Solstad has a solvency problem not (just) a liquidity problem…

The motions of Grace, the hardness of the heart; external circumstances.

Pascal, Pensee 507

“Lend without limit, to solvent firms, against good collateral, at ‘high rates’.”

Bagehot

I disagree with Solstad on this:

It has therefore been decided to commence negotiations with lenders and other stakeholders to improve the overall liquidity situation and to create a robust long-term platform for the Company.

Solstad doesn’t just have a liquidity problem it has a solvency problem. They may have enough broker valuation certificates to keep the auditors happy that the assets add up to the liabilities in a balance sheet sense, but in reality does anyone really believe that the fleet can service ~NOK 30bn in debt? Solstad fails a balance sheet test under a realistic set of assumptions. The fact is if the banks really thought they could sell the vessels for the outstanding debt and be made whole they would have done so long ago. This situation has been allowed to continue, despite clear evidence to the public protestations of its success, because the creditors have no good options. A liquidity problem can be solved with more short-term measures but a solvency problem is endemic and structural and requires a fundamental adjustment. Bagehot’s dictum of lending freely when in crisis relied on the collateral being of high quality and the crisis being temporary in nature, a situation that clearly does not apply here where there has been a structural industry shift.

I’m struggling to see why you would create Solstad today in its current form and my base view is if you can’t answer that question then you don’t have a viable business model in the current market. The scale of the credit write-downs that need to occur here to keep the business alive are just so large it is hard to know if Solstad are just good at PR or good at avoiding reality. I don’t know what the number is but the debt must need to be reduced somewhere in the range of NOK 15-20bn to make Solstad a viable business? The rump of Deep Sea Supply will never be a viable business. And then it needs equity…

The only way to get equity is to find an investor who is going to potentially get such a big return on their investment that the creditors get nearly nothing. There is probably someone willing to make that trade but it is a small pool and it offers the creditors nothing. Market sentiment, as opposed to the actual market, has worsened substantially since MMA pulled of the most successful OSV equity based solution. There is no guarantee that Solstad will survive this encounter with creditors intact and almost a certainty a very different beast will emerge. I am not even sure now splitting the subsea fleet from the supply tonnage will make much difference? The subsea fleet has a large number of marginal vessels that still need scale to survive and given many are being hawked out on windfarm work there is no guarantee their value will “recover” in percentage terms more than a supply vessel. And when some of them come of contract the day rates will also be dramatically reduced.

Systemically it will be interesting to see what happens here. The banks will be desperate not to be handed the keys to Solstad, but as Pacific Radiance in Singapore has shown getting someone to come in behind the banks in the capital structure is tough (with exceptionally good reason). The size of the write-offs the banks would have to take to induce this will make for some uncomfortable meetings in the coming days. Surely soon auditors will force companies to use market transactions (like the recent SDSD FS Arundel for $2.8m!) as the actual realistic value not this “willing buyer/willing seller” ruse?

Not everyone can survive a downturn on the scale we have seen. If the banks somehow, and it will be hard, find a way of keeping the money flowing then all it guarantees is that another company will go. And it will have to be another large “unthinkable” one at that, because there is simply not enough work, and unlikely to be for the next couple of years, for all the supply companies to survive.

The other missing piece of this puzzle is the changing financial structure of the industry and the huge amounts of equity that need to be raised to keep it viable. All the banks behind Solstad have no intention of lending to similar companies for the forseeable future, and every bank is the same, this is a systemic issue directly related to depressed vessel values. But as the contract coverage has shortened so the economic rationale for leverage has also disappeared: lending against a PSV on a 5 x 365 contract is very different to one on a 270 day contract. That sort of spot market risk is essentially equity risk and the average day rate needed to make this economically viable is significantly above current levels. An industry which needs to cover 365 costs on a 270 day utilisation year is again a very different economic model from the past for offshore supply and it only reinforces the size of the adjustment the industry still requires. This is an industry that will significantly delverage going forward and that will mean far more (expensive) equity levels and lower asset values.

An interesting conundrum is whether Standard Drilling and Solstad can really co-exist? I mean either you can buy vessels for a few million and bring them to the most sophisticated market in the world and make money against historic tonnage, or you can’t? At the moment both companies are a financial disaster but surely a recovery story really only works for one company as a logical proposition? There is no indication that the Solstad vessels are trading at a premium in the PSV market to the Standard Drilling/ Fletcher vessels which gives you an idea of what the Solstad fleet would be worth in an open market sale. The same is true for the high-end AHTS fleet where rates remain locked at marginal costs (or below on a 365/economic basis) and competition shows no sign of abating.

