Offshore Drilling

Diamond Offshore (NYSE: DO) today went to Chapter 11 heaven. Offshore drilling is even more expensive than drilling for oil by digging into your backyard, and paying somebody US$40/barrel for your crude oil isn’t a very economical business model.

The demise in Diamond Offshore was generally projected by the stock market:

There was also a very explicit hint on April 16th, where they stated they were withholding interest payments on one of their senior notes – never a good sign!

Diamond Offshore Drilling, Inc. (the “Company”) elected not to make the semiannual interest payment due in respect of its 5.70% Senior Notes due 2039 (the “Notes”). Under the terms of the indenture governing the Notes, the interest payment was due on April 15, 2020, and the Company has a 30-day grace period to make the payment. Non-payment of the interest on the due date is not an event of default under the indenture governing the Notes but would become an event of default if the payment is not made within the 30-day grace period. During the grace period, the Company is not permitted to borrow additional amounts under the Credit Agreement (as defined below).

On December 31, 2019, the balance sheet had $2 billion in debt, entirely in four Senior notes and $5 billion in drilling assets. Subsequent to the 2019 year end, they drew some capital on a revolving credit facility before going to Chapter 11, but otherwise most of the debt is pari-passu, which means they will probably get a slab of equity in the restructured entity.

The senior debt has been very volatile in trading today, hovering around the 10 cent level. If I had deep enough pockets (it is nearly impossible and highly risky for retail players to get involved in outcomes of Chapter 11 proceedings) I’d consider buying a slab of the senior notes. They’ll probably wipe out 3/4 of the debt, give out a bunch of equity in compensation, extend the rest of the maturities out for five years, and then pray that there is a recovery in oil where everybody can be made whole.

Other related companies I keep an eye on: Transocean (NYSE: RIG), and Seadrill (NYSE: SDRL). Seadrill went through a recapitalization a couple years ago, and Transocean looks to be on the brink (although they are not in as bad a shape as Diamond was, they can probably find enough spare change in the couch to survive until around 2022).

Seadrill Chapter 11 details

Seadrill, a publicly traded company that does offshore oil drilling, filed a Chapter 11 arrangement. The salient terms of the pre-packaged deal are:

The chapter 11 plan of reorganization contemplated by the RSA provides the following distributions, assuming general unsecured creditors accept the plan:

• purchasers of the new secured notes will receive 57.5% of the new Seadrill equity, subject to dilution by the primary structuring fee and an employee incentive plan;
• purchasers of the new Seadrill equity will receive 25% of the new Seadrill equity, subject to dilution by the primary structuring fee and an employee incentive plan;
• general unsecured creditors of Seadrill, NADL, and Sevan, which includes Seadrill and NADL bondholders, will receive their pro rata share of 15% of the new Seadrill common stock, subject to dilution by the primary structuring fee and an employee incentive plan, plus certain eligible unsecured creditors will receive the right to participate pro rata in $85 million of the new secured notes and $25 million of the new equity, provided that general unsecured creditors vote to accept the plan; and
• holders of Seadrill common stock will receive 2% of the new Seadrill equity, subject to dilution by the primary structuring fee and an employee incentive plan, provided that general unsecured creditors vote to accept the plan.

This is one of those strange instances where the common stock was trading like something terrible was going to happen, but in relation to its closing price Monday, they received a relatively good “reward” out of this process, 2% of the company (compared to zero if creditors take this to court).

The question is whether the unsecured debtholders will agree to this arrangement – my paper napkin calculation suggests that bondholders will get about 10 cents on the dollar (probably less after the “subject to dilution” is factored in) compared to the trading around the 25 cent level before this announcement.

Their alternative is that if they vote against the deal, the secured creditors will receive everything.

Please read the Pirate Game for how this will turn out and also a lesson on why being an mid-tier creditor in a Chapter 11 arrangement that requires all capital structures to vote in favour of the agreement can be hazardous to your financial health.

I will also note that Teekay Offshore effectively went through a recapitalization, and this leaves Transocean and Diamond Offshore that both in relatively good standing financially.

Not finding a lot to invest in

Barring any investment discoveries in the next month, the cash balance I will be reporting in June is going to be a considerably high fraction of the portfolio.

While cash is great, it also earns zero yield.

Compounding this problem is the majority of it is in US currency.

Unfortunately I have done some exhaustive scans of the marketplace and there is little in the way of Canadian fixed income opportunities (specifically in the debenture space) that I have seen that warrants anything than a small single-digit allocation. I would consider these to be medium reward to low-medium risk type opportunities. Things that won’t be home runs, but reasonable base hit opportunities.

Rate-reset preferred shares have also piqued my interest strictly on the basis of discounts to par value and some embedded features of interest rate hike protection, but my radar on future interest rates is quite fuzzy at the moment (my suspicion is that Canadian yields will trade as a function of US treasuries and the US Fed is going to take a bit longer than most people expect to raise rates since they do not want to crash their stock market while Obama is still in the President’s seat).

I have yet to fully delve into the US bond space, but right now the most “yield-y” securities in the fixed income sector are revolving around oil and gas companies.

