I became interested in the offshore drilling sector 8 years ago as an asset class fairly uncorrelated to the S&P 500, and as a diversifier against my reinsurance stocks. I also believe that oil supplies are becoming harder to find and the growing global demand for oil necessitates going to offshore sources to meet that demand. Look no further than the fact that new wells are being drilled in water that is 12,000 feet or deeper as a testament to the fact that the easier and cheap sources of oil are largely exhausted. In a way, offshore oil drilling is "the last frontier", and an expensive one. Frankly, I'd rather invest in the companies with the tools necessary for this drilling, rather than the oil companies that have to pay for these costs of drilling. (The rig owner gets paid even if it ends up being a dry hole).
Offshore drilling industry
Put simply, the business of offshore drilling is to use capital obtained from equity financing, debt financing, and retained earnings to purchase offshore drilling rigs, and to lease those rigs out to oil companies drilling their offshore mineral leases. Profit comes from leasing these drill rigs at contracted day rates that exceed the company's cost of capital and operating costs.
The offshore drilling companies are leveraged to long term price trends of oil. It is often stated that the break-even for deepwater drilling is oil over $70 a barrel. Oil seems to be stuck in a range higher than that for years now. While shale drilling and new hydraulic fracturing technology have increased land-based drilling, the bulk of that is for natural gas, and I think we will increasingly turn to offshore sources for oil.
The most important distinction is in the water depth in which the rigs operate. Jackup rigs drill on the continental shelf, which is often defined as 400 feet water depth or shallower. These rigs have footings that rest on the ocean floor, and usually 3 steel trusses which the platform is literally jacked up upon, above the waterline. The drilling machinery resides on this platform.
Deepwater drillings is often defined as greater than 400 feet, and is divided into midwater (400-5000 feet), deepwater (5000-7500 feet), and ultradeepwater (>7500 feet). These are different rigs that require some kind of floating drillship, and either a mooring system or dynamic positioning thrusters to keep the ship stationed over the drill hole on the ocean floor. These are high-tech ships. It is truly amazing how they function.
There are many different rig types even among these broad categories, but I think shallow (jackup) and deepwater (drillship) is the most useful distinction to know when comparing companies. The reason it matters is because day rates and operating costs are vastly different. Day rates are typically $75,000 per day for jackups, and $400,000 or more a day for deepwater (rates vary widely, based on market conditions and rig availability). Obviously, there are big differences in rig costs too. Shallow and deepwater are drastically different markets. Most companies operate in both spaces, although deepwater is the real profit center.
Most companies that were predominantly shallow water in focus have deepwater drillships either on order or completed, and are attempting to move into that market because of higher operating profit margins, although that's a trend that in itself tends to bring down margins long term. Interestingly, the jackup market got neglected due to its worse margins and lower utilization, and that fleet is now aging with an average age of over 25 years (many are 40 years old), so there could be a story there for companies specializing in jackups, which include Rowan Companies (NYSE:RDC) and Hercules Offshore (NASDAQ:HERO). Also, the newer requirements for continental shelf drilling are moving toward higher specification jackups, of which there are many fewer of in the fleet.
You can find out about company fleets by going to the investor relations section of each company's website. A few that I regularly visit include Noble Corp (NE), and Ensco (ESV). There are monthly updates posted which describe the day rates, any downtime, and any repositioning of the fleet, as well as details about contract duration and water depth. It is interesting if you like to really dig into the details of the company and attempt to fully understand their source of profits. Also, the investors' website will have recent investor presentations you can flip through, which will give you insight into new rigs under construction and details about their fleet.
No discussion about investing would be complete without a discussion of risks and what can go wrong. Probably the biggest negative headline to happen in the offshore drilling space is the BP Macondo well disaster in 2010. Not only was the environmental damage disturbing, but the business of offshore drilling was hurt as well, with a moratorium on new drilling permits in the US Gulf of Mexico waters. Oil companies used the force majeure clause to get out of some long term drilling rig leases, which significantly impacted corporate revenue.
The other risk is that things like new hydraulic fracturing technology or a renewed global economic downturn could bring down oil prices back below the break-even point of deepwater drilling. We could quickly end up with an excess deepwater rig count which would result in plummeting day rates, and thus drastically lower corporate earnings.
