It’s grim up North… And the labour theory of value…

It’s Grim Up North.  The Justified Ancients of Mu Mu

Ricardo, Marx, and Mill believed that prices were determined by how much people had, in the past, invested. And that blinded them to any understanding of the workings of the market.

Friedrich Hayek

[I am not really a Hayek fan (in case anyone is interested). But he was a very smart guy who understood social and economic change processes better than most. Beyond that you get diminishing returns. As an aside I have been too busy to blog much lately, which is a shame as some really interesting things have been happening, but it doesn’t seem to have affected my visitor numbers much, which just goes to show maybe my silence is more valuable.]

The Oil and Gas UK 2018 Economic Report is out. For the North Sea supply chain there is no good news. There is clearly a limited offshore industry recovery underway as we head towards the end of summer. However, the market is plagued by overcapacity, and while service firms without offshore assets are starting to see some positive gains, if you are long on floating assets chances are you still have a  problem, it is only the severity that varies.

The UKCS is what a declining basin looks like: fewer wells of all types being drilled and dramatically lower capital expenditure. There is no silver lining here: an asset base built to deliver 2013/14 activity levels simply has too many assets for the vastly reduced flow of funds going through the supply chain. The report makes clear that the base of installed infrastructure will decline and there will be a relentless focus on cost optimisation to achieve this.

UK Capital Investment 2018.png

The volume of work may be increasing marginally but the overall value may even down on 2017 at the lower end of the 2018 forecast (purple box). Clearly £10bn being removed from the oil and gas supply chain, c. 60% down on 2014, is a structural change.

And the OpEx numbers unsurprisingly show a similar trend:

UKCS OpEx 2018.png

Party like it’s 2012 says Oil and Gas UK. Unfortunately a lot more boats and rigs were built since then.

Unit Operating Costs 2018.png

An unsurprisingly the pressure on per barrel costs seems to have reached the limits of downward pressure.

This should make supply chain managers seriously consider what their investment plans are for assets specific to the region and the likelihood of assets having to work internationally to be economic. It should also make people reassess what stuff is actually worth in a market that has reduced in size by that quantum and from which there is no realistic path to 2014 activity levels.

Technip paid $105m for the Vard 801, about $55m/45% discount to the build cost. Such a deal seems realistic to me. Some of the deals I have seen in offshore remind me of The Labour Theory of Value: if you dig a massive hole that costs a lot it must therefore be worth a lot. In reality with so much less cash floating around for assets that will service the UKCS an asset is worth the cash it can generate over its life, and the fact that it is substantially less than its replacement cost is just another clear example of how the industry will reduce its invested capital  as production levels in the basin decline. Like airlines offshore assets have a high marginal cost to operate and disposable inventory which is why you can lose so much money on them.

Boskalis appears to have paid an average of c. $60m for the two Nor vessels which equates to a similar discount on an age weighted basis. Quite where this leaves Bibby needing to replace the 20 year old Polaris and 14 year old Sapphire is anyone’s guess. But it is not a comfortable position to be in as the clear number four by size (in terms of resource access) to have competitors funding their newest assets on this basis. Yes, the shareholders may have paid an equivalent discount given the company value they brought in at, but if you want to sell the business eventually then you need a realistic economic plan that the asset base can self-fund itself, and at these sort of prices that is a long way off. Without an increase in the volume and value of construction work 4 DSV companies looks to be too many and this will be true for multiple asset classes.

As a mild comparison I came across this article on $Bloomberg regarding Permian basin mid-stream investment:

Operations in the Permian that gather oil and gas, and process fuel into propane and other liquids, have drawn almost $14 billion in investment since the start of 2017, with $9.2 billion of that coming from private companies..

That is just one part of the value chain. I get you it’s not a great comparison, but the idea is simply the ability to raise capital and deploy it in oil production, and it is clear that for Permian projects that is relatively easy at the moment. The sheer scale of the opportunities in the US at the moment is ensuring it gets attention and resources that belie a strictly “rational” basis of evaluation.

IMG_0957.JPG

That is what a growth basin looks like. The narrative is all positive. Once short-term infrastructure challenges are resolved that stock of drilled but uncompleted will be turned into production wells.

Oil and Gas UK go to great pains to explain the economic potential of the UKCS. But finance isn’t strictly rational and I still feel they need to be realistic about the cycle time tradeoff offshore entails. Shale, as we have seen, has an enormously flexible cost base relative to offshore and that has value.

