Solstad has a solvency problem not (just) a liquidity problem…

The motions of Grace, the hardness of the heart; external circumstances.

Pascal, Pensee 507

“Lend without limit, to solvent firms, against good collateral, at ‘high rates’.”

Bagehot

I disagree with Solstad on this:

It has therefore been decided to commence negotiations with lenders and other stakeholders to improve the overall liquidity situation and to create a robust long-term platform for the Company.

Solstad doesn’t just have a liquidity problem it has a solvency problem. They may have enough broker valuation certificates to keep the auditors happy that the assets add up to the liabilities in a balance sheet sense, but in reality does anyone really believe that the fleet can service ~NOK 30bn in debt? Solstad fails a balance sheet test under a realistic set of assumptions. The fact is if the banks really thought they could sell the vessels for the outstanding debt and be made whole they would have done so long ago. This situation has been allowed to continue, despite clear evidence to the public protestations of its success, because the creditors have no good options. A liquidity problem can be solved with more short-term measures but a solvency problem is endemic and structural and requires a fundamental adjustment. Bagehot’s dictum of lending freely when in crisis relied on the collateral being of high quality and the crisis being temporary in nature, a situation that clearly does not apply here where there has been a structural industry shift.

I’m struggling to see why you would create Solstad today in its current form and my base view is if you can’t answer that question then you don’t have a viable business model in the current market. The scale of the credit write-downs that need to occur here to keep the business alive are just so large it is hard to know if Solstad are just good at PR or good at avoiding reality. I don’t know what the number is but the debt must need to be reduced somewhere in the range of NOK 15-20bn to make Solstad a viable business? The rump of Deep Sea Supply will never be a viable business. And then it needs equity…

The only way to get equity is to find an investor who is going to potentially get such a big return on their investment that the creditors get nearly nothing. There is probably someone willing to make that trade but it is a small pool and it offers the creditors nothing. Market sentiment, as opposed to the actual market, has worsened substantially since MMA pulled of the most successful OSV equity based solution. There is no guarantee that Solstad will survive this encounter with creditors intact and almost a certainty a very different beast will emerge. I am not even sure now splitting the subsea fleet from the supply tonnage will make much difference? The subsea fleet has a large number of marginal vessels that still need scale to survive and given many are being hawked out on windfarm work there is no guarantee their value will “recover” in percentage terms more than a supply vessel. And when some of them come of contract the day rates will also be dramatically reduced.

Systemically it will be interesting to see what happens here. The banks will be desperate not to be handed the keys to Solstad, but as Pacific Radiance in Singapore has shown getting someone to come in behind the banks in the capital structure is tough (with exceptionally good reason). The size of the write-offs the banks would have to take to induce this will make for some uncomfortable meetings in the coming days. Surely soon auditors will force companies to use market transactions (like the recent SDSD FS Arundel for $2.8m!) as the actual realistic value not this “willing buyer/willing seller” ruse?

Not everyone can survive a downturn on the scale we have seen. If the banks somehow, and it will be hard, find a way of keeping the money flowing then all it guarantees is that another company will go. And it will have to be another large “unthinkable” one at that, because there is simply not enough work, and unlikely to be for the next couple of years, for all the supply companies to survive.

The other missing piece of this puzzle is the changing financial structure of the industry and the huge amounts of equity that need to be raised to keep it viable. All the banks behind Solstad have no intention of lending to similar companies for the forseeable future, and every bank is the same, this is a systemic issue directly related to depressed vessel values. But as the contract coverage has shortened so the economic rationale for leverage has also disappeared: lending against a PSV on a 5 x 365 contract is very different to one on a 270 day contract. That sort of spot market risk is essentially equity risk and the average day rate needed to make this economically viable is significantly above current levels. An industry which needs to cover 365 costs on a 270 day utilisation year is again a very different economic model from the past for offshore supply and it only reinforces the size of the adjustment the industry still requires. This is an industry that will significantly delverage going forward and that will mean far more (expensive) equity levels and lower asset values.

An interesting conundrum is whether Standard Drilling and Solstad can really co-exist? I mean either you can buy vessels for a few million and bring them to the most sophisticated market in the world and make money against historic tonnage, or you can’t? At the moment both companies are a financial disaster but surely a recovery story really only works for one company as a logical proposition? There is no indication that the Solstad vessels are trading at a premium in the PSV market to the Standard Drilling/ Fletcher vessels which gives you an idea of what the Solstad fleet would be worth in an open market sale. The same is true for the high-end AHTS fleet where rates remain locked at marginal costs (or below on a 365/economic basis) and competition shows no sign of abating.

