Sep 2017

Subsea 7 have the liquidity to make it through to a forecast upturn and other shareholders will have the confidence they are following on the back of Siem Industries,  who have been remarkably honest about the problems they face at Siem Offshore and their commodity tonnage.

I think it likely that at the top end of SURF FMC Technip, Saipem, Subsea 7 and McDermott pull away from the other companies and create a small pool of competitors who bid for projects offshore globally that only they can realistically do given the technical sophitication and asset base required for delivery. A large number of the tier two installation contractors are no more (Swiber, EMAS Chiyoda, SeaTrucks), so the bigger contractors should gain market share on some of the more basic installations and offer a host of technical capabilities that will make it impossible for smaller companies to compete on the larger projects.

Therefore the question is whether a small number of firms bid each other out of profits or whether they create economic value? I think you can make a bull case for Subsea 7, and the other large integrated SURF contractors, based on theories of market power and argue that this is a case where if they can push the technical and asset window enough they will generate significant economic profits, and this vessel order needs to be seen in that light. This isn’t true for every segment in the subsea market and is unique to the financial strength and product breadth the large integrated contractors have.

Markets with a small number of selling firms who are in a strong position are known as oligopolies. These market structures have fascinated economists for years because of the potential for collusion and price setting (as well as the failure of the firm profits to decline over time as classical theory would suggest). But two theories, based on French mathemeticians (who looked at a spring water duopoly) allow some insight into how the SURF companies will behave in the future: Bertrand competition, which argues that companies in this position would sell on price; or Cournot competition, which argues that companies in this position maximise sales and ultimately profitability.

In a much longer post (for another day and likely of limited interest) I will argue that this likely oligopoly of large SURF contractors will compete on a Cournot model, and therefore these firms are likely to make significant economic profits, despite the capital intensity of the industry. Cournot models are defined by:

  • [M]ore than one firm and all firms produce a homogeneous product, i.e. there is no product differentiation;
  • Firms do not cooperate, i.e. there is no collusion;
  • Firms have market power, i.e. each firm’s output decision affects the good’s price;
  • The number of firms is fixed;
  • Firms compete in quantities, and choose quantities simultaneously;
  • The firms are economically rational and act strategically, usually seeking to maximize profit given their competitors’ decisions.

The high-end SURF market is a clear case of this: a relatively small number of firms (n=4 maybe n=7 in some cases) and specialised asset base, well known to competitors and easily monitored, allows firms to understand well what there rivals are doing. For game theorists it is a market made in heaven where the signalling intentions of all parties are obvious. From an E&P perspective, when you cut through the enginering voodoo language, the product is homogenous: it takes oil from a well to a transfer point. Firms will not irrationally bid down project margins constantly as they are aware of the competitive effect of doing this (which is different from when EMAS Chiyoda and other pretenders were in existence), and in reality the high-end SURF firms are well aware what projects suit their asset base and are “must win” projects. The network of alliances, and integrated solutions from the seabed, cannot be easily replicated but are not so different in technical terms that competitors cannot make intelligent judgements about a competitors cost base.

Each firms output decision will affect price because the large step increase in investment required for new capacity will make these companies more cautious is a more depressed market. The quantity theory of output is likely the least intuitive part of the theory for subsea but in essence firms will limit the supply of new vessels and concentrate on utilisation. The big four SURF contractors will only add vessel capacity when it generates profits well above capital costs – which simply hasn’t been true in the past. Over time as the new build wave subsides the firms will choose to limit the supply and focus on cash which will drive up rates (above marginal cost). This is different from a bank enforced asset freeze I have mentioned before as these companies are large enough to access asset funding.

For the tier 2 companies and vessel owners below my depressing tone of poor margins and over capacity will continue for some time I guess. But technical innovation and high CapEx, with mildly increasing demand, should allow the top SURF contractors to exercise a degree of non-collusive pricing power that will generate real economic profits in the not too distant future. These firms will take market share in the more commoditised (and shallow) field development market and face limited competition for high-end field development work which is a growing segment of the market (hence Subsea 7’s move into the Gulf of Mexico in a big way with the EMASC assets).

