Deepwater Drillers: Not in a Very Deep Hole

Includes: DO, NE, RIG
by: Bullish Bankers

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. (NYSE:NE), Transocean (NYSE:RIG) and Diamond Offshore (NYSE: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 (NYSE: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.