The Will to Drill

First-quarter results and management teams’ commentaries during conference calls with analysts reaffirmed our bullish take on the market for ultra-deepwater drilling rigs.

How tight is the market for ultra-deepwater rigs? Transocean’s (NYSE: RIG) Deepwater Expedition, which lost a contract because of extended downtime at the end of 2011, secured a two-year fixture at a day-rate of $650,000 from an undisclosed customer.

Executives from Diamond Offshore Drilling (NYSE: DO), Ensco (NYSE: ESV), SeaDrill (NYSE: SDRL) and Transocean also indicated that customers have already approached them about extending contracts that expire in 2013 and 2014.

SeaDrill’s CEO Alf Thorkildsen discussed this phenomenon during a conference call to discuss first-quarter results:
There are very few rigs available, and sometimes our clients…are concerned [about] getting that capacity. So they would just knock on your door. Normally, we knock on their door. This time, they are knocking on our door and asking [us]…to sit down and have some negotiation. That is kind of the current supply-demand situation. And that is, of course, very positive [for] us.
With customers contacting contract drillers about extending contracts a year or two before they expire, we expect day-rates to remain elevated. Management teams agreed that the market for ultra-deepwater drilling vessels would remain tight through at least 2014, with many arguing that a bevy of new offshore discoveries should ensure that the market will absorb coming capacity additions.

Contract drillers across the board cited accelerating exploration and development of fields offshore West Africa as an indication that this up-cycle would last longer than the prior boom. However, several management teams were also bullish on the potential for Petrobras (NYSE: PBR, PBR A) to contract additional rigs to support its ambitious production goals. Transocean, for example, predicted that Petrobras would issue a tender for up to two rigs this year, as delayed deliveries from inexperienced domestic shipyards force Brazil’s national oil company into the international market.

Diamond Offshore Drilling’s CEO Lawrence Dickerson told analysts that he expected this trend to continue in coming years:
[I]t’s not going to be easy to build the number of rigs that they’re talking about and brand new shipyards in Brazil. They’re going to give it a good go. They’re intelligent people, but I think that will not transform overnight. And when you look at the size of their geological prospects that they’re drilling on, it’s going to require active high-efficiency rigs going at it now.

If you wait the period of time then it’s going to take to deliver all of these rigs and then get started, you’ve taken significant cash flow from increased production and kicked it down the road seven to ten years. So, if you do all the math on that, I think in the foreseeable future that the US guys are not necessarily going to be squeezed out, whether or not Brazil builds rigs locally or continues to contract from the outside.
Meanwhile, resurgent demand and rising day-rates for premium jack-up rigs have also bolstered the industry’s growth prospects, although firms with sizable fleets of less-sophisticated models continue to suffer from lower utilization rates. At this stage in the cycle, the bifurcation of the rig market is most evident in the jack-up category, where many lower-specification rigs remain cold-stacked (in storage) and operating units struggle to secure term work.

Contract driller Transocean aims to divest between $500 million and $1 billion worth of lower-specification jack-up rigs over the course of 2012, while Diamond Offshore Drilling’s management team has also expressed an interest in divesting some assets if the price is right. Ensco’s jack-up fleet had a utilization rate of 84 percent in the first quarter, largely because of cold-stacked units. Management indicated that deals to divest some of these assets are in the works.

Contract drillers continue to benefit from a tight supply-demand balance in key markets, which has filtered down to conventional deepwater rigs and the still-weak midwater segment.

Nevertheless, we continue to favor names with newer fleets. Not only do recently built vessels tend to command higher day-rates than older models—particularly in the deepwater and jack-up segment—but these vessels also require less downtime for maintenance and repair.

Operators with older fleets continue to invest heavily in rig modernization. For example, Transocean in late August 2011 acquired Aker Drilling in an all-cash deal worth $1.46 billion, a 96 percent premium to Aker’s market value. The deal netted Transocean two harsh-environment, ultra-deepwater rigs and two new drillships slated for delivery in 2013. Meanwhile, the company continues to divest legacy assets that have fallen out of favor.

The recent pullback in oil prices and a volatile stock market gives investors an opportunity to add shares of SeaDrill, our favorite contract driller at favorable valuations.

Based on the company’s strong first-quarter results and an order backlog of $13.8 billion, management saw fit to increase SeaDrill’s quarterly dividend to $0.82 per share from $0.80 per share. The firm also announced a special, one-time dividend of $0.15 per share that returns some of the proceeds from Kencana Petroleum’s acquisition of SupuraCrest, a Malaysia-based oil services provider in which SeaDrill owned an equity interest.
Many investors gravitate toward the stock’s 9.7 percent dividend yield, an appealing prospect in an environment where corporate bonds and many dividend-paying equities offer insignificant yield.

However, investors shouldn’t overlook the near-term and long-term growth trends under way in the ultra-deepwater market. Among the contract drillers, SeaDrill’s management has been consistently bullish on the industry’s growth prospects, even withholding newly built ships from the market in anticipation of higher day-rates in the back half of 2011. Although some analysts scoffed at this move, the strategy yielded a term fixture at a day-rate in excess of $500,000.

SeaDrill secured a handful of impressive fixtures for its drilling rigs during the first quarter of 2012, headlined by the ultra-deepwater drillship West Leo’s three-year contract with Tullow Oil (LSE: TLW) at a rate of up to $649,000 per day. Other contracts inked during the quarter include Saudi Aramco’s lease of the premium jack-up West Callisto at a day-rate of $150,000.

More important, management expects near-term supply limitations in the ultra-deepwater segment to keep day-rates elevated for at least the next two to three years. CEO Alf Thorkildsen addressed this opportunity at length during SeaDrill’s conference call to discuss first-quarter results. “We are now experiencing client requests for rig availability in 2014,” Thorkildsen told analysts, “and [customers are seeking] to contract these units for a long-term duration.”

With six ultra-deepwater drillships slated for delivery through the end of 2014 that haven’t yet been placed under contract, SeaDrill has ample exposure to rising day-rates for these in-demand rigs.