Is Offshore Drilling Sunk or Destined to Recover?

Image source: Seadrill.

It's been a bloodbath in the oil industry in 2015, and offshore drilling stocks have been among the hardest hit. Even industry giants Transocean (RIG 2.24%), Seadrill (SDRL), and Ensco (VAL) are struggling to stay afloat as demand for their rigs drops off the map.

Short term, the industry is in dire straights, as many other energy companies are. But if you take a long-term view of the industry, the picture becomes brighter. Companies just need to last long enough to get there.

Low oil prices won't last forever
Long term, the oil markets are all about supply and demand. When prices were over $100 per barrel, supply increased and demand growth slowed, causing an oversupply in the market. But now we're seeing prices correct in the other direction and production plunging while consumers are using more and more oil.

A recent presentation from Transocean with estimates from Morgan Stanley Research suggests that oil markets will become undersupplied as early as next year if oil prices stay at $50 per barrel. Even at $70 per barrel, markets will be undersupplied by 2017.

Data source: Transocean investor presentation.

While market conditions aren't favorable for offshore drilling companies today, the long-term picture should be brighter, especially for companies that can get there.

Backlog will hold the strongest companies over
Surviving until the market recovers will be the biggest challenge for offshore drillers. Hercules Offshore has already gone into bankruptcy and it wouldn't be surprising to see other small players do the same.

What Seadrill, Transocean, and Ensco have going for them is a large backlog of revenue that can keep them afloat through the next year.

Note: Seadrill's backlog is as of the end of the second quarter 2015. Transocean's backlog includes $6.0 billion in backlog from 2020-2027. Data source: Company earnings reports.

Backlog may be a stopgap measure, but it's important in the short term. And with companies pushing most of their debt maturities out beyond 2017, they just need to be able to survive for a year or two to make investors money.

Rig scrapping will balance the market
If oil prices remain below $50 per barrel for the next year, we'll continue to see scrapping of older drilling rigs. According to Transocean's latest investors presentation, 34 rigs have been cold stacked in the last 12 months and 42 rigs have been scrapped.

Data source: Transocean investor presentation.

Transocean alone has scrapped 22 floaters and cold stacked another 11 in the last year. Ensco has scrapped two and cold stacked 8 floaters in that time.

If oil prices remain low, that kind of rationalization of supply will continue. But it will also create more upside if oil rises to $70 or $90 per barrel, where Transocean says incremental supply and demand will balance out.

Still afloat, for now
Long term, I don't have any doubt that offshore drilling will be in high demand once again and rig owners will be able to command high dayrates and margins. But as long as oil remains below $50 per barrel, there's going to be nothing but pressure on offshore rig owners to lower prices and even scrap rigs that can't find work.

So, the bullish investment case is still dependent on oil prices rising significantly in the next year or two. I think that's coming and offshore drillers will benefit, but it's been a wild year in energy, and even for the best-positioned offshore companies, the risks are high for investors. Tread carefully.