In the competition for the cheapest stocks on the open market, offshore-rig owner trio Transocean (RIG -2.10%), Ensