Pacific Drilling May Be More Exposed to Industry Downtime Than the Market Thinks

Investors who intently follow the oil space are by this point no doubt aware of the market weakness that has been plaguing the offshore drilling sector. This market weakness has caused the stock prices of many of the companies particularly active in the space to get beaten down from the highs they achieved last year. But, not all stocks in the sector have been beaten down.

In fact, there are some offshore drilling companies whose stock prices have remained remarkably stable since the industry began to experience difficulties. One of those stocks is Pacific Drilling (PACD). Through this stability, Mr. Market appears to be telling us the company will not be affected by the weakness in the sector. But, is he correct? Let's find out.

Explaining the problem in the market
According to offshore drilling giant Seadrill (SDRL) in its fourth-quarter 2013 earnings report, the weakness in the offshore drilling sector is primarily limited to the ultra-deepwater environment as opposed to the shallow-water environment. In fact, Seadrill states oil and gas companies are still quite actively demanding shallow-water jack-up rigs.

However, exploration and production companies have been forced to reduce their exploration budgets because of rising production costs in areas such as onshore North America (primarily in the shale regions). Unfortunately, offshore drilling rigs are mostly used in exploration, so the reduction of spending in exploration activities has reduced the demand for offshore drilling rigs. As ultra-deepwater rigs cost significantly more to contract out than shallow-water jack-up rigs, they have been most affected by the reduction in spending.

Another reason for the weakness in the ultra-deepwater sector is an increase in supply. During the offshore drilling boom that lasted from 2011 to 2013, offshore drilling contractors ordered a large number of new rigs. However, the reduction in exploration spending has meant many firms have had difficulty securing contracts for their new rigs. This is why there are 17 ultra-deepwater rigs that will be delivered to their respective drilling companies in 2015 and 2016 that do not yet have contracts. However, this is not so many that it will result in a glut in the industry.

There were 28 rigs delivered in 2011, for instance, and that most certainly did not cause a glut. However, exploration spending was high in 2011, and that is not the case today. With demand soft because of lower exploration spending and the supply increasing, day rates are being forced downward. This could result in lower revenues and cash flows for some companies in the sector .

How does Pacific Drilling fit in?
Well, Pacific Drilling only owns and operates ultra-deepwater rigs. The company has no shallow-water rigs in its fleet. Therefore, it would be reasonable for us to conclude that the company would be more affected by the weakness in the ultra-deepwater market than a company such as Ensco (VAL) or Seadrill, which also have shallow-water fleets to offset the weakness in the ulta-deepwater environment. Yet, the market has not borne this out, as we can see by looking at the stock charts for the three companies.

PACD data by YCharts.

As the chart shows, Pacific Drilling has outperformed two of its largest competitors despite the fact that its fleet is entirely ultra-deepwater rigs. It is also by far the most expensive stock on a price-to-earnings basis. So, what's going on?

Pacific Drilling is not less exposed than peers
At first, we may conclude Pacific Drilling is not as exposed to the downturn as its fleet composition may make us think, but this does not appear to be the case. Here is the company's fleet along with the contract status of each of its rigs.

Source: Pacific Drilling. 

As this chart shows, Pacific Drilling has two rigs that will leave the shipyard in 2014 and 2015 that it has not yet secured contracts for. In addition, the company has two rigs that will come off contract in 2014 or 2015 that the company has not secured replacement contracts for.

These new rigs and expiring contracts mean Pacific Drilling will be attempting to shop around half of its rigs for new contracts in 2014 and 2015. These are the two years when the market is expected to be weakest. Thus, Pacific Drilling may have to settle for lower dayrates on its rigs than it otherwise would if the market were stronger. With that said, the company is still likely to see growth if it can secure contracts for all of its rigs that need them because it will have more rigs operating than it does now.