Well, I have bad news for you. Today's "bargain" price is tomorrow's "falling knife." The brutal truth is that there is no correct price for anything. There's only a price that is a compromise between a buyer (who is greedily looking for the lowest springboard to appreciation), and a seller (who is either afraid or is in turn seeking greener pastures for the same ultimate reason). Nobody buys because they truly think their purchase is overpriced, and few sell because they are convinced the item is extremely cheap. Notice, though, I said "few" in the prior sentence. And that's really important. People do, on occasion, sell things for tremendously low prices because they think they have little choice. They sell in despair ("I give up, this damn thing is headed for the toilet"), or they sell to raise cash to meet desperate needs (say the dreaded margin call).
In the broad flow of events, markets swing irregularly from euphoric highs to irritably dreary years of minor ups and downs, to occasional moments of sheer terror. When the market has risen inexorably for six years (hmm, remind you of any recent period?), people start thinking the abnormal is normal, and grasp for things that have already risen to the stratosphere. You hear variations of the greater fool theory underlying the purchase recommendations of market professionals ("yes, it's relatively high for the moment, but long-term dynamics will make today's price look trivial" - think of the endless flow of Amazon hype).
It is the moments of terror, though, that really interest me. While they seem like extreme outliers, I find them popping up fairly frequently: 2001-2, 2008-9, the euro crisis of 2010-11, and today's oil price collapse. If the crisis is severe enough, truly irrational behavior results. I've documented the extreme opportunities that occurred in the great recession and the euro kerfluffle. Now, lo and behold, they're on full display in the oil sector.
After trumpeting the "Case for $35 Oil", Barron's recently raised the ante ("The Case for $20 Oil"). If it hits that $20, what do you think Barron's next prediction will be? Of course, NOBODY (well, maybe a Saudi or two) makes money at $20/barrel, and very few at $35. So, those lows will disappear in the blink of an eye. In the last oil collapse (2008), oil plunged from $145 to $32 a barrel. So, it's pretty safe to say that $32/barrel is a VERY low price, as is the recent $44. The bulk of the world's producers have break-even somewhere around $50, so that too is a pretty low price. At $60, most folks start making money, but few make a whole lot. So, $60 is also a pretty low price. Fracked oil has a median break-even around $65. So, even $65 looks reasonably low.
The tug of war in the next few years will be between the low-cost producers who can make a buck below $60 and those who need to see $80 or more. Political winds will, at times, distort this struggle to the upside, while prolonged dips below $60 will dampen production. Frackers, after all, have no ideology; they'll postpone or halt drilling when they see no way to make a good buck. And, they'll jump right back in when they do see a way.
The quick response capabilities of frackers and other alternative producers (plus steady growth of wind and solar energy) pretty much guarantee that we won't see historical oil highs ($145 in 2008, $124 in 2010) any time soon. So, you can safely say that prices north of $100/barrel are high, just as $32 or $44 is low. So, that's what cheap and expensive are in the world of oil, at least for now. IMHO.
In writing about this sector absolutely flattened by recent oil price drops, one company in particular interests me: the maritime driller Transocean. It recently bottomed (maybe) at around $15, and is now hovering around $18. Are these low prices? Well, there's a fair amount of ink arguing that it's too high. A Motley Fool investor just threw in the towel (after a 62% drop in his holdings of Transocean), and hints that others should too (even though he admits the company will probably trade sharply higher in the near future). As with the price of oil itself, though, I think it's fairly obvious that the company's price is cheap. The blood in the water helps me see this.
So, forget the bottom, just focus on the essentials: will the company survive the present crisis, and will it ever have a future in the future? I've think Transocean (symbol RIG) will survive short-term (adequate cash, fairly modest demands on that cash). Long term, the question relates to whether oil drillers, as a group, will be needed. Well, much as people are focused on fracking as a direct threat to ocean drilling, it's also quite clear that frackers represent incremental production. Their costs are relatively high (probably break-even north of $65), and relatively short well-life requires constant (and probably ever more expensive) replacement of supply.
