Deep Sea Oil Drillers Show Potential for Gains

This has been the first week in a long time I have heard the consistent talk of a possible bottom. Technical charts could still break down, but many of the experts are saying that the small and midcaps are starting to lead us out of recession. I am unsure they are right, but I think we could see a leveling out of respect to the S&P 500. One company that seems to be following this thesis is Electronic Arts (ERTS). Their terrible miss with respect to earnings should have caused this stock to lose 20% of its market cap, but instead we saw a rally in the stock based on a "not so bad" guidance. Jeff Macke was dead on when he bought calls, too bad I owned puts.

One sector that could be a good buy, is the deep sea oil drillers. Oil service looks ok, but companies with high specification semi submersibles seem to be very well positioned. I had owned Transocean (RIG) and Diamond Offshore (DO) for quite some time before selling them for profits, as the price of oil started to tumble, but I believe stocks in this sector could be a good place to be with respect to a possible run in stocks, that should also see an increase in the price of oil.

I purchased February 21 of 2009 calls yesterday in Atwood Oceanics (ATW). This was done for a few reasons. The first was what seems to be a leveling off in the price of oil. The second is ATW has beat or met EPS expectations for at least the last four quarters with respect to Yahoo Finance numbers. The third was their size as they are a smaller company than the likes of RIG and will recognized earnings increases much faster. The fourth was the information I garnered from their Goldman Sachs presentation earlier this year.

They currently have three semi submersible rigs that can drill from ocean depths of up to 5000 ft. They have a fourth that has a 2000 ft. specification. These four are the most important with respect to earnings. They also have a lower depth semi submersible, a submersible and two jackups. They have two semi submersibles being built, one dynamically positioned. These are to be finished in 2011 and 2012 respectively. The first will add and EPS of $1.25-$1.35 per year. The second will add $1.40-$1.80 EPS per year as well it should as it will perform in depths of up to 10000 feet of water.

If you look at this company with respect to deployment of their rigs, it is another positive. The Gulf of Mexico is a highly volatile space with respect to oil drilling and weather. Only one of their rigs are located here, and it is their submersible. The others are located in Asia, Africa and the Middle East.

As of January first of this year, ATW has contracted 75% of their rig days for this year, 45% next year, 34% in 2011, and 20% in 2012. These companies also get almost all of their revenues from contracts. These contracts have been found to be unbreakable as long as the rigs are performing up to estimates. Most believe these deep water drillers can be shut down with a lowering price of oil, although this is not the case.

On January 5th Oilexco demobilized RIG's the Sedco 712. The courts promptly backed the contract and it remains in full force with RIG "pursuing appropriate remedies." These are long term investments for companies that lock down semi submersibles for three to seven years. Depending on your strategy, RIG signs the shorter of these contracts and DO the longer. Jimmy Tisch remembers the time he bought DO knowing he could get his most his money back by scrapping the steel.

Oh how times have changed. A true test of the contracts came up when the price of oil dropped from $150 a barrel to today's price. Some of the smaller exploration companies have tried to get out of their contracts only to be held to their deals. For ATW, these contracts have secured revenues of $410 million this year, $560 million next year and $610 million by 2012. One of their rigs is contracted out through 2014. This gives an operating cash flow of $1.3 billion by January 1 of next year.

ATW's earning report on February 4th of 2009, has given reason to be bullish. Not only are the majority of their contracts backed by large solid companies, but the revenues will keep rolling in. ATW is also bullish going forward as they believe the price of oil will rebound, probably not to $150 anytime soon but $60 is possible. The majority of their cash flows are being piled into their new rigs as the demand is still high, and margins are quite good in this arena. Within this group, ATW will see much greater growth than some of the larger companies (RIG, DO), but could lose much more if the world economy continues to linger in a downside direction.

Lastly, look at how ATW has performed over the past few years. Since 2004, revenue has increased from $163 million to $527 million last year. Over the same time frames, operating cash flow has increased from $32 million to $245 million, net income increased from $8 million to $215 million, and gross operating margins have increased from 39% to 59%.

Looking at this sector, all of the deep water plays have done well. RIG may be the safest bet as their merger with Global Sante Fe, created one of the largest monopolies I have ever known. They do have a large exposure to the jackup market although they are deep drilling jackups, their market is still much more inundated then the semi submersible.

The market to watch are the drillships. These are global positions and seem to be the in dire need. Drillships can cost up to one billion dollars to build (check NOV's earnings) and now creative contracts are still being signed. Many are being built with as a coop, with companies owning a 50% share and still paying day-rates, plus incentives to RIG. In the majority of contracts, RIG will take full ownership of the rig when the contract expires. This is done so the exploration company will have the ability to extend their contract for up to a full ten year option. Also it takes years to complete, so it is good for the exploration company. It is expected that oil will increase in price over the next few years, so they are making an investment in the future of oil price. It also, gives the ability to get out of the contract if the price of oil stays low, or exercise the option to extend if the price rises. The reason I use RIG as an example is they seem to be future of deep sea drilling and many of their actions will be duplicated in the future by smaller players.

No matter how you look at it, many of these companies are trading at a forward PE of 3-4 and unlike financial companies have a very steady contracted revenue stream. So whether you are looking for a growth stock as these companies grow into their high specification rig prices or looking for a cash cow, this group looks solid heading towards 2010.

Disclosure: Long ATW Feb. 09 calls

Comments

[Larry House:]

Forward PEs are a total shot in the dark. You can't count what you can't see. The price of oil will determine if these rigs are called into action or not. I like the area too, but it could be years before this sector revives.

Feb 05 10:53 AM

[Jae Jun:]

I agree that this sector has been unduly punished.

Long ATW.

Feb 05 12:37 PM

[legmaker:]

Forward PEs dont mean anything unless you have contracts to cover your assumed earnings. The reason that forward PEs mean nothing with respect to financials is we have no idea what their writeoffs will be on CDOs and etc. or consumer discretionary we are unsure how many people will lose their jobs so we dont know if they will buy the more expensive tooth paste. Whether or not a rig is called into play is not like the ground drillers as their contracts can be ended at anytime. The article shows what they have for revenues locked into contracts, these rigs are as close to a guarantee as you can get. Watch these stocks go up like crazy.

Feb 05 04:56 PM

[ripskii:]

Deep water drilling capability is a very specialized skill and only a few process it. As anyone who has followed recent trends knows, the major unexplored regions of the earth are under the seas (oceans) and deep water covers most of the earth’s surface (4/7's). Future discoveries of significant resources depend largely on overall deep water capability. Costs for accessing those resources are the major issue and increased technical capability tends to lower them, but the cost for new entry remains very high. Therefore it is unlikely many new competitors will challenge the existing leading firms. Considering the extensive (and costly) experience the few major firms have acquired there seems little possibility that additional major competition will surface to threaten the present leaders in the field such as RIG, DO, NE, and ATW.

Feb 06 12:33 AM

[dsrtwriter:]

Very good analysis,Michael.Keep us posted on how the calls do.Not biting this time but maybe the next set.

Feb 06 03:25 PM

[Alphameister:]

Excellent article, Michael. These stocks would be cheap if earnings were to come in at half estimated levels. I own both RIG and ATW, but ATW is my choice for current purchases based on comparative PEG ratios and other fundamental considerations.

Feb 06 10:47 PM

[Ryan Vanzo:]

Great analysis on ATW and the sector. I agreed with most of the things you said and I too prefer ATW or RIG. This preference is due to ATW's lower multiples against RIG. I don't see them being justified.

Mar 08 05:30 PM