Deep Sea Drilling: A Risk Worth Taking?

Includes: GSF, NBL, PDE, SDRLF
by: Travis Johnson

It looks like the consolidation that many of us foresaw for the deep water drilling business might not come to fruition after all, or at least, not to the degree that was expected. Many of these companies, including Global SantaFe (NYSE:GSF), Noble (NYSE:NBL), and Pride International (NYSE:PDE), have been rumored takeover or merger candidates as the day rates for deep water drilling ships and rigs have skyrocketed.

One of the possible acquirers of many of these companies, however, sounds like it just took themselves out of the game - and in the process, gained a nice share boost in return for that comment. Las year, SeaDrill (OTC:SDRLF), my largest individual stock holding, was a rumored suitor for Pride International, and for Noble and Global SantaFe earlier this year, among others (and it has done its share of acquiring, with the biggest one being its takeover of Smedvig, a company it bought by outbidding and outmaneuvering Noble, by the way).

But now, in an announcement that it was ordering yet another deep water rig, SeaDrill management noted that its "believes that this new building opportunity at the Jurong Shipyard is superior to U.S. Corporate acquisitions from a financial, as well as fleet quality point of view.''

So instead of pouring cash into a U.S. acquisition, which had been a top priority for the company, it'll be pouring some of it into a very expensive rig that will only be delivered in about three years (and even that's pretty early since, according to some other interested parties, the slots at the best yards are even pretty full through 2010).

It's hard to argue with them, considering the relatively high prices of the U.S. drilling rig owners, relative to their fleet value - but I still wouldn't be surprised to see John Fredriksen do more acquiring. It looks like it's finally going to finalize the takeover of the rest of Eastern Drilling that it doesn't own (although that's really just one rig - one fantastic rig, but still only one rig).

I still really like this investment, despite the fact that not only are the yards quite overtaxed as they build these rigs in a frenzy of demand (including the yards owned by Keppel Fels, which is another one of my portfolio companies), but the rig customers are also having to wait in line. It seems that the oil exploration companies, at least, still believe that there is a significant amount of oil to be found in the deep waters of the world, and that it will be worth finding and extracting.

After all, even though these rigs can cost $500 million, the latest letter of intent that SeaDrill signed with a customer is for $531,000 a day to lease a similar rig. At that rate, the lease payments pay off the cost of the rig in just about three years (without taking into account other costs), which is just about the ratio SeaDrill is still looking for. (The total value of that five-year letter of intent is $970 million, which is close to 2X what they're now paying for a newly built rig - not bad)

As long as the rigs are in demand and users are willing to sign five year contracts that don't even start for several years, it's certainly worth it to buy one for over $500 million, even if you won't see it hit the water until mid-2010. Phew. Crazy business, but it is one with massive cash flows, and if SeaDrill continues along this track without major acquisitions I'd expect it to begin paying a significant dividend of those cash flows to shareholders within the next couple years, just as Fredriksen did with his Frontline tanker business (perhaps in part by selling the rigs off to Ship Finance, which is also riding high, and getting relatively generous lease-back deals). It should be a very interesting company and space to watch, at least over the next three years.

Oh, and it doesn't hurt that the Department of the Interior is proposing to open up the outer shelf to drilling on the West and East coasts and not just on the (poorer) Gulf coast. These leases are scheduled to begin at a time when there are very few advanced drill rigs available for rent. I don't know if that will go through, but it's certainly politically volatile. If it does, the impact on drill rig owners and service companies with U.S. exposure could be significant in the short term.