Offshore Drilling - Deepwater On Fire

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Includes: BNO, HERO, NADL, ORIG, PACD, SDLP, SDRL, USO
by: Vladimir Zernov

Summary

Oil continues to fall, and this leg down could be terminal to several offshore drillers.

I discuss why the damage of $30 oil goes beyond direct implications.

I discuss which companies are almost doomed in my view.

At the end of September 2015, I wrote an article titled, "Here Is The First Victim Of Low Oil Prices", where I argued that we should forget about harsh-environment drilling perspectives for the next years. This view was a building block for my bearish thesis on North Atlantic Drilling (NYSE: NADL), a company whose entire fleet was made to work in the unfriendly waters of the North.

North Atlantic Drilling had other problems besides the outlook for H-E drilling, but it is the absolute impossibility of any kind of a rebound in H-E drilling in the current oil price environment that makes the company's shares doomed.

The company has recently made a 1:10 reverse stock split, but it did not help, and North Atlantic Drilling's shares are trading at just $1.50 as I write this article and I believe they will trade sub-$1 soon.

The decisive role of the market sentiment

Meanwhile, oil prices continue to plunge. I have to admit that the recent price action is purely technically based. It's a traders' market, and fundamentals won't have a major impact on the oil market for some time.

There was no new information that suggested that the supply glut is increasing. China is in the spotlight with its stock market tumbling, but whether or not this action is limited to stock valuations rather than the broad economy remains to be seen.

Iran is seemingly causing Brent oil (NYSE: BNO) to trade at a discount to WTI (NYSE: USO), but everyone knows that Iran is going to push its production to the market the very day the sanctions are lifted.

The topic of Iran's influence on the market is beaten to death, almost everyone had their say on whether Iran will kill oil prices or not. It looks like the market believes Iran's role will be significant, and oil capitulates day after day.

Here I would like to share my view on the importance of belief in the market. Stocks move one way or the other for one simple reason - there are more buyers than sellers or vice versa.

The company may have the strongest balance sheet in the world, the best prospects, the most competent management or the largest market share, but this will mean nothing for the stock if no one wants to buy it.

Market perception, or belief, often creates self-fulfilling prophecies. That's why I often highlight market sentiment in my works. And that's why I believe the current oil price action has very profound implications for the offshore drilling industry even if oil miraculously returns to $50 per barrel in a matter of days.

The next logical candidate for big problems

So, with H-E prospects under water, who is the next obvious candidate for a serious hit? Deepwater and ultra-deepwater drilling.

Let's look back to 2012, a time when the seeds of current rig oversupply were sown. Back then, deepwater production was expected to grow at 6% per year from 2010 to 2030 and ultra-deepwater production was expected to increase by as much as 12% per year. Four years later, it is obvious that these expectations won't come true.

On the contrary, deepwater and especially ultra-deepwater drilling will take an enormous hit in the next few years. The $30 oil price has certainly planted fear into the hearts of oil companies, and it will take a lot of time to get rid of this fear even when oil prices rebound.

Oil executives sound mostly upbeat about the prospects of oil during industry conferences, but my bet is that we will see a knee-jerk reaction in cutting capex during this earnings seasons. We don't have to wait too much before we know about the next round of cuts by Exxon Mobil (NYSE: XOM) or BP (NYSE: BP).

Exploration will be hit the hardest. No matter what they say, the world can live without deepwater and ultra-deepwater exploration for several years.

The focus will now be only on the lowest cost production, which includes conventional oil, shallow water oil and, probably, best tight oil plays. Exploration brings the biggest number of jobs by definition, and the fact that exploration will be cut to the bone does not bode well for the drilling industry.

Casualties

Last year, we lost several companies as major exchange - listed stocks, including Hercules Offshore, Vantage Drilling and Paragon Offshore. Hercules Offshore (NASDAQ: HERO) reemerged as a listed stock, but brought no relief to any new investors as it had only a couple of green days since it restarted trading in November.

The next companies whose fate is almost decided are the ones with high debt and modern deepwater and ultra-deepwater fleet. Strength turns into weakness as newest, state of the art assets have no jobs to do in the current oil price environment. My candidates for potential elimination from the landscape of tradable drilling stocks are Pacific Drilling (NYSE: PACD) and Ocean Rig (NYSE: ORIG).

Both companies fit perfectly into the thesis. Both have young fleets and high debt loads. Ocean Rig is somewhat better positioned with a better contract coverage, but if the damage done is as big as I expect it to be, the company's chances to survive are very small.

As for Pacific Drilling, the market already assumes its bankruptcy, as the shares trade at just 35 cents. There still could be some upside frenzy in Pacific Drilling shares based on some rumors or a rapid oil bounce, as this often happens with penny stocks, but longer-term the company's chances to survive are minimal.

The last time I wrote about Pacific Drilling I was very cautious but still believed in some survival chances for the company. With the last move in oil, these chances almost evaporated.

Seadrill (NYSE: SDRL) together with Seadrill Partners (NYSE: SDLP) are also potential candidates. Seadrill's high debt load is extremely dangerous. The real test for Seadrill will begin in the next year, as I previously highlighted in my work on the company's contracts in 2017. Seadrill Partners' main problem are its cross-default provisions with Seadrill.

Bottom line

The outlook for offshore drilling industry is getting worse day by day. If oil somehow stays under $30 per barrel, it will be a killer for a lot of companies in the space. Forget the talk about the quality of assets and watch balance sheets first.

P.S. If you liked this article, consider reading my previous pieces on offshore drilling industry to watch the evolution of my views:

Offshore Drilling: Discussing The Future Of The Industry

Offshore Drillers: Results Of The Earnings Season

My Nightmarish View Of The Offshore Drilling Industry In 2016

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: I may trade any of the mentioned stocks.

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