Sunday, 21 August 2016

My Downstream Oil & Gas Recovery Operations

Last week, I blogged about My Upstream Oil & Gas (O&G) Rescue Operations. This week, the focus is on my downstream O&G stocks. Upstream O&G refers to the exploration and production of crude oil, while downstream O&G refers to the processing of crude oil into refined oil products such as gasoline. If you refer to the profit contributions at oil majors such as Exxon Mobil, BP, Shell, etc., downstream operations have been the segment that is making up for depressed profits at upstream operations. The figure below shows the breakdown of profits from upstream and downstream operations for BP (source: Bloomberg).

Fig. 1: Profits from Upstream & Downstream Operations for BP

The fact that downstream operations are making more money than before the oil crash is not surprising. Refineries buy crude oil and sell refined oil products. Given the prolonged crash in crude oil price since mid 2014, their input price has dropped and refining margins have increased. However, the increased refining margins are only temporary, eventually, the glut in crude oil volume will find its way to the refined oil product market and depress the selling price of refined oil products, thereby diminishing the refining margins. Fig. 2 below shows the diminishing refining margins (source: Bloomberg).

Fig. 2: Refining Margins

Still, downstream O&G is comparatively more stable than upstream O&G. In Singapore, we do not have any listed companies that operate refineries. However, we have a couple of companies that build and maintain petrochemical plants, storage tanks, oil terminals, etc. Some of these Engineering, Procurement and Construction (EPC) companies include Rotary, PEC, Hiap Seng, Hai Leck and Mun Siong. 

Generally, compared to upstream companies, the business of these EPC companies are much more stable, because the more OPEC countries pump oil to increase market share, the more oil that needs to be transported, processed and stored. However, some of the customers in this segment are the oil majors which are cutting costs wherever possible. There is also increased competition for less new EPC projects, thereby depressing margins for these companies. Nevertheless, downstream companies have performed better than upstream companies at withstanding unexpected shocks. When Swiber announced winding-up in Jul, Pacific Radiance announced that it had to provide for about $13.5M (USD10.1M) in doubtful receivables, which led to a sustained sell-off in its shares (together with other upstream O&G stocks). In contrast, in Oct last year, PEC had to write-off trade receivables of about $19M when Jurong Aromatics went into receivership. Its share price held steady after the news.

Among the listed companies mentioned above, PEC has ventured into Middle East and increased its revenue. It essentially points the way to what companies can do to survive the long and harsh O&G winter: go into Middle East where oil production is increasing at the expense of everywhere else and have a large portion of revenue from maintenance projects. Even if companies stop buying/ building new facilities, they still have to maintain their existing ones. In FY2015, Middle East contributed 18% of total revenue by geography while maintenance contributed 31% of total revenue by segment. Action-wise, at the middle of last year, my original cost price in PEC was $0.59. After its announcement of Jurong Aromatics going into receivership in Oct 2015, I averaged down at $0.375.

Rotary operates in a similar size and geography as PEC. However, it relies predominantly on projects rather than maintenance. The proportion of revenue from maintenance is only 17% in FY2015. Due to a lack of new projects, its revenue in FY2015 fell by 52%. Middle East contributed 30% of total revenue. As the business prospects are uncertain, I have not averaged down. My cost price remains at $0.62.

Hiap Seng is smaller than both Rotary and PEC and operates predominantly in South East Asia. In FY2016, it swung from a loss of $12.7M to a profit of $5.6M. When oil was trading at below USD30 in Jan, I initiated a small position at $0.10 as a turnaround play.

Hai Leck is even smaller and operates in Singapore only. It derives 67% of its revenue from maintenance in FY2015. What attracted me to it initially was its high dividend. It paid interim dividend of $0.05 in Jun. I initiated my position in Jun/Jul at an average price of $0.38, hoping for more dividends to come.

Mun Siong is the smallest of all the companies mentioned above and operates in Singapore only. I decided to give it a miss, although it also pays fairly good dividends. 

Finally, there is an oil trader in China Aviation Oil (CAO). Like all other upstream O&G companies, its revenue and share price crashed in 2015. I was concerned initially, but eventually accepted the explanation that Noble gave, which is that it is a commodity trader and is not affected by the commodity price. CAO was identified as 1 of the 2 O&G stocks in my portfolio that could save itself and others. However, there was a problem: I had maxed out the position limit on this stock. Thus, when the share price recovered to my cost price of $0.86 in Apr, I sold about half my position, hoping to create some space to buy should it decline subsequently. It went up instead and there went a part of my O&G rescue plans. (Note: Given the significant run-up in price, CAO is now considered as available-for-sale.)

Conclusion

Although all are in the O&G industry, the prospects of upstream and downstream O&G companies could not have been more different. Upstream companies are facing the most significant challenges seen in decades, with no signs of letting up yet. In contrast, downstream companies are comparatively more stable, although profits are nothing to shout about. 

