The Deep End
Last year was the best year for the broader market averages since 2003 with the S&P 500 up nearly 16 percent. And while energy-related stocks turned in a solid performance overall, it wasn’t quite as impressive as 2005. Nonetheless, the Philadelphia Oil Services Index (OSX) managed a 10.4 percent gain on the year.
The good news is that The Energy Strategist Portfolios outpaced both the broader market and the major energy-related indexes for the year and in the fourth quarter. For the first half of the year, the straight average of all holdings across the three Portfolios—Proven Reserves, Gushers and Wildcatters—was just shy of 25 percent.
Recall that, after midyear, I enhanced my return calculations and began tracking each Portfolio separately on a week-to-week basis. I created an index representing each Portfolio to allow convenient week-to-week graphical comparison of results. Check out the chart below for a closer look.
Source: The Energy Strategist
The income-oriented Proven Reserves Portfolio is designed for stability of capital and high income. Although this Portfolio offered the lowest overall returns at around 13 percent, it also offered the highest stability; except for one brief period in late September, the Portfolio never dropped into the red. In the fourth quarter, my recommended master limited partnership (MLP) holdings surged to new heights. MLPs remain my top income idea for 2007. (Check out the Nov. 22, 2006, issue of TES, Leading Income, for a detailed rundown of my favorites.)
My long-term, growth-oriented Wildcatters Portfolio trounced both the S&P 500 and the OSX, returning 16.6 percent in the fourth quarter and 23.4 percent overall in the final six months of the year. My big winners in this Portfolio were biofuels player Bunge (NYSE: BG) and Oil Country Tubular Goods specialist Tenaris ((NYSE: TS). (I highlighted both in the most-recent issue of TES.) In addition, French nuclear utility stock Electricite de France (Paris: EDF) was a huge winner in the latter half of this year, returning nearly 40 percent. (I highlighted this stock in the July 26, 2006, issue, The Nuclear Option.)
And last but certainly not least is this quarter’s star performer, the aggressive Gushers Portfolio. Although this portfolio saw some weakness over the summer, alongside most energy stocks, the Portfolio was never down more than 8.5 percent. A jump of more than 38 percent in the fourth quarter made up for any summertime selling; the Portfolio returned close to 32 percent overall in the latter half of the year. The biggest winners in this Portfolio: the biofuels and uranium plays outlined in the most-recent issue of TES. Several of these are up well more than 100 percent since the end of June.
In This Issue
It’s now time to re-focus our attention on trying to equal last year’s performance once again in 2007. In this issue, I will review one of my favorite long-term themes that I see as resistant to any weakness in commodity pricing: deepwater exploration and development activity. I’m adding two new stocks to the Portfolios–Seadrill (Oslo: SDRL; OTC: SDRLF) to Gushers and FMC Technologies (NYSE: FTI) to Wildcatters–as plays on this long-term theme.
Deepwater exploration and development will prove to be an integral part of the oil industry as “easy” oil production continues to decline and new reserves must be sought out. Expect to hear more news similar to the Gulf of Mexico reserve announcement this year. See The Final Frontier.
Transocean isn’t just a rig supplier—it’s the rig supplier. As such, it’s the greatest indicator of what’s going on in the drilling industry. See The Canary.
Despite Transocean’s massive holdings and sustained rig contracts, I see a better way to play the drilling industry. My new Norwegian rig supplier holding in the Gushers Portfolio has more upside catalysts and some considerable growth coming in from its newbuilds. See How To Play It.
Deepwater drilling is a tricky business, in needs of equipment like trees, BOPs and subsea separators to prevent risks such as blowouts. In addition to my new rig supplier, I’ve also found a great play on deepwater drilling technology for my Wildcatters Portfolio. See Deep In Equipment.
Several of my other Portfolio recommendations also benefit from increased interest in deepwater drilling activity, which continues to make them attractive holdings. See Other Beneficiaries.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
The Final Frontier
One of the longest-standing themes of this newsletter has been the end of “easy” oil. The world’s giant, easy-to-produce, onshore oil reserves are now mature and experiencing flat or declining production.
To offset these declines, producers are increasingly targeting more-complex reserves that can only be produced using the most modern, advanced technologies. In many cases, these hard-to-produce reserves are also more expensive to produce than conventional onshore oilfields. (I outlined this basic thesis in the Nov. 30, 2005, issue of TES, Not So Easy.)
There’s a distinction to be made between the idea that the world is running out of oil and the concept of the end of “easy” oil. In my view, the world will never truly run out of oil; the last barrel of oil will never even be produced.
The question isn’t whether the world runs out of oil entirely but whether supply can continue to increase and, more important, grow fast enough to keep pace with demand. The question isn’t just one of how much oil is in the ground but of how fast that oil can be produced.
You may have heard of the theory of “peak” oil. One of the most-interesting modern books on this topic is Matthew Simmons’ Twilight in The Desert; I heartily recommend this book to all subscribers. The theory of peak oil isn’t that the world is literally running out of oil but that actual daily production of oil is at, or very near, a peak.
In other words, sooner rather than later, the world’s rapidly maturing oilfields will see a gradual decline in production; after all, once-prolific fields in the US, North Sea and the rest of the world are already seeing production decline rapidly. Supplies of oil would certainly be unable to keep pace with rapidly rising demand from emerging markets.
The end of “easy” oil is a slightly different philosophy. The theory isn’t that world production is necessarily near a peak but that increasing production to meet demand will require tapping more-complex fields and unconventional reserves.
Although I have considerable sympathy for the concept of peak oil, it’s almost impossible to know exactly when that peak will occur. I’ve heard compelling arguments that global oil production will peak in the next three years and equally well-thought-out predictions that we have 20 years of rising production ahead.
But from an investment standpoint, the actual timing of peak oil isn’t all that important. The simple fact is that growing production will require tapping more-complex reserves; producing these reserves will require enormous investment and the use of the most-advanced oilfield technologies.
Examples of harder-to-produce reserves include oil sands, Artic reserves and, of course, the deepwater. There’s broader consensus among oil experts that these types of reserve will need to be produced to meet growing global demand.
I regard deepwater as one of the single most-interesting and important new oil exploration and production stories of the next few years. I also see the 2007-08 period as a key growth period for deepwater developments; we’re now entering the sweet spot of deepwater production growth thanks to the large deepwater exploration and development investments of the past five years.
I fully expect further announcements along the lines of last year’s Chevron/Devon Jack Field deepwater well test in the Gulf of Mexico. The announcement of new deepwater discoveries and successful well tests will help catalyze interest in deepwater.
As such, companies that are leveraged to ongoing deepwater developments will be one of the top oil and gas-related themes for investors. Check out the chart below for a closer look.
Source: Energy Information Administration
This chart uses data and forecasts provided in the Energy Information Administration’s (EIA’s) Annual Energy Outlook for 2006. To create the chart, I simply took actual and forecasted US deepwater oil production and divided it by total production, creating a percentage figure.
In 1990, for example, US deepwater oil production was negligible, accounting for less than 2 percent of overall domestic supply. Now, deepwater production accounts for more than a fifth of US oil supplies; by 2030, that figure is expected to reach close to 40 percent. Deepwater reserves are becoming an ever-more-important piece of the US supply puzzle. Check out the chart below.
Source: EIA
This chart depicts the actual, raw numbers and projections on US oil production from the EIA. It’s clear that every category of US oil production is expected to decline between now and 2030, save one. Lower 48 state production, Alaskan production and shallow-water production will all continue the recent trend; production will decline at a slow-but-steady pace over the next 25 years.
The one exception is deepwater production. The EIA projects that deepwater US oil production won’t peak until the middle of next decade.
And remember that this is just a government projection. Although the EIA puts out some truly excellent research, I think we can all agree that the government is far from infallible. Some private projections I’ve seen suggest that US deepwater oil production could top 5 million barrels per day by 2020 and won’t peak for another two decades. Whether you accept the EIA’s conservative case or a rosier picture, it’s clear that US deepwater production is set to grow.
And the US Gulf of Mexico is only part of the story. Deepwater exploration and development are truly global phenomenons; development is underway in the North Sea, Australia, Africa, South America and even Asia.
Because of the technical complexities involved with exploring for and producing deepwater reserves, it should come as little surprise that this is the energy market’s last exploration frontier–the last major potential pocket of global oil and gas reserves to be exploited. There are plenty of promising prospects for deepwater development all over the world.
Deepwater developments require large upfront capital investments and take years to finalize. Once deepwater wells are completed, however, these wells can flow at rates reminiscent of Texas wells a century ago. Although growing deepwater production will be at least partially offset by declining production from mature onshore reserves, it remains one of the most-likely candidates for delaying the actual peak in global oil production.
The good news about deepwater from an investing standpoint is that it’s considerably more complex technologically that onshore or shallow-water exploration and production. That makes deepwater a highly playable theme; there are dozens of companies leveraged to growth in the sector. I see benefits accruing to the following major sub-groups:
One more important point to note before I delve into my favorite deepwater picks: Deepwater activity is relatively insulated from commodity prices. Once the upfront capital investments are made in exploration and development, deepwater reserves are economical to produce–far more economical, in fact, than many onshore reserves being exploited today.
