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.]

Long-term North Sea subsea demand…

One of the reasons I don’t believe smaller contractors can survive in the North Sea is the change in rig demand. You can argue, although I wouldn’t, that there is going to be a boom in rig demand that might happen quickly. But for subsea to grow there has to be a CapEx boom, and unless someone can explain to me how that happens without a surge in rigs working then clearly that isn’t happening anytime soon. Funding will run out for marginal contractors long before the rigs generate enough work at this rate given the lag time between rig and subsea projects.

I made the above graph from the Baker Hugher Rig Count. The data is stark and shows that based on current rig levels the UK subsea industry must face a large contraction in construction and tie-in work in the upcoming months. The UK rig count peaked in Jan 2013 at 22 working rigs, that has dropped to 7 in Sep 18. In Norway, as can be seen from the dark blue area, the rig count peaked in Dec 12 at 25, reached that again in Sep 13, and apart from an aberration of 9 in Oct 16 has never really dropped below the upper teens, although there are currently 13 working.

The UK sector has seen peak-to-trough declines far in excess of Norwegian levels where demand has been more constant. There are a host of reasons for this including tax and industrial policy that I don’t want to get into: but the net result is clear that in Norway offshore activity is far less volatile in demand terms. Exposure as a pure UK subsea business means accepting a large decrease in the size of the opportunity.

As a follow-up to my thoughts yesterday clearly this puts Bibby under pressure. Bibby’s core competency of diving is useless in Norway (as the company has no NORSOK compliant dive vessel) and it has been unable to crack the ROV led market against DeepOcean, Reach and Ocean Installer, all of whom have strong Equinor connections and have made substantial local investments. In the UKCS a large amount of the recent rig work has been concentrated on West-of-Shetland work where there is little, if any, diving involved in the projects.

Boskalis recently won the contract for the Tyra redevelopment subsea (including diving) scope. Bibby did the original work on Tyra and it was surely a high profile priority for them to win? IRM diving has never been that profitable but the project work was. Bibby may have a large hedge fund as a shareholder (and debt owner) but that doesn’t help them. Putting that you have your shareholders’ support on the accounts only highlights it is needed to be regarded as a going concern by your auditors (necessary if you aren’t going to write the debt off). As Vard found to their dismay having a large hedge fund back a diving venture is no guarantee of getting paid when they decide to exit the industry. Customers signing large value orders over a multi-year period with Bibby may rightly be nervous that the company has the financial strength to finish their contract. Work-in-progress is merely an unsecured creditor in insolvency event.

It’s not good for Ocean Installer either. Whereas Bibby is a specialist in one area of the market OI is a generalist contractor that relied on a booming market. It has no rigid-pipelay spread or differentiating competitive advantage. Anyone can hire a vessel with a big crane and some shore based engineers and provide exactly what they do. Because of this they are a price taker in a competitive market, and the price at the moment is low. Providing day-rate engineers in China is a fully low-rent activity. Equinor has Reach and DeepOcean and whether they want to support OI as a charity project remains to be seen.

My thesis isn’t complicated (or original): when the market boomed it drew in new entrants as demand expanded rapidly and money flowed through the industry. But now the demand isn’t there and given the scale of the pullback it is the marginal contractors, the ones who entered the industry because of the booming conditions, who will be the first to go. The market adjustment from the supply side of subsea has a lot of adjustment to go before it catches up with the amount of project work that can be generated based on current rig working levels.

Scrapping and UKCS North Sea demand…

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

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

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

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

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

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

UKCS Statistics (2017)

Oil and Gas UK activity 2017.png

Source: Oil and Gas UK.