Random weekend energy thoughts… Productivity, costs, and DSV asset values…

Permian shale and tight production in the third quarter was 338,000 barrels per day, representing an increase of 150,000 barrels per day. Let me say it again: this is up 80% relative to the same quarter last year. As many of you will realize, that’s the equivalent of adding a midsized Permian pure play E&P company in a matter of months.

Pat Yarrington, CFO, Chevron, on the Q3 2018 results call

John Howe from UT2 posted the photo above on Friday and kindly allowed me to reproduce the it. The Seawell cost £35m in 1987 and according to the Bank of England Inflation Calculator the same vessel would cost ~£94m in 2018 in real terms. In 1987 the USD/UK exchange rate was ~1.5 so the Seawell cost $53m and inflation adjusted around $132m (at current exchange rates).

Compare that with the most recent numbers we have for a new Dive Support Vessel (“DSV”) of a similar spec: the Vard 801 ex Haldane that was contracted at $165m (sold for $105m).  That price is roughly 25% above the cost of the Seawell in real terms. You get a better crane and lower fuel consumption but in productive terms you can still only dive to 300m (and no riser tower) and I doubt the crane and the lower fuel consumption are worth paying 25% more in capital terms.

These prices don’t reflect how much the MV Seawell pushed the technological boundary when she was built when and recognised as one of the most sophisticated vessels in the world. The major £60m/$75m upgrade she received in 2014 highlights again the myth that old tonnage will naturally be scrapped as an iron cast law is wrong, but more importantly highlights the technical specification of the vessel has always been above even a high-end construction class DSV (clearly visible in the photo the riser tower must have been seen a major technological innovation in 1987) and yet it is more economic to upgrade than build new for a core North Sea well intervention and dive asset. Helix has invested in an asset that brings the benefits of low-cost from a different cost era to a new more uncertain environment.

The reasons for price inflation in OSVs are well-known and I have discussed this before (here): offshore vessels are custom designed and have a high labour content which is not subject to the same produtivity improvements and lower overall cost reduction that manufactured goods have (Baumol Cost Disease). The DP system and engine might have come down in real terms, but the dive systems certainly haven’t. Even getting hulls built in Eastern Europe and finished in Norway has not reduced the cost of new OSVs in real terms (you only have to look at Vard’s financial numbers to see the answer isn’t in shipbuilding being a structurally more profitable industry).

That sort of structural cost inflation, a hallmark of the great offshore boom of 2003-2014, was fine when there was no substitute product for offshore oil. Very few OSVs were built in a series (apart from some PSV and AHTS). But the majority of the vessels were one-off or customised designs with enormous amounts of time from ship designers, naval architects, class auditors (i.e. labour) before you even got to the fit-out stage. Structural inflation became built into the industry with day-rates in charters etc expected to go up even as assets aged and depreciated in real economic terms because demand was outpacing the ability of yards to supply the tonnage as needed.

The same cost explosion happened in pipelay but did allow buyers to access deeper water projects. Between 2003-2014 an enormous number of deepwater rigid-reel pipelay vessels were built (in a relative sense) with each new vessel having even more top tension etc. than the last; but the parameters were essentially the same: they were just seeking to push the boundary of the same engineering constraints. The result was (again) a vast increase in real costs but one that was partially offset by advances in new pipe and riser technology that allowed uneconomic fields to be developed. Now Airborne and Magma are working on solutions that could make many of these assets redundant. Only time will tell if those offshore companies who have made vast investments in pipelay vessels will have to sell them at marginal cost to compete with composite pipe if the solution gets large-scale operator acceptance (i.e. Petrobras). However, if composite pipe and risers get accepted by E&P companies on a commercial scale those deepwater lay assets are worth substantially less than book value would imply (I actually think the most likely scenario is a gradual erosion of the fleet as it is not replaced).

But now there is a competitor to offshore production: shale. And it is clearly taking investment at the margin from offshore oil and gas. And shale production is an industry subject to vast economies of scale and productivity improvements. The latest Chevron results make clear that they have built a vast, and economically viable, shale business that added 150k barrels per day of production at an 80% growth rate year-on-year:

Chevron Q3 2018 Permian .png

To put that in perspective when Siccar Point gets the Cambo field up and going they will be at 15k per day and it will have taken them years (and the point is they are a quality firm with Blackstone/Bluewater as investors ensuring the do not face a financing constraint).

What makes shale economic is the vast economies of scale and scope available to companies like Chevron. E&P companies producing shale are adding vast amounts of production volume every year and theories that they are not making money doing this are starting to sound like Moon photo hoax stories. E&P companies throw money and technology at a known geological formation and it delivers oil. The more money they invest the lower the unit costs become and the greater the economics of learning and innovation they can apply at even greater scale.

