The first-quarter results and management teams' commentaries during conference calls with analysts reaffirmed my bullish take on the deepwater drilling market. Alf Thorkildsen, CEO of Seadrill (SDRL), summarized the growth drivers for deepwater drillers during a May 14 conference call:
The high and stable oil price, numerous significant oil and gas discoveries, many of which are in new frontier areas such as East Africa and the Barents Sea, and limited near-term availability of rigs have created a very strong market for ultra-deepwater fleet, with day-rates exceeding $600,000 per day.
How tight is the market for ultra-deepwater rigs? Transocean's (RIG) Deepwater Expedition, which lost a contract because of extended downtime at the end of 2011, secured a two-year fixture at a day-rate of $650,000 from an undisclosed customer.
Thorkildsen discussed this phenomenon during a conference call to discuss first-quarter results:
There are very few rigs available, and sometimes our clients…are concerned [about] getting that capacity. So they would just knock on your door. Normally, we knock on their door. This time, they are knocking on our door and asking [us]…to sit down and have some negotiation. That is kind of the current supply-demand situation. And that is, of course, very positive [for] us.
With customers contacting contract drillers about extending contracts a year or two before they expire, I expect day-rates to remain elevated. Management teams agreed that the market for ultra-deepwater drilling vessels would remain tight through at least 2014, with many arguing that a bevy of new offshore discoveries should ensure that the market will absorb coming capacity additions.
Contract drillers across the board cited accelerating exploration and development of fields offshore West Africa as an indication that this up-cycle would last longer than the prior boom. But several management teams were also bullish on the potential for Petrobras (PBR, PBR.A) to contract additional rigs to support its ambitious production goals. Transocean, for example, predicted that Petrobras would issue a tender for up to two rigs this year, as delayed deliveries from inexperienced domestic shipyards will force Brazil's national oil company into the international market.
Diamond Offshore Drilling's CEO Lawrence Dickerson told analysts that he expected this trend to continue in coming years:
[I]t's not going to be easy to build the number of rigs that they're talking about and brand new shipyards in Brazil. They're going to give it a good go. They're intelligent people, but I think that will not transform overnight. And when you look at the size of their geological prospects that they're drilling on, it's going to require active high-efficiency rigs going at it now.
If you wait the period of time then it's going to take to deliver all of these rigs and then get started, you've taken significant cash flow from increased production and kicked it down the road seven to ten years. So, if you do the all the math on that, I think in the foreseeable future that the US guys are not necessarily going to be squeezed out, whether or not Brazil builds rigs locally or continues to contract from the outside.
Meanwhile, resurgent demand and rising day-rates for premium jack-up rigs have also bolstered the industry's growth prospects, though firms with sizable fleets of less-sophisticated models continue to suffer from lower utilization rates. At this stage in the cycle, the bifurcation of the rig market is most evident in the jack-up category, where many lower-specification rigs remain cold-stacked (in storage) and operating units struggle to secure term work.
Contract driller Transocean aims to divest between $500 million and $1 billion worth of lower-specification jack-up rigs over the course of 2012, while Diamond Offshore Drilling's management team has also expressed an interest in divesting some assets if the price is right. Ensco's jack-up fleet had a utilization rate of 84 percent in the first quarter, largely because of cold-stacked units. Management indicated that deals to divest some of these assets are in the works.
Contract drillers continue to benefit from a tight supply-demand balance in key markets, which has filtered down to conventional deepwater rigs and the still-weak midwater segment.
Nevertheless, I continue to favor names with newer fleets. Not only do recently built vessels tend to command higher day-rates than older models-particularly in the deepwater and jack-up segment - but these vessels also require less downtime for maintenance and repair.
Operators with older fleets continue to invest heavily in rig modernization. For example, Transocean in late August 2011 acquired Aker Drilling in an all-cash deal worth $1.46 billion - a 96 percent premium to Aker's market value. The deal netted Transocean two harsh-environment, ultra-deepwater rigs and two new drillships slated for delivery in 2013. Meanwhile, the company continues to divest legacy assets that have fallen out of favor.
I expect deepwater rigs to fetch elevated day-rates in the current supply-demand environment. Meanwhile, the summer soft patch will present investors with an opportunity to buy this growth story at a discount.
Disclosure: I am long SDRL.