The comments I make below are part of a bigger piece that I keep wanting to write but a) don’t have the time; and, b) probably doesn’t work for a blog format. But I think the impact of the private equity companies taking over North Sea assets needs to be realistically assessed.

Don’t get me wrong here I am a massive supporter of them. In terms of the volume of cash, and the ability to buy and invest at the bottom of the cycle, the North Sea would clearly have been worse off without private equity. But the results are in and there has not been a development boom… there has been a focus on the best economic assets that may make the fields last longer, but that is a different test. There may clearly have been an investment boom relative to what there would have been without private equity money, but again that is a slightly different point.

Private equity firms have a much higher cost of capital than traditional E&P companies and at the margin that will limit the number of projects they fund. The focus on lowering costs and returning cash as quickly as possible, often to compensate for how hard it will be for the owners to exit such sizeable positions, also adds to the change in the investment and spend dynamic (on the downside obviously). I am genuinely interested to see how these large multi-billion dollar investments are exited given how much trouble the super-majors are having at getting out.

Private equity may well be the future of the North Sea but that has huge implications for the supply chain. It is also worthwhile pointing out that while the smaller companies maybe able to sweat old assets they have a limit for larger projects. Quad 204 is a classic project where it is hard to see even one of the largest PE backed companies having the technical skills and risk appetite to take on such a vast project.

The majority of the larger deals also involved significant vendor financing from the sellers. Shell had to lend Chrysaor $400m of the $3bn initial consideration. This happened not through generosity, or a desire to maintain economic exposure to the assets, but because debt finance from the capital markets or banks was simply unavailable even to such large and sophisticated buyers. Siccar Point went to the Norwegian high-yield market in January borrowing $100m at 9% for five years. The fact is finance is scarce, and when available expensive, and this is impacting the ability of E&P projects to get financed. Enquest has had to do a deeply discounted rights issue, and borrow off BP, to complete Sullam Voe.

The E&P majors are helping to finance their own exit because it is the only way they can get out. The turnaround from that to an investment boom that could raise asset values in the supply chain is a long one.

In order to make money in this environment the E&P companies, particularly those backed by private equity, are focusing on driving down costs and limiting Capex with a ruthless efficiency and commitment few in the supply chain believed possible long-term. Where offshore assets are concerned the oversupply situation only assists with this. I met one of the private equity investors last week and I can assure you there is no pressure to replace old assets, safety first definitely, economics and finance second just as definitely.

The reality for the supply chain is this is a market where it will be very hard to make money for a very long time, and in reality the glory days of 2012-2014 look extremely unlikely to return. The Oil and Gas UK report gives some important data in explaining why.

The oil price meme…

As the oil price passes USD 80 there is a really interesting post (lengthy, but great) here from Epsilon Theory on memes:

If you get nothing else from Epsilon Theory, get this: we are ALL hard-wired — literally hard-wired through millions of years of neurological evolution — to respond positively to effective meme introduction. We are ALL programmed — literally programmed through tens of thousands of years of cultural evolution — to respond positively to effective meme introduction. It’s no exaggeration to say that our biological and cultural symbiosis with memes defines the modern human species. This is a feature, not a bug.

Eusocial animals (the “pure” form of what it means to be a social animal) swim in an ocean of constant intra-species communications. It’s why these species — the ant, the termite, the bee, and the human — are the most successful multicellular animal species on the planet. Eusocial animals have the ability to store, retrieve and broadcast information (yes, eusocial insects communally “remember” incredibly complex informational structures) in a way that non-eusocial animals simply can’t, and it allows the eusocial animal not only to survive its environment, but to master its environment. Any environment. Humans are essentially giant termites with opposable thumbs and fire, and that combination is particularly unstoppable. But it’s the termite-ness … it’s the swimming in an ocean of constant intra-species communication … that’s the most important of these qualities.

Right on cue this week the FT carried a piece from the research firm Energy Aspects:

While there has been breathless attention paid to prompt Brent prices climbing to $80 a barrel for the first time since 2014, what has received less attention is that the entire Brent forward curve is now trading above $60, including contracts for delivery as far out as December 2024.

This development is an important psychological milestone for the oil market. The market is, in effect, saying that “lower for longer” is dead. (Emphasis added).

Narratives and memes are getting a lot of focus in economics for the right reasons as the above authors realise.

The Bank for International Settlements this week came out with some research that suggested 30-35% of the movement in oil prices was down to demand and supply and the rest of the movement down to potentially financialisation, speculation and other factors.