Ocean drilling is targeted to the largest and relatively least exploited sources of big-time supply. Roughly half of world production comes from offshore drilling at various depths. While exploration and development is expensive, lifting costs (simply pumping the stuff) are quite low, on average $10/barrel, with total upstream costs around between $41 for offshore shelf, $51 for deepwater and $56 for ultra deepwater oil. Even the expensive rigs therefore compare favorably to highly-hyped fracking. So ... is there a future for the sector? Of course there is. When oil returns to $60, new business will start trickling in, while there will probably be a rush once $80 is reached.
Right now, the balance of fear and greed is overwhelmingly on the side of fear. Taking action is hard, things might get even cheaper. True enough, but do you seriously think oil will STAY at $20, or $30, or $40? So, I think doing SOMETHING makes sense. I'm buying Transocean calls (10 of January, 2017) for astonishingly small time premiums (around $.50 per share for a two-year leap). I've already locked in some spreads (selling calls 18 of 2017), with a maximum profit to expiration of 140%. That profit will be realized if the stock closes at or above $18 in January 2017. Will it? Heck if I know. But I think the odds are heavily in my favor, as the stock closed at $18.51 yesterday.
I'm also nibbling at the bonds, particularly an issue of Global Marine (7%, 6/1/28) now yielding over 10% to maturity. This issue is actually an obligation of Transocean, but apparently the folks considering buying it don't know. The bonds yield a full point higher than similar Transocean bonds, even though the two are actually the same entity, with the same credit rating (Baa- Moody's, subject to possible downgrade). I wrote about the math of buying such bonds in my last post: a four to five year doubling of the investment is entirely feasible.
Update: one week later, 2/9/15. Busy week. The stock has moved from about $18.50 to $20.44. I have bought, in total, 65 call options, most 10's of 2017, at prices varying from $7.37 to $9.80. As RIG rose, I began selling call options, first at 18, then at 20 (all of 2017). All but 10 options are now spread-paired, with a maximum profit potential of $29,000 if the stock stays at or above $20 by January of 2017. Today's close of $20.44 makes the prognosis highly favorable.
My sense is that RIG is will approach some version of "normal" valuation around $30, so I intend to keep the process up until it approaches that level. As during the past week, I'll try to buy call options with the minimum possible time premium (perhaps $.50 or so), and pair then pair them with a short call at the money, as the stock rises. Each two point rise allows for a 150% profit on the spread, so I might get five more chances to ride this wave. The reason I'm selling calls at the money is, I hope, obvious: to limit risk while still allowing for fairly huge gains over a two-year period.
Update: February 18. Transocean has cut the dividend by 80%, and fired the idiot who let Carl Icahn bully the company into an unsustainable $3.00 rate in the first place. This is good news. A new sense of urgency and common sense will lead the company to cut back on buying hugely expensive new drilling rigs, and thus conserve enough cash to maintain the company's investment grade credit rating. So, the bonds, will, I am fairly sure, start rising sharply. As will the company's stock. At today's $19/share, my call positions are in the money, but only slightly. Any number of things could cause crude to rise sharply from today's levels, and the stock will float with that tide. Is this the sure thing of 2008-9? No, but it's not a whole lot removed from it.
There is a huge range of opinions about Transocean, with one Chicken Little predicting a bottom of $6/share, and other folks projecting $25-30. So, this is the exact moment when predicting things can, or should, establish soothsaying credibility. I'm doing frequent updates to document, here and now, what I am expecting to see down the road. By the way, when I edit older posts (and I do so, frequently), it is always to correct word choice and thought flow. I don't believe in modifying predictions based upon subsequent events. So, if future events make my Transocean thread look witless, then so be it.
