Having recently read an analysis of the failure of Chinese shipping by Charles de Trenck, published by Splash as well as Joseph Triepke’s article published in OilPro, a common theme seems to be emerging in the oil and gas sector, particularly service providers. This theme can best be summarised as the lack of focus in the underlying fundamentals in the sector can be catastrophic for decision making. When the oil price was buoyant, marine service providers could be robust in their assumptions that could focus on one or two elements to support their notion of ongoing profitability and sustainable growth. In the case of Charles’s article, investment in Chinese shipyards was based on the cost advantage in manufacture presented by Chinese yards but failed to take account of risk associated with the availability of large amounts of ‘free money’ with a focus on cheap ships and not the real cost of associated activities, such as containers. Joseph’s article highlights a worrying trend in those servicing the oil patch – namely the financial treatment of orderbacklog. He highlights that Technip has good value in its backlog, however all profitable work for 2016 was booked in 2013/14. This will not be good for their P&L and key banking ratios next year, leading Technip to now predict that the worst is still to come for the sector.
Current debate in the sector, includes the ongoing impact of oil price volatility and how it will shape the structure of service and support industries to the sector. Unfortunately, much of the debate focusses on simple supply / demand economics, without taking a deeper look at the issues that make up price. If you are within the demand driven camp, and use the growing energy demand projections as a base for saying the price of oil is going up to the $90 – $100 mark , you generally ignore the fact that other energy sources become viable at the $70 mark, hence more competition in sources of energy. Further confusing the issue is the IEA recently revising its forecast down when talking of global oil demand, stating that the market will contract in 2016. Other factors, at a more generic level are the number of drilling and uncompleted wells (DUCs) available and less measurable impacts such as Iran supply and other geopolitical issues.
I have taken a bit of time looking at some of the macro picture in the sector, highlighting that one needs to look below the headline to get a better understanding of how the market is shaping up or how to guide your investment behaviour. I will now drill down into a single service provider to the oil and gas sector and extrapolate some of the more detailed DD that needs to be done. As a case study, I will use Singapore-based Ezion Holdings not only because I know the company fairly well but I have been a regular commentator to the industry, on this particular sector. I will also look at underlying assumptions made by the recent RHB report (2/7/2015) that was used in the recent Malaysian fund raising road show undertaken by Ezion Holdings. This will also challenge some of the assumptions, particularly what they see as strengths/opportunities, as this is where I believe investors should be focusing as these are used to smooth over the companies serious leverage issues.
These claims include, and discussed as follows:
- Southeast Asia leader in liftboat and 65% growth in their fleet: Yes, they have had a significant growth in their fleet, but it is the composition of their fleet that is the concern. Twenty vessels are service rigs and this sector is under significant pressure as operators cut back offshore activity. When one notes that the useful life of a service rig is around thirty five years, risks for Ezion is that the average age of the Ezion rigs is 33 years. Furthermore, increase in fleet size is contrary to what is happening in the sector. There have been four liftboats, new but incomplete, offered on the open market in Singapore as well as witnessing newbuild contracts being delayed or cancelled. Companies are also in the process of downsizing their fleets to consolidate their financial position and in particular are scrapping or cold stacking their old fleet as there is an anticipated 30% oversupply of newer and more efficient rigs for 2016/17. An example of this activity is Transocean that has retired / scrapped 20 rigs in 2015 and will shrink its fleet to 63 rigs, and this is a company that does have a cash and balance sheet strength. In fact there are 110 new rigs due to be delivered in the 2105/16 cycle.
- Forecast earnings to grow on the back of long term contracts and renewal of contracts on same terms: There used to be a time when a company could bank on contracts, but it is clearly evident from the activity in the market that this is no longer the case. In fact what we are finding is operators / contractors meeting to explore cost reductions as well as innovation to boost competitive advantage, this has led to lower project awards. Furthermore, there has been a 40% reduction in charter rates, and we are now seeing charter contracts being cancelled as a means to drive down costs. Rig owners such as Hercules and Transocean have felt this, with operators such as Statoil and Saudi Aramco culling contracts that still have in excess of 12 months to run – it is unlikely that Ezion will escape this. It is also possible that the recent legal case between AMS / Ezion with regard a long term Maersk charter was in fact a push to leverage charter rates down.
Furthermore, other issues that have not been included in the roadshow include the following:
- Environmental approval issues tied to the sale of the Tiwi Island / Teras Australia logistics business to Ausgroup is under pressure, with the approval application only being submitted recently, potentially having catastrophic consequences for the proposed port / supply base. It has already been subject to an Australian government senate enquiry that has made potential users of the facility back away.
- Business strategy suggests that there are a lot of moving parts and coordinated. For example, 30% acquisition of ROS Pte Ltd (Rotating Offshore Services) whilst introducing a new competitor into what they regard as their core strength via the TriYards deal.
Whilst there are many other issues one could debate, this opinion piece is not written to suggest whether Ezion presents as a good buy or not. It comes from the perspective of highlighting to potential investors / fund managers to look at the underlying fundamentals of a business / sector or industry before making an investment decision. One needs to be more robust in their due diligence when looking at opportunities that may arise, particularly in the shipping and service providers to the offshore oil / gas sector. The fundamentals in this market have changed and we see the closing down of profit loopholes that contractors could enjoy over the past few years. As the movie Hollow Man suggests, it is not what you can see that is the problem, it is the invisible that does the killing.