Bully for Brontosaurus…

“I am truly convinced that both the shipping and the offshore markets will recover.”

Mads Syversen, CEO Arctic Securities (26 Jan 2016)

Arctic and ABG Merger valuation.png

From the Solstad Farstad merger prospectus (9 May 2017) highglighting the extreme optimism of the investment bankers putting the deal together. It should be noted the asset market was under huge stress at the time (the bankers of course were paid in cash on completion).

The Golden Bough

In point of fact magicians appear to have often developed into chiefs and kings.

 James George Frazer, “The Golden Bough” (1890)

The Emporer

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)

Mons Aase, DOF Subsea CEO, said: “The appointment of Mr. Riise is an important step towards realizing our vision of being a world-class integrated offshore company, delivering marine services and subsea solutions responsibly, balancing risk and opportunity in a sustainable way, together, every day. I look forward to working closely with our new CCO and I welcome Steinar to DOF Subsea.” (15 October, 2018)

“Our business will probably die over the next 10 yrs because the demand for oil probably will start peaking – we think in 2028-2029.”

Ian Taylor, Vittol Chairman, June 8, 2019

“If you get lucky for a long period of time, you think the rules don’t apply to you… These guys thought they could walk on water. They weren’t smart, they were lucky”.

Maarten Van Eden, Anglo Irish Bank CFO, in Anglo Republic: The Bank that Broke Ireland

(Anglo Irish bank initially assessed its downside losses in the credit crunch at less than €2bn. Over €45bn later they had nearly bankrupted the Irish state by lending on illiquid property assets reliant on a booming Irish economy and a global credit boom).

 

Have a look at the graph in the header, particularly 2016/17, and then the Solstad liabilities for 2016/17, just as they were “buying” Farstad and DeepSea Supply:

Solstad liabilities 2016_17.png

(I saying “buying” because it was then second major rescue attempt after Aker made a spectacular error in timing with REM. It was a deal pushed by the bankers who didn’t want to deal with consequences of Farstad and Deepsea Supply).

That would be just the time the rig count in the Permain was to explode:

BH rig count June 2019.jpg

And here are the latest Solstad Q1 2019 liability figues:

Solstad Q1 2019 Liabilities.png

Roughly NOK 2bn higher! The assets are older, the market isn’t much better, and they owe NOK 2bn more! (Don’t get me started on look at the assets side of the balance sheet: it was well known the Farstad/DESS were worth significantly less than book value).

If you believed Solstad had a future in anything like its current form you would be asked to believe the impossible: that despite the most extraordinary structural shift the oil and gas industry, despite owning depreciating assets barely covering actual running costs, despite no indication of oversupply ending (and in fact every indication that funding a mutually assured destructive battle will continue with NAO planning to raise money), you would be asked to believe Solstad could actually pay that money back… And of course they can’t: the numbers on paper, the amounts the banks and creditors claim they are due, are indeed a fantasy. A wish, with no basis in economic substance despite their accounting clarity.

Solstad made an operating profit of NOK 162 918 000 in Q1 2019 on NOK 33bn of balance sheet and asset risk. If someone had lost the petty cash tin they would have been in a loss. It’s totally unsustainable.

It may have been reasonable to believe that NOK 30bn of debt could be supported by offshore demand when the US graph was at 2014 levels but it is no longer credible now. Too much of the investment and maintenance expenditure flowing through the global energy industry is just going to other places. This is a structural shift in the industry not a temporary drop in demand like 2009.

I am not picking on Solstad here, they are just the most obvious example as their resolution seems (reasonably) imminent. Without exception all these crazy asset play deals that relied on the market coming back will fail.

When I was at university I first read the palaeontologist Stephen J Gould who introduced me to the difference between Lamarckian and Darwinian evolution (Bully for Brontasaurus). If you can’t bothered clicking through to the links the easiest way to think about this (in a purely demonstrative example) is that Lamarckian evolution argues that giraffes evolved by gradually growing longer necks and reaching for higher leaves on trees that others couldn’t reach – which is wrong. One of the many brilliant things about Darwin was that he realised that it was the randomness in evolution that caused the process – giraffes that just happened to have the long neck gene prospered and had more baby giraffes and passed the gene on. The race of giraffes that prospered was the result of random selection that ended up adapting best to their environment. They got lucky not smart.

