Brazil, The New Offshore, and Contractor Profitability…

“My salad days, When I was green in judgment, cold in blood, To say as I said then!”

Cleopatra – Act 1, Anthony and Cleopatra

Bassoe Offshore had a very good and insightful article on Brazil this week. The key thing for me was the sheer drop in volume of rigs working in Brazil:

As we noted earlier this year, the number of drilling rigs in Brazil has gone from over 80 to under 30 during the past five years.  Currently, 26 rigs are on contract (all for Petrobras), but only about 20 are on full dayrate and drilling due to Petrobras’ reduced effective demand.  By the end of 2018 – assuming no new contracts or contract extensions – Petrobras will have 14 rigs working for them.  By 2021, this number becomes three. 

We estimate that Petrobras has a minimum requirement of around 20 rigs to sustain production through 2021.

Rigs are obviously the leading indicator of future subsea work and it’s worth putting some context on this as Bassoe Offshore did in April:

If you were an offshore rig owner back in 2010–2014, Brazil was the land of opportunity.  Petrobras offered long term contracts with solid dayrates.  Everyone wanted to be there.  Rigs were built; demand seemed insatiable. 

Petrobras even initiated Sete Brazil, a company with plans to build 29 Brazilian-content, deepwater semisubs and drillships, which was slated to be Brazil’s path to global prominence in rig construction and a boost to the country’s industry and economy.

And in order to keep production going from all the well work these rigs would be doing Petrobras went just as long on flexlay capacity. The strategy here was slightly different: Petrobras choose the two most capable subsea contractors in the world and signed them up for a vast investment campaign to buy specialist Pipe-Lay Support Vessels (PLSVs) and contract them for a period of c. 30% of their expected economic life. Technip, who always seem to call these things correctly, decided to share the risk 50/50 with DOF Subsea for four vessels, while Subsea 7 decided to build and own its three vessels.

There is a constant commentary about how high the margins are on these contracts, and it is true that during the firm period they look good, outstanding even, but there is a very real risk that some of these vessels will be re-delivered. A company that had 80 rigs working and went long on flex-lay capability with 7 vessels is unlikely to need that number in the future when it has c. 20 rigs working. For a whole pile of reasons the drop in demand is unlikely to be linear, but you only need to be directionally correct here to understand the scale of the issue.

Brazil also has proper emerging market risk characteristics in it’s local cabotage regulations that favour local tonnage as Subsea 7 found out this year when the Seven Mar had its charter terminated early,effectively for convenience, and therefore had to reduce backlog by USD 106m. So clearly the economic reason you get a good margin is because there is actually a fair bit of risk in building such a specific asset for such a unique (and having worked on a Petrobras contract I use the word in its most expressive sense) customer: the downside here is in 7 years you get a ship back quayside in Brazil that costs USD 15k per day to run and is only good for laying pipe in 3000m of water. All of a sudden that healthy margin for the last seven years doesn’t look quite so attractive, and this is a very real possibility here for at least 3 or 4 of these vessels.

This fact clearly had a massive impact of the ability of DOF Subsea to get an IPO away and is one of a number of huge strategic issues DOF Subsea has. The DOF Subsea investors were hoping to remove some of the risk of vessel redelivery, and the price the investors were offering to do this just wasn’t enough, or in sufficient volume, for a deal to be agreed. Given the binary nature of the payoff involved it is no surprise a mid-point on the two positons could not be reached: Because a downside scenario is that Petrobras halves the number of contract PLSVs it wants and Subsea 7 comes in with a low bid and the Technip/DOF Susbea JV has its entire fleet redelivered. It may not be likely but it cannot be ruled out either.

The greater IOC involvement in Brazil may also change what has been one of the great comparative anomolies of the market: the complete lack of a spot market (which made sense when Petrobras was the only customer). Should PB and the IOCs decide to bid flexlay work on a project-by-project basis the revenues for the purpose built PLSVs will be much less secure and the valuation assigned to them will be significantly lower to reflect this income volatility. These investments rightly required a very healthy margin.

I always find it amusing to read statements like “the investors think this is an even better investment” and then read the latest accounts and come across comments like this:

In the 2nd quarter the Group has seen improvement in both numbers and activity compared to 1st quarter, however the general market conditions within our industry are challenging, especially in the Atlantic region and the North America region…

During the quarter, the Group has seen a low utilisation of the vessels Skandi Constructor, Skandi Neptune, Skandi Achiever and the JV vessel Skandi Niteroi… In the Subsea/IMR project segment the idle time between projects has increased, however the Group saw an increased project activity toward the end of the quarter.

Ah… the famous greenshots of recovery… at the end of every quarter everyone always sees activity picking up… not quite enough to make it into the current results… but jam tomorrow…

Which led to these numbers:

DOF Subsea Q217

So you might believe it’s a “real out performer”, but in a financial sense it’s a very hard case to make. All the key indicators are going South.

DOF Subsea is an extremely hard investment case to make (to highlight just the three most obvious examples):

  1. Is it a contractor or a contractors’ contractor? A falling out with FMC Technip would devastate the business yet it is hard to see where the clear division of capabilities and competencies at the lower end between the two is? Are DOF Subsea really going to put the Achiever to work against the Technip North Sea DSVs? Even if you really believe they will do this how many jobs would they have to win off Technip before Mons got a call asking what was going on?
  2. The pay-off from the Brazil PLSV project is highly uncertain but it is almost certain that the current margins will drop from their current levels
  3. DOF Subsea has all the costs of being an international EPIC contractor with none of the associated scale benefits. The scale benefits of being international require large diameter pipelay and its associated margins, a move into this area is financially impossible given their current constraints and would clearly precipitate a major ruction with FMC Technip

I think DOF Subsea is just the wrong size to compete as a global contractor and I mark it as likely to underperform significantly in the future. I see a world where FMC Technip, Subsea 7, McDermott, and maybe Saipem, become almost unassailable as the profitable global SURF contractors for mid-sized field development up. Each with a very strong base in one geographic region, with an asset base that can trade internationally enough to gain scale economies from other international operations, and with the balance sheets to invest in capabilities that will standardise and drive SURF costs down. DOF Subsea, despite having a lot of nice ships and clever people, is by an order of magnitude behind these companies.

