The never appearing subsea CapEx boom…

The graph above highlights why comments about the impending offshore capex boom, long prophesied as a certainty by true believers, maybe a long time coming… What the graph shows effectively is that the Energy Select Sector ETF (a proxy for all S&P 500 E&P companies) has significantly underperformed in percentage terms the price increase in WTI (oil) throughout 2018. Not only that the rebased price volatility of oil is high.

E&P shareholders have been saying loudly they want money back from E&P companies not a capex driven option on a future supply shortage. The easiest way for E&P companies to give shareholders comfort at this point, and hopefully boost the share price, is to reduce their forward commitments to long-lived expensive projects (deepwater) and focus on shorter payback projects (shale) to supply volume. From the $FT:

Investors have been pushing executives to cut costs, reign in investments in the type of oil megaprojects that might take decades to pay back, and focus on generating cash, either for dividends or share buybacks. Bernstein Research said this week that companies were responding, noting that those who had raised capital expenditure in the second quarter had been taught a lesson.

“Investors punished E&Ps that raised guidance by 230 basis points on average,” said Bob Brackett at Bernstein.

You read comments all the time about how it is a “certainty” that high oil prices and reserve rundown must, as if some metaphysical law, lead to increased offshore activity. It simply isn’t true. The shareholders don’t want it for a whole host of good reasons: the energy transition, the benefits of higher prices and reduced supply, price volatility when making long commitments etc. This week Equinor reduced CapEx forecasts $1bn for 2019 (from $11bn to $10bn), Total confirmed theirs at the lower limit, and Conoco Phillips did the same. All the E&P companies are making similar noises. You can come up with some really complex reasons for this or just accept the CEO’s are being consistent externally and internally: they are rationing capex reasoning the upside of doing so is better than the downside.

There has been change in perceptions and market sentiment since the last energy rebound in 2008/09:

IMG_1064.JPG

If E&P companies are not going to get share price appreciation through sentiment they will have to do it the old fashioned way through dividends and share buy-backs; and cutting back CapEx is the single most important lever they control to do this.

Yes subsea project approvals are increasing (from WoodMac <50m boe):

WM Subsea FID.png

But in order for there to a “boom”, one that would influence day rates and utilisation levels across the offshore and subsea asset base, marginal operators have to be able, and willing, to spend and that simply isn’t the case. There is a flight to larger projects, with larger operators, who are ruthless about driving down price. So yes, spend levels are increasing, but check out the size of the absolute decline from the North Sea (from the $FT):

Investments in new North Sea projects have hit £3bn in 2018, the highest level since 2015, after two oil and gas projects received regulatory approval from authorities on Monday…

Capital investments in new North Sea fields were less than £500m in both 2016 and 2017, down from £4.6bn in 2015, but were much higher before the downturn, reaching as much as £17bn in 2011.

£17bn to to less than £500m!!! Seriously… just complete a structural change in the market and the supply chain needs to reduce massively in size and capacity to reflect a drop like that. And a recovery at £3bn is still less than 20% of the 2011 which the fleet delivered (and 30% down on 2015): volumes might be up but the drop in value is just too extreme for anything other than the major players to hold out here. It goes without saying a vastly larger number of businesses are viable with £17bn flowing through the market than £500m. The North Sea might be an extreme example by global levels but it’s illustrative of a worldwide trend.

E&P companies are spending increasing sums on shorter-cycle, potentially lower margin, projects because of the flexibility it offers in uncertain times. Subsea and offshore expenditure and volumes will be up in 2019 but not at the levels to keep some of the more speculative ventures alive.

Affirming the consequent: Standard Drilling and vessel recovery…

A ship is at best an opportunity and at worst a liability.

Anon.

If you wanted to pick on one company to highlight how diminished expectations are of the offshore sector SDSD, down 66% for the year, would be a good candidate.