Another of the big (related) reasons for the procyclicality of the oil price (which the BIS touch on) is the structutral nature of the trading firms in the oil market. When the price is going up CFOs/Risk Officers feel good because they are buying at 70 and selling at 75. So bid/ask spreads narrow, inventory goes up, leverage goes up, and risk is on… whereas on the way down the value of inventory is declining, leverage does down, the bid ask spreak widens, volumes drop… we’ve been here before. Where we haven’t been before is in an oil market where a marginal producer has potentially such a powerful impact on the market.

The trade-off between shale and offshore investment and the effects on marginal demand…

The rising oil price is about to test one of the major tenets of this blog: namely that there has been a structural change in how oil is produced and that a sharp comeback in offshore demand, as has been seen in previous cycles, is extremely unlikely. At the moment all the data appears to be pointing to the ever increasing importance of shale over offshore for marginal investment dollars, and in fact the higher price may be encouraging shale investment over offshore as smaller E&P companies can meet volume increases through cash generated and open capital markets and larger E&P companies take a margin hit but keep CapEx commitments steady and not expanding offshore much beyond long signalled commitments.

It is also worth noting that this recent price rise does not seem related to demand factors:

physical markets for oil shipments tell a different story. Spot crude prices are at their steepest discounts to futures prices in years due to weak demand from refiners in China and a backlog of cargoes in Europe. Sellers are struggling to find buyers for West African, Russian and Kazakh cargoes, while pipeline bottlenecks trap supply in west Texas and Canada.

At the moment Permain is trading on a discount to WTI of between $7-12 per barrel given transportation constraints via pipeline out of the region. Something like 1.5m barrels per day opens up by March next year though so this is a temporary problem. The process of capital deepening for shale is also occuring as refineries in the region change their intake capacity for the ‘light sweet’ crude that currently needs to be mixed with heavier Brent. This will take time, and cost billions, but every year this capacity slowly increases with each maintenance cycle at the large refineries, incentivised by the large discount to Brent.

PVM has reported that as the oil price has rised Texas’s energy regulator issues 1,221 drilling permits in April, up around 34% from a year ago. The BH rig count added another 10 rigs to the US oil fleet last week but also another 2 offshore rigs, but that only brought the offshore count back to a year ago, the same for the Gulf of Mexico (+1); whereas the land rig count is up ~19% from a year ago.

BH rig count 11 May 2018.png

Again this leads directly to higher production. In June alone US shale production will add the rough equivalent of a Clair Ridge to their output levels:

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The US shale industry is the single biggest transformation to the oil and gas industry since the pre-salt fields were discovered and developed in Brazil. Those developments led to an extraordinary rise in the price of tonnage and changed the entire offshore supply chain. It is simply not logical to accept that a change as big as this in volume terms is occurring in the US and that it will not have similarly profound impact on the offshore industry.

The correlation between the oil price and the US rig count and the oil price and US production levels has an r-squared of ~.6 according to IHS Markit (data below) if anyone is interested. That means each $1 increase in the price of oil leads to a .6 increase in the rig and production volumes.

IMG_0512.JPG

Whereas for offshore a strong increase in the price of oil over the last twelve months has seen this happen to the jack-up and floater count:

Jackup and rigs 11 May 18.png

Source: Pareto Securities.

Jack ups and Floaters demand has been effectively static over the past year. The workhorses of future offshore production increases and demand simply haven’t moved in a relative sense. The cynic would argue their correlation to the oil price has been reduced to zero (which clearly isn’t true), but it shows how time delayed this recovery cycle is for the front end of offshore. But the flat demand for jackups and floaters is exactly what most subsea vessel and supply companies are saying: demand has bottomed out but over supply and a lack of pricing power persists. The good explanation of why so many OSV and subsea companies claim to be doing record tendering and their  continued poor financial performance lies in the data above.

What I call (sic) “The Iron Law of Mean Reversion”, which seems to substitute for thoughtful analysis, can be seen in this slide:

Transocean Iron Law.png

The heading is simply a logical fallacy. There is a load of evidence to say shareholders are more comfortable with lower reserves now and less offshore production is being sanctioned because the money is being spent on shale.

