Has the Market Overreacted to Offshore Drillers?

by: Chain Bridge Investing

The fallout from the Deepwater Horizon incident (the “Incident”) not only continues to decrease the market capitalizations of those companies involved, but also has triggered price declines of similar magnitude in offshore, oil-related, and gulf-related companies not directly involved in the incident. Although there are reasons for these declines, which appear to be driven primarily by uncertainty, it would behoove any value investor to take the time to analyze a few of these companies, especially the ones in the offshore drilling industry, as the downward pricing pressures appear to be overdone in certain companies.

At present, there are two groups of companies, those companies that are directly involved with the Incident and those that have operational exposure to the Incident or the affected industries. The directly involved companies face the following threats:

  • Threat One: clean-up costs and legal liabilities;
  • Threat Two: potential increases in insurance and regulatory operating costs;
  • Threat Three: potential restrictions on the future of offshore drilling in the Gulf of Mexico; and
  • Threat Four: the impact of the changes in the Gulf of Mexico to each company’s respective global industry.

Furthermore, the recent increase on the credit default swap spreads of the directly involved companies indicates that market participants believe these companies face increased default risk. Such an increase in going concern risk is likely to be driven primarily by the uncertainty of Threat One, instead of the other threats.

The following exhibits (Exhibits 1 and 2, click on each to enlarge) provide an illustration of the price declines experienced by the involved companies relative to the levels of selected market indices. Transocean’s (NYSE:RIG) decline of 43.1% has been of the largest magnitude of the companies involved, while the others have experienced declines from 25.9% to 38.5%. Furthermore, one can see that the companies involved in the Incident have lost a total of $103.3 billion in market value.

Such a number greatly exceeds the current estimates of clean-up costs and potential liabilities, which have ranged from $12 billion to $50 billion. Given the excess by which the decline in market value exceeds the current estimates of clean-up costs and legal liabilities, these companies appear to have suffered – on the surface – an overreaction and are worthy of further investigation.

At present, the only company and industry of those directly involved with the Incident that Chain Bridge Investing has reviewed extensively is Transocean and the offshore drilling industry. In our opinion, Transocean represents a good buying opportunity at the current price for those investors willing to hold the company for a two-year period.

Despite the increase in the credit default spreads, Transocean has a strong liquid asset position with regard to its outstanding liabilities and does not appear at risk of breaking any of its covenants. This position is derived from the free cash flow it gathers from its international operations, its current cash position, and the company’s insurance coverage. Such attributes will allow Transocean to manage through the consequences of the Incident, the current industry down cycle, and Threat Two through Threat Four – which are primarily industry headwinds (these will be discussed more with the offshore drillers below).

As long as the company maintains its fleet of drilling units, especially the deepwater and ultra-deepwater units, the company maintains its long-term ability to produce significant cash flow even though the industry’s headwinds may temporarily pressure both its earning power and cash flow. At the end of the day, the industry is cyclical and a rebound in the next year or two will most likely favor the company’s stock price.

Our evaluation of Transocean, while focused on operations, does not ignore the possibility of Threat One. We believe that this threat is offset, in part, with the indemnification provided in Transocean’s contract with BP and the history of contract sanctity that has prevailed in the offshore drilling industry. Yet, we are aware that the possibility of gross negligence on Transocean’s part could override the indemnification, even if such evidence has not yet surfaced. At present, such a possibility currently appears to be of low risk. Nevertheless, although we may like Transocean as a buy in the current situation, the existence of Threat One may remove it as an investment option for some investors.

For these investors, we recommend considering the second group of companies, which consists of those companies not involved in the Incident but with exposure to the Gulf of Mexico, the oil industry, and/or the offshore drilling industry. In particular, the following primarily focuses on the offshore drilling industry. These companies have various degrees of exposure to Threat Two through Threat Four and avoid exposure to Threat One. Yet, these companies have experienced price declines of similar magnitude to those of the involved companies, as seen in Exhibit 2, 3 and 3a. Such price declines may be indicative of an industry wide negative price overreaction by market participants. Nevertheless, while such declines appear worthy of investigation, one must not assume - without proper research – that the previous market values represented the companies’ actual fair value.

From a top-down perspective of the offshore drilling industry and Threat Two through Threat Four, the offshore drillers listed in Exhibit 3, (click to enlarge), appear worthy of further investigation due to the following:

  • Offshore drilling will not cease to exist. Offshore work and opportunities continue to expand in Asia, Africa, the Middle East, and South America. Energy demand continues to be viewed as increasing in the mid to long term and thus more offshore reserves will have to be tapped. Furthermore, the depletion rates of wells are increasing, fueling the need for increased drilling activity in the future. Alternatives still have a ways to go before replacing the existing demand for global petroleum demand.
  • Offshore drillers will likely face increased insurance and regulatory costs. One must remember that many drillers post operating margins between 40% to 60%, thus providing the drillers with some room to absorb decreases in dayrates and increases in costs. Moreover, the offshore drillers may be able to pass a portion of the increased costs to their customers. Also, the additional costs are likely to be more acute in the near term than in the mid to long term. As time goes on, not only will the offshore drillers’ expense line likely consist of more recurring expenses than one time expenses, but efficiencies in manufacturing the new equipment and implementing the new regulations will likely decrease the costs. Furthermore, drillers with large fleets may be able to lower their increased costs by using their size to achieve scale discounts on certain additional equipment.
  • The moratorium in the Gulf of Mexico, which prevents new drilling and forces current drilling to stop for the next six months, will most likely be lifted before or during early 2011. With the Gulf of Mexico accounting for approximately 31% of domestic oil production and 11% of total domestic natural gas production, the United States should not risk the economic consequences of delaying continued development of this area for too long. A continued freeze on the Gulf of Mexico could eventually result in higher petroleum prices, less royalty payments to the Federal Government, and increased unemployment with nearly 150,000 jobs related to offshore drilling in the Gulf of Mexico.
  • The moratorium, in the near term, will produce an additional surplus of drilling units available for contracts. This situation will most likely decrease dayrates for new contracts, especially in deepwater and ultra-deepwater areas, across the whole industry. Nevertheless, as mentioned above, there continues to exist growing offshore growth (including deepwater and ultra-deepwater) outside the Gulf of Mexico. Moreover, most of the oil companies (the customers of the drillers) currently involved with the Gulf of Mexico are large and liquid enough to wait this situation out. When the moratorium is lifted, some of the decline in dayrates may, in part, be offset by pent up demand for drilling.
  • The offshore drilling industry is currently in a cyclical downturn and may not have bottomed yet. While some of the offshore drillers report that the current state of the economy and their industry have forced a few competing drillers out of the industry, the industry, surprisingly, has not witnessed the significant weed out of smaller players that it had expected during a downturn. With additional potential pressure coming on dayrates and more available drilling units on the market as a result of the Incident, more competitors may be forced out of the industry.

Combine our view of the industry topics mentioned above with an analysis of each driller’s characteristics, and one appears likely to find at least one or two companies that recently suffered a negative pricing overreaction. As seen in Exhibit 3a (click to enlarge), each driller has varying degrees of exposure to the Gulf of Mexico and fleets with different drilling units. Consequently, the Incident cannot affect each company the same way, especially when they are not exposed to Threat One. For value investors looking to hold a company for a year or two, they may find it profitable to look for possible investments amongst the companies involved with the Incident and those that were not involved.

For the benefit of our readers, we have included Exhibit 4 (below, click to enlarge), for those interested in companies outside the offshore drilling industry.

Disclosure: Long RIG