Some investors, like myself, like the excitement of finding multi-baggers, and the O&G industry presents opportunities as well as significant risks. However, as explained in Different Types of Bears, upstream companies are facing a ferocious bear. When faced with such a bear, it is not good enough just to have sufficient endurance, i.e. buy and hold for as long as it takes to outlast the bear. Not all companies will survive and we have already seen a couple of companies falling by the sideways. More are expected to come. Make one mistake and it would be difficult to recover.

On the other hand, downstream companies are facing the long-winded bear which is milder. Given sufficient endurance, it is usually possible to outlast it. This is why the plans for the downstream O&G stocks are considered as recovery operations (i.e. average down and hold) but that for the upstream O&G stocks are rescue operations (i.e. average down and sell)!

Finally, O&G is highly risky. I would not recommend it to anybody. Like what BullyTheBear said, it is not as if there is only this sector to focus on!

Just a disclaimer, this post is not a recommendation for anyone to buy or sell any O&G stocks. It is a recollection of my actions to rescue the downstream O&G stocks in my portfolio.


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Sunday, 14 August 2016

My Upstream Oil & Gas Rescue Operations

If you have been following my blog in recent months, you would know that I have been blogging about the Oil & Gas (O&G) industry, starting with oil and moving down the industry value chain to Exploration & Production (E&P), Offshore Support Vessel (OSV) and finally ship/rig building sectors. It is time to string everything together to discuss my rescue operations for the upstream O&G stocks that I have carried out since the start of this year. Please note that the rescue operations were formulated before the Brexit referendum and Swiber's application for judicial management. Post-Brexit and post-Swiber, I am not so sure I can pull off these rescue operations.

Oil

As explained in The Demand and Supply for Oil, there is an inflexion point at around USD35, below which the supply for oil becomes elastic and oil price becomes more resistant to further falls. At this level, it is only a matter of time before oil price recovers. Furthermore, unlike companies operating in the O&G industry, oil price will never go down to zero and be bankrupt. Thus, an Exchange Traded Fund (ETF) that tracks oil price is one of the safer investments in the O&G industry. You just have to wait very patiently for the recovery in oil price.

There is only 1 ETF listed on the Singapore Exchange that tracks oil price, but it is not a pure oil play. Besides oil, it also tracks other commodity prices such as gold, industrial metals and grains. The ETF is Lyxor Commodities, which has a 31% exposure to oil price and 6% exposure to gas price. 

Thus, when oil price was languishing around USD30 in end Jan, I bought Lyxor Comm at USD1.55 and brought my average price down to USD2.20.

Exploration & Production Companies

As discussed in The Missing Link Between Oil Price & O&G Profitability, only companies that are involved in oil exploration and production have a direct relationship with oil price. These E&P companies produce and sell oil in the market. Any change in oil price has a direct impact on their profitability. Thus, when oil price recovers, E&P companies will stand to gain.

Nevertheless, there are also significant risks for E&P companies. The exploration part of the business is high-risk and high capex, not unlike buying a lottery ticket. You can never be sure that the oil field purchased will be able to produce sufficient quantity of oil to be commercially viable. When an oil field is found to be commercially viable, the company will then have to spend more money to develop the oil field for commercial production. Given the uncertainty in oil price, spending money to explore and develop oil fields are risky decisions. 

There are a couple of mostly small E&P companies listed on SGX. My picks in this sector were Kris Energy, Interra Resources and Ramba Energy. Each company has its own dynamics and challenges. Ramba Energy has not produced a single drop of oil yet but plans to do so later this year. It also plans to issue a rights issue soon. Interra Resources is on the other end of the spectrum. It is already producing oil, but oil is a depleting resource. Without incurring money to explore and develop new oil fields, its oil production will continue to decline. Kris Energy is the biggest E&P companies listed on SGX. It has a pipeline of both production and exploration oil fields. Unfortunately, it also has SGD330M of outstanding bonds that will mature in 2017 and 2018.

Thus, even though E&P companies will stand to gain from a recovery in oil price, they are not without risks. Linc Energy, for example, has gone into voluntary administration. My investments in these companies are purely speculative and involved only a small amount of money.

Oil Services and OSV Companies

Among the various sectors in the O&G industry, oil services and OSV sectors are probably among the worst hit currently. We have Technics Oil & Gas and Swiber going into judicial management. As explained in The Missing Link Between Oil Price & O&G Profitability, the primary reason they are not doing well is because they rely on oil majors for their business. In their attempt to navigate the deep and prolonged slump in oil price since Jun 2014, oil majors have cut E&P spending budgets, jobs and deferred major projects. In my opinion, even if oil price were to recover to higher levels, oil majors will be very cautious in raising spending budgets to previous levels after going through such a difficult period. For more information on OSV companies, you can refer to Lessons for Investing in OSV Companies from Shipping Trusts.

These are the sectors to avoid for now. My worst O&G stock (MTQ) is from the oil services sector. The average price for MTQ is $1.34 and I have maxed out the position limit for this stock. I can only ignore it for now. The consolation is that its debt/equity ratio is still manageable at 44%. 