I think its great that if investors want a counter-cyclical investment vehicle they have one, but I just don’t think there is any industrial strategy here at all, and it is really hard to see how this can ever make money without some sort of extraordinary market movement. Depreciating 2007 and 2008 built PSVs, some of which required upgrades to DP II,  must be the ultimate “have faith in offshore” investment. Let’s have a look at the SDSD strategy:

Strategy.png

The thing is that Standard Drilling sold all the KFELs units prior to delivery, so maybe its been lost a little in the translation: but quite why buying assets in a booming market and selling them prior to delivery illustrates the success of buying minority shares in PSVs and putting them in lay-up in the worst downturn to hit the offshore vessel sector is beyond me? Just because I am good at rugby is unlikely to make me good at cricket (and the company isn’t called Jeff Wilson Drilling). The logical error is I believe called affirming the consequent.

It doesn’t mean you can’t make make money from this: but you are taking not only asset risk, on the vessel prices, but market risk on the stock price as well. So it’s not ideal (although you would think in this case they are highly correlated).

My broader point is that offshore supply is probably at the absolute nadir for demand. The PSVs working are supporting working operational infratsructure, or the few rigs working, and it probably cannot get any lower. But as Maersk Supply reported this week there remains an industry characterised by revenue at opex levels and huge oversupply. The SDSD are primarily older and/or in layup. The original plans to operate the vessels at cash break even, or above, and try and pay dividends. Even if one or two projects manage to achieve this there is no chance of this happening at a corporate level. Quoting historic vessel values I also think is a little absurd given the whole point of accepting the scale of the current downturn must mean they want revert to their previous implied value?

Look I don’t have an issue with this: SDSD has allowed the public a show of the price discovery mechansim that is identical to how many distressed funds viewed these types of investments. The fact is at this time last year, when the world seemed a different place, people thought the market couldn’t get any worse, and the plain fact is that it has. Substantially both at an asset value level and an operational level.

In specialty vessels Nor Offshore raised USD 15m almost to the day at this time last year. Now the reports are Fearnleys is basically trying to get them out completely as you can see from the SDSD share price graph that the cost of equity financing these vessels without visible backlog must have materially increased.

Longer term I don’t really get though how European companies, burdened with bank debt that the banks are reluctant to write-off, are going to compete with the likes of Tidewater and Gulfmark? SolstadFarstad must be the most worried of all the European companies given their commodity tonnage exposure. Sitting on a bunch of Asian built AHTS and PSVs from DeepSea Supply with inflexible European banks and no Chap 11 possibility must seem like a Sisyphean challenge at this point in the cycle.

But in the Tidewater’s case all the investors had an incentive to save the operational company to maximise value, whereas in the SDSD case the asset manager is paid regardless and isn’t making the returns required to back the assets.

Bassoe noted this week that they expect nearly 340 rigs to leave the market permanently. If you assume that supply vessels now are serving the base load of work on production assets and maintenance associated with them, and that a meaningful part of the E&P rig fleet that drove demand  will be scrapped, you need a real good story to explain a recovery play in offshore supply. There is more pain to come for investors before the market stabilises I feel.

 

Great Exepectations and Asset Values in The New Offshore…

“Suffering has been stronger than all other teaching, and has taught me to understand what your heart used to be. I have been bent and broken, but – I hope – into a better shape.”

Charles Dickens, Great Expectations

Further evidence of the narrative turning to shale:

When the facts change … ” Hall wrote to investors in his Stamford, Connecticut, hedge fund, Astenbeck Capital Management LLC, in a July 3 letter obtained by Bloomberg News. “Not only did sentiment plumb new depths but fundamentals appear to have materially worsened.”

U.S. shale drilling is expanding “at a surprisingly fast rate, thus raising the odds for significant oversupply in 2018, even if OPEC maintains its production cuts.”

“When the facts change … ” Hall wrote to investor… “Not only did sentiment plumb new depths but fundamentals appear to have materially worsened.”

