The Drilling Dozen
However, as I noted in the last issue of this newsletter, the focus in oil markets is shifting to supply as demand stabilizes. Non-OPEC supplies are already in decline and OPEC’s spare capacity will erode as demand returns. I am looking for crude to reach $85 a barrel by the end of this year and top $100 the following year.
My bullish thesis on natural gas is also beginning to play out. Although fundamentals remain bearish, the rig count continues to plummet, and I expect to see accelerating production declines in coming months. Monday’s surge in gas prices, even as oil sold off, suggests investors are beginning to sense this turn.
As commodity markets stabilize, the groups most leveraged to this recovery tend to be services and contract drillers. I’ve written extensively about services companies in the past few issues of The Energy Strategist. In this issue, we’ll take a closer look at one of the most widely watched–and poorly understood–sectors of all, the contract drillers.
Some contract drillers stand to benefit from a recovery in oil and natural gas prices, but not every company and market segment is poised for the pop. I correct some common misconceptions that could lead investors to make some costly mistakes. See The Drilling Business.
Don’t dive into the deep end without a swimming lesson. I explain how the different types of floating rigs work and analyze the prospects for each category; find out why I favor deepwater rigs over the midwater segment. See Floaters.
Jump into the shallow end and learn how shallow-water drillers work and about the challenges facing drillers highly levered to the Gulf of Mexico. See Shallow-Water Rigs.
In the world of contract drillers, everybody isn’t a winner. I examine the business prospects for the leading contract drillers and explain the rationale behind my latest addition to the Wildcatters Portfolio. See Playing the (Offshore) Field.
For those feeling a little waterlogged, a quick reminder about land drilling. See Land Rigs.
Investors and analysts closely monitor the business of contract drillers such as Transocean (NYSE: RIG) and Nabors (NYSE: NBR) for a number of reasons.
First, contract drilling stocks offer a window into the health of global drilling activity; I always listen carefully to the largest drillers’ conference calls for useful insights into the prospects for other players in the energy patch. And second, when this segment is hot it can be among the most profitable and fast-moving subsectors for growth-oriented investors.
Before delving into the prospects for the contract drilling space and the best plays in the current environment, it’s worth correcting a couple of popular misconceptions about the business.
Many investors believe that drillers actually produce oil and natural gas, but that’s not the case: Contract drillers merely supply energy producers with rigs, which include the basic equipment and personnel required to drill an oil or gas well. The producers pay a daily fee known as a day rate to lease the rig. Day rates are the main source of revenue for contract drillers and bear no direct relationship to the value of the oil or natural gas extracted from these wells.
Another common misconception crops up when investors lump contract drillers into the oil services industry, which includes firms like Schlumberger (NYSE: SLB) and Weatherford (NYSE: WFT). That popular indexes such as the Philadelphia Oil Services Index (OSX) contain both pure-play services firms and contract drillers reinforces this association.
Although both groups benefit from increasing interest and investment in oil and gas exploration and development, there are subtle but important differences between contract drillers and services firms. These distinctions are becoming increasingly pronounced as oilfield technologies advance, resulting in widening performance gaps between the two groups. Needless to say, investors gain a great deal from analyzing services and drilling stocks separately.
Here’s a table showing the 12 pure-play contract drilling firms in my coverage universe, some fundamental data and how I classify each company.
Source: Bloomberg, Company Reports
When evaluating contract drillers, it’s essential to understand the business dynamics of the three basic kinds of rigs: floaters, shallow-water rigs and land rigs. I’ll analyze each type separately, detailing the prospects for each segment, the main stocks in each category and my favorite picks.
Floaters are offshore drilling rigs used in deeper waters. Rather than attaching legs or columns to the seafloor, floating rigs usually rely on a combination of mooring and dynamic positioning systems. Whereas mooring systems hold the rig in place using large-diameter rig cables, dynamic positioning systems activate computer-controlled thrusters on a rig to counteract even the choppiest of seas.
Today there are two main types of floating rigs in use around the world: semisubmersibles, often referred to as “semis,” and drillships. Here’s a photo of a semisubmersible rig.
Source: Seadrill
Semis consist of a platform with two large pontoons. Crews tow these rigs to the desired location and fill the pontoons with water, sinking the lower part of the rig to the requisite depth. Pontoons can sink to more than 100 feet below the ocean’s surface.
Semis are typically moored and dynamically positioned, while the submerged pontoons offer additional stability. Despite these advantages, maneuverability concerns often preclude operators from using semis in remote locations.
The semi rig pictured above is Seadrill’s (Norway: SDRL, OTC: SDRLF) West Phoenix, built in a South Korean shipyard and delivered to the driller in 2008. As currently outfitted, the rig is designed to operate in depths of around 10,000 feet and can drill wells with a total depth of about 30,000 feet. The rig began a contract with Total (France: FP, NYSE: TOT) in January and is drilling off the coast of Norway for a day-rate of $495,000.
The drillship is the other class of floating rig currently in use. These rigs resemble normal ocean-going ships and move under their own power rather than relying on another vessel to tow them–a distinct advantage over semisubmersible rigs. Offering greater maneuverability and equipped to drill to great depths, drillships are used to exploit remote reserves that aren’t easily accessible to semis.