Offshore is full of companies that may have been lucky on the way up but are totally inappropriate financial and operational structures to survive in the modern energy era. Evolution is a brutal, mechanical, and forward acting process. It is irreversible and path dependent. In economics the randomness of the evolutionary process is well understood with most research showing industry effects are stronger than firm effects. By dint of randomness the genes of many of the asset heavy offshore companies companies, but especially those with debt held constant at 2015/16 levels, are fundamentally unsuited to their new environment.

In case you are wondering where I am going with this (and want to stop reading now) I have two points:

  • A lot of the offshore supply chain confused managerial brilliance on the ride up to 2014 with good luck, a high oil price, and a credit bubble. Seemingly being lucky enough to have been running small fishing vessels when North Sea oil was found was rarely posited as an explanation for the growth of many West Coast Norwegian offshore firms, but it is in reality true. A random act of economic circumstance that threw them into a rising commodity and credit bubble. A newer, far less wealthy, future beckons for many of the small coastal towns that supported this boom.
  • The randomness of US geology colliding with the most efficient capital markets in the world, the largest energy consuming nation, and technological circumstance has caused a complete change in the structure in the underlying oil market. The profound implication for North Sea producers, and the supply chain underpinning them, is a transition to be an ever more marginal part of the global supply chain. That will mean less dollars in flow to them and that however long companies try to fight this will be in vain because we are dealing with a profound structural change not a temporary reduction in demand.

What the offshore industry is faced with now is a fundamental regime change – in its broadest sense both statistically (which I have argued before) and sociologically. The economic models of debt fuelled boats and rigs with smaller contractors are over in principal. It’s just the messy and awkward stage of getting to the other side that beckons now.

For pure SURF contracting and drilling consolidation is the answer and will occur. Financial markets will squeeze all but the largest companies from taking asset risk. DOF Subsea’s business model of buying ships Technip wasn’t sure about long-term will look like the short term aberration to economic rationality it was. For offshore supply the industry will be structurally less profitable forever. Asia shows the future of offshore is a vast array of smaller contractors, operating on minimal margin and taking vast risks, and yet the E&P companies are happy with this outcome because they get competitive prices. There is no reason to believe this model will not work in Europe as well. Where procurement is regional there are no advantages to being a global operator as the unit onshore costs are such a small proportion of the offshore/asset costs.

Although it feels unique to many in offshore it isn’t. If you only read one book about a collapse of ancien regime make sure it is Ryszard Kapuscinski’s “The Emperor” (1978)  on the collapsing Ethiopian empire. By interviewing a large number of the courtiers Kapuscinski gets you into the collective mind of an institution unable to face the reality of circumstance. The inability of Haile Selassie to realise that his random luck was totally unsuited to adaptation in the modern world is deeply reminiscent of the management in offshore, and to a certain extent the banks behind it (I’ll write more on the Stiglitz- Grossman paradox which answers why this may occur later).

Slowly the power and the capital of marginal oil production is being shifted to the Lower 48. Make no mistake the replacement of low capital cost Super Majors for high cost of capital (often PE backed) E&P companies in the North Sea marks the slow withdrawal of capital long-term from the area. Note not removal: just slower investment, higher cost hurdles, more pressure on cost etc. That will require a structurally smaller supply chain.

Old capital structures, and especially debt obligations, written in the good times will be completely re-written. Over the next couple of years the Nordic banks are going to write off billions dollars (that isn’t a misprint) as the hope thesis of recovery loses credibility. They will shut down credit to all but the most worth borrowers and sellable assets (if you think that is happening now you aren’t watching the crazy deals going on in the rig market). Equity across the industry will rise and leverage will substantially decline.  Smaller operators will vanish driven the same process reducing biodiversity on earth now: a less munificent environment. I believe when these banks have to start really taking write-offs, and Solstad and DOF are important here because they are close in time and significant in value, bank loan books will in effect close for all but the largest companies. In the rig market where are few companies have been responsible for nearly all the deals and private bubble has built up in the assets this will be contrasted with a nuclear winter of credit. And if banks aren’t lending then asset values fall dramatically.

