How much is the Lewek Constellation worth? Somewhere between USD 43m and USD 370m (I’m closer to the former)…

“His services are like so many white elephants, of which nobody can make use, and yet that drain one’s gratitude, if indeed one does not feel bankrupt.”

G. E. Jewbury’s Letters, 1892

The EMAS Chiyoda restructuring plan nears execution. The most interesting aspect to me is what the Lewek Constellation is valued at and how the banks get this problem off their hands (i.e. how much of a loss do they have to take?) Outside of Saipem, SS7, Technip, McDermott, and Heerema (maybe) it is very hard to see who the realistic buyers would be? There is no spot market for these assets because you need a huge engineering capability (and cost base) on the beach to run one of these assets. And the real problem is that all these potential buyers have added substantial new tonnage in deepwater pipelay very recently. (My previous thoughts on asset specificity and transaction costs are here). Without a dramatic improvement in the market it’s hard to see why anyone would want this asset?

Or not? In the Chapter 11 reorg Subsea 7 and Chiyoda are essentially providing a USD 90m Debtor-In-Possession  facility that sees them take over 5 EMAS Chiyoda entities emerge that have 15 projects with c.1bn in backlog. Subsea 7 obviously decided this was the easiest way to get the work, and when you drop c.USD 1bn in backlog in a year it’s easy to see why you want to be inventive. The big SURF scopes are Cape Three Points and Chevron Tahiti Vertical Expansion. Given how far the engineering had advanced and the fact the contracts had been awarded it is easy to see why Subsea 7 would want to take some risk getting this work.

Some context: back in 2013, the build year of the Lewek Constellation, Clarkson published this graph:

Clarkson Subsea Trees Nov 25 2013

Now Clarkson’s are no different to anyone. I could have picked any number of information providers, the commonly held view was only how much growth there would be, and how much kit you needed to access it. Shale was not in vogue and starting it’s extraordinary journey.  Although as an aside, because I don’t want to delve into shale productivity here (but you can read some of my thoughts here and here), the US rig count was higher than it currently is.  But the point is clearly that boards, managers, and financing institutions all thought the market would evolve something like that graph. On such a basis the investment decision was made for the Lewek Constellation and DNB and a syndicate of banks advanced USD 503m in two facilities and got two Panamian mortgages and a credit agreement in return. Of that USD 370m in capital is outstanding under facuility A (and the 100m from facility B is effectively written off) in the Chap 11.

The market has obviously changed somewhat:

Subsea Tree Awards 2000-2019e

The single best indicator of future demand for heavy installation vessels is subsea tree awards. Now it is clear that demand has dropped and will remain depressed for a long time at around 2003/2004 levels. Strip out Brazil, where Petrobras has extensive spare PLSV capacity for flexlay, and you are within a margin of error of 2003 numbers. Yes, more proportionately will be in deep water, but the subsea lay fleet was built for 2013/14 not 2003 and no amount of deferred consideration can change that.

Let’s be clear the Lewek Constellation is a capable vessel, but I wrote here about competition: a significant number of competing vessels have been built in recent years and this is all about competition at the margin. These types of vessels don’t work to their maximum potential every day, they work on a broad range of smaller jobs and then make real money on a couple of jobs of a year where the competition is less and pricing is based not only on vessel capability but about engineering value added by the contractor. None of them is differentiated enough to win a project in its own right.

So a market transaction has been reached whereby Newco (owned by Subsea 7) will charter the vessel for USD 4.3m per annum and the cost of the dry dock (c. 2018) is split 50/50 at ~USD 5m each. That is, in the current environment Subsea 7/Newco judges that it is economic to add marginal (extra) lay capacity at bareboat rate per year of USD 4.3m, plus drydock accrual and operating expenses,  and the bank/owner has agreed it is economic to charter their asset at this rate. That is a market-based economic transaction between a “willing-buyer/ willing-seller” for the capital value of the asset and it reflects some backlog that a qualified purchaser can deliver with it. Subsea 7/Newco has an option to purchase the asset for USD 370m during the first 2 years of the charter agreement and this is then used a “floor” going forward or broker valuations less USD 20m. The extension options rise dramatically (see below).

