Stephen Butz – CFO and EVP
Kathryn O'Connor - Deutsche Bank
Hercules Offshore, Inc. (HERO) Deutsche Bank Leveraged Finance Conference October 1, 2013 4:00 PM ET
Kathryn O'Connor - Deutsche Bank
Thanks again for joining us after the lunch speakers. We’re continuing on with our energy panel and here we have HERO, and this year we’ve done a lot of work with, especially in the last few weeks even. And from the company we have CFO Stephen Butz.
Thank you, Kathryn. And good afternoon everyone. Thanks for joining us today. I see couple familiar faces and also some new faces. So we’ll start out the presentation with just really a brief overview of the company for those of you that aren’t familiar with us. But we’ll spend the bulk of the presentation walking you through these fundamentals in each of our business segments and talking about our outlook and some of our strategic plans going forward.
So first, our company is a relatively young company by the industry standards. We were just formed in 2004 but we’ve grown rapidly. Scale is very important in our business and in that time we’ve amassed world’s third largest fleet of jackup rigs as well as the largest fleet of liftboats that work in international markets. You can see on the map that we have established operations really around the world, with the exception in the North Sea and of course, we’ve opened the office there last year and we look to expand there with our discovery rigs.
We have a very experienced management team that hails from a lot of the household names in the energy business. And our customer base includes some of the premier companies in the industry, including Saudi Aramco and Chevron which the two largest customers.
The last quarter was very active for us and we had a number of strategic events. Probably the most significant was the Discovery Offshore acquisition. Discovery Offshore was a company that we formed in January of 2011 which ordered two new ultra-high specification rigs from Keppel FELS. That was really our first step towards significant fleet renewal and we’ll walk through some of the key aspects of that transaction in a couple of slides.
Also, really simultaneous to that move, just coincidentally we were able to reach agreement to sell our Inland Barge segment and our Domestic Liftboats segment, both of which were not really core to the company, particularly the Inland segment. But the Domestic Liftboats segment was one that was also plagued by overcapacity and we really didn’t see that changing for the foreseeable future. And so the returns there were low. Neither those businesses were generating cash. So we were able to use some of those proceeds from the sale to help fund the Discovery acquisition.
Then two weeks ago, we announced that we had secured two new five-year contracts with Saudi Aramco, with two of our jackups that were already in the region, working for Aramco through the end of ’14. So now those are contracted through the end of the decade. So we’re very excited about those new contracts and we’ll touch on those in more detail shortly. And also two weeks ago, we issued $300 million of new senior unsecured notes to refinance the issues that we put in place in 2009 and so that will reduce our interest cost by about 9 million per year. It also extends our maturity profile and has a number of other benefits.
Okay. Now just again with a little more on the Discovery acquisition. I think the rationale for this acquisition is pretty straightforward. Again, we, like most of our competitors, need to get some newer assets into the fleet. These rigs can be maintained and continue to work for the foreseeable future, but at the same time over time some of the newer rigs will be more competitive, particularly when you get in the down cycle when the rates tend to compress. And so we’d like to have a little more balance in our portfolio between some of the newer rigs and some of the older rigs. And the older rigs, typically the capital cost is much lower. And so your returns can be much higher during the up-cycle, but over the cycle we think it's important to have some of our earnings coming from some of the newer assets, which will provide more stable earnings profile for the company.
Over time as well, you would expect over the longer run the maintenance capital spending to increase on the older assets. Right now it's certainly not at the level that’s very, very onerous but over time that will increase. And again as I mentioned, this is a company that we formed back in 2011 but we only owned 8% of it initially. And as our financial profile improved, we increased our stake to just under a third and then in the summer, we made the move to bring the entire company in-house, so to speak, and it really -- there is a number of benefits to that. It certainly reduces the administrative burden versus managing two public companies in different jurisdictions created in different markets as well as just the fact that the companies with newer assets tend to have lower cost of capital, that's a big benefit as well.
