The marginal revolution and offshore contractor demand… the shrinking market thesis…

Mankiw’s third principle: Rational People Think At The Margin


It is not that pearls fetch a high price because men have dived for them; but on the contrary, men dive for them because they fetch a high price.

Richard Whately, Introductory Lectures on Political Economy (1832)

The Marginal Revolution refers to the discovery of the concept of diminishing marginal returns, which led to indifference curves, and ultimately the demand and supply curves that define modern microeconomics. A marginal revolution is also happening in offshore contracting and supply as E&P companies develop less marginal fields. I think most people know this intuitively so I hope this provides something of a framework around this.

I have written a lot here about how I think the smaller offshore contractors are less well positioned than the larger contractors in the current downturn. This isn’t just a balance sheet effect: it relates to how the whole market is structured and the types of projects that were developed as the oil price rose and how the smaller tier 2 contractors built their business models and asset base around these.  [I am also taking some methodological short-cuts here and mixing dyamic and static analysis slightly but I have done this in the interests of simplification].

Firstly, lets imagine the demand and supply for offshore services at any time up until 2013. I would argue they looked broadly like this:


Supply shortage.png

I.e. there was a supply shortage. Offshore contractors could not supply all the demand for offshore services at a price the E&P companies wanted to pay. And actually as the oil price continued to rise the E&P companies would have paid to get more work done, and develop more fields, but the long run nature of the supply curve meant that offshore companies simply could not move up the supply line fast enough to reach the equilibrium point.

Driving the demand side was E&P companies pushing ever more marginal fields into development. The costs of doing this were high as this data from McKinsey shows (for the North Sea but I believe these numbers to be broadly representative of a global trend):

North Sea Cost Inflation

What this meant for the market as a whole is that ever more marginal fields were being developed: these fields had a higher economic breakeven cost per barrel as the cash cost was higher in construction terms but often the reservoir itself was of lower quality in a relativse sense to previous developments. But the capacity was being added on the service side by companies with a higher marginal cost of capital and who were adding assets that were marginally more expensive than their competitors who had built a portfolio of assets up over a longer time frame with a lower (real) average unit cost. This happens because the cost of bringing each new unit of production becomes more expensive: the marginal cost increases.

These marginal fields, with the highest level of breakeven output, the highest levels of risk, and the smallest production lives, were often backed by the smaller E&P companies, in the North Sea think Enquest, Ithaca, Premier. When the oil price declined in 2014 it had dramatic effects on the North Sea as Oil and Gas UK reported:

  • Capital investment is falling rapidly to around £9 billion this year [2015] from a record £14.8 billion in 2014.
  • Only one new field has been approved so far this year [2015], with less than £100 million of fresh capital committed to the basin. This compares with five greenfield projects sanctioned in 2015 with associated development capital in excess of £4.3 billion.
  • The rate of brownfield investment is also slowing. Just five new projects were approved in the first eight months of 2016, compared to ten in total in 2015.

Activity appears to have picked up mildly in 2017, but mainly due to bigger projects that the larger SURF and offshore contractors are doing. And that is my point: the smaller projects grew the market and allowed a reduction of competitive behaviour in the market have gone. The number of marginal projects has been reduced. [Hardly rocket science I realise].

On the supply side these were companies who came to the market later and therefore paid the highest cost in real terms for their assets and missed the technical evolution (path dependence) of some of the more complex technologies (e.g. rigid reel pipelay) which they simply didn’t have the capital or market share to get into. Almost without exception these tier 2 contractors did take on the most debt as well though which is why there is a balance sheet effect as well as they have the least financial flexibility.

This leads me to my theory of why the smaller contractors have lost not just market size but also market share:

Representation of Change at the Margin in Offshore Contractor Supply

[Not to scale.]

JPU Theory.png

  1. There has been a change in the demand curve (not a change along the demand curve) so severe that it had dramatically lowered the amount of work demanded and the pricing equilibrium (Demand to Demand’). Simply lowering price hasn’t helped offshore contractors and supply companies. This is a secular change not a cyclical one
  2. Demand above the top orange line in each demand/supply combination is the most marginal demand and supply. It is where the price had to be the highest to attract new supply but also the costs are the highest and demand from E&P companies the most fragile
  3. Only fields that aren’t marginal are developed offshore now. The economics have to be compelling under even low oil price scenrios to work, and that generally favours larger projects with lower average lift costs
  4. The tier 2 contractors were pulled into the market, and committed more assets, as the shortage in demand in graph 1 led to cost pressures in the E&P companies. The scale of the transformation in the demand curve has led to a smaller market of marginal projects and they have lost market share in this as tier 1 contractors re-deploy capacity

This is clearly a generalisation to which there will be exceptions.

The combination of the most marginal contractors being heavily reliant on the most marginal projects has been toxic for the smaller general contractors. I am not picking on DOF Subsea, Bibby Offshore, Ocean Installer, Hallin Marine, EMAS Chiyoda, BOA, Fugro etc. but there are simply too many relative to the amount of work available when the demand curve moves that significantly to the left (i.e. a whole drop in demand that a price movement cannot correct). Unfortunately I don’t see 2018 being different for these contractors (those still in business) as they have similar asset bases and and higher costs than the larger global contractors.

Unfortunately if I am right the smaller offshore contractors/supply companies will also be the last to feel any upswing in the market. Consolidation and rectructuring will continue.


The Economics of Constraints and (Really) Deepsea Diving…

It’s a poor sort of memory that only works backwards.

Lewis Carroll, Alice in Wonderland

In historical events what is most obvious is the prohibition against eating the fruit from the tree of knowledge.

Leo Tolstoy, War and Peace

One of my frustrations with offshore/SURF is that despite the mathematics of engineering and economics being the same, both are really optimisation problems, there is precious little of the latter influencing the former in offshore. A classic case of this came in Frontrunner today where there was an attempt at a serious discussion about diving below 300m. Now I accept that this is technically possible, lots of things are technically possible, for a billion dollars you can probably get NASA to take you on holiday to the moon, but because not that many people want/are able to spend a billion dollars on such a holiday there are very few companies offering this as an economic choice. If money is not a constraint then you have few constraints, but in economics and business money is always a constraint.

Diving at up to 600m is definitely technically possible, but it would be economic lunacy. Don’t get me wrong if I was an equipment supplier I would want to believe it was possible as well, but that doesn’t make it viable. There are so many realistic economic and organisational constraints on this I can’t be bothered going into them all, but here are a few, all of which are complete showstoppers:

  1. There is no market: the list of marginal field developments that could be made viable between 300-600m of water if a DSV could be used is minimal, even on a global basis. Most shelves drop off completely below 300m and there simply no proof that there are suitable reserves that could be tapped by this technology
  2. In order to service this (non) market you would have to build a 600m capable DSV completely at risk (which is admittedly what UDS claims to be doing), budget $160-185m, then prove the technology and procedures, which will be months of testing and practice dives etc, and only then be ready to sell it, all the while burning vast amounts of risk capital. Then you would need to get a bunch of global oil companies to change their entire HSE approval process, which will take years, and get this to coincide with a project approval process. This strikes me as an enormous barrier because even if you could prove this worked there is no demonstrable evidence of the long-term health effects on the divers and you risk creating an abestos like residual legal claim on the oil companies (as the diving contractor may be bankrupt) for approving this. And then, and only then, years after building a 25 year asset and burning through working capital you might, just might, win a project competitively tendered against an ROV solution. That is without going into IMCA, class, various regulatory agencies etc. All this for a project whose financial upside must by definition be capped at what a comparable ROV service could deliver the project for. So a venture capital investor has no possible way of making a returns in the 100s of % to cover the risk. Literally nuts.
  3. ROVs are currently oversupplied and operating below their capital cost, and are likely to for an extended period, so not only would this harebrained plan have to compete for work against the above constraints it would have to with competitors who will be selling at below economic cost

If you speak to divers who go below 250m they will tell you the joints hurt and they really notice the pressure. It is not a popular depth to dive at. Subsea 7 and Technip now have special dive procedures in place for anything over 200m and there is enormous resistance to diving over this depth level even if you could prove what it costs. Changing this organisational inertia for marginal benefits only just don’t represent a viable economic time/cost trade-off.

This is just a classic case of someone trying or thinking of doing something because it is technically possible not because there is any economic rationale to it. The idea is so DOA from an economic perspective it doesn’t bear serious analysis.

SOR also make the following highly questionable claim:

Sources close to the scene, suggest BP’s huge west of Shetland Quad -204 redevelopment might have cost a third of the total bill if the project could have used divers. [Emphasis added].

