Noble Corp. (NYSE: NE) has recently reported its fourth-quarter results. The report itself was covered here on SA by other contributors, so I won't beat the dead horse and focus solely on the very important topic of rig retirements as NE's report and the subsequent earnings call gave great food for thought on the topic.
Don't forget about oversupply
In my view, it's very important to keep in mind that the current crisis of the offshore drilling industry is due to two factors - the sudden drop of oil prices and the oversupply of rigs. The first factor gets the most press, as it influences so many industries and countries all around the world. The second factor is specific to the offshore drilling industry, but it's very important too.
Offshore industry as a whole has been able to postpone the deliveries of the newbuild rigs beyond 2016. This move certainly eased the short-term pain for the industry and provided time to deal with the oversupply problem. In theory, the solution to the oversupply problem is very simple - excess rigs should go to scrap as soon as possible.
Once the process is finished, the industry will be equipped with new, most capable rigs ready to satisfy customers' needs. Thanks to the young age of this fleet, the industry's capital requirements will be rather small for years. At some point, the demand for offshore drilling services will return, and the industry will enjoy great margins and prosper.
The real world is far from ideal. The offshore industry is not a cartel - it's a competitive industry with a number of players. Each of these players has a unique financial situation, fleet and strategy to deal with the current crisis. I would argue that in current circumstances, the burden of rig retirement lies on the stronger companies.
In my view, companies in financial distress (or on the verge of financial troubles) will try to market all their rigs until the very end. After these companies go through the bankruptcy process, they will reemerge with a cleaner balance sheet and new owners who will be eager to extract value from existing assets. We've already witnessed the first wave of the process, with weak spin-offs like Paragon Offshore.
Who should retire rigs now?
The next wave won't be retiring rigs as these companies have young fleet. Most of you know my primary candidates for bankruptcy - Pacific Drilling (NYSE:PACD) and the hotly debated Ocean Rig (NASDAQ:ORIG). In my view, the worst-case scenario also implies the drowning of Seadrill (NYSE:SDRL) and Atwood Oceanics (NYSE:ATW), whose earnings report I recently covered. The worst-case scenario may not be realized, but if it does, the above-mentioned companies won't be retiring much rigs (with the exception of Seadrill, perhaps).
In this light, industry leaders with cleaner balance sheets have the responsibility to scrap older rigs. With this in mind, let's return to Noble Corp. The company decided to retire two rigs - the drillship Noble Discoverer and the jackup Charles Copeland. Both rigs were built back in the '70s. Their contracts ended, and it's not a big surprise that NE decided to retire them.
However, one could expect more retirements from Noble Corp. if the company chose to be really proactive. During the conference call, the company stated the following:
"We believe that one noteworthy and healthy by-product of the current cyclical trough is the probable retirement of a good number of rigs in the global fleet, both floaters and jackups".
These are good words, but I think that Noble Corp. does not want to contribute much to this process. Judging by the company's actions and the conference call, I arrive to the conclusion that NE won't retire its rigs until it's 100% evident that there are no other options left. It's my subjective perception of the company's conference call, but I think the management is too focused on the "inevitable" rebound in demand for offshore drilling services and will try to preserve as many rigs as it can.
If you share a bullish view on oil, you'll likely be happy with what you've heard from Noble Corp. To me, with my rather pessimistic view on oil prices, it means that the rig oversupply problem will be present for a long time. In the end, Noble Corp. will likely be forced to scrap all the old rigs - after paying expenses for stacking them and marketing them. It's not good for the company, and it's certainly not good for the industry.
Noble Corp.'s peers will do the same
I bet that Noble Corp. won't be the only one to adopt this strategy. The companies that likely feel that they will be surviving the current market downturn, including Diamond Offshore (NYSE:DO), Rowan (NYSE:RDC), Transocean (NYSE:RIG) and Ensco (NYSE:ESV) will likely try to prepare for the "inevitable" upside by keeping all the rigs they can keep. These players are yet to report their results and share the views on the conference calls, so we'll see if my thesis plays out a little later.
This topic has serious implications for the possible M&A activity. In short, I expect there will be no M&A activity in the industry until more players go bust and the whole fleet of older warm stacked and cold stacked rigs goes to scrap. Why a stronger company will be stretching its balance sheet to purchase assets from the unlucky competitor when it has stacked rigs of its own?
I believe that the situation in the offshore drilling industry continues to develop according to the bearish scenario. I have no crystal ball, and I can't tell you whether we are witnessing a severe cyclical downturn or a tectonic shift in the oil industry. What can be measured in this environment is the industry's response to the challenge.
So far, the offshore drilling industry has been slow in responding to its internal oversupply problems as companies seem to prepare for the upside part of the cycle instead of focusing on surviving the downturn first. In my view, if the oil price does not bail out the offshore drilling industry, it will pay the price for being slow in rig retirements.
I maintain my view of Noble Corp. as one of the primary survival candidates. However, I remain cautious about the outlook for the company's shares due to the gloomy outlook for the offshore drilling industry. I don't think that a "good company in a bad neighborhood" can expect serious upside until there are at least first signs that the industry's problems are starting to get solved.
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 abovementioned stocks.