So while this doesn’t seem maybe that significant when you think about two rigs versus the size of our existing fleet, the earnings power that these two rigs can generate is very meaningful. You couple that with the new liftboat that we acquired in the spring and those three new assets could generate somewhere in the range of 20% of our EBITDA even during upcycle. Then during a downcycle you might expect that to be even more significant.
The Discovery rigs were on contract at the time of the acquisition. We just secured about a month and half ago an initial contract for the Triumph and that's the first rig that was just delivered in the summer. And so that should be on dayrate here within the next few weeks with Cairn in India. This is a relatively short-term contract. It's about four months. You can see that while the operating dayrate of 215,000 which is very attractive, the overall effective dayrate that’s extremely attractive is the customer paying for all of the mobilization costs and you amortize that over a short contract, it’s very significant -- $330,000 per day . So, we’re excited about that contract. We ultimately would like to contract these rigs long term, put them on two or three year contracts but mainly the starts that we see are for later -- mid to late '14 for some of the longer term contracts that we're targeting. So, we were pleased to get this short-term contract and we are continuing to negotiate and bid on longer term mark for the Triumph as well as the Resilience which will be delivered in November and we would expect that rig to be on dayrate by March of next year.
So I touched on this on slide seven but again last -- two weeks ago we announced that we had received five year extensions on two of our rigs that we are currently working with Aramco, that were contracted through the end of 2014. It may now contract to those through the end of the decade. The dayrates that we were being able to achieve were 50% higher over the previous dayrates. So that these will be generating revenue per day of $125,000 to $130,000 and for the rest of the decade. Again, and that increased our company's backlog by about 60%.
These were various substantial contracts. We were quite frankly relatively surprised that many of the equity analysts and other analysts that cover the industry didn't focus that much on these contracts, because it had no impact on the 2014 estimates but really this increases the value of the company, being able to secure these contracts this far. And then you think about the positive signaling, the fact that the world's largest oil company went out six years on these rigs that were built in the early ‘80s, very attractive rates to us, what does that say about their view of supply and demand of rigs and oil for that matter. So that was very positive as well.
And it just exemplifies the fact that while there’s certainly going to be growing demand for some of the newer rigs that not every customer in the world is going to want to pay $180,000, $215,000 a day for new equipment if they don't need it. And so this is a prime example of that. The customer doesn't need the capabilities of the new rig. So they’ve secured our rigs for the long term at a much lower rate, but yet it was very attractive to us relative to the amount of capital that we have in the rigs.
Just a quick word before we move on to the segments about our debt since this is a leveraged finance conference and the fact that we issued debt two weeks ago and that was this $300 million and 7.5% notes. You can see our maturities are fairly staggered, first maturity is in 2017, but one of the things that we like about the way our balance sheet is now structured relative to our bonds, we do have options to prepay some of this debt with the early redemption options essentially laddered for the next four years. And the reason we did that and went out with earlier redemption options than what's typical is we were bullish on our credit. It’s strategic for us to continue to improve our credit. And so right now most of these are in the money, so to speak, when you get to those early redemption options. So there is good visibility of further reduction in our fixed charges as the secured notes come up in April and then the senior unsecured notes 10 ¼% in April 19th. Again our unsecured borrowing cost is now about 7.5% on the margin.
Moving on to the outlook for each of our businesses. I’ll start with Domestic Offshore since this is our largest segment. You can see on the right hand side we show a graph of the supply and demand. And you can see while demand has been fairly flat, supply in the region has been flat as well. So demand is really constrained by supply and the industry continues to run about 38 to 40 rigs and we could probably -- there will be demand for more quite frankly if there were more rigs in the region. So that's led to very next fundamental where our utilization rates have been quite high. The last several years we've been able to improve our backlog and increased our rates. And so I'll go through that in a little more detail.
