Offshore Drilling Drama

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Includes: ATW, DO, ESV, NADL, NE, ORIG, PACD, RDC, RIG, RIGP, SDLP, SDRL
by: Vladimir Zernov

Summary

Oil falls, offshore drilling stocks follow.

I share 9 observations on the current market.

I lay out my view on traded offshore drilling stocks.

All offshore drilling stocks gained much ground in March, when everything oil-related caught bids from speculators. Since then, their fates divided, and companies' shares traded based on their perceived strength and even the percentage of short float.

However, the recent oil price action made offshore drilling stocks trade as a group again. This volatility is good for traders but bad for investors who were betting on the industry recovery.

Frankly, oil was just a trigger for the sell-off in the offshore drilling space. Almost all preceding data suggested that the industry has not reached its bottom.

However, the stock market sometimes needs to look at an external factor to pay attention to previous developments. This factor is across all headlines now - oil is falling almost on a daily basis. The speed with which oil went from $50 to $40 is fascinating and troubling for the offshore drilling outlook.

In this article, I will summarize my views on offshore drilling stocks and the industry as a whole. Recent companies' reports brought important data, and we can now start thinking not only about the next year, but even how the industry will perform until the end of the decade.

Observation #1: Contracting activity continues to fall

The bottom for the industry will be reached when rigs who roll off their respective contracts will be replaced by rigs that just won new jobs. We are clearly not seeing this. Some companies have fleets of stacked rigs that would have been sufficient enough to start a new firm in better days.

The reserve replenishment mantra does not seem to work. Oil producers are preserving their budgets and their actions are primarily driven by the short term agenda.

Such behavior may plant the seeds of future supply shocks, but these developments take time. There are no signs that majors are rushing to replenish their reserves at all costs.

This is what Diamond Offshore Drilling (NYSE: DO) had to say during its earnings call: "Some of the larger diversified oil field service providers have declared a bottom in activity and are suggesting that a recovery is imminent. While this may be the case for certain onshore basins, it is not so for deepwater drilling".

Diamond Offshore's management has been proved right in its expectations throughout the current crisis. Other teams always sounded much more optimistic, and some continue to express optimism is some form. For example, Ensco's (NYSE: ESV) management was telling how many days it takes to reactivate a stacked rig during the recent earnings call.

Observation #2: Dayrates continue to fall as well

It's not rocket science - as supply of rigs increases while the demand for rigs decreases, rates have nowhere to go but down. The natural bottom for day rates are drillers' operating costs.

In some cases, even they don't serve as a bottom as warm-stacking costs bite into a company's finances. If operating loss is lower than warm-stacking costs, a driller may choose to do the job to keep the rig in the active fleet.

Rates fall not only for new contracts, but for contract extensions as well. For example, Diamond Offshore Drilling saw a day rate drop from $285,000 to $205,000 on just a three-month contract extension. All in all, rates on the recent contracts in the industry might in fact be bottom rates, but this bottom should be tested.

Observation #3: Cold stacked rigs are out of the market for years

Companies may want to present cold stacked rigs as assets to investors, but the real situation is harsh for offshore drillers. Cold stacked rigs are not competing with warm stacked rigs or active rigs for contract and won't be doing this any time soon.

I find it interesting that public statements on reactivation costs vary significantly. For example, Diamond Offshore mentioned reactivation costs of $60 million - $90 million, while Ensco was speaking about $25 million - $35 million costs. Of course, the figure will wary widely between the rigs depending on their age, class, condition etc., but the absence of any kind of consensus is a worrisome sign.

Observation #4: Most cold stacked rigs will never enter the market again

This observation directly arises from the previous one. Rigs that have been stacked for years will not be able to compete with rigs from the shipyards. The cost of reactivation will likely be too big, and the day rates might not recover soon.

We are already seeing that drillers start scrapping their rigs, although the process is rather slow. I expect that scrapping activities will intensify in 2017.

Observation #5: Dayrates will likely stay low until the end of the decade

In my view, Atwood Oceanics' (NYSE: ATW) new contract for Atwood Osprey is a prediction of what we'll see rate-wise in 2018 - 2019. As a reminder, the company contracted Atwood Osprey at a $190,000 dayrate for a 20-month job. The previous dayrate was $450,000.

Oil operators will follow Woodside Energy's example and contract rigs for longer-term jobs at rock-bottom dayrates. Drillers will have no choice but to agree in order to service existing debt. Rigs waiting in the shipyards will provide enough pressure on industry players.

Observation #6: Next year will only bring small jobs

Oil failed to stay around $50 for any meaningful period of time. This is a big blow to the confidence of oil producers. The budgeting season has not yet started, and oil could easily gain ground and even go past $50 per barrel, but the confidence has been shaken once again.

I expect that major players won't be ready to commit much capex to 2017 and will postpone major work to 2018. In 2018, as I stated above, they will secure long-term work at low dayrates.

Observation #7: The debt market is almost closed for drillers

Transocean's (NYSE: RIG) recent bond offering led to an unpleasant discovery for other industry participants. Even a perceived survivor received a 9% interest rate on its bonds. Given the recent oil price action, the debt market is now effectively closed for the offshore drilling industry.

