Sunday, 26 June 2016

What's Next for Brexit?

I seldom like to blog about the latest financial news, primarily because I am a slow but deep thinker. Nevertheless, after the financial mayhem that Brexit caused on Fri, Brexit was at the top of my mind. So, I might as well pen down my thoughts. Furthermore, blogging helps to sharpen the thoughts on it. The current thoughts that you see in this post are already the second iteration. The first iteration of thoughts are similar to the general consensus, which is that UK is likely to break up with Scotland seeking independence and UK faring worse than the European Union (EU) post-Brexit. The second iteration of thoughts, however, is a refutation of the first iteration. Let's begin.

The single most important question after Brexit is, what will happen to UK? Will Scotland and Northern Ireland seek to break away from UK so as to remain in the EU? The initial thinking was yes, because Scotland voted clearly in favour of staying within the EU. In fact, when Scotland rejected its own independence referendum in 2014, it was partly on the premise that UK would remain in the EU. Now that Scotland will be taken out of EU against her wish, it is likely that the Scottish Government would seek a second referendum and succeed in gaining independence. It is interesting to note that in the 2014 independence referendum, 55% voted to stay in the UK. In the Brexit referendum, 62% of Scottish voters chose to stay in the EU. A net 7% of Scottish voters do not mind leaving UK but staying in the EU. So, a new independence referendum would definitely result in Scotland's independence from UK.

The current thinking is, Scottish independence is unlikely. With all these referendums happening, it seems that people could choose to conduct a referendum and vote to leave a country or union as they wish. However, referendums actually need approval from higher authorities for the results to have any legal effects. In the case of the 2014 Scotland independence referendum, approval from the UK Parliament was needed (see Agreement between the United Kingdom Government and the Scottish Government on a referendum on independence for Scotland). To run another independence referendum, similar approval would be required. Given the shock results of the Brexit referendum and the likely outcome of the next Scottish independence referendum, nobody would be in the mood for another shock.

The more important reason why Scottish independence is unlikely is that none of the major powers wish to see a break-up of UK. UK is a major ally of US, often siding with it on major issues. A UK without Scotland would be weakened, which would be to the disadvantage of US. This is why President Obama said that the special relationship with UK would remain despite Brexit. Even the EU, despite the current squabbles with UK, would not wish for a weakened UK when it faces Russia to the east. Thus, the major powers would tell the Scottish Government that a Scottish independence would not be welcomed, at least in the near future. To understand the geo-political considerations of nations, a very good book to read is George Friedman's The Next 100 Years. Anyway, as will be explained later, staying within UK might not be a bad option.

So, UK is likely to remain intact with Scotland and Northern Ireland staying put. The next question is, will UK enter into a long-term decline post-Brexit? Together with the earlier question, this question has implications on the value of UK assets and British Pound. UK would lose privileged access to the EU single market that is reserved for EU members. It might also see companies relocating across the English Channel to EU. All these present serious challenges for UK. However, as a civilisation, UK/England has faced significant challenges in her history, recovered and prospered. Despite years of war, England failed to conquer the whole of the British island and had to share the island with Scotland, yet, both nations managed to put aside their historical rivalry to join in a political union to create the Kingdom of Great Britain that would later dominate the world. Also, despite failing to gain an edge over France in the 100 Years' War, UK/England went ahead in the 16th century to build an empire that would eventually span across the entire globe. In addition, despite losing its first empire (i.e. America) in the American War of Independence, it went ahead to build a second empire in Asia, Africa and the Pacific. During this period, UK also ushered in the first industrial revolution that changed the world forever. It was only in the last century that UK declined, no thanks to the 2 world wars fought in Europe. The most glorious days of UK were actually when she was looking outwards towards the rest of the world. It would be a mistake to write off the British people. Thus, UK would also recover from this event and prosper in the medium to long term.

In the short term, UK would suffer an economic decline due to investors' uncertainty over the eventual shape of UK, reduced cross-border trade with EU, relocation of companies to EU, etc. She would also have to re-establish trade pacts with other countries. There is a global backlash against globalisation and free trade currently, which is one of the reasons contributing to Brexit and the rise of nationalism in many countries. However, given UK's status as the 5th largest economy in the world and the fact that the existing EU trade pacts are going to be missing the UK portion, I believe that UK should not have much difficulties re-establishing such trade pacts, so as to make whole the EU trade pacts at least.

The third question from Brexit is whether other EU members would be emboldened by the move and follow UK out of EU. The implication for this question is whether EU and Euro will survive. In the short term when UK is suffering an economic decline from Brexit, the answer is no. EU members who aspire to do their own EUxit would want to see what happens to UK first before making the move. However, in the medium term, if UK prospers despite leaving the EU and if EU remains the current state, then yes, more countries will exit EU.