U.S. shale drilling is expanding “at a surprisingly fast rate, thus raising the odds for significant oversupply in 2018, even if OPEC maintains its production cuts.”

Reuters notes:

“The market is in trouble and looks very vulnerable to lower numbers,” PVM brokerage said in a note.

I can’t help wondering if some of the private equity money that flooded the North Sea when the price declined in 2015/16 isn’t getting a little worried. The investors behind Siccar Point and Chrysoar for exmaple are some of the largest private equity funds in the world, and the transactions were de-risked by paying a contingent amount on prices following the transaction, but prices are lower than the dominant narrative was at closing and they surely weren’t based on a mid 40s oil price but rather a long-term appreciation trend? Both are very different as well with Siccar Point exposed to Clair Ridge and some new deepwater projects where as Chrysoar is more exposed to the legacy Shell assets. But even still the only viable exit is another massive private sale or preferably a listing and both these companies offer very poor growth prospects in a high cost environment in what are officially declining basins. For North Sea contractors the implications for future demand are serious given how well the new players like Ineos have been at driving down OpEx in other markets. And E&P company spending obviously drives spending for offshore contractors and therefore asset values…

I have gone on about this before but I think the downturn in 2008/09 has a lot to answer for when a short price dip was followed by a very healthy five year boom, but shale simply wasn’t such a big deal and OSV supply was more limited. Just as in offshore fields so in offshore support vessels: those who piled into the Harkand/Nor bonds were typical: Justin Patterson of Intermarket (www.intermarket.us) proudly announced he was a holder of record of the Nor/Harkand bonds in November 2016. Constrained in the number of opportunities in the sector they could buy into they were not interested in understanding the assets or the market, they would just buy and hold… what could go wrong?

The investment is of course now worthless. The Nor investors are discovering either you have a North Sea diving operation or the vessels are only worth what someone in Asia will pay, and that is an order of magnitude less than the implied depreciated value of a North Sea class DSV. There is no magic solution here and as I don’t believe the Demand Fairy will save people here. With a load of sellers of similar assets who would be willing to sell or charter for $1 cheaper than the Nor investors, whatever the price, they need a good story to tell here if they want to convince anyone there is value in their investment.

Surely at some point auditors are going to insist on more cash-flow based assessments of vessel values and that is likely to cause chaos in such investments because they all rely on the Greater Fool Theory at the moment? The Harkand/Nor DSVs are an egregious example of where the valuation of USD 58m per vessel for their last set of accounts simply bears no relation to any realistic sale price the assets may fetch, it may help people like Intermarket show a positive Fair Market Value in their accounts but it isn’t a real number. Similarly Bibby held their DSVs combined at over GBP 100m in the last accounts… collectively this means that 4 North Sea class DSVs that cannot be operated at even cash flow break even are worth in excess of USD 240m, despite no credible reports of an uptick in day rates and other comparable vessels such as the Vard Haldane for sale? Something will have to give and it won’t be economic reality or the “cash flow constraint” as Minsky recoognised.

Expectations of future cash flows are the main driving force of offshore asset transactions at the moment (as opposed to “valuations”) not concerns over lack of supply (so 2014) or the ease of selling the asset to someone else (so 2013). Barring a major change in demand therefore expect asset values to have been permanently impaired and wait for the auditors to start calling time as liquidity needs continue to strain companies that have made it this far despite the hoped for Great Expectations of the 2015/16 investment class.

DeepSea Supply, bank behaviour, credit, and the Great Depression

Contagion is a significant increase in comovements of prices and quantities across markets, conditional on a crisis occurring in one market or group of markets.

A Primer on Financial Contagion

Massimo Sbracia and Marcello Pericoli

 

“No one has seen a worse offshore market than what we’re going through now,” Kristin Holth, head of shipping, offshore and logistics at DNB ASA, said in an interview at the Nor-Shipping conference… “It hasn’t been a regular downturn. In many ways, we’ve seen the collapse of an industry.”