So despite a generally depressed industry it is easy to imagine the high-end SURF firms prospering to a certain extent. Brazil is the country however that hangs over Subsea 7 and to a lesser extent FMC Technip (and I wonder if it really sank the DOF Subsea IPO): too much flexlay capacity. It’s very hard to see how much capacity Petrobras is going to give back, but a look at tree awards suggests a degree of discomfort for the vessel owners.With one dominant customer the downside is clearly and intense period of price competition between FMC Technip and Subsea 7 in Brazil to keep their assets working. This is a classic example of Betrand competition where two firms who offer an identical product, and cannot collude, find the buyer chooses everything from the firm with the lowest price. Such a statement seems vaguely tautological but in economic terms it is more about a formal proof that two firms can push industry margins down to zero economic profits as efficiently as a large number of firms competing.

Note: For Saipem I am talking SURF only. At a corporate level I don’t see any respite for them).

(P.S. The header pictire is of a “Kinked” demand curve which is core to the oligopoly model.)

 

 

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).

The Carnegie Triple, Transaction Costs, and offshore economics

Any problem that can be posed directly or indirectly as a contracting problem is usefully investigated in transaction cost economizing terms…

Williamson, 1985

From my earliest involvement in the offshore industry, the framing device I have always looked at to understand issues is transaction cost economics, a branch of economics that originated in the seemingly mundane question “Why are firms different?”. The question sounds innocuous because it seems so obvious that they are, but neo-classical economics, in particular, sought to argue that all humans are rational actors, and therefore if they all saw the same opportunities all firms would make the same decisions, and the world would be awash with homogenous firms and products, all priced at the same level: utopian perfect competition.

Of course, the world isn’t like that, blatantly there are many different firms and business models, all supplying similar products. The first person to really tackle this (although this is a little unfair on Knight) was Ronald Coase, who earned himself a Nobel prize for the privilege of putting forth an argument based on transaction costs economics (“TCE”): simply put if it was cheaper for the firm to do something internally it would do it, if it was more expensive it would outsource. This might seem tautological now but in 1937 it was a serious advance in knowledge and the full article is an exercise in eloquence an insight that my few words can not do justice to here.  The field was later developed further, by interdisciplinary scholars, particularly Oliver Williamson, who gives a very good introduction here (and I especially like the Carnegie Triple as a philosophy.)

The reason it is so relevant to offshore is because a large part of the contribution in transaction costs research came from legal scholars:

The study of governance also appeals to bounded rationality, but the main lesson for the science of contract is different: all complex contracts are unavoidably incomplete, on which account the parties will be confronted with the need to adapt to unanticipated disturbances that arise by reason of gaps, errors, and omissions in the original contract.

Williamson, 2007 (emphasis added)

The above is torturously obvious to anyone who has sat through a project engineer and an opposing client rep trying to explain why the other is to blame for a project overrun.

Asset specificity, which I often mention here has its origins in Coase and Williamson:

Williamson (1975, 1985, 1986) argued that transaction-specific assets are non-redeployable physical and human investments that are specialized and unique to a task…

Like diving or pipelay for example… I was always fascinated that there was a spot market for DSVs in Asia, but not one in the North Sea? Another intriguing conundrum was why Toisa only chartered DSVs by Bibby and others were saturation dive contractors? Offshore construction and maintenance is a contracting business, it involves agency issues and internal organisation questions about efficiency because of its short-and-long run nature. It is almost the perfect textbook example to delve into to understand industrial organisation.