Solstad has also provided a natural experiment into the limits of synergy realisation versus the depth of this industry depression: quite simply consolidation alone will not be sufficient. All year Solstdad has highlighted the cost synergies it has achieved by combining with DeepSea Supply (in default before the first quarterly results) and Farstad (in default before the second quarterly results). But these are insignificant in relation to overall running costs and the level of day rate reductions E&P companies have extracted from OSV (and rig) operators. Pretending that consolidation alone is an answer now lacks credibility. New business models need to emerge and a fundamental factor of these will be collectively less supply and capacity.

The Solstad announcement presages a horror season of Q3 reporting coming up across the OSV sector. As I said some time back the summer simply hasn’t come in terms of the volume or value of work for either the supply firms or the subsea contractors. The cash crunch is coming. New money will be come on extortionate terms and prices to reflect the risks involved and not everyone will get it. Rebalancing is beginning to start in earnest and the fact is this market is the “recovery”: a slightly busier summer to build up a cash reserve to cover the costs of an expensive an under-utilised winter. The new normal – lower for longer is the reality of offshore supply and subsea.

HugeStadSea goes wrong…

If completed, the Combination is expected to provide Solstad Offshore, Farstad and Deep Sea with an industrial platform to sustain the current downturn in the offshore supply vessel (“OSV”) market and be well positioned to exploit a market recovery. The Board of Directors of the three companies consider this to be a necessary structural measure that will enable the Merged Group to achieve significant synergies through more efficient operations and a lower cost base. The Combination will influence the SOFF Group’s financial position as total assets and liabilities as well as earning will increase substantially.

SolstadFarstad merger prospectus, 2017

This was always going to happen… nice timing though… just a few days before Easter, with everyone looking the other way, and only a short time before the Annual Report was due (with its extensive disclosures required), SolstadFarstad has come clean and admitted that Solship Invest 3 AS, more familiarly known as Deep Sea Supply, is in effect insolvent, being unable to discharge its debts as they fall due and remain a credible going concern:

As previously announced, Solstad Farstad ASA’s independent subsidiary, Solship Invest 3 AS and its subsidiaries are in discussions with its financial creditors aiming to achieve an agreement regarding the Solship Invest 3 AS capital structure.

As part of such discussions, Solship Invest 3 AS and its subsidiaries have today entered into an agreement with its major financial creditors to postpone instalment and interest payments until 4 May 2018.

I am not a lawyer but normally getting into agreements and discussions like this triggers the cross-default provisions of debts, including the bonds which look set for a default… and this would make all of the c. NOK 28bn debt become classed as short-term (i.e. payable immediately). Maybe they saw this coming and omitted those clauses when the loans were reorganised, but its a key provision, and I struggle to see it getting through compliance and lawyers without this? But it strikes me as a crucial question. The significance of this for those wondering where I am going with this is that it would be hard to argue SolstadFarstad is actually a going concern at that point. Maybe for a short while, but getting the 2017 accounts signed off like that I think would be tricky (ask EMAS/EZRA).

Investors, having been told  how well the merger is going, may want to have a think if they have been kept as informed as they would like here? There is nothing in this statement on 19 Dec 2017 for example to reflect clearly how serious things were at Deep Sea Supply. Indeed this statement appears to be destined for future historians to recall a management team blithly unaware of their precarious position:

With the reduced cost base we will be more competitive and with our high quality vessels and operations, we will be in a very good position when the market recovers.

The PR team may have liked that statement but surely more cautious lawyers would have wanted to add the rider “apart from Deep Sea Supply which is rapidly going bankrupt and the vessels are worth considerably less than their outstanding mortgages. We anticipate in the next 12 weeks defaulting on our obligations here until a permanent solution is found.” To make the above statement, when 1/3 of merger didn’t have a realistic financial path to get to this mythical recovery is extraordinary.

But the real and immediate problem the December 19 press release highlights is that in an operational sense Deep Sea Supply has been integrated into the operations of HugeStadSea:

The merger was formally in place in June 2017 and based on the experiences from the first six months in operation as one company, Solstad Farstad ASA is now increasing the targeted annualized savings to NOK 700 – 800 mill.

By the end of 2017 the cost reductions relating to measures already implemented represents annualized savings of approximately NOK 400 mill…

new organization structure implemented and the administration expenses have been reduced by combining offices globally and centralization of functions.

