Deepwater Drillers: Not in a Very Deep Hole

By Charles W. Petredis

Are the deepwater drillers done for? No is the answer, if you are looking for a simple answer; but the reasoning why is more important than the answer to the question itself.

The deepwater drillers, namely Noble Corp. (NE), Transocean (RIG) and Diamond Offshore (DO), were the darlings of many analysts during the energy bull run that took place in the first half of this year. Analysts have quickly soured on these drillers, and they have become in some ways the “enemy of the state.” Many investors became sour on the drillers after crude fell from $147 back towards $40, but their reasoning as to why they wanted to prompt a sell-off in these names was a product of flawed thinking.

Many investors held (and continue to hold) the false assumption that the deepwater drillers are highly correlated to the price of crude oil. While this may seem to have been the case over the course of the last half-year, which happens to be the second-worst financial crisis in the history of the world, this is actually untrue. These equities are services companies, not exploration and production companies. They have no direct exposure to commodity prices, including crude oil. Their exposure to commodity prices is indirect, mainly through the companies which pay them for their services.

The key to these contracts is that they are signed for long periods of time, or in other words the deepwater drillers will be able to have guaranteed revenue streams coming in for many years into the future. Due to this, the deepwater drillers aren’t worried about the day-to-day movements of crude oil prices. For example, Noble Corp. was able to sign multiple contracts with Petrobras (PBR), the partially state-owned energy company of Brazil, that in some cases stretched all the way through 2014. These massive six-year contracts totaled over $4B dollars in guaranteed revenues for Noble as long as they were able to reach moderate performance bonuses.

Not all of the deepwater drillers' contracts are six years long, but almost all of their contracts are at least six months in length when dealing with their deepwater vessels. The demand for deepwater drillers comes directly from the companies who hold the leases on the land which they are drilling. While it is true that the demand for exploration and production companies' services can be affected by the price of crude oil over the long run, there is no direct link between the price of crude and the demand that the deepwater drillers will need in order to continue signing contracts. The deepwater drillers are technically only worried about the price of crude oil at the end of their contracts so that they can see greater demand from a larger number of exploration and production companies for their rigs. What happens in between the contracts is the downside risk of the exploration and production companies, not of the deepwater drillers.

There is another side to the deepwater drillers' story. All three of the major deepwater drillers have shallow water drilling arms, and in some cases these shallow water drilling arms contribute more than 50% of revenues. These operations are not nearly at the same level of risk as the deepwater operations, as the exploration and production companies have a much lower cost per barrel of production. Some of these shallow-water shelf-type projects could have production costs as low as $10-$15 per barrel as opposed to production costs that sometimes escalate past $70 per barrel for deepwater projects. As you can see, even with depressed crude oil prices almost all of these shallow-water projects can continue to operate. These drilling companies will not be out of business just because the price of crude has fallen so drastically. Don’t forget that these companies existed even when crude oil was in the $20 range, and they will be able to operate in this range again.

Another important factor to remember is that costs in the energy industry lag the selling prices for the commodities. Costs will begin to fall as production is shut in due to lower demand. Companies will no longer produce crude from expensive projects if the demand is not present. With stable crude prices these companies' margins will return over time, even if the crude prices are not nominally as high as they once were. This leads into another old saying within the energy industry, “The solution to low prices is low prices.” Over time this extremely cheap crude oil will cause demand to pick back up, and the squeeze between supply and demand will begin again, driving up prices.

All of that being said, the road for the deepwater companies is going to be a rough one. Earnings estimates for 2009 for these companies have been cut by around 20% in the last few months. Don’t be surprised if these estimates fall by up to another 20%, as analysts are always too bullish in the forward projections. Most of this unspoken information has already been priced into the equities, but there is more downside. Crude oil could collapse lower, and some of these companies could have exploration and production companies cancel projects and contracts. None of these three companies has had any cancellations yet, but that is not to say that cancellations are not possible. The risks are somewhat high and very transparent, but the upside of these equities is also very high.

Disclosure: The mutual fund the author manages, the author, and the author’s family are all long NE.

Comments

[Alan von Al...:]

Nice company. GOM and North Sea contracts are probably good. No way to enforce a "memorandum of understanding" with Pemex or Petrobras. I don't own the stock and don't recommend buying drillers. They need bank funding for new builds, refits, customs, towing and operations.

