More for less… Tier 2 contractors is where capacity will leave the market

I don’t get the ROV business. At the small end numerous small firms, often with private equity money, all with exactly the same strategy of getting cheap ROVs and finding  a (desperate) vessel operator to charter them the vessel for next to nothing on a profit share. They all have exactly the same business model and have no ability to differentiate on anything other than price, entry barriers are low, and buyers have a vast array of choice. It is a textbook example of an industry structure designed to produce poor profitability. Against this there are large international contractors who make minimal profit but clearly have enough capital and cash to have staying power. Surely, if demand remains at current levels something has to give?

Back in February Reach Subsea raised money, I didn’t get their logic, or that of people backing it, and I don’t get it now. However, unlike ROVOP, M2, and a host of others, they are publicly listed so you can get access to exactly how they are performing, and I would be really surprised if any of the other smaller companies are doing any differently given their business model and strategy are exactly the same. It is also worth noting that Oceaneering, the worlds biggest ROV company by some margin, has just reiterated its commitment not to pay dividends until the market improves. So with all the benefits of scale that Oceaneering has they still cannot return any cash to investors for all their free cash flow.

Now Reach Subsea are maybe great engineers and operations people, and they may have good relations with Statoil, but here in essence is the problem:

Reach key figures Q4 2018.png

Compared to 2016 in 2017 Reach sold 49% more ROV days, 63% more offshore personnel days, and 35% more vessel days and yet increased turnover by only 10%. It is the very definition of business facing decreasing returns to capital: For every unit of capital they throw at the market they get a decreasing amount of economic value back. (I won’t even get into the EBITDA and operating loss because they brought some equipment during the year and claim to be building up scale, but the turnover number tells you all you need to know).

This is interesting as well:

Reach Operating Profit Q4 2018.png

To get 360m in sales in 2017 cost 387m in direct expenses. Or look at it another way: it cost 387m to sell 360m. That is a totally unsustainable business model. I get they are working their way out of terminating some historic vessel charters but businesses that cannot make an operating profits are axiomatically dependent on external funding eventually. Like everyone else in the ROV space this business is simply keeping capacity going while waiting for other people to drop out of the market and wait for the magical demand fairy to appear and save everyone.

Despite this they are opening an office in Houston, which is a major expense for a company of this size, to offer exactly what everyone else in the market there does: cheap ROVs on vessels with no commitments. Like everyone else they are doing loads of tendering and are in advanced discussions with potential clients. I get the US has the best structural growth characteristics of any ROV market, but there are a lot of companies there doing exactly this,  and firms like Bibby had to pull out despite investing substantial amounts in kit and infrastructure.

I therefore find it amazing that you can get comments like this:

Reach q4 comment 1.png

And then get this:

Reach Q4 comment 2.png

What attractive growth opportunities? The installation market is forecast to be flat next year and the IRM will grow modestly but nowhere near enough to soak up excess capacity. But despite this the obvious answer is to go to Houston, well behind ROVOP, M2 … ad infinitum

But clearly some people disagree because despite everything I have written above look at the Reach share price:

Reach Share Price 06042018.png

Up 42% in the last 12 months. 20% since November. Not only that the company according to Bloomberg is trading 1.6x book value which implies that the asset base can generate signficant value (Tobin’s Q) above its cost. For a company where the operating losses were NOK -17m and the Depreciation charge was NOK 27m that is verging on the astonishing, and definitely on the irrational.

You can say the stockmarket is meant to anticipate forward earnings and I agree, but there is nothing structural in the market that would lead you to believe 2018 is going to be very different from 2017 (as the graph from Oceaneering in the header makes clear). I get Reach have announced over 100 days work recently, but without any information on day rates and margin levels can you believe it is value accretive?

The longer all the ROV companies remain in business and keep capacity high it guarantees that margins will be breakeven-to-low in the best case for everyone in the game. This is an industry that built capacity for 349 tree installations in 2014 and is coping with 243 in 2018 (a 44% decrease), and at the moment the new investors piling in are simply providing a subsidy for the E&P companies who take rates at below economic levels.

