Corporate finance Borr Drilling style…

One of the more curious corporate finance transactions took place earlier this year when Borr Drilling, an enormously leveraged rig company when financial commitments are taken into account and using its revolver for working capital, then purchased 1.5m of its own shares at NOK 35.50. As can be seen above the shares have since declined 18% and are now worth NOK 29, which is signficantly below the price they last raised capital at ($4.6/ ~NOK 39).

In the scheme of things the loss isn’t that much money,  it’s really a question of whether for such a  (sic) “high-growth” company is depleting liquidity to buy back shares the best use of its capital? I noted at the time this was close to extraordinary for a company that needs to raise hundreds of millions of dollars (not a misprint) in capital over the next three years to remain a going concern ? In which case why are they doing it?

For what it’s worth my own view is I think the Management and the Directors of Borr understand how deeply in financial trouble they are: the market simply isn’t coming back to anything like what they and their original backers planned. Without a massive increase in demand the entire investment thesis is flawed and the company has no reason for existing in a very real sense. By embedding leverage in the shipyard delivery times as well as the bonds, and using a revolver for working capital, Borr requires the market to come back strongly and for them to activate a vast number of warm-stacked units in this hypothetical demand pickup… just for Borr to remain solvent, yet alone make an economic return. As an external observer reading the public anouncements it feels like a degree of panic is setting in.

As the Borr Drilling prospectusin early 2018 made clear this is a highly competitive business:

The profitability of the offshore drilling industry is largely determined by the balance between supply and demand for rigs. Offshore drilling contractors can mobilize rigs from one region of the world to another, or reactivate cold stacked rigs in order to meet demand in various markets.

The shallow water segment of the drilling industry is particularly competitive with no single contractor having a dominant market share. Competitive factors include price, rig availability, rig operating features, workforce experience, operating efficiency, condition of equipment, safety record, contractor experience in a specific area, reputation and customer relationships. [Emphasis added].

Particularly competitive” with “no single contractor having a dominant market share” tells you how absurd the plan here is, and how much alternative investors wanted to believe in an outcome they knew to be economically illogical. Market share and competitive factors are directly related to profitability. With no fast growing market this company is simply a financial time bomb. Yet as recently as September Borr’s Chairman stated:

“We have an ambition to return a significant part of cash back to shareholders quickly … if we don’t pay dividends in 2020, we have failed,” Troeim told Reuters.

I’ll bet my house that doesn’t happen. [Actually that isn’t strictly true because Troeim could clearly afford to take me up on that and my domestic happiness would be rapidly curtailed if I started playing in the futures market with matrimonial property… But you get where I am coming from].  But the dividend comment springs from the same belief that the current market is some mis-pricing anomaly rather than a deep structural change in the oil market.

Now for plan B. A rights issue that would heavily dilute shareholders is the most logical fundraising strategy here, but finding more hedge funds to by your stock when it keeps on going down 30% is not easy. I just cannot believe Schlumberger are going to carry on committing capital to this venture on a proportionate basis. Debt? really? With no backlog or even utilisation?

The idea that this slide seems to highlight ,that banks or other debt providers would lend against the unencumbered rigs when they have absolutely no work available, seems so very 2012, quaint almost:

Built to last .png

The title of this slide is surely begging irony? The whole Borr business plan relies on growth significantly faster than the market when the market has extreme overcapacity from well capitalised (and desperate) competitors, and financing this by borrowing against rigs with no work or backlog. What could go wrong? See more here.  Borr management have done a lot, struck deals, brought kit etc., but the possible economic value creation is a simply a vastly leveraged play on a never appearing demand boom. It is a microcosm of offshore investment sentiment and a stubborn willingness to accept the scale of change shale as wrought on the market. At some point the business case must be a logical inconsistency if shale keeps growing at current rates? I’d suggest that point was passed a while ago.

The blow-up here is unlikely to be as dramatic and spectacular as something like EMAS because the perceived asset value is so high. But the scale of the amount of capital that needs to be raised, and the likely time period before it could be returned is so long, that each additional round of funding here is likely to be very expensive. Something “the market” seems to be belatedly waking up to. Borr Drilling is the ultimate measure of investment risk and sentiment in the alternative investment community in my opinion and serves as a useful barometer for how to perceive market risk.

