DOF Subsea IPO looks like a market bellweather of what financial investors believe…

Successful investing is anticipating the anticipations of others.

John Maynard Keynes

I was always sceptical of the DOF Subsea IPO, any subsea company raising capital at the moment would need an exceptional value story and this never offered that. I saw it as insiders selling out aware of how the future could look, so news that it was canned doesn’t come as a huge surprise. First Reserve wanted out but not at any price, and so the IPO was pulled. Let’s be clear this wasn’t a casual conversation, bankers will have had sounding out conversations with key investors who either gave a steadfast refusal, or said they would only buy it really cheap. The investment narrative is moving to shale in financial hubs at the moment, no one is paying full price for assets at the moment, and as the numbers make clear this is an asset business. The DOF Subsea Q1 numbers also make really clear that talk of a recovery at the moment just isn’t substantive.

DOF Subsea is a good company, and they are strong in Brazil and Norway which strategically is as good as it gets in macro terms for offshore, but they simply cannot be immune to the enormous retraction in demand the industry is experiencing. DOF Subsea also has the DOF problem which they blithely dismiss but which no one can get past: are they a contractors’ contractor or a contractor? As the industry consolidates it is increasingly hard to see someone being able to be both. It is also hard to believe that when all the flexlay vessels come off contract with Petrobras they will be employed at anything like the current rate creating a huge residual value issue on entry for stockholders (unless they were relying on the greater fool theory).

A quick look at at the Q1 results shows why the IPO was always going to be tricky:

DOF Subsea Utilisation Q1 2017

Despite what the Ops guys try and tell you about the boat stuff being black magic voodoo knowledge that simple people can’t understand subsea (and offshore supply) is a utilisation business, just like a hotel. Even at the top end of projects the value added by the marine delivery assets outstrips all the other costs of the SURF installations and therefore the performance of the vessels dictates the cost base and obviously the financial results of offshore contractors. Offshore contractors have high fixed costs on a depreciating asset base, vessel days are “disposable inventory” that if not sold have a set cost. Given DOF Subsea only have 1 chartered vessel so fleet utilisation shown above is clearly declining massively. This dropped straight to the bottom line:

DOF Subsea Q1 2017 EBITDA

It is a really simple business model: when the ships work you make money. DOF Subsea has a load of liquidity and has no immediate issues, but if anything goes wrong in Brazil then there is a massive problem. Petrobras are too long on flexlay capability and are unlikely to simply get rid of Subsea 7 only.

Despite the name and it’s ambitions DOF Subsea is still essentially a supply company:

DOF Subsea EBITDA Segment

Project accounting is notoriously complicated but in short in the six months from Oct 16 to Mar 17 DOF Subsea turned over NOK 1.5bn in subsea project delivery and made only NOK 96m EBITDA (as a rough cash proxy). The cash conversion rate is down substantially from 2016, whereas chartering vessels, by far the vast majority of EBITDA on a smaller number of vessels, drops with remarkable efficiency to EBITDA (c.80%).

I am always perplexed then to read comments like this:

DOF Subsea AS (“DOF Subsea”) and its shareholders have decided to start reviewing the opportunity for DOF Subsea to apply for a listing on Oslo Stock Exchange.
Proceeds from the primary issuance will provide flexibility for DOF Subsea to decisively pursue further organic and strategic growth opportunities and enhance the Company’s competitive position ahead of an anticipated market recovery.
You would think announcing numbers like the above you would want a better explanation before just casually dropping in a market recovery story/theory. Maybe even a data point or two? But no… straight in with this:
The Board of Directors is disappointed with the financial numbers for 1st quarter of 2017, especially with the performance in the North America region and the high number of vessels facing idle time between projects and downtime due to maintenance.
The real problem would appear to be believing that subsea vessels now have different economic drivers to offshore supply vessels. Maybe DOF would be better of just combining with DOF Subsea and accepting its all about scale now? Subsea vessels used to command a premium but not for the foreseeable future, a point bizzarely HugeStadSea have implicity accepted. I note that no ROV information is provided at all. Everyone in the ROV space is complaining about pricing pressure and with 69 systems DOF Subsea are a big player, you can read into that blank what you want.
At some point not everyone can benefit from this increasingly distant, and potentially mythical, recovery. With the amount of tonnage delivered a demand side recovery will also not translate directly into a supply side boom.  Investors paying full price for assets that were ordered for a different era are a rare breed at the moment as it is hard to argue that asset values have not been permanently impaired. Whether this is structural or cyclical downturn is for individual investors to decide (I saw an email last Friday from  the senior management at one offshore company stressing again the fervent hope that the market would turn eventually), clearly in this case investors decided they needed to see a different set of numbers.