These Tier 1 contractors will make disproportionate margins to the rest of the supply chain where overcapacity is rampant and balance sheets are weak. These Tier 1 contractors will need to own only core enabling assets and simply contract in all commodity tonnage, which will remain oversupplied for years. Tier 1 margins will improve as they need proportionately less CapEx, or operational leverage, now the OSV fleet has more options. It is not all salad days as apart from MDR the Tier 1’s have some issues from the boom years, but on a project level, for larger SURF work, they are creating a very strong competitive position. You will able to have a strong regional presence/competitors, but the gap between the few global SURF contractors and the “also rans” is going to become very wide indeed as backlog declines going into 2018.

Expect DOF Subsea to remain privately held for a good while longer if the investors really believe it’s undergoing a current period of out-performance that no one else is clever enough to see.

“Short-cycle production” could be about to get an economic test…

The dots clearly show that oil prices and oil production are uncorrelated…

Caldara, Dario, Michele Cavallo, and Matteo Iacoviello

Board of Governers of the Federal Reserve System, 2016

The number of US oil rigs went down by 5 last week to 744 rigs, while the number of US gas rigs increased by 4 to 190 rigs. In terms of the large basins, the Permian rig count increased by 6 to 386 rigs, while both the Eagle Ford and Bakken rig counts declined by 3 each to 68 and 49 rigs respectively. 

Baker Hughes Rig Count, Sep 25, 2017

 

The multi-billion dollar question is: Can shale handle an increse in demand? Closely related: Is shale in a boom that is unsustainable and not generating sufficient cash to reward investors for the massive risk they have taken? Because if the latter is correct the former must be answered in the negative. The above quote is slightly mischevious and merely highlights economic research that supply factors have historically had a far bigger impact on the oil market than demand factors  (whether this is true going forward is not for today).

The NY Fed today reports that it is supply shortages now that are driving the price (and I have no idea about the construction of the model but the reduction in the residual leads me to believe it is broadly accurate), so this is a supply driven event not a demand driven event:

Oil Price Decomp 25 Sep 2017.png

If, as Spencer Dale argues (speech here), we are in the midst of a technical revolution then this is what we would expect. Hostoric levels of inventories should come down because supply is more flexible, these short-term kinks in demand caused by natural or geopolitical events should merely spur an increase in the rig count or a change in OPEC quotas. Other senior BP staff today were on message:

“Rebalancing is already on the way,” Janet Kong, Eastern Hemisphere Chief Executive Officer of integrated supply and trading at BP, said in an interview in Singapore. But OPEC needs “definitely to cut beyond the first quarter [2018]” to bring inventories down and back to historically normal levels, she said…

“If they extend the cuts, yes it’s possible” to achieve $60 a barrel next year, she said. “But it’s hard for me to see that prices will be sustainably higher,” she added.

Or is Permania simply the result of the Federal Reserve flooding the market with liquidity that is allowing an unsustainable production methodology to continue unabated storing up yet another boom and bust cycle? Bloomberg this week published this article on Permania, where the incipient signs of a bubble are showing in labour and infrastructure shortages and the outrageous cost overruns:

Experienced workers are harder and harder to find, and training newbies adds to expenses. The quality of work can suffer, too, erasing efficiency gains. Pruett said Elevation Resources recently had a fracking job that was supposed to take seven days but lasted nine because unschooled roughnecks caused some equipment malfunctions.

By this point, “we’ve given up all of our profit margin,” he said, referring to the industry. “We’re over-capitalized, we’re over-drilling and, if prices don’t rise, we might be facing a double dip in drilling.”

If I was being cynical about offshore production I would note that he was two days over with a rig crew while in the same calender week Seadrill and Oceanrig had collectively disposed of billions of investment capital and will still have the inventory for years. This guy is literally two days out of forecast and he is worried about being over-capitalized (and also that wiped his profit margin? Hardly redolent of a boom?) Offshore drilling companies are like 10 years and 100 rigs out of kilter… Anyway moving swiftly on…

Bloomberg also published this opinion on Anadarko noting:

Late on Wednesday, Anadarko Petroleum Corp., which closed at $44.81 a share, announced plans to buy back up to $2.5 billion of its stock; which is interesting, because almost exactly a year ago, it sold about $2 billion of new stock — at $54.50 apiece.

(That’s pretty clever, they sold stock at $54.5 and are buying it back at $44.8, like Glencore never buy off these people when they are selling, at heart they are traders. More importantly most research suggest companies nearly always overpay when buying stock back so if the oil price keeps creeping up they are going to look very smart indeed.)

