Satire is dead…

I just want to remind myself in the future that Dennis Rodman, sponsored by a crypto-currency company seeking to transact in legal marijuana transactions, went to assist Donald Trump negotiate with North Korea. I didn’t see that coming. Love the photo as well,

Shale and offshore… the competition for marginal investment dollars…

Last week the Baker Hughes rig count for the US came in and again it was up. In the graph above Woodmac are highlighting it that Lower 48 US shale production may crack 12m barrels a day.  As recently as 2013, when offshore was starting to go really long on ships, US shale production was ~3.0m per day. It has in short been an industrial phenomena, one as I have noted here before no other economy in  the world could have marshalled as it has required enrmous flexibility in capital markets and the ability to turn a service industry into a manufacturing process.

The narrative has changed as well. Shale has consistently outperformed even optmistic forecasts:

US-Shale-Production-Outlook-Revised-Upward-Repeatedly-20160210-v2.png

As recently as 2016 even BP’s renowned research team were only predicting a fraction of actual demand. Shale now represents an enormous portion of workd output and it’s economic model of short-cycle low-margin is the antithesis offshore but this flexibility around spending commitment is clearly very valuable to E&P companies in an era of price volatility.

So I get as the price declined in 2014/15 you could maybe make a reasonable case for a quick rebound in offshore? 2016 at a stretch, although I think the market signals for offshore were already clear byt then, but I have to say it strikes me as hard now for people ignore the scale of this change and to argue there will be some demand driven boom coming in offshore. E&P companies have stated repeatedly they are sticking to forecast offshore CapEx numbers and they seem to be sticking this.

I still think there are too many business plans floating around which have as a core assumption. This from Ocean Rig:

Ocean Rig Recovery.png

“[F]or the market upturn” (emphasis added)… like it’s a given? I get it’s off a low base but I think we all know when people talk about that sort of recovery they mean a deep cyclical one that flows to rig and vessel operators who will make a ton of money.

But let’s look at the scale in terms of shift at the margin in incremental output:

Long term offshore.png

The last time the oil price dropped and offshore boomed back,whichever cycle you were talking about but especially the quick 2008/09 rebound, that yellow portion of incremental investmnent simply didn’t exist on the graph in a meaningful sense (and since this graph was done shale is more important). A business plan that simply ignores this reality an insists on a change in market conditions as it’s defining principal is simply logically inconsistent to my mind. Clearly offshore is an important part of the energy mix going forward, but in 2009 it was really the only alternative to traditional onshore production and that clearly isn’t the case now.

Offshore used to have very high utilisation rates, that is what made small companies in an extremely capital intensive industry viable, but it is clear that the scale of investment in shale is having a profound impact on utilisation levels and this is changing the entire economic structure of the industry. This point is a prelude to a further few posts that have this logic as there core.

Ocean Installer and SolstadFarstad… endless financial winter..

Ocean Installer held a “must attend” townhall this morning. The CEO moves out to a BD role and the CFO is out altogether. In comes an increasingly realistic HitecVision who now must know that the current losses are unsustainable and there are very few suitors in sight who can bail them of this investment.

OI’s problem is that the summer hasn’t come in terms the quantum of work or the rates at which projects are being contracted. Last year shareholders (and creditors) across the subsea contracting industry wanted a business plan which showed them breaking even at worst in 2018 and then a significant recovery in 2019. So in  2017 those business plans were dutifully delivered to the various stakeholders by management. The problem of course is they had no basis in reality and now as the summer has come, schedules are firm, contracts have been signed, and there is now no place to hide from the reality that this is going to be another terrible financial year for many companies. No other plan would have been acceptable to put before the Board, but now it hasn’t been achieved, and there is no realistic chance of doing so, something has to be done.

This scenario is happening now repeatedly across the industry and the bet the industry would recover this year has proven to be wrong. For those with exposure to boats, or business models based on vessel operations, this is a miserable summer.

And who actually can see a catalyst for change that will make 2019 any different? The oil price is higher than most could have hoped for 6 months ago and while it is leading to more work it just isn’t on the scale required to allow a PE house to recover what has been a considerable investment in OI. It is all well and good saying the North Sea semi-sub market is going crackers but that means it is years away before this will flow through to the subsea construction market. The tier one contractors will be there for that work, whether OI will be is another story altogether.

I don’t think there was a problem with the management of OI but rather with the business model. When founded OI took time risk on scarce vessel assets and made a margin on this risk. It was a sensible and sound idea given the market fundamentals at the time. But the cash costs were huge as it took  on engineers at the peak of the market to bid work and try and get market share. Brazil, Perth, and Houston were all significant loss making offices with a lot of engineers at costs of up to USD 1000 per day… Like Ceona the ramp up costs and timeframe to realistically build a sizeable contractor were I think dramatically underestimated (along with not having a rigid reel strategy).

