Zombie offshore companies… “Kill the zombie…”

“I’ve long said that capitalism without bankruptcy is like Christianity without Hell. But it’s hard to see any good news in this.”

Frank Borman

“In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor”.

Warren Buffet

The Bank for International Settlements defines a Zombie Company as a “firm whose interest bill exceeds earnings before interest and taxes”. The reason is obvious: a firm who is making less in profits than it is paying in interest is likely to be able to eke out an existence, but not generate sufficient profits to invest and grow and adapt to industry changes. A firm in such a position will create no economic value and merely exist while destroying profit margins for those also remaining in the industry.

The BIS make clear that zombie companies are an important part of the economic make-up of many economies. I am sure sector level data in Europe would show offshore comfortably represented in the data.

Zombie Firms.png

Conversable Economist has an excellent post (from where I got the majority of my links for this post) on Zombie Companies and their economic effects, which timed with a post I have been  meaning to right about 2018 which I was going to call “year of the zombie”. Zombie companies have been shown to exist in a number of different contexts: in the US Savings and Loans Crisis zombie firms paid too much in interest and backed projects that were too risky, raising the overall costs for all market players. Another example is Japan, where post the 1990 meltdown Hoshi and Kashyap found (in a directly analogous situation to offshore currently):

that subsidies have not only kept many money-losing “zombie” firms in business, but also have depressed the creation of new businesses in the sectors where the subsidized firms are most prevalent. For instance, they show that in the construction industry, job creation has dropped sharply, while job destruction has remained relatively low. Thus, because of a lack of restructuring, the mix of firms in the economy has been distorted with inefficient firms crowding out new, more productive firms.

In China zombie firms have been linked to State Owned Enterprises, and have been shown to have an outsize share of corporate debt despite weak fundamental factors (sound familiar?). The solution is clear:

The empirical results in this paper would support the arguments that accelerating that progress requires a more holistic and coordinated strategy, which should include debt restructuring to recognize losses, fostering operational restructuring, reducing implicit support, and liquidating zombies.”

The subsidies in offshore at the moment keeping zombie firms alive don’t come from central banks but from private banks, and sometimes poorly timed investments from hedge funds. Private banks are unwilling to treat the current offshore market as anything more than a market cycle change, as opposed to a secular change, and are therefore allowing a host of companies to delay principal payments on loans, and in most cases dramatically reduce interest payments as well, until a point when they hope the market has recovered and these companies can start making payments that would keep the banks from having to make material writedowns in their offshore portfolios.

Now to be clear the banks are (arguably) being economically rational here. Given the scale of their exposure a reasonable position is to try and hold on as the delta on liquidating now, versus assuming even a mild recovery, is massive because of the quantity of leverage in most of the offshore companies.

But for the industry as a whole this is a disaster. The biggest zombie company in offshore in Europe is SolstadFarstad, it’s ambition to be a world leading OSV company is so far from reality it may as well be a line from Game of Thrones, and a company effectively controlled by the banks who are unwilling to face the obvious.

A little context on the financial position of SolstadFarstad makes clear how serious things are:

  • Current interest bearing debt is NOK 28bn/$3.6bn. A large amount of this debt is US$ denominated and the NOK has depreciated significantly since 2014, as have vessel values. SolstadFarstad also takes in less absolute dollar revenues to hedge against this;
  • Market value equity: ~NOK 1.73bn/$ 220m;
  • As part of the merger agreement payments to reduce bank loans were reduced significanlty from Q2 (Farstad)/Q3 (Solstad) 2017. YTD 2017 SOFF spent NOK ~1.5bn on interest and bank repayments which amounted to more than 3 x the net cash flow from actually operating all those vessels. While these payments should reduce going forward it highlights how unsustainable the current capital structure is.

