DSV market runs out of ‘Greater Fools’… Keppel version…

It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it for “keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence.

— John Maynard Keynes

If something cannot go on forever, it will stop.” (Stein’s Law)

— Herbert Stein

The greater fool investment theory is acribed to the Great Man, who in a famous passage noted that the stock market worked like a beauty parade and that picking a winner was not about backing one’s own judgement:

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

(Keynes, General Theory of Employment, Interest and Money, 1936)

This led to the ‘greater fool’ theory as it has been observed that assets trade not on an intrinsic value (i.e. the cash they can be assumed to generate) but on the basis of what people believe others will pay for them at some point in the future. The boom in DSV building is running into the wall of cash requirements and a shortage of fools willing to invest in them.

If the market scuttlebut is true, and I believe it is, somewhere in 31 Shipyard Road, if it hasn’t happened already, a terrible realisation is taking place: New Orient Marine Pte Ltd, a subsidiary of  Marine Construction Services Ltd (Luxembourg), has a financing issue with the new ICE Class DSV, and in reality isn’t going to take delivery as planned. SOR reported last week that they were seeking a charterer at rates of USD 80-100k a day, a number that if true is so absurd it is beyond satire. The vessel as you can see from the Keppel Q1 presentation is due to be delivered at some time this year.

You can write the script here I suspect: New Orient will be a thinly capitalised company that had sufficient funds to make the progress payments only. Unable to get work for the vessel they have now have no takeout financing, and will be unable to take delivery from Keppel. A frantic search is therefore underway to find someone, anyone, to try and take the vessel off their hands.

At the time the order was signed in 2015 (when the market was cooling significantly), Keppel issued this press release with the comment:

Mr Knut Reinertz, Director of Maritime Construction Services, said, “There is a demand for modern ice-class multi-purpose vessels in the market and we believe this new state-of-the art vessel we are building with Keppel Singmarine is ideally suited to meet this need.

The problem I have with this statement is that how much demand there was/is? And how you split the risk? And even more importantly what is the supply side looking like? MCS/MRTS have used the Toisa Paladin in the region and it has never been on a 365 basis, and they certainly never had the forward order book to justify going long on a vessel of this complexity and cost. So they were either completely mad, or wildly optimistic as to their prospects to resell or recharter the vessel prior to delivery (and they aren’t the only people doing this in the DSV space). Unfortunately the timing is spectacularly bad. I don’t know what the payment profile was for this asset but I can guess it was something like 5% down with 10% later, and if Keppel were lucky, another 10% further on. But apart from that I don’t see them getting any more for this.

I actually believe this vessel, with a reported build costs of USD 200m, or SGD 265m, is valueless. I say this not to be controversial but a cold examination of the market and the asset.

Firstly, and most importantly, the vessel is being classed by Bureau Veritas. That wasn’t a joke, I’m serious. You can read the BV press release and documentation here. Those who have worked for a saturation diving company will appreciate the significance of this, while others may wonder where I am going with it? Saturation diving isn’t rocket science, but not everyone can do it either, you need a certain number of systems, and processes, and high quality people to be there to create a certain institutional knowledge base to do it safely and efficiently (particularly North Sea/ ICE work). Small things can cost you a lot of money and this is a classic example where cutting corners, is I believe, going to render this hull worthless. For those still here, there is no other DSV in the world classed by BV, it is just not a classification society recognised to give a vessel SAT notation. The only reason you would use them, and not DNV or Lloyds (and maybe ABS at a push), is to save money, and anyone looking at buying this vessel at anything close to its construction cost would know the original purchaser did this to be cheap. Very cheap.

Secondly, the chambers and other equipment are not NORSOK compliant. I don’t even think a BV system could be NORSOK compliant without a vast amount of bridging documentation and ancillary work (I am happy to be proven wrong on this). The only market in the world where you can get day rates that would cover that build cost is Norway, and they already have two NORSOK DSVs for a total market of 550-600 DSV days on a good year.

Thirdly, the dive system is a Lexmar, and has had known installation problems throughout the build. No one spends USD 200m on a dive vessel with a Lexmar system. Again it was done to be cheap and it will in all likelihood render the vessel unsellable.

