Addressing Some Recent Misconceptions Regarding Ocean Rig

| About: Ocean Rig (ORIG)


Discussing the catalysts behind the recent 200% rise in the shares.

The purchase of the former Dryships stake was solely done to ensure the CEO's full control over the company and disempower outside shareholders.

Providing some much needed background on the recent auctions of the drillships Cerrado and Deepsea Metro II.

Cerrado purchase might prove to be just another costly, overly aggressive move by George Economou.

Interests of George Economou are by no means aligned with outside shareholders.

Junior offshore driller Ocean Rig's (NASDAQ:ORIG) shares have staged a major comeback as of late, gaining more than 200% on an interim basis over the last six weeks. But even after the shares have given back some of their recent gains, the stock is still up more than 150% from the beginning of April when the share price tested previous all time lows around the $0.75 level initially set in February.

Granted, a good chunk of the recent momentum is attributable to the ongoing recovery in oil prices and yes, the rising tide has more or less lifted virtually all offshore drilling stocks by a considerable amount, but only Ocean Rig's stock managed to easily more than double in recent weeks.

So what happened here?

Actually there have been two major catalysts.

At first, Ocean Rig announced the purchase of former parent DryShips' (NASDAQ:DRYS) remaining roughly 40% stake in the company on April, 5.

Secondly, the company announced the acquisition of the 6th generation ultra deepwater drillship "Cerrado" in a court supervised auction for $65 mln on April, 25.

The Cerrado was built by Samsung Heavy Industries (OTC:SMSHF) in 2011 to similar design specifications as the remainder of Ocean Rig's existing 6th generation drillship fleet. The published construction costs for the rig amounted to $678 mln.

Both actions were celebrated by both market participants as well as fellow contributor "Fun Trading" as near genius moves engineered by Ocean Rig's colorful CEO and chairman, Greek shipping magnate George Economou.

Particularly fellow contributor "Fun Trading" adulated both deals in two highly enthusiastic articles, that can be accessed here and here.

In fact his overwhelmingly positive assessment of the Dryships' stake purchase already prompted me to express my deep concerns about the transaction in a detailed article, published on April, 6.

Here's the quintessence of the article:

As Ocean Rig does not intend to retire the shares purchased from former parent Dryships, this wasn't the typical share buyback usually done to return excess capital to shareholders. In fact, the shares were purchased by the company's recently established unrestricted subsidiary Ocean Rig Investments and are still being held within this entity as of today. The transaction effectively ensures George Economou's full control over Ocean Rig by moving the shares from troubled Dryships, which recently defaulted under its credit lines, to an unrestricted subsidiary of Ocean Rig where it is now safely stored for the time being.

Moreover, George Economou would be able to effectively take possession of the stake without using any cash by simply moving some assets from his private entities into Ocean Rig Investments at a later date.

Even better, the roughly $50 mln paid by Ocean Rig to Dryships were mostly pocketed by George Economou himself as evidenced by the press release published by Dryships regarding the stake sale:

The Company has agreed to sell all of its shares in Ocean Rig UDW Inc. ("Ocean Rig") to an unrestricted subsidiary of Ocean Rig for total cash consideration of approximately $49.9 million. The sale proceeds will be used to partly reduce the outstanding amount under the Revolving Credit Facility (Revolver) provided to us by a company controlled by our Chairman and CEO Mr. Economou and for general corporate purposes. (...)

So George Economou not only protected his total control over the company and established a future way to personally take possession of the former Dryships stake without using any cash, he also managed to actually funnel a large amount of cash out of Ocean Rig's coffers right into his own pockets.

While indeed a truly genius move, it seems quite evident that the transaction wasn't done for the benefit of the outside shareholders. Actually quite the opposite looks true here, given that in conjunction with the transaction Ocean Rig redomiciliated from the Marshall Islands to the Cayman Islands. Among other reasons the company's respective filing with the SEC provided us with the true background of the redomiciliation:

(...) under Cayman Islands law, shares of a parent company held by a subsidiary company are not characterized as treasury shares and are entitled to vote and be counted in determining the total number of outstanding shares (...)

By contrast, under the Marshall Islands Business Corporations Act (...) treasury shares and shares of a parent corporation held by a subsidiary corporation are not entitled to vote or be counted in determining the total number of outstanding shares.

So in effect the company's outside shareholders were entirely disempowered by Economou's clever move while he moreover managed to get paid handsomely for the transaction. Great job, George.

Let's now get into the discussion of the recent Cerrado purchase:

The market's overly enthusiastic reaction to the announced purchase of the Cerrado was seemingly due to the large discount when compared to another recent drillship auction sale, the Deepsea Metro II transaction, another 6th generation ultra deepwater drillship built in 2011 by Hyundai Heavy Industries at an initial price tag of $860 million according to fellow contributor Vladimir Zernov.

While Ocean Rig was able to pick up the Cerrado for just $65 mln, the purchase price of the Deepsea Metro II was reported at $210 mln, so seemingly Ocean Rig made an eye-catching bargain.

The purchase was actually a repeated topic of analysts' questions on some of the recent quarterly earnings conference calls held by Ocean Rig's peers. The answers were pretty similar as a couple of executives actually more or less openly questioned the quality of the Cerrado, citing a very poor execution history with the effective utilization of the rig only having been around 80% in the past. In addition, none of Ocean Rig's peers took the view, that buying distressed assets at this time could potentially yield decent returns in the future. In fact, in most executives' opinion there will be far superior assets hitting the market going forward that might be worth a closer look then.