I think Borr were trying to use the share buyback as a small signal to keep the share price high and to cut the dilution effect that will be imposed on the insiders who hold a large amount of the shares. I think the reactivation of 4 rigs speculatively was literally a gamblers last-roll as there have been no updates since about possible work for these units. A signalling event spectacularly mis-timed given the decline in the price of oil.

Share buybacks, particularly open-ended purchase programmes like the one Borr is engaged in, are extremely well-studied. There is evidence that managers can time the market (i.e. buy the shares cheap) and that smaller firms do this better than bigger firms… but you can also see “Share repurchases as a potential tool to mislead investors“, which is close to what I think happened here, although I temper this a view that offshore seems to have a number of people who see a declining oil price as contrary to some law of nature.

The fabulously optimistic Rystad Energy (more recently here and in direct contravention to DOF on AHTS, (who like actually own boats)) predict higher rates, proof that maybe you can build a great information business without having great information… a skill I grant you.  But there is no question now that most rational participants are coming to grips with the fact that the subsea and offshore market isn’t going to “recover” next year and that leaves Borr Drilling with an enormous funding hole to cover. Borr is the ultimate leveraged play on the “market recovery and scrapping” thesis, a momentum play that has lost inertia, and slowly the (hot) air seems to be draining from this balloon and the market sentiment in general.

 

Offshore takeovers and the psychology of preferences…

Haile selassie.jpg

Courtier T.L. — Amid all the people starving, missionaries and nurses clamoring, students rioting, and police cracking heads, His Serene Majesty went to Eritrea, where he was received by his grandson, Fleet Commander Eskinder Desta, with whom he intended to make an official cruise on the flagship Ethiopia. They could only manage to start one engine, however, and the cruise had to be called off. His Highness then moved to the French ship Protet, where he was received on board by Hiele, the well-known admiral from Marseille. The next day, in the port of Massawa, His Most Ineffable Highness raised himself for the occasion to the rank of Grand Admiral of the Imperial Fleet, and made seven cadets officers, thereby increasing our naval power. Also he summoned the wretched notables from the north who had been accused by the missionaries and nurses of speculation and stealing from the starving, and he conferred high distinctions on them to prove that they were innocent and to curb the foreign gossip and slander.

Ryszard Kapuscinski, “The Emperor” (1978)

“It was surreal. When someone asked why he was doing the deal, here–now, he actually said, basically, ‘Because Americans are the dumbest investors around, and there’s lots of liquidity in this market.’”

From Kathryn Welling

 

An industry in decline has much in common with the decline of an Empire and the ancien regime. The changing of the guard, the Schumpterian competition that upsets the stability of the known order, is a constant in the evolution of social systems. Kapuscinski’s account of the fall of Haile Selassie’s empire is a classic account of a system unable to intepret information in the light of new objective realities with direct relevance to businesses facing structural changes. 

I think one needs to look at recent takeovers in offshore with a degree of cynicism that moves beyond the stated narrative of ‘confidence in the future’ based on rising oil prices, but also reflects the unwillingness of the participants to objectively view the risks being taken as the ancien regime of offshore faces a more competitive environment. One of the best comments I have read on the Tranocean/Ocean Rig deal is from Bassoe Offshore ‘Transocean Saves Ocean Rig from slow-moving train wreck‘. But the article only highlights the huge utilisation risks this deal (like so many others) creates: if the work doesn’t come at forecast levels Transocean will have gifted value to Ocean Rig who had few other options. A collection of rigs in cold-stack is not worth billions.

I would also add that I think the Transocean/Ocean Rig and Tidewater/Gulfmark takeovers bear striking similarities beyond the superficial of underutilised asset companies proffering a Common Knowledge of future confidence in future demand. The core similarity is that the shareholders of the selling entities were largely restructured debt holders and distressed debt investors seeking an exit from their investments. Behind the scenes these investors appear to have looked at the lack of forward demand, the high cash burn rate, and the willingness and ability of their competitors to burn cash with an identical strategy and asset base, and instructed an investment bank to get them out of their position. A peculiarity of the ORIG deal is the ability of the colourful Mr Economou to extract $130m over and above his proportionate economic interest in the company (the MSA break fee in the presentation), a situation that I imagine only encouraged the other shareholders to want to relinquish control (FT Alphaville has some interesting background on the him and here).

