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).

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Lending Loop – Why even bother?

Lending Loop is one of those peer-to-peer financing companies where you can allow yourself to be the recipient of future defaulted loans in the name of some business cause or another spending it without any real accountability. When you sign up, on top it states “Start investing today and earn a projected return of 5-8% per year*”

The “*” leads to a link with a model that uses words like “projected”, “estimated”, and other such mumbo-jumbo that is nearly as good as a COVID-19 mortality prediction.

Why the heck would anybody want to lend some random small business money at 5% when you can pick a brain-dead debenture (e.g. Rogers Sugar RSI.DB.F, 6.25% YTM) of a publicly traded company that has a billion more layers of accountability, and actual consequences (i.e. owners lose equity) if there is a default?

Finally, during this COVID-19 crisis, we have the following:

We have implemented a temporary hardship program for borrowers that are currently distressed as a result of impacts of COVID-19. This program will allow Lending Loop clients that meet certain criteria to make interest-only payments on their loans for a period of 3 months to accommodate this unexpected event.

I am guessing they are not doing this with the consent of the lenders. If the terms and conditions of the loans are so malleable, why would anybody ever bother putting their money in Lending Loop or other peer-to-peer lending services? This never made sense to me.

This is also why companies like Alaris (TSX: AD) never made sense to me. Companies have to be pretty desperate to lend money at double-digit coupons, and if you’re willing to sell royalties on revenues, you’re likely to destroy the margins that are required to keep your business competitive. It might make sense in specific scenarios (e.g. gold mining streams can make economic sense at times, e.g. “some percent of something versus 100% of nothing”) but gold miners are not like widget manufacturing where you have to squeeze out 200 basis points of margin in order to make a living. (Very abstractly, the less competitive the industry is, the more possibility that royalty selling makes sense).

And finally, if you want your double digit yields on questionable debt of corporations, there’s always gems like Bombardier unsecured, which when I last checked would net you 20% YTM if you feel brave. Less riskier than most stuff on Lending Loop and higher potential return, in addition with the likely possibility of getting a few morsels of recovery if they defaulted!

The future of monetary policy

We are all forced to be closet macroeconomists and for that, I’d suggest reading Ray Dalio’s primer on money, credit and debt:

More specifically, the ability of central banks to be stimulative ends when the central bank loses its ability to produce money and credit growth that pass through the economic system to produce real economic growth. That lost ability of central bankers typically takes place when debt levels are high, interest rates can’t be adequately lowered, and the creation of money and credit increases financial asset prices more than it increases actual economic activity. At such times those who are holding the debt (which is someone else’s promise to give them currency) typically want to exchange the currency debt they are holding for other storeholds of wealth. When it is widely perceived that the money and the debt assets that are promises to receive money are not good storeholds of wealth, the long-term debt cycle is at its end, and a restructuring of the monetary system has to occur. In other words the long-term debt cycle runs from 1) low debt and debt burdens (which gives those who control money and credit growth plenty of capacity to create debt and with it to create buying power for borrowers and a high likelihood that the lender who is holding debt assets will get repaid with good real returns) to 2) high debt and debt burdens with little capacity to create buying power for borrowers and a low likelihood that the lender will be repaid with good returns. At the end of the long-term debt cycle there is essentially no more stimulant in the bottle (i.e., no more ability of central bankers to extend the debt cycle) so there needs to be a debt restructuring or debt devaluation to reduce the debt burdens and start this cycle over again.

Does this remind you of anything that is going on right now?

With monetary policy at an effective zero bound (I don’t really care whether the interest rate is 0.25%, 0.75% or -0.5%, it is effectively zero and the negative bound is the ability to store paper currency underneath the mattress), the ability for central banks to stimulate the economy (without causing reams of economic damage with massive inflation) is effectively toast. The large recent failure was to not attempt a better normalization after it was perfectly evident the 2008-2009 economic crisis was passing, coupled with the US government not being fiscally responsible. In Canada, Harper was on the right track (he got the budget balanced and the Bank of Canada was able to escape the economic crisis with far less intervention than the US Federal Reserve), but Trudeau and the Liberals have done an exceedingly fine job of reversing this, and now Canada is basically in the same boat as the USA – central banks are employing quantitative easing as a last resort to stimulate economic activity.

The big difference this time is that when the government also mandates a shutdown of the economy, it doesn’t matter how much stimulus you put out there, the real economy is not going to respond. Why would a restaurant owner at this point in time make any investment at all when you have talks of COVID-19’s “second wave” and this can just start all over again?

The real interesting implications occur after one asks what the new currency will look like when it goes from fiat back to something that the public has confidence in. Will that be gold, or bitcoin (or some other crypto)? My big problem with bitcoin, and most cryptocurrencies in terms of them providing a “hard asset” is the dominance of the hash – most of the power in the network has been increasingly centralized to miner pools and it is getting to the point where the possibility and allure of collusion is effectively the equivalent of 51% of people deciding to steal the 49%’s capital.

I would deem it more likely that central banks will try to introduce a parallel currency.

The blowup in oil – and what’s next

I posted about it the oil situation earlier, and here are some ramifications: Interactive Brokers took a $88 million hit on client margin accounts on oil futures:

Several Interactive Brokers LLC (“IBLLC”) customers held long positions in these CME and ICE Europe contracts, and as a result they incurred losses in excess of the equity in their accounts. IBLLC has fulfilled the firm’s required variation margin settlements with the respective clearinghouses on behalf of its customers. As a result, the Company has recognized an aggregate provisionary loss of approximately $88 million.

Other financial institutions and/or funds were probably cleaned out on this transaction as well.

Anybody investing in the USO ETF (US Oil) is actually investing in a combination of the two front month futures contracts (retail is crazy to use this ETF as an oil instrument – if they really feel like ‘safely’ speculating on oil, better to put some money in XOM, COP, or if they insist on Canada, SU or CNQ). At the time of the May 2020 contract calamity, USO had zero exposure (they already rolled over to June), but today there was visibly obvious trading action on the charts that are classic liquidation trade signs:

Whenever you see “V” type charts, especially sharp ones that you see here, this is most likely due to a function of margin trading and customers getting cleared out en-masse – a cascade of market sell orders in the accounts with insufficient equity. Conversely if you’re bright enough to put some layered orders on the buy side (and have sufficient fortitude to not catch the absolute bottom since you have no idea when the forced selling will end) you can make huge profits in a very short period of time.

Needless to say the negative oil prices on the May 2020 contract (coupled with some rumours of Supreme Leader Kim) has increased the perception of market volatility and risk, and I have been nimble enough to reduce risk and get out of the way of any potential blowups of this magnitude. The net result of this is that a whole bunch of oil producers are going to go belly up and this will drastically reduce the supply going forward, probably at a higher rate than the decrease in demand exhibited to date.

Now my next question is: Are banks the next to drop? They are ultimately backstopped by central banks, but I deeply suspect they are in more trouble than it may seem. People looking for “safe dividends” in Canadian financial banks should be very, very cautious right now. It’s very difficult to predict how much of their lending will go belly up.