The fruit is ripe. Now what?

This is one of those moments of inflection: the fruit is ripe, but the future is murky.

For several years, I have been on a lonely, silent crusade to identify value, and act upon the insights of my search.  The sore thumb of value investing has been energy: specifically oil, and its protracted, painful collapse.  From a peak of $107 per barrel in 2008, it plunged to a low of $37 in 2016.  Such a swoop is by no means unusual: prices hit $111 in 1980, and dropped to $32 in 1986.  A price of $43 in 1990 was followed by 1993's $28.  By now, a sane person must understand that volatility in oil prices is .. normal.  But that's not the way people look at things.  Each high has been accompanied by endless speculation that "this is just the start"; peak oil has arrived, and a world of endlessly expensive oil is just beginning.  The troughs also bring out gloom and doom, none more emphatic than the most recent set of predictions that peak oil's opposite (obsolete oil?) is on the horizon.  Shale oil drillers, along with electric automobiles, windmills, solar arrays and gigantic storage batteries, mean the end of fossil fuel, sooner rather than later.  So, oil will slump into irrelevance.  Stay away!

Except, it looks like the cycle is entering the next up stage.  2017's average domestic oil price has hovered around $43, up sharply from 2016.  And now there's a steady drumbeat of news regarding production cuts, and potential supply shortages.  The hurricanes have had an effect, but it's dwarfed by the stark fact that new production doesn't begin to compensate for drawdowns of existing supply.  So, very long term, oil might still dwindle into irrelevance, but in the next ten years, that's a TERRIBLE bet.  

Which brings me (surprise, surprise) back to my favorite value theme: Transocean as a proxy for oil.  Yes, I know it's only one small part of a gigantic tapestry, but it occupies an important niche; one that will unquestionably participate both in the downs AND ups of the industry.  I've followed the stock and (more importantly) bonds for several years now.  A careful, quarter-by-quarter analysis of its financial statements has led me, repeatedly, to predict the company's ultimate survival, and concomitant recovery of its stock (and more importantly) bonds.

We appear to be at an inflection point.  Most of Transocean's bonds have recovered from huge discounts to recent par and near-par results.  My favorite issue, the Global Marine 7% bonds of 2027 are how trading above 100 (par).  Considering that I bought significant numbers of these bonds at and below 40, the effect on my portfolio has been galvanic!

The story is still incomplete: bonds due in 2038 and 2040 still trade at a substantial discount to par (as low as 80), and sport yields above 9%.  And the stock still trades below 11, near the bottom of the range is has traversed since I got on board.  So, is Transocean still a value story?

I think so.  With bonds ten years out trading at par, it is clear that the cautious folks who invest in them are no longer worried about the company collapsing anytime soon.  Certainly, they think it will survive through 2027.  They still clearly worry about the longer future.  And the stock price still reflects deep worry about Transocean's immediate profitability.  But notice, profitability is NOT the same thing as survival.  The company will (bond-holders say) survive long enough to pay its debts through 2027; but it may not be a good investment (say the stock-holders).

Note: both groups might be right.  But it's really interesting that the historically most worry-prone group is now complacent.  To me, that is a good hint at where the stock is likely to go.  Would I bet the farm on it?  Of course not.  Rather, I will still (cautiously) push the bond envelope (maybe the 7.5% notes of 2031).  

And, continuing a theme I pursued awhile back, I'm also establishing paired options; long in-the-money calls with short at-the-money calls.  My present positions (a variety of leaps maturing in 2018 and 2019) will ripen to a gain of $20,000 if the stock closes at or above $10 in 2018 (the first set) or 2019 (the second set).  Since the stock is presently hovering above $10, this scenario looks pretty good.  I also have a few un-paired long calls ($5s of 2019), and am waiting for the stock to rise enough to permit the sale of corresponding 10's or 15's).  The magic point will probably be somewhere around $12.  Sounds like a plan.   Going forward, the story looks good. 