Solstad has also provided a natural experiment into the limits of synergy realisation versus the depth of this industry depression: quite simply consolidation alone will not be sufficient. All year Solstdad has highlighted the cost synergies it has achieved by combining with DeepSea Supply (in default before the first quarterly results) and Farstad (in default before the second quarterly results). But these are insignificant in relation to overall running costs and the level of day rate reductions E&P companies have extracted from OSV (and rig) operators. Pretending that consolidation alone is an answer now lacks credibility. New business models need to emerge and a fundamental factor of these will be collectively less supply and capacity.

The Solstad announcement presages a horror season of Q3 reporting coming up across the OSV sector. As I said some time back the summer simply hasn’t come in terms of the volume or value of work for either the supply firms or the subsea contractors. The cash crunch is coming. New money will be come on extortionate terms and prices to reflect the risks involved and not everyone will get it. Rebalancing is beginning to start in earnest and the fact is this market is the “recovery”: a slightly busier summer to build up a cash reserve to cover the costs of an expensive an under-utilised winter. The new normal – lower for longer is the reality of offshore supply and subsea.

The slow fade to obscurity and Gell-Mann amnesia…

Dum loquimur, fugerit invida ætas: carpe diem, quam minimum credula postero.

(While we speak, envious time will have fled; seize today, trust as little as possible in tomorrow.)

Horace

For this will to deceive that is in things luminous may manifest itself likewise in retrospect and so by sleight of some fixed part of a journey already accomplished may also post men to fraudulent destinies.

Cormac McCarthy, Blood Meridian 

Amid the seeming confusion of our mysterious world, individuals are so nicely adjusted to a system, and systems to one another, and to a whole, that by stepping aside for a moment man exposes himself to a fearful risk of losing his place forever.

Nathaniel Hawthorne

Media carries with it a credibility that is totally undeserved. You have all experienced this, in what I call the Murray Gell-Mann Amnesia effect. (I call it by this name because I once discussed it with Murray Gell-Mann, and by dropping a famous name I imply greater importance to myself, and to the effect, than it would otherwise have.)

Briefly stated, the Gell-Mann Amnesia effect works as follows. You open the newspaper to an article on some subject you know well. In Murray’s case, physics. In mine, show business. You read the article and see the journalist has absolutely no understanding of either the facts or the issues. Often, the article is so wrong it actually presents the story backward-reversing cause and effect. I call these the “wet streets cause rain” stories. Paper’s full of them.

In any case, you read with exasperation or amusement the multiple errors in a story-and then turn the page to national or international affairs, and read with renewed interest as if the rest of the newspaper was somehow more accurate about far-off Palestine than it was about the story you just read. You turn the page, and forget what you know.

That is the Gell-Mann Amnesia effect. I’d point out it does not operate in other arenas of life. In ordinary life, if somebody consistently exaggerates or lies to you, you soon discount everything they say. In court, there is the legal doctrine of falsus in uno, falsus in omnibus, which means untruthful in one part, untruthful in all.

But when it comes to the media, we believe against evidence that it is probably worth our time to read other parts of the paper. When, in fact, it almost certainly isn’t. The only possible explanation for our behavior is amnesia.

Michael Crichton

Fearnley Securities resumes OSV coverage as slow pickup starts to take shape…Analyst Gustaf Amle places buy ratings on Tidewater and Standard Drilling at a time market is experiencing a slow recovery…

Tradewinds

Energy companies and investors are focused on profits and reluctant to boost spending even after crude prices surged to four-year highs, a senior Goldman Sachs banker said on Thursday…

But this time round, the barriers for investments are high, with investors seeking returns of as much as 15 to 20 percent from multi-billion dollar oil and gas projects, Fry said.

“In the near term the focus is on returns as opposed to growth for the sake of growth,”

Big Oil still reluctant to open spending taps: Goldman

I haven’t written much lately a) because I have been busy with an LNG project I am working on, and b) because it’s a bit like Groundhog Day at the moment: a bunch of offshore companies come out with bad results and tell you it’s grim out there and then a bunch of Norwegian investment banks and consultants write reports about what a good time it is to invest. In the same way the relentless expansion of shale continues apace so to does the inevitable decline in value of the offshore fleet and the capital intensity required to maintain it.