Here on this graph on slide 11, you can see the backlog. This is in days per marketed rig. And you can see on the left hand side of the graph, this was a previous upcycle back in 2007 and backlog really never got that much above 50 days per rig. The rates got high because commodity prices were so high and with that sort of backlog we were repricing as the industry very quickly and so rates got to very high levels. But it was not sustainable with low level of backlog and you can see this cycle is a much different story with the backlog at much higher levels anywhere from really four to eight months per rig generally over the last two years. And that's much healthier for the long term for us.
And that's been driven by a number of factors. One is a shift in our customer focus from natural gas in the previous cycle to oil this cycle. Of course, U.S. natural gas is one of the most volatile commodities in the world whereas our customers have tended to have much higher degree of confidence in oil. So that enables them to contract the rigs for longer periods of time.
Then I think furthermore there has been a lot of consolidation in the suppliers of rigs where we now have about 50% of the rigs that are in the region and (inaudible) also probably has about 25% or 30%. So there not as many suppliers of the equipment. So I think that leads our customers to contract rigs for longer periods of time as they are concerned about rig access.
Of course, that backlog has led to again nice upward momentum in pricing and you can see here over the last three years, our dayrates have essentially tripled. And really this is continuing. We’re continuing to price the rigs higher when they roll off contract, typically bidding $2,000, $3,000, $4,000 a day higher on the next job than the previous job. They're not going to move in $10,000 increments at this point and they are certainly not going to triple again either. But we do see continued upper bias to the rates just because of the supply and demand balance in the region and then some of the other dynamics that I’ve touched on.
And again, our customer base has been very focused on oil. Almost all the incremental drilling activity is focused on oil. We pulled our customers consistently over the last three years and typically about 16 of our 18 rigs are targeting oil, which is a complete reversal with where it would have been for really the better part of the last 15 years. So that, that is definitely a very positive development for the industry.
And you can see in this table on the right hand side, this is some of the larger customers in the region. This represents their production profile. So ranging anywhere from 39% to 75% of their production is now liquids. And of course, the incremental drilling activity is even higher.
One of the characteristics that we like about the U.S. Gulf is the large and diverse customer base. Now while this has tended to -- led to sort of contracts in some of the regions, because you do have smaller companies that really don't have three years of rig demand and can't contract the rigs for as long as someone like Saudi Aramco. You also have much greater ability to have that upward momentum that we showed a few slides back with the dayrate progression that we have with this type of customer base. And it’s a very diverse customer base with companies like Chevron and then Apache on the higher end than other smaller public companies like Energy XXI and EPL. They’ve been very aggressive, large private companies like Arena and Tana and then some smaller companies as well. And private equity has been an increasing force, I would say, in the space and of course, it’s evidenced by the recent deal with Riverstone acquiring Apache's properties. They named that company Fieldwood Energy and that was about a $4 billion deal.
You can see all of the transactions in the U.S. Gulf of Mexico and this just represents transactions that are focused on the shelf. There have been something like $8 billion in transactions over the last three or four years and that's another characteristic of the Gulf of Mexico that we like when the properties are in someone's hands that -- that becomes less active, they will typically look to sell those to someone who will see more value and typically get more active. So the properties never really like to [have low] that long. And so we would expect a year from now that (inaudible) will probably more active than Apache was as an example.
One of the drivers that we've had and this hasn't been a huge driver for us, because we haven't been overly aggressively and adding capacity to region, but we do have a number of idle rigs that we can reactivate. We've reactivate one that just started up in April and that was the Hercules 209, which you see here. And then we've just recently that we're reactivating the 203. And you can see these have very attractive economics. When you look at them on their own eight months payback for the 209, 11 months payback for the 203, so very high return on incremental capital, relatively small capital investment.
At the same time we've been very cautious to add capacity to the region because we are the largest provider of supply, no one else is adding supply. And with 18 other rigs in the region, we understand that we're probably better off if we can price those other rigs up $3,000 to $5,000 a day, for example, as opposed to bringing one in and slowing down that dayrate momentum. Just a math on those other 18 and it's much more powerful than the incremental economics from these adds. But these first two were relatively easy decisions and that we're very confident now and I don't think that adding to the supply will impact the dynamics.