The synergies laid out here can only be achieved by getting rid of each individual company’s systems and processes and integrating them as one, indeed that is the point of the merger? So how do you hand Deep SeaSupply back to the banks now? For months management consultants from Arkwright have been working with management and Aker to turn three disparate companies into one, now apparently, as an afterthought, the capital structure needs sorting as well along with disposing of “non core” fleet. Quite why you would get into a merger to create the largest world class OSV fleet while simulataneously combining it with a “non core” fleet at the same time (that wasn’t mentioned in the prospectus) is a question that seems to be studiously avoided?

Just as importantly going forward here management credibility is gone. Either you were creating a “world class OSV company” with the scale to compete, or you weren’t, in which case taking on the Asian built, and pure commodity tonnage of Deep Sea Supply was simply nuts.

Around 12 months after the merger announcement, and six momths after the legal consumation, when managers have had sufficient day rate and utilisation knowledge to build a semi-accurate financial forecast, they are back to the drawing board. If SolstadFarstad hand the Deep Sea fleet back to the banks they will have to either fire-sale the fleet or build up a new operational infrastructure to run the vessels independently of SolstadFarstad… does anyone really believe the banks will allow that to happen? The problem is the tension between the different banking syndicates: a strong European presence behind SolstadFarstad and Asian/Brazilian lenders to Deep Sea. This is likely to get messy.

Is Deep Sea Supply really ringfenced from SolStadFarstad? Will the lending banks be able to force SolStadFarstad to expose themselves more to the Deep SeaSupply vessels? As an independent company Deep Sea Supply would have been forced to undergo a rights issue, and if not supported by John Fredrikson/Hemen it would have in all likelihood have gone bankrupt, the few hundred million NOK Hemen putting into the merger barely touched the sides here. For the industry that would have been healthy, but for the banks a nuclear scenario. Now management face a highly embarrassing stand-off with the banks to force them to take the vessels back, or the equally highly embarrassing scenario of admitting that the shareholders were exposed to the Deep Sea Supply fleet all along, and that the assumptions underpinning this deal were wrong… Something easily foreseeable at the time to all but the wilfully blind.

The “project to spin off the non-core fleet”, which I have commented on before, is the Deep Sea Supply fleet that makes a mockery of the industrial logic of the merger. That was started in Q3 2017 according to their annoucements, only a few months later needs to be sold? What is the plan here? Or more accurately is there one?

There are no good options here. The only credible option for the management team and Board to survive unscathed would surely be the banks writing down their stake in Deep Sea Supply entirely and making a cash contribution to SolstadFarstad to recognise the time and costs involved in running it. You can mark that down as unlikely. But just as unlikely is a recovery in day rates where Deep Sea Supply can hope to cover its cash costs even in the short term

The Board of SolsatdFarstad and their bankers need to ask some searching questions here. The merger was a very bad idea that was then executed poorly.  It is therefore hard to argue SolstadFarstad have the right skills in place at a senior management and Board level? This wasn’t a function of a bad market, this was the result of bad decisions taken in a bad market. This constant mantra that scale will solve everything, when the company has no scale, needs to be challenged. The other issue is how disconnected management seem to be from basic market pricing signals, and moving the head office away from its current location should also be seriously considered along with a changing of the guard.

I said at the time this merger was the result of everyone wanting to believe something that couldn’t possibly be true and merely delaying for time, but eventually reality dawns as the cash constraint has become real. The banks need to write off billions of NOK here for this to work. Probably, like Gulfmark and Tidewater, the entire Deep Sea Supply/ Solstad/Farstad PSV and smaller AHTS fleet need to be equitised at a minimum, and some of the older vessels disposed of altogether. The stunning complexity of the original merger, where legal form trumped economic substance, needs to be reversed to a large degree, but this will not be easy as the shareholders in the rump SolstadFarstad will surely balk at being landed with trading their remaining economic interests for a clearly uneconomic business.

The inevitable large restructuring that will occur here arguably marks the start of the European fleets and banks catching up with their American counterparts, and to some degree matching the pace of the Asian supply fleets. The banks behind this need to start a series of writedowns that will be material and will affect asset values accross the sector. Reporting season will get interesting as everyone tries to pretend their vessels are worth more than Solstad’s and the accountants get worried about their exposure if they sign off on this.