Ship/Rig Building Companies

The ship/rig building sector is further downstream of the OSV sector. It is also facing declining business, but as explained in Keppel Corp – A Good Captain Sailing Through Rough Waters, we have not seen the worst in this sector yet, which explains why shipbuilders seem to perform better than oil services and OSV companies for now.

Having said the above, the actions that individual companies take can help to mitigate the impact to some extent. For more information on Keppel Corp's mitigation actions, you can refer to the above-mentioned post and How Will Keppel Corp Navigate the Oil Crash?

Action-wise, at the start of the year, my cost price for Keppel Corp was $6.83. Not only that, I also had the stock in my joint account with my father. When Keppel Corp crashed to below $5 in Jan, I decided to take over the stock in the joint account, which meant I faced double the loss. This left me with no choice but to execute a risky averaging down action which brought my average price down to $6.08. Thankfully, when Keppel Corp recovered to above that price in Mar, I quickly sold 70% of it. I hesitated to sell the remaining 30%, because I knew among all the O&G stocks in my portfolio, Keppel Corp was probably 1 out of only 2 stocks that could save itself and others. When I finally concluded that I should sell all of it, it had already dropped below my average price. Anyway, as explained in Keppel Corp – A Good Captain Sailing Through Rough Waters, keeping it might not be too bad a choice, except that it might probably take 5 years or more to recover.

The other shipbuilding stock in my portfolio is Baker Tech. My original cost price was $1.25 and I averaged down at around $0.875 in Jan and Mar in anticipation of the recovery in oil price. Unfortunately, I forgot that it planned to carry out a share consolidation and most companies that do so end up having lower prices post-consolidation. It does not have much shipbuilding business, so it gave itself an order to build a liftboat. It currently trades at $0.555, but has $0.558 in cash and no debt as at end Jun 2016. Having said that, the cash reserves will continue to drop as construction of the liftboat progresses. Given its large cash reserves, it should be able to survive the harsh O&G winter.

Conclusion

This has been a long post. To summarise my rescue strategy for the upstream O&G stocks, I am relying on oil price to recover. Direct beneficiaries of this will be ETFs that track oil price and E&P companies that sell oil. I am also relying on the market failing to understand The Missing Link Between Oil Price & O&G Profitability, so that all O&G stocks will rise when oil price rises. However, post-Brexit, oil price has retreated back to USD40 from USD50. Post-Swiber, the market has also realised that some O&G companies have significant challenges in surviving the long and harsh winter. Time is running out in these rescue operations.

Just a disclaimer, this post is not a recommendation for anyone to buy or sell the above-mentioned or any O&G stocks. It is a recollection of my actions to rescue the upstream O&G stocks in my portfolio.


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Sunday, 7 August 2016

Is Keppel Corp's Provision for Sete Brasil's Orders Adequate?

When both Keppel Corp and SembCorp Marine announced their financial results for FY2015 earlier this year, they made provisions of $230M and $329M for Sete Brasil's orders respectively. SembMar's provision is 43% higher than Keppel Corp's, even though SembMar's orders ($7.0B) are only 13% higher than Keppel Corp's ($6.2B). The big question is whether Keppel Corp's provision for Sete Brasil's orders is adequate and whether further provisions are likely in future quarters. 

I have not attempted to answer this question earlier, mainly because it requires a lot of information to do so. Furthermore, the margin of error is large due to the imprecise nature of the information. Compared to the total contract value of $6.2B, a rounding error of $0.1B is only a 1.6% error, however, it can mean $100M in provisions! Thus, I can only hope to be generally right rather than precisely right in this post.

In the 2Q2016 financial results released 2 weeks ago, Keppel Corp has reiterated that its provision of $230M is adequate. It also, for the first time in its financial results, disclosed that its outstanding order book for Sete Brasil's orders is about $4.0B, rather than the $3.7B estimated in my earlier post on How Will Keppel Corp Navigate the Oil Crash? With this additional piece of information, there is better clarity on whether the Sete Brasil's provision is adequate.

The total contract value of Sete Brasil's orders is $6.2B. After deducting the outstanding contract value of $4.0B, Keppel Corp has carried out works worth $2.2B. In the briefing on FY2015 financial results, Keppel Corp disclosed that $1.8B (the Q&A mentioned $1.3B, likely to be in US dollars. You can download the Q&A here.) has been collected from Sete Brasil prior to it stopping progress payment in Nov 2014. This leaves it with a contract value of $0.4B for which work has been carried out but payment not collected yet. There is a need to understand whether this $0.4B of contract value appears in the balance sheet as Work-in-Progress, for which profits have not been booked and therefore requires lower provisions, or trade receivables, for which profits have been booked and need to be reversed out. Assuming the worst case scenario that it is a trade receivable, the full $0.4B needs to be provided for. Keppel Corp has made provisions for $0.23B, which leaves another $0.17B of potential provisions. Note that this figure assumes that Keppel Corp's liabilities to its suppliers have been fully accounted for, because it is possible for Keppel Corp to receive materials from suppliers but not carry out work using these materials yet. Keppel Corp will have to pay suppliers even if no work has been carried out using them. If this has not been accounted for, the potential provisions will increase further.