Offshore has a place but it needs to match the productivity benefits offered by shale because it is at a disadvantage in terms of capital flexibility and time to payback.The cost reductions in offshore that have been driven by excess capacity and an investment boom hangover, these are not sustainable and replicable advantages. In offshore everything, from the rig to well design and subsea production system, has traditionally been custom designed (or had a significant amount of rework per development). When people talk of “advantaged” offshore oil now it generally means either a) a field close to existing infrastructure, or, b) a find so big it is worth the enormous development cost. Either of those factors allow a productivity benefit that allows these fields to compete with onshore investment. But to pretend all known or unknown offshore reserves are equal in this regard is ignoring the evidence that offshore will be a far more selective investment for E&P companies and capital markets.

One of the reasons I don’t take seriously graphs like this:

IMG_1067.JPG

…and their accompanying “supply shortage” scare stories is that the market and price mechanism have a remarkably good track record at delivering supply at an economically viable price (since like the dawn of capitalism in Mesopotamia). Modelling the sort of productivity and output benefits that E&P majors are coming up with at the moment is an issue fraught with risk because 1 or 2% compounded over a long period of time is a very large number.

As an immediate contra you get this today for example:

(Reuters) – The oil market’s two-year bull run is running into one of its biggest tests in months, facing a tidal wave of supply and growing worries about economic weakness sapping demand worldwide.

Which brings us back to DSVs in the North Sea, their asset values, and the question of whether you would commission a new one at current prices?

Last week the OGA published an excellent report on wells in the UK and its grim for the future of UK subsea, but especially for the core brownfield and greenfield projects in shallow water that DSVs specialised in. And without a CapEx boom there won’t be a utilisation boom:

OGA wells summary 2-18.png

Future drilling is expected to pick-up  mildly, although it is unfunded, but look at this:

EA well spud.png

Development Drilling.png

So the only area in the UKCS that isn’t in long-term decline is West-of Shetland which is not a DSV area. CNS and SNS were the great DSV development and maintenance areas and the decline in activity in those areas are a structural phenomena that looks unlikely to change. Any pickup is rig work is years away from translating into a Capex boom that would change the profitability of the UKCS DSV and small project fleet.

DSV driven projects have become economic in the North Sea because they are being sold well below their economic cost. Such a situation is unsustainable in the long run (particularly as the offshore assets have a very high running cost). The UKCS isn’t getting a productivity boom like shale to cover the increased costs of specialist assets like DSVs and rigs: E&P companies are merely taking advantage of a supply overhang from an investment boom. That is no sustainable for either party.

So while the period 2003-2014 was “The Great Offshore Boom” the period 2015-2025 is likely to be “The Great Rebalancing” where supply and demand both contract to meet at an equilibrium point. Supply will have to contract because at the moment it is helping to make projects economic by selling DSVs below their true economic worth, and the number of projects will have to contract eventually because that situation won’t last. E&P companies will need to pay higher rates and that will simply make less projects viable. You can clearly see from the historic drilling data that a project boom in shallow water must be a long time coming given the lags between drilling and final investment decisions.

The weak link here in the North Sea DSV market is clearly Bibby Offshore (surely soon to be branded as Rever Offshore?). As the most marginal player it is the most at risk as marginal demand shrinks. Bibby, like other DSV operators on the UKCS, serves an E&P community that is facing declining productivity relative to shale (and therefore a higher cost of capital), in a declining basin, where the cost of their DSVs is not reducing proportionately or offering increased productivity terms to cover this gap. Both Technip and Boskalis were able to buy assets at below economic cost to reduce this structural gap but the York led recapitalisation of Bibby still seems to significantly over value the Polaris and the Sapphire – particularly given implied DSV values with the Technip purchase of the Vard 801 (TBN: Deep Discovery).

DSVs made the UKCS viable and built the core infrastructure, but they did it in a rising price environment where the market was based on a fear of a lack of supply. One reason no new North Sea class DSVs were built between 1999 the Bibby Sapphire conversion in 2005 is because the price of oil declined in real terms but the price of a DSV increased meaningfully in real terms. A new generation of West of Shetland projects may keep the North Sea alive for a while longer but this work will be ROV led. A number of brownfield developments and maintenance work may keep certain “advantaged” fields going for years that will require a declining number of DSVs.

North Sea class DSV sales prices for DSVs are adjusting to their actual economic value it would appear not just reflecting a short-term market aberration.

#structural_change #this_time_it_is_different #supplymustequaldemand

Scrapping and UKCS North Sea demand…

Spirit Energy (67% owned by Centrica) awarded a 3 well / 6 month drilling contract this week to the Transocean Leader. The Transocean Leader was built-in 1987, 4500ft 3G semi, that had a major upgrade in 2012. I remember 1987, my first year of high school, the All Blacks won the inaugural Rugby World Cup with ‘The Iceman (Michael Jones)’, Fleetwood Mac and U2 were cool (or I thought they were), my sister listened to Whitney Houston (okay that isn’t strictly true more The Dead Kennedys). In other words it was a while ago. I’m not a rig expert, and like vessels there are a lot of nuances around what kit can at times do what job. I don’t want to get into those, and my point here isn’t to publish a post every time an old rig wins a job.