It is only a question of which tier 2 companies leave the market if The Demand Fairy doesn’t make a rapid deus ex machina appearence soon. This is an industry with too much capacity and capital relative to demand and the equity market here is sending the wrong price signal about allocating more capital.

What will a deepwater recovery look like for contractors?

In the five years since the 1996 bill became law, telecommunications companies poured more than $500 billion into laying fiber optic cable, adding new switches, and building wireless networks. So much long-distance capacity was added in North America, for example, that no more than two percent is currently being used. With the fixed costs of these new networks so high and the marginal costs of sending signals over them so low, it is not a surprise that competition has forced prices down to the point where many firms have lost the ability to service their debts. No wonder we have seen so many bankruptcies and layoffs.

Brookings Institute, 2002

McKinsey Energy Inisghts has a good article on how a recovery in the offshore energy might play out. The article makes the point I have made here that large deepwater projects, especially in Brazil and the Gulf of Mexico, are likely to economically attractive going forward but smaller, and shallower projects are in trouble.

First let’s appreciate the scale of the downturn the offshore contracting and supply industry is dealing with:

Global upstream investment has suffered dramatic cuts in the recent low oil price environment. Upstream oil and gas capex was halved from ~$800 billion in 2014 to ~$400 billion in 2016, and global exploration and appraisal spending fell by 40% to $11.2 billion during the same period…

Spending cuts are expected to cause a 50-60% decrease in oil volumes coming online from new projects in the next three to five years, compared to the 2010-14 average. As with brownfield projects, the greenfield pipeline for the next few years has been significantly reduced due to the lack of investment since 2014, especially for shallow water developments. [Emphasis added].

So if you own a shallow water asset, like a DSV for example, this massive drop in demand is proportionately harder. Mckinsey say $654bn will need to be invested in currently unsanctioned projects by 2030, but that doesn’t come close to replacing the level of spending cut. Obviously a greater volume of work is being delivered for a greatly reduced price, which is one of their key points. Having predicted a supply gap in the oil market I also thought this prediction was interesting:

Projects that reached FID before 2014 – including mega-projects such as Lula and Golden Eagle – will cover 60% of the anticipated supply gap in 2020-21…

This is an industry with a long run supply curve. Talk of “inflection points” from some contractors just don’t seem to be backed by data.

Read the whole thing. I have a broader point than simply doing a cut and paste from McKinsey but it is based on this:

As a result of cost compression, deepwater breakeven levels are likely to continue being 20-25% lower than 2014, despite a situation where oil prices increase to $70/bbl in our base case. The wider margin created by lower costs should place deepwater investments firmly at the left side of the global oil cost curve, making these projects viable to close the supply gap.

McKinsey see the cost reductions in the offshore supply chain as permanent and structural. Not all relate to oversupply, but they are all based on spending less time offshore.

Although not as widely reported a bigger investment boom than the Dot Com investment bubble was the telecoms investment bubble that occurred at roughly the same time. The global, but particularly US, industry was overcapitalised as companies laid the “dark fibre” of the future internet. A vast number of firms went bankrupt and were subject to fraud (remember Bernie Ebbers and Worldcom?) before they even “lit” the fibre. It was a speculative mania in an industry that like offshore had very high fixed-costs and very low marginal-costs. But the thing is the telecoms companies made nothing from the boom, shareholders and bondholders were largely wiped out, the same thing happened in the English railway mania of the 1840s, and an earlier canal boom in the 1790s which ended in 1793 (and here). The winners from the telecoms investment boom have been companies like Netflix, Google, and Facebook which have used the networks paid for earlier at well below their true economic cost (and without the coordination issues of splitting the installation costs between themselves), similar arguments can be made for railways and canals. The net private losses were potentially an overall social gain.