Here on this slide on page 17, we just walk through the potential earnings upside. Our average rate this year is likely to be somewhere in the $80,000 to $85,000 range per day. And we're signing up new contracts and our backlog is largely in low to mid $100,000 a day range. So you can see a $20,000 move per day against our fleet, assumed to be 19 rigs, is about $140 million of incremental EBITDA. So there is really a significant jump in analyst consensus estimates for the company next year. I think the consensus estimate for next year is close to $500 million of EBITDA. While we don't provide earnings guidance, we can certainly see how they can get there just rolling over our domestic fleet to current market rates. And then when you layer in the international contract status as well as the incremental contribution that we have from new assets that we've acquired over the last year or two, you can see pretty easily how you can get that kind of growth.
One of the things that we focus on in the U.S. Gulf of Mexico, again we have a very large position in the market with about 50% of the current fleet. So we’re always very concerned if we see additional supply coming into the market. And you can see here, of course, the rigs are mobile, so they can move from one region to the other. Typically there is a cost of $5 million to $10 million, but they can move and have over the years. But right now the economics are generally slightly better still in international regions. The operating cost may be a little higher but you can see the rates are higher, contract durations typically longer internationally still, or again where our average contract in the U.S. today is about five months, internationally the average contract is about 16 to 18 months. So that tends to be more attractive for the contract.
So, the key point being it's unlikely that many rigs are going to move back to the U.S. Gulf of Mexico despite how strong it is and how excited we are about the fundamentals there. And if you don't operate in the U.S. you’re very unlikely to move a rig to the region today. And then the area where this mobilization cost is least significant would be Mexico because it’s so close and you can move a rig for much less than $5 million. But PEMEX has doubled their rig count over the last three years and they are expected to double it again over the next five. So we don't see incremental supply coming in from Mexico or really anywhere else for that matter.
Moving on to our International Offshore segment. Again, while investors tend to focus on our domestic business because we have 18 rigs and we are the largest provider in the region, we do have a nice and growing international offshore business with nine rigs, which tends to provide little more stability, again the contracts tend to be longer.
You can see here some of the – the shaded portion on the graph represents backlog per rig. And so again, you can see the average contract duration is about 17 months and that's really, well that's an all-time high and you can see here over the last 15 years, I think if you go back even further, it represents an all-time high. But it's much higher than the backlog was even last cycle and the dayrates you can see aren't quite as high. We think that’s just driven by the fact that there is a relatively large newbuild order book and rigs are steadily being added to the fleet. So that’s providing some cap on the upward momentum that we have as a industry in these international markets. And again the rates have been rising but certainly not at the same pace that they did last cycle. When it was more supply constrained and there wasn't any new capacity coming in.
Here is another look at some of the fundamentals internationally. The grey shading represents demand. And you can really see that the growth rate since the bottom in early 2010 has been actually greater than the growth in supply. Demand has been growing around 10%, 11%, 12% somewhere in that range and supply has been growing I think at about 7% or 8%.
Now supply is going to continue to grow at that sort of pace for the foreseeable future. As I mentioned, there is about 120 rigs on order that are going to be delivered over the next three to four years and there will continue to be rigs added to that order book unfortunately. But at the same time with oil prices where they are, we continue to expect our customer capital spending to grow in the either high single digit pace or low double-digit pace as it has for much of the last 15 years.
Now I think what worries us obviously is that when for some reason there is some exogenous event that could affect demand, then instead of demand growing at 7% or 8%, [if it stalls] and declines by 5% or 10% it will take you a couple of years to absorb that supply. That's what leads just to be a cyclical industry. And so we certainly prepare for those sorts of downturns and that's one of the reasons that we want to invest in some newer assets that can tend to garner much longer contracts and help to insulate us in those downturns.