The above additional provision of $0.17B assumes that no further work is carried out on the Sete Brasil rigs. It is possible that Keppel Corp will complete some of the rigs already in advanced stages of completion and sell them in the open market. However, given the depressed market for rigs, Keppel Corp might not fetch a good price for the completed rigs. If the selling price is lower than the cost to complete them, further losses are likely. Let us examine this scenario.

The rate of completion for the 6 rigs is estimated to be 92%, 70%, 40%, 21% and less than 10% each for the remaining 2 rigs (see Sete Brasil is not the only thing Keppel needs to worry about, say analysts). Let us assume that Keppel Corp will complete the first 4 rigs. Assuming the price of each of the 6 rigs is the same, the total contract value will be $4.1B. In FY2014, when times were good, Keppel Corp could generate an operating margin of 14%. That means the profit from these 4 rigs is $0.6B and the cost to complete them is $3.5B (For now, please ignore the fact that the rigs are partially completed and there is no need to spend the full $3.5B to complete the rigs). I do not know how much the rigs will fetch in the open market. Let us assume they can fetch only 70% of the original contract price of $4.1B, or $2.9B, which means Keppel Corp will lose $0.6B on these rigs.

In a normal transaction, if a buyer and a seller agree to a price of $100 for a goods, but the buyer could not fork out the money and the seller could only resell it at $80 in the open market, the buyer is still liable to the seller for the shortfall of $20. Depending on what are the terms of the contracts with Sete Brasil, Keppel Corp might have remedies to get Sete Brasil to top up the $1.2B difference between the market price of $2.9B and the contract price of $4.1B. However, Sete Brasil has now gone into backruptcy protection and cannot fork out the money. Thankfully, Keppel Corp has collected $1.8B in progress payments from Sete Brasil for the 6 rigs. That will be used to top up the difference. Thus, no further provisions are required when the rigs are sold. In fact, the previous provision of $230M could be written back and Keppel Corp could book a profit on the rigs. Just take note that it will be a fairly long time before the market for oil rigs can recover and Keppel Corp can sell the rigs.

In conclusion, Keppel Corp's provision of $230M for Sete Brasil's orders is generally adequate for now. Further provisions are possible, but the provisions can be written back when the market recovers and the rigs are sold.


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Sunday, 31 July 2016

The Type of Debts O&G Companies Have Matters

Swiber shocked the stock market on Thu by announcing that it had applied to wind up the company. This is unexpected because based on latest financial results for 1Q2016, Swiber is still generating a positive operating cashflow. Anyway, the latest on this episode is that Swiber has applied to withdraw the winding-up application and apply for judicial management instead. The issue in this episode is the high indebtedness of the company. However, the nature of the debts also matters. Swiber has both bank loans and bonds. Had its debts been solely bank loans, the outcome might have been different.

To understand why, it is useful to look at DBS' announcement of the financial impact of Swiber's potential winding-up. DBS announced that its total exposure to Swiber, which comprises loans, bonds and off balance sheet items, is about SGD700M. The exposure is partially secured and it expects to recover half of the exposure. Of the estimated SGD350M of bad debt, DBS will tap on its general surplus allowances and book a loss of about SGD150M.

Given a choice, would DBS want the company to be wound up? If Swiber is kept afloat, the worst thing that could happen to DBS for now is Swiber does not repay its loans and interest on time. However, if Swiber is wound up, DBS would receive collaterals of SGD350M that are used to secure the loans and immediately realise a bad debt of SGD350M. What is the nature of the collaterals? If it is properties, it might be easy to sell them off quickly for a reasonable price at an auction. However, if it is Oil & Gas (O&G) vessels, then it might be hard to sell them off. Swiber's financial results for 1Q2016 listed the types of collaterals used to back the bank loans:
"The bank loans and finance leases are secured by:
(i) First legal mortgage over certain vessels and equipment.
(ii) Assignment of all marine insurances in respect of the vessels mentioned above.
(iii) Assignment of earnings/charter proceeds in respect of the vessels mentioned above.
(iv) Lessors’ title to the lease assets.
(v) Charge on certain trade receivables."
Among the items above, Item (v) trade receivables is most easily converted into cash, but it is not clear how much of the collaterals is in trade receivables. For Item (iii) charter earnings/ proceeds, Swiber reported charter hire income of USD74.6M but chartering expenses of USD168.9M in FY2015, so it is not clear how much cash this item can provide. It is likely that DBS will end up with some O&G vessels which cannot be liquidated quickly for a reasonable price. For the duration that the assets are on its books, DBS will have to spend some money to maintain those assets until sellers can be found.