So the question really is has the offshore industry just supplied a huge amount of latent capacity that will allow E&P companies to close the supply gap cost effectively while wiping out the equity of those who built the infratsructure behind it? I hope pre-2016 Seadrill shareholders (amongst others) enjoy their quality viewing, direct from the internet, and appreciate the irony.

Capital raising and marginal production…

A very good article in the Houston Chronicle outlines the scale of the capital being raised in the US to pour into shale and the related infrastructure:

Private equity firms have raised more than $200 billion in funds for energy investments since 2014, including $50 billion set aside for shale drillers, according to research firm IHS Markit. They have stakes in more than 350 privately held U.S. oil producers, including 73 companies launched last year with $12.4 billion in investments, according to research firm 1Derrick. Those investments came in about one-third higher than in 2016.

Private equity firms also were involved in $15 billion worth of oil-production transactions last year, three times more than from 2008 to 2012. They were party to 15 of the 20 biggest deals last year. Now, roughly 40 percent of the 979 rigs drilling across the continental United States are tied to private equity-backed companies, investors said…

In Houston, 20 local private equity firms have raised a combined $56.3 billion in funds over the past decade, most of it meant for the oil industry, according to Preqin, a company that collects data on alternative investment industry. A portion has been set aside for investments in the health care, manufacturing and other industries.

In contrast, and not strictly a fair one, last week Chariot Oil and Gas, a small London offshore explorer listed on the Alternative Investment Market (“AIM”), announced the final stages of a capital raising, having raised USD 15m earlier in February the follow on issue seeking €5m got only 41% acceptance. Chariot looks to be a well run company, focused on Atlantic frontier exploration, but the sentiment is simply not there in the equity market to back these offshore exploration companies at the moment. I think that this is one of the few capital raises on the whole of the London Stock Exchange for oil and gas companies in 2018. The money just isn’t there.

The London AIM market has always been a good proxy for the availability to fund marginal offshore developments. By virtue of history and the leading position taken by the UK and Norway in developing the offshore industry (Brazil would not have been possible without the pushing of the technical envelope that was achieved in the North Sea) there was a base of investors who understood, and would back, offshore projects.  EY used to publish an index of the Oil and Gas companies on AIM, the fact they have stopped  (2014) is a data point alone in how this source of funding is declining in importance. As a comparison in 2012 and 2013 here are the stats for capital raising in London:

LSE funds raised.png

Nearly all the capital was destined for riskier, more marginal, offshore projects: Cameroon, Nigeria, Senegal, Mozambique, and the UKCS amongst others. On the main board Premier Oil raised money for Falklands exploration and Enquest was riding high as investors felt the protracted process to get these marginal fields into production was worth the time as risk capital. It’s not just a billion of risk capital that has been withdrawn, it’s a reflection of a wider market sentiment of the difficulties faced in raising money for offshore projects.

And that is really the link: AIM used to fund marginal production, new risky exploration and development outside that which larger, and more cash rich, E&P companies would undertake. Now in the US that source of capital is being provided by PE companies (and high yield debt) which reflects both the potential geological opportunities available but also where the highest profit at the least risk can come from. And that capital isn’t backing offshore anymore it is backing shale. When the price of the underlying commodity is so volatile, and not on a seemingly unstoppable upward trend, then smaller bets in an industry with lower upfront costs and a lower risk payoff profile seems like a better place for money to go. For an industry as dependent on capital as offshore E&P is this is not a good macro indicator. Capital begets capital in a self-referencing cycle sometimes because it provides the illusion of liquidity and asset price appreciation for investors, the more private equity money that piles in, the easier an exit will be, so more private money piles in.