So, the Discovery rigs that we just acquired, they are what we call ultra-high spec jackups. They are really a notch above most of the newbuilds that are under construction, probably about 25% to the two-thirds of the new rigs that are under construction we would consider ultra-high spec, that's 2 million pounds of hook load, 400 foot water depths, ability to drill high pressure, high temperature wells and work in harsh environments. And you hear a lot of analysts talk about bifurcation in the market and typically they are referring to new rigs versus old rigs. And we don't see it that way because you see these dots represent fixtures, any new contract and you can see all the fixtures in the offshore drilling market over the last several years, the grey represents the rigs that were built in the early ‘80s. The orange represents the standard newbuilds and you can see the rates are slightly higher but they are not dramatically higher. But then the blue dots represent the ultra-high spec rigs and so for an incremental $30 million or so of investments on a $200 million investment, you're able to achieve much higher rates and much higher returns. And so that's why we build the rigs of that class. We just saw incremental returns on that investment over these orange rigs.
On slide 22, you can see the contract status of our fleet. And again we expect to secure long-term contracts for both of the Discovery rigs, the Triumph and Resilience sometime over the next six months or so. And when you layer that -- whatever that new backlog is on versus our existing backlog, it's going to be a nice attractive piece of our business that will provide some stability through the cycles. Again the Hercules 261 and 262 are now contracted through the end of the decade. The 266 is also with Aramco, it currently runs into mid-2015. And so we wouldn't be surprised to see something similar at some point over the next year there with a potential extension of that contract as well.
So we like our position in the international market. It’s sort of a niche position with a third of our rigs in Saudi where we’ve met the upfront requirements. We expect those rigs to remain there for the long term. The 261 and 262 moved in 2008 and again now good visibility of them being there till 2020. And then of course, the Triumph and Resilience at the high end of the industry, so we are excited about those as well.
Moving on to our international liftboat business. Since the company was formed, this business has provided the most stable results as well as the highest returns. So we also have a very strong position, much like we do in the U.S. Gulf, we have a very strong position in the West African liftboat market. We have about a 60% share of the fleet in that region and demand there has been growing since we have been in that business since 2005. And the dayrates have been very stable at high levels. Our average dayrate is about $23,000, our operating costs are about $8000 per day, so very nice margins, nice returns, very stable business, tends to be focused on production oriented activities, well intervention and maintenance, platform maintenance. So it's a big infrastructure in West Africa of about 900 fixed production platforms that need maintenance whether or not oil prices are high or low.
And really the key difference I think between the U.S. market which again we divested of our position there and in West Africa or the Middle East is the fact that the U.S. market was much more fragmented. We didn't see a good opportunity to consolidate that and there was excess capacity with really no visibility of that abating given the demand has been fairly stagnant.
One of the questions that we get a lot is would you sell the international liftboat business? And of course, anything is for sale at a price, we received attractive price for one of our rigs in Mexico a couple of years ago. We weren't necessarily looking to sell it but it was attractive and so we took it. So of course we will sell anything for the right price. But I think more importantly we do see opportunities to grow this segment, if we're unsuccessful in those and that, let’s say, down the road our jackup business grew materially and we looked up in this business was only 5% of our overall revenue or something like that, we might change our view and say it's not core. But today it's still very meaningful to us. It represents about 20% of our revenue.
Moving on to some of our strategic items and events that we've -- accomplishments over the last few years. Again we're a opportunistic company, we're acquisitive. We don't have just a consistent newbuild program. We're going to try to time on investments given that this is a cyclical business and be very selective in what we acquire. We already touched on the Discovery rigs, but aside from that we've only acquired two other rigs over the last two years. And we’ve looked at certainly a lot more than that, expected a lot of other rigs, again speaking to how selective we are but these first two acquisitions that are shown here, the first is Ocean Columbia and the second the Ben Avon, very similar deals. We structured a transaction with the seller whereby we had marketing rights for those rigs for about 90 days. That enabled us to go secure long-term contracts, three year contracts in both cases with Chevron in one case and Aramco in the other and really de-risk those investments. So, we wouldn't have had to do the acquisition if we were unsuccessful. That also enabled us to really push the rates because we didn’t have anything to lose, if we were successful, we just wouldn't have acquired the rig.
