The wrong side of history…

“Until an hour before the Devil fell, God thought him beautiful in Heaven.” …

The Crucible, Arthur Miller


On the IHS Markit projection, by 2023 the Permian is likely to be producing an additional 3m b/d of oil, along with an extra 15 bcf of gas. For the US economy this news is positive. America will have a secure source of supply that, through its production, distribution and consumption, will generate significant economic activity across the country.

The volumes involved will further reduce the unit of production, probably to below $25 a barrel. The study estimates the total investment needed to deliver the new supplies will be some $300bn. For the global oil market the effect will be dramatic. The US will become a significant exporter. The IHS Markit paper suggests that by 2023 the country will be exporting around 4m barrels a day. That will absorb much of the expected growth in demand. [Emphasis added].

Nick Butler, Financial Times, June 25, 2018


For one thing, customers have an unfortunate habit of asking about the financial future. Now, if you do someone the single honor of asking him a difficult question, you may be assured that you will get a detailed answer. Rarely will it be the most difficult of all answers – “I don’t know.”

Where are the Customers’ Yachts? 

Fred Schwed

In case you missed it another major pipeline looks certain to go ahead in the Permian by 2020 (in addition of course to the Exxon Mobil 1m b/d). If the 30″ version is selected then 675k barrels a day will be added in export capacity to the port at Corpus Christi, where a major upgrade is also taking place that will allow significantly larger tankers into the region:

Oil export capacity from the Corpus Christi area is expected to rise to 3.3 million bpd by 2021 from 1.3 million bpd this year, keeping its rank as the top oil export port, according to energy research firm Wood Mackenzie.

In fact if you believe Pioneer Natural Resources (on S&P Platts) then Permian pipeline capacity will double by 2020 (to 3.5m b/d) and the US production will reach 15m b/d by 2028. The graphic at the top of the page highlights that top Permian wells are profitable at $22 per barrel. There is a good point on the interview where the CEO of Pioneer points out in 2015 the dominant narrative was shale would go bankrupt and in fact there has been a rebound.

This continuous process of capital deepening, infratsructure upgrades, and productivity improvements has driven the recovery of the US shale industry and has devastated the offshore industry. There is a link: it is not all inventory and reserve rundown. Offshore used to have to run at very high utilisation in order to work and without it the economic model is broken. No other economy in the world excels at this kind of constant, small-scale, mass production improvement like the American economy. Once a product can be mass produced at scale the ability of the US economy to drive down per unit production costs is unmatched.

At the moment there is a boom in the Permian and Eagle Ford basins: wages are high and there are delays and bottlenecks (I read a story last week of a power company demanding 40k to put in one power pole) but this capital deepening will alleviate some of these issues in the short-term. Trucks will be replaced with pipelines etc, a new generation of high spec rigs in the  offing. Deliver, review, improve. Always with a focus on productivity and efficiency. Shale is a process of horsepower and capital and those are two attributes the US economy is preternaturally endowed with. Each incremental pipeline becomes less important in a relative sense so the investment bar is lower. Slowly but surely unit costs get lower every year. It is a relentless and predictable process.

That is the competition for offshore for capital at the margin: an industry improving its efficiency and cost curve with every month that passes. And the solutions to constraint problems in the Permian are on a timescale measured in months while investments in offshore take years to realise.  Offshore offers huge advatages over shale in terms of high volume flow rates and low per barrel lift costs but it is a long term CapEx high industry and not suited to production of marginal volumes. There is every likelihood it is used as a baseload output in years to come while shale supplies marginal demand. This is a massive secular change for offshore and will fundamentally alter the demand curve to a lower level. The clear evidence of this seems to be causing a degree of cognitive dissonance in the offshore industry where any other outcome that a return to the past is discounted.

To just focus the mind: if offshore were to improve productivty by 3% per annum for three years- which is considerably slower than the productivity improvement in shale – day rates for offshore assets in 3 years would need to be at c.92% of current levels per unit of output (i.e. a 8% reduction [1/1.03^3]). Not all of this is going to be possible in offshore execution terms given the aset base, some of this will come from equipment suppliers who are manufacturers and subject to scale economies reducing costs, but this is the challenge for offshore bounded by Bamoul constraints. There are limits to the volumes that can be produced by shale but they have constantly exceeded market expectations and they have eaten a meaningful share of global oil output and this will not change only increase.