The market capitalisation is significantly less than the cash SOF had on the balance sheet at the end of Q3 2017 (NOK 2.1bn). Supporting that enormous debt load are a huge number of vessels of dubious value in lay up: 28 AHTS, many built in Asia and likely to be worth significantly less than book value if sold now, 22 PSVs of the same hertiage and value and 6 ageing subsea vessels. The two vessels on charter to OI cannot be generating any real value and sooner or later their shareholders will have had as much fun as they can handle with a loss making contracting business.

But change is coming because at some point this year SolstadFarstad management are in for an awkward conversation with the banks about handing back DeepSea Supply (the banks worst nightmare), or forcing the shareholders to dilute their interest in the high-end CSV fleet in order to save the banks exposure to the DeepSea fleet (the shareholders worst nightmare and involves a degree of cognitive dissonance from their PSV exposure). Theoretically DeepSea is a separate “non-recourse” subsidiary, whether the banks who control the rest of the debt SolstadFarstad have see it quite that way is another question? It would also represent an enormous loss of face to management now to admit a failure of this magnitude having not prepared the market in advance for this?

Not that the market seems fooled:

SOFF 0202

(I don’t want to say I told you so).

SolstadFarstad is in a poor position anyway, the company was created because no one had a better idea than doing nothing, which is always poor strategic logic for a major merger. What logic there was involved putting together a mind numbingly complex financial merger and hoping it might lead to a positive industrial solution, which was always a little strained. But it suited all parties to pretend that they could delay things a little longer by creating a monstrous zombie: Aker got to pretend they hadn’t jumped too early and therefore got a bad deal, Hemen/Fredrikson got to put in less than they would have had to had DeepSea remained independent, the banks got to pretend their assets were worth more than they were (and that they weren’t going to have to kill the PSVs to save the Solstad), and the Solstad family got to pretend they still had a company that was a viable economic entity. A year later and the folly has been shown.

Clearly internally it is recongised this has become a disaster as well. In late December HugeStadSea announced they had doubled merger savings to 800mn NOK. The cynic in  me says this was done because financial markets capitalise these and management wanted to make some good news from nothing; it doesn’t speak volumes they were that badly miscalculated at that start given these were all vessel types and geographic regions Solstad management understood. But I think what it actually reflects is that utilisation has been signifcantly weaker than the base case they were working too. Now Sverre Farstad has resigned from the Solstad board apparently unhappy with merger progress. I am guessing he is still less unhappy though than having seen Farstad go bankrupt which was the only other alternative? I guess this reveals massive internal Board conflict and I also imagine the auditors are going to be get extremely uncomfortable signing vessel values off here, a 10% reduction in vessel value would be fatal in an accounting sense for the company.

The market is moving as well. In Asia companies like EMAS, Pacific Radiance, Mermaid, and a host of others have all come to a deal with the banks that they can delay interest and principal payments. Miclyn Express is in discussions to do the same. This is the very definition of zombie companies, existing precariously on operating cash flows but at a level that is not even close to economic profitability, while keeping supply in the market to ensure no one else can make money either. Individually logical in each situation but collectively ruinuous (a collective action problem). These companies have assets that directly compete with the SolstadFarstad supply fleet, with significantly deeper local infratsructure in Asia (not Brazil), and in some cases better assets; there is no chance of SolstadFarstad creating meaningful “world class OSV company” in their midst with the low grade PSV and AHTS fleet.

Even more worrying is the American situation where the Chapter 11 process (and psyche) recognises explicitly the danger of zombie companies. Gulfmark and others have led the way to have clean, debt free, balance sheets to cope in an era of reduced demand. These companies look certain to have a look at the high-end non-Norwegian market.

SolstadFarstad says it wants to be a world leading OSV company that takes part in industry consolidation but: a) it cannot afford to buy anyone because it shares are worthless and would therefore have to pay cash, and b) it has no cash and cannot raise equity while it owes the banks NOK 28bn, and c) no one is going to buy a company where they have to pay the banks back arguably more than the assets are worth. SOF is stuck in complete limbo at best. Not only that as part of the merger it agreed to start repaying the banks very quickly after 2021. 36 months doesn’t seem very far away now and without some sort of magic increase in day rates, out of all proportion to the amount of likely subsea work (see above), then all the accelerated payment terms from 2022 will do is force the event. But still is can continue its zombie like existence until then…

In contrast if you want to look at those doing smart deals look no further than Secor/COSCO deal. 8 new PSVs for under $3m per vessel and those don’t start delivering for at least another 18 months. Not only that they are only $20m new… start working out what your  10 year old PSV is really worth on a comparative basis. There is positivity in the market… just not if you are effectively owned by the bank.