Now the best estimate of the costs I have is £4.4bn ($5.7bn), but that includes drilling, fabrication, control modules, a FPSO etc. Traditionally the SURF installtion scope is 10-15% of the total project budget, so at best what I think SOR mean is they could have saved 1/3 of this… so maybe 5% of the total budget. But that is a pretty minimal saving in the scheme of things and exposes the installation to a lot more weather and other operational and contractual risks. For a 5% saving on the overall cost you would have exposed yourself to having a minimal choice of assets to complete the task and run the risk that all future OpEx operations would have to be done by divers (i.e. no ROV handles) and that needs to be factored in to the total economic cost.

[But if I am wrong I am happy for SOR to publish some more detailed information to correct my erroneous logic and I will happily publish a correction having been suitably educated].

But again the Quad 204 cost statement avoids the economics of this situation: if Quad 204 was going offshore in 2014, when every North Sea class DSV was operating at capacity the job would probably have cost more because DSV rates were at a premium. Re-bid the job now and you might get a different answer. Markets are dynamic not static. So there “might” have been a saving, but there is a much smaller North Sea class DSV fleet than ROV fleet that “might” have been busy, or it might not, and the saving would have been dependent on that. And surely the losing contractor would have gone back and offered to make such a substantial saving? But whatever the situation it would not have transformed the economics of a project the size of Quad 204 as suggested.

Interestingly the whole Frontrunner is relatively bullish on diving. Although, frankly any previous investors in vessels backing MEDS would be amazed if their ability to get hold of a vessel should be seen as a sign of confidence in  the market given the losses they have suffered on the Altus Invictus and Altus Extertus (disclosure of interest: I was a Director of one such company). I don’t think SAT diving is going to go away, that isn’t what I am arguing at all, but until significant CapEx projects involving DSVs return to the North Sea then the market on any reasonable basis remains over-supplied and day rates and utilisation levels will remain under huge pressure.

SOR has been at the forefront of reporting the creditors involved in the rescue of Bibby Offshore and I’d be interested to know if they have a consulting relationship with any of the bondholders who they have named? Either someone very close to the deal is speaking to them or they are working on this deal… And you would really have to believe in a degree of bullishness about diving that isn’t grounded in current market reality to buy into the Bibby deal at current value levels…. And frankly any financially rational actor would be more than a little nervous now Boskalis have the Nor vessels… contracts for small DSVs in Brazil won’t save the North Sea market…

I am wondering if a lack of clear economic thinking has permeated the deal for the investors, maybe they have been blinded by perceived benefits such as 600m diving, because when you have to get management to warrant that:

  • Within the next 7 days, Bibby Offshore will appoint an independent consultant on behalf of the noteholders to support management on the ongoing cash flow management and transition of the business to the new shareholders.

you clearly don’t have a great handle on the business or what you plan to do with it. This could well be a classic situation of the “Winners Curse” in M&A.

At the time I had worked with two seperate hedge funds who were also looking at the deal. We valued the business at ~.08 – .15 of the outstanding bonds (£14.0 – 26.5m) reflecting the new working capital required. Different people have different perceptions of value and therein will lie the answer to who makes money on this deal. A 2 x North Sea DSV operation, focused only on being a low cost operator, was the plan. In order to get to a bigger number you need to back a platform business to expand. No one outside of the large contractors has made diving work on a global basis as there are no economies of scale and procurement is all regional and follows different standards. So in order to recover £115m Enterprise Value York & Co., are backing a subscale, loss-making business, in an industry that is consolidating with large competitors, in a market with huge cost pressures. Traditionally that has been a poor route to value creation… but it is also true that counter cyclical investments generate huge returns. The hard part here is that because of the lead times for projects (which are well documentted), and Bibby’s own investment documents show, this is a market forecast to grow at CAGR c. 7%… roll the dice…

Private equity and offshore: Bibby/York Offshore, DOF Subsea, and Ocean Installer and “stuck in the middle”..

Realism provides only amoral observation, while Absurdism rejects even the possibility of debate.



The firm stuck in the middle is almost guaranteed low profitability. It either loses the high-volume customers who demand low prices or must bid away its profits to get this business away from low-cost firms. Yet it also loses high-margin businesses — the cream — to the firms who are focused on high-margin targets or have achieved differentiation overall. The firm stuck in the middle also probably suffers from a blurred corporate culture and a conflicting set of organizational arrangements and motivation system.”

Porter, Competitive Strategy, p. 41-42


“Alice laughed: “There’s no use trying,” she said; “one can’t believe impossible things.” “I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

Bibby/York Offshore, DOF Subsea, and Ocean Installer are all tied into the same economic dynamic in the offshore market: the improvement in the market is coming in IRM spend (marginally), large-deepwater projects, and  step-outs associated with existing deepwater infrastructure, not the markets that made these firms viable economic entities (although the DOF Subsea question is just as much about leverage and overcommitting to assets). These companies highlight that although offshore spending may increase in 2018 over 2017, though DNB notes risk to the downside, a recovery will not benefit everyone equally: asset choice and strategy that recognise different market segments are important to identify.

I have read the Bibby Offshore “Cleansing Document” that was sent out as part of the takeover/recapitalisation notice. A cleansing document is required when investors, who are classed as “outsiders”, gain confidential information as part of deal and therefore become “insiders”, who learn confidential information, and must make all the investors aware of what they know. It’s an extraordinary presentation, a business plan so outrageous that it can’t be taken seriously. The document obviously has its origins in the EY attempted distress M&A transaction, that couldn’t be funded, and when you read this you can see why. Worringly the new investors must accept something similar or they are involved in a gigantic scheme to knowingly lose money.

The most obvious affront to intelligence is the 2017 growth rate for revenue pegged at 52%!!! Seriously, in this market someone is telling you they are going to grow at 52% and they actually have enough chutzpah to put it to paper… words don’t often fail me. Not only that they then double down and state it will rise 50% again the year after. I can tell you there is a 0 (zero)% chance of that happening. There is more chance of drydocking the Sapphire on the moon to save money. It’s not just the fact that IMR spend, the core Bibby/York offering, is set to grow at 3.3%, or the fact that total market spend is due to grow at 6.7%, that is just a common sense point: if the market grows at 6.7% and you are growing at 53% then 46% of your growth is coming from winning market share. Does anyone really think Bibby’s competitors are just going to wake up one day and allow them to be the only company in the entire industry that can grow that fast and let them take all that market share? Really?

Fictional Revenue and EBITDA Forecast

Lewis Carrol

Source: Lewis Carroll

To be clear the previous best year of growth was 2013-2014 when Bibby chartered in tonnage, in the greatest North Sea DSV boom ever, and it grew a measly 46%… seriously you can’t make this up.

North Sea Outlook

The fact is this forecast shows the core Bibby/York IRM market declining after 2019 and all the growth is coming in windfarm work. A portion of the windfarm work is likely to be bundled with installation workscopes, and that leaves Subsea 7 and Boskalis well positioned with their topflight installation capacity. And I have said many times the lack of oil and gas construction work (the light grey bar EPCI) will leave a surplus of DSVs as there are no multi-month construction projects to soak up capacity. There is an even more absurd graph later on designed to show a market shortfall in a few years that ignores latent capacity in meeting supply challenges.

Bibby/York will turnover £85m if they are lucky for 2017. In this market, if they have an amazing year next year they will turnover £95-100m, and if they have a bad year they will come in at £70-75m. And the risk is on the downside here because the first six months of 2017 included ROVs in Asia that were sold, most of which were working. But in offshore contracting in general some jobs will go your way and some won’t, so everyone in the industry budgets a modest increase and some get lucky. But what definitely won’t happen is putting 15 Red on at the casino and winning 30 times in a row, and talk of £130m in revenue is more unrealistic mathematically than that.

Even more the Sapphire now looks to be going into layup! So not only is turnover going up 53% but DSV capacity is going back 33%. It’s a miracle I tell you! That’s not profitability that is top-line!

The US office is of course a giant millstone and is put in the presentation as a “Diversification” play rather than as a cost centre – and certainly no spefic financiakl data on the office is offered. The US must be costing Bibby/York c.USD 250k per month in cash terms and now has no boat to bid. That puts them Bibby against DOF Subsea and OI for any significant project except they don’t have a boat? Zero chance. Literally less than zero. Only someone who really didn’t understand, or didn’t want to, the reality of the current market would sanction such move. Operating margins of similar competitors, following exactly that strategy are less than 10%, which means you will be losing cash forever. Nuts. Not needed and not wanted in an oversupplied market, it is simply a matter of time before that office is closed.

But I don’t want to get into it in a micro level because it degrades the wider point: in this market businesses don’t grow organically at 53%. It is a preposterous statement and needs to be treated as such on that basis only.

Not only that, Bibby claim they will make an EBITDA of ~£12m on the 2 x DSVs in the North Sea, and a staggering c.£11m using vessels of opportunity. So not only are they betting they will take enormous amounts of market share off their competitors they are also planning to do it at margins way above anyone else in the industry. And this from a management team, with exactly the same asset base, who presided over a revenue decline of 56% in 2016 and is on target for a 45% decline in 2017. The first few people who got this presentation must have phoned up and asked if the printer had had a typesetting error, not believing that intelligent people would send them this.