A common fault of all the really bad investments in offshore since 2014 was people simply pretending the market is going to miraculously swing back into a state that was like 2013. It was clear late in 2016 this would not happen. The stronger that view has been has normally correlated with the (downside) financial impact on the companies in question, and there is no better case study than HugeStadSea.

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. 

Follow the money… it’s all in the numbers…

“We no longer believe because it is absurd: it is absurd because we must believe.”

 Julio Cortázar, Around the Day in Eighty Worlds

At some point companies are going to have to stop reporting poor financial results and say things are looking good from a tendering perspective to retain credibility (or will they maybe their shareholders want to believe as well?). This week Solstad seemed to pull this trick, while the most brazen appears to be Subsea 7 who while annoucing that their order book had dropped significantly, stated that:

[We have] [c]ause to believe in an improvement in SURF project award activity within 12 months

Early engagement activity increasing

This despite the fact that 1 year ago they had $6.1bn in backlog and they currently only have $5.1bn. Subsea 7 is more exposed to EPIC projects and I believe these will form a bigger percentage part of the market going forward, but it’s still a bold call.

For Solstad the alternative explanation, announced by Bourbon, is that there is no recovery. Or as Siem Offshore stated this week:

we believe there will still be an oversupply of AHTS vessels and PSVs and expect the market to remain challenging for several years. The charter rates and margins still remain below what is sustainable. (Emphasis added).

Part of me thinks the offshore industry just isn’t used to an environment where the forward supply curve price isn’t fundamentally different from the current price. It is worth noting that on an inflation weighted basis the oil price peaked in 1979 and then dropped in real terms for 19 years to reach an all-time low in 1998, before stagnating for a couple of years, before the inexorable rise that we all regard as the new normal, began.

The major reason for the steady decline was both supply and demand based. New sources of supply came on, technology advanced, and high prices encouraged substitution. Clearly it isn’t an iron law that prices will keep rising over the long run as if it is an immutable economic law, yet it is taken as a given by certain sectors of the offshore community.

Solstad announced results this week that seemed to defy all logic. I don’t know how much money Aker have, but they have played the OSV market stunningly badly since the downturn began, and one would think sooner or later they will get sick of throwing more money away on vessel OpEx. Aker jumped into Solstad way to early, and yet for some inexplicable reason, (other than blind faith in a vessel recovery?) when more than 100 North Sea class PSVs were in lay-up in January, agreed to effectively bail Farstad out and combine with DeepSea Supply. Now Solstad came out with this predictable bullet point from their results presentation:

Majority of revenue and EBITDA from CSV segment

Really what a surprise! You just can’t make this up. What is working for them in this downturn is their high-end CSV fleet and then Solstad jump headlong into the most overbuilt commodity shipping in the offshore industry, Madness. The rest of the presentation is an exercise in mental dislocation from industry reality: DESSC’s cost leading business model is praised… but that doesn’t help at the moment when ships are going out for less than their economic value? It’s also not scaleable or transferable in an acquisition of  other vessels (or companies) because it relies on all vessels in the fleet being similar? And can you really have a low cost business model in this sector anyway? Its a boat + crew? What special insight does DESSC have in making this low cost? Apparently a strategic driver for saving Farstad’s banks is their AHTS experience? Great… Farstad are the most skilled company in a market segment that is structurally unprofitable? If the shareholders are like Aker and like owning companies that are the most competent at what they do regardless of whether they make money or not then this is a very good investment idea. I suspect it’s niche though because investors like that are rare.

It is all well and good highlighting that Farstad and DESSC are non-recourse subsidiaries of Solstad wth the implication being if it all goes wrong then they can be jettisoned. But of course JF took his holding in Solstad not the subsidiary which shows you where he thinks the value is. The Solstad supply fleet will simply not be big enough to generate economies of scale that outweigh the negative industry structure or induce pricing power in any region. It is also debatable what the minimum efficient scale is in offshore supply? This was a transaction driven by the desperation of Farstad’s bankers and recognition by DESSC that trying to do a rights issue without a different investment story would have been extraordinarily dilutive given the cash would have been used for OpEx only. Quite how it was sold to Solstdad/ Aker is anyone’s guess.