I am a bit late getting to this but the DeepSea Supply (“DESS”) Q1 results when combined with the Solstad merger information memorandum are extremely interesting… they beg the question: would you pay USD 600m for some Asian built PSVs and AHTSs when 16 of them are in lay-up? Some of these are not flash tonnage: the six year old 6800bhp vessels built at ABG and the UT 755 PSVs built in Cochin look extremely vulnerable. To put that figure in perspective it is USD 28.5m for every working vessel (with 16 of the 37 in lay-up) and even on a average basis it is still USD 16.2m. In the current market most of those vessels would strugggle to go for more than USD 8m, collectively they would make asset values even lower than that they are such a large fleet.

It is an absurd figure… but of course the banks behind DESS, who are owed that much, don’t have a choice now, they lent in a different era. The reason balance sheet recessions are so severe is that debt obligations remain constant long after the equity is wiped out. If enough debtors default this travels to the banking system. And one of the problems offshore has at the moment is a lack of lending from the banking system: it is no different to the housing market, if banks will not lend then asset prices decline, and on depreciating assets such as vessels, I would argue the impairment is likely to be permanent for certain assets (Asian built commodity tonnage being part of that for sure). The problem for the offshore supply industry is when will the banks start to lend? Because for a long time I think risk officers at banks will insist this tonnage stays off the balance sheet once they have closed their positions. Risk models hate volatility and these assets have it in large quantities.

In the DESS case the banks and Solstad have branded DESS a low cost operator, not low cost enough to come close to break-even in this downturn, but apparently this is the future. It is really hard not to think that the closer they get to this merger Solstad can’t be wondering if there was anyway of getting rid of this company… If it was a horse you would shoot it.

Sooner or later someone is going to have get some of the banks behind these assets to start getting real. Part of the business of banking is what economists call maturity transformation: banks borrow deposits off people and then re-lend them out for projects with a much longer contractual requirement, it is a a very risk business model, particularly when done on very thin layers of capital. They are a lot like a hedge fund in other words, in the industry vernacular banks “borrow short and lend long”.  The Nordic banks involved in both Farstad and DESS are effectively becoming hedge funds in another way: thinking they can play the market. These banks are the prime movers in failing to liquidate assets to discover their true floor price.

In order for the HugeStadSea merger to go ahead the DESS banks must make the following concessions:

Main elements in this context are the following:

(i) Reduction of amortization to 10 % of the original repayment schedule until 31 December 2021;

(ii) Pre-approval to sell certain vessels at prices below allocated mortgaged debt (only applicable under the combined fleet facility);

(iii) Minimum value clause set to 100 % and suspended until 1 January 2020;

(iv) Removal of financial covenants related to value adjusted equity, and

(v) Introduction of cash sweep mechanism.

Point (i) makes clear the assets cannot generate sufficient cash flow in the current market to pay them back more than a token amount. One of the troubles is the 10% is for the entire 37 vessels not the 26 working so even this looks optimisitic.

Point (iv) means the banks will just pretend that even though you are insolvent you are a going concern while (v) just makes sure they collect any surplus cash.

Does anyone in this industry believe that a Chinese built UT 755 will in 4 years time, having made no payments for 25% of its economic life, be able to keep the bank whole on this loan? It is just absurd.

Solstad are going to need an enormous rights issue fairly early on (not just because of DESS I hasten to add, Farstad is arguably more of a basket case). According to the announcement JF/Hemmen put in NOK 200m (c. USD 23m) into Solstad shares (approximately 3.8% of the loans outstanding or c. 180 days of EBIT losses). So in crude terms the DESS gift to Solstad’s high class CSV fleet (with some supply vessels as well to be fair)  is a commodity fleet of 37 vessels, with 16 laid up, constant debt obligations of USD 600m, and a proportionate capital increase against this of 4%. Potentially there are some cost savings but these seem contrived in the extreme (when you cash flow losses are this high you can’t meaningfully talk of measurable synergies as opposed to normal cost cutting)… but I don’t think anyone would buy the shares based on those anyway.