It is worth taking a recap on what the Common Knowledge was until quite recently (see here and here ) regarding the offshore industry (pushed by the Missionaries at the investment banks and other promoters). In 2017 and at the start of 2018 a credible story, as can be seen from the Seadrill restructuring presentation below, was for a sharp rebound in day rates and utilisation. The Seadrill restructuring was so complex and long that by late 2017 when it was actually due for completion, an update had to be issued and lo-and-behold the recovery was further off than first anticipated (if at all)…

Seadrill VA Dec 17.png

This presentation was by no means unique. Credible people will tell you that not only will day-rates double in three years (or less), but also that this will happen in addition to utilisation hitting 2014 levels. And this will all happen apparently in an environment where E&P companies are deliberately using shale as a competing investment to lower offshore costs…

It may happen, I don’t know the future, there is Knightian uncertainty, but on a probability weighted basis I would argue these sorts of outcomes are low probability events. The offshore industry will over time reach a new equilibrium in terms of demand and supply, in almost all other industries where there has been severe overcapacity issues before normalisation, it has led to lower structural profits on an ongoing basis.

Financial markets work on narratives and Common Knowledge as much fundamental valuation models rooted in the Efficient Market Hypothesis. Indeed these are the core of a financial bubble: a mis-alignment of current prices with long-term risk-weighted returns. What offshore industry particpants wanted to believe in 2017, against the face of significant evidence to the contrary, was that there would be a quick rebound in the demand for offshore drilling and subsea services. Despite the public pronouncements of the major E&P companies that CapEx was fixed and excess cash would be used to pay shareholders or reduce debt, despite the clear investment boom forming in shale, and despite stubbornly low day rates from their own contracting operations. People wanted to believe.

And so the investors rushed in. For Seadrill, for Borr Drilling, for Standard Drilling, for Solstad Farstad, and a myriad of others. While other investors through restructurings became reluctantly (pre-crash security holders) and willingly (post-crash distress debt investors) owners of these companies. Now, having realised that they own asset heavy companies, losing vast amounts of cash, with no possibility of bank lending to support asset values, and a slow growing market, they want out.

The meme for these deals is meant to be one of success… but really it isn’t. And just as the hard cash flow constraint is binding on the individual companies involved many of the hedge fund investors who get involved in these deals are required to produce quarterly performance reports. Charging 2/20 for an oil derived asset declining in the face of rising oil prices can cause questions, or even worse, redemptions.

So having rapidly opened the ‘black box’ of the companies they own the shareholders in both Gulfmark and ORIG realised that they were the proud owners of companies with no immediate respite from the market. The the most logical way to get out was to get shares in an even bigger entity where the shares are significantly more liquid and tradeable. That management of the acquired entities managed to get an acquisition premium is testament to the skills of the bankers involved no doubt, but also down to the fact that the acquiring companies wanted to be bigger, not because they really believe in a market recovery and pricing power (although the pricing power is valid), but because if or when they next raise capital it is better to be bigger in absolute value terms. Show me the incentive and I’ll show you the outcome…

In behavioural finance it is well known that humans overweight the possibility effect of unlikely high risk outcomes and underweight more likely certainty effects (the canonical reference is here):

POP 2018

What does this mean for offshore in general and Transocean/ORIG in particular? It means that the managers backing this deal are overweighting the possibility of a sudden and unexpected rise in offshore demand versus the more statistically likely chance of a gradual return to equilibrium of the market. It is exactly the same miscalculation that the management and shareholders of Borr Drilling appear to have made. The decline in share values recently indicates some shareholders in all these companies get the deal here. The risk of a slow recovery, and a vast increase in the stacking costs of the ORIG rigs is borne more significantly by Transocean shareholders who have borrowed ~$900m to fund the deal, while the upside is shared on a proportionate economic interest basis.

I have confidence in offshore as a production technique for the long-term. It will be a significant part of the energy mix for the foreseeable future. But a 2008 style recovery, given the importance of shale as a marginal producer and the increased offshore fleet size, looks to be an unlikely outcome that is still being heavily being bet on.

