You can’t stop time…

“In 1936 I suddenly saw that my previous work in different branches of economics had a common root. This insight was that the price system was really an instrument which enabled millions of people to adjust their effort to events of which they had no concrete knowledge.”

Friedrich Hayek

“They say I’m old-fashioned, and live in the past, but sometimes I think progress progresses too fast!”

Dr Seuss

In Singapore both EOL and Pacific Radiance are trying to freeze time to their advantage. I can’t see it working. Both parties seem to be using a judicial process to try and slow the reality of weak market conditions, and yet the longer this keeps on the worse the offers to finance these businesses seem to get.

EOL signed a “binding” term sheet with new investors in September 17… Then BTI/Point Hope came back and said they wanted new terms, and then again… and again. The only possible explanations were A) EMAS is performing even more poorly than was estimated last September when they first agreed a “binding” term sheet, or perhaps than in December 17 when they agreed a revised “binding” term sheet; or, B) the market hasn’t recovered so the new investors don’t want to put cash in. The parties were looking to sign another (“binding” I presume?) term sheet so asked the court for a moratoria that will allow them to keep operating while they tried to sort out a $50m investment. But then today BT accepted reality walked away. It bodes ill for Pacific Radiance.

At some point the creditor groups led  by DBS and OCBC must be forced to either recognise the market value of the assets or just accept what is needed in terms of the size of the write down, which is going to be very large if they liquidate the EMAS fleet now, or new working capital required and what it will be priced at. It is very hard to see anything viable coming out of EMAS whatever the price.

Pacific Radiance can’t even get the binding part of a term sheet: they just have a group of investors so keen to move forward they can only agree preliminary terms. News reports suggest that these are investors from outside the industry looking for a bargain. Good luck with that. The only operational plan appears to be for the company to carry on as before and spend a ton of new money on OpEx while waiting for the market to turn (and enter the nascent Asian wind market). That’s fine if you could actually get the money signed up to do this, but of course that hasn’t happened yet…

The Pacific Radiance restructuring involves USD 120m cash going in and the banks writing off $100m but getting $100m cash out immediately. Getting effectively .5 in the dollar on some aging offshore support vessels is a great deal in this market (see above)… almost too good to be true… The remaining USD 120m gets paid back over three years starting on January 1 2021. This is the ultimate bet on a market recovery in the most margin sensitive OSV market in  the world. Pacific Radiance generated a cash loss from operations of $4m in Q1 2018, so should the market not come back then you have a small amount of cash sitting behind USD 120m of fully secured bank debt. Given current OSV rates if investors are putting money into this project they are betting that this company can generate at least $40m per annum to pay the banks back before they have any prospect of their equity having any value in only 3 years time.

I will be really will be surprised if the Pacific Radiance deal goes ahead in this form. At this stage of the cycle if you are providing working capital finance to help the banks recover their asset value you should have some prospect of getting your money back first. A three year repayment profile just doesn’t reflect the economic realities of these vessels or the likely market moving forward no matter how much the banks behind this may choose to believe something else.

People keep telling me that DBS and OCBC have have taken large internal write-offs with their investments in these companies. I struggle to believe this as if this were really the case the banks would surely just equitise their investment fully, bring the new money in, and sell the shares when they started trading again, which in simplistic terms is what happened to the creditors in the Tidewater and Gulfmark. Both banks, as with all banks with lending to the sector, should be maximising their own position, but in doing so they are ensuring collectively the poor financial performance of the entire fleet they longer they keep the extensions up.

There is a fine line in these situations between judging when the market is being excessively negative in the short-term, and therefore put new money in, or just liquidate. I know the bankers are loo king at Pacific Radiance going how can USD 600m be worth so little? But the answer is the assets have a very high holding cost and breakeven point and they lent in the middle of a credit boom. Given current market prices it looks like the banks are holding out not just for the unlikely now but the impossible. In economic terms these banks own nothing more than a claim to some future value on a vessel if the market recovers, and for a load of reasons (some related to accounting regulations), they want others to front this cost. But the economic substance of their claim remains the same.

Both Pacific Radiance and EMAS are  locked in a problem of mutually assured destruction if they both get temporary funding for another season. The market is structurally smaller than it was five years ago and ergo the vessels are not worth as much, and at the moment cannot generate enough cash to cover more than OpEx (not even including dry docking). The market hasn’t come back and shows no sign of doing so in any substantial way. If both of these firms secure further cash to blow on operating at cash break even for another season or two they will simply ensure overcapacity remains and no one in the industry can make money and therefore no rational investor should put money into the industry until capacity is reduced.

This Tidewater presentation shows quite how oversupplied the market is: from 4.5 vessels per rig to 8 on a significantly lower rig base down 40% from the peak in 2014.

