Posted by Doug Sheridan - EnergyPoint Research
Opportunists lurk in today's offshore oil and gas industry. And like the buccaneers of old, they are starting to make waves.
Last week, Luminus Management issued a press release criticizing the management and board of Valaris. Luminus, through its affiliates, owns 18.7% of Valaris. The firm is the company's largest shareholder.
Luminus says it will call a meeting of shareholders to consider the firm's handpicked “upgrades” to the board. Once in place, the new board members are expected to push one or more Luminus proposals to return capital to shareholders.
Luminus has decidedly raised the black flag. The firm blames Valaris's leadership for a “litany of failures” and an “astounding number of mistakes.” This, it claims, has led to “unfathomable” and “horrific” performance for shareholders. It's grim stuff.
But the attacks belie the facts. Valaris's legacy companies have dominated the customer satisfaction rankings over the years. Lest this matter not to the firm's luminaries, we'd point them to evidence of customer satisfaction's tie to investor returns in the oilfield. Satisfied customers are one of Valaris's most valuable assets.
Luminus has also done some cherry-picking. To wit, the comparison of Valaris's stock-price performance to that of Noble Corp, Diamond Offshore and Transocean is incomplete. A full comparison should also include Seadrill and Pacific Drilling—both of which filed for bankruptcy.
The troubles don't end there. Hercules Offshore, Vantage Drilling, Paragon Offshore, Ocean Rig and Parker Drilling have also visited bankruptcy. Luminus itself suggests Atwood Oceanics, prior to its purchase by Ensco, was courting insolvency.
It is true that Valaris's stock is down 80.4% over the last year and down 97.3% over ten years. But a slew of other offshore drillers have lost it all for investors during the downturn. Even Luminus's favored comparables are down 95% over the last decade.
According to Valaris, Luminus has proposed returns-of-capital to shareholders ranging from $500 million to $2.5 billion—all funded by debt and cost reductions. Based on the estimated impacts of the proposals on Valaris's balance sheet, it's hard to see where the romance lies.
By our calculations, Valaris's total net debt-to-capital currently current sits at 36.2 %. The peer-group average is 40.1%. Luminus's most aggressive proposal would push the level past 50%. This is higher than for any of Luminus's selected comparables. The least-aggressive proposal increases leverage by ~300 basis points.
It's hard to see the rational in raising Valaris's leverage above peer-group levels when most of the industry is eschewing debt althogether. What's more, for a company that has incurred almost $500 million in negative cash flow in 2019, additional leverage seems irresponsible.
It's not clear if any of Luminus's proposals are even viable. More than one Wall Street bank projects the price of West Texas Intermediate to fall below $50 in 2020. Finding lenders that won't demand moratoriums on dividends and buybacks in such a market seems unlikely.
To sidestep this hurdle, Luminous reportedly proposes it take on the role of lender. While its willingness to assume risks that others won't might get a deal done, it's far from a selling point.
None of this is to say leveraged recaps don't have their place. They can represent legitimate pursuit of value. But there's a time and place, and this isn't it. History suggests aggressive capital structures in the offshore can bring more problems than they are worth.
Transocean's merger with Global Santa Fe over a decade ago is a case in point. As part of the transaction, the combined company took on $15 billion in new debt to fund a special dividend to shareholders of the same amount. To facilitate the deal, the companies' respective advisors—Goldman Sachs and Lehman Brothers—provided the financing.
Pointing to the combined company's significant backlog, the Wall Street Svengalis expressed confidence in the deal's efficacy. The capital structure was touted as allowing room for growth and investment even as debt service antithetically consumed the first two years of operational cash flow.
What happened next is a warning for the ages.
Previously one of the top-rated offshore drillers in customer satisfaction, Transocean's scores began to decline as cost cuts stretched the organization. Investments in people and assets were reined in as debt service took priority.
Then, on April 20, 2010, the unthinkable happened. Transocean's Deepwater Horizon rig caught fire in the Gulf of Mexico, capsized and eventually sank to the ocean floor. Eleven people died in the incident. Millions of barrels of oil were spilled, and an environmental disaster ensued.
For its role, Transocean was forced to pay $1.4 billion in fines. It also admitted that its personnel were partly responsible for the incident. But the company paid an even greater price in terms of reputation.
In the years since, Transocean has worked hard at changing its ways. Safety is still paramount, but so is financial stability. Today, the company's net debt-to-capital is actually below that of Valaris.
The point? The oil and gas industry doesn't need to repeat the mistakes of the past. While playing the long game doesn't ensure Valaris outperforms, it does allow the company to focus on its strengths—safe and efficient operations underpinned by world-class assets, ample liquidity, and a strong bond with customers.
For the foreseeable future, surviving in the offshore is winning. If the price for survival is short-term investors jumping ship, so be it. There's too much at stake for drillers to be courting gratuitous risks, especially when such rolls of the dice so often seem come up snake eyes.
Best to leave some things to the pros.
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