Equity offerings might still be an option, but current equity prices are not attractive for new offering for most offshore drillers. Those drillers who theoretically have the ability to raise capital through an equity offering like Rowan (NYSE: RDC) or Diamond Offshore don't have the necessity to do this.

Observation #8: Forget about M&A

At first glance, the industry needs M&A badly. There's no reason to support so many management teams when the work is so scarce and rates are so low. Some drillers spend millions on G&A and get zero contracts.

Perhaps, this is not the fault of their salespeople or managers, but the situation is clearly ineffective from the perspective of the whole industry, which now has to battle with shale for oil producers' budgets.

However, there's no way how acquisitions can happen when drillers carry so much debt on the balance sheet. Also, there's no incentive to purchase a competitor when your own rigs are stacked without work.

Observation #9: Market for used rig sales is probably dead

Ocean Rig's (NYSE: ORIG) purchase of the Cerrado drillship was the last prominent news on this front. The price made the headlines - $65 million is an awkward price for a modern drillship - but the move does not look good at all.

A drillship without a contract is not an asset; it's a pure liability nowadays. So, until a driller got contract for most of its rigs, it makes no sense to purchase another rig in speculation.

Also, many new rigs are waiting in the shipyards. I suspect that they will finally be sold to surviving drillers - not necessarily the ones who ordered them. This is another nail in the coffin of the used rig market.

Now that we've discussed the general situation, let's turn to exact names.

Industry leader

In my view, Diamond Offshore stands out from the competition. The main reason for this is its management team, which did not underestimate the severity of the current crisis. As a result, the company currently has no warm-stacked rigs - only rigs that work and cold stacked rigs.

I'm skeptical that many Diamond Offshore's cold stacked rigs will re-enter the market, but the company's fleet looks balanced anyway, especially given the absence of balance sheet problems and the easy debt schedule.

The main problem for Diamond Offshore as a stock is that it is constantly overbought. Perhaps, the current oil price downside will finally provide a good entry point in the company's shares.

Followers

This group includes other potential survivors - Rowan , Noble Corp. (NYSE: NE), Ensco and Transocean .

Noble Corp. has been out of investors' favor lately, and I cannot find the exact catalyst why Noble Corp. is trading near its yearly lows and Transocean does not. Speaking about a potential long play in this group, Noble Corp. is my favorite. I'm most pessimistic on Transocean.

The company's management team is poor (or just unlucky) with timing, as was once again highlighted by Transocean's offer to purchase Transocean Partners (NYSE: RIGP).

I read that many Transocean Partners investors were unhappy with the deal, but I'd argue that the deal announcement allowed to bail out at an attractive price instead of waiting to receive Transocean shares as a result of the deal.

Speculative group

This group includes Seadrill (NYSE: SDRL), Seadrill Partners (NYSE: SDLP), Atwood Oceanics and Ocean Rig .

I am outright bearish on Seadrill. The restructuring talks will be extremely tough now given the latest market developments. I expect that the process will ultimately end in a big dilution for current shareholders.

Seadrill Partners' fate depends on whether it manages to stay out of Seadrill's restructuring. Seadrill previously stated that Seadrill Partners was not included in its talks, but I am not taking this statement for granted.

Seadrill Partners has recently cut its distribution, and the pressure from frustrated yield-seeking investors weighs on the stock. In my view, Seadrill Partners is a traders' stock right now and is not suitable for long-term play.

Atwood Oceanics held up well until the recent trading days. The company faces a backlog cliff in 2017 and it's a serious challenge given the current market environment. The stock is heavily shorted so those who want to join the party on the downside should seriously consider risks.

Ocean Rig is another bet on the recovery of the UDW segment. If you have read this article thus far, you already know that I'm skeptical about such a recovery.

Add to the mix questionable actions of the management team which include the set-up of the subsidiary called Ocean Rig Investments, the purchase of its own shares without canceling or selling them at a higher price and the purchase of Cerrado and you get my message - Ocean Rig should be avoided by investors.

The stock is suitable for traders as it will continue to have wild swings in the future, where periods of manic hope will be followed by periods of dark despair.

Walking dead

Pacific Drilling (NYSE: PACD) and North Atlantic Drilling (NYSE: NADL) made serious upside moves in June as low float after stock splits led to a short squeeze. Now both stocks are back to where they belong.

North Atlantic Drilling is just not viable as a separate entity and will end up reabsorbed by Seadrill as a part of the latter's restructuring. Pacific Drilling has problems with debt and contract coverage which it will not be able to overcome in the current market environment.

Bottom line

Offshore drilling remains a fascinating industry to watch and trade. So far this year, trading techniques certainly yielded better results over passive buy and hold as stocks went up and down together with the price of oil or on their own.

Recent developments provide both short-term and long-term opportunities. Short-term opportunities are concentrated on the bear side of the trade. Seadrill is my candidate, although the stock has already fallen from the most optimal levels for a bear bet. Atwood Oceanics may be a good catch-up play, but the high short float is alarming. On the long side, Noble Corp. is worth watching.

Disclosure: I am/we are short SDRL.

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.