“Preparing for the recovery”… Whatever…

The IEA has recently published it’s new World Energy Review and if you have been reading this blog this comment will come as no surprise:

One notable trend concerns the relationship between oil prices and upstream costs. In the past, there has been a roughly linear relationship between upstream costs and oil prices. When price spiked, so did costs, and vice versa. What we are noting now is a decoupling. While prices have more than doubled since 2016, global upstream costs have remained substantially flat and for 2018 we estimate those increasing very modestly, by just 3%. Companies appear to have learned to do more with less.

Too many business models in the offshore supply chain are simply ignoring this. If you are going long on Borr Drilling shares (for example), as anything other than a momentum trade, then you need to look at data driven forecasts like this, which in statistical terms are called a structural break. Look at the cost deflator in the graph above! In an industry with high fixed costs (both original and operating) that is a straight financial gain for E&P companies and with the volatility in the oil prices they will not give that up easily… and in a world of oversupply they won’t have to.

The future will be different. Some vast market snapback where the Deamnd Fairy appears, and everyone brave enough to have paid OpEx in the offshore supply chain has found a clever get rich quick scheme, is an extremely unlikely event.

More data points like this should make you think as well:

IEA Source.png

Yes, I get the volume in absolute terms is growing, but it is change at the margin that defines industry profitability.

There is still too much liquidity and too many business plans talking as if a return to 2013/14 is a certainty when in reality such a scenario would be an outlier.

For the tier 2 contractors summer isn’t coming… a long hard grind beckons…

Back in the dark ages of November 2016 a consensus was forming amongst the more optimistic of the subsea and investment community: things had got so bad there must be an upturn in 2017? M2 raised money from Alchemy, the Nor DSV bondholders did a liquidity issue, SolstadFarstad started their merger discussions, York began acquiring a position  in the Bibby bonds, Standard Drilling went back to the market to buy more PSVs (could they be worth less?), and early in 2017 on the same wave Reach also raised money… what could possibly go wrong? A quick rise in the price of oil and the purchase orders would flow robustly again… risk capital would have covered essentially a short-term timing issue and as the summer of 2017 came things would revert, if not back to 2014, at least some degree of normalcy and cash profitability. Everyone would be positioned for the next big upturn… This wasn’t a solvency issue for the companies involved figured the investors, this was merely a liquidity issue that they could profit from by supplying the needed funds…

Things haven’t quite worked out the way they planned. Summer, in terms of high day rates and utilisation didn’t come last year, and it hasn’t come this year with sufficient force to change much this year, but next year the true believers tell you it will be massive. Bigger than ever. You just need enough money to cover another loss-making winter to get there…

No one can know the future, although I think many of the signs were there, and a lack of any due diligence was a common theme of many of the above transactions; but the real question now is when the industry accepts the scale of the change required and the necessary exit of some capital to reflect new demand levels? Or not maybe? There is so much excess liquidity (that’s the technical term for dumb money) floating around, and the capital value of the assets in  subsea is perceived as so high, maybe another cycle of working capital to burn beckons… but certainly not for everyone. And there will be some mean reversion here but it is looking on the downside not the up.

Alchemy Partners appear to have realised this and seem committed to a quick exit from M2, the sale process appears to be highly geared to an asset only deal. Such a transaction would save them from the timing and cost of issuing a full IM, due diligence, and the time spent negotiating an SPA for a loss-making business that a self professed special situations investor cannot bring itself to commit more to. The first question anyone would ask them would be “why is one of the once great names in UK retsructuring unable to make this work?”.  Reputational risk alone for them argues for a quick process here… With XLXs going for $1.5m used Alchemy may feel they get just as much from a clean asset sale as from any possible going concern basis, when matched with the profits made from being in the Volstad Topaz bond they may not come out too badly here.

Reach Subsea have decided the numbers are so bad that their Q1 2018 results won’t appear on the website. (Reach aren’t the only people playing this strategy; for all their entrenched bureaucracy Maersk Supply can’t seem to find their numbers to put up after Q3 last year either). As a general rule in this market if you aren’t putting up numbers it’s because they are even worse than people feared.

