Description

Company:                 Oro Negro Drilling Pte. Ltd (“INTSPN”)

Security:                   $939MM 7.5% Senior Secured Bond due January 2019

Recommendation:    Long

Current Price:           45c (in default since Oct. 2017)

Executive Summary

Oro Negro Drilling Pte. 7.5% Senior Secured Bonds (in default) are materially undervalued at ~45c. Concerns over sector, jurisdiction, and complexity are deterring many investors from looking more closely at an asset recovery opportunity with attractive upside and limited downside.

Orderly liquidation of recently seized ‘warm stacked’ (idle but operational) premium jackup rigs should provide bondholder recoveries of 48-52c (+6.5%-12.5% upside from mid-40s). Additional sources value, primarily disputed cash held in trust and litigation claims, could increase recoveries to the mid-high 50s. Upside optionality (+30-50% return in ~12 months) is achievable if creditors win contracts or negotiate equity participation. Downside is protected by asset collateral controlled by bondholders.

Brief Description

Oro Negro (translates to ‘Black Gold’) is a Mexican limited liability company established in 2012 to acquire interests in operating companies, strategic standalone assets and other interests in the oil & gas services sector. The company aimed to become one of PEMEX’s leading integrated service suppliers in the Gulf of Mexico. Managements’ early strategy focused on establishing a high-quality fleet of premium jackup rigs. 5 premium jackup offshore platforms were delivered between 2012-2014 for an average acquisition cost of $208,500 per rig. All rigs began drilling contracts with PEMEX upon delivery with dayrates of $130,000 to $160,000.

The main shareholder is Axis Capital Management, a private investment firm formed in 1990 specializing in financial advisory services, venture capital investments and structured credit. Ares Management, Temasek and Mexican pension funds have also provided equity capital.

PEMEX experienced liquidity pressure following the oil market downturn in 2014. Oro Negro’s contracts were repeatedly renegotiated at reduced dayrates or suspended. In August 2017, PEMEX requested additional amendments, including suspension period extensions for two rigs (Primus, Laurus) and contracting the remaining three rigs at $117,000 per day. As a result, Perfordora Oro Negro (Mexican-registered Opco) filed under Mexican bankruptcy law (Ley de Concursos Mercantiles or LCM) in September 2017. PEMEX terminated all contracts in October 2017. All rigs have been ‘warm-stacked’ in Mexico’s Bay of Campeche since late 2017.

Investment Thesis

Oro Negro’s bonds, issued by Singapore registered entities, have been in default since October 2017 following bankruptcy filing with Mexico City’s Second District Court. Bonds traded near all-time lows (mid-to-high 30s) in early May reflecting uncertainty regarding asset sale timing, liquidation proceed amounts, and the potential for recovery dilution from additional liquidity injections.

Recent Mexican court orders create an attractive asymmetric return profile over a relatively short time horizon (likely less than 1 year). Process risk has fallen significantly following court orders on May 16/17th requiring management-controlled OpCo (Perfordora) to deliver warm-stacked rigs worth ~50pts recovery to bondholders. Bonds are now quoted 8/9pts higher. Bondholders’ seizure of rigs effectively eliminates scenarios in which one or more rigs leaks to the debtor/management.

The primary sources of value are five premium jackup rigs currently warm stacked in Mexico (Primus, Laurus, Fortius, Decus, Impetus), Mexican Trust Assets, and PEMEX litigation claims.

Jackup rigs:

·         Jackup rig valuations provide the foundation of recovery values. $100-105MM average valuation per ‘warm stacked’ Oro Negro rig is a reasonable base case given recent secondary jackup rig purchases (i.e. ~25-30% discount to Borr Drilling October 2018 jackup fleet purchase) and quotes from offshore valuation services/brokers. $100MM per rig implies 48pts bondholder recovery excluding potential proceeds from Trust Assets or PEMEX litigation.

·         Buyer interest for Oro Nego’s rigs should be supported by higher specification rigs relative to competitors in the Gulf of Mexico (more accommodation, deeper drilling capabilities). Potential strategic buyers include Seamex (Mexican jackup JV formed by Seadrill and David Martinez’s Fintech), Borr Drilling, and Shelf Drilling. Entities associated with Seadrill chairman John Fredrickson (GHL Investments, Ship Finance) are members of the bondholder coordinating committee.

·         Bondholders’ ownership of rigs free of legacy charters would allow for renewed participation in contract tenders. Contract backlog prior to rig sale would materially increase the value of the rigs; Oro Negro’s legal statements reference values per rig of $120MM to $160MM without contracts versus $280MM to $320MM with contracts.

$84MM frozen Mexican Trust Assets

·         In June 2018, the Mexican bankruptcy court issued an order instructing PEMEX to pay approximately $96 million for services provided by Oro Negro prior to October 3, 2017 (bankruptcy filing date). After PEMEX deposited the cash, bondholders initiated a criminal investigation into Oro Negro and certain of its executives for misappropriating rent payments owed to the Singapore Rig Entities from the Mexican Trust. The courts froze the Trust account until 22 July 2019. The trust currently holds $84MM, implying an additional 7pts of recovery if fully distributed to bondholders.