In addition, deepwater projects are long term and multi-year in nature, pursued mainly by large, multinational integrated oil firms and national oil companies. Short-term swings in commodity prices have absolutely no impact on these spending plans.
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The Canary
A century ago, before coal miners had access to gas testing equipment, miners would carry a small bird into the mines with them. If the bird got sick or died, that meant gas levels were dangerous and the miners would leave the mine to wait for ventilation to improve.
When it comes to deepwater activity, my canary in the coalmine is Transocean. Transocean is a contract drilling firm. The company doesn’t produce or sell oil or natural gas; rather, it owns a fleet of drilling rigs that are used to drill wells. Companies like ExxonMobil and Chevron pay Transocean a day-rate for leasing its rigs.
Contract drillers tend to be classed by the type of rigs they own; Transocean specializes in rigs used for offshore deepwater activity. I explained the different rig types and how they work in the June 14, 2006, issue of TES, “The Good, The Bad, The Ugly,” under the subhead Contract Drillers. I recommend all new subscribers check out that explanation.
There are two main rig types used in deepwater–drillships and semisubmersibles. Drillships look like regular ships and move to a drilling location under their own power. Typically, they’re dynamically positioned; computer-controlled thrusters hold the ships in place during the drilling process.
Modern drillships are capable of drilling in very deep waters. The advantages of drillships include flexibility and maneuverability; because they move under their own power, they’re appropriate for exploiting even remote reserves. The main disadvantage: In rough seas, drillships will rock just like any other ship and thrusters may have a hard time maintaining position. Therefore, typically, they’re used in calmer waters.
Semisubmersibles (semis) are essentially a platform with two large pontoons. Semis are towed to location, and those pontoons are filled with water, sinking the lower part of the rig. Pontoons can be sunk as far as 100 feet beneath the ocean’s surface.
Semis are typically moored and dynamically positioned; the submerged pontoons offer a further level of stability in even the roughest seas. Semis are typically capable of drilling in deeper waters, and their main advantage is stability in rough seas. The main disadvantage: They must be towed to location, so they can be tough to move into remote locations.
Offshore deepwater rigs can be further divided into “generations.” The first deepwater rigs were built back in the 1970s; since that time, they’ve become progressively more advanced. Newer generations of rigs are capable of drilling into deeper waters, offer greater stability and have more-advanced onboard equipment.
There have been essentially five generations’ worth of rigs since the ’70s, and a sixth generation is now in the design-and-construction process. Day-rates for advanced offshore rigs can be close to or more than $600,000 per day in the current market environment. Such rigs cost upward of $700 million dollars to construct, a process that takes more than three years.
To make a long story short, Transocean owns 42 semis and 13 drillships; its nearest competitor, Diamond Offshore, owns just 30 deepwater rigs and a single drillship. Moreover, Transocean’s rigs are the most advanced: It has more fourth and fifth generation rigs and advanced drillships than any of its competitors. If you want to know how the deepwater business is performing, look to Transocean for an answer.
And based on the company’s most-recent conference call in early November, the deepwater business has never been stronger. Almost the entire fleet of rigs is currently working on some sort of contract somewhere around the world. The rigs that aren’t working are either not yet constructed or are in the shipyard undergoing repairs and upgrades.
Even better, the company’s newbuilds–newly built rigs that are mainly still under construction–are also contracted. As soon as the newbuilds leave the shipyard, they’re headed out to start working on signed, guaranteed contracts.
But signing contracts is just half the story; the other point to consider is just how high day-rates are for rigs being contracted right now. The fact is that Transocean is continually setting new record day-rates for deepwater rig contracts.
Day-rates for some rigs can easily be double or more what they were just a few years ago; even newbuilds are getting contracts at sky-high day-rates despite the fact they’re not scheduled for delivery for another year or two. Check out the chart below for a closer look at Transocean’s backlog and contracted day-rates.
Source: Transocean, Third Quarter Results Presentation
Source: Transocean, Third Quarter Results Presentation
The company has more than $20 billion in backlogged day-rate revenues over the next eight years. These are all firm, signed contracts that are unbreakable. That figure includes more than $5 billion in signed, contract revenues for both 2007 and 2008.
The reason why pricing power on day-rates is so high is simple: a lack of available supply. Transocean noted in its third quarter call that there are 33 high-specification rigs industrywide capable of drilling in ultra-deepwater. Of those 33 rigs, there’s only one rig with any uncontracted time in either 2007 or 2008.
Looking at Transocean specifically, the company stated that the vast majority of its high-specification rigs are booked solid from 2007 through 2008 with only very limited capacity in 2009. Management clearly stated in the conference call that it wasn’t “overly anxious to contract” these rigs.
The reason is simply that day-rates have been rising steadily for deepwater rigs because of tight supply and high demand for deepwater drilling projects. Several big, integrated energy firms have been forced to delay projects because they simply couldn’t secure rig availability over the next two to three years.
Now with only a small handful of rigs available in 2007 through 2009, there’s an even more acute scarcity premium to be paid. Transocean’s management team is simply making the bet that it can sign up its last few rigs at even higher day-rates by waiting for producers to become really desperate for rigs. This bet has certainly been paying off; since the third quarter call, the company has announced more contracts at new record-high rates.
And while the strongest demand and most-acute supply shortage is in the ultra-deepwater rigs, day-rates have been rising almost as quickly for less-advanced rigs. Consider that in mid-December, Transocean signed a second generation semi for a day-rate of more than $400,000 per day, exceeding the prior record for this class of rig; that rig is heading for Australia next summer.
The company also extended a contract for a third generation rig in the North Sea, earning a day rate approaching $400,000, up from less than $150,000 per day on the current contract. And finally, Transocean rolled another North Sea third generation rig contract over at $350,000 per day, roughly 75 percent higher than the same rig is currently earning.
All of this is bullish for Transocean and suggests continued strong demand for deepwater drilling activity. This also suggests a general willingness to pay up to try and secure rigs. In addition, I found several additional bits of news from Transocean indicative of the strength in demand and activity:
Transocean’s day-rate revenues are basically locked in over the 2007-09 period. The rigs are covered by firm, signed contracts, so their revenue stream is highly visible. Recent contracting activity suggests that Transocean will also be able to lock in contracts for rigs post-2009 at highly attractive rates.
Bottom line: As the company rolls over legacy contracts to newly agreed contracts at sky-high rates, earnings will rise. The company’s growth is locked in for the next few years. But check out the chart of Transocean’s stock over the past few years.
Source: StockCharts.com
It’s clear that, after a near quintupling in price from the 2003 lows through the middle of 2006, Transocean stalled. While the fundamental new has continued to just get better, Transocean hasn’t been able to make any real headway.
Whenever you see positive fundamentals and a declining or consolidating stock, you have to wonder if there’s something wrong with the story. In other words, is the market anticipating something that’s not yet apparent in the fundamentals of the company? Sometimes the market anticipates a slackening of demand long before that slowdown becomes readily apparent.
In Transocean’s case, that’s simply just not the case. As highlighted at great length above, the company’s revenues are all but locked in for the next few years. Demand is clearly strong and getting stronger; producers are looking to lock up deepwater rigs going out to 2015.
That said, I see a number of factors that have contributed to Transocean’s mediocre near-term performance. Here’s a quick rundown:
Rig Supply
Although we know rig demand is strong, there have been some concerns over the sheer number of newbuild rigs due to be constructed in the next three to five years. At the time of this writing, there are a total of about 43 semis and drilliships under construction, most for delivery between the second quarter of 2008 and the fourth quarter of 2009. In addition to these newbuilds, a number of older generation rigs are being upgraded to handle more demanding work. Many of the rigs being constructed are spec rigs.
The fear has been that the addition of all these new rigs–a significant addition to the global fleet–would overwhelm demand and put pressure on sky-high day-rates.
My take is that this isn’t a concern. First, since mid-year many of the spec rig newbuilds have already signed contracts at attractive rates; demand is there. And Transocean and others have reported strong interest in contracts covering 2009 and afterward. As this marks the entry of all that new supply, it seems there’s plenty of demand to build the new rigs.
Leveraged Re-Capitalization
Transocean has been buying back a lot of stock recently. In 2006 through the end of October, Transocean bought back $3 billion worth of stock. In just the July-October period, Transocean used the weakness in its stock to back up the truck on another 28 million shares. With a share count of around 290 million, this is a significant repurchase in a very short period of time.
During the conference call, however, analysts questioned why Transocean wasn’t willing to be even more aggressive with buybacks. In particular, the stock is cheaper on a price-to-earnings basis than it’s been in many years; the stock trades at 11 times 2007 earnings and should grow by at least 40 percent annualized in the next few years.
Meanwhile, free cash flows have ballooned and the company has aggressively paid down debt. Check out the chart below.
Source: Bloomberg
Note that operating cash flow has been generally rising for several quarters. While cash flow also spiked in 2001-02, it’s been far more sustainable during this cycle. Given the rollover of legacy contracts next year, cash flows should increase rapidly once again.