So, we were able to get very attractive contracts, long-term de-risk the investment, lock-in returns in the low 20% range. So both these rigs were built in the early ‘80s. So looking at rigs like that we are going to de-risk the investment. The Bull Ray was a relatively new liftboat. It’s a good example of our opportunistic strategic. It’s a company that really has stranded asset there. They initially had a rig and a liftboat in the region. The rig had an unfortunate incident where there was a total loss and so they were really looking to move out of the region and so saw us as the largest provider of liftboats in the region and someone who had cash that could move quickly on the deal, we were able to strike an attractive deal to acquire this new high spec liftboat that was built in 2008. So it’s the youngest liftboat in our fleet now and the largest and it's been working at $65,000 a day since we acquired it in April. And the operating costs on the vessel are about 14. So a very attractive deal for us, also it should generate greater than a 20% return based on those dayrates .
You can see here on slide 26 where historically our Domestic Offshore business again has been our largest segment at 50% of our revenue. But we are slowly transforming the company where we are going to continue to have a strong position in the U.S. but we are building our international business, more diversifying geographically. So, with the recent moves, those two acquisitions I just mentioned the Ben Avon, Ocean Columbia, later in the Discovery rigs we should move -- our domestic offshore will now be about a little over 40% but international offshore importantly moves up from about 20% to 40% as we sold these low return Inland Barge business and the Domestic Liftboat business. So we like this mix and quite frankly we would expect this international offshore to grow further over the next five years, that's where we see most of our growth opportunity is.
I touched on this briefly but again with the recent contract extensions to Aramco, we've increased our backlog by 60%. So, very substantial build in our backlog and I think it’s important to note that’s in advance of any long-term contracts on the Discovery Offshore rigs which again we would typically expect those to build the secure contracts two to three years at some point, we haven't been able to match up the timing yet and we contracted the first rig for relatively short-term but at some point both will probably go on long-term contract and really expand this backlog further and take it to the next level.
So in conclusion, again we had a very active second quarter. We are excited about the Discovery Offshore acquisition. While it’s only two assets you couple that with the new liftboat those two generate a very substantial portion of our cash flow, even next year in a upturn about 20%, but in a downturn those will provide very stable results.
Again we're continuing to high grade the fleet and tweak the portfolio. We were pleased to be able to sell our low returns Domestic Liftboats and Inland Barge segment and use some of those proceeds to reinvest in the higher spec assets. The U.S. Gulf of Mexico business is very strong right now, continuing to have upward momentum. Our backlog has slid gradually over the last few months. We think that's just a seasonal occurrence. And as we move into the budget time for the E&P companies that we'll begin to see that rise again if they look to lock up rigs for their 2014 drilling programs. And again they are largely focused on oil, which has been much more stable.
The international jackup market is very strong right now. Despite the fact that you don't have the same dayrate momentum that you had in past cycles, dayrates are still relatively attractive providing high returns. We think the recent contract on the Triumph as well as the 261 and 262 are good examples of that. We are going to continue to try to acquire assets that can add backlog we want to continue to reduce the risk in our business, it's been very strategic for us to reduce the risk. We think that will improve the trading multiples on our securities. So, all these strategic moves are -- tend to focus on reducing risk. The recent refinance of our 10.5% notes with 7.5% debt, it’s again going to reduce our fixed charges by about 10% next year and we have good visibility of future improvement with the early call provisions on notes in 2014 and 2015.
And lastly no investor presentation will be complete without applaud for our management team. I think we did a pretty good job of navigating the down cycle and some of the challenges that were thrown our way that were like the Macondo event that were no doing of our own. And anyway so we continue to see good improvement in the credit that's going to be important for us as well as we've had the leading shareholder return in our business for the last two years. And this year we're right now into the top of the charts again. So, thank you.
I think Kathryn, we have time for any questions so? No? Okay. All right, thank you for your interest.
[No Q&A event]
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