The only certainty of this plan is that it will fail. Statements around its release confirm the company ~50 days of work for 2018 yet they are planning 78% utilisation (up from 53% in 2017), yet if the first quarter work isn’t booked in now it won’t happen in a meaningful sense.  And once you are chasing you tail to that extent a dreadful dynamic sets it because you have committed to the cost and the revenue miss means you know early in the year you are facing a massive cash flow deficit. The fixed cost base is so high in the operation that a miss on the revenue side produces catastrophic financial results; just like a budget airline, the inventory is effectively disposable (i.e. after a possible days sale has passed) yet the cost base is committed. This of course explains how the model was created I suspect: a revenue number that magically covered the costs was devised, how real management believed that number to be at the time will be crucial by March (only 12 weeks away) when the plan is revealed as a fantasy. I’m not saying it’s deliberate, humans are strange, it took Hiroo Onoda until 1974 to surrender, so if you want to you can believe a lot of things, and unless you believe the revenue number then the whole economic model falls apart.

York clearly got into this late in 2016 and early 2017 not believing the scale of the decrease going on in the business in revenue terms, and without clearly understanding how the competitive space was directly supported by the construction market. Instead of pulling out they have doubled down and appear set to pump more in working capital into the business than the assets are worth (one of which is going into lay-up for goodness sake). York appear to have confused a liquidity problem with a solvency one.

The funds this come from are large but this is till going to be a painful episode for York while doing nothing to solve the long-term solvency issues at Bibby who now only have a 6 month liquidity runway based on current expenditure. At an Enterprise Value of £115m it values a business with one DSV on lay-up and a cost centre with no work, and an operation with a 1999 DSV and one chartered asset, losing substantial amounts of money and with historic liabilities, way above a the operation Boskalis are building with 2 x 2011 DSVs at a blended capital cost of ~USD 80m. Good luck with that.

I still wouldn’t rule out a Swiber scenario here where as York get close to the drawdown/ scheme of arrangement date they get lawyers to examine MAC clauses (e.g. Boskalis buying the Nor vessels), or simply not pay and worry about getting sued by the administrator. They must know now this is a terrible financial idea.

DOF Subsea on the other hand have the opposite issue: First Reserve looked to reduce their position earlier in the year via an IPO and couldn’t. Now DOF are slowly diluting First Reserve out in  the latest capital raise… there is no more money coming from First Reserve for DOF Subsea. I get the fact that some technical reasons are in  play here: it is difficult for late-life private equity funds to buy inter-related holdings, but they always seem to manage it on the up but never on the down.

DOF Subsea might be big but the problem is clear:

DOF Subsea Debt repayent profile Q3 2017


DOF Subsea EBITA Q3 2017

DOF Subsea isn’t generating enough cash to pay the scheduled debt repayments. And in these circumstances it is no surprise that the private equity fund is reluctant to put more equity in. DOF Subsea could sell its crown-jewels, the flexlay assets, to Technip but that would involve a price at nothing like book value; or maybe DOF/Mogsters’ bail them out but that will further dilute First Reserve. Either way First Reserve, some of the smartest energy PE money in history on a performance basis, have decided if you can’t get someone else to buy your equity then dilution is a better option.

Ocean Installer is a riddle wrapped in a mystery. OI has some chartered tonnage and some smart people. But it is subscale in nearly everything and I doubt it was even cash flow positive in the boom years as they were “investing” so much in growing capacity. The company had takeover talks with McDermott, that failed on price, and seems to exist solely because Statoil is worried about having an installation duopoly in Norway. It can’t continue like this forever. Rumours abound that Hi Tec have now installed staff in the Aberdeen office and are seriously looking at how to cut the burn rate.

There is nothing in OI that you couldn’t recreate for less in todays market, and that unfortunately means the equity is worth zero. Hi Tec, whose standard business model of taking Norwegian companies and opening a foriegn office, expanding both the quantum and size of the acquisition multiple (admittedly a fantastic idea in the boom), will not work here. Now it’s hunker down and build a substantial business of scale or exit. All the larger players have to do is sit this out, no one needs to pay an acquisition premium, buying work at a marginal loss, which will eventually reduce industry capacity, is a far more rational option.

Not all of these companies can survive as they are simply too similar and chasing the same projects that are also now being chased by the larger SURF contractors. Clearly DOF Subsea is in the best position as OI and Bibby/York have a very high cost of capital and owners with unrealistic value assumptions.

All these firms suffer from two problems:

  1. In strategic terms they are “stuck in the middle”. In 1980 Michael Porter wrote his famous text (“Competitive Strategy“) positing that a company chooses to be either low cost or value added; firms that didn’t  were “stuck in the middle” and destined to low profitability forever. In subsea the deepwater contractors are the value-add and the contractors without a vessel, or the regional companies with local tonnage,  are the low cost. Bibby/York, DOF Subsea, OI are stuck in the middle – not deepwater/rigid reel to add value and with too high a cost base to compete with the regional low cost operators – given their funding requirements this will not carry on indefinitelyPorter stuck in the middle
  2. The projects that made these companies profitable (if OI ever was) have suffered the largest fall in demand of all the market segments. Small scale field development, with flexibles as the core component, just aren’t big enough to move the needle for the the larger companies and the smaller E&P companies can’t raise the cash. All the FID stats show these developments to be almost non-existent. These were projects commissioned at the margin to satisfy high oil prices and therefore are the first to fall off as the price drops. That is why these companies have suffered disproportionately in the downturn: they have lost market size and market share (Bibby Offshore revenue has dropped by 77% since 2014 where as Subsea has (only!) dropped 45%

The subsea/SURF market is an industry that private equity/ alternative asset managers struggle with: a market with genuine advantages to industrial players with economies of scale, scope and knowledge. In an age of seemingly endless debt and leverage these equity providers are not used to coming across industries where their organisational advantages of capital and speed cannot work. But for the next few years, as the industry requires less capital not more, the smart money here will be on the industrial companies. It wasn’t the distressed debt investors in Nor Offshore who made money on the liquidity bond (issued this time last year), it was Boskalis when the reckoning came for more liquidity. That is a parable of this market.


The scale of the challenge…

Deliveroo lost £129m in 2016 – more than its revenue. It does not have a business model – basket case. Investors will lose everything.

Luke Johnson, Risk Capital Partners

There’s still too many DSVs in the North Sea, even with an upturn, but that’s my guess. Perhaps the scrappage and departure of the Sapphire will reset the NS market to something sustainable for when the market recovers, but I have my doubts.

I’m interested to hear your prediction beyond year 1, where there’s the shuffling of cards (market share), year 2 where the slush fund is running low and we possibly come full circle again?

Email from senior exec at a North Sea contractor

The scale of the challenge the new owners of Bibby Offshore have is revealed in the Q3 financials that were released on the same day as the takeover:

BOHL Q3 Highlights

A quiet November/December and they will lose more than revenues. Or actually in Total Comprehensive Income they have managed this trick:

Q3 2017 Financial Results.png

Now it isn’t a fair comparison because the charters on the Ares and Olympic Bibby are well above market rate and will substantially change the performance of the business when they have ended (one has). But the point is it is not the bond alone that killed Bibby: it was going long on expensive vessels with a neglible equity cushion and a complete rigidity in the business model therefore to reduce costs when the market changed. But then again the Polaris and Sapphire were valued at USD 220m! in 2014 and they still look way to high on the books. Non cash charges are fine if you don’t have liquidity issue but they are very real in measuring economic return.

What I like (sic), and they aren’t the only people guilty of this (I have named others doing it as well) is the Orwellian use of English (although it’s more Catch 22). On summarising these results, which entailed handing the business over to the creditors, the following sentence appears (emphasis added):

The recapitalisation of the business together with the improving market outlook, reflected in the growing summer campaign, means the Group is well placed to weather the current market conditions and to capitalise on new opportunities.

A mere four lines later, 4!, just 4, comes this:

Despite the seasonal increase in activities the pressure on margins has not eased, impacting total revenue. Revenue also reflects the mix of work, which includes further air diving projects in shallower waters, which command lower day rates.

They have less than 50 days for next years booked and over 1000 days of inventory.

Seriously! Make it stop. Please make it stop…

Bibby has a really simple business model: you sell boats days and some associated engineering. One of the two variables has to change: days or the price. If one of those is declining, or you have to reduce the other in price in order to sell more days, then it is sophistry of the highest order to claim an improving market outlook. I was just waiting for the quote “and we are doing record amounts of tendering”.