Meanwhile, Transocean has been steadily paying down debts. The debt-to-equity ratio spiked a bit in the third quarter because the company took out around $2 billion in loans to help fund its opportunistic stock buyback. But management plans to pay most or all of this off by the first part of 2007; cash flows are more than sufficient to retire that debt quickly.
Source: Bloomberg
The big question many analysts ask is why Transocean doesn’t take on a big chunk of additional debt and use that money to pay a big dividend or buy back a huge amount of stock. With cash flows guaranteed by long-term contracts, Transocean could raise that debt capital at highly attractive rates; most analysts believe Transocean is under-leveraged at this time.
Analysts have been looking for a so-called leveraged re-cap–the purchase of stock using debt capital. Earlier in the year, there was plenty of speculation that Transocean would pursue just such a transaction.
Management tells us that it wants to keep some powder dry in case it wants to make an acquisition or arrange for newbuild rigs; the company doesn’t want to pursue such a transaction. But the company probably should reconsider, especially if its stock does see another dip next year. At any rate, disappointment surrounding this also has been a headwind for Transocean.
Lack Of Contract News Flow
As I noted above, there’s been plenty of news flow surrounding Transocean’s older rigs; several of the older semis have managed to secure highly attractive, record day-rates. But the company has already booked most of its high-spec rigs for 2007-09.
There could well be news about some more post-2009 contracts, but I suspect the company will want to hold back some of these rigs unless it’s able to secure some truly impressive day-rates. After all, Transocean doesn’t want to lock in a day rate that looks good now only to watch prevailing day rates rise another 50 percent by 2009.
In other words, Transocean has locked in solid growth for the next few years. But that growth is “known” growth; the potential for big, new, surprise contract announcements that could really juice up the stock is limited. In a way, Transocean stock is a victim of its own success.
This argument seems rather ridiculous at first blush, but the market does work as a discounting mechanism; perhaps the fivefold run-up in the stock from 2003 to 2006 already priced in the huge improvement in earnings and day-rates. The market is now looking for a new growth catalyst.
Cost Control
Signed contracts lock in revenues but not earnings. In other words, if Transocean’s operating costs rise too far, too fast, they could eat into earnings even though revenues will keep on rising. In particular, Transocean surprised the market in the second quarter with some higher-than-expected cost inflation. There was considerable concern this summer that this pace of inflation would continue to eat into earnings estimates.
Cost inflation in the oil and gas industry is high and likely to remain that way. There’s a global shortage of experienced labor in the rig industry; the cost of hiring drilling crews is rising. Equipment for rigs is getting more expensive, as is maintenance, construction and shipyard work. In addition, because day-rates are so high, the cost of idling a rig to move it or handle repairs is soaring. Just a one-day delay in moving a single high-spec rig can cost Transocean upward of $600,000 in lost revenues.
According to Transocean, cost inflation in the industry is running around 2.5 percent per quarter; that’s about 10 percent annually. In Transocean’s second quarter, costs rose even faster than that.
There’s no way to totally avoid rising costs; costs aren’t likely to come down unless there’s a meaningful slowdown in deepwater activity. Given the rig contracts out there, this is highly unlikely.
But cost growth at that level is already factored into earnings estimates for the next few years. And several factors suggest that Transocean’s second-quarter cost explosion was an anomaly.
The company was in the midst of reactivating three rigs; rigs that had been in storage were upgraded and put back into serviceable use. Delays in reactivations caused a good bit of the upside cost surprise. But the last of these rigs is out of the shipyard in the first two months of 2007. Shipyard activity should return to more normal levels.
And Transocean has taken further steps to mitigate cost inflation. Most important, the company has adopted a more-stringent budgeting and cost forecasting system. Management claims that this has already helped fuel greater efficiency.
The important takeaway from all of these factors is that not one of them has anything to do with demand. Moreover, as noted, several recent developments suggest all of these concerns are overblown. Deepwater activity remains ultra-strong, and there are concrete signs it’s likely to remain strong well into the coming decade.
The only real negative about Transocean is that it lacks near-term upside catalysts. The pace of new contract signings should slow because the company has already signed up most of its rigs on very attractive terms. For this reason, and this reason alone, investors will need to be patient with Transocean during the next quarter or two.
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How To Play It
I’m raising Transocean to a buy in How They Rate, but I’m not adding it to the model Portfolios. Instead, I’m adding a stock that looks more leveraged to the strengthening drilling cycle and has more upside catalysts. Seadrill (Oslo: SDRL; OTC: SDRLF) is added to my higher-risk Gushers Portfolio.
Seadrill, like Transocean, is a contract driller with a particularly strong focus on the deepwater. It’s perhaps the most-aggressive drilling contractor anywhere in the world today.
Seadrill currently has an operating fleet of five semis and one drillship. In addition, the company has a number of other high-quality jack-ups and tender barge rigs designed for shallower water work.
Currently, all of these rigs are out on contracts and earning revenues; Seadrill was profitable in the second and third quarters of 2006. But the company’s real value isn’t the rigs it already has working: It’s the newbuild rigs it owns that are scheduled for delivery during the next two years.
Seadrill has a total of two drillships on order in Samsung’s Korean shipyards. And the company has four deepwater semis on order–two being constructed in Korea by Samsung and two in Singapore by Jurong.
Both of these are large, well-known shipyards with a reputation for keeping more or less on schedule with construction projects. Designs for these rigs are copies of existing, proven rigs.
In addition, Seadrill owns a 60 percent-plus stake in Eastern Drilling ASA, a publicly traded company on the Oslo Stock Exchange. Eastern has two additional highly advanced semis under construction in Korea.
The first of Seadrill’s new rigs is scheduled for completion in the fourth quarter of 2007, perhaps slipping into the early first quarter of 2008. The remaining rigs are scheduled for completion and delivery in 2008. That means that all these rigs will be ready for contracting at that time.
In fact, the first semi to be completed will be Eastern’s West E-drill. That rig is signed up on a contract with Total at a day-rate of $480,000 starting in the first quarter of 2008. Contracts have also been secured on the drillship West Polaris and the semi West Sirius; both contracts commence in mid-2008 at day-rates of $520,000 and $460,000, respectively.
There’s even more potential value in Seadrill’s other uncontracted rigs. As I noted earlier in this issue, there are very few deepwater rigs that haven’t yet been contracted between 2008 and 2010. The company owns five deepwater rigs that are scheduled for delivery in 2008 and don’t currently have contracts. That’s more rig availability than any other company on Earth.
The point is that Seadrill has some spare capacity in a market that has no spare capacity. If you’re a producer looking for a rig, it may well be the only option.
There’s plenty of potential upside surprise for Seadrill as it announces contracts at high rates for uncommitted rigs; this is the key contrast to Transocean, which doesn’t have much uncommitted capacity. Even if another company wished to contract rig newbuilds immediately, those rigs couldn’t be delivered until 2010; Seadrill has zeroed in on the real sweet spot of this supply squeeze.
I also must admire Seadrill’s aggression in what’s clearly a very strong contract drilling market. The company has stated that it’s interested in making more acquisitions, possibly of a large, US-based driller. The company believes that it could target an acquisition of as high as $16 billion by taking on more leverage.
Because of the strong, locked-in revenues coming from contracts, servicing that debt shouldn’t be a problem. Although the company may have to issue stock to make such an acquisition, the stock has actually reacted positively to talk of its role as an acquirer; most believe industry consolidation is desirable longer term in the drilling business.
Seadrill trades over-the-counter (OTC) in the US. The OTC shares trade reasonably liquidly, though daily volume traded is low. Be sure to use a limit order when buying the stock OTC. If you do have access to the Oslo exchange, consider purchasing Seadrill in the local market. Check out the chart below for a closer look at how the company has been trading in the OTC market.
Source: Bloomberg
Another point worth noting: Because of some odd Oslo Stock Exchange rules, the exchange has ruled that Seadrill must either take full control of Eastern Drilling or reduce its stake. The exchange will also be issuing some guidelines on an appropriate takeover price for Eastern.
Eventually, provided the price is reasonable, Seadrill will likely take out Eastern, which was the company’s original intention. I’m not overly concerned about this news flow because it’s been well-known for some time; analysts were already assuming that Seadrill would have to pay up more cash to buy Eastern.
However, there’s good news in that dark cloud: Management was so irritated by the Oslo ruling that it’s decided to switch its primary listing to either New York or London. Both of these markets are far easier for US-based investors to access than Oslo. (See the Sept. 20, 2006, issue of TES, Fueled By Food, for a closer examination of how to buy stocks listed on foreign exchanges.)
In addition, more brokers are offering access to foreign shares every year. Be sure to call your existing broker directly to see if he/she can execute such trades.
I would expect to see further news considering the possibility of a US listing on a primary exchange in 2007. If that happens, Seadrill will gain additional visibility–a big positive fro the stock. For now, I’ll track the company in the Gushers Portfolio assuming the purchase of the OTC-traded shares.
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Deep In Equipment
Whether a well is located onshore or in deepwater, it eventually has to be fitted with a device known as a Christmas tree, or simply a tree. A tree is nothing more than a series of pipes, valves and gauges that are used to control the production of oil or gas from a well. The tree is so named because the network of pipes and valves tend to appear reminiscent of a tree and branches.