For Reach Subsea one is treated to  the newshub with a few bullet points of “financial highlights”. It is hard to comment without seeing the full financial statements but Subsea World News appear to have seen the full numbers and say that turnover was NOK 114m and operating costs were NOK 101m ROV days sold were up 89% and EBITDA was up to NOK 13.2m. However, losses before tax were up 50% on the same period last year. This could just be an accounting convention as part of the change to a new accounting standard for leases, but with M2 unprofitable, along with a host of other ROV companies, the chances of Reach making money with exactly the same business model and service offering have to be regarded as remote.

The spot market nature of the Reach business is highlighted by the fact that their order book is at NOK 147m (mostly for 2018) which is 10%< of the amount of work they are bidding for in the pipeline. Everyone goes on about tendering but it’s a real cash cost and if you aren’t winning 30% of the work you are tendering for then you are tendering too much and just wasting time and resources. Tendering NOK 1.7bn in work implies Reach Subsea should turnover about NOK 600m this year, with their firm pipeline at NOK 147m in Q1 that has seem a long way off.

All these companies are doing is providing capacity at below economic rates of return and burning OpEx in a way thay ensures the industry as a whole cannot make a profit. Eventually investors, not usually management because these are lifestyle businesses, tire of this. ROV rates are such at the moment that even though most are purchased with only a 20% deposit operators are not making enough to cover the deposit on a new one when they wear out. Eventually the small players get ground out because even if they can survive in operational terms hopes of replacing equipment becomes a fantasy. This is how the industry appears to be reducing capital intensity.

I have expressed my scepticism consistently on the ROV industry on many occassions based on one simply premise: Oceaneering. Oceaneering is the market leader, widely regarded as a well run company and has signficant economies of scale and scope, and even they can’t make money off ROVs. Neither could Subsea 7 in  the i-Tech division… so how on earth are all these small companies going to make money? All they can sell on is price, and there is sufficient overcapacity to ensure the E&P companies play all the tier 2 contractors off against each other. To my mind this is one of the drivers of increased tendering that all the tier 2 contractors claim while their numbers become even worse.

Oceaneering is by an order of magnitude the largest ROV company in the world:

Oceaneering market position.png

And yet with all that scale cash flow is getting worse:

Oceaneering FCF.png

That’s not a reflection of Oceaneering management that is a reflection of market conditions. And if the largest company in the industry can’t get any uplift then the small companies, with no pricing power, are also operating at a significant loss without the resources of the larger companies. Talk of other companies doing a buy-and-build strategy in the ROV market is just laughable given the sheer scale of the top 5 companies controlling more than 50% of the market. Someone got there first 10 years ago, and executed well, this isn’t the market for an imitator it is  the market for large industrial players to grind out market share.

What is happening, and will continue to happen, is that those companies with scale and resources will continue to grind out market share and volume by pricing at whatever they can get (in economics terms below marginal cost) and they can keep this game up longer as they have more resources. It is just that simple.

DOF Subsea, DeepOcean, and Reach Subsea, have within days of each other announced they have framework commitments from Equinor. Such “contracts” (in the loosest sense of the word only) guarantee no work just a pricing and standards level from the contractors. The only obvious economic implication from this contracting method is that Equinor believes it doesn’t need to cap it’s costs going forward as overcapacity will keep rates down. Equinor is keeping it’s options open and help keep some small Norwegian contractors alive to prevent SS7 from Technip from strangling them, but it’s generosity appears limited. (It should also be noted Saipem/Aker appear to be making real moves now to bid the Constellation and Maximus in Norway so even tier 1 rates there look set to suffer.)

DeepOcean is the one company that appears to really be on the point of being regarded as a tier 1 contractor in terms of IRM and renewables scale. Acquisitions at the bottom of the market in Africa and the US, a smart charter of the Rieber vessel, and a large European business with a strong renewables business have probably given it enough scale to be regarded as in a different league now from the smaller companies. But it shows the size of commitment a buy-and-build strategy would require and the industry simply doesn’t have enough inherent profitability to make it worthwhile. A point Alchemy have now implicitly acknowledged and their commitment to the socialist idealogy of helping E&P companies lower maintenance costs by supporting them with investors funds seems to have ended. DeepOcean should probably be regarded as the minimum efficient scale a company in this market needs to be to survive, a vast mountain to climb for any investor coming in this late no matter how cheaply they buy some kit.

