Ponzi finance and asset values…

When the present phase of the stock market is written, we believe it will be referred to as ‘the era of projected inflation’ … the period when enthusiasm for future profits obscured actual earnings to an excessive degree. We are on the way towards the age of reason of several years ago when stocks had to show substantial earnings power, reasonable book value, and dividend returns comparable to the cost of carry.

Barr, Cohen, and Co, October 21, 1929

Rainbow’s End: The Great Crash of 1929, Maury Klein

The financial instability hypothesis, therefore, is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated…

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell  assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.

Hyman Minsky

Ponzi finance is happening in the rig market. And it is certainly the form of finance that McDermott got from Goldman’s (yielding over 14% today and essentially locking MDR out any future financing). This never ends well.

When this goes wrong it goes really wrong because unlike equity people thought they were getting their money back for 100c in the dollar. Banks in particular. When these rig and asset deals go wrong, and the banks shut down the loans books, and indeed contract the asset side of the balance sheet to compensate for the lost equity, things will really get tough in the financing market and force restructurings and supply side contraction.

A very small number of companies have been buying “assets” at inflated prices, cheered on by self-serving analysts, at rates that bear no relationship to their ability to generate cash. Some banks appear to be  lending against these nominal asset values when the underlying entities do not have suffient order book, yet alone cash flow, to pay them back. This is the classic dying throws of a credit boom and we know how this script ends. When someone asks you how do these moments of clear financial irrationality occur you are looking at one. No one wants to admit the madness or remove the punch-bowl.

Charle’s Ponzi’s original idea was actually legal and profitable… just not at the scale he wanted:

Ponzi emigrated to the United Sates in November 1903 moving from city to city working different jobs and serving prison sentences at least twice before settling into Boston in 1917. Employed as a typist and answering foreign mail, in August 1919 Ponzi discovered his path to the wealth he had always envisioned for himself. He was going to trade in postal reply coupons. What Ponzi identified was a flaw in the coupon system that he could use to his advantage. He realized the value of the International Reply Coupon (IRC) had been set at fixed exchange rates that had not changed since 1919, creating a market in which he could parlay the IRCs into profit if he exchanged coupons from countries with deflated valuations into the higher valued US dollars ostensibly buying low and selling high.

The flaw in Ponzi’s coupon scheme was that he probably could have earned a 400 percent profit on individual coupon redemptions but in absolute terms, the net would be infinitesimal. To amass the millions of dollars Ponzi alleged, an enormous amount of coupons would have to be traded. Two important reports were about to emerge that would ultimately lead to panic and a run on Securities Exchange Company. First, after examining Ponzi’s operation, financial analyst Clarence Barron reported that to be making the money that he was, 160,000,000 IRCs would have to be in circulation when, in fact, only about 27,000 were. Second, the United States Post Office announced that IRCs were not being purchased in large lots (Zukoff, 2006). Therefore, Ponzi could not hold the millions dollars of liquid assets he claimed. Charles Ponzi was arrested on August 12, 1920.

 

The same could almost be argued for the rig and asset deals going on… If you could sell these assets for 520 days a year at twice the market rate you could make a fortune. It’s the execution of this that is causing problems not the math…

But when loans are made, or rolled-over, to companies with no hope of paying them back eventually things stop. You can feel the credit noose tightening in the market now and the equity market is closed no matter how good the summer season. Expect the effects throughout the market to get progressively worse. 

I made this note today to remind me when I look back that some of the credit deals being announced for rig companies are literally insane. People who should know better who are simply not prepared to accept their original thesis of a recovery in rig market was correct and continue, again all the evidence to the contrary, to do anything other than continue to go long on something that cannot be true. Credit committee’s becoming equity investors by accepting that markets have to change before they can be paid back for a few hundred basis points above LIBOR. Nuts.

McKinsey came out with this recently for those who want a dose of big data rationality:

As non-national-oil-company operators shift focus to deepwater fields because of increasing break-even costs of shallow-water fields, jack-up demand should grow 1 percent per year through 2035. Following this trend, utilization will recover to above 80 percent by 2023, driven by a large number of retirements and continued deferment of the order book. The chronic jack-up oversupply appears set to end, as extensive retirements of older and lower-spec rigs in the near future are expected to lead to a 9 percent decline in the overall jack-up fleet by 2035.

