Solstad has a solvency problem not (just) a liquidity problem…

The motions of Grace, the hardness of the heart; external circumstances.

Pascal, Pensee 507

“Lend without limit, to solvent firms, against good collateral, at ‘high rates’.”

Bagehot

I disagree with Solstad on this:

It has therefore been decided to commence negotiations with lenders and other stakeholders to improve the overall liquidity situation and to create a robust long-term platform for the Company.

Solstad doesn’t just have a liquidity problem it has a solvency problem. They may have enough broker valuation certificates to keep the auditors happy that the assets add up to the liabilities in a balance sheet sense, but in reality does anyone really believe that the fleet can service ~NOK 30bn in debt? Solstad fails a balance sheet test under a realistic set of assumptions. The fact is if the banks really thought they could sell the vessels for the outstanding debt and be made whole they would have done so long ago. This situation has been allowed to continue, despite clear evidence to the public protestations of its success, because the creditors have no good options. A liquidity problem can be solved with more short-term measures but a solvency problem is endemic and structural and requires a fundamental adjustment. Bagehot’s dictum of lending freely when in crisis relied on the collateral being of high quality and the crisis being temporary in nature, a situation that clearly does not apply here where there has been a structural industry shift.

I’m struggling to see why you would create Solstad today in its current form and my base view is if you can’t answer that question then you don’t have a viable business model in the current market. The scale of the credit write-downs that need to occur here to keep the business alive are just so large it is hard to know if Solstad are just good at PR or good at avoiding reality. I don’t know what the number is but the debt must need to be reduced somewhere in the range of NOK 15-20bn to make Solstad a viable business? The rump of Deep Sea Supply will never be a viable business. And then it needs equity…

The only way to get equity is to find an investor who is going to potentially get such a big return on their investment that the creditors get nearly nothing. There is probably someone willing to make that trade but it is a small pool and it offers the creditors nothing. Market sentiment, as opposed to the actual market, has worsened substantially since MMA pulled of the most successful OSV equity based solution. There is no guarantee that Solstad will survive this encounter with creditors intact and almost a certainty a very different beast will emerge. I am not even sure now splitting the subsea fleet from the supply tonnage will make much difference? The subsea fleet has a large number of marginal vessels that still need scale to survive and given many are being hawked out on windfarm work there is no guarantee their value will “recover” in percentage terms more than a supply vessel. And when some of them come of contract the day rates will also be dramatically reduced.

Systemically it will be interesting to see what happens here. The banks will be desperate not to be handed the keys to Solstad, but as Pacific Radiance in Singapore has shown getting someone to come in behind the banks in the capital structure is tough (with exceptionally good reason). The size of the write-offs the banks would have to take to induce this will make for some uncomfortable meetings in the coming days. Surely soon auditors will force companies to use market transactions (like the recent SDSD FS Arundel for $2.8m!) as the actual realistic value not this “willing buyer/willing seller” ruse?

Not everyone can survive a downturn on the scale we have seen. If the banks somehow, and it will be hard, find a way of keeping the money flowing then all it guarantees is that another company will go. And it will have to be another large “unthinkable” one at that, because there is simply not enough work, and unlikely to be for the next couple of years, for all the supply companies to survive.

The other missing piece of this puzzle is the changing financial structure of the industry and the huge amounts of equity that need to be raised to keep it viable. All the banks behind Solstad have no intention of lending to similar companies for the forseeable future, and every bank is the same, this is a systemic issue directly related to depressed vessel values. But as the contract coverage has shortened so the economic rationale for leverage has also disappeared: lending against a PSV on a 5 x 365 contract is very different to one on a 270 day contract. That sort of spot market risk is essentially equity risk and the average day rate needed to make this economically viable is significantly above current levels. An industry which needs to cover 365 costs on a 270 day utilisation year is again a very different economic model from the past for offshore supply and it only reinforces the size of the adjustment the industry still requires. This is an industry that will significantly delverage going forward and that will mean far more (expensive) equity levels and lower asset values.