That said, maneuverability has its drawbacks: In rough seas, drillships will rock just like any other ship, and thrusters may struggle to maintain the vessel’s position. Here’s an image of a drillship to complete the picture.
Source: Seadrill
This photo shows SeaDrill’s West Capella rig, also built in 2008, and capable of drilling in waters of 10,000 feet to a total depth of 35,000 feet. As of March, this particular vessel was contracted to Total of France and is operating off the coast of Nigeria for a day rate of $546,000.
Offshore deepwater rigs can be further divided into “generations.” The first deepwater rigs were built in the 1970s; since that time, they’ve become progressively more advanced. Newer generations are capable of drilling in deeper waters, offer greater stability and have more-advanced onboard equipment.
Some contractors will use terms like “sixth generation floaters” to describe their rigs during conference calls, but ultra-deepwater, deepwater and midwater are the designations usually used to categorize rigs by drilling capabilities.
Although the terms are subject to some interpretation, ultra-deepwater rigs usually can drill in water 7,500 feet or deeper; deepwater rigs can drill to depths of 4,500 to 7,500 feet; and midwater floaters can drill to depths of around 1,500 to 4,500 feet.
These two classification schemes are related. For example, a fourth-generation floater would be a midwater rig; many of these rigs are more than 20 years old. An older fifth-generation semi-submersible is likely a deepwater rig, while some newer fifth- and all sixth-generation rigs are ultra-deepwater floaters.
And there are further wrinkles to this already complicated taxonomy. Industry insiders often classify floating rigs as either suited for a harsh environment (HE) or a benign environment (BE). HE rigs are capable of drilling in extreme weather conditions; for example, operations in the North Sea usually require HE rigs because of severe winds, choppy waters and inclement temperatures. BE rigs, on the other hand, are suitable only for calmer waters such as parts of the Gulf of Mexico.
Floaters are the most expensive type of rigs operating today. An ultra-deepwater semisubmersible or drillship would likely cost $600 to $800 million to build or buy in the current market–and that’s somewhat off from last year, when steel prices were much higher and shipyard space was fully booked. A deepwater floater would set the purchaser back somewhere between $450 and $600 million, while a midwater rig might cost around $200 to $300 million, depending on specifications. These rigs also take years to build; supply adjusts slowly to changes in demand.
Demand for deepwater and ultra-deepwater rigs depends largely on deepwater drilling activity. As I explained in “Islands of Growth,” spending on deepwater drilling projects has held relatively steady amid the recent commodity price downturn.
Part of this resilience stems from the companies involved in deepwater drilling projects: integrated oil companies (IOCs) like Chevron (NYSE: CVX) and ExxonMobil (NYSE: XOM) as well as national oil companies like Brazil’s Petrobras (NYSE: PBR). The big IOCs usually ink multiyear, multibillion dollar oil and gas development deals and don’t cancel those agreements based on short-term swoons in commodity prices. Because the leading IOCs generally earn high credit ratings and have ample cash on hand, lower energy prices and shaky credit markets haven’t disrupted their spending plans; these firms do not rely on immediate cash flows, debt or equity markets to fund their projects.
And there’s a certain sense of urgency to deepwater exploration and development: In many ways, these projects represent the final frontier for the IOCs. Some of the world’s most attractive onshore oil deposits, such as fields in the Middle East, are locked up by state-owned national oil companies (NOCs). Instead of partnering with IOCs to tap their technical know-how, many NOCs are hiring large services firms to handle their projects–a business line known as integrated project management (IPM).
However, deepwater projects are one growth area where the IOCs remain extremely active. Deepwater fields are extraordinarily difficult and expensive to produce; not surprisingly, these areas were among the last to be explored. Over the past two decades, most of the largest oil and gas finds have been in the deepwater: the Chevron/Devon Jack field in the Gulf of Mexico and a long list of oil and gas fields off the coast of Brazil are just two examples. IOCs have the capital, motivation and technical expertise to drive growth in deepwater oil and gas production.
National oil companies (NOCs) are the other big players in deepwater, often partnering with IOCs and services firms to produce these complex fields. NOCs resemble IOCs in that their access to capital and state support insulates their operations from short-term gyrations in oil and gas prices. Brazil’s Petrobras is a classic example. The country has recently discovered some of the world’s largest fields in the deepwater Santos Basin off the coast of Rio de Janeiro, as depicted in the graphic below. 
Source: Personal Finance
All told, Brazil estimates that these pre-salt fields will produce 219,000 barrels of oil per day by 2013 and 1.875 million barrels per day by 2020. Some analysts think production could ramp up even faster than that.
But it’s important to note that Brazil’s deepwater plays in the Santos Basin are a long-term strategic national asset. Producing these fields requires oil prices to be at least $60 to $70 a barrel; however, even though a barrel of oil commanded between $30 and $40 late last year and early in 2009, Petrobras maintained its commitment to deepwater production. And Brazil isn’t the only country to recognize the promise of the Santos Basin; China lent Petrobras $10 billion to help develop the fields.