As the analysis below will make clear the emergency rights issue that a “leading bondholder” has underwritten gives the business, at current cash burn rates, around six months working capital as the best case assumption. This is not a war chest for acquisitions this, is simply survival money while options are assessed and some quick wins on the cost side are made. I don’t have any inside knowledge at all of what will happen here, the thoughts below I believe to be directionally correct, but the one thing I definitely know for certain is this: the money going in will not be willingly frittered away in OpEx while the business simply waits for the market to return. However, the winter months are ruinuously expensive for boat owners with without work…

The cash flow makes clear Bibby had burned through £10.5m in cash in what should have been the best quarter of the year for 2017:

Q3 2017 cash flow.png

The closing cash balance at Sep 30 gives the game away: Bibby had drawn down on the revolver and that is simply insufficient for working capital purposes. It is very hard to see how the November payroll could have been made on those numbers as another 6 weeks of losses (by the time the creditors rescued the business) must have meant an actual cash positon of less than £2m. But what is really apparent is how much worse the business is performing than last year: £58m in operating losses YTD versus £26.8m last year! If it was a horse you would have shot it!

Those losses were driven not only by the Olympic Vessel charters entered into at the top of the market but by the Sapphire utilisation at 3%. Fully crewed and maintained in port waiting to win the BP Trinidad work that went to Nor (a move I accept I said would never happen), and a US office that inexcusably had 19 people in it until August and is now on it’s third ex-pat manager as the company struggles to define its market position now it is not proceeding with a Jones Act vessel. The fact is Bibby have taken the Hotel du Vin to a market where customers resent the prices at the local Holiday Inn, and you can offer all the upgrades you want, but it just won’t work without a base level of demand that isn’t there. The US business model is broken  and that is an intractable issue for the new owners.

The £50m the emergency rights offering puts in will need to cover a variety of new expenses: consultants (and there will be a lot), transaction expenses (tier 1 law firms etc), working capital banking facilities (say £5-10m) etc. This is unlikely to be the only injection made to keep the firm solvent if the new owners are serious about keeping the business going.

The big outstanding commitments relate to vessel costs and things like offices (Atmosphere 1, Houston, ROV hanger) all of which were entered into at the top of the market. Olympic are no doubt nervous because their charter on the Olympic Bibby goes into Q2 next year at a rate of c. $35k per day (c. $1m per month). I suspect the Scheme of Arrangement the bondholders are using here will allow them to take the assets to the Newco and leave residual commitments to Oldco Bibby should they want. The communications have promised trade suppliers will be paid, and that is certain, but when the new corporate structure emerges a conversation will be held about how much shareholder support will be provided to the BOL/BOHL (the answer is likely to be none i.e. these are the entitites that will be liquidated) and all the contracts will be moot. All the smaller trade creditors who are nescessary for trading will clearly be fine but I am not sure about Olympic and property commitments at all (and it would have the nice effect of getting rid of the Trinidad tax issue).

But this is the easy part in a way. There will clearly be an urgent and deep effort to slash costs in a way there hasn’t been before. Engineers, Bus Dev, people that add real economic value can expect this to be a better place to work. But there are 5 PAs in Aberdeen for business on target for £80m turnover and a Risk and Business Continuity Department that has about 5 people per vessel! All good people to be sure but just not sustainable in any shape or form. I suspect when these consultants walk into the Houston office and get presented with a spreadsheet with $9 trillion of possible tenders and zero purchase orders for 2018, 11 people, a boat at 3% utilisation (according to the Q3 report), and an expensive ex-pat ex-COO, there is going to be a quick call back to the UK about WTF is going on? Some of these things are a direct reflection on current management which will only increase tension with the new owners.

The real problem though is how you get your £115m back…

Let’s assume you need to sell out at 8x EBITDA (Acteon went for 10x in the boom but they were lighter CapEx and had more booked revenue); that means you need to get EBITDA to about £14m from its current level. The scale of this challenge becomes clear if you have a look at BOHL bond prospectus, which for all of us in offshore was a different era:

BOHL Prospectus EBITDA

Basically the “new Bibby” needs to look something like old Bibby between 2011 and 2012. which handily we get some stats on:

BOHL prospectus operational data.png

In 2011 Bibby were delivering their biggest ever construction project: Ithaca Athena hence the reason other project revenue is so high (that and mob fees were high) and it is also woth noting that the Topaz worked much of the year on that project. Now the fact is companies like Ithaca, Premier, Enquest have given up development for debt repayment so these projects just aren’t there, and with Technip and Subsea 7 in hunger mode no one is winning small development projects outside that duopoly. But DSV rates in 2017, prior to the Boskalis entry, were about 2011 levels at the end of 2016 but utilisation is way down.  Bibby administration costs were on £10.4m for the 2011 year whereas this year they are on target to be 70% higher at £17.5m.

But admin costs while part of the problem aren’t the core of it: the decline in revenue, and therefore the scale of the business is:

BOHL Pros P&L.png

If Bibby does £80m in 2017, and that is a very big if at this point, the business will be 70% smaller in revenue terms than 2014. Subsea 7 by contrast has seen revenue drop from c.  $6.8bn (2014) to c. $3.8bn for 2017, which is only a drop of 45%. I have said it before that the smaller firms have not only lost market size but market share as the market has contracted and that is unsustainble. You can see the effect that scale has because despite having seen its turnover drop by such a large amount, even with such high fixed costs, Subsea 7 kept its fleet utilisation at 78%, and then generated $250m in EBITDA and even Net Income came in at $111m. One business model is sustainable and one isn’t.

If you look at the types of projects heading for FID at the moment they are disproportionately complex and expensive projects that mean this trend is likely to continue. Its not just a Bibby problem: OI, DOF Subsea etc all suffer from the fact that they were marginal capacity working on smaller projects that added marginal production. Production and capacity at the margin is expensive and therefore it is no surprise these business models suffer disproportionately in a downturn. [What I mean by marginal capacity/production is that these were the extra units added as the existing industry and companies hit their production frontiers. This new capacity/production is added but at a higher per unit cost as suppliers etc push up prices to reflect increasing demand].

I guess the positive side of this is it shows how much operational leverage the business has: fixed costs are so high that a small addition to the day rate and/or the number of days worked and the results drop straight to the bottom line. The downside is it looks like 2013 and 2014 were an aberration in terms of day rate and utilisation and that actually the industry was in a nice little equilibrium in 2011 with day rates that made projects work for E&P companies and kept everyone in profit, and maybe that is as good as the industry can hope to get back to (before the Harkand/Nor/Boskalis DSVs arrived but with the DiscoveryKestrel and Oriella.

A major structural change has also occured in the market: in 2011 you could not get your hands on a CSV with a 250t crane for almost any money. Rates for these vessels was c. £130-150k and this was purely a supply shortage. Therefore you simply added a mark-up on those boats for all work undertaken. I doubt any other class of vessel has been so over built now and they are all in lay up (the Boa vessels) or doing windfarm work for €20k per day (Olympic). The other project revenue flatters the margins made on non-DSV projects because anyone who had access to a vessel in those days just placed a large mark up on the vessel (a number that was already high).

Now everyone (Reach, M2, Bibby Offshore, James Fisher) is a “boatless” contractor. This de-risks the fixed costs but obviously at the reduction of margin. In Asia there used to be a number of “boatless contractors”, running around organising bid bonds and all the other associated issues that come with trying to fix a schedule. One of the many problems is that because everyone can do it the profitability on it is very low and you actually take quite a bit of project risk to get this margin because you often go lump sum and the vessel operator gets paid every day.

And the elephant in the room is now Boskalis. It is pointless here to go on about the advantages an industrial player has in this game. There are 100 reasons why Boskalis is better positioned that the “New Bibby” going forward, and the first 20 are signficant. A much lower cost of capital for one, existing marine, crane, and other departments spread over a much larger fleet (lower unit costs), a serious position in renewables with full cable lay equipment etc.  When day rates were much higher everyone used to measure the cost of ancillary departments (i.e. crane) by looking at the cost to the vessel being out of service and the price was just increased, but that obviously isn’t the case now where these costs are material and need to be spread over a big fleet. Sometimes commitment signals count in economic situations and the fact is that Boskalis likely to be here in 20 years and the same just isn’t true of the New Bibby.

This really makes me question whether it is possible to have an economic model that is based solely on being a DSV operator, particularly a smaller one? For every other competitor to the “New Bibby” diving is an ancillary, but important, service to a broader offering. Boskalis probably only need to get 100-150 days per annum of pur SAT work to be cash flow positive on an asset basis if they use the rest of the time to back up the renewables fleet. Subsea 7 and Technip can cross subsidise limited construction work by keeping utilisation up in the IRM market at low day rates. If these operators commit enough capacity to a market in that situation where their breakeven cost is significantly lower the overall industry rates will be low. These three companies all know that the “New Bibby” will live or die by the North Sea SAT DSV rates, and all they need to do is keep these low for a period and the entire edifice is at risk.