2008 Dec 27 04:44 AM

[Clavis:]

An interesting article, not my field, I expect that an investigation concerning all gamuts of the spectrum would need to be undertaken.

2008 Dec 27 08:10 AM

[long_on_oil:]

I own and am currently building a bigger position in RIG (transocean). The stock is selling at $6 less than book and only 4 times depressed 2009 earnings. The company recently moved to a country with a lower tax base which will appear on the bottom line in the coming year. RIG is a best of breed company with great management.
It always puzzles me as to why we investors always want to buy stocks when they are close to their all time highs but we will not touch them when they are a gift. Isn't the objective to buy low and sell high. RIG below $60 is a gift.
RIG at this price is like SU (suncor) at $18 ($36 pre split). I bought SU at $32 when oil was low like now and I sold it at $80+. Wake up investors it is deja vue all over again.
I can see staying away from the oil related if you are a trader but if you are an investor these are must own stocks.

2008 Dec 27 08:50 AM

[Paul Killinger:]

It will be interesting to see how drillers and their equipment manufacturers fare during this economic downturn. Besides long contract cycles, the shales now being explored (eg. Barnett, Marcellus, Haynesville, the Bakkens, et al) each require HUNDREDS of wells, and are still economic at current prices. Moreover, as of this time, no one is convinvced the price of oil and gas will remain at its presently depressed levels.

2008 Dec 27 08:52 AM

[jamino1:]

I own a block of RIG and had owned GSF as well before the merger. While there are certainly risks going forward and these shares can certainly go lower, they are in my opinion low enough to begin accumulating now. One factor that needs to be considered is that capitol intensive industries such as oil service have an advantage in a capital constrained world. It is difficlt and expensive to build these things and none will be ordered or built in this economic environment. THe worst thing about the fall in the price of oil may turn out to be a good thing. ANd that is the price fall was very rapid. IT has more to do with the continued deleveraging going on than the acknowledged demand destruction. Prices may return to higher levels sonner than most people think even as they can still go lower in the short run. RIG is my favorite. Like XOM, they know what they are doing and they know how to survive in the hard times and make tons of money in the good times. IT is good to remember that oil has enduring and constant utility. World currencies do not and what the world is doing to paper money right now almost assures we will see another oil spike in the not too distant future. Buy low; sell high. Keep leverage low or non-existent so you cannot be taken out against your will.

2008 Dec 27 09:37 AM

[biomedlives:]

I wonder about the possibility of renegotiation of deepwater contracts at lower dayrates or cancellation. The recent renegotiation of some long term dry shipping contracts is a useful analogy, in my view. I recognize that if a lessor was able to cancel a contract, there would be a cancellation fee. That fee would probably be considerably less than the present value of the revenue stream, however.

2008 Dec 27 09:38 AM

[Alan von Al...:]

This was starting to get a little wacky, so I glanced at the Bullish Bankers profile -- students at Penn State?? -- okay, mystery solved. Uh, gentlemen this may come as a shock, but those oil service jobs aren't coming back. Small onshore drillers don't have enough of a financial cushion to make it longer than a month or two, and those shale plays you mentioned are not profitable at $40. More importantly, you need to know something rather awkward. About half of the proved reserves aren't. Production is the only thing that matters.

From an industry point of view, most of the minnows have done quite well out of the 2007-2008 investor/partner game. They'll fold up and retire, citing market conditions. Pretty good exit story.

If you want to do some research, look at bank lending to the oil service sector, especially companies like FlowServe and FMC. They're all in trouble unless they can borrow more. Big offshore projects are stalled. The IOCs will survive, although I have some doubts about Conoco. But the service companies that do spec seismic, workovers, wildcats and well completions, expect a serious shake-out.

Premature to buy "must own" oil service stocks. Maybe in Q3 09 if there's a recovery that significantly draws down inventory. Then see which companies are still in business or merged and downsized. Lot of well-paid people are going to be out of work in the domestic oil patch.

BTW expect it to slam Merrill Lynch too. Something like $10B or so.