Now if you add 3% per annum to the charter rate, add in dry dock costs, assume 10m salvage value in 20 years, and discount this back by the DNB WACC (10.4% today) you get an implied vessel value of ~ USD 43m.  I would argue that is a fair value for the vessel, which is pretty much in line with the discount MDR paid for the Amazon and NPCC paid for Atlantis (I mentioned this yesterday).  [I used the 3% growth in the annual day rate to reflect an industry with excess capacity and therefore growth roughly inline or above a CPI measure, obviously the mortgage banks would regard this number as unacceptably low. However, I think the discount rate at DNB WACC (rather than funding costs or liquidity spreads perhaps) given the project risk is far too low. Obviously different inputs will lead to different results.] For the sake of a comparison in order to get the vessel value to anything like USD 370m you have to increase the charter rate 25% per annum for the entire assumed 20 year period! The charter rate is also linked to a LIBOR adjustment, something that is very rare, and highlights how senstive the banks are to a valuation projection here.

This purchase option number strikes me as a fantasy and reflects the fact that DNB recorded a capital value of USD 370m outstanding in the Chap 11 filing. If you look at the forward order book for subsea trees or announced projects in three years, and all the excess capacity on the vessels, who really believes Subsea 7 is going to pay USD 60 000 per day in 4 years time (USD 21.9m per annum) rising to USD 80 000 per day (USD 29m per annum) in 5 years time? You might do under the assumptions in the first graph but not in the second. It is a chimera to help the banks out and allow everyone to play for time. The initial charter rate implies a 1.16% interest rate on the capital outstanding, so DNB don’t really believe the USD 370m figure, but it highlights the size of the economic subsidy required now for everyone to pretend they haven’t lost as much money as they say.

I was a big fan of Subsea 7 just handing the asset back and forcing the banks into a lengthy period of nervousness and reality, but it would have meant Subsea having to tender for the work. I believe that the Lewek Constellation is such a specific asset that it is actually effectively valueless in the current market. The best thing for the industry was for the asset to fade into obscurity; in this market, and after Ceona, no one would risk a start-up and few other companies would have agreed to help DNB. Clearly Subsea 7 have a strong cash and liquidity position, need the work, and this gives them an option if the market really did take off again. However, surely the most likely scenario from the banks point-of-view, under any objective reading of the market, is that in two years Subsea 7 come back and tell them to start getting real about the price and the asset value? There is a very Norwegian behind the scenes solution going on here with DNB obviously desperate not to have to recognise the vessel at a fire sale price now, or expose itself to the OpEx, and in all likelihood was involved in soliciting Subsea 7 as part of the financing shop around discussed in the documents.

If the Bibby bondholders are looking at these transactions closely they must be getting nervous now. With the bonds trading in the mid-60s the implied valuation of the Polaris and Sapphire is c.GBP 105m, a number that looks as egregious as the USD 370m purchase option for the Lewek Constellation.

The big risk for Subsea 7 isn’t the committed expenditure, which amounts to USD 4.3m for charter per annum (+ the undefined LIBOR spread), + vessel OpEx (probably the same), and c. USD 5m for the dry-dock, it is that they appear to have agreed to deliver the EMAS Chiyoda contracts for the same lump sum price and contractual terms. The few projects EMAS Chiyoda delivered were a disaster in engineering terms, and that isn’t just Angostura, I have spoken to people who have managed other jobs with them. If Subsea 7 haven’t had enough time to due diligence the project engineering and costing properly, which is notoriously hard in lump sum jobs, they are going to have a big problem. Although the contracts appear to be novated to Newco, who exposure in one set of documents appears capped at USD 90m (that may be a placeholder), such a situation is likely to involve other Subsea 7 tonnage and exposure through the supply chain. Subsea 7 are one of the world’s great engineering houses but in 2013 a painful conference call to discuss Guara Lula (which they had bid themselves) led to these comments:

[w]e moved into the offshore phase of the project in the second quarter, with the Seven Polaris and the Seven Oceans being deployed on location. We are experiencing more weather downtime than originally planned due to severe weather conditions in the Santos Basin during the Brazilian winter. We have suffered equipment damage and the resulting downtime on the Polaris due to this bad weather. We expect these conditions to continue until the season is over. Although we are contractually covered for time spent by the prime vessel waiting on weather, we incur additional costs, both offshore and onshore, which are not covered. In addition, we have taken a more cautious approach in evaluating what can be achieved offshore during periods of calm weather, in view of the complexity of the facts involved…

Second, the stretched supply chain is resulting in delays from international and local suppliers….

[t]here was a delayed start to pipeline fabrication at the Ubu spool-base largely due to customs clearance issues. Initial productivity at Ubu has also taken longer to ramp up than expected…

A re-evaluation of the offshore risks based on experience to date, and the extended timeline of the project, has resulted in us increasing the estimate full-life project loss by between $250 and $300 million.

