Atwood Oceanics' Latest Contract Win Speaks Volumes About Management's Assessment Of Current And Expected Industry Conditions

| About: Atwood Oceanics (ATW)

Summary

The company just contracted a modern rig for an abysmal $190k dayrate until the end of the decade.

The contract terms are in stark contrast to management's recent optimistic comments with regard to an expected 2017 industry recovery.

Atwood is approaching a severe backlog cliff in 2017.

Should the industry remain in the doldrums, the company is facing a debt restructuring in 2019.

Atwood Oceanics (NYSE:ATW) released its latest fleet status report on Wednesday. Fellow contributor Vladimir Zernov has already provided a detailed overview with regard to the changes from the previous report, so I decided to mainly focus on the only major development included in the report -- the initial 20-22 month contract extension for the 2011 6th generation Semi-Submersible "Atwood Osprey" with the rig's current contractor Woodside Energy Ltd., a subsidiary of Australia's largest oil and gas production operator, Woodside Petroleum Limited.

Back in March 2016, Atwood and Woodside already agreed to an early contract termination for the 1982 Semi-Submersible "Atwood Eagle" with the remaining backlog being transferred to the "Atwood Osprey." Meanwhile the rig has commenced the remaining 165-day term under the original "Atwood Eagle" contract for Woodside offshore Australia which is now scheduled to end during December 2016. The dayrate for this old contract has remained at $450,000.

Unfortunately the ongoing industry turmoil has caused dayrates to drop dramatically from their heydays three years ago and the Woodside contract extension is no exemption as the dayrate will be reduced by $260,000 or close to 60% from its current level to a mere $190,000.

The industry has responded to the downturn with rigorous cost cuts that have already been benefiting the bottom line of most companies for a couple of quarters now. Accordingly, Atwood's gross margins have improved from the low 60% to the high 60% in recent quarters. So given the much lower cost basis, even the weak $190,000 dayrate for the new contract extension will translate into a positive cash contribution for Atwood, which I estimate to be at about $60-65,000 a day. So over the life of the contract Atwood might realize positive cash flow of roughly $40 mln, which isn't all that bad when taking into account current industry conditions.

While the dayrate clearly is nothing to write home about, I was initially somewhat surprised to see Atwood's stock trading quite weakly on the heels of the announcement -- at least until I noticed that the new contract won't start before January 2018, which I find a quite puzzling development. So Atwood decided to enter into a contract at a record-low dayrate that won't commence for another 18 months and is scheduled to last almost up to the end of the decade.

Given management's optimism during the recent Q2/FY 2016 earnings conference call with regard to "offshore drilling getting a seat at the table" going into the 2017 budget season, this new contract is actually telling quite the opposite. At least Woodside obviously left Atwood's desired "seat at the table" empty for the 2017 season as the "Atwood Osprey" will be released from its current contract at the end of 2016 and will not re-commence work for Woodside until the beginning of 2018.

Moreover, the decision will require Atwood to market the Osprey for short-term work in order to avoid potentially elevated costs for idling and warm-stacking the rig. So far the company has been able to secure a one-well job with ConocoPhillips (NYSE:COP) scheduled to begin in mid-February 2017 for a period of 45 days at a dayrate of $185,000 with an option for another 45 days of follow-on work. At this point, the projected idle time for the rig in 2017 calculates to 320 days. At estimated warm-stacking costs of $30-$35,000 per day, Atwood is currently facing stacking costs for the Osprey of $10-$12 mln in 2017.

Given the commitment of a modern rig almost until the end of the decade, I would at least have expected some provisions for potential rate adjustments in line with management's expected improvements in industry demand, but the rate has obviously been fixed over the entire contract term. So Atwood management is acting in stark contrast to its rather optimistic industry assessment just three months ago and obviously now does not expect material improvement with regard to the abysmal demand situation until the end of the decade anymore.

As a reminder, management's optimistic remarks about a potential 2017 industry recovery and a discounted bond buyback caused the company's shares to soar 35% at the date of the last earnings release -- given the obvious change in sentiment, investors better prepare for much more conservative commentary from management when the company reports its Q3/FY 2016 earnings next week. Moreover, the company is approaching an obvious backlog cliff rather quickly as backlog as of the time of this writing is down to roughly $800 mln with four more rigs scheduled to roll off contract later this year, effectively leaving the company with only two rigs under contract for 2017 (out of a total of 11).

And while the company recently negotiated some covenant relief for its senior secured credit facility, an interest coverage ratio covenant will kick back in at the end of the third quarter of calendar year 2018. Furthermore, the credit facility will be up for renewal in 2019 and with roughly $1 bln drawn as of today, this won't be an easy task should the market remain weak.

The company recently tried to buy back up to another $150 mln of its remaining outstanding $496 mln 2020 bonds but ended up with just $42 mln in bonds being tendered. Most likely the company will allocate the unused cash to re-commence its previous open market purchases of the notes. There's some hope for the company though as the recent credit facility amendment allows for the issuance of up to $400 mln in second lien debt -- while this would clearly be a very costly exercise when judging by the recent Transocean bond offering, it might help the company when it comes to negotiations with its banks.

With roughly $600 mln in available liquidity as of this writing, Atwood won't face problems during 2017 and 2018 despite the apparent backlog cliff (assuming the company will be able to further delay the delivery of two uncontracted newbuilds), but 2019 will be the "make or break" year for Atwood Oceanics.

To avoid a threatening debt restructuring at that time, Atwood will have to convince its banks to extend the revolving credit line at acceptable conditions but it will take a recovery in the industry to get to a positive outcome. Looking at the terms of the recent "Atwood Osprey" contract with Woodside, the odds are seemingly against the company at this point.

Despite the very poor contract coverage, the company's market cap of almost $700 mln makes Atwood looking quite expensive compared to many of its peers. Thanks to a very high short interest, the stock is among the most volatile in the industry making it a potentially great trading vehicle.

Bottom Line

The terms of the recent contract extension for the "Atwood Osprey" speak volumes about Atwood's managements seemingly revised assessment of industry conditions going forward. As virtually all oil majors have now publicly committed to prioritizing potential incremental investments towards land-based drilling (shale), just like Atwood management I do not expect any material recovery for the offshore drilling industry at least until the end of the decade. With shale opportunities providing a more flexible solution in times of volatile oil prices and much higher short-term investment returns, unconventional land-based drilling will be the preferred choice of investments for potentially many years to come.

Offshore drilling, of course, won't go away given that a couple of countries like Brazil or Norway are mainly commanding offshore reserves, so there will be ongoing demand for exploration work going forward - but most likely not to an extent to re-balance the current giant supply overhang in the industry. With overcapacity most likely to persist for several years to come, pricing power for industry players will remain subdued.

Virtually the entire industry is facing large debt maturities and credit line re-negotiations towards the end of the decade and it will take at least some type of recovery for most companies to survive this downturn without debt restructuring which would be particularly painful for the companies' equity holders.

Seadrill Ltd. (NYSE:SDRL) will be the first major industry player to undergo a comprehensive debt restructuring later this year. Currently, investors and analysts are still awaiting the concrete terms to be announced, but my expectations aren't very optimistic - to say the very least. The shares of most industry players (including Atwood's) have been trading like options on the oil price for a couple of quarters now and I don't expect this pattern to change anytime soon going forward.

In fact, the shares of offshore drillers will predominantly serve as a playground for traders and speculative retail investors for the foreseeable future. Given the elevated risks associated with owning offshore drilling stocks at this point, more conservative investors would in fact be well served to continue to avoid the industry as a whole until there will be at least some light at the end of the tunnel.

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.