Although I am a paid consultant I have therefore done Keppel a favour and compiled a list of all the possible buyers for this asset (who says consultants ask for your watch and then tell you the time?):

 

 

 

Unfortunately, as you can see, it’s quite a small list. But the number of people needing a USD 200m DSV at the moment is 0. The largest owner of high class DSVs is rapidly beoming Yard Inc. Lichtenstein is still in Shenzhen, Vard has the Haldane, and now Keppel has the New Orient DSV. And that is without getting into idle tonnage and the DSVs still to be delivered. If you speak to people associated with these assets they all assure you that they are close to selling them, yet if these vessels are not used in the North Sea they are only worth the Asian/African DSV price, where you are competing with modular systems on a PSV, and all the North Sea contractors have too much tonnage, as the Nor vessels prove. Find me a CFO from one of the big 6 who could take one of these DSVs at anything like book value, and who is willing to go to the stockmarket, with backlog collapsing, and say he has paid anything less than a steal for one of these? No one outside of these companies could get the vessel into a region where they could hope to recover that sort of cost – and even then not in the current market.

New Orient Marine Pte Ltd , are in turn linked with MRTS, a Russian owned contractor focused on the Sakhalin region (although I think they have done other work in the Caspian).  It’s worthwhile having a look at their fleet to see the sophistication of vessel they are normally used to dealing with here and the risk Keppel took in this contract given this. MCS have hired DSVs on a time charter basis, but have never owned a DSV; you therefore have to admire their… courage?… in striking out to build one of the most advanced DSVs in the world.

Clearly they were hoping to sell something well above it’s intrinsic value by being bold. The payoff was an asymetric one to MCS though, who stood to benefit enormously while Keppel are going to be stuck with this eccentric design for a long time prior to reality setting in I suspect. Keppel are a big company with a multi-billion market cap so this isn’t a “farmburner” for them, but they could realistically have to writeoff USD 150-200m here which is going to be very painful all the same. The Chinese yards have decided to play for time, the Tasik DSV was yard financed and  UDS are the potential saviour for the Lichtenstein. Not everyone can be saved here because there is just insufficient demand until the DSVs return to construction work not maintenance, and that looks a long way off.

The oil market narrative…

Robert Schiller gave this lecture earlier on the year on the power of the narrative in economics and it concerns:

 the epidemiology of narratives relevant to economic fluctuations. The human brain has always been highly tuned towards narratives, whether factual or not, to justify ongoing actions, even such basic actions as spending and investing. Stories motivate and connect activities to deeply felt values and needs. Narratives “go viral” and spread far, even worldwide, with economic impact.

It’s wide ranging and I would recommend all 57 pages. Schiller argues that epidemological models from biology maybe a good basis for integrating narratives into economics. Evolutionary economics has been hugely influenced by biologicals models of change and there is no reason to believe behavioural economics cannot be just as influenced.

Given the action in the oil market I regard this as a good a theory of market price developments as any other. Deep down clearly the market fundamentals count i.e. the basic where demand will meet supply. But up until a few weeks ago the dominant logic in the oil industry was clearly just how rapid price rises would be, and yet how quickly this has changed in the past week after the IEA claimed we were underinvesting massively.

Reuters published an interesting story last week about how bullish oil companies were, indeed the market narrative was summed up by this analyst:

“The investor mindset is switching to growth again,” said Anish Kapadia, analyst at investment bank Tudor, Pickering, Holt& Co.

“Oil prices are above $50 a barrel, companies are generating cash and are starting to talk about growth again, we are at that point of the cycle.”

But they also dumped in this casual data point:

Even as prices LCOc1CLc1 hold near $50 per barrel, the firms – Royal Dutch Shell Plc (RDSa.L), Exxon Mobil Corp (XOM.N), Chevron Corp (CVX.N), BP Plc (BP.L), Total SA (TOTF.PA), Statoil ASA (STL.OL) and Eni SpA (ENI.MI) – plan to grow output by a combined 15 percent in the next five years…

The seven companies will add almost 3 million barrels per day to their combined output in the next five years effectively generating production the size of another major like Chevron. [Emphasis added].