But not compelling.  Transocean can still yield generous returns, but no more home runs.   Frankly, I'm a bit at (Tran)sea.  The Transocean story was very clear to me a couple of years ago.  It looked volatile, and yes, risky.  However, the opportunity seemed to solidly outweigh the peril.  So, I took actions, step-by-step, and waited for the good news to trickle in.  It took a lot longer than I originally expected, but the narrative never changed.  

Now I need to find a new story. 

What will that be?  I have absolutely no idea, just a little faith that moments like this ultimately give way to clarity (and fear, and second-guessing).  

Update: April, 2018.  When you have a solid investment idea and commit to it aggressively, there is usually an extended period of uncertainty.  That's been the case with my recent flirtation with Transocean options.  The stock has been highly volatile, rising to over 11, and sinking back to the mid-nines.  I've used the drops to buy back short calls (which had dropped drastically as the stock receded) and establish new long positions.  I've also been shifting the portfolio from 2019 strikes to 2020.  At one point, very recently, the combined positions showed a paper loss of $14,000.  However, the recent burst to the mid-11 range turned that into a net gain of $18,000.  Now for reap mode!  The upturn enabled me to reestablish the spreads by selling at-the-money 2019 calls.  This locks in a 250% gain if the stock remains at or above $10.  So, to date, I have a total profit of $42,000 in realized and paper gains.  Since the cumulative investment is around $24,000, that's spectacular.  When a bet works out as predicted, the feeling is absolutely ecstatic!

The scenario above has played out at least twice since I began the Transocean option experiment.  Pairing options (long call in-the-money, short call at-the-money) allows for positive outcomes in both down and up markets.  The short calls gain value as the stock drops (that is, you owe less); the long calls gain as the stock rises.  So, you can buy back the short calls after a substantial drop, realizing a gain to cushion the long call drop.  Then, when/if the stock rebounds, short calls at-the-money can be written again.

Basic to this yo-yo investing is a correct judgement as to the long-term direction of the stock.  If Transocean were to begin the two-year cycle at 11 and end at 3, then the loss would be 100%.  NEVER forget that fact.  If it becomes clear that the initial thesis was wrong, then accepting a haircut (say 50%) would be wise, if painful.  This also means that you need to be quite greedy about the upside.  My rule of thumb is to try for a two-fer plus or better.  So, I want to turn a net $4000 investment into $10,000.  That's what my latest set of spreads will permit.  This lets me be wrong twice for every success, assuming I stop the bleeding at 50% for the duds.

The game works best (theoretically) with the longest LEAPS you can find.  The trouble is that the market spreads on the longest LEAPS are generally very high indeed.  So, it's usually best to wait a few months after they appear before buying the in-the-money initial positions.  Then you wait for your prescient judgment regarding the stock to be validated by the market.  After the rise, you can then pair the long calls with short ones at-the-money.  Good luck!

Update:  Just a couple days later.  Now the stock has jumped to $12.60, enabling me to sell another set of covering calls (2020 at 12),  Again, the potential profit for the 25 paired Leaps is 250%.  Selling the at-the-money calls also reduces risk sharply, as my uncovered positions are now down to 35 (from 60).  The swing over just a couple of weeks has been dramatic, over $40,000 to the upside.
And yes, I am very aware it can turn on a dime!  That's why I'm covering as the stock rises.

Update: October, 2019. 
Where to begin?  It's been absolutely horrid!  RIG was at $12.60 in my last update; now it's at $4.53! And that's not even the bottom, which was $4.24!  That's a stomach-churning 66% drop!  So, at least up to now, I've been consistently, terribly wrong about the stock.  AND, I've booked a net profit of $370,000 (income and capital gains) on the various bond and option investments!  The latter have been largely a wash, with 2019 drops pretty much wiping out earlier gains, but the bonds have performed marvelously.  I took advantage of a recent surge in price with the Global Marine bonds, which recent rose again to near-par, to lock in gains and reduce exposure to securities now rated in the CCC range.  This is not to say that I regard the bonds as lost money. In fact, I still own a fair number of Transocean and Global Marine bonds, presently showing a profit over purchase cost. But I'm watching them like a hawk!