As the graphic below shows this is a supply side revolution as demand for the underlying commodity has increased consistently since 2006:

Global Oil Demand 2006 to 2018F


So the only possible explanation for the continuing drop in the utilisation of offshore assets is that the demand has fallen for their use relative to the global demand for the underlying commodity they help produce.  I accept that may look tautological but we just need to clear that point out early.

I have been on before about how I don’t think a quick recovery is likely for the offshore market for those long on offshore delivery assets only (the tier one SURF contractors are different as their returns are driven by engineering as well as asset leverage). I can’t see how an industry like the shale can develop in parallel with a “snap back” in offshore, particularly when the larger E&P companies have been consistent and vocal about limiting CapEx.

The reason jack-up companies are like offshore supply companies, and not SURF contractors, is that they take no project risk. An oil company doesn’t handover well risk to a drilling contractor (as Macondo showed). Shallow water drilling contractors are the AHTS and PSV of drilling: you get a day rate and that is the only value we expect you to provide. It is an asset return and utilisation gig completely different from SURF contracting. And yet against this background there is a bubble developing in the jack-up market seemingly unsupported by any fundamental demand side recovery. I am not alone here: McKinsey forecast jack-up demand to rise 2% per annum to 2030 (about a 10% growth in market size over the next five years).

Bassoe on the other hand are forecasting that day rates will double in the jack-up market in five years, which equates to a 15% compound average growth rate.  I realise this narrative is one everyone wants to hear, you can almost hear the sighs of relief in New York and London as the hedge funds say “finally someone has found a way to make money in offshore and profit from the downturn”. And as the bankers stuff their best hedge fund clients full of these jack-up companies stock this is the meme they need as well. At least in this day and age the investors have better yachts than the bankers.

Yet the entire jack-up market thesis seems to rest on the accepted market narrative of scrapping and therefore higher utilisation. As Bassoe state:

If 85% jackup utilization seems relatively certain, then a doubling of dayrates is too.

Certain is a strong word about the future… As if the entire E&P supply chain will benignly accept day rates increasing 15% Y-O-Y from every single market participant without worrying about it…

Ensco is a good place to look because it also considers itself a leader in premium jack-ups. Ensco has exactly the same business model as Borr and Shelf (indeed it is focusing on exactly the same market segment in jack-ups): raise a ton of money, go long on premium assets and wait for the market to recover… Ensco’s recently filed 10K shows how well this jack-up recovery is going:

Ensco q1 2018.png

Oh hold on it doesn’t show that at all! Instead it shows the jack-up business revenue declined 17% Q1 18 versus Q1 17. Awkward… So like everyone else here is the crunch of the “market must come back” narrative: Scrapping.

Ensco jackup fleet forecast.png

The problem with this argument is the scale of the scrapping required in the red bars (not to mention the assumptions on China). If that slows and/or the market growth doesn’t quite come then the obvious downside is that there are too many jack-ups for the amount of work around. Somewhere between 2% and 15% compound per annum leaves a lot of room for error.

When your revenue figures drop 17% on the previous year management in most normal companies, but especially those with a very high fixed cost base and a disposable inventory base (i.e. days for sale), tells the sales reps to cut the price and win market share. And that is exactly what will happen here. In fact far more accurate than forecasting the market is an iron law of economics that in an industry with excess capacity and high fixed costs firms will compete on price for market share. Investors going long on jack-ups are making a very complicated bet that the market growth will outpace scrapping in a way it hasn’t done in the past despite E&P companies being under huge pressure to keep per unit production costs low.

On the point of the age of the jack-up fleet: this is clearly valid to a degree. But as anyone who has negotiated with an NOC in places in South East Asia and Africa can tell you all this talk of new and safe over price is Hocus Pocus. Otherwise in the greatest down market around none of these units would be working or getting new work and that clearly isn’t the case.

