This week’s bond review focuses on a company that provides products and services to oil and gas exploration and production companies that assist in locating oil and gas (hydrocarbon) resources both underground and undersea. ION Geophysical (IO) Q2 results showcase a company that has weathered the unprecedented decline in capital spending from its main customers, and is now ready to profit as the oil and gas industry begins to recover. The company’s most recent results illustrate its tenacity and successes as oil prices seem to have finally begun a slow but steady march upward.
ION reduced it’s the debt on its senior notes by $26 million in Q2, and extended maturities on most of its remaining debt to 2021.
Revenues in Q2 were up 60% sequentially from Q1 2016.
ION reduced its operating expenses in Q2 by 30% year-over-year.
The company’s Ocean Bottom Services segment is currently on contract in Nigeria for a project that is slated to generate around $46 million of new revenues this year.
Low oil prices have virtually ceased all capital spending targeted towards developing new wells. Because of this, decline rates will cut output by several million barrels per day each year in 2016 and 2017 unless oil producers invest to maintain production levels from existing fields and develop replacement fields. Oil producers need to begin stepping up capital investments, with companies like ION Geophysical, in order to ensure continued supply.
ION’s May 2018 bonds, couponed at 8.125% are currently priced about 76 and offer a high flying 28.5% yield to maturity. With its Ocean Bottom Services segment back to work, the company appears to be on track to greatly increase its second half (2016) revenues. The current discounted price on these very short 19-month bonds indicates the market’s caution toward ION, but also spells opportunity for savvy investors to increase portfolio return, and as such, these high-yield bonds have met the criteria for addition to both our FX1 and FX2 portfolios.
Debt and Expense Reductions
Earlier this year, ION Geophysical completed a successful exchange offer and consent solicitation related to these outstanding 8.125% Senior Secured Second Priority Notes due 2018. As a result of the exchange offer, almost 84% of the outstanding notes were exchanged for 9.125% 2021 notes.
The exchange de-levered ION’s balance sheet by nearly $26 million and extended the maturity of $121 million of its outstanding debt until the end of 2021, providing the company with additional flexibility and liquidity. The exchange also put ION in a position where it is better able to execute its strategic and operating plans in 2016 and beyond. More importantly, ION only has $28.5 million in debt maturities in 2018.
Due to the extended low prices of oil and gas, many Exploration and Production (E&P) companies cut capital expenditures related to finding and drilling new wells and setting up new production sites. ION’s products and services directly benefit oil and gas companies. As companies have continued to minimize capital budgets, spending on services like the ones provided by ION have decreased. In 2014, ION began to see the decline in oil and gas prices and began cost cutting measures. These measures can clearly be seen in the company’s latest quarterly results. In Q2, operating expenses registered a decrease of 30% year-over-year. In addition, the company instituted a 12% workforce reduction in April 2016, which should save the company $9 million in 2016 and $15 million annually moving forward.
About the Issuer
For over 40 years, ION Geophysical has helped geophysical service providers and Exploration & Production (E&P) companies explore for and locate the world’s hydrocarbon resources.
Through ongoing research and development programs and strategic acquisitions, Ion has assembled a comprehensive toolkit that spans the seismic lifecycle. The company provides advanced seismic acquisition equipment, command & control software, planning and acquisition services, seismic data processing services, and seismic data libraries to the global oil & gas industry. Its products and services are used by E & P companies and seismic contractors to generate high-resolution images of the Earth’s subsurface during exploration, exploitation, and production operations. In addition to 2D and 3D surveys, and in applications like 4D reservoir monitoring, and full-wave, multicomponent data acquisition, ION’s technologies have been used to address some of the industry’s toughest challenges including Arctic exploration, complex geologies, basin exploration and reservoir exploitation. Headquartered in Houston, Texas, ION has 23 offices in key petroleum centers in the United States, Canada, Latin America, Europe, Africa, Russia, China, and the Middle East.
There has been a flurry of insider buying at ION Geophysical in recent months. According to the latest SEC filings, insiders at ION Geophysical Corporation (NYSE:IO) have increased their position in the stock by 122.42% over the past 6 months. The company’s Chairman of the Board, James Lapreyre Jr., has purchased approximately 75,700 shares of ION during the months of July and August. His most recent trades were on October 17th and 18th. With his latest trades, he now owns 852,909 shares of ION common stock. At least nine other members of ION’s upper management and board members have also increased their holdings in ION stock over the past few months. Oftentimes, if insiders are buying stock in their own companies, they might know something that a normal investor does not. Peter Lynch, regarded as one of the greatest investors of all time, notes “insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.” While ION management is predicting a more profitable second half to 2016, the recent volume of insider trades would seem to agree.