Bibby worked from 2004-2012 because it was the “Healthy Dwarf” of the North Sea in SAT diving. The excess cash from this business was used to fund ROVs and develop other areas. But Singapore never worked beyond ROVs and neither did other ideas. It was an opportunistic business with a really good local market position that allowed it to try different things when the market was booming. But it patently does not have a magic formula that would allow it to grow in other markets or some sort of magic ingredient that is scaleable.The “land grab” was in fact made by DOF Subsea, Ocean Installer, and others who had access to what Bibby desperately needed: adequate equity/ CapEx ability in an extremely capital intensive industry.

When there have been four SAT dive companies in the North Sea only 3 have really made money: Bibby helped drive Harkand out of business, Bluestream didn’t last more than a season, ISS chartering the Polaris just allowed them to fill a six month charter in a peak period. It is very hard to see how Boskalis isn’t going to be a lot more than a “healthy dwarf”, and likely the first non-RMT unionised major contractor, and that really doesn’t leave a lot of space for anyone else.

If you look at the Bibby 2012 P&L above it also makes it clear that even when times are good, and Bibby dived over 900 days that year, and after tax it only made £13.3m, a rate of return on the asset base of 7.8%. The ROE (40%)looks high because of the leverage… which brings up the issue of risk: in this business model you go extremely long on some very specific assets, which have a huge volatility in value (as Boskalis can affirm), and match these against a series contracts that are short in duration and have almost no visibility, and must be competitively won… and that’s before you even get into execution risk. I know private equity firms love EBITDA (and the £55m Bibby did in 2014 is proof of that) but it is a really inappropriate number for an industry with such high CapEx requirements because the depreciation amount on the fixed asset base is a crucial number in how much real economic value is being created.

I get people can make a lot of money on counter-cyclical bets. That is the essence of the investment proposition: having the ability to make a bet like that. But the dynamics of any upturn in the North Sea, with vastly more tonnage than the last upswing, would seem to err more to there being too much tonnage and that will only lead to lower day rates. And there are far more North Sea class DSVs that can be drafted in to keep rates down than were previously available: Technip for example could just re-commision the Achiever as an IRM vessel, and at some point Vard are going to have to sell the 801.

So in answer to the question of what I see happening for the next few years I think there will be three serious players in the North Sea SAT market and a fourth company that maybe viable if the market booms. But that will be a struggle. Even if the price of oil doubled overnight the ramp up in logistical terms required in the North Sea would be immense before a serious impact in CapEx spend would be felt. Smaller companies would have to access financing, hire engineers, consultants, approve drilling, arrange interconnection agreements etc… all this before small scale subsea development CapEx came back at a meaningful level to affect the overall fleet demand and profitability. An increase in IRM spend just won’t cut it. The worst case scenario is someone like DeepOcean taking a DSV and using it as a split ROV/DSV for 6 months a year as IRM spend increases. At that point the Bibby business model is well an truly dead. But in the interim Subsea 7, Technip, and Boskalis can rapidly add capacity if the IRM market improves, in a way that simply wasn’t possible in the past and in a manner that is simply too credible and likely to ignore.

I am a long term believer in subsea and the meaningful amounts of production it will be responsible for going forward. But in the past when it was the marginal producer of choice for the oil market the whole industry was profitable, almost without exception, and that simply will not be the case going forward where the process of economic natural selection will far more brutal and will favour larger players.

DSV age and new build demand… To Fathom the future…

In an insightful LinkedIn post Gareth Kerr, MD and owner of Fathom Systems (who make components for DSVs) raised a couple of important issues. Gareth noted:

As I recall, about 30% of the worldwide fleet is older than 30 years so when these vessels are scrapped (which will be soon) there will certainly be space at the table for a new generation of green, efficient and sensibly priced assets.

There is a lot going on in that sentence so let’s deconstruct it a little bit. Firstly, I agree with the fact that ~30% of the worldwide fleet is older than 30 years. The problem at the moment of course is that the global DSV fleet is nowhere near utilised at an economic level, so the safest assumption is that DSV owners will scrap tonnage when it cannot cover its economic cost of capital (eventually), and are unlikely to replace this tonnage until demand picks up signficantly and for a long period of time (and in reality there is a significant change in the financing market). The mistake Gareth has made here is only looking at the supply side of the market and not integrating it with the demand side.

Discussing the DSV fleet as a global market also makes no sense as it is in reality 3 regional markets with no inter-regional procurement. This lack of economies of scale in diving has confounded many people, most recently Harkand, who tried to claim they were building a global IRM business despite it being obvious that if people didn’t run procurement like that so there was no demand for such a business.

The three distinct markets are: 1) Norway, 2) North Sea other, and , 3) Rest of the World. I don’t intend to discuss Norway much as the total number of DSV days has fluctuated from about 480-620 for the past 10 years. It is a 2 vessel DSV market and will be forever, and I doubt anyone will ever build a new NORSOK class DSV without a firm commitment from an operator to cover the financing costs of the vessel (i.e. a 200-250 day charter for 10 years), but the reality is one won’t be needed. However, when it is very quiet in Norway these vessels trade down to the UKCS/North Sea sector.

Then North Sea other, a market that includes the UKCS, Canada, Denmark, Netherlands etc. Vessels can trade down from this market but ROW tonnage cannot trade up. It is therefore a supply constrained market in boom times and releases tonnage as the market contracts as the higher spec vessels seek to trade down and take work from other lesser spec boats.

From a demand perspective the outlook the North Sea region is grim: until shallow water construction returns to the region DSV rates will remain low. Construction work uses vastly more DSV days than IRM work and what made the market tight was the multi month construction work the North Sea fleet used to undertake. Now the same assets, that covered the 2014 boom year, are doing a reduced amount of IRM work. This isn’t going to change anytime soon as this data from Oil and Gas UK shows:

UKOG Capital Investment 2017

You get a sense of the drop from over £14bn in 2014 to c. £8bn in 2016 to a likely drop to under £8bn in 2017. It is not surprise that in 2014 IRM DSVs were going out at £180-200k per day (+ mob fees) and now the vessels are going out at £90-130k per day. Until that Capex number picks up the DSV fleet will not be fully utilised and an increase in IRM work. In 2014 Bibby had four North Sea class DSVs but the Harkand/ Nor vessels still had to go to Africa for work. The supply side was already peaking in the best year of demand.

It is no coincidence that the highest operating costs came in the regions with the highest DSV requirements that were pulled off maintenance work and into marginal construction projects:

UK Operatng costs.png

The E&P company plans are to drive these costs down and the increasing supply of DSVs, relative to their demand, makes this easy. In an environment with this sort of cost pressure and volatility in demand the investment risk for new assets, that operate in the spot market, is insurmountable. The pressure on operations departments will be to reduce DSV costs for years not to get to first oil and that creates a completely different contracting environment.

Unit operating costs

Ultimately DSVs are an expensive plumber connecting the wellhead to other infrastructure so a good leading sign of future construction is drilling that could lead to further subsea projects. Again its all grim for the North Sea:

Exploration wells spudded.png


Appraisal and Development wells.png


The industry is just not building enough well “stock” that will lead to subsea development projects. And the projects that will be brought forward for development are just not the small, shallow-water, step-outs/ tie-ins that keep the DSVs busy. Oil and Gas UK notes the most promising areas for investment:

the potential of the UK remains exciting, with opportunities such as the fractured basement plays west of Shetland; ultra-high-pressure high-temperature prospects in the central North Sea; and the carboniferous resources in the Southern Gas Basin.

These are not projects that will require much DSV time (but Subsea 7’s new pipelay vessel will be useful). Clair Ridge, Mariner, Bressay, all these high flow/high Capex projects need next to no DSV time and they are driving the construction stats in volume terms.

Now let’s look at the supply side of the fleet. I put the core North Sea fleet at this:

North Sea DSV Fleet.png

That doesn’t include the Vard 801 (2017 build) that at some point will enter the market. I have been generous to DOF putting the Achiever in, I have left off a Subsea 7 vessel that is in lay-up and can be reactivated, and I have left out the Boskalis Constructor/ EDT Protea and others that are mainly Southern North Sea/ Dutch sector. There are also assets that could return to the market (the Mermaid Endurer and Bibby Sapphire were all working in the region in 2014). Toisa also have some vessels (Pegasus/Paladin) that could, for a fraction of the new build cost return to the region.

But it is obvious to even the casual observer that there has been a massive capital investment in the fleet and that this is a relatively new fleet for assets that can work for at least 20-25 years in the region before seeking more benign conditions. Since this fleet upgrade started day rates have dropped from c. 180k per day to c.90-120k (a 30% reduction) yet the cost of the vessels has increased from ~$100m for the Topaz in 2007 to ~$160m for the Vard 801 (a 60% increase). In that time the two independent operators and new builders of North Sea class DSVs have had their equity wiped out (Harkand and Bibby) and the assets trade at substantially below depreciated book value and has ensured debt providers have also taken a hit. This is not a market where it will be easy to order or finance new assets.