But the real point of the story is that capital is slowing up to the E&P sector, well equity anyway no mention of high-yield:

Equity US E&P Sep 2017

Meaning that maybe people are getting sick of being promised “jam tomorrow”. However I can’t help contrasting this with productivity data, Rystad on Friday produced this:

Rystad Shale Improvement Sep 17

So despite the anecdotal evidence on cost increases in the first Bloomberg article the productivity trend is all one way.  And the stats seem clear that a large part of deepwater is at a structural cost disadvantage to shale:

ANZ cost structure 2017

Frac sand used to be c.50% of the consummables of shale, but surprise:

Average sand volumes for each foot of a well drilled fell slightly last quarter for the first time in a year, said exploration and production consultancy Rystad Energy. Volumes are expected to drop a further 2.5 percent per foot in the current quarter over last, Rystad forecast…

Companies including Unimin Corp, U.S. Silica Holdings Inc (SLCA.N), and Hi Crush Partners LP (HCLP.N) are spending hundreds of millions of dollars on new mines to address an expected increase in demand.

On Thursday, supplier Smart Sand SND.O reported it shipped less frack sand in the second quarter than it did in the first. Rival Fairmount Santrol Holdings Inc (FMSA.N) forecast flat to slightly higher volumes this quarter over last.

In the last six weeks, shares of U.S. Silica and Hi Crush are both off about 30 percent. Smart Sand is off about 43 percent since June 30…

Some shale producers add chemical diverters, compounds that spread the slurry evenly in a well, and can reduce the amount of sand required. Anadarko Petroleum Corp (APC.N) and Continental Resources Inc (CLR.N) are reducing the distance between fractures to boost oil production. The tighter spacing allows them to extract more crude with less sand.

Technological innovation and scale: Less sand used and increased investment going on that will reduce the unit costs of sand for E&P producers. This is the sort of production that brought you the Model T in the first place and the American economy excels at. Bet against if you want: just remember the widowmaker trade.

Shale is a mass production technique: eventually it will push the cost of production down as it refines the processes associated with it. To be competitive offshore must emulate these constantly increasing cost efficiencies. I have said before that shale won’t be the death of offshore but it will make a new offshore: a bifurcation between more efficient fields, low lift costs, and economies of scale in production that make the “one-off” nature of the infratsructure cost efficient, and smaller, short-cycle E&P of shale (and some onshore conventional).

Offshore is going to be here for a long time, it is simply too important in volume terms not to be. But what a price increase is not going to see is a vast increase in the sanctioning of new offshore projects in the short-term. These will be gradual and provide a strong base of supply, as there longer investment cycle represents, while kinks in short-term demand will be pushed towards short cycle production. Backlog, or lack thereof, remains the single biggest threat to all offshore contractors.

Or this thesis is wrong and I, and to be fair people far cleverer (and more credible) than me, are spectacularly wrong, and a new boom for offshore awaits in the not too distant future…

Backlog, boats, and oligopolies…

“[E]conomists usually assume that people know how the economy works. This is a bit strange since economists don’t even know how the economy works”. …

Xavier Gabaix

There was a lot of talk about Subsea 7 ordering a new pipelay vessel last week, and given the engineering quality at Subsea 7 I am sure it will be an efficient, if not technically brilliant, asset. I don’t have a counter-opinion on this: Subsea 7 shareholders expect them to be a market leader and this means buying assets, particularly when yard prices are likely to be advantageous.  The plan would seem to try and push the technical window of pipelay even further and make it harder for smaller tier two contractors to offer a competitive product with such technical features as heated pipe-in-pipe.

As a replacement for the erstwhile Navica it will ensure a leading edge capability. The Navica was built in 1999 so Subsea 7 had 16 good years out of her and  for a number of years Technip and Subsea 7 offered the only realistic reel lay in the North Sea, and I would say the vessel made real money for the shareholders from 2004 onwards (especially when considering the huge number of DSV days she generated) until 2014. Subsea 7 depreciates vessels between 10-25 years and I wonder what the figure is for pipelay assets?  If the pace of innovation in the pipe technology is such that you need a new vessel as a platform every few years then the economics would dictate a slow diffusion of pipe technology (I don’t think it’s likely).

At USD~300m it is not a massive purchase for Subsea 7 either. In 2017, in the midst of the worst industry crisis ever, Subsea 7 made a special dividend of USD 191m, and this vessel is 3 years away from the take-out payment (and could probably be pushed back if needed). The interesting thing is given the delivery time how Subsea 7 see the market coming back… because its not in the backlog. In 2013 Subsea 7 published their backlog as USD 11.8bn:

Subsea 7 Backlog Q4 13

Strangely, for the last few quarters the bar graph has been dropped in favour of the pie graph and the number is materially smaller:

Subsea 7 Backlog June 2017.png

That USD 4.4bn also includes ~USD 1.4bn for the PLSVs in Brazil. Now to be fair when Subsea 7 had backlog of USD 11bn it had six vessels under construction and was targeting CapEx of ~USD 1bn, 60% on new builds and 25% on replacement CapEx. As the order book at Subsea 7 has dropped so has CapEx pretty much proportionately. It is also interesting that they can cut maintenance CapEx back so much with guidance for total CapEx this year guided in at USD 180-220m. Yes, it’s a lot less than Depreciation, but as the industry contracts this is going to become more normal, the asset base has to shrink to reflect the total macro demand.

However, I think you can get a sense of Subsea 7 managements’ confidence in the future from this graph in their 2016 annual report:

Subsea 7 Outlook Feb 17

2014-2018 look like lean years with the tap opening up in 2018. The sceptic in me always looks at the variability of the grey box (USD/bbl 40-60) and thinks the longer market sentiment remains negative the less likely this segment is likely to fulfill its potential, because the baseload of offshore projects at USD 40 is depressingly small. But if Subsea 7 shareholders expect their company to be a market leader, and if the market is moving to longer tie-ins with heated pipe, then that is the direction the company must go. What is interesting, and will be impossible to tell for outsiders initially, is how they price this in the market? If they only have 10 years to get a return on the investment the project day rate will have to be substantially higher than if it’s a 20 year investment.