But I digress… the big one that got me was pipelay. Every single company with a pipelay spread was fully vertically integrated and there is no spot market for pipelay vessels (the same isn’t true for barges and work that can be done with a modular spread that were far less common in 2005). And then I started to negotiate a JV between a DSV company and a pipelay company… On paper a good idea between two companies, one turns up and drops the pipe and the other turns up and ties it in… everyone goes home for tea and biscuits after making a ton of money: the DSV company can avoid shelling out on a pipelay vessel it knows nothing about, and the pipelay company can save themselves $120m (in those days) on a DSV…

In theory sound. But the problem comes when you look at the actual costs and coordination problems (where inefficiency in knowledge lowers returns to everyone participating). What happens if the pipelay vessel is late to the worksite? What happens if it lays at a slower speed than budgeted (yet all construction jobs are lump-sum)? What happens if they buckle the pipe? And the same set of issues worry the pipelay guys about the DSV… what happens if the bell-runs are too slow? What happens if they are late and the joint bid suffers from liquidated damages? If they damage the pipe who pays for the pipelay vessel to return and lay the new pipe? The beauty of transaction cost theory is it recognises that if you wanted to you could solve all these problems contractually. But on a risk-weighted basis it is simply easier to internalise these and other coordination issues and make them one firm. It is simply a more efficient form of organisation and both customers and shareholders are happier. Hence Subsea 7, Technip, McDermott, Saipem, and briefly EMAS Chiyoda, were all long the assets that made up the majority of the value of a construction job and brought in DSVs at the margin. They either owned them or just contracted them in. (There is another theory about why business models coalesce buried in institutional theory but I’ll save that for another day).

 

Williamson made a major contribution as well through what he calls “the fundamental transformation”. Space precludes a deep discussion about this, but essentially he argues that there is a change from “thick markets” at contract selection (i.e. lots of choice) to “bilateral dependency” at contract execution. If ever an idea summed up the implicit nature of the complexity of an offshore project to me this is it. I am no disciple of Williamson, I am not sure he and the Great Man would have agreed on a lot, but in the offshore construction industry, he has described it perfectly.

I am constantly reminded of this at the moment because in an industry downturn people are trying to put together solutions that are not economically efficient but operationally can be done. Yes, all the problems can be solved with all manner of subcontractors, suppliers, and different vessels, but really, is it needed? Is is sustainable?

A good example, and I need to stop going on about it, is EMAS Chiyoda and the Lewek ExpressI wrote here about why I don’t think there is a long-term solution other than a liquidation, but to add to this point is that even in addition to the capital issues (which are vast an insurmountable) one of the problems is the owners (lenders) of that vessel are either in for a full contracting company or nothing. There is no charter market for the Lewek Express. No one contracts with an oil company to deliver 20″ pipe at 2000m meters below sea level and then hires the vessel in with all the attendant risks (only a few I have mentioned above for demonstration purposes). It’s not that it’s just not sensible it’s not even sane!

The banks/lenders can’t hope that they grab a few of these vessels and park them up at Loyang and charter them out to other contractors for a few hundred thousand a day to cover their costs until the market picks up. There is no market for these assets on a charter basis, even if the other contractors were short on capacity (which they are not). And unlike CDOs from a mortgage market crash the OpEx/CapEx ratio is painful in the extreme.

So the banks and other creditors either fund a fully new offshore contractor or they sell the assets at a loss. You can’t be half pregnant, and you can’t charter a ship when no one wants to charter one, or the only people who will logic would argue are going to lose money. Unless of course you do it so cheaply it is cheaper for them to do it externally, but that rate will be so low only the other party will win (this is an asymmetric information problem and won Akerlof a Nobel prize for used cars and lemons) which is self-defeating.

Subsea 7 has a market cap of c. 5.2bn, McDermott 1.6bn, Sapiem 4.0bn. You get the idea. The banks and lenders are either funding a new EZRA/EMAS to compete against these types of companies, vertically integrated with appropriate transaction cost business models and equity buffers, or they invent a way to compete against them by virtue of having had a ship redelivered. It’s just not serious.

I have said this a lot before, but it has never been truer in offshore: just because something cost a lot to build doesn’t make it valuable.

EZRA fate depends on more than debt write off… it would need significant capital

“Don’t cry because it’s over, smile because it happened.” 

