Avoid or Sell Drilling Rig Operators

World oil demand will grow anemically versus abundant supply, according to Platts' Global Editorial Director for Oil Dave Ernsberger. He laid out Platts' bear case for oil prices at the energy analytics service's Commodity Week earlier this month in Houston. Presented with strong data, the packed room of energy industry top guns leaned forward, bug-eyed at persuasive data that oil at $100 per barrel is unlikely to last.

Investors in offshore drilling rig operators face the most risk, but industry sees only blue skies and calm seas ahead. Investors should avoid, sell, or short their stocks.

China demand peaking, U.S. needs falling
China's thirst for oil has helped keep global pricing high and firm, but that's ending. Though China does not release official oil demand data, Platts calculates apparent demand by adding refinery throughput to net oil products. Platts' data crunching finds that China's oil demand growth has slowed and seems stuck below 10 million barrels of oil per day, or BOD. This comes with other not-so-great news:The United States is rapidly approaching oil independence for light sweet crude, though not heavy crude, removing a major source of world demand.

With other major growing sources of supply including Brazil's massive offshore finds and the African west coast, Platts sees world oil demand growing at an anemic 1 million BOD and supply growing well beyond that at today's $100 per barrel pricing.

As supply rises to meet slowing demand growth, prices are likely to fall. When they drop below the level at which some producers can make money, they shut in production. This has implications throughout the energy exploration, production, and distribution chain, but it may well bring the most unpleasant surprises to the offshore drilling rig operators.

Whistling past Davy Jones' Locker
In September, the drilling rig industry order book -- the number of rig newbuilds, in the industry parlance, under construction at the world's shipyards -- stood at 12.1% of existing capacity in dead weight tons. This is down from October 2010's 18% -- yowza -- but 25% up from a year ago with strong industry optimism.

As in so many industries requiring leverage such as oil tankers, cars, and real estate, everybody starts projects in good times when financing is easier. Plus, drilling operators today run at high capacity -- for example, Transocean (NYSE: RIG  ) at 93% -- and any business lost for lack of rigs costs $500,000 a day and up for the behemoth rigs . At these rates a new ultra-deepwater rig or drillship costing $600 million-$700 million pays for itself after expenses in roughly eight years, so long as the good times roll.

But these are all projects that take a year or more to complete. As shipyards and rig operators crack champagne bottles on new rigs hitting the water, the same thing is elsewhere.  Eventually, supply exceeds demand, dayrates decline, and companies are sitting on a lot of rigs with lower dayrates. This squeezes net margins that are running, for example, at an astonishing trailing-12-month 51% at Seadrill (NYSE: SDRL),.

This is what happened to the crude oil tanker industry, in a slump with no end in sight. Today tankers must either set sail at a daily loss or sit in harbor incurring bunker costs, industry  for ships awaiting charter filled with oil. That's like unused and unsold inventory.

Offshore drilling rig operators may find their markets slacken. Customers will find oil less profitable to drill for and produce. Five important offshore rig operators -- Transocean, Ensco (NYSE: ESV  ) , Seadrill, Noble (NYSE: NE  ) and Diamond Offshore Drilling (NYSE: DO  ) -- may find themselves closer to the devil than the deep blue sea.

How bad off are they?
Those most likely to suffer have the heaviest debt and larger orders for newbuilds as a percentage of current fleet. Debt comes with the territory given the high costs of new ultra-deepwater rigs and drillships. But you don't want to be caught with huge debt when utilization rates decline and interest rates rise.

Company

Enterprise Value (EV) in billions

Net Debt to EBITDA

EV/TTM EBITDA

Market Cap/TTM FCF

Order Book % Current Fleet*

Seadrill (8/28/13)

33

4.4

14.9

None 

38%

Transocean (10/16/13)

24

2.7

8.8

None

9% 

Ensco (10/17/13)

17

1.9

7.7

None 

12%

Noble (10/10/13)

15

2.8

8.4

None

13 %

Diamond Offshore (9/9/13)

9

0.2

6.7

37.3 

21%

Source for stock-specific multiples: S&P 500 CapitalIQ
*Current fleet excludes cold stacked or in storage rigs.

