Subsea 7 (and Chiyoda) lose the plot… And the Red Queen theory.

I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.

Maslow, 1966 (often referred to as “The Law of the Instrument”)

I’ve thought about it all day… and had five double espressos, (so I’m in the mood for a rant)… but try as I might I see no sensible rationale for Subsea 7 turning from an offshore contractor into a provider of Debtor-in-Possession  (“DIP”) financing for a failed offshore company. I see no strategic rationale for this at all… When I say none I guess simplistically if you could buy some work then maybe, but I’ll come back to this, because what are you actually buying?

Subsea 7 and Chiyoda extending DIP financing strikes me as the final stage of lunacy before acceptance that the industry is going to be very different in the future from 2014. This deal looks like one put together by bankers (for the fees); lawyers, promising they can mitigate any losses structurally, and they probably can here (for the fees), and corporate development staff desperate to show they are “adding value” by buying some options. There is no industrial logic to this deal at all. The reason EMAS Chiyoda is in Chap 11 is because there was insufficient demand for what they offered, and when they did manage to win work and deliver it, the end product was substandard and normally over budget. It’s that simple.

The hardest thing to do sometimes is nothing, which is what needed to happen here. When a market contracts capacity needs to as well, and the weakest, most inefficient, and poorly run companies need to go. Schumpeter rightly called this “gales of creative destruction”. And boy did EMAS Chiyoda need to go. Everyone at Subsea 7, and particularly the Directors, have better things to do than try and be too clever here and spend time, and money, on an angle that is opaque when the answer is blindingly obvious. This is a deal being done because it can and because people need to be seen to be doing something. When you’re a banker, a lawyer, or an corporate M&A person, the answer is always a deal, no matter how complicated, or frankly illogical. This was a deal done because a hammer thinks it can see a nail.

Economists have put a lot of effort into studying organizational change at the population level in a field known as “organisational ecology”. I am a subscriber to “Red Queen” theory:

which highlights the relative nature of progress. The theory is borrowed from ecology’s Red Queen hypothesis that successful adaptation in one species is tantamount to a worsening environment for others, which must adapt in turn to cope with the new conditions. The theory’s name is inspired by the character in Lewis Carroll’s Through the Looking Glass who seems to be running but is staying on the same spot. In a 1996 paper, William Barnett describes Red Queen competition among organizations as a process of mutual learning. A company is forced by direct competition to improve its performance, in turn increasing the pressure on its rivals, thus creating a virtuous circle of learning and competition.

Simply put EMAS Chiyoda was “maladapted” for the new economic environment. [The best paper ever on revolutionary change and organisations is this one on the “Punctuated Equilibrium” if you are interested. Offshore oil and gas has definitely been through a period of stasis followed by a punctuated equilibrium.] Anyway…

Firstly, Subsea 7 really doesn’t need an more vessels: they have 33 committed vessels at the moment, a relatively poor order book given the fixed cost commitments, and no capacity issues.The current committed fleet cover every possible industrial, and geographic, permutation the most pedantic engineer could dream up. Subsea 7 needs a vessel like the Lewek Constellation like I need to be left at home with the kids indefinitely: it just wouldn’t be good for either party. Don’t worry about someone else being dumb enough to take it at any price, there has been a huge capacity and capability increase in shallow and deepwater pipelay in the last 5 years, the top 6 players are fine for the next 9 shale revolutions. Anyone taking on that vessel is assuming a liability certainly, and maybe an opportunity: it’s the banks problem don’t make it yours.

The reason 2014 was boom was because there was insufficient supply combined with high demand. While demand might recover the supply is now fixed, so even an increase in demand won’t make an EPIC pipelay resurgence a boom (and no independent data suggest this is likely anyway). I get Boards need to think of the future, but surely the most logical strategy here it to back yourself for margin expansion: if the market recovers try and recover some of the equity lost in the last three years? The solution to a capacity problem probably isn’t another cheap vessel.

Yes, the Lewek Constellation is a really capable ship (although built in Vietnam at Triyards so you’d want a good survey before taking ownership), but I am about to share a shock revelation with you: there are loads of really capable ships with no work at the moment, and they cost a lot to run. In the last Subsea 7 results backlog was down nearly USD 1bn… as a general rule going long on fixed assets with a high running cost while you’re order book is shrinking is a bad idea.

If Subsea 7 want to do something positive with the EMAS Chiyoda vessels I suggest they team up with McDermott, Technip, and Saipem for an en bloc deal with the banks and sink them somewhere. That is likely than being a better investment than getting some of this tonnage “cheap”. The Constellation would be a far safer, and more interesting, dive than the Thistlegorm and potentially more value accretive this way. (Competition authorities please note this should not be construed as investment advice or an inducement to collusion).