Now why does OI exist? Would you start it tomorrow if you could? If you can’t answer those questions easily in this market, and you don’t have a lot of cash, then the answer is unfortunately you won’t exist eventually. Just taking someone elses vessels and making a tiny markup on them is an okay business model, except for the fact it’s risky and low margin with no hope of scaling up without more investment if a market recovery happens. One wrong bid with a fixed price contract and you are paying for a vessel to finish the job at a rate that quickly wipes out any potential profit from the original job.

All “boatless” contractors, and the majority of ROV operators taking contract risk, have a strategy that is the equivalent of trying to pick up pennies from in front of a steamroller: the risk reward is totally disproportionate now.

The maximum price anyone would be prepared to pay for OI should really be capped at what is would cost to replicate the company. The major assets are its relationship with Statoil and …. Anyway it has a good relationship with Statoil. All the other aspects of the business: access to vessels, an engineering pool that cannot cover it’s fully loaded costs, its international network with no economies of scale etc can all be replicated for minimal costs. This is an easier business to get into than get out of.

Solstad Farstad also announced a small extension to their situation today and they have the same problem as OI: the business plan simply isn’t real. I have no wish to repeat ad infinitum my constant critique of Solstad Farstad. The extension to the Deep Sea Supply fiascof***up unfortunate situation will now not be revealed until June 30. This is a very bad sign. There is clearly no agreement and probably no plan with apart from hope… which has worked badly so far.

The same problem infects it as with OI: the lack of credibility of a demand side recovery on which the entire Solstad Farstad plan was based on. I repeat: a major restructuring is needed if the company is to survive and 4 week extensions on one portion of the business in no way reflect the operational or financial reality of the company. Having taken on the operational responsibility of the Deep Sea Supply  fleet there is no credible way for the banks to do anything other than firesale the assets now or hand their lay-up over to another ship manager. Such a scenario would require a dramatic revision of the actual cost savings the merger had achieved, but a scenario where Solstad Farstad continue to spend time and money on the Deep Sea Supply fleet is also unsustainable and untenable under the current financial structure.

I would be amazed if a final solution is rolled out in four weeks. Expect major delays here as the banks face up to the scale of the losses. The new Solstad balance sheet is likely to look dramatically different to the 2017 final version published recently, and whether OI is a customer when they come to publish it is also a debatable question. Expect more of the same as a summer of weak demand in the North Sea rolls on unabated.

SOCAL, Saudi Arabia, and Bitcoin… If you thought the oil industry had booms…

I meant to note this two days ago but the photo on the top is the signing ceremony on 29 May1933 between SOCALm (Standard Oil Company of California) and Saudi Arabia to manage the Kingdom’s oil concession. Clearly a historic event in the development of the oil industry.

As a contrast… I couldn’t help noticing this story about Bitcoin and it’s energy usage. In Chelan County, renowned for cheap electricity and:

an area famous for apples, wheat and conservative politics [it] has been transformed into a kind of cyber-boomtown, with Bitcoin mining operations that range from large-scale, state-of-the-art warehouses to repurposed cargo containers to backyard sheds. By the end of this year, according to some estimates, the Mid-Columbia Basin could account for as much as 30 percent of the global output of new Bitcoin and large shares of other digital currencies, such as Litecoin and Ethereum.

There is a boom going on:

In a normal year, demand for electric power in Chelan County grows by perhaps 4 megawatts ­­— enough for around 2,250 homes — as new residents arrive and as businesses start or expand. But since January 2017, as Bitcoin enthusiasts bid up the price of the currency, eager miners have requested a staggering 210 megawatts for mines they want to build in Chelan County. That’s nearly as much as the county and its 73,000 residents were already using…

 The scale of some new requests is mind-boggling. Until recently, the largest mines in Chelan County used five megawatts or less. In the past six months, by contrast, miners have requested loads of 50 megawatts and, in several cases, 100 megawatts. By comparison, a fruit warehouse uses around 2.5 megawatts.

However, the acquisition of resources has not gone quite as smoothly:

China electricity.png

I am pretty sure the crypto-miners from China are thinking about crypto-sceptics (like me), from the comfort of their private jet, sure that we are the people who just don’t get it.  In future years maybe someone will dig up a photo of the dam master and the Chinese miner signing a supply agreement… but I have my doubts…

Chinese subsea vessels…

Last month COOEC successfully delivered a high spec DSV and IMR further adding capacity to an already depressed market. The only effect is that companies like who used to charter DSVs and IMR vessels in the region have now lost completely the chance for this work and these vessels will be offered at rock bottom rates when they are quiet domestically.