All of these are vulnerable to lower oil and customer weakness, but one is clearly the worst.

Avoid or sell Seadrill
Seadrill is most at risk by all measures. It has the worst debt situation, highest valuation, and an absurdly high ratio of orders to current fleet. A spinoff from Norwegian shipping magnate John Fredriksen's Frontline (NYSE: FRO  ) empire, Seadrill is like all Fredriksen companies leveraged beyond its competitors. As with all leverage -- think margin debt -- this is great in a cyclical upturn and brutal on the down cycle. (By the way, Frontline is at some point going to be ready to profit in a cyclical upturn in oil tanker operations, but today it's a burn-your-money speculation.)

It's best to avoid or sell Seadrill. But if investors have the savvy, pockets, and patience for shorting, Seadrill is a good candidate. Short interest is only 4% of the float. With that and Seadrill's large daily volume, there is no short squeeze risk.

Platts has presented some very important data on oil demand versus supply ahead. Investors should stay away from drilling rig operators because they present far too much downside risk for upside potential. Seadrill presents by far the biggest risk.

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Read/Post Comments (8) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 24, 2013, at 3:53 PM, sklarb wrote:

    I completely disagree with this analysis. China and India will continue to expand oil imports, and the amount of recoverable shale oil and gas, especially gas, in the US is vastly overhyped.

    China to leapfrog US in oil imports by 2017

    http://www.chinadaily.com.cn/china/2013-08/22/content_169123...

    From this article:

    "From 2005 to 2020, China's oil imports will rise from 2.5 million barrels per day to 9.2 million barrels a day. US imports, on the other hand, will fall from a peak of 10.1 to 6.8 million barrels per day within the same period. That roughly represents a 360 percent increase in China's crude oil imports and a 32 percent decline for the US during that period."

    And oil isn't just used for fuel:

    China & India to lead global PTA demand growth – GBI

    http://www.fibre2fashion.com/news/textile-news/newsdetails.a...

    However, the amount of US shale gas reserves is disputed by a number of industry experts, and there will be no export market for it and not enough to replace oil as a fuel:

    US shale gas: game changer, or game over?

    http://www.power-technology.com/features/featureus-shale-gas...

  • Report this Comment On October 24, 2013, at 3:59 PM, sklarb wrote:

    Demand for oil "will outstrip supply" by 2015 - new research

    http://www.imeche.org/news/engineering/demand-for-oil-will-o...

    From this article:

    "Demand for oil will start to outstrip supply in the middle of the decade and reserves have been exaggerated by at least 250 billion barrels, new research from Oxford University has found.

    The study, by the Smith School of Enterprise and the Environment at Oxford, said the “age of cheap oil” was at an end and that estimates of reserves should be downgraded from between 1,150-1,350 barrels to between 850-900 billion barrels."

    And:

    "

    Dr Oliver Inderwildi, head of the low carbon mobility centre at the Smith School, said efforts should be made to improve energy efficiency to mitigate demand for oil and that the idea that biofuels could supplement oil effectively was “pie in the sky”. “There is not sufficient land to cater for both food and fuel demand. Instead of relying on those silver bullet solutions, we have to make better use of the remaining resources by improving energy efficiency,” he said.

    “Alternatives such as a hydrogen economy and electric transportation are not mature and will only play a major role in the medium to long term,” Inderwildi added."