How much is the Skandi Nitteroi really worth? There is no spot market for PLSVs, Petrobras have no tenders for flexlay? No one else capable using it needs one and Seadras are getting theirs redelivered? Banks are going to take the hit here and then the industry will really feel it.

I am reading Anglo Republic, a book about the collapse of Anglo Irish Bank, at the moment. Again the inability of management (and Treasury, and the goverment) to see the scale of the losses has a strong parallel with offshore. And like offshore initially everyone believed the Irish propery market would come back, that liquidity not solvency was the problem, that this was temporary blip. The crisis was a slow burner for this reason. But when it really came, just like all asset heavy industries, it starts with the refusal of credit institutions to renew liquidity lines because they know it’s a solvency problem. And that is why Solstad and and DOF are significant. They are the BNP Paribas of the next phase. But you know what… my next book is this, and it will have the same story of excessive optimism, leverage, an event (literally a revolution in this case), and default. If there are only really seven major plots in literature there is surely smaller set in economic history? So we know what is coming here.

This needs to happen in an economic sense. The cost to produce offshore will have to rise to reflect the enormous risk the supply chain take in supplying these hugely unique assets on a contract basis. But for this to happen there needs to be a major reduction in supply and it needs to happen while competing against shale for E&P production share. And it cannot happen while the industry continues to attract liquidity from those who buy assets solely on the basis of their perceived discount to 2016 asset values in the hope of a ‘recovery’ to previous profitability levels.

Which brings us on to what will happen to Solstad? It is in the interests of both the major equity investors (Aker/ Fredrikson) and the banks to play for time here. I fully expect a postponement of the 20 June deadline. Next summer, the bankers will tell themselves, the rates will be high and we will be fine (just like the Irish bankers and countless others before). But some of the smaller syndicate banks clearly get the picture here, the business is effectively trading while insolvent, regulators will also eventually lose patience, and the passage of time will not be kind. The solution everyone wants: to put no more money in and get all their money back isn’t going to happen.

Normally in situations like this, where the duration of the assets is long and illiquid, like a failed bank, a ‘bad bank’ and a ‘good bank’ are created. One runs down (as DVB Bank is doing with offshore) and the good one trades and is sold (as DVB Bank have done with aircraft finance). That would see the Solstad of old split off into a CSV fleet maybe or a Solstad North Sea while the old Asian/Brazil DESS was liquidated and the Farstad AHTS business also liquidated. But that will require the banks writing off c. NOK 20bn (maybe more) and I don’t think they are there yet.

After Solstad comes DOF. And in all likelihood following them will be some smaller tier 2 contractors, and certainly some rig companies, who realize that in an economic sense this just cannot continue. No matter how hard they keep reaching for the greener leaves higher up.

How much more recovery can the industry handle?

Results from HugeStadSea for Q4 were predictably dire. I like the line “project to spin off non core fleet initiated – no transaction concluded so far“. That would be like the entire DeepSea Supply fleet they merged with a year ago? This is rapidly turning into a huge embarrassment for the companies, directors, and advisers involved in this: it was obvious at the time it was a terrible idea, and it is even more obvious, and cash depleting, today.

To be clear: SolstadFarstad made NOK 741m from operating its vessels in the quarter, and paid interest of NOK 1.1bn (and made a debt repayment of NOK 1.4bn). A giant restructuring beckons here when a) someone figures out how to break it to the banks and bondholders that they need to take a 30-50% haircut on their debt; and, b) the investment bankers and lawyers are sure the company has enough money to make it worthwhile to tell the balance sheet banks and bondholders this.

I recently spoke with a shipbroker who assured me that Reach had chartered the Normand Vision for their most recent job for between NOK 275-325k a day. That included 50% Oceaneering ROV crew and Proserv survey, Reach supplied the rest of crew. SolstadFarstad are desperate for other offers of work and longer term work could be had potentially cheaper. That’s for work in 2018. So much for the Vision being a strategic asset for OI… Banks looking at those sorts of numbers must realise the game is up.

