Changing of the North Sea guard in Leith…

Pictured this week are two stalwarts of the North Sea subsea market in Leith on their way to be scrapped.

The Seven Navica above has arguably gone earlier than envisaged when she was upgraded in 2014, but her replacement is a global asset for longer tiebacks and pipe-in-pipe projects and it reflects how much offshore development types have changed in a few short years. Not that long ago there were only two options for rigid-reel pipelay in the North Sea (excluding the s-lay Falcon) and that guaranteed Technip and Subsea 7 a substantial business where on they could integrate DSVs and rigid reel, which was the development methodology of choice. Now there are at least five options I can think of, flexibles technology has improved, and UKCS CapEx has shrunk so much the market doesn’t need dedicated assets but rather more flexible global ones.

Whereas this old girl below, caught on the same day, has more than paid for herself over the years and marks the end of what has been a very profitable investment for her owners. Rockwater shows you need to do a lot more than paint a DSV red to make money from it.

Rocky Scrap.JPG

A journey in graphs and capital intensity…

The above graph was taken from a JP Morgan report into the oil price this week. I wouldn’t read too much into the headline, as I have said before in the short-term I think the oil price is a random walk, but it gives you an idea of what a well researched analysis thinks the long term breakeven price is in the 50s. That isn’t my view but it reminded me of this graph from 2013:

Berenberg 2013.png

This is from a report in 2013 that Berenberg Bank published (using Infield as their source). Rystad had a similar one in 2013 (the article is very perceptive in retrospect):

Rystad 2013

The key for me is how far shale has dropped down the cost curve and the fact that this has been driven by productivity improvements while utilisation in the industry has been high (i.e. cost pressure was on the upside not the downside). I would argue a majority of the decrease in offshore costs has come about through over capacity and economic value (debt and equity) being wiped out. Given that many offshore assets are designed for 25 years of operational life this is a real issue.

I was interested to see the Noble/GE link this week with the aim of reducing drilling timing by c. 20%. But surely this points to the future where more planning and onshore data work will lead to less offshore execution time? I thought this was cool:

The Digital Rig solution combines data models from a digital replica of physical assets, known as a digital twin, along with advanced analytics to detect off-standard behavior, providing an early warning to operators to mitigate a problem before it strikes. Thanks to vessel-wide intelligence, personnel both on the vessel or onshore can gain a holistic view of an entire vessel’s health state and the real-time performance of each piece of equipment onboard.

Offshore is going to have to work out how to increase productivity to keep winning projects but a common theme is the need for less capital intensity:

Chevron Corp. is studding the ocean floor with heavy-duty pumping gear as part of an effort to make deepwater oil discoveries competitive with shale.

The idea is to force crude from newly drilled wells in the deepest parts of the Gulf of Mexico to flow through miles and miles of pipe to platforms built a decade or more ago, said Jay Johnson, Chevron’s executive vice president for upstream. By lopping off the billions it would cost to construct each new platform, offshore exploration begins to make economic sense again.

That methodology will use a lot less asset time than a traditional tie-back/FPSO or trunkline solution I am sure. A realistic view of the next offshore cycle requires a recalibration of many mental models I feel.

 

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).

 

Industry consolidation and market power… Is consolidation really the solution?

Last week the creation of a new offshore company was announced: Telford Offshore. I presume financially related to Telford International. The company has purchased the four Jascon vessels for USD 215m and looks to be setting up a UAE/ Africa subsea construction and IMR business. I know one of the guys there and wish them all the best of luck, they are a strong team and seem likely to make it work having both financial backing, local connections, and managerial skill.

From an industry perspective though it is a microcosm of why I think industry profitability will elude those long on vessels for a prolonged period of time without a significant change on the demand side. Telford isn’t taking capacity out of the market, it is merely recapitalising assets at a lower valuation level, and giving them the working capoital to operate, and it will compete with other existing companies for work in the region. That excess capacity competes on price is as close to an iron law as you can get in economics and something everyone in the offshore industry knows intuitively to be true at the moment.

The talk in the industry at the moment is all about consolidation and how that will save everyone… but I don’t see it? Consolidation is only beneficial if it generates maket power and therefore some ability to charge higher prices to E&P companies: A bigger company in-and-of-itself is of no economic benefit unless it can generate economies of scale or scope i.e. a) lower unit costs, or, b) lower integration costs of supplying a range services . At the moment, in both subsea and supply, there is no evidence that this is the case.