One of my themes here, highlighted by the graph at the top, is that there has been a structural change in the market and not a temporary price driven change in demand. Sooner or later, and it looks likely to be later, the banks are going to have to kill off some of these companies for the industry as a whole to flourish, or even just to start to undertake a normal capital replacement cycle. Banks, stuffed full with offshore don’t want to back any replacement deals for all but the biggest players, and banks that don’t have any exposure don’t want to lend to the sector. In an economy driven by credit this is a major issue.

I don’t believe recent price rises in oil will do anything for this. E&P budgets are set once a year, the project cycle takes a long time to wind up, company managers are being bonused on dividends not production, short cycle production is being prioritised etc. So while price rises are good, and will lead to an increase in work, the scale of the oversupply will ensure the market will take an even longer time to remove the zombie companies. At the moment a large number of banks are pretending that if you make no payments on an asset with a working life of 20-25 years, for 5 years (i.e. 20-25% of the assets economic life), they will not lose a substantial amount of money on the loan or need to write the asset down more than a token level. It is just not real and one day auditors might even start asking questions…

I don’t have a magic solution here, just groundhog day for vessel owners for a lot longer to come. What will be interesting this year is watching to see the scale of the charges some of the banks will have to make, a sign of the vessel market at the bottom will be when they start to get rid of these loans or assets on a reasonable scale.

Kill the zombies for the good of the industry, however painful that may be.

A market recovery? Not in the data…

Danish Ship Finance have just published their latest report. As usual it is thorough and measured, and frankly not uplifting if you are long on vessels or rigs. The graph above really covers a lot of things I have blogged about here, it’s all well and good coming up with graphs showing how offshore MUST get more investment, as if it were a divine economic law, but that isn’t what companies are ACTUALLY planning on spending.

Another great graph is this one:

DSV Charter Rates DSF.png

What the commentary in the report omits, and I think is very important, is the fact that the divers costs, which are c. £50k for a 15 man team, have not dropped. So for the vessel owner the rate hasn’t dropped 50% it has actually dropped 67% because the labour cost of the dive crew is fixed (again I have blogged about the Baumol effect here). This is probably more pronounced on DSVs than any other asset class but it is a real problem for offshore because the industry isn’t getting more productive (just cheaper which is different). Removing 67% of the revenue for any business is bad, in an industry that had binged on debt, as can be seen, it is beyond a disaster.

DSF also note that while spending on Subsea Production Systems is rising this because smaller step out developments are being done, which require less vessel days, than larger greenfield developments. Again I have discussed this before here.

DSF SPS.png

Finally, it highlights again the scale of the pullback in offshore and why any recovery will not be a repeat of the past. The speed at which contractors are working through backlog is a real concern. Subsea 7 won work recently on the Johan Castberg field that was valued at c. USD 2.0 – 5.0m per well, a 75% decline from the peak. So even an increase in the volume of work awarded will not help the industry recover to previous levels.

Big Three Backlog.png

Subsea Contract Awards.png

This matters because offshore used so much leverage to purchase assets in the past. Now the companies revenues and profits are materially smaller and they are struggling to pay the banks back leading to a credit crisis in the industry. Debt is a fixed obligation that must be paid back for firms to have value and that is much harder to do when the industry is in a deflationary cycle. This is no different to a banking crisis without a central bank.  It is this credit crisis that when combined with the demand crisis makes this so serious. DVB Bank, a specialist lender to the sector, went bankrupt! Indeed I have discussed this many times and it is one my one recurring theme.