These fields won’t produce substantial volumes of oil until after 2012, but Brazil is making the long-term (and I believe low-risk) bet that crude oil prices will eclipse the $60 to $70 level needed to earn a solid economic return. To drill all of its finds in the Santos Basin, Petrobras will require as many as 40 deepwater and ultra-deepwater floater rigs.
In short, the demand side of the floater market looks to be resilient, even amid lower commodity prices, and should see strong growth in coming years as exciting new deepwater plays are developed. If oil and gas prices rise as I expect, that would only accelerate the uptrend. Even better, the companies that lease deepwater and ultra-deepwater rigs tend to be big IOCs and NOCs with solid credit ratings and cash positions; these firms aren’t likely to renege on signed contracts or pull back on planned expenditures because credit conditions have deteriorated.
As you might expect, contracts for most deepwater and ultra-deepwater rigs extend for several years. In many cases, drillers arrange contracts with customers before new rigs even leave the shipyard; at the end of 2008 there were roughly 220 floater rigs in operation worldwide, 13 of which were newbuilds.
The five largest contractors of floating rigs are Transocean, Diamond Offshore (NYSE: DO), Pride (NYSE: PDE), Noble (NYSE: NE) and Seadrill; together these firms control roughly 150 rigs, the vast majority of ultra-deepwater and deepwater rigs.
Of these five, Pride, Transocean and Diamond Offshore provide in-depth data on contract coverage through 2012 on their 55 ultra-deepwater and 58 midwater floaters. The chart below shows contract coverage for their deepwater and ultra-deepwater rigs.
Source: Company Reports
As you can see, these three have booked out almost all of their deepwater and ultra-deepwater capacity for 2009 and 2010. Starting in 2011 those contracts begin to expire; however, contract coverage will still average above 50 percent in 2012. While I don’t have exact percentages for the other major operators, a quick glance at their periodic fleet status reports shows a similar picture.
For example, the first deepwater or ultra-deepwater rig that Noble has available is the Noble Paul Romano, which is due to complete its project with Marathon Oil Corp (NYSE: MRO) in the Gulf of Mexico next February. This rig was slated to work on another contract in the Gulf, but that operator will now use the Noble Clyde Boudreaux instead. This substitution allows the contractor to begin its work earlier. Noble has stated that it has received some interest in the Romano for projects outside the Gulf of Mexico. Those deals would likely command a higher day rate.
Noble’s next available in the Gulf of Mexico won’t complete their current projects until March 2011. Outside the Gulf, Noble’s earliest availability is April 2012, when its 6,000 foot Noble Homer Farrington semi is due to complete its contract with ExxonMobil in Libya.
Newly built rigs also boast extensive contract coverage. For example, a look at Transocean’s fleet status report reveals the operator has 10 rigs under construction, 9 ultra-deepwater drillships and a single deepwater semi. Each of these rigs already has a multi-year contract in place that will commence as soon as the rigs exit the shipyard.
When it comes to assessing supply and demand for ultra-deepwater and deepwater rigs, the company I watch most carefully is Transocean because they’re the largest operator in the space. Transocean also provides a great deal of useful market commentary during its quarterly earnings releases and conference calls. Here are some salient comments from CEO Robert Long during the company’s first-quarter conference call:
I continue to be optimistic about the deepwater market. We’ve only done a few fixtures so far this year but all three have been in the mid-$500,000 to low $600,000 day-rate range and for terms ranging from three to eight years.
We are also seeing continued interest on the part of operators both for additional capacity and renewal of existing capacity…There is some farm-out interest in the deepwater business but not out discounted prices. During the first quarter one of our deepwater rigs was farmed out from the original operator for a short-term program but it was at the existing rate in excess of $600,000 a day.
Transocean indicated that while the total number of rigs it has contracted was low in the first quarter, day rates for those rigs are still close to $600,000. At the peak of the market, some deepwater rigs were going for rates in excess of $600,000, but just a few years ago those same rigs were going for half that price.
Day rates for deepwater rigs are down slightly but remain at historically high levels and, more importantly, at levels which will generate a solid return to operators.
The second part of Long’s statement is even more interesting. A farm out occurs when an existing operator has contracted a rig for a long period, but decides they no longer need that rig. That operator can then sub-let that rig to another operator to cover its day-rate costs while the rig isn’t being utilized.
Earlier this year some analysts expressed concerns that a large number of operators would mothball deepwater drilling plans and farm out the contracted rigs to recoup some of the rental cost, flooding the market and driving down prices for all deepwater rigs. In this worst-case scenario, analysts predicted that some operators might even renege on their contracts or negotiate price reductions.
That hasn’t happened. To the extent that there are farm-outs in the deepwater space, other operators appear willing to grab the rigs at regular prices. And, remember that the conference call I quoted above was held in early May and referenced activity in the first quarter of 2009, when oil prices were much lower; even in that depressed environment, the worst-case scenario didn’t materialize.