When people saw the US housing crisis emerge they realised it wasn’t just NINJA loans and MBS that was the problem, it was also second mortgages to pay for current consumption. Shipping banks also make the same mistake as this paragraph outlining DNBs exposure to DESS makes clear:

The facility amount under the DNB Facility is USD 140,640,000 repayable in quarterly instalments until 31December 2021…The DNB Facility is secured by, inter alia, first priority mortgages over the financed vessels… Additionally, the lenders under the DNB Facility will… receive (silent) second priority mortgages over the vessels in the NIBC Facility (described below) and the Fleet Loan Facility

How much would you pay for the second mortgage on a Chinese AHTS at the moment? If you give me a number in anything other than Turkish Lira, and a small one at that, please PM me your details so my Nigerian banking associates can request your account details as we have a Euromillions win we wish to deposit there.

And here is what I have been saying in words laid out graphically for you:

DESS Repayment profile

What the banks behind DESS and Solstad want you to believe is that in five years time a company with a collection of Asian built PSVs and AHTS, many over 10-14 years old, will be able to get another bank or group of bondholders to pay them USD 515m to settle their claim (c. USD 13.9m per vessel!). These same banks refuse loans to vessels older than 8 years! It’s just not serious,  but it shows how desperate the banks are not to take losses to the P&L here and pretend they don’t have the problem. Note the lead bank here is DNB who as Mr Holth has made clear do understand the scale of the problem. Mr Holth is extending five years further credit to an industry he believes has collapsed?

[Obviously the loan will be rolled over in 5 years or written down massively]. Quite why banks with the self-professed capital strength of DNB, Nordea and others involve themselves in such shenanigans is for another post. But these numbers are material and not even realistic: at USD 21m per annum of interest all of the 21 working vessels (at less than 100% utilisation) need to make USD 57.5k per day just to pay the interest bill (USD 2.7k per vessel) when most are working at OpEx breakeven if lucky.

To really drive home what a bad deal the merger is checkout this paragraph:

As per the date of this Information Memorandum, the SOFF Group does not have sufficient working capital for its present requirements in a twelve month perspective. Under its current financing facilities, there is a minimum liquidity requirement of NOK 400 million, and by March 2018, a shortage of approximately NOK 100 million is expected.

The document states the banks will relax this covenant but that isn’t really the issue. The issue is in more prudent times the banks thought they needed 400 and now that asset values have plummted they suddenly don’t. A “world leading” OSV company with 157 vessels doesn’t even have USD 48m in liquidity… please… You need to be flexible in these situations absolutely, but really, for this merger? I love the way the lawyers have forced them to write if they cannot agree this the banks may demand accelerated repayment, despite the fact everyone has gone to such extraordinary efforts to ensure that is exactly what doesn’t happen.

And I guess at base level that is what I don’t like about this merger: the owners should have played harder with the banks and forced them to realise that their values are nothing like the book values. Forcing people to keep book values high with low ammortisation payments just delays things and makes raising new equity even harder. We are starting to get into a philosophical debate about the nature of money here, that a loan contract is just a claim on future economic outcomes, and these ones are worth substantially less than when they were willingly entered into. Friedman was wrong (about a lot):

“Only government can take perfectly good paper, cover it with perfectly good ink, and make it worthless”

Shipowners and banks combined have also done an excellent job of doing the same. Particularly the OpEx demon…

If you wonder what the expression “zombie bank” is look no further than the offshore portfolios of these banks because they will never take this sort of exposure on balance sheet again and unless the Chinese banks do, who are much more likely to support new builds from Chinese yards, then the industry has an asset value problem.