Final losses were USD 355m and that was on vessels and a project they tendered internally. Subsea 7 don’t know this vessel at all, and the engineers and tendering staff had all been instructed to win these tenders at all costs having spoken to people involved in tendering at that stage for EMAS. It may not happen, and they may have done sufficient due diligence, but when you agree to go basically lump sum you are taking execution risk on a tender and asset outside of your management system. Don’t complain later you couldn’t have forseen it, but backlog looks like it is going down so fast they may feel they have few options.

At some point the industry (contractors and financing institutions) are going to have to accept that if all this tonnage remains in operation, and the operating costs are included, then it will have a structural profitability issue without a dramatic change in demand that just isn’t occuring. Yes the Lewek Constellation is a flexible asset, and it can save a variety of vessels working in the field, but those vessels exist now, amongst the current contractors. If an E&P company really wants this specific vessel because of its advantages let them buy it? It only looks more “efficient” in the field compared to other vessels because it isn’t being compared to the historic investments currently solvent contractors have made in a fleet of vessels that collectively perform the same function.

Maybe Subea 7 are looking to retire some older tonnage later on and the easiest way to get over a difficult discussion with the banks was to kick the problem into touch? But at some point the discussion will have to come and I would have thought the banks auditors would have forced it now because in a default situation the value of the vessel is very clear: about USD 43m on a standard capitalised valuation framework. Convincing the auditor that in 36 months you will get a 6x uplift in the day rate when the market forecast is for negligible growth and stable supply strikes me as unlikely in the extreme.

The amount of offshore work may have hit its bottom level and some good contracts are being awarded, but as Eidesvik reminded us today more restructurings are coming, Solutions like this which simply push the eventual reduction in asset values further into the distance will only ensure continued weak profitability for vessel owners (and banks).

The market isn’t coming back anytime soon… Asset values will suffer.

“It’s not the despair, Laura. I can take the despair. It’s the hope I can’t stand. ~ Brian Stimpson, Clockwise ”

I have been struck over the last couple of weeks by the contrast between the rig market and the subsea market. OceanRig, Seadrill, Vantage, all seem to be realistic that the equity is nearly gone and the previous business model was unsustainable. Borr Drilling has shown that with a clean balance sheet, and access to assets at potentially “low point” pricing, and a clear cash runway to 2020, you have something investible. It’s a punt, but at least one with a plan. Subsea and offshore seems some way away from this reality, Rigs lead the market in terms of creating demand and it seems the sheer scale of their financial needs has made them face economic reality to a greater degree as well. At least the rig guys have a plan, which is not something you can say of subsea yet (apart from sitting around until the market recovers).

I haven’t had a lot to say on the EZRA/ EMAS situation since Chapter 11 mainly because I don’t have anything constructive to add apart from the fact I think it is good for the industry to have this supply side capacity reduced. US Chap 11 is a court run process, and not one I know much about, the only thing I am sure here is that there is a very complicated problem coming regarding the Lewek Express. In order to frame it properly I ask the question can you be a boatless contractor?

The banks now own this asset, although Bibby was in court a few days ago trying to spread the cost of arresting the vessel with the fellow court participant Waksey Bridges, but I expect eventually the banks to have this asset returned, and then, what do they do with it? Even if the US judge returns EMAS Chiyoda to the market free of onerous charters, like that of the Lewek Express (and everything else) then all that remain is a project management company with perhaps the ability to charter ships? But the new owners aren’t going to put enough capital into the Newco to charter the Lewek Express, and without this asset there is no real point to the company. The reason subsea construction companies own vessels is because they have an asset specificity issue: it is cheaper once all the integration and contractual costs are included to own one.

If you try and charter a deepsea pipelay asset who pays for the liquidated damages if it arrives on the site late? Who pays if you buckle the pipe? Who pays if the vessel doesn’t lay at the speed forecast? These issues go on ad infinitum. And yes you can solve them all contractually, but the whole point is it’s cheaper to own the vessel than do this contractually. In the boom days you also needed the vessel to actually have access to one, and for the sort of work EMAS Chiyoda was chasing that is still the case: Technip and Subsea 7 aren’t going to charter them high-end vessels to do deepwater lay. Saipem might as it starts to get desperate enough, but actually they will just bid lower and cross-subsidize the engineering with sub-economic vessel costs. Without access to a vessel EMAS Chiyoda is just a project management house without a boat, no sane investor in this market would create more capacity by injecting equity in a company that would have to charter a vessel off a bank that requires years of tendering before it could win any project work. Remember the cash cost of running the Lewek Express is at least USD 15k per day, so someone might buy it for 100m but they are not buying it at anything like a level that will keep the banks whole.

