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.

Greece, Solstad Farstad, and other restructurings…

The recent Greek debt deal is proof that when no other option exists lenders will sometimes do the right thing. Greece it should be remembered was a banking crisis as well as a sovereign debt crisis, and although the Greek banks are recovering five years after the first major ructions they are still on life support from the ECB. This should provide both some degree of hope and reality for Solsatd Farstad when they announce where they are on the latest restructuring this week. I understand that as part of the process the Farstad name will be dropped in October/ November and the Farstad’s will sell out and not be associated with the company.

The banks and investors now seem to be aware of the scale of the problem here and realize that a booming market isn’t coming and isn’t going to save anyone. The high-end AHTS have even had disappointing day rates relative to expectations (hopes?) and the Q2 numbers will simply not bank enough for a long idle winter to give anyone real comfort. And all the while the Deep Sea Supply fleet festers like a cancer on what healthy tissue remains in the body. Now only an agreement with the banks can  provide any long term solution.

Offshore companies remind me of banks in a funding sense, hence why I mention Greece, as the debt dynamics and issues are broadly similar. Offshore vessel operators fund themselves in charter markets that are significantly shorter than the economic life of the assets they buy. Charter periods dropped from 5-8 years in the early 2000s to complete spot market/ at risk vessels by 2013/14. That is complete market risk funding the purchase of a 25 year asset.

Banks also borrow-short and lend-long, in simplistic terms they borrow money as deposits and lend them to businesses for significantly longer periods of time, and while the deposits can be drawn down as requested the loans cannot. There is in effect a funding mismatch called “maturity transformation” which creates value.

This same sort of duration mis-match between the vessels owned and the charter market created huge value for offshore vessel and rig companies in a booming market. Vessel owners committed to 25 year assets, with 10 year loans on 12-15 year repayment profiles, and funded this in some cases purely in the spot market. In trading terms it was a carry-trade with the high yield short term market being funded by a long term lending market. This was a totally procyclical financial phenomenon that meant the short-term market had a pricing premium compared to the long term cost to anyone who took the risk to commit assets to the short-term market. Now, just like a banking crisis, there has been a freeze in the short-end of the market and this is impacting their ability to meet long term commitments. As Paul Krugman stated “if you borrow short and lend long you are a hedge fund and should be regulated like one”, and that is in effect the embedded funding profile of many offshore operators prior to 2014.

That model is now dead, although not completely, but I think this is the most important, and maybe the least discussed, part of the industry change. And there will be change, not through any grand initiative, but eventually as the market recovers and banks lend on offshore assets again they will force the counterparty to have a longer term contract, and gradually the time/duration risk will be more equitably split than it currently is in an oversupplied market. But I think that is going to take a long time.

It will also mean for smaller E&P operators, marginal producers, their costs could increase significantly for assets on the spot market… and they should! Building assets in the tens-to-hundreds of millions and relying on the spot market to clear them just isn’t rational, as is currently being shown. Being able to call up a jack-up PSV, AHTS, CSV or whatever at a moment’s notce and get it delivered in a few hours or days is currently proving to be a terrible business model for asset owners. Longer term the industry should move to larger operators with a series of longer contracts that roll off in a time efficient way rather than everyone thinking they can clear excess capacity in a short-term market. Larger E&P companies will commit to longer contracts and get a much lower margin as a result. Those providing short term assets will have to charge a substantial premium for this given the risk involved but it will be a smaller, risker part of the market, with substantial amounts of equity to cushion the cyclicality required. It is this factor that I think will drive consolidation far more than any cost savings: how much idle time can your business model handle?

The solution is therefore going to look like banking resolutions in Europe. Traditionally that has meant either a) bankruptcy/insolvency (and there is still more of this to come), or; b) a good bank/ bad bank split (e.g. Novo Banco). Solstad I think could eventually go this way: Solship 3/ Deep Sea Supply was an early attempt at this but failed. More radical solutions are needed now but the final solution will end up more like this. In order to compete with Standard Drilling and others in the North Sea the banks behind Solstad would need to equitise their entire expsoure to the PSV fleet and the most likely new “bad bank” starts here. The “bad bank” they already own, Deep Sea Supply, needs to be cauterised. All the banks have with these assets anyway is a claim to some future value when the market recovers and they want someone else to pay the OpEx to get there. It might have worked in 2016 but the investment narrative has changed since then.