My point is that this is a 31-year-old rig, that earlier this year had operational problems forcing it to return to a shipyard for repair before it could continue its contracted workscope, could comfortably win work with a significant UKCS (and international) operator. At 31 years old, and operating in the UK sector, it would be unreasonable to not to expect the odd issue, and indeed when that happened Dana and Transocean settled on a commercial deal to avoid contract termination. E&P operators may prefer new kit, find me an engineer who doesn’t, but the commercial guys like best priced kit in the current environment, and at the moment they are firmly in-charge of procurement.

For all the talk of scrapping being inevitable there are a lot of examples of older kit being contracted by big owners. Simply marking a build year and saying that everything older than that will be scrapped is proving to be an unrealistic forecast methodology across all asset classes (i.e. Fletcher Shipping with the Standard Drilling PSVs). Scrapping is likely to be far more selective around owner financial resources, work programmes forecast, and age, with the relationship between all three more important than any one variable.

In any other industry with cyclical demand equipment is often worked until likely maintenance costs exceed marginal profits. Fully depreciated equipment can have a major (positive) impact on the P&L for struggling companies. As industry demand rises older, less efficient, equipment is brought out to operate at a higher marginal cost. The oil industry is going the same way and while newer rigs and jack-ups may be preferred for drilling work that is clearly not the case in all situations. In plug-and-abandonment work in particular, which is less time-sensitive and more price-sensitive, there is absolutely no indication that new rigs are preferred unless their performance compensates for a cost differential (a very high bar to pass). There is also minimal-to-no evidence of newer rigs attracting anything like the sort of day rate that would allow them to cover their cost of capital versus new-build cost which is surely the first stage in a demand driven recovery?

There has been a lot of discussion lately about the new investors in the North Sea and how they are changing the economic makeup of the area, the UKCS in particular. For the supply chain one thing the new (operationally and/or financially) leveraged companies definitely bring is a relentless focus on pragmatism and cost control that simply was not as evident at larger E&P companies (who tend to excel at larger more complex developments). These might well be the right type of companies to extract the maximum resources from a mature basin, but for the supply chain the relentless focus on cost control over global and gold standards marks a significant change in procurement priorities. This is a long-term deflationary trend for the supply chain.

However, for the subsea and supply industries on the UKCS they better hope this works. The most recent stats from Oil and Gas UK show that CapEx work simply does not have the drilled inventory for a quick upturn in demand, and while the construction assets play in the maintenance market oversupply will continue. The decline in development wells, which drive tie-back activity and is leading indicator of small field developments, is what is causing huge problems for the tier-2 subsea contractors on the demand side. This isn’t going to change until drilling programmes increase in volume.

UKCS Statistics (2017)

Oil and Gas UK activity 2017.png

Source: Oil and Gas UK.

 

Increased production in the North Sea…

A good article in the FT this weekend on the resurgence in production in the North Sea and the influence of some of the private equity backed companies (behind a paywall):

Production from the North Sea has bucked the long-term decline and energy consultancy Wood Mackenzie expects it to average 1.9m barrels of oil equivalent (boe) a day in 2018, its highest since 2010. This is, in part, driven by new developments such as Catcher, as well as Dana Petroleum’s Western Isles and EnQuest’s Kraken.

The rise “highlights that while the UK North Sea is in decline, these smaller independents and new private equity players are helping drive a bit of a renaissance,” said Neivan Boroujerdi, an analyst at Wood Mackenzie.

Chrysaor’s Mr Kirk said: “If someone had said then [during the downturn] that UK production from the North Sea would increase for three straight years or more, nobody would have believed them. That kind of thing changes people’s perceptions.”

But the article misses a few things important for the contracting community (and context in general):

  1. As the graph above from Oil and Gas UK makes clear this increased production is the result of historic investment in 2012-2015 and has absolutely nothing to do with these new entrants who were not part of the decision making entities that drove this production increase
  2. There has been a massive drop in Capex that will eventually reduce production
  3. Enquest and Premier, two major “small producers”, are locked out of the capital markets until their debt burdens reduce transformationally and have no plans for significant North Sea developments. Kraken and Catcher simply will not be repeated by smaller players without a massive change in funding conditions for small E&P companies
  4. The FT highlights the reduced cost of per barrel production and unit development costs. These have been at the economic cost to a large amount of equity in the supply chain and really show no short-term likelihood of changing
  5. The new private equity backed companies (and I especially include Ineos in this) are ruthless about supply chain costs. This is healthy for the long-term future of the basis but brutal for those long on assets in an over supplied market

Look, I am as happy about an increase in production as anyone, and clearly it is good economic news, but there is a degree of unreality creeping into this: CapEx spending has dropped by an order of magnitude and is not likely to rebound to anything like it’s previous levels in the next few years. Some firms will do well as the amount of work increases, but for anyone long on vessels or rigs that just isn’t likely to be the case.