Siem Offshore also came out with a loss and said:

Although we expect an uptick in the activity level during the summer period, we believe that the market rates will remain volatile and generally low in 2018.

Despite indications of increased activity, the timing of a significant sustainable improvement in utilization and rates is uncertain and this situation will continue to put financial pressure on owners and lenders.

And DOF, where the real takeaway is the business is substantially smaller in revenue terms than 2016, but with just as many assets and as much debt:

DOF Subsea Q4 17

And in case you think that is because DOF is a supply heavy company look at the DOF Subsea results:

DOF Subsea Q4 2017

I get that the recovery may in 2018… but why is backlog down then? When the DOF Subsea IPO  was pulled an offshore publication and consulting business, with a strong track record in music, announced it as a sign of confidence from the shareholders… I hope no one brought DSVs based on their advice?

I don’t have a magic solution, but I would say that reports of a general market recovery seem somewhat premature. Some segments of the offshore market are doing well and growing again, but those that are asset heavy, and leverage high, are unlikely to see a recovery for the foreseeable future.

Follow the money… it’s all in the numbers…

“We no longer believe because it is absurd: it is absurd because we must believe.”

 Julio Cortázar, Around the Day in Eighty Worlds

At some point companies are going to have to stop reporting poor financial results and say things are looking good from a tendering perspective to retain credibility (or will they maybe their shareholders want to believe as well?). This week Solstad seemed to pull this trick, while the most brazen appears to be Subsea 7 who while annoucing that their order book had dropped significantly, stated that:

[We have] [c]ause to believe in an improvement in SURF project award activity within 12 months

Early engagement activity increasing

This despite the fact that 1 year ago they had $6.1bn in backlog and they currently only have $5.1bn. Subsea 7 is more exposed to EPIC projects and I believe these will form a bigger percentage part of the market going forward, but it’s still a bold call.

For Solstad the alternative explanation, announced by Bourbon, is that there is no recovery. Or as Siem Offshore stated this week:

we believe there will still be an oversupply of AHTS vessels and PSVs and expect the market to remain challenging for several years. The charter rates and margins still remain below what is sustainable. (Emphasis added).

Part of me thinks the offshore industry just isn’t used to an environment where the forward supply curve price isn’t fundamentally different from the current price. It is worth noting that on an inflation weighted basis the oil price peaked in 1979 and then dropped in real terms for 19 years to reach an all-time low in 1998, before stagnating for a couple of years, before the inexorable rise that we all regard as the new normal, began.

The major reason for the steady decline was both supply and demand based. New sources of supply came on, technology advanced, and high prices encouraged substitution. Clearly it isn’t an iron law that prices will keep rising over the long run as if it is an immutable economic law, yet it is taken as a given by certain sectors of the offshore community.

Solstad announced results this week that seemed to defy all logic. I don’t know how much money Aker have, but they have played the OSV market stunningly badly since the downturn began, and one would think sooner or later they will get sick of throwing more money away on vessel OpEx. Aker jumped into Solstad way to early, and yet for some inexplicable reason, (other than blind faith in a vessel recovery?) when more than 100 North Sea class PSVs were in lay-up in January, agreed to effectively bail Farstad out and combine with DeepSea Supply. Now Solstad came out with this predictable bullet point from their results presentation:

Majority of revenue and EBITDA from CSV segment

Really what a surprise! You just can’t make this up. What is working for them in this downturn is their high-end CSV fleet and then Solstad jump headlong into the most overbuilt commodity shipping in the offshore industry, Madness. The rest of the presentation is an exercise in mental dislocation from industry reality: DESSC’s cost leading business model is praised… but that doesn’t help at the moment when ships are going out for less than their economic value? It’s also not scaleable or transferable in an acquisition of  other vessels (or companies) because it relies on all vessels in the fleet being similar? And can you really have a low cost business model in this sector anyway? Its a boat + crew? What special insight does DESSC have in making this low cost? Apparently a strategic driver for saving Farstad’s banks is their AHTS experience? Great… Farstad are the most skilled company in a market segment that is structurally unprofitable? If the shareholders are like Aker and like owning companies that are the most competent at what they do regardless of whether they make money or not then this is a very good investment idea. I suspect it’s niche though because investors like that are rare.