These are moves that take months not weeks and not all the stakeholders are in the same place. A cold winter with lots of tied up vessels is likely to bring these groups closer together. Resolution is some way off. Eventually, when all the other options have been exhausted, the banks are likely to do the right thing here.

Anecdote is not the singular of data…

“As regards the scope of political economy, no question is more important, or in a way more difficult, than its true relation to practical problems. Does it treat of the actual or of the ideal? Is it a positive science concerned exclusively with the investigation of uniformities, or is it an art having for its object the determination of practical rules of action?”

John Neville Keynes, 1890, Chapter 2

Music journalists know a lot about music… if you want some good summer listening I would advise taking them seriously. However, as a general rule, their knowledge of finance and economics is less sound… ‘Greatest Hits’ have for example included complete confidence that EMAS Chiyoda would be recapitalised right before they went bankrupt… or that the scheme from Nautilus to put ancient DSVs in lay-up wasn’t stark raving mad because the Sapphire couldn’t get work either… I digress…

On a logical basis it is very hard to argue that a majority of companies in an industry can consistently be under margin pressure and and that they will exist indefinitely regardless of cash flow losses. It might make a good album cover but as economic reasoning it leaves a lot to be desired.

Let me be very clear here: if the total number of firms in an industry are operating at below cash break-even only one of three things (or a combination of) are possible:

  1. Some firms exit the industry. Capacity is withdrawn and the margins of the remaining firms rise to breakeven (a supply side correction).
  2. The market recovers or grows (a demand side correction).
  3. An external source injects funds into the loss making companies or they sell assets (a funding correction).

There are no other options. I write this not because I want people to lose their jobs, or because I hate my old company, or because I didn’t like the Back Street Boys as much as the next music journalist in Westhill, I write it because it is an axiomatic law of economics. To write that firms, backed by private equity companies, who have a very high cost of capital, will simply carry on funding these businesses indefinitely is simply delusional.

A deus ex machina event where a central bank provides unlimited liquidity to an industry only happens in the banking sector generally (in the energy space even Thatcher made the banks deliver in general on their BP underwriting commitment). Subsea appears to flushed out the dumb liquidity money, convinced of a quick turnaround, and being turning toward the committed industrial money now.

The real problem for both York and HitecVision, or indeed any private equity investor in  the industry isn’t getting in it’s getting out (as Alchemy are demonstrating). Both have ample funds to deploy if they really believe the market is coming back and this is just a short-term liquidity issue, but who do they sell these companies to eventually? It was very different selling an investment story to the market in 2013 when all the graphs were hockey sticks but now anyone with no long-term backlog (i.e. more than a season) will struggle to get investors (even current ones). The DOF Subsea IPO, even with their long-term Brazil work, failed and the market is (rightly) more sceptical now. Every year the market fails to reover in the snap-back hoped for each incremental funding round gets riskier and theoretically more expensive.

Private equity firms have a range of strategies but they generally involve leverage. Pure equity investment in loss making companies in the hope of building scale or waiting for the market to develop is actually a venture capital strategy. Without the use of leverage the returns need to be very high to cover the cost of funding, and if the market doesn’t grow then this isn’t possible because you need to compete on price to win market share and by definition firms struggle to earn economic profits, yet alone excess profits, that would allow a private equity investor to profit from the equity invested. For private equity investors now each funding round becomes a competition to last longer than someone else until the market recovers. In simple terms without a demand side boom where asset values are bid up significantly above their current levels the funding costs of this strategy become financially irrational.

In this vein HitecVision are trying to exit OMP by turning it into an Ocean Yield copy. The GP/LP structure will be ditched if possible and the investment in the MR tankers shows the strategy of being a specialist subsea/offshore vessel company is dead. Like the contracting companies it isn’t a viable economic model given the vintage year the funds all started.

Bibby Offshore may have backlog but it is losing money at a cash flow level. The backlog (and I use the 2013 definition here where it implies a contractual commitment) it does have beyond this year consists solely of a contract with Fairfield for decom work. This contract is break-even at best and contains extraordinary risks around Waiting-On-Weather and other delivery risks that are pushed onto the delivery contractor. It is a millstone not a selling point.