For all the tier 2 contractors there is no respite. Pricing pressure will remain extreme, they have identical business models and assets, there is no scope for differentiation, and capacity far outstrips any reasonable expectations of demand inceases. Make no mistake Alchemy won’t be the first to throw in the towel and other investors need to think what they know that Alchemy Partners doesn’t? For as long as the industry can find investors willing to believe the downturn is a normal cyclical part of the oil industry, rather than a secular change where the relationship between the oil price and offshore expenditure has fundamentally changed (a regime shift in econometrics) then this seems to be the only likely outcome.

Overdiscounting… the future of offshore…

The qualities most useful to ourselves are, first of all, superior reasons and understanding, by which we are capable of discerning the remote consequences of all our actions; and, secondly, self-command, by which we are enabled to abstain from present pleasure or to endure present pain in order to obtain a greater pleasure in some future time.

Adam Smith, 1759

 

For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence.

John Maynard Keynes, 1936

 

The slide above taken from Transocean highlights how competitve offshore has become on a per barrel recovered basis. I’ll ignore the fact that the cost estimates for shale appear high because it isn’t my point: the real point is that to compete in the modern environment offshore oil production will have to be significantly more profitable on a per barrel recoverable basis because there is significant evidence managers underestimate (“overdiscount“) future financial returns the further away they are. Shale returns, while lower, are produced in a much shorter time period than offshore and behavioral finance shows strong evidence that managers prefer these sorts of returns at lower levels when compared to higher returns further away.

In  2011 Andrew Haldane, Executive Director, Financial Stability at the Bank of England, and Richard Davis, and Economist at the Bank of England spoke at a Bank for International Settlements conference and noted:

[r]ecently, in 2011 PriceWaterhouseCoopers conducted a survey of FTSE-100 and 250 executives, the majority of which chose a low return option sooner (£250,000 tomorrow) rather than a high return later (£450,000 in 3 years). This suggested annual discount rates of over 20%. Recently, Matthew Rose, CEO of Burlington Northern Santa Fe (America’s second biggest rail company), expressed frustration at the focus on quarterly earnings when locomotives lasted for 20 years and tracks for 30 to 40 years. Echoes, here, of “quarterly capitalism”.

In 2013 McKinsey & Co and CPPIB surveyed 1000 Board members and found:

  • 63% of respondents said the pressure to generate strong short-term results had increased over the previous five years.
  • 79% felt especially pressured to demonstrate strong financial performance over a period of just two years or less.
  • 44% said they use a time horizon of less than three years in setting strategy.
  • 73% said they should use a time horizon of more than three years.
  • 86% declared that using a longer time horizon to make business decisions would positively affect corporate performance in a number of ways, including strengthening financial returns and increasing innovation.
  • 46% of respondents said that the pressure to deliver strong short-term financial performance stemmed from their boards—they expected their companies to generate greater earnings in the near term.

The implications for offshore investment (decision tree here) versus the certainty of a short payoff from shale investment are obvious. It has been well known in economics for years that managers overdiscount future returns: in behavioural economics it falls under time preference problems. Humans are neurologically wired with a preference for immediacy that affects economic behaviour. As Haldane and Davis make clear:

This evidence – anecdotal, survey, quantitative – is broadly consistent with popular perceptions. Capital market myopia is real.

As early as 1972 Mervyn King, who would later become Governor of the Bank of England, noted that managers in the UK overdiscounted returns from long term investments. This stream of literature dried up as the Efficient Market Hypothesis took over as the vogue theory but it doesn’t change an actual reality.

The fact is that in competition for marginal oil investment dollars there are institutional and behavioural factors pushing for short-term solutions. This article in the Financial Times notes that Shell is under pressure as the CFO hasn’t outlined when the promised $25bn share buyback will start. Do you think the CFO at Shell is pushing for a new Appomattox because it has lower economic costs (but high CapEx) or will she simply seek to favour short pay-off, lower margin, projects?

Managers pushing offshore projects in E&P companies are running into senior managers who represent exactly those type of Board members surveyed by McKinsey and CPPIB. These managers aren’t wilfully myopic, the shareholders are pushing them to be, but they are more focused on immediate payoffs and overdiscounting the costs of the offshore projects. Again this quote from Haldane and Davis seems apposite:

Graham, Harvey and Rajgopal (2005) surveyed 401 executives. They found three striking results. First, managers would reject a positive-NPV project if that lowered earnings below quarterly consensus expectations. Second, over 75% of the sample would give up economic value in order to smooth earnings. Third, managers said that this was driven by the desire to satisfy investors.