A good comparison is Gulfmark which is going into a voluntary Chapter 11. Gulfmark will emerge with a clean balance and 72 vessels in the supply sector. If you want to look at a company with the potential to consolidate the PSV sector it is right there with a simple operational structure and balance sheet focused on one sector that investors can understand and measure. It is very rare  for companies to consolidate an industry that come from one of the high cost markets and then work out how to be cheap internationally – it usually works in reverse. US companies like Seacor and Gulfmark are going to be well placed to drive proper industry consolidation in a way that may not be possible for a company coming from a relatively high cost environment. Yet this industry feels a long way from the bottom when NAO Offshore with a mere 10 vessels, and 30% of the fleet in lay-up, all working at nowhere near their cost base, can say blithely:

Nordic American Offshore closed a follow-on offering March 1, 2017, strengthening the Company by about $48.8 million in cash. The main objectives of the offering were to strengthen NAO financially and position NAO for further expansion...

NAO sees opportunities to grow the Company… 

(Emphasis added).

I sometimes wonder if when Norwegian schoolchildren are young they are indoctrinated with a special ship class in which the answer to every question is “ship”. I imagine an immaculate schoolroom (paid for with petrodollars of course), a very small class, and 20 children with their eyes closed humming and intoning gently “skip… skip…. skip…” And the teacher asking “What is the meaning of life?”… and the gentle reply coming back immediately “Skip”… “What is 2 + 2?” … “Skip, Skip + Skip Skip”… “E=MC2?” “Skip”….

I am just not sure the answer to the current problems are more ships… I have a nagging suspicion it’s less ships. A lot less. Consolidation isn’t the only answer here a quantative reduction in vessel numbers is an yes smaller operators need to go.

DOF came in with revenue 23% below Q1 last year which makes it hard to point to any recovery. DOF also announced this week that they may list DOF Subsea as First Reserve would appear to want out. First Reserve have been in DOF Subsea a long-time, and it’s natural they would want to exit at sometime. But you should always ask why inside and knowledgable investors are selling now, at what some are calling the bottom of the cycle; maybe it isn’t the bottom? DOF Subsea project margins were 2.0%! Yes the DOF PLSVs in Brazil are now up an running, but as we all know Petrobras has far too much PLSV capacity and so I suspect First Reserve is trading off a very low point in the cycle against the cost of waiting which brings you a day closer to the possibility of a vessel being redelivered from Brazil.

DOS Subsea specialise in light IRM and small scale projects and out of the North Sea market (where you need a North Sea class DSV) owning a vessel is a disadvantage not an advantage (which isn’t true at the top end EPIC SURF contracting where you need a specialist lay vessel) for some projects as costs become purely variable. Every single asset DOF Subsea have can be chartered in from another company if you are project management house. There used to be a number of project companies that delivered projects but didn’t own vessels, that didn’t last as the market tightened from 2006 onwards and you simply couldn’t charter a vessel (I am trying to think of the Singapore/Perth company Technip brought?). But now that isn’t the case and so not only is there loads of delivery capacity in vessel owners and charterers, but small project management houses can, and will, bid and compete for jobs, which will lower industry profits structurally. The best strategy going forward is to have a fleet much smaller than your delivery schedule requires but still some core tonnage, companies that didn’t splurge in the last boom are clearly better positioned here.

Whatever the reason for First Reserve selling it is a fact that one of the most successful investors in the energy industry is lightening their exposure to the offshore sector. If you buy DOF Subsea shares you need to ask what you know that First Reserve don’t? Interestingly First Reserve hasn’t invested in an offshore exploration company since 2011 (Barra), but has invested in 7 tight oil plays since 2011, a pattern that seems to mirror capital flows in the industry. One wonders if Technip weren’t encouraged to try and by DOF Subsea and a lack of interest led to this way of getting out?

The obvious reason that First Reserve might well be selling is that they think the poor financial results are likely to continue for sometime and they see no easy answer to an industry awash with capacity and declining levels of investment and simply don’t want to fund working capital with an uncertain payback cycle. DOF Subsea has excellent project delivery capability but it simply too long on ships and unlike other contractors these are an essential part of their strategy going forward and they have no ability to given chartered tonnage back as the industry continues to contract.

DOF Subsea also have 67 ROVs. The quiet underperformer in the industry at the moment is the ROV space. Everyone at the moment is giving the ROVs away at costs + crew only. In the old days ROVs were so profitable because you used to able to hide a mark-up on the vessel in the contract amount and they looked very profitable. Now the vessel is given away for free as is the ROV and only the engineering generates some margin. There is clearly going to be some consolidation here and I believe it will be very hard for the smaller companies to raise additional funding without profitable backlog as it becomes clear that there will not be a recovery in 2017. A lot of companies in the ROV market have raised money yet offer the same thing as the industry leaders who have very strong liquidity positions and can play this game far longer than speculative investors. Reach is a well managed company, and can give vessels back eventually, M2 got it’s ROVs cheap, but both are going up against companies like DOF and Oceaneering and eventually, surely, investors are going to realise that without some sort of increase in demand the structure will favour the larger companies who have more equity to dilute to see them through to the final stages of consolidation. There is an argument that smaller nimbler ROV companies can respond better to IRM workscopes than larger companies, particularly at the moment with oversupply in the vessel market; we are about to find out if they can win sufficient market share to be viable.