Aside from the cost base another major issue for Bibby is the Polaris. Polaris will be 20 years old next year and in need of a 4th special survery: only the clinically insane would take that cost and on if they didn’t already own it (i.e. buy the company beforehand). Not only that but at 10 years the vessel is within sight of the end of her working life. Any semi-knowledgeable buyer would value her not as a perpetuity but as a fixed-life annuity with an explicit model period and this has a massive impact on the value of the firm. In simple terms I mean that the vessel within 5-10 years needs to generate enough cash to pay for a replacement asset (to keep company revenues and margins stable) that costs new USD ~165m and for a spot market operator might need to be paid for with a very high equity cheque (say ~$80m). Sure a buyer can capture some of this value, but not much and they don’t need to give this away.

In order to fund her replacement capital value the Polaris needs to bank ~USD 22k per day on top of her earnings. Good luck with that. When I talk about lower secular profits in  the industry and the slow dimishment of the capital base that is it in a microcosm: an expensive specialist asset that will be worked to death, above cash flow breakeven in a good year, with no hope of generating enough value in the current economic regime to pay for a replacement. This is how the capital base of the industry will shrink in many cases, not the quick flash of scrapping, but the slow gradual erosion of economic value.

Ocean Installer also have limited work although it is installation work and firmly grounded in Norway. Like everyone else this is not a management failing but a reflection of market circumstances.

McDermott and OI could not reach a deal on  price previously. MDR realised they could just hire some engineers, get some vessels (and even continue to park them in an obscure Norwegian port if needed by Equinor), and recreate OI very quickly. All OI has worth selling is a Norwegian franchise the rest is fantasy. An ex-growth business with single customer risk and some chartered vessels has a value but nowhere near enough to make a venture capital strategy work in financial terms.

Now at both companies there are some extremely astute financial investors are doing the numbers and they must either send out letters to fund investors requiring a draw down to inject funds into these businesses, explaining why they think it is worth it, and putting their reputations on the line for the performance. It may have been worth a risk in 2016, and 17, but really again in 18? Really? [For those unaware of how PE works the money isn’t raised and put in a bank it is irrevocable undertaking to unconditionally provide the funds when the investment manager demands. Investors in big funds know when the money goes in generally and what it is being used for.] And again in 19? And the more they draw down now the higher the upturn has to be to recover. (In York’s case I think it’s more subtle as the investment exposure seems to have moved from the fund to Mr Dinan personally given the substantial person of interest filings).

But whatever. If they do this all the firms do this forever then they will all continue to lose money barring a significant increase in demand. And we know that this is not possible in the short-term from data supplied to the various regulatory agencies. And for the UK sector we know production starts to decline in two years (see graph). So in the UK two years just to keep the same available spend in the region the price of oil will have to go up or E&P companies will have to spend more proportionately on the service companies. This is not a structurally attractive market beset as it is with overcapacity.

Aside from the major tier 1 companies are a host of smaller companies like DOF Subsea, Maersk, Bourbon, and Swire, long on vessels and project teams, and with a rational comnmitment and ability to keep in the market until some smaller players leave. I repeat: this is a commitment issue and the companies with the highest cost of capital and the smallest balance sheets and reources will lose. These companies don’t need to win the tie-backs etc. that OI (and Bibby) are really aiming for: they just need to take enough small projects to ensure that the cost base OI and Bibby have to maintain for trying to get larger projects is uneconomic and expensive in short-term cash costs. It is a much lower bar to aim for but an achievable one.

So the private equity funded companies are left with option 3 as are the industrial companies. The problem is that the industrial companies have a Weighted Average Cost of Capital of ~8-15% and private equity companies who like to make a 2.5x money multiple have about a 25-30% (including portfolio losses) The magic of discounting means the nominal variance over time is considerably larger.

And for both OI and Bibby the fact is they face a very different market from when they started. Both companies went long on specialised tonnage when there was a shortage, taking real financial and operational risk, and growing in a growing market. That market looks likely never to return and the exit route for their private equity backers therefore becomes trying to convince other investors that they need to go long on specialist assets that operate in the spot the market with little visibility and backlog beyonnd the next six months. As someone who tried raising capital for one of these companies in downturns and booms I can tell you that is a very hard task.

So if you want some easy listening summer music I suggest you take advice from a music journalist. On the other hand if you want a serious strategic and financial plan that reflects the market please contact me.