– Dr Suess

An update on the EZRA situation in the Straits Times this morning deals with one part of the EZRA problem:

Much of the company’s fate now hinges on the willingness of its creditors, including bondholders, to write off – whether partially or in full – its massive debt.

Which is true as I have said many times before here, but this would be nowhere near enough. What EZRA would need in addition to a massive debt writedown is a gargantuan injection of equity to fund the company through until profitability. I don’t what the exact number would be, but it is in the tens of millions, and I suspect that number is scaring the banks now. It would also need a completely new leadership team, but I will treat that as a given.

As the article rightly points out the banks exposure is to the high-end vessels like the Lewek Constellation. An engineering marvel it may be, a liquid asset that could be sold at anything like book value, it is not. I often talk here about asset specificity, which the offshore industry and their financial providers spectacularly mispriced in the last boom, but the Lewek Constellation is also an example of a complementary asset: the return on the asset increases the marginal return to another (or its owner). In the hands of a contractor wanting to do deepwater pipelay it’s a very valuable asset, but the reverse is also true, without the right owner such a specific asset is actually close to valueless. Intuitively we know this to be right about the Lewek Constellation, there is nothing else that can be done with that vessel without enormously expensive modifications. Banks should have had a much lower loan-to-value ratio on the vessel, in effect it was a project that was entirely equity risk should it go wrong, because even to hold it at port costs ~USD 15k per day, and it will take months to sell at a fraction of its build cost (unless Subsea 7 are silly enough to buy it) as the Ceona Amazon did.

There was a straight asymmetric payoff for EZRA shareholders here where they put up a fraction of the value of such a complex asset and received all the benefits if it worked and the banks were left holding an unsellable asset with high running costs if it didn’t. It is also clear, and this should be a warning to anyone thinking of funding this, that EZRA massively underestimated how long it would take the vessel to get decent utilisation, and therefore how much capital would be required to fund the roll-out of the Lewek Constellation. A new contractor could realistically only hope to win one or two jobs a year with such a new specialised asset, the EZRA equity holders would have had to accept dramatically lower utilisation than anyone else, and therefore lower immediate payouts (dividends), for the prospect of a higher value firm in the future (if you were following MM theory). But that is equity risk and it is clearly a big number when funding a deepwater pipelay asset to challenge the world’s industry leaders.

But the banks behind EZRA have a choice: accept the loss now, or risk putting millions more in working capital into the venture in the hope that the asset values will increase enough, and the company can repay even more money in the future. Both are really bad options in the current market. Any new equity investor not already exposed to this company would demand market prices for the assets, which doesn’t help the banks at all, but to take an equity position (whatever for the semantic legal definition the capital injection took) to dig themselves out of a very deep hole is a real problem for banks. Equity risk has to be reserved at almost a 1:1 ratio under capital adequacy provisions at the moment, and for good reason: no one can tell when this market is coming back, and indeed if it will ever come back like before.

And even if the market turns a reconstituted EZRA would be competing against Technip, Subsea 7, McDermott, and maybe, longer-term, Saipem (for another blog day). This new company would require sufficient capital to convince the Board of any potential customers that they were the right partner for a large, strategically important, complex offshore field development that would cost in the tens-to-hundreds of millions of dollars. I don’t see anyone taking them up on such a remarkably unattractive offer, in this market, with a surplus of good assets and contractor capacity, you would be mad to willingly choose EZRA as your offshore development partner. All engineering and procurement work for long-term projects is effectively contractor specific and exposes potential E&P customers to becoming unsecured creditors should the new EZRA fail, so it would need a fortress-like balance sheet to convince people they will be here next year, or the year after, but would you hand over a key strategic project to a contractor who has just come out of Chap 11 and defaulted on a large number of people throughout the supply chain? I just don’t see it.

In addition, it would appear that the Norwegian arm is to be liquidated and contracting on this scale only works as a global operation. There is simply no industrial logic for a recapitalised EZRA.