Tidewater Market Equilibrium.png

The other point to note is that turnover for Pacific Radiance dropped 16% on last year for Q1 2018. Price deflation in an asset industry, particularly one with debt, is the nuclear bomb of finance as debt remains constant in nominal dollars while real earnings to service it decline. I doubt Pacific Radiance lost market share so I think that is indicative of pricing pressure that customers are pushing on them. What is clearly not happening, as in every other sector of offshore, is that E&P companies are asking vessel owners to scrap older tonnage so they can pay a premium for newer kit. In fact they are just demanding, as they always have but particularly in Asia, the cheapest kit that meets a minimum acceptable standard. The “aging scrapping” myth will have to wait a while longer before becoming reality. Pacific Radiance might be right and the nadir of the market has arrived, but there is precious little sign of an upward trajectory from here, and plenty of signs from contracted day rates that market expectations are for at least another season of rates at this level.

To be fair the graph is contrasted with this:

Supply is tight.png

But “adjusted supply” is a forecast and a nebulous concept at best. And with a 16%% drop in revenue over last year even if the increased utilisation figure is true it just means productivity is dropping. There is no good news at the moment on the supply side.

If prolonged these constant judicial delays to economic reality risk doing further harm to the sector as they will actually discourage private sector investment. MMA raised private money on market terms to manage the downturn, yet it’s returns are being forced lower because it is effectively competing against firms being kept on life support by a seemingly never ending stream of judicial moratoria from its competitors. The more this happens the less other private investors will become to get involved because a never ending overcapacity situation becomes effectively a court annoited market.

There is a moral hazard problem here where these indefinite moratorium agreements encouragement management, and in some cases creditors, to negotiate in bad faith while the costs of this are paid for by private sector investors who have put new money into competitor companies. The BT/ EMAS position shows the folly of allowing parties unlimited time to negotiate as it worsens the economic pain for firms that have proactively sought solutions. At some point these parties need to be given a “hard stop” date at which time the courts will not allow moratoria to be rolled over.

Eventually the restructuring in Asia will begin in earnest because there are simply not enough chairs now the music has stopped (with apologies to Chuck Prince). EMAS surely looks likely to kick this off.

Groundhog day for EZRA…

Another day and another trading halt for EZRA. This episode is now starting to make the SGX and its listing regulations look silly. There is no real market in these shares and there is no purpose in helping to create a market by stopping trading, then starting (with no real explanation) and then stopping (repeat indefinitely)… SGX and investors need a decent explanation now. The whole point of trading shares is to provide an ongoing market, not an optional time when management can dictate if they think the shares should be traded. EZRA and its affiliates have also been given far too much dispensation for a listed company around their “going concern” status and are at the risk of over trading. Either you are a going concern, and your shares should trade continuously and the Directors feel comfortable the company can meet its obligations, or you are not and the shares should be de-listed and you should be in administration. Small, extremely irregular, events that may induce a false market in the shares warrant a temporary suspension. But investors and capital markets are not well served by these sorts of events when it is clear to even the most economically illiterate that the EZRA group of companies has extensive financial problems.

Either EZRA and its associates have almost secured a funding deal, in which case the need to give a “highly confident” statement to SGX justifying the timing; or they haven’t, and administration is nigh, or an explanation of why it isn’t. Trade creditors are publicly stating they haven’t been paid and are taking legal action, clearly those involved in the creditor standstill, most publicly Ocean Yield and Forland, have lost confidence in this process and have bowed to the inevitable. Forland in particular is clearly looking to force the issue. The length of time now between announcements regarding creditor standstills but the lack of clarity (which speaks volumes) on any alternative funding plans makes it clear that there is no solution close.

I stated as far back as December that Forland and Ocean Yield are were getting their vessels back and this is now starting to happen. Ocean Yield clearly deciding a managed handover being an infinitely better option than simply allowing the vessels to be left in an uncontrolled environment when this credit event occurs.

The real issue here clearly appears to be the banks. I read with a mild degree of mirth this week that OCBC and DBS claimed the were collateralized on their outstanding loans. Its an interesting notion this because if DBS and OCBC really believe they can sell such specialist vessels as the Lewek Constellation for anything like book value they haven’t been told the truth. All potential buyers for it as a deep-water construction vessel have sufficient tonnage and in a declining market and only the deal of a life-time may induce them to buy more assets. Without getting into a technical details “deal of a lifetime” is nothing like book value for the banks.