I see no future for EZRA, EMAS, or EMAS Chiyoda. The first two were too long on vessels and the third simply isn’t viable as a boatless contractor and the market doesn’t need one. A court can’t change an economic reality. The only real question of interest is what percentage recovery rate the bondholders get and what the assets go for?

But at least the drama for this is in its final stages. The North Sea DSV farce continues. I don’t know who should be more terrified of the Bibby results: Bibby or the Nor Bond holders?

The Bibby results were as bad as feared, they actually could not have been any worse, a GBP 10m write-off to EMAS Chiyoda being the real low point of the US expansion strategy. A £-52m Operating Profit indicates a business model entered into in much better times and limited ability to change it as the market declines. The profits from leverage are so great in the good times succumbing to the temptation to go too long on vessels is hard to resist. And so it proved at Bibby. With the Olympic charters (Bibby and Aries) having significantly more time to run (late September 17 and June 18) unless the market changes significantly its a question of when, not if, the restructuring process begins. Customers should sign up now because the contracts will be novated across. The real question is why the bonds are still trading in the mid-60’s which implies an Enterprise Value of £105m, which for a business consuming cash at that rate seems extraordinary. Even stripping out exceptionals the business seems to be going back at £100k per day in cash terms.

I have to be honest and say I don’t think the solution here is to borrow more… The solution proposed seems to be that Bibby Line Group put £10m into the revolver and Barclays open it up for £20m more. If Barclays really follow through and increase their borrowing limits to fund this then they are braver than most commercial bankers; by putting the money in at the revolver level Bibby Line Group would guarantee themselves a seat at the creditor restructuring table, something Barclays and the bondholders are unlikely to welcome. One bondholder has already asked why the BLG £10m (50% of the dividend they took in January 2016) contribution to the revolver wasn’t put it as equity? The answer is BLG has enough accountants not to be that stupid: it’s a risk-free loan (given the revolver has seniority over the bonds) or nothing at this point from Group for Bibby Offshore.

But Bibby got DSV utilisation up to 77% which is impressive. I have put a little comparison in with the Nor vessels:

Bibby DSV Utilisation:      77%

Nor Atlantis Utilisation:    0%

Nor Da Vinci Utilisation:   0%

The problem isn’t that there isn’t any work out there the problem is no one wants to buy what Nor are offering, and this despite the fact The Contracts Department (“TCD”) claimed that they had a plan for the vessels and they were the first point of call people would naturally go to for the vessels and associated work (or so I was told by AMA Ca[ital the bondholders financial adviser). It is hard to know if TCD actually believed this, in which case they aren’t close enough to the market to know what they are doing, or if it was a cynical ploy to extract some money from a dispersed group of clueless financial investors. Most rational people would think sitting at Blyth for well over a year, waiting for the mountain to come to you, was not the most cunning plan, and as sometimes happens the madness of the crowds was right in this instance. The Nor vessels have turned into a rort for contractors and service providers, the dive systems are being maintained by a company whose previous strength was in mobilising Ampleman systems, the Contracts Department are fighting with them now (no doubt to try and get their friends at Rocksalt on the vessels), and there is no economic incentive for any party to actually save the Nor bondholders money because they don’t know when this gravy train will end, so just front load the returns everyone figures. The only work, for one vessel only, appears to be in the Middle East where Nor are one of 18 bidders. Nor Offshore remains a salutary reminder that financial investors can continue to get taken to the cleaners by Ops personnel who realise how limited the general financial investors’ knowledge of the asset is. Any serious charterer or buyer for the Nor DSVs  just needs to sit around until November now, when the owners will be nearly through their USD 15.9m, without having worked a day, and get the firesale price they demand or force them into another complicated fundraising (given the last USD 15 was “super senior”). Given Subsea 7 fired up a DSV for 200 days for Apache the logic of this strategy has really been laid bare for all the risks it entailed.

But unfortunately for Bibby they have got utilisation up by getting real on price (and it’s a credit to the operational managers who have got utilisation this high). Day rates for DSVs have been as low as GBP 75-100k for SAT diving (and the divers/ project crew are £50k of that), there is precious little in the mob fees etc. All that is happening is that equity is being eroded (or is gone), and older DSV operators, who have depreciated the vessel, are at an advantage over newer owners, who must at some time try to recover their capital. Scale and scope count at this point which benefits Technip, Subsea 7 and DOF.

Everyone is chasing wind farm work, but as all those involved in the industry know it is hugely margin dilutive, even if it gets you utilisation, it comes with greater contract risk. Civil contracts are used (not LOGIC), variation orders are hard to get through, there is a greater reliance on free issue equipment etc, and because production doesn’t bring “first oil” there just isn’t the ability for a contractor to make as much money.