In addition, typically a device known as a blowout preventer (BOP) is installed on top of a well. When drilling for oil or gas, drillers pump a substance known as drilling mud into the well. Originally, drilling fluids were made quite literally of mud; nowadays, fluids are far more complex than that.
The purpose of drilling mud is to offset the natural underground pressure of the hydrocarbons in the reservoir. In other words, the pressure of the mud in the well helps prevent oil from rushing into the well and gushing out the top of the well bore.
That uncontrolled gushing is called a blowout. Blowouts are undesirable; uncontrolled oil flow wreaks environmental havoc, wastes a valuable resource, and can ignite and explode. In addition, noxious gases often coexist with hydrocarbons underground; these gases can literally kill you if inhaled.
Of course, if the mud isn’t mixed correctly or the reservoir pressure surges for some reason, a blowout situation can quickly develop. The BOP is simply a high pressure valve that can seal off the well in an emergency situation during driller or well repair.
Trees installed on onshore wells are simple devices. But offshore, the process is far more complex, especially in the deepwater. When a well is completed in deepwater, a tree is installed–not on the surface but directly on the seabed above the well. Such trees are known as subsea trees; producers control the flow of oil and gas remotely through these trees.
As you may imagine, when you’re installing a well in water depths of 7,000 to 8,000 feet, it’s not a simple process at all. Unlike relatively cheap and simple onshore trees, deepwater trees are expensive pieces of equipment and are technically highly complex.
Pressures at 8,000 feet are absolutely enormous. When you consider that some deepwater wells extend another mile or so underneath the seabed, the underground reservoir pressures are also overwhelming. Equipment that can handle that sort of operating environment is highly advanced; installing such equipment properly is also a complex project.
Oil that flows through subsea trees typically enters a subsea pipeline grid and then travels through a flexible metal pipe known as a subsea riser. The riser is the conduit to a surface-based floating production platform. Alternatively, in areas located reasonably close to shore, hydrocarbons can simply travel through a subsea pipe to shore-based facilities.
As more deepwater exploration and development work takes place, demand is rising quickly for advanced subsea trees. The best play on this trend is FMC Technologies (NYSE: FTI), the newest addition to my Wildcatters Portfolio.
Please note that the symbol is no typographical error: The symbol for FMC Technologies is “FTI” and not “FMC.” Not only does FMC have a 40 percent share of the subsea market, but it’s also the technological leader.
FMC actually has two divisions: energy services and food processing/material handling. At this time, more than three-quarters of revenues come from energy services and almost all the growth potential.
The shining star of the energy services business is subsea equipment. Consider that in 2001, the company’s revenues from subsea equipment totaled $494 million; by 2005, revenues stood at more than $1.4 billion from subsea alone. Last year, the company again likely posted growth in excess of 30 percent.
In 2003, there were just 226 subsea trees installed globally between FMC and all its competitors. But in the next 15 months, FMC expects that producers will contract for a grand total of 700 installations. One of the key catalysts I see developing for FMC in 2007 will be the awarding of all those contracts; FMC stands to gain more than its fair share of the business.
FMC has been gradually ramping up manufacturing capacity to meet demand. Right now, capacity stands at about 250 trees annually; during the next two years, the company plans to push that closer to 320.
On a unit basis, 40 percent of the subsea trees installed in a given year are manufactured by FMC. But the company makes the most-advanced subsea systems; these systems cost considerably more than trees designed for shallower water environments. Therefore, its market share on a dollar basis is far higher.
Even more interesting, CEO Joseph Netherland outlined some of the technological initiatives that FMC is pursuing. One of the most compelling is a subsea separator. FMC recently won the contract for the world’s first subsea separator from Statoil for installation in the Norwegian North Sea’s Tordis Field.
Basically, production from most wells worldwide consists of some combination of oil, natural gas and water. As oilfields age, oil production tends to drop and water production rises, a phenomenon known as a water cut. Tordis has been onstream since 1994 and is no exception to this rule.
In a traditional deepwater development, the combined stream of gas, oil and water gets pumped to the surface, most likely to a floating platform. In Tordis’ case, Gullfaks C platform is located about 10 kilometers away. There, the hydrocarbon stream is separated into oil gas and water and sent to shore. But FMC’s subsea separator will handle all of this right on the seafloor adjacent to the well.
There are advantages to this. The subsea separator system is part of Statoil’s grand plan to squeeze more oil out of this reservoir. Currently, Tordis is expected to ultimately recover about 49 percent of the total oil in place. This is a typical recovery factor for a field like this; you can never truly recover all of the oil actually contained in a reservoir.
Statoil wants to boost the recovery factor to about 55 percent. This would allow the company to ultimately squeeze another 20 million barrels of oil from this field. Obviously, 20 million barrels of additional oil would be worth more than $1 billion at today’s prices; that’s a worthwhile amount.
The separator accomplishes this enhancement by first separating the production stream into oil, gas and water on the seafloor. The water separated is then immediately reinjected into another subsea well. Reinjecting water helps to maintain higher reservoir pressures. Falling reservoir pressures are what ultimately kill wells, so this process extends the life of the well.
The total cost of the Statoil Tordis project is in the neighborhood of $100 million. When you consider the value of the additional oil it’s recovering, the project seems like a cost-effective option for Tordis. This first project is set for completion in October 2007; if it goes as well as planned, I wouldn’t be at all surprised to see other energy firms start looking for opportunities to construct a similar project on existing mature fields.
Two other slightly more distant technologies FMC has outlined are subsea gas compression and subsea light well intervention. The former technology aid the production of gas wells that have been de-pressured.
Basically, in a traditional development, the natural underground pressure of gas flowing from a reserve is enough to push that gas through a pipeline to shore or a platform. But when wells age and begin to lose pressure, that production rate can drop.
To get around this problem, FMC has partnered with Germany’s Siemens on a low maintenance compressor that would allow gas to be forced through a subsea pipeline. One advantage of this technology is that gas could travel longer distances through a pipeline; instead of pumping gas to a platform, natural gas could theoretically be piped all the way to the coast. Platforms are expensive and have limited capacity, so this is potentially a money saver.
The term intervention refers to the need to re-enter a well and effect repairs or adjustments. The problem with reworks in deepwater is that you’d normally need to hire out a semi rig to perform the task; as noted above, these rigs are very expensive to lease, so doing reworks and repairs isn’t particularly cost effective. At the same time, a producer can dramatically increase recovery factors by performing these minor repairs and adjustments.
FMC has developed some subsea equipment and systems that allow basic light work to be performed from a dynamically positioned ship. The potential is for this to cut down on the need to actually have a semisubmersible rig on site. This technology has a wide application as FMC estimates there are 2,000 subsea wells in the world that are aging to the point repairs are becoming necessary.
With superior technology and a solid market position, FMC sits at the heart of the deepwater trend. FMC is added to the Wildcatters Portfolio.
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Other Beneficiaries
In addition to Seadrill and FMC, we already have a host of companies in the Portfolios that stand to benefit handsomely from the growth of deepwater project development.
Chief among those are services giant and Wildcatters Portfolio holding Schlumberger. Schlumberger is a leader in advanced oilfield technologies and deepwater seismic mapping. Also, Petroleum Geo-Services performs seismic mapping services in the North Sea and elsewhere. I outlined the case for Schlumberger and Petroleum Geo-Services in the Nov. 1, 2006, issue of TES, Earnings Bonanza.
It’s also worth noting that Petroleum Geo recently split its stock 3-for-1; I’ve adjusted the entry price and the buy and stop recommendations to reflect that change.
Finally, don’t forget Oil Country Tubular Goods manufacturer Tenaris. The company’s advanced seamless pipes can handle extreme deepwater pressures and temperatures. I outlined the case for this stock in the Dec. 6, 2006, issue, Looking For Some Upside.
The good news is that The Energy Strategist Portfolios outpaced both the broader market and the major energy-related indexes for the year and in the fourth quarter. For the first half of the year, the straight average of all holdings across the three Portfolios—Proven Reserves, Gushers and Wildcatters—was just shy of 25 percent.
Recall that, after midyear, I enhanced my return calculations and began tracking each Portfolio separately on a week-to-week basis. I created an index representing each Portfolio to allow convenient week-to-week graphical comparison of results. Check out the chart below for a closer look.
Source: The Energy Strategist
The income-oriented Proven Reserves Portfolio is designed for stability of capital and high income. Although this Portfolio offered the lowest overall returns at around 13 percent, it also offered the highest stability; except for one brief period in late September, the Portfolio never dropped into the red. In the fourth quarter, my recommended master limited partnership (MLP) holdings surged to new heights. MLPs remain my top income idea for 2007. (Check out the Nov. 22, 2006, issue of TES, Leading Income, for a detailed rundown of my favorites.)
My long-term, growth-oriented Wildcatters Portfolio trounced both the S&P 500 and the OSX, returning 16.6 percent in the fourth quarter and 23.4 percent overall in the final six months of the year. My big winners in this Portfolio were biofuels player Bunge (NYSE: BG) and Oil Country Tubular Goods specialist Tenaris ((NYSE: TS). (I highlighted both in the most-recent issue of TES.) In addition, French nuclear utility stock Electricite de France (Paris: EDF) was a huge winner in the latter half of this year, returning nearly 40 percent. (I highlighted this stock in the July 26, 2006, issue, The Nuclear Option.)