Over the course of 2019, floating-rig demand will drop slightly because of unstable oil prices, but growth—to the tune of 6 percent per annum between 2019 and 2027, then 2 percent per annum until 2035—is expected to follow. Key growth regions will be Africa, Brazil, and the Gulf of Mexico. We anticipate that supply will remain relatively stable through 2026, leading utilization to recover to 80 percent by 2026 and long-term floater-supply growth to reach about 13 percent by 2035. [Emphasis added].

Most rig companies will be bankrupt long before those recovery times at current day rates.

When all these guys stop running around congratulating themselves for buying rigs at 70% of their build cost, when day rates have gone down by 50% and utilisation the same, and actually have to pay for them, chaos is going to ensue in the financing market. The start of which is clearly visible now.

Presenting the results, Van Eden gave a plain spoken account of how Anglo had come to rack up such losses. ‘There was no substance behind the borrowers,’ he said. ‘They had nothing but the collateral (property assets) they were providing. There was no equity in the system. They took all the equity out of deals and replenished it in new deals. It was one big leveraged play. It was one big Ponzi scheme’.

Anglo Republic: Inside the Bank that Broke Ireland, Simon Carswell

[This blog is largely becoming a storage post for what I hope will be a PhD in economic history that argues the offshore boom was largely the conjunction of a commodity boom but also, and importantly, a credit boom combined with structural industry change. The consequences a credit boom are well understood for asset heavy industry backed by high debt and it is not a comforting picture for anyone long in assets at the moment.]

Bully for Brontosaurus…

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

Mads Syversen, CEO Arctic Securities (26 Jan 2016)

Arctic and ABG Merger valuation.png

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

The Golden Bough

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

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

The Emporer

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

 Ryszard Kapuscinski, “The Emperor” (1978)

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

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

Ian Taylor, Vittol Chairman, June 8, 2019

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

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

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

 

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

Solstad liabilities 2016_17.png

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

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

BH rig count June 2019.jpg

And here are the latest Solstad Q1 2019 liability figues:

Solstad Q1 2019 Liabilities.png

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A total failure of governance… McDermott and the cost of money at the margin…

If you want to know what the cost of raising funds for a corporation in trouble following a failed acquisition is the recent disclosures from McDermott provide a good guide. Crucial to the continued ability of the firm to stay within its banking covenants and remain a going concern in the Q3 2018 results was the $300m in 12% preference shares sold by McDermott to Goldman Sachs and Company (and affiliated funds). From the sale McDermott received $289m, meaning Goldman banked $11m in fees… to start with… The kicker is that Goldman and its funds (likely credit opportunity funds managed by the bank) also ended up owning warrants to purchase 3.75% of MDR at .01 per share… at the time of pixel those options are worth ~$51.5m (at an MDR share price of c. $7.61).

If you don’t believe MDR is in real financial trouble you need to ask yourself why the best course of action for management was to engage in a financing that cost shareholders ~$62m to “borrow”/ strengthen their balance sheet (sic) to the tune of $300m. The $289m the company got has an interest cost of $36m per year (excluding tax effects) and cost the shareholders 3.75% of their company. No wonder the shares dropped ~40% when the news was announced (already well down on the pre-acquisition price): investors knew they were losing a lot more than 3.75% of the value of the company. Not only that the increased working capital lines ($230m) required that this capital went in. MDR had maxed its borrowing capacity just a few short months after the takeover. In short: it was a financial disaster.

This isn’t a rage against the Great Vampire Squid, because if you need to get your hands on $300m quickly, and you are running out of cash, then for a good reason money tends to be expensive. The real question is how MDR got here, and so quickly, since acquiring CBI?

In my view the short answer is: a total failure of governance from the MDR Board that allowed management to buy a much bigger business they knew literally nothing about. The famed “One McDermott Way” was about installing cheap pipe and jackets in the Middle East and Africa not building on-shore low-margin refining plants. It is about as relevant as an orange juice manufacturer buying Tesla because they are going to apply the lessons learned in de-pipping oranges to extending the battery life of electric-powered vehicles.

The failure of this deal will I believe lead to the end of the MDR offshore contracting business as an independent entity. The reason is nothing more than a failure to ask a basic and honest question about where the skills of the company reside? And for the Board to realise that for MDR management the worst option of being acquired was probably the best option for the shareholders.

This presentation given to shareholders in August indicates that shareholders already had a serious case of post-acquisition regret, and reading between the lines here management are clearly under huge pressure despite the upbeat tone of their communications. The 40% decline their investment post-August is likely to have induced a sense of humour failure amongst even their most loyal of followers. Someone senior is going to have to carry the can soon and that does not make for a harmonious exec. I can’t think of another M&A deal that has locked in  such a loss of value so quickly.