At some point the disconnect between companies like Standard Drilling, buying PSVs at pennies in the dollar and keeping them in the active fleet, and the general oversupply will be realised. In the CSV/ Subsea fleet things are no different: Bourbon, Maersk, and other vessel owners state they are building up contracting arms, yet again all they do in total is keep supply high for a relatively undifferentiated service and erode each others margins (and spend a lot on tendering). The service they operate has no real differences to the ROV companies like Reach, M2, ROVOP, IKM ad infinitum and other traditonal vessel contractors like DOF Subsea. Sometimes they have a good run of projects… and other times…

Bourbon Q1 2018 Susbea.png

Project work is lumpy but Bourbon stated that the project market was especially poor versus suppy. In the old days boats were scarce and enginneering had a relatively small mark-up which the mark-up on the vessel accentuated and flattered. But getting a CSV with a large deck and crane now is so average it is no wonder everyone claims to be tendering: E&P companies are clearly getting them all to bid to reduce project costs. There is clearly more work being done on vessels at the moment, but there is a limit as shown above, and no project delivery companies have any pricing power.

The larger contractors appear to be winning a greater porportionate share of work at ever lower margins as TechnipFMC recently showed:

Technip Q1 2018.png

Given Technip is now winning as much work as it burns through demand has clearly hit the bottom. But even it has to lower margins to win. The commodity work, where you grab some project engineers and a couple of ROVs on a cheap boat (often IRM related), is clearly going to have all the profit bid away for a long time, whereas construction work still has value even in the downturn; but it entails serious risk and range of competencies that are beyond the realms of dreaming about for the smaller contractors.

This relationship between the rising price of oil and marginal demand for shale verus offshore will make this recovery cycle for offshore different to any other. IRM is important in the short-run, but the fewer wells and pipes laid now will ensure not only is future construction work lower but so to is the installed based. There will clearly be a recovery cycle, demand is above last year’s levels and subsea tree orders are well ahead of 16/17 lows, but there is clearly huge competition at the margin for E&P investment dollars in offshore versus onshore which is a competitive dynamic the offshore industry has never had before.

End of an era… goodbye to Orelia…

The end of an era as the DSV Orelia is scrapped (above). I would wager she has been one of the most profitable offshore assets in an economic sense over her life. With a build cost much lower in real terms than new build tonnage, and in a market with a much lower number of competitors, this asset would have paid for her keep many times over.

As she goes it is worthwhile considering that the huge margins Orelia generated were a signal for other players to try and replicate this formula and build competitive assets and businesses. Such is the long run nature of the supply curve these new assets continue to arrive long after the margins have vanished, and despite some new-builds costing vastly more in a nominal and real sense, it is not clear, beyond being more fuel efficient, that they are superior economic assets. It is notable that Technip has sold off a large potion of her diving businesses and assets and is only really present in the North Sea now, which is a clear signal how profitable they think the SAT business will be in the coming years. The unwillingness of Technip to commit to specialised replacement tonnage for the North Sea market I also thinks signals their view, and mine, that there has been a structural change in the North Sea SAT diving market and anyone going long on it should have a very robust business case, because without a rebound in construction work, the market looks oversupplied for years. Soon the well Wellservicer will join her and a new generation of assets moves to the fore.

The latest rumour I heard regarding replacement tonnage was that the Vard new build had been sold to Middle Eastern interests (specifically Bahrain) who were going to charter the vessel back to Technip. Given that this is the third version of this story I have heard (although from two sources now) I treat it with a degree of scepticism (linked to JMT!): surely with TechnipFMC’s balance sheet the best option would be just to make Vard a take-it or leave-it cash offer? Vard have always insisted on a clean sale, maybe time and reality have intruded on this wish.

Industry consolidation and market power… Is consolidation really the solution?

Last week the creation of a new offshore company was announced: Telford Offshore. I presume financially related to Telford International. The company has purchased the four Jascon vessels for USD 215m and looks to be setting up a UAE/ Africa subsea construction and IMR business. I know one of the guys there and wish them all the best of luck, they are a strong team and seem likely to make it work having both financial backing, local connections, and managerial skill.

From an industry perspective though it is a microcosm of why I think industry profitability will elude those long on vessels for a prolonged period of time without a significant change on the demand side. Telford isn’t taking capacity out of the market, it is merely recapitalising assets at a lower valuation level, and giving them the working capoital to operate, and it will compete with other existing companies for work in the region. That excess capacity competes on price is as close to an iron law as you can get in economics and something everyone in the offshore industry knows intuitively to be true at the moment.

The talk in the industry at the moment is all about consolidation and how that will save everyone… but I don’t see it? Consolidation is only beneficial if it generates maket power and therefore some ability to charge higher prices to E&P companies: A bigger company in-and-of-itself is of no economic benefit unless it can generate economies of scale or scope i.e. a) lower unit costs, or, b) lower integration costs of supplying a range services . At the moment, in both subsea and supply, there is no evidence that this is the case.