In fact in many manufacturing businesses old machines, fully depreciated and therefore providing only positive cash flow to the P&L, are highly prized if they are reliable. There is no evidence that this will not happen in offshore and plenty of counter-examples showing that oil companies will take cheaper older assets. The best example is Standard Drilling: bringing 15 year old PSVs back to the North Sea that were originally DPI, and getting decent summer utilisation (day rates are another issue but for obvious reasons). Eventually as the munificence of an industry declines the bean-counters overpower the engineers and this is what I believe will happen here, there is plenty of evidence of it happening in offshore at the moment. Every single contracts manager in offshore has had a ridiculous conversation with an E&P company along the lines of: “we want a brand new DP III DSV, 120m x 23, 200t crane, SPS compliant, and build year no later than 2014 and it’s a global standard… and we want to pay 30k a day”… and then they go for the 30k a day option which is nothing like the tender spec.

The reason is this: North Sea E&P companies are competing against shale for scarce capital resources and they need to drive costs out of the supply chain constantly. Offshore has dropped its costs in a large part because the equity in many assets and companies has been wiped out, that is not sustainable, but what is really unlikely to happen here is a whole pile of asset managers wake up simultaneously at E&P companies over the next three years and tell people to wholesale scrap units knowing it will increase their per barrel recovery costs while watching shale producers test new productivity levels.

There may well be a gradual process on a unit-by-unit basis, a cost benefit analysis as the result of some pre-survey work or a reports from a offshore crew that the unit isn’t safe, but not suddenly 30 or 40 units a year, and if does happen too quickly and prices rise then the E&P companies will revert to older units to cap costs. Fleet replacement will be a gradual process and some operators will be so keen to save money that they will let some older units be upgraded because it will have a lower long term day rate than a newer unit because they get that to continue to have capital allocated they need to drive their costs down.

The investment bubble in jack-ups is centred on Borr Drilling and Shelf Drilling. These companies have no ability or intention to pay dividends for the next few years. Credit to them: raising that sort of money is not easy and if the market is open you should take the money. Their strategy, in an industry that patently needs less capital to help rebalance, is to add more and wait for a recovery. Place everything on 18 red at the casino. Wait for higher prices and utilisation than everyone else despite doing exactly the same thing (just better). And that’s fine it’s private money, and it might work. But economic theory I would argue suggests it is extremely unlikely, and it will be a statistical outlier if it does. Five years ago the US shale industry was producing minimal amounts and the dominant thought was they required $100 oil to work so think how different the world will be by the time these companies have any hope of returning cash to investors?

Forecasts are hardly ever right, not for lack of effort but the inability to take into account the sheer number of random variables, the epsilon, in any social process. Forecasts that a segment of the offshore market will double given the headwinds raging against it should probably be viewed as bold, a starting point for debate rather than a base case for investments. Having picked 9 of the last 0 housing crashes you should also realise that while my arguments will eventually be proven right the timing of them can be wildly inaccurate as well.

What could possibly go wrong?… The $130m MBA….

For those with some knowledge of the financing of offshore assets over the last few years comes this amusing little story in the FT this morning:

Hedge funds are turning in increasing numbers to the business of buying planes and then leasing them to airlines, as the era of low interest rates pushes firms into more esoteric corners of finance in the hunt for higher returns.

A yield backed by an asset… Where have I heard that before?:

“People today are very focused on yield and it is driving investors to focus on aviation assets because you get yield and you have a hard asset — you have collateral,” said Marc Lasry, Avenue Capital’s co-founder.

As the article points out equity yields are dropping and a credit bubble follows:

The rising interest in buying and leasing aircraft has also triggered a surge in sales of debt tied to aircraft leases. Sales of bonds backed by aircraft leases jumped to $6.6bn in 2017 from $4.2bn in 2016, according to data from Finsight.

What is more, newer hedge fund entrants have focused on the higher yields available from leasing older, typically less fuel-efficient aircraft, but the rebound in oil prices is cutting their attraction for airlines.

This time it’s different….