The FT this morning had an article about Leonardo Maugeir, who used to head strategy for ENI,  and his views who has written this article:

In January, my similar field-by-field analysis indicated that world oil production capacity and actual production were still growing—while prospects for demand growth were not sufficiently high to absorb the excess supply. In particular, actual oil production (which includes crude oil and other liquids such as condensates, NGLs, and more according to the standard definition used by most statistics) was almost 99.5 million barrels per day (mbd)—leaving a voluntary and involuntary spare capacity (the result of local civil wars and other geopolitical factors) of more than 4 mbd.

Frankly any sane person is going to be bored-to-death by potential supply/demand imbalances of 1-2m barrels a day (or 4m or whatever, life is too short), and the models underpinning these are so complicated they can only ever be directionally correct, but the core point here is how they are shaping the narrative. The narrative seems to have turned to the downside, to the potential of shale as a marginal production source of choice, and the potential for oversupply in the industry. Too many people in the industry still just refer to “when the next boom comes”, but having predicted 9 of the last 0 house price crashes in New Zealand I realise that such predictions offer little value. Is there really going to be another boom? What will it look like? And when really will it come?

But the value, and the interest, in oil, seems to be the euphoric highs and lows (and the investment returns that mimic this), driven partly by the narrative.  I wonder if it’s a function of the sheer scale of the capital investments that have previously been required to make a meaningful increase in production? I wonder if shale won’t modify this somewhat?

I’m a long run guy. Maybe in the long-term shale, with much smaller capital commitments per well, will make the oil industry less cyclical as marginal production can be more efficiently brought in and out of use? Everything in life is relative (in an economic sense). Modern economic growth is usually dated from c. 1500 (which the Great Man ascribed to the price revolution), maybe the importance of oil from the beginning of the 19th century was just a blip in the economic cycle of the post 1890 long globalisation age, in which case we have just been through a Cambrian Explosion of innovation and now the oil extraction industry settles down to maturity with less price volatility and more constant productivity improvements one would expect from a more mature industry? Maybe shale is the productivity revolution that matches supply and demand after a 40 year lag when oil prices really took off in real terms? Productivity improvements are not linear but erratic. The dominant narrative until just a few years ago was that “all the easy oil is gone”, now that just isn’t true again.

oilprice1869.gif

Maybe I am actually a random walk guy? As always I back technology and productivity improvements over long-run resource scarcity and supply issues given relatively free markets. I therefore err on the side of lower oil prices for some time, especially given oversupply in the servive sector.

 

“This time it’s different…”

“The four most expensive words in the English language are, ‘This time it’s different.’”

Sir John Templeton

In investment theory a key part of recognising that a bubble is close to bursting is the logic that “this time it’s different”, the internet boom of 1999-2000 being the classic case. The core argument is actually regression to the mean: eventually all profits drop back to normal levels, but this time, they won’t.

In oil services, particularly offshore, there seems a view that this downturn is the same as others. Everyone wants to believe that next time will be the same. Somehow, magically, demand will equal supply, day rates will rocket, and everyone will go back to building USD 100m vessels with USD 20m equity, to put on the spot market and and that will be the new normal. I think the narrative is driven by the extremely mild (in hindsight, it didn’t feel like it at the time) dip in 2008/9, and the strong recovery in 2000, where people who had invested early, and took serious risk, made some exceptional returns (Integrated Subsea Services springs to mind). It might happen, but I doubt it.

For one thing the daily fascination with the oil price seems entirely inappropriate for offshore contractors. The industry is wallowing in a sty of capacity: it’s the supply side that important in the short-run here not the demand side. As everyone in the industry knows (deep down) the number of project staff laid-off will ensure it would take a long time for the E&P companies to ramp up projects even if they wanted to.

The oil production industry is clearly undergoing a structural shift with the impact of shale. It won’t be the end of deepwater and offshore, but it seems unlikely to return as before. I wrote before about the changing economics of shale and the extraordinary drop down the cost curve that has affected that industry. My core point is that when you can drive standardisation you get massive efficiencies that can transform the cost curve, and therefore, the underlying economics of an industry.