Offshore supply is so grim, with such vast oversupply, it is not even worth the effort to rebut some of the more outlandish claims being made. But if you buy Standard Drilling shares expecting the World Wide Supply Vessels to reocver anything like 60% of their historical value I wish you luck, the money would probably be better spent on lottery tickets, but good luck. If you have relied on one of these above-mentioned reports it is likely you are suffering from Gell-Mann amnesia, forgetting the false positives these self-same analysts saw before (this time it’s different…)

On the contracting/subsea side in the North Sea a denouement slowly approaches regarding capacity and the number of firms. I am interested in the North Sea not only because I worked in that market but also as a quite specialised market, with a small number of players and potential assets, it is as close to a natural experiment in economics as you are likely to get. So when you see a load of small firms losing cash, charging rates below what it would cost them to replace capital equipment, and competing against diversified and well capitalised multi-national corporations, the most likely scenario is that sooner or later their private equity owners decide they are not worth putting money into and they are shut down.

It isn’t the only scenario: the investment industry is awash with liquidity, every PE house wants to be the hero that called the bottom of the market right before it boomed. This idea found its ultimate expression in Borr Drilling, but York Capital buying Bibby Offshore was based on a similar sentiment. The problem is that the price of oil has doubled and the amount of offshore work has remained relatively fixed. Next year (apparently?) the oasis in the desert will appear…

Despite the music journalist from Aberdeen claiming that the management reshuffle at Ocean Installer a few months back was just a small thing and all about focus, this week the ex-CEO left to join DOF Subsea. No one would have had more share options in OI than Steinar, and I bet DOF Subsea wasn’t buying any out: when insiders know the shares are worthless you can bet they are. Even a PE house as big as Hitec Vision has to admit sometimes they cannot keeping pumping money into such a marginal venture as OI with such clearly limited upside for an exit? McDermott and OI couldn’t agree on price and unless another bidder can be conjured up to pay more for a business than you could build it from scratch then it’s days are surely numbered?

OI is a subscale business with a few chartered vessels and is exposed to their charter rates rising if the market booms. The downside is limited to zero for equity and but the upside effectively capped. It is no one’s fault it is just a subscale firm in a remarkably unattractive industry from a structural perspective. Eventually, just as with M2, the grown-ups take charge and face reality. As my shore-based offshore engineering guru reminded me: only a well-timed exit from the Normand Vision kept the business open as long as it has been in all likelihood.

But in the long-run OI has no competitive advantage and will be lucky to earn a cost of capital beyond Reach or other such comparable firms, certainly not one to move the needle on a PE portfolio for Hitec. Is there a market in Norway big enough to keep OI as a Reach competitor? I doubt that despite it being a favoured Equinor outcome.

DOF Subsea revealed in it’s most recent numbers that it only makes a ~9% EBITDA margin on projects (excluding the long-term pre-crash Brazil boats).

DOF pre-post.png

That one graphic shows you the scale of the change in the industry: contracts signed pre-2014: profitable, business post that? Uneconomic. No firm in the market will be making much more than DOF Subsea in IMR  and that is loss making in an economic sense: a signal to the market that there is severe excess capacity in contracting.

The Chief Strategy Officer of Maersk Supply recently went public and admitted even an oil boom won’t save them (a relatively frank admission for a company seeking a buyer whose only interest must be seeing MSS as a leveraged play on an oil boom!). For Maersk Supply the future is charity projects (waste collection), decom (E&P forced waste collection), deepsea mining, and a crane so clever it will make windfarms more than a zero sum game for the vessel provider. The chances of that being as profitable as helping an oil company get to “first oil” are zero. But still with a big corporate parent Maersk remain there supplying capacity at below economic cost and ensuring “the great recovery” remains an elusive Loch Ness styled creature.

A slow descent into obscurity would seem the best case scenario for OI while the worst case is clearly a suddent stop in funding when the investors realise 2019 will just be another drain on cash. Something the ex CEO and CFO have acknowledged in their career choices…

I fear the same thing for Bibby. Clearly York are delaying spending on the re-branding (required by their acquisition) because they were hoping to sell the business before the year was out. The financial results released make it clear how hard that will be. Not only did they overpay to get into the business they then, despite Bibby having spent £6m on advisers, had to pump in £15m more in working capital. When you have to put 30% more investment into working capital don’t believe the line about customers paying slowly: it was a simple, yet dramatic, complete misundertsanding about how much cash the business could generate and would therefore need. If you really believed Polaris, Sapphire, and the ROV fleet were worth 80m you would take the money and run…