You can make a bear case for Subsea 7 being too long on pipelay capacity in Brazil and for it going too early with this vessel if the recovery doesn’t come, otherwise they have arguably handled and read the downturn better than anyone. But I guess what the management really don’t want is a company that doesn’t have the asset base if the market comes back and this is only balanced against the very high cost base vessels have if they don’t work.  Again in the latest SS7 presentation they showed this market data which would give the Management/Board the confidence to invest:

Subsea market outlook Sep 2017

Subsea 7 have the liquidity to make it through to a forecast upturn and other shareholders will have the confidence they are following on the back of Siem Industries,  who have been remarkably honest about the problems they face at Siem Offshore and their commodity tonnage.

I think it likely that at the top end of SURF FMC Technip, Saipem, Subsea 7 and McDermott pull away from the other companies and create a small pool of competitors who bid for projects offshore globally that only they can realistically do given the technical sophitication and asset base required for delivery. A large number of the tier two installation contractors are no more (Swiber, EMAS Chiyoda, SeaTrucks), so the bigger contractors should gain market share on some of the more basic installations and offer a host of technical capabilities that will make it impossible for smaller companies to compete on the larger projects.

Therefore the question is whether a small number of firms bid each other out of profits or whether they create economic value? I think you can make a bull case for Subsea 7, and the other large integrated SURF contractors, based on theories of market power and argue that this is a case where if they can push the technical and asset window enough they will generate significant economic profits, and this vessel order needs to be seen in that light. This isn’t true for every segment in the subsea market and is unique to the financial strength and product breadth the large integrated contractors have.

Markets with a small number of selling firms who are in a strong position are known as oligopolies. These market structures have fascinated economists for years because of the potential for collusion and price setting (as well as the failure of the firm profits to decline over time as classical theory would suggest). But two theories, based on French mathemeticians (who looked at a spring water duopoly) allow some insight into how the SURF companies will behave in the future: Bertrand competition, which argues that companies in this position would sell on price; or Cournot competition, which argues that companies in this position maximise sales and ultimately profitability.

In a much longer post (for another day and likely of limited interest) I will argue that this likely oligopoly of large SURF contractors will compete on a Cournot model, and therefore these firms are likely to make significant economic profits, despite the capital intensity of the industry. Cournot models are defined by:

  • [M]ore than one firm and all firms produce a homogeneous product, i.e. there is no product differentiation;
  • Firms do not cooperate, i.e. there is no collusion;
  • Firms have market power, i.e. each firm’s output decision affects the good’s price;
  • The number of firms is fixed;
  • Firms compete in quantities, and choose quantities simultaneously;
  • The firms are economically rational and act strategically, usually seeking to maximize profit given their competitors’ decisions.

The high-end SURF market is a clear case of this: a relatively small number of firms (n=4 maybe n=7 in some cases) and specialised asset base, well known to competitors and easily monitored, allows firms to understand well what there rivals are doing. For game theorists it is a market made in heaven where the signalling intentions of all parties are obvious. From an E&P perspective, when you cut through the enginering voodoo language, the product is homogenous: it takes oil from a well to a transfer point. Firms will not irrationally bid down project margins constantly as they are aware of the competitive effect of doing this (which is different from when EMAS Chiyoda and other pretenders were in existence), and in reality the high-end SURF firms are well aware what projects suit their asset base and are “must win” projects. The network of alliances, and integrated solutions from the seabed, cannot be easily replicated but are not so different in technical terms that competitors cannot make intelligent judgements about a competitors cost base.

Each firms output decision will affect price because the large step increase in investment required for new capacity will make these companies more cautious is a more depressed market. The quantity theory of output is likely the least intuitive part of the theory for subsea but in essence firms will limit the supply of new vessels and concentrate on utilisation. The big four SURF contractors will only add vessel capacity when it generates profits well above capital costs – which simply hasn’t been true in the past. Over time as the new build wave subsides the firms will choose to limit the supply and focus on cash which will drive up rates (above marginal cost). This is different from a bank enforced asset freeze I have mentioned before as these companies are large enough to access asset funding.

For the tier 2 companies and vessel owners below my depressing tone of poor margins and over capacity will continue for some time I guess. But technical innovation and high CapEx, with mildly increasing demand, should allow the top SURF contractors to exercise a degree of non-collusive pricing power that will generate real economic profits in the not too distant future. These firms will take market share in the more commoditised (and shallow) field development market and face limited competition for high-end field development work which is a growing segment of the market (hence Subsea 7’s move into the Gulf of Mexico in a big way with the EMASC assets).

So despite a generally depressed industry it is easy to imagine the high-end SURF firms prospering to a certain extent. Brazil is the country however that hangs over Subsea 7 and to a lesser extent FMC Technip (and I wonder if it really sank the DOF Subsea IPO): too much flexlay capacity. It’s very hard to see how much capacity Petrobras is going to give back, but a look at tree awards suggests a degree of discomfort for the vessel owners.With one dominant customer the downside is clearly and intense period of price competition between FMC Technip and Subsea 7 in Brazil to keep their assets working. This is a classic example of Betrand competition where two firms who offer an identical product, and cannot collude, find the buyer chooses everything from the firm with the lowest price. Such a statement seems vaguely tautological but in economic terms it is more about a formal proof that two firms can push industry margins down to zero economic profits as efficiently as a large number of firms competing.

Note: For Saipem I am talking SURF only. At a corporate level I don’t see any respite for them).

(P.S. The header pictire is of a “Kinked” demand curve which is core to the oligopoly model.)

