Bully for Brontosaurus…

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

Mads Syversen, CEO Arctic Securities (26 Jan 2016)

Arctic and ABG Merger valuation.png

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

The Golden Bough

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

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

The Emporer

Courtier T.L. — Amid all the people starving, missionaries and nurses clamoring, students rioting, and police cracking heads, His Serene Majesty went to Eritrea, where he was received by his grandson, Fleet Commander Eskinder Desta, with whom he intended to make an official cruise on the flagship Ethiopia. They could only manage to start one engine, however, and the cruise had to be called off. His Highness then moved to the French ship Protet, where he was received on board by Hiele, the well-known admiral from Marseille. The next day, in the port of Massawa, His Most Ineffable Highness raised himself for the occasion to the rank of Grand Admiral of the Imperial Fleet, and made seven cadets officers, thereby increasing our naval power. Also he summoned the wretched notables from the north who had been accused by the missionaries and nurses of speculation and stealing from the starving, and he conferred high distinctions on them to prove that they were innocent and to curb the foreign gossip and slander.

 Ryszard Kapuscinski, “The Emperor” (1978)

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

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

Ian Taylor, Vittol Chairman, June 8, 2019

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

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

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

 

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

Solstad liabilities 2016_17.png

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

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

BH rig count June 2019.jpg

And here are the latest Solstad Q1 2019 liability figues:

Solstad Q1 2019 Liabilities.png

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Buying time for a managed exit from Deep Sea Supply….

The solution to a debt crisis is rarely more debt and a complete avoidance of the issue. From Solstad:

The Financial Restructuring includes a deferral of scheduled instalments, interests and bareboat payments until December 31st, 2019 in a total amount of approximately USD 48 mill. The Financial Restructuring also entails suspension of the majority of financial covenants in the same period.

As part of the Financial Restructuring, SI-3 will be provided a loan from Sterna Finance Ltd. in the amount of USD 27 million, which shall be applied for general corporate purposes in SI-3.

So the banks stop time and Fredriksen (Sterna Financial) lends the company $27m to get them through the next 18 months? And then what? Day rates rise and solve everything? Where that loan sits in the capital structure will be interesting…

Ships depreciate. That means they are worth less next year than this year ceteris paribus, and therefore their earning power is reduced. This plan is predicated on the fact that this is the bottom of the market and the vessels must work next year. Good luck with that. For the old Deep Sea Supply vessels this is your competition.  Yet in 18 months time they have to earn, after OpEx, $48m just to keep the creditors at bay? It’s just not serious. All the more so because the vessels have an Asian focus and there is widespread agreement that that is the most price-competitive oversupplied region in the world.

All this deal does is keep potential credible supply in the market. The problem for any industry rebalancing is the perceived capital value is so high compared to the actual layup or running costs, and that is an industry wide problem. Pacific Radiance, EMAS, Solship, etc., they can’t all survive at current demand levels, but while they try it is mutually assured destruction.

#lastrollofthedice surely?

Which leads me to believe that all involved know this. Have a look at the bulk of these assets and their status:

SF PSV.pngSF AHTS.png

No lenders really believe they are getting paid all they are owed here surely? My guess is that the JF money has been provided on some sort of “super senior” basis, which gets paid out before the banks, and provides working capital while the next 18 months is spent trying to unwind the Solstad exposure to the DESS fleet. The banks don’t write off anything because it protects their legal position to the claim and preserves the illusion of commitment (and allows the loss to be booked later). A managed wind-down of a clearly not viable business that avoids an immediate firesale would seem the most likely scenario here. A bottle of champagne awaits the first person to send me the IM 🙂

 

The new trading game… and the deal of the downturn…

It is my belief that no man ever understands quite his own artful dodges to escape from the grim shadow of self-knowledge. The question is not how to get cured, but how to live.

Joseph Conrad

 

La fatal pietra sovra me si chiuse. / “The fatal stone now closes over me”)

Morir! Si pura e bella / “To die! So pure and lovely!”)