The large subsea companies are currently all reporting book-to-bill numbers of less than 1 (apart from maybe McDermott), that means they are burning through work faster than they are replacing it, and this is consistent with the macro numbers. This is happening because the market is contracting in both volume, and especially, value terms. Simply adding another UAE/ West African contractor to the mix will only prolong this problem in the region. Not that it is unique to the region, as the industry grew up until 2014 a host of tier 2 construction companies grew their geographic footprint and asset base as well. Now they are committed to those regions because they have no economic option but to stay. Over time, as all the companies compete against each other for minimal profits, not everyone will be able to afford to replace their asset base, that is how capital will leave the industry and how it will rebalance on the supply side; but when you have gone long on very specific 25 year construction assets it takes a long while!

It is a fundamental tenent of ecoomics that industry profits, outside of firm specific events, is a function of industry concentration. Every person who has done a ‘Porter’s Five Forces’ analysis is actually using a microeconomic model that has a deep intellectual heritage in examining if the structure of markets drives profitabilty. More recent research has highlighted firm specific factors in determining profitability, but market power, firm concentration, normally the result of consolidation, is always crucial. That is why competition authorities focus on market power when looking at whether they should allow transactions that heighten market power to progress: because scale allows firms to drive pricing power.

A normal threshold for competition authorities to get concerned about market power is ~40% market share level for any one company, and often they like to see 3 or more companies in total, below this level it is understood that consumers have options and companies will compete on price to a certain extent. While Technip and Subsea 7 dominate the market for subsea installations they have nothing like that level of market share. Any large project could theoretically go to Saipem, McDermott as well at a minimum, and below large projects an E&P company is spoilt for choice. In other words there is no pricing power at all for offshore contractors, and as all they have all committed to assets with high fixed costs, and low relative marginal costs, vessel days are essentially “disposable inventory” that must be sold or paid for anyway (just like a low-cost airline) and have no other uses.

The scale of consolidation that would have to occur in order to generate any pricing power for the contracting community defies any realistic prospect of execution for the next few years. It will happen, and slowly, but the scale of the change will be enormous, and as it nears its final stages expect the E&P companies to protest vigorously to competition authorities. Instead of the vessel companies and the subsea production system companies getting closer, eventually, the vessel companies will start to be acquired or merge. But until savings in replacement capital can be made, a while away given the huge new building programme we have had in the vessel fleet between 2010 and 2014, then it will not make sense for an acquisition premium/ nil premium merger to unlock these cost savings. One day it will be cheaper, for example, for Subsea 7 to buy the Saipem business than set out on a new build programme (through both cost savings and reduced CapEx)… but we are some way from that point and a long way from the institutions themselves accepting this.

It is even worse in offshore supply. A measure for assessing market power in economics is the Herfindahl-Hirschman Index (also used widely by competition authorities) to assess if markets have concentration levels that would allow their participants to extract excess profits through concentration. I went to calculate this quickly (the math is not difficult) based on this data from Tidewater:

Tidewater scale and scope.png

The US Justice Dept gets concerned if the HHI number comes in at 1500-2500 and is likely to take action if the number is above 2500 and there is a 200 point movement based on anyone transaction. The supply industry has an HHI well below 1000. Bourbon, the largest company with a 6% market share, only has an HHI score of 36! All the named companies on this slide could merge and chances are the DOJ would wave the deals through because it wouldn’t think the enlarged mega company would still have any pricing power (this is a reductio ad absurdum here and clearly a real situation would be more complicated) and would therefore be able to extract excess rents.

Not only that entry costs/barrier in offshore supply are nothing which just dilutes any possible positive effects consolidation could bring: Standard Drilling can buy supply vessels for $12m and park them in a reconstructed North Sea operator and compete against SolstadFarstad and Tidewater? So how does merging all of the PSV assets that makeup HugeStadSea make any difference?

In offshore contracting it is not just construction assets like Telford, a host of ROV companies now don’t need to buy or charter vessels but merely pay on use allowing a host of small companies to enter the industry. ROVOP, M2, Reach, and a host of others have entered the industry and kept capacity (or potential capacity) high and margins low with vessel operators supplying vessels below economic cost while the ROV contractors make a margin on equipment they brought at 30c in the $1 and well below replacement CapEx levels. MEDS despite defaulting on a number have charters have been given the Swordfish to operate on charter!