 

 

Like Facebook and Alphabet… Nautalis Marine Plc and First Bitcoin Capital Corp… a hot M&A tip…

a company for carrying out an undertaking of great advantage, but nobody is to know what it is

From the listing prospectus of a company issuing shares during the South Sea Bubble, c. 1720

On February 27th Grand Pacaraima Gold Corp., a mining corporation focused on Venezuela,  changed its name to First Bitcoin Capital Corp (“BITCF”) thus moving from a small penny listed Canadian mining corporation to being a small listed Canadian penny listed Bitcoin/Altcoin focused corporation (h/t Matt Levine). Similarly on 16th January Global Energy Development Plc changed its name to Nautalis Marine Plc, having been previously invested in E&P production in South America, in a related party transaction purchased potentially the worst 11 vessels in the entire global subsea fleet and continued their lay-up in Louisiana, and became a small cap listed offshore vessel owner (not operator as all the assets are in lay-up).

Global Energy/Nautalis entered into a complicated loan note, validated by advisors, although this opinion has not to my knowledge been made public, to complete this transaction in which the related parties released their interest in the vessels and thus exchanged a highly uncertain equity stake, in 11 of the oldest (and most operationally compromised) OSVs in the world, for fixed obligation loan notes. The company, having generously lent the related parties money to buy the vessels in the first place, then even more generously extended credit to purchase them back. Now the company seriously states it is looking for technology focused acquisitions to add value to their vessels… one of these was built in 1967…

BITCF is also fond of complicated transactions. BITCF has managed not only a share buyback but also a dividend in cryptocurrency: BITCF used XOM “the internet of money” to buy back ordinary shares, and then Tesla Coin (“TESLA”) to pay a dividend (BITCF owns 20% of TESLA). Unfortunately, the Securities and Exchange Commission appears to have had a sense of humour failure and has suspended trading in the shares, which is a shame because on mirth value alone I recommend reading the letter explaining this which states:

BITCF is extremely rare in this regard for an OTC company as most are dilution machines designed either to grow their company or unjustly enrich management and promoters. Our management has never sold one share of our stock in spite of the meteoric rise in price per share.

The reason we have been able to succeed without external funding is due to the fact that we early learned how to develop crypto assets on a shoe string, so to speak. This also resulted in our being able to pay off our debt which was owed to management with one of our created crypto currencies.

Clearly BITCF found mining for coins easier than finding gold. In a similar vein Global/Nautalis found buying decrepit DSVs, in a related party transaction, easier than foraging for oil. Both are essentially technology plays they claim, kind of like Facebook and Snap… I guess…

I often wonder these days why I am not involved in a cryptocurrency. Can life have meaning without one? I get The Bank of England shares doubts about the stability and role of this unit of account in a modern world… but really can a bank created to finance a government loan see the future?

I note that Nautalis seeks a niche a specialised offshore technology. I think the M&A bankers can already see the possibilities that I do?! DSV Coin? There are over 850 cryptocurrenciesalready (none of which carrying the symbol DSV that I am aware of?) and BITCF allows users to mine their own coins based on their own blockchain, (although the company itself has mined 20.7m of the potential 21.0m coins). How can you not want to invest in a company that issues the following statement:

the company intends to pay additional dividends in various crypto currencies that may include crypto exchange symbols $WEED $FLY $PRES, $HILL, $GARY, $BURN, $OTX and $KLC. We may also from time to time pay dividends in our own common shares in their crypto form which trades under the crypto symbol $BITCF on various foreign cryptocurrency exchanges.

$WEED coin listed on 3 exchanges during 3rd successful ICO (Initial Coin Offering).

WEED coin now trades on the OMNIDEX, COINQX and CRYPTOPIA https://www.cryptopia.co.nz/Exchange/?market=WEED_BTC

Similarly Nautalis (who also have some great promotional material) makes much of the of the fact that they are they are “unique”:

Nautalis Differentiation.png

That is my favourite slide ever. And I say that as an ex-management consultant who was virtually paid by the slide at one point and can make the cleverest idea into a meaningless deck of slides in an instant. They should have added a line “Number of offshore energy services companies with their entire fleet in lay-up – 1 (.001%)”, that is the only improvement I could suggest. I once had a boss who was a stickler for detail who would have crucified me for not explaining the correlatation/causation aspect of so few offshore companies and the need for the industry to have less capital as E&P spending decline… but maybe not if the slide was of this quality.

Nautalis have noticed a “massive” industry (one they also have limited experience in) and are therefore “targeting a niche market”… with 11/11  vessels in lay-up that is patently true! Nautalius note there are 10 000 companies…. and probably none with their entire fleet in lay-up either! It’s a veritable Cambrian explosion of wealth…

Nautalis Opportunity.png

These companies are made for each other. NautalisBITCF can issue the first cryptocurrency based on DSVs. As the oil market recovers the vessels can be scrapped to issue genuine metal tokens (“money”) in the blockchain, backed by actual ships: A quaint physical symbol of the past perhaps? Or you could short the ships (defintitely if I offered investment advice, which I don’t) and go long AltCoin, or DSVCoin, or whatever you could get away in an Initial Coin Offering.

