- Why the diminishing stock value?
- Ensco's competitive advantage.
- Driving forces that will create shareholder value.
- When is the buying opportunity?
Over the past year, Ensco PLC's (NYSE:ESV) stock price has been under significant pressure. Since its high in March of 2013, the stock is down just over 16%. What are some of the factors contributing to this? And what should an investor expect moving forward?
If we look at the whole sector, you will notice all of the companies within the sector have experienced a tough 2013 and 1st half of 2014. As the chart indicates below, Transocean (NYSE:RIG), Seadrill (NYSE:SDRL), Diamond Offshore (NYSE:DO), and Noble (NYSE:NE) have also significantly declined over the past 12 months. The chart below shows that Seadrill has held up the best, while Diamond Offshore has performed the worst as that stock is down 26.8%.
So, as the whole sector has been declining, what are some of the factors weighing down the stocks and what are some of the possible outcomes?
Over the past few years, the demand for deep-water drilling has been strong. Driven by rising commodity prices and advancing technology that has made deep-water and ultra-deepwater reserves economical, the industry has seen substantial gains. As the demand and ultimately day-rates increased, the drillers responded by placing orders for a record number of rigs. So, as there has been a record number of rigs flooding the market, we have the issue of over capacity.
As the chart provided by Offshore Magazine reveals, there was a dip in the amount of working offshore rigs in late 2013. Coinciding with the dip was an increase in total fleet. As there were less rigs working and an increase in total fleet, we began to see the issue of over capacity.
Magnifying the issue of over capacity was the major E&P companies' announcements that they were going to cut capital spending in order to increase margins. As you can see by the chart, the industry experienced a significant drop in price in late January. This drop occurred around the same time these companies, being Exxon (NYSE:XOM), Chevron (NYSE:CVX) and France's Total SA (NYSE:TOT), made their announcements.
In a press release issued by Exxon, Rex Tillerson, chairman and chief executive officer for Exxon, stated:
Capital spending will decline to $39.8 billion this year from a peak of $42.5 billion in 2013. Excluding potential acquisitions, capital expenditures are expected to average less than $37 billion per year from 2015 to 2017.
As many of these deep-water reserves are more capital intensive than their onshore counterparts, many E&P companies put some of their more expensive projects on the back burner.
So in late 2013 and early 2014, the industry had some major setbacks. As the price chart indicates above, this has had a significant effect on the stock prices.
What is in store for the industry moving forward
The short-term outlook does look volatile for the sector. As E&P companies are looking to increase their margins, this will have a significant effect on the floater market. Currently, the floater market is expected to remain weak over the next year or so. Recently, Ensco's management stated in the Q1 report:
"Nevertheless we have seen the floater market soften this year, including some floaters going idle recently in certain regions, as the supply of new rigs coming into those markets and delays in customer drilling programs have affected the balance of supply and demand."
This statement is supported by Morgan Stanley research as they estimate a weak floater market through to 2016.
As the ultra-deep reserves are the most capital intensive, this area of the market is expected to be the "hardest hit" by the majors capital cutbacks in the short-term.
From a driller's point of view, the weakness in the floater market is of significant concern as the bulk of their revenue come from that side of market.
In Q1, Ensco PLC reported revenue of $740.5 million from floaters such as drill ships and semi-submersibles. This is up 3% from Q1 2013, but equates to ~79% of the company's total revenue. Ensco's Q1 floater dayrate was reported at $446.301 which is in line with the industry average listed below.
Chart sourced by (Offshore Magazine)
Even though the floater market is displaying weakness, demand for the jack-up market in general has remained fairly strong.
In Q1, the jack-up market provided Ensco with a revenue of $429.9 million which was up 5% from a year ago. Their Q1 jack-up dayrate was reported at $130.934 which again is in line with the industry average.
So, as Q1 dayrates are in line with the industry, what is a catalyst for the company?
If we look a little deeper at where the company's earnings are located along with new rigs coming on board, we will see where the value is and get an estimate of where the company is going.
Jackup rigs coming online:
Over the past couple of years, Ensco PLC has had two ultra premium, harsh-environment jack-up rigs and a premium, harsh-environment rig under construction. The ENSCO 120, 121 and 122 are rigs that will demand a premium dayrate.
Was the 1st of three ultra premium, harsh-environment jack-ups to come online last year. Commissioned by Nexen, the rig currently has a dayrate in the mid $230,000.
The second of the three ultra premium, harsh-environment jack-ups is contracted to work in the North Sea beginning this month at a dayrate of ~$230,000.