When there was no shale this wasn’t an option as the question was “Do you want oil or not?”. The question is a whole lot more complex now and involves and assessment of certainty, risk, payoff potential and timing, and the pricing uncertainty of a volatile commodity over the long run. All this points to the fact the the financial and institutional barriers to new offshore projects are much higher than simple “rational” expectation models of future payoffs would suggest.

 

The trade-off between shale and offshore investment and the effects on marginal demand…

The rising oil price is about to test one of the major tenets of this blog: namely that there has been a structural change in how oil is produced and that a sharp comeback in offshore demand, as has been seen in previous cycles, is extremely unlikely. At the moment all the data appears to be pointing to the ever increasing importance of shale over offshore for marginal investment dollars, and in fact the higher price may be encouraging shale investment over offshore as smaller E&P companies can meet volume increases through cash generated and open capital markets and larger E&P companies take a margin hit but keep CapEx commitments steady and not expanding offshore much beyond long signalled commitments.

It is also worth noting that this recent price rise does not seem related to demand factors:

physical markets for oil shipments tell a different story. Spot crude prices are at their steepest discounts to futures prices in years due to weak demand from refiners in China and a backlog of cargoes in Europe. Sellers are struggling to find buyers for West African, Russian and Kazakh cargoes, while pipeline bottlenecks trap supply in west Texas and Canada.

At the moment Permain is trading on a discount to WTI of between $7-12 per barrel given transportation constraints via pipeline out of the region. Something like 1.5m barrels per day opens up by March next year though so this is a temporary problem. The process of capital deepening for shale is also occuring as refineries in the region change their intake capacity for the ‘light sweet’ crude that currently needs to be mixed with heavier Brent. This will take time, and cost billions, but every year this capacity slowly increases with each maintenance cycle at the large refineries, incentivised by the large discount to Brent.

PVM has reported that as the oil price has rised Texas’s energy regulator issues 1,221 drilling permits in April, up around 34% from a year ago. The BH rig count added another 10 rigs to the US oil fleet last week but also another 2 offshore rigs, but that only brought the offshore count back to a year ago, the same for the Gulf of Mexico (+1); whereas the land rig count is up ~19% from a year ago.

BH rig count 11 May 2018.png

Again this leads directly to higher production. In June alone US shale production will add the rough equivalent of a Clair Ridge to their output levels:

IMG_0511.JPG

The US shale industry is the single biggest transformation to the oil and gas industry since the pre-salt fields were discovered and developed in Brazil. Those developments led to an extraordinary rise in the price of tonnage and changed the entire offshore supply chain. It is simply not logical to accept that a change as big as this in volume terms is occurring in the US and that it will not have similarly profound impact on the offshore industry.

The correlation between the oil price and the US rig count and the oil price and US production levels has an r-squared of ~.6 according to IHS Markit (data below) if anyone is interested. That means each $1 increase in the price of oil leads to a .6 increase in the rig and production volumes.

IMG_0512.JPG

Whereas for offshore a strong increase in the price of oil over the last twelve months has seen this happen to the jack-up and floater count:

Jackup and rigs 11 May 18.png

Source: Pareto Securities.

Jack ups and Floaters demand has been effectively static over the past year. The workhorses of future offshore production increases and demand simply haven’t moved in a relative sense. The cynic would argue their correlation to the oil price has been reduced to zero (which clearly isn’t true), but it shows how time delayed this recovery cycle is for the front end of offshore. But the flat demand for jackups and floaters is exactly what most subsea vessel and supply companies are saying: demand has bottomed out but over supply and a lack of pricing power persists. The good explanation of why so many OSV and subsea companies claim to be doing record tendering and their  continued poor financial performance lies in the data above.

What I call (sic) “The Iron Law of Mean Reversion”, which seems to substitute for thoughtful analysis, can be seen in this slide:

Transocean Iron Law.png

The heading is simply a logical fallacy. There is a load of evidence to say shareholders are more comfortable with lower reserves now and less offshore production is being sanctioned because the money is being spent on shale.

