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Tokyo based, expat Cape Bretoner. Learning to live in a de-leveraging world. Better suited to the crusades. CFA & FRM charter holder. Disclaimer: @Firehorsecaper reminds investors to always due their own due diligence on any investment, and to consult their own financial adviser or representative when warranted. Any material provided is intended as general information only, and should not be considered or relied upon as a formal investment recommendation.
Joined Jun 23, 2015
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OIL SERVICES: OFFSHORE DRILLERS; $SDRL DRILL, BABY DRILL

Offshore Drillers: Seadrill Limited ($SDRL); Leap Option on Higher Oil; Drill Baby Drill – Offshore

The 10% rise in Seadrill Ltd (SDRL US) equity to $1.91on Oct. 11, 2019 is rare and masks the 81% drop ytd in 2019. Seadrill has been the laggard, but the other names in the offshore drilling space are down >50% as well (the largest player $3.7bln mkt cap Transocean Ltd (RIG US) is down 45%). Seadrill Ltd. is a micro cap, $190mm.

Macro weakness and high levels of financial leverage are the primary culprits for the performance of the group.

The world needs oil and increasingly the only viable answer is deepsea. Frackers, oil sands, deepsea; Seadrill is a concentrated bet on offshore being deemed the “cleanest dirty shirt”. 5-bagger on an 18th month time frame provides an ample, if not compelling risk:reward profile. Dig deeper in the article that follows.

$SDRL Sunrise or Sunset?

Any discussion of Seadrill Limited must start with its founder John Fredriksen (self made fortune, net worth exceeding 11 billion):

#129 John Fredriksen His offshore drilling rig firm Seadrill emerged from bankruptcy in 2018, with Fredriksen helping to raise about $1 billion in new debt and equity. His biggest holding is Marine Harvest, now named Mowi, which has rolled up competitors to become the biggest fish farmer in the world. (source; Forbes)

Mr. Fredriksen is key to the Seadrill story and is the main driver. Seadrill’s plan of reorganization (Ch. 11) was filed in September 2017 and they emerged from bankruptcy in July 2018 after a protracted negotiation with creditors. Fredriksen had $5 billion of his worth tied up in Seadrill at peak in 2014. As part of the restructuring plan, largely crafted and executed by John Fredriksen and a compact investor group, no draconian DIP financing package was required, importantly;

-Maturities on $5.7bln of secured bank debt were extended (5 years). 97% of secured lenders agreed to the plan. Debt servicing begins in 2021/22.

-Unsecured debt of $2.3bln was converted to equity in the new company (15% ownership stake). 40% of bondholders were onside with the restructuring plan.

-Legacy equity holders were effectively wiped-out (dead last in the cap structure) garnering 2% ownership in equity in newco.

-New money, $1.08bln in fresh capital came from Fredriksen and his investor group, $200mm in equity and $880mm in secured notes;

Seadrill New Finance Ltd. bonds with a coupon of 12% and a 2025 maturity have been holding in despite all the calamity in the listed equity. SDRLNO 12 7/15/25  last traded $94.166 for a yield to maturity of 13.48%. Bond investors are a conservative bunch overall. Seadrill Limited tendered for up to $311million of the noted bond issue in April 2019 at $100.70 (post the tender offer closing just over $476mm remain outstanding). Typically not a move you see from a company experiencing death throws. As a comp, the Transocean bonds of equivalent maturity are trading with a yield of 10.9% (RIG 7 11/1/25 @$85.74).

Seadrill Ltd. reported $1.5bln in cash after the Senior Secured Notes tender offer and an order backlog of $1.bln (Q2 2019, 30 June 2019).

Usually equity holders are the optimists and debt holders the pessimists (as their coupon and par at maturity are their capped upside). In the case of Seadrill Ltd., the roles appear reversed, where the debt is holding in and the equity has been in virtual free fall. When the roles are reversed “hedged high yield” can often be a compelling trade, where one buys the bond and concurrently sells the related equity (notional on the equity short matching the expected recovery rate on a filing). The canary appears to be fine in this example, with the bonds trading in the mid 90’s in price terms.

One potential reason for the recent relative weakness in $SDRL shares (vs. peers) is the recent delisting of affiliate company, Seadrill Partners, by the NYSE. The company has stated they will appeal, but now trade otc (pink sheets). The delisting was due to the low market capitalization of Seadrill Partners.

Seadrill Limited has the newest high spec drillships and semi-submersible fleet in operation globally, with a lease up rate approaching 80% (versus sub 70% for the industry). Drilling contract take up shows signs of recovery (5 of the contract confirmation months in the last 5 years have taken place in the last 15 months, Brazil, Angola and India active). The harsh environment floater market is tight. New, higher spec rig pricing could be the catalyst for an upward trajectory in overall rig pricing (Seadrill Q2 fleet status attached).

