Case Study - Nabors Drilling

Est. Reading Time: 12-15 minutes

In the course of investing, or in life, the idea of probabilistic thinking is a very valuable one.

It is a broad topic, so there is a lot that can be written about it, but here I’d like to use a case study to give a real-world example highlighting this particular mode of thinking.

When COVID-19 hit the US in March of 2020, it sent the equity markets (well, all markets) into a spiral. Even safe haven assets were dumped in the name of liquidity.

As the markets bottomed and the dust settled, the next macro effect became abundantly clear, demand was about to drop off…that is, for sectors that weren’t selling stationary bikes with iPads attached.

Oil, already relegated to the corner of shame by the ESG movement and still plagued by the ghosts of reckless spending during the frac boom, was perhaps the most unloved and beaten down industry of all. 

But when occurrences come up like oil prices turning negative (-$37.63/bbl for WTI at the bottom), it pays to take notice. 

A few of the facts on the oil situation just before the COVID demand shock

• Oil consumption globally was sitting at 101 million barrels per day leading up to COVID

• Oil supply moved around demand within about a +/- 2% range every quarter going back to at least 2014 (i.e. not a ton of backup supply)

• Demand had been growing steadily since that time by about 1.5% annually

So aside from the short-term shock to the system, a prudent question would have been:

“Is there anything already in place or resulting from this situation that might change the fundamental landscape of this industry? If the answer is no, is there an investment opportunity?”

While demand was certainly taking a hit in the near term, COVID was unlikely to permanently erode demand given its progressive growth leading up to the pandemic. The worst and most extreme case would’ve been demand erosion from the actual loss of life. But, with the mortality estimates approaching 3% on the higher end, this was unlikely to directly cause a long-term drop in demand. For instance, a 10% drop in demand volumes would’ve sent us back only to 2013 levels.

This is oversimplified and somewhat morbid, but we are looking for approximations.

From an alternative energy source point of view, despite the progress that was and has been made in the green energy space, it was hard to state that a global shift had taken place given the supply and demand data. It is, and was, safe to say that given the steady rise in oil demand green technology was not making large enough strides to be eroding the growing usage of oil.

Further, if we all agreed that a shift away from oil needs to occur, it was unlikely to occur while we were all stuck in our homes. It takes time and unfortunately the use of current energy sources to enact change.

This is an extremely simplified view and ignores the immense amount of friction and chaos that could have ensued had some of the worst-case scenarios come to pass. But it’s better to be approximately right than exactly wrong and you may not have been worrying about investments anyhow if the worst case had come to fruition.  

So, we have an unscientific approximation of the situation.

Chances of the need for oil returning given the use data leading up to COIVD?

Pretty high.

Chances of a new paradigm shift in energy use coming about while we were locked down?

Pretty low.

Chances the effect of COVID (i.e. mortality or lifestyle changes) erodes long term demand? Or we stay locked down indefinitely.

Pretty low. 

It was safe to say oil was coming back, the only unknown was how long it would take. We could be right, but artificial demand suppression can still last quite a while. Could we get paid to wait, without letting go of the appreciation potential?

Despite several screaming value buys in the sector, which eventually did become too good to pass up towards the end of 2020 and in the first half of 2021, I passed on all oil and gas common equity opportunities in those first several months and settled on convertible preferred shares as the vehicle for energy related choices given the uncertainty.

A preferred share does not have voting rights but pays a stated dividend which is sometimes cumulative (they must pay back any skipped dividend payments) and sometimes non-cumulative. A convertible preferred share works the same way with the additional feature of being convertible into a stated amount of the common shares of the company either by election of the holder or at a predetermined date.

In the chaos, the convertible preferred shares of Nabors Drilling had dropped so low its cumulative dividend payments had gone over an 80% annualized rate. Additionally, it was mandatorily convertible into common at over 5 shares of common stock to each preferred share in May of 2021. So a just over a year.

A few details on Nabors at the time:

• Its common share price was trading well below 50% of its book value

• Its operations were roughly 50% US domestic, and 50% abroad, so geographically diversified

• Its current ratio was in excess of 1.2

• It hadn’t missed a dividend payment on its preferred to date

So here was the proposition, get roughly your entire investment back (there were 4 dividend payments left until conversion at about 20% of invested capital per payment) and then be mandatorily converted into holding an underpriced common stock position in just over a year.

 It's a good exercise when you think you might be getting a freebie to ask, “why am I so lucky?”

There were three main risks to consider with this position.

