This year didn't start well for investors in offshore drilling companies. Shares of Diamond Offshore (NYSE:DO), Atwood Oceanics (NYSE:ATW), and SeaDrill (NYSE:SDRL) continued the downtrend already in place at the end of 2013. These companies look cheap based on their forward P/E multiples, but there are several reasons why the weakness could continue.
Day rates are depressed
In its fourth quarter earnings call, Atwood Oceanics stated that its competitors had newly built rigs without contracts, which would likely put some pressure on day rates. This pressure is already there.
Seadrill has a significant pipeline of ultra-deepwater drillships that will be finished in 2014 and 2015. Seadrill's latest fleet status report showed that 7 out of 8 of these drillships had not been contracted yet. In its latest quarterly report, Seadrill stated that exploration and development companies remained comfortable with rates in the range of $550,000-$650,000 per day for the highest-end classes of rigs.
Two of Diamond Offshore's ultra-deepwater rigs that will start their work in 2014 -- Ocean Onyx for Apache and Ocean BlackHawk for Anadarko -- received contract day rates below $500,000. Another problem for Diamond Offshore is that its fleet is relatively old. The rates for such rigs are pressured even more as newly built rigs flood the market.
The mid-water fleet brought 43.3% of revenue for Diamond Offshore in the fourth quarter, while ultra-deepwater rigs brought 33.4% of revenue. This is not the most favorable revenue mix.
Excess leverage could hurt in the long term
Seadrill has a very young fleet, but this comes at a price. The company has amassed more than $10 billion of long-term debt. This could present a significant problem if the excess supply remains in the market for a long period of time, pressuring day rates. Diamond Offshore and Atwood Oceanics also have significant debt obligations, though they are smaller than Seadrill's.
Another point of concern is that the oil industry is beginning to focus on cost discipline. Atwood Oceanics stated that a significant number of pending deepwater and ultra-deepwater rig contract rollovers clouded its yearly outlook. The company had seen several operators delay or cancel their drilling programs. From a big picture point of view, it looks like demand for rigs is at best stagnant while supply continues to increase.
As I've stated at the beginning of this article, drillers trade at cheap valuations if judged by forward P/E. This could mean that investors are less optimistic about drillers' future results than analysts are.
Supply clearly outpaces demand, and this is the main problem. I don't see any signs of a pick-up in demand, at least in the short term. A lot of oil companies are increasing their horizontal drilling onshore programs, and their capital budgets are allocated accordingly.
This means that some supply must be put out of the market to balance supply and demand. For this, some older rigs must be idled. This is not an easy decision for any company, because when you decide to idle the rig and remove the personnel to eliminate costs, the rig is unlikely to be recovered in the future. Because of this, companies will be trying to search for acceptable contracts for such rigs for some time.
All in all, offshore drillers are likely to remain under pressure.
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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool recommends Atwood Oceanics and Seadrill. The Motley Fool owns shares of Atwood Oceanics and Seadrill. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.