The high capital values of these assets encourages investors to supply working capital to keep the assets working knowing they are competing against others who paid a higher capital value. It is a very hard dynamic to break and I don’t see a huge difference between offshore supply and subsea in economic structure which is why I deliberately merged the industries here.

Part of the reason consolidation doesn’t work is because the costs of the fixed assets, and the costs to run them, are so high in relation to the operational costs. The fixed costs of the vessels, and the non-reducible operating costs dominate expenditure, getting rid of a few back-office staff, who represent less than a few % of the day rate of a vessel just doesn’t make a big enough difference overall.

Another reason is the banks are still pretending they have value way above levels where deals such as Telford are priced at. No amount of consolidation to remove some minor backoffice costs can make up for the scale of capital loss they have in reality will solve this. If Standard Drilling is buying large Norwegian PSVs in distress for $12m, and SolstadFarstad has similar vessels on the books for $20m, then you can’t consolidate costs that would be capitalised at $8m per vessel no matter how many other companies you buy. The same goes for subsea only the numbers are bigger and more disproportionate.

So when someone tells you the answer is consolidation the real question is why?

 

That consolidation is the answer is simply an economic myth. Gales of Schumpterian creative destruction are the only real solution here barring some miraculous development on the demand side of the market.

The oil market…

I am not an oil forecaster, if merely use of the word isn’t a misnomer, but I am interested in the psychological effects the market has on the physical and pricing of offshore services. Only last week Goldman called $80 oil, coincidentally when they called oil going to $20 in 2016 (when it was $36), it marked the low point in the market, now it seems this maybe the high as the price dropped yesterday.

To put these daily fluctuations into perspective there is a good article here on the swings in the oil price since 1973 until 2014. The story of shale gets a passing mention but remains to be written.

I have also noticed a lot of commentary mocking the market analysts from investment banks for their inability to predict accurately the turns in the market. I would note firstly if you think analysts at an investment bank have a job to do beyond helping the firm sell securities then you are wrong. IB analysts fall under the remit of marketing and that is their job, not to provide independent, and free, research to the community at large.

And even if they are trying to be accurate, say a firm with a limited corporate finance arm, one should remember Alfred Cowles. Cowles was the inheritor, and investment advisor, to a large Chicago newspaper fortune, as well as being a statistician and economist. In 1929 he was long on stocks and lost a great deal of money and set out to find the answer to a question made famous when asked by the Queen to LSE academics in 2008, namely “Why did nobody notice it?” (as in the Global Financial Crisis). Specifically, Cowles wondered why the big Wall Street brokerages didn’t see the crash of 1929 coming? Did they know any more than their customers? (I mean The Great Vampire Squid was keen on Ceona when anyone with a modicum of pipelay knowledge knew the Amazon lay system was a busted flush?)

In a famous paper “Can Stock Market Forecasters Forecast?”, published in Econometrica in 1944,  Cowles proved that they can’t. I urge you to read the whole article (aside from anything the language is beautiful), for example Cowles found:

Cowles.png

The answer would be exactly the same for the oil market today if replicated I would wager. This comes up time again in mututal fund research and other areas of finance, where essentially the outcome is random and cannot be predicted with accuracy (a statistical theory known as “Random Walk“). In case you think technology has improved things this paper was published recently “Do Banks Have an Edge” … and the answer is no… you would be better off buying a portfolio of treasuries than going to all the effort of taking a complex mix of loans and securities that banks do. And that is when the bank is acting as a principal not even trying to sell the stuff!

So when you read that someone is calling the oil market, or whatever, you need to treat it with the scepticism it deserves, and not be surprised when it is wrong.

Zombie offshore companies… “Kill the zombie…”

“I’ve long said that capitalism without bankruptcy is like Christianity without Hell. But it’s hard to see any good news in this.”

Frank Borman

“In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor”.

Warren Buffet

The Bank for International Settlements defines a Zombie Company as a “firm whose interest bill exceeds earnings before interest and taxes”. The reason is obvious: a firm who is making less in profits than it is paying in interest is likely to be able to eke out an existence, but not generate sufficient profits to invest and grow and adapt to industry changes. A firm in such a position will create no economic value and merely exist while destroying profit margins for those also remaining in the industry.

The BIS make clear that zombie companies are an important part of the economic make-up of many economies. I am sure sector level data in Europe would show offshore comfortably represented in the data.

