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The oil services and drilling companies like SeaDrill (SDRL) benefit from the increased capital expenditure on developing new assets by energy companies. The trend in spending on developing off-shore assets has been extremely encouraging for the drilling companies. Capital expenditure by the energy companies is directly related with the commodity prices and reserves levels. Despite harsh macroeconomic conditions, oil price have been on the higher side and Brent is still above $105 per barrel. Furthermore, it seems that the upward trend in the oil prices will continue as the recovering global economy fuels the demand for oil. As a result, capital spending by the energy companies is expected be on the higher side. The situation becomes very favorable for SeaDrill as it is one of the premier off-shore drillers.

Trend in Oil Prices

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The graph above is taken from the Energy Information Administration. It is clear from the graph that despite the volatility, oil prices have been on an upward trend. And current prices are substantially higher than the levels in June 2009. The upward trend in the oil prices despite harsh economic conditions is an encouraging sign for the energy companies. However, due to the increased focus on production and increased supply, we might see a short-term trend in oil prices. Nonetheless, long-term fundamentals for oil prices are strong and it looks like the price will remain on the higher side.

Contribution of Off-shore Drilling in the Total Production

The total contribution of off-shore drilled oil is rising in the total global oil production. In 2010, off-shore hydrocarbons accounted for about 6% of the production, which is expected to go up to 9% by 2020. There are unconventional oil reserves available to replace depleting land reserves; however, the faster depletion of unconventional reserves has brought more focus to the off-shore reserves. The supply of rigs is increasing due to the increased demand from the energy companies. However, the market for ultra-deep water rigs is very strong. There have been over 20 discoveries on average in the past two years, and the increased success rate has also prompted the energy companies to spend more on off-shore drilling.

Petrobras, Brazilian oil giant, has announced that it will contract 26 rigs in order to develop its deep-water oil field discovered in 2006. These rigs will be rented for about 15 years and there are estimated reserves of about 8 billion barrels of light sweet oil. Petrobras is only one example in the sector; there are a number of players trying to get more blocks to develop off-shore assets. ONGC Videsh recently received license for two oil and gas blocks in Sudan. Furthermore, Chevron (CVX) has also received approval to develop Alder Field in the North Sea.

Premium Prices for Services

Off-shore drilling is an extremely complex way of accessing oil, especially, deep water and ultra-deep water drilling requires very high level of technical expertise and results in premium pricing. As a result, drilling companies like SeaDrill are able to generate extremely impressive margins. As I mentioned above, the trend in oil prices indicates that the spending on exploration will likely remain high, which means there will be future contracts for drillers.

At the moment, the ultra-deepwater drilling day rates are over $550,000 - a rig costs around $600 million and it is rented for about 2/3 years contracts. At these rates, the payback period of the rig becomes considerably short. In my opinion, the supply of ultra-deepwater rigs will not exceed the demand in the short-medium term. As a result, the day rates will likely remain on the higher side. The trend in oil prices and capital expenditures indicates that the development of off-shore assets will continue at a high rate resulting in high demand for rigs.

Conclusion

The fundamentals remain strong for SeaDrill. There is strong demand for rigs for ultra-deepwater drilling and day rates remain high. Furthermore, the energy companies continue to focus on the untapped off-shore reserves in order to replace depleted reserves. Majority of the off-shore drillers have handsome order backlogs, which provides clarity regarding future earnings and cash flows. Furthermore, the capital spending by drilling companies also indicates that there are no short-medium term concerns about the demand for their services. SeaDrill should continue to grow due to the strong demand for its services, and the stock price will rise over the next two-three years.

Source: Market Fundamentals Are Strong For SeaDrill