Knowing the Drill
We last wrote about 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 May 25 article, Here’s the Drill: Buy the Pullback.
This article highlighted what we regarded as an opportunity to pick up shares of our favorite contract drillers at favorable valuations; at the time, concerns about global economic growth and weakening oil prices weighed on the sector.
In the intervening months, the Bloomberg Global Offshore Drillers Index has rallied 14 percent, besting the 9.3 percent gain eked out by the Philadelphia Stock Exchange Oil Services Index and almost doubling the 7.1 percent return posted by the S&P 500.
Within the model Portfolios, shares of SeaDrill (NYSE: SDRL) generated a total return of 15.2 percent, while our position in Ensco (NYSE: ESV) has gained 19.3 percent. Aggressive Portfolio holding Pacific Drilling (NYSE: PACD), which went public in November 2011 and boasts a fleet of four operational ultra-deepwater rigs, has lagged its peers since May 25, retuning only 6.6 percent.
We’ve geared our stock selections to take advantage of rising day-rates on fixtures in the capacity-constrained ultra-deepwater market, where few rigs are available in 2013. Management teams throughout the industry noted that customers are also eager to secure drilling units for 2014.
During a conference call to discuss second-quarter results, Noble Corp’s (NYSE: NE) vice president of marketing and contracts, Simon Johnson, even went so far as to suggest that producers had already booked the majority of rigs with availability next year:
We have a view that not only has all 2012 supply been contracted, but signs indicate the most of 2013 ultra-deepwater supply is effectively booked also. How do we reach this conclusion? At the time of our last earnings call, the ultra-deepwater sector had approximately 36 rigs with 168 rig-months of availability in 2013. This included new capacity and existing rigs with contract rollovers.
Of the 36 rigs, 11 units had options of varying lengths of time. Based on our experience and the preference of customers today to secure the capabilities of such rigs, we believe that most, if not all, of these 11 rigs are unavailable. That is, the current customer will exercise the option and keep the rig. This effectively leaves 25 ultra-deepwater rigs with around 123 rig-months of clear availability in 2013.
Once we review our own database on customer specific programs and timing preferences, and match rig availability with those programs, we conclude that as many as 22 of these 25 rigs are already spoken for, with most of the units expected to be deployed in the Gulf of Mexico and West Africa.
Robust drilling activity in ultra-deepwater plays should ensure that the supply-demand balance in the market for advanced drilling rigs remains tight. According to Johnson, exploration and production companies announced 22 oil and gas discoveries in fields located at least 4,000 feet beneath the ocean’s surface. These discoveries occurred in an average water depth of 6,400 feet in 10 different countries.
Projects in established deepwater fields in the Gulf of Mexico and offshore Brazil and West Africa are the backbone of rig demand, with the recent resurgence of drilling activity in the US Gulf further tightening the market. Meanwhile, emerging plays off the coasts of Mozambique, Tanzania and other East African nations, as well as opportunities for development in the Black Sea and elsewhere, should continue the bull market for ultra-deepwater drillships.
In early 2011, analysts scoffed when SeaDrill withheld some of its newly built vessels from the market until the back half of the year in the hopes of securing a fixture at a daily rate of more than $500,000–a strategy that ultimately paid off. Today, day-rates for ultra-deepwater rigs routinely range between $550,000 and $650,000 on three-year contracts, depending the unit’s capabilities and operating locale.
Two developments in the industry suggest that customers expect day-rates to remain elevated in coming years.
SeaDrill on July 25 announced that the firm had inked a deal with an as-of-yet unnamed international oil company for one operating ultra-deepwater drilling unit and two newly built rigs slated for delivery in the first half of 2013. What stands out about this three-rig package is the term: A total of 19 rig years, or roughly six rig years per vessel. SeaDrill has indicated that these vessels will likely be a part of a master limited partnership, which in part explains the unique terms of this deal, but the length of these contracts suggests yet again that customers are eager to secure available capacity.
Meanwhile, several management teams at the Barclays Capital 2012 CEO Energy-Power Conference indicated that more and more customers are seeking contracts for vessels that haven’t yet been built. From the perspective of oil and gas producers, this strategy prevents prevailing day-rates in the ultra-deepwater segment from climbing higher.
Transocean’s (NYSE: RIG) CEO Steven Newman commented on this trend during his presentation:
There are more discussions in the marketplace today with customers, focusing on the opportunity to build to a contract, more so than there were six months ago, and I think that’s just reflective of the tightening balance between supply and demand in ultra-deepwater, the fact that customers are having to look further and further out. 2013 and 2014 availability is now the subject of conversation, and so if you’re faced with the prospect that you might not have access to capacity, there is a greater willingness on the part of the customers to enter into a contract that would support the construction of a new vessel.
At present, the biggest headwind facing contract drillers in the ultra-deepwater market: unexpected rig downtime for equipment repair. However, the industry has sought to curtail these challenges by stepping up routine maintenance to address equipment before they take excessive amounts of time and money to correct and pushing through the higher costs of more rigorous equipment test to customers.
