Based on the current market cap $1.73B ($7.13 per share) and an average of $300m Owner's Earnings Cash Flows in 2020 assuming the company survives the down cycle, Noble Corp (NYSE:NE) will yield an 18% annual Owner's earnings return with a conservative 76% fleet utilization, and 40% with 92% utilization. The stock has a 200-400% upside by 2020 if it trades in line with 9-10% fcf yield. Noble's rigs are valued at $11.9B while the Enterprise Value is $6.1B ($1.7B equity and $4.4B net debt), a 49% asset to EV discount. Even with a few upcoming write-offs totaling $1.6B in the next two years, the replacement cost of the assets will be $10.3B - a 69% premium to EV.
The offshore drilling contractors have been obliterated in the past year and the fear-mongering chorus gets louder as the oil price keeps dropping. But before we get too far ahead of ourselves and declare the drillers dead, I will make a prediction: The best-managed drillers with the right equipment, deepest backlogs, and strong liquidity positions will survive this downturn and will be in position to generate substantial owner's earnings when the oldest rigs are retired and the oil price recovers.
"I'm more worried about running out of hydrocarbons than I am of climate change" - Charlie Munger.
Offshore drilling is an elementary component of the energy complex because offshore fills 33% of 92m boe daily demand, or 30.3m boe. Shallow water drilling satisfies 24% (22m barrels), and deepwater gets 9% (8m barrels). Collectively, 10 companies (NE, DO, RDC, ESV, ATW, SDRL, RIG, ORIG, PGNPF, PACD) represent the majority of the offshore drilling industry.
The OSD survival thesis pivots around two crucial points:
1. The assumption that oil will be higher than $30 in 2017, and will likely be higher than $50, or even $65 per barrel in 2017/18.
2. Bifurcation of the OSD rig market reflecting old vs new rigs will drive out excess older rig supply by 2018-19. 30+yr old rigs won't work, while newer ones will be contracted at a reasonable day rate. At $65-68 oil, NE will be able to renew contracts.
To elaborate on the point about oil prices, oil supply will balance out with demand before 2019 because
o Worldwide production breakeven costs are above the current oil price
o EIA's confidence intervals are as wide as I have ever seen (95% confidence interval between $20-100 oil), indicating they have no idea of what the future price curve looks like. So you have to take Goldman's and Morgan Stanley's $20 oil price predictions with a grain of salt.
o Annual well decline rates are around 6% onshore and faster offshore according to EIA. NE's IR stated that offshore decline rates are around 12%.
"Based on an analysis of the production history of more than 1,600 conventional fields between 1950 and 2012, the IEA has estimated decline rates for a range of fields. For fields which have passed their peak, observed output declined on average by 6.2 percent per year, according to the IEA ("World Energy Outlook 2013"). Decline rates for offshore wells, especially in deepwater, are faster than for onshore fields because the greater upfront cost of drilling them encourages operators to develop them more aggressively to earn their money back."
o 23% drop in upstream Capex in 2015 and a further 15% drop expected in 2016.
o 1.2m boe 2016 demand increase, and .5-1m thereafter (but EIA has been wrong often and actual demand increase may well be over 1m in years to come if oil stays low)
o King Salman may find it difficult to keep other OPEC members steady in the low oil price environment for much longer, especially at $30 oil. The Saudis + Gulf States will lose $300B in revenue this year alone.
o There is no global oil glut like in the 1980's and Saudi spare production capacity is smaller than in 2009 during the last oil price downturn, and much smaller than 1986 downturn.
o Shale production requires constant capital investment, which is not happening at $30 oil. Without it, production declines on new wells can reach up to 75% after a couple of years.
Noble Corporation offers the best investment opportunity among offshore drillers
We should begin by looking through Noble's numbers to determine if there is an asymmetric risk/reward payoff. Certainly, the OSD landscape isn't pretty, and a number of drillers may have to restructure or even liquidate by 2019. But let's not throw the baby out with the bathwater. The right offshore driller offers a multi-bagger opportunity, and that's what we're hunting for here. While the margin of safety on the investment has been eroded, the commensurate returns are also disproportionately higher compared to safer, but less opportunistic options in the energy complex - like refineries (NYSE:PSX), or the oil majors (NYSE:XOM).
Noble Corp - Bear Case scenario
1. Oil price recovers to ~$70 by 2019
Capex will be maintained at $360m per year.
3. Elimination of dividend after 1st quarter 2016.
4. Asset write-offs will include $800m per year (2015, 2016), totaling $1.6B
a. At ~270m per rig for 3 rigs per year, 6 total.
5. No new contracts until 2019
6. BREAKING: 2 FCX contracted rigs are idled as of Jan 26/2016 when FCX announced quarterly results. Estimate is FCX will pay $670m to NE for these rigs, $400m in '16 and $270m in '17.
7. Saudi Aramco rigs reduce revenues by $200m in 2016 and 2017 ($100m each year).
The most important measure to address is the debt/tangible book covenant of .6 on the $2.4B revolving credit facility due 2020. Noble will be able to stay around .5 number including writeoffs by the end of 2019. The current experience is so painful for the upstream sector that even if the price recovers in 2017 to $65-70, producers will likely wait until 2018 to begin tendering offshore rigs. The OSD players need to be able to survive until 2019 at the earliest, with 2020 as a possible safety margin year.