Der Schrei der Natur …

It is very likely that the North Sea starts next summer without Ocean Installer, M2 Subsea, and Bibby Offshore. In fact I am going for probable rather than possible. Private equity owners are looking at having to inject real cash resources into these businesses and they are not happy given the prospects of getting it back.

Another minor sign: more changing of the guard in the tier two contractors with Bibby Offshore now parting company with their CEO today. This looks stage managed coming almost 6 months to day after York Capital took control (6 months is a standard BOHL executive notice period). Although there are clearly some specific circumstances in play here the driving force at Bibby Offshore is the same as at the other tier two contractors: the cash crunch (see here). As business plans are developed for next year, and the poor summer season continues, Boards are facing up to the fact they will need new funding for next year.

Just as the Board of Ocean Installer demanded a plan that saw HitecVision sever the cash umbilical this year, so Bibby Offshore had to go through the farce of a “recapitalisation” late last year (which was more Rabelais than reason). It was frankly an embarrasment (and here) although it has led to a severe dispute between York (who fell for it) and its authors EY.

Now in 2018 York are having to do it again with Bibby who have no path to cash flow profitability. Bibby Offshore is very vulnerable: In financial terms they are likely to consume £10-15m in cash this calender year, then start next year needing to put Polaris through a 4th special survey (£2-3m?) and Sapphire through an intermediate (£1m?). At current run rate they may need £10m more in cash before next April. It’s grim.

I don’t believe a sale of the business is realistic now it has this trading history behind it (see here). A potential buyer is now gets a business locked in a battle with Boskalis at the low-end and TechnipFMC and Subsea 7 at the top-end. Without a sustained improvement in market conditions, which now will not come at the earliest until summer 2019, the shareholders face another hefty cash call. And all to fund more of the same: a subscale business battling giants and losing cash with an increasingly aging asset base. It’s a hard pitchbook for investment bankers to write. There is no upside here in terms of expansion potential or margin expansion. And it’s very risky. Why not leave your money in the bank?

It’s sad for me to see but the honest truth is it was Bibby Line Group that killed the business: a 50% dividend policy in a capital intensive business like offshore simply cannot work long-term. The GBP 175m bond, the only real money Bibby Offshore ever had, was used to pay off SCB (USD 110m) and then a dividend recap to group of ~£35m. There were never funds to grow the business when the market boomed and no equity as a cushion when the market tanked. We are in the final stages of a tragic denouement now.

York are in a terrible position now with no realistic course of recovering their investment and no logical argument to keep putting money in. A dispute with EY over the “missing £50m” is apparently causing some tension between the two firms. The story as I have heard it (from a person directly involved in the deal) was that EY had their numbers wrong and had miscalculated the financial runway Bibby had. York realised too late and “had” to follow through not seeing how bad the current downside could be. On current performance the bondholders would be better off with the EY liquidation assumptions than current exit strategies would imply.

Quite how a self-professed set of financial geniuses and a Big 4 missed the obvious fact that a firm losing £1m in cash a week would run out of money quickly is being kept quiet for obvious reasons (see here June 2017). York blame EY but really it was obvious to any outside observer with a basic knowledge of offshore economics that this would happen and it’s just embarrassing for both parties.

The new management have strong experience with Songa and are in all likelihood extremely capable and talented individuals. They are unfortunately not alchemists and the fact is that the North Sea DSV and small projects market has not had a rebound of the scale needed to help firms of this size and it suffers from chronic overcapacity. Until the CapEx market comes back, and we know from field development plans it cannot in the short-term for the UKCS, then this situation will not change. It is a commitment battle and the firm with the highest cost of capital and smallest balance sheet will lose.

Throughout the supply chain this continues: Olympic Subsea came out with numbers last week and it shows again that this continues to be a broad, deep, structural market contraction. Have a look at the cash flow because at the moment nothing else matters:

Olympic Cash Flow Q1 2018.png

Olympic spent more on financial repayments in Q1 2018 than they received net from operating the vessels. And despite talk of a market improvement they have 3 CSVs for fairly close delivery available by the end of August. Olympic look like the will make it to their 2020 runway with the cash they have on hand, but then what? This summer isn’t going to save them only slow the cash burn.

For those without the cash the decisions are starting to get ominiously close.The North Sea summer next year is likely to have  a very different economic ecosystem from the one currently exists.

 

 

Ocean Installer and SolstadFarstad… endless financial winter..