There are plenty of oil and gas companies in Canada that have insolvent entities with outstanding debt issues, so I am not too interested in the US oil and gas sector since the dynamics are mostly the same, just different geographies.

I’m expecting Albertan producers to feel the pain when the royalty regimes are altered once again by their new NDP government. There will be a point of maximum pessimism and chances are that will present a better opportunity than present.

Even a driller like Transocean (NYSE: RIG) that is basically tearing down its own rigs in storage have debt that matures in 2022 yielding about 7.9%. If I was an institutional fund manager I’d consider the debt as being a reasonable opportunity, but I think it would be an even bigger opportunity once the corporation has lost its investment grade credit rating.

Canadian REIT equity give off good yields relative to almost everything else, but my deep suspicion is that these generally present low reward and low-medium risk type opportunities. Residential REITs (e.g. TSX: CAR.UN) I believe have the most fundamental momentum, but the market is pricing them like it is a done deal which is not appealing to myself from a market opportunity.

The conclusion of this post is that a focus on zero-yield securities is likely to bear more fruit. While I am not going to be sticking 100% of the portfolio in Twitter and LinkedIn, the only space where there will probably be outsized risk-reward opportunities left is in stocks that do not give out dividends. It will also be likely that a lot of these cases will involve some sort of special or distressed situations that cannot easily be picked up on a robotic (computerized) screening.

I would not be saddened to see the stock markets crash this summer, albeit I do not think this will be occurring.

General comments – furiously conducting research

I have been intensely researching the oil and gas sector, and specifically looking for companies that have decent metrics and enough fortitude to not be operationally taken down due to financial impacts of low commodity prices. I also have been trying to find collateral damage, typical cases of the baby thrown out with the proverbial bathwater.

There are many, many “hits” on my screens which makes the research very slow going. Specifically I want to know about hedging, and financial covenants and their financial structure in general in addition to the usual metrics. Dredging this stuff is very slow going.

There is a lot of high-yield out there which is trading at quite distressed levels, some of which seems very alluring. But high yield of course comes with risk.

A simple example: Do you want to lend your money to Russia for 10 years even though you are compensated with a 13% yield to maturity? I’d actually gamble that their large cap companies (NYSE: RSX is their ETF) would fare better than an investment in their sovereign debt at the moment.

Here’s a more specific example: Do you want to be a HERO? Specifically (Nasdaq: HERO) Hercules Offshore is a third-tier deepwater drilling firm, which is of a lower tier than Seadrill (Nasdaq: SDRL), Diamond Offshore (NYSE: DO), Transocean (NYSE: RIG), etc. All of the drillers have gotten killed over the past couple months simply due to the fact that nobody wants to drill into expensive ocean when you can’t even make money on the shale inland.

In HERO’s case, their equity is trading as if the company is already dead, while the bond market is placing their 2019 debt issue at a yield to maturity of about 28%. So, what is more risky: Investing in Vladimir Putin, or Hercules Offshore?

Seadrill, however, is comparable to Russia – roughly 11.5% yield to maturity on 6 year debt vs. 13% for 10-year Russian debt.

Reviewing track record of IPOs and other matters

Now that I have been thinking about some IPOs that I have covered in the past, we have the following:

Whistler Blackcomb (TSX: WB) – I stated in an earlier article that this is one to avoid and I might think about it at $5.30/share and so far nothing has changed this assessment.

Athabasca Oil Sands (TSX: ATH) I did not have a firm valuation opinion other than that the shares seemed to be overpriced at the offering price ($18/share) and stated the following (previous post):

Once this company does go public it would not surprise me that they would get a valuation bump, and other similar companies that already are trading should receive bumps as a result. I have seen this already occur, probably in anticipation of the IPO.

If you had to invest into Athabasca Oil Sands and not anywhere else, I would find it extremely likely there will be a better opportunity to pick up shares post-IPO between now and 2014.

While the valuation pop from the IPO did not materialize (unlike for LinkedIn investors!) the rest of the analysis was essentially correct – investors had the opportunity to pick up shares well below the IPO price (it bottomed out at nearly $10/share in the second half of 2010), although I don’t know whether the company represents a good value at that price or not. I didn’t particularly care because Athabasca Oil Sands has some other baggage that made it un-investable (in my not-so-humble opinion).

While I am reviewing my track record on this site, one of my other predictions dealt with BP, Transocean and Noble Drilling, that:

Over the course of the next 2 years, $10,000 invested in BP (NYSE: BP) at the closing price of June 16, 2010 will under-perform $10,000 evenly invested in Transocean (NYSE: RIG) and Noble (NYSE: NE). Assume dividends are not reinvested and remains as zero-yield cash.

At present, BP would have returned US$14,392.46 to investors, while RIG and NE would have returned US$14,198.52. If I had the ability to close this bet for a mild loss, I would – the political risk for the three companies in question have completely gravitated toward the “status quo” once again after the Gulf of Mexico drilling accident. Drilling capacity is likely to rise, depressing the value of the contractors and favouring BP in this particular bet.