I am writing a book on Nimrod/ the offshore bubble with the working title “The $130m MBA: The Nimrod Sea Assets Story”… a chapter on comparing the forthcoming airline crash would make a nice comparison I feel.

Dogecoin … you can’t make this up…

Great NYT story about a guy who made a digital coin as a “satirical mash-up” to poke fun at the Bitcoiners… But then it’s market value climbed to $400m before dropping to a mere $100m! You literally cannot make this up: read the whole thing.

During the South  Sea Bubble someone floated a company to “drain the Irish Bogs” and this is of a similar ilk.  No one can really believe this. I keep quoting Keynes beauty theory here because nothing else sums it up better:

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment, Interest and Money, 1936).

The article contains a definition of an initial coin offering that is set to become a classic:

Imagine that a friend is building a casino and asks you to invest. In exchange, you get chips that can be used at the casino’s tables once it’s finished. Now imagine that the value of the chips isn’t fixed, and will instead fluctuate depending on the popularity of the casino, the number of other gamblers and the regulatory environment for casinos. Oh, and instead of a friend, imagine it’s a stranger on the internet who might be using a fake name, who might not actually know how to build a casino, and whom you probably can’t sue for fraud if he steals your money and uses it to buy a Porsche instead. That’s an I.C.O

You think it’s a joke but the Wall Street Journal found:

Union Square Ventures, Bessemer Venture Partners and Sequoia Capital all have reacted—using investor funds—by buying digital tokens directly or by putting money into hedge funds that buy tokens. Some venture investors, such as Nick Tomaino of Runa Capital, left their firms to set up crypto hedge funds.

“If you are in the business of investing in the future you probably have to change the style of investment to accommodate novel ideas and opportunities,” said Brad Burnham, managing partner at Union Square Ventures.

Union Square Ventures is a tier 1 NYC VC firm whose founders made hundreds of millions in South American telcos and social media. Maybe cash shells represent the apex of a bubble: Social Capital Hedosophia Holdings Corp. got $600m in an IPO to buy another company who wants to go public but doesn’t want the hassle of it (but then it will be public?).

Like Facebook and Alphabet… Nautalis Marine Plc and First Bitcoin Capital Corp… a hot M&A tip…

a company for carrying out an undertaking of great advantage, but nobody is to know what it is

From the listing prospectus of a company issuing shares during the South Sea Bubble, c. 1720

On February 27th Grand Pacaraima Gold Corp., a mining corporation focused on Venezuela,  changed its name to First Bitcoin Capital Corp (“BITCF”) thus moving from a small penny listed Canadian mining corporation to being a small listed Canadian penny listed Bitcoin/Altcoin focused corporation (h/t Matt Levine). Similarly on 16th January Global Energy Development Plc changed its name to Nautalis Marine Plc, having been previously invested in E&P production in South America, in a related party transaction purchased potentially the worst 11 vessels in the entire global subsea fleet and continued their lay-up in Louisiana, and became a small cap listed offshore vessel owner (not operator as all the assets are in lay-up).

Global Energy/Nautalis entered into a complicated loan note, validated by advisors, although this opinion has not to my knowledge been made public, to complete this transaction in which the related parties released their interest in the vessels and thus exchanged a highly uncertain equity stake, in 11 of the oldest (and most operationally compromised) OSVs in the world, for fixed obligation loan notes. The company, having generously lent the related parties money to buy the vessels in the first place, then even more generously extended credit to purchase them back. Now the company seriously states it is looking for technology focused acquisitions to add value to their vessels… one of these was built in 1967…

BITCF is also fond of complicated transactions. BITCF has managed not only a share buyback but also a dividend in cryptocurrency: BITCF used XOM “the internet of money” to buy back ordinary shares, and then Tesla Coin (“TESLA”) to pay a dividend (BITCF owns 20% of TESLA). Unfortunately, the Securities and Exchange Commission appears to have had a sense of humour failure and has suspended trading in the shares, which is a shame because on mirth value alone I recommend reading the letter explaining this which states:

BITCF is extremely rare in this regard for an OTC company as most are dilution machines designed either to grow their company or unjustly enrich management and promoters. Our management has never sold one share of our stock in spite of the meteoric rise in price per share.