In particular, several industry participants have noted that exploration and production companies are willing to pony up to outfit leased vessels with a second blow-out preventer (BOP), the mammoth fail-safe devices that seal, control and monitor subsea wells. After the Macondo’s blowout preventer failed to prevent the BP (LSE: BP, NYSE: BP) oil spill in the Gulf of Mexico, this piece of equipment has come under greater scrutiny. A redundant BOP can dramatically reduce a rig’s downtime, as Transocean’s CEO recently explained at the Barclays CEO Energy-Power Conference:
I think there’s a lot of benefit to having a second BOP on the rig. If you think about the time it takes to maintain the BOP between wells compared with the efficiency with which the rig can move from one location to the next, you frequently find yourself in a situation where the rig’s ready to go to work and we haven’t concluded the maintenance on the BOP, so if you have a second BOP on the rig, you can remove BOP maintenance from the critical path. There is a clear economic benefit to the customers. And the customers recognize that, and they are increasingly willing to step up and underwrite the cost of it because of the economic benefit.
Meanwhile, the upsurge in newly built rigs also requires contract drillers to recruit and train new employees to staff them, which at first tends to reduce operating efficiency. In particular, small-cap operator Pacific Drilling has grappled with this challenge.
Strength in the ultra-deepwater segment has started to trickle down to other rig categories, including the mid-water market, where the supply-demand balance for premium jack-up rigs has tightened and day-rates continue to climb.
Within the mid-water segment, activity in the UK and Norwegian North Sea has proved surprisingly robust. Many industry observers had given up the North Sea for dead, but new technology and market dynamics have given the region a new lease on life.
Exploration and production companies have ramped up drilling in the region, seeking to take advantage of the premium price commanded by Brent crude oil (relative to West Texas Intermediate) and the region’s mature infrastructure, which makes it easier to bring new wells onstream. Meanwhile, the harsh environment limits the number of new vessels that can be relocated to the region.
In a conference call to discuss second-quarter results, Transocean’s CEO opined that the North Sea “will remain undersupplied through 2013, possibly well into 2014, providing ample growth opportunities with a few customers requiring harsh environment new builds for their programs.” Meanwhile SeaDrill’s CEO Alf Thorkildsen noted that the market had absorbed all available rigs in 2013 and only limited capacity was available in 2014 and 2015.
Despite these broad improvements, 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.
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 (NYSE: DO) sold 15 of these units in the second quarter.
The three offshore contract drillers in our model Portfolios 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. Here’s a review of our investment thesis for each of these names.
SeaDrill (NYSE: SDRL) has come a long way since 2005, when its fleet consisted of 11 drilling rigs. Today, the outfit is the second-largest contract driller by enterprise value and boasts a growing portfolio of roughly 60 rigs. SeaDrill remains our favorite contract driller for several reasons.
For one, the stock tends to trade at a premium to its peer group because of the company’s ample quarterly dividend, which equates to a 8.2 percent yield at the current share price. This sky-high yield has captured the fancy of income-hungry investors, particularly in an environment where corporate bonds and many dividend-paying equities offer scant yields and little upside potential.
The stock’s stratospheric dividend yield has enabled the company to grow its market capitalization substantially since its primary listing shifted from Oslo to the New York Stock Exchange.
With roughly $8 billion in debt, the company has taken on significant leverage in an effort to grow 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. As of early September 2011, the company tabbed its average debt cost at roughly 5 percent–well below the industry average of roughly 5.6 percent.
Management has also invested the proceeds wisely, assembling the industry’s second-largest fleet of deepwater drilling rigs–a business line that boasts strong fundamentals.
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. On the other side of the equation, rising global demand for oil and natural gas should incentivize long-term investment in deepwater fields.
In addition to SeaDrill’s outsized exposure to deepwater drilling, we also like the company’s commitment to assembling a modern fleet. In fact, 51 of the company’s 60 drilling rigs were built after 2000.
These high-specification rigs are in high demand among oil and natural gas producers, particularly in a post-Macondo world. The firm also boasts the largest and most modern fleet of jack-up and tender rigs in the industry, providing the firm with a distinct advantage over firms with older fleets.
SeaDrill has invested judiciously in its growth, weighing the costs of newly built vessels versus acquisitions. For example, the company recently paid $54 million for a one-third stake in Asia Offshore Drilling, a company with three $185 million premium jack-ups under construction. Under the terms of the deal, SeaDrill will oversee the marketing and operation of these units upon delivery.
After ordering new rigs before many of its competitors, the firm also has the option to purchase nine additional newly-built rigs at locked-in, a distinct advantage as the cost of new rigs increases and near-term delivery slots fill up. SeaDrill rates a buy up to 45.
Growth Portfolio holding Ensco (NYSE: ESV) 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 these vessels available in 2013 that should secure favorable day-rates
Ensco’s average ultra-deepwater rig is only two years old and its average deepwater unit is seven years old. By comparison, Transocean’s average ultra-deepwater vessels are seven years old, while its deepwater rigs sport a mean age of 15 years.
Ensco’s efforts to standardize its fleet also bode well for the company’s success. Several manufacturers produce deepwater and ultra-deepwater rigs, so the parts aren’t necessarily interchangeable between models. In addition, each manufacturer has different maintenance schedules for its rigs. By standardizing the types of rigs it owns, Ensco ensures that its employees can operate more efficiently. Downtime for maintenace is also easier to schedule.
When an ultra-deepwater rigs earns upward of $600,000 daily, a few days of additional downtime across a sizeable fleet can impact the bottom line significantly. Ensco continues to rate a buy under 60.
Pacific Drilling (NYSE: PACD) 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. Buy Pacific Drilling under 11.