So you can hold all the positive meetings you want in Bergen and discuss cool diving technology, but the economics of this are pretty obvious: neither the demand side or the supply side will push for any new build North Sea class DSVs for at least the next 5-7 years. I don’t see any new buildings in this market commissioned without some sort of contract underwriting the financing cost, and even then it could well be a decade or more before someone (other than Helix) commissions one.

The one thing I can guarantee is that there is almost no chance of any of the sepculative builds in Asia entering the North Sea market. If Technip and Subsea 7 ever want a new DSV (as opposed to a project one) they will get a contract with a yard that has export financing and they will see the pickup in construction activity early enough to order it early enough such that it arrives in time for another boom and not too early. At this stage it is more rational to wait to order a DSV and lose some market share in IRM if they need to and bag the construction work at a higher margin, than to order or commit to a $150m vessel that only trades in the spot market. The high fixed costs and barriers to entry virtually ensure no new market entrants will follow Boskalis into the market, and the vastly reduced industry spend makes it questionable whether there is even room for more than three substantial SAT dive contractors.

The ROW market is almost irrelevant in supply terms. There is sufficient new tonnage for years and as the market booms there sre substitute products in the form of modular diving systems that will reduce the pressure on day rates. As I have said before there is a very obvious reason why no one has been building North Sea spec vessels for Asia: No one will pay for them. There are more than sufficient high-end DSVs to cover for demand and there are no signs that the market is coming close to absobing the new tonnage coming. Yard Inc. is rapidly becoming the biggest owner/financier of new tonnage in Asia with the Southern Star, all the UDS vessels, the Keppel new build, and others all being owned by the yard effectively.

Old DSVs will work out in Asia because the marginal cost of operating them i.e. the cost of one extra diving day, is substantially below the cost of building a new one and comparable in productivity terms to a modular system with a PSV. Day rates are substantially below the North Sea and vessels like the Mermaid Endurer simply don’t command a sufficient price premium to regional tonnage (although they have utilisation advantages). It is a cheap market for cheap ships and until customers pay more then it will remain so.

It is just not credible to suggest that in a market like Asia, where there is substantial overcapacity, rates at Opex breakeven on a full year basis, and massive utilisation risk for owners/charters/operators, that age alone will provide the route to new build demand. These assets have to be paid for and the assets in Asia are not generating an economic return and until they do they cannot be financed. The future could well be India where old assets eke out a living more or less indefinitely.

All the indications from brokers in Asia is that UDS is as desperate as anyone else to get work. They cannot achieve a price premium for these assets and the assets operate at substantially below economic return levels. A wave of new buildings will only occur if Chinese yards decide they want to build DSVs that they then operate at below economic levels more or less indefinitely. I just don’t see that going on for more than the ordered vessels at the moment.

Gareth also asks the question:

We have all seen the industry restructure over the past 3 years where companies were losing money at >$100 oil but are now making profits at $60 oil.  Why should the DSV market be any different?

I think I can answer that question. The major reason is that at $60 oil companies sell 100% of their output above the cost of production, overhead, and finaning and at a rate that allows them to meet dividend commitments. At $60 oil, and with an increasing amount being produced via US tight oil, there is not enough DSV demand to cover the cost of operating the vessels and associated overhead, yet alone making an economic return. Gareth has again made the mistake of looking at only the supply side of the market.

So let’s leave the ‘black magic’ diving stuff to the people who know best (clearly not me). But let’s also let discussions on likely future demand for extremely expensive capital investment decisions be guided by economics and data rather than meaningless prayers of hope for the future. The fact is the DSV industry needs less capital not more in order to help the market to equilibrium.

DOF Subsea, Bibby Offshore, and The Pecking Order Theory…

We always plan too much and think too little.

Joesph Schumpeter

We were succeeding. When you looked at specifics, this became a war of attrition. We were winning.

General William Westmoreland on US involvement in Vietnam

DOF AS/ Subsea reported numbers yesterday that were frankly terrible. All those who keep telling you the market is getting better seem blithely ignorant of the constantly decreasing financial performance of nearly all the companies in the sector. It’s like Comical Ali or General Westmoreland constantly assuring everyone that victory is just around the corner, if not in fact delivered. Tendering, like the Viet Cong, never ceases to stop appearing in increasing numbers, and it will bring victory…

I have another theory why tendering is increasing: there are a lot of engineers who are worried about their jobs. In a completely rational strategy they are increasing the number of parties who receive tendering documents, spending more time assessing them, and making the tenders ever more complex. Turkeys don’t vote for Christmas. More people appear to be spending increasing amounts of time and money on the same tenders and it is making industry margins even thinner, and allowing management to claim that completely unproductive work is actually a sign of an industry returning to health.

But back to the numbers… this is the same DOF Subsea that as recently as Q1 and Q2 this year was hoping to get an IPO away. It’s a good reminder, as if anyone needed one, that when insiders are selling out you should be wary of what you are buying. I call it the Feltex Carpets or Dick Smith theory. Economists have however developed a far more robust theory about how firms decide on their capital structure: The Pecking Order Theory. It’s based on the information asymmetry that exists between the insiders of the firm (shareholders and management) and the outsiders (investors and funders). Basically it’s a deeply cynical view (which probably means it is right) that managers and owners use internally generated funds first, then use debt and only issue equity as a last resort.

In a classic paper Myers and Majluf (1984) argue managers and owners issue equity only when they believe it is overpriced. It is very hard not believe that early in 2017 the insiders at DOF Subsea (i.e. the private equity owners) looked at the vessel schedules and the likely win/loss ratio of the tender pipeline (not the amount of tendering), and decided that if they could dump some stock they would. Luckily investors are aware of the asymmetric information problem and “they discount the firm’s new and existing risky securities when new issues are announced“. Or in other words they just refuse to buy at the asking price which is what happened in the DOF Subsea case.

You should always be wary of financial presentations that start with highlights that don’t include any financials (like the latest DOF Subsea one). Just to be clear the DOF Subsea revenue was down 11% on the same period as last year and EBITDA was down 6%. Luckily, they are doing more tendering.

DOF also helpfully provided this chart of the business:

DOF Business Model.png

Basically without the long term chartering business, which is really just a risk diversification move by Technip, there is no business: the 10% EBITDA on the projects side wouldn’t cover the economic costs and frankly potentially the cash costs either. This is a business where unrealised gains from derivatives (probably interest rate and/or currency swaps) were 6 x the operating loss for the period of NOK (41m).  Year to date DOF Subsea has had to turnover NOK 2.8bn to get a mere NOK 45m in profit. It is pretty clear from the above that actually the projects business, with 17 very expensive fixed costs assets, is not an economic entity; and as I have said before you need a very good return on the vessels on long-term charter in Brazil because as the above graphic makes clear if their contracts aren’t renewed (and no one believes they will be on anything like the current terms) then the value of the vessels will drop like a stone if you believe at some point a vessel is only worth what it can earn in cash terms. The number of other activities you can perform with a 650t vertical lay system is actually pretty small which lowers resale value regardless of how much it cost to build. In which case the value of the business is probably much smaller than the current shareholders would be willing to admit to themselves. Time is not a friend to the investors in this deal because everyday they hold this company future investors get one day closer to finding out what happens in Brazil.

DOF Subsea is a pretty good projects house and the EBITDA margin is just a reflection of market overcapacity. If you were going to invest new money in a subsea projects business you would need therefore to look at that as a realistc EBITDA margin you could earn for the foreseeable future until further supply capacity leaves the market or there is a significant increase in demand. Bear that in mind if you were, for example, looking at injecting funds into a company about to default on its bonds…

The Pecking Order Theory is also helpful in explaining (some of) the shennanigans involved in the Bibby Offshore attempted refinancing at the moment. The insider shareholders in this case also saw the writing the on the wall and in January 2016 took a cheeky £20m off the table in the form of a dividend (after a c.£40m dividend recap that was flagged in the prospectus). In the next 12 months Bibby Offshore lost £52m at the operating profit level, and it must have been known to the Directors by June 16 that without some sort of miracle the business would require a restructuring (which to be clear is an event of default as defined by the ratings agencies even if consensual). It was certainly apparent to any responsible Director by Oct 16.

Bibby Offshore cannot realistically make an interest payment in December, and management have qualified the accounts such that it is not a going concern without a refinancing. And now  the insiders (Bibby Line Group and management) have decided they want outsiders to put money in. They don’t think the equity is overvalued (they know it is valueless);  the insiders think the debt overvalued is and there is too much of it. All the talk of a supportive shareholder reveals it for the sophistry it is: the insiders don’t believe enough to contribute financially. BLG aren’t putting in any of the £60m they have taken out not just because they don’t have it but also because they know the business better than anyone and The Pecking Order Theory makes clear they want someone elses money here.