Like OI the most likely, but not the only scenario, is that Bibby is simply ground down by Technip, Subsea 7, and Boskalis. At the moment North Sea DSV day rates are such that they do not come close to covering the funded purchase of a new DSV (likely to be USD 170m), and yet Bibby have a relatively old fleet. The 1999 built Polaris for example only has 10 years life left in her: on a DCF valuation model that means she has a finite life and not a capitalised value. In all probability Polaris simply cannot earn enough money in the next ten years to pay for the deposit on a new-build to replace herself (particularly given the dearth of bank financing). When I talk of capital leaving the industry this is a classic case of how this will happen. Boats can be chartered now but then the value accrues to the owner, a situation Volstad are only too aware of and will take advantage of when the Topaz charter comes up for renewal.

A quiet winter and a couple of dry-docks later in June 2019 and it is going to be hard to convince an investor to put another £15m because the customers just keep paying slowly (sic). A bidding competition to renew the Topaz charter would in effect render the business worthless.

There are other scenarios for these firms. I sometimes think optimism is a mineral in Lofoten. A veritable army of Norwegian investment bankers are no doubt trudging around with pitchbooks and research reports showing that if you just pay them a transaction fee in cash these contracting companies will bring you untold wealth (next year). But the most likely scenario is that a dramatic reduction in demand is followed by a large reduction in supply and at the moment only the first of these outcomes has occured as the previous cyclical nature of the industry has encouraged hope for a demand led revival. “It’s not the despair, Laura. I can take the despair. It’s the hope I can’t stand” as John Cleese famously remarked.

But it is starting to feel like the end of the road… Solstad has become a national embarrasment, OI a vanity project, and Bibby simply a mistake (to name just three examples). Eventually, when all the other possibilities have been exhausted mean reversion and cash needs will begin dictate economic reality.

One of the most bullish offshore data firms recently published this forecast:

IMG_0992

Just remember as a general rule: the larger the orange bar at the bottom (particularly in a relative sense) the less your offshore asset is worth.

[Graph in the header from this Seadrill presentation. Not a graph I suspect that will appear in one from Borr Drilling soon].

Offshore takeovers and the psychology of preferences…

Haile selassie.jpg

Courtier T.L. — Amid all the people starving, missionaries and nurses clamoring, students rioting, and police cracking heads, His Serene Majesty went to Eritrea, where he was received by his grandson, Fleet Commander Eskinder Desta, with whom he intended to make an official cruise on the flagship Ethiopia. They could only manage to start one engine, however, and the cruise had to be called off. His Highness then moved to the French ship Protet, where he was received on board by Hiele, the well-known admiral from Marseille. The next day, in the port of Massawa, His Most Ineffable Highness raised himself for the occasion to the rank of Grand Admiral of the Imperial Fleet, and made seven cadets officers, thereby increasing our naval power. Also he summoned the wretched notables from the north who had been accused by the missionaries and nurses of speculation and stealing from the starving, and he conferred high distinctions on them to prove that they were innocent and to curb the foreign gossip and slander.

Ryszard Kapuscinski, “The Emperor” (1978)

“It was surreal. When someone asked why he was doing the deal, here–now, he actually said, basically, ‘Because Americans are the dumbest investors around, and there’s lots of liquidity in this market.’”

From Kathryn Welling

 

An industry in decline has much in common with the decline of an Empire and the ancien regime. The changing of the guard, the Schumpterian competition that upsets the stability of the known order, is a constant in the evolution of social systems. Kapuscinski’s account of the fall of Haile Selassie’s empire is a classic account of a system unable to intepret information in the light of new objective realities with direct relevance to businesses facing structural changes. 

I think one needs to look at recent takeovers in offshore with a degree of cynicism that moves beyond the stated narrative of ‘confidence in the future’ based on rising oil prices, but also reflects the unwillingness of the participants to objectively view the risks being taken as the ancien regime of offshore faces a more competitive environment. One of the best comments I have read on the Tranocean/Ocean Rig deal is from Bassoe Offshore ‘Transocean Saves Ocean Rig from slow-moving train wreck‘. But the article only highlights the huge utilisation risks this deal (like so many others) creates: if the work doesn’t come at forecast levels Transocean will have gifted value to Ocean Rig who had few other options. A collection of rigs in cold-stack is not worth billions.