EU was born out of a desire to end the centuries of war waged among the various civilisations in Europe and to replicate the large single market of US. However, despite the grand and noble vision, EU remains very much a work-in-progress after almost 60 years of existence. The main issue is the unwillingness of individual countries to relinquish further power to a central EU government (i.e. European Commission) for complete integration. For as along as EU citizens see themselves as British, Germans, French, Greek, etc. and not as EU citizens, there can no integrated and united Europe like the US. Look at the economic side of the union. There is economic and monetary union, meaning EU members have a common set of trade rules and can share a common currency and a common central bank, but there is no fiscal union, meaning there is no fiscal transfer of money from one member to another via a central government budget. Thus, when the threat of Grexit erupted almost a year ago, individual EU member governments had to approve the bailout for Greece instead of the European Commission dispensing money to help its member state in need. As an analogy, when West Germany merged with East Germany, if West Germany had refused to help East Germany, very soon East Germany would not want to be part of a united Germany. Thus, EUxit, whether Grexit or Brexit, is only a matter of time. I just did not predict it to be Brexit. Unless EU integrates further, the likely outcome is some EU members will follow the footsteps of UK in leaving and the Euro will fall apart.

The figure below shows the performance of the UK and European stock markets on the first day after the Brexit news. 

European Stock Market Performance on Day 1 after Brexit News

The UK market dropped 3.15%, but the German, French and Spanish markets dropped even more, at 6.82%, 8.04% and 12.35% respectively. If the conventional wisdom is that UK will fare worse than EU post-Brexit, why is it that the German, French and Spanish stock markets dropped more than that of UK? Granted, this is only Day 1 after the Brexit referendum, but it is something for us to think about.

Finally, the most important question for investors is, will markets recover or continue to tank further after Fri? It is difficult to answer. In Fri's stock market rout, banks led the decline. Early this year, even without the threat of Brexit, European banks had shown signs of stress with doubts over the banks' ability to meet their liabilities in contingent convertible (CoCo) bonds. With Brexit, there is further economic slowdown, reduced cross-border business, forex losses at UK operations, etc. The current thinking is central banks will step in to prevent a repeat of the Lehman Brothers collapse, so perhaps it is not as bad as it seems. The stock market rout in Jan this year taught me that if I cannot figure out what the market will do, at least I must figure out what I should do.

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Sunday, 19 June 2016

Lessons for Investing in OSV Companies from Shipping Trusts

I used to own a number of shipping trusts and lost heavily in them during the Global Financial Crisis (GFC). Like shipping trusts, Offshore Support Vessel (OSV) companies own and charter ships to other Oil & Gas (O&G) companies. Are there any lessons that shipping trusts can teach us about OSV companies?

Shipping trusts buy ships and charter them out to shipping companies on long-term contracts. They provide a steady stream of revenue to service the debt used to buy the ships and pay distribution to unitholders. Initially, they started off with a small fleet of ships and low debts. However, over time, they bought more ships and took on more debt as a result. Things went on smoothly initially, until business deteriorated for the shipping companies during the GFC. Spot rates for the ships fell. Although the ships were chartered out on long-term contracts at higher charter rates than the spot rates, shipping trusts were not immune to the shipping slump. Firstly, some shipping companies returned the ships to the shipping trusts upon or ahead of charter expiry to save on chartering expenses. Shipping trusts had to find new employment for the returned ships at the prevailing charter rates, which were lower than the original charter rates. This resulted in reduced revenue for the shipping trusts.

Not only that, the market value of their ships dropped in tandem with the lower charter rates. This resulted in a rising Loan-to-Value (LTV) ratio, which breached the LTV covenant in the bank loans for some shipping trusts. In return for waiving the breach, shipping trusts had to pay a higher interest rate for as long as the LTV ratio was above the threshold. Again, this meant that shipping trusts had less income to distribute to unitholders, leading to lower share prices.

Are any of these difficulties happening to OSV companies? OSV companies are experiencing declining utilisation rates for their ships as some ships have completed their charters. Using EMAS Offshore as an example, its utilisation rate has dropped steadily from 84% in FY14 to 75% in FY15 and to 59% in 1H FY16. The figure below shows that the revenue from ship chartering is going to drop further, unless new charters are found.

OSV Revenue Stream for EMAS Offshore

Due to the impairment in asset value from the lower utilisation and charter rates, EMAS Offshore reported in its 2Q16 financial statement 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."

EMAS Offshore is still growing its fleet of ships. It had committed to buy new vessels/ vessel equipment amounting to USD92M as at end Feb 16. Assuming no change to the capital commitment, it will mean that EMAS Offshore has to take on more debt and/or raise equity.

