US Bankruptcy can be a very rewarding process for a company. Unprofitable contracts are eliminated and debt is reduced. For a cyclical, capital intensive and commodity industry, bankruptcy can be a godsend.
Look at Tidewater (TDW – USA), an operator of Offshore Service Vessels (OSVs) used in oil production. Through bankruptcy, it’s eliminated all of its in-chartered vessels, reducing expenditures on leases at a time when industry utilization is at generational lows. Even more importantly, it’s substantially reduced its debt. Heck, it has net cash on the balance sheet at this point.
In a commodity industry that normally operates with high levels of financial debt, reducing most of your interest expense, gives you a massive competitive advantage, as does eliminating contracts that were incurred when oil prices were higher and are no longer economic. This lower cost structure allows TDW to out-bid competitors and increase utilization at a time when demand is weak. However, that’s only one reason to like TDW.
During bankruptcy, TDW dramatically impaired the value of its vessel fleet of OSVs. $3.5 billion of vessels were written down to under $900 million. This means that at current prices, you can buy one of the newer, most geographically diversified and largest fleets in the industry for about 22% of previous depreciated value (which already included some impairments), on a net cash balance sheet. Sure, there are many offshore operators with fleets at a discount to fair value, but they also have substantial net debt. Only TDW gives you the net cash necessary to see the recovery out.
What is the correct value for TDW’s fleet? I want to start by saying that with TDW at roughly cash-flow breakeven; it’s no longer a melting ice cube. That means the fleet shouldn’t be worth 22% of book. My hunch is that on a moderate recovery in OSV demand, this fleet is worth something more like 50% to 70% of depreciated value, or between $64 and $87 a share. For a point of reference, the shares traded for between 1 and 1.5 times depreciated value for most of its history until 2014 when oil prices hit the skids.
Let’s face it; I have no idea if oil gets back to 2014 levels, nor do I know what future demand for drilling rigs will be. However, you don’t need crazy assumptions to make money on TDW. All you need, is for a marginal recovery in the number of active drill rigs while the number of active OSVs sort of trails off—leading to more of a balance than exists today. How do we get there?
On the demand side, at the peak in 2014, there were roughly 700 operating rigs. Today, roughly 420 are operating and this number has now stabilized and even started to recover slightly from the lows. I believe that the number of operating rigs will ultimately stabilize at around 500 if oil stabilizes at current levels. This is due to offshore costs still dropping rapidly, while onshore shale pricing is seeing cost inflation, which should get both sectors to normalize costs in the same range. If anything; offshore is actually cheaper now per full cost of a barrel produced, offset by the need for substantial upfront capital which shale doesn’t need.
In the immediate term, the reason for the collapse in the OSV sector is that the number of active rigs dropped by about 40% over 2 years. However, that isn’t the whole story. The other half is that OSV operators ordered a substantial number of new vessels to match the expected increase in new rigs and the total number of global OSV is now roughly 3500. The industry is considered in balance if there’s around 2.5 OSVs per active rig after subtracting the 1000 or so that are involved in production activities that will be employed no matter what happens to the oil price as lifting costs are so low offshore. So at the peak, we were at 2500 OSV involved in drilling (3500 global OSV – 1000 production OSV). At 700 rigs, that’s 3.6 OSV per active rig, which is higher than the last decade average of 2.5-3.0 but deep water rigs tend to need more OSVs so the average per rig has been shifting higher. Unfortunately today, we’re at 6.0 OSV per rig (2,500/420) and there’s a glut.
If we return to an average of 3.0 OSV per active rig (moderate OSV surplus) at today’s level of 420 rigs, we need 1260 OSV (3.0 X 420) on drilling, plus 1000 in production activities or 2260, which means that either 1240 active OSV need to retire or drilling needs to increase or a combination. Fortunately, both are happening, which is gradually bringing equilibrium back.
To start with, 600 global OSV are over 25 years old. An additional 400 OSV are between 25 and 15 years old. With day rates often not covering operating costs, these assets are increasingly marginalized and retired due to the much higher upkeep and operating costs for older vessels. Once a vessel is stacked, it’s unlikely to return to work due to the roughly $1 million cost of a special survey to return it to work. So once these are gone, they’re gone. Simply sidelining these vessels will create an equilibrium moment and that moment is happening as I write this, especially as smaller operators go bankrupt and cannot pay for recurring surveys and upkeep. Additionally, since most offshore work is contracted by super majors and NOCs, they are demanding newer equipment in tendering, due to lower insurance costs and less perceived environmental and operational risk. It will just take some more time to wind through this older supply.
Unfortunately, roughly 300 new OSVs are still on order from when times were good. Fortunately, many of these vessels will continue to get deferred as their purchasers do not have the capital to acquire them. Even with them coming to market over the next few years, as older vessels are scrapped, it will still lead to a rough equilibrium for the market. If you include all the vessels on order, there are 1560 too many vessels today (1240 currently + 300 on order). If the industry scraps the 1000 that are older than 15 years and add in 80 more active rigs (500 total active rigs), you only have about 320 too many OSV—which isn’t a crisis—especially with other offshore activities like wind turbines taking up additional slack. Fortunately, those 300 on order are only going to trickle into the market, giving more time for equilibrium.
In summary, I do not expect any heroics here in the short term. I expect a few more quarters of awful utilization levels and roughly break-even cash results, with a gradual recovery into 2019 as older vessels are scrapped and demand increases slightly. This should eventually increase utilization and give TDW a bit of pricing power to earn sub-par returns on capital. If that happens, I believe the company is worth 50-70% of net depreciated fleet value and potentially a whole lot more if oil prices increase about $10 or $20 from here and drilling activity picks up.
Disclosure: Funds I manage are long TDW and TDW warrants