I would also add that I think the Transocean/Ocean Rig and Tidewater/Gulfmark takeovers bear striking similarities beyond the superficial of underutilised asset companies proffering a Common Knowledge of future confidence in future demand. The core similarity is that the shareholders of the selling entities were largely restructured debt holders and distressed debt investors seeking an exit from their investments. Behind the scenes these investors appear to have looked at the lack of forward demand, the high cash burn rate, and the willingness and ability of their competitors to burn cash with an identical strategy and asset base, and instructed an investment bank to get them out of their position. A peculiarity of the ORIG deal is the ability of the colourful Mr Economou to extract $130m over and above his proportionate economic interest in the company (the MSA break fee in the presentation), a situation that I imagine only encouraged the other shareholders to want to relinquish control (FT Alphaville has some interesting background on the him and here).

It is worth taking a recap on what the Common Knowledge was until quite recently (see here and here ) regarding the offshore industry (pushed by the Missionaries at the investment banks and other promoters). In 2017 and at the start of 2018 a credible story, as can be seen from the Seadrill restructuring presentation below, was for a sharp rebound in day rates and utilisation. The Seadrill restructuring was so complex and long that by late 2017 when it was actually due for completion, an update had to be issued and lo-and-behold the recovery was further off than first anticipated (if at all)…

Seadrill VA Dec 17.png

This presentation was by no means unique. Credible people will tell you that not only will day-rates double in three years (or less), but also that this will happen in addition to utilisation hitting 2014 levels. And this will all happen apparently in an environment where E&P companies are deliberately using shale as a competing investment to lower offshore costs…

It may happen, I don’t know the future, there is Knightian uncertainty, but on a probability weighted basis I would argue these sorts of outcomes are low probability events. The offshore industry will over time reach a new equilibrium in terms of demand and supply, in almost all other industries where there has been severe overcapacity issues before normalisation, it has led to lower structural profits on an ongoing basis.

Financial markets work on narratives and Common Knowledge as much fundamental valuation models rooted in the Efficient Market Hypothesis. Indeed these are the core of a financial bubble: a mis-alignment of current prices with long-term risk-weighted returns. What offshore industry particpants wanted to believe in 2017, against the face of significant evidence to the contrary, was that there would be a quick rebound in the demand for offshore drilling and subsea services. Despite the public pronouncements of the major E&P companies that CapEx was fixed and excess cash would be used to pay shareholders or reduce debt, despite the clear investment boom forming in shale, and despite stubbornly low day rates from their own contracting operations. People wanted to believe.

And so the investors rushed in. For Seadrill, for Borr Drilling, for Standard Drilling, for Solstad Farstad, and a myriad of others. While other investors through restructurings became reluctantly (pre-crash security holders) and willingly (post-crash distress debt investors) owners of these companies. Now, having realised that they own asset heavy companies, losing vast amounts of cash, with no possibility of bank lending to support asset values, and a slow growing market, they want out.

The meme for these deals is meant to be one of success… but really it isn’t. And just as the hard cash flow constraint is binding on the individual companies involved many of the hedge fund investors who get involved in these deals are required to produce quarterly performance reports. Charging 2/20 for an oil derived asset declining in the face of rising oil prices can cause questions, or even worse, redemptions.

So having rapidly opened the ‘black box’ of the companies they own the shareholders in both Gulfmark and ORIG realised that they were the proud owners of companies with no immediate respite from the market. The the most logical way to get out was to get shares in an even bigger entity where the shares are significantly more liquid and tradeable. That management of the acquired entities managed to get an acquisition premium is testament to the skills of the bankers involved no doubt, but also down to the fact that the acquiring companies wanted to be bigger, not because they really believe in a market recovery and pricing power (although the pricing power is valid), but because if or when they next raise capital it is better to be bigger in absolute value terms. Show me the incentive and I’ll show you the outcome…

In behavioural finance it is well known that humans overweight the possibility effect of unlikely high risk outcomes and underweight more likely certainty effects (the canonical reference is here):

POP 2018

What does this mean for offshore in general and Transocean/ORIG in particular? It means that the managers backing this deal are overweighting the possibility of a sudden and unexpected rise in offshore demand versus the more statistically likely chance of a gradual return to equilibrium of the market. It is exactly the same miscalculation that the management and shareholders of Borr Drilling appear to have made. The decline in share values recently indicates some shareholders in all these companies get the deal here. The risk of a slow recovery, and a vast increase in the stacking costs of the ORIG rigs is borne more significantly by Transocean shareholders who have borrowed ~$900m to fund the deal, while the upside is shared on a proportionate economic interest basis.

I have confidence in offshore as a production technique for the long-term. It will be a significant part of the energy mix for the foreseeable future. But a 2008 style recovery, given the importance of shale as a marginal producer and the increased offshore fleet size, looks to be an unlikely outcome that is still being heavily being bet on.

