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.
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