The key is the carry cost of such future optionality the vessel provides, the running cost for the EZRA/ EMAS Chiyoda fleet is in the tens of millions each year and there is insufficient work on the books in all likelihood to even cover the basic operating expenses. Any new investor coming into this business is stuck with a very high cost base from day one. In the current market it is a stunningly bad investment proposition. In addition without a restructure there are sufficient trade creditors whose claims are starting to be significant. Bibby is in for USD 15m, I met the MD of another subcontractor last week who is owed USD 8m from July last year (and who then went and did more work for them in October which is now becoming due), and these are clearly the tip of the iceberg. (As an aside he told me the engineering he had seen coming out of Singapore was some of the worst he had ever seen).

I maintain my view that the only realistic solution here if EZRA is to survive is a massive debt-for-equity swap in conjunction with new equity. I wonder how realistic this is, especially as it seems clear now that EMAS Chiyoda has lost some real money on the projects it has actually won in the last year, but expecting sufficient new equity to come in and recapitalise these businesses on anything like the scale that would give them a financial runway to make it through to an industry upturn, seems unrealistic. The Ocean Yield and Forland moves also indicate that there is no real progress in this regard and it looks to me as if the banks are trying to deny the seriousness of the problem. But only the banks here can have sufficient future confidence in long-term asset values to provide sufficient liquidity for EZRA to trade through. Like a central bank, if they really believe their collateral is good, and this is a mere market event, then DBS and OCBC and others should follow the Bagehot dictum and lend freely on collateral that would be good quality in ordinary times.

Of course if DBS and OCBC do this they are taking equity risk and their shareholders will likely question management judgement. But there are no good options left. Offshore assets have been sold in distressed state for between .1 and .3 in the $1 implying writedowns and running costs of hundreds of millions are coming for the banks and it seems they really don’t want to accept this. The regulatory bodies should insist on using Swiber like-for-like transactions when OCBC and DBS report.

 

 

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.

 

One E(nor)MAS Chiyoda mess…

our-fleet-inspector-top.jpg

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Offshore contractors face ‘bank run’ scenarios

lewek-constellation

I was struck by how much EMAS (and other offshore contractors with poor balance sheet strength) need to be viewed as facing a ‘bank run’ like scenario after reading this BIS article on the collapse of Continental Illinois. The key question is can a ‘funding run’ be stopped for both contractors (and banks). The Lewek Constellation (above) is an amazing operational asset, but it needs a vast flow of future profitable project work to keep it going (and proper deepwater construction work not infield), and the question at the  moment when looking at the financial strength of EZRA/EMAS/ EMAS Chiyoda is who would award them a complex multi-year construction project?

The only thing that keeps these vessels (and others in the fleet like the currently in default Lewek Connector) is large lump sum jobs with a strong blended cost of high value, low capital intensity, project management fees to balance out OPEX of the vessels. At the moment large companies are all doing this at relatively low margins; where is the incentive to get an even cheaper price from EMAS Chiyoda and find mid project there has been a credit event? The offshore phase is the capstone of all the earlier custom engineering work that has been paid in stages along the way. No one ever got fired for buying IBM was an ad used with great effectiveness to convince mid-level procurement managers to go for the brand. In the current environment no one is going to get fired for buying Technip, Subsea7 and McDermott; but risking a multi-million dollar field development on EMAS Chiyoda is whole different story. Should a credit event occur all pre-funded engineering and procurement spent would in reality make the purchaser an unsecured creditor (and a lot of it would be vessel specific so no use anyway); not to mention performance bonds etc. There have been no significant news of awards for the Lewek Constellation recently and in reality there are unlikely to be.

Offshore contractors are in a pro cyclical industry and take long positions in assets with long funding and economic lives that are in a downturn illiquid to the point of having no saleable value (like now). These assets are funded with some equity but also a significant quantity of debt, with a funding profile less than economic life of the asset, from senior banks and more recently by increasing amounts of (often “issuer rated”) high-yield bonds, or off balance sheet financing from vessel charters. In operational terms an offshore contractors asset base has been funded by a series of offshore CAPEX projects significantly smaller in length and value than the underlying asset base. In banking this is called maturity transformation: banks lend long and borrow short; in offshore the contractor goes long on illiquid assets and funds them in the short-term project market. There is a clear analogy here with contractors serving the E&P companies by going long on highly specific illiquid assets and funding this with a series of short-run projects. Clearly the capital structure of the industry in a macro sense has not reflected this reality well as increasing margins led to ever increasing amounts of debt and rising asset values substituting for real equity (and Swiber and EZRA/EMAS were two of the best exponents at this form of financing). Minsky would have seen this coming a mile off

Net fee income is important for banks as the money they make on the asset base often only covers the funding costs with a small margin. This is true for offshore contractors as well, as discussed above, when that “fee income’ for engineering and project management dries up in poor market conditions the operational offshore asset base cannot even come close to covering its funding costs.

