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.

The new trading game… and the deal of the downturn…

It is my belief that no man ever understands quite his own artful dodges to escape from the grim shadow of self-knowledge. The question is not how to get cured, but how to live.

Joseph Conrad

 

La fatal pietra sovra me si chiuse. / “The fatal stone now closes over me”)

Morir! Si pura e bella / “To die! So pure and lovely!”)

Aida

Solstad Farstad announced it’s 4th extension to its Solship/ Deep Sea Supply problem last week. The Q1 2018 results also noted that they had breached the covenants for the Farstad  entity as well and were therefore seeking a waiver for this part of the Group. Solstad state they expect the Farstad part to fall into compliance in the 2nd half of 2018, this is significant because if this doesn’t happen then two of the three legs of the merger have effectively broken and the entire industrial logic for this merger will have fallen apart less than a year after closing. That this has occured so rapidly after the merger is a large credibility blow to all those involved putting the deal together.  All the major stakeholders, except for the Deep Sea Supply shareholders, bet all on a market recovery that had no basis in reality, and now, unsurprisingly, it hasn’t happened they are bereft of ideas. It is no wonder the Chairman has been recently replaced.

I think Solstad are actually aware of the scale of the problem now, the new Chairman who not only has a strong financial background but as Chairman of the Norwegian National Opera and Ballet surely apprecites drama and tragedy, seems to be playing for serioius time? The Q1 2018 report is significantly more downbeat than the annual report released only a few weeks earlier and the financial risks section highlights how serious the problems are.

It is very hard to underplay what a mess this is from an industrial perspective, with a Group holding company responsible for two insolvent trading companies (of three trading entities) and yet the scale of all three put together was the core rationale of the deal? In a bizarre twist of logic Solstad claim the merger cost synergy targets remain in place despite the fact they must be close to simply handing back the Deep Sea/ Solship 3 fleet to the banks and yet remain liable for the running costs of the company, despite it being a massive economic drag on the group? Surely if they do this they need to explain what synergy number cannot now be achieved? This is just one example that highlights in reality getting out of this deal will be far harder than it was to get into. What will the new Solstad look like? The banks will be seeking to get out as soon as possible from all but the aquaculture business, and the relationship to Hemen/ Fredriksen just another complication from an industrial perspective the company doesn’t need.

Not to put too finer point on it but the Q1 2018 results for Solstad Farstad really made clear that the company is insolvent, by that I mean in the accounting sense where the ability of the asset base to generate enough economic value to pay their liabilities is clearly compromised. Solstad don’t have a liquidity problem immediately but they will soon having gone back NOK 400m in Q1… unless they have a stonking Q2, and there is no reason to believe they will. An upcoming (round 2) restructuring appears imminent because its financing costs are killing it. The comparison with the efficiency of the American Chapter 11 system which has allowed  Tidewater, Gulfmark, Harvey etc. to emerge and take market share is such a contrast to the European system it merely adds another nail in the coffin here.

Like Siem Offshore, and so many other offshore vessel companies, Solstad can pay for everything up to finance costs, and then it falls into a pit of actual cash outflow. Welcome to the new normal. Eventually, in an industry with depreciating assets that need replacing, this model doesn’t work.

One amazing financial revelation of the Q1 2018 results is the fact that Solstad depreciate vessels over 20 years to 50% of original cost! If anyone thinks a 20 year old AHTS is worth 50% of the new build price they either know nothing about the industry or enjoy a healthy portion of magic mushrooms. These values are apparently adjusted by broker values but this policy must massively overstate the book equity in the company relative to current market values. The policy itself seems a remnant of a bygone era when a demand boom meant assets depreciated less slowly than book value implied. The only thing making those creditor claims look economically realistic appears to be a policy that has consistently over valued the asset base above its long-term economic value.

As an argument for how some audit firms are too close to their clients Solstad Farstad makes a strong case given the EY statements regarding the financial positon of the Group. On the 18.04.18 Solstad Farstad published their 2017, and inaugural, accounts for the combined entity which EY accepted as fairly representing the positon at year end 2017. A mere 2 weeks later, literally just before the Easter holidays, the first deferral of the Solship 3 “investment” was made, something that would have been blatantly obvious to all concerned closing the accounts, and this allowed all the long term debt to be recorded as just that. In effect, as became clear at the Q1 2018 accounts, coming only a few weeks after the Solship deferral and was clearly obvious in Q4 2017, Solstad Farstad had a massive problem and a covenant breach,  therefore a major portion (NOK 11bn) needed to be reclassified as short-term as the lenders could theoretically call this in immediately. This looks stage managed in the extreme. One would think this was such a significant post balance sheet date event that it must be reported…