Although oil prices will likely experience a correction at some point this summer, crude isn’t headed back to its recent lows. In fact, I would be surprised to see oil slip below $60 to $65 a barrel when this pullback occurs. As I mentioned in “The New Super-Cycle,” I suspect we’ll see oil closer to $80 a barrel in late 2009 and $100 a barrel in 2010. In addition, don’t believe the argument oil’s rally is solely a function of a weak US dollar; I bust that myth in the last installment of The Energy Letter, “$70 Oil: Myths and Reality.”
If my commodity price assumptions are even half-right, demand for deepwater rigs should remain strong in coming quarters; I see day rates remaining near $600,000 for the most capable rigs. And the strong backlog of contracts at the major operators provides a high degree of earnings visibility through 2011 to 2012.
That being said, I don’t expect day rates to increase at the feverish pace they did between 2004 and 2007; over that period, day rates for a deepwater rig boomed from about $100,000 to more than $600,000. In the coming cycle, rig rates should remain high but aren’t likely to move beyond $600,000 to $650,000.
Rising oil prices and a concomitant uptick in demand for deepwater drilling catalyzed the last spike in rig rates, but back then there were only about 200 deepwater rigs in the world. That number held steady up until last year, producing a supply squeeze of epic proportions as operators bid rig rates up in an effort secure the few available rigs for their projects.
But as demand for rigs picked up and day rates spiked, the price system worked its magic: Contractors made arrangements to build new rigs. Rigs of this complexity take years to build and just started leaving shipyards last year. In total about 80 new floaters are slated for delivery between 2008 and the end of 2011, a roughly 40 percent jump in supply.
There’s enough demand to soak up this incremental supply. That operators have already contracted out these newly built rigs is a testament to the hardy demand for deepwater drillers.
The story is much different for the midwater market. Check out the chart below for a closer look.
Source: Company Reports
This chart shows the contract coverage in the midwater market for the three largest operators. It’s clear that coverage for these rigs is not as solid as in the deepwater space. Although much of the big three’s capacity is under contract for 2009, contract coverage drops to 60 percent next year and to around 25 percent by 2012.
In other words, there’s no shortage of rigs available in the midwater market. At the same time, the operators that contract midwater rigs tend to be smaller independents that have borne the brunt of shaky credit markets and slumping commodity prices. These operators and their projects are more vulnerable to spending cutbacks than the deepwater deals I outlined above.
Because of these unfavorable supply and demand dynamics in the midwater market, it’s a logical conclusion that this segment could languish until the business climate improves. Midwater operators have already acknowledged this weakness.
Pride’s Vice President of Marketing and Business Development made the following comments in the company’s most recent conference call:
Midwater markets, which we define as water depths from 1,000 to 4,500 feet of water, are under utilization pressure, and we have seen a couple of midwater rigs stacked since the beginning of the year. Of the 109 midwater floaters, 92 are marketed competitively. However, 17 of the 92 marketed rigs will roll off their contracts in 2009 and 26 more will be looking for new contracts in 2010…
Operators working in midwater have reacted quickly to the commodity price and capital markets environments by cutting capital budgets and deferring projects, but we expect more rigs to be idle and for midwater rates to weaken. This situation is a concern as it pertains to the Pride South Seas, which we have available in the late third quarter of 2009.
There is one midwater tender ongoing in West Africa in 3,600 feet of water for operations in early 2010. We expect that this tender will attract offers from some of the lower specification deepwater rigs, such as fourth generation moored semis. We typically see the more efficient and higher specification rigs working into lower water depths and displacing lower specification units as markets soften.
There are three main takeaways from this statement. First, as I noted earlier, a large number of midwater rigs come off contract in the next few quarters. Because of a shortage of projects, some of these rigs are already being cold-stacked, or placed into storage. In contrast, warm-stacked rigs are stored in such a way that they can be reactivated relatively quickly.
Second, operators of midwater rigs have been far quicker to reduce their activity than deepwater players. Pride mentions the risk that it will have difficulty finding new work for its Pride South Seas rig, a semi built in 1977 that’s capable of drilling in water 1,000 feet deep and drilling wells about 20,000 feet in total length.
This rig is currently contracted to a small NOC, PetroSA, and is working off the coast of South Africa at a day-rate of $315,000. In short, this is an old rig that doesn’t have great prospects for re-contracting once its current deal expires in October; there’s an abundance of advanced midwater rigs available at even lower rates.
Finally, and perhaps most important, we should also examine the market for lower capability deepwater rigs. Operators solicit rigs through a tendering process that outlines their specific needs; operators then offer a particular rig, or group of rigs, at a certain rate to fill that tender.
At present, some lower-end deepwater rigs are actually being bid to tenders normally reserved for midwater rigs; the entry of older, less capable deepwater rigs into the midwater market is putting further downside pressure on the rates commanded by midwater floaters. This trend also indicates that technically deficient deepwater rigs are subject to pricing pressures.
Bottom line: midwater rates are already declining in some markets and that will accelerate as the supply of rigs rises. Continued strength in crude prices will mitigate this weakness to an extent and raises the odds that rigs like Pride South Seas will find work eventually. However, midwater and some marginal deepwater rigs will likely find the next two to three quarters particularly challenging.