Obviously there are different views about when the industry is going to recover and how it will look. That is legitimate as no one can know ex ante what will happen ex post but it is becoming apparent that 2017 isn’t going to be the recovery year people hoped and that more people are going to have to raise money to get through this. The Nor DSVs will need to start fundraising in August at the current burn rate, as will others, the dilution that the new money makes on the old money for these secondary fundraisings will be a clue I believe as to how close we are to pricing the bottom. The investors in Nor represented a group who thought there would be a quick bounce back in 2017 in the price of oil and subsea asset values, there are bound to be fewer the next time around and surely they will charge a higher price for their capital, and in many ways this is microcosm of the industry.

The best guide to calling this appears to be those that have looked at previous investment bubbles. Charles Kindleberger, in his classic study of financial panics and manias stated the final stage of an investment bubble led to panic selling which would mark the bottom of the cycle:

‘Overtrading,’ ‘revulsion,’ ‘discredit’ have a musty, old-fashioned flavor; they convey a graphic picture of the decline in investor optimism.

Revulsion and discredit may lead to panic (or as the Germans put it, Torschlusspanik, ‘door-shut-panic’) as investors crowd to get through the door before it slams shut. The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets…

We still look a long way off this in offshore supply and subsea.

 

Increased offshore expenditure not sufficient to change inevitable consolidation and shake-out

Rystad Energy have a good article on offshore CAPEX versus North American Shale. I am not sure it offers a huge degree of comfort for offshore contractors and vessel owners:

  1. 70% of expenditure comes from 10 projects (most of which were in planning long before the current downturn). Should this pattern continue the industry would become dominated by a few large contractors that worked on mega-projects only. The entire ecosystem of smaller contractors would be reduced to servicing these large EPIC contractors at hugely reduced margins and competing fiercely for IRM work to keep utilisation high. The sheer scale of these types developments favours large well-entrecnhed competitors with links across the value chain to subsea processing companies. Again the space for smaller firms is likely to be limited to subcontractors only
  2. As noted above these were all sanctioned and had final investment decisions some time ago. Large, high volume and low OPEX, deepwater fields are likely to be the core of offshore demand going forward. GIven the lead bid times the projects being bid now are likey to be extremely margin compressed for years to come, so an increase in the oil price will drop straight to the E&P company bottom line without helping the offshore fraternity at all. Time is not the friend of those long on ships and drill rigs at the moment
  3. Given current industry supply levels these larger contracting entities will likely be more “asset-light”, apart from core delivery assets, than we are used to. This is likely to result in continued, and long-lived, margin erosion for anyone apart from a tier 1 offshore contractor. If you want an unbiased example of this look to the civil contracting industry where anyone other than the prime contractor makes operating profit at close to marginal cost
  4. Jusr as importantly the pick-up in demand, if indeed it is that, has occured only by a decrease in offshore and subsea rates below what it is economically possible to supply in the long-term
  5. 3-4 large contractors, and Technip, Subsea 7, Saipem, and McDermott (with limited asset and competitive differentiation) will all be there, with some strong regional players, is enough to drive industry margins down to normal economic profit for the foreseeable future

Rystad mention the drop in drilling and offshore subsea rates, but everyone is operating at below cash break even on projects at the moment to win work. Currently in order to fund this cost deflation all drilling operators of note are refinancing and the loss in equity has been huge, and a somewhat more delayed pattern is also occurring in the OSV market. It would not appear that demand and supply are therefore balanced, or even close to it. All it indicates is the brutality of the E&P supply chain and the willingness of offshore contractors, long on fixed assets with high running costs, to bid at whatever it takes to win some work and try and last longer than anyone else.

The market would appear to be some way off equilibrium. The graph at the top is the Subsea 7 (orange line) share price versus Solstad (blue line) over the past 12 months, essentially a proxy for my thesis above (in the most general sense and picked because the weight of their relative debt should strengthen my argument and magnify equity returns), and it would appear the market consensus is similar to mine.