EMAS Offshore has not paid any dividend since its listing on Singapore Exchange in Oct 2014, while its parent company, Ezra, has stopped paying dividend since Feb 2014. This shows the difficult economic conditions OSV companies are facing.

Although I used EMAS Offshore as an example, it is by no means the only OSV company that is experiencing difficulties. POSH's fleet utilisation rate ranges from 57.6% to 69.4% for its range of vessels in FY2015, which is a drop from 63.5% to 84.6% in FY14. It also announced a litigation with a shipping company to recover money owed from the charter hire of 3 vessels in Mar 2016. It plans to buy 15 more vessels with outstanding capital commitment of USD145M as at end Mar 2016. POSH has cut its dividend from 1.5¢ in FY14 to 0.5¢ in FY15.

Having said the above, OSV companies are taking steps to shore up their finances. Ezra issued a 190-for-100 rights issue at a price of $0.105 in Jun 2015 and sold a 60% stake in its EMAS AMC division (now renamed as EMAS Chiyoda Subsea) to Chiyoda and NYK from Japan for a collective USD216M in Mar and Jun 2016. Together with EMAS Offshore, Ezra has proposed divestment of assets. They are also reducing vessel operating cost and actively seeking new charters for the vessels.

In summary, the difficulties previously experienced by shipping trusts are being played out in the OSV sector. OSV companies are still facing a tough time despite the recovery in oil price since Jan 2016. To understand why a rising oil price does not translate into better business for OSV companies, you can refer to The Missing Link Between Oil Price & O&G Profitability.

Sunday, 12 June 2016

The Economics of An Oil Exploration & Production Company

Last week, I mentioned that the Exploration & Production (E&P) spending budgets of oil majors hold the key to the recovery of most Oil & Gas (O&G) companies. Moreover, E&P companies are the most direct beneficiaries of the recent recovery in oil price among all O&G companies. This week, we will explore the economics of a small E&P company listed on Singapore Exchange -- Interra Resources. Interra was chosen for this analysis as it has a detailed breakdown of its Profit & Loss (P&L) statement.

Interra is involved in the exploration and production of oil in several oil fields in Myanmar and Indonesia through production sharing contracts. For Financial Year 2015, Interra's sale of shareable oil was 0.64M barrels. It earned a revenue of USD23.5M from the sale of oil and petroleum products. The average selling price works out to be USD36.87 per barrel. The total cost of production was USD34.1M, which works out to an average cost of USD53.56 per barrel. Thus, for each barrel of oil sold in FY15, Interra lost USD16.69. For Interra to turn a profit, the price of oil must exceed USD53.56. The current price of Brent is around USD50. Assuming that the price of oil that Interra sells is similar to that of Brent (a big assumption), Interra would be close to turning a gross profit.

Besides the total cost of production, Interra also breaks down the cost into 2 components -- production expenses and amortisation of producing O&G properties. The first component represents the cost to extract oil from the oil fields while the second component represents the depletion of oil reserves, which could also be viewed as the depreciation of the historical cost of purchasing the production sharing rights. The first component is a cash item, while the second component is a non-cash item as the cash had already been paid upfront when purchasing the rights. For FY15, the 2 components were USD16.9M and USD17.2M respectively. On a per-barrel basis, they work out to be USD26.52 and USD27.03 respectively. In other words, even though Interra was making a loss when selling oil at an average price of USD36.87, it was recovering cash from each barrel of oil produced as the average selling price of USD36.87 exceeded the extraction cost of USD26.52. This is why Interra (and other oil producers) kept on producing oil even though it was making a loss. Only when the selling price drops below the marginal cost of production would it make sense to shut down production.

Interestingly, in FY15, Interra made an impairment loss of USD31.8M on its producing O&G properties and almost wiped out the entire item from its balance sheet. This means that moving forward, there is not much depletion/ depreciation cost to be accounted for in the P&L statement and the only cost is the extraction cost. In 1Q16, Interra turned a small gross profit of USD0.6M. The average selling price was USD22.29 while the average cost dropped to USD17.72, which was almost entirely made up of extraction cost only.

Even though oil production looks like a passive type of investment, it is not the case. Oil production drops over time. In FY15, Interra's share of oil production dropped by 19.5% compared to FY14. Thus, although Interra almost wiped out the entire value of producing O&G properties from its balance sheet, it needs to keep on exploring and drilling new oil wells to replenish the diminishing production from existing oil wells. Even as it made an impairment loss of USD31.8M on the existing oil wells and fields, it spent USD7.9M on exploring and drilling new oil wells. This cost is capitalised, which means that it does not show up as an expense in the current P&L statement but as an asset in the balance sheet. If oil is found from these new oil wells, this cost will need to be amortised in future sale of oil products.