Back to In This Issue
Shallow-Water Rigs
The most common sort of shallow-water rig is the jackup rig. Jackups are bottom-supported rigs that have legs or columns that touch the sea-floor, support the rig platform and anchor it in place. Here’s a picture of a jackup rig.
Source: Seadrill
The photo shows Seadrill’s West Atlas jackup rig from underneath, looking up. The jackup would be towed into location on a barge and then the rig’s three legs would gradually descend to the seafloor. At this time, the rig’s platform, or hull, would be “jacked up” until it surpasses the maximum wave height.
An independent-leg cantilever (ILC) jackup, the West Atlas was built in 2007 and drills wells about 30,000 feet deep in up to 400 feet of water.
“Cantilever” refers to the fact that the jackup rig’s drilling equipment can be extended out from the hull. This allows the operator to drill or perform maintenance operations on existing wells where the rig can’t be directly over the drilling area. The alternative, slot-type design features fixed drilling equipment that accesses the target area directly through a hole or slot in the platform. Cantilever rigs are generally more versatile and command higher prices.
“Independent leg” refers to the way the rig’s legs are supported on the bottom. When the legs are placed on the seafloor and the platform starts to lift above the water’s surface, this puts weight the legs. Because the platform itself is quite heavy, the jackup’s legs sometimes sink into the sea-floor and sustain damage–a situation that operators refer to as a punch-through. In some instances, the rig’s tripod legs might become stuck. And if one appendage sinks further than the other, the legs may bend under torsional stress.
Operators reduce the likelihood of a punch-through by dispersing the rig’s weight over a larger portion of the seafloor. One such approach, mat footing, involves flooding a large rectangular structure and sinking it to the sea floor; the legs of the jackup rest on this mat, spreading the weight of the rig across a wider area. This solution isn’t as effective on uneven bottoms, which could cause the mat to bend.
Independent legs allow rigs to operate on sloped bottoms because, as the name implies, the legs move independently of one another and include large feet that assist with weight distribution. However, independent legs may be more vulnerable to punch-throughs in some bottoms; they don’t distribute the weight of each leg across as large an area as a mat would.
Now that we understand how jackup rigs function, let’s return to business side of the pictured rig. A benign environment rig, the Atlas is working off the coast of Australia for $255,000 a day until its contract terminates in August. Prior to this assignment, the Atlas earned $306,000 per day on another project in Australia.
In the current market environment, the Atlas is a fairly advanced rig and would probably cost about $200 million to purchase. Independent-leg cantilever units are the most sophisticated and expensive jackup rigs available today and cost about $275 million to build.
On the other end of the spectrum, Hercules Offshore’s (NSDQ: HERO) Hercules 120 is an example of a low-specification jackup, or a commodity jackup. Originally built in 1958 and refurbished in 1980, this mat-supported cantilever rig operates in about 120 feet of water and can drill wells up to 18,000 feet deep.
The rig is currently located in the Gulf of Mexico on a short-term project for Chevron at a day rate of just $36,000. Because there’s little demand for such rigs, it would likely command even less in the current market.
The Gulf of Mexico is by far the biggest market for less-capable commodity jackups. Shallow-water drilling in the Gulf primarily targets natural gas rather than crude oil. The shallow-water Gulf was the first major offshore hydrocarbon play to be produced extensively; many fields have already been depleted, and the remaining fields are relatively small.
Projects in the Gulf are typically short-term operations conducted by smaller independent producers. Even Chevron’s contract for the Hercules 120 lasts just 10 days and will be near completion as you read this issue. While I can’t be certain, my guess is that the rig is performing maintenance procedures on an older well.
For the most part, the shallow-water Gulf also has a high cost of production. Certainly producing gas in the Gulf is a higher cost and less attractive proposition than the major unconventional gas shale plays such as the Barnett Shale of Texas and the Haynesville Shale in Louisiana. Not surprisingly, when natural gas prices tumble, the Gulf of Mexico is one of the first regions to suffer a drop in drilling activity and, accordingly, demand for jackups.
That’s what happened when commodity prices fell off a cliff last year, and the credit crunch only exacerbated the problems facing the highly-leveraged, independent operators that predominate in the Gulf of Mexico. Mariner Energy (NYSE: ME), for example, depends on debt financing and loses money when gas prices are near current levels. Although some producers are spending a bit more on drilling now that oil prices have recovered, the gas-focused shallow-water Gulf just hasn’t benefited.
In late 2005 and last summer elevated natural gas prices bumped day rates in the Gulf of Mexico to between $80,000 and $120,000, depending on the exact specifications and the duration of the contract. Nowadays, $35,000 to $60,000 is a more likely range for those same rigs. At those levels, the rigs are marginally profitable at best.
In this environment, securing even a marginally profitable contact is a victory. Hercules Offshore, one of the largest operators in the region, has just 10 rigs under contract in the region; the company has warm-stacked two of its jackup rigs and cold-stacked 11 more. And because the few operating rigs are under contract for an average of 43 days, there’s a risk that the company could fail to secure new projects and rigs could go idle; after all, the utilization rate (the percent of available rigs engaged in drilling) for jackups in the Gulf of Mexico is currently less than 50 percent.
