Hercules Offshore: Undervalued Titan In The Gulf

Mar.26.14 | About: Hercules Offshore (HERO)


Shallow water day rates at historic highs; riskier deep water rates dropping.

Hercules Offshore dominates the Gulf of Mexico; grows internationally.

Russia may push oil rig operators to record valuations.

Hercules Offshore (NASDAQ:HERO) operates the 4th largest jack up fleet in the world. This shallow water driller has undergone a phoenix transformation. Once a $40 stock, the company came on hard times when the recession hit in 2009. This was nothing in comparison to the after effects of the BP (NYSE:BP) oil spill of 2010, which all but shut down any meaningful GOM production. Competitors closed shop, bankruptcy prevailed and under Executive Order from the White House the industry operating in this region came to a complete standstill. With the common trading at $3 many felt the company was destined for the scrap heap. Management had other plans, as 2011 heralded a strategy that has been described as one of the most epic turnarounds in drilling history. In 2011, Hercules Offshore consolidated complete control of the GOM, by acquiring Seahawk Drilling, the second largest shallow water driller. This buy drew accolades far and wide. The deal had Hercules Offshore buying Seahawk's 20 rigs out of bankruptcy for $25 million in cash and 22 million shares of their common stock. The deal was not without controversy as Seahawk creditors were forced to accept a $105 million valuation, when many felt that Seahawks rigs were worth more than triple that amount. The combining of 30 Hercules Offshore rigs with the 20 rigs acquired from Seahawk, resulted in substantial cost savings. Then with little fanfare the Presidential ban on drilling the GOM was lifted and Hercules emerged nearly twice as large, with newly acquired oil leases in tow.

Significant Day Rate growth & stability in shallow water:

Since 2010, day rates for Hercules Offshore rigs operating in the GOM have jumped from the mid $30K range to over $100K today. Correspondingly the average contract length has increased as well. While GOM shallow water day rates have gone up to historic highs, and remain in place, the deep water players have seen day rates weakness. Recently Diamond Offshore (NYSE:DO) reported downward day rate pressure on its deep water rigs. Noteworthy in that earnings report where falling rates, over previous 2013 price peaks. Many expressed concern over the supply-demand balance in 2014. Offshore Driller Noble (NYSE:NE) also saw day rate declines in their deep water segment, but noted a stable jack up market. The issues impacting deep water driller are primarily due to the influx of newly built deep water rigs that are now entering the market.

Shallow water drillers in the GOM appear immune from the travails of the deep water drillers, and entrance barriers to market keep it that way. Moving a jack up rig to the GOM is a massive undertaking, factors have to be weighed:

‒ Mobilization cost ($5 million to $10+ million)

‒ Insurance cost (up to 60% higher in US GOM)

‒ Labor cost and existing shore base/scale

‒ Income tax rates typically higher in the U.S. GOM

‒ Opportunity cost to leave existing market

These entrance barriers are expected to keep "new built" shallow water rigs in this market closed for the foreseeable future. Operators are reluctant to send new builds to the GOM, when better terms exist in many other sites across the globe. According to Rig Logix, the jack up rig count in the GOM was as high as 170 in 2001. Today, only 58 rigs remain with 38 actively marketed.

Backlog is at Record Levels:

While the jack up rig count is down in the GOM, work for shallow water appears to be on the rise. Indeed, Ensco (NYSEMKT:EVP) reported on their most recent earning call a strong customer demand for their jackups in the U.S. Gulf of Mexico in 2013, and expect the market to remain in balance going forward. Noble who I mentioned earlier, also remarked on the stability of the jackup market in their recent earning calls.

The future stability of GOM shallow water drilling appears to be gaining more steam, with billions invested in the shelf since 2010. Of special note is Houston-based Fieldwood Energy LLC, who recently closed on the sale of the Gulf assets, owned by SandRidge Energy Inc. (NYSE:SD), and Apache's (NYSE:APA) shallow-water Gulf assets for a combined investment in the shelf of over $4 billion. Fieldwood CEO, Matt McCarroll has said that new seismic acquisitions and processing technologies allows the company to see deeper than before, and find more oil and gas that he believes is waiting to be discovered.

With over $8 billion invested in the GOM shelf, Hercules Offshore's dominance in the GOM shallow waters stands to be a main benefactor of this increased activity and historic day rates highs. Internationally, Hercules enjoys a Middle East presence that includes several rigs under long term contracts, some as far out as 2019. Their success in the GOM and internationally has created a billion dollar backlog for their jack up fleet, placing them in their strongest position since the stock traded over $30. Recent financials illustrate this driller has been undervalued, and under appreciated by Wall Street for some time.

Bright Future:

So what is Hercules Offshore doing with this new found cash flow? They are upgrading their fleet by focusing on ultra high spec harsh environment drilling. Their recent purchase of two Keppel FELS Super A rigs, valued at $416 million, allows them to compete in this highly desired drilling segment. Due to the limited supply of this class of rigs, day rates in the low to mid $200K range are common with longer contracts durations than other jackups. The Super A's can drill deeper under extreme temperature conditions and are able to withstand Cat 5 Hurricane type winds. The Hercules Triumph and Resilience rigs are among the most capable in the world today.

The Triumph's first contract was short in duration, but had a day rate in excess of 214K plus a sizable mobilization fee and is expected to sign a long term multi-year contract. First the rig must complete its contract with Cairn India (OTCPK:CRNCY), where is it drilling several high temperature high value wells in the Ravva Field. A location for this long term work has not been disclosed, but the North Sea or Southeast Asia is a possibility. The Resilience has picked up some short term work in Southeast Asia at the TGT field and is being marketed for a long term deal as well.

Hercules also announced in November a rig management agreement with Perisai Petroleum to act as operations and maintenance manager of the Perisai Pacific 101 and Perisai Pacific 102. As part of the agreement, Hercules has the right of first refusal to purchase those rigs.


From an investment valuation perspective, Hercules Offshore's book value is $5.16 and is currently trading at a discount. When we compare their estimated 2014 sales growth to other jackup players like Ensco and Rowan (NYSE:RDC), we see that Hercules Offshore ranks highest with a 26.80% projected sales growth; Ensco is next with 6.5% and Rowan with 2.4%

As higher day rates have a tremendous flow thru to earnings, we see that Hercules Offshore dominants with a 2014 earnings growth estimate of 122%. Rowan is next with 45.8% and Ensco with 3.7%. From a forward looking PE perspective, Hercules Offshore has the lowest at 6.7, with Ensco next at 7.26 and Rowan at 7.31.

An announcement of a long term contract, on the Super A Rigs, should have a positive impact to Hercules Offshore's sales and earnings estimates. The investment community is waiting for this catalyst. Analyst have set a price target from $5 to $11 with $7.39 as the average price. The stock price is currently under the lowest price target making it an excellent entry point.


While rising day rates in the GOM have had a significant positive flow thru to Hercules Offshore's earnings, they have also allowed the company to fund their international expansion into the harsh environment drilling sector. This remarkable transformation that started 36 months ago, gives investors a clear picture of the charted profitable future of this enterprise. Owning Hercules under $5.00 a share could very well prove to be the best oil and gas play of 2014.

With the recent developments in Russia, and the discussion of allowing US exports of natural gas and oil to Ukraine and other European countries, Hercules could see export market factors drive shareholder market cap beyond projections, making a strong case for share accumulation now. As always I encourage everyone to perform their own due diligence before they make investments.

Disclosure: I am long HERO, NE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.