The reason we have been able to succeed without external funding is due to the fact that we early learned how to develop crypto assets on a shoe string, so to speak. This also resulted in our being able to pay off our debt which was owed to management with one of our created crypto currencies.

Clearly BITCF found mining for coins easier than finding gold. In a similar vein Global/Nautalis found buying decrepit DSVs, in a related party transaction, easier than foraging for oil. Both are essentially technology plays they claim, kind of like Facebook and Snap… I guess…

I often wonder these days why I am not involved in a cryptocurrency. Can life have meaning without one? I get The Bank of England shares doubts about the stability and role of this unit of account in a modern world… but really can a bank created to finance a government loan see the future?

I note that Nautalis seeks a niche a specialised offshore technology. I think the M&A bankers can already see the possibilities that I do?! DSV Coin? There are over 850 cryptocurrenciesalready (none of which carrying the symbol DSV that I am aware of?) and BITCF allows users to mine their own coins based on their own blockchain, (although the company itself has mined 20.7m of the potential 21.0m coins). How can you not want to invest in a company that issues the following statement:

the company intends to pay additional dividends in various crypto currencies that may include crypto exchange symbols $WEED $FLY $PRES, $HILL, $GARY, $BURN, $OTX and $KLC. We may also from time to time pay dividends in our own common shares in their crypto form which trades under the crypto symbol $BITCF on various foreign cryptocurrency exchanges.

$WEED coin listed on 3 exchanges during 3rd successful ICO (Initial Coin Offering).

WEED coin now trades on the OMNIDEX, COINQX and CRYPTOPIA

Similarly Nautalis (who also have some great promotional material) makes much of the of the fact that they are they are “unique”:

Nautalis Differentiation.png

That is my favourite slide ever. And I say that as an ex-management consultant who was virtually paid by the slide at one point and can make the cleverest idea into a meaningless deck of slides in an instant. They should have added a line “Number of offshore energy services companies with their entire fleet in lay-up – 1 (.001%)”, that is the only improvement I could suggest. I once had a boss who was a stickler for detail who would have crucified me for not explaining the correlatation/causation aspect of so few offshore companies and the need for the industry to have less capital as E&P spending decline… but maybe not if the slide was of this quality.

Nautalis have noticed a “massive” industry (one they also have limited experience in) and are therefore “targeting a niche market”… with 11/11  vessels in lay-up that is patently true! Nautalius note there are 10 000 companies…. and probably none with their entire fleet in lay-up either! It’s a veritable Cambrian explosion of wealth…

Nautalis Opportunity.png

These companies are made for each other. NautalisBITCF can issue the first cryptocurrency based on DSVs. As the oil market recovers the vessels can be scrapped to issue genuine metal tokens (“money”) in the blockchain, backed by actual ships: A quaint physical symbol of the past perhaps? Or you could short the ships (defintitely if I offered investment advice, which I don’t) and go long AltCoin, or DSVCoin, or whatever you could get away in an Initial Coin Offering.

The link here as always is investment bubbles: BITCF are hoping to ride the wave up whereas Nautlis Plc appear to have timed spectacularly badly the offshore oil services downturn. The one thing you can guarantee here is that that those Nautalis vessels won’t dive again (unless they are sinking), or in the case of the barge lay pipe, and anyone not taking seigniorage on “money” issued by BITCF is unlikely to get a return…

Farstad restructuring… owe the bank 1m you are in trouble, owe the bank (NOK) 10bn and the bank is in trouble…

News that the Siem deal had fallen over and led to the banks staying their position didn’t come as a huge surprise. I got the Aker/Solstad deal: maybe Aker came in too early but Solstad is defined by its subsea fleet which differentiates it from almost all the other large Norwegian owners. The dominant logic in the industry, and one I find hard to disagree with, is that the subsea fleet will recover and the good times will eventually come again. But AHTS/PSV is a whole different story: there were 121 North Sea PSVs in layup last week (more than 2 x the number last year) and 58 AHTS.