Subsea work takes years to work through from initial discovery and field approval decisions, and as this data point from Oil and Gas UK makes clear the outlook in this respect is poor:

UKOG Field approvals.png

One Penguin doesn’t make a summer.

North Sea DSV update… Has the Vard vessel been sold? Will IMR save the world?

We’re eyeball to eyeball, and I think the other fellow just blinked.”

Secretary of State Dean Rusk, during the Cuban Missile Crisis, 1962

It was a little windy (80-100 mph) up the mountain today as you can see from the photo… I thought it was a good metaphor for offshore at the moment anyway…

So in clearing out my emails I have now been told Technip have reached a deal with Vard on the 801. A price of ~$100m, but with no delivery risk and commissioning liability for Vard, has apparently been agreed. Technip is large enough for that to be a sensible risk to take as the Wellservicer needs to be replaced at some point. Unless ordered by SS7 or Technip I think this will be the last North Sea class DSV built without E&P company contract coverage for at least 10 years, maybe ever,  barring some unheard of change in the market. (This isn’t the place to get into why I don’t think any of the UDS vessels will end up North of the Med).

We are watching how an extremely illiquid and asset specific market clears in a huge market downturn. The interesting thing is that Technip and Subsea 7 seem to be making a renewed commitment to IMR having really lost focus during the construction boom, this graphic from Technip makes clear:

Technip Market Growth.png

If you are a smaller IMR contractor expect Technip to come up more often on tenders you are spending money on bidding. A near new DSV fleet fits this theme. It also shows you what sort of percentage/revenue increase on IMR a market leading company thinks it can get and how it is planning on taking market share. Smaller companies should be worried and anyone who publishes documents claiming they can grow organically at 50% in this market just isn’t serious.

I find the pricing of this asset fascinating: to Technip and Subea 7, taking a 25 year asset view it is an asset you could spend some real money on. One needs to replace the Wellservicer and the other the Pelican. But outside of those two companies the asset is almost unsellable at anything like it’s build cost. If you can’t operate that vessel in the North Sea (and it’s not even NORSOK) then it’s just an ROW DSV and you would be lucky to get $50-60m… and only then if you could find a bank to lend against it. So really they are just bidding against each other to take on the asset (not that I think Subsea 7 were)? How long do you make Vard sweat or risk seeing a really good vessel go to a competitor? Other vessels could also have been purchased from distress sellers e.g. How much better is the Vard vessel to the Toisa Pegasus (currently in lay-up)?

Both sides blinked at 100m if you ask me. More compromise than Mexican standoff.

The Seven Kestrel is arguably the best DSV in the world and as soon as construction work starts to pick-up SS7 will just ask the Koreans to build a replica (for less) if the need to relace the Pelican. And at that point that will be the last North Sea class DSV built for a very long time.

Both Technip and SS7 have some pretty new DSVs and both have an old (fully depreciated) one that operates when the market peaks… But as I wrote earlier the only realistic scenario for 2018 is for North Sea day rates to stay low for DSV work, and in this market making a trade off against a low capital cost to lose money on OpEx for a bargain purchase is getting ever harder to make? The lower than expected contract size for the Snorre Extension for Subsea 7 shows how low margins are for awarded work at the moment and how long it may take for day rates to recover. And if, as looks likely,  Boskalis and Bibby start a brutal price war to gain or keep market share, then dropping $100m on a vessel to go out at $100k a day (a cash loss amount in the North Sea) doesn’t seem that clever at the moment. Go back $10m a year for a few years on a DSV, easily possible in this market, and savings in CapEx were illusory.

Optimists point to graphs like this:

North SEa SAt MArket.png

But this ignored Boskalis taking the Nor vessels and Vard vessel replacing the Rockwater 1. [As a methodological point it is also worth noting that each movement on the vertical axis represents 3 DSV vessel years! showing you how easily the forecast could be out here]. It is also worth noting that if those Decom figures are wrong, and they look agressive, the market imbalance is illusory. No one in this market is going to force E&P companies to pay divers to remove mattresses etc off the seabed.. its just not going to happen. Just as importantly, a modest increase in day rates, which would see the DSV fleet operating at below economic cost, could curtail IRM or EPIC project demand as this graph seems to assume constant demand. There is a large amount of latent supply in the market that will come into the market as rates increase (which happened in 2014)… economic change happens at the margin… which is not reflected in a static graph like this.