Given the skull and cross bones warning of the sector, based on recent equity performance,  and Seadrill Ltd’s track record of flying too close to the sun from a leverage perspective (Ch. 11 exit in 2018), modest allocations are recommended (2% max). Despite recently being re-rated lower due to a combination of multiple de-rating (compression) and EBITDA revisions lower by the street, Transocean and Valaris are the other 2 players in the space warranting further vetting. Their stories are in some ways cleaner, but both are working through ill timed acquisitions which added to their leverage and hence uncertainty.

With respect to John Fredriksen there is certainly some key man risk. While John is in good health and certainly has experience to pull off a Seadrill resurgence, he is 74 presently.

Deepsea competitors:

1.) Shale

Some think the sun is setting on the oil shale revolution. A investment in Seadrill Ltd. is partially a bet on shale’s demise (it costs little comparatively to drill shale). Wells are reaching peak production quicker than modeled before declines set in, requiring a faster drilling pace to maintain production. Some firms expect the maintenance spend to exceed 80% of total as soon as 2021.

Most prime areas have been drilled already in the US shale patch and prospect quality is low. Prime offshore sights have B/E well below shale. Exxon recently announced plans to reconsider long shelved plans to a tap a 100 billion barrel oil field in ultra deep waters off Brazil. Exxon recently expanded the oil resource in Guyana (wedged between Venezuela and Brazil), first announced in 2015 (Liza discovery, 190km offshore Stabroek Block) and with the recent expansion is surely the biggest E&P story of the decade with economics far surpassing the best of US shale, a potential Oman by 2026.

National Oil Co. (NOCs) are active in the semi submersible space whereas the international oil companies (IOCs) tend to dominate the deepwater space in terms of rigs (Exxon, Eni, Shell, Equinor, Oxy, etc.).

2.) Oil sands

Growing restrictions on fracking have US shale players, frustrated by well performance issues and a lack of profits looking north to the Canadian oil sands. The supreme court in Canada changed the law to have environmental reclamation rank ahead of all other claims in bankruptcy going forward. Several of the biggest operators lease their land from indigenous tribes.  Ongoing infrastructure issues abound and while some have been tempted in on valuation metrics, this might me my #1 choice for stranded asset status, at least as long as oil remains < $100 barrel.

Geopolitical backdrop:

Saudi Arabia:

Recent attacks on critical petrochemical infrastructure in Abqaig, Saudi Arabia in mid September has highlighted the fact that the global sheriff, the United States is less omnipresent. While production was brought back on line quickly, the fact that 10 drones could wreak such havoc was a wake up call to the world with respect to potential global oil supply disruptions going forward.

In absolute terms Saudi is the 3rd biggest spender on defense, much of it coming from US suppliers. Only the US and Saudi spend >8% of GDP on military spending. China is the 2nd largest because of the size, but as a % of GDP stand at 1.9%, below the 2% min. threshold recommended by NATO (Canada is 1.5% as an aside).

Saudi Arabian Oil Co., aka Aramco is planning to move forward with their initial public offering (IPO) soon. They will be floating 2% of Aramco for $40bln implying a valuation of $2 trillion for Aramco. Trusted advisors are walking it back to $1.5 trillion given a few factors. While still the world’s largest, the Ghawar oil field is in an advanced stage of depletion. The IPO will be listed exclusively on the domestic stock exchange, Tadawul, not in New York and/or London as initially envisioned. Some of the kingdom’s richest families, some who previously boarded at the Ritz Carleton, have been asked to “dig deep” as anchor investors.

Friday past, the US announced they will be sending an additional 1,800 troops to Saudi Arabia to assist in their defense efforts against and to deter Iran.

An Iranian oil tanker was struck last week on the Red Sea by missiles, less than 100 km from the port of Jeddah, Saudia Arabia on October 11, 2019 (as an aside John Fredriksen ran oil for Iran in the 80’s and was struck by missiles; if you live long enough you get to see everything twice).

Strait of Hormuz:

The Strait of Hormuz is a strait between the Persian Gulf and the Gulf of Oman. It provides the only passage from the Persian Gulf to the open ocean and hence is a both a bottleneck for oil supply and a critical artery for supply to China (>60% passes through the strait).

VLCC shipping rates have skyrocketed in the last week. This is a direct result of the US sanctions on COSCO. A trade deal resolution between China and the US may have seen this relaxed, but as per the latest meeting, much work lies ahead. 11 year highs in crude shipping rates ($11 million for 1 ship topped by $13mm later in the week). Even clean tankers are opting to transport crude at these prices. This hurts China most and helps increase the shipping rates for all.

Summary:

The offshore drillers perform a critical role. Day rates remain 20%+ below 2014 levels, but signs of life abound, due to issues of supply/demand. Oil prices will be the driver and increased geopolitical risk could be the thumb on the scale going forward.

Global PMI’s drifting sub 50 are signaling global slowing and have stoked fears of a global recession, but the world still needs its 1000 gallons of oil a second.

Offshore drillers, a key oil services supplier, could be due for a day in the sun.

Caleb Gibbons, CFA, FRM

@firehorsecaper

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