The third of the series is also contracted to NAM in Dutch and the UK sector, and is expected to be delivered in Q4 2014. Like the previous two rigs, it is also expected to generate a dayrate of ~$230,000.
The rigs unique design significantly increases Ensco's capability to provide high specification, harsh environment jack-ups across the North Sea.
Still under construction are the ENSCO 140, ENSCO 123, which are expected to be delivered in 2016, and the ENSCO 110, which is expected to be online in 2015.
While customer demand in the jack-up rig market remains positive, the presence of uncontracted new build deliveries has created supply pressure in the market which is expected to result in an increased number of older jack-ups and floaters being retired.
As the market is "squeezing out" the older less efficient rigs, Ensco has divested 14 of them since 2010. Recently, Ensco sold its two remaining cold-stacked jack-up rigs for $33 million. The company did well as net book value of the two rigs, ENSCO 69 and Wisconsin, was approximately $9 million.
So, as the company is selling off the weaker assets and putting cash into newer assets, Ensco will be able to demand higher than average dayrates for its rigs within this weaker market.
With the world's largest fleet of premium jack-ups, the 47-rig fleet includes, two ultra premium harsh-environment jack-ups and one premium jack-up which is still under construction. Since 2005, Ensco has invested more than $2 billion in its jack-up fleet and is set to outperform its competition within the short-term.
Short-Term Outlook for Ensco
As issues surrounding overcapacity and capex reduction are on the table, how will this effect Ensco? At this time, I expect that Ensco's operating margins within the short term could show some weakness. We have already seen this, as the company's operating income dropped by 4% compared to a year ago. This is expected due to over capacity issues and weakness within the floater market. As 2015 looks to be the weakest year for offshore capex spending, I expect this trend to continue.
In an updated estimate of deep-water capex spending by Douglas-Westwood, you can see the decline in capex spending estimated for 2015. Having stated that, at this point 2016 and beyond look to be very strong. As the industry absorbs the capacity issues, commodity prices increase and technological enhancements create opportunities for E&P companies to access their reserves while keeping their margins, the door again will open for deepwater drillers.
If we look beyond 2016, oil prices are expected to increase to $125-$150 a barrel. The main driver for this increase is the global consumption of oil and gas. Total oil production is expected to grow just 1.3% CAGR through 2020, but ultra-deepwater production is projected to increase by ~19% CAGR. This will have a positive impact on the floater market thus creating revenue and increasing margins for the drillers.
So, the next year will pose some issues for offshore drillers and companies that focus on the offshore drilling market. Having stated that, the issue of overcapacity will quickly be absorbed as capex spending resumes its upward trend.
Who to invest in?
I do not think it is a coincidence that the two companies that have performed the best are the two best positioned to weather this storm.
Currently, Seadrill has an average floater age in the range of 6 years, while Ensco has an average floater age in the 12 year-old range. When analyzing rigs that serve depths equal to or below 7500, Seadrill has an average floater age of 3.1 years, while ESV has an average floater age of 3.8 years. In this soft market, these rigs will demand a premium.
Charts sourced by (Seadrill)
When looking at the average jack-up age, Ensco has one of the oldest fleets. With the average age at ~28 years, the advantage that ESV has over the competition is the sheer number of rigs. As stated earlier in the article, the dayrates for ESV are in line with the industry average.
Risk and Value
In the short-term with the issues of overcapacity and capex spending hanging over the industry's head, Ensco is a company that is not immune to these circumstances.
Over the next couple of years, as market conditions look to be on the weak side, I do not anticipate much in the way of capital appreciation but do see support driven by a robust jack-up market.
Long-term, as E&P companies focus on their deep-water reserves, the floater market will again pick up. When this time comes, Ensco has one of the youngest and most versatile fleets in the market. These ships are expected to demand a premium.
Over the past year, Ensco investors have watched the stock fall ~16%. As the stock has come off, I believe a slow and steady accumulation on weakness is a strategy that will payoff in the long-term. In looking at the current issues regarding overcapacity and capex spending, I believe the market will absorb these issues over the next year or so. The fact is, the oil and gas is there and the market will want it. At this point in time, the majors have stated they will wait for the right market conditions to access the energy so they maintain their margins. Even though the next year or so could be quite volatile and there is limited earnings growth expectations for the company, Ensco pays a very attractive 5.80% yield, and has the largest fleet of jack-up rigs in the market which will help the company weather the current storm. Over the next 3 to 5 years, as the market again focuses on ultra-deep reserves, ESV has a strong fleet designed ready to capitalize on this demand. Next year will pose some issues for the company, but long-term, as capex spending increases and the market focuses on deepwater reserves, Ensco PLC is well positioned to capitalize on this.