Gulf of Mexico Offshore Drillers May Underperform

We are lowering our view on the Gulf of Mexico [GOM] Offshore Drillers to Caution from Positive. Our cautious view is based on jack-ups day rates being re-contracted to the mid-$90’s to $115’s level from the $100’s to $150’s level; Natural Gas prices falling from $7.80 to $4.97/MMbtu; and higher than expected hurricane preparation expenses due to a hurricane season that did not materialize. More points for consideration:

• It is clear that current Natural Gas prices are not making it economical for operators to move forward with drilling projects in the GOM. Also, current day rates are at a level that makes the internal rate of return [IRR] prospectively unattractive. Further, we are in a high cost inflation environment that is adding additional pressure to the IRR. Thus, we are concluding that day rates will continue to fall until Natural Gas Prices reverse and once again push demand higher.
• In addition, Natural Gas inventories are currently at 3.08 trillion cubit feet, or about 12.4% above the 5-year average and higher than any months in September. This data point should add pressure to day rates and to the shares of the Offshore Drillers-hence our view of Caution.
• With the level of uncertainty surrounding Natural Gas Prices, we are adjusting our sequential Q4 2006 average jack-ups lower, to a decline of 7.8% to $110,813, versus our recent forecast of a decline of 4-5%. We now believe that our 7.8% sequential decline for Q4 2006 is SLIGHTLY conservative. Given the 36.3% decline in natural gas prices, it is possible that day rates could fall further in the GOM if Natural Gas Prices fall below $4.50/MMbtu. Spot price is at $5.07.
• Consensus estimates continue to move higher in a period of falling Natural Gas Prices. We would advise investors to temporarily shift money away from drillers whose contracts are indexed, i.e., ENSCO (ESV) and Pride International (PDE). New money should shift to the deepwater names, i.e., Diamond Offshore (DO) and Transocean (RIG [despite higher costs]).
• Still we expect the momentum to slowly pick up as we approach year-end. In the near term, shares of the Offshore Drillers could be range bound or could continue to experience some downward pressure.