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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Asian Shipbuilders Brace For Rough Times As Offshore Sector Wavers

The New Year is setting off on a dour note for energy investors of all stripes, but among those who should be the most concerned are investors in the offshore sector.

The offshore industry is beyond awful at this point. Offshore drilling is one of the most complex and capital intensive forms of E&P, and with every oil company in the world from Exxon to Mom & Pop operators looking to cut back, demand for offshore rig services is on life support. That reality is obvious looking at the abysmal performance of the world’s biggest ship builders which happen to be a trio of Korean companies.

Korean ship builders had a terrible 2015 and 2016 looks like it will be even worse. That’s not a big surprise. A significant chunk of their business comes from building offshore oil vessels and there were already too many of those in 2014 before oil prices started collapsing. At this stage of the cycle, only a very bold CEO would be ordering new vessels. Related: Saudi Arabia Throws Down The Gauntlet, But To Whom?

Offshore drilling will likely be one of the last sectors to recover from the oil price rout. It is a capital intensive business, which relies on a high price of oil and confidence from company executives in a long-term project’s profitability. Confidence from executives and sufficiently high oil prices are likely to be quite a ways off, so it could be several years before the business truly starts to heat up again. That pessimism is reflected in offshore oil drillers’ stocks. Even industry giants like Noble, Ensco, and Transocean have all seen their stock prices slide by 75 percent or more versus peak valuations. Related: Why The U.S. Can’t Be Called A ‘Swing Producer’

The question for investors in 2016 is ‘will this industry get even worse?’ That may be hard to imagine for some investors reviewing the stock performance, but it is a possibility. Bankruptcies among some offshore companies could be coming this year or next. Hercules Offshore declared bankruptcy in 2015 and has already exited that bankruptcy, but it was among the weakest offshore drillers in the first place. It is a measure of how bad the market is that HERO’s stock has fallen roughly 80 percent after exiting bankruptcy in November 2015. In a span of just a few months investors in the “new” HERO have already lost a significant piece of their investment. Related: 10 Key Energy Trends To Watch For In 2016

The most investible companies in this space are among the largest ones - Transocean, Noble, and Ensco. Each of the three is far better positioned than many smaller peers. The rating agency Fitch is sounding the alarm about many of the weaker drillers, but even among these “strong” three there are non-trivial risks. Take Transocean for instance; the company has a relatively high “junk” bond rating – Ba2 from Moody’s for instance, and BB+ from Fitch.

Ratings at these levels are not indicative of an imminent default. Historically, the probability of default within one year for a company with roughly a BB rating averages around 1.5 percent. Yet investors often have a time horizon longer than one year. The risk for an eventual default given a rating of BB is approximately 20 percent - a much more dismal proposition for investors. For most investors at this stage, there is nothing to be done about any of the offshore stocks. Given the magnitude of declines, return prospects over the medium-term are bright enough that the stocks are worth holding. That doesn’t mean that there aren’t real downside risks from here though, or that 2016 will be a happy time.

By Michael McDonald of Oilprice.com

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