 

Borr Drilling… The Tesla of Offshore…

Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of  . Such units need to”rollover”their liabilities: (e.g. issue new debt to meet commitments on maturing debt)…

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.

Hyman Minsky

It is true that Tesla needed capital to build up its production capacity, especially given its promise to deliver hundreds of thousands of Tesla 3s in 2018, but it is also true that the best way to raise this capital for a company with negative earnings and cash flows and significant growth potential is to use equity, not debt. To the counter that this will cause dilution, it is better to have a diluted share in a much valuable company than a concentrated share of a defaulted entity.

Aswath Damodaran

Borr Drilling is a Rubin’s Vase, just like Tesla. Some see a visionary company accurately calling the end of the offshore down cycle. Others see the worst of the offshore boom with vast, unfunded, embedded leverage in to-be-delivered jack-ups with no work. One (Borr) has a charismatic Chairman while the other has an enigmatic CEO. Both are start-ups funded using vast amounts of debt, and both sail very close to the wind in financial terms. Without spectacular operational success and market growth they will also be terrible financial investments. The comments by the world-renowned valuation expert Aswath Damodaran on Tesla could virtually be repeated for Borr.

For the non-believers Borr is a play on a market recovery in shallow water drilling and operations that has been called too early and simply has no market pricing power or backlog to take on the quantum of new units they have committed to. Transocean and other deepwater drillers exited the shallow water market because just as in subsea there are far lower barriers to entry and therefore more firms compete lowering margins for everyone. The entire jack-up industry is racked by over capacity, has new buildings aplenty to be delivered, has seen the collapse of the shallow water US market (100% due to shale), and has had numerous competitors successfully complete restructurings or fund-raising that allow them to (continue to) operate at cash break-even at best. Direct comparison companies like Shelf, with a far longer operational history, are still losing money.

Don’t get me wrong Borr is a fundraising machine and executes a lot of things. In fact it is clearly part of the strategy: in an under-researched market it hires every conceivable investment bank thereby ensuring nearly all the research on it is positive. And thus the momentum continues… I take my hat off to the sheer outrageousness of the vision: To become a listed contrarian investment almost (bar say Tesla) without equal. This graph from the latest results shows what needs to happen for Borr to have any realistic chance of financial success:

BD Market Q2 2018.png

Activity is in offshore is clearly picking up, I am not denying that, not like 300% though? More of a modest  increase surely… But this graph, if it proves to be an accurate forecast, is amazing. Higher shallow water well investments, in fact almost double, 2010, when shale was far more marginal source of volume and smaller US independents were still doing shallow water work. Note as well how long it took these Final Investment Decisions to flow through to work with the 2008 approvals creating the 2013/14 project boom.

Even more amazing is that E&P companies are promising to sanction such an increase in this niche market without managing to drive up day rates in any of the assets that perform the work or adding substantially to the asset backlog of any asset owners in the space. The public prognostications of E&P company executives that they will not allow a cost explosion in the supply chain are running head-to-head with the investors and management who believe a boom must be coming.

I would be interested to know what sort of price and other assumptions are behind this forecast. As E&P companies don’t publish this data publicly graphs like this without the assumptions the “data” is based on actually useless because without knowing on that you are 100% reliant on quality of the forecast. In order to come up with this number Rystad have had to take actual (and assumed?) project sanctions and multiply them by an internally derived number on field development costs and assumed bidding levels of subcontractors etc. It is better than nothing but it’s all about the room for forecast error which is likely to be huge in something like this. The Gulf States and Asian regions shallow water spending is going up but the NOC’s don’t seem to have increased their CapEx budgets that much so where the money is coming from is an interesting question?

Plus markets are about demand and supply (the core Borr market is the  >350 segment). In 8 years a fleet of assets that lasts 30-35 years has doubled. 31% more (77 units out of 249) are on order and 99 our of 249 units are uncontracted! For this market to even equilibriate at a point where companies are earning their cost of capital requires an enormous move, yet alone make an unexpected gain.

KM August 2018 JU.png

Source: Kennedy Marr, August, 2018.