One deal that is on the table is some “Super Senior” financing (i.e. paid before anyone else) provided by the distressed debt desk at Deutsche Bank. Now Deutsche are arguably the best desk at this in the City, but if you need this sort of financing it is pretty much the end of the road. If EY have resorted to the distress desk at Deutsche as an alternative it shows that no long term investor is interested. This form of financing is more suited for a company in bankruptcy (where it is called debtor-in-possession financing) than for one imminently approaching it. The Deutsche plan would be to lend fully secured against the Polaris and the Sapphire and give Bibby enough money to make until next summer when DSV day rates miraculously improve and the business can service this new debt and bonds. But don’t the bond holders own those boats I hear you ask? Yes. And I am not close enough to this to know exactly the specifics but the security agent is only likely to hand over the ownership papers to the vessels if the bond holders agree to this (I guess); and (I guess) Deutsche would only advance the funds in conjunction with a writedown of their claim. Unbelievably management will argue they are they best people to trade the business out of this mess.

The real tension here appears to be how much equity the bondholders take, and how consensual the handover is, as the business undertakes a debt-for-equity swap. The bondholders can hold out for 100% of the equity as their only other asset apart from the DSVs (and a couple of ROVs) is the shares of Bibby Offshore, but in  order to follow through on this they have to push the company into administration and a liquidation scenario is completely possible at that point as customers and suppliers refuse to trade. The Bibby/Management/EY plan envisages a far more generous structure whereby any money Bibby Line Group put in is also fully secured and they retain majority control so they can consolidate Bibby Offshore in their Group accounts (20% of net assets). The problem with this is of course that BLG don’t have anywhere near enough money to put in proportionately.

A nightmare scenario for the bondholders is taking over a company in such circumstances where agency conflicts abound and in a practical sense now it is a hostile takeover with management having acted until the last possible moment to realise the rights of the debt holders. It is arguable for all of this year Bibby Offshore should have been run with the creditors interests at the forefront of all decisions and it is clear that this has not happened.

In case you’re wondering what is in it for Deutsche: it’s the fees. They are looking at advancing c. £20-30m on the vessels and it would have to be cleared before the bondholders get paid. They would get a 7 figure upfront fee and an interest rate of c. 15%, and if a default occurred they would sell the assets in a fire sale to get their money as quickly as possible. Which is why you can’t get much money from such deals because the bank needs to be conservative here (and I think this deal will die on broker valuations given the likely fire sale prices of Polaris and Sapphire). The problem is of course that debt got Bibby into this mess and it is very unlikely to be the cure to get them out of it. I don’t think the Deutsche proposal has passed credit committee and even though they would make an eye-watering fee on the this the risk is clear: becoming the proud owner of 2 x North Sea class DSVs (and as their offices are some way from the Thames they wouldn’t even add to the famed Deutsche art collection).

With no significant work booked for next year the Bibby plan relies 100% on day rates increasing significantly above current levels. And therein lies the real problem for the bondholders and any potential distress desk coming in on this: at some point the only solution to a market in oversupply is for some capacity to go. How can Bibby credibly claim to make a better margin than DOF Subsea? At the moment Boskalis look almost certain to enter the market in a big way and other companies are also looking to enter the market. Not only does Bibby need tens of millions of pounds under its current cost structure just to make it until next summer there is actually no certainty that this magical scenario of higher rates will allow them to come close to settling the outstanding debt obligations they are generating to get there.

DOF Subsea made clear that while tendering activity is robust project work is dismal (and indeed they made a specific comment that amounted to a profit warning about it). At 7.0 x debt to last-twelve-months EBITDA DOF Subsea (and everyone else in the market) will be throwing everything into trying to win work… all the non-DSV work will compete with Bibby (no one really expects them to reactivate the SAT system on the Achiever) and they will keep margins at ~EBITDA breakeven in order ot get utilisation. As a committed industrial player that is a rational economic strategy. Subsea 7 and Technip are booking DSV days at less than £120k for 2018 to get utilisation in early and they can clearly keep this up virutally indefinitely. The dumb non-industrial money won’t last as long as those with an operational logic and an industrial strategy + balance sheet in this market.

The problem for the Bibby bondholders is that not only at current prices (.36) have they capitalised the firm at c. £63m, way above what it could hope to earn in an economic sense, it also needs £20-40m just to keep trading until next summer.  The major competitors have no cash flow issues (Boskalis has €1bn in the bank) and every reason to chase market share over profit. There is therefore no rational economic reason why under this scenario North Sea class day rates will rise, particularly if Boskalis enters, and every reason to believe they will stay at current levels. Any rational investor in Bibby Offshore would shut down everything apart from the UK business, but 2 x DSVs in the UK doesn’t justify anything like £60m in value…

The Nor bondholders tried super senior financing on their DSVs in Nov 2016 and it is clear, as they slowly run out of money and cannot raise anymore at anything like the 15% fully super senior they did last time, that when someone says you can’t lose on a North Sea class DSV, you can on some. It’s all down to asset specificity as I have said before. Deutsche and other distress desks will be well aware of the mistake the Nor bondholders made, and frankly if I was going to make a mistake on two DSVs I’d rather do it with the Nor vessels than the Bibby ones.

This will all be resolved soon. A bondholder meeting is scheduled for next week and everyone will lay out their plan. The problem is of course there isn’t one really and it should never been allowed to have get this close to Dec 14 when the interest payment is due. The Bibby plan is for it to continue as a lifestyle business where external investors allow the family and management to stay in control and fund it until the market returns. A few (27) redundancies are underway but in a microcosm of the cost and conflict issues that define the company the CEO’s wife, who runs the Business Excellence department, is staying , as is the Director of Small Pools and Innovation, while the Engineering Manager is made redundant (seriously).

The Bibby plan relies on a small number of bondholders, enough to block the majority, being so afraid of the great unknown they back them to carry on as before. This will just delay things until next summer because the cash burn is just so high that even £20-30m would be gone by this time next year without a wholesale change in market conditions. Handing back the Olympic Bibby cuts the cash burn, and may allow the business to come close to cash break even, although the US will make another substantial trading loss in 2018 as will Norway (and without the Ares why bother?); but doesn’t solve the core problem that the business itself is unprofitable at an operating profit level. Call it the slow-burn and pretend strategy. It was disastrous for Nor as eventually reality comes and the cash is gone. As plans go it is pretty terrible.

But the bondholders don’t have a good one either. The bondholders appears to have spectacularly misread the willingness and ability of Bibby Line Group to support Bibby Offshore as well as how badly the business would perform in 2017 versus 2016 (revenue -50%). Some of the funds involved in the bonds don’t need money from an institution like Deutsche, but unless they control the company they have to hold a bondholder vote every time they want to make any significant moves, and letting the company go into administration risks a total wipe-out of value. Stripping the company back to a smaller business locks-in a loss, continue funding it until the market returns is simply throwing good money after bad and it’s real cash. If they do take the business over they will have an awkward period where almost the entire senior management are changed out and they will be cash funding a business, with an unknown financial commitment, while their consultants re-do the numbers and tell them how much capital they will need to inject. I have done that as a management consultant and it is hugely destabilising while it goes on and makes normal operations almost impossible. If if takes consultants 6 weeks to produce an initial report (30 working days), and Bibby Offshore is losing c. 100k a day in the interim even an emergency facility of £3m + £1m for the consultants is real money given the limited upside sale potential. And then they are only in February with a real funding commitment until the mythical summer season that will save everyone… until it doesn’t…

There is a more complicated scenario here where the Bibby Offshore is restructured through a pre-pack insolvency that the current bondholders control. This will remove the historic liabilities incurred (i.e. property leases, Trinidad tax) and see a new company emerge free of its past shareholders and with a new capital structure. I think this the most likely but it will be a dramatically smaller business and will be run solely for sale ASAP. I also see no guarantee it will realise more value than a liquidation despite it being enormously risky given changing market conditions.

The Bibby Offshore refinancing is a mess and liquidation is clearly a very real possibility here. Getting to less than 28 days of an interest repayment before trying to finalise a refinancing is irresponsible in the extreme when it has been telegraphed for months and your plan is simply not to hand the company to the bondholders. The only thing I can definitely tell you is that if you brought Bibby bonds at .36 you are going to lose some real money here.

Business Sense versus Economic Sense… UDS and Say’s law …

A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest the value should vanish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is the purchase of some product or other. Thus, the mere circumstance of the creation of one product immediately opens a vent for other products.