Should Subsea 7 really believe it has insufficient pipelay capacity in Asia it should go to Petrobras and strike a deal to remove one of the flexlay vessels from the region (which are far more capable than the EMAS Chiyoda fleet). Operationally they are perfect for Asia, and they might make more money this way that getting it redelivered under a technicality, which PB seems prone to at the moment. Subsea 7 need to harden-up, back themselves competitively, and realise some vessels need to leave this market. Pipelay is hard: jobs are bid a long time in advance, you need a lot of working capital, even tendering is expensive, and in this market E&P companies are going with the safest options etc.: the chances of an upstart picking up the EMAS Chiyoda vessels and winning sensible work at a decent margin in literally trivial.

The other major problem, far greater actually,  is that it is well known at a project level that the engineering EMAS Chiyoda has been doing, for at least the last twelve months, is some of the shoddiest ever seen in the industry. Subsea 7 needs projects, not capacity, and any short-term vessel needs can be met on the charter market. What the Subsea 7 backlog definitely doesn’t need is a commitment to deliver projects bid by a company tendering where the management were telling the engineers they must “win at all costs” to keep their jobs. Subsea 7 wants to be really careful about accessing this work because if the contracts are simply novated across they have brought backlog without any controls over how it was bid, from a firm with a history of losing money on offshore delivery. If they aren’t novating the contracts why bother supplying financing? E&P companies take a huge risk when awarding lump sum in that progress payments are effectively unsecured creditors, and on big projects, like Jack St Malo, this is a material number. But much of the offshore work is vessel specific anyway and that takes us back to the problem that Subsea 7 doesn’t need to help the customers, or creditors, by chartering these vessels to deliver the projects. This is just a bad idea.

Subsea 7 could offer to help due diligence the bid project work, or maybe adapt it to their vessels for free (but that just dilutes margin), but honouring EMAS Chiyoda contracts would be an act of commercial madness in all but the most exceptional circumstances (and a clear incentive mechanism is created here for the people from Subsea 7 who negotiated these agreements to encourage the company to take these risks to prove they struck a good deal: it’s a personal asymetric payoff which should always make you cautious).

The real solution here is just to let EMAS Chiyoda go to the wall. I feel terrible for the staff, but unfortunately the world has changed and there is simply no industrial logic for its continued existence. No one needs the assets, or the second-rate, uneconomic, but exceedingly cheap (in all senses) solutions it offered. The industry will be a better place with it gone and instead of trying to work out some really clever angle to this Subsea 7 just need to help it happen.

EMAS… I never saw that coming!

Of course I saw the Chap 11/ restructuring event coming… what I didn’t see coming was buried in the filing where Subsea7 and Chiyoda appear to have entered into a Debtor-in-Possession credit agreement. I can only assume they want the work booked already with Chevron and in Africa.

Normally DIP (“super senior”) is provided by banks and starts the dilution process for unsecured crditors. I didn’t think this gave providers preferential rights to assets etc (other than secured for collateral). Frankly SS7 has too many ships, and I would have thought Chiyoda had had all the fun it could handle in subsea, so I will be interested to see what comes of this…

One E(nor)MAS Chiyoda mess…

our-fleet-inspector-top.jpg

I hope the agreement Forland Shipping reached with EMAS Chiyoda was that if they didn’t get cash up front they were going to take their ship, with all the project equipment on board, and sail away. Let the lawyers fight out preferential creditor treatment once you have the money. Unlike Ocean Yield (“OY”) Forland are on a time charter and as a small operator they simply cannot afford to take the hit here because the more I look at this the more convinced I am that we are heading for an administration scenario here.

I read the EZRA and EMAS financial information this morning so you don’t have to… As a general rule when accounts are so byzantine I treat them with increasing scepticism… and with my Minsky debt hat on this morning I see why…

Before I bore you with some numbers, and therefore those who aren’t interested can switch off, just look at this from the ‘big picture’ scenario: EMAS Chiyoda charters the majority of its assets off either EZRA/EMAS and its associates or bareboat charters from OY or time charters from Forland. They have a cash problem and want the shareholders to participate in a fundraising while also seeking a creditor solution. What the EZRA/EMAS side want in effect, given their asset concentration through charters on the Lewek Constellation, the barges etc, is Chiyoda and NYK to fund 60% of these charters as well as providing a credible financing path to winning long-term projects. Fool me once it’s your fault, fool me twice it’s mine…

Chioyda paid USD 180m in April for a 50% stake to EZRA (USD 360m equity value) and of the consideration USD 30m was given as working capital to the company. Later EZRA sold a 10% stake to NYK for USD 36m (in order to keep the valuation constant I assume). For c. USD 186m the Japanese investors have ended up with a 60% share in a company with no work and some very expensive vessel charters to the seller of their “investment”… (imagine the hangover… pass the sake please it’s a bad morning…?)

Apart from that it’s all going swimmingly well… Or is it? I understand the work for BHP in Caribbean (Angostura) was a disaster financially. Having taken lump sum construction risk the weather and currents worked against them (read: poor tendering and the need to buy work) and BHP didn’t accept any variation orders. If correct this was surely part of the issue in the quick onset of these financial issues and will make fundraising even harder.

