Offshore drilling industry has been around for a long time now. The industry has seen many ups and down but there has never been a question mark on its long term sustainability. Oil & Gas still forms a major mix of our energy consumption and will do so for next generation or so. However for the past year or so the offshore drilling industry in itself has been suffering from oversupply of rigs but now its short-term problems have been compounded by oil glut from shale and a struggling world economy.
This brings us to the question of whether the drilling industry never saw this coming? Or just forgot to prepare itself for any external shock? Or was it just looking at renewable energy sources such as wind/solar as its competitors while the actual competition came from shale?
For this post let’s have a look the performance of four major offshore drilling companies: Transocean, Diamond Offshore, Noble Corp and Ensco Plc.
- Rising costs. While both prices and demand for offshore rigs went up, until the recent downturn, margins for drilling contractors have actually been falling. Older rigs have been one part of the problem as is evident from the continuous decline in Return On Assets (ROA), graph below. But other issue has been inability of the industry to innovate to keep costs down. Sudden decrease in 2011 has been primarily due to the Macondo disaster in 2010.
- Different fate for different drillers. Although the general trend has been a decline in operating margins, some drillers have actually been able to stabilize their margins in the last 3-4 years. Obvious outlier is Noble Corp whose revenues has increased and operating margin has been more or less stable. It’s ROA and Earnings Per Share (EPS) also has been stable for last 3 years.
- Issue of sustainability. This brings us to the question of sustainability. With revenues rising and margins stabile, is Noble Corp really the best positioned in the market currently?
If you dig a little deeper a major part of rising revenues can be attributed to the rising debts in these companies, see graph below. Blame it on the cheap money that is available from quantitative easing from US Federal Reserve if you wish. But there is no denying the fact that debt has been the main driver. If you look at the long-term debt graph below carefully, rise in both debt and revenues happened around 2010. So is this strategy sustainable in the long run?
Major increase in debt for Transocean has been in 2007, due to merger with GlobalSantaFe. And in 2011, due to Macondo incident. Well the main issue is that those debts are still at that high level.
- Debt problems. Most of these companies now have debt-equity ratio far above their historical standards, see graph below.
What happens if growth in global economy remains fragile? (Medium probability)
Or, shale oil from US just keeps increasing? (High probability)
Or, oil prices doesn’t rise much? (High probability, considering the above two scenarios)
Well in short the oversupply of rigs in the offshore industry will become an even bigger problem, with drillers trying to undercut each other on price. And these companies still have to repay their debts or refinance it with higher interest rates.
It would be fair to say that industry has been hit by a triple whammy from oversupply of rigs, shale oil and fragile global growth. To add to it companies now seems to have a growing debt problem. It is quite clear that the industry was ill prepared for such an external shock/competitors and has been waiting on its heels in terms of innovation. On the productivity matrix industry seems to have actually gone in reverse.
For the short-term these companies would welcome some breathing space, although it’s not clear where that is going to come from. For investors looking for the bottom, just watch out for oil prices.
Note: For 2014, trailing twelve months (TTM) has been used where relevant.