Wednesday, 20 September 2017

Dana Gas: Creditors Negotiating With Themselves?

The Chicago Way But Not Milton Friedman's Way

As reported by Bloomberg, DG’s tragically unfortunate creditors made DG an offer to restructure the approximate USD 700 million of outstanding sukuk with the following terms:
  1. An upfront repayment of USD 300 million (par value) in principal.
  2. A maturity extension of three years. 
  3. Maintenance of the existing interest rates:  7% on the exchangeable sukuk and 9% on the ordinary sukuk. 
  4. A request for a dual listing of DG shares on the London Stock Exchange. 
  5. Maintenance of the existing conversion price at AED 0.75 for the exchangeable sukuk. 
  6. Payment of interest amounts due last July and this October. 
DG rejected the offer and is said to be pursuing a litigation-based strategy. Bloomberg cited an unnamed party not authorized to speak on DG’s behalf.  The FT was more categorical that the company had rejected the offer.  FT article here. 
Some comments. 
AA wonders about the creditors’ negotiating strategy.  In Middle Eastern carpet stores, the seller’s initial price is a long way from the price at which he sells.  The prospective buyer needs to have a similar negotiating strategy.  Once the buyer begins negotiations and gives his first price, it's hard to go lower. 
But DG’s creditors face a more complicated situation that buying a rug from a reputable merchant.  DG has adopted an extreme position.  Its current “offer” to the creditors is (a) you owe us money or (b) in worst case we owe you no more than USD 60 million.   
That’s what Herb Cohen would describe as a “Soviet” negotiating strategy.   The appropriate response is not to make a typical counteroffer and then split the difference because the Soviet tactic moves the frame of reference way off market terms.  
Often the counterparty (the party not adopting the Soviet style tactic) proceeds as though it’s in a “normal” negotiation, replies with a counteroffer to the extreme offer, and winds up in effect negotiating with itself to its detriment. 
DG’s creditors need to be very careful not to embark on that path. 
They’ve made an offer (their first price in rug shop terms) from which they will most likely negotiate less favorable (to themselves) terms.  So what does that mean?  A five year tenor?  A USD 100 million principal payment?  An interest rate of 3%?  All of the above. 
A Jimmy Malone (pictured above) strategy seems to be more appropriate given DG’s negotiating strategy and its less than sterling behaviour.  When you’re negotiating with someone you don’t trust, the typical rules of negotiation go out the door.  There’s no “win-win” when the other party is trying to cheat you.  
One other bit of unsolicited advice for creditors: a single word “amortization”. 
No doubt some clever mind has stated that with a three year instead of a five year tenor the average life of the sukuk has been drastically reduced – 5 to 3 years.  But –a rather large but—a bullet is a bullet.  Payment is promised in one lump sum in the future. Creditors would be better off with recurring principal payments (amortization).  Money in the hand now is much more valuable than a promise of money in the future, particularly when the integrity/ethics of the party making the promise to pay are doubtful. 
AA was particularly intrigued by the creditors’ request for a dual listing on the LSE. 

Listing this mutt on the LSE is not going to turn it into a purebred. Or magically create investor demand.  The dumb money is already present.  

Is this an attempt to try and force better corporate governance on DG or somehow bind them closer to English law?   Corporate governance is fundamentally a people issue.  Listing on the LSE doesn’t by itself change that.   Unless DG reincorporates, it is a Sharjah company with all the drawbacks of UAE law. 

Is this an attempt to scare shareholders that the creditors intend to convert the sukuk and take some or all of this “gem” of an investment from their hands, thus, prompting shareholders to put pressure on DG’s board to be more accommodative?  Not bloody likely, the shareholders are a disparate group.  From ADX trading statistics, they appear to be primarily retail investors who no doubt are right now calculating how they will spend their share of the USD 1 billion they imagine will soon be in DG’s hands. The major shareholder is a related party no doubt on board with DG’s “clever socks” strategy. 
To AA’s surprise Goldmine and Blackrock are apparently holders of DG paper.  Unless they bought their stakes at a deep discount and have a reasonable prospect of turning a profit with a fractional return of nominal principal, they should not be DG investors. 
Side note: If they purchased their stakes at a discount, then “whole” dollar creditors should understand there is a fundamental conflict between their own full price interests and  creditors whose entry price is much less. 
In defense of Goldmine and Blackrock, you might be inclined to remind AA about the role of risky securities in a well-diversified portfolio. 
AA is well-schooled in how such a portfolio can tolerate some risky securities.  DG paper certainly falls into that category.  The promised return is tempting, particularly in the current low rate environment.  But there are some risks that one shouldn’t take.  Or if one mistakenly takes them, one should exit.  Despite widespread belief to the contrary, finance theory doesn’t magically protect one from unwise investment decisions. 
Some of the "red" flags on this paper.
  1. This company defaulted five years ago. 
  2. Since then, its performance (ROE and ROA) and cash generation are dismal -- clear signs of likely future inability to repay. 
  3. The sukuk is structured as a bullet which is not appropriate for an issuer like DG nor one that operates in squirrely markets (that’s a technical finance term). 
  4. If that weren’t enough, DG is based in a country whose fine legal system motivated the government of one of its constituent emirates to set up an offshore regime, including offshore laws and an offshore court system.  It doesn’t take a law degree to figure out that legal protections for creditors are uncertain (you knew I’d slip a euphemism in somewhere) in DG’s home “court”. 
  5. Exacerbating that factor, the deal is highly structured with cross-jurisdictional legal issues abounding.  The fundamental (“Islamic”) structure is not well tested in courts.  Courts in more “certain” legal jurisdictions are unfamiliar with Shari’ah and likely to defer to local courts, undermining to some extent the benefits cross-jurisdictional legal structuring was designed to confer. 
Just one or two of these factors should disqualify this paper. But all of these? One can surely find other high yield securities with less risk baggage.   
One further point for those who read the FT article cited above.  To get more insight into the KRG settlement take a look at my earlier post. And don't miss the posts in reply.  Despite a comment in the FT article about the settlement removing DG’s “ability to pay” defense, cash is not about to rain down on DG.    

