By Stephen Ellis
In 2009, we wrote that we thought 2010 would be the year of Brazil, thanks to its huge offshore discoveries and equally large spending plans. In hindsight, we should have focused our gaze a little further north, as the aptly-named Macondo well and Transocean's (RIG) Deepwater Horizon made the Gulf of Mexico one of the biggest stories of the year. The ongoing impact of the spill has several implications for the sector in 2011. We believe that the short-term outlook for the sector is fairly murky, but the long-term outlook remains bright, as a significant portion of the global oil production being added over the next few years will come from offshore projects. In our view, the production increase should lead to higher rig activity levels and day rates.
The Moratorium Is Finally Over
The early lifting of the moratorium is possible because the industry has met several of the conditions that the Bureau of Ocean Energy Management, or BOEM, outlined as necessary, which include availability of spill clean-up resources, improved industry response plans, and the final plugging of the Macondo well. In addition, the BOEM has already required new safety and drilling practices in order for the drillers to obtain drilling permits, and the industry has shown progress here as well. Several deepwater drillers have managed to obtain permits, including Noble (NE) and Ensco (ESV), so progress is slowly being made.
Unfortunately, there has been limited progress for shallow-water drillers. The administration has very effectively halted shallow-water drilling in the Gulf by basically refusing to issue any new drilling permits, which has created a de facto moratorium. The hardest impacted players are Gulf specialists such as Seahawk Drilling (HAWK) and Hercules Offshore (HERO), but larger drillers like Diamond Offshore (DO) and Ensco also have a few Gulf rigs. The sector is fairly volatile in the best of times, but weak natural gas prices and difficult credit markets had driven rig activity to a fraction of its previous highs prior to the spill. Post-spill, the administration's new shallow-water rules about safety and operating practices have been unclear, stymied by red tape, and served by an understaffed group of regulators. Drillers are taking weeks and months to obtain permits that took just days to obtain prior to the spill. Thus, the shallow-water drillers may be in an even tougher position than the deepwater drillers, as many of the rigs in the Gulf cannot move elsewhere, as they are specifically designed to drill in the Gulf. Given that the typical shallow-water contract in the Gulf is for just a few months, and around $30,000 to $40,000 a day, it's harder for a large oil and gas operator to justify keeping the rig on standby, whereas a deepwater rig at $500,000 a day locked into a five-year contract is an entirely different question.
The significant financial and opportunity costs involved with cutting loose a deepwater rig explains why very few Gulf rigs have left the region since the moratorium was announced. Rather than risk losing the rig to a peer (likely Petrobras (PBR)) and introducing even more delays to potential billion-dollar projects, oil and gas firms are choosing to hold onto the rigs for the most part. The limited duration of the moratorium and the likely requirement that exiting a contract would result in the rest of the contract payment being due to the drillers are other reasons why the operators searched for alternatives. Happily, the drillers and their customers have reached a compromise with standby arrangements. The agreements will let the drillers receive low day rates for the duration of the moratorium, with the ability to resume their contracts at a full day rates after new drilling permits are obtained.
What's the Path Going Forward?
The lifting of the moratorium means that the offshore drilling industry faces an improved, but still murky, picture. We don't expect the BOEM to be in a hurry to issue shallow-water and deepwater drilling permits. In fact, we believe that absent a significant near-term increase in the price of natural gas, shallow-water drilling in the Gulf will remain at extremely depressed levels. In our view, the increased regulatory and operating risks will make future shallow-water investment harder to justify, especially as the region has already been extensively explored and developed. We are more optimistic about future deepwater development. Large discoveries such as BP's (BP) Tibor and Kaskida are likely to be pushed out, but the reservoirs should remain highly profitable investments for BP over the long run at current oil prices. Even though BP is selling numerous assets, we believe these two particular Gulf discoveries are not for sale, thanks to the huge potential.
We think BP's pragmatic approach indicates why the deepwater Gulf will be fine in the long run. In the near-term, we expect the 30 or so remaining deepwater rigs in the Gulf will slowly return to work throughout 2011 after they obtain the needed permits. We expect the rebound will be very slow, which will cause immense frustration to many in the industry. It will take time for the BOEM to finalize new regulations as well as speed up the process for approving new drilling permits. We believe the regulators currently handling the permits are woefully understaffed (only 20 employees are working on shallow-water permits) and do not have the resources to fully evaluate if the drillers' permits are meeting their more complex requirements.
Still, for the same reasons that the oil and gas operators didn't cut and run during the moratorium, the industry will largely keep its Gulf drilling plans intact. The actual timing of the rigs returning to drilling and moving off standby agreements will play havoc with 2011 results for the drillers, which include Transocean, Noble, Ensco, Pride (PDE), and Diamond Offshore. Still, we believe the increased regulatory and safety-related costs are manageable, as the initial guidance from the administration implies a 1% to 2% increase in the cost of drilling a shallow-water or deepwater well. Ultimately, we think additional rules that will likely require enhanced blowout preventers will push the cost increases to around 10% to 20%, but the costs can be passed through by the driller to the operator over time through a higher day rate. From the oil and gas companies' perspectives, the Gulf still remains one of the best ways to obtain access to oil in a world where the majority of the world's oil reserves are controlled by national oil firms. This analysis suggests strong levels of deepwater Gulf investment over time, and the drillers' Gulf results gradually returning to their pre-spill earnings power in 2012 and later.
Best Ways to Play the Gulf
We view Transocean as the best way to play this thesis, as it has one of the largest Gulf exposures among the drillers that we cover. In our view, the legal uncertainties surrounding the firm's role in the spill will diminish over time, or be much less than what the market is pricing in, which should lead to a higher stock price. We believe Transocean's long-term earnings power is greater than $10 per share. Even in the $60 per share range, we view the stock as undervalued.
For an investor who wants to avoid the legal uncertainties associated with the spill, we think Noble is an attractive opportunity. The firm's deepwater exposure is lower than Transocean's, but we think highly of management's ability to allocate capital, and its overall focus on shareholders. Outside of Transocean, the company has probably suffered the harshest near-term impact, with many of its deepwater Gulf rigs shifting to standby agreements for the moratorium.
Noble has tried to turn lemons into lemonade with the acquisition of Frontier Drilling. We think the deal was smart, as it cemented a long-term relationship with Shell (RDS.A), and acquired several deepwater rigs at a very reasonable price from a distressed seller. However, the Shell relationship came at a short-run cost, as many of the acquired rigs are on standby agreements for the length of the moratorium. The economic impact of $500,000-a-day rigs converting to $60,000 to $70,000-a-day standby arrangements has taken down our 2010 estimates. That said, 2011 should improve as the rigs return to work. 2012 looks brighter, as the industry recovers from the spill, and Noble's earnings start to resemble its long-term earnings power. Trading at only slightly above the book value of the firm's rigs, Noble looks like a solid opportunity to us.