On the SGD350M bad debt, even though DBS is able to tap SGD200M from its general surplus allowances and reduce the loss to SGD150M, that allowance must be replenished in subsequent quarters from increased provisions. The purpose of a general surplus allowance is to set aside some money every quarter to absorb potential losses so that the impact is more manageable. Earnings in subsequent quarters will be impacted. 

Thus, DBS has much to lose and little to gain from the unexpected winding-up of Swiber. Judicial management will be more beneficial for DBS, since Swiber is still able to generate a positive operating cashflow, as that will allow Swiber to continue operating, collect cashflow and hopefully, over time, it will be able to pay down the loans to DBS. The important corollary is this: banks will not pull the plug from O&G companies. When bank loans come due, banks will just let the O&G companies refinance, because if they do not, O&G companies will default on the loans and the issues discussed above will happen. In 1Q2016, Swiber repaid bank loans of USD137.6M but borrowed USD128.3M at the same time.

For further proof that banks will not pull the plug on O&G companies, you can refer to EMAS Offshore's 2Q2016 financial statement, which stated that it "had breached certain financial covenants relating to its borrowings. As at announcement date, the Group had rectified the breach by way of obtaining covenant waiver and/or amendments to the financial covenants by the lenders." Also, shipping trusts have been facing difficulties due to the shipping glut since the Global Financial Crisis. After 9 years, they are still around, because most of their debts are bank loans. Banks are financial institutions; they are mostly interested in getting back their money rather than owning illiquid assets. Having said the above, banks will also not blindly refinance O&G debts. If the company is not expected to generate positive cashflow and pay down the loans over time, banks will have no choice but to pull the plug at an appropriate time.

Bonds are different from bank loans. When bonds come due, there are usually only 2 choices: repay in full or default. There is no option to roll-over the bonds. Thus, prior to the bonds coming due, the company would have to find ways to raise cash in advance, so that there is money to repay the maturing bond. In the case of Swiber, it did not manage to complete the issue of USD200M of preference shares in end Jun, thus putting strains on its cash resources. As at end Mar 2016, Swiber had USD130.0M in cash. On 6 Jun and 6 Jul, it redeemed bonds totaling SGD205M (approximately USD153.0M). After repaying these 2 bonds, there is no much cash left. On 8 Jul, Swiber announced the receipt of the first letter of demand for USD4.8M, which triggered the chain of events that we have seen.

If its debts were solely bank loans, the outcome might have been different. Also, it is good to pay attention to companies with bonds that are maturing soon.


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Sunday, 24 July 2016

Keppel Corp – A Good Captain Sailing Through Rough Waters

If you had read my previous post on How Will Keppel Corp Navigate the Oil Crash?, you would know that I am ready to sell Keppel Corp before the full force of the storm hits it. Yet, I have to admit that Keppel Corp's management is doing a pretty good job in steadying the ship given the circumstances which they have not much control over. The recently released financial results for 2Q2016 reaffirms my belief that Keppel Corp has a chance of surviving the harsh winter, and if it survives, it will come out much stronger.

It has been said that the Oil & Gas (O&G) industry is facing a long and harsh winter. But how long and harsh will it be? A glimpse of Keppel Corp's order book for the Offshore & Marine (O&M) segment provides an indication of how harsh the winter is going to be. In 1H2016, Keppel Corp booked a revenue of $1.54 billion, which is 56% down from a year ago. Over the same period, it has only managed to secure new orders of $0.36 billion (I excluded the recent order of $0.1 billion because it was announced after the close of 2Q2016). This means that for every $1 of revenue that Keppel Corp delivered, it only managed to secure $0.23 of new orders. From another perspective, the book order is decreasing rapidly at a rate of $1.18 billion every 6 months, or $2.36 billion per year. As at Jun 2016, the net order book stands at $4.28 billion after excluding Sete Brasil's orders. Assuming the same rate of depletion of order book, Keppel Corp's O&M segment will effectively run out of business in less than 2 years' time (note: the last delivery is in 2021, but there is not much business to sustain high utilisation of the yards). Currently, Keppel Corp's O&M segment is still turning out a profit (its 2Q2016's net profit is $61 million, a 65% drop from a year ago), but it will not be long before the segment incurs losses. I do not have any information on how badly the losses are going to be, but I believe the depreciation and manpower costs are not going to be small. 

For Keppel Corp's O&M business to recover, its customers, i.e. the oil drilling companies, have to recover first. Below is a figure of the utilisation and day rate for semi-submersibles from IHS, the ones Keppel Corp is building for Sete Brasil.