And last but certainly not least is this quarter’s star performer, the aggressive Gushers Portfolio. Although this portfolio saw some weakness over the summer, alongside most energy stocks, the Portfolio was never down more than 8.5 percent. A jump of more than 38 percent in the fourth quarter made up for any summertime selling; the Portfolio returned close to 32 percent overall in the latter half of the year. The biggest winners in this Portfolio: the biofuels and uranium plays outlined in the most-recent issue of TES. Several of these are up well more than 100 percent since the end of June.
In This Issue
It’s now time to re-focus our attention on trying to equal last year’s performance once again in 2007. In this issue, I will review one of my favorite long-term themes that I see as resistant to any weakness in commodity pricing: deepwater exploration and development activity. I’m adding two new stocks to the Portfolios–Seadrill (Oslo: SDRL; OTC: SDRLF) to Gushers and FMC Technologies (NYSE: FTI) to Wildcatters–as plays on this long-term theme.
Deepwater exploration and development will prove to be an integral part of the oil industry as “easy” oil production continues to decline and new reserves must be sought out. Expect to hear more news similar to the Gulf of Mexico reserve announcement this year. See The Final Frontier.
Transocean isn’t just a rig supplier—it’s the rig supplier. As such, it’s the greatest indicator of what’s going on in the drilling industry. See The Canary.
Despite Transocean’s massive holdings and sustained rig contracts, I see a better way to play the drilling industry. My new Norwegian rig supplier holding in the Gushers Portfolio has more upside catalysts and some considerable growth coming in from its newbuilds. See How To Play It.
Deepwater drilling is a tricky business, in needs of equipment like trees, BOPs and subsea separators to prevent risks such as blowouts. In addition to my new rig supplier, I’ve also found a great play on deepwater drilling technology for my Wildcatters Portfolio. See Deep In Equipment.
Several of my other Portfolio recommendations also benefit from increased interest in deepwater drilling activity, which continues to make them attractive holdings. See Other Beneficiaries.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
- FMC Technologies (NYSE: FTI)
- Petroleum Geo Services (NYSE: PGS)
- Seadrill (Oslo: SDRL; OTC: SDRLF)
- Schlumberger (NYSE: SLB)
- Tenaris (NYSE: TS)
- Transocean (NYSE: RIG)
The Final Frontier
One of the longest-standing themes of this newsletter has been the end of “easy” oil. The world’s giant, easy-to-produce, onshore oil reserves are now mature and experiencing flat or declining production.
To offset these declines, producers are increasingly targeting more-complex reserves that can only be produced using the most modern, advanced technologies. In many cases, these hard-to-produce reserves are also more expensive to produce than conventional onshore oilfields. (I outlined this basic thesis in the Nov. 30, 2005, issue of TES, Not So Easy.)
There’s a distinction to be made between the idea that the world is running out of oil and the concept of the end of “easy” oil. In my view, the world will never truly run out of oil; the last barrel of oil will never even be produced.
The question isn’t whether the world runs out of oil entirely but whether supply can continue to increase and, more important, grow fast enough to keep pace with demand. The question isn’t just one of how much oil is in the ground but of how fast that oil can be produced.
You may have heard of the theory of “peak” oil. One of the most-interesting modern books on this topic is Matthew Simmons’ Twilight in The Desert; I heartily recommend this book to all subscribers. The theory of peak oil isn’t that the world is literally running out of oil but that actual daily production of oil is at, or very near, a peak.
In other words, sooner rather than later, the world’s rapidly maturing oilfields will see a gradual decline in production; after all, once-prolific fields in the US, North Sea and the rest of the world are already seeing production decline rapidly. Supplies of oil would certainly be unable to keep pace with rapidly rising demand from emerging markets.
The end of “easy” oil is a slightly different philosophy. The theory isn’t that world production is necessarily near a peak but that increasing production to meet demand will require tapping more-complex fields and unconventional reserves.
Although I have considerable sympathy for the concept of peak oil, it’s almost impossible to know exactly when that peak will occur. I’ve heard compelling arguments that global oil production will peak in the next three years and equally well-thought-out predictions that we have 20 years of rising production ahead.
But from an investment standpoint, the actual timing of peak oil isn’t all that important. The simple fact is that growing production will require tapping more-complex reserves; producing these reserves will require enormous investment and the use of the most-advanced oilfield technologies.
Examples of harder-to-produce reserves include oil sands, Artic reserves and, of course, the deepwater. There’s broader consensus among oil experts that these types of reserve will need to be produced to meet growing global demand.
I regard deepwater as one of the single most-interesting and important new oil exploration and production stories of the next few years. I also see the 2007-08 period as a key growth period for deepwater developments; we’re now entering the sweet spot of deepwater production growth thanks to the large deepwater exploration and development investments of the past five years.
I fully expect further announcements along the lines of last year’s Chevron/Devon Jack Field deepwater well test in the Gulf of Mexico. The announcement of new deepwater discoveries and successful well tests will help catalyze interest in deepwater.
As such, companies that are leveraged to ongoing deepwater developments will be one of the top oil and gas-related themes for investors. Check out the chart below for a closer look.
Source: Energy Information Administration
This chart uses data and forecasts provided in the Energy Information Administration’s (EIA’s) Annual Energy Outlook for 2006. To create the chart, I simply took actual and forecasted US deepwater oil production and divided it by total production, creating a percentage figure.
In 1990, for example, US deepwater oil production was negligible, accounting for less than 2 percent of overall domestic supply. Now, deepwater production accounts for more than a fifth of US oil supplies; by 2030, that figure is expected to reach close to 40 percent. Deepwater reserves are becoming an ever-more-important piece of the US supply puzzle. Check out the chart below.
Source: EIA
This chart depicts the actual, raw numbers and projections on US oil production from the EIA. It’s clear that every category of US oil production is expected to decline between now and 2030, save one. Lower 48 state production, Alaskan production and shallow-water production will all continue the recent trend; production will decline at a slow-but-steady pace over the next 25 years.
The one exception is deepwater production. The EIA projects that deepwater US oil production won’t peak until the middle of next decade.
And remember that this is just a government projection. Although the EIA puts out some truly excellent research, I think we can all agree that the government is far from infallible. Some private projections I’ve seen suggest that US deepwater oil production could top 5 million barrels per day by 2020 and won’t peak for another two decades. Whether you accept the EIA’s conservative case or a rosier picture, it’s clear that US deepwater production is set to grow.
And the US Gulf of Mexico is only part of the story. Deepwater exploration and development are truly global phenomenons; development is underway in the North Sea, Australia, Africa, South America and even Asia.
Because of the technical complexities involved with exploring for and producing deepwater reserves, it should come as little surprise that this is the energy market’s last exploration frontier–the last major potential pocket of global oil and gas reserves to be exploited. There are plenty of promising prospects for deepwater development all over the world.
Deepwater developments require large upfront capital investments and take years to finalize. Once deepwater wells are completed, however, these wells can flow at rates reminiscent of Texas wells a century ago. Although growing deepwater production will be at least partially offset by declining production from mature onshore reserves, it remains one of the most-likely candidates for delaying the actual peak in global oil production.
The good news about deepwater from an investing standpoint is that it’s considerably more complex technologically that onshore or shallow-water exploration and production. That makes deepwater a highly playable theme; there are dozens of companies leveraged to growth in the sector. I see benefits accruing to the following major sub-groups:
- Deepwater-focused contract drillers. As I’ll explain in a moment, drilling deepwater reserves requires the use of very expensive-to-build specialized drilling rigs. There are only a highly limited number of such rigs globally, and right now, they’re nearly 100 percent utilized. Producers are bidding up day-rates—the rates charged for hiring rigs—to try to secure availability.
- Oil and gas services. As I noted in the introduction, exploration and development of deepwater reserves requires considerably more-advanced technologies than onshore reservoirs. The list includes advanced deepwater seismic services for mapping reserves and directional drilling services for more efficiently producing oil and gas. Services firms with the advanced technology needed to produce deepwater reserves are in the catbird’s seat.
- Subsea equipment. As you may expect, the pressures encountered in reserves located 7,000 feet underwater are considerably greater than pressures in reserves located in shallow-water and onshore. The pipes and valves used to produce deepwater reserves are specialized to handle the extreme conditions. And much of the equipment used to produce deepwater wells has to be installed directly on the seafloor; a handful of equipment firms specialize in this business.
- Producers with deepwater plays. Finally, of course, companies with access to promising deepwater reserves have an opportunity to realize the production growth potential of energy’s last frontier.
One more important point to note before I delve into my favorite deepwater picks: Deepwater activity is relatively insulated from commodity prices. Once the upfront capital investments are made in exploration and development, deepwater reserves are economical to produce–far more economical, in fact, than many onshore reserves being exploited today.
In addition, deepwater projects are long term and multi-year in nature, pursued mainly by large, multinational integrated oil firms and national oil companies. Short-term swings in commodity prices have absolutely no impact on these spending plans.