I don’t know enough about the funds Siem was raising or investing from but if I was long Subsea 7 and Siem Offshore (and clearly far be it from me to question his investment judgement) I would want extraordinarily good terms before going long on the Farstad fleet with only 6 subsea vessels out of 55. It looks dire for Farstad: of the 27 AHTS only 6 had any decent contract coverage at Q3 16. 5 are 15 or more years old but more concerning is that the large 2013/14 built, 24 000 bhp, units are in lay-up or have no work. It has always been an article of faith in offshore that newer units will find work, but that clearly isn’t the case now. The PSV fleet is just as bad with decent contract coverage for only five. I would classify only 3 of the the subsea fleet as proper subsea vessels, and the others as PSVs with a crane suitable really for wind farm work.

For the industry as a whole the best thing that could happen would be unfortunately for Farstad to vanish into the ether. A great company that simply went too long on ships in a cyclical industry. Like the Italian banks though I think there are a few more acts to play here as the secured lenders work out what they are going to do. One of the really interesting pieces of information that would have come out of this was the % cut the senior banks were prepared to take. Unlike many of the Norwegian restructuring the bonds are of minor importance here (and this really highlights how conservative Farstad was), of the ~NOK 11.6bn debt only NOK 1.4bn is in bonds. In the Siem plan the bondholders became equity holders and clearly that will happen in any plan and at a dilution rate I suspect that leaves them with nothing effectively.

But NOK ~ 10.2bn (USD ~1.2bn) is still real money. Here we have the age old problem that if you owe the bank a million you are in trouble but if you owe the bank a billion they are in trouble. The four largest banks listed in the 2015 year end were DNB (NOK ~1.6bn), Danske (NOK ~1.6bn), GIEK (NOK~1.5bn), and Nordea (NOK ~1.3bn). Nordea is interesting because in its latest results (Q3/16) the entire bank included loan losses of only EUR 135m,  (NOK 1.2bn), 53% of these already from oil and gas related loans. So although the banks prefer to report numbers like Exposure at Default, which for Nordea shows that of EUR 516bn of loans only 1.4% is at risk, and of these 42% is oil and gas related, the point is writing off everything in Farstad would have doubled the Q3 loan losses for Nordea and that is a material number for the bank. There is clearly no systemic risk to Nordea (and I have merely picked on them here) but the number, just from one company, admittedly a fairly large and niche one, is important and not simply a rounding error on a massive loan book.

Nordea appears to be a very well run bank and  banks take risks that don’t always payoff and charge a margin for it; although the over the years banks have become more dependent on fee income than margin income, and this incentivises bankers on long-life asset deals like this to load up the loans at the start and worry about the credit quality later. Essentially commercial banks have become investment banks for long-term loans with all the agency and moral hazard problems this presents. Anyone in shipping who has dealt with banks over the last 10 years always comments on the pressure to get sold multi-product deals and the associated fees: 5 product deals which included interest swaps, forex hedges etc were the gold standard as loan margins remained ultra slim… anyhow I digress…

Thus the work-out teams from all the banks are trying desperately hard here to pretend that their “secured” position is really more than worthless exposure to vessels with a high operating cost and minimal chance of asset price recovery with so many similar vessels available for sale. Even worse the size of the fleet is large enough to move the sale and purchase market prices down even further (if possible). Selling the subsea vessels won’t help as I would guess they will barely cover their liabilities if lucky.

So the best rational thing, for the industry, is the least likely and rational strategy for the banks. For as long as this happens the supply side of the industry will not correct itself. I accept the demand side has probably plateaued, at least in the short-term, but the supply side has a lot of pain to come. The PSV Opportunity (I and II) investment, backed by Standard Drilling (an equity play on structural recovery), saw 3 x Norwegian built PSVs come back to the North Sea from Asia and can economically at current day rates. While these PSVs are older (2005/06 built) in operational terms they can do everything a 2015 built vessel can and they arrived in the North Sea for ~USD 4m per vessel. The disparity between the book/bank values and the distress sale price seems far too wide to pretend the industry is recovering. Applying those type of sale values to the Farstad fleet would end up with huge losses for the banks and with the 2009 built PSV Rem Star being sold recently for fish farm work that is all but assured.