2008 Dec 27 10:07 AM

[Paul Killinger:]

Pardon me, but last I checked Bakkens oil is profitable at $20. And shale gas works between $2-3. Additional exploration has taken something of a pause due to adequate supply, but continued production makes money at present prices.

As for financing, except for overly leveraged dummies like Chesapeake, most explorers are using the CASH they made during the bull market, a substance foreign to the Feds and Wall Street. Look at the amount and type of debt on their balance sheets.

2008 Dec 27 11:46 AM

[Burticus:]

Drillers who have enough cash to survive temporarily low oil prices will profit handsomely when supply depletion causes oil to rocket past 250 FRNs a barrel and their debt-laden competitors are gone. Same goes for gold and silver miners.

2008 Dec 27 07:08 PM

[long_on_oil:]

The temporary crdeit crunch the world is suffering will end and we will start the entire cycle again. The problems facing all countries of the world is keeping economies going by increasing and decreasing liquidity to a point where we can have longer periods of stability. The more the world population increases the more liquidity is needed. When commodity prices get to high we have to put on the brakes or suffer hyper inflation which would be almost impossible to contain.
We will reach a point once again where there is so much money sitting idle that Banks and other lenders will take excessive risk just to make a buck. And the junk debt will build again. Human nature never changes and history repeats itself...lol

2008 Dec 27 08:26 PM

[Alan von Al...:]

Killinger: "Bakkens oil is profitable at $20"

Bakken horiz/frac drilling cost = $4 million + lifting costs + royalties
average per well breakeven = 158,000 bbls ($75 per barrel)
average per well production = 100,000 bbls
historical average all Bakken wells = 64,000 bbls
2007 Bakken per well production = 16,000 bbls
"sweet spots" gone
very low perm, low porosity

2008 Dec 27 09:14 PM

[Alan von Al...:]

Sidebar on production cost:

"Iraq is one of the cheapest countries to extract oil from, costing as little as $4-$5 per barrel thanks to the easy geology and high flow rates." (London Times Online)

The breakeven I gave for Bakken at $75 per barrel assumed a 50% success ratio, five times better than historical US drilling.

2008 Dec 28 03:18 AM

[mplaut:]

A similar play is Seadrill, a Norweigan company owned by Jon Fredriksen. At their last conference call they were asked if there is any pressure to renegotiate contracts and they said that they only calls they get from customers are asking when they will get the rigs they ordered, and the sooner the better.

2008 Dec 28 09:07 AM

[Alan von Al...:]

"Seadrill will continue its efforts to raise further debt in order to increase the robustness for unforeseen events" (Q3 report). Dividend suspended. Net loss. Up to their eyeballs with funding commitments to Petrobras.

2008 Dec 28 09:43 AM

[wingfootedg...:]

The oil companies are looking at 5 to 12 year time lags between exploration and deepwater development. Short term movements of oil prices are of limited impact. Yes there will be some earnings impact as rig rates are negotiated downwards and almost all of RIG's contracts have rate adjustment clauses tied to the price of crude. Cancellations will be minimal and RIG has long waiting lists.

Deepwater drilling is not for the faint of heart with wells costing $50MM to $100MM each.

Transocean is not involved in the land based gas resource plays and is strictly an offshore driller. I would imagine 90% of their fleet is involved with drilling for oil, mostly outside the US Gulf Coast.

Seadrill is a much smaller operator, less a reputation and represents a highly leveraged investment. Be advised. Like someone has commented it will be very difficult to enforce penalty clauses with Petrobras. They are hanging on for dear life.

Recently have went long RIG and SLB and short the January 09 calls for a trade.

2008 Dec 28 10:31 AM

[E Nuff Sed:]

The best solution for a lay investor is to buy a closed end fund like PEO. With 0.5 expense ratio you gain a diversified oil related portfolio as well as expertise in the field. Bonus: It is selling at a discount to net asset value.

2008 Dec 28 12:57 PM

[mwswi:]

Alan von Altendorf: This may an ideal time for you to short energy big-time ("...those oil service jobs aren't coming back"). Meanwhile, some of us don't find it feasible to think that energy pricing will stay suppressed for the long-term. Only time will tell if you are correct or some of us are badly mistaken. And when all is said and done, none of us truly know what's in the cards for the future.