But regardless of potential differences in the quality of Cerrado and Deepsea Metro II, most investors and even fellow contributors obviously missed the real story behind the Deep Sea Metro II sale:

The drillship had been put up for auction by the company's senior creditors (represented by DVB Bank America), but due to the high reserve price of $175 mln the auction failed to draw any valid bids. In fact, cash bids from external parties were reported to have come in between just $50-100 mln.

After the failed auction, the Deepsea Metro II was actually sold to Chalfont Shipping Ltd. for a reported purchase price of $210 mln.

Never heard of Chalfont Shipping ? Don't worry, the company is in fact just a special purpose vehicle solely designed to take possession of the Deepsea Metro II, recently established by the very same senior creditors that initially seized the rig and put it up for auction.

The court supervised auction was actually necessary to defeat potential claims of the former owner's, Chloe Marine, second lien bondholders and because Chloe Marine had already rejected a similar deal previously.

So while a nominal $210 mln transaction value was placed on the deal, there was actually no cash involved and the rig in fact will remain with the senior creditors for the time being.

So the creditors decided to keep the asset for now despite the ongoing stacking costs and to wait for the industry to recover in due time.

On the contrary the Cerrado creditors clearly had no intention to stay with the rig for much longer given that the reserve price was set at a mere $65 mln. To also provide some more details on this auction, Ocean Rig was reportedly the only bidder while the rest of the industry did not even show up.

So with all the additional information now at hand - was the Cerrado purchase indeed a once-in-a-lifetime bargain? Or just another overly aggressive bet by George Economou that has a great chance to fire back on the company like the remaining commitments for three newbuild drillships ordered two years ago without a firm contract at hand?

Only time will tell, but I don't view combining a drillship with a substandard execution history with the company afflicted by the highest percentage of contract disputes and cancellations in the entire industry as an exact recipe for success.

For now, Ocean Rig will not only have to pay the $65 mln purchase price, the company will also be burdened with an estimated $15-25 mln in stacking costs annually. Moreover the Cerrado, now renamed "Ocean Rig Paros" will have to undergo a costly 5-year-special-survey (SPS) before potentially returning to service - depending on the condition of the rig, the costs might range anywhere from $10-$50 mln and potentially beyond.

Lastly the rig will have to be retrofitted according to Ocean Rig's standards and this will clearly not be done with just a new paint job.

As evidenced, the rig will require quite an amount of upfront investment before being suitable for a potential contract award and this does not even include potential additional retrofitting required by specifications contained in the tender processes the rig will be bid on.

And given the pretty much tainted execution history, it's actually difficult to envision the Ocean Rig Paros picking up an adequate contract anytime soon.

Investors should also note, that in 2013 Ocean Rig has entered into a couple of services and consultancy agreements with entities privately owned by George Economou that provide for material transaction fees in connection with financing agreements or asset sales and purchases. Using these constructs, Economou managed to funnel another $90 million out of Ocean Rig into his own pockets until the end of FY2015. Moreover during 2015 one of these agreements was changed to the material benefit of George Economou's privately held entity, providing for a 30% profit sweep on every investment yielding at least 10%. Investors looking for more information on these ominous agreements should take a closer look at page 79 of the company's recent 20-F filing with the SEC.

Lastly investors should remember the $120 mln unsecured loan facility provided to Dryships in late 2014 as another great example of George Economou's ongoing self-dealings. The loan was ultimately settled in August 2015 by Dryships transferring a combined 22.2 mln Ocean Rig shares to the company. Economou earned cash fees for both the signing of the loan agreement and the later settlement estimated at more than $4 mln when applying the terms of the services and consultancy agreements.

Economou also recently pocketed additional fees of an estimated 1.0 mln for the purchase of the former Dryships stake and the Cerrado acquisition.

For what it might be worth, the company's executive vice president, Anthony Kandylidis, is actually George Economou's nephew, having also been involved in a great deal of related party transactions with his uncle in the past.

Bottom line:

Seemingly investors have been misled by Ocean Rig's latest actions, particularly with regard to the purchase of the former Dryships stake. As evidenced, CEO and Chairman George Economou's interests are by no means aligned with the outside shareholders of Ocean Rig with the company now substantially in danger to replace Dryships as Economou's future playground for his seemingly never-ending slew of self-dealings.

Also George Economou's aggressive strategy of going against the grain by purchasing a drillship with substandard performance history while the rest of the industry decided to not touch the Cerrado with a ten foot pole, might fire back on the company just like his speculative orderings of the Ocean Rig Santorini, Amorgos and Crete without having firm contracts in place. Until then, Economou will continue to pocket outsized fees from Ocean Rig almost regardless of the operational performance of the company.

The downfall of the offshore drilling industry over the last 18 months has caused a considerable turnover in the shareholder base of virtually all companies as many institutional, yield orientated investors have exited their holdings with mostly unsophisticated retail investors, in many cases simply by frequently averaging down on an initial small position, having taken their place often causing highly erratic movements in the stock prices.

That said, I continue to expect Ocean Rig's stock to trade as an option on oil prices for the time being - as already witnessed for quite some now. Alongside most of their peers, the shares will predominantly serve as a playground for traders and speculative retail investors for the foreseeable future.

More conservative investors would in fact be well served to continue to avoid the industry as a whole until there will be at least some light at the end of the tunnel.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: As a daytrader I have traded the company's shares on many occasions in the past and might consider to do so going forward.