An interesting conundrum is whether Standard Drilling and Solstad can really co-exist? I mean either you can buy vessels for a few million and bring them to the most sophisticated market in the world and make money against historic tonnage, or you can’t? At the moment both companies are a financial disaster but surely a recovery story really only works for one company as a logical proposition? There is no indication that the Solstad vessels are trading at a premium in the PSV market to the Standard Drilling/ Fletcher vessels which gives you an idea of what the Solstad fleet would be worth in an open market sale. The same is true for the high-end AHTS fleet where rates remain locked at marginal costs (or below on a 365/economic basis) and competition shows no sign of abating.

Solstad has also provided a natural experiment into the limits of synergy realisation versus the depth of this industry depression: quite simply consolidation alone will not be sufficient. All year Solstdad has highlighted the cost synergies it has achieved by combining with DeepSea Supply (in default before the first quarterly results) and Farstad (in default before the second quarterly results). But these are insignificant in relation to overall running costs and the level of day rate reductions E&P companies have extracted from OSV (and rig) operators. Pretending that consolidation alone is an answer now lacks credibility. New business models need to emerge and a fundamental factor of these will be collectively less supply and capacity.

The Solstad announcement presages a horror season of Q3 reporting coming up across the OSV sector. As I said some time back the summer simply hasn’t come in terms of the volume or value of work for either the supply firms or the subsea contractors. The cash crunch is coming. New money will be come on extortionate terms and prices to reflect the risks involved and not everyone will get it. Rebalancing is beginning to start in earnest and the fact is this market is the “recovery”: a slightly busier summer to build up a cash reserve to cover the costs of an expensive an under-utilised winter. The new normal – lower for longer is the reality of offshore supply and subsea.

Hasty generalisations and shale…

The being without an opinion is so painful to human nature that most people will leap to a hasty opinion rather than undergo it.

Walter Bagehot

John Dizzard in the FT this week spoke to a man from Oaklahoma and decided that the whole shale sector was just the result of market liquidity pumping money into the small debt financed E&P companies. Dizard suggests capital markets are “subsidising” the sector. This appears to have been a hasty generalisation… The data point appears to be based on Drilled-But-Uncompleted wells:

As one Oklahoma oil and gas man I know says: “There is still unlimited capital, and as long as that is true, you can grow anything. If the companies had been forced to live within their cash flow, then their production would go down. Then they would have run into a death spiral where nobody would want to invest in them.” The shale companies struggling with sub-$40 or sub-$50 oil prices were also able to live off the excess inventory of drilled-but-uncompleted (DUC) wells that had built up during the boom years.

As our Oklahoman says: “There were thousands of DUCs that had not been taken account of. The companies could just complete and connect those to offset the declines in production from older wells.”

The problem is I don’t see this:

DUC 17

Source: EIA, Baker Hughes, Jeffries

First of all we had the meme that shale was too expensive on a per unit basis, and now we have the meme that actually it is only possible because high-yield investors don’t understand what they are buying and funding. Admittedly HY doesn’t always get it right, as offshore bonds currently show, but to suggest that shale is solely the result of a capital misallocation is surely mistaken?

US capital markets are probably the most efficient in the world at adapting. The various restructurings happening in offshore (Paragon, Tidewater etc) highlight that banks and investors take the writedowns and move on. They are also efficient at funding companies for long periods prior to cash flow break even (Uber being the most notorious example). Shale is here to say it is only a question of how big it is.

Illiquid or insolvent? Bagehot and lenders of last resort to the offshore industry…

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.

Irving Fisher

SINGAPORE – Offshore marine services firm Pacific Radiance has been granted S$85 million in loans under two Government-backed financing schemes.

I’d suggest the Singaporean Government brush-up on the difference between a shift in the demand curve and a shift along the demand curve To non-economists the difference may look semantic but to every stage 1 student it is drilled into them that a shift along the demand curve occurs when price changes and then the quantity demanded responds, a shift in the demand curve means a fundamental change in demand. It is the difference between a change in the quantity demanded versus a change in demand, which are self-evidently two completely different things.