Borr with assets of $2.6bn, had $54m in the bank of unrestricted cash at the enf of Q2 2018, had an Operating Cash Deficit of $40m in the same period, and made a draw down of $30m on its revolving credit line of $200m, a short-term financing instrument that requires the company to have at least $50m in cash. It has 11 active jack-ups and 12 stacked with 11 to be delivered in the next 27 months. It can only be described as an enormously leveraged (financially and operationally) play on a large unforecasted surge in offshore demand.

BD FA P2.png

So if the market doesn’t grow massively in the next 27 months, or a vast array of the jack-up fleet is scrapped, Borr will have doubled their capacity in a market growing at a much slower rate, where all their competitors have excess capacity and the financial resources to compete on price, and roughly ~30% of the global fleet is still to be delivered. As a general rule firms in such situations, offering a near identical product as their competitors, with strong knowledgeable customers, in a market with widely known price statistics, are called price takers. And in all probability such firms are lucky to cover their cost of capital let alone earn the excess returns shareholders in ventures like these require. The market is fragmented and Borr simply does not have enough market share with 30 odd units to influence pricing.

All the new building are financed by the yards who had no other option but to provide non-takeout vendor financing to Borr. In all reality there were few other buyers. In every shipping and offshore cycle a key signal of excess credit is the unfinanced deliveries where yards and owners take on “take-out” risk (getting a commercial bank on board to pay the yard on delivery). I have no idea what rights Keppel and PPL have if Borr cannot come up with the money in 5 years post delivery, but it must surely involve the ability to wipe out the shareholders? Borr won’t have earned enough by then so if the market does not literally boom then shareholders are buying into a massive funding hole risk. This was a classic Minskian insight into the causes of financial instability (and see the article link above for the original source).

So it was a surprise when Borr announced yesterday they are buying back up to $20m of their shares, and then duly followed up today by stepping into the market today for $420k worth. Borr surely needs more long-term capital not less? Borr will literally have to dip into a short-term loan facility (the revolver) to finance purchasing its own shares when in the very near future it will have to raise significant sources of new funds to pay for its OpEx. This at a time when management say they are going to reactivate units stacked on risk?

The Borr Q2 18 EBITDA figure was $3.2m: they are spending 6x that buying back their own shares? There are very few reasons to do this. The obvious one is to make sure the share price doesn’t dip as you prepare for a major equity raise, potentiall related to a takeover (Borr own options on a listed driller). Only one of those options can solve Borr’s financial constraints as they simply cannot get enough jack-ups to work at rates sufficient to cover anything like their forecast expenditure (and the working capital takes a big hit every time they mobilise one). There will be a deal here. I suspect fundraising for a loss making jack-up firm is getting hard the longer the well-known (sic) offshore recovery takes to arrive and given the sheer scale of the company now getting meaningful percentage increases in capital size. Clearly this very short-term strategy is part of how the Board will deal with this.

Borr has enough asset value to cover this but just like Tesla it has loaded up on convertible debt instead of start-up equity. Returning to the equity market to cover basic OpEx given the scale of the company now is likely to be very expensive.

The other interesting dynamic here is what Schlumberger are going to do as a ~13% shareholder. Schlumberger bailed on Western Geco (seismic) earlier in the month in another clear signal of their intention to focus on shale. They have also pulled out of their Golar venture. Finding another credible shareholder on this scale will not be easy should they choose to leave.

The Borr investment case is based on the scrapping of over 100 units and the Rystad figures leading to over 2.8x increase in FID in their target market. All the people buying the shares are presumably informed financial buyers, some of whom may well just be taking a leveraged play on a dramatic increase in offshore work. There is clearly a market for such an investment.

But as I keep saying here if Borr, like everyone else in the offshore market, keeps raising money to keep capacity high and day rates low, then “the recovery” will by definition never arrive. Which is I admit not quite the same (one of the many?) problem(s) Tesla has at the moment but still bear some striking similarities from a financial perspective.

The wrong side of history…

“Until an hour before the Devil fell, God thought him beautiful in Heaven.” …

The Crucible, Arthur Miller

 

On the IHS Markit projection, by 2023 the Permian is likely to be producing an additional 3m b/d of oil, along with an extra 15 bcf of gas. For the US economy this news is positive. America will have a secure source of supply that, through its production, distribution and consumption, will generate significant economic activity across the country.