If you look at Enquest and Premier Oil, two major independent investors in the UKCS, they are struggling under enormous debt loads and have prioritised payments back to debt and equity holders over development activity. With Enquest bonds trading at ~88% of par, £1,9bn in debt, and only £344m of equity, it is easy to see why: lenders and shareholders want their money back not worry about IEA predictions of impending supply shortages. It is worth noting in Jan 2017 when Enquest took over the Magnus field from BP that BP had to lend them the money, one can assume as both parties knew that external funding, even for such a good strategic deal at only £75m,  was unavailable. Shareholders in these companies don’t feel rich they feel like they might not lose everything:

Enquest Bonds over 1 Year (hardly investment grade as of 28/03/18 and as recently as Sep 17 pricing in  default effectively):

Enquest bonds.png

Enquest Share Price over 5 Years (as at 20/03/18):

Enquest Share Price 5 Year.png

If you are a shareholder in Enquest the current oil price doesn’t make you want to go mad on increasing production it just gives you comfort you might get your money back. Enquest is a leveraged bet on an increase in the oil price no matter how well run. This is emblamatic to me that even today some people talk about an increase in offshore spending as if it is a given as the oil price improves, but no one can actually explain in a logical fashion where the money is coming from? Or how companies like Enquest could actually afford to spend more? Increased offshore spending isn’t simply a linear function of an increased oil price it requires a change in capital market conditions as well.

The UK is a marginal development region meaning it needs higher prices to sustain E&P: $60 – 70 oil keeps the lights on and the administrator away, it isn’t a money making machine.  When credible forecasts come in that the oil price could drop as low as $51 in 2018 shareholders are pressing oil companies to lower CapEx and not rush into projects. Enquest also won’t be turning on the maintenance spend more than needed in this environment as a relatively small price decline would cause it real issues given the high fixed cost base and finance commitments. If anything it needs to build some financial latency if it can.

Coincidentally I came across this amazing video of the Ithaca Energy’s Stella development (it really shows off the scale of the development and the capital commitments). Ithaca both an AIM and UKCS success story, recently sold to the Israeli energy company Delek, for less than some of its longer term investors were happy about. Historically using the AIM market Ithaca was able to raise sufficient capital over a number of years to increase in size and gradually develop ever more complex and sizeable developments. You couldn’t repeat that trick now as the money and market sentiment isn’t there.

Ithaca also highlights that investors in these companies were hoping not just for the business to work but also for a takeover premium when the company got to a certain size. A bid in the form of a takeover often carried >25% takeover premium. Investors wanted not just exploration and production success but also dreamed of the next Cove Energy. Cove raised money on AIM over time at an ever increasing premium:

  • June 2009: £4 million at £0.12 per share
  • September 2009: £42 million at £0.20 per share
  • March 2010: £26 million at £0.40 per share
  • November 2010: £110 million at £0.76 per share…

… And then attracted a bidding war that Shell eventually won (at a 70% premium to the undisturbed share price). Everyone got rich. Whereas Ithaca, a great and successful company, showed how remote chances are for a massive takeover battle for an offshore-based production company are. Again as a contrast takeover activity in the US Shale sector is booming, last week Concho Resources paid a 15% premium to access RSP Permian (an $8bn equity acquisition).

Yes, private equity has made significant investments in the UKCS, but these are essentially deals that allowed others to exit. Chrysoar, Siccar Point, and Ineos were all mainly exit deals for someone else. All the purchasers have a significantly higher cost of capital than the sellers and must surely rely on some profit on exit to make the economics work? As private equity companies prefer to use leverage they will also face a constraint on how much cash flow from operations they risk on development spending as the price of oil fluctuates.  Their debt commitments are fixed and they have less to spend on development if prices do not rise.

News that Siccar Point is looking to offload half it’s stake in Rosebank to reduce CapEx commitments show the feeling of their shareholders (Blackstone with $7bn in energy portfolio investments and Blue Water Energy) regarding UKCS developments and their likelihood of recovering this with increased oil prices (although both are going long in Norway with Mime). I see this news as a real marker for a change in investment sentiment in the PE community for investment in offshore. The longer the oil price stays range bound at current levels, and forecasts come in for the downside, expect PE investors to be far more nervous about offshore CapEx commitments than industry companies. The constant focus on delaying Rosebank until costs have been driven down to an acceptable level show that while the supply chain may get some utilisation from this project they are unlikely to make money from it.

