Offshore Drilling: A Look At The Industry At The End Of Q1

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Includes: BDRLF, DO, ESV, NE, PACD, RDC, RIG, SDLP, SDRL
by: Vladimir Zernov
Summary

Rebound is on the way, but the pace of this rebound is slow.

The market has previously expected a faster rebound and looks disappointed.

This disappointment translates into poor stock performance for many drillers in the last two months.

However, the situation when certain stocks go down while industry fundamentals slowly improve may create interesting opportunities in the second quarter.

The first quarter was full of developments for the offshore drilling industry. Oil prices (both WTI (USO) and Brent (BNO)) staged a major rebound after the awful performance in the fourth quarter of 2018. Ensco (ESV) finalized the merger with Rowan (RDC). Noble Corp. (NE) bought a second jack-up. Diamond Offshore (NYSE:DO) decided to reactivate another semi-sub. Borr Drilling (OTCPK:BDRLF) started to put its armada of rigs to work. However, with all those things going on, offshore drilling stocks have only had a bump at the very beginning of this year, and then they have either stayed roughly flat or declined - all while Brent oil prices are near their local high. Why?

Lately, management teams have been optimistic on offshore drilling recovery. However, the pace of this recovery is rather slow. Let's look at expectations presented in recent Ensco presentation.

Source: Ensco presentation

In my view, the pace of the projecting increases in capital spending is not that big enough. In my recent article "What If Offshore Drilling Fully Recovers Only In 2027?", I highlighted that drillers need a timely recovery to get through a debt wall in 2023-2026. This is a major challenge for drillers like Ensco, Transocean (RIG), Seadrill (SDRL) and Noble Corp., less so for Diamond Offshore. Seadrill Partners (SDLP) will know its fate earlier, depending on the outcome of future negotiations with creditors.

While the topic of reserve replacement has been one of the key bullish arguments for offshore drillers, actual numbers point a picture of reserve decline, not a picture of reserve catastrophe:

Source: Ensco presentation

There is clearly a need to keep reserves at reasonable levels, but it does not look like the industry will rush to explore new reserves at any costs. A gradual improvement of activity looks like a more likely scenario at this point.

This month, I have discussed rig supply fundamentals in detail for drillships, semi-subs and jack-ups. Current data suggests that we should be looking for gradual improvement in dayrates for modern rigs that secure their place in the market. However, there's hardly a case for a fast dayrate improvement both from the demand and the supply sides of the offshore drilling market.

Source: Bassoe Offshore

At this point, it looks like dayrates for premium jack-ups will continue to increase, while dayrates for drillships have a chance to get to $200,000 by the end of this year. However, these gradual improvements are likely not what the market expected when it was giving most drillers higher valuations back in 2018 before the major drop in oil prices that happened in the fourth quarter of 2018.

Currently, drillers' shares will likely need a catalyst to get more interest from the market. At the same time, continuous market disappointment (assuming flat oil prices) before the projected pick-up in contract activity in H2 2019-H1 2020 may create an interesting situation for a speculative entry in beaten-down names like Noble Corp. or Ensco.

Speaking about the longer-term, my favorite driller on the floater side is Diamond Offshore, thanks to the good balance sheet and clever conservative strategy, and Borr Drilling on the jack-up side due to the modern fleet and access to capital markets. Pacific Drilling (PACD) also looks interesting after restructuring, but it's significantly more speculative.

As a group, offshore drilling stocks will continue to attract those who seek volatility and momentum on both upside and downside moves. I maintain my view that these stocks will be a difficult choice for the buy-and-hold type of bets. The next quarter will certainly be interesting, so stay tuned!

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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 above-mentioned stocks.