Update: February 26. Another adventurous week, this time to the downside. Transocean has sagged to just under $16/share. While my overall options position is showing a small loss, I am comforted by the observation that the position would, ultimately, result in a decent profit by January, 2017, assuming the stock stayed right where it is now. That is due to the fact that the short options (18 and 20) are both out of the money, and would expire worthless in 2017 at today's price. The long calls, however, are still solidly in the money, and would be worth the final 2017 price less $10. The upside I outlined above continues unchanged: roughly 150% if the stock closes at or above $20 in January of 2017. By the way, Moody's just downgraded the debt to Ba1, just into junk territory. S&P and Fitch are still rating it investment grade. While all three might fall into line, I wouldn't be surprised if the split rating continued awhile. Such tag-teaming is not unusual, as it often influences a company to fall into line financially. So, let's see what transpires next.
Update: 5/14. Even more action, now on the upside. After tottering just below 16 (which brought out a wave of sell-side advice, with the above-cited Chicken Little now predicting a bottom of 3!), the stock has since shot up to 21. Yesterday's pundit? "Transocean is 20% undervalued." My spreads are in the pink, needing no further up movement to achieve their maximum profit in January 2107. Upon reflection, I decided to stop establishing spreads and sold back a few unpaired calls for a $2000 profit. Instead, I intend to focus on the bonds. I've repositioned my IRA, selling some mature (and richly priced) positions to make room for the Global Marine 7% bonds of 28, average purchase price around 77. I have also used margin to buy a fairly substantial number of bonds in my taxable accounts. The margin ratio is roughly 50%, so the yearly return with IB's 1.25% margin rate is roughly 16%.
My shift in emphasis is based on the consideration that I have little idea of what the "correct" price is for Transocean (yeah, 15 is very low, 60 is very high). I do, however, have a very clear idea of what is sensible for the bonds: par, or better yet, 110% of par. That's based on a simple comparison of their present yields with a broad spectrum of high level junk bonds. Even considering the risk, they are wildly underpriced. Now trading around 83 (up from the very low 70's), the bonds still have a long way to go. If they regain their investment status (very very likely, as the company seems to be weathering the oil crisis quite well), the bonds will probably go up to 120 or so. I intend to be along for the ride.
Update: 11/9/15. Movement in both the stock and bonds has been very negative, although both are now slightly above their lows. Moody's rating has ticked down one notch further, to Ba2. I took the the opportunity, following a spurt in the stock price to the mid 16 level to close out my option positions, with an overall profit of $7500. Not great considering the risk, but I won't complain. The bonds continue to sag, with my Transocean 7% of 28 positions hovering around 60. So that bargain price of 77 mentioned above now feels more like a falling knife. Global Marine's implied yield of 13.5% to maturity is a full 2% higher than its Transocean sisters, a persistent and illogical disparity. It stands out like a sore thumb, as other companies with similar yields are well down the junk ladder from Transocean. It is also, of course, a temptation for the brave. I have, however, temporarily reached my limit for bravery. I won't sell, but would rather wait for the bandwagon to roll forwards before jumping back on.
Still, there is plenty of reason for good cheer. Of paramount importance is the way Transocean has responded to the turn-down. They've cut the dividend entirely, delayed the delivery of multiple rigs and cold-stacked a bunch of other units. Better yet, though, from the point of view of a bond investor, they have attacked debt with a vengeance. In the last three quarters alone, they have retired $.9 billion of current debt, as well as $.4 billion of longer term debt, a 13% reduction of total debt. Since 2011, Transocean's liabilities have shrunk from $19.4 billion to $11.8 billion. That's a 39% reduction and bodes very well for the company's survival down the road. To sum up: from a cash management point of view, Transocean does not look like a junk-rated company at all.
Will this strict attention to finances be good for the company in the long run? That's hard to tell. Those delayed next generation drilling rigs might be sorely missed in a couple of years, hurting long-term growth. But, one of the great things about being a bond investor is that we don't need to worry so much about long-term growth. The stock-holders can gnaw on that. Our concern is more basic: will Transocean honor its debts long enough for us to cash them in at par? Ask the holders of Transocean's 4.95% of November 2015 what they think!