 

Dead man walking…

Hilton Barber: [at Matthew Poncelet’s appeals hearing] The death penalty. It’s nothin’ new; it’s been with us for centuries. We’ve buried people alive; lopped off their heads with an axe; burned them alive at a public square… gruesome spectacles. In this century, we kept searchin’ for more and more *humane* ways… of killin’ people that we didn’t like. We’ve shot ’em with firing squads; suffocated ’em, in the gas chamber. But now… Now we have developed a device that is the most humane of all. Lethal injection. We strap the guy up. We anesthetize him with shot number one; then we give him shot number two, and that implodes his lungs, and shot number three stops… his heart. We put ’em to death just like an old horse. His face just, goes to sleep, while, inside, his organs are going through armageddon. The muscles of his face would twist, and contort, and pull, but you see, shot number one relaxes all those muscles so we don’t have to see any horror show… We don’t have to taste the blood of revenge on our lips, while this, human being’s organs writhe, and twist, and contort… We just sit there, quietly. Nod our heads, and say: ‘Justice has been done.’

Dead Man Walking

Let’s just be clear: there is no chance of Viking Supply suriving as an economic entity. The question is around the method of demise not the ultimate question of it. For those aware of my history with the Odin Viking there are no surprises, and the irony of it’s association with “war, death divination, and magic” is not lost on me.

GOL Offshore was also put into liquidation last week. Again a subscale operator with no discernable point of difference from all the other assets and service providers out there.

This is how the industry in the supply side will rebalance. Small operators with commodity ships, no competitive advantage, and simply not enough asset value or liquidity to survive. But there are a lot more to come.  These size of these companies are small enough for the banks to write-off and are simply not worth saving. When the asset sales are done Viking Supply will effectively be in wind-down mode, the result of structural forces more than any other reason, but a necessary step to economic rationality. I don’t know what the minimum efficient scale is for a supply company but it’s a lot more than 15 vessels.

The largest companies in the supply industry have either large parent companies (Maersk, Swire, etc) or so much asset value post-restrcturing there will always be some logic to put money into to see the next year (Tidewater). For those without a cheap local cost base and contacts or without the advanatges of financial scale a grim existence beckons.

The real question is do the Viking Supply results presage the Q2 results for other operators or have they lost significant market share in the AHTS space? I think you can take it as a given that this comment reflects the general industry conditions:

The offshore supply market was very disappointing throughout the first half year, and the very weak market has caused both fixture rates and utilization to remain on unsatisfactory levels.

The real question isn’t who is selling the shares of companies like Viking, Solstad, and Standard Drilling but who on earth is buying them? The banks were desperate for Viking to survive but even they have abandoned hope now. Expect more banks and investors to do the same in offshore supply.

Buying time for a managed exit from Deep Sea Supply….

The solution to a debt crisis is rarely more debt and a complete avoidance of the issue. From Solstad:

The Financial Restructuring includes a deferral of scheduled instalments, interests and bareboat payments until December 31st, 2019 in a total amount of approximately USD 48 mill. The Financial Restructuring also entails suspension of the majority of financial covenants in the same period.

As part of the Financial Restructuring, SI-3 will be provided a loan from Sterna Finance Ltd. in the amount of USD 27 million, which shall be applied for general corporate purposes in SI-3.

So the banks stop time and Fredriksen (Sterna Financial) lends the company $27m to get them through the next 18 months? And then what? Day rates rise and solve everything? Where that loan sits in the capital structure will be interesting…

Ships depreciate. That means they are worth less next year than this year ceteris paribus, and therefore their earning power is reduced. This plan is predicated on the fact that this is the bottom of the market and the vessels must work next year. Good luck with that. For the old Deep Sea Supply vessels this is your competition.  Yet in 18 months time they have to earn, after OpEx, $48m just to keep the creditors at bay? It’s just not serious. All the more so because the vessels have an Asian focus and there is widespread agreement that that is the most price-competitive oversupplied region in the world.

All this deal does is keep potential credible supply in the market. The problem for any industry rebalancing is the perceived capital value is so high compared to the actual layup or running costs, and that is an industry wide problem. Pacific Radiance, EMAS, Solship, etc., they can’t all survive at current demand levels, but while they try it is mutually assured destruction.

#lastrollofthedice surely?