Markets can remain “irrational” longer than you can remain solvent…

This cheery news came in from Hornbeck today (shares down only 2% so let’s not start the EMH debate now):

The Company projects that, even with the current depressed operating levels, cash generated from operations together with cash on hand should be sufficient to fund its operations and commitments at least through the end of its current guidance period ending December 31, 2018.  However, the Company does not currently expect to have sufficient liquidity to repay its three tranches of funded unsecured debt outstanding that mature in fiscal years 2019, 2020 and 2021, respectively, as they come due, absent a refinancing or restructuring of such debt.

That is on the back of poor numbers from DOF yesterday, in which a restructuring/refinancing of DOF Subsea is clearly an issue, and yet another month of no work for the Nor vessels, to pick just a couple of examples… I could go on. I know Europeans like to look down on the American fleets, and technically they are clearly not as good as the European tonnage,  but by virtue of market size they represent a bellweather of the industry, and the fact is it is across the board. I still feel Aker/ DSS caught a falling knife in supply rather than using capital to solve a structural issue. The price at which Hornbeck (and Tidewater) solve their financing will be interesting. Quite why Solstad didn’t leave these scale companies to sort out supply and stick to OSV/CSVs, where you can hopefully build some value into service delivery and therefore boost Enterprise Value, is beyond me.

Is there a bull case? Am I being too negative? I came across this graph from Surplus Energy Economics (a great blog I have just discovered and while I don’t agree with everything it’s very well written), from this article:

Average Annual Oil Price (constant 2015 dollars)

oil-price-trend-since-1965

It’s all the bulls in offshore have got left. The arugument is that this is a temporary dislocation in demand for offshore energy and maintenance services and that shale will hit the limits of its production and energy prices will return to their long-term averages and we can all go back to beer and skittles and the demand/supply imbalance will disappear.

The problem with trends is getting caught in the middle of a bad period. I am a believer in offshore energy long-term, I just worry about the running costs of the vessels to get there, and there is a real risk of moving too early in these assets given the high carry cost. In some options time is your friend, not in OSV/CSVs… The potential equity “funding gap”, between when the red line causes day rates and utilisation to increase, is the key question facing the industry and investors.

If you brought an OSV in 1994 and sold it in 2001 it wasn’t a great investment generally. 1985 to 1999 was generally a poor time to be in oil services as an investor. Alternatively, you could be like Bibby Offshore and by a North Sea class DSV for USD 10m in 2003, just before a boom in day rates, and make extremely high risk weighted returns. The core issue (as always) is when demand comes back to signficantly increase utilisation and day rates. The offshore industry is going into this downturn with a number of vessels beyond comprehension in any previous decline and with a new competitor at the margin in shale.

Financial return depends on the the numerator (cash flow) and the denominator  (discount rate) when assessing returns (CF/DR). Its not enough that day rates bounce back its the money injected in the interim. A really clever financial model could be made showing the equity gap for offshore vessel operators between now and a market recovery, but it depends on the gradient of the red slope as much as the current running cost. But as no one knows when demand will come back its not just the numerator that is important its the denominator to reflect the risk of this happening. Discounting is a brutal game, invest a dollar now with no payback, at only a 15% return (and frankly I would want more for buying such expensive options), and you calculating on only a .65 return in the dollar in three years to break even, on depreciating assets in an oversupplied market that is a bold call. A 30% IRR (common to alternative investors) is equivalent to a .45 return on the dollar in three years. A discount hurdle in day rates that just seems extremely unlikely to be met given the oversupply.

One of the areas I disagree with Surplus Energy is the view that shale cannot reduce the absolute cost of production. As I have written before shale demonstrably has. Anyone who bets against the ingenuity of US engineers to drive down economies of scale and scope, and find capital market support to do it, is making a very big call, and not one backed by many examples. Small shale wells appear susceptible to standardisation that will push the cost curve down again. I don’t see Moore’s law kicking in but the fact is the shale industry is relatively immature and suffered huge bottlenecks in the last boom. Yes, shale is using the best acreage at the moment, so productivity numbers are boosted, but the supply chain is in its infancy in terms of driving down unit costs. However, whether enough acreage can be brought on quickly enough is the defining question.