Saturday, 16 September 2017

Dana Gas: Comments on KRG Settlement

Unless you’ve been asleep you’ve already read about the settlement between the Kurdistan Regional Government and Pearl Petroleum announced on 30 August by Dana Gas. 
Most of the headlines focused on the USD 1 billion payment by the KRG to Pearl Petroleum and did not discuss other aspects of the transaction.  The market reacted with characteristic irrational exuberance. Hence this post.
To start a side comment. In a rather bizarre but not uncharacteristic move, DG did not confirm PPL’s receipt of the payment until 5 September after receiving “numerous market enquiries”.  Apparently, neither DG’s crack investor relations staff nor its management thought that there were parties who would be interested in knowing for certain that the KRG actually made the payment.
Not a particularly “brilliant” move to sit on such critical and positive news but sadly par for the course at DG.  Or as AA’s brother no doubt would have it, “shelled another dolly.” 
Here’s an extract from the joint KRG/PPL press release published by Dana Gas.
The agreed settlement highlights are as follows:
  1. The KRG will immediately pay Pearl (PPL) a sum of US$600 million.
  2. The KRG will also immediately pay Pearl a further US$400 million to be dedicated for investment exclusively for the aforesaid further development to substantially increase production.
  3. Pearl will increase gas production at Khor Mor by 500 MMscf/day, a 160% increase on the current level of production (the "Additional Gas"). The Additional Gas, together with significant additional amounts of condensate, is expected to begin production in approximately two years.
  4. The balance of sums awarded by the Tribunal ($1,239 million) is no longer a debt owed by the KRG and will be reclassified as outstanding cost recoverable by Pearl from future revenues generated from the HoA areas.  The profit share allocated to Pearl from future revenues generated from the HoA areas are adjusted upwards to a level similar to the overall profit levels normally offered to IOCs under the KRG's Production Sharing Contracts. This adjustment reflects the larger investment risks and costs involved in the development of natural gas resources compared to oil developments. After the recovery of costs and a return on investment by the Consortium, 78% of revenues generated from the HoA areas will be for the account of the KRG, and 22% for the account of Pearl.  
  5. The Parties have clarified the Khor Mor block boundary coordinates and the KRG has awarded the Consortium investment opportunities in the adjacent blocks 19 and 20, and added these to the HoA areas, with commitments by the Consortium to make appraisal investments on these blocks, and developments if commercial oil and gas resources are found.  The KRG will purchase 50% of the Additional Gas on agreed terms to boost the gas supply to power generation plants in the Kurdistan Region.  The other 50% of the Additional Gas (250 mmscf/d) will be marketed and sold by Pearl to customers within Iraq or by export, or can be sold to the KRG as well to further boost power generation within Iraq.
  6. Pearl will also expand its local training and employment programs towards achieving maximum localization and content, as well as supporting local communities through its active Corporate Social Responsibility (CSR) programmes.
  7. The Parties have exchanged mutual releases, waivers, and discharges in relation to all claims in relation to the Arbitration and related court proceedings. The Parties have also amended and clarified the HoA language and terms, including extension of the term of the contract until 2049. 
Now for a closer look. 
  1. DG is a 35% shareholder in PPL so at a first cut, DG’s share of the USD 1 billion payment is USD 350 million.  Sounds good, but there are at least a few wrinkles.
  2. That money is at Pearl not DG, though DG will show the USD 350 million in its September financials, just as it shows its 35% share of PPL’s aggregate trade receivables.  If and until PPL transfers funds to DG, DG will not have use of the funds.
  3. Also note the money in two tranches.  One of USD 210 million and one of USD 140 million.
  4. Let's start with the second amount the USD 140 million. That amount will not be available for DG to use as it wishes because the USD  400 million tranche is required to be spent in the KRG to expand production, assuming of course that PPL honors its commitment to the KRG. 
  5. As regards the first amount DG's USD 210 million share of the USD 600 million, how much of this DG will ultimately obtain unrestricted use of depends on Pearl's cash needs, particularly if PPL will require more than USD 400 million to fund the promised increase in production.   If the amount exceeds USD 400 million, then any funds ultimately transferred to DG and its partners for their own use will be lower than the USD 600 million discussed above. 
  6. PPL has agreed to release the KRG from its obligation to pay the remaining USD 1.239 billion of the arbitral award.  However, this amount is not completely forgiven or “lost”.  It’s been transformed into a “recoverable cost”.  Under concession agreements, the operator is entitled to recover its invested costs plus a certain return (not specified here and I could not locate it in DG’s financials or other information it publishes) before the profit sharing mechanism becomes operative. 
  7. What this means is that PPL and thus DG and its partners will recover this amount over time, if the Kurdistan fields produce.   PPL is thus highly incentivized to ramp up and maintain production as soon as possible.  That’s the good news. 
  8. The bad news is that this is an installment payment which is estimated to begin some two years hence.  On a present value basis then PPL will recover less than the USD 1.239 nominal sum.  Depending on the timing of production, the amount may be much less. 
  9. The KRG has increased DG’s share under the profit sharing agreement to 22% and has extended the concession period to 2049.  That gives PPL the opportunity for additional earnings and will counteract to some extent the present value loss on the USD 1.239 billion.  Just how much is not clear as again it will depend on the timing of cashflows. 
  10. Dana will also be able to sell 50% of the Additional Gas for export neatly side stepping further exposure to the KRG's creditworthiness.
  11. PL and the KRG have issued mutual releases on arbitral claims.  You will recall that earlier this year PPL was reported to be pursuing some USD 26.5 billion in claims against the KRF for alleged damages. On a positive note, the settlement of all claims may lead to an increase in KRG payments of outstanding be-whiskered trade receivables which would help DG’s cash flow but not its profit.   The stale receivables have already reduced DG’s realized profit from that reported by the operation of present value.  Nonetheless, more cash in hand would provide DG additional flexibility in conducting its operations.  Were it so inclined—an assumption for which there is scant evidence so far—the cash could be used to repay the sukuk.  This claim has been dropped as language from the preface to the press release indicate. 