The statistics point to the UKCS entering a period of massive investment decline, larger than relative to the rest of offshore, that will be very hard to reverse, and the AIM/London Stock Exchange reflects not a lack of potential projects but a lack of willingness to invest in a sector with such long-term and risky structural characteristics.

I think there are two factors that are really important for the UKCS:

  1. The payback time for offshore projects is significantly longer and more complex than for shale projects: see the decision tree at the top of this article. The cost of a well for shale is ~USD 10-12m and the payback, although lower, can start to come in months (this is true globally as well obviously).
  2. Tax: one of the reasons the Norwegian shelf has held up better compared to the UK is that you get a cash reimbursement of 78% of actual drilling costs from the tax authorities, this is consistent with loss aversion theory which recognises that people prefer to avoid losing money than acquire an equivalent gain. The UK fiscal regime takes less but you have to find oil first at a significantly greater risk weighted loss ratio.

For the wider offshore community I guess given the size of the funds being raised in Houston that people will end up trying to raise funds there more than London. In that way new offshore projects will end up being evaluated side-by-side with shale projects, some investors may like the diversification element. But the trend for offshore to be focused on fewer “mega projects”, dominated by cash rich larger companies that can afford the financial and technical risks, seems to be locked-in for as long as capital markets remain in their current state. It’s not the end of offshore it’s just a different offshore, particularly at the margin.

For the offshore supply chain in general any recovery story that is credible needs to explain where the capital is coming from to fund projects. Because without the capital there clearly won’t be an increase in project demand and the Demand Fairy will fail to appear (again).  For an industry too long on supply that is where the adjustment will be made.

What gets measured gets managed…

Chevron and BP released data this week highlighting their continuing focus on reducing production costs and productivity improvements. To set the tone in their Annual Report for 2017 for BP made this comment to the above graph:

Dated Brent crude oil prices averaged $54.19 per barrel in 2017 – the first annual increase since 2012 but roughly half the average of over $110 seen in 2011-13.

Which just goes to show that while the offshore industry is using an oil price USD 60-70 to show increasing confidence it may not feel like that to an E&P company who spent billions on projects with significantly higher price assumptions a few years ago:

BP Upstream 2017.png

 

This Chevron slide highlights why the Demand Fairy hasn’t appeared in  offshore despite a rise in prices:

Chevron category cost reductions.png

Spending on Subsea at Cheron is down nearly 70% since 2014! This is an absolute number so the fact that Chevron have completed some major projects influences this, but it also doesn’t change the fact of the scale downwards in subsea spending that a ‘Super Major’ has managed to make in a very short space of time. That drop in production costs comes solely from doing stuff internally cheaper but in reality by procuring from the supply chain at ever cheaper rates.

BP has also dropped its production costs significantly:

BP Unit production costs 2017.png

The blue “REM” by the way means the remuneration committee looks at this before allocating senior manager pay. In other words senior managers have a great deal of economic interest in ensuring this gets lowered constantly, as the dictum goes “what gets measured gets managed”. Interestingly in 2013 this wasn’t a metric, then it was all about operating cash flow and delivering production targets and projects. Now saving a few thousand a day on a rig or vessel, going offshore for less days, doing more work onshore if possible, all these will be looked at with a degree of rigour unknown in past times. This is a new and constant trend in the offshore industry and I doubt it will ever go away now.

The continuing impact of this for those involved in offshore is clear: there will be a relentless focus, despite an easing of spend for offshore, on driving costs down. These targets will be filtered down the organisation through objectives and goals to other managers who will be bonused against cost reductions. Pushing the supply chain to lower costs will be measured and therefore managed: the clear implication in a period of oversupply is continuing margin pressure.