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The Canary
A century ago, before coal miners had access to gas testing equipment, miners would carry a small bird into the mines with them. If the bird got sick or died, that meant gas levels were dangerous and the miners would leave the mine to wait for ventilation to improve.
When it comes to deepwater activity, my canary in the coalmine is Transocean. Transocean is a contract drilling firm. The company doesn’t produce or sell oil or natural gas; rather, it owns a fleet of drilling rigs that are used to drill wells. Companies like ExxonMobil and Chevron pay Transocean a day-rate for leasing its rigs.
Contract drillers tend to be classed by the type of rigs they own; Transocean specializes in rigs used for offshore deepwater activity. I explained the different rig types and how they work in the June 14, 2006, issue of TES, “The Good, The Bad, The Ugly,” under the subhead Contract Drillers. I recommend all new subscribers check out that explanation.
There are two main rig types used in deepwater–drillships and semisubmersibles. Drillships look like regular ships and move to a drilling location under their own power. Typically, they’re dynamically positioned; computer-controlled thrusters hold the ships in place during the drilling process.
Modern drillships are capable of drilling in very deep waters. The advantages of drillships include flexibility and maneuverability; because they move under their own power, they’re appropriate for exploiting even remote reserves. The main disadvantage: In rough seas, drillships will rock just like any other ship and thrusters may have a hard time maintaining position. Therefore, typically, they’re used in calmer waters.
Semisubmersibles (semis) are essentially a platform with two large pontoons. Semis are towed to location, and those pontoons are filled with water, sinking the lower part of the rig. Pontoons can be sunk as far as 100 feet beneath the ocean’s surface.
Semis are typically moored and dynamically positioned; the submerged pontoons offer a further level of stability in even the roughest seas. Semis are typically capable of drilling in deeper waters, and their main advantage is stability in rough seas. The main disadvantage: They must be towed to location, so they can be tough to move into remote locations.
Offshore deepwater rigs can be further divided into “generations.” The first deepwater rigs were built back in the 1970s; since that time, they’ve become progressively more advanced. Newer generations of rigs are capable of drilling into deeper waters, offer greater stability and have more-advanced onboard equipment.
There have been essentially five generations’ worth of rigs since the ’70s, and a sixth generation is now in the design-and-construction process. Day-rates for advanced offshore rigs can be close to or more than $600,000 per day in the current market environment. Such rigs cost upward of $700 million dollars to construct, a process that takes more than three years.
To make a long story short, Transocean owns 42 semis and 13 drillships; its nearest competitor, Diamond Offshore, owns just 30 deepwater rigs and a single drillship. Moreover, Transocean’s rigs are the most advanced: It has more fourth and fifth generation rigs and advanced drillships than any of its competitors. If you want to know how the deepwater business is performing, look to Transocean for an answer.
And based on the company’s most-recent conference call in early November, the deepwater business has never been stronger. Almost the entire fleet of rigs is currently working on some sort of contract somewhere around the world. The rigs that aren’t working are either not yet constructed or are in the shipyard undergoing repairs and upgrades.
Even better, the company’s newbuilds–newly built rigs that are mainly still under construction–are also contracted. As soon as the newbuilds leave the shipyard, they’re headed out to start working on signed, guaranteed contracts.
But signing contracts is just half the story; the other point to consider is just how high day-rates are for rigs being contracted right now. The fact is that Transocean is continually setting new record day-rates for deepwater rig contracts.
Day-rates for some rigs can easily be double or more what they were just a few years ago; even newbuilds are getting contracts at sky-high day-rates despite the fact they’re not scheduled for delivery for another year or two. Check out the chart below for a closer look at Transocean’s backlog and contracted day-rates.
Source: Transocean, Third Quarter Results Presentation
Source: Transocean, Third Quarter Results Presentation
The company has more than $20 billion in backlogged day-rate revenues over the next eight years. These are all firm, signed contracts that are unbreakable. That figure includes more than $5 billion in signed, contract revenues for both 2007 and 2008.
The reason why pricing power on day-rates is so high is simple: a lack of available supply. Transocean noted in its third quarter call that there are 33 high-specification rigs industrywide capable of drilling in ultra-deepwater. Of those 33 rigs, there’s only one rig with any uncontracted time in either 2007 or 2008.
Looking at Transocean specifically, the company stated that the vast majority of its high-specification rigs are booked solid from 2007 through 2008 with only very limited capacity in 2009. Management clearly stated in the conference call that it wasn’t “overly anxious to contract” these rigs.
The reason is simply that day-rates have been rising steadily for deepwater rigs because of tight supply and high demand for deepwater drilling projects. Several big, integrated energy firms have been forced to delay projects because they simply couldn’t secure rig availability over the next two to three years.
Now with only a small handful of rigs available in 2007 through 2009, there’s an even more acute scarcity premium to be paid. Transocean’s management team is simply making the bet that it can sign up its last few rigs at even higher day-rates by waiting for producers to become really desperate for rigs. This bet has certainly been paying off; since the third quarter call, the company has announced more contracts at new record-high rates.
And while the strongest demand and most-acute supply shortage is in the ultra-deepwater rigs, day-rates have been rising almost as quickly for less-advanced rigs. Consider that in mid-December, Transocean signed a second generation semi for a day-rate of more than $400,000 per day, exceeding the prior record for this class of rig; that rig is heading for Australia next summer.
The company also extended a contract for a third generation rig in the North Sea, earning a day rate approaching $400,000, up from less than $150,000 per day on the current contract. And finally, Transocean rolled another North Sea third generation rig contract over at $350,000 per day, roughly 75 percent higher than the same rig is currently earning.
All of this is bullish for Transocean and suggests continued strong demand for deepwater drilling activity. This also suggests a general willingness to pay up to try and secure rigs. In addition, I found several additional bits of news from Transocean indicative of the strength in demand and activity:
- PEMEX, the Mexican national oil company (NOC), has come out with a request for two deepwater rigs and likely a third. PEMEX has been slow to develop Mexico’s deepwater reserves and unwilling to pay up for rigs. This recent tender for rigs suggests that yet another market for deepwater rigs is finally opening up.
- Transocean highlighted that deepwater rig commitments aren’t commodity sensitive. The majority of the company’s customers are either major oil companies (like ExxonMobil and Chevron) or NOCs. The projects being drilled over the next two to three years were planned out years ago when oil prices were much lower; they’re not at all sensitive to short-term fluctuations in commodity prices. The company estimates that, based on its conversations with these customers, oil prices would need to fall under the $35 to $40 per blue barrel range before there’s any impact on activity.
- Interest in contracts for out years (2009-15) is increasing. Producers have become increasingly interested in firming up contracts and securing rigs at attractive day-rates to commence drilling after 2009. This suggests a level of confidence in the sustainability of energy prices and a commitment to finding and producing new reserves.
- Interest in contracting “spec” rigs is also rising. Spec rigs are newbuild rigs that are constructed without a firm contract in hand. In other words, when Transocean decides to build a new rig, it first secures a contract on that rig. This policy reduces risk. Some more-aggressive companies don’t secure the contract first; in essence, they’re building the rig on the speculation that they’ll be able to secure a contract once the newbuild is ready to begin work. Just since mid-year, several of these spec rigs have managed to secure contracts (years before they’re ready to drill) at attractive day-rates. This, too, suggests plenty of pent-up demand for deepwater drilling.
Transocean’s day-rate revenues are basically locked in over the 2007-09 period. The rigs are covered by firm, signed contracts, so their revenue stream is highly visible. Recent contracting activity suggests that Transocean will also be able to lock in contracts for rigs post-2009 at highly attractive rates.
Bottom line: As the company rolls over legacy contracts to newly agreed contracts at sky-high rates, earnings will rise. The company’s growth is locked in for the next few years. But check out the chart of Transocean’s stock over the past few years.
Source: StockCharts.com
It’s clear that, after a near quintupling in price from the 2003 lows through the middle of 2006, Transocean stalled. While the fundamental new has continued to just get better, Transocean hasn’t been able to make any real headway.
Whenever you see positive fundamentals and a declining or consolidating stock, you have to wonder if there’s something wrong with the story. In other words, is the market anticipating something that’s not yet apparent in the fundamentals of the company? Sometimes the market anticipates a slackening of demand long before that slowdown becomes readily apparent.
In Transocean’s case, that’s simply just not the case. As highlighted at great length above, the company’s revenues are all but locked in for the next few years. Demand is clearly strong and getting stronger; producers are looking to lock up deepwater rigs going out to 2015.
That said, I see a number of factors that have contributed to Transocean’s mediocre near-term performance. Here’s a quick rundown:
Rig Supply
Although we know rig demand is strong, there have been some concerns over the sheer number of newbuild rigs due to be constructed in the next three to five years. At the time of this writing, there are a total of about 43 semis and drilliships under construction, most for delivery between the second quarter of 2008 and the fourth quarter of 2009. In addition to these newbuilds, a number of older generation rigs are being upgraded to handle more demanding work. Many of the rigs being constructed are spec rigs.
The fear has been that the addition of all these new rigs–a significant addition to the global fleet–would overwhelm demand and put pressure on sky-high day-rates.