The volumes involved will further reduce the unit of production, probably to below $25 a barrel. The study estimates the total investment needed to deliver the new supplies will be some $300bn. For the global oil market the effect will be dramatic. The US will become a significant exporter. The IHS Markit paper suggests that by 2023 the country will be exporting around 4m barrels a day. That will absorb much of the expected growth in demand. [Emphasis added].

Nick Butler, Financial Times, June 25, 2018

 

For one thing, customers have an unfortunate habit of asking about the financial future. Now, if you do someone the single honor of asking him a difficult question, you may be assured that you will get a detailed answer. Rarely will it be the most difficult of all answers – “I don’t know.”

Where are the Customers’ Yachts? 

Fred Schwed

In case you missed it another major pipeline looks certain to go ahead in the Permian by 2020 (in addition of course to the Exxon Mobil 1m b/d). If the 30″ version is selected then 675k barrels a day will be added in export capacity to the port at Corpus Christi, where a major upgrade is also taking place that will allow significantly larger tankers into the region:

Oil export capacity from the Corpus Christi area is expected to rise to 3.3 million bpd by 2021 from 1.3 million bpd this year, keeping its rank as the top oil export port, according to energy research firm Wood Mackenzie.

In fact if you believe Pioneer Natural Resources (on S&P Platts) then Permian pipeline capacity will double by 2020 (to 3.5m b/d) and the US production will reach 15m b/d by 2028. The graphic at the top of the page highlights that top Permian wells are profitable at $22 per barrel. There is a good point on the interview where the CEO of Pioneer points out in 2015 the dominant narrative was shale would go bankrupt and in fact there has been a rebound.

This continuous process of capital deepening, infratsructure upgrades, and productivity improvements has driven the recovery of the US shale industry and has devastated the offshore industry. There is a link: it is not all inventory and reserve rundown. Offshore used to have to run at very high utilisation in order to work and without it the economic model is broken. No other economy in the world excels at this kind of constant, small-scale, mass production improvement like the American economy. Once a product can be mass produced at scale the ability of the US economy to drive down per unit production costs is unmatched.

At the moment there is a boom in the Permian and Eagle Ford basins: wages are high and there are delays and bottlenecks (I read a story last week of a power company demanding 40k to put in one power pole) but this capital deepening will alleviate some of these issues in the short-term. Trucks will be replaced with pipelines etc, a new generation of high spec rigs in the  offing. Deliver, review, improve. Always with a focus on productivity and efficiency. Shale is a process of horsepower and capital and those are two attributes the US economy is preternaturally endowed with. Each incremental pipeline becomes less important in a relative sense so the investment bar is lower. Slowly but surely unit costs get lower every year. It is a relentless and predictable process.

That is the competition for offshore for capital at the margin: an industry improving its efficiency and cost curve with every month that passes. And the solutions to constraint problems in the Permian are on a timescale measured in months while investments in offshore take years to realise.  Offshore offers huge advatages over shale in terms of high volume flow rates and low per barrel lift costs but it is a long term CapEx high industry and not suited to production of marginal volumes. There is every likelihood it is used as a baseload output in years to come while shale supplies marginal demand. This is a massive secular change for offshore and will fundamentally alter the demand curve to a lower level. The clear evidence of this seems to be causing a degree of cognitive dissonance in the offshore industry where any other outcome that a return to the past is discounted.

To just focus the mind: if offshore were to improve productivty by 3% per annum for three years- which is considerably slower than the productivity improvement in shale – day rates for offshore assets in 3 years would need to be at c.92% of current levels per unit of output (i.e. a 8% reduction [1/1.03^3]). Not all of this is going to be possible in offshore execution terms given the aset base, some of this will come from equipment suppliers who are manufacturers and subject to scale economies reducing costs, but this is the challenge for offshore bounded by Bamoul constraints. There are limits to the volumes that can be produced by shale but they have constantly exceeded market expectations and they have eaten a meaningful share of global oil output and this will not change only increase.