Last year probably was the low point in terms of demand. But as the first graph makes clear there is not a wave of investment coming here, just a long slow increase in spending.

Read the whole thing. Many business plans simply don’t reflect this reality yet. Not everyone will survive. 2018 promises to be another tough year for asset heavy companies.

When is a vessel delivered? Keppel version…

Show me the incentive and I’ll show you the outcome…

Charlie Munger

Keppel came out with a S$619m loss last Thursday, the result of a corruption fine and other related costs. The subsidiary Keppel Offshore and Marine are where most of the problems lie, mainly as the result of Brazilian exposure. There is a good article here on how provisioning for losses on the Sete contracts and other jack up exposure Keppel has.

But I am intrigued by the recently “delivered” MPV Everest. Keppel reports on a Jan – Dec financial year, and on Dec 18 2017, a relatively quiet time of the year, it announced it had delivered the MPV Everest… Just in time to book the associated revenue for 2017 which would help prop up what had been a dreadful financial year for the Group.

Now for those not in  the know, the MPV Everest is a strange beast, and one of the most expensive DSVs ever built (my previous thoughts on it are here). Marine Construction Services are taking the vessel, they are linked to Edison Capital who are linked to New Orient Marine Ltd, the legal purchaser, (an SPV formed to finance the vessel). MCS/ Edison have supplied their offshore tonnage to MRTS in Russia. Earlier in the year, about the time New Orient would need to have been organising take-out financing, shipbrokers I know were approached about marketing the vessel at an outrageously high day rates, seemingly desperate to back on to a financing deal. Now none can get Edison to tell them what is happening with the vessel.

The MPV Everest, at S$265m is by an order of magnitude more complicated and expensive than any vessel these companies have experience in. Admittedly, MRTS have taken the Toisa Paladin to Russia on a time charter previously, but this is on a different scale. And it is very hard to see without a long term charter, at significantly above current market rates, from an extremely creditworthy counterparty, any bank backing an SPV to provide takeout financing for New Orient Marine Ltd to pay Keppel? People who have been on the vessel have told me there have been some real problems in commissioning the dive system (although that would have been pushed to JFD).

I have also worked with an Eastern European contractor looking to get a vessel to MRTS, and if you think Indian companies don’t like to pay for boats wait until you get feedback from a Russian company… so paying for this?

As I said before I have real doubts about the value and economic credibility of this vessel: it is ICE class but not NORSOK? And it is a BV classed DSV? The dive system is Lexmar? These characteristics make the resale value of the vessel, should there be an event of default, extremely hard to gauge but must point towards the extreme downside in value and in length of time taken to even get a sale. The DSV  market itself is replete with lay-ups and loss making companies and this asset, unless it goes to Russia, has extraordinarily poor prospects for economic work in the short-to-medium term.

It is very strange that MCS, Edison, and MRTS (for whom the vessel was surely destined) have remained extremely quiet and their websites fail to reflect the enormity of the task they have completed? Verging on a world first? Announcing some work and plans maybe? A photo of the naming ceremony perhaps?

The vessel according to AIS has not left Keppel since delivery and here we are are six weeks later? It is not unusual for a vessel of this complexity to face sea trials, commissioning issues etc. But I have real doubts this is the case here. I look forward to the annual report with interest because there are only a few scenarios that would make sense here:

  1. Keppel have been paid and the vessel is merely undergoing the final few stages of fitout and sea trials;
  2. There is a handover issue between the “owner” and the yard, and actually New Orient Marine Ltd have not accepted delivery (and in all likelihood can neither pay for the vessel,  nor in this market even want it);
  3. A nuclear scenario where Keppel have booked a sale of the vessel and moved the debt to the balance sheet and/or another entity. I hasten to add I have no proof of this, but it seems so extraordinary that New Orient Marine Ltd could actually have paid S$265m for this vessel that they have no work for? Maybe some of the S$54m of other unexplained writedowns was the start of a slow series of writedowns on this vessel? All the rig owners at Keppel are paying for delayed delivery because they have no work but this vessel, in the middle of the greatest ever OSV downturn, is simply going to float away and make money? I don’t see it.