In recent years more capable jackup rigs have been relocated to other areas at higher day rates, mitigating this oversupply to a degree: The total number of jackups in the Gulf has declined from more than 150 in 2004 to about 50 or 60 today. With natural gas priced at $4 per million British thermal units, that rig count is still too high; however, if natural gas heads higher again, day rates could jump if the region experiences a shortage of rigs. Day rates in the Gulf can change quickly, in a matter of weeks rather than months or quarters.
The international jackup market typically involves rigs capable of drilling deeper wells in deeper water and harsher environments. Whereas the Gulf is typically a short-term “spot” market for rigs, international operators tend to lease rigs on multi-year or, at least, longer-term deals.
Rowan Companies (NYSE: ROW) is an operator that owns mainly high-specification jackup rigs–for example, the Rowan Gorilla VII, a harsh environment rig capable of drilling 35,000 foot wells in water up to about 400 feet. This particular rig is booked on a contract in West Africa through April 2010 at a rate of $330,000 per day. Another example would be Seadrill’s Atlas rig.
To date, the international jackup market has performed significantly worse than the market for midwater floaters but not as poorly as the US Gulf market for commodity jackups. Most international jackup operators have stacked at least some rigs already, and contract coverage for 2009 is less than 50 percent on average. That figure drops into the mid-20 percent range or lower in 2010.
In their first quarter conference calls, operators were candid about the weakening prospects for international jackups. Transocean operates a fleet of ten advanced jackups and 55 standard rigs, none of which operate in the Gulf of Mexico. With reference to this fleet, the company’s CEO Robert L. Long noted:
The jackup business has been much weaker than the deepwater market, and it appears the jackup market is weakening at an accelerating pace, particularly in West Africa. We now have nine jackup rigs stacked versus three stacked at the time of our last call. I expect you’ll see us stacking more rigs before the year is out.
Clearly the international jackup market has also deteriorated with commodity prices in recent months; some previously strong jackup markets such as West Africa are declining at an “accelerating pace.”
Credit availability and dependence are big reasons for the drop off in the formerly robust West African market. Several highly leveraged exploration firms that were active in this area shuttered their drilling operations last year, finding themselves wholly cut off from the nonfunctioning credit markets.
Rig quality does provide a bit of a cushion. Premium jackup operator Rowan noted this trend in its first-quarter conference call:
According to ODS-Petrodata, there are currently 441 jackups worldwide. Demand is 358 rigs with utilization at 81 percent. We don’t expect to see an improvement in the supply/demand balance before early 2010. Despite the decrease in demand for the total jack-up fleet, demand for high-spec rigs…has remained at very high levels and is currently at 96 percent.
…we will continue to benefit from higher utilizations and higher dayrates as operators recognize this level of excellence in drilling performance. We’re very proud of our fleet but realize that we’re not immune to current market conditions. Of the total industry jackup fleet, more than half is either not working or will roll off contract in 2009.
In summary, the jackup rig market is far weaker overall than the market for floating rigs; day-rates for jackups have fallen further, and the downturn began earlier. Unlike the deepwater deals, the types of projects jackups target typically have some degree of commodity sensitivity. The US Gulf of Mexico is the worst market for jackup rigs; conditions are more favorable for advanced rigs operating in markets like the North Sea and Middle East.
Playing the (Offshore) Field
Of the dozen drillers in my coverage universe, nine are primarily offshore contractors. Some of these drillers are focused primarily on deepwater floaters; others are primarily jackup operators. Most contractors own a mix of rig types.
In my detailed description of the contract drilling business, I analyzed the prospects for various types of rig contractors. But there’s more to investing than simply assessing a company’s growth potential and buying its stock. One must also consider a stock’s valuation–that is, what’s already discounted and factored into a particular company’s share price.
I see three basic investment angles for contract drillers in the current environment. First, deepwater drillers, particularly those with heavy ultra-deepwater capacity and many high-spec rigs, have built up sufficient backlogs to weather the commodity price downturn and will flourish once oil and gas prices recover. From a fundamental perspective, these operators are the most defensively positioned drillers.
(As long-term readers know, I have been bullish on oil prices all year and continue to forecast $100 oil next year. Natural gas should top $6 per million British thermal units, up from $4, by the year’s end. I outline the rationale behind this contrarian view in “Gas Up“).
I see more upside leverage in jackup markets. Rates on jackups began falling long before rates on midwater and deepwater floaters and have fallen much further in percentage terms. However, with oil prices recently surpassing $70 a barrel and credit markets improving, demand for international jackup rigs is bottoming out.
Many such rigs operate in markets like West Africa and the North Sea and generally become profitable when oil is priced between $60 and $70 a barrel. If I’m right about oil topping $100 a barrel next year, activity should pick up even more dramatically. In short: I see limited additional downside in international jackup rig rates. I suspect that investors looking to play a turn in commodity prices will look to international jackup operators as the segment most leveraged to such a recovery.