Ultimately running vessels, even for companies the size of Subsea 7 and Technip, is a utilisation game as the fixed costs are so high that a small drop in utilisation and day rates /project margins can lead to a massive drop in profitability and cash losses. Shareholders would not welcome a cash call if it means they have overpaid for vessels and ultimately been diluted in a down market, and a North Sea class DSV is a very expensive vessel to have underutilised. I am always reminded mentally that Technip looked seriously at acquiring CGG not that long ago… in which case this would be a great bargain…

Let’s wait and see…I still have my doubts… but if the Vard 801 rocks up to the North Sea in April/May under Technip control for the North Sea summer my photo above will be a good reflection of economic conditions for North Sea DSV owners in 2018…

If you thought North Sea DSV rates were cheap last year…

Next week Bibby Offshore is shutting down the US business Bibby Subsea Inc. completely. It’s the right move as the business is subscale, lacks a competitive position or asset, has a very high cost base, and has no booked work at all for next year. However, it does mean the new owners, only three weeks in, have given up on the £130m revenue target for 2018 management had been promoting to potential investors in November. The gulf between the new owners and management would appear to be huge and it is a total repudiation of the past management strategy and actions. The new strategy is clear: create a small UK DSV business and sell as quickly as possible to minimise losses.

The new owners of the business, clearly outlined in the Scheme of Arrangement document here, now own a 2 x North Sea DSV business, one chartered and one operational, and the Bibby Sapphire in lay-up. Norway, Singapore and the US have gone, dreams of building an international contractor have collided with the cash cost and risk of building one. This is going to be a much easier business to get into than get out of and the consequence of this will be a very competitive North Sea DSV market for 2018 as the new owners are forced to try and build up the order book at any cost in order to get out of the business before next winter.

The closure of the US means the new owners have to sell and make profitable a 2 x DSV  North Sea business. There is an entire layer of corporate management now that is surplus and it doesn’t take a genius to see what will happen here. In all likelihood a strong Executive Chairman will be brought in above the current UK management to help sell the business. M&A advisers will be brought in, and as soon as the order book has some substance, and some costs reduced, look to get the investors out of this position before the company consumes too much of the £40m cash that has been pumped in.

This will not be an easy business to run or sell. The new owners only have a year to use the Bibby name, and won’t want to spend money on an expensive rebranding exercise, so use the branding as an external sign of how confident they are of selling the business.

The question is how long the £40m can last?  This isn’t a project management business it’s a hotels like business, only one thing matters for a small boat owner: days utilised * day rate. I suspect the new owners have now done some downside calculations based on air dive work and a forecast cost base and are horrified at how much cash they could burn through by June, hence they taking no risk at all on sticking with the US business. The UK business needs the vessels in SAT, at fairly high utilisation levels, or it simply isn’t an economic entity. It is very hard to see any more money going in now the strategy is clear and the only thing being sold is a small UK focused contractor, so it has to last until a sale.

The asset base is the weakest now of any North Sea contractor. The Bibby Sapphire (a vessel I feel a strange emotional attachment to as the first ship I ever transacted) is likely never to return to the North Sea I believe, but even  lay up costs are likely to be $1200-1500 per day + 500k to get it there (e.g. a lot will need to be spent on the dive system procedures to make sure reactivation is possible, humidifiers). The problem is that outside of the North Sea DSV rates are low, driven by oversupply (unless your ship is painted red), and there is a binary price difference between a North Sea DSV and one that isn’t (although the Boskalis transactions blurred that boundary). Brokers I have spoken to think USD 10m is reasonable and even that could take time to achieve. No one needs the boat for the same reason Bibby couldn’t get her utilised: there is no work unless it is bid very cheaply. There might be an interesting discussion between the auditors and investors on vessel values in the last accounts coming up.

The 1999 built Bibby Polaris is a generation behind the other DSVs in the market. The vessel is popular with customers but the awkward forward bell arrangement means no one would go out of their way to buy it, but it is working and a core UK asset. The Topaz is on charter with minimum committed spend and a charter that de-risks cash spend but lowers margin as the vessel works in SAT mode.

The Olympic vessels are a smokescreen: they are total commodity vessels in the current market. Every single small ROV contractor out there has access to similar tonnage and on pay-as-you-go charters the margin is minimal. No one is giving Bibby a real construction contract until their financial position is sorted, and they if don’t have one for 2018 now (which they don’t) then it isn’t real anyway. James Fisher recently used one of the Olympic vessels and even put their own ROV crew on. Access to the Olympic vessels might move the revenue needle a little but in reality they add nothing to the economic cost base. The only question is if the current Olympic charter is continued for whether the creation of the new TopCo allows for its legal termination? The cost of this charter is material as it is significantly above market rates.

The only thing in the M&A bankers arsenal is the cost synergies a new owner could get from taking over this 2 x DSV operation and further reducing the costs. Pretty quickly, if the US office example is anything to go by, the unescessary costs will go from the business and a small 80-90 person business will emerge. But it will be hard for any buyer to reduce that dramatically in cost terms because you still need three project crews per DSV and a certain number of commercial personnel. But it is the only financial incentive to buy beyond the contracted revenue, which is all short-term.