Aida

Solstad Farstad announced it’s 4th extension to its Solship/ Deep Sea Supply problem last week. The Q1 2018 results also noted that they had breached the covenants for the Farstad  entity as well and were therefore seeking a waiver for this part of the Group. Solstad state they expect the Farstad part to fall into compliance in the 2nd half of 2018, this is significant because if this doesn’t happen then two of the three legs of the merger have effectively broken and the entire industrial logic for this merger will have fallen apart less than a year after closing. That this has occured so rapidly after the merger is a large credibility blow to all those involved putting the deal together.  All the major stakeholders, except for the Deep Sea Supply shareholders, bet all on a market recovery that had no basis in reality, and now, unsurprisingly, it hasn’t happened they are bereft of ideas. It is no wonder the Chairman has been recently replaced.

I think Solstad are actually aware of the scale of the problem now, the new Chairman who not only has a strong financial background but as Chairman of the Norwegian National Opera and Ballet surely apprecites drama and tragedy, seems to be playing for serioius time? The Q1 2018 report is significantly more downbeat than the annual report released only a few weeks earlier and the financial risks section highlights how serious the problems are.

It is very hard to underplay what a mess this is from an industrial perspective, with a Group holding company responsible for two insolvent trading companies (of three trading entities) and yet the scale of all three put together was the core rationale of the deal? In a bizarre twist of logic Solstad claim the merger cost synergy targets remain in place despite the fact they must be close to simply handing back the Deep Sea/ Solship 3 fleet to the banks and yet remain liable for the running costs of the company, despite it being a massive economic drag on the group? Surely if they do this they need to explain what synergy number cannot now be achieved? This is just one example that highlights in reality getting out of this deal will be far harder than it was to get into. What will the new Solstad look like? The banks will be seeking to get out as soon as possible from all but the aquaculture business, and the relationship to Hemen/ Fredriksen just another complication from an industrial perspective the company doesn’t need.

Not to put too finer point on it but the Q1 2018 results for Solstad Farstad really made clear that the company is insolvent, by that I mean in the accounting sense where the ability of the asset base to generate enough economic value to pay their liabilities is clearly compromised. Solstad don’t have a liquidity problem immediately but they will soon having gone back NOK 400m in Q1… unless they have a stonking Q2, and there is no reason to believe they will. An upcoming (round 2) restructuring appears imminent because its financing costs are killing it. The comparison with the efficiency of the American Chapter 11 system which has allowed  Tidewater, Gulfmark, Harvey etc. to emerge and take market share is such a contrast to the European system it merely adds another nail in the coffin here.

Like Siem Offshore, and so many other offshore vessel companies, Solstad can pay for everything up to finance costs, and then it falls into a pit of actual cash outflow. Welcome to the new normal. Eventually, in an industry with depreciating assets that need replacing, this model doesn’t work.

One amazing financial revelation of the Q1 2018 results is the fact that Solstad depreciate vessels over 20 years to 50% of original cost! If anyone thinks a 20 year old AHTS is worth 50% of the new build price they either know nothing about the industry or enjoy a healthy portion of magic mushrooms. These values are apparently adjusted by broker values but this policy must massively overstate the book equity in the company relative to current market values. The policy itself seems a remnant of a bygone era when a demand boom meant assets depreciated less slowly than book value implied. The only thing making those creditor claims look economically realistic appears to be a policy that has consistently over valued the asset base above its long-term economic value.