If the banks want a lesson in how expensive a strategy of providing working capital in a depressed offshore market can be they need look no further than Nor Offshore and their two DSVs parked at Blyth. Having raised USD 15m last November, and making a big deal about how much financial flexibility this gave them, they now look certain to have to raise funds again at the end of this year as the entire amount will have been spent on working capital without any work being generated in 2017 (remarkably like 2016 for them).

Nor are desperately hoping that their combined bid with Oceaneering for the BP Trinidad work will come to them. I don’t see it. Bibby have the Bibby Sapphire in the Gulf, know the worksite etc. DOF have the DOF Achiever in the region as well. Would BP really bring a new DSV, with a new crew, that hasn’t dived in a year, and put it into a complex and tidal worksite? I rate their chances at less than 5% (and on a rational basis 0%). Unless Oceaneering has a remarkable relationship with someone at BP I don’t see it happening: at the end of the day a DSV puts people on the seabed and someone at BP would be accepting that if anything went wrong from a safety perspective they had taken a very risky option. And given the market BP would not save any money in doing something so risky. BP need the work done and they need it done safely.  Sure BP, try and get the price down, but who would risk their job to take such a decision? Safety first in everything we do right?

And even if Nor/Oceaneering won the work it’s a 20-25 day transit, 400k on fuel (which BP won’t pay for), and then sea trials, bell run trials etc. Madness. The Nor bondholders will be going backwards in cash flow terms given current day rates at OpEx only, just to get the boat moved. So they will be raising money at the end of the year, or selling the vessels for a lot less than they had hoped, when they raised the USD 15m last year. It is literally locked in because they have no other work and no hope of recovering their liquidity position given the market and their position in it.

Such a situation is magnified a hundred times for the banks involved in EZRA. Someone senior would have to agree to in effect provide enough working capital for at least 24 months to prove they were going to make it through, potentially offer refund guarantees against procurement and engineering etc. As Nor has shown there is no guarantee that conditions will improve in time if you simply sit back and watch. And Nor is bidding on short-cycle projects, most of the construction projects EZRA would have to tender take years to come to fruition and the tendering costs, which require vast engineering resources, are extremely expensive (particularly when you are starting with a pipeline of nothing). As I have said before as well there is no proof that EZRA was actually any good at contracting: the BHP project in Trinidad I believe was a significant loss maker, I have had many people tell me the engineering coming out of Singapore was substandard, and I spoke to someone about the work performed in the Med and they couldn’t have been more critical of the work standard. EZRA is a busted flush.

Investors, or potential investors, should remember my favourite maxim of The Great One: markets can remain irrational longer than you can remain solvent (and I am not even sure they are being irrational at the moment). People keep coming up with really complex theories about EZRA and yet I see it really simply: find me a rational investor who would pump hundreds of millions of dollars into a new subsea contracting company at the moment, in an oversupplied and fiercely competitive market, with an uncertain future, and the industry as whole operating at negative economic value? Until you can find this mythical institution there will be no EZRA. The working capital costs of offshore contracting are so high that only a fool backs a business model with no clear path to decent utilisation.

The solution here is clearly for the banks to approach another contractor with a deal that would preserve asset value while taking capacity out the market. Maybe the banks swap the assets for a stake in Ocean Installer? Let Subsea 7 take the specialist vessels for nothing and some warrants? Save face somehow through financial engineering. Because the truth is the assets really are worth collectively hundreds of millions less than book value in the new environment and no one wants to be exposed to the OpEx of them. Pumping a company with a poor industrial strategy and futile market position full of working capital is the last thing the industry needs, and frankly won’t help the organisations that do it in the long-run.

 

How good a deal was the Amazon? Pipelay demand and supply, change at the margin, and dynamic competencies

As all of us were taught, but most of us have long since forgotten, economic change occurs at the margin, where the action takes place… individuals who can think on the margin always have an advantage over those who cannot.”