The need for synergies means that only an industrial buyer makes sense here. Bokalis may want the service agreements but it has two better boats now so won’t want the assets. DOF Subsea? No cash to buy and won’t want the DSVs, but it may make sense to take the infrastructure and get the Achiever working (although what they really want is for the market to pick up and Technip to take her back) and get the Vard newbuild. DeepOcean? Triton as the controlling shareholder will not be bailing this deal out and won’t want Polaris or Sapphire. McDemott? Just done a large deal and don’t need a loss making DSV operation to win work. Ocean Installer? The sellers will be getting shares only in another subscale business. It is a depressingly small list for a sell side adviser.

If you were going to recreate the business from scratch really you’d just take the Vard DSV and the Topaz and not bother with Polaris. But for the current owners that isn’t an option… but for anyone else as a buyer it is? Splitting the operational and asset base makes perfect sense for any buyer here but almost none for the seller as if the Polaris leaves the North Sea she too will see her limited value drop by a quantum.

Another problem the Bibby owners face is that to get out quickly all the cost savings and new operational model will not have any operating history. When you sell completely on pro-forma accounts you take a big discount though, and worse a discount combined with paper/shares not cash normally, because it’s all just a promise. However, stick with this until next summer and the business will in all likelihood need another cash injection and a special survey for Polaris beckons. The bankers will earn their money on this.

So the new owners have to sell SAT days: now. They need an order book.  Working as an air dive contractor at 90k a day won’t even cover the new reduced cost base. A sale requires market share in SAT, and the only way to guarantee that is to drop the rates and build backlog. A sale by June, when hopefully the burn rate has slowed, and there is some SAT order book, is now the imperative.

Unfortunately there is the competition: three multi-billion market capitalisation companies with open DSV schedules. Boskalis has just taken delivery of two North Sea class DSVs and needs to get them working. Technip and Subsea 7 also realise now there is a chance to finish off a fourth player in the market and can flood the market with cheap capacity. The new shareholders cannot cross subsidise from other business lines and have a much higher cost of capital. It is a very weak strategic position to be in for a company with such a high fixed cost base, something the competition is only too aware of.

Therefore every single one of these companies will be calling on the Aberdeen market with once-in-a-lifetime pricing on DSVs next year. If you thought rates were low at the start of 2017, at £90k for a fully kitted out DSV with a 15 man team, you can expect them to be there again now for periods and won’t rise above last year’s peak of £130k

Demand won’t save anyone for 2018. The planned increases in spend are marginal and relatively fixed now and there is very little DSV construction work. Platform shutdown plans and schedules have been made. Engineering capacity for the 2018 summer has been locked in E&P company budgets with only small increases possible. Only unplanned outages, or rates so low work is brought forward, offer room for increases in planned work now. And the reason Bibby and others don’t have much work now is the E&P companies believe they will have ample options in the new year… and they are right. 2018 promises to be another grim year to be a DSV owner in the North Sea.

Morton’s Fork, Nor Offshore, and the North Sea DSV market

John Morton was my kind of optimist (and economist actually): as the Archbishop of Canterbury (1486-1500) he devised the logic for imposing forced loans on people that those who were rich could obviously afford to pay, and those whom lived frugally obviously had savings buried away somewhere (and could therefore afford to pay). This somewhat quaint logic is the origin of Morton’s Fork, a bifurcation that leads to no good options.

An article in the FT today on the increasing free cash flow of North Sea oil producers highlights the Morton’s Fork for the Nor bond holders. In November last year, after raising money again they had the decision to make of continuing the spectacularly unsuccessful strategy of sitting in Blyth, with no diving contractor,. waiting for work when all the dive contractors had excess DSV capacity, or changing. Admittedly the decision was a Morton’s Fork, work anywherre is hard and there is excess capacity everywhere. But serious work in the North Sea, given the industry structure and regulations, was never possible. Suddenly the USD 15m liquidity issue, having been depleted roughly a third, without a day of work and absolutely none in the schedule, just on OPEX, doesn’t seem like such a big number (and there appear to be valid questions about the technical condition of the Atlantis where the crane for example has been downrated to 50t).

However, the bond holders decided they would wait for the mountain to come to them. After a recent fiasco where the Contracts Department/ Nor were awarded a five day job, and then couldn’t close it commerically, the mountain is looking strangely distant, and the FT article shows why:

Alongside cuts to operating expenses, North Sea operators reduced project investments during the downturn — last year only two relatively modest field development plans were approved, involving BP and Apache. Up to six new projects could get final approval from operators this year, and a further eight in 2018, said Oil & Gas UK, but it warned in a report published on Tuesday that these are “not certain to be delivered and may be subject to delay or cancellation”.

As I have stated before until the construction work returns the maintenance market will not save these vessels. It’s worth pointing out that Clair Ridge, the BP project above, used no DSV days, nor will any West of Shetland (except for potentially some minor riser hook-up work).

