The oil and gas market, in general, isn't doing so hot, and the offshore rig market is probably the worst off of the industry. The one-two punch of cheap oil and lower-cost, shorter-development-time shale wells has kept producers from venturing onto the seas for the next big payday. While the market is suffering, this is an opportune time for better-positioned companies to take advantage of the chaos, and that is exactly what Ensco (NYSE:VAL) did by buying Atwood Oceanics (NYSE: ATW).
To better understand why Ensco decided it was the right time to make this kind of deal, here's a look at a selection of quotes from both the earnings conference call before the transaction took place and from the deal announcement call. These quotes help to decipher where the industry is today, some of the big changes coming down the pipe, and the ultimate decision of bringing Atwood into the fold.
Outlook warming up, but it's still pretty cold out there
Offshore rigs have been a tough market over the past few years. Not only is cheap oil discouraging producers from spending money, but shale reservoirs are now economical at much lower prices and are taking away investment dollars from potential offshore projects. It's no surprise, then, that the major offshore rig companies have all seen their stock prices plummet over the past couple years.
According to Ensco CEO Carl Trowell, there are some signs of promise, but certainly not anything that investors can take to the bank just yet:
As we mentioned on our last earnings call, we are in the midst of arguably the worst downturn this sector has ever experienced. But we feel that we are now in a different phase of the cycle. We feel even more confident in this view today, as we have seen a broad-based pickup in customer activity, especially for jackups, albeit off a very low base. For example, during the first quarter, the number of new contracted rig years awarded globally increase sequentially for the third consecutive quarter.
Tenders and inquiries, which are a leading indicator of future contracts, are up year over year for both floaters and jackups. On a trailing-six-month basis, the total number of tenders and inquiries and rig years required for these opportunities has doubled as compared to a year ago.
With tenders and inquiries going up, we can expect we are at least another quarter or two away from seeing an uptick in actual business. If shale production continues to put pressure on oil prices, though, that waiting period could last even longer.
Gaining market share
For Ensco investors, though, there are some signs that the company is outpacing the broader recovery of offshore rig companies. According to Trowell, Ensco's recent contract awards and tenders suggest it is taking market share from others:
In this environment, companies with excellent operational performance and strong financial positions are winning a disproportionate amount of the available contracts. And we believe Ensco is in a unique competitive position to capitalize on this trend.
Recent contract awards support this view. And over the past six months, we have secured nearly 20% of all new contracted rig years globally. This recent contracting success has contributed to a 10-percentage-point increase in Ensco's fleet utilization, while industry utilization has flattened over this time period.
Hopefully, the company will be able to apply its marketing success to Atwood's assets as well. Most of Atwood's contracts will end in 2017. Atwood will be at less risk as part of Ensco, but that many idle rigs will do a number on profitability.
Long-term contract or not?
One of the most critical decisions when it comes to contracting rigs -- especially offshore rigs -- is the duration of those contracts. Locking in long-term contracts ensures a steady, predictable cash flow for several quarters, but it risks losing out on higher rates down the road if demand increases. Conversely, there is always the risk that the market could turn south and rigs ending contracts could be without work. Trowell was asked by one analyst how Ensco is balancing this need, here is what he said:
[W]e are very much in the mode of building back our utilization and maintaining a core active fleet, particularly for contracts in the sort of the next 18 to 24 months. And so that's very much a primary driver of our marketing. Now that said, we are not in the mode of trying to lock in a large number of long-term contracts. Where there are long-term contracts, where possible we are trying to get them where they have some price escalations in or performance escalations when they're sort of longer than, say, a 24-month period. Now as you've probably seen, there aren't as yet too many contracts that are very long term. And we're also imbalanced with this. We are running a portfolio approach, which is that we are as happy as we can be in the current market. But we are happy to put some of our rigs away on long-term contracts that we know are working, that are cash generative and that we then have them working. We would not lock away all of our rigs like that.
A new business model for oil services?
There have been a lot of interesting moves in the oil services industry lately. Traditional service-only providers are now teaming up with equipment owners to offer service and equipment bundles. In fact, Schlumberger, the largest oil services company, just took a 20% stake in newly formed rig company Borr Drilling. Of course, analysts are curious about whether this is a one-off sort of situation or if we can expect a larger trend toward bundled offerings and joint ventures between services and rig companies. Here's Trowell's response:
[W]e do see some contracts which are sort of either who could fall into the book of being called integrated or bundled contracts. In many cases, they're not performance-based. They are really a form of kind of management of services or bundling. The number of truly potential integrated offshore contract at this point are very limited. It's potentially an area that could grow. We don't see a huge amount of client pull for it at this point outside of one or two places, but we would definitely be willing to participate in that either as a lead or in -- or joint partnership or alliance with one of the big service companies, and we have pursued those contracts, and we are doing.
Producers with an eye on the long term would be looking to lock in rigs at the longest contract durations right now, and Ensco is correct not to be too tempted to contract out its entire fleet on multiyear deals. A lot of these negotiations will ride on what oil prices do over the next 12 months, though, because there are lots of rigs slated to roll off contract in that window.
Rationale for acquisition
There have been a lot of whispers about merger and acquisition activity in the offshore rig industry, and Ensco was on the short list of companies in a position to make a deal happen. The question that is on everyone's mind, though, is why Ensco decided Atwood was the right company to buy and why now was a good time to make the move. Here's Trowell's response from the conference call on the day of the merger announcement:
I think why now, partially, because I think this is now -- this is probably a good time to start acting in preparation for a recovery in the market. And there's been a long -- it's been a long time now where people have been discussing the general need for M&A within the space. And I think that we've been long saying that as we go through this cycle, which is arguably the worst one the sector's ever been through, that a highly disaggregated challenged sector would benefit from consolidation. And I think we're reaching the point where it's now time to enact that. And as we begin to see some early signs of recovery in market activity, that this is a good time to act. I think from our side, from both Rob and my side, we felt that it was better to take an early action proactively together and choose your partner than it was to see how the landscape fell out around you. And we still believe in the general view that the industry is going to consolidate around a few smaller, bigger -- sorry, bigger, more well-capitalized companies with a diverse geographic spread. And so we wanted to take our destiny on our own hands. Now with respect to Atwood, I think, for us, it became extremely clear that the fleet structure that Atwood had was extremely compelling for us. Being present in both the deepwater drillship space plus the semis and some high-end jackups fit very well with our strategy and our fleet structure. It significantly enhances our capabilities in the deepwater sector, and it helps refresh our jackup segment. So from that point of view, the fleet structure and size of Atwood made a lot of sense.
I'm speculating here, but I don't think this is the last deal we will see in the offshore rig industry today. Ensco may not have the firepower to do another deal of this size, but the all-stock nature of this transaction does give it the opportunity to pick up a rig or two that may be on the auction block. Ensco isn't the only one in this position, though, and there are lots of rigs out there ripe for the picking.