I am a long-term believer in offshore. Deepwater projects  by there nature are one-off projects that are hard to standardize. They require huge investments in project specific engineering and fabrication (i.e. a much higher CAPEX) but they can offer much higher, and more consistent, flow rates (i.e. substantially lower OPEX/unit) and therefore they will be part of the energy mix going forward. These sorts of projects offer huge scope for contractors to add value and therefore earn above average rates of return. Infield projects are going to be far more challenging: launch it at the wrong time and your entire 5-7 year operational period could be one of low prices. That will significantly raise the hurdle rate for these projects.

[Headline is from the Great Man].

Where has the market gone?

The chart above is from the Olympic restructuring presentation given to the market this week. Of all the data points I have seen recently this one summed up the current market to me more than anything. Olympic are a great operator, with great assets and backup infrastructure, and even then the cupboard is bare. There is nothing more to say really. Recovery looks a long way off and the optimists who talk of a boom in IRM projects this year look deluded.

Have a look at the fleet quality underpinning this lack of work:

olympic-vessels

HugeStadSea and Olympic

Two major pieces of restructuring news today with Solstad merging with Farstad and Deep Sea Supply and Olympic finalising its deal. The interesting thing is the contrast: Solstad goes long on offshore supply while Olympic goes for subsea. I get the Olympic deal but for what its worth I’m not sure about creating a bigger HugeStadSea.

The Solstad/Farstad/Deep Sea is about as complicated as it gets (full details here). However in simple terms Solstad currently has 20 PSVs (32%), 16 AHTS (25%), and 27 CSV/Subsea (43%) as opposed to the new merged fleet of 154 vessels has 66 PSVs (43%), 55 AHTS (36%), and 33 CSV/ subsea (21%). That doesn’t seem like a good deal to me. I get the financial metrics mean Solstad, with a (slightly) better debt profile and fleet profile, is taking a proportionately bigger share. But the economics seem simple to me: Supply and Subsea have similar daily running costs but unless you are a true beliver its hard to see asset price appreciation in supply whereas subsea has the potential for a service element that can add value beyond the steel in addition to the vessels holding their value better. Not many people would trade a fleet with 43% exposure to subsea and trade it for one with 21% in this market.

I don’t see how this business will have enough scale to lower unit costs to make the merger worthwhile? Procurement is still regional in the industry and while it will be a large company with 2100 supply vessels in the industry it won’t be big enough to have any effect on market pricing. Savings of NOK 500m across a fleet of 154 vessels with such high running costs look to have almost no effect. Put me in the sceptical camp. I would have passed on Farstad if I was either Deep Sea or Solstad but I accept different people are more confident in the long-term supply market, but exposing yourself to a similar cost base on commodity vessels when the upturn seems so uncertain is bold to say they least (which could well be one of the many reasons JF is a billionaire and I am not).

Olympic seem to have realised this and effectively cauterised the risk of the supply vessels (by handing them back to the bank and bondholders effectively) and offering upside only on the subsea fleet while providing only for basic running costs for the supply fleet (deal here). Significant new equity is injected (from the main shareholders), along with the ship and crew management companies, and the medium-term liquidity looks confirmed (barring a credit event I guess?). This strikes me as a far more investible proposition whereas the HugeStadSea looks more like assets looking for a transaction to buy them time and hope.

Waiting for Godot: Nor DSVs

In a previous article, I outlined why I believe the market for North Sea class DSVs is as structurally unattractive as could possibly be designed. The investors backing Nor/Harkand are Waiting for Godot. With their own Vladimir and Estragon, parked quayside at Blyth, they don’t know when Godot is coming, and they don’t exactly know what it looks like apart from an unexpected increase DSV days in the North Sea, but at the moment they can’t agree to leave either. This is totally unsustainable given the running costs and there is clearly an oversupply of North Sea class DSVs, a situation that hasn’t existed since 2002. I believe the offshore industry (globally) will only reach back to a new equilibrium when a focus on economics forms the core of decision-making, and at the moment we appear to be some way off that.

One of my real (and clearly biased) issues with offshore has always been the dominance of engineering and operations people who were feted as their skills became so scarce in the boom. Offshore contracting isn’t at a base level a complicated industry, the execution can be, but the economics is relatively simple. Yet for years the “black magic” of operations has been allowed to obfuscate the economic issues, engineering could dominate all other disciplines because there was no cost pressure. First oil mattered to the exclusion of everything else.