 1. The stated dividends did not get paid

2. By the time of the mandatory conversion the common stock had declined further

3. Worst case, by the time of the mandatory conversion they had filed for bankruptcy

In regard to the dividends, these were cumulative so any pause in payments would’ve had to be made up by the conversion date which was less than eighteen months out. Additionally, not paying the dividend on preferred shares would’ve been akin to a bond default and given the current climate it was unlikely any company was going to voluntarily add that to their plate if they could make the payments. These payments also represented a relatively small amount of cash flow to sacrifice every quarter, so the payments were not material to the overall operation.

Risk number one, very low.

If the common stock had declined further, it would’ve only made it a more attractive purchase. But, from the standpoint of liquidating right after conversion, given the nearly 100% payback that was contractually obligated any drop would’ve likely been immaterial. It would have to drop a further 80% to start producing a real loss. For instance, a 50% further drop in the common, liquidated at conversion, would’ve still been a 30% gain (80% distribution + 50% of liquidated value = 30% return). We’re ignoring taxes for simplicity or annualized return conversion since it was so close to one year.

 Risk number two, very low.

The potential for bankruptcy was the big one that was likely the majority cause of this opportunity even being available. But this was the sentiment across the whole industry and here it would’ve been (and was) incorrectly applied. First, the current ratio was in excess of 1.2 at the time, meaning they could do nothing new and service their obligations out to the conversion date. The quick ratio wasn’t much behind the current ratio either. Much of their revenue was contractual, which of course could be disrupted, but was unlikely to be enough to warrant bankruptcy in the near term.

Second, trading at such a discount to book value ensured that in a liquidation scenario there would be excess to distribute even after a fire sale. Additionally, their balance sheet is made up of the largest oil rig fleet in the world which has two things going for it. First, it’s the largest and given that demand was unlikely to stay depressed once normal life (somewhat) resumed there would’ve been buyers for something that is not easily replaced. Secord, a rig fleet is a highly depreciable asset, meaning that even in a downturn or fire sale scenario the book value was not likely to be a good indicator of the prices these assets would fetch. They’ve would’ve been higher.

Full disclosure, in a previous life as an oil and gas engineer, I’ve had the chance to work on and around several of Nabors’ drilling rigs. So, some preexisting due diligence was helpful in understanding the value and makeup of these assets.

This looks to be the only scenario that might produce a real loss, but given the near whole payback via the dividend, even if it came to pass it would unlikely have been a material loss. The worst case would be a drug out unwinding that would’ve subjected the investment to opportunity cost.

Risk number three, very low and tolerable if experienced.

While even in highly uncertain, but low risk, situations like this there is naturally more investigation than is outlined here. Several years of annual reports were needed to track these preferred shares from creation to current situation to ensure things like dilution clauses were not hiding somewhere.

You still have to do your homework, but the point here is the thought process.

This approach of thinking probabilistically and going through the decision tree of “if-this-than-that” pathways is what helps to understand to full extent of what you are doing or signing up for.

Here we have an example of risk does not equal uncertainty. While the macro situation was a precarious one, was this investment inherently risky?

How It Panned Out

In April of 2020 I bought at a price that gave me an annualized return of 91% via the dividends. So, I managed to snag a price that would pay me back just about the entire investment by the time it was converted. At the time, the common was trading below $15/share. This was pretty much the low but had one taken more time to consider this situation there were several chances to enter with the common below $30 between April and September.

For those thinking about it, no there was no convertible arbitrage opportunity to collapse the timeline even further, and I prefer the long term tax rate if I can get it anyhow.

While 2020 was a tough year for oil and gas, no bankruptcy proceedings came to pass for Nabors and by the time the preferred shares were converted the common was trading around $100/share. This equated to a roughly 6.75x value increase on the initial investment after already being paid back.

After that it was a bit more difficult to value a long term hold of the company. Truthfully, I didn’t care much for the management’s approach and tactics and if I were going to hold a commodity driven company I would prefer it to be one with a claim to that commodity. Despite the irreplaceable fleet.

But there was one more twist. In June of 2021, right after conversion, it was decided to award all common shareholders two warrants executable at $167 for five years for every five common shares they held. This was as suitable a time as ever to exit the initial position, which was now north of $110/share, and hold onto the warrants.

All told the upside was a nearly complete repayment of investment via dividends, a +7x gain on the sale of the converted common and an unrealized gain on the warrants which are trading in excess of $50/share at the time of writing. Mapped back to the original investment at the 2/5 ratio this would be equivalent to another +130% return over the basis.

It’s easy to go back and look at the correct decisions in hindsight and this is clearly a rare event. But everyone experienced the disruptions caused by COVID in 2020 and just about everyone has an opinion or experience with the oil and gas industry as of late.

So, this serves as a good case study. Not to pretend that returns like this are abundant if you just look at more complex investments like preferred shares, but how a probabilistic approach can help you determine if it’s really risk or uncertainty you are taking on.