We will see. Russia is involved so you can never rule anything out here. Maybe I am being harsh given the Sete scandal, but Keppel just doesn’t strike me as a yard that did a lot of due diligence on customers in the offshore oil boom when this vessel was ordered, and so the chances of them collecting hefty upfront contributions strike me as remote.

The one thing I defintiely know is that no serious saturation diving contractor has chartered this vessel and no one in the industry knows anything about where she is going. It strikes me as very binary, either a) in the immediate future we are going to hear of a long-term charter of the vessel by a Russian company to operate the vessel in Sakhalin, at way above market rates; or b) Keppel have a massive credit issue.

I await with interest…

Increased production in the North Sea…

A good article in the FT this weekend on the resurgence in production in the North Sea and the influence of some of the private equity backed companies (behind a paywall):

Production from the North Sea has bucked the long-term decline and energy consultancy Wood Mackenzie expects it to average 1.9m barrels of oil equivalent (boe) a day in 2018, its highest since 2010. This is, in part, driven by new developments such as Catcher, as well as Dana Petroleum’s Western Isles and EnQuest’s Kraken.

The rise “highlights that while the UK North Sea is in decline, these smaller independents and new private equity players are helping drive a bit of a renaissance,” said Neivan Boroujerdi, an analyst at Wood Mackenzie.

Chrysaor’s Mr Kirk said: “If someone had said then [during the downturn] that UK production from the North Sea would increase for three straight years or more, nobody would have believed them. That kind of thing changes people’s perceptions.”

But the article misses a few things important for the contracting community (and context in general):

  1. As the graph above from Oil and Gas UK makes clear this increased production is the result of historic investment in 2012-2015 and has absolutely nothing to do with these new entrants who were not part of the decision making entities that drove this production increase
  2. There has been a massive drop in Capex that will eventually reduce production
  3. Enquest and Premier, two major “small producers”, are locked out of the capital markets until their debt burdens reduce transformationally and have no plans for significant North Sea developments. Kraken and Catcher simply will not be repeated by smaller players without a massive change in funding conditions for small E&P companies
  4. The FT highlights the reduced cost of per barrel production and unit development costs. These have been at the economic cost to a large amount of equity in the supply chain and really show no short-term likelihood of changing
  5. The new private equity backed companies (and I especially include Ineos in this) are ruthless about supply chain costs. This is healthy for the long-term future of the basis but brutal for those long on assets in an over supplied market

Look, I am as happy about an increase in production as anyone, and clearly it is good economic news, but there is a degree of unreality creeping into this: CapEx spending has dropped by an order of magnitude and is not likely to rebound to anything like it’s previous levels in the next few years. Some firms will do well as the amount of work increases, but for anyone long on vessels or rigs that just isn’t likely to be the case.

Subsea work takes years to work through from initial discovery and field approval decisions, and as this data point from Oil and Gas UK makes clear the outlook in this respect is poor:

UKOG Field approvals.png

One Penguin doesn’t make a summer.

UDS and Tiger Subsea… the mystery continues…

The image above is from the Tiger Subsea Services website. I was trying to find their address, switched on to Google Maps satellite, and helpfully noticed their office address, on which they (or their website designer) located their pin, is in the middle of intersection… Which along with explaining why they have no telephone (the desk being in a rather dangerous position that would conflict with an IMCA standard risk assessment) began to explain a lot of other things…

As a general rule, and please don’t take this as investment advice, chartering two of the world’s most advanced DSVs (with a capital value of c. USD 300m)  to a company whose head office is in the middle of an intersection, and doesn’t even have a telephone, is a bad idea. No good will come from this I predict.

Not only do they not have a telephone number but they also don’t appear to be registered as a business in the state of Louisiana (check for yourself: https://coraweb.sos.la.gov/CommercialSearch/CommercialSearch.aspx). Nor in Delaware which is the most logical place to register a business in the US.