But in order for the industry to move ahead, financial investors need to face reality as well. How low could subsea vessel prices go? Look at the rig market: Ocean Rig purchased Cerrado at c. 10% of cost and the Deepwater II cost NOK 7.3bn (USD 870m) and sold for USD 210m.  Subsea 7 sold the ROV vessel Petrel for c. 7, maybe 1/3 of book value. A wave of bankrupt OSVs are coming to market and some sales are close to being announced which may set new benchmarks. OSVs in general are a classic case of asset specificity. But what gives them such high values in a boom market also works in a counter-cyclical way on the way down. That’s a complicated way of saying if you build a ship that’s really good at one thing, and that thing isn’t needed anymore, it’s not worth a lot regardless of how much it cost to build.

Nothing seems more financially irrational than the behaviour of the Nor/Harkand bond-holders. Having taken re-delivery of the vessels from the Harkand administrator in 2016 they then proceeded to move the vessels to Blyth in hope of getting work. The fact that no consultants were engaged to provide some guidance on the regulatory requirements and operational realities of getting work shows how truly out touch these investors and advisers were. Even a basic knowledge of the North Sea DSV market shows that there are only five serious companies and all were too long on tonnage, with massive (non) utilisation issues of their own fleet, and therefore these vessels were simply going to be tied-up quayside. There are enough data providers out there for this not to have been missed.

Apart from Technip, who had used the Da Vinci before, anyone wanting to use these assets would have had to invest in bridging documents from the vessel dive operating system to their company HSE system and then get HSE approval. Its not impossible, ISS did it with the Polaris when they brought it to the North Sea, but its probably 4-5 people taking at least 4-6 weeks. It’s time-consuming, process oriented, work. Then you need to get HSE approval which needs a few weeks best case scenario. And that’s before you tender for work because no one is going to award you work on the off-chance something goes wrong on your approval process. And more importantly, why would you bother? There are five companies in the market with really good assets and track record and they don’t have enough work for their own boats and are bidding at less than OPEX just to get the vessels away from the quay? Economists call this market an oligopoly: a few firms dominate it. In a period of oversupply it leads to an efficient market where there are no economic rents to be made by these firms. In plain English it means they compete on price and there is no economic room for new entrants.

For this reason there has never really been a spot market for DSV charters in the North Sea, it’s actually the opposite, you need to control an asset before being seriously considered for work. So in reality there was never any chance of the Nor/Harkand assets getting any work at all in 2016 as any independent party could have pointed out (saving millions in transit and operational costs).

But what the Nor/Harkand investors lack in humility and foresight they make up for in intractability. These vessels, having sat around for the better part of 9 months without any work, raised USD 15m in November last year giving them more time to pursue exactly the same strategy for longer. Like Haig at the Somme, no amount of money is too great to commit to proving their point, against the face of all evidence to the contrary, that the North Sea market is going to bounce back. The Nor/Harkand vessels, like Vladimir and Estragon, wait in Blyth to take advantage of a break-out of demand so extreme all the current dive contractors are going to suddenly go-long on two more vessels and allow the whole crazy cycle to start again. [And it’s actually more than that because with the Vard new-build and a couple of other you could add 20% capacity to the market almost instantly.]

To be fair I met one of the distressed investors who said to me “if they were going to win work with this strategy they would have done it last year, hopefully we’ll have to so another cash call and I can buy some more when people realise how bad it is”. I get that….It’s not quite as irrational as trying to put the Cal Dive band back together, but its not that far off either.

The Atlantis and Davinci are totally unsuited now to the North Sea market (where demand meets supply as opposed to strictly environmental factors). As DSVs go they clearly have the technical capability to operate in the region but the real question is who would need them and for what? One of problems with DSV is that because you cannot put a diver down more than 300m, the same technological boundary of 30 years ago, newer vessels offer few advantages over old ones, and certainly nothing price cannot fix.

E&P companies buy DSV time on 5 criteria : 1) the operator, 2) the SAT system, 3) the crane, and 4) deck space 5) schedule. A DSV is a compromised vessel on everything compared to a general purpose OSV unless it’s working as dive vessel. If you are not working as a dive vessel what are you?

Obviously as an operator the Nor/Harkand proposition doesn’t make sense. There is no infrastructure, management team, capital or long-term plan that would make someone buy a complex project off them. Using a bunch of subcontractors to replicate a solution that other integrated SAT dive companies could provides a solution for Nor but not for the customers. Nor seemed to have recognised this and have stated explicitly they are not seeking dive work… but then what are they seeking?