Ocean Installer held a “must attend” townhall this morning. The CEO moves out to a BD role and the CFO is out altogether. In comes an increasingly realistic HitecVision who now must know that the current losses are unsustainable and there are very few suitors in sight who can bail them of this investment.

OI’s problem is that the summer hasn’t come in terms the quantum of work or the rates at which projects are being contracted. Last year shareholders (and creditors) across the subsea contracting industry wanted a business plan which showed them breaking even at worst in 2018 and then a significant recovery in 2019. So in  2017 those business plans were dutifully delivered to the various stakeholders by management. The problem of course is they had no basis in reality and now as the summer has come, schedules are firm, contracts have been signed, and there is now no place to hide from the reality that this is going to be another terrible financial year for many companies. No other plan would have been acceptable to put before the Board, but now it hasn’t been achieved, and there is no realistic chance of doing so, something has to be done.

This scenario is happening now repeatedly across the industry and the bet the industry would recover this year has proven to be wrong. For those with exposure to boats, or business models based on vessel operations, this is a miserable summer.

And who actually can see a catalyst for change that will make 2019 any different? The oil price is higher than most could have hoped for 6 months ago and while it is leading to more work it just isn’t on the scale required to allow a PE house to recover what has been a considerable investment in OI. It is all well and good saying the North Sea semi-sub market is going crackers but that means it is years away before this will flow through to the subsea construction market. The tier one contractors will be there for that work, whether OI will be is another story altogether.

I don’t think there was a problem with the management of OI but rather with the business model. When founded OI took time risk on scarce vessel assets and made a margin on this risk. It was a sensible and sound idea given the market fundamentals at the time. But the cash costs were huge as it took  on engineers at the peak of the market to bid work and try and get market share. Brazil, Perth, and Houston were all significant loss making offices with a lot of engineers at costs of up to USD 1000 per day… Like Ceona the ramp up costs and timeframe to realistically build a sizeable contractor were I think dramatically underestimated (along with not having a rigid reel strategy).

Now why does OI exist? Would you start it tomorrow if you could? If you can’t answer those questions easily in this market, and you don’t have a lot of cash, then the answer is unfortunately you won’t exist eventually. Just taking someone elses vessels and making a tiny markup on them is an okay business model, except for the fact it’s risky and low margin with no hope of scaling up without more investment if a market recovery happens. One wrong bid with a fixed price contract and you are paying for a vessel to finish the job at a rate that quickly wipes out any potential profit from the original job.

All “boatless” contractors, and the majority of ROV operators taking contract risk, have a strategy that is the equivalent of trying to pick up pennies from in front of a steamroller: the risk reward is totally disproportionate now.

The maximum price anyone would be prepared to pay for OI should really be capped at what is would cost to replicate the company. The major assets are its relationship with Statoil and …. Anyway it has a good relationship with Statoil. All the other aspects of the business: access to vessels, an engineering pool that cannot cover it’s fully loaded costs, its international network with no economies of scale etc can all be replicated for minimal costs. This is an easier business to get into than get out of.

Solstad Farstad also announced a small extension to their situation today and they have the same problem as OI: the business plan simply isn’t real. I have no wish to repeat ad infinitum my constant critique of Solstad Farstad. The extension to the Deep Sea Supply fiascof***up unfortunate situation will now not be revealed until June 30. This is a very bad sign. There is clearly no agreement and probably no plan with apart from hope… which has worked badly so far.

The same problem infects it as with OI: the lack of credibility of a demand side recovery on which the entire Solstad Farstad plan was based on. I repeat: a major restructuring is needed if the company is to survive and 4 week extensions on one portion of the business in no way reflect the operational or financial reality of the company. Having taken on the operational responsibility of the Deep Sea Supply  fleet there is no credible way for the banks to do anything other than firesale the assets now or hand their lay-up over to another ship manager. Such a scenario would require a dramatic revision of the actual cost savings the merger had achieved, but a scenario where Solstad Farstad continue to spend time and money on the Deep Sea Supply fleet is also unsustainable and untenable under the current financial structure.

I would be amazed if a final solution is rolled out in four weeks. Expect major delays here as the banks face up to the scale of the losses. The new Solstad balance sheet is likely to look dramatically different to the 2017 final version published recently, and whether OI is a customer when they come to publish it is also a debatable question. Expect more of the same as a summer of weak demand in the North Sea rolls on unabated.