As an argument for how some audit firms are too close to their clients Solstad Farstad makes a strong case given the EY statements regarding the financial positon of the Group. On the 18.04.18 Solstad Farstad published their 2017, and inaugural, accounts for the combined entity which EY accepted as fairly representing the positon at year end 2017. A mere 2 weeks later, literally just before the Easter holidays, the first deferral of the Solship 3 “investment” was made, something that would have been blatantly obvious to all concerned closing the accounts, and this allowed all the long term debt to be recorded as just that. In effect, as became clear at the Q1 2018 accounts, coming only a few weeks after the Solship deferral and was clearly obvious in Q4 2017, Solstad Farstad had a massive problem and a covenant breach,  therefore a major portion (NOK 11bn) needed to be reclassified as short-term as the lenders could theoretically call this in immediately. This looks stage managed in the extreme. One would think this was such a significant post balance sheet date event that it must be reported…

This is just another sympton of how out of control the whole situation is. What is clearly happening in the background here is that Solstdad Farstad needs to hand back the entire Deep Sea Supply to the banks, something everyone in the industry knows, but the banks don’t want it. It also means all this talk of a recovery in large AHTS is hokum. A few good weeks over summer doesn’t make an asset economic over 52 weeks. Without this mirage of scale of the merger is a busted flush and someone then needs to go back to the market and explain that the stated industrial strategy and planned synergies as outlined in the original merger document, less than one full financial year before this became apparent, are totally unrealistic and have in fact threatened the very existence of the entity. Without new equity, which would require a substantial writedown in bank debts, Solstad will simply limp along as a zombie company with the banks extracting what they can over time and the equity remaining worthless at best. It will be like a bank in run off with the asset base eventually eroding away to nothing.

Solstad (and it will be just Solstad going forward) is probably only viable as a Norwegian area (re: Equinor sponsored) PSV and AHTS operator, with an option on some Brazilian tonnage. The CSV operation is still potenitally considerably overvalued: it is an aging fleet that will never realise book value because no bank will lend against assets that old and and without long term contracts going forward. The Australian/Asian operations need to go immediately and the laid up Brazilian assets (i.e. the majority of the Brazilian fleet) need to go as well. Siem Offshore appear to be pulling out of Australia and Solstad cannot be far behind them on any rational basis. The aquaculture business will surely revert to Hemen/Seatankers/Fredriksen or be sold.

Quite why Solstad is therefore publishing two week extensions when this problem will take months to sort out is anyone’s guess. But a whole pile more deferrals are coming unless some rabbit is pulled from a hat. The Q2 results are likely to lead only to the creditors starting to get real about the scale of the problem.

To be clear this isn’t only a Solstad issue, although the merger was clearly a folly on an epic scale: in the the same week Bourbon Offshore announced that they were suspending debt repayments (again). Miclyn Express Offshore, Pacific Radiance and EMAS (again) cannot find sustainable financial positions. Siem Offshore recently reached agreement to defer payments on debt

It defies the laws of economics and common sense to believe that any one firm can outperform any others in this market in a meaningful financial sense when they all offer assets that are identical in function and form to their (identical) customer base. Siem Offshore now isn’t paying it’s lenders back in full until 2022 and lowered (again) payments by 30%. It will simply reduce day rates to get utilisation and it shows the banks know they have no leverage here. Deferring all borrowers across the industry indefinitely however will ensure they never get paid paper claims. Eventually winners will have to be picked and it will clearly be those burning the least cash.

I have followed the Solstdad situation more closely than any other simply because a) from an industrial and financial perspective it was clearly such a bad idea; and, b) their public prognostications have been so divergent from any actual data points in the market, and so far removed from realism, it makes a fascinating sociological experiment. Those of you who have read The March of Folly will know what I mean.

The funny thing about all the banks delaying the bullet payments outstanding (to Siem Offshore, MMA, Pacific Radiance, Solstad, ad infinitum) is that each bank knows in truth their own bank would never lend on the other side of the deal. The Siem deal recognises this. The banks in these deals are locked into the boats and companies they have backed because the bullet payment will never be made unless they sell it at a huge discount to a distress debt investor. The banks are stuck in these deals but they are not getting into any more, but in this self-perpetuating cycle it also locks in low asset prices and day rates. Breaking this self-reinforcing circle will only occur when the mythical demand fairy appears.