2008 Dec 28 02:47 PM

[bcncv:]

I'm not an expert in this market, but I'm hearing that the price of oil needs to generally average over $70 a barrel for deep water drilling to be profitable long term. That means the price of oil needs to nearly double for the business model to work.

I'm sure there will be value there someday, but there's nothing here that is convincing me to be a buyer at this point in time.

2008 Dec 28 04:20 PM

[Alan von Al...:]

I expect crude to climb in price sometime in 2009, maybe Q2 and beyond, but at present world supply is slightly in surplus, led by increased oil production in Angola, Azerbaijian, Russia, and China (Mexico, Norway and Nigeria down). My remarks about shut in US onshore production and oil service job losses have to do primarily with debt financing. The first thing to go and last to bounce back will be high wage US jobs.

2008 Dec 28 06:10 PM

[been there:]

please look back to the late 1980s and see if those long term contracts didn't end up in the trash can just as these will if the the price of oil stays low long enough.

2008 Dec 28 09:33 PM

[Market Folly:]

fully agree that these companies can be very, very profitable going forward. the problem is, many of them need oil > 60 to really have the audacity to keep ramping dayrates. i still think it will happen long-term as oil heads back higher after trading somewhat sideways here the next year and a half or so. we gave our take on RIG back in september as a long term holding: www.marketfolly.com/20...

2008 Dec 28 11:52 PM

[Alan von Al...:]

Goldman RIG target was $178
Market Folly said buy at $120
Goldman new target is $79
Petredis likes it at $44
how about $30?

2008 Dec 29 02:36 AM

[daffy:]

Alan,

I have heard news that Mexico is drying up. Now, Brazil's new recent find has rallied reserves but it is not enough to fill the void should China's economy stabilize and remain in the positive growth territory.

That being said, there are many more emerging markets that are increasing the demand even with this downturn. We will have to see what happens in the next 6 months to get a better picture. I am a bit worried about the commercial real estate and what implications that might have on lending in the next year. Time will tell.

Now, Oil shales are a last reserve desperate attempt (with today's technology) to compete with easy oil of the middle east. I think one should look at that being the oil that runs the infrastructure when most are too poor to go visit grandma in the nursing home. And here is where the big issue is with the oil game. Oil services (with the exclusion of small exploration companies, et cetera) are not subject to short term fluctuations in oil prices. You seem to understand the oil industry well enough to know that a short time period for the Oil industry is 2-3 years. They just can't mobilize that quickly so why pay attention to it? XOM et cetera think in term of 5 - 10 years. They have to. In today's world, the average human mind thinks in terms of days to months at the most. There is a big disconnect there. Oil services are always a long term play, although if there were smart people, some (RIG) can played on the short term.

One thing we should be looking for in the next six months is to what the countries who depend on oild prices at a stable level, ($75 so they say) need to stay afloat, and what they are willing to do should Oil prices remain low.

I personally think there will be pipeline attacks, escalation of mid east tensions, and other disruptions and fear mongering that will send oil prices back to the 70 - 90 range in the next 4 months. Wait for the next puppet to take office, that is when it will really start. While RIG has been following closely to the per barrel price lately, it really shouldn't be, that is the truth, and you know it. Compare to DO (although RIG has greater deep water exposure). Oil prices will not remain low. Devalue the dollar, start the next commodity boom! PRINT . . . PRINT . . . PRINT.

2008 Dec 29 09:12 AM

[Chris B:]

The author seems to miss the following points:

1) Deepwater contracts expire and are renegotiated on a regular basis. With low petroleum prices, the drillers have no choice but to set their next set of contracts at the low prices offered by the market. To believe that drillers timed their contracts so that none expired during the coming crash in oil prices is to assume an impressive degree of market timing on their part, and poor judgement on the part of their customers. There is no convincing evidence for this hypothesis.

2) Many of the specialized and expensive deepwater rigs may no longer be economical to produce oil at these low prices. At that point, the oil companies walk away and the drillers are stuck with idle equipment rusting away and costing hundreds of millions in interest, maint., depreciation, insurance, etc. If you think otherwise, tell me why most of this equipment was suddenly built in an era of $75+ oil prices and not before.