-Arthur Zeikel

I have seen a lot of press coverage regarding the McDermott/ Amazon deal. The word “steal” has even been used. I’m not convinced. Let’s take the upper limit price of USD 80m. For that you get a big, a really big (200m), ship with enormous deckspace and two 400t cranes. I take it from the McDermott comments that they are ditching the G-lay spread and going for a straight J-lay spread. I don’t know how much of the Huisman system they can raid for the new system, but I bet not much, and a new system is likely to be in the USD 75m-100m range. On that basis they didn’t get the vessel at an 80% discount to new they got the vessel at c.50% to new. But as I said the other day the world is a very different place from when the order was placed, which tautalogically is of course why they got the fire-sale price. But USD 50-80m isn’t scrap value and this vessel has a very high operating cost which is essentially fixed.

As a heavylift vessel it’s clearly cheap. McDermott have enough work in the Gulf and Africa to utilise a mutlipurpose vessel like this, and if the market recovers put a J-lay spread on it, and they will have had a cheap option on a deepwater lay vessel. Over a 30 year period it will have been a good buy, and even if the market doesn’t recover they didn’t overpay, so its clearly a sensible transaction.

But since I got involved in offshore in 2005 no segment of the market has changed more than pipelay. In 2005 there were only two vessels that could lay rigid reel pipe (the Technip Apache and the Seven Navica) with the Acergy Falcon and its ancient S-lay system making up a triumverate of possible lay contractors in the North Sea. Vessels such as the Deep Pioneer roamed the Golden Triangle, but they were more riser installation and Allseas and Heerema were serious forces but only did risers and flowlines. There were a few options for spooled flexibles, but these were a niche product and these vessels could generally perform flexlay more efficiently for anything other than short jobs. And these vessels were essentially global assets that returned to the North Sea over summer after completing projects elsewhere.

Globally it was different, and there were options, but mainly because environmental conditions were different. For example in shallow water  you could use a barge in Asia, UAE, Africa and the US or use more S-Lay. But the bigger specialist vessels were global assets (the Apache went to NZ at about 8 knots once to build the Maui field!) and made a ton of money off a couple of jobs a year and then spent the rest of the year operating in a sub-optimal operational fashion (maybe doing small tie-ins or flexlay) to keep utilisation up an spread the OPEX cost.

Over the past 10 years however no class of asset has been built up more proportionally than pipelay, and for all the work these vessels used to do on a marginal basis there is now at least one (and often more) specialist assets. Not only that, modular spreads from Aquatic, MDL, and others, have become increasingly large and compete with dedicated spreads for small flowlines/risers and all sorts of umilical and cable lay jobs. If you doubt this check out the size of this MDL kit on the North Sea Giant.

This is a really complicated way of saying that there has been a massive increase in the supply of pipelay vessels and just as importantly an increase in the supply of competitive products at the margin which reduce the utilisation potential of said pipelay vessels. This at a time when the demand for their core services has plummeted. Since 2005 Technip has built a new Apache II (a replacement but with the old lay spreadand Deep Energy in addition to the Deep Blue; it also went out and brought Global Industries to get 2 x s-lay vessels to lay even more pipe (2011). In 2013 Deep Orient joined the Technip Asia fleet, in Africa the Skandi Africa (2015), and four vessels for Brazil with 2 more to come to join the Deep Pioneer. The are geographic assets to reflect the combination of flexlay and risers in the region. Subsea 7 has been just as extreme: Seven Oceans (2007), Seven Seas (2008), Seven Waves (2014), Seven Rio (2015), Seven Sun (2016), Seven Cruziero (2016). All 25 year assets on eight year contracts at best.

Yes there are few of the really utlradeepwater lay vessels around, but they all used to do less complicated work to keep up utilisation. At the margins now are the Normand Vision (Ocean Installer), the Normand Maximus (Saipem), and the Lewek Express (presently chartered by EMAS Chiyoda but soon to be owned by the banks and clearly going cheap). Yes, I get it, they all have their niches and can do things differently, but the number of jobs where they have a competitive advanatge on an asset basis is small, whereas the number where they overlap is large… not to mention Allseas and Heerema.