At some point the disconnect between companies like Standard Drilling, buying PSVs at pennies in the dollar and keeping them in the active fleet, and the general oversupply will be realised. In the CSV/ Subsea fleet things are no different: Bourbon, Maersk, and other vessel owners state they are building up contracting arms, yet again all they do in total is keep supply high for a relatively undifferentiated service and erode each others margins (and spend a lot on tendering). The service they operate has no real differences to the ROV companies like Reach, M2, ROVOP, IKM ad infinitum and other traditonal vessel contractors like DOF Subsea. Sometimes they have a good run of projects… and other times…

Bourbon Q1 2018 Susbea.png

Project work is lumpy but Bourbon stated that the project market was especially poor versus suppy. In the old days boats were scarce and enginneering had a relatively small mark-up which the mark-up on the vessel accentuated and flattered. But getting a CSV with a large deck and crane now is so average it is no wonder everyone claims to be tendering: E&P companies are clearly getting them all to bid to reduce project costs. There is clearly more work being done on vessels at the moment, but there is a limit as shown above, and no project delivery companies have any pricing power.

The larger contractors appear to be winning a greater porportionate share of work at ever lower margins as TechnipFMC recently showed:

Technip Q1 2018.png

Given Technip is now winning as much work as it burns through demand has clearly hit the bottom. But even it has to lower margins to win. The commodity work, where you grab some project engineers and a couple of ROVs on a cheap boat (often IRM related), is clearly going to have all the profit bid away for a long time, whereas construction work still has value even in the downturn; but it entails serious risk and range of competencies that are beyond the realms of dreaming about for the smaller contractors.

This relationship between the rising price of oil and marginal demand for shale verus offshore will make this recovery cycle for offshore different to any other. IRM is important in the short-run, but the fewer wells and pipes laid now will ensure not only is future construction work lower but so to is the installed based. There will clearly be a recovery cycle, demand is above last year’s levels and subsea tree orders are well ahead of 16/17 lows, but there is clearly huge competition at the margin for E&P investment dollars in offshore versus onshore which is a competitive dynamic the offshore industry has never had before.

Random Friday afternoon thought… Borr and McKinsey….

They both can’t be right can they?

From a downbeat McKinsey view on the jackup and floater market:

McKinsey jackup demand 1.0.png

From a recent Borr Drilling presentation:

Borr Jackups business.png

I know you can argue high-end jackups will recover etc… it’s just not a booming market if you have this much uncontracted capacity:

Borr fleet status.png

And maybe you would prefer less analysis like this from McKinsey:

After seeing rig activity stabilize during the first half of 2017, it resumed a declining trajectory in the second half of the year, hitting record low levels (estimated at about 300 units for jackup rigs and 140 for floaters). This will keep downward pressure on day-rates, with the few rigs that are finding new contracts, doing so at a sharp discount to the rates earned prior to the oil price decline (about 25 percent for jackups and about 75 percent for floaters from 2014 levels). This means lower margins for rig owners, even though they have reduced operating costs by around 70 percent since 2014.

Roll the dice!

 

Investment will be sufficient…

I think this is very big news for offshore energy:

“Over the next 10 years, we see that supply will continue to keep up with demand growth,” said Espen Erlingsen, an analyst at Oslo-based consultant Rystad. “The surge in North American shale activity and start up of new fields are the main drivers for this growth.”…

The upshot is that it costs less to expand global oil production today than it did back in 2014. Rystad said industry spending in recent years will deliver the necessary 7 percent growth in global oil production to just over 103 million barrels a day by the end of the decade. That trend will continue over the next 10 years if oil remains between $60 and $70 a barrel, it said.

For as long as the downturn in offshore has been going on the Demand Fairy of recovery has been posited on the seemingly axiomatic logic that insufficient investment now would bring a boom in demand in later years and only offshore could supply this capacity. Indeed almost every restructuring presentation or positive talking up on the sector seemed to have a variation on this theme, it was the meme that made a quick recovery believable to those determined to try.