This is just another sympton of how out of control the whole situation is. What is clearly happening in the background here is that Solstdad Farstad needs to hand back the entire Deep Sea Supply to the banks, something everyone in the industry knows, but the banks don’t want it. It also means all this talk of a recovery in large AHTS is hokum. A few good weeks over summer doesn’t make an asset economic over 52 weeks. Without this mirage of scale of the merger is a busted flush and someone then needs to go back to the market and explain that the stated industrial strategy and planned synergies as outlined in the original merger document, less than one full financial year before this became apparent, are totally unrealistic and have in fact threatened the very existence of the entity. Without new equity, which would require a substantial writedown in bank debts, Solstad will simply limp along as a zombie company with the banks extracting what they can over time and the equity remaining worthless at best. It will be like a bank in run off with the asset base eventually eroding away to nothing.

Solstad (and it will be just Solstad going forward) is probably only viable as a Norwegian area (re: Equinor sponsored) PSV and AHTS operator, with an option on some Brazilian tonnage. The CSV operation is still potenitally considerably overvalued: it is an aging fleet that will never realise book value because no bank will lend against assets that old and and without long term contracts going forward. The Australian/Asian operations need to go immediately and the laid up Brazilian assets (i.e. the majority of the Brazilian fleet) need to go as well. Siem Offshore appear to be pulling out of Australia and Solstad cannot be far behind them on any rational basis. The aquaculture business will surely revert to Hemen/Seatankers/Fredriksen or be sold.

Quite why Solstad is therefore publishing two week extensions when this problem will take months to sort out is anyone’s guess. But a whole pile more deferrals are coming unless some rabbit is pulled from a hat. The Q2 results are likely to lead only to the creditors starting to get real about the scale of the problem.

To be clear this isn’t only a Solstad issue, although the merger was clearly a folly on an epic scale: in the the same week Bourbon Offshore announced that they were suspending debt repayments (again). Miclyn Express Offshore, Pacific Radiance and EMAS (again) cannot find sustainable financial positions. Siem Offshore recently reached agreement to defer payments on debt

It defies the laws of economics and common sense to believe that any one firm can outperform any others in this market in a meaningful financial sense when they all offer assets that are identical in function and form to their (identical) customer base. Siem Offshore now isn’t paying it’s lenders back in full until 2022 and lowered (again) payments by 30%. It will simply reduce day rates to get utilisation and it shows the banks know they have no leverage here. Deferring all borrowers across the industry indefinitely however will ensure they never get paid paper claims. Eventually winners will have to be picked and it will clearly be those burning the least cash.

I have followed the Solstdad situation more closely than any other simply because a) from an industrial and financial perspective it was clearly such a bad idea; and, b) their public prognostications have been so divergent from any actual data points in the market, and so far removed from realism, it makes a fascinating sociological experiment. Those of you who have read The March of Folly will know what I mean.

The funny thing about all the banks delaying the bullet payments outstanding (to Siem Offshore, MMA, Pacific Radiance, Solstad, ad infinitum) is that each bank knows in truth their own bank would never lend on the other side of the deal. The Siem deal recognises this. The banks in these deals are locked into the boats and companies they have backed because the bullet payment will never be made unless they sell it at a huge discount to a distress debt investor. The banks are stuck in these deals but they are not getting into any more, but in this self-perpetuating cycle it also locks in low asset prices and day rates. Breaking this self-reinforcing circle will only occur when the mythical demand fairy appears.

All offshore supply companies, and by that I mean OSV operators who do not engage in engineering and execution, are price takers in the current market: there is no ability to add value, they are in effect trading firms wholly depedendent on the market price and demand levels for a commodity asset, with no ability to take anything other than what they are offered. This isn’t what the original funders signed up for, isn’t the skill set of the majority of management, and is significantly more risky given the risk/reward basis that rational investors should be comfortable with. Eventually funders will realise this and new equity will stop flowing into the industry under the promise that all you have to do is burn cash and wait. Pacific Radiance and EMAS are two good examples where clearly due diligence has revealed the downside of this strategy.

Anyone investing in this market should realise they are betting against the greatest shipping trader of the age: John Fredriksen. When the chips are counted from this downturm the greatest deal in offshore will not be an acquisition at the bottom of the market it will almost certainly be a divestment: and it will be the story of how JF managed to put only $20m in to rid himself of a bankrupt entity, with some really low market tonnage, that surely his major bankers would have demanded substantially more support for had it not been folded into Solstad? Now Deep Sea Supply is inextricably tied to Solstad and it is a management and funding issue of this company not a Seatankers/Hemen problem.