The link here as always is investment bubbles: BITCF are hoping to ride the wave up whereas Nautlis Plc appear to have timed spectacularly badly the offshore oil services downturn. The one thing you can guarantee here is that that those Nautalis vessels won’t dive again (unless they are sinking), or in the case of the barge lay pipe, and anyone not taking seigniorage on “money” issued by BITCF is unlikely to get a return…

Offshore and shipping recovery cycles…

Clarksons reported results yesterday and offered the view that that shipping cycles seem to be turning. The interesting thing is the scale of the retrenchment in the traditional shipping sector that has been required to being the market back to equilibrium (if they are right). Traditonal shipping had a boom driven mainly by Chinese raw material imports (and to a lesser extent exports which were less bulky):

Clarksea Index.png

Chinese import and export growth:

Which looks somewhat similar to the oil price and investment boom:

It is worth noting that if Clarksons are right it has taken 8 years since the slump for normality and equilibrium to start to emerge. The scale of the pullback is severe with tonnage delivered down from 2047 vessels in 2013 to 217 in 2016 (a 90% reduction) and only 266 orders for 2017. Shipyards are down from 305 to 50 (an 83% reduction). It shouldn’t be a surprise because the assets are built for a 20-25 year economic life, the offshore subsea fleet is smaller (~600 vessels), but each one had a high build cost, whereas offshore supply with its larger fleet and more commodity like structure looks set to suffer a similar pull back.

The other really interesting data point Clarksons highlight is the decreasing loan exposure banks have to the sector (which I am assuming covers offshore as well):

Global ship finance lending volumes

Source: Clarksons, 2017

Lending volumes from the top 25 banks, surely more than a representative sample and clearly the most important by size with DNB Nor having 5x greater exposure than KDB, is down 25%, over $100bn,  over a six year period. More than any other factor this is surely helping the sector rebalance but it will keep a check on asset prices for years, especially as getting a loan for a ship older than 8-10 years is nigh on impossible.

The historical reasons for the shipping boom are analogous to the oil price boom that drive offshore: As China boomed so did commodity shipping, this quote should be well understood by anyone in  offshore this quote should be well understood by anyone in  offshore:

Less than a decade ago, just before the global financial crisis, the largest of the commodities-carrying bulk ships cost some $150 million and commanded as much as $200,000 a day on charter markets. Today, a similarly modern capesize class ship is worth $30 million and a vessel owner can expect to earn just $9,000 a day in a business where the prices for iron ore, coal and other industrial goods have deteriorated.

Ships that were increasing in value (as day rates rose) were used as collateral to borrow more money from banks to buy more ships in a self referencing cycle. Which is exactly what happened in offshore, and when even the banks got nervous the high yield bond market was tapped. What could possibly go wrong?

Banks hold the key to the restoration of normality. Like normal shipping offshore will require dramatically more equity and lower leverage levels going forward. Capital will be significantly more expensive. Banks, especially those in the graph above, that continue to take large losses on their portfolios, will be very reluctant to materially increase exposure and will continue to wind the loan books down with concommitment reduction in asset prices. This will go on for years as the above graph makes clear. Yes some smaller newer banks (e.g. Merchant and Maritime) and specialist lenders will fill the void, but rationally they will charge much higher rates (as they will have a higher funding cost to reflect the risk) and will require more equity. As retained earnings are lower this will take longer to build up.

Many of the new shipping projects at the moment are 100% equity financed and until asset values stabilise even newer players are likely to avoid offshore. Slowly, over years when combined with scrapping, the offshore fleet will rebalance, but it will be a long way off. Offshore would appear to be closer to the start of its journey than the end (a point Clarkson appear to agree with in their research). Nearly all distress investors who moved in 2016 looks to have moved too early (e.g. Standard Drilling, Nor Offshore) and faces a capital loss on the positions taken as opposed to industrial companies buying one-off assets (e.g. McDermott), With high running costs and demand stagnant its hard to see 2017 being any different. 

As the author of the above quote notes:

A sizable part of the portfolio of nonperforming shipping loans cannot be expected to bring market pricing much higher than the scrap price of the ships collateralized, however. In this case, shipping banks can take a deep breath and mark them to scrap value, and then make certain those ships are dismantled and removed from the market. Under this scenario, the immediate accounting losses would be mitigated over time by a more balanced market which theoretically will push freight rates and the value of the remaining ships higher.

Whatever path they take, European banks will be shaken by the unfolding of their shipping loan portfolios. Their capital structures will be affected, and given the freight market and banking regulatory headwinds, their appetite for ship finance will be diminished. The shipping industry likely will never be the same.

The same can be said for offshore I suspect.

Boskalis holds all the cards, the importance of windfarms, and restructuring transactions…

I don’t need a watch, the time is now or never.

Lil Wayne

A couple of people have sent me emails asking some questions relating to my Bibby/ Boskalis post and it is easier to answer them once. Obviously this isn’t investment advice (and no one reading this is likely to own the minimum of GB 100k anyway) and is a general indication of events not specific advice. Deals never go the way anyone plans.

Firstly, under UK law a company is insolvent if the assets do not cover the debts or if it cannot pay its debts as they fall due. Should either of these circumstances occur the shareholders have lost control of the company and it is in effect run for the benefit of the creditors and at that point the debtholders can decide whether to call in administrators. Trading while insolvent is a very serious offence for the Directors as it increases creditor losses knowingly.

In Bibby Offshore’s case the only assets of note are the cash, DSVs, and ROVs which combined would come nowhere close to the value of the debts, and in fact Bibby is one of the few companies in the entire offshore industry not to have taken an impairment charge recently on vessel values, so everyone knows the GBP 100m book value is simply not real and the delta is a number like £50m not £2m. The next trading results will make it clear that without an immediate liquidity injection the company is unlikely to make the December interest payment and therefore the Directors now have a very limited window in which to gain funding (this is where is gets complex because a “highly confident” letter from a reputable financial institution may be enough to cover them for a bit but within a strict legal corridor). Given Bibby Offshore is operating at a loss in every geographic region, and has minimal backlog, and seems unable to meaningfully reduce its cost base, it is very unlikely to get this as any investor has to deal with the bondholders who realise they are going to take a substantial write-off here and have to work out how to minimise this loss. To all intents-and-purposes Bibby Offshore Holdings Ltd is controlled by the bondholders not the shareholders now, and it is their interests that are paramount. This can be seen from the BOHL balance sheet in March and the cash balance will be down at least around another £7-10m at best since then (excluding interest costs that have been paid).