All offshore supply companies, and by that I mean OSV operators who do not engage in engineering and execution, are price takers in the current market: there is no ability to add value, they are in effect trading firms wholly depedendent on the market price and demand levels for a commodity asset, with no ability to take anything other than what they are offered. This isn’t what the original funders signed up for, isn’t the skill set of the majority of management, and is significantly more risky given the risk/reward basis that rational investors should be comfortable with. Eventually funders will realise this and new equity will stop flowing into the industry under the promise that all you have to do is burn cash and wait. Pacific Radiance and EMAS are two good examples where clearly due diligence has revealed the downside of this strategy.

Anyone investing in this market should realise they are betting against the greatest shipping trader of the age: John Fredriksen. When the chips are counted from this downturm the greatest deal in offshore will not be an acquisition at the bottom of the market it will almost certainly be a divestment: and it will be the story of how JF managed to put only $20m in to rid himself of a bankrupt entity, with some really low market tonnage, that surely his major bankers would have demanded substantially more support for had it not been folded into Solstad? Now Deep Sea Supply is inextricably tied to Solstad and it is a management and funding issue of this company not a Seatankers/Hemen problem.

If you are buying AHTS’s and PSV’s you need to ask yourself what you know that JF doesn’t? And what your industrial angle is that is better than Seatankers?

Anyone who tells you scale and consolidation will save all needs only to look at how many high-end AHTS Solstdad Farstad have, and after a year of operation all it brought them was a covenant breach. Scale without pricing power is meaningless, the costs of the vessel operations are so high relative to the onshore costs that saving a few dollars a day on SG&A costs is just a rounding error. A new industry narrative is required for the lender to be kept happy but each becomes more tenuous than the last.

Not all offshore supply firms are going to survive, but quite understandably the banks want the failures to be someone elses. There is nothing written in stone that Solstad Farstad will survive. Every Solstad report talks of a willingness to participate in consolidation but the equity has no value and anyone taking it over would want the banks to write-off the billions of NOK. Given the post-merger performance of the Group it isn’t a serious proposition that anyone would take their shares in a consolidation play either. My money would be on a take-private deal where the Solstad backers hope to use it as a consolidation vehicle, but everyone is doing this at the moment and eventually some firms need to drop out and take a hit before this works for someone. But if you think some of the public firms valuations are high I bet some of the private fund accounting going on is even more aggressive…

For the industry to recover a few big firms, and their associated asset bases, are going to have to go and some losses way beyond those taken to date are going to have to realised by banks and increasingly equity investors. Even the most outrageous demand forecasts for next year don’t offer the sort of demand boom required to fundamentally alter vessel profitability. Unless this relationship below reverses the global OSV fleet has substantially less value than some recent deals presume:

McKInsey BH Q1 2018.png

Source: McKinsey.

Working out when  profits come again is highlighted by the Siem Offshore results which pointed out that owners are laying vessels up and bringing them out when day rates recover. Scrapping simply hasn’t happened at the levels that some were forecasting. Something has to give and at the moment it’s day rates and utilisation. For as long as the high-capital values of vessels relative to marginal day-rates make this worthwhile, or companies like Standard Drilling buy cheap and sell cheap, then this is just a straight trading game. The scale of any recovery in offshore work required to make the whole fleet even economically breakeven so far into the distance it is definitely a chimera.

Devil take the hindmost…

“They run all away, and cry, ‘the devil take the hindmost’.”

Philaster

You can’t make this up: the above slide from the latest SolstadFarstad results sums up the problem: in putting together 3 companies to create a “world leading OSV company”, before they can even get the first annual report out, they have to admit that one of the three is insolvent and  another of the three has a serious covenant breach. This was always a triumph of hope and complexity over a serious strategy.  Having spent NOK 986m in Q1 to get NOK 875m in revenue, a NOK 469m loss after adding back depreciation, a financial highlight was considered a NOK 12m saving in overhead due to synergies! Personally I would have forgone the NOK 12m in synergies to not have two subsidiaries in default that threatened the entire company’s solvency? You don’t get any sense from the public announcements that anyone has a handle on how serious this is.