Finally, for those with a higher risk tolerance, I see Gulf-focused jackup plays as a deep-value group leveraged to any improvement in natural gas prices. As I outlined above, the number of rigs operating in the Gulf has collapsed, with many cold-stacked and some unlikely to ever return to work. But if prices recover to $6 per million British thermal units by late 2009 as I expect, activity in the shallow-water Gulf will likely pick up. Given limited near-term potential for rig supply growth, this would send day-rates sharply higher.
One area to avoid: midwater and lower-end deepwater rigs. These rigs are neither defensive nor do they offer much upside potential when commodity prices bounce. Rates for midwater rigs didn’t collapse in early 2009 and haven’t fallen as much as jackup rates; in my view, these rates are further from a bottom. Moreover, while investors clearly recognize the weakness in jackup rates and have largely priced in that weakness, share prices in the midwater segment haven’t fully priced in these challenges.
Here’s a specific look at some of the nine drillers listed in my coverage universe that are leveraged to one of these three growth themes. Please note that I am looking for rising crude and natural gas prices to push all of the drillers higher in coming years. My buy, hold, advice should be regarded as relative; for example, stocks rated a hold aren’t necessarily going down but aren’t likely to perform as well as my buy-rated picks.
Transocean (NYSE: RIG)
Transocean is the largest operator of floating rigs in the world, boasting 18 ultra-deepwater rigs, 18 deepwater rigs and 32 midwater rigs. And the company has 10 additional ultra-deepwater rigs under construction. Simply put, the company owns the largest fleet of advanced floating rigs in the world.
As I noted earlier, most of Transocean’s rigs are already booked under long-term contracts at relatively attractive day-rates. In some cases, Transocean was early in contracting rigs and didn’t benefit from the real spike in rates back in 2006 and 2007.
However, this still represents a solid backlog of more or less guaranteed revenue–just the sort of visible earnings stream investors look for in a weak market environment. Although all contract drillers performed abysmally in the second half of 2008, Transocean was among the best performers as investors sought refuge in its defensive earning stream.
Transocean’s midwater and jackup fleet have less contract coverage and are vulnerable in the current market environment. The jackups aren’t a huge worry in my view because this weakness is well-known and understood by the investment community–it’s already priced into the stock. The midwater exposure is more worrisome because these rates haven’t fallen a great deal yet,and the risks in this market aren’t as well understood. There could be some nasty surprises in store.
That being said, the jackup and midwater business are a sideshow for Transocean. Given the firm’s massive deepwater fleet, investors tend to focus on these rigs–in fact, the stock functions as a sort of proxy for deepwater activity.
Playing devil’s advocate, I foresee two major issues for Transocean: the lack of a dividend and a likely investor Beta grab. To the first point, Transocean generates huge amounts of cash, and that cash flow is basically guaranteed under contract. Transocean has used the cash to pay down debt, repurchase shares and make strategic acquisitions, but investors would like a regular dividend–a request that frequently comes up in conference calls with management. With the exception of a special dividend paid out a few years ago, management has resisted the idea.
As noted in the opening table, Diamond Offshore trades at a significant valuation premium to Transocean even though its rigs are absolutely inferior. The reason for this apparent discrepancy is simple: Diamond could pay a total of $8 in dividends this year, a near 10-percent yield based on the current price. I suspect that if Transocean were to declare a dividend, it could capture a significant valuation premium to the sector. I’d look to add the stock to the portfolio on any sign such a move is in the works, but that probability looks low for now.
On a more technical note, the stable earnings stream that makes Transocean a favored play in weak markets also means that it doesn’t have as much exposure to stronger drilling markets.
I like Transocean’s assets and management team, though the stock lacks any real near-term upside catalysts; Transocean is a Hold in How They Rate.
Diamond Offshore (NYSE: DO)
Diamond boasts a solid fleet of 11 deepwater and ultra-deepwater rigs that are heavily contracted over the next few years. And Diamond has 19 newly built floaters entering service this year, 32 next year and 29 in 2011–70 percent of those rigs already have contracts. This gives Diamond a nice backlog of locked in cash flows to back up its dividend distribution.
On the downside, Diamond has significant exposure to the midwater business, and several of these rigs are already having trouble securing contracts. Day rates have also come down from last year’s highs for this rig class.
Long-term income-oriented investors can consider buying Diamond. However, thanks in large part to its high dividend, the stock is among the most expensive in my coverage universe, limiting upside. And there is the potential for negative news regarding some of its rigs. I am rating Diamond a hold in How They Rate at this time.
Noble (NYSE: NE)
Noble offers investors a compelling combination of deepwater and international jackup exposure. The stock is also cheaper on a price-to-earnings and price-to-cash flow basis than any of the other contract drillers, save Gulf-focused Hercules Offshore.
In total, Noble has 14 deepwater and ultra-deepwater rigs. As I noted above, all of these rigs operating in the Gulf are contracted through early to mid 2011 with one exception, the Noble Paul Romano. Outside the US, the next deepwater rig to roll off contract is the Noble Homer Farrington in 2012. In total, these booked contracts amount to around $10.6 billion, a solid base of defensive, visible earnings.
The fundamental upside turnaround potential for Noble resides in its jackup fleet, which consists of 40 rigs of varying qualities. In total, Noble has 12 jackups working for Mexico’s Pemex, primarily at day rates in the $125,000 to $160,000 range. Five of these rigs operate under longer-term commitments, but the day rates reprice every three months based on published indices of international jackup rates; these rigs offer exposure to any improvement in international jackup rates.