·         The trust agreement governing the account implies that bondholders should have priority over payments from the account. The Mexican Trust Agreement was entered into by the Trustee (1st place), rig owning entities (2nd place), Perforadora (3rd place) and Fiduciary Bank (DB as trustee of Trust Agreement). The trustee is responsible for ensuring claims, demands and receives all payments under Mexican Drilling Contracts and transfers them to relevant Rig owners Earnings Account.

PEMEX litigation claims

·         Perforadora is seeking to force PEMEX to fulfil its contractual agreements via the courts. Early in the bankruptcy process (18th October 2017), the Mexican bankruptcy judge ordered PEMEX to refrain from terminating lease agreements. Perforadora was told that it should continue invoicing under the current day rates for the applicable contract term. On January 30th, 2019, 5th District Court of Mexico City upheld Perforadora contract with PEMEX and confirmed that PEMEX is liable for damages. Damages would likely range between $200MM- $325MM (or higher) depending on dayrate and contract termination assumptions.

·         The court appointed mediator decided to extend the negotiation deadline to June 11th. The extension was reportedly linked to expectations of an impending legal decision on the PEMEX dispute.

·         The PEMEX litigation outcome remains highly uncertain. The investment thesis does not depend on successful resolution, but positive outcomes could drive materially higher recoveries. For example, $200mm damage claim of which bondholders receive 50% would increase recoveries by 10pts.

Valuation Summary

The table below shows possible recovery scenarios. Key assumptions include amount of leakage to debtors, rig asset values, proceeds from the Trust Account, and PEMEX litigation claims.

·         Base – $100-105MM is a conservative estimate of Oro Negro rigs’ average warm stacked value implying bondholder recoveries ~50c. The ‘Base’ cases should be considered conservative estimates of intrinsic value assuming proceeds from jack-up rig sales and no other sources of recovery.

·         Upside – Proceeds from ‘warm stacked’ rig sales will likely occur alongside additional recovery from some combination of trust account cash, litigation proceeds, and rigs being sold on contract. $64MM bondholder recovery from the DB Trust Account ($20MM leakage to debtor) would increase recoveries to 55-57c (25-28% upside). PEMEX litigation proceeds of $100MM would increase recoveries by an additional 10c, implying +40% upside if combined with trust account proceeds. $140MM is a conservative estimate for operational rigs contracted for 3 years near current dayrates (two-stage DCF approach, stable longer-term dayrates); rigs on contract could increase fleet valuation from ~$500MM to $600MM or higher (+60c recovery).

·         Downside – Bondholder recoveries below 45c would require rig sale proceeds lower than $100MM per rig on average and no other sources of value. Selling the rigs at an average price of $90MM would generate 40c recovery (-11% downside without any additional sources of recovery). Rig sales at prices materially below $90MM are highly unlikely. Ship Finance disposed of the Soehanah, a jack-up built in 2007 with 375ft water depth, for $84MM in mid-2018; Oro Negro’s rigs were built five or more years later with higher specifications.

Why does the opportunity exist?

Mispricing likely exists for the following reasons:

Litigation: Proceedings are complicated by litigation, discovery and accusations by both debtor and creditors. Aggressive management seek large cash settlement from bondholders. Mexico City prosecutors investigated Oro Negro for fraud and a criminal court judge ordered restitution of the rigs. The company accuses bondholders of collaborating with PEMEX to bankrupt the company.

Jurisdiction: The situation is complicated by previous or ongoing proceedings in Mexico, Singapore, and the United States. Foreign investors’ experience in previous Mexican bankruptcies discourages involvement. The Southern District of New York granted the debtor’s plea for chapter 15 protection in May 2018 (Judge Chapman, case no. 18-11094). Proceedings are therefore largely driven by Mexican courts.

Investors’ concerns partially reflect outdated concerns resulting from unfavourable outcomes prior to LCM’s 2014 amendments. Most notably, 2014 amendments directly counteract strategies to cram down creditors using intercompany loans as employed by Vitro S.A.B de C.V. Process concerns are also more relevant for unsecured claims given lack of differentiation between unsecured classes in LCM; secured claims, in contrast, cannot be forced to relinquish their collateral.

Bondholder fatigue: Investors expecting amicable settlement have been disappointed by lack of progress. Those involved prior to filing or from early bankruptcy stages will have experienced meaningful mark-to-market losses over ~18 months. Maximizing future returns may require additional injections from bondholders in the form of further liquidity bonds or auction participation.

Risks

Fundamental Risk: Jackup rigs valuations depend on the offshore drilling market’s dayrate/utilization trajectory, particularly in the Gulf of Mexico in particular. Recovery in offshore drilling has been notoriously difficult to predict. The jackup valuations assumed above require stability in dayrates, rather than material improvements.