Pipes and risers need to be replaced infrequently and umbilicals perhaps more so. But nothing like construction demand. So if these vessels aren’t working on construction what can you do with them? They make expensive ROV vessels.

In the new world of pipelay, integration with subsea equipment manufacturer is also crucial. Technip-FMC-Heerema, and Subsea 7- Aker are clearly the two strongest alliances. McDermott-Petrofac just isn’t in the same league. A market only needs two serious competitors to keep margins down, three just keeps the pressure on. Meanwhile Saipem and and OI wait in the wings to keep margins down on less complicated jobs. The TechnipFMC and Subsea7/Aker alliances are spending serious money integrating subsea processing equipment with vessels to ensure that offshore installation (and therefore future vessel days used offshore) is reduced materially to lower project cost and execution risk. Again this adds to the capacity problem in the industry.

… and just when you thought I was getting over the bad news there is Brazil. Petrobras is redelivering some of the flex lay vessels it has gone long on. These will have to go somewhere. At the margin they compete with a large heavylift vessel with a modular installation system, despite costing 1.5x as much, these vessels will globally drive installation costs down. I don’t know if the number redelivered will be 2 or 4, worst case maybe 5, but relative the size of the market its a material number.

I get it: these are not comparable to J-Lay work. But few vessels work in J-lay mode for 365 days and they used this sort of work to split the cost base. Now the day-rates for this sort of “ancillary” work will remain low for years. This will drive lay costs down, and encourage projects that would have been marginal, but this will be cold comfort for you had you invested in a lay vessel in 2013 as the financial returns are likely to struggle to keep the debt holders whole.

So while McDermott may have got the vessel for much less than it cost it to build that cost is almost irrelevant. The assets simply don’t generate the cash they used to, or even likely have the potential to, so they must be cheaper to any rational buyer.

The other thing about pipelay that EMAS Chiyoda (“EMASC”) have shown is that not everyone can do pipelay well. McDermott have huge intellectual heritage, and long term are a credible tier 1 contractor, Technip, Subsea 7, Heerema, and Saipem didn’t wake up one day and have the ability to drop Steel Catenary Risers at 3000m: they have followed a path dependent process to develop what economists call dynamic capabilties:

Dynamic capabilities, unlike ordinary capabilities, are idiosyncratic: unique to each company and rooted in the company’s history. They’re captured not just in routines, but in business models that go back decades and that are difficult to imitate. Lynda Gratton and the late Sumantra Ghoshal called them “signature processes.” They are “the way things are done around here.”

It has taken these companies years, trial and error, and organisational learning to ensure that they can profitably and reliably do this, day-in and day-out. I mention this  to highlight that McDermott still has a long and costly process to go through before it can do this. Not only does it need the ship and lay system, it needs systems and processes, it needs to win customers (will the first customer need to be brought?), and in all likelihood it will make a few (affordable) mistakes along the way. Subsea 7, and I am only picking on them here as it has happened to every contractor, lost hundreds of millions on Guara-Lula by underestimating the weather complexity around the final stage of the riser installations in Brazil and the ability of the Seven Waves to perform the hook-up. EMASC are likely to have the dubious honour of never having made money off the Lewek Express for their entire (short) existence. Chances are McDermott will have a few similar issues should it compete in the ultradeep J-Lay segment.

Simply jumping into a market, even an adjacent one, where there are a small number of extremely high risk/ return (and maybe not even that given the competitive dynamics I have outlined above) projects is full of Knightian Uncertainty (i.e. an immeasurable risk). You can de-risk that by buying cheap but I’m not sure that makes it a bargain in terms of risk-adjusted returns.

So McDermott have clearly been smart buyers but very few people actually could credibly put themselves on a path to utilise the vessel and have the balance sheet to do it. If I owned a share on the mortgage of the Lewek Express I would be starting to accept the size of the writedown coming.