Zombie Firms.png

Conversable Economist has an excellent post (from where I got the majority of my links for this post) on Zombie Companies and their economic effects, which timed with a post I have been  meaning to right about 2018 which I was going to call “year of the zombie”. Zombie companies have been shown to exist in a number of different contexts: in the US Savings and Loans Crisis zombie firms paid too much in interest and backed projects that were too risky, raising the overall costs for all market players. Another example is Japan, where post the 1990 meltdown Hoshi and Kashyap found (in a directly analogous situation to offshore currently):

that subsidies have not only kept many money-losing “zombie” firms in business, but also have depressed the creation of new businesses in the sectors where the subsidized firms are most prevalent. For instance, they show that in the construction industry, job creation has dropped sharply, while job destruction has remained relatively low. Thus, because of a lack of restructuring, the mix of firms in the economy has been distorted with inefficient firms crowding out new, more productive firms.

In China zombie firms have been linked to State Owned Enterprises, and have been shown to have an outsize share of corporate debt despite weak fundamental factors (sound familiar?). The solution is clear:

The empirical results in this paper would support the arguments that accelerating that progress requires a more holistic and coordinated strategy, which should include debt restructuring to recognize losses, fostering operational restructuring, reducing implicit support, and liquidating zombies.”

The subsidies in offshore at the moment keeping zombie firms alive don’t come from central banks but from private banks, and sometimes poorly timed investments from hedge funds. Private banks are unwilling to treat the current offshore market as anything more than a market cycle change, as opposed to a secular change, and are therefore allowing a host of companies to delay principal payments on loans, and in most cases dramatically reduce interest payments as well, until a point when they hope the market has recovered and these companies can start making payments that would keep the banks from having to make material writedowns in their offshore portfolios.

Now to be clear the banks are (arguably) being economically rational here. Given the scale of their exposure a reasonable position is to try and hold on as the delta on liquidating now, versus assuming even a mild recovery, is massive because of the quantity of leverage in most of the offshore companies.

But for the industry as a whole this is a disaster. The biggest zombie company in offshore in Europe is SolstadFarstad, it’s ambition to be a world leading OSV company is so far from reality it may as well be a line from Game of Thrones, and a company effectively controlled by the banks who are unwilling to face the obvious.

A little context on the financial position of SolstadFarstad makes clear how serious things are:

  • Current interest bearing debt is NOK 28bn/$3.6bn. A large amount of this debt is US$ denominated and the NOK has depreciated significantly since 2014, as have vessel values. SolstadFarstad also takes in less absolute dollar revenues to hedge against this;
  • Market value equity: ~NOK 1.73bn/$ 220m;
  • As part of the merger agreement payments to reduce bank loans were reduced significanlty from Q2 (Farstad)/Q3 (Solstad) 2017. YTD 2017 SOFF spent NOK ~1.5bn on interest and bank repayments which amounted to more than 3 x the net cash flow from actually operating all those vessels. While these payments should reduce going forward it highlights how unsustainable the current capital structure is.

The market capitalisation is significantly less than the cash SOF had on the balance sheet at the end of Q3 2017 (NOK 2.1bn). Supporting that enormous debt load are a huge number of vessels of dubious value in lay up: 28 AHTS, many built in Asia and likely to be worth significantly less than book value if sold now, 22 PSVs of the same hertiage and value and 6 ageing subsea vessels. The two vessels on charter to OI cannot be generating any real value and sooner or later their shareholders will have had as much fun as they can handle with a loss making contracting business.

But change is coming because at some point this year SolstadFarstad management are in for an awkward conversation with the banks about handing back DeepSea Supply (the banks worst nightmare), or forcing the shareholders to dilute their interest in the high-end CSV fleet in order to save the banks exposure to the DeepSea fleet (the shareholders worst nightmare and involves a degree of cognitive dissonance from their PSV exposure). Theoretically DeepSea is a separate “non-recourse” subsidiary, whether the banks who control the rest of the debt SolstadFarstad have see it quite that way is another question? It would also represent an enormous loss of face to management now to admit a failure of this magnitude having not prepared the market in advance for this?

Not that the market seems fooled:

SOFF 0202

(I don’t want to say I told you so).

SolstadFarstad is in a poor position anyway, the company was created because no one had a better idea than doing nothing, which is always poor strategic logic for a major merger. What logic there was involved putting together a mind numbingly complex financial merger and hoping it might lead to a positive industrial solution, which was always a little strained. But it suited all parties to pretend that they could delay things a little longer by creating a monstrous zombie: Aker got to pretend they hadn’t jumped too early and therefore got a bad deal, Hemen/Fredrikson got to put in less than they would have had to had DeepSea remained independent, the banks got to pretend their assets were worth more than they were (and that they weren’t going to have to kill the PSVs to save the Solstad), and the Solstad family got to pretend they still had a company that was a viable economic entity. A year later and the folly has been shown.