It is all well and good highlighting that Farstad and DESSC are non-recourse subsidiaries of Solstad wth the implication being if it all goes wrong then they can be jettisoned. But of course JF took his holding in Solstad not the subsidiary which shows you where he thinks the value is. The Solstad supply fleet will simply not be big enough to generate economies of scale that outweigh the negative industry structure or induce pricing power in any region. It is also debatable what the minimum efficient scale is in offshore supply? This was a transaction driven by the desperation of Farstad’s bankers and recognition by DESSC that trying to do a rights issue without a different investment story would have been extraordinarily dilutive given the cash would have been used for OpEx only. Quite how it was sold to Solstdad/ Aker is anyone’s guess.

A good comparison is Gulfmark which is going into a voluntary Chapter 11. Gulfmark will emerge with a clean balance and 72 vessels in the supply sector. If you want to look at a company with the potential to consolidate the PSV sector it is right there with a simple operational structure and balance sheet focused on one sector that investors can understand and measure. It is very rare  for companies to consolidate an industry that come from one of the high cost markets and then work out how to be cheap internationally – it usually works in reverse. US companies like Seacor and Gulfmark are going to be well placed to drive proper industry consolidation in a way that may not be possible for a company coming from a relatively high cost environment. Yet this industry feels a long way from the bottom when NAO Offshore with a mere 10 vessels, and 30% of the fleet in lay-up, all working at nowhere near their cost base, can say blithely:

Nordic American Offshore closed a follow-on offering March 1, 2017, strengthening the Company by about $48.8 million in cash. The main objectives of the offering were to strengthen NAO financially and position NAO for further expansion...

NAO sees opportunities to grow the Company… 

(Emphasis added).

I sometimes wonder if when Norwegian schoolchildren are young they are indoctrinated with a special ship class in which the answer to every question is “ship”. I imagine an immaculate schoolroom (paid for with petrodollars of course), a very small class, and 20 children with their eyes closed humming and intoning gently “skip… skip…. skip…” And the teacher asking “What is the meaning of life?”… and the gentle reply coming back immediately “Skip”… “What is 2 + 2?” … “Skip, Skip + Skip Skip”… “E=MC2?” “Skip”….

I am just not sure the answer to the current problems are more ships… I have a nagging suspicion it’s less ships. A lot less. Consolidation isn’t the only answer here a quantative reduction in vessel numbers is an yes smaller operators need to go.

DOF came in with revenue 23% below Q1 last year which makes it hard to point to any recovery. DOF also announced this week that they may list DOF Subsea as First Reserve would appear to want out. First Reserve have been in DOF Subsea a long-time, and it’s natural they would want to exit at sometime. But you should always ask why inside and knowledgable investors are selling now, at what some are calling the bottom of the cycle; maybe it isn’t the bottom? DOF Subsea project margins were 2.0%! Yes the DOF PLSVs in Brazil are now up an running, but as we all know Petrobras has far too much PLSV capacity and so I suspect First Reserve is trading off a very low point in the cycle against the cost of waiting which brings you a day closer to the possibility of a vessel being redelivered from Brazil.

DOS Subsea specialise in light IRM and small scale projects and out of the North Sea market (where you need a North Sea class DSV) owning a vessel is a disadvantage not an advantage (which isn’t true at the top end EPIC SURF contracting where you need a specialist lay vessel) for some projects as costs become purely variable. Every single asset DOF Subsea have can be chartered in from another company if you are project management house. There used to be a number of project companies that delivered projects but didn’t own vessels, that didn’t last as the market tightened from 2006 onwards and you simply couldn’t charter a vessel (I am trying to think of the Singapore/Perth company Technip brought?). But now that isn’t the case and so not only is there loads of delivery capacity in vessel owners and charterers, but small project management houses can, and will, bid and compete for jobs, which will lower industry profits structurally. The best strategy going forward is to have a fleet much smaller than your delivery schedule requires but still some core tonnage, companies that didn’t splurge in the last boom are clearly better positioned here.