Given that it is cheaper, and will be for some time to charter vessels rather than own them, one wonders why construction on these vessels was started long after this became clear?

A good article here highlights the scale of the subsidies for Chinese shipbuilders and the effect this has had on the industry:

Chinese shipyards.png

Given the conclusion:

[t]his calculation implies that a frequent assertion that China developed shipbuilding to benefit from low freight rates for its trade seems to be unsubstantiated. Indeed, the benefits of subsidies to shipping are minimal. Perhaps instead, the Chinese government is aspiring to externalities for sectors such as steel and defense, or even national pride …

[t]he results of my study suggest that Chinese subsidies dramatically altered the geography of production and countries’ market shares. Although price (and thus consumer) gains are small in the short run, they may grow in the long run as the operating fleet becomes larger.

It is hard not to see this as a move to ensure China moves up the value chain in the production chain for high spec vessels. Not good news for residual values long term I would suggest.

Popiah Radiance apparently?

If this story in The Business Times is true, and I have no reason to believe that it isn’t, then the Pacific Radiance restructuring is not going well.

As a general rule bringing an Ultra-High Net Worth individual in on this deal means the fundraising banks have exhausted all the institutional money they can find to inject some equity in here. The investment banks have been around the fund managers who have had as much fun as they can handle in offshore, and looked at situations like this (disclosure I am an ex-Director of Bukit Timah AS):

Singapore’s Kim Heng Offshore and Marine Holdings Limited has purchased three anchor handling tug supply (AHTS) vessels for USD9.6 million, securing them at a fraction of a previous valuation…

Kim Heng said that the vessels were previously valued at approximately USD33 million each, but it was able to acquire them “at extremely low valuations” due to the downturn in the oil and gas industry…

So now the banks are forced to widen the circle to people who may know nothing about offshore, but have a lot of money and can be sold on the “new” rebound story. Let’s wait and see if this deal actually executes like as outlined. The only attraction for an UHNW investor coming in would be an extreme price discount and unbelievable terms and conditions, and the Pacific Restructuring term sheet doesn’t indicate that?

I mean even the bankers here can’t really believe this plan will work? Surely? They must be in it for the fees and targeting an UHNW who is the client of another bank? You wouldn’t sell this deal to your own clients would you?

There is an excellent article here in OSJ that again just emphasises how bad things are in the offshore support market. Especially in Asia. What could go wrong? Ignoring the fact someone very wealthy, and therefore potentially credibly litigious, is your cornerstone investor when no credible market reports suggest an upturn.

Pacific Radiance’s last accounts show bank debt and loan notes of USD 526m. The term sheet indicates that the secured banks are writing off $100m, getting $100m immediately, and end up with a reprofiled $120m and everyone else (unsecured) gets shares (I am assuming having read it quickly). So quite how much cash in the bank you get from putting in $120m is unclear but it clearly isn’t a massive number.

The gap between the actual transacted values and the book values of offshore support vessels is still just so extreme that if there is a trading problem equity holders are guaranteed to get nothing. At some point simply saying the loans don’t have to be paid back for three years must still be realised as unrealistic. This is the deal from the term sheet:

The remaining re-profiled Bank Loans of approximately US$120 million will be repaid over 3 years from 1 January 2021 to 31 December 2023.

50% of the contractual interest margin payable under the re-profiled Bank Loans shall be deferred for a period of 3 years from 1 January 2018 to 31 December 2020 and the deferred interests shall be paid by 31 December 2023.

So before this new equity would have a claim of value the current Pacific Radiance fleet would have to generate enough cash to pay the banks back $40m per annum starting in 2021? Oh and make good the interest. Really? And if they don’t? The new shareholders will be wiped out in another refinancing or sale? And what sort of upside is the spreadsheet showing? Which is just the situtation SolstadFarstad has arrived at earlier… It’s just not real unless the term sheet isn’t showing some protections on offer to the equity investors.

 

I’ll be interested to see if a canny self-made man really puts money in under those conditions. It smacks of desperation on the capital raising side in that all the institutions, who have the time and resources to undertake due diligence, get that this is simply keeping the banks going here without any industrial solution at all.

All you are getting for that money is a future claim on a declining asset base which you must compete with on price to get utilisation. That is the only deal on the table here and this is not a high quality fleet in terms of residual value. The US supply firms have got real: any claims to these vessels are equity in economic reality if not legal status. Everyone should just convert their claims and then it would be easier, but if they can really find people who go for this then well done. But it is a short-term solution and nothing more. #denial

Watching with interest.

 

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.