Overall, it's been a humbling experience.  Throughout, my conviction level about RIG as a company was high, but faulty.  What does shine through, though, is the resilience of my thesis regarding bonds: they may wobble all over the place, but most of them muddle through.  For every Clear Channel, which ultimately died after a decade of torment, there are twenty stories of survival. And even lousy old Clear Channel, if traded judiciously, might have spun off handsome returns for the adventurous.  That's not my game, but there are times when I wonder whether it should be part of the grander scheme.

Black Swans and Crypto-Timing

My last blog was dedicated to my most recent extended topic: identifying value where others see trash, specifically relating to the driller Transocean.  Recent events seem to have validated my analysis, as the company's bonds trudge ever closer to par. This triumphant moment (actually, probably an extended period of small up-ticks) will present its own challenge: what to do next.  What new absurdity will the markets offer?

A great deal of scholarly effort has gone into examining the pricing of publicly traded assets, from tulips to cotton to gold to stocks to options and to bonds.  A very useful insight is that daily price movements are, by and large, random, while longer term movements are, by and large, dictated by large, fairly comprehensible trends (supply and demand, interest rates, the endless cycle of boom and bust, the equally endless swing from euphoria to fear, and the kitchen sink).  Of course, such trends are mostly clear only in retrospect.  Still, a considerable body of mathematical analysis has provided very useful tools for pricing things.  Perhaps most interesting is the attention now being given to "black swans", things that are (or supposed to be) very rare.  They tend to be ignored by standard pricing models, but their inconvenient (and statistically improbable) recurrence has made pricing things far less precise than the mathematically-minded like.  

Black swans have fat tails.  That means, if you look at a standard bell curve of things like IQ and height, you will see very small numbers at the far left and far right of the mountain.  In the world of finance though, the outliers are distinctly more numerous, so ... fat tails.  This means that really unlikely things are not, in fact, quite so unlikely after all.  

The oil collapse is a classic black swan.  No one predicted it, because it was, frankly, stupid.  If a large new supply of oil enters the market, then it makes sense for others to cut back.  That is, after all, the entire point of OPEC.  A little shared pain (by way of production cutbacks) would have made things far smoother for all producers, and the collapse would have been far less severe.  Of course, that's what is finally happening.  But only after a black swan spread its wings.

I personally feel this black swan effect is a boon to small investors like me.  Since they arrive unheralded, and with enormous disruptive effect, mainstream participants (brokers, analysts, bankers, company heads, etc.) tend to react en masse, and inevitably arrive at over-reaction.  With oil, predictions of calamity poured forth: $60/barrel, $40, $30, $20. 

Now black swan math is fiendishly complicated.  While it might lead to substantial improvements in the correct pricing of things (i.e. pay more for a option that is far out of the money than standard models would dictate), that is of little use to the small guy.  However, the large trend, that of extreme over-reaction, is very much open to him.  Will oil really hit $20, or $10, or $5?  If you really don't believe it, then a world of opportunity opens up.  Start looking at things whose pricing seems absurd, and ask whether the experts are missing the boat.  They frequently are. 

One thing that can be very useful to the moderately brave following a black swan is a persistent, stubborn form of market timing.  Analysts will often be in substantial agreement about a company's long-term prospects, but then recommend holding back: it's too soon, they will say.  Read market commentary about Transocean, and this theme recurs like clockwork.  Sure, the company will almost certainly double, triple, quadruple from today's depressed levels ... but it's too soon to commit.  

My question to them is: when is the right time?  When oil prices have already recovered, and the company has just signed a flock of lucrative new contracts, will that be the right time?  Question asked is question answered: NO! It'll be too late.  That double will have already occurred.

Just think a bit about the mathematics of doubling.  If you compound an investment at 7% for ten years, then it will double.  Most investors would be pleased as punch with that: a ten-year double.  So, believing, as most experts do, that Transocean will double, or triple, or quadruple in the next five to ten years, then WHAT ARE YOU WAITING FOR?  Pausing until "just before" the stock takes off is market timing.  What makes you think you'll be any better at it than all the other impulsive monkeys I've derided in past blogs?  If you act now, and it turns out you're five years early for the double, then you compound at 15%!  If you wait until the stock has nearly doubled already, well then you will probably miss the boat entirely.