If you are buying AHTS’s and PSV’s you need to ask yourself what you know that JF doesn’t? And what your industrial angle is that is better than Seatankers?

Anyone who tells you scale and consolidation will save all needs only to look at how many high-end AHTS Solstdad Farstad have, and after a year of operation all it brought them was a covenant breach. Scale without pricing power is meaningless, the costs of the vessel operations are so high relative to the onshore costs that saving a few dollars a day on SG&A costs is just a rounding error. A new industry narrative is required for the lender to be kept happy but each becomes more tenuous than the last.

Not all offshore supply firms are going to survive, but quite understandably the banks want the failures to be someone elses. There is nothing written in stone that Solstad Farstad will survive. Every Solstad report talks of a willingness to participate in consolidation but the equity has no value and anyone taking it over would want the banks to write-off the billions of NOK. Given the post-merger performance of the Group it isn’t a serious proposition that anyone would take their shares in a consolidation play either. My money would be on a take-private deal where the Solstad backers hope to use it as a consolidation vehicle, but everyone is doing this at the moment and eventually some firms need to drop out and take a hit before this works for someone. But if you think some of the public firms valuations are high I bet some of the private fund accounting going on is even more aggressive…

For the industry to recover a few big firms, and their associated asset bases, are going to have to go and some losses way beyond those taken to date are going to have to realised by banks and increasingly equity investors. Even the most outrageous demand forecasts for next year don’t offer the sort of demand boom required to fundamentally alter vessel profitability. Unless this relationship below reverses the global OSV fleet has substantially less value than some recent deals presume:

McKInsey BH Q1 2018.png

Source: McKinsey.

Working out when  profits come again is highlighted by the Siem Offshore results which pointed out that owners are laying vessels up and bringing them out when day rates recover. Scrapping simply hasn’t happened at the levels that some were forecasting. Something has to give and at the moment it’s day rates and utilisation. For as long as the high-capital values of vessels relative to marginal day-rates make this worthwhile, or companies like Standard Drilling buy cheap and sell cheap, then this is just a straight trading game. The scale of any recovery in offshore work required to make the whole fleet even economically breakeven so far into the distance it is definitely a chimera.

You can’t stop time…

“In 1936 I suddenly saw that my previous work in different branches of economics had a common root. This insight was that the price system was really an instrument which enabled millions of people to adjust their effort to events of which they had no concrete knowledge.”

Friedrich Hayek

“They say I’m old-fashioned, and live in the past, but sometimes I think progress progresses too fast!”

Dr Seuss

In Singapore both EOL and Pacific Radiance are trying to freeze time to their advantage. I can’t see it working. Both parties seem to be using a judicial process to try and slow the reality of weak market conditions, and yet the longer this keeps on the worse the offers to finance these businesses seem to get.

EOL signed a “binding” term sheet with new investors in September 17… Then BTI/Point Hope came back and said they wanted new terms, and then again… and again. The only possible explanations were A) EMAS is performing even more poorly than was estimated last September when they first agreed a “binding” term sheet, or perhaps than in December 17 when they agreed a revised “binding” term sheet; or, B) the market hasn’t recovered so the new investors don’t want to put cash in. The parties were looking to sign another (“binding” I presume?) term sheet so asked the court for a moratoria that will allow them to keep operating while they tried to sort out a $50m investment. But then today BT accepted reality walked away. It bodes ill for Pacific Radiance.

At some point the creditor groups led  by DBS and OCBC must be forced to either recognise the market value of the assets or just accept what is needed in terms of the size of the write down, which is going to be very large if they liquidate the EMAS fleet now, or new working capital required and what it will be priced at. It is very hard to see anything viable coming out of EMAS whatever the price.

Pacific Radiance can’t even get the binding part of a term sheet: they just have a group of investors so keen to move forward they can only agree preliminary terms. News reports suggest that these are investors from outside the industry looking for a bargain. Good luck with that. The only operational plan appears to be for the company to carry on as before and spend a ton of new money on OpEx while waiting for the market to turn (and enter the nascent Asian wind market). That’s fine if you could actually get the money signed up to do this, but of course that hasn’t happened yet…

The Pacific Radiance restructuring involves USD 120m cash going in and the banks writing off $100m but getting $100m cash out immediately. Getting effectively .5 in the dollar on some aging offshore support vessels is a great deal in this market (see above)… almost too good to be true… The remaining USD 120m gets paid back over three years starting on January 1 2021. This is the ultimate bet on a market recovery in the most margin sensitive OSV market in  the world. Pacific Radiance generated a cash loss from operations of $4m in Q1 2018, so should the market not come back then you have a small amount of cash sitting behind USD 120m of fully secured bank debt. Given current OSV rates if investors are putting money into this project they are betting that this company can generate at least $40m per annum to pay the banks back before they have any prospect of their equity having any value in only 3 years time.