McDermott got into this because in late 2017 their viability as an independent company looked shaky. Management had a very good offshore crises through a mix of skill and luck: their low-cost Middle Eastern model, not applicable when the Norwegians and French were in competition to build a more expensive OSV than the company before them, was more shallow-water focused than Brazil/UDW, and they didn’t have a complex about working old assets to death. McDermott picked up some cheap assets like the 105 when the opportunity presented itself, but management didn’t blow money on value dilutive acquisitions either or go to long on assets or debt. MDR management had steered the company back from the brink to create a genuinely competitive company with an ideal geographic footprint and asset base for the new offshore environment. I was a real admirer of the company.

But then GE started sounding out Subsea 7 (and being turned down), and the MDR footprint would have been perfect for Subsea 7 (BHGE would clearly have made a hash of MDR). There are very few companies the size of MDR that remain independent in an environment where consolidation is the market mantra: they had very little net debt, were big enough to buy and move the needle for a large company in revenue terms, but small enough to acquire in financing to terms. And there is some real intellectual and engineering skills in the core DNA of the McDermott business, no matter how complex the offshore problem, someone in McDermott knows the answer.

At some point in 2017 MDR management and the Giant Vampire Squid decided on a plan to buy CB&I and their shareholders really did think Christmas had come early that December 17th. To avoid being acquired McDermott opted for a type of ‘Pac Man’ defence: it went on to acquire a larger company. You can see the balance sheet of CB&I was substantially larger than MDR:

CBI Balance sheet:

CBI BS .png

MDR Balance Sheet:

MDR BS.png

Crudely MDR had $3.2 bn in assets and almost no debt while CB&I had $6bn in assets but $5.6bn in debt.

The reason MDR could do this was the debt and CB&I losses. CB&I was losing, and had been for a considerable period of time, vast amounts of money in its core business. A pretty crucial question would therefore be “could the One McDermott Way” transform this situation? A secondary question if the answer was yes was how much due diligence should be undertaken to prove this?

This isn’t hindsight talking. Here are the last four years financial performance of CBI:

CBI losses 2014-2017.png

Can any of you, even those without financial training, see something that might worry you about buying this company? (I’ll give you a clue it’s in the last line and it’s a material number). As Bloomberg noted at the time:

MDR Stamp.png

Bridge to Nowhere.png

Boom!

The problem with buying a larger company as a defence is its asymmetric returns: it is a leveraged bet on management and financial skill and if it goes wrong the value in the acquiring company is wiped out. And that unfortunately is what has happened here.

In case you were wondering the merger between MDR and CB&I consumed ~$300m in fees, slightly more in cash than McDermott later managed to raise from Goldman (and paid in cash of course), a symmetry in irony I am sure the bankers enjoyed.

McDermott CBI fees.png

And yet for the $300m in fees the due diligence didn’t uncover the cost overruns in the projects, and despite having three of the most illustrious banks on Wall Street: Goldman, Sachs, & Co, (lead adviser), Moelis & Co (advising on the financing only), Greenhill & Co (advising the Board of MDR) no one managed to ask: really, can we do this? And if they did, get the right answer!

But after the fees comes the interest bill… in cash and kind now… the hangover so to speak, and this one is mind-numbingly painful:

MDR Capital Structure

MDR Cap Structure.png

MDR are paying an interest bill (per annum) of: ~$90m for the Senior Loan, ~$138m for the notes, $36m for the preference shares (not included here), and the Amazon lease payments which must be ~$30m for a $345m vessel: ~$294m in total per year (say one Amazon per year at current build costs?). MDR only made an operating profit of $324m in 2017.  In addition, the three CB&I projects they have taken a hit on will consume $425m in cash in 2019! So by the end of 2019 MDR will have spent ~$1bn in cash on deal fees, interest, and project costs. As someone nearly said “a billion here, and a billion there, and pretty soon you’re talking real money“.

All this talk of “synergies” is hokum. Everyone involved in projects knows that the pipeline fabricator in Dubai isn’t getting cheaper steel because MDR are losing money building an LNG train in Freeport. But the interest and fees are real cash. Maybe they will sell the non-core businesses and bring the debt pile down but it brings execution risk and no certainty the debt reduction will be proportionate. These asset sales have the feeling of looking for change down the back of the sofa as they were never announced as part of the original deal and the tanks business is a complex carve out that will involve vast consultants fees and by MDR’s own admission take at least nine month… on the other hand interest, like rust, never sleeps…

The fact is the reason the on-shore business of CB&I is structurally unprofitable is because despite the contract size and complexity there are a large number of equally competent (more so actually) companies who bid all the margin away. That’s no different to subsea but MDR had a genuine competitive advantage in that business and CB&I didn’t in on-shore (as their financials showed).

