The offshore drilling business has suffered its deepest downturn in 30 years, as investment capital has rushed to land, chasing shale. But there are early signs of a return to the sea, and investors who dive in now could profit nicely.
The clearest sign of a turnaround is the worldwide offshore rig count, which is up 28% over the year through February, according to a report this past week from Baker Hughes. A more nuanced clue is where some of these rigs have come from. Kurt Hallead, an analyst at RBC Capital Markets, counts 25 dormant or “stacked” rigs that have been put back to offshore work over the past 15 months.
“If there were ample supply, an oil company would wait for an active rig to become available rather than contracting one that’s been sitting on a beach for two years,” says Hallead.
This isn’t an industry for investors who like stocks with low price/earnings ratios and steady earnings. The shares are deeply depressed; Transocean (RIG), the blue chip among rig owners, briefly topped $150 a share in 2008 but recently changed hands at $8 and change. The company continues to lose money, and even though contract rates for future rig leases have recently jumped, that might not turn into a full-blown earnings recovery for years.
History says to buy the stock before the earnings return. The recent bottom for the offshore rig utilization rate, hit in 2017, was under 60%. The industry hasn’t looked that bleak since the mid-1980s. An investor who bought a basket of offshore stocks back then made about 35% a year annualized for three years as utilization climbed back to 80%, reckons Hallead.
Some contrarians have already waded in. Graeme Forster manages the international equity strategy at Bermuda-based Orbis Investment Management, which oversees $33 billion. Since inception in 2009, the strategy has turned a $10,000 investment into $28,560 after fees, versus $19,353 for the average international equity fund. He has taken positions in Transocean, Ensco (ESV), Diamond Offshore Drilling (DO), and Oslo-based Borr Drilling (BDRLF), founded in 2016.
Capital flows back and forth between offshore and onshore drilling in cycles, says Forster. When all of it has flowed in one direction, run in the other.
“There’s nothing wrong with shale, but there’s so much capital there that returns have been crushed,” says Forster. “And you’re never going to fulfill all the world’s energy needs from shale.”
All else held equal, shale drilling offers a faster return than subsea drilling, and a lower upfront investment, but also faster depletion of reserves. Offshore wells can pay off for many years, if the price of oil cooperates. The recent downturn forced a reckoning among offshore companies. Some smaller outfits went bust. Others consolidated. And major oil companies took hard looks at their offshore assets, prioritizing ones that can earn attractive returns with Brent crude at or below $50 a barrel. Brent recently sold for $66 a barrel.
Meanwhile, costs for offshore drilling have fallen. One reason is that some service companies have joined forces. In 2017, Houston’s FMC Technologies , a subsea equipment maker, merged with France’s Technip, a subsea installation and engineering concern, to form TechnipFMC (FTI). The year before, Schlumberger (SLB) bought Cameron International, combining well technology and project management with flow equipment.
“Oil companies used to have to deal with a lot of different service and equipment companies, which led to cost overruns and delays,” says Evercore ISI analyst James West. “Now there’s more one-stop shopping, and costs are lower.”
West predicts a rebound for deepwater drilling, and favors shares of Transocean, Ensco, and Rowan (RDC). Last month, shareholders of Ensco and Rowan approved an all-stock merger. He’s also bullish on Diamond, but it’s already heavily contracted, and might not have as much upside when conditions pick up. He calls Transocean, which appointed National Oilwell Varco ’s Jeremy Thigpen chief executive in 2015, the best-managed company in the group, and yet says it has plenty of room for improvement after its December purchase of Ocean Rig UDW, which didn’t have especially strong contracts. Transocean owned the Deepwater Horizon rig, which had a deadly explosion and massive oil spill in 2010.
Forster says he’s investing in a handful of offshore stocks because all are likely to do well when the market comes back. He is particularly bullish on tiny Borr, which has scooped up 29 rigs near the bottom of the market at roughly half of what it would have cost to build them. Rigs can last 30 years, so the economic value of Borr’s rigs through the next upturn is likely higher than what’s indicated by the company’s book value, Forster says. Borr recently traded at close to book value.
Rig leasing companies have diverse fleets. For shallow water, relatively inexpensive jack-up rigs are platforms with legs that can extend to the seabed. Semisubmersibles are floating platforms with large pontoons that can take in water to put much of the bulk just below sea level, increasing stability in rough water. Deepwater drill ships can carry plenty of equipment and are exceptionally mobile, making them useful for exploration.
The number of semisubmersibles peaked at 171 in 2014 and plunged to 53 by 2017 as companies scrapped rigs, according to Hallead. Recently negotiated contract rates have topped $300,000 a day, up from about $150,000 a day at the low, but many of the new contracts won’t start for a year or more, he says. Back in September, he upgraded Transocean, Diamond, Rowan and Noble (NE) to Outperform.
David Anderson at Barclays has been bearish on offshore drillers for five years, and remains cautious, but began testing the water last month, upgrading Transocean and Diamond straight to Overweight from Underweight. Fleet quality will matter most from here, he predicts, as companies with modern, efficient rigs will be the first that win new work and will command the best rates.
Christopher Jacobsen, a derivatives analyst at Susquehanna Financial Group, has a strategy for investors who only wish to dip a toe into deep-sea drilling. Buy the August $8 call options on Transocean, he recommended this past week.
Those who buy shares had best not fall in love with them indefinitely. “This has not been a great business over time,” says Forster. “But if you invest at the right time of the cycle, you can do well.”
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