11/16/15. One additional note: a Motley Fool article "Transocean's Recent Earnings Show a Company on Track to Survive" dated 11/14/15 reads the figures far more positively than I did. The article states that Transocean has reduced its total liabilities by $2.6 billion in the last year. Its net debt / EBIDTA ratio of 2.03 and current ration of 2.68 compare very favorably to fellow driller Ensco. But Ensco has a Moody's investment grade rating of Baa2, three levels higher than Transocean! Ensco's debt trades at a maximum yield to maturity of 9%, compared to Transocean's present 14% for Global Marine bonds. As I said above, something is seriously out of whack here. Transocean doesn't look at all like a junk-rated company.
12/14/2015. WHEEEEEE! The roller coaster (I hope that's what this is) hurtles down! My Transocean bonds (7% of 2028) have cracked 50 on the downside! That's a yield to maturity of nearly 18%! Why, in light of the fairly benign third quarter results cited above, is this happening? I think I know, or at least, I hope I know. The ratings cut into junk-land has put pressure on funds of various kinds to offload the Transocean/Global Marine bonds. It's now December, and I think the year-end deadline is causing a sharp imbalance in the supply/demand ratio. So, even though I'm fairly terrified, I've started buying ... again! Transocean's mere survival will make these bonds soar, and I suspect the ascent will start in January. I promise an update then, even though my chin might be smeared with egg. You can take a picture to scare your kids.
2/26/16 UURRRPP! Still down! Most recent trades for the Global Marine bonds are just below 40! And yet ... full year results are in for 2015. Despite retiring $1.5 billion in debt, and buying new ships to the tune of $2 billion, the company's cash is actually up for the quarter, to $2.3 billion. With the line of credit, that's $5.3 billion, cash in hand, to cover future expenditures of $3 billion in debt maturities and $2.4 billion in new builds between now and 2020. So, the company just has to earn $100 million in the next three years to keep afloat. With a backlog of $16 billion, that's a no-brainer.
About the backlog: a lot of commentary goes into cancellations, treating them as a disaster for the company. From a cash-flow point of view, that's simply wrong. What really happens is that Transocean gets a hefty payment, right now, to compensate for the loss it suffers for not doing future work. These contracts were written back in the days when deep drilling rigs were in peak demand, and so the penalties are severe. In effect, Transocean books an immediate profit, gets an immediate infusion of cash, and is still perfectly free to hire the rigs out at any price they can get. Sure, it will be a pitiful day rate, but even that represents additional cash flow.
So, allow me a moment of sheer speculation, as I have no knowledge of the contracts Transocean has made with its many clients. The company's gross margins are somewhere in the 50% range: ie, $1 in earnings for every $2 in billings. At present, I think it's better than that. So, a penalty clause for early cancellation will certainly be designed to compensate the company for a substantial percentage of that profit. I'm gonna guess $25% of the contracted amount. If that's right, then cancelling the entire backlog would still bring in $4 billion, for which the company would perform zero work.
So, the 2016, 2017 and 2018 bonds look totally safe, even though some are trading to yield 20% to maturity. This is the surest bet I've seen since the US government basically guaranteed the banks' debt in 2008. The bonds with maturities past 2018 are another story, but still a good one, I think.
So, let's look at 2019. Assuming the company has tapped its line of credit to pay off bonds maturing in 2018, Transocean would need to come up with $3 billion to pay off that line. Since I am hypothesizing a minimum of $4 billion in backlog revenue going forward, that would result in $1 billion in positive cash. With capex complete, the company would have a year of breathing space, with no debt due. Then, between 2020 and 2022, there will be an additional $2.7 billion of debt to repay, say a little over $3 billion with debt interest. Over that four years, therefore, the company needs to come up with roughly $2 billion of cash to stay afloat. Transocean could sell stuff, at a loss probably, but $2 billion is entirely possible. OR, the company could resume selling its product, deep and mid-water drilling, once demand recovers. Will that recovery occur?