Subsea 7 recently reactivated the DSV Seven Pelican, currently off to do 200 days for Apache, and the Seven Osprey, which is having a new thruster installed in Gdansk and then heading East. Subsea 7 and Technip are recommitting to diving because the work is there and they can. With huge engineering and tendering teams they can move old assets back into the market to take advantage of what little work there is. I have been told, but I have no idea of the veracity, that market rates are GBP 65-75k, strip out GBP 50k for divers/project crew and no one is making much money here, but neither are they losing it tied up. But the North Sea DSV fleet will not face a demand driven recovery until the tie-backs/tie-in market, which soak up huge amounts of DSV days return.

Any serious hope the bondholders had that a mild uptick in maintenance work would lead to a charter in the North Sea must now have vanished to all but the most die-hard optimists. Setting up a tin-shed operation in the most regulated market in the work (bar Norway) was simply a bad idea, even had the market returned, but looks even worse in a poor market. The Nor vessels will move before the mountain one would assume.

How much is enough?

How much equity and working capital do you need to be a UKCS saturation dive contractor? And just as importantly, how much can you make from such an investment? Two different groups of North Sea DSV bondholders are pondering this question at the moment.

On the one hand are the Bibby Offshore Holding Ltd (“BOHL”) bondholders who must realise now that a financial restructuring is coming. Moodys noted in November that:

Bibby Offshore cash generation has been negative since the beginning of the year resulting in a reduction of cash on balance sheet of approximately GBP40 million out of the GBP97.1 million it had at the start of the year. Moody’s believes that cash generation will remain negative in 2017 to approximately GBP30 million with increased pressure in the first half of 2017 due to seasonality. Cash generation in the second half of 2017 should slightly improve due to the anticipated positive effects of the renegotiation of charter rates.

In anything things have only got worse… Let’s leave out the fact that the only charter open for renegotiation in 2017 is the Bibby Topaz and here BOHL have a problem: give the vessel back and the bond holders know they are not getting paid back in full as BOHL can’t generate enough revenue; or, keep the vessel, and spend some of the remaining cash on a vessel with little backlog.

Moody’s estimated Bibby will generate EBITDA of GBP 12m for 2017 and means leverage rises to more than 20x EBITDA (including operating lease calculations): a totally unsustainable number. The only hope could have been a really busy 2017 summer with extraordinarily high day-rates; however, despite high tendering levels, rates are rock bottom and the volume of work is small. The question for BOHL is only the size of the financing gap not the reality of the need for one.

BOHL needs a debt-for-equity swap. [Non-financially interested don’t need to worry about the specifics here but in essence the people who lent the company money on a fixed basis agree to turn this into shares accepting the may carry some upside potential].  In reality, I think there will be a raidcal restructuring of the BOHL. I believe the bondholders will seek a restructuring that takes the business back the 2005 model of 2 x DSVs based in Aberdeen. Singapore, Norway, and the US are gone. No offices outside Aberdeen appear to be cash flow generative at all even taking into account ROV utilisation. The bondholders are in for the Sapphire and Polaris anyway so the need to come up with the least cash exposure that offers them the maximum return. ROVs are not a BOHL specialty and there is no reason to fund that business with precious working capital beyond the DSVs own need. Its back to Waterloo Quay and 2005 for those of us who were there (and they were great days I can assure you).

Given the size fof the debt write-down the bondholders will be expected to take they will leave enough cash in to allow the business to trade for a few years in a way that maximises their chances of recovery and nothing more. So unless they can reach a revenue sharing agreement with the Volstad Topaz bond holders that won’t feature as well. The ramifications to the BOHL brand will be enormous but the cash call will be of a magnitude that will allow for little sentimentality.

What % of the business they demand for this is anyone’s gusess and will be dependent on any equity Bibby Line Group agree to put in.  These things are a matter for negotiation rather than hard-and-fast rules. Remember also this is a business that is going to have to be 100% equity financed for the foreseeable future as no one will lend to such specialist vessels without backlog (i.e. an asset and cash flow facility) for a long time. However what does seem reasonable is this:

EBITDA per DSV: GBP 8 – 12m; Corp Overhead: GBP 4m; Implied cash flow for debt multiple: GBP 16m (mid-point average). [Debt at 4.0x EBITDA: 64m]; [Debt at 5.0x EBITDA: 80m]. Outstanding debt: GBP 175m.

I get valuation and cash flow modelling are an art not a science and that I have made a lot of assumptions here. But also bear in mind most DSV operators will kill to get EBITDA of GBP 10m per vessel this year, many DSVs are going out at OPEX plus a small margin if they are lucky, and given the way discounting works I could be seen to be generous here front-loading cash flow. Don’t forget the risk either: this market is far more volatile than anyone, including me, ever thought possible. I think I am directionally correct here and I don’t need to to into greater detail in this forum. The core point is this: under any number of reasonable scenarios the bondholders are looking at writing off at least 50% – 66% of their debt and if a working capital call is made then way more than that; and that selling the DSVs in this market is probably the worst, but not unthinkable, option for them.