I would argue, and have on this blog consistently, that we are seeing a complete reconfiguration of the offshore supply chain, think Woodside moving to electronic Dutch Auctions for commodity supply vessels, rather than a short-term fluctuation in demand as the result of temporarily low oil prices.

Quite why the Singaporean Government feels it knows better than the market is beyond me here? I should note at this point I am not an unadulterated free-marketeer, my favourite paper at University in NZ at the height of Rogernomics and its successors in a supply-side revolution, was “State-Led Development in South-East Asian Tiger Nations: Singapore, Hong Kong, Taiwan, and South Korea”. In the debate between the World Bank and the activists I took my lead from Robert Wade (also from NZ) and others who saw active government involvement in the economies as an essential part of the process that drove these economies to outperform and pull their people out of poverty. I was a believer, I agree still to a certain extent, with Alice Amsden who argued the governments’ of the region actively set out to “get the market price wrong”.

But I also grew up in New Zealand, which terrified of rising oil prices in the 1970’s had launched Think Big, and by the time the Motonui synthetic “gas-to-gasoline” plant was finished the tax payer footed the bill for every single litre manufactured. It was in short an economic disaster. Trusting a Government ministry to out-judge the energy market is a dangerously expensive passtime.

I should also note that Stanley Fischer, in an unbiased review of South East Asian development policies following the East Asian Crisis noted:

As to Asian industrial policy… some degree of government involvement can in principle be successful, and that it was successful in practice, too, in some Asian economies by allowing new industries to overcome coordination failures and exploit economies of scale. I also believe the potential for such interventions to go wrong is very high, both because the government may make the wrong decisions, and also because they are conducive to corruption. In most cases the best approach is for a country to create a supportive business environment, including policies and institutions that encourage innovation, investment and exports in general, and to leave allocative investment decisions to the private sector.

So when I read that Pacific Radiance has secured loans from two entities affiliated with the Singaporean Government I have to question what is going on?

Firstly, there is a moral hazard element here as the shareholders and the banks appear to benefit from an overly generous dose of leverage on average assets. The Straits Times notes:

The Government will take on 70 per cent of the risk share for both the IFS and BL loans, which were rolled out last November to help local offshore and marine companies weather the current prolonged industry downturn by gaining access to working capital and financing.

These are loans largely owned by DBS and UOB. I don’t undertand how if this is an economic transaction these banks need this level of support? This is an assymetric payoff where the Government takes most of the risk and the banks pick up most of the upside.

Secondly, the sanity: this money is going on OpEx:

The loans … will help support the group’s working capital needs over the medium term, said Pacific Radiance in a statement on Thursday.

Really? Does the Government of Singapore believe that a short-term market dislocation has occured that will see USD 5-10k per day per vessel of OpEx recovered when the market comes back? Pacific Radiance has USD 605m of liabilities over a fleet of 60 vessels and JVs with a further 60 in Indonesia. Like Deepsea Supply, and a host of others pretending the vessels are worth anything like this is a fantasy. But another problem isn’t just the size of the debt, and the quality of the assets underpinning it, but the income being generated to service it:

PAC RAD Sales Q1 2017

Sales are dropping like a stone, and as a general rule depreciating assets that earn less than you thought are worth less. The loan doesn’t solve the fundamental problem: Pacific Radiance have borrowed too much money relative to the revenue these assets can now earn and are likely to in the forseeable future. As you can see over the same period comparison as above Pacific Radiance is consuming cash at an alarming rate:

PAC RAD Cash Flow Q1 2017

Most worrying is the amounts due from related companies which would have to be seen as doubtful, but the business is also using large amounts of cash in operations and this loan is simply going to go in and then go out on that operational expenditure. Loan covenants on fixed assets were simply not designed to cope with turnover dropping 24% quarter-on-quarter: there was too much leverage in the offshore sector to support this. The banks need to come to the party here for this to be a viable firm.

Third, this seems completely contrary to what other major players in the market, like Bourbon are saying (and they are surviving without government assistance):

Mr Pang noted that the longer-term outlook for the industry has improved, as Opec and certain non-Opec producers have sustained oil production cuts until June this year and have also agreed to extend these cuts by another nine months. “This concerted effort by oil producers should enable supply and demand to balance in the medium term.”

