Oil At $71, Drillers Are Lagging, What's Going On?

by: Vladimir Zernov

Oil rallies but offshore drilling shares sink.

I examine potential reasons for this pattern.

I do not think such a situation will last long assuming oil holds above $70.

I discuss three big players to watch in case momentum activity picks up.

Brent oil (BNO) quickly spurted to $71 per barrel as tensions in Libya intensified and the U.S. labeled Iran’s Revolutionary Guards as a terrorist group. The whole setup was favorable for everything oil-related to rally, but offshore drilling stocks had a disappointing day. At the time of writing these words, Transocean (RIG), Diamond Offshore (DO), Rowan (RDC), Ensco (ESV), Noble Corp. (NE), Seadrill Partners (SDLP), Awilco Drilling (OTCPK:AWLCF), Borr Drilling (OTCPK:BDRLF), and Pacific Drilling (PACD) were all in the red zone, with the exception of Seadrill (SDRL) which managed to keep its head above the water.

Such performance is especially startling given the fact that offshore support vessel (OSV) providers like Hornbeck Offshore (HOS), Tidewater (TDW), and Nordic American Offshore (NAO) (a special situation as the company announced a deal with creditors) were in the green zone for the day. OSV services are the last in the offshore drilling “chain” to benefit from recovery, so the fact that their stocks are upbeat on oil rally while drillers’ stocks are not adds to the “conspiracy”.

So, what’s going on and is there a way to profit from this?

The obvious suspect is some kind of a negative headline that has put pressure on the sector. The most negative news that I have been able to find is Norway taking a step to ban drilling in Lofoten archipelago. This place is known for very picturesque views which has most likely contributed to the political shift.

However, given the fact the Norwegian Sea is the most robust sector in the whole offshore drilling market by dayrate dynamics (Saipem’s (OTCPK:SAPMF) Scarabeo 8 has just received a contract from Wintershall in Norway at a dayrate of $295,000 – I recently wrote on Saipem’s plans to sell the offshore drilling business), there are no systemic problems with drilling in Norway yet. It does not look like the news could have pushed all drillers who have operations across the globe to sell off almost in sync.

One could argue that increased tensions with Iran and problems in Libya could somehow impact the offshore drilling industry, but this is not the case. Iran does not have rigs from international drillers (not a surprise given decades of sanctions after the revolution), while the only rig in Libya is Ensco 5004 (data from Bassoe Offshore, Ensco’s fleet status report lists location as Mediterranean).

Another thing to consider is that there haven’t been too many new contracts announced in recent weeks. The “density” of contract announcements could have been better:

Source: Bassoe Offshore

Indeed, the pickup in offshore drilling has been slower than drillers hoped, and this is surely one of the reasons why their stocks have mostly failed to capitalize on initial rebound that happened at the beginning of 2017. Another potential explanation is that the market sees oil prices above $70 as not sustainable, and that oil will go down once tensions ease.

Whatever the real reason behind offshore drilling stocks' underperformance, the whole group is speculative and trades more on expectations than on current numbers (which do not look good due to the impact of the market downturn on the companies’ financials). Thus, it is highly likely that the market’s interest will return to drillers if oil stays above $70. Here are my thoughts on three possible plays on major U.S. exchanges in this case:

Diamond Offshore above $12.00 is probably the clearest speculative momentum play in the space right now. The company has adopted a conservative strategy that has so far proved to be the best approach during the downturn. Also, its floater fleet is more sensitive to higher oil prices over the longer run.

Ensco's shares have seen little action after the company finalized the details of the Rowan merger. I’d expect them to return back to more volatile trading once the merger is completed. In my opinion, the time to start watching the stock closely is now.

My regular readers know that I have been critical of a number of Transocean’s moves, notably the decision to acquire Ocean Rig. I maintain my views, but, speaking about shorter-term perspectives, I cannot ignore the fact that Transocean and its industry-leading backlog attract plenty of investors' and traders' attention and that the stock could see an influx of speculative money once it flows into the sector due to higher oil prices.

Conclusion: I think it’s time to put offshore drilling stocks on prime watchlist and monitor them closely. I do not think that the whole sector will continue to ignore the upside in oil if it continues. Also, fleet status reports are coming soon this month, followed by earnings reports, so the market will have more fundamental information to digest.

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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.