The BOHL bondholders are (rightly) terrified of getting the Polaris and Sapphire redelivered. Not only have the Nor/Harkand bondholders taken the vessels out of the market for them they have also highlighted what a shambles getting re-delivered such vessels can be. It is very doubtful the two BOHL DSVs could be sold at anything like the value implied by recent bond market prices (.60-.67) if at all. The bondholders knew the DSVs didn’t cover the value of the bond (i.e. it wasn’t fully secured) but they are currently spending funds they thought would be used to grow the business on basic working capital (that is the fault of the market not management it needs to be said and was a risk they took signing up to a huge unsecured portion of the bond for “general corporate purposes” in a cyclical industry). The cash position could be significantly worse than Moody’s forecast: I doubt EMAS has paid for the Angostura work and some sort of agreed deal with Borderlon, currently in arbitration, could see c. USD 5m handed over for a settlement for 10% of the outstanding claim. Anything more could mean a nuclear outcome for BOHL. Better to stem the exposure now…

At these sort of levels the bondholders are going to ask for a significant dilution of the Bibby Line Group stake (potentially all of it if a signficant amount isn’t invested with the bondholders in the new working capital facility). But the most logical option here is therefore to cut the business back to what could realistically trade at a profit and cauterise the loss making exposure. That means everything apart from the core UK dive business with maybe a couple of ROVs to support it. But the BOHL bondholders are disparate and international. And while M&G (who have their own workout team) are the largest I believe, and may have some interest in a controlled restructuring, this was a “US 144 issue” meaning that a lot of the bonds will be held by US institutions who may just write this off as it becomes to complicated. In such a situation a rump business being sold is the most likely option as there is some value there, just nothing like GBP 175m + working capital.

I think we are looking at a pre-pack here with a “credit bidding” element where the bondholders, or new investors, agree to buy the vessels, backlog, IP and management system and very little visibly changes apart from the closure of international operations and the redlivery of the Topaz and the Olympic vessels with the Borderlon claim left in the insolvent rump. Quite how far they will run the cash reserves down to before such a transaction happens will be the call of from the legal/financial advisers. Olympic, who would appear not have to any Bibby Line Group guarantee, will simply end up as an unsecured creditor and have to accept redelivery of their vessels for what in this market are essentially onerous charters. Borderlon in Houston potentially have the most to lose: having built a vessel for Bibby in the US the charter was cancelled when the market turned. I have no idea who was wrong or right legally, but UK companies traditionally do very badly in US Courts/ Arbitration and they must be hoping for a meaningful payout.

I am not sure the scale of the problems are acknowledged. The company has 10 Directors now, and seems to be focusing on such diverse strategies as small pools (which offer the prospect of cost with no immediate revenues). It’s the ultimate re-arranging of deck chairs on the Topaz  Titanic. I undertand why. I have been in a similar position and there is an element of cognitive dissonance involved. But to believe the bondholders would write off at least half their debt and fund an international expansion for a loss-making business is about as likely as believing the UKCS SAT diving market will miraculously recover. Stranger things have happened.

The only other option would seem to be an investor throwing millions into this business to keep it going until the market recovers and would involve keeping the bondholders whole. I just don’t see it and it pains me to say that. Because the answer to the first question is of course, like all post-modern phenomena, the answer is relative. BOHL not only need enough working capital to satisfy their creditors they need enough to outlast other players in the market especially DOF Subsea.

The marionette Nor Bondholders and their puppet-master Maritime Finance Corporation have a plan so cunning Blackadder would be confused. The top secret idea is to do exactly what they did last year and tie the DSVs up in Blyth and wait for the market to recover and thus, without any investment in infrastructure and systems that the other five SAT dive companies have spent millions per annum on; they will ride a demand wave and recover their investment. Like all cunning plans it involves an element of risk, namely, exactly like last year where they end up spending USD 350k per vessel per month and get no work. But hey I realise I’m a glass half empty guy…

The Nor bondholder have gambled that USD 15m is enough. However, they have burned through at least USD 2.1m since November when they raised the money and appear no closer to some paid days. The problem for Bibby isn’t that they are seriously threatening work its that it is artifically depressing DSV asset prices. I’ll discuss my views on the Nor vessels in depth later. But while their strategy is economically irrational it isn’t depressing rates because 1) E&P companies buy a system + DSV (i.e. engineering, HSE, etc); or 2) the current SAT dive companies all have excess tonnage.

The amount of working capital and the financing gap BOHL have is dependent on all these factors and there is no firm answer here. Keep the debt high and you need a lot. But whatever the agreement is it represents a number in the low tens of millions each year until a market recovery and no one can supply any quantitative information suggesting one, in fact a lot can be shown to make the opposite: this is a period of structural decline for UKCS DSVs.