  • Report this Comment On October 24, 2013, at 5:04 PM, sklarb wrote:

    As for the Brazilian offshore finds, the salt layer, depth of the water, distance from shore and the depth of the oil under the salt provides many technological and logistical challenges:

    Salt Dome: challenges and opportunities for OCTG

    http://www.connection-mag.com/?p=1123

    Here is one in well design:

    "Regarding to tubular supplies, these extreme conditions must be studied thoroughly at a very early stage by both the operator and the tubular supplier in order to get the right metallurgy and connection chosen to meet efficient drilling & production objectives: enabling the well architecture to maximize production, avoiding casing collapse, enabling the surface or subsea equipment to withstand the weight of the whole casing column, and avoiding corrosion to set in. Most obviously, the combination of reservoir depths, external pressure from the 2,000 m salt layer and high fluid pressure imposes usage of tubulars with high yield strength and high collapse performances; OCTG casings up to 140 ksi in yield strength have been used in some exploratory wells, and high collapse grades are routinely incorporated in well designs. In such critical deepwater environments and with wells engineered for 20 year lifetime minimum, the basic expectations of well designers is for OCTG connections to be designed as robust as the pipe and qualified to the highest ISO 13679 level CAL IV. Besides mechanical loads, tubulars might also be subjected to H2S presence. Therefore High Strength Sour Service grades such as C110 or proprietary125 SS grades, or even combined collapse & H2S resistance (HCSS) are typical choices for production casing. Extremely high CO2 contents from the reservoir, with potential worsening due to CO2 reinjection, also drives material selection toward special CRA (Corrosion Resistant Alloys) materials such as super13Cr. This applies not only to the tubings that are already commonly selected with such metallurgies for other projects in corrosive situations, but also to production casings placed at the bottom end of the strings that may be exposed to both the corrosive fluid and significant collapse pressures. Such constraints on the tubulars therefore imply production of heavy wall large OD CRA casings: manufacturing of the tubular in such thickness, as well as design and qualification of adapted connections, imply early collaboration with the operator."

  • Report this Comment On October 24, 2013, at 11:30 PM, Plier wrote:

    You lost me at "China demand peaking..."

    I find that hard to believe.

  • Report this Comment On October 25, 2013, at 12:12 AM, DukeMontrose wrote:

    This fool applauds the comment by Sklarb.

    Having said that, I've been commenting for months about the SDRL foolishness of pushing the dividend envelope close to 100% payout.

    A Nordic banker wonders per chance the Admiral of SDRL personally needs that high dividend payout to keep his previous fiasco, Frontline, [FRO - NYSE] afloat == [another once-high flyer which had once a near 100% pay-out]

  • Report this Comment On October 25, 2013, at 6:58 AM, tankerat wrote:

    An entertaining article...for all the wrong reason..

    First of all drilling, rig numbers or capacity are not measured in "dead weight tons" and they take 2.5-3 years to build...not "a year or more"..

    Seadrill was not a spin off from Frontline..[that was SFL]...

    This all depends on just one set of facts we will all know real time as they are announced. That will be the rates Seadrill locks in on its coming newbuilds. if they are able to grow their EBITDA by 70% by 2016 [as they have repeatedly projected]...everything will be fine and the dividend and the share price will grow. If that happens and you are short, you will regret that...a lot.

    I suggest you check out, as just one example, the work of Morgan Stanley's Ole Slorer who actually understands the UDW rig sector and tracks industry capacity vs. demand as well as rig utilization rates, and the contract activity for the newbuild UDW rigs..

    You might also check recent activity such as last week's deal between Chevron and Transocean which is for a new UDW rig at $600,000 per day running 2016-2020..

  • Report this Comment On October 25, 2013, at 7:57 PM, awallejr wrote:

    Author might want to factor the following into his analysis:

    "A recent presentation from SeaDrill, citing Rystad Energy's work, predicted that the current global fleet of 256 floating drill rigs will increase to as much as 358 by 2020, but the market may demand 455 rigs. There's an opportunity to double the number of rigs being built by then."

    There is nowhere near overbuilding as there was with tankers.

    Also you need to remember that it is illegal to export oil from the US. So all that supply might keep energy costs low in the US (actually a good thing for the country) that oil isn't going to China. SDRL drills all over the world with a small portion involving the US.

    Before you advise people to do something incredibly risky as shorting a stock (especially high paying distribution ones) know what you are talking about.

  • Report this Comment On October 27, 2013, at 3:01 PM, akaralph wrote:

    Saudi Arabia just announced that their demand for rigs will grow by 200 near term.

    These authors really need to become more familiar with the subjects of their articles.

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