I was driven to this because a friend of mine contacted me today to say that if you send an enquiry form regarding the vessels Shel will email back directly. Strange I thought. Another very UDS like quality also popped up on the TSS LinkedIn page:

ESV 301

This company, with no phone and an office in an intersection are building a self-elevating accommodation lift boat! 97m x 43m with a 250t crane! ESV is the nomenclature Ensco use on their jack-ups but they are not listing this unit and I can find no records of this ship anywhere. If someone can point me on the direction of this vessel, if it exists I would be very keen to hear?

I think we all know what is going on here. The audacity of this is astonishing, and coming from Downunder I appreciate this, like Stephen Horvarth’s car, but when all this ends, and the denouement would appear to be rapidly approaching, someone is going to have to work out what to do with these vessels.

UDS and Tiger Subsea…

So one, and maybe two (vessel specs), of the UDS vessels is clearly going to Tiger Subsea Services, a start-up based in Louisiana that appears to be made up of ex-Oceaneering staff. I wish the guys luck, starting a business is hard, and bringing a North Sea class DSV to the US hasn’t worked for Bibby (Sapphire), DOF Subsea (Achiever), and Oceaneering (Nor Da Vinci). Having said that of course those companies were seeking to make a return on the capital cost and maintenance of running such a vessel, and there is simply no way that this “charter” is done on a similar economic basis. And if someone offers you a brand new $150m vessel for a one way option I guess you take it? TSS will have taken these vessels on based on some sort of risk/utilisation based charter as they simply don’t have the capital to take on a traditional BIMCO Supplytime Agreement, and in this market no one needs to anyway.

The DSVs above  that have moved to the Gulf for other contractors have really only worked subsatantially as SAT DSVs in the tidal regions of Trinidad, and only really for BHP and BP, because no one in the Gulf of Mexico needs such a sophisticated vessel and is therefore prepared to pay for it. SAT diving in the Gulf is arguable the most price sensitive market in the world and handled by a lot of 4 point mooring vessels of questionable quality run by Mom and Pop contractors (with a couple of mid-sized players). There is no evidence that any of the major E&P companies want such sophisticated vessels and plenty of evidence that they will not pay for one.

UDS and TSS are essentially taking  a huge gamble, one that has been tried many times before and failed without exception, that if you put an asset in the market at well above the quality of local tonnage you will get work. The problem is in the Gulf of Mexico no one wants the Malmaison they just want to stay at the Travelodge, and pay accordingly. Building a Malmaison and only being able to sell at Travelodge rates is rarely a winning strategy. Maybe the strategy is to take the vessels to the US and sit it out and wait for a market recovery in other regions which could maximise the later value of the vessels, but I have my doubts.

The Chinese yards behind this, and there is no evidence of any take-out financing from the yards at all, are merely doing what the German yards and banks did in traditional freight shipping that caused over €100bn in losses: namely getting work for yards without caring about counterparty risk. Eventually, and it can take a very long time given delivery cycles and how these yards are funded, someone will put a stop to this, but it clearly has some way to go. But eventually, as the Germans found, reality catches up with you, and at least the yards had farmed the risk out to the banks (and therefore ultimately the taxpayer)

From an economic perspective this is all bad for industry profitability and residual asset values. Don’t get me wrong, again I admire the sheer audacity of UDS, the scale of their ambitions, and their ability to deliver vessels without actually paying for them in a traditional sense. Maybe they have soft deal with the Chinese where in exchange for teaching them how to build a DSV they don’t expect any money? I don’t know, it seems a long-shot, and the Lictenstein was clearly an opportune deal. But it is just not possible to believe that in this market, with established payers fighting for anything that moves, that UDS and TSS have discovered a well of work, above market rates, that no one else has managed to find, that would pay for these vessels in any objective economic sense. To be clear these vessels need to work at c. 270 days per annum at ~$120-130k per day in order for that to be the case. A lot of work in the Gulf goes out at ~$40-60k at the moment.