If there was any value in it stakeholders might want to have an honest look about what got them to this point? In reality I don’t think it is anything more complicated than wanting to believe something that couldn’t possibly be true: namely that at the back end of 2016 the market would recover in 2017. Not confronting that meant not having to come up with a proper financial structure for this enterprise, but really it meant not having to liquidate Farstad and Deep Sea Supply. But it also means that management and their financial advisers were unable to structure a credible 12 month business plan to be accurately reflected in the transaction documentation. This a serious failure and any realistic plan forward needs to recognise this. Talk of SolstsadFarstad being part of industry consolidation, as anything other than a firesale by the banks, just isn’t serious either.

Prospect theory, an area of behavioural finance that recognises people overweight smaller chances of upside rather than accept losses, and the disposition effect where people hold losing investments for longer than they should, seem apt for the lending banks  and management here as an explanation. But the current plan of getting waivers from the banks and waiting for the market to recover is clearly not a serious plan either.

SolstadFarstad will not survive in its current form. There is absolutely no way the assets are worth NOK 30bn (under any realistic valuation  metric be it cash flow, economic, or asset) and no way that they can ever hope to pay the banks back NOK 28bn, without even worrying about the bondholders. The scale of increase in day rates in a few years time would have to be so extreme it just isn’t credible, and every year day rates stay  low requires you add back the forgone assumptions about their increase on a future year increase. The assets are aging and maintenance costs are going up. SolstadFarstad is like a zombie bank where it has no capital because no one will lend it any money to grow (wisely) but it cannot get any equity because the debt is so high. The only chance of survival would appear to be a massive debt haircut, I don’t know what the number is but I would guess at least NOK 15-18bn, and then to get new equity in and come up with a sensible plan.

However it isn’t just money. I don’t think I have ever seen a major merger go wrong so quickly and then have senior management so blithely unaware about how serious the situation is.  The timing on the Deep Sea/ Solship 3 announcement being just one example. A good study here shows management who look beyond the external environment are more likely to survive significant industry change.

One very simple fact of the environment changing is was made by Subsea 7 recently:

John Evans

Yeah. So, what we’re seeing in the market today is the return to the seasonality we saw five to six years ago where the North Sea was relatively quiet in quarter one and quarter four. It’s really, really straightforward that, you know, the weather conditions are particularly extreme in those periods, and therefore then, clients are not looking for their work to be performed during those periods. During the high point in the market, we work right away through those periods and clients were prepared to pay the additional cost to get their first production online faster. Our aim is that we will see in quarter one and quarter three our active fleets and we’ll be back towards a reasonable level of utilisation in line with previous percentages for active fleet utilisation. But then we expect to see again the corner of sea market going relatively quiet in quarter four. So that’s what we really see and in terms of seasonality for us. [Emphasis added].

SolstadFarstad used to charter ships on a 365 basis. Now it has a large number of vessels that take time risk on some other company’s projects. These vessels are going to have less utilisation than before because 2 of the 4 quarters of a year are quiet. Unless there are very high day rates, which there aren’t, a ship that works 50% of the year is worth less than one that works 100% of the year. SolstadFarstad, Bourbon, Maersk, all these similar vessel owners are dealing with a fundamental change in the market and therefore the economic value of their asset base is dramatically lower given the fixed running costs. SolstadFarstad pretending they can ever make the banks whole in such a situation is absurd. A major restructuring gets closer by the day.

[Book recommentdation: Devil Take the Hindmost: A History of Financial Speculation]

HugeStadSea goes wrong…

If completed, the Combination is expected to provide Solstad Offshore, Farstad and Deep Sea with an industrial platform to sustain the current downturn in the offshore supply vessel (“OSV”) market and be well positioned to exploit a market recovery. The Board of Directors of the three companies consider this to be a necessary structural measure that will enable the Merged Group to achieve significant synergies through more efficient operations and a lower cost base. The Combination will influence the SOFF Group’s financial position as total assets and liabilities as well as earning will increase substantially.