In addition, Noble has eight harsh environment jackups working in the North Sea. These rigs currently have higher day-rates than the Pemex jackups, and most are set to roll off contract later this year. The North Sea market already appears to be showing signs of stabilization; several operators have reconstructed rigs in the region at higher-than-expected rates.
Finally, Noble is a conservative operator with an outstanding balance sheet and a solid backlog of rigs. I am adding Noble to the Wildcatters Portfolio as a buy under 37. For now, I will place a loose stop loss at 27.
Seadrill (Oslo: SDRL; OTC: SDRLF)
Norway-based driller Seadrill is already a member of the Gushers Portfolio and has been among the best performers thus far in 2009. The company owns a mixture of primarily ultra-deepwater rigs and high-specification jackups.
In total, Seadrill owns 12 ultra-deepwater semis and drillships, one deepwater rig and one midwater rig. These rigs all have multi-year contracts, many signed in the high-rate environment of 2006 through 2007. Five of these rigs are signed under long-term deals above or near $600,000 per day. Seadrill’s next available deepwater rig is July 2010, and the current operator has the option to extend the contract for another year. The next Seadrill deepwater rigs roll off contract starting in late 2011.
Seadrill also owns 12 jackups, four of which are under construction and slated for delivery next year. The company has warm-stacked three of its jackup rigs because of low demand; however, all but four of its jackups are rated to drill in water 400 feet deep or greater. These rigs should benefit handsomely from a turn in commodity prices.
Finally, Seadrill owns a fleet of so-called tender rigs. These rigs are used to transport equipment and act as work platforms offshore. They tend to earn lower day rates, but all are under long-term contracts.
Suffice to say, this is an attractive asset base. Seadrill’s average day rate on ultra-deepwater floaters is higher than what Transocean pulls in, and it’s a dominant player in this market niche. The jackups offer turnaround upside.
The real upside leverage for Seadrill, however, is a further normalization of global credit markets. As the table of drillers illustrates, Seadrill has a heavy debt burden. Although a rock-solid backlog of contracts on ultra-deepwater rigs ensures that this debt is serviceable, Sealdrill’s stock was slammed when investors aggressively sold any company with heavy debt last year. That prompted the company canceled plans to pay dividends in an effort to conserve cash and shore up confidence in its stability.
To make matters worse, some executives and institutional buyers owned Seadrill stock using what’s known as a total return swap, a leveraged way to own the stock. The crumbling debt markets meant these trades had to be unwound, further pressuring share prices.
And while Norway is an oil power, it’s still a small market; when the US and UK debt and equity markets are troubled, those same markets in Norway essentially disappear.
But credit spreads are improving globally, and Seadrill recently secured a credit facility that will be used to pay down some of its more-expensive debt obligations. It would have been impossible for Seadrill to take out this loan six months ago.
Bottom line: I like Seadrill’s asset base and see more upside in the stock as credit markets continue to find their footing. Buy Seadrill.
Hercules Offshore (NSDQ: HERO)
Hercules was once a TES recommendation; fortunately we were stopped out last year at much higher prices. The company owns primarily low-end jackup rigs in the Gulf, where it’s a dominant operator.
In addition, Hercules has a fleet of 12 higher end rigs that operate internationally. As noted above, the majority of Hercules’ US jackup fleet is cold- or warm-stacked because ofl ow activity levels. On the international front, one rig is cold-stacked and one rig is warm-stacked.
I see two catalysts for Hercules. First, an improvement in natural gas prices would allow it to raise day rates on its gas-levered US jackup fleet. Meanwhile, the international jackup markets appear to be improving already as crude rallies.
Second, Hercules is heavily leveraged but unlike Seadrill it doesn’t have a huge backlog of guaranteed revenues. In fact, unless activity picks up, the company is in danger of breaching covenants with its debtholders.
A few short weeks ago the stock plunged to around $1 per share, reflecting the assumption that Hercules could never renegotiate its loans amid a global credit crunch. But the normalization of credit markets has improved sentiment, and given management’s long track record, I suspect the company will renegotiate the relevant debt covenants by year-end if it actually does report a material breach–after all, it’s unlikely a bank would recover much from selling these jackups in a depressed market.
This makes Hercules an attractive highly leveraged bet on a turnaround in natural gas prices into late 2009 and early 2010. It’s an appropriate play for only those investors with a higher risk appetite. However, I can easily see the stock more than tripling from current levels over the next year if it successfully renegotiates covenants and/or gas prices recover. For now, I will track Hercules in How They Rate as a Buy, but I am looking for a chance to add it to the aggressive Gushers Portfolio in coming weeks.
Land Rigs
Land rigs are a totally different market than offshore rigs. For investors unfamiliar with the group, I recently analyzed the space in “A Turn for the Better.”
My favorite remains Nabors (NYSE: NBR) thanks to its high-specification rigs and strong exposure overseas. Nabors rates a buy under 19 in my Gushers Portfolio.
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