In really simple terms now McDermott must make a smaller offshore business, in very competitive market that consumes vast amounts of capital to grow; pay for a larger unprofitable onshore operation where management lack skills and knowledge. The odds of success must be seen as low? The square root of zero I would suggest. McDermott will be starved of CapEx as the CFO uses any cash he can to pay for the interest and charter commitments while trying to compete against onshore behemoths much larger in scale. Maintaining market share in offshore will be impressive, forget about growing it. And all this to feed a beast in a low margin onshore business that competes against giants like Fluor.

If the Board of McDermott took shareholder value seriously they would try to get Subsea 7 management back to the table and sell them the offshore business for a price close to what Subsea 7 were offering last year. The world has changed but the price for a trophy asset might still be good. What happens to the rump CB&I would be sold at auction, for probably not much, but such is reality. Such a scenario would yield more than letting this state of affairs continue.

It’s grim up North… And the labour theory of value…

It’s Grim Up North.  The Justified Ancients of Mu Mu

Ricardo, Marx, and Mill believed that prices were determined by how much people had, in the past, invested. And that blinded them to any understanding of the workings of the market.

Friedrich Hayek

[I am not really a Hayek fan (in case anyone is interested). But he was a very smart guy who understood social and economic change processes better than most. Beyond that you get diminishing returns. As an aside I have been too busy to blog much lately, which is a shame as some really interesting things have been happening, but it doesn’t seem to have affected my visitor numbers much, which just goes to show maybe my silence is more valuable.]

The Oil and Gas UK 2018 Economic Report is out. For the North Sea supply chain there is no good news. There is clearly a limited offshore industry recovery underway as we head towards the end of summer. However, the market is plagued by overcapacity, and while service firms without offshore assets are starting to see some positive gains, if you are long on floating assets chances are you still have a  problem, it is only the severity that varies.

The UKCS is what a declining basin looks like: fewer wells of all types being drilled and dramatically lower capital expenditure. There is no silver lining here: an asset base built to deliver 2013/14 activity levels simply has too many assets for the vastly reduced flow of funds going through the supply chain. The report makes clear that the base of installed infrastructure will decline and there will be a relentless focus on cost optimisation to achieve this.

UK Capital Investment 2018.png

The volume of work may be increasing marginally but the overall value may even down on 2017 at the lower end of the 2018 forecast (purple box). Clearly £10bn being removed from the oil and gas supply chain, c. 60% down on 2014, is a structural change.

And the OpEx numbers unsurprisingly show a similar trend:

UKCS OpEx 2018.png

Party like it’s 2012 says Oil and Gas UK. Unfortunately a lot more boats and rigs were built since then.

Unit Operating Costs 2018.png

An unsurprisingly the pressure on per barrel costs seems to have reached the limits of downward pressure.

This should make supply chain managers seriously consider what their investment plans are for assets specific to the region and the likelihood of assets having to work internationally to be economic. It should also make people reassess what stuff is actually worth in a market that has reduced in size by that quantum and from which there is no realistic path to 2014 activity levels.

Technip paid $105m for the Vard 801, about $55m/45% discount to the build cost. Such a deal seems realistic to me. Some of the deals I have seen in offshore remind me of The Labour Theory of Value: if you dig a massive hole that costs a lot it must therefore be worth a lot. In reality with so much less cash floating around for assets that will service the UKCS an asset is worth the cash it can generate over its life, and the fact that it is substantially less than its replacement cost is just another clear example of how the industry will reduce its invested capital  as production levels in the basin decline. Like airlines offshore assets have a high marginal cost to operate and disposable inventory which is why you can lose so much money on them.

Boskalis appears to have paid an average of c. $60m for the two Nor vessels which equates to a similar discount on an age weighted basis. Quite where this leaves Bibby needing to replace the 20 year old Polaris and 14 year old Sapphire is anyone’s guess. But it is not a comfortable position to be in as the clear number four by size (in terms of resource access) to have competitors funding their newest assets on this basis. Yes, the shareholders may have paid an equivalent discount given the company value they brought in at, but if you want to sell the business eventually then you need a realistic economic plan that the asset base can self-fund itself, and at these sort of prices that is a long way off. Without an increase in the volume and value of construction work 4 DSV companies looks to be too many and this will be true for multiple asset classes.