Clearly internally it is recongised this has become a disaster as well. In late December HugeStadSea announced they had doubled merger savings to 800mn NOK. The cynic in  me says this was done because financial markets capitalise these and management wanted to make some good news from nothing; it doesn’t speak volumes they were that badly miscalculated at that start given these were all vessel types and geographic regions Solstad management understood. But I think what it actually reflects is that utilisation has been signifcantly weaker than the base case they were working too. Now Sverre Farstad has resigned from the Solstad board apparently unhappy with merger progress. I am guessing he is still less unhappy though than having seen Farstad go bankrupt which was the only other alternative? I guess this reveals massive internal Board conflict and I also imagine the auditors are going to be get extremely uncomfortable signing vessel values off here, a 10% reduction in vessel value would be fatal in an accounting sense for the company.

The market is moving as well. In Asia companies like EMAS, Pacific Radiance, Mermaid, and a host of others have all come to a deal with the banks that they can delay interest and principal payments. Miclyn Express is in discussions to do the same. This is the very definition of zombie companies, existing precariously on operating cash flows but at a level that is not even close to economic profitability, while keeping supply in the market to ensure no one else can make money either. Individually logical in each situation but collectively ruinuous (a collective action problem). These companies have assets that directly compete with the SolstadFarstad supply fleet, with significantly deeper local infratsructure in Asia (not Brazil), and in some cases better assets; there is no chance of SolstadFarstad creating meaningful “world class OSV company” in their midst with the low grade PSV and AHTS fleet.

Even more worrying is the American situation where the Chapter 11 process (and psyche) recognises explicitly the danger of zombie companies. Gulfmark and others have led the way to have clean, debt free, balance sheets to cope in an era of reduced demand. These companies look certain to have a look at the high-end non-Norwegian market.

SolstadFarstad says it wants to be a world leading OSV company that takes part in industry consolidation but: a) it cannot afford to buy anyone because it shares are worthless and would therefore have to pay cash, and b) it has no cash and cannot raise equity while it owes the banks NOK 28bn, and c) no one is going to buy a company where they have to pay the banks back arguably more than the assets are worth. SOF is stuck in complete limbo at best. Not only that as part of the merger it agreed to start repaying the banks very quickly after 2021. 36 months doesn’t seem very far away now and without some sort of magic increase in day rates, out of all proportion to the amount of likely subsea work (see above), then all the accelerated payment terms from 2022 will do is force the event. But still is can continue its zombie like existence until then…

In contrast if you want to look at those doing smart deals look no further than Secor/COSCO deal. 8 new PSVs for under $3m per vessel and those don’t start delivering for at least another 18 months. Not only that they are only $20m new… start working out what your  10 year old PSV is really worth on a comparative basis. There is positivity in the market… just not if you are effectively owned by the bank.

One of my themes here, highlighted by the graph at the top, is that there has been a structural change in the market and not a temporary price driven change in demand. Sooner or later, and it looks likely to be later, the banks are going to have to kill off some of these companies for the industry as a whole to flourish, or even just to start to undertake a normal capital replacement cycle. Banks, stuffed full with offshore don’t want to back any replacement deals for all but the biggest players, and banks that don’t have any exposure don’t want to lend to the sector. In an economy driven by credit this is a major issue.

I don’t believe recent price rises in oil will do anything for this. E&P budgets are set once a year, the project cycle takes a long time to wind up, company managers are being bonused on dividends not production, short cycle production is being prioritised etc. So while price rises are good, and will lead to an increase in work, the scale of the oversupply will ensure the market will take an even longer time to remove the zombie companies. At the moment a large number of banks are pretending that if you make no payments on an asset with a working life of 20-25 years, for 5 years (i.e. 20-25% of the assets economic life), they will not lose a substantial amount of money on the loan or need to write the asset down more than a token level. It is just not real and one day auditors might even start asking questions…

I don’t have a magic solution here, just groundhog day for vessel owners for a lot longer to come. What will be interesting this year is watching to see the scale of the charges some of the banks will have to make, a sign of the vessel market at the bottom will be when they start to get rid of these loans or assets on a reasonable scale.

Kill the zombies for the good of the industry, however painful that may be.