As ROV vessels the Atlantic and Davinci don’t work: they are over specified and too heavy on fuel. M2 have ROVs on board, but they have also struck a deal on the Go Electra, and need to build their first year campaign around this vessel (which is a great ROV vessel and full credit to the guys here). Who would cover tendering costs, bid bonds, warranty issues etc? I will write on ROVs soon, but they are shaping up to be an extremely competitive area with everyone from start-ups to established companies having access to a huge variety of custom ROV tonnage these assets simply aren’t needed in the market,

As a heavy-lift vessel they don’t work. The cranes are rated at 140t but that is double fall. More importantly, these vessels have not worked doing lift operations in a long time. Anyone looking to do a decent lift isn’t going to save a few dollars to have a temp crane driver do the lift offshore on an asset that hasn’t worked in a year with an offshore team that has never worked together.

In the current market where every asset type is oversupplied these assets simply have no logical market space. Simply being cheap doesn’t help because everyone is cheap. The Nor bondholders are soon likely to find that their USD 15m bazooka is actually a pea-shooter and simply will not convince potential customers or buyers they are here for a long time. Long-term DSV charters are extremely rare, and at the moment some of the most contested contracts around. Everyone is competing on price so Nor offer nothing. And there are NONE in the North Sea where their vessels are.

Nor have a basic commercial problem: no one wants to buy what they have to sell. Nor need a massive change in strategic direction. However, Maritime Finance Corp, the largest shareholder, appear committed to following this strategy to its logical conclusion (another fundraising round after months of no work) as to pull out now would mean owning up the residual value of the assets being significantly lower than they would like. MFC purchased about 37% of the bonds on issue meaning they put in c. USD 81.4m in 2014. In the current market you would be lucky to get that for both vessels implying that MFC would have to write off c.50m (i.e. 37% of USD 80m is USD 30.1m).

Moving the vessels out of the region means owning up to the fact that they aren’t worth all the extra money above an Asian or US flagged DSV. Keeping the vessels in the North Sea requires an act of faith, a contrarian view, that diving in the UKCS will bounce back. Sooner-or-later this strategy must fail. The core point is this (thanks to DNB):

The UKCS and NCS saw a boom in oil and gas investments post the financial crisis in 2009, particularly the former, where development capex increased by ~125% from 2010 to 2013. The rebound in the oil price made several smaller projects economically attractive, and a sizeable majority of these were developed as subsea tie-backs. In addition, ageing infrastructure needed significant upgrades to accommodate a much longer lifetime than originally envisaged, and new production from smaller fields…

The outlook on the UKCS does not look as strong, however, and we highlight that only ~GBP0.5bn of new investments was sanctioned in 2016, versus an average of ~GBP8bn in 2010–2015. In other words, we believe the recovery in activity in 2017– 2019 is likely to be limited to the NCS, which is a major difference from the 2010–2013 recovery in this region.

CAPEX is at 1/16 of previous levels. The CAPEX vessels are trading in the OPEX market and will do for a significant period of time given lead times. A small CAPEX project could easily take 180-270 DSV days, that work simply doesn’t exist now, and Technip and Subsea 7 have moved their corporate resources back to IRM. A strategy to add capacity, without infrastructure, in a brutally declining market, against better-capitalised and more committed competitors, is economic madness.

2017 not looking good for offshore but especially Europe

2016/17 Global E&P Spending by Company Type/Region

evercore-global-capex-28-dec-2016

Evercore ISI recently published a good piece on the a potential recovery in the energy services and offshore in 2017. If anything to my mind it leads weight to Spencer Dale’s thesis that onshore share, and specifically US, will be the marginal producer of choice. Its my pet theory as well, but I am also a catastrophist having predicted 9 of the last 0 house price corrections in the London market, so I always try and test my beliefs constantly in this regard. So I agree there will be a recovery, markets eventually correct as demand and supply move back to equilibrium, but I fear that this is some way off happening.

One thing is clear from the graphic above though is that nothing is coming to save the North Sea demand side of the OSV market in 2017. Anaemic CAPEX will mean more vessels chasing the OPEX work. The only sanctioned projects really moving ahead are deepwater mega projects, but they are far fewer in number, and at the moment all that work is going to all the largest contractors who can take more risk and offer better terms.

Worrying for vessel operators as well is the drop in the expenditure of the Majors (Intl) spend. Big complex projects are undertaken by these companies and the increase in spend by the NAM Independents is only 10% of the total drop from the majors. Yes there are other companies in different locations but the US Capital markets are really the only place open at the moment, the London AIM is slowly opening, but at nothing  like the rate needed to fund a steady stream of profitable projects. Only big offshore projects, which take a large number of vessels for extended periods, have a hope of bringing the market back to equilibrium without further painful reductions on the fleet supply side.

So while 2017 may start to see a thaw in the permafrost conditions of demand for drillers it isn’t going to flow into the offshore support vessel market for 2017.