Lastly, Interra had this to say about its strategy for surviving the current oil slump:
"Due to the falling oil prices, the Group has adopted an extremely cautions approach with its capital and operating expenditures. All significant capital expenditures have been suspended until the current oil price situation improves."
Interra is a very small E&P company which might not represent the views and actions of major E&P companies like the oil majors. However, if correct, its views and actions suggest that the downstream oilfield services and equipment companies (e.g. Offshore Support Vessel companies and shipyards) that support the E&P companies will have a difficult time navigating the oil slump.

P.S. I am vested in Interra Resources, KrisEnergy (both recently) and a host of other O&G companies.

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Sunday, 5 June 2016

The Missing Link Between Oil Price & O&G Profitability

Oil price has moved higher to almost US$50 per barrel recently. Yet, there is a continuous stream of bad news from Oil & Gas (O&G) companies. We had Linc Energy going to voluntary administration in Apr, Ezra reporting quarterly losses of US$283 million at the same time and Technics Oil & Gas going into judicial management recently. Is the disparity between oil price recovery and bad news from O&G companies just a lagging effect or are there some other factors unaccounted for? If it is solely a lagging effect, the gradual improvement in oil price in recent months should progressively lead to better business conditions for O&G companies and the current wave of bad news could potentially mean the worst of the slump is near. However, if it is some other factors at work, the wave of bad news might not end so quickly and the prices of O&G stocks might continue to slide. Just a disclaimer before we continue: I do not work in the O&G industry. Like many investors, I have invested and lost money in O&G stocks. The information in this post is based on information that I gathered in my attempt to recover the losses in my O&G stocks. Hence, any incorrect information is unintentional and regrettable. Do not rely on this post for your investment decisions.

The answer to the question above is both. Let us tackle the more fundamental question first. Although the fortunes of O&G companies are tied to oil price, the relationship is not a direct one for most companies. Only companies that are involved in oil exploration and production (E&P) such as Kris Energy and Interra Resources 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. The majority of the O&G companies listed on Singapore Exchange, however, do not produce oil. Instead, they supply equipment and services such as Offshore Support Vessels (OSVs) to the E&P companies. These OSV companies include the likes of Ezra, CH Offshore, etc. Then, there are shipyards that build equipment for the OSV companies such as Keppel Corp, SembMar, Triyards, etc.

Thus, from the relationships above, the fortunes of shipyards are dependent on the OSV companies, which in turn are dependent on the E&P companies, which then in turn are dependent on the oil price. I reproduce this diagram from Marina Money Offshore to illustrate the O&G industry supply chain.

O&G Industry Supply Chain

Thus, to understand the fortunes of OSV companies and shipyards, it is not only necessary to know the trend of oil price, but also the spending budgets of E&P companies. Oil price has been discussed previously in The Demand and Supply for Oil and Understanding Saudi Arabia's Game Plan on Oil Price. This post moves the discussion downstream to the E&P sector which has a greater influence on the profitability of OSV companies and shipyards than oil price.

Although there are small independent producers like Kris Energy and Interra Resources, the E&P sector is dominated by National Oil Companies (NOCs) such as Saudi Aramco and Petronas and Intenational Oil Companies (IOCs) such as Exxon Mobil, Royal Dutch Shell, BP, etc. As mentioned earlier, oil price directly affects the profitability of E&P companies. In their attempt to navigate the deep and prolonged slump in oil price since Jun 2014, they have cut E&P spending budgets, jobs and deferred major projects. Such spending cuts are likely to continue (see Oil Spending Seen Down $70 Billion Next Year (i.e. 2016)), even though oil majors have reported better than expected earnings in 1Q2016 due to their downstream operations (see Oil's Profit Surprise Has Analysts Wondering How Well Exxon Did). 

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. As discussed in Understanding Saudi Arabia's Game Plan on Oil Price, there are structural changes to oil price. With OPEC producing to their full capacity regardless of price, oil price is likely to become more volatile and oil majors are likely to become more conservative in their capital expenditure. All these mean that while some business will return, the good old roaring business is not going to return for some of the OSV companies and shipyards.

I mentioned earlier that there is a lagging effect between oil price and profitability of OSV companies and shipyards. Based on the industry supply chain discussed earlier, there is indeed a lagging effect between higher oil price and improved profitability of O&G companies. However, from the discussion in the previous paragraphs, it is likely to take a fairly long time before we see higher profitability for O&G companies. In the meanwhile, it is still downhill based on E&P spending budgets and you can expect to see more bad news from the O&G companies.

Just a reminder, I am no expert in O&G. I am only an investor trying to work my way out of the O&G mess in my portfolio. It is a battle that I have no confidence of winning.

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