Here’s the Drill: Buy the Pullback

We last outlined the tightening supply-demand balance in the market for deepwater (water depths of 4,500 feet to 7.500 feet) rigs with advanced capabilities and ultra-deepwater (water depths in excess of 7,500 feet) drilling rigs in the Feb. 2 article, Going Deep.

First-quarter results and management teams’ commentaries during conference calls with analysts reaffirmed our bullish take on this market segment. Alf Thorkildsen, CEO of Aggressive Portfolio holding SeaDrill (NYSE: SDRL), summarized these growth drivers during a May 14 conference call:

The high and stable oil price, numerous significant oil and gas discoveries, many of which are in new frontier areas such as East Africa and the Barents Sea, and limited near-term availability of rigs have created a very strong market for ultra-deepwater fleet, with day-rates exceeding $600,000 per day.

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

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. But 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 will 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 the 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, though 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. Growth Portfolio holding 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 three offshore contract drillers in our model Portfolios also have significant ultra-deepwater capacity available over the next two years; we expect these rigs to fetch elevated day-rates in the current supply-demand environment. Nevertheless, two of our three model Portfolio holdings are down more than 10 percent since the beginning of the new year, presenting investors with an opportunity to buy this growth story at a discount.

Without further ado, here’s a review of how these names have fared in the first three months of 2012.

SeaDrill (NYSE: SDRL)

Key Takeaways:

  • Raised quarterly dividend to $0.82 per share from $0.80 per share and declared a one-time payout of an additional $0.15 per share.
  • Management expects growing demand for high-specification jack-ups to push prevailing day-rates for these rigs $20,000 to $30,000 higher by year-end.
  • Customers are contacting SeaDrill about the availability of ultra-deepwater rigs two years ahead of contract expiration–an indication of the tight supply-demand balance in this key market.
  • SeaDrill ordered three additional ultra-deepwater rigs during the first quarter of 2012, taking advantage of favorable financing terms and adding exposure to rising day-rates.
  • Plans to raise capital by spinning off some Brazil-based assets and forming a master limited partnership.

SeaDrill posted another solid first quarter, generating net income of $439 million and revenue of $1.05 billion. The contract driller’s utilization rates ticked up slightly across all asset classes, a testament to the firm’s execution and customer demand for modern drilling rigs.

Nevertheless, the firm’s West Alpha and West Taurus rigs faced unscheduled downtime during the quarter to address issues with their subsea equipment. SeaDrill subsequently announced the purchase of five additional blowout preventers (BOP), the five-story tall devices used to seal failing wells. After the BOP on the Deepwater Horizon rig failed to prevent the largest offshore oil spill in US history, a number of rigs have faced extensive downtime to check and maintain this critical well-control device.

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 9.4 percent dividend yield, an appealing prospect in an environment where corporate bonds and many dividend-paying equities offer insignificant yield.

But 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 included 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.”

Demand for advanced deepwater rigs with flexible positioning and mooring systems should also continue to strengthen, while management likewise expects growth opportunities to emerge for modern deepwater rigs capable of operating in harsh environments:

We have seen during the last year that there has been significant oil and gas discovery made both in well-established region such as the UK and Norwegian Continental Shelf, as well as frontier areas such as Canada and the Norwegian part of the Barent Sea. The current harsh environment fleet is coming of age with more than 50 percent of the rigs currently in operation in Norway being older than 24 years, with some of the rigs overdue for replacement. SeaDrill [and its recently listed subsidiary, North Atlantic Drilling (Oslo: NADL, OTC: NATDF)] could potentially replace some of this capacity.

Thorkildsen also noted an uptick in inquiries from customers about premium jack-up rigs and improvement in day-rates and contract durations. The CEO sees the potential for day-rates in this category to increase by $20,000 to $30,000 by the end of 2012.

With six ultra-deepwater drillships slated for deliver 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.

Investors often worry about SeaDrill’s elevated debt burden and the sustainability of the firm’s dividend. The company follows the playbook of tanker owner Frontline (NYSE: FRO), another company in which Norwegian billionaire John Frederiksen owns a substantial stake. SeaDrill disburses the majority of its quarterly cash flow as a dividend to shareholders, a payout that’s supported by a backlog of about $13.8 billion in revenue.  

The outlook for the company’s modern fleet of drilling rigs, particularly its core fleet of 22 ultra-deepwater drillships, appears sanguine and provides ample support for the firm’s dividend. In the near term, the supply-demand balanced for high-specification rigs continues to tighten. Meanwhile, faced with maturing fields and sluggish reserve-replacement rates, the world’s major exploration and production companies will continue to invest heavily in deepwater developments over the long term. Rising global demand for oil and natural gas will incentivize these efforts.