The large subsea companies are currently all reporting book-to-bill numbers of less than 1 (apart from maybe McDermott), that means they are burning through work faster than they are replacing it, and this is consistent with the macro numbers. This is happening because the market is contracting in both volume, and especially, value terms. Simply adding another UAE/ West African contractor to the mix will only prolong this problem in the region. Not that it is unique to the region, as the industry grew up until 2014 a host of tier 2 construction companies grew their geographic footprint and asset base as well. Now they are committed to those regions because they have no economic option but to stay. Over time, as all the companies compete against each other for minimal profits, not everyone will be able to afford to replace their asset base, that is how capital will leave the industry and how it will rebalance on the supply side; but when you have gone long on very specific 25 year construction assets it takes a long while!

It is a fundamental tenent of ecoomics that industry profits, outside of firm specific events, is a function of industry concentration. Every person who has done a ‘Porter’s Five Forces’ analysis is actually using a microeconomic model that has a deep intellectual heritage in examining if the structure of markets drives profitabilty. More recent research has highlighted firm specific factors in determining profitability, but market power, firm concentration, normally the result of consolidation, is always crucial. That is why competition authorities focus on market power when looking at whether they should allow transactions that heighten market power to progress: because scale allows firms to drive pricing power.

A normal threshold for competition authorities to get concerned about market power is ~40% market share level for any one company, and often they like to see 3 or more companies in total, below this level it is understood that consumers have options and companies will compete on price to a certain extent. While Technip and Subsea 7 dominate the market for subsea installations they have nothing like that level of market share. Any large project could theoretically go to Saipem, McDermott as well at a minimum, and below large projects an E&P company is spoilt for choice. In other words there is no pricing power at all for offshore contractors, and as all they have all committed to assets with high fixed costs, and low relative marginal costs, vessel days are essentially “disposable inventory” that must be sold or paid for anyway (just like a low-cost airline) and have no other uses.

The scale of consolidation that would have to occur in order to generate any pricing power for the contracting community defies any realistic prospect of execution for the next few years. It will happen, and slowly, but the scale of the change will be enormous, and as it nears its final stages expect the E&P companies to protest vigorously to competition authorities. Instead of the vessel companies and the subsea production system companies getting closer, eventually, the vessel companies will start to be acquired or merge. But until savings in replacement capital can be made, a while away given the huge new building programme we have had in the vessel fleet between 2010 and 2014, then it will not make sense for an acquisition premium/ nil premium merger to unlock these cost savings. One day it will be cheaper, for example, for Subsea 7 to buy the Saipem business than set out on a new build programme (through both cost savings and reduced CapEx)… but we are some way from that point and a long way from the institutions themselves accepting this.

It is even worse in offshore supply. A measure for assessing market power in economics is the Herfindahl-Hirschman Index (also used widely by competition authorities) to assess if markets have concentration levels that would allow their participants to extract excess profits through concentration. I went to calculate this quickly (the math is not difficult) based on this data from Tidewater:

Tidewater scale and scope.png

The US Justice Dept gets concerned if the HHI number comes in at 1500-2500 and is likely to take action if the number is above 2500 and there is a 200 point movement based on anyone transaction. The supply industry has an HHI well below 1000. Bourbon, the largest company with a 6% market share, only has an HHI score of 36! All the named companies on this slide could merge and chances are the DOJ would wave the deals through because it wouldn’t think the enlarged mega company would still have any pricing power (this is a reductio ad absurdum here and clearly a real situation would be more complicated) and would therefore be able to extract excess rents.

Not only that entry costs/barrier in offshore supply are nothing which just dilutes any possible positive effects consolidation could bring: Standard Drilling can buy supply vessels for $12m and park them in a reconstructed North Sea operator and compete against SolstadFarstad and Tidewater? So how does merging all of the PSV assets that makeup HugeStadSea make any difference?

In offshore contracting it is not just construction assets like Telford, a host of ROV companies now don’t need to buy or charter vessels but merely pay on use allowing a host of small companies to enter the industry. ROVOP, M2, Reach, and a host of others have entered the industry and kept capacity (or potential capacity) high and margins low with vessel operators supplying vessels below economic cost while the ROV contractors make a margin on equipment they brought at 30c in the $1 and well below replacement CapEx levels. MEDS despite defaulting on a number have charters have been given the Swordfish to operate on charter!

The high capital values of these assets encourages investors to supply working capital to keep the assets working knowing they are competing against others who paid a higher capital value. It is a very hard dynamic to break and I don’t see a huge difference between offshore supply and subsea in economic structure which is why I deliberately merged the industries here.

Part of the reason consolidation doesn’t work is because the costs of the fixed assets, and the costs to run them, are so high in relation to the operational costs. The fixed costs of the vessels, and the non-reducible operating costs dominate expenditure, getting rid of a few back-office staff, who represent less than a few % of the day rate of a vessel just doesn’t make a big enough difference overall.