The Continental Illinois demonstrated how hard a bank run is to stop, as even with a Government guarantee, financially rational investors choose to leave in droves ensuring institutional failure. Just like a bank loan portfolio an asset like the Lewek Constellation will be worth nothing like its book value in the current market; it  may actually be “worth” close to zero given the high running costs and the lack of other uses. The same will apply to EMAS Chiyoda as a whole (and other offshore contractors): a run in confidence on their ability to be in business in 12 months time will become a self-fulfilling prophecy in all but the most exceptional cases because the financial gain from any price reduction that could be offered cannot compensate the risk of a large offshore project not being completed.

The pro cyclicality of operational offshore and financial assets  leads to huge volatility and as the Cerrado deal showed the OPEX costs may actually induce steeper depressions than problem loans from financial institutions. One thing is clear: at the moment many assets in an offshore construction/support vessel fleet are almost unsellable at any price and there is no Bagehot inspired institution willing to lend freely on any quality asset to stop a liquidity crisis becoming a solvency one. In fact as the current wave of restructuring among contractors at the moment indicates these are  solvency and liquidity issues combined. Like a banking crisis the offshore industry is awash in leverage and this will in all likelihood prolong the downturn and make a recovery harder.

What really needs to happen for EZRA/EMAS/EMAS Chiyoda is for all the creditors together  to undertake a massive debt-for-equity swap (if you have faith in the assets be the Bagehot: effectively lend freely on collateral that would be good in “ordinary” times – of course there isn’t much because the vessels are chartered); to try and get over the current downturn (if you believe it is just that or DCF some future recovery value anyway) and try and recover value in an orderly fashion accepting that the asset base may simply not be  worth what it was a couple of years ago. Like Continental Illinois though what is likely to happen is that regardless of extra support and measures that management can negotiate to slow the process everyone (funders in the broadest sense) just decide this is a situation they need to get out of as soon as possible.

It’s a bank run… there is no incentive for anyway to stay in and game theory suggests getting out first may be best individually even if staying in collectively would be better. For the offshore industry as a whole this is probably a good thing as EMAS Chiyoda doesn’t really solve any customer problems and was always (in hindsight) a symbol of an investment bubble. But this is going to hurt… I’d love to read the due diligence report Chiyoda and NYK got for this… the only possible solution is that they double down and fund this for a couple years but it would be bold move given current conditions.

Banks need to take a hit too…

Gulfmark Offshore has launched a tender offer to purchase USD 300m in unsecured notes back at 52% of par value. The transaction is pre-funded and includes new equity. But to my mind surely this is the most realistic, market-driven, level of what the debt in more commodity type vessels is worth (and that means EV level as well the equity went a long time ago). As this is being funded with USD 100m secured loan and USD 50m equity they USD 156m consideration changes the balance sheet completely for Gulfmark as the notes represented 64% of LTL in September 16.

If accepted its another example of bondholders being realistic about asset values and recovery times and good corporate finance in getting more equity into a capital structure to provide recovery times. I don’t think the industry will recover until debt holders accept the fundamental proposition that the industry has overbuilt far too much capacity in most market segments for anything like a recovery to previous day rates and utilisation levels to ever occur.

Gulfmark is similar in size to EMAS Offshore (excluding the FPSOs which are going); although EMAS had higher debt on a slightly smaller number of vessels. Unrealistic banks and debt holders in Europe wish the market of 2013/14 is coming back and will save them but this just isn’t going to happen. There are too many vessels in lay-up particularly in the commodity PSV/ AHTS.

Even though the Gulfmark notes were unsecured 52% seems like a good marker for what asset sales could realistically be “worth”, if they really could be traded at all, in the current environment. Without a similar dose of commercial reality the long-term survival of EMAS seems less than assured. I think for some of the more specialist tonnage the recovery rates could well be less because the asset specificity is just so highly leveraged to expensive offshore construction with few other viable uses.

The contrast to Viking Supply is even more stark: the bondholders have been realistic and taken 50% of the bonds in shares and 50% redeemed at 35% of par; but the banks however have only changed maturity dates and amortisation schedules. For a fleet long on ICE class vessels this cannot be sustainable.

Because the industry issued so much high yield debt between 2003 and 2015: NOK 81n just to oil service companies according to some estimates there is a lot of this to burn through before the banks come under pressure. But I don’t see any change in the market coming until the banks start getting realistic about residual values, and therefore the par values of their current loans, and then they may start opening loan books again. When this happens offshore service companies can start financing again and liquidity will return to the vessel S&P market as demand slowly ebbs toward supply.  The market appears to be a long way off that happening.

[Disclosure of interest: I was involved as an  investor and Director of Odin Viking and took part in the initial stages of the Viking Supply restructuring].