Which leads me to believe that all involved know this. Have a look at the bulk of these assets and their status:

SF PSV.pngSF AHTS.png

No lenders really believe they are getting paid all they are owed here surely? My guess is that the JF money has been provided on some sort of “super senior” basis, which gets paid out before the banks, and provides working capital while the next 18 months is spent trying to unwind the Solstad exposure to the DESS fleet. The banks don’t write off anything because it protects their legal position to the claim and preserves the illusion of commitment (and allows the loss to be booked later). A managed wind-down of a clearly not viable business that avoids an immediate firesale would seem the most likely scenario here. A bottle of champagne awaits the first person to send me the IM 🙂

 

Tidewater and Gulfmark… big but not big enough…

The Tidewater-Gulfmark combination is a classic M&A play in a market awash with overcapacity: two companies merge and cut costs, integrate, get the savings, and everyone goes home for tea and biscuits. In a market that has declined so substantially the deal clearly makes financial sense: if you can run the same number of boats with 1/2 the management team you should take the money and run. But how much money are they (the shareholders) actually really taking here?

The Tidewater-Gulfmark acquisition is predicated on two types of synergies:

  1. Cost savings of around ~$30m per annum from 2020 onwards. That is based on the combined spending of both companies and they seem fairly certain on it. But the combined company will have  245 vessels, so that is about $336 per boat per day (based on a 365 year). In other words it isn’t going to fundamentally alter the economics of the (combined) company or their ability to take market share on cost. Bear in mind that Tidewater alone spends $245m per annum on direct vessel operating costs.
  2. Revenue synergies. Always beware of this number as it is nebulous to calculate and even harder to achieve in practice. These are meant to be achieved when a combined entity can sell more but that isn’t the case here. What little logic you can deduce from management is transparently thin, this is far more a market recovery play based on higher utilisation and day rates. This makes logical sense as well: all that has happened here is one management team are being removed and the number of boats increased. Nothing has changed the ability of the combined entity to sell more days something this confusing slide seems designed to obsfucate.

Offshore leverage.png

The higher day rates strike me as extremely optimistic given Siem Offshore recently announced that North Sea rates has been capped by vessel reactivations. But Tidewater are full of optimism:

In a market recovery, utilization should improve to approximately 85% for active vessels, including 82 Tier 1 vessels and 91 non-Tier 1 vessels.

With an increase in offshore drilling activity, the combined company should also be able to quickly reactivate 20 currently-idle Tier 1 vessels.

The combination of higher active vessel utilization and additional active vessels could yield in excess of $100 million in additional annual vessel operating margin.

With potentially higher average day rates in a recovering market, the impact on vessel operating margin could also be significant.

To give you a sense of the sensitivity of operating margins to higher industry-wide average day rates, if we were to assume overall active utilization of 85% and 20 incremental working vessels over and above the two companies’ respective active fleets during the 12 months ended March 31, 2018, and also assume no OpEx inflation, each $1,000 day of rate increase on the Tier 1 vessels could result in an annual incremental vessel operating margin of approximately$45 million.

I think someone then had too much coffee:

This analysis also assumes $500 day increase in average day rate for the active non-Tier 1 vessels.

If we were to assume somewhat stronger market conditions, a $5,000 a day increase in average day rates on the Tier 1 vessels (and a $2,500 per day increase in average day rates on the non-Tier 1 vessels), would put the combined company on a path towards more than $450 million of annual vessel operating margin, or about 50% of the company’s combined vessel operating margin at the last industry peak in 2014.

Yes, and we would also need to assume then that the shale revolution hadn’t happened, the Chinese shipyards hadn’t overbuilt with “at least a hundred” vessels waiting to be delivered (something acknowledged on the call), and that vast quantities of drill rigs weren’t idle.

To put those utilisation figures in context here is Tidewater’s utilisation from their latest quarterly filing:

Tidewater Utilization 2018.png

Yes, it’s a Q1 number but 85% utilisation is 311 days per annum, a boom number if ever there was one for supply vessels, and it is a massive increase year-on-year that would basically entail the vessels working fulltime from 1 February to 30 November. There is no indication in the backlog of any buildup of this size. Management are asking you to believe a realistic scenario is that not only do they add more vessels to their fleet from layup but they do it on the back of large percentage increase in day rates. There is no indication in the rig market that the kind of order backlog required for this sort of demand side boost is coming to fruition.