After a laborious process the investors in the Nor DSVs gave up in December 2017 and sold their (similar) vessels to a well capitalised industrial player en bloc for $60m for one vessel, and USD 4500 per day for the second, roughly averaging out at $45m per vessel. These vessels offer little more operationally (and indeed I would argue a DSV is at its most valuable ~5 years old after its first major dry dock), so Boskalis set up a similar business for c.1/3 of the cost with considerably less risk because of their backlog. Sooner or later that sort of finanical advantage will be important.

No one, even UDS, on any reasonable assumptions, or even speculation, should be building another North Sea class DSV and all these vessels are doing, by adding supply to a market trading at below cash break even in many cases, is destroying what residual equity DSV owners have in their vessels (unless you brought at the right time like Boskalis). You can lose money for a long time building market share, look at Netflix, but normally you need a large cache of diversified shareholders making a bet on a market that will grow exponentially,  not something you can make the argument for here. You can make a countercyclical bet, like John Paulson, but he did it with an asset that was highly leveraged with essentially no holding cost.

The delivery of these assets will arguably delay any sort of fleet upgrade that may have been going to happen. No one wants to build a $150m vessel when one for a near substitute in operational capability could appear on the market at a fire sale price. Having said that I don’t believe another North Sea class DSV beyond a Kestrel replica will be built for a very long time and only the Vard 801 needs a home (at Technip).

Everyone finds this fascinating because everyone involved in DSVs knows how hard it is to win work at the moment, and that it is even harder to do so at a cash flow positive margin. Although the amount of work is picking up a little oversupply remains chronic and new deliveries (e.g. Kruez Challenger and the Said Aletheia) continue to arrive.

Prior to 2014 everyone used to say that SAT diving had very high barriers to entry, and therefore would be profitable, and that was a reasonable assumption. But it is simply not the case now as there are a vast number of high-end SAT vessels that could cover any realistic short-term upswing in the market, and while setting up diving systems might be time consuming, a large number of people are doing it. That is going to mean structurally lower profits for SAT diving companies for a very long time and in all likelihood even poorer returns from owning DSVs as assets and shipowners/yards help dive contractors win work. This is a complete reversal of market dynamics and fortunes that drove the market post 2003.

I wish everyone luck, but the only realistic outcome is that this will ensure low profitability, and likely losses, for the industry as a whole, the longer this continues.

Hat-tip: GR.

The age of abundance… Schlumberger exits seismic…

“Geophysical measurement, survey design and seismic operations have been an essential part of Schlumberger and our R&E [research and engineering] efforts for more than 30 years,” Kibsgaard said, pointing out the company’s unique position in terms of intellectual property and its engineering and manufacturing capabilities. But as the downturn enters a sixth year for the seismic data acquisition business, “the present outlook provides no line of sight for the market recovery.”

E&P

Spencer Dale and Bassam Fattouh published an excellent article at Oxford Economics on Peak Oil Demand and Long-Term prices this week (where the headline graph comes from and is a summary of various forecasters). The core of the article is that we have entered an ‘age of abundance’ in oil and it discusses some of the consequences of this:

the real significance of peak oil demand is that it signals a shift in paradigm from an age of (perceived) scarcity to an age of abundance. The conventional wisdom that dominated oil market behaviour over the past few decades, based around the notion of peak oil ‘supply’ and the belief that oil would become increasingly scarce and valuable over time, has been debunked.

Over the past 35 years or so, for every barrel of oil consumed, two have been added to estimates of Proved Oil Reserves.  In its recent Outlook, BP estimated that based on known oil resources and using only today’s technology, enough oil could be produced to meet the world’s entire demand for oil out to 2050, more than twice over! And future oil discoveries and improvements in technology are likely to only increase that abundance. The world isn’t going to run out of oil. Rather, it seems increasingly likely that significant amounts of recoverable oil will never be extracted.

Co-incidentally, or perhaps thinking abstractly causatively, Schlumberger also announced this week that it was divesting it’s interests in seismic.