Another reason is the banks are still pretending they have value way above levels where deals such as Telford are priced at. No amount of consolidation to remove some minor backoffice costs can make up for the scale of capital loss they have in reality will solve this. If Standard Drilling is buying large Norwegian PSVs in distress for $12m, and SolstadFarstad has similar vessels on the books for $20m, then you can’t consolidate costs that would be capitalised at $8m per vessel no matter how many other companies you buy. The same goes for subsea only the numbers are bigger and more disproportionate.

So when someone tells you the answer is consolidation the real question is why?

 

That consolidation is the answer is simply an economic myth. Gales of Schumpterian creative destruction are the only real solution here barring some miraculous development on the demand side of the market.

New ship Saturday…

Yet again UDS seemed to have pulled off an amazing feat, right after becoming the greatest DSV owner and charterer in the world, with a record 4 out of 4 (or maybe 5) DSVs on long term charter, they appear to have Technip, McDermott, and Subsea 7 quaking with fear as they look at helping a company enter the deepwater lay market:

UDS Lay vessel.png

This is a serious ship. Roughly the same capability as the Seven Borealis.

Seven Borealis

Although the Seven Borealis  can only lay to 3000m, not the 3800m UDS are looking at. As depth is really a function of tension capacity then I guess they will have a significantly bigger top tension system than the Seven Borealis as well?

I can see why you would go to UDS if you wanted to build a pipelay vessel significantly more capable than any that the world’s top subsea contractors run. Sure UDS may never have built a vessel of such complexity, and actually haven’t even delivered one ship they started building, but they have ambition and you need that to build a ship like this. Not for this customer the years of accumulated technical capability, knowledge building, and intellectual competency, there is nothing an ex-diver can’t solve.

UDS is building vessels the DSVs in China. The closest the Chinese have come (that I know of) to such a vessel is HYSY 201:

HAI-YANG-SHI-YOU-201.jpg

But that only has 4000t system? No wonder this new mystery customer, who I assume is completely independent of the other customers that have chartered their other vessels, wants to up the ante. The HYSY 201 cost ~$500m though, which is quite a lot of money to everyone in the subsea industry, apart from UDS.

The last people I know who went to build a vessel like from scratch were Petrofac. There is a reason this picture is a computer graphic:

Petrofac JSD 6000.jpg

To do this Petrofac hired some of the top guys from Saipem, a whole team, with years of deepwater engineering experience… And when the downturn hit Petrofac took a number of write offs, and even with a market capitalisation in the billions, didn’t finish the ship. To be fair though, they hadn’t engaged UDS.

But I think the reason you go to UDS “to explore the costs”, you know instead of like a shipyard and designer who would actually build it, is because they appear to have perfected the art of not paying for ships. So if you go to them and ask for a price on an asset like this chances are you get the answer: the ship is free! It’s amazing the yard just pays for it. Which is cheap I accept but ultimately the joy-killing economist in me wonders if this is sustainable?

Coincidentally I am exploring the costs of building a ship. I have just as much experience in building a deepwater lay vessel as UDS. On Dec 25th 2017, with some assistance from my Chief Engineer (Guy, aged 9), we completed this advanced offshore support vessel, the Ocean Explorer,  from scratch!

Ocean Explorer.jpg

Ocean Explorer Lego.jpg

Not only that I had take-out financing for the vessel in place which is more than UDS can claim at this stage!

Now having watched Elon Musk launch a car on a rocket into space (largely it would appear to detract some appalling financial results, although far be it for me to suggest a parallel here) we (that is myself and my Chief Engineer) have designed a ship: It will be 9000m  x 2000m, a semi-sub at one end to drill for oil, a massive (the biggest in the universe) crane to lay the SPS,  j-lay, s-lay, c-lay, xyzzy lay in the middle, and two (Flastekk maybe?) sat systems at the other end in case we forgot something, and to make it versatile. Instead of launching a car into space we are having a docking station for the space shuttle in order to beat the Elon Musk of Singapore. It is also hybrid being both solar powered and running on clean burning nuclear fusion. Not only that the whole boat works on blockchain and is being paid for with bitcoin. The vessel is also a world first having won a contract forever as the first support vessel for Ghawar field. We are also committing to build a new ship every week forever.

I expect to bask in the adulation on LinkedIn forever once I announce this news, and it will feel like all the hard work was deserved at that point. I am slightly worried about the business model as my Chief Engineer asked “Won’t we have to get more money in for the boat than we paid for it?”. When I have an answer for that trifling problem I will post the answer.

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.)