With about $9.7 billion in long-term debt, SeaDrill has taken on significant leverage leverage in an effort to expand its fleet rapidly. But 88 percent of this debt matures after 2014; SeaDrill’s near-term refinancing needs are limited. Many of these loans are secured by liens on its rigs, ensuring a favorable interest rate on its borrowings.

Although the company continues to benefit from favorable rates for long-term financing, management is pursuing several options to reduce the firm’s financing cost and increase the firm’s capacity to grow its dividend. Options currently on the table include the listing of the firm’s Brazil-based operations as Seabras Serviços de Petróleo on the local exchange and the creation of a master limited partnership that will hold four to six rigs that currently operate under long-term contracts. In both instances, SeaDrill would maintain a majority equity interest in these entities.

Not only do shares of SeaDrill sport a dividend yield of 9.4 percent after the recent pullback, but the stock also offers exposure to the tightening supply-demand balance in the market for ultra-deepwater drilling units and solid fundamentals in other rig categories. Buy SeaDrill up to 45.

Ensco (NYSE: ESV)

Key Takeaways:

  • Ensco’s first-quarter results benefited from the acquisition of Pride International and better utilization rates after equipment issues on two newly built rigs weighed on the company in the fourth quarter of 2011.
  • Management echoed SeaDrill’s bullish assessment of the market for modern drilling rigs but provided additional color on regional developments in the market for premium jack-up units.
  • Management is in discussions with Petrobras about extending existing contracts on some rigs and fielding inquiries about units available in 2013.
  • Ensco is nearing deal to sell some of its cold-stacked rigs, a move that would improve the firm’s overall utilization rate and further reduce its fleet’s average age.

Since offshore contract driller Ensco joined the Growth Portfolio on March 8, 2012, the stock has given up about 14 percent of its market value. This correction reflects investors’ growing concern about the EU sovereign-debt crisis and rising concerns about the health of the global economy as Europe sinks into recession. The decline in oil prices has also given investors an excuse to take profits in energy-related names that ran up in the first three months of the new year.

However, the Ensco’s recent weakness in the stock market doesn’t reflect deteriorating earnings or operational headwinds. The company generated $1.026 billion in revenue during the first quarter, about $461 million of which was related to the firm’s acquisition of Pride International. Excluding these newly acquired operations, Ensco’s first-quarter sales totaled $565 million–a 56 percent improvement from year-ago levels.

All three of Ensco’s operating segments posted solid results in the first quarter.

Bolstered by the addition of two new ultra-deepwater semi-submersible rigs and units acquired from Pride International, the deepwater fleet generated $549 million in quarterly revenue–up from $98 million in the first quarter of 2011. The units acquired from Pride International contributed about $333 million. During the first quarter, Ensco’s deepwater vessels operated at a utilization rate of 87 percent (compared to 77 percent a year ago) and earned an average of $380,000 per day (compared to $300,000 in the first three months of 2011).

Ensco’s midwater fleet, which consists entirely of rigs acquired from Pride International, generated $91 million in revenue and operated at a utilization rate of 68 percent and earned an average of $227,000 per day.

Finally, the company’s portfolio of jack-up rigs pitched in $365 million in first-quarter revenue, up 39 percent from a year ago because of a higher average utilization rate and day-rate. Although the Ensco’s marketed jack-up rigs posted a utilization rate of 94 percent, a number of cold-stacked, lower-specification assets reduced the segment’s overall utilization rate to 84 percent.

We expect this figure to improve over time, as management disclosed that the company is close to inking a deal to sell some of these cold-stacked units.

Management’s comments during a recent conference call to discuss first-quarter earnings suggest that there’s more upside to come. CEO Daniel Rabun echoed SeaDrill CEO Alf Thorkildsen’s bullish assessment of the prospects for offshore contractors with modern fleets:

To summarize, customer demand is growing, and there is limited near-term supply of new rigs. This is driving up deepwater and jack-up utilization and day rates. Exploration and appraisal success, new deepwater basins, improved permit activity in the US Gulf [of Mexico], healthy commodity prices, these are all positive indications for long-term growth.

In addition to these factors, clients are placing a greater value on newer high specification equipment and on rigs that are part of a series that have performed well due in part to standardization, as seen with Anadarko contracting three 8500 series rigs and BP [LSE: BP, NYSE: BP] contracting another drillship, ENSCO DS-6. Clients are also focused on hiring companies with proven operational experience, competent crews, and successful safety and environmental track records. All of these factors bode well for Ensco and put us in a great position to meet incremental customer demand.