The argument that offshore spending will have to increase as the Reserve Replacement Ratio is dropping is starting to look tenditious as well:

Chevron resources.png

Clearly it’s all about the shale at Chevron, but BP was fine as well:

BP RRR 2017

Chevron is making clear where future investment will go:

  1. Deepwater US

Deepwater US.png

2) Shale in the Permian (note the comments re: “factory” something I have discussed here before)

Permian.png

While BP is also making clear that offshore is important but will only be part of its investment in projects:

BP project mix 2021

Two companies doesn’t make an industry, but these were, and remain, significant investors in the offshore space. But it is clear they have changed in a structural way how much they will invest in offshore, and how the invest in offshore, and the amounts are significant to the offshore industry supply chain as a whole (especially as they don’t seem to be anomolies).

When I look at data like this,l and see business plans that rely solely on an “inflection point” in demand, or waiting it out for “the recovery”, I don’t think they are reflecting likely scenarios now. A base case for offshore is surely one without a dramatic change in demand conditions? The implications for many business models in the offshore space from that are profound nearly four years after the price decline began.

 

 

Shale productivity and operating costs…

Some interesting data from the Dallas Federal Reserve Dallas Federal Reserve:

Dallas Fed Q2.png

I get the survey methodology isn’t perfect, but it’s a good indication. The trend on cost is interesting, down on 2016 but up on 2017 as cost pressures rise despite productivity improvements.

Look at the required operating costs:

Dallas Fed Q1.png

A slight rise since last year but comfortably below the spot price. The US has shown that financing costs are important, but ultimately given a downturn these producers will find capital provided they can produce above the marginal operating cost per barrel.

Cost pressures are on the rise as capacity constraints become clear. But this is an industry operating comfortably within in its cost and profitability constraints at current price levels.

HugeStadSea goes wrong…

If completed, the Combination is expected to provide Solstad Offshore, Farstad and Deep Sea with an industrial platform to sustain the current downturn in the offshore supply vessel (“OSV”) market and be well positioned to exploit a market recovery. The Board of Directors of the three companies consider this to be a necessary structural measure that will enable the Merged Group to achieve significant synergies through more efficient operations and a lower cost base. The Combination will influence the SOFF Group’s financial position as total assets and liabilities as well as earning will increase substantially.

SolstadFarstad merger prospectus, 2017

This was always going to happen… nice timing though… just a few days before Easter, with everyone looking the other way, and only a short time before the Annual Report was due (with its extensive disclosures required), SolstadFarstad has come clean and admitted that Solship Invest 3 AS, more familiarly known as Deep Sea Supply, is in effect insolvent, being unable to discharge its debts as they fall due and remain a credible going concern:

As previously announced, Solstad Farstad ASA’s independent subsidiary, Solship Invest 3 AS and its subsidiaries are in discussions with its financial creditors aiming to achieve an agreement regarding the Solship Invest 3 AS capital structure.

As part of such discussions, Solship Invest 3 AS and its subsidiaries have today entered into an agreement with its major financial creditors to postpone instalment and interest payments until 4 May 2018.

I am not a lawyer but normally getting into agreements and discussions like this triggers the cross-default provisions of debts, including the bonds which look set for a default… and this would make all of the c. NOK 28bn debt become classed as short-term (i.e. payable immediately). Maybe they saw this coming and omitted those clauses when the loans were reorganised, but its a key provision, and I struggle to see it getting through compliance and lawyers without this? But it strikes me as a crucial question. The significance of this for those wondering where I am going with this is that it would be hard to argue SolstadFarstad is actually a going concern at that point. Maybe for a short while, but getting the 2017 accounts signed off like that I think would be tricky (ask EMAS/EZRA).

Investors, having been told  how well the merger is going, may want to have a think if they have been kept as informed as they would like here? There is nothing in this statement on 19 Dec 2017 for example to reflect clearly how serious things were at Deep Sea Supply. Indeed this statement appears to be destined for future historians to recall a management team blithly unaware of their precarious position:

With the reduced cost base we will be more competitive and with our high quality vessels and operations, we will be in a very good position when the market recovers.

