One important financial concept is the payback period. The payback period is defined as "the length of time needed to recover the cost of an investment." In other words, the payback period tells you how long it will take for the cash flows from an asset to total the cost; this metric tells us how long it takes for an asset to pay for itself. Investopedia offers further insights:
All other things being equal, the better investment is one with a shorter payback period.
For example, if a project costs $100,000 and is expected to return $20,000 annually, the payback period will be $100,000/$20,000, or five years.
There are two main problems with the payback period method:
- It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.
- It ignores the time value of money.
As Investopedia points out, relying solely on the payback period to make investment decisions is foolish. It can still be a helpful metric to consider in an analysis, however. The payback period simply tells a decision-maker how long it takes to make them whole on their investment. The cash flow earned by the asset after the payback period is fulfilled is thus creating wealth for the owner of the asset.
The concept of the payback period can be used to provide one analysis of the drilling rigs used by the offshore drilling industry. SeaDrill (SDRL), one of the largest companies in the offshore drilling industry, included this chart in their presentation (.pdf) at the SEB Enskilda Nordic Seminar:
right click to enlarge
As this chart reveals, an ultra-deepwater or tender rig will pay for itself after approximately 5.7 years of operation. Jack-up rigs are not nearly as profitable, requiring approximately 7.5 years of cash flow to pay for itself. This suggests that tender rigs and ultra-deepwater rigs are preferable to jack-ups from the perspective of an offshore drilling investor as it takes a much shorter period of time for those rigs to reach their breakeven point.
This would seemingly suggest that investors should prefer offshore companies that have large percentages of their fleet as ultra-deepwater or tender rigs. These two types of rigs do indeed look to be preferable to jack-ups in the current market.
As I discussed in a previous article, dayrates have been trending up for both ultra-deepwater and tender rigs. However, this is not the case for jack-up rigs. The dayrates for jack-ups have remained relatively flat. This should cause more rapid earnings growth among operators of tender and ultra-deepwater rigs compared to operators whose main focus is in jack-up rigs.
SeaDrill Ltd. owns and operates the world's largest fleet of tender rigs. Furthermore, they are the only major offshore drilling company with a presence in this lucrative market. SeaDrill's fleet contains 15 tender rigs, 8 of which are the most desirable semi-tender class. This represents 25% of the total sixty rig fleet. 13.33% of the company's total fleet are semi-tender rigs.
SeaDrill also has one of the largest ultra-deepwater rig fleets in the world, second only to competitor TransOcean (RIG). SeaDrill has 19 ultra-deepwater rigs in their fleet or in that of a subsidiary company. This represents 31.6% of the company's total fleet. Those rigs are by far the highest earners, boasting dayrates in excess of $500,000. They are also the most expensive rigs to construct, having an upfront cost of approximately $600 million. The market price for ultra-deepwater rigs has been increasing recently, just like that of tender rigs, and this has the effect of reducing the payback period on these rigs.
The rising market price of tender rigs is easier for investors to exploit than the rising market rates for ultra-deepwater rigs. This is because tender rigs typically carry shorter contract periods than ultra-deepwater rigs. This allows the rig operator to more rapidly garner a higher price for the rig. The longer contract term of ultra-deepwater rigs means that the rig operator cannot increase the dayrate until the end of the contract term. The contractor most certainly can and will recontract at the market rate but with the average contract term for ultra-deepwater rigs hovering at 2.5 (with some being contracted out for four or five years) compared to the 1.8 years of a semi-tender contract, it is obvious that the semi-tender operator can increase their profits and cash flows more rapidly than the ultra-deepwater operator.
There is a strong case to be made for investments in ultra-deepwater rigs as well. Permits for deepwater drilling in the U.S. Gulf of Mexico fell to almost nothing following the Macondo oil spill. The regional industry is now showing signs of a recovery as an increasing number of permits are being issued.
These new permits are increasing demand for premium deepwater assets. The Brazilian market, led by Petrobras (PBR), is also increasingly a source of demand for these rigs. The supply of rigs, meanwhile, is not keeping up with the growth in demand. Offshore drilling companies are slowly replacing their aging midwater and deepwater units with ultra-deepwater units. The average age of the world's midwater fleet is 30 years and the average age of the global deepwater fleet is 25 years.
As SeaDrill pointed out in their seminar presentation, there are currently 36 uncontracted UDW newbuilds under construction for the global fleet with an average delivery date of September 2013. These uncontracted newbuilds are consequently needed just to replace the aging rigs in the existing floater fleet. Therefore, the industry is in a situation where demand is increasing rapidly and supply is stagnant. This will have the inevitable effect of driving up the market price for ultra-deepwater rigs.
I previously discussed that the long contracts of ultra-deepwater rigs means that operators cannot increase their profits as rapidly as they could if the contracts were shorter. However, we should remember that the stock market is a forward-looking mechanism. The stocks of ultra-deepwater operators could still go up as the market expects higher future cash flows and profits as rigs are recontracted out at higher prices.
SeaDrill remains an excellent way to profit off of the aforementioned trends in tender rigs. The company is the largest player in the tender rig niche market and is the only major offshore drilling company participating in this market. The company is also an excellent way to profit off of the growing demand for ultra-deepwater rigs.
Investors interested in the opportunities available in the UDW market may also want to take a look at North Atlantic Drilling Limited (NATDF.PK) which was created through an equity carve-out from SeaDrill last year. North Atlantic Drilling does not have a presence in the U.S. Gulf of Mexico or Brazil so this may be a drag on the stock. The North Sea and Barents Sea regions, where North Atlantic Drilling operates, has seen a revitalization in demand recently though as there have been a few large discoveries there over the past year. The lack of presence in the growth markets of the U.S. Gulf of Mexico and Brazil may not be as large a problem as they first appear in light of this.
Another option to watch is the upcoming filing of Seabras, SeaDrill's Brazilian subsidiary.
Disclosure: I am long SDRL.