You can imagine the Japanese joint criteria for any further investment: they aren’t going to put more money in now until the sellers (and probably OY and Forland as well) take substantial reductions in the fixed cost base i.e. the vessels. But EZRA/EMAS can’t do that because they have their own financial problems. EZRA has provided guarantees for many of EMAS’s charters and EMAS, 75% owned by EZRA, is insolvent effectively if the assets were to be liquidated in the current market.  EMAS has announced it has reached a term sheet deal with its lenders, and given the PSV and AHTS exposure this is no surprise, but the equity in this business has in effect gone.  One of the minor highlights of interest from the most recent accounts is the split of EZRA/ EMAS originally generated goodwill of USD 154m via the transaction but EMAS has just written its equity down to USD 90m. On an asset base that big in an illiquid market like this that is within the margin of error and the line between insolvency and illiquidity becomes akin to taking a measuring stick to Lilliput. All that is solid melts into air

So in reality that leaves EZRA as the owner of Triyards and a minority shareholder in a bankrupt contractor which is the largest customer of its asset base.  On 31 August 2016 EZRA had debts due within 12 months of USD 1.1bn which mean they are long-term debts that have fallen current and the senior lenders understand how serious this is and EZRA states that if agreement cannot be reached with them it has a going concern issue (Net Debt to Equity having risen from 0.77 to 3.05 in one year). EZRA have negligible cash in relation to this and their biggest asset, the Lewek Constellation, wouldn’t be worth half of what they paid for it if it could be sold at all. And therein lies the problem in financing anything because even if you believed EMAS Chiyoda could be competitive in deepwater installation the shareholders are not going to inject capital at historic asset levels in today’s market given the risks, but without fresh capital into EMAS Chiyoda, EZRA cannot support its debt on the assets. The amount of money now required to make EMAS Chioyda a viable proposition in deepwater construction, where tens of millions are handed over in procurement and engineering prior to offshore execution, is I believe prohibitive to any rational investor. At the moment the CFO of any major project where EMAS Chiyoda has bid is calling up the tendering guys and telling them to throw that bid in the trash no matter how good the terms. This will takes weeks of financial stability to turn around not 60 days and will involve some serious write downs from the banks… so park that in the unlikely space.

If L&T ride to the rescue to protect the single Saudi contract it will be an assets only deal. In distress M&A you may be able to find a credible white knight to alleviate this concern but this isn’t likely here given the inter-relationships and the size of the debt obligations that need to be met. Either that or the Japanese have been the smartest guys in the room and they are just going to call the EZRA banks and offer to take the assets they want at pennies in the dollar and then inject some real equity into the “JV” and dilute EZRA out?

This brings us nicely to the problems of debt and as always therefore to Hyman Minsky. Minsky would have termed EZRA/EMAS a firm financed by Ponzi finance, not indicating criminality, but a firm that had to constantly keep borrowing to meet its debt obligations. Forland would have been categorised as a speculative firm, in that it had difficulty meeting payment obligation in the short term (although in such pro-cyclical asset industry the line between solvency and liquidity is very thin); most firms in offshore would fall into this category. OY however, even with re-delivered tonnage, would only be a hedge firm, able to meet cash expenses from income, the redelivery will hurt the dividend but isn’t fatal (and highlights again the quality of the management at OY).

Both EZRA/EMAS and Forland in their own way were able to grow on the back of a massive investment bubble. EZRA constantly grew by borrowing and creating little industrial value; the decision of lenders to allow it to build the Constellation, a vessel so outside its known technical parameters as a company and in relation to its balance sheet, was a sign of how far the market had peaked. It’s an amazing vessel but it takes more than offshore crew to make it work, the balance sheet and in-house competencies to generate regular work at the margin levels to pay for that vessel were never there. Much like a bank EMAS became an asymmetric payoff model except there will be no lender of last resort here (although whether OCBC and DBS are allowed to use a proportion of their exposure for liquidity purposes at MAS is a whole different story).

Forland was typical of the smaller end of the bubble where a small Norwegian ship owner was able to take on extreme leverage based on a counter party with very little equity and on a charter substantially less than the economic life of the asset. Provided everyone kept paying there was no problem. But as Minsky always stated it was the cash flows, the hard financing constraint, that started the reflexive cycle to asset prices…

Unless there was some pre-funding commitment as part of the original sale to the Japanese (which surely would have been invoked now) this refinancing just looks too hard. Too many players, too many different tranches of securities and agendas, and simply not enough time if there are cash flow problems now. And unlike Italian banks I can’t see three rounds of rights issues, each one ever more dilutive than the last, being a viable strategy here.

The Singaporean judicial management process just isn’t developed enough for this either being relatively new so this is going to be a mess which means that OY are getting the Lewek Connector back without a shadow of doubt and Forland will get the Lewek Inspector back as well.

As a wise New Zealand philosopher once remarked: if something is impossible it isn’t likely to happen…

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.