My take is that this isn’t a concern. First, since mid-year many of the spec rig newbuilds have already signed contracts at attractive rates; demand is there. And Transocean and others have reported strong interest in contracts covering 2009 and afterward. As this marks the entry of all that new supply, it seems there’s plenty of demand to build the new rigs.
Leveraged Re-Capitalization
Transocean has been buying back a lot of stock recently. In 2006 through the end of October, Transocean bought back $3 billion worth of stock. In just the July-October period, Transocean used the weakness in its stock to back up the truck on another 28 million shares. With a share count of around 290 million, this is a significant repurchase in a very short period of time.
During the conference call, however, analysts questioned why Transocean wasn’t willing to be even more aggressive with buybacks. In particular, the stock is cheaper on a price-to-earnings basis than it’s been in many years; the stock trades at 11 times 2007 earnings and should grow by at least 40 percent annualized in the next few years.
Meanwhile, free cash flows have ballooned and the company has aggressively paid down debt. Check out the chart below.
Source: Bloomberg
Note that operating cash flow has been generally rising for several quarters. While cash flow also spiked in 2001-02, it’s been far more sustainable during this cycle. Given the rollover of legacy contracts next year, cash flows should increase rapidly once again.
Meanwhile, Transocean has been steadily paying down debts. The debt-to-equity ratio spiked a bit in the third quarter because the company took out around $2 billion in loans to help fund its opportunistic stock buyback. But management plans to pay most or all of this off by the first part of 2007; cash flows are more than sufficient to retire that debt quickly.
Source: Bloomberg
The big question many analysts ask is why Transocean doesn’t take on a big chunk of additional debt and use that money to pay a big dividend or buy back a huge amount of stock. With cash flows guaranteed by long-term contracts, Transocean could raise that debt capital at highly attractive rates; most analysts believe Transocean is under-leveraged at this time.
Analysts have been looking for a so-called leveraged re-cap–the purchase of stock using debt capital. Earlier in the year, there was plenty of speculation that Transocean would pursue just such a transaction.
Management tells us that it wants to keep some powder dry in case it wants to make an acquisition or arrange for newbuild rigs; the company doesn’t want to pursue such a transaction. But the company probably should reconsider, especially if its stock does see another dip next year. At any rate, disappointment surrounding this also has been a headwind for Transocean.
Lack Of Contract News Flow
As I noted above, there’s been plenty of news flow surrounding Transocean’s older rigs; several of the older semis have managed to secure highly attractive, record day-rates. But the company has already booked most of its high-spec rigs for 2007-09.
There could well be news about some more post-2009 contracts, but I suspect the company will want to hold back some of these rigs unless it’s able to secure some truly impressive day-rates. After all, Transocean doesn’t want to lock in a day rate that looks good now only to watch prevailing day rates rise another 50 percent by 2009.
In other words, Transocean has locked in solid growth for the next few years. But that growth is “known” growth; the potential for big, new, surprise contract announcements that could really juice up the stock is limited. In a way, Transocean stock is a victim of its own success.
This argument seems rather ridiculous at first blush, but the market does work as a discounting mechanism; perhaps the fivefold run-up in the stock from 2003 to 2006 already priced in the huge improvement in earnings and day-rates. The market is now looking for a new growth catalyst.
Cost Control
Signed contracts lock in revenues but not earnings. In other words, if Transocean’s operating costs rise too far, too fast, they could eat into earnings even though revenues will keep on rising. In particular, Transocean surprised the market in the second quarter with some higher-than-expected cost inflation. There was considerable concern this summer that this pace of inflation would continue to eat into earnings estimates.
Cost inflation in the oil and gas industry is high and likely to remain that way. There’s a global shortage of experienced labor in the rig industry; the cost of hiring drilling crews is rising. Equipment for rigs is getting more expensive, as is maintenance, construction and shipyard work. In addition, because day-rates are so high, the cost of idling a rig to move it or handle repairs is soaring. Just a one-day delay in moving a single high-spec rig can cost Transocean upward of $600,000 in lost revenues.
According to Transocean, cost inflation in the industry is running around 2.5 percent per quarter; that’s about 10 percent annually. In Transocean’s second quarter, costs rose even faster than that.
There’s no way to totally avoid rising costs; costs aren’t likely to come down unless there’s a meaningful slowdown in deepwater activity. Given the rig contracts out there, this is highly unlikely.
But cost growth at that level is already factored into earnings estimates for the next few years. And several factors suggest that Transocean’s second-quarter cost explosion was an anomaly.
The company was in the midst of reactivating three rigs; rigs that had been in storage were upgraded and put back into serviceable use. Delays in reactivations caused a good bit of the upside cost surprise. But the last of these rigs is out of the shipyard in the first two months of 2007. Shipyard activity should return to more normal levels.
And Transocean has taken further steps to mitigate cost inflation. Most important, the company has adopted a more-stringent budgeting and cost forecasting system. Management claims that this has already helped fuel greater efficiency.
The important takeaway from all of these factors is that not one of them has anything to do with demand. Moreover, as noted, several recent developments suggest all of these concerns are overblown. Deepwater activity remains ultra-strong, and there are concrete signs it’s likely to remain strong well into the coming decade.
The only real negative about Transocean is that it lacks near-term upside catalysts. The pace of new contract signings should slow because the company has already signed up most of its rigs on very attractive terms. For this reason, and this reason alone, investors will need to be patient with Transocean during the next quarter or two.
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How To Play It
I’m raising Transocean to a buy in How They Rate, but I’m not adding it to the model Portfolios. Instead, I’m adding a stock that looks more leveraged to the strengthening drilling cycle and has more upside catalysts. Seadrill (Oslo: SDRL; OTC: SDRLF) is added to my higher-risk Gushers Portfolio.
Seadrill, like Transocean, is a contract driller with a particularly strong focus on the deepwater. It’s perhaps the most-aggressive drilling contractor anywhere in the world today.
Seadrill currently has an operating fleet of five semis and one drillship. In addition, the company has a number of other high-quality jack-ups and tender barge rigs designed for shallower water work.
Currently, all of these rigs are out on contracts and earning revenues; Seadrill was profitable in the second and third quarters of 2006. But the company’s real value isn’t the rigs it already has working: It’s the newbuild rigs it owns that are scheduled for delivery during the next two years.
Seadrill has a total of two drillships on order in Samsung’s Korean shipyards. And the company has four deepwater semis on order–two being constructed in Korea by Samsung and two in Singapore by Jurong.
Both of these are large, well-known shipyards with a reputation for keeping more or less on schedule with construction projects. Designs for these rigs are copies of existing, proven rigs.
In addition, Seadrill owns a 60 percent-plus stake in Eastern Drilling ASA, a publicly traded company on the Oslo Stock Exchange. Eastern has two additional highly advanced semis under construction in Korea.
The first of Seadrill’s new rigs is scheduled for completion in the fourth quarter of 2007, perhaps slipping into the early first quarter of 2008. The remaining rigs are scheduled for completion and delivery in 2008. That means that all these rigs will be ready for contracting at that time.
In fact, the first semi to be completed will be Eastern’s West E-drill. That rig is signed up on a contract with Total at a day-rate of $480,000 starting in the first quarter of 2008. Contracts have also been secured on the drillship West Polaris and the semi West Sirius; both contracts commence in mid-2008 at day-rates of $520,000 and $460,000, respectively.
There’s even more potential value in Seadrill’s other uncontracted rigs. As I noted earlier in this issue, there are very few deepwater rigs that haven’t yet been contracted between 2008 and 2010. The company owns five deepwater rigs that are scheduled for delivery in 2008 and don’t currently have contracts. That’s more rig availability than any other company on Earth.
The point is that Seadrill has some spare capacity in a market that has no spare capacity. If you’re a producer looking for a rig, it may well be the only option.
There’s plenty of potential upside surprise for Seadrill as it announces contracts at high rates for uncommitted rigs; this is the key contrast to Transocean, which doesn’t have much uncommitted capacity. Even if another company wished to contract rig newbuilds immediately, those rigs couldn’t be delivered until 2010; Seadrill has zeroed in on the real sweet spot of this supply squeeze.
I also must admire Seadrill’s aggression in what’s clearly a very strong contract drilling market. The company has stated that it’s interested in making more acquisitions, possibly of a large, US-based driller. The company believes that it could target an acquisition of as high as $16 billion by taking on more leverage.
Because of the strong, locked-in revenues coming from contracts, servicing that debt shouldn’t be a problem. Although the company may have to issue stock to make such an acquisition, the stock has actually reacted positively to talk of its role as an acquirer; most believe industry consolidation is desirable longer term in the drilling business.
Seadrill trades over-the-counter (OTC) in the US. The OTC shares trade reasonably liquidly, though daily volume traded is low. Be sure to use a limit order when buying the stock OTC. If you do have access to the Oslo exchange, consider purchasing Seadrill in the local market. Check out the chart below for a closer look at how the company has been trading in the OTC market.
Source: Bloomberg
Another point worth noting: Because of some odd Oslo Stock Exchange rules, the exchange has ruled that Seadrill must either take full control of Eastern Drilling or reduce its stake. The exchange will also be issuing some guidelines on an appropriate takeover price for Eastern.
