Offshore Drillers: In dire need for some breathing space

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.

Short-Term Challenges

  • 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.

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  • 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.

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  • 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.

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  • Debt problems. Most of these companies now have debt-equity ratio far above their historical standards, see graph below.

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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.

Conclusion

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.

End not yet in sight for weak Floater market

Drilling rig market has seen substantial slump in the past 12 months. The total utilization of drilling rigs has fallen from almost 89% in August 2013 to about 83% at the end of July 2014 (see figure below). This has been mostly on the back of overcapacity and slump in spending by the oil majors. While the number of rigs under contract has gone up by just 2.5% in the past 12 months, the number of rigs that has come in service has far outstripped demand. Total rigs available has increased at a staggering rate of 9% in the same period.

utilization of rigs

However, there is one category that is doing well in between all this bad news, Drillships. Not only has their number saw an increase of 22% in the market but their utilization has also increased by almost 2%. On the other hand number of Jackups in the market has increased by almost 10% while their utilization rates has dropped by more than 5%. Semisub market has followed a similar trend as well, their number in the market has remained flat while their utilization rates have fallen by more than 8%. See figure below.

utilization of rigs 2

And looking at the market the worst doesn’t seem to be over yet. Hope for Jackups is heavily dependent on the revival of marginal fields around the world. While for Semisubs the hope lies in the fact that if difference in day rates between Drillships and Semisubs increases substantially, many companies might shift back and start leasing Semisubs.

Oil Demand And Movement Of Oil Prices

Last few blog posts would have given readers a good idea about oil supply. How through development of shale oil production has been able to keep pace with consumption. And despite geopolitical instability in Middle East oil prices have been relatively stable through the past one year.

Now let’s have a look at the demand or consumption side of oil. Oil consumption is very closely related to the economic activity or GDP of the world as a whole. Looking at the figure below you can quickly make a rough estimate of the growth in oil consumption.

gdp - consumption

 

Most of the GDP growth for past decade or two has come mostly from Asia. These Asian countries have also become big consumers of oil. So if you want to make any bets on the future of oil prices, GDP growth prospects of these big Asian economies should definitely come under consideration. The figure below points to the exact numbers. Europe consumption has fallen while Asia’s increase has by far been the biggest.

oil consumption

 

So next time you see GDP growth in China or India faltering, expect oil prices to go down and vice-verse.

Offshore Drilling vs Shale Oil

Here are two very good articles in Financial Times about how on one hand shale oil production is booming in the US and on the other hand offshore drillers are headed for even tougher times. The links between these two industries are beginning to get clearer by the day. For now it seems safe to say that shale oil is definitely imposing a lot of pain on offshore drilling companies.

Fred Olsen: all at sea

http://www.ft.com/intl/cms/s/3/e1502936-0907-11e4-8d27-00144feab7de.html#axzz37bBMFNAe

Energy: The indispensable country

http://www.ft.com/intl/cms/s/0/601a8476-0b5d-11e4-ae6b-00144feabdc0.html#axzz37bBMFNAe

Both these articles above contain lots of good information and are very much in line with what was published in this blog before.

https://marineoffshore.wordpress.com/2014/07/09/where-are-the-stocks-for-offshore-drillers-headed/

https://marineoffshore.wordpress.com/2014/07/04/shale-oil-imposing-pain-on-offshore-drilling-industry/

Bottom Line: Be ready for more pain in the coming months for offshore drillers and keep a close eye on those earnings report.

Is Weakness In Offshore Drilling Industry Starting To Have An Effect?

Weakness in the offshore drilling industry and oversupply of rigs is not a hypothesis anymore. Industry is well aware of the challenges and most of the companies are getting ready for this upcoming rough phase. Offshore rigs count for the month of June has shown another decline in terms of number and usage for jackups and semisubs, continuing the trend for past one year. Drillships on the other hand has been able to hold up due to continuing increase in ultra deepwater activities around the world. See graph below.

usage of rigs

rigs under contract

 

Although the decline is slow and gradual, this will likely have an effect on day rates for rigs in the near future. And with upcoming new deliveries the situation can turn even more dire.

Where Are The Stocks For Offshore Drillers Headed?

Many people believe that oil price is a major indication of the offshore drilling industry prospects. However if events of this year are taken into account things look very different.

Let’s first have a quick look at oil price (Brent Crude) which has risen slowly and steadily by about 3.3% this year to current state of $109. On the other hand stocks of offshore drillers have been trading well below that mark. See graph below for comparison between stock prices of Seadrill, Ensco, Noble and Transocean.

drillers stock

 

 

Only recent political instability in Iraq has brought some respite and gains. But as oil production from other parts and sources increase, oil price will more or less likely be stable going forward. Also since Iraq is one of the biggest producers from OPEC, other countries are likely to come to its rescue if things go worse. Add to it the fact that offshore industry is dealing with oversupply of drilling rigs (see blog post: https://marineoffshore.wordpress.com/2014/07/03/oversupply-or-replacement-of-rigs), and you can expect stocks of these drillers to fall again this year.

Watch out for those quarterly earnings report and geopolitical situation in the Middle East if you are keen to invest in these companies.

Shale Oil Imposing Pain On Offshore Drilling Industry

Offshore oil & gas industry is going through a tough phase and its prospects in short to medium run aren’t looking that bright either. The industry will maintain its importance but definitely less so than shale oil. The graphs below might just convince you as well.

So let’s start with world oil production first. In 2014 that figure will be close to 92.5 million barrels per day (bpd). Now see graph below to have a look at top 3 oil producers in the world.

oil production

Do you see anything strange? For starters US is now the biggest oil producer in the world producing close to 12.3 million bpd compared with 8.5 million bpd in 2008. That’s almost 45% increase in just 5 years. Majority of that breakneck growth has come from shale oil which is still land based and not offshore drilling.

oil production - growth

True that 10~11% growth rate in shale oil production isn’t going to last forever but the short to medium term prospects of shale industry looks very strong. Most of the increase in global oil consumption are indeed well covered by the increase in shale oil. Which in effect will subdue the prospects of offshore oil industry.

Add to it the facts below:

–          Many other countries are looking to extract shale oil.

–          Imminent oversupply of offshore drilling rigs for next 2~3 years.

–          Oil & gas majors cutting their spending.

–          Iran coming out of sanctions.

All points to the fact that offshore oil & gas will remain weak for some time. And offshore drilling contractors are going to feel the pinch even more. Unexpected supply shock from political instability or war might still play a part but most other pointers are facing in the wrong direction.

The industry has faced these sort of rough times before, now let’s see how it will regain its mojo this time round.