While things look bleak right now, is it reasonable to assume they will be equally (extremely) bleak in 2020, 2021, 2022? With the world gulping 35 billion barrels of oil a year, while replacing a modest fraction of that in exploration, will the demand for drillers never recover? While the demise of oil is touted frequently, how will the hundreds of millions of new Chinese, Indian and Brazilian middle class entrants fuel their new automobiles? With hydrogen or electricity? Ha! Oil demand will rise, inexorably, while supply will be challenged, inexorably.
Update: March 23, 2016. There are signs the worst is over. Crude oil prices have soared from about $26/barrel to a present $41. That's a fat 57% rise! Of course, who would have been wise enough to start buying at $26? Not I. However ... Those 7.375% Transocean bonds of April 2018 sold down briefly to below 75, an annual yield to maturity of nearly 25%. While one might have legitimate concerns about bonds maturing past 2019, it appeared absolutely obvious to me that Transocean's cash hoard of $2.3 billion and line of credit of $3 billion made the redemption of the 2018 bonds nearly certain. So, I started buying. Just a day or two later, the idea seemed to percolate widely. The price jumped quickly from 74 to 90, and is now hovering between 92 and 95. At 95, the yield to maturity is still juicy (11% or so), so I've continued loading up along the way. With one-to- one margin, the two-year return will still be 40%! To make the story even sweeter, Transocean just announced a delay of up to four years in the delivery of five new drilling rigs. This means the company will have an additional $500 million cash in hand (in addition to its present $2.3 billion cash hoard and $3 billion line of credit). So, that's $5.8 billion available to pay off $2.7 billion of debt and $1.3 billion of capex between now and the end of 2018. Even if the company didn't earn a dime in 2016, 2017 and 2018, there would still be a cash cushion of $1.8 billion. But a considerable amount of revenue (as discussed above) is nearly certain. A mere $1 billion yearly would enhance the cushion by 50%
Update: July 2016. The uptrend continues, with bumps. Oil is now hovering around $45 per barrel, having peaked recently at $50. Transocean's stock has been on a roller-coaster. It plunged to $8.50, only to soar to today's $12.14, a rise of 42%! Across the board, the bonds have risen sharply from drastic lows. The action has been particularly robust in the near maturities: 2018 and 2020. The 7.375% 2018 bonds are now trading above par. The 6.5% bonds of 2020 are now at 94.
Two things account for this sharp improvement. One is the delay Transocean negotiated in delivery of new-builds into 2020-21. A second step was just announced: the company will issue new bonds in the amount of $1.25 billion, maturing in 2023. At the same time, they announced a tender offer of $1 billion to redeem bonds maturing in 2020, 2021 and 2022. Since the 6.5% bonds of 2020 represent $910 million by themselves, it is reasonable to assume that they will absorb most of the buybacks. The bonds now trade at roughly 94 because the tender offer is at 94.5. The discounts on the other two issues are sharper, so they will probably not be tendered in bulk.
So, why target 2020? Well, there is a large challenge then. In addition to approximately $.9 billion of bonds coming due, the company also needs to pay out $1.9 billion for new ships. If the company's core business continues to languish over the next four years, it would be challenged to come up with that nearly $3 billion in cash. The new bond issue is precisely targeted to address this cash flow problem. It gives the company an additional three years to handle its debt concerns. Make no mistake: the tender means that Transocean is expressing high confidence in its ability to weather the period from 2016-2019.
What does the tender plus new bond issue portend for later issues (2021, 2022, 2027, 2028, 2029, 2031, 2038, 2041)? Well, according to Moody's, it's a near-catastrophe. Their rating was promptly cut to Caa1, a stomach-churning two notches below their prior rating of B2. Their reasoning is that the new bonds will have provisions ensuring they are favored over the company's other senior debt. Fair enough, but ... really? On the narrowest front, the net increase in debt is only $250 million, quite modest in comparison to total outstanding debt of over $7 billion. And, let's be clear, delaying the grim reaper might mean he doesn't visit at all. Companies, unlike people, don't necessarily die at all.