There are reasons to expect improvements in the Gulf of Mexico. Mexico’s Ministry of Finance projects higher oil production in recent preliminary budget figures for 2020 (+7.4% higher than 2019). PEMEX’s approved capex for 2019 ($13.7BN) increased by over 22% yoy. Offshore drillers such as Rowan and Borr Drilling have also referenced increasing jackup activity during recent results presentations.

Process Risk: Few precedents and lack of dedicated Mexican bankruptcy judges increase uncertainty in legal processes. Delays to expected timeline may occur due to debtor or external interference.

Corporate structure

·         Oro Negro Drilling Pte. Ltd is the Singaporean registered issuer for Senior Secured Notes

·         Each rig is owned by a corresponding Singaporean registered entity, each of which are fully owned by Oro Negro Drilling Pte. Ltd (bond issuer)

·         Perforadora Oro Negro (Opco) is a limited liability company incorporated under the laws of Mexico. Perforadora leases rigs from the rig owning entities via agreements known as bareboat charters. PEMEX then leases the rigs from Perforadora.

·         Integradora de Servicios Pertroleros Oro Negro (ParentCo) is suing PEMEX for cancellation of contracts.

Capital Structure

The capital structure consists of $990MM of debt, with $939MM senior secured bonds due Jan. 2019 issued by Singapore registered Oro Negro Drilling Pte Ltd. Bonds are backed by first priority liens on jackup rigs, shares in issuer & guarantors accounts (including the Mexican registered parent), Mexican Trust Agreement, share charges, and collection rights. Remaining debt consists of $50MM super senior liquidity bonds (provided by secured bondholders) and $1.2MM shareholder loan.

Recent Events

Mexico’s in-court bankruptcy proceedings have two main stages. The first stage is mediation (Conciliacion) during which the court appointed mediator attempts to agree settlement terms between the debtor and creditors (185 days); Oro Nego is currently nearing the end of the mediation stage. The second stage is bankruptcy and liquidation (Quiebra) of an insolvent entity which automatically follows unsuccessful mediation.

·         April 4th 2019 – The debtor’s final settlement proposal during mediation phase contemplates bondholders receiving four jackup rigs, $20MM of Trust Assets and 50% of litigation claims. Bondholders rejected the proposal (Final settlement proposal: https://www.stamdata.com/documents/NO0010700982_IB_20190403.PDF) Applying an average valuation of $100MM per jackup rig implies 39% bondholder recovery under the recently rejected settlement proposal.

·         May 8th, 2019 – The court appointed mediator extended the deadline for negotiated settlement agreement by 40 days to June 11th. The liquidation stage of Mexican bankruptcy process would begin following deadline expiry, effectively. Settlement agreement (50% creditor consent) and/or further negotiation deadline extensions (75% creditor consent) seems unlikely.

·         May 16th – Judge Benito Arnulfo Zurita of the Mexico City-based Second District Civil Court issued an order stating that the shareholder controlled Perforador had 24 hours to allow for the rig owning entities (creditor controlled) to take possession of the five rigs

·         May 17th – Judge Zurita issued a second sealed ruling on Friday, affirming a previous order requiring the transfer of five Mexico-based rigs to rig-owning entities, from Perforadora. The order states that rig-owning entities must keep the rigs in Mexican waters until June 12th (new deadline for mediation), implying rigs can be moved after that date.

·         May 17th to 20th – Representatives for the creditors began seizing assets. All five rigs are now in the hands of rig-owning entities.

·         May 21 – The foreign representative for Perforadora (Opco) and Integradora (Parentco) filed a notice with the South District of New York bankruptcy court presiding over Chapter 15 proceeds. The filing confirming that debtors had complied with the order and delivered the jackups to the rig-owning entities.

Next steps

Bondholders’ negotiating position has improved considerably following recent events. It’s possible that the debtor would propose a revised offer prior to June 11th in which creditors receive all five rigs plus additional compensation. Trust account cash and any litigation proceeds would be distributed to bondholders upon receipt. The coordinating committee would be free to sell or market the rigs for contracts.

Failure to settle during mediation phase results in liquidation proceedings (LCM’s bankruptcy stage) in which a receiver is appointed to administer the debtor. The receiver is tasked with liquidating and distributing proceeds from sale of the debtor’s assets. Sale of the business as a going concern or separate assets is completed by a public auction or alternative court-approved process. The receiver is responsible for maximizing recovery for creditors in the shortest period possible. Official rules state that liquidation is to conclude 180 days following bankruptcy stage commencement. Few cases have reached liquidation stage and even fewer have adhered to the time frames set forth by LCM.

Catalyst

Catalysts include favourable ruling on PEMEX litigation, unfreezing of Trust Assets on 22 July 2019, expression of interest by strategic buyers, liquidation progressing on schedule.