The PR team may have liked that statement but surely more cautious lawyers would have wanted to add the rider “apart from Deep Sea Supply which is rapidly going bankrupt and the vessels are worth considerably less than their outstanding mortgages. We anticipate in the next 12 weeks defaulting on our obligations here until a permanent solution is found.” To make the above statement, when 1/3 of merger didn’t have a realistic financial path to get to this mythical recovery is extraordinary.

But the real and immediate problem the December 19 press release highlights is that in an operational sense Deep Sea Supply has been integrated into the operations of HugeStadSea:

The merger was formally in place in June 2017 and based on the experiences from the first six months in operation as one company, Solstad Farstad ASA is now increasing the targeted annualized savings to NOK 700 – 800 mill.

By the end of 2017 the cost reductions relating to measures already implemented represents annualized savings of approximately NOK 400 mill…

new organization structure implemented and the administration expenses have been reduced by combining offices globally and centralization of functions.

The synergies laid out here can only be achieved by getting rid of each individual company’s systems and processes and integrating them as one, indeed that is the point of the merger? So how do you hand Deep SeaSupply back to the banks now? For months management consultants from Arkwright have been working with management and Aker to turn three disparate companies into one, now apparently, as an afterthought, the capital structure needs sorting as well along with disposing of “non core” fleet. Quite why you would get into a merger to create the largest world class OSV fleet while simulataneously combining it with a “non core” fleet at the same time (that wasn’t mentioned in the prospectus) is a question that seems to be studiously avoided?

Just as importantly going forward here management credibility is gone. Either you were creating a “world class OSV company” with the scale to compete, or you weren’t, in which case taking on the Asian built, and pure commodity tonnage of Deep Sea Supply was simply nuts.

Around 12 months after the merger announcement, and six momths after the legal consumation, when managers have had sufficient day rate and utilisation knowledge to build a semi-accurate financial forecast, they are back to the drawing board. If SolstadFarstad hand the Deep Sea fleet back to the banks they will have to either fire-sale the fleet or build up a new operational infrastructure to run the vessels independently of SolstadFarstad… does anyone really believe the banks will allow that to happen? The problem is the tension between the different banking syndicates: a strong European presence behind SolstadFarstad and Asian/Brazilian lenders to Deep Sea. This is likely to get messy.

Is Deep Sea Supply really ringfenced from SolStadFarstad? Will the lending banks be able to force SolStadFarstad to expose themselves more to the Deep SeaSupply vessels? As an independent company Deep Sea Supply would have been forced to undergo a rights issue, and if not supported by John Fredrikson/Hemen it would have in all likelihood have gone bankrupt, the few hundred million NOK Hemen putting into the merger barely touched the sides here. For the industry that would have been healthy, but for the banks a nuclear scenario. Now management face a highly embarrassing stand-off with the banks to force them to take the vessels back, or the equally highly embarrassing scenario of admitting that the shareholders were exposed to the Deep Sea Supply fleet all along, and that the assumptions underpinning this deal were wrong… Something easily foreseeable at the time to all but the wilfully blind.

The “project to spin off the non-core fleet”, which I have commented on before, is the Deep Sea Supply fleet that makes a mockery of the industrial logic of the merger. That was started in Q3 2017 according to their annoucements, only a few months later needs to be sold? What is the plan here? Or more accurately is there one?

There are no good options here. The only credible option for the management team and Board to survive unscathed would surely be the banks writing down their stake in Deep Sea Supply entirely and making a cash contribution to SolstadFarstad to recognise the time and costs involved in running it. You can mark that down as unlikely. But just as unlikely is a recovery in day rates where Deep Sea Supply can hope to cover its cash costs even in the short term

The Board of SolsatdFarstad and their bankers need to ask some searching questions here. The merger was a very bad idea that was then executed poorly.  It is therefore hard to argue SolstadFarstad have the right skills in place at a senior management and Board level? This wasn’t a function of a bad market, this was the result of bad decisions taken in a bad market. This constant mantra that scale will solve everything, when the company has no scale, needs to be challenged. The other issue is how disconnected management seem to be from basic market pricing signals, and moving the head office away from its current location should also be seriously considered along with a changing of the guard.