I stand by my previous statements that unless there is a substantial pick-up in construction activity this is the new normal in the North Sea DSV market. IRM has reached its lower limits and will not drop more. But Subsea 7 and Technip have introduced new tonnage, and USD 50 oil just isn’t enough to get new projects launched that are based on the “small step-out/ infield” model that drove previous construction booms. Both Bibby and Nor seem to be like rabbits stuck in headlights just pretending that if they wait in the middle of the road long enough, and with enough determination, the good old days will return. Unfortunately for the rabbit it takes a road a very long time before the road returns to it vegetative state, normally longer than the rabbit can last.

 

These cases are just microcosms of a bigger problem which not enough people in subsea have realised in my humble opinion: the fabled recovery, the great hope that everyone holds out for doesn’t seem to have a good economic foundation: supply has increased, demand dropped dramatically, and the “constant” of maintenance work proved to be illusory. At some point asset values are going to have to reflect the fact that OpEx has remained constant (these costs have “nominal rigidity” due to the high labour input), and therefore it is an identity that the asset values must be lower when overall expenditure is capped. Getting there strikes me as a painful journey that has just begun.

DSVs and pipelay vessels have in common that in the old days (c.2014) banks and bondholders would lend against them and that made asset values higher. This downturn has shown how illiquid these assets are, and in the worst case scenario even running them while waiting to recover the costs can entail significant cash expenditure. This means quantitatively the assets are worth less: they will be financed with less gearing (if any) and the payback period will need to be shorter. The biggest change in offshore finance going forward will I believe be the realisation of this factor creeping across the industry: smaller players will struggle to come close to matching the financing advantages of larger companies, a situation that has never before existed in offshore. On any rational basis, the industry will be financed with a significantly higher degree of equity than people were used to in the past and that pool of equity will be chasing more limited financial returns from projects. This will lead to significantly lower equity returns for an extended period that will dry the investment market for all but the best companies and business models, and the slow, inexorable, correction process will continue… just like the rig market, only slower by the look of it.

Subsea 7, Ingleside, and excess capacity…

Mankiw’s third principle: Rational People Think At The Margin.

Thanks to all those who pointed out the “363″ sale in the DIP documentation of Ingleside to Subsea 7. I still think this agrees with my last post. Quite how this fits with a Helix repossession is one for the lawyers. But it would appear Subsea 7 is buying the Ingleside spoolbase, superior to its own in the region, but also leasing, for a minimum of 2 years, the site on a co-lease arrangement back to an EMAS Chiyoda subsidiary. So yes Subsea 7 gets a better spoolbase, but it also helps keep a competitor and the Lewek Constellation (“LC”) remain in the market. In a world of excess capacity that strikes me as a poor strategic move.

Thanks also to the people who pointed out that Subsea 7 doesn’t have a vessel like the LC in the market. I get they may not have an exactly capable vessel (deepwater reel-lay), but you don’t take on ownership a vessel for one project; and more importantly Subsea 7 should want this vessel to leave the market permanently. Chartering the vessel for BP Mad Dog, and allowing access to Ingleside, which keeps the LC in the market, is just allowing someone entry in the market. Buy Ingleside without a lease, or allow the banks to own the LC and Ingleside, sooner or later they will crack, and just sell it for what they can get. After Ceona I imagine the number of private equity buyers for a subsea business, with a complex asset base and no work, is small. The LC without a decent spoolbase is worthless and the banks, who would really have been in trouble without this agreement, must feel they have a get-out-of-jail card. It will take years to get a sale and some work for the vessel if it can be done. Back yourself to win market share instead of committing resources to help others out.

There might be the odd project each year where Subsea 7 could have won it with the LC in the fleet, but are there really enough to take ownership of the boat when the backlog is declining so much? The good Susbea 7 results today were a virtue of projects tendered in better times and supply chain costs coming down in the final delivery phases. Don’t expect this trick to carry on indefintely.

Subsea 7 may lose the odd big project against TechnipFMC/ Heerema (Aegir), but they were not going to win 100% of the possible work anyway.  One of the problems with subsea is the lack of standardisation, so if an E&P company wants the option of a project that can only be done with deepwater reel-lay, then they expect more than one company to tender. But what if there is a natural monopoly?

A natural monopoly is a distinct type of monopoly that may arise when there are extremely high fixed costs of distribution, such as exist when large-scale infrastructure is required to ensure supply. Examples of infrastructure include cables and grids for electricity supply, pipelines for gas and water supply, and networks for rail and underground. These costs are also sunk costs, and they deter entry and exit.

