- The market is putting too much focus on the short-term.
- The offshore drilling segment will make a strong comeback.
- Oil and gas companies will eventually increase the capital expenditures.
The off-shore drilling sector has come under pressure due to the concerns about a decline in the capital expenditures by the oil and gas companies and the fear of falling day rates. Most of the companies operating in the sector are feeling the heat and the stock have lost value. Seadrill (NYSE:SDRL) is one of the biggest and most important players in the sector, which I have covered in detail in my previous articles. Seadrill is also down year-to-date along with its peers - Seadrill, Transocean (NYSE:RIG) and Diamond offshore (NYSE:DO) have lost about 19%, 20% and 21%, respectively.
The fundamentals of the industry as well as the players involved remain strong, in my opinion, and I believe the market has been harsh on these companies due to a short-term risk. I believe the recent fall in the stock price has offered a great opportunity to the long-term investors to increase their exposure to the off-shore drilling sector. I expect these companies to make strong recovery over the next 12-18 months due to the increased activity - however, my focus will be on Seadrill in this article and I will talk about the long-term prospects of the company.
The biggest fears about the sector are oversupply and decreased capital expenditures by the oil and gas companies. As I have mentioned in my previous articles, the fear of oversupply is overblown and the companies having the newer ultra-deep water fleet will not be affected by the increasing supply of rigs in the sector. As it is clear from this fleet status report, most of Seadrill's rigs are sixth-generation ultra-deepwater rigs, which fetch the highest day rates. The demand for these rigs will remain high even if the supply of rigs increases over the next few years. The oil and gas companies are more concerned with the environmental risks that can result in heavy penalties. As a result, these companies are ready to pay premium for the newer, safer rigs with a company that has long experience of safe and efficient operations. The decision by the oil and gas companies to decrease the capital expenditures will also be short-term, in my opinion.
Capital expenditures only in North America has risen by about 46% over the last four years - at the end of 2009, capital expenditures by the energy companies in the region were $243 billion, which has gone up to $355 billion by the end of 2013. The last four years have seen elevated levels of capital spending due to the shale revolution in North America. It is normal that the industry is going to experience a lower level of capital expenditure in the short-medium term. Most of the companies are now focusing on achieving higher efficiency from the current operations, and the capital expenditures are now shifting towards midstream segment. Furthermore, after such a period of high capital budgets, these companies are under pressure from the shareholders to cut back on costs and return more capital to shareholders in the shape of cash dividends and share buybacks.
Companies like Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) and Statoil (NYSE:STO) have announced decreased capital expenditures - Shell will decrease its CapEx by 20% and keep it around $37 billion and Statoil will keep its CapEx around $20 billion over the next two years, 8% below the previous estimates. Chevron (NYSE:CVX) will spend over $35 billion on E&P activities during the current year, out of which, about $8 billion will be spent on the deepwater and Permian basin developments. At the moment, there are 58 rigs operating in the Gulf of Mexico and 17 new floaters are scheduled to enter the area through the first quarter of 2015, indicating the activity in the region will remain strong. However, these companies will eventually need to increase the capital expenditures in order to replace depleting reserves. Furthermore, another reason for tighter capital budget is the expected weak price of oil during the current year, which I believe will improve in the medium-long term.
Seadrill has taken measures to counter the short-term slowdown in the sector. The company has already halted its own capital expenditures and turned its focus to enhancing its own balance sheet. Seadrill is dropping down its assets to its subsidiary, Seadrill Partners (NYSE:SDLP), and the cash generated from these dropdowns will be used to decrease the debt of the company as well as increase the future dividends. The most recent dropdown was the sale of West-Auriga, contracted to BP Plc (NYSE:BP) till 2020 and the rig is in operation in the Gulf of Mexico. At the moment, the rig is fetching a day rate of $565,000 and it will continue to operate in the region till the expiration of the contract as I have mentioned in a previous article that BP plans to invest about $4 billion every year in the region. Furthermore, the company has decided to keep its dividend unchanged in the short-term, which should give more support to its cash flows and EBITDA.
The bottom line is that the market is putting too much focus on the short-term and it has resulted in these companies losing considerable value. However, the long-term prospects of the industry as well as Seadrill remain bright, in my opinion. The company has shown that it is able to negotiate contracts for its new rigs as well as out of contract rigs - the day rates are still high - and the capital expenditures will eventually increase as the short-term pressure dissipates and the companies try to exploit the reserves in East Africa and the Arctic. Long-term shareholders of Seadrill should not be worried and those investors, who believe in the long-term prospects of the sector, should increase their holdings as I believe the fall in price has given a very good entry point.