Historically one of the key drivers of offshore (and onshore) demand at the front-end has been the need to keep reserve replacement ratio (“RRR”) above 100% for supermajors. If you want an idea of how key this is read the first few chapters of Steve Coll’s outstanding book ‘Private Empire: ExxonMobil and American Power‘ (and while you’re at it do yourself a favour and grab a copy of ‘Ghost Wars’). In an age of scarcity knowing that you had a stock of a scarce resource was an important differentiating factor and gave shareholders comfort that they were paying for a company with a future.

Now the RRR of the E&P majors is declining:

Reserve Replacement Ratio Majors Since 2014

Eventually it will tautologically lead to increased exploration activity in the future. For offshore a key question is how much and in what time scale? Clearly Schlumberger think it is someway off happening. In an age of abundance reserves assume considerably less importance.

And indeed investors don’t seem to value it as much either:

Rohan Murphy, energy analyst at Allianz Global Investors, which holds shares in Shell, BP, Total and Statoil, sees a reserve life of eight to 10 years as “quite a healthy level”.

“I don’t think these companies should have a reserve life much above eight to 10 years, especially when we are trying to get to grips with what oil demand will be in 10 years from now.”

From an E&P company these reserves will not be worth as much in the future, and potentially with technology changes will be cheaper in real terms to extract. So what investors are saying (already) is don’t pull forward this expenditure now, wait… And that is a completely different dynamic to the one prior to 2014 where first oil drove all decisions.

Not only are reserves going nowhere but neither is demand as Dale and Fattouh point out. The demand side of the market is likely to be relatively stable for decades, it’s on the supply side where the action is occurring. But it is hard to overplay the significance of this, an 8 year RRR would be a ~30% drop from historical levels and see a massive reduction in rig work and associated activity. Schlumerger is changing its business model accordingly. Slowly working through these reserves down to an 8 year period would fundamentally change models used to forecast rig demand used in exploratory wells for example.

This is playing out exactly as Spencer Dale predicted in 2015 where shale can act as a “kink” in the supply curve. Marginal production gives E&P companies more flexibility and lowers CapEx and offshore commitment. It makes uncomfortable reading for offshore as the logical assumption, from a senior figure who obviously has a large influence in how an E&P major acts, is that short-term price movements will be met with an increase in investment in tight oil. It might not be as profitable per barrel, but it can adjust quickly to short term movements, and isn’t as risky given the cycle times and upfront commitment offshore requires.

The call on offshore requires a vast number of assumptions in models, which as the graph at the top of this post shows can lead to a multiplicity of reasonabe assumed outcomes contains vast room for deviation. A few percentage points in extending current fields, a few percentage points increase in productivity from existing wells, and a small drop in forecast demand (either from efficiency, substitution, or a global recession) and the amount required from offshore drops signficantly. E&P companies are underpinning a huge amount of base demand on offshore but those few percentage points in each assumption that could change they appear to be backing themselves to supply with tight oil. The future for offshore will not be a mirror of the past.

Schlumberger exiting seismic is a small example of how the offshore industry will delverage from a position of being overcapitalised as an industry relative to the amount of work, and it is a clear industrial sign that “the age of abundance” isn’t some ethereal academic concept. Schlumberger also took a huge writedown on the asset value associated with its seismic business which again places a numerical value on an economic theory. If you go long on seismic companies at this point you might want to ask yourself what you know that Schlumberger management, actively reweighting their corporate investment profile to tight oil, know that you don’t?

The scrapping of older tonnage, which has begun in earnest in the rig industry, has been delayed for longer in the offshore industry as banks resist the economic reality of depreciating tonnage by delaying principal payments. Such a situation cannot continue forever. The Seacor/COSCO deal this week, which sees vessels taking delayed delivery in the future is a sign of industry weakness not recovery. Declining values highlight that these assets no longer offer access to a scarce resource but something now viewed as an abundant commodity.

I’d have to say the more I look at presentations where the core of the logic is a return to 2013/14, after a suitable gap for the market to return to “normality”, the less convinced I am.