Fig. 1: Utilisation & Day Rates for Semi-Submersibles

The utilisation is down by nearly 50% from its peak 3 years ago while the day rate is down by almost 60%. The trend is the same with other types of oil rigs. Multiplying the utilisation by the day rate, you will see that the revenue of drilling companies has fallen by more than 70% from the peak! It is no wonder that drilling companies are not placing new orders for oil rigs. Even North Altantic Drilling, which ordered a semi-submersible from SembCorp Marine, has deferred taking delivery of it until a drilling contract is found. Looking at the steep decline in utilisation, it will be a fairly long time before utilisation bottoms out and recovers. Even when utilitisation and day rate recover, it will still take some time for the benefits to trickle down to the shipbuilders, as drilling companies need several years of profit to repair their balance sheets. I think it will be faster for Britain to recover from Brexit than it is for O&G companies to recover from this severe slump.

Yet, despite the extremely challenging conditions facing Keppel Corp, its management has done a pretty good job in steering the ship. On the corporate side, Keppel Corp is leveraging on the expertise within its various business segments to maximise revenue. One of the key planks of this strategy is to strengthen its asset management segment by consolidating individual REIT, business trust and fund management units into a newly set up unit known as Keppel Capital. The figure below provides an example of how the various business segments will work together to maximise revenue for Keppel Corp.

Fig. 2: Different Business Segments Working Together to Maximise Revenue

From the set-up of a new fund, to developing new data centres to managing data centres, Keppel Corp's business units are involved in every step of it. And when the data centre is sold to Keppel DC Reit, the capital is recovered and the entire process can be repeated. In the meanwhile, Keppel DC Reit continues to derive asset management fees from managing the data centres. The strategy is not confined to data centres only. It works with any operating assets that are capable of generating regular stream of income, including O&M assets (when utilisation and day rate recover). Below is an extract from Keppel Corp's CEO speech when he released the 2Q2016 financial results:
"Established institutional investors have told us that they want to get closer to the coal face to own 'real assets', including those in the offshore and marine, real estate and infrastructure industries."
This new corporate strategy has the potential to rapidly expand its assets under management and generate good revenue for Keppel Corp in the years to come.

Even in the O&M segment, Keppel Corp has taken the right steps. It acquired the LeTourneau rig business to provide aftermarket sales and services. Even though drilling companies are not ordering new rigs, they still have to maintain their existing rigs, so that business provides a steady revenue stream to supplement the rapidly slowing revenue stream from ship and rig building.

It has also partnered Shell Eastern Petroleum to provide Liquefied Natural Gas (LNG) bunkering business. This might yet open more doors in the LNG area, such as building/ retrofitting LNG vessels. Given the concern over climatic changes and resulting search for cleaner fuels, LNG might gain greater prominence in future.

Although the above 2 actions might not yield immediate results as oil majors are still cutting costs wherever possible, it demonstrates that Keppel Corp knows what it needs to do. In the 2Q2016 speech, Keppel Corp's CEO said that if necessary, they might mothball yards with low work volumes. If implemented, this will reduce the depreciation cost of its yards. 

If there is any action that can be reconsidered, it is Keppel Corp's privatisation of Keppel Land in Jan 2015 for $3.1 billion in cash. Keppel Corp's net debt is $7.3 billion, with a net gearing ratio of 0.62 as at Jun 2016. Imagine how nice it would be to have an additional $3.1 billion in cash. Having said that, the privatisation decision is more bad timing rather than bad decision. Sete Brasil had just stopped progress payment on its rigs 2 months earlier in Nov 2014, and it was not clear at that time if it would be temporary or permanent. Given the sharp fall in oil price, it was reasonable to diversify earnings away from O&G by privatising Keppel Land. The decision cannot be faulted given the circumstances at that time.

In conclusion, Keppel Corp is sailing into the full force of the storm. However, the captain (i.e. its management) has demonstrated that he is a very capable captain. Even if I do not manage to sell Keppel Corp at above my purchase price and have to ride through the storm with it for 5 years, with such a capable captain at the helm, I can relax, knowing that it is in good hands.


Sunday, 17 July 2016

How Will Keppel Corp Navigate the Oil Crash?

Keppel Corp is a favourite stock among Singapore investors, given its strong earnings and good dividends (prior to the oil crash in Jun 2014). I have it in my portfolio too, after it came off its high 6 months later. Having held it for 1.5 years and sitting on paper losses, I am beginning to reach a conclusion over whether I should continue to hold or sell the stock. Do note that this post involves some speculation over how Keppel Corp would navigate the oil crash, which might not turn out to be correct. After all, stock investments are about predicting the future rather than knowing the present.

The headlines hogging Keppel Corp this year has been the bankruptcy of Sete Brasil and its failure to take delivery of the 6 semi-submersibles (semi-subs) on order from Keppel Corp. However, in my opinion, Sete Brasil is a much smaller problem that can be managed. If you understand the corporate structure of Keppel Corp, you will notice that for every business segment, there is always a REIT or a business trust. For properties, there is Keppel Reit. For infrastructure, there is Keppel Infrastructure Trust. For data centres, there is Keppel DC Reit. The REITs/ business trusts provide avenues for Keppel Corp to recycle capital. The only exception to this is the Offshore & Marine (O&M) segment, which builds ships and rigs for customers and therefore does not hold any operating assets that can be put into a business trust. But with Sete Brasil saddling it with as many as 6 semi-subs worth a total of $6.2 billion when completed, putting all these assets into a business trust might be a solution to recover the capital. After all, Keppel Corp is an expert when it comes to recycling capital with REITs and business trusts. Fig. 1 below is taken from Keppel Corp's presentation of its financial results for 2015. If it cannot sell and service the rigs (upper branch of the tree), it might as well choose the lower branch of the tree and own, operate, stabilise, monetise and eventually inject the rigs into a trust or fund.