In the case of natural monopolies, trying to increase competition by encouraging new entrants into the market creates a potential loss of efficiency. The efficiency loss to society would exist if the new entrant had to duplicate all the fixed factors – that is, the infrastructure.

It may be more efficient to allow only one firm to supply to the market because allowing competition would mean a wasteful duplication of resources.

What if the number of projects only supports one such vessel on a rational economic basis globally? Then TechnipFMC/Heerema would bid at a level that would force E&P companies to look at other technical solutions better suited to another contractors fleet and skills and prices would magically adjust. If the E&P companies are so convinced they want more than one deepwater reel-lay system in the market ask them to have a whip around and buy the LC and operate it on a pool basis? Or underwrite the OPEX and dry-dock costs for a few years for a reduction in day-rate when they get a project?

This is economic change at the margin where all the real action takes place. Substitution when prices get too high, and new economic actors finding new solutions. The fact is EMAS Chiyoda could not make the LC work in the current economic environment. Not through lack of effort but through lack of demand. That capacity needs to leave the market and Subsea 7 need to be doing everything in their power to assist that not helping potential competitors stay in the market and depress margins.

You simply cannot see the scale of CAPEX reductions coming from E&P companies for further offshore investment and argue all the large assets need to remain. It is simply illogical at the macro level. If the big five contractors simply refuse to help EMAS Chiyoda here, and there is no rational incentive for any of them to move here given they all have extreme excess capacity, the LC is worthless as a pipelay vessel and the banks will have to sell the spoolbase at its fair market value. This DIP provided by Subsea 7 merely delays inevitable restructuring and may peversely keep industry margins depressed for longer than necessary. If I was a shareholder I would be furious.

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.

Bibby and EMAS restructuring… you can’t borrow your way out and the Bezzle…

The end is nigh. What a mess.

Firstly, I was wrong in my previous post. Obviously, if Bibby Offshore (“Bibby”) was trying to arrest vessels owned by EZRA/EMAS they wouldn’t have a valid claim as EMAS Chiyoda (“EMASC”) only charters in the vessels. I should have thought of that. In which case the entire USD 15m is as good as gone with this announcement.

Secondly, this announcement essentially confirms that EMASC is not a viable business. When all three shareholders write the value of their loans and equity to zero they are confirming numerically what has been obvious for some time. I note that the statement from EMAS states that Forland hasn’t yet called on the EMAS guarantee, I think we can safely assume that isn’t because they have no intention of doing it, merely they are playing for time like everyone else here, hoping against all reality that someone has missed something and there is a magic solution here.

These carefully worded PR statements belie the chaos that is occurring behind the scenes. Bankers and lawyers pouring over documents and contracts, finance departments frantically trying to put together models and cash balances under various scenarios that show some hope. I feel for the EMAS staff here who must be under huge pressure. Various credit committees escalating the issue at the bank because calling time on a default this big is a very senior decision…

Apart from size there is one very obvious difference between Bibby and EMAS: the industrial logic of a core business. Both have borrowed too much money to have any hope of redemption under their current capital structures, but Bibby has a good business trapped under a mountain of debt and the same cannot be said of EMAS.

The core Bibby business, North Sea saturation diving  (mainly UKCS but also Denmark and Netherlands), is very good. Bibby delivers a good product and has a team of some very capable people, who day-in and day-out safely put divers on the seabed and deliver essentially a good service. The issue is the capital structure and an internationalization strategy, that although unlucky with timing simply hasn’t worked, and the EMASC write-off is likely to be the nail in the coffin for it.

But the whole point of a restructuring is to take a business with a poor capital structure and a sound business and fix it: this is the way the creditors get the best payoff. The logical solution here is for Bibby to seek a structural solution that sees it exit the international businesses,  the majority of the ROV business, exit the onerous vessel charters, and return to being a UKCS saturation dive contractor with the Sapphire and Polaris fixed firm and the current risk-based arrangement with the Topaz. There is a core industrial logic to this but this business has no hope of generating enough cash to repay the bondholders their £175m (at par), pay Olympic for the vessels charters, and keep funding the US (and potentially settle the Borderlon claim).

Given discussions I have had in the City this week, an attempt to financially restructure the business is clearly underway. The first proposals I have had mentioned clearly do not reflect the gravity of the situation: one involved lending money against the Sapphire and Polaris, with the lenders on these assets becoming “super senior” to the bondholders. Someone even tried to suggest that they were going to unlock their revolver to cover short-term cash needs. Bearing in mind they have lost access to the revolver due to breaching the covenants quite why the lender would open this up and increase their exposure to the current capital structure is beyond me? I get the revolver bank is super-senior, but all that means is that if Bibby burn through that cash before the market recovers the bank is the proud owner of two North Sea class DSVs and cash at hand. Ask the Nor bondholders how well that works out… The problem here is too much debt, not too little or not enough access to it, and too little equity.