Eventually, provided the price is reasonable, Seadrill will likely take out Eastern, which was the company’s original intention. I’m not overly concerned about this news flow because it’s been well-known for some time; analysts were already assuming that Seadrill would have to pay up more cash to buy Eastern.
However, there’s good news in that dark cloud: Management was so irritated by the Oslo ruling that it’s decided to switch its primary listing to either New York or London. Both of these markets are far easier for US-based investors to access than Oslo. (See the Sept. 20, 2006, issue of TES, Fueled By Food, for a closer examination of how to buy stocks listed on foreign exchanges.)
In addition, more brokers are offering access to foreign shares every year. Be sure to call your existing broker directly to see if he/she can execute such trades.
I would expect to see further news considering the possibility of a US listing on a primary exchange in 2007. If that happens, Seadrill will gain additional visibility–a big positive fro the stock. For now, I’ll track the company in the Gushers Portfolio assuming the purchase of the OTC-traded shares.
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Deep In Equipment
Whether a well is located onshore or in deepwater, it eventually has to be fitted with a device known as a Christmas tree, or simply a tree. A tree is nothing more than a series of pipes, valves and gauges that are used to control the production of oil or gas from a well. The tree is so named because the network of pipes and valves tend to appear reminiscent of a tree and branches.
In addition, typically a device known as a blowout preventer (BOP) is installed on top of a well. When drilling for oil or gas, drillers pump a substance known as drilling mud into the well. Originally, drilling fluids were made quite literally of mud; nowadays, fluids are far more complex than that.
The purpose of drilling mud is to offset the natural underground pressure of the hydrocarbons in the reservoir. In other words, the pressure of the mud in the well helps prevent oil from rushing into the well and gushing out the top of the well bore.
That uncontrolled gushing is called a blowout. Blowouts are undesirable; uncontrolled oil flow wreaks environmental havoc, wastes a valuable resource, and can ignite and explode. In addition, noxious gases often coexist with hydrocarbons underground; these gases can literally kill you if inhaled.
Of course, if the mud isn’t mixed correctly or the reservoir pressure surges for some reason, a blowout situation can quickly develop. The BOP is simply a high pressure valve that can seal off the well in an emergency situation during driller or well repair.
Trees installed on onshore wells are simple devices. But offshore, the process is far more complex, especially in the deepwater. When a well is completed in deepwater, a tree is installed–not on the surface but directly on the seabed above the well. Such trees are known as subsea trees; producers control the flow of oil and gas remotely through these trees.
As you may imagine, when you’re installing a well in water depths of 7,000 to 8,000 feet, it’s not a simple process at all. Unlike relatively cheap and simple onshore trees, deepwater trees are expensive pieces of equipment and are technically highly complex.
Pressures at 8,000 feet are absolutely enormous. When you consider that some deepwater wells extend another mile or so underneath the seabed, the underground reservoir pressures are also overwhelming. Equipment that can handle that sort of operating environment is highly advanced; installing such equipment properly is also a complex project.
Oil that flows through subsea trees typically enters a subsea pipeline grid and then travels through a flexible metal pipe known as a subsea riser. The riser is the conduit to a surface-based floating production platform. Alternatively, in areas located reasonably close to shore, hydrocarbons can simply travel through a subsea pipe to shore-based facilities.
As more deepwater exploration and development work takes place, demand is rising quickly for advanced subsea trees. The best play on this trend is FMC Technologies (NYSE: FTI), the newest addition to my Wildcatters Portfolio.
Please note that the symbol is no typographical error: The symbol for FMC Technologies is “FTI” and not “FMC.” Not only does FMC have a 40 percent share of the subsea market, but it’s also the technological leader.
FMC actually has two divisions: energy services and food processing/material handling. At this time, more than three-quarters of revenues come from energy services and almost all the growth potential.
The shining star of the energy services business is subsea equipment. Consider that in 2001, the company’s revenues from subsea equipment totaled $494 million; by 2005, revenues stood at more than $1.4 billion from subsea alone. Last year, the company again likely posted growth in excess of 30 percent.
In 2003, there were just 226 subsea trees installed globally between FMC and all its competitors. But in the next 15 months, FMC expects that producers will contract for a grand total of 700 installations. One of the key catalysts I see developing for FMC in 2007 will be the awarding of all those contracts; FMC stands to gain more than its fair share of the business.
FMC has been gradually ramping up manufacturing capacity to meet demand. Right now, capacity stands at about 250 trees annually; during the next two years, the company plans to push that closer to 320.
On a unit basis, 40 percent of the subsea trees installed in a given year are manufactured by FMC. But the company makes the most-advanced subsea systems; these systems cost considerably more than trees designed for shallower water environments. Therefore, its market share on a dollar basis is far higher.
Even more interesting, CEO Joseph Netherland outlined some of the technological initiatives that FMC is pursuing. One of the most compelling is a subsea separator. FMC recently won the contract for the world’s first subsea separator from Statoil for installation in the Norwegian North Sea’s Tordis Field.
Basically, production from most wells worldwide consists of some combination of oil, natural gas and water. As oilfields age, oil production tends to drop and water production rises, a phenomenon known as a water cut. Tordis has been onstream since 1994 and is no exception to this rule.
In a traditional deepwater development, the combined stream of gas, oil and water gets pumped to the surface, most likely to a floating platform. In Tordis’ case, Gullfaks C platform is located about 10 kilometers away. There, the hydrocarbon stream is separated into oil gas and water and sent to shore. But FMC’s subsea separator will handle all of this right on the seafloor adjacent to the well.
There are advantages to this. The subsea separator system is part of Statoil’s grand plan to squeeze more oil out of this reservoir. Currently, Tordis is expected to ultimately recover about 49 percent of the total oil in place. This is a typical recovery factor for a field like this; you can never truly recover all of the oil actually contained in a reservoir.
Statoil wants to boost the recovery factor to about 55 percent. This would allow the company to ultimately squeeze another 20 million barrels of oil from this field. Obviously, 20 million barrels of additional oil would be worth more than $1 billion at today’s prices; that’s a worthwhile amount.
The separator accomplishes this enhancement by first separating the production stream into oil, gas and water on the seafloor. The water separated is then immediately reinjected into another subsea well. Reinjecting water helps to maintain higher reservoir pressures. Falling reservoir pressures are what ultimately kill wells, so this process extends the life of the well.
The total cost of the Statoil Tordis project is in the neighborhood of $100 million. When you consider the value of the additional oil it’s recovering, the project seems like a cost-effective option for Tordis. This first project is set for completion in October 2007; if it goes as well as planned, I wouldn’t be at all surprised to see other energy firms start looking for opportunities to construct a similar project on existing mature fields.
Two other slightly more distant technologies FMC has outlined are subsea gas compression and subsea light well intervention. The former technology aid the production of gas wells that have been de-pressured.
Basically, in a traditional development, the natural underground pressure of gas flowing from a reserve is enough to push that gas through a pipeline to shore or a platform. But when wells age and begin to lose pressure, that production rate can drop.
To get around this problem, FMC has partnered with Germany’s Siemens on a low maintenance compressor that would allow gas to be forced through a subsea pipeline. One advantage of this technology is that gas could travel longer distances through a pipeline; instead of pumping gas to a platform, natural gas could theoretically be piped all the way to the coast. Platforms are expensive and have limited capacity, so this is potentially a money saver.
The term intervention refers to the need to re-enter a well and effect repairs or adjustments. The problem with reworks in deepwater is that you’d normally need to hire out a semi rig to perform the task; as noted above, these rigs are very expensive to lease, so doing reworks and repairs isn’t particularly cost effective. At the same time, a producer can dramatically increase recovery factors by performing these minor repairs and adjustments.
FMC has developed some subsea equipment and systems that allow basic light work to be performed from a dynamically positioned ship. The potential is for this to cut down on the need to actually have a semisubmersible rig on site. This technology has a wide application as FMC estimates there are 2,000 subsea wells in the world that are aging to the point repairs are becoming necessary.
With superior technology and a solid market position, FMC sits at the heart of the deepwater trend. FMC is added to the Wildcatters Portfolio.
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Other Beneficiaries
In addition to Seadrill and FMC, we already have a host of companies in the Portfolios that stand to benefit handsomely from the growth of deepwater project development.
Chief among those are services giant and Wildcatters Portfolio holding Schlumberger. Schlumberger is a leader in advanced oilfield technologies and deepwater seismic mapping. Also, Petroleum Geo-Services performs seismic mapping services in the North Sea and elsewhere. I outlined the case for Schlumberger and Petroleum Geo-Services in the Nov. 1, 2006, issue of TES, Earnings Bonanza.
It’s also worth noting that Petroleum Geo recently split its stock 3-for-1; I’ve adjusted the entry price and the buy and stop recommendations to reflect that change.
Finally, don’t forget Oil Country Tubular Goods manufacturer Tenaris. The company’s advanced seamless pipes can handle extreme deepwater pressures and temperatures. I outlined the case for this stock in the Dec. 6, 2006, issue, Looking For Some Upside.
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