While this line of thought applies equally to stock and bonds, the latter offer a special reason to act sooner rather than later: you're being paid to wait for the upturn.  Some of my Transocean bonds were purchased at current yields of 20% and more.  Default would have made that choice feel rotten, but the subsequent price recovery has turbocharged my portfolio.  Did I lose a little sleep along the way?  Sure did.  


June 2017.   The stock has dropped, sharply, to $8.50.  This is due to renewed worries about the price of oil (now about $45/barrel).  There's an uptick in commentary about the death of oil; renewables will make the internal combustion engine obsolete ... etc, etc.  The only thing, though, is that the world continues to consume nearly 100 million barrels of oil daily, while replacement exploration lags by a huge margin.  Take a very recent year: 2015.  Net discoveries were 2.7 billion barrels; less than 1/10 the usage for that year. 2016 was worse: 2.4 billion barrels. This imbalance dwarfs ANY potential upsurge in supply from any source, much-trumpeted shale included.  In a fairly short time, there will almost certainly be a huge gap between supply and demand, even if demand falters considerably.  I can't predict the inflection point, but today's extreme pessimism will, I believe, look really foolish in just a couple of years.

Interestingly, Transocean's bonds have held up quite well during the recent kerfluffle; the Global Marine bonds of 2027 have dipped back into the high 80's (from the low 90's), and seem fairly stable there.  Their 9% present yield is certainly junk-level, but half of what it was only a year or so ago.  

The company's recent financial actions are revealing.  First, they sold a number of rigs to Borr Drilling, receiving a cash infusion of $320 million and sharply reducing future capex outlays.  In May, they then did a private placement :  roughly $400 million, maturing in 2022 with a very favorable rate of 5.5%.  

So what will the company do with the cash infusion?  Just this week, we got an answer.  It issued a tender offer to retire $1.5 billion of its debt from 2017 to 2021.  This is NOT the action of a company with liquidity problems.  The company will end up saving a good deal of money in interest payments over the next few years (clearly the point), but there's no way it would be tossing over $1.5 billion in cash if management had any concerns about paying the bills between now and 2021. This is yet another step in the smoothing out of its debt/capex curve, in anticipation of better days following 2021. 

Bottom line; these recent actions are favorable for all Transocean debt. Pushing the liquidity horizon out several years vastly improves the chances of making good on all their obligations. What it means for the stock is murkier (the price dropped a fast 7% when the news hit), but that's probably knee-jerk.  

When I first started writing about Transocean, the stock was chasing $16.  The longer term bonds were trading about 80 (a bit lower than now).  I boldly predicted that the crisis in oil would be over in three to six months!  Well, THAT was wrong! Instead, there has been a thrilling series of rapid rises, followed by sickening plunges.  The stock rose briefly to $20, and I predicted a return to "normal" of 30.  Well, THAT was wrong!

The stock plunged, and so did the bonds.  But then it rose to $21.  The rise let me close out some options at a very nice gain ($7500).  Good thing, because the subsequent drop in stock and bond prices was sickening.  I kept buying bonds, and they kept dropping.  I froze in place for a good while, but when the Global Marine bonds hit 40, I actually forced myself out of paralysis and bought more.  Very good thing indeed, because the next move was up.  These bonds moved steadily into the low 90's, bringing my overall Transocean results sharply into the black.  

So, I began with the stock at $16, and it's now $8.5.  But I've actually MADE a lot of money along the way (some of it paper profits, but I could realize them if I wanted).  All this while being pretty much wrong about what was "going" to happen.  The reason is that I was not wrong about the company itself.  By concentrating mostly on the bond story, and the company's agile steps to protect its fiscal strength, I have done very well indeed.  

With the stock so low, I'm now, very cautiously, purchasing a few more long calls (3's and 5's of 2019), with the intention of selling corresponding strikes (10 or higher) once (if) the stock recovers.  The amounts are low; the possible profit margins huge.  Yes, a 100% loss is entirely possible, but so is a triple or quadruple.