The Singaporean Government is essentially making a bet on a private company that seems to have no other plan than simply hanging around waiting for the market to improve. To be honest that doesn’t strike me as a great plan, and if enough investors agreed with Mr Pang surely getting an equity rights issue away should be easy for the company to raise the money and wait for this miraculous occurrence? In fact of course with the Swiber AHTS going for 10% of book value the loan already looks doubtful.

The government of Singapore has now become the Lender of Last Resort to the offshore sector and therefore the Bagehot dictum applies “lend freely at a penal interest rate against collateral that would be good quality in normal times” (I have discussed this before) . The formula is help the illiquid but not the insolvent. Bagehot outlined this formula in 1873 after repeated shutdowns in the London money market put sound financial institutions at risk. The Bank of England had followed this dictum in 1866 when London had its own Lehman moment and the Bank of England allowed Overund, Gurney and Co., one of the largest institutions, to fail.

I haven’t done a full valuation of the Pacific Radiance fleet but a quick overview of the assets on the website makes it clear this is pure commodity tonnage and some of it very low end. Quite why anyone thinks this is going to recover to previous levels needs to be outlined explicitly I would have thought given the scale of the commitment that is in the process of being made. I don’t think in the current market this would qualify as high quality collateral in normal times. There also appears nothing penal in the loan at all.

Worringly for Singaporean tax payers, looking at Ezion and others, Bagehot also wrote:

‘either shut the Bank at once […] or lend freely, boldly, and so that the public will feel you mean to go on lending. To lend a great deal, and not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies’

I think Pacific Radiance had a solvency problem not just a liquidity issue, but the systemic problem is now the longer Singapore props up companies like this the longer the industry will take to recover. If Singaporean taxpayers decide to support Ezion and a host of others they need to be prepared to write some very big checks, and the US companies fresh from Chap 11, with clean balance sheets, will be in a far better place to compete.

During the last Global Financial Crisis Paul Tucker of the Bank of England stated the Bagehot dictum as ‘to avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at ‘high rates.’ These loans do nothing of the sort by backing poor quality collateral and providing uneconomic liquidity to a company with an unsolvable problem. People are not paying less for these vessels because there is a panic they are paying less because E&P companies are using them less and they cost a lot to run! These loans will only delay the pain and hinder other struggling firms. The banks should have been forced to realise the assets at current market values as the penal rates both Bagehot and Tucker outlined and the shareholders should have been completely wiped out.

As a comparison I do not think MMA will be so lucky. I have experienced Australian banks first hand and I suspect the “Big Four” will be ruthless and simply shut the company down soon having given the company temporary respite to see if this was just a short-term dislocation. Unfortunately from an economic perspective this type of capacity reduction is exactly what is needed to rebalance the industry.

Offshore contractors face ‘bank run’ scenarios

lewek-constellation

I was struck by how much EMAS (and other offshore contractors with poor balance sheet strength) need to be viewed as facing a ‘bank run’ like scenario after reading this BIS article on the collapse of Continental Illinois. The key question is can a ‘funding run’ be stopped for both contractors (and banks). The Lewek Constellation (above) is an amazing operational asset, but it needs a vast flow of future profitable project work to keep it going (and proper deepwater construction work not infield), and the question at the  moment when looking at the financial strength of EZRA/EMAS/ EMAS Chiyoda is who would award them a complex multi-year construction project?

The only thing that keeps these vessels (and others in the fleet like the currently in default Lewek Connector) is large lump sum jobs with a strong blended cost of high value, low capital intensity, project management fees to balance out OPEX of the vessels. At the moment large companies are all doing this at relatively low margins; where is the incentive to get an even cheaper price from EMAS Chiyoda and find mid project there has been a credit event? The offshore phase is the capstone of all the earlier custom engineering work that has been paid in stages along the way. No one ever got fired for buying IBM was an ad used with great effectiveness to convince mid-level procurement managers to go for the brand. In the current environment no one is going to get fired for buying Technip, Subsea7 and McDermott; but risking a multi-million dollar field development on EMAS Chiyoda is whole different story. Should a credit event occur all pre-funded engineering and procurement spent would in reality make the purchaser an unsecured creditor (and a lot of it would be vessel specific so no use anyway); not to mention performance bonds etc. There have been no significant news of awards for the Lewek Constellation recently and in reality there are unlikely to be.

