Deepwater Rig Building Boom May Leave Casualties

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About two weeks ago I wrote about the flurry of orders for deepwater drilling rigs that kicked off late last year. The pace has not subsided, with Daewoo Shipbuilding & Marine Engineering since pulling in three more drillship orders: two from Aker Drilling -- a Norwegian drilling contractor prepping for an IPO on the Oslo Stock Exchange -- and one from Atwood Oceanics (NYSE: ATW  ) .

We've seen the ticket price for a new drillship pull back from its peak, but contractors aren't exactly getting deep value at $600 million per rig. Many of them are also willing to commit to newbuild orders without a drilling contract in hand -- something that Transocean (NYSE: RIG  ) has typically refused to do.

Are these outfits simply that bullish on the long-term demand outlook for deepwater drilling, or is there something else driving this herd-like behavior?

The folks at JPMorgan think there's something else at work. That something is a company named Seadrill (NYSE: SDRL  ) . This hard-charging company has taken the drilling market by storm, amassing a world-class drilling fleet in a shockingly short period of time. JPMorgan's analysts basically see Seadrill forcing other companies' hands, in that the more top-shelf rigs Seadrill brings into its stable, the less competitive operators like Diamond Offshore (NYSE: DO  ) become.

Diamond, a cornerstone of the Tisch family's Loews (NYSE: L  ) empire, has historically shown a knack for opportunistic purchases and a preference for upgrades over newbuilds. Even this company is joining in the newbuild rush, which is pretty telling. Whether it's Seadrill that's pushed it into a corner, or simply the broader market trends toward ever-deeper drilling targets and higher-capacity rigs, Diamond Offshore seems to find itself in a bit of a bind.

The firm is popular with value and income-oriented investors, but I question whether Diamond's high returns on capital and outsized special dividends are sustainable. Looking at the age and capabilities of this contractor's fleet, I foresee significant future capital expenditure requirements in order to stay competitive with the more modern fleets of firms like Seadrill and Ensco (NYSE: ESV  ) . That implies a drag on future free cash flow, and perhaps a lower valuation than the market is awarding this company today.

Atwood Oceanics is a Motley Fool Stock Advisor selection. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his CAPS profile or follow his articles using Twitteror RSS. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool owns shares of Diamond Offshore, Ensco, and Transocean. The Motley Fool has a disclosure policy.

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Related Tickers

10/27/2016 4:01 PM
ATW $8.58 Up +0.15 +1.78%
Atwood Oceanics CAPS Rating: ****
DO $17.36 Down -0.04 -0.23%
Diamond Offshore D… CAPS Rating: **
ESV $8.43 Down -0.34 -3.88%
Ensco CAPS Rating: *****
L $41.01 Up +0.13 +0.32%
Loews CAPS Rating: ***
RIG $10.38 Up +0.06 +0.58%
Transocean CAPS Rating: ****
SDRL $2.28 Up +0.01 +0.44%
Seadrill CAPS Rating: ***