The Parties have mutually agreed to fully and finally settle all their differences amicably by terminating the Arbitration and related court proceedings, and releasing all remaining claims between them, including the substantial damages asserted by the Consortium against the KRG.
While there is both some good and some not so good news for DG in the PPL settlement, on balance it probably is a net positive.  AA suspects that those who have read the news of the settlement and are expecting a cash bonanza at DG will be like the bankers who are anticipating "rich investment banking fees" in Saudi Arabia.
But Is this good news positive enough for AA to change his recommendation against investing in DG equity or debt? 
A resounding no. 
The first rule of investing is not to invest with issuers who have demonstrated that they cannot be trusted to honor obligations.   

Friday, 15 September 2017

Tulips and Bitcoin

At Least They're Real

This Tuesday self-described “no nonsense take no prisoners” Jamie Dimon lambasted Bitcoin at a New York investor conference as per press reports. 
The cryptocurrency “won’t end well,” he told an investor conference in New York on Tuesday, predicting it will eventually blow up. “It’s a fraud” and “worse than tulip bulbs.”
Indeed, at least if you buy a tulip bulb, you have something tangible.  A Bitcoin is the monetization of a wish.
Many self-described “sober investors” who buy Bitcoin offer as their “sound” rationale that governments create national currencies out of thin air without “backing” the issuance with any tangible asset and that as a result these currencies are inherently dangerous.  To avoid this “clear” danger they instead “invest” in a currency issued by a private sector entity out of thin air without “backing” by any tangible asset.  
But there are key differences that make this investment a “wise” one so they say. 
  • First, aggregate issuance is limited.  
  • Second, unlike a government, the private sector entity issuing Bitcoin has no legal powers or ability to support its currency’s value, instead relying on the proven performance of the “free market” for magical solutions.  A dogma that almost certainly Jamie sadly won't have time to address.
To those wise investors AA wants to offer an even more compelling opportunity: AA’s new “virtual” company that will manufacture digital electronic vehicles.  The upside is clearly unlimited as costs of manufacture and selling are low. No raw material except an odd electron here and there is used in the manufacturing process.  There are no associated shipping costs for the product.  Nor do our dealers need to hold physical inventory.
AA’s digital cars also are environmentally friendly.  There are no emissions associated with the manufacturing process or the finished product when in operation.       
Patriotic investors will be happy to note that AA is a proud participant in the current Administration’s Make America Great Again Manufacturing Program.  Our factory is based in the United States where we project that we will employ a virtual workforce of over 150,000 when full capacity is reached.  Strict sourcing standards ensure that only US electrons are used in our product.    
Disclosure: AA and a member of his direct household (Madame Arqala) hold investments in tulips between 15 and 30 bulbs planted in the elegant gardens of Chez Arqala.