In that vein, inspired by this piece from the FT (which is broadly dismissive of electric vehicles), I read this from the Grantham Institute. The report focuses on the Solar Photovoltaic and Electric Vehicle cost reductions that come from scale improvements in the manufacturing process and producitivity of the units (particularly battery efficiency for electric cars). Under their model oil demand peaks in 2020:

E[lectric] V[ehicle]s account for approximately 35% of the road transport market by 2035 – BP put this figure at just 6% in its 2017 energy outlook. By 2050, EVs account for over two-thirds of the road transport market. This growth trajectory sees EVs displace approximately two million barrels of oil per day (mbd) in 2025 and 25mbd in 2050. To put these figures in context, the recent 2014-15 oil price collapse was the result of a two mbd (2%) shift in the supply-demand balance.

Now there are a number of caveats in the research and I also get that they have an agenda. So of course does BP. No one is lying here,  it’s just that humans are “boundedly rational“; they can only process so much, and what they do therefore is referenced in cognitive analogies and models. The arguments form part of a “dominant logic” of analysis and decision making. Both are statiscally sophisticated models with regression analysis at the core and therefore one is reminded of the Great Man’s warning (to Koopman’s) on the problems with this sort of analysis:

Many thanks for sending me your article. I enjoyed it very much. I am sure these matters need discussing in that sort of way. There is one point, to which in practice I attach a great importance, you do not allude to. In many of these statistical researches, in order to get enough observations they have to be scattered over a lengthy period of time; and for a lengthy period of time it very seldom remains true that the environment is sufficiently stable. That is the dilemma of many of these enquiries, which they do not seem to me to face. Either they are dependent on too few observations, or they cannot rely on the stability of the environment. It is only rarely that this dilemma can be avoided.

Letter from J. M. Keynes to T. Koopmans, May 29, 1941

The point is I guess that somewhere between BP and the Grantham Institute we are likely, barring a major technological development, to see the outcome. But directionally the Grantham Institute research seems to be right side of change, and that is important when you see this graph:

Global Oil by Sector

In the long run I favour productivity and technical improvement over most other drivers in the economy. You can pass an inflection point where the whole economics of an industry changes. Shale has had it, and solar and EV might have it as well. But a core point is it requires standardisation and scale combined with technology improvements, and my worry for offshore is it has none of these except the potential of marginal improvements.

As I have argued offshore energy isn’t going to go away: in volume terms it too much of an important part of the supply chain for that. But is it going to be on the scale and have the importance it did before? BP and the other oil companies are right to keep investing, that is their business and their shareholders believe that, it’s capitalism, and a very efficient market mechanism. These productivity improvements are marginal at the moment, and car replacement cycles are long, competition is never stagnant etc. But it is hard to see a dramatic fall in the price of oil extraction productivity given it’s maturity (blended across production sources), and the same cannot be said for electric vehicle productivity. I accept that I have said that about shale, and there appears to be much further to run down the productivity curve, but subsea production is subject to dimishing returns, high capital utilisation, and asset productivity limits. Subsea is very efficient at scale but it is not easy to transform the limits of that scale, which isn’t true for manufacturing electric batteries and their potential capacity increases and price decreases (in real terms), and also to a lesser degree shale, which is limited by a high-service/labour input element.

There are issues with this negative theory: production that ends is harder to track and much less visible, I think I am biased by being amazed how quickly Tesla seems to to be growing, resource constraints could be found in battery manufacture etc. But it feels to me like we are passing a stage where after having been dependent on one source of energy for so long, admittedly a remarkable one on a calorie/output efficiency basis, other technologies are catching-up.

I don’t have a crystal ball, but going long on 25 year assets like drilling rigs and vessels, on the logic that it will always bounce back, because it did before, unless it’s part of a portfolio investment, strikes me as more risky than at anytime in the past 25 years. Whatever the industry will looked like in five years from now I doubt offshore will look like it did in 2013 ever again.