Particularly curious is that the downgrade applies equally to the specific issue that is most likely to be retired: the 6.5% bonds of 2020. Even if a holder doesn't tender, it seems nearly guaranteed that the remaining scraps will be paid off upon maturity in 2020. These bonds aren't weaker than before; they are virtually as safe as the equally dismally-rated 2018 bonds.
I regard Moody's downgrade as a hissy-fit, addressing a real, but narrow risk. Sure, in default, the post 2023 bonds would suffer. But guys, the likelihood of a default is substantially lower now than it was before the new issue. The company's near-term cash crunch has been alleviated, while the cushion increases by $.25 billion.
A Caa1 rating shrieks doom, and doom soon. That's simply wrong for a company responding to a threat four years down the road. Sure, bad things might happen after 2020, but even then, Transocean has a variety of alternatives. It could issue more debt, issue more stock, further delay delivery of new ships (with penalties, to be sure) and/or sell off the very new-builds that created the cash crunch in the first place. At a fire-sale of fifty cents on the dollar, Transocean would pull in up to $3 billion to toss to circling p(c)reditors. None of these steps merits rave reviews, but each could keep the wolf from the door.
Caa1 also proclaims that today's abysmal environment is unlikely to change within the next four years. Well, that might be true, but linear projections of short-term trends are usually stupid. The path of oil prices has been repeatedly marked by sharp declines followed by equally sharp up-turns. Most experts point out that total oil consumption is destined to rise steadily, regardless of Western conservation efforts. At the same time, replacement of existing oil reserves continues to lag drastically. Bottom line, I think a supply crunch is far likelier for 2020 than continued slump.
As long as the 2020 bonds trade below par, I think they're a screaming bargain. Don't tender them; instead collect the income till maturity, along with that extra five point gain to par. Without leverage, that's a 36% gain. With 50% leverage, it jumps to 65%. Better yet, wait until the tender premium of 3 points passes (July 18). The bond price will probably fall to 91, or less, once the tender period has ended. That will represent a huge buying opportunity: a $900 gain to par on ten bonds plus $2925 in interest makes for an unleveraged 42% return to maturity (77% with 50% margin). That's the kind of highly favorable risk/reward you can find only rarely in bonds.
Once the 2020 bonds approach maturity, it will be time for the new 9% bonds of 2023. Since they will have status senior to later Transocean bonds, they too have very nice potential. Of course, pricing will be critical: it would be nice to pick them up at or below par. Considering that the later bonds now yield in the 13% range, that should be distinctly do-able. (Update 3/13/17. Or not. Looks like these bonds are not - yet - available for public trading. Dunno why.)
To prepare for this pivot, I've been selling off part of my large position in the 7% Global Marine bonds of 2028. Since I bought a large slice of them at prices as low as 41 (yes, 41!), these trades have been cash-neutral. At 66, I can pair the sales against bonds bought at at higher prices to establish tax losses, but mentally match them against my rock-bottom purchases. As long as prices hold up for the Global Marine bonds, I can continue the pivot with only nominal losses, while substantially enhancing the safety of my overall Transocean exposure.
As to the 6.375% notes of 2021 and the 3.8% notes of 2022, well they'll require more fortitude. Their potential returns are large, though, and the risk is significantly lower today than it was before Transocean issued the new bonds. Absent an early default, they will be long-gone before the post-2023 holders are possibly savaged by their drop in priority in bankruptcy court. Even so, I think these longer bonds are a better bet than they were a week ago.
Moody's, perversely, has in general started being super cautious after its criminally negligent treatment of mortgage securities leading up to 2008. Over-reacting now, Moody's, won't make up for those catastrophic errors eight years ago. I'm just itching to revisit this issue in a couple of years. I'll bet Moody's present stance will look just as stupid then as it clearly was in 2008.