SolstadFarstad merger prospectus, 2017

This was always going to happen… nice timing though… just a few days before Easter, with everyone looking the other way, and only a short time before the Annual Report was due (with its extensive disclosures required), SolstadFarstad has come clean and admitted that Solship Invest 3 AS, more familiarly known as Deep Sea Supply, is in effect insolvent, being unable to discharge its debts as they fall due and remain a credible going concern:

As previously announced, Solstad Farstad ASA’s independent subsidiary, Solship Invest 3 AS and its subsidiaries are in discussions with its financial creditors aiming to achieve an agreement regarding the Solship Invest 3 AS capital structure.

As part of such discussions, Solship Invest 3 AS and its subsidiaries have today entered into an agreement with its major financial creditors to postpone instalment and interest payments until 4 May 2018.

I am not a lawyer but normally getting into agreements and discussions like this triggers the cross-default provisions of debts, including the bonds which look set for a default… and this would make all of the c. NOK 28bn debt become classed as short-term (i.e. payable immediately). Maybe they saw this coming and omitted those clauses when the loans were reorganised, but its a key provision, and I struggle to see it getting through compliance and lawyers without this? But it strikes me as a crucial question. The significance of this for those wondering where I am going with this is that it would be hard to argue SolstadFarstad is actually a going concern at that point. Maybe for a short while, but getting the 2017 accounts signed off like that I think would be tricky (ask EMAS/EZRA).

Investors, having been told  how well the merger is going, may want to have a think if they have been kept as informed as they would like here? There is nothing in this statement on 19 Dec 2017 for example to reflect clearly how serious things were at Deep Sea Supply. Indeed this statement appears to be destined for future historians to recall a management team blithly unaware of their precarious position:

With the reduced cost base we will be more competitive and with our high quality vessels and operations, we will be in a very good position when the market recovers.

The PR team may have liked that statement but surely more cautious lawyers would have wanted to add the rider “apart from Deep Sea Supply which is rapidly going bankrupt and the vessels are worth considerably less than their outstanding mortgages. We anticipate in the next 12 weeks defaulting on our obligations here until a permanent solution is found.” To make the above statement, when 1/3 of merger didn’t have a realistic financial path to get to this mythical recovery is extraordinary.

But the real and immediate problem the December 19 press release highlights is that in an operational sense Deep Sea Supply has been integrated into the operations of HugeStadSea:

The merger was formally in place in June 2017 and based on the experiences from the first six months in operation as one company, Solstad Farstad ASA is now increasing the targeted annualized savings to NOK 700 – 800 mill.

By the end of 2017 the cost reductions relating to measures already implemented represents annualized savings of approximately NOK 400 mill…

new organization structure implemented and the administration expenses have been reduced by combining offices globally and centralization of functions.

The synergies laid out here can only be achieved by getting rid of each individual company’s systems and processes and integrating them as one, indeed that is the point of the merger? So how do you hand Deep SeaSupply back to the banks now? For months management consultants from Arkwright have been working with management and Aker to turn three disparate companies into one, now apparently, as an afterthought, the capital structure needs sorting as well along with disposing of “non core” fleet. Quite why you would get into a merger to create the largest world class OSV fleet while simulataneously combining it with a “non core” fleet at the same time (that wasn’t mentioned in the prospectus) is a question that seems to be studiously avoided?

Just as importantly going forward here management credibility is gone. Either you were creating a “world class OSV company” with the scale to compete, or you weren’t, in which case taking on the Asian built, and pure commodity tonnage of Deep Sea Supply was simply nuts.