Jean-Baptiste Say, Traité d’économie politique, (1802)

[Say’s law: Supply creates its own demand as Keynes described it. ]


Men err in their productions, there is no deficiency of demand.

David Ricardo in a letter to Thomas Malthus commenting on Say’s law (c. 1820).


More than one press appearence lately of the UDS Lichtenstein (ex Marmaid Ausana) in transit to the Middle East for Sat diving work in Iran apparently. I am a huge supporter of any new business, and taking over assets that others can’t work is a time tested model in cyclical industries. The question is: who is the winner here and who is going to make money? As anyone who has run a dive vessel in Iran, or tendered for work there, can explain the rates make India look attractive. A plethora of choice from around the region and customers who only care about price, and perhaps the size of the backhander, mean that even a 30 year old PSV with a portable Sat system can struggle to make money… Thus a newbuild 130m+ DSV is not a natural candidate for the region.

But there can be a real difference between business sense and economic sense: if you can convince a Chinese yard to build you a ship without having to pay for it I think it is a great business model, and UDS are well connected in certain regions to get DSVs working, I am just not sure of the longevity. I haven’t seen the deal UDS have agreed but if it is similar to others floating around then UDS will only be paying for the vessel when it is actually working, and even then a proportion of profit the job generates not a fixed fee. In Iran that is likely to be the square root of a very small number, and if it’s linked to actual payment then even that is a long way off.

UDS therefore is likely to be making money. How much it is impossible to say with certainty but it is possible to have a good guess…The beauty of this business model is its splits the oversupplied capital element away from the necessary cost of operating the service. It’s like a good bank/bad bank with Chinese yards operating as central bank. Cash costs are covered by the profitable service companies while asset owners hope The Money Illusion and the miracle of demand saves them. The Money Illusion is just that and this demand chart shows why demand is unlikely to help DSV owners:

Global E&P Capex

Near stagnant shallow water Capex for years meaning an oversupplied maintenance market.

One of the reasons new DSVs struggle to trade at a premium to old DSVs is the lack of functional benefits from a new vessel for the customer. 30 years ago people were diving at 300m below sea level and we still are now (in fact I have been told Tehcnip and Subsea 7 now call all dives over 200m “special” and need higher approval). Sure the newer vessels may use a bit less fuel on DP, carry a few more people, have a better gym etc, but for the customer, especially in a place like Iran, no one actually cares. The fact is an old banger can do pretty much what a new build Chinese all-singing all dancing DSV can do.

In brutal terms going long on a $150m doesn’t command any pricing premium, or only marginally so, it may just help you secure the work. When people are operating at cash breakeven only that may be a blessing for the company who operates the vessel but that extra capacity is curse for the industry.

Not only are customers cheap in every region outside the North Sea, they can afford to be! Environmental conditions are far more benign which means for a lot of jobs you can use a PSV with a modular system or one of the many $50m build cost Asian focused DSVs… they might not be quite as “productive” or “efficient” as a North Sea class but the owner just reduces the day-rate to the customer to reflect this.

What makes this important is this: for as long as UDS can convince (yard) shipowners that they are the best people to manage unpaid for DSVs, or their own, then they should make money. For the yards and DSV industry it’s a difference story…

In normal times people like to make a return on their capital. The reason you invest is obviously because you want to be paid back. Economists have a really easy way to calculate this: economic profit (which is completely different to accounting profit) and is derived by simply allowing for the cost of the capital in the investment. In crude terms SS7’s cost of capital today is ~12%. Assume a new DSV, with no backlog, all equity financed (a realistic assumption as what bank would lend on this (ignore fleet loans)?). So the “market capital cost” per annum of a new DSV for a recognised industrial player is c. $18m per annum ($150m * 12%); at 270 days utilisation the vessel needs to make $67k per working day just to pay the capital provider. No Opex, no divers, no maintenance, just finance. No one in Iran gets more than $85-90 in total, and it may well be substantially less.

Now UDS don’t need to pay that because the yard unfortunately had a customer credit event and got left with a vessel. Mermaid wrote of over $20m so the yard is probably exposed for $130m, and it maybe more because rumours abound of a fisaco with the dive system which will have been expensive to fix. But there is no doubt UDS have added great value to the yard by providing them with the technical expertise to finish this vessel. UDS just needs to cover their costs and the yard can get something which they probably feel is better than nothing, but it doesn’t mean this work is “economic”. The subsidy here is being paid for by the yard’s equity holders, effectively the Chinese taxpayer, who are involved in an extremely expensive job creation scheme… but times were different… who am I to criticise anyone for going long on OSVs in 2013?

The UDS new-builds are a somewhat different story. If a private equity firm were financing a new build DSV their cost of capital would be ~30% (in this environment probably a lot higher); so at 270 days utilisation that would be c. $167k per working day as a cost of capital. That is after paying for divers, maintenance, and OpEx, a market level of return commensurate to the level of risk of starting a new build DSV company would require that just for the vessels, ignore the working capital of the company. Each new build DSV needs to generate $167k per working day to make an economic profit for the investors. Rates have never been that high in the region, which maybe why economics is a “dismal science“, but it also explains why no one has built $100m+ DSVs for Asia: no one will pay for it!

Rates have been higher in the North Sea but never anything like that consistently and cannot realistically be expected to grow to even half that economic level.  There is also simply no realistic chance of any of the UDS vessels being a core part of the North Sea fleet where rates could traditionally support a capital cost appropriate to the investment in such a specialised asset. SS7 and Technip simply do not procure 25 year assets by chartering off companies like UDS, and frankly they could get a better or cheaper product in Korea or the Netherlands if they built now.  And even if the Chinese built the most amazing DSVs ever (a big if) no one in the North Sea would believe it and pay for it. Given the high profile problems of chartering North Sea DSVs it simply isn’t credible to have any scenario where any of these DSVs come North of the Mediterranean.

I haven’t even dealt with the most important problem: There isn’t enough work in the North Sea. People relax constraints in the region when they need to but at the moment they don’t. The UDS vessels when completed will not be North Sea tonnage… and the only market I think it’s harder to sell a DSV into than Iran is China…

The UDS startegy seems pretty clear at this point: to try and flag the vessels locally and take advantage of local cabotage regulations (like OSS did in Indonesia with the Crest Odyssey) to ensure some local regulatory support for utilisation. The problem with this strategy seems to be it doesn’t have a meaningful impact on day rates. Asian markets with strong flag state rules have never paid top dollar before and it is hard to see these vessels changing the situation. On a boring technical note it is normally impossible to get a mortgage over the vessel as arresting it can be difficult. It’s probably worth a punt for utilisation but it isn’t going to change the profitability of this and makes the capital commitment enduring for anything other than a token price.

I think UDS has great business sense don’t get me wrong. Owe the bank $1m and you are in trouble… owe the bank $100m and they are in trouble. UDS looks set to owe yard c. $450-600m, depending on how many vessels they take delivery of. UDS has great business sense because the yards have a problem way bigger than any of the shareholders in UDS and in an economic sense the yards are never going to make money from this.

All of which brings me to Jean-Baptiste Say, who in 1802 ennuciated a theory that dominated economics for over 120 years. Say’s law was actually the macroeconomy but that wasn’t invented until Keynes. Say looked at the incredible industrial development of the early 19th century cotton industy and thought the economy as a whole must work like that. Without people building something there would be nothing to sell, and therefore there could be no recessions. To anyone working in oil services Say’s further writings looks close prophetic:

Sales cannot be said to be dull because money is scarce, but because other products are so. … To use a more hackneyed phrase, people have bought less, because they have made less profit.

But this was a world away from when Keynes wrote The General Theory at the start of The Great Depression. Until this time Say’s law was the dominant theory of what Keynes later termed “aggregate demand”. We now know that at a macroeconomic level there can be a chronic demand problem, it took WWII for the world economy to recover from The Great Depression, and it is impossible to overstate the importance of the new view in 1936 when Keynes published The General Theory which intellectually overturned Say’s law. Say had confused what happens with companies for what happens to the economy as a whole.

I am reminded of UDS when I think of Say’s law: they might make money out of this, but whether this is economically rational for the whole economy is another story.  Say was wrong in micro and macroeconomics: supply doesn’t create demand.

All the UDS vessels will do is create extra capacity from sellers who are forced to accept lower than opex from anyone with an external financing constraint. The UDS vessels, and the Magic Orient, and the Keppel Everest, and the Vard 801, and the Toisa new build etc will simply wipe out the equity slowly of all those who stay at the table playing poker.

Sooner or later the funders of this enormous gamble will come out. Unwittingly China Yard Inc. is clearly going to be a dominant equity holder, they might think they have a fixed obligation at this point, but just as Keppel and others are finding out: at this level of leverage debt quickly becomes equity. For existing DSV operators in markets where these vessels turn up they are nothing short of an economic disaster. 2018 is going to be another poor year to be long DSV capacity.