BOHL Balance Sheet

BOHL Balance Sheet 20 June 2017

The only refinancing deal Bibby (BLG and BOHL) had been working on was a complex capital injection which required the bondholders to take a loss and work with new capital providers (such as M2 backer Alchemy) who would inject the funds for working capital and agree to pay the bondholders back less than the £175m but more than they would receive in a liquidation scenario. There is simply no realistic way the company could trade out of present situation even if the market recovered. The only conditonal funding from BLG was to back-up the revolver facility that essentially meant they got their money back before bondholders. I imagine this move went down badly with the bondholders.

The other things that seems to have been forgotten here is that the cash being burned is the creditors cash. If the bondholders can turn this spigot off then that money is available for distribution to them, so an option where they stop the cash burn at £15m in the bank is potentially an 8% increase in their recovery, which is meaningful when the only other option is watching it being burned on by a company with poor cost control who are seeking a free option on timing for their shareholder. The bondholders and their bankers will be remarkably unemotional when the first chance comes protect value. It is clear that the BOHL Directors  (and frankly at least one banker involved in the bond issue) failed to understand the seriousness of the 2016 financial result and the Non-Exec Directors at BOHL have performed particularly poorly. Making an interest payment in June, and then running into a liquidity issue now is not a market driven event. The backstop offered by BLG is insignificant in relation to the cash burn rate and reflects the lack of realism about the precarious nature of their situation.

Boskalis have therefore now made a price and pitched it to the “owners” of the company: the bondholders. The offer which I understand is for the bondholders to sell them certain assets of the company,  in-effect the North Sea Bibby Offshore, and leave the legal structure and debts with bondholders. These will be liquidated and generate a minimal recovery but that company will recieve the consideration for the assets it has sold and therefore the bondholders would be paid out of these funds. The price is c. £52m I have been led to believe which equates to the bondholders getting around 30% of the face value (par) of the bond. That means that any competing offer to control the company needs to give the bondholders the certainty of £52m (or whatever the final price agreed on is). Boskalis has wisely laid a marker in the ground, and with nearly €1bn cash on their balance sheet on the last reported financials, there is no doubt they can complete the transaction so the bondholders can bank this number.

It’s pony up with your money time if you are in the race to own these assets (the company will not be sold as the company has a legal obligation to pay the bondholders £175m which only liquidation or a restructuring agreement can extinguish). That sum of money, and the required OpEx for the company to trade through its losses for the next 12 months (say £20m), is so far beyond the capacity of Bibby Line Group to come up with up it might as well be a trillion, barring Sir Michael winning Euromillions twice in one week (and it needs to be next week).

So the only other question the bondholder advisers will be trying to answer now is can they can get a better offer… and who that might come from? I think the only credible bidder would be DeepOcean, as like Boskalis they have North Sea windfarm backlog and a customer base and chartered vessels they could hand back, to de-risk the asset OpEx. But DeepOcean are not as attractive for the bondholders as they are owned by a consortium of PE investors, and raising that sort of capital adds an execution risk to the deal,  one the bankers advising the bondholders will be acutely aware of. The worst case scenario for the bondholders is to lose a deal for accepting a higher price only to find the other side cannot deliver.

I don’t see McDermott (or someone like them) entering the race. Although they are the largest diving contractor in the world now, the North Sea is expensive, and as Bibby have shown perhaps not even profitable for a third player. McDermott want to get the 105 working in the North Sea, but having Boskalis or DeepOcean owning the Bibby DSVs gets them covered on that front without being exposed to the OpEx risk which they have no work in the region to cover so would be starting from scratch. DOF won’t want assets that old and would only be buying backlog of which there isn’t much.

Without any material backlog I don’t see any private equity bidder coming in period. It leaves them 100% exposed to execution risk and market recovery and the very real possibility of losing everything, and to be clear they would have to offer the bondholders something at least as good as £50m cash. Also for the bondholders advisers’ PE companies require due diligence and conditonal closing clauses that they simply don’t want to take execution risk on.

Such competing theories may also be irrelevant: last week (as I noted here) a large buyer of the Bibby bonds sent the price up. If that buyer was Boskalis, and I suspect it is, they may now own enough bonds to dominate (or at least block) the restructuring talks anyway and any competing proposals would be a waste of time. In that case all that is going on here is the protocols required to close this as a deal. In such a scenario Boskalis have probably also reached out to Barclays, who as owner of the revolver just want their money back quickly and will work on any constructive financed proposal to get out rather than risk having to recover their funds from a liquidator. The inability of BLG/BOHL and Barclays to agree a deal that was outlined in the 2016 YE results shows you exactly where Barclays are with this and they are an important stakeholder. It would also highlight this was essentially a hostile offer because the Bibby Town Hall recently, where Sir Michael reassured the staff about their solution, would not have taken place (or would have had a different tone).