There are plenty of historical precedents for these issues in the banking system. In innovative research Postel-Vinay looked at banks, housing, and second mortgages in Chicago during the Great Depression and found:

[a]s theory predicts, debt dilution, even in the presence of seniority rules, can be highly detrimental to both junior and senior lenders. The probability of default on first mortgages was likely to increase, and commercial banks were more likely to foreclose. Through foreclosure they would still be able to retrieve 50 per cent of the property value, but often after a protracted foreclosure process. This would have put further strain on banks during liquidity crises. This article is thus a timely reminder that second mortgages, or ‘piggyback loans’ as they are called today, can be hazardous to lenders and borrowers alike. It provides further empirical evidence that debt dilution can be detrimental to credit.

When those second mortgages on vessels turn out to be valueless this will cause an issue in the banks risk models. Then what economists call “interbank amplification” where banks withdraw money from certain asset sectors, and in this case reduce lending to similar asset classes, further lessening the available money supply available in total and reducing asset values (ad infinitum). Researchers at the Richmond Fed looked at this in the Great Depression:

Interbank networks amplified the contraction in lending during the Great Depression. Banking panics induced banks in the hinterland to withdraw interbank deposits from Federal Reserve member banks located in reserve and central reserve cities. These correspondent banks responded by curtailing lending to businesses. Between the peak in the summer of 1929 and the banking holiday in the winter of 1933, interbank amplification reduced aggregate lending in the U.S. economy by an estimated 15 percent.

I keep referencing the Great Depression here because one of the issues in recovery from it was asset values and the problems associated with a reduction in the monetary supply (and here I will concede Friedman was on to something). These two issues fed on one another in a self reinforcing circle and also led to a collapse in credit because no one had collateral that financial institutions would accept as worthy lending against. Taking macro models to micro industries has methodological issues, but I think it is valid here (*methodologiocal reasoning too technical for this forum). Suffice to say the supply side of this recovery will follow a different dynamic to the demand side and those who watch the daily fluctuations in the oil price with hope are wasting their time.

One of the controversies of the Great Depression is did Andrew Mellon, arch tycoon in a Trumpian sense, really tell Hoover to “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.”? Mellon always denied it and it suited Hoover to claim it. In a macro sense it is clearly ill advised, but in offshore I can’t help feeling it would be good advice. At the moment we are slowly grinding through the inexorable oversupply where banks are propping up failed economic propositions though moves like this that potentially put companies out of business that may have survived. Such is the life of credit, but as I have said before until this clears out the entire industry will make suboptimal returns. 

A miracle at sea apparently… or an oversupplied vessel market?

Offshore windfarm costs.png

A really good article from Bloomberg on the unit cost reductions occurring in the offshore windfarm space:

Across Europe, the price of building an offshore wind farm has fallen 46 percent in the last five years — 22 percent last year alone. Erecting turbines in the seabed now costs an average $126 for each megawatt-hour of capacity, according to Bloomberg New Energy Finance. That’s below the $155 a megawatt-hour price for new nuclear developments in Europe and closing in on the $88 price tag on new coal plants, the London-based researcher estimates.

Clearly, as the cost reductions started five years ago, some of this is all about economies of scale and the experience curve. But I am willing to wager a good chunk of the 22% reduction last year came from cheaper vessels for installation as the oil and gas vessels hunt for work.

In the UK the newer locations are in deeper water that theoretically should have increased installation costs but the major programmes are going ahead just as the vessel market hits its lowest point. Diving at 60m is SAT diving not air (Greater Gabbard I think?). A breakdown of the source of cost savings would be very interesting. But as I always say regarding shale versus offshore: be wary of betting against industries that can standardise and turn the output into a manufacturing process, as in the modern age this should lead to dramatic cost reductions (as we have seen with shale).

Oil and gas contractors hate offshore wind because the use civil contracting documentation, and as there is no first oil pressure rates are lower. But offshore wind could be an important source of vessel demand moving forward with productivity gains like this.

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].

Groundhog day for EZRA…

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

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

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

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

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

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

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