Look for good average profit margins, and look for increasing retained earnings (on the balance sheet) as a sign of profitability. The cash flow statement, for example as found on 10Q SEC filings from Ensco and Transocean (RIG), will tell you if their cash is coming from investing activities or core operating activities. This is a capital intensive business, with deepwater drillships costing $500 million or more, and requiring up to 3 years for delivery from the time of ordering.
Thus, I like using long-term debt to equity as a key metric to follow. Ideally I think this should be 30% or less. Higher degrees of leverage make the company vulnerable to a market slowdown or cyclical overcapacity. The three year lag in time to delivery can heighten the cyclicality. I also like price to book value, but this can suffer from differences in age of the rig fleet and how they depreciate them on the balance sheet.
Dividend yield varies among these companies, with some retaining all earnings, and some paying dividends. Diamond Offshore (NYSE:DO) in particular is known for paying special dividends that are sometimes quite large (and also result in adjustments to their option strike prices, which you'll notice if you follow my put writing strategy for acquiring shares). The yields of some companies can appear deceptive due to special dividends, so always do some more investigating. Also, I suspect that some companies that don't currently pay dividends may initiate them, such as Atwood Oceanics (NYSE:ATW) and Rowan Companies, due to their profitability.
Finally, market capitalization will give an idea of relative size, which implies operating efficiencies for large companies, while smaller size could indicate a takeover candidate. There has been some consolidation in the sector, most recently Ensco acquiring Pride International (NYSE:PDE) in May 2011.
|Company name||Price||Earnings per share ($)||Price to Book||Mkt Cap ($)||Dividend yield (%)||debt / equity (%)|
|Noble Corp (NYSE:NE)||$35.87||2.05||1.22||9.0B||1.45||55|
Seadrill Ltd (NYSE:SDRL)
|Vantage Drilling (NYSEMKT:VTG)||$1.74||-0.07||0.73||511M|
Table 1. Selected offshore drilling companies and financial metrics as of December 22, 2012, as reported by Google Finance.
Putting it all together
After reviewing this table of valuation metrics, and recent 10Q filings, and investor presentations I have an idea to explore in the coming weeks. I already hold Noble Corp, Diamond Offshore, and Ensco Plc. I have active put-writing and covered call-selling programs in place for each of those companies.
However, based on my recent analysis, I would like to explore Rowan. The thesis for this is:
- Lowest debt-to-equity
- Lowest price-to-book, among profitable companies.
- Largest number of high-specification (premium) jackups, with 19.
- Expanding from their jackup market focus, with 4 deepwater drillships due for delivery by 2015. This will lead to higher profit margins, and expose them to a market with different cycles - a diversifier of profit streams.
- Looks like a good candidate to initiate a dividend (ok, that is a little soft, and speculative. It's only a minor point, not a key driver of the decision.)
Balanced against these factors is the fact that the return on equity for Rowan has looked weak against competitors, in the 3-4% range. All too often, when a company is identified on the basis of what looks like a favorably low valuation, further due diligence turns up good reasons why the market is pricing a given company lower than its competitors. That certainly may be the case here. I am simply pointing out a candidate for further evaluation - in no way is this analysis complete enough at this point to make a buy decision.
Assuming further analysis proved favorable and addressed one's potential concerns: My entry point would be either just below the current price of $32.11, such as a limit buy order of $30.00, or to sell a January 2014 $30 put for $3.40. With both methods, I like to wait for a further decline as a safety margin, just in case my thought process had been overconfident or even just plain wrong. Notice how both methods (limit buy below current price, and writing put contracts) would get me into the stock at the same price, but the put writing gives additional premium - somewhat like earning a dividend on a stock that doesn't even pay a dividend.
And that put-writing strategy would result in a buy price of $30 on a stock currently trading higher than that. If the stock never traded down below $30, well, then that just would earn $3.40 per share for the willingness to buy at $30. I have found the volatility of the offshore drilling sector makes it ideal for selling options on these stocks. As always, don't do this unless it's a stock you want to own - because you just might end up doing so.
Thanks for reading, and good luck, and have a fantastic 2013!