So this could happen very quickly because the bondholders now have the certainty of a number and a credible counterparty, and the only internal/competing proposal is not “fully financed” in investment venacular i.e. the BLG shareholders don’t have an investor or an agreement in principal with the bondholders to renounce a proportion of their debts. My broad understanding, and only lawyers can answer these questions definitively, is that the bondholders and Barclays are within their rights now to call in the administrators, or will definitively be able to when results are due in the next few days. The vessels must have been revalued now so there is no place to hide and brokers giving valuations will be aware of their position so will be extremely realistic. The bondholder advisers then will simply seek irrevocable undertakings from the majority of bondholders to back the Boskalis deal, this would save the execution risk of a bondholder vote and this may have already been done, then agree a final deal with Boskalis. The they will call in the administrators with the deal being done at the same time. In legal terms it would all happen in a couple of hours as the major agreements will have been prengotiated and documented and the firm may have a small period in administration while the execution period vests (e.g. formal bondholder vote and Boskalis will seek to novate contracts for work).

This isn’t meant to be a definitive guide as to what will happen but it is a likely scenario and the final version will not be too different. There are numerous specific legal hurdles that must be covered and all insolvencies are different (I am also not a restructuring expert but I have been involved in some so this is broad rather than specific guidance), but I don’t believe the path will be materially different from the one I have outlined unless Boskalis pull out (and they have no reason to here because they are in control of this process).

Boskalis and DeepOcean show how much the market has changed since the oil and gas work dropped and how building up from a low cost windfarm environment has allowed them to take advantage of these opportunities. Both firms have the backlog and work that will allow them to trade the DSVs as peak SAT assets in the North Sea summer, doing diving work and minor project work only and the core maintenance work that Bibby used to do almost exclusively.

Windfarm work in the UK is getting deeper, some of the newer installations are at a depth of 60m which is pure SAT diving work, and work that was is on the margin of SAT or air diving can be carried out by  the Sapphire and Polaris economically given the purchase price. Without that base of windfarm work to spread the OpEx over it is very hard to see how a third major 2 vessel SAT diving player could survive in the UK North Sea because it is clear the Technip and Subsea 7 will protect market share aggressively in a quiet period for oil and gas. DOF Subsea could be expected to bid more aggressively but there is no certainty here as a few staff moves lately make it clear they are backing away a bit.

That will leave Technip and Subsea 7 to the major construction projects and who will hopefully be able to introduce some pricing sanity. Boskalis will do the lower end IRM work that Bibby used to specialise in, keep the cost base at an appropriate level, and yet still support companies like McDermott who need DSV support for SURF work but don’t have commit to running a DSV fleet.. This is a microcosm for how the whole offshore contractting industry will adapt to lower for maybe forever.

As I have said before in The New Offshore all that matters is: liquidity (a derivative of backog), strategy, and execution.

Bibby to Boskalis looks likely…

I have been told by mutliple credible people now that Boskalis are negotiating directly with the Bibby Offshore bondholders to purchase certain assets of the company that would in effect be the refinancing of the company. Booskalis are pitching at around .30 which values Bibby Offshore at c.£52m if true. For that they would get the Sapphire, Polaris, and all intellectual property etc and simply collapse the North Sea business into their current operations. The rest will be left for the creditors who will make a minimal recovery.

Despite the fact the bonds have recently traded at .39 if I was a bondholder I would jump at this offer and be running to find a pen to sign. The only other option is likely to involve them putting money in or a hugely dilutive liquidity issue (like the Nor Offshore one). Instead this is clean and well above any possible recovery they would get in a liquidation event.

The London high-yield market will get a timely reminder that covenant light issues have real risks. The Bibby shareholders took a £39m dividend when the bond was issued and another £20m at the start of 2016, at that stage they must have known the order book was empty,  in the end the company lost £52m at the operating profit level that year. As I have said before at that stage this event, or if it doesn’t happen one similar, became only a matter of time. Bibby Offshore may not have created as much value as Bibby Line Group would have dreamed only a few years ago but they have still done okay out it, whereas bondholders who in effect lent a non-ammortising loan on depreciating assets at the peak of the market, have suffered severe losses. They should be thankful however because a Nor scenario that saw them taking delivery of the Polaris and Sapphire in this market would have seen losses I believe as high as 90-100%.

It will be very interesting to see what happens to the Topaz. I suspect Boskalis don’t need it and will seek a charter that is 100% risk based if at all. I could be wrong on this as they have substantial North Sea operations and windfarm backlog that could use the vessel in a support role. Either way Bibby will revert to a small UK 2 or 3 x North Sea DSV operation supporting the Boskalis operations in Europe with management 100% dominated by Boskalis.

Whether this is in effect a hostile offer or is supported by Bibby Line Group I don’t know. I would struggle to see it being friendly given it would wipe out BLGs equity entirely but it would be the best thing for the company and provide a degree of security or at least certainty for those involved. The bond requires, according to my broad reading, only that interest payments are current and that BOHL has £10m, so a struggle whereby the necessary administration is delayed for a situation that cannot be changed would help no one. Waiting until December for an interest payment that cannot be made (interest accruing at c. £35k per day), or for the cash covenant to be broken allowing the bondholders to act, would be disastrous for their postion. The only thing I am sure of here is that some very expensive lawyers from both sides will be reviewing the bond indenture very carefully.

A competing offer from private equity looks unlikely as they simply do not have the contract coverage Boskalis does to risk some overhead on the vessels. Boskalis can probably release some chartered tonnage and have the DSVs work as ROV vessels on some of their windfarm projects if needed. For Boskalis this is a very sensible acquisition that offers upside only for them really with very minimal risk on running costs.

This will not take long to play out. When the BOHL financials are released it will all become obvious because if the assets have been revalued at anything like market levels it won’t just be a liquidity issue but a solvency one forcing the Directors to protect the creditors, and highlighting how close they company is to running out of actual cash. Resolution by the end of August is my prediction here.