We're likely to see the following bankruptcies in the bear case:
2019 - RDC, ESV, and ATW. These companies have newbuild payments, RCF's due, expiring backlogs, and debt payments in excess of cash flows due.
2017/18 - ORIG, SDRL and RIG. Same as above, but more severe. Transocean (NYSE:RIG) has a massive newbuild program with 7 ships on spec. Seadrill (NYSE:SDRL) is already talking to banks with chapter 11 being an option in 2017.
NE is superior to all of its OSD competitors in the following metrics when taken in aggregate through 2020.
- Debt Maturity Schedule (liquidity) - will survive through 2020 assuming status quo. Not one of the above drillers can say the same.
- New Builds Payment Schedule (liquidity)
- Backlog (revenue visibility)
By the end of 2019, NE will have to draw $997m of the revolver, and by the end of 2020E, $1,916m. The funds will need to be repaid or refinanced by Aug 2020. So the bear case scenario assumes that oil prices will only turn by 2019, and Noble will be the last driller standing without restructuring by 2020. The wild card in the bear case scenario is whether the restructured drillers will be able to function more aggressively after the creditors convert into shareholders, reducing their balance sheet debt. If so, NE will be handicapped with a heavier debt load and may not be able to compete effectively. I doubt that the recently experienced pain would encourage a new wave of new-builds for drillers without carefully considering rig supply/demand dynamics, but it's something to think about.
Noble Corp - Upside/Realistic case scenario
1. Capex maintained at $360m per year.
2. Elimination of dividend after 1st quarter
3. Asset write-offs total $1.6B and 6 rigs to reduce fleet from 32 to 26.
4. New Contracts
a. 2018 - $700m, add to current backlog of 966m
b. 2018 - $1.2b, add to current backlog of 462m
c. Assume 20 rigs work at average $250k day rate for 330 days a year (76% utilization).
d. Compare $250k day rate assumption to 2014 - $339k and 2013- $301k. Note this is a mix of drillships and jackups.
Noble will generate $1,149m by 2020 in FCF available to repay debts. The company's debt load will be 2.95B and it will have $2.45B of liquidity assuming the company doesn't renew the $225m annual revolver due Jan '16.
The OSD industry will survive, but it will have to clear out 30+yr old rigs to balance out rig supply/demand. The good news is that current oil price is imminently forcing these rigs out of the market and the new builds are being delayed into 2018/19. I suspect that many newbuilds will not be delivered because of pending bankruptcies in 2016/17. Once the rig supply/demand equilibrium is met with a rising oil price, the catalysts for Noble's stock price increase will align with fundamentals.
$7.13 is the cheapest price offered for Noble since I can find on record (as of Jan 19) and many people think it's a value trap because deepwater drillers are at the highest end of the cost curve. But the oil industry can't function without offshore oil, and Noble Corp has a new fleet that constitutes 1/2 deepwater ships/semisubs and 1/2 jackups. If it survives the down cycle, which I view as most likely, the current price will yield 18% on FCF while only utilizing 76% of the asset base at $250k avg day rate. If utilization rises to 92% and the day rates rise to $300k, the cash flow yield would be nearly 40% and the price of NE would triple if not quadruple to match its historical average to bring down the yield to 10%.
- Oil price stays below $50 into 2018/19, and at this price, offshore drilling is uneconomical. In that case, drillers will not be awarded new contracts and most drillers will restructure by 2019. Noble would be forced to file Chapter 11 in late 2020.
- The looming credit ratings downgrade from BBB- could increase the costs to service debt. I am assuming that ~5% cost of debt will be sufficient until 2019, but this may not be the case.
o If NE underperforms on its contract obligations, producers would be happy to cancel rigs and reduce NE's revenue stream/backlog.
o OSD companies are working with a reduced capital expenditure structure that may increase risk of accidents such as RIG's explosion in 2010. Another large accident would negatively affect all drillers.
- as of Jan 26, 2016, the uncertainty regarding FCX rigs and counterparty risk has been somewhat resolved. FCX will pay approximately $670m to NE to idle the rigs. NE will be able to use funds to pay off some debt.
o 24% short as of Dec 2015. Any short covering will create upward price momentum.
o Shale companies' consolidation would substantially reduce oil supply.
o Shale sharp decline rates & bankruptcies in 2016 will reduce supply.
o 1.2m boe demand growth in 2016 and .5-1m annually thereafter.
5-12% conventional and offshore well decline rates will generate a supply/demand gap by 2017-2018 without continued infill and new well investment. According to Transocean , estimates range from 8m-10m daily boe gap by 2018.
o ~125 floaters are contracted by 2017 vs ~200 in 2016. This number is unsustainable if 9% of world oil supply is to be recovered from deepwater.
o Older rig attrition will help balance out rig supply/demand market by 2017/2018.
o Petro States can't survive in $30 oil environment for the next 3 years -> will cause political unrest and State bankruptcies. Even $50 oil will cause a lot of stress because many nations depend on $100 oil to balance their budgets.
Disclosure: I am/we are long NE.
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.
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