Offshore contractors are in a pro cyclical industry and take long positions in assets with long funding and economic lives that are in a downturn illiquid to the point of having no saleable value (like now). These assets are funded with some equity but also a significant quantity of debt, with a funding profile less than economic life of the asset, from senior banks and more recently by increasing amounts of (often “issuer rated”) high-yield bonds, or off balance sheet financing from vessel charters. In operational terms an offshore contractors asset base has been funded by a series of offshore CAPEX projects significantly smaller in length and value than the underlying asset base. In banking this is called maturity transformation: banks lend long and borrow short; in offshore the contractor goes long on illiquid assets and funds them in the short-term project market. There is a clear analogy here with contractors serving the E&P companies by going long on highly specific illiquid assets and funding this with a series of short-run projects. Clearly the capital structure of the industry in a macro sense has not reflected this reality well as increasing margins led to ever increasing amounts of debt and rising asset values substituting for real equity (and Swiber and EZRA/EMAS were two of the best exponents at this form of financing). Minsky would have seen this coming a mile off

Net fee income is important for banks as the money they make on the asset base often only covers the funding costs with a small margin. This is true for offshore contractors as well, as discussed above, when that “fee income’ for engineering and project management dries up in poor market conditions the operational offshore asset base cannot even come close to covering its funding costs.

The Continental Illinois demonstrated how hard a bank run is to stop, as even with a Government guarantee, financially rational investors choose to leave in droves ensuring institutional failure. Just like a bank loan portfolio an asset like the Lewek Constellation will be worth nothing like its book value in the current market; it  may actually be “worth” close to zero given the high running costs and the lack of other uses. The same will apply to EMAS Chiyoda as a whole (and other offshore contractors): a run in confidence on their ability to be in business in 12 months time will become a self-fulfilling prophecy in all but the most exceptional cases because the financial gain from any price reduction that could be offered cannot compensate the risk of a large offshore project not being completed.

The pro cyclicality of operational offshore and financial assets  leads to huge volatility and as the Cerrado deal showed the OPEX costs may actually induce steeper depressions than problem loans from financial institutions. One thing is clear: at the moment many assets in an offshore construction/support vessel fleet are almost unsellable at any price and there is no Bagehot inspired institution willing to lend freely on any quality asset to stop a liquidity crisis becoming a solvency one. In fact as the current wave of restructuring among contractors at the moment indicates these are  solvency and liquidity issues combined. Like a banking crisis the offshore industry is awash in leverage and this will in all likelihood prolong the downturn and make a recovery harder.

What really needs to happen for EZRA/EMAS/EMAS Chiyoda is for all the creditors together  to undertake a massive debt-for-equity swap (if you have faith in the assets be the Bagehot: effectively lend freely on collateral that would be good in “ordinary” times – of course there isn’t much because the vessels are chartered); to try and get over the current downturn (if you believe it is just that or DCF some future recovery value anyway) and try and recover value in an orderly fashion accepting that the asset base may simply not be  worth what it was a couple of years ago. Like Continental Illinois though what is likely to happen is that regardless of extra support and measures that management can negotiate to slow the process everyone (funders in the broadest sense) just decide this is a situation they need to get out of as soon as possible.

It’s a bank run… there is no incentive for anyway to stay in and game theory suggests getting out first may be best individually even if staying in collectively would be better. For the offshore industry as a whole this is probably a good thing as EMAS Chiyoda doesn’t really solve any customer problems and was always (in hindsight) a symbol of an investment bubble. But this is going to hurt… I’d love to read the due diligence report Chiyoda and NYK got for this… the only possible solution is that they double down and fund this for a couple years but it would be bold move given current conditions.