Offshore Drilling: The Return Of P/B Argument

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

Summary

P/B argument appears again in discussions of offshore drilling stocks.

P/B proponents argue that OPEC deal changed everything.

This is not true and I show why P/B is an irrelevant metric for offshore drilling stocks in 2017.

When I wrote "Discussing Price-To-Book Ratio In Offshore Drilling Stocks" back in September 2016, I thought that P/B will gradually disappear from offshore drilling discussions as was the case with the P/E argument.

About a year ago, P/E was a common guest in offshore drilling comment threads as some investors failed to acknowledge the irrelevance of the P/E metric when the earnings part is doomed to be negative in the future.

Low P/E numbers turned into dashes in offshore drilling stocks' sections on financial websites as earnings became negative, and P/E vanished from discussions.

However, the P/B argument is more vital by definition - book value won't go below zero without a combination of heavy debt load and massive impairments. Therefore, we are almost guaranteed to see discounts to book value in all offshore drilling stocks.

It turned out that this fact fueled enthusiasm among P/B theory proponents. The argument goes that OPEC/non-OPEC deal changed everything and now P/B matters. Stocks will gradually drift towards their normal P/B values, implying massive upside from current levels for offshore drilling stocks. I cannot disagree more with this statement.

Let's start by looking at current P/B ratios for offshore drilling stocks.

Company

P/B

Atwood Oceanics (NYSE:ATW)

0.28

Diamond Offshore Drilling (NYSE:DO)

0.70

Ensco (NYSE:ESV)

0.43

Noble Corp. (NYSE:NE)

0.25

North Atlantic Drilling (NYSE:NADL)

0.20

Ocean Rig (NASDAQ:ORIG)

0.07

Rowan (NYSE:RDC)

0.47

Transocean (NYSE:RIG)

0.38

Seadrill (NYSE:SDRL)

0.18

Seadrill Partners (NYSE:SDLP)

0.37

Pacific Drilling (NYSE:PACD)

0.03

All offshore drilling stocks are trading with a discount to their book values, which is of course not a surprise to anyone who follows the industry. In my view, the numbers above tell us nothing about the overvaluation/undervaluation of these stocks. Here's why.

First of all, let's deal with extreme cases - Ocean Rig and Pacific Drilling.

Pacific Drilling has little backlog left and maturities coming in 2017 and 2018. Even if offshore drilling rebound starts in 2017, it will be too late for Pacific Drilling. The company can't be a going concern with the current capital structure, therefore, we should expect it to go through restructuring proceedings this year.

It's hard to tell whether shareholders will get anything in such a restructuring. Most likely, the will get nothing or at best will be extremely diluted and their stake in the "new" Pacific Drilling will be miserable. Therefore, it does not matter what book value Pacific Drilling has. The company has no time to realize this book value.

The case of Ocean Rig is more interesting and complicated, although the company indicated that it was in restructuring talks and did not rule out bankruptcy. In this case, time is also an important factor. However, it is not the only factor in play.

Why should we believe that Ocean Rig rigs will be worth their book value sometime in the future when the industry rebounds even if we assume that the company somehow manages to avoid restructuring?

I am not talking about some simple depreciation here. The issue that I want to highlight is that rich-era dayrates are not guaranteed in the rebound. So, if you were judging the value of the rig by a discounted cash flow perspective, this value should be adjusted downward compared to the value established at the beginning of 2014.

You will have to adjust the value if you use the replacement cost too. Costs to build a rig have been reduced dramatically as yards are full of newbuilds that drillers don't want to take. You can buy a rig or order a new rig now for significantly less money than in 2012-14. The replacement cost will come back only after the idle rig backlog is worked through, the newbuild rig backlog is worked through and dayrates come back.

I can't imagine how this will happen fast. So we come back to the factor of time once again. We live in a fast-developing world from a technology point of view. The assumption that rigs will certainly rebound to their value over time implies no technological advance and no new regulations. Is it possible? I seriously doubt that modern rigs will have the same life span as rigs from the seventies-eighties as technological progress has intensified.

Let's return to book values of offshore drilling stocks. At best, the can show how the market evaluates the companies' viability with the current capital structure.

It's easy to show in the case of the Seadrill Group. Seadrill and North Atlantic Drilling await restructuring, and their current P/B ratio fluctuates around 0.20. Seadrill Partners is thought to be excluded from restructuring so it trades at a 0.37 P/B.

Despite significant upside during last months, Atwood Oceanics trades at 0.28 P/B. This should not be a surprise, because the company has backlog problems and has yet to show its ability to navigate through the current market downturn with the current capital structure. The recent equity issue was a step in the right direction, but the market will demand more if oil stays at current levels without further upside.

It's really hard to gain any actionable insight from looking at P/B values at this part of the cycle. Perhaps, the market is too hard on Noble Corp. in comparison to peers and a bit overoptimistic on Diamond Offshore Drilling.

In the current market environment, all that matters is the companies' ability to survive without wiping out their shareholders. The recent oil upside brought support for offshore drilling stocks, but will it translate into immediate benefit for offshore drilling in competition with shale for investment dollars?

Here are the latest SA headlines. "Noble Energy to buy Clayton Williams for $2.7B, boosts Permian presence." "Exxon to buy companies double Permian Basin resource to 6B barrels." This is where the money is going right now. Time remains the crucial factor for offshore drillers. Balance sheet strength, maturity profile and backlog are keys to survival. P/B ratio does not matter right now and will not matter in 2017 for sure.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: I may trade any of the abovementioned stocks.