After fracking, offshore drilling.

At the leading edge is rig-contractor Hercules Offshore. In March 2014, before the oil price collapsed, it had the temerity to sell for 100 cents on the dollar $300 million in junk bonds. Since then, its shares have collapsed to near zero. Its bonds have collapsed too. And on Thursday last week, it and a whole gaggle of related companies filed for Chapter 11 bankruptcy.

It won’t be the only junk-rated offshore driller with that fate, according to Fitch Ratings. Investors are going to get their pockets cleaned.

“This is the lowest level of demand we have seen since the early days of the offshore industry,” Hercules CEO John Rynd had told investors in a quarterly conference call on April 29. Hercules had already cut its global workforce – about 1,800 employees at the end of 2014 – by nearly 40%, he said.

Offshore drillers have been buffeted from two directions: the collapse of drilling activity and the collapse in the daily rates they can charge for their offshore drilling rigs. So fewer rigs, and less money for each of the fewer rigs: Hercules’ revenues in the second quarter plunged 67% from a year ago!

And junk-rated companies like Hercules that need new money to stay afloat and service their debts are finding out that their burned investors have shut off the spigot.

“A leading indicator of further bankruptcies among other challenged high yield (HY) offshore drillers,” is what Fitch Ratings calls Hercules.

In the prepackaged bankruptcy, Hercules swaps four senior bond issues totaling $1.2 billion for 96.9% of the company’s equity. So how do these bondholders fare?

The recovery rate for senior noteholders would be 41%, the company said in its disclosure statement. According to S&P Capital IQ LCD’s highyieldbond.com, “the range of reorganized equity value implies a recovery rate of 32-47.8%.” Meanwhile, the notes are quoted in the “low” 30-cents-on-the-dollar range. So for now, nearly a 70% haircut.

Stockholders get the remaining 3.1% of the equity, plus warrants. Mere crumbs.

To finish construction of the Hercules Highlander rig and to stay afloat a while longer, the company will also get $450 million in new money for 4.5 years, at LIBOR +9.5% per year, with a 1% floor. No more cheap money, even after bankruptcy, though it dramatically deleveraged the balance sheet at the expense of investors.

This has been in the works for months, as the company tried to get enough support from its creditors. Hercules claims in its restructuring statement that an “overwhelming majority” of its creditors support its proposal. Now the bankruptcy court will need to put its stamp of approval on it.

According to Fitch, it moved the energy trailing 12-month default rate to 3%, up from 2.5% at the end of July. The coming Chapter 11 filing by natural gas driller Samson Resources will push it to 4%, “over twice the historical 1.9% mark.”

And it’s still just the beginning for offshore drillers. Fitch:

The recent oil price drop has compounded the effects of the offshore rig oversupply cycle, resulting in limited tenders, weak day rates, and legacy fleet rationalization. Existing backlogs have generally insulated offshore drillers from lower market activity and day rates so far. However, backlog protections for offshore drillers are falling away at a fast clip.

As they eat through their backlog and can’t replace it with new business, offshore drillers will see their cash flow wilt further. Larger, investment-grade offshore drillers “tend to be better positioned to bridge the downcycle,” Fitch said. They can still borrow new money. But junk-rated drillers not so much.

Day rates for ultra-deepwater rigs have plunged from the high-$400,000 to $600,000 range to about $325,000, according to Fitch’s “best guess.”

This would probably represent a “purge day rate” that disincentivizes uncontracted newbuild deliveries and facilitates legacy fleet rationalization, leading to an eventual inflection point currently anticipated to be late 2016/early 2017. Other rig types are anticipated to see similar day rate reductions with uncompetitive rigs being stacked or scrapped.

Junk-rated offshore drillers are also going to be at a “contracting disadvantage, relative to larger, more established offshore drillers, due to their smaller size, limited customer history, and higher counterparty risk.” And so Fitch expects that customers may be “giving careful consideration to an operator’s size, staying power, geological familiarity, and historical operating performance.”

This would “greatly reduce” the ability of these shaky, junk-rated, over-indebted offshore drillers to get new business during the oil bust, thus “raising their probability of default.”

In this context, HY offshore driller recovery prospects and restructuring plans begin to come into focus in a hypothetical default scenario. Fitch recently reviewed three HY offshore drillers – Vantage Drilling Company, Pacific Drilling S.A., and Ocean Rig UDW Inc. – and determined that secured noteholder had above average (i.e. greater than 50%) recovery prospects, while unsecured noteholders had poor (i.e. 0%-10%) prospects.

And when unsecured bond holders get 0% to 10%, stockholders wouldn’t even get crumbs.

But when something collapses, new opportunities open up, though “maybe this isn’t a great indication of the state of the economy.” Read… Wall Street Sees Junk Bond Collapse, Prepares to Profit from it

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