I will be really will be surprised if the Pacific Radiance deal goes ahead in this form. At this stage of the cycle if you are providing working capital finance to help the banks recover their asset value you should have some prospect of getting your money back first. A three year repayment profile just doesn’t reflect the economic realities of these vessels or the likely market moving forward no matter how much the banks behind this may choose to believe something else.

People keep telling me that DBS and OCBC have have taken large internal write-offs with their investments in these companies. I struggle to believe this as if this were really the case the banks would surely just equitise their investment fully, bring the new money in, and sell the shares when they started trading again, which in simplistic terms is what happened to the creditors in the Tidewater and Gulfmark. Both banks, as with all banks with lending to the sector, should be maximising their own position, but in doing so they are ensuring collectively the poor financial performance of the entire fleet they longer they keep the extensions up.

There is a fine line in these situations between judging when the market is being excessively negative in the short-term, and therefore put new money in, or just liquidate. I know the bankers are loo king at Pacific Radiance going how can USD 600m be worth so little? But the answer is the assets have a very high holding cost and breakeven point and they lent in the middle of a credit boom. Given current market prices it looks like the banks are holding out not just for the unlikely now but the impossible. In economic terms these banks own nothing more than a claim to some future value on a vessel if the market recovers, and for a load of reasons (some related to accounting regulations), they want others to front this cost. But the economic substance of their claim remains the same.

Both Pacific Radiance and EMAS are  locked in a problem of mutually assured destruction if they both get temporary funding for another season. The market is structurally smaller than it was five years ago and ergo the vessels are not worth as much, and at the moment cannot generate enough cash to cover more than OpEx (not even including dry docking). The market hasn’t come back and shows no sign of doing so in any substantial way. If both of these firms secure further cash to blow on operating at cash break even for another season or two they will simply ensure overcapacity remains and no one in the industry can make money and therefore no rational investor should put money into the industry until capacity is reduced.

This Tidewater presentation shows quite how oversupplied the market is: from 4.5 vessels per rig to 8 on a significantly lower rig base down 40% from the peak in 2014.

Tidewater Market Equilibrium.png

The other point to note is that turnover for Pacific Radiance dropped 16% on last year for Q1 2018. Price deflation in an asset industry, particularly one with debt, is the nuclear bomb of finance as debt remains constant in nominal dollars while real earnings to service it decline. I doubt Pacific Radiance lost market share so I think that is indicative of pricing pressure that customers are pushing on them. What is clearly not happening, as in every other sector of offshore, is that E&P companies are asking vessel owners to scrap older tonnage so they can pay a premium for newer kit. In fact they are just demanding, as they always have but particularly in Asia, the cheapest kit that meets a minimum acceptable standard. The “aging scrapping” myth will have to wait a while longer before becoming reality. Pacific Radiance might be right and the nadir of the market has arrived, but there is precious little sign of an upward trajectory from here, and plenty of signs from contracted day rates that market expectations are for at least another season of rates at this level.

To be fair the graph is contrasted with this:

Supply is tight.png

But “adjusted supply” is a forecast and a nebulous concept at best. And with a 16%% drop in revenue over last year even if the increased utilisation figure is true it just means productivity is dropping. There is no good news at the moment on the supply side.

If prolonged these constant judicial delays to economic reality risk doing further harm to the sector as they will actually discourage private sector investment. MMA raised private money on market terms to manage the downturn, yet it’s returns are being forced lower because it is effectively competing against firms being kept on life support by a seemingly never ending stream of judicial moratoria from its competitors. The more this happens the less other private investors will become to get involved because a never ending overcapacity situation becomes effectively a court annoited market.

There is a moral hazard problem here where these indefinite moratorium agreements encouragement management, and in some cases creditors, to negotiate in bad faith while the costs of this are paid for by private sector investors who have put new money into competitor companies. The BT/ EMAS position shows the folly of allowing parties unlimited time to negotiate as it worsens the economic pain for firms that have proactively sought solutions. At some point these parties need to be given a “hard stop” date at which time the courts will not allow moratoria to be rolled over.

Eventually the restructuring in Asia will begin in earnest because there are simply not enough chairs now the music has stopped (with apologies to Chuck Prince). EMAS surely looks likely to kick this off.