Whatever the reason for First Reserve selling it is a fact that one of the most successful investors in the energy industry is lightening their exposure to the offshore sector. If you buy DOF Subsea shares you need to ask what you know that First Reserve don’t? Interestingly First Reserve hasn’t invested in an offshore exploration company since 2011 (Barra), but has invested in 7 tight oil plays since 2011, a pattern that seems to mirror capital flows in the industry. One wonders if Technip weren’t encouraged to try and by DOF Subsea and a lack of interest led to this way of getting out?

The obvious reason that First Reserve might well be selling is that they think the poor financial results are likely to continue for sometime and they see no easy answer to an industry awash with capacity and declining levels of investment and simply don’t want to fund working capital with an uncertain payback cycle. DOF Subsea has excellent project delivery capability but it simply too long on ships and unlike other contractors these are an essential part of their strategy going forward and they have no ability to given chartered tonnage back as the industry continues to contract.

DOF Subsea also have 67 ROVs. The quiet underperformer in the industry at the moment is the ROV space. Everyone at the moment is giving the ROVs away at costs + crew only. In the old days ROVs were so profitable because you used to able to hide a mark-up on the vessel in the contract amount and they looked very profitable. Now the vessel is given away for free as is the ROV and only the engineering generates some margin. There is clearly going to be some consolidation here and I believe it will be very hard for the smaller companies to raise additional funding without profitable backlog as it becomes clear that there will not be a recovery in 2017. A lot of companies in the ROV market have raised money yet offer the same thing as the industry leaders who have very strong liquidity positions and can play this game far longer than speculative investors. Reach is a well managed company, and can give vessels back eventually, M2 got it’s ROVs cheap, but both are going up against companies like DOF and Oceaneering and eventually, surely, investors are going to realise that without some sort of increase in demand the structure will favour the larger companies who have more equity to dilute to see them through to the final stages of consolidation. There is an argument that smaller nimbler ROV companies can respond better to IRM workscopes than larger companies, particularly at the moment with oversupply in the vessel market; we are about to find out if they can win sufficient market share to be viable.

Obviously there are different views about when the industry is going to recover and how it will look. That is legitimate as no one can know ex ante what will happen ex post but it is becoming apparent that 2017 isn’t going to be the recovery year people hoped and that more people are going to have to raise money to get through this. The Nor DSVs will need to start fundraising in August at the current burn rate, as will others, the dilution that the new money makes on the old money for these secondary fundraisings will be a clue I believe as to how close we are to pricing the bottom. The investors in Nor represented a group who thought there would be a quick bounce back in 2017 in the price of oil and subsea asset values, there are bound to be fewer the next time around and surely they will charge a higher price for their capital, and in many ways this is microcosm of the industry.

The best guide to calling this appears to be those that have looked at previous investment bubbles. Charles Kindleberger, in his classic study of financial panics and manias stated the final stage of an investment bubble led to panic selling which would mark the bottom of the cycle:

‘Overtrading,’ ‘revulsion,’ ‘discredit’ have a musty, old-fashioned flavor; they convey a graphic picture of the decline in investor optimism.

Revulsion and discredit may lead to panic (or as the Germans put it, Torschlusspanik, ‘door-shut-panic’) as investors crowd to get through the door before it slams shut. The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets…

We still look a long way off this in offshore supply and subsea.

 

Markets can remain “irrational” longer than you can remain solvent…

This cheery news came in from Hornbeck today (shares down only 2% so let’s not start the EMH debate now):

The Company projects that, even with the current depressed operating levels, cash generated from operations together with cash on hand should be sufficient to fund its operations and commitments at least through the end of its current guidance period ending December 31, 2018.  However, the Company does not currently expect to have sufficient liquidity to repay its three tranches of funded unsecured debt outstanding that mature in fiscal years 2019, 2020 and 2021, respectively, as they come due, absent a refinancing or restructuring of such debt.