As the graphic below shows this is a supply side revolution as demand for the underlying commodity has increased consistently since 2006:

Global Oil Demand 2006 to 2018F

IMG_0611.jpg

So the only possible explanation for the continuing drop in the utilisation of offshore assets is that the demand has fallen for their use relative to the global demand for the underlying commodity they help produce.  I accept that may look tautological but we just need to clear that point out early.

I have been on before about how I don’t think a quick recovery is likely for the offshore market for those long on offshore delivery assets only (the tier one SURF contractors are different as their returns are driven by engineering as well as asset leverage). I can’t see how an industry like the shale can develop in parallel with a “snap back” in offshore, particularly when the larger E&P companies have been consistent and vocal about limiting CapEx.

The reason jack-up companies are like offshore supply companies, and not SURF contractors, is that they take no project risk. An oil company doesn’t handover well risk to a drilling contractor (as Macondo showed). Shallow water drilling contractors are the AHTS and PSV of drilling: you get a day rate and that is the only value we expect you to provide. It is an asset return and utilisation gig completely different from SURF contracting. And yet against this background there is a bubble developing in the jack-up market seemingly unsupported by any fundamental demand side recovery. I am not alone here: McKinsey forecast jack-up demand to rise 2% per annum to 2030 (about a 10% growth in market size over the next five years).

Bassoe on the other hand are forecasting that day rates will double in the jack-up market in five years, which equates to a 15% compound average growth rate.  I realise this narrative is one everyone wants to hear, you can almost hear the sighs of relief in New York and London as the hedge funds say “finally someone has found a way to make money in offshore and profit from the downturn”. And as the bankers stuff their best hedge fund clients full of these jack-up companies stock this is the meme they need as well. At least in this day and age the investors have better yachts than the bankers.

Yet the entire jack-up market thesis seems to rest on the accepted market narrative of scrapping and therefore higher utilisation. As Bassoe state:

If 85% jackup utilization seems relatively certain, then a doubling of dayrates is too.

Certain is a strong word about the future… As if the entire E&P supply chain will benignly accept day rates increasing 15% Y-O-Y from every single market participant without worrying about it…

Ensco is a good place to look because it also considers itself a leader in premium jack-ups. Ensco has exactly the same business model as Borr and Shelf (indeed it is focusing on exactly the same market segment in jack-ups): raise a ton of money, go long on premium assets and wait for the market to recover… Ensco’s recently filed 10K shows how well this jack-up recovery is going:

Ensco q1 2018.png

Oh hold on it doesn’t show that at all! Instead it shows the jack-up business revenue declined 17% Q1 18 versus Q1 17. Awkward… So like everyone else here is the crunch of the “market must come back” narrative: Scrapping.

Ensco jackup fleet forecast.png

The problem with this argument is the scale of the scrapping required in the red bars (not to mention the assumptions on China). If that slows and/or the market growth doesn’t quite come then the obvious downside is that there are too many jack-ups for the amount of work around. Somewhere between 2% and 15% compound per annum leaves a lot of room for error.

When your revenue figures drop 17% on the previous year management in most normal companies, but especially those with a very high fixed cost base and a disposable inventory base (i.e. days for sale), tells the sales reps to cut the price and win market share. And that is exactly what will happen here. In fact far more accurate than forecasting the market is an iron law of economics that in an industry with excess capacity and high fixed costs firms will compete on price for market share. Investors going long on jack-ups are making a very complicated bet that the market growth will outpace scrapping in a way it hasn’t done in the past despite E&P companies being under huge pressure to keep per unit production costs low.

On the point of the age of the jack-up fleet: this is clearly valid to a degree. But as anyone who has negotiated with an NOC in places in South East Asia and Africa can tell you all this talk of new and safe over price is Hocus Pocus. Otherwise in the greatest down market around none of these units would be working or getting new work and that clearly isn’t the case.

In fact in many manufacturing businesses old machines, fully depreciated and therefore providing only positive cash flow to the P&L, are highly prized if they are reliable. There is no evidence that this will not happen in offshore and plenty of counter-examples showing that oil companies will take cheaper older assets. The best example is Standard Drilling: bringing 15 year old PSVs back to the North Sea that were originally DPI, and getting decent summer utilisation (day rates are another issue but for obvious reasons). Eventually as the munificence of an industry declines the bean-counters overpower the engineers and this is what I believe will happen here, there is plenty of evidence of it happening in offshore at the moment. Every single contracts manager in offshore has had a ridiculous conversation with an E&P company along the lines of: “we want a brand new DP III DSV, 120m x 23, 200t crane, SPS compliant, and build year no later than 2014 and it’s a global standard… and we want to pay 30k a day”… and then they go for the 30k a day option which is nothing like the tender spec.