Around 12 months after the merger announcement, and six momths after the legal consumation, when managers have had sufficient day rate and utilisation knowledge to build a semi-accurate financial forecast, they are back to the drawing board. If SolstadFarstad hand the Deep Sea fleet back to the banks they will have to either fire-sale the fleet or build up a new operational infrastructure to run the vessels independently of SolstadFarstad… does anyone really believe the banks will allow that to happen? The problem is the tension between the different banking syndicates: a strong European presence behind SolstadFarstad and Asian/Brazilian lenders to Deep Sea. This is likely to get messy.

Is Deep Sea Supply really ringfenced from SolStadFarstad? Will the lending banks be able to force SolStadFarstad to expose themselves more to the Deep SeaSupply vessels? As an independent company Deep Sea Supply would have been forced to undergo a rights issue, and if not supported by John Fredrikson/Hemen it would have in all likelihood have gone bankrupt, the few hundred million NOK Hemen putting into the merger barely touched the sides here. For the industry that would have been healthy, but for the banks a nuclear scenario. Now management face a highly embarrassing stand-off with the banks to force them to take the vessels back, or the equally highly embarrassing scenario of admitting that the shareholders were exposed to the Deep Sea Supply fleet all along, and that the assumptions underpinning this deal were wrong… Something easily foreseeable at the time to all but the wilfully blind.

The “project to spin off the non-core fleet”, which I have commented on before, is the Deep Sea Supply fleet that makes a mockery of the industrial logic of the merger. That was started in Q3 2017 according to their annoucements, only a few months later needs to be sold? What is the plan here? Or more accurately is there one?

There are no good options here. The only credible option for the management team and Board to survive unscathed would surely be the banks writing down their stake in Deep Sea Supply entirely and making a cash contribution to SolstadFarstad to recognise the time and costs involved in running it. You can mark that down as unlikely. But just as unlikely is a recovery in day rates where Deep Sea Supply can hope to cover its cash costs even in the short term

The Board of SolsatdFarstad and their bankers need to ask some searching questions here. The merger was a very bad idea that was then executed poorly.  It is therefore hard to argue SolstadFarstad have the right skills in place at a senior management and Board level? This wasn’t a function of a bad market, this was the result of bad decisions taken in a bad market. This constant mantra that scale will solve everything, when the company has no scale, needs to be challenged. The other issue is how disconnected management seem to be from basic market pricing signals, and moving the head office away from its current location should also be seriously considered along with a changing of the guard.

I said at the time this merger was the result of everyone wanting to believe something that couldn’t possibly be true and merely delaying for time, but eventually reality dawns as the cash constraint has become real. The banks need to write off billions of NOK here for this to work. Probably, like Gulfmark and Tidewater, the entire Deep Sea Supply/ Solstad/Farstad PSV and smaller AHTS fleet need to be equitised at a minimum, and some of the older vessels disposed of altogether. The stunning complexity of the original merger, where legal form trumped economic substance, needs to be reversed to a large degree, but this will not be easy as the shareholders in the rump SolstadFarstad will surely balk at being landed with trading their remaining economic interests for a clearly uneconomic business.

The inevitable large restructuring that will occur here arguably marks the start of the European fleets and banks catching up with their American counterparts, and to some degree matching the pace of the Asian supply fleets. The banks behind this need to start a series of writedowns that will be material and will affect asset values accross the sector. Reporting season will get interesting as everyone tries to pretend their vessels are worth more than Solstad’s and the accountants get worried about their exposure if they sign off on this.

A common fault of all the really bad investments in offshore since 2014 was people simply pretending the market is going to miraculously swing back into a state that was like 2013. It was clear late in 2016 this would not happen. The stronger that view has been has normally correlated with the (downside) financial impact on the companies in question, and there is no better case study than HugeStadSea.

How much more recovery can the industry handle?

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

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

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

Siem Offshore also came out with a loss and said:

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

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

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

DOF Subsea Q4 17

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

DOF Subsea Q4 2017

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

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