I said at the time this merger was the result of everyone wanting to believe something that couldn’t possibly be true and merely delaying for time, but eventually reality dawns as the cash constraint has become real. The banks need to write off billions of NOK here for this to work. Probably, like Gulfmark and Tidewater, the entire Deep Sea Supply/ Solstad/Farstad PSV and smaller AHTS fleet need to be equitised at a minimum, and some of the older vessels disposed of altogether. The stunning complexity of the original merger, where legal form trumped economic substance, needs to be reversed to a large degree, but this will not be easy as the shareholders in the rump SolstadFarstad will surely balk at being landed with trading their remaining economic interests for a clearly uneconomic business.

The inevitable large restructuring that will occur here arguably marks the start of the European fleets and banks catching up with their American counterparts, and to some degree matching the pace of the Asian supply fleets. The banks behind this need to start a series of writedowns that will be material and will affect asset values accross the sector. Reporting season will get interesting as everyone tries to pretend their vessels are worth more than Solstad’s and the accountants get worried about their exposure if they sign off on this.

A common fault of all the really bad investments in offshore since 2014 was people simply pretending the market is going to miraculously swing back into a state that was like 2013. It was clear late in 2016 this would not happen. The stronger that view has been has normally correlated with the (downside) financial impact on the companies in question, and there is no better case study than HugeStadSea.

A journey in graphs and capital intensity…

The above graph was taken from a JP Morgan report into the oil price this week. I wouldn’t read too much into the headline, as I have said before in the short-term I think the oil price is a random walk, but it gives you an idea of what a well researched analysis thinks the long term breakeven price is in the 50s. That isn’t my view but it reminded me of this graph from 2013:

Berenberg 2013.png

This is from a report in 2013 that Berenberg Bank published (using Infield as their source). Rystad had a similar one in 2013 (the article is very perceptive in retrospect):

Rystad 2013

The key for me is how far shale has dropped down the cost curve and the fact that this has been driven by productivity improvements while utilisation in the industry has been high (i.e. cost pressure was on the upside not the downside). I would argue a majority of the decrease in offshore costs has come about through over capacity and economic value (debt and equity) being wiped out. Given that many offshore assets are designed for 25 years of operational life this is a real issue.

I was interested to see the Noble/GE link this week with the aim of reducing drilling timing by c. 20%. But surely this points to the future where more planning and onshore data work will lead to less offshore execution time? I thought this was cool:

The Digital Rig solution combines data models from a digital replica of physical assets, known as a digital twin, along with advanced analytics to detect off-standard behavior, providing an early warning to operators to mitigate a problem before it strikes. Thanks to vessel-wide intelligence, personnel both on the vessel or onshore can gain a holistic view of an entire vessel’s health state and the real-time performance of each piece of equipment onboard.

Offshore is going to have to work out how to increase productivity to keep winning projects but a common theme is the need for less capital intensity:

Chevron Corp. is studding the ocean floor with heavy-duty pumping gear as part of an effort to make deepwater oil discoveries competitive with shale.

The idea is to force crude from newly drilled wells in the deepest parts of the Gulf of Mexico to flow through miles and miles of pipe to platforms built a decade or more ago, said Jay Johnson, Chevron’s executive vice president for upstream. By lopping off the billions it would cost to construct each new platform, offshore exploration begins to make economic sense again.

That methodology will use a lot less asset time than a traditional tie-back/FPSO or trunkline solution I am sure. A realistic view of the next offshore cycle requires a recalibration of many mental models I feel.