Management also highlight how tough the market is in Asia. These are global assets (within reason) and regional increase in day rates will be met with increased supply. As a follow up on my note on vessel operators now being traders. I noticed that Kim Heng, ostensibly a shipyard (of ther Swiber AHTS fame), had purchased another two cheap AHTS coterminously selling one to Vietnam and getting a charter for another in Malaysia (at rock bottom rates one can assume).

A lot of offshore supply equilibrium models show increasing day rates and utilisation levels and use scrapping as the balancing factor. They need to because the only variables you can use are day rates, utilisation, and fleet size, and the easiest way to boost the first two is to lower the third. But as the Kim Heng deal makes clear scrapping is coming extremely reluctantly, and in a large number of markets (especially Asia and Africa) well connected local players with low quality tonnage can consistently take work. I doubt Kim Heng purchased the vessels becaise they expected to scrap them at 20 years of age. They will run them until they literally rust away or fall apart and need a day rate substantially below the prices paid per vessel implied by this deal ($12-13m  per vessel). For as long as these “long tail” companies remain realistic competition then the upside in this industry is capped at the current prices implied in “distressed” sales. [I am going to write a whole post when I get the time on “The Scrapping Myth”].

Tidewater management acknowledge what I think will be the most powerful determinant of profitability in offshore supply going forward: the industry structure. After the merger there will still be 400 companies worldwide with 5 vessels on average and Tidewater will control only 10% of the market:

Vessel count.png

There is substantial evidence that you need more than 20% market share to exert pricing power and you need a far smaller competitor set than 400. None of these companies will be strong enough in any region to have any pricing power and all will have enough local and regional competition to ensure that there is limited upside. There is substantial redundant capacity via companies that have enough capital to reinstate it as rates pick up. Maybe this is only a first step but it would take years of mega M&A given the long tail of the industry to create even a few companies with pricing power and the asset base is so homogenised that you only need a couple of credible competitors with sufficient supply to ensure profitability is at cash breakeven levels. The fact that the operating costs, including dry docking, are so far below new build costs will I think encourage marginal tonnage to hang around for a long time and there are no signs E&P companies are forcing scrapping. Indonesia, India, and Malaysia have all been markets dominated by aging tonnage financed all with equity, and Standard Drilling is leading the charge to bring this model to the North Sea. But it kills resale values and inhibits bank lending to all but the largest companies because of the volatility in asset prices.

Industry debt levels.png

Unless The Demand Fairy appears every European supply company is going to struggle to compete with those with equity finance. From NAO to the right (bottom graph) all these companies look like financial zombies.

Over time the long tail of the offshore supply industry is going to struggle with getting access to capital which I think will be a far stronger driver of supply reduction than M&A. One area where I totally agree with Tidewater management is the ability of larger companies to have superior access to finaning. Larger companies will pull away from the smaller as they also will have access to credit and the ability to handle the cost of idle days (a key factor in OSV profitability). If you only own 5-20 boats then you will simply become unbankable because the residual value of your assets will wipe out your book equity (if it hasn’t already) and each idle day is simply too expensive relative to the upside of a working day for banks to lend money on. Even then companies really need to aim at a much higher number, but there will always be the odd Kim Heng waiting to capture any excess margin. Private equity companies will eventually leave the industry as they realise that these depreciating assets do not offer the IRR return required to keep investing and disress investors realised that current prices aren’t “distress” prices at all but “market” prices given current and likely demand levels.

It is easy to sit on the sidelines and throw stones. Management in the industry, particularly for a company the size of Tidewater, have to act within the constraints of what they are given in terms of an external environment and cannot simply decide to exit. In an option set with few good choices this is in all likelihood the best. Ultimately supply needs to reduce to ensure the supply demand balance is reallocated in the vessel operators favour, or at least falls into balance, and this looks to be some way off. Management and investors in more marginal companies can decide to exit and without The Demand Fairy appearing more will have too.

Heart of darkness…

Colonel Kurtz: Did they say why, Willard, why they want to terminate my command?
Capt. Benjamin Willard: I was sent on a classified mission, sir.
Colonel Kurtz: It’s no longer classified, is it? Did they tell you?
Capt. Benjamin Willard: They told me that you had gone totally insane, and that your methods were unsound.
Colonel Kurtz: Are my methods unsound?
Capt. Benjamin Willard: I don’t see any method at all, sir.
Colonel Kurtz: I expected someone like you. What did you expect? Are you an assassin?
Capt. Benjamin Willard: I’m a soldier.
Colonel Kurtz: You’re neither. You’re an errand boy, sent by grocery clerks, to collect a bill.
Someone needs to collect the bill here. It isn’t the only one that needs to be paid.