In the past couple of weeks, I have been studying the offshore drilling industry. After digging into companies such as Ensco (NYSE:ESV), Rowan Companies (NYSE:RDC), Transocean (NYSE:RIG), North Atlantic Drilling (NYSE:NADL), Ocean Rig (NASDAQ:ORIG) and Atwood Oceanics (NYSE:ATW), I have come to a few conclusions. My conclusions are more negative than positive -- by a lot. I have decided to end my research on the offshore drilling industry with this article.
High Fixed Costs and an Overly Levered Industry
The first thing that I noticed about the offshore industry was its overly high fixed costs. Fixed costs are derived from high interest payments, capex requirements and operating expenses. The majority of offshore drillers are so debt ridden that their bulk of cash flows run directly into interest payments. For example, take a look ORIG's interest payments:
Source: ORIG Annual Report.
I guess when the historical price of oil was trending near $100/bbl and all offshore drillers were getting rich, it was hard not to lever up the balance sheet and take on new builds. Drillers are also hurt by their own horrible business models. For example, drillers are price takers. They have zero influence on what their forward revenues will be. In all, forward revenues are dictated by whatever the price of oil is. Thus, if the price of oil falls dramatically, dayrates will also head downward.
Additionally, if dayrates fall from a decrease in the price of oil, labor expenses generally stay fixed. Even if E&P producers terminate contracts, drillers basically have two choices: They can either idle or stack their rigs. When they idle rigs, operating expenses will generally stay the same. Alternatively, rig operators could stack their units. However, they will take hefty impairments to their income statement. If you think about it, it's kind of a lose-lose situation.
You Will Never Get a Competitive Advantage
Offshore drillers will never have a competitive advantage. Sure, one driller could end up buying out the majority of market share. However, there isn't much of a hoop to jump through in order to barge into this industry. Furthermore, since drillers cannot control prices, any significant downturn can end up taking out the guy with the largest market share. In my opinion, zero competitive advantage is not a function of a good business model or investment.
There Will Be More Downside Than Upside
In my honest opinion, I believe that we will see more downside before there is upside. The majority of offshore drillers have a significant number of contracts running off in 2016. This will put a cash flow crunch on these companies. If contracts are not signed post-2016, we will most likely see significant downside, if not 100% losses, for a few of these drillers.
Furthermore, the offshore drilling market will become significantly oversupplied with new builds in the next one to two years. With a significant number of new builds looking for contracts, it will be very difficult for older rigs to find work. This will force companies to stack, scrap, and sell rigs. Investors should expect huge impairment hits to offshore drillers' income statements going forward. This will put additional downward pressure on stock prices.
Assets Are Worthless
When the price of oil is at historical highs, offshore rigs are valuable. However, when the price of oil crashes, offshore rigs practically become worthless. This can become problematic for drillers. First, when the price of oil is at historical lows, it is almost impossible to sell rigs above costs. In fact, many offshore drillers looking to sell their rigs are either forced to sell them at basement-level prices or just scrap them.
Second, when offshore rigs do not have contracts, they actually produce negative value. Negative value comes from upkeep costs. As I stated before, if a rig is idled it will have the same operating expenses as if it were drilling. If an offshore driller cold stacks or warm stacks a rig, they will continue to have upkeep maintenance. It is estimated that upkeep maintenance of cold stacked rigs can range upward to $10,000/day.
Finally, it does appear as if the offshore oil industry could be a straight asset discount play. Though, in my opinion, playing the industries discount from assets is a dangerous game. If the price of oil does not go back up, the majority of these rigs or assets will become worthless. Betting the farm on a reversion based on a discount from assets is speculative, to say the least.
I was planning on researching every offshore driller that I could find when I first started this project. However, the more I dug into the industry, the more I felt like I was wasting valuable time. To me, the offshore drilling industry appears to be cheap, but valuations are skewed.
Additionally, I believe that the offshore drilling industry can be compared to when Warren Buffett bought Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) back when it was a textile firm. BRK.A looked cheap from a historical perspective, but all cash flows were required to go directly back into the business in the form of capex upgrades. Is this not the same as offshore drillers? Won't offshore drillers always have to build new rigs and put in upgrades to keep up with the competition? This is not a function of a good investment.
Finally, I believe that investing in offshore drillers has a really high opportunity cost. Yes, the industry is undervalued on a historical basis and there might be good upside in the future. However, there are much better investments out there, with cheaper valuations and the ability to compound cash flows. Don't believe me? That's fine. You can stick with your drillers while I compound my cash.
Disclosure: I am/we are long ESV.
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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