That is on the back of poor numbers from DOF yesterday, in which a restructuring/refinancing of DOF Subsea is clearly an issue, and yet another month of no work for the Nor vessels, to pick just a couple of examples… I could go on. I know Europeans like to look down on the American fleets, and technically they are clearly not as good as the European tonnage,  but by virtue of market size they represent a bellweather of the industry, and the fact is it is across the board. I still feel Aker/ DSS caught a falling knife in supply rather than using capital to solve a structural issue. The price at which Hornbeck (and Tidewater) solve their financing will be interesting. Quite why Solstad didn’t leave these scale companies to sort out supply and stick to OSV/CSVs, where you can hopefully build some value into service delivery and therefore boost Enterprise Value, is beyond me.

Is there a bull case? Am I being too negative? I came across this graph from Surplus Energy Economics (a great blog I have just discovered and while I don’t agree with everything it’s very well written), from this article:

Average Annual Oil Price (constant 2015 dollars)

oil-price-trend-since-1965

It’s all the bulls in offshore have got left. The arugument is that this is a temporary dislocation in demand for offshore energy and maintenance services and that shale will hit the limits of its production and energy prices will return to their long-term averages and we can all go back to beer and skittles and the demand/supply imbalance will disappear.

The problem with trends is getting caught in the middle of a bad period. I am a believer in offshore energy long-term, I just worry about the running costs of the vessels to get there, and there is a real risk of moving too early in these assets given the high carry cost. In some options time is your friend, not in OSV/CSVs… The potential equity “funding gap”, between when the red line causes day rates and utilisation to increase, is the key question facing the industry and investors.

If you brought an OSV in 1994 and sold it in 2001 it wasn’t a great investment generally. 1985 to 1999 was generally a poor time to be in oil services as an investor. Alternatively, you could be like Bibby Offshore and by a North Sea class DSV for USD 10m in 2003, just before a boom in day rates, and make extremely high risk weighted returns. The core issue (as always) is when demand comes back to signficantly increase utilisation and day rates. The offshore industry is going into this downturn with a number of vessels beyond comprehension in any previous decline and with a new competitor at the margin in shale.

Financial return depends on the the numerator (cash flow) and the denominator  (discount rate) when assessing returns (CF/DR). Its not enough that day rates bounce back its the money injected in the interim. A really clever financial model could be made showing the equity gap for offshore vessel operators between now and a market recovery, but it depends on the gradient of the red slope as much as the current running cost. But as no one knows when demand will come back its not just the numerator that is important its the denominator to reflect the risk of this happening. Discounting is a brutal game, invest a dollar now with no payback, at only a 15% return (and frankly I would want more for buying such expensive options), and you calculating on only a .65 return in the dollar in three years to break even, on depreciating assets in an oversupplied market that is a bold call. A 30% IRR (common to alternative investors) is equivalent to a .45 return on the dollar in three years. A discount hurdle in day rates that just seems extremely unlikely to be met given the oversupply.

One of the areas I disagree with Surplus Energy is the view that shale cannot reduce the absolute cost of production. As I have written before shale demonstrably has. Anyone who bets against the ingenuity of US engineers to drive down economies of scale and scope, and find capital market support to do it, is making a very big call, and not one backed by many examples. Small shale wells appear susceptible to standardisation that will push the cost curve down again. I don’t see Moore’s law kicking in but the fact is the shale industry is relatively immature and suffered huge bottlenecks in the last boom. Yes, shale is using the best acreage at the moment, so productivity numbers are boosted, but the supply chain is in its infancy in terms of driving down unit costs. However, whether enough acreage can be brought on quickly enough is the defining question.

I am a long-term believer in offshore. Deepwater projects  by there nature are one-off projects that are hard to standardize. They require huge investments in project specific engineering and fabrication (i.e. a much higher CAPEX) but they can offer much higher, and more consistent, flow rates (i.e. substantially lower OPEX/unit) and therefore they will be part of the energy mix going forward. These sorts of projects offer huge scope for contractors to add value and therefore earn above average rates of return. Infield projects are going to be far more challenging: launch it at the wrong time and your entire 5-7 year operational period could be one of low prices. That will significantly raise the hurdle rate for these projects.

[Headline is from the Great Man].