Fig. 1: Keppel Corp's strategy

Given investors' penchant for yields in the current low interest rate environment, investors might buy into the idea of a business trust. Even if an O&M business trust IPO is not well received by the market, Keppel Corp could always distribute the business trust in specie to shareholders. Simplying hiving off the non-performing assets (together with the corresponding debts) will do a lot of good for Keppel Corp's balance sheet. 

If it is able to pull this off, the impact will be significant. If you read my earlier post on Understanding Shipbuilders' Balance Sheets, the uncompleted rigs have resulted in elevated levels of inventory and Work-In-Progress (WIP) in the balance sheet. Keppel Corp has stopped work on the Sete Brasil rigs, which means that they remain stuck in the balance sheet as inventory and WIP and cannot move on to receivables (upon rig delivery) and cash (upon customer's settlement of invoices). A lot of capital is locked up in this state. By completing the rigs and hiving them off into a trust, inventory and WIP can come down significantly, cash will go up and debt will come down.

Although this strategy sounds workable, the feasibility of it depends a lot on finding drilling companies willing to charter the rigs. Fig. 2 below shows the current utilisation and day rate for semi-subs from IHS.

Fig. 2: Utilisation and Day Rates for Semi-subs

The current utilisation for semi-subs is 50%, which means now is still not the right time to execute this strategy. Keppel Corp will need to be very patient and wait for the utilisation to recover before executing this strategy. Even so, there is no need to wait for a full recovery to the point that drilling companies start to order new rigs. At some point in the recovery, there will be demand but uncertainty over how long the demand will last. It is at this stage that drilling companies might be willing to lease rigs instead of owning them outright. That is the time the strategy can be executed. Thus, there is a solution to the Sete Brasil issue, but it will require a lot of patience.

In my opinion, the far bigger problem is the dwindling of orders for the O&M segment. Although each succesful delivery of a rig means there is no further deferment, it also means that the order book is reduced correspondingly. As at Mar 2016, the order book stands at a respectable S$8.6 billion. However, this figure includes the Sete Brasil rigs. The order completion rate for the rigs is estimated to be 92%, 70%, 40%, 21% and less than 10% each for the remaining 2 rigs (see Sete Brasil is not the only thing Keppel needs to worry about, say analysts). This means that of the S$6.2 billion order for the 6 semi-subs, there is approximately another $3.7 billion still on the order book. Removing the $3.7 billion worth of orders, the order book reduces significantly to $4.9 billion. In Q1 2016, Keppel Corp received only $0.2 billion in new orders. This is hardly sufficient to replenish the depleting order book. Fig. 3 below shows the uncompleted contract value of Keppel Corp's O&M order book according to year of delivery.

Fig. 3: Keppel Corp's O&M Orderbook

For comparison purpose, I have added the $3.7 billion attributed to Sete Brasil's orders. Most of Sete Brasil's 6 rigs are pushed to 2019-2020 for delivery. After removing Sete Brasil's orders, there is not much business left for Keppel Corp after 2018, assuming that new orders continue to remain weak. Given the low utilisation and day rate for rigs as shown in Fig. 2, it is difficult to see how new orders can recover strongly in the next 2 years.

Although Keppel Corp has reduced headcounts significantly to cope with the slump, there is a point at which core competencies start to be affected. Keppel Corp has to decide whether to further cut manpower to save costs in the short term or maintain core competency in anticipation of recovery in the long term. I believe Keppel Corp will choose the latter, which means high depreciation and manpower cost for the O&M segment in the short term. Having chosen to retain core manpower, Keppel Corp will also not let its facilities and staff idle. Remember the 6 uncompleted Sete Brasil rigs? Keppel Corp will go ahead and complete them in 2019-2020, even if it does not receive further payment from Sete Brasil.

Besides hoping for new rig orders, Keppel Corp also recently acquired Letourneau's rig business so that they are able to provide aftermarket sales and services. Although drilling companies are not in the mood to place new rig orders, they still have to maintain their existing rigs, so that business provides an additional revenue stream for the O&M segment. Recently, Keppel Corp has also diversified into Liquefied Natural Gas (LNG) business to reduce reliance on the oil sector. How much help these moves provide is uncertain.

Finally, please note that although I wrote a lot about the O&M segment, Keppel Corp is not a pure O&G company. It also has properties, infrastructure and investments. The reason why I did not write about them is because I do not have insights in these segments. For a complete assessment of Keppel Corp, you need to assess these segments as well.