Ensco’s management team also provided additional color on regional conditions in the market for premium jack-up rigs, highlighting the following trends:

  • Gulf of Mexico: The utilization rate is effectively 100 percent for premium jack-ups in the market. With two jack-up units slated to leave the area and PEMEX (Mexico’s national oil company) looking to grow its rig count significantly by year-end, day-rates could head higher as drilling activity picks up in the Gulf.
  • North Sea: Demand for premium jack-ups should exceed regional supply in 2013. Day-rates achieved by standard-duty jack-ups in recent weeks indicate how tight the supply-demand balance has grown. Ensco continues to receive work inquiries for 2013 and 2014, primarily in the Central North Sea.
  • Mediterranean: Market remains challenged, and rigs continue to leave the region.
  • Africa: Four new rigs are slated to arrive in the coming months. Day-rates on premium jack-ups continue to improve. Tendering activity for standard jack-up rigs has dropped off a cliff since the fourth quarter of 2011.
  • Middle East: Elevated commodity prices continue to stimulate demand for premium jack-up rigs in the Middle East. Saudi Aramco inked contracts to lease six jack-up rigs in the first quarter, while Maersk has a tender order for five jack-up rigs to operate offshore Qatar. Management expects the utilization rate for premium jack-up rigs to remain elevated in the region, with only a handful of low-specification units becoming available.
  • Asia-Pacific: The region currently faces a shortage of rigs as national oil companies accelerate their offshore exploration and development efforts. Some projects slated for the second and third quarter have been pushed back to early 2013.

After these first quarter results and management’s bullish comments, we remain confident in Ensco’s growth story. The contract driller boasts a fleet of seven ultra-deepwater drillships, 20 semisubmersible rigs and 49 premium jack-up rigs. The firm stands to thrive in the near term because it owns one of the youngest deepwater and ultra-deepwater fleets in the industry and has a number of deepwater and ultra-deepwater rigs available in 2012-13.

Take advantage of the recent pullback and buy Ensco under 60.

Pacific Drilling (NYSE: PACD)

Shares of Pacific Drilling have pulled back about 10.3 percent since we added the stock to the Aggressive Portfolio on Feb. 22, 2012, as a pure play on the tightening supply-demand balance in the market for ultra-deepwater rigs. The company won’t report first-quarter earnings until next week, but here’s a quick review of the firm’s growth prospects and recent strategic and operational developments.

Pacific Drilling owns a fleet of four newly built ultra-deepwater drillships and will receive two additional rigs in 2013. These state-of-the-art vessels are capable of drilling in water depths of 10,000 feet to 12,000 feet and to a total well depth of 40,000 feet, making them suitable for a wide range of jobs.

The firm has already booked its fleet under favorable long-term contracts. The Pacific Bora was delivered in mid-2011 and secured a contract with Chevron Corp (NYSE: CVX) in Nigeria that expires in late 2014 and amounts to a day rate of $475,000. Conservative Portfolio holding Total (Paris: FP, NYSE: TOT) booked the Pacific Scirocco through the end of 2012 at a day-rate of $470,000 and on May 24 opted to extend the contract for at least another year at a higher price.

The Pacific Mistral is now under contract to Petrobras (NYSE: PBR A) through 2013 at a day rate of $458,000, while the Pacific Santa Ana will start a five-year contract with Chevron in spring 2012 at a day rate of $467,000. Pacific Drilling secured these fixtures months ago, when prevailing day rates were a bit lower than they are today.

Pacific Drilling’s newest fleet additions, the Pacific Khamsin and the Pacific Sharav, will arrive April and September 2013, respectively. The timing couldn’t be better: Few rigs will be available at that time, so Pacific Drilling could secure day rates that are above $600,000.

With a fleet of only six rigs, booking two new rigs at much higher rates could be a major upside catalyst for the stock. As a percentage of the size of its existing fleet, no deepwater drilling contractor has more available capacity in 2013 than Pacific Drilling.

Management recently announced that the company opted to have Samsung Heavy Industries (Seoul: 010140) build a seventh ultra-deepwater drillship that would arrive in mid-2014.

The recent pullback and investor’s lack of familiarity with Pacific Drilling–the stock went public relatively recently–gives aggressive investors a golden opportunity to buy into this growth story. Buy Pacific Drilling under 11.

Stock Talk

Add New Comments

You must be logged in to post to Stock Talk OR create an account