Rystad appear to have re-run their models with the structural break I referred to earlier, where altering the volume of output to the value of input, produces much higher output levels than previously assumed. Rystad aren’t saying there won’t be growth, but it will not be exponential driven by a supply shortage, in the next three years anyway, and maybe not for the next ten years. ‘Lower for longer’ might not be strictly accurate for the oil price but it is likely to be for rig and vessel rates. And magically supply will equal demand. Just as the shale pessimists always had a mind numbingly boggling theory about how it could never work in the long run, so the offshore bulls have always stuck to their theory that the market was being irrational in the short-term and would eventually see sense. The longer the downturn has gone on the more unsustainable that argument has become.

Interestingly offshore global investment (not defined) rises from $164bn in 2018 and 31% of total spend ($345bn/39% in 2014!) to $189bn and 32% of total investment spend in 2020 (a compound growth of ~7%). Shale goes from 12% in 2016 to 24% in 2020. Total upstream CapEx drops from $890bn to $584bn from 2014 to 2020 in the Rystad forecast. If that is correct (even directionally) it is a severely deflationary market environment with huge implications for asset values and solvency going forward.

The IEA says spending dropped about $338 billion, or 44 percent, between 2014 and 2017.

The shale revolution is real and here to stay and it is completely unrealistic for the offshore supply chain not to accept the scale of change required to adapt to this new environment. If you see a “recovery play” that doesn’t explain how it works within this macro context, or how this is wrong, then it isn’t realistic. Expect to hear the phrase “we are doing a lot more tendering” instead of an intelligent response.

The oil market was previously very cyclical because there was no short-cycle marginal prodcuer who could respond quickly to changes in demand. Investment was hugely cyclical because of this. Supply was met with a series of large and lumpy projects planned years in advance and oil companies erred on the side of caution in doing so. Marginal production was supplied by smaller tier two producers who were predominantly offshore. The price change-to-output response time was slow but could be brutal as the downturn in oil price in 2009 showed where a host of small high cost producers went bankrupt. [Read Spencer Dale!].

Now US shale producers are very responsive to price trends and production increases as price does. This is the major change to the market and it is such a significant change that this is why it is (rightly) called “the shale revolution”. It was a price-output feedback meachanism that simply didn’t exist before. Yes, shale might be more expensive, but it is an immediate dollar of revenue, lower risk and lower margin because of it, and that is what the marginal barrel, the next barrel of oil required for the market to balance, should be priced at. Oil as a spot market will be less cyclical going forward as the market responds more incrementally to price changes, a point that Rystad effectively make above.

In a more rational market, with smaller supply/demand imbalance the logical solution would be for larger vessel and rig companies to get into a series of longer term contracts with E&P companies for the provision of assets. This would reduce the cost of ownership (and finance) and therefore the day rate, and also reduce the risk of oversupply. Over time the market may well go this way and this will drive real consolidation, particularly in the offshore supply market, smaller operators of high-end OSVs will become a relic. But for the moment the E&P companies will simply take advantage of the over-supply to gain access to an asset at below it’s economic cost.

The New North Sea…

[Pictured above a sneak preview of the new (TBC) York Capital/Bibby/ Cecon OSV]

Subsea 7 came out with weak results last week and specific comments were made regarding the weakness of the North Sea market. I have been saying here for well over a year that this UKCS in particular will produce structurally lower profits for offshore contracting companies going forward: you simply cannot fight a contraction in market demand this big.

In Norway spending has remained more consistent, largely due to Statoil. But it is worth noting how committed they are to keeping costs down:

Statoil Cost reduction Q1 2018.png

A 10% increase in production is balanced with a 50% reduction in CapEx and a 25% reduction in per unit costs. Part of that is paid for by the supply chain… actually all of it. What I mean is only part of it is paid for by productivity improvements and lower operational costs… the rest is a direct hit to equity for service companies.

But as a major offshore player this presentation from Statoil highlights how efficient they have become in the new environment (and how offshore will compete going forward):

Statoil drilling efficiency.png

Cutting the number of days per well by 45% not only vastly reduces the costs for rigs it clearly reduces the number of PSV runs required to support the rig for example. The net result is that offshore is more than competitive with shale/tight oil:

Statoil break even.png

In fact Statoil is claiming its breakeven for offshore is USD 21 ppb on a volume weighted basis. It’s just a timing and economic commitment issue on a project basis to get there, but the future of offshore in demand terms is secure: it is an efficient end economically viable form of production. Especially when your supply chain has invested billions in assets that they are unable to recover the full economic value from. Demand is clearly not going any lower, and is in fact rising, just nowhere near the level required to make the entire offshore even cash breakeven.