As a mild comparison I came across this article on $Bloomberg regarding Permian basin mid-stream investment:

Operations in the Permian that gather oil and gas, and process fuel into propane and other liquids, have drawn almost $14 billion in investment since the start of 2017, with $9.2 billion of that coming from private companies..

That is just one part of the value chain. I get you it’s not a great comparison, but the idea is simply the ability to raise capital and deploy it in oil production, and it is clear that for Permian projects that is relatively easy at the moment. The sheer scale of the opportunities in the US at the moment is ensuring it gets attention and resources that belie a strictly “rational” basis of evaluation.

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That is what a growth basin looks like. The narrative is all positive. Once short-term infrastructure challenges are resolved that stock of drilled but uncompleted will be turned into production wells.

Oil and Gas UK go to great pains to explain the economic potential of the UKCS. But finance isn’t strictly rational and I still feel they need to be realistic about the cycle time tradeoff offshore entails. Shale, as we have seen, has an enormously flexible cost base relative to offshore and that has value.

The comments I make below are part of a bigger piece that I keep wanting to write but a) don’t have the time; and, b) probably doesn’t work for a blog format. But I think the impact of the private equity companies taking over North Sea assets needs to be realistically assessed.

Don’t get me wrong here I am a massive supporter of them. In terms of the volume of cash, and the ability to buy and invest at the bottom of the cycle, the North Sea would clearly have been worse off without private equity. But the results are in and there has not been a development boom… there has been a focus on the best economic assets that may make the fields last longer, but that is a different test. There may clearly have been an investment boom relative to what there would have been without private equity money, but again that is a slightly different point.

Private equity firms have a much higher cost of capital than traditional E&P companies and at the margin that will limit the number of projects they fund. The focus on lowering costs and returning cash as quickly as possible, often to compensate for how hard it will be for the owners to exit such sizeable positions, also adds to the change in the investment and spend dynamic (on the downside obviously). I am genuinely interested to see how these large multi-billion dollar investments are exited given how much trouble the super-majors are having at getting out.

Private equity may well be the future of the North Sea but that has huge implications for the supply chain. It is also worthwhile pointing out that while the smaller companies maybe able to sweat old assets they have a limit for larger projects. Quad 204 is a classic project where it is hard to see even one of the largest PE backed companies having the technical skills and risk appetite to take on such a vast project.

The majority of the larger deals also involved significant vendor financing from the sellers. Shell had to lend Chrysaor $400m of the $3bn initial consideration. This happened not through generosity, or a desire to maintain economic exposure to the assets, but because debt finance from the capital markets or banks was simply unavailable even to such large and sophisticated buyers. Siccar Point went to the Norwegian high-yield market in January borrowing $100m at 9% for five years. The fact is finance is scarce, and when available expensive, and this is impacting the ability of E&P projects to get financed. Enquest has had to do a deeply discounted rights issue, and borrow off BP, to complete Sullam Voe.

The E&P majors are helping to finance their own exit because it is the only way they can get out. The turnaround from that to an investment boom that could raise asset values in the supply chain is a long one.

In order to make money in this environment the E&P companies, particularly those backed by private equity, are focusing on driving down costs and limiting Capex with a ruthless efficiency and commitment few in the supply chain believed possible long-term. Where offshore assets are concerned the oversupply situation only assists with this. I met one of the private equity investors last week and I can assure you there is no pressure to replace old assets, safety first definitely, economics and finance second just as definitely.

The reality for the supply chain is this is a market where it will be very hard to make money for a very long time, and in reality the glory days of 2012-2014 look extremely unlikely to return. The Oil and Gas UK report gives some important data in explaining why.

My holiday reading…

I’m off to Spain for some reading and beach time on Wednesday… Strangely prescient reading awaits …

If anyone wants a book recommendations one of favourite economic history books is The Wages of Destruction (but The Deluge is up there as well) and The Museum of Innocence is one of my favourite novels. I went to Turkey for the first time in 2001 and then everyone wanted dollars, then I went back four years later and everyone wanted €. The script looks written for a currency crisis here when the President asks the population to change $ into Lira as an act of patriotism, and so when I next go back to Turkey they may well be looking for Yuan if David Goldman is right.

The graph above just shows that Turkey isn’t going to stop buying Iranian oil. They will just barter for it and actually end up paying less in $ terms. Russia and China are getting a back door channel to the whole region the longer this keeps up.