Bibby needs a major debt for equity swap, new working capital lines, and a fundamental pull-back to the North Sea market. The scale of this adjustment is so big, both financially and organisationally, that I understand why this isn’t the first option. But this will be the final solution here: everything else is economically irrational and eventually the brutal reality of the cash burn and strategic position will hit home. I have heard mentioned many times “won’t Group put more cash up?” In my experience BLG are extremely rational financial investors, and if you own a house over a mineshaft, where the mortgage is worth more than the house, and it’s a limited recourse deal (i.e. no Group guarantee), why would you keep the bank whole rather than walk away? Any new money going in would need to reflect the position of the business today not when the bonds were issued. Bibby doesn’t have a short-term financing problem it has a capital structure issue because the business is, and will be, fundamentally smaller than when the bonds were issued. Revenue has dropped by more than 50% so it simply cannot earn enough to satisfy all the creditors and there are no reasonable assumptions one can make about the size and timing of a market turnaround that would make this a short-term financing issue rather than a longer term capital structure issue.

EMAS on the other hand, have no industrial logic behind them at all. They timed the move into deepwater spectacularly badly and there are plenty of companies that will fill the void when they are gone. EMAS was a financing proposition looking for an industrial strategy, it relied on a boom market and constant acquisitions and financial engineering to appear as if value was being created in lieu of cash. Markets can remain irrational longer than you can remain solvent the Great Man is said to noted,  in this case however for EMAS the market demand for oil services moved back to a lower, more rational level, and their strategy reflected the “greater fool theory“. The industry as a whole needs EMAS to collapse to start to restore the supply/demand balance. There is simply no investment case here: they have no backlog, no distinct competitive advantage, a wall of competitors with extensive financial resources and years of experience, and no credible core market. I don’t know exactly how this is going to play out but I know the end result with great clarity.

EMAS, and the bubble that surrounded it in Singapore, is best summed up by Galbraith (to be clear I am not yet suggesting anything criminal has taken place it is more the mentality although it clearly applies to Swiber):

To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.”

 

Toisa, Emas Chiyoda, and Bibby… oversupply meets a wall of debt.

News that Toisa had gone into Chap 11 felt significant across the industry today I think because of their DSV exposure. On the face of it Toisa was just another mid-sezed operator, subscale in any one asset class, apart from dive vessels. Like a small Norwegian fishing boat owner the company had ridden the boom of offshore to end up with an enormous asset base exceeded only by its debts. This story also increasing the noteriety of the somewhat enigmatic owner.

Having been involved in negotiating a charter and purchase of a Toisa DSV I stuggle to feel sympathy for their collapse (as opposed to the Sealion team who were always extremely professional and nice guys). Times have changed since then, the bidding for the Polaris so hot betwen us and another party we each had 30 minutes to approve each round of day rate increases until the other side pulled out, this at 2200 at night UK time with each number feeling uncomfortably large. Callminopolous from NYC calling the shots and demanding we work on NY time. Such was the shortage of North Sea class DSVs, and the lack of spot market, we had no option. How times have changed…

 

In one of the great ironies of the “new normal” of offshore the only people who don’t seem to know there is no spot market for North Sea class DSVs own two and are keeping them tied up, fuly crewed, in Blyth in the hope of creating one! I digress… Toisa is big news because they went long, and were known for DSVs, and by going under they have shown that we are in unchartered territory for DSV ownership.

Which leads nicely on to Bibby/ EMAS. If there was any doubt that EMAS has a solvency problem, as opposed to a liquidity problem, the news today that Bibby was taking them to court for unpaid work and seeking to seize vessels for unpaid bills should put the question to rest. Bibby appears to have done  USD 18m of diving and has only been paid for USD 3.5m. Let’s be clear what happened here: EMAS Chiyoda (“EMASC”) has taken lump sum construction risk on the Angostura development and this had a diving element. EMASC have contracted Bibby to do the diving, in all likelihood on a day-rate basis, and EMASC have underestimated how long it would take to do. You can take 10 or 15% off a dive contractor for some spurious reason, say the bell-runs were slow for example, but you can’t credibly claim an 80% reduction from your dive contractor. EMASC aren’t paying because they don’t have the money. You only take risk you can control in offshore, and lump sum exposure to dive time, when you don’t have the correct DSV for the weather and tidal flows (it needed the Bibby Sapphire not a modular system like the one on the Lewek Toucan) is risky, some might say crazy, but whatever it was they miscalculated and lost.