The reason is this: North Sea E&P companies are competing against shale for scarce capital resources and they need to drive costs out of the supply chain constantly. Offshore has dropped its costs in a large part because the equity in many assets and companies has been wiped out, that is not sustainable, but what is really unlikely to happen here is a whole pile of asset managers wake up simultaneously at E&P companies over the next three years and tell people to wholesale scrap units knowing it will increase their per barrel recovery costs while watching shale producers test new productivity levels.

There may well be a gradual process on a unit-by-unit basis, a cost benefit analysis as the result of some pre-survey work or a reports from a offshore crew that the unit isn’t safe, but not suddenly 30 or 40 units a year, and if does happen too quickly and prices rise then the E&P companies will revert to older units to cap costs. Fleet replacement will be a gradual process and some operators will be so keen to save money that they will let some older units be upgraded because it will have a lower long term day rate than a newer unit because they get that to continue to have capital allocated they need to drive their costs down.

The investment bubble in jack-ups is centred on Borr Drilling and Shelf Drilling. These companies have no ability or intention to pay dividends for the next few years. Credit to them: raising that sort of money is not easy and if the market is open you should take the money. Their strategy, in an industry that patently needs less capital to help rebalance, is to add more and wait for a recovery. Place everything on 18 red at the casino. Wait for higher prices and utilisation than everyone else despite doing exactly the same thing (just better). And that’s fine it’s private money, and it might work. But economic theory I would argue suggests it is extremely unlikely, and it will be a statistical outlier if it does. Five years ago the US shale industry was producing minimal amounts and the dominant thought was they required $100 oil to work so think how different the world will be by the time these companies have any hope of returning cash to investors?

Forecasts are hardly ever right, not for lack of effort but the inability to take into account the sheer number of random variables, the epsilon, in any social process. Forecasts that a segment of the offshore market will double given the headwinds raging against it should probably be viewed as bold, a starting point for debate rather than a base case for investments. Having picked 9 of the last 0 housing crashes you should also realise that while my arguments will eventually be proven right the timing of them can be wildly inaccurate as well.

Random Friday afternoon thought… Borr and McKinsey….

They both can’t be right can they?

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

McKinsey jackup demand 1.0.png

From a recent Borr Drilling presentation:

Borr Jackups business.png

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

Borr fleet status.png

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

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

Roll the dice!

 

Rigs and vessels… traders become operators…

Yet again another great commentary from Bassoe on the Borr acquisition of Paragon. I like this bit:

In the beginning, some may have considered Borr to be an asset play with no intention of becoming a long-term, established contractor.  The company could stack its rigs efficiently, wait for a rise in rig values, and sell everything for a profit.  In and out.

As time went on, Borr continued adding assets.   And although jackup values rose (primarily as a result of Borr’s transactions), the prospect of Borr selling off rigs at higher prices faded as they eventually became too big for any of the established drilling contractors to acquire them.

Whether this was the plan the from the beginning or something that just happened over time, the quick sale and profit option became less tenable.   So what could have started as a pure asset-flipping maneuver turned into a deliberate quest to become a fully-fledged drilling contractor. [Emphasis added.]

That has happened to a lot of people in the industry. Standard Drilling now aim for medium term capital appreciation, which is a significant change in their original position. The Nor bondholders had to sell out to an operational company in less than a year after their 2016 capital raise. York can’t really believe the Bibby DSVs or their Rever Offshore assets will ever appreciate? Will the Boa Deep C and Sub C ever return to active service? What on earth will someone pay for the Lewek Constellation? etc…

Without some fundamental change in the demand side of the market the asset recovery story should really be dead-and-buried now under a welter of evidence and transactions. You need to be long delivery capability and short assets to profit from “The New Offshore”. Backlog, liquidity, and capability. Everything else is noise.