New Projects – Increasing Revenues
In Q2, Ion Geophysical secured a contract for a Nigerian project for its Ocean Bottom Services segment. Since the work did not start on this contract until late June, most of the revenues from this project will be recognized in Q3. ION expects this project to bring approximately $46 million of new revenues in the second half of 2016. ION already has $60 to $65 million of committed revenues for Q3, which already exceeds its revenues from the first half of 2016. The company expects that Q2 was the low point in terms of cash flow and liquidity and it anticipates generating positive cash flows in the second half of 2016. Also, Q4 has generally been the company’s strongest quarter.
Oil – Where Are We Now?
While oversupply has been the buzzword the past two years in the oil industry, that condition is beginning to change. A recent report by the International Energy Agency (IEA), a Paris agency that monitors energy trends for oil-consuming nations, shows that the current glut of crude oil is decreasing, even as OPEC oil producers continue to pump at near-record levels. The IEA also commented that it sees no oversupply in the second half of the year (2016). Healthy global demand for crude oil as well as deep output cuts by producers outside the OPEC countries have both contributed to decreasing oversupply. Estimates predict that crude production in North and South America will fall by 700,000 barrels a day in Q3 2016 as compared to Q1 production. This recent graph from the U.S. Energy Information Administration (EIA) shows how crude oil production has fallen from its peak in June 2015 of 9,610 Mbbl/d to 8,464 Mbbl/d for the week of October 7, 2016.
The biggest contributor to these lower production numbers is natural decline rate for existing wells. Production from shale wells, which represented a majority of U.S. domestic oil production, declines by 60% to 70% in the first year alone. For traditional / conventional fields which have passed their peak, observed output declines on average by 6.2 percent per year, according to the IEA (“World Energy Outlook 2013”). With no or very little capital investment in developing new oil sources, the natural decline rate will necessitate increased capital spending.
Global demand for oil should also contribute to rising prices. Demand in China remains stable and the demand for oil in India has grown significantly this year. India’s demand for crude oil has increased by 350,000 barrels a day this year which now makes the country the world’s third-largest oil buyer. Demand for gasoline in India has also risen by 14% this year and should continue to climb as motorcycle and car purchases increase.
For the three months ending June 30, 2016, ION recorded a loss from operation of $16.6 million and interest expense of $4.7 million. At this time, the company is using accumulated cash to pay interest on its bonds, rather than paying from current cash flow. While we don’t normally recommend bonds that do not have adequate interest coverage, ION had committed revenues in Q3 that surpass its revenues for the first half of 2016. With Q3 now concluded (as of September 30, 2016), we anticipate ION’s Q3 results will report positive cash flows and adequate interest coverage.
The default risk is ION Geophysical’s ability to perform. ION has shored up its balance sheet and extended the maturity of the bulk of its debt with its recent bond exchange. The company’s Ocean Bottom Services is now on contract in Nigeria, after being on the sidelines since late 2014. This new contract is a key contributor to ION’s committed revenues for Q3, which already exceed revenues for the first half of 2016. The spectacular 29% yields on these very short 19-month bonds attest to the market’s caution in regards to ION. However, this outstanding yield does appear to outweigh the risks identified here.
Since ION’s revenues are directly tied to capital spending from oil and gas E&P companies, the company is, albeit indirectly, exposed to effects from the volatility of oil and gas prices on the open markets. As most are aware, the past two years have seen unprecedented declines in the prices of these commodities. However, many in the oil and gas industry believe that prices are on the path to recovery. The remaining debate is just how quickly prices will recover. Certain larger, multinational oil and gas companies, such as BP and Shell are starting to loosen the purse strings a bit on capital expenditures for exploration. As oil prices continue to recover, it is likely that more E&P oil companies will follow suit.
As mentioned in the Financials section, as of the end of Q2, ION was not covering its interest expense from current cash flow, but paying interest from accumulated cash. While we anticipate much improved financials when the company reports its Q3 results, any variations that reduce the amount of anticipated revenues could adversely affect the company’s ability to cover interest payments.
Summary and Conclusion
ION Geophysical has felt the effects of low oil prices over the past few years, but has been proactive in taking steps to remain on solid footing and position itself for the time when oil and gas begins its march upward. It reduced costs by 30%, reduced its overall debt, and pushed out its remaining debt maturities in order to provide the company with additional flexibility as it navigates the tricky waters of the oil and gas recovery. We believe the recent, extensive insider buying of its stock could indicate an extremely positive development in the second half of the year. In addition, the natural decay rate of existing wells necessitates an increase in capital spending to secure new wells to maintain production. The nearly 28.5% yields on these very short term bonds presents another opportunity for investors to increase portfolio returns by investing in an industry that looks to finally be climbing from its lowest point in recent memory. In consideration of these factors, we are targeting these bonds for addition to both our Fixed-Income1.com and Fixed-Income2.com high yield global income portfolios.
Issuer: Ion Geophysical Corporation
Yield to Maturity: ~28.48%
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Disclosure: Durig Capital and certain clients may have positions in ION Geophysical 2018 bonds.
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