Statoil has also changed its contracting mode which is probably part of the reason Subsea 7 is suffering from margin erosion in the North Sea. Statoil has clearly made a conscious decision to break workscopes into smaller pieces and keep Reach and Ocean Installer viable by doing this (and helping DeepOcean but it is clearly less vital economically for them). Part of this maybe long term planning to keep a decent base of contractor infrastructure for projects, but part of it maybe rational because previously for organising relatively minor workscopes larger contractors were simply making too much margin. A good way to reduce costs is to manage more internally in some circumstances, and especially in a declining market. I doubt you can be a viable tier 2 size contractor in the North Sea now without a relationship with Statoil to be honest, it just too big and too consistent in spend terms relative to the overall market size (Boskalis is clearly a tier 1 if you include its renewables business).

I still struggle to see Ocean Installer as a viable standalone concept. At the town hall recently the CEO stated that Hitecvision were in for another two years as they needed three of years of positive cash flow to get a decent price in a sale. But what is a buyer getting? They have no fixed charters on vessels (not that you need them) and no proprietary equipment or IP? All they have is track record and a Statoil relationship. In a volatile market even investors with as much money as Hitecvision must want to invest in businesses with a realistic chance of outperforming in the market?

The UKCS is a different story. Putting the Seven Navica into lay-up is an operational reflection of a point I have made here before: there is a dearth of UKCS CapEx projects. Demand is coming back in the IRM market overall but the diving market remains chronically oversupplied and this is likely to lead to much lower profits in a structural sense regardless of a cyclical upswing.

As I have said before Bibby, surely to be renamed soon if York cannot sell the business, remains by far in the weakest position now. Bibby appear to have won more than 70 days work for the Sapphire but that is just the wrong number. Bibby are caught in a Faustian pact where they need to keep the vessel operating to stop Boskalis getting market share, but they have no pricing power, and are not selling enough days to cover the cost of economic ownership on an annual basis. The embedded cost structure of the business overrides the excellent work on the ground the operational and sales staff do.

Boskalis with a large balance sheet are clearly using this year to get out and build some presence and market share. The operating losses from the Boka DSVs won’t please anyone, but would have been expected by all but the most optimistic, and all that is happening is they are building a pipeline for next year. Coming from Germany and the Netherlands, areas more cost-focused, gives them an advantage, as does their deep experience and asset base in renewables. Boskalis know full well the fragile financial structure of Bibby and this is merely a waiting game for them.

The problem for Bibby owner’s York Capital (or their principals if the music journalist from Aberdeen is to be believed)  is the lack of potential buyers beyond DeepOcean or Oceaneering. I spoke to someone last week who worked on the restructuring and told me it was a mad rush in the end as EY were £50m cash out in their forecast models of the business (which makes the June 17 interest payment comprehensible). This makes sense in terms of how York got into this it doesn’t help them get out, and frankly raises more (uninmportant) questions, because it was obvious to all in the offshore community Bibby was going to be out of cash by Nov/ Dec 17 but not to the major owner of the bonds? Bizzare.

Internally staff don’t believe the business is in anything other than “available for sale mode” because the cost cutting hasn’t come, the fate of the Business Excellence Dept is seen as a talisman for the wider firm, and there is no question of money being spent on the needed rebranding by year end unless required. A temporary CFO from a turnaround firm continues without any hint of a permanent solution being found for a business that continues to have major structural financial issues.

Managers at Bibby now report complete a complete lack of strategic direction and stasis, it would appear that winning projects at merely cash flow break even, with the potential for downside, is making the business both hard to get rid of and the current shareholders nervous of where their commitments will end. Any rational financial buyer would wait for the Fairfield decom job to finish and the Polaris and Sapphire to be dry-docked before handing over actual cash, but there is a strong possibility the business will need another cash infusion to get it to this stage. And even then, with the market in the doldrums, all you are buying is a weak DSV day rate recovery story with no possibility to adding capacity in a world over-supplied with DSVs and diving companies. An EBITDA multiple based on 2 x DSVs would see a valuation that was a rounding error relative to the capital York have put into the business. All that beckons is a long drawn out fight with Boskalis who will only increase in strength every year…

On that note Boskalis look set to announce an alliance with Ocean Installer. In a practical sense I don’t get what this brings? Combining construction projects with DSVs from different companies is difficult: who pays if a pipe needs relaying and the DSV has to come back into the field for example? But the customers may like it and having a capped diving cost may appeal to Ocean Installer… it’s more control than most of their asset base at the moment.