A loss to the secured lenders could realistically look like this if they were forced sellers tomorrow:

Farstad Fleet
Price per vessel (USD)/ Total Proceeds
AHTS 27 8,000,000 216,000,000
PSV 22 5,000,000 110,000,000
Saga/Scotia/Swift 3 7,000,000 21,000,000
Samson 1 50,000,000 50,000,000
Sleipner 1 50,000,000 50,000,000
Sentinel 1 50,000,000 50,000,000
 Sales proceeds (USD) 497,000,000
Exchange Rate 8.71
NOK 4,328,870,000
Current secured portion (10,600,000,000)
Loss to secured lenders 59% (6,271,130,000)

This is clearly meant to be an example rather than a serious valuation and it assumes Superior is not delivered and pre-delivery commitments are written off, no sale expenses, and no opex until sale. But I use it to highlight that when a market becomes as illiquid as the current OSV market asset prices collapse to levels previously thought unreachable and certainly well outside the norms of bank risk models. But from an equity story I find it really hard to see why someone would buy in at a level significantly above this as the new book value of the assets (and I have been exceedingly generous on the subsea vessel valuations) as Farstad is essentially an operations company not a service company.

I don’t think the banks are here yet, or even close to accepting sale prices like this. The inexorable process grinds on here: all the other security holders have lost everything and now the banks are facing their position. There is a straight trade-off between committing more (even waiving payments essentially prefers other creditors) or admitting now there is no future. The reason Farstad, Havila, and EMAS are so interesting is that not all the large companies can survive (or the small obviously). Sooner or later a rational group of financial of investors will pull out of this game. The survivors will make more but someone, probably more than one, has to fall before the supply side of the industry recovers.

Having a guess at how much working capital would be required is tricky. Farstad again highlights the extraordinary opex requirements of these vessels, in more ordinary times these would be integral to credit modelling, approximately 17% of the asset base is expended is vessel opex annually at Farstad (vessel opex/ vessel book value). Cut the asset value by half and you are well over 34% per annum. On a per day/per vessel at USD 13.9k looks expensive, but I have no reason to believe Farstad was especially inefficient in this regard. Banks could see CDOs at 30 cents in the dollar and you could hold them and wait for a rebound but with a vessel the opex, even in layup, is a killer.

The Siem solution effectively valued the company at NOK 1bn. Without knowing the size of the bank write down agreed its hard to see what the new Enterprise Value would have been. Finding an equity investor willing to take on a risk like this will be a daunting project but without it the banks are going to have to look at marking their loans to some sort of realistic recovery rate, and simply assuming a market recovery in 2018 and being made whole isn’t viable; which means the nuclear scenario will clearly be in play here. Meanwhile long-term contracts get harder to win as people (rightly) worry about the trading prospects of the Group. Siem might just be driving one of the great deals, realising the position of the banks the offer has just become extremely aggressive, but it takes a brave investor to follow through on this and I suspect we are looking at a solution that protects any investment, something more akin to super-senior than pure equity which was outlined in the first announcement.

The logical industrial strategy here is for the subsea vessels to be sold, the PSVs that aren’t strong regionally to be sold/scrapped, and a recapitalised Farstad to return to its roots and be a major player in AHTS as the industry inevitably consolidates. At some point in the future one would think a rational market would entail vessel owners offering open book type contracts for long term E&P rates, and the spot market being defined by very high rates that reflect the risk. Spot market vessels would need to be all equity financed because the correlation between a severe downturn in the oil price and asset prices is stronger than anyone thought possible prior to 2015. But the reason we all love offshore is while it maybe rational in the long run it is anything but in the short… and in the long run we are all dead as the Great Man may have quipped.

Having burned through the equity holders in 2014 and the bond holders in 2015/16 it would appear 2017 is the year when the banks will be the ones to face the economic reality. This will be healthy long term but this is likely to be a tortuous and long process as the losses here go straight to tier 1 capital and the banks will resist to the last. The good news is that this really does mark the industry lows and it will be recovery from here… but maybe not for Farstad.

One E(nor)MAS Chiyoda mess…


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


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.