Its a sign of the current market that people are taking extraordinary commercial risk to win backlog and when this goes wrong, which it inevitably will sometimes, the already razor-thin margins are gone. The EMASC shareholders will surely be looking at the Angostura project in detail before they advance further funds.

And as we all know this comes right in the middle of an attempted refinancing. Chiyoda issued this statement today:

EMAS CHIYODA Subsea Limited (“ECS” registered in the U.K.; Chiyoda Share 35%) is engaged in subsea construction work and due to the current harsh business environment has been conducting a detailed review of its operating strategy. It is anticipated that current and future profitability of this affiliate will be much lower than planned.

If you buy a business in June and have to issue this in January I think you need to revisit the due diligence report. My contacts in Chiyoda tell me the mistake occured because the Japanese thought that there was a mistake in the DD report and the forecast losses were in Yen not dollars, the realisation of this not being the case coming as somewhat of a shock (that was a geeky finance joke but hey its my blog). But I seriously read this statement, acknowledging a USD 336m writeoff, as some form of corporate acceptance that they are not continuing with this. I love the dry PR speak “profitability… much lower than planned”… You think? I’d be interested in the variance analysis in the DD report of what was planned… It would make a smashing waterfall chart (maybe on a logarithmic scale?)

Paying Bibby USD 15m is material when you only paid USD 180m for 50% of the business. I think on any reasonable basis EMASC could have lost somewhere between USD 30-50m just on Angostura alone. If that is right then any hope of a major financial rescue for the company looks nigh on farcical as Chiyoda appears to be accepting.

Splash 247 appear to have spoken to EMAS Chiyoda regarding the vessel arrests and they issued an anodyne response but accepting this action was taking place to seize the vessels. I am no expert on maritime law but if this is the case it strikes me as a clever move on Bibby’s part: I think the mortgage holders on the vessels will have to assert their rights (who are the banks behind EMAS) and then clear Bibby out before they get the vessels back lien free (but this will very much depend on where they are seized).  This will really throw a hand greande into the restructuring talks because if the banks won’t release the funds to Bibby they may have a problem getting clear title to the vessels, but if they do they will be preferring one  creditor over another which is a big issue in administration.

Whatever the answer the game is surely nearly up here for EMAS. Its almost sad to watch. Like an elephant being downed leg-by-leg, slowly falling to the ground. EMAS and its affiliates are just not economically viable in this market. Seriously who is going to sign a major offshore construction project with this company?

Bibby simply cannot afford to write off USD 15m. I expect the majority of this cost had been taken when they released their cash figures for Sep 30 2016, although looking at schedule timings there may still have been another 30% to be made, say USD 5m. If so it only highlights what I have been saying for a while that a restructuring here is inevitable. Some sort of structural solution to getting out of their expensive US offices and the Borderlon dispute make this virtually a neccessity. The EMAS claim will be in the name of the US entity (Bibby Subsea Inc), I have no idea if it can be assigned but I suspect not, so Bibby need this resolved now.

Bibby have had to pay for divers and other project crew and given current vessel rates I would say that USD 18m was all cost (i.e. the vessel was bid at cost). The accounts for last year will have to be restated even if a majority of the costs were taken last year. Given Bibby was down to GBP 53m cash at Sep 30 last year, is probably going back c. GBP 4m per month over the winter, a c. GBP 12m writeoff for EMASC is going to hit hard. A business Bibby’s current size needs c. GBP 20m in working capital so we are not far off a change in the capital structure and corporate form here.

Quite how Bibby allowed EMASC to rack up such a debt is nearly beyond my comprehension, but unfortunately well within it. You have the most leverage when the DSV is in the field and you threaten to pull unless you are paid. The problem with that is it’s a nuclear option which makes a legal outcome virtually inevitable. You need to the judgement of Solomon to really order the vessel to leave the worksite, but for a company with GBP 53m in cash and going backwards rapidly, to lose GBP 12m to a single creditor needs a decent explanation. Barring some magic with this latest legal move I think that is the position they are in unfortunately because I don’t think EMASC have the money to pay them even if they want to (which they clearly don’t).

Toisa, EMAS, and Bibby share a common problem: too much debt. EMAS have compounded that by buying backlog in-order to get cash flow with poor contractual terms as well as low-prices. It’s a stunningly unattractive investment proposition for the Japanese or anyone else wanting an entry point into offshore.

 

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.