Subea 7 and Technip just need to keep their new DSVs working. They are building schedule at c. £120k per day and peak bookings at c.£150k per day and are winning the little project work there is. Although even the large companies are having to take substantially more operational and balance sheet risk to do this. The Hurricane Energy project, where Technip are effectively building on credit and getting paid on oil delivery, highlights that what little marginal construction work there is in the North Sea will go to companies with real balance sheet and field development integration skills. I have real doubts about this business model I will discuss another day: the solution to a debt crisis is rarely more leverage to a different part of the value chain.

But services are clearly holding up better than owning vessels. The contrast between the supply companies and the contracting companies continues the longer the downturn for vessels continues. The  old economic adage that organisation has a value is true. Technip and Subsea 7, along with McDermott and Saipem, have not needed to restructure as many vessel companies have. The worst years of the downturn were met with project margins booked in the best year of the upturn giving them time to restructure, hand back chartered ships, and reduce costs to cope with a new environment. There has been a natural portfolio diversification benefit the smaller companies and supply operators simply haven’t had.

Subsea 7 for example is a very different business to 2014 (investor presentation):

Subsea 7 cost reductions.png

Staff costs down 60% and a very decent effort at reducing vessel costs despite declining utilisation (and despite reducing vessel commitments by 12 vessels):

Subsea 7 vessel utilisation.png

In the past people in susbea used to say they were in the “asset business”. Without assets you couldn’t get projects. And that was true then. Now the returns in subsesa will come from adding intellectual value rather than being long on boats, and that is a very different business. In the North Sea it will lead to a clean out of those businesses who effectively existed only as entities that were willing to risk going very long on specific assets. I count Reach, OI, and Bibby in that group. Historically the returns to their asset base, or access to it, vastly exceeded all other economic value-added for these companies. The Norwegians went long on chartered vessels, Bibby chartered and purchased them, but it doesn’t matter in the end because service returns for such generic assets as OI and Reach run are minimal and easily repliacted, and the returns on DSVs are economically negative due to oversupply in Bibby’s case. Rigid reel pipe, full field development, long term embedded flexlay contracts in Brazil, all these provide sufficient economic return to ensure long term survival (very high organisational and commitment value), and a return that will exceed the cost of capital in an upturn. But for the smaller companies there isn’t a realistic prospect of replicating this now their returns from commoditised tonnage have been so dramatically lowered.

Outside of diving Bibby, OI, and Reach all do exactly the same thing: they charter ships only when they win work, after having dumped a ton of money tendering, and bid the same(ish) solution against each other. Bibby are even using an (ex) core OI asset for a break-even decommissioning job. In the end, regardless of the rhetoric, the compete on price doing this and it is a business model with low margins because it has low barriers to entry (i.e. a lot of people can do it). Eventually in a declining or very slowly growing market that leads to zero economic margin. And as subsea has shown in Asia what eventually happens is someone takes too much contractual risk with a vessel and gets wiped out in a bad contract. This is how the North Sea will rebalance for the marginal providers of  offshore contracting supply without a major increase in demand. That is as close to a microeconomic law as you can get. They simply do not have the scale in a less munificent market to compete.

Goiung forward balance sheets, intellectual capital, visible market commitment and financial resources will all be as important as the asset base of a company. Services will be important in economic terms, they will provide a positive economic return going forward, but not all services, and not in a volume likely to outweigh historic investments in offshore assets. There is a far more credible consolidation story for offshore contracting than for offshore supply with a smaller relative asset base spread over a global service provision set to tilt to regional purchasing by E&P companies.

For the North Sea as whole, a market that provided disproportionate structural profits due to the environmental requirements of the asset base and regulatory requirements, there is also the slow but gradual realisation that the supply chain will have to exist in a vastly less munificent environment than before. Scale will clearly be important here. A market that has contracted in size terms like the North Sea just doesn’t need as many marginal service companies, or assets, and that is the sad fact of life.