Sunday, 10 July 2016

Is Brexit Just Noise?

And so, Brexit fears went as quickly as they came. Within 4 trading days, the Straits Times Index had recovered all of its losses from news of the Brexit referendum, giving very little time for investors to either buy or sell. Does the speed at which Brexit fears came and went and the relatively limited damage to the stock market make Brexit a non-event and noise to be ignored by investors of all stripes?

First of all, whether Brexit is a noise or not depends a lot on the investor's investment strategy. For a passive investor, Brexit (and most other events) is just noise. Regardless of Brexit or not, an investor using Dollar Cost Averaging would continue to put in the same amount of money at the same fixed time intervals. Likewise, an investor relying on Portfolio Rebalancing would rebalance his portfolio at fixed intervals or when the asset allocation moves away from the target allocation by a pre-defined threshold. For a long-term active investor with an investment horizon of 5 years or more, Brexit is also irrelevant as UK would have completed its exit from EU and established new relationships with the EU and other trading partners. However, for active investors with a shorter investment horizon of 2-3 years, Brexit is not without impact. Just because the stock markets recovered rapidly after the Brexit news does not make it irrelevant and just a noise.

As news of the Brexit referendum results broke out on 24 Jun, Japan's Nikkei index crashed 7.9%, Germany's DAX index dropped 6.8%, France's CAC index fell 8.0% while UK's FTSE index declined by a much smaller 3.1%, despite being the protagonist of this episode. When I wrote my initial thoughts about Brexit in What's Next for Brexit?, I was still wondering why UK's FTSE index fell much less than the other European stock markets. It turns out that the answer lies with the forex markets.

Over the same period, British Pound (GBP) declined by 8.1%, from USD1.4877 to USD1.3679. EUR also declined, but by a smaller 2.4%, from USD1.1385 to USD1.1117. On the other hand, JPY rose by 3.9%, from JPY106.16 to JPY102.22 per USD, as investors fled from GBP to safe havens such as JPY. The implication of these currency fluctuations is that UK's goods have suddenly become 8% cheaper while Japanese goods have become 4% more expensive. It is no wonder then that Japan's (and other European) stock markets dropped more than the UK stock market! To a global investor, should Brexit be considered economically irrelevant and just noise to be ignored?

Now, 2 weeks after the Brexit referendum, GBP has declined further to USD1.2954, EUR stayed relatively flat at USD1.1051 while JPY rose further to JPY100.54. From just before the Brexit referendum till 8 Jul, GBP has declined by 12.9%, EUR by 2.9% while JPY rose by 5.6%. Over the same period, in the stock markets, UK's FTSE index has not only recovered all of its Brexit losses but also gained 4.0%, Germany's DAX index is still losing 6.1% while Japan's Nikkei index is still down by 7.0%. The economic effects of Brexit are just beginning.

A major reason why global stock markets did not fall off the cliff after the Brexit news was the realisation that central banks around the world would loosen monetary policies to stave off any economic fallout from Brexit. The impending US Fed interest rate hike went from near certainty in Jun/ Jul to being postponed at least until the end of the year. This has pushed up stocks that are sensitive to interest rates like REITs. On the other hand, bank shares have been relatively flat, ranging from -1.5% for DBS to 1.9% for OCBC during the 2-week period. If you think about it, if interest rate sensitive stocks are gaining from lower interest rate expectations, why are banks not suffering from it? Banks make money from the interest rate differential that they charge on the loans and pay on the deposits. Since the begining of this year, the 3-month Singapore Interbank Offered Rate (SIBOR) has declined from approximately 1.25% to 0.93% as at end Jun. They have also reduced the interest rate charged on housing loans recently. Coupled with lower loan growth and no improvement on Non Performing Loans from the Oil & Gas industry, banks are likely to see lower profitability moving forward, until US Fed decides to raise interest rates. To a local bank investor, should Brexit be considered a non-event and just noise?

If local banks are going to see reduced profitability from lower interest rates, imagine what would happen to European banks which had shown signs of stress even without the threat of Brexit in early this year, due to increased regulations, global economic slowdown, commodity price collapse, etc. (see Why investors are freaking out over European banks (again)). With Brexit, there is further economic slowdown in Europe, reduced cross-border business, forex losses at UK operations, and now, reduced profitability from lower interest rates. European banks are a major cause of concern (see Italy eyes €40bn bank rescue as first Brexit domino falls). Having said that, it is unlikely that there would be a repeat of the Lehman Brothers incident as central banks would step in to rescue any banks deemed as systematically important.

In conclusion, even though stock markets have recovered quickly from news of the Brexit referendum, it does not mean that Brexit is economically irrelevant and can be treated as noise and ignored, at least not by active investors with shorter investment horizons. It is akin to leaving the door unlocked and no thief came in. Does it mean that it is safe to leave the door unlocked? We might just be plain lucky.


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