3) Oil prices can remain irrationally low for decades (e.g. the 80's-90's) and are utterly unpredictable. Iraqi production or Chinese investment in Iran are just two of hundreds of variables that could produce a market glut for decades. Peak oil will occur, but regional production spurts and worldwide demand fluctuations could obscure it and result in wild price fluctuations over the next couple of decades.

4) Drilling contracts can be walked away from as easily as a subprime mortgage. You stop paying money, you tie it up in court (friendly courts in your own country) for decades, and even if you lose, you save billions of dollars. There's no incentive for PBR, Russia, or XOM to go bankrupt paying for uneconomical contracts. Don't expect an honor system to be worth billions of dollars. The world doesn't work that way. The smartest drillers are working to proactively offer concessions on existing multi-year contracts to keep their equipment leased, perhaps even at a smaller loss than they would experience if the equipment was idled.

Thus, the drillers are a leveraged bet on the price of oil - exactly the opposite of the author's thesis. Their earnings are magnified in times of high prices, as are their losses in times of low prices. The markets are correctly reflecting this dynamic.

Disclosure: still long (and underwater on...) RIG because I'm betting oil prices will someday rise above current levels. I'm critical of this article because it relies on the same assumptions and overly simplistic reasoning that got me into RIG at $100!

2008 Dec 29 10:13 AM

[Alan von Al...:]

Daffy, I've written about the Petrobras subsalt play and that's my chief concern re deepwater drillers, especially semisubmersible platforms....

2008 Dec 29 11:54 AM

[jimmy46:]

Companies will no longer produce crude from expensive projects if the demand is not present."""

This is a bit misleading, deep water oil may cost $70 a barrel total cost,
BUT, most of that cost is up front drilling the well.

Once the drilling is done the cash cost of pumping the oil probably isn't much higher than shallow water projects.

So no one is going to shut in the "expensive projects"

2008 Dec 29 05:06 PM

[daffy:]

Alan,

The geophysical environs in Brazil, and all of the transform faults that are there make for a very tricky drilling environment. And at depth. Those holes are deep.

I just visited your website. I would love to read what you have written on the field in question. It is a very complex area . . . and the cooking was dicey and fluids have been so mobile. I would love to know more. I haven't done anything with that type of environ since about 2004.

Thanks . . .

You can find me on my contact page on my website if you would like to forward a link . . .

2008 Dec 29 10:02 PM

[scotty1560:]

posted by "long on oil" and I agree
It always puzzles me as to why we investors always want to buy stocks when they are close to their all time highs but we will not touch them when they are a gift.

I'm not smart enough to be a trader. One thing I can vouch for during my time
on this planet is "pure" raw materials are disappearing without "cheap" replacements- just ask the "snapper" in the gulf or the "primate" in Africa.
Pure air, Pure soil, pure water, cheap oil, bountiful oceans all vanishing- compliments of the humans species and the "machine age" over say 100+ "short" years. Take some photos of the glaciers for the grand kids. Those fertilizers do make my lawn look good though.

Not long ago water was cheap while today my rates keep doubling along with
restrictions. And oh yea, my area is quietly talking of "recycled waste
water"...doesn't that sound healthy. Atlanta, Phoenix, California, Florida-
ready for water rationing down the road?

Back to oil, same thing..yes, you have years of supply but not the easy "cheap" supply. So I say let's buy a share or two and stick it under the mattress. Thinking in a couple of years does it matter if I paid 23$ or $29 for
a simple play like USO? Again, I'm not a trader but neither is Warren Buffet
if I recall. Now is the time to take a deep breath and make your long term
bets. I doubt it will take "decades" to be rewarded, although 3-5 years might
be prudent, and maybe 10 years pays for Jimmy or Suzie's new video game.

I might be wrong but oil has to many factors in play to spend a great deal of
time below $35-40. Count on our Russian or Middle East "cartel" to "shake the
bushes" or "beat the war drum" if needed. Don't forget our ally the "Weather
Channel" providing minute by minute details of that next Category 4 storm
headed into the gulf of Mexico. And don't forget the convenience of an extra
vacation or boat ride with these cheap oil prices...only Mr Market knows.

2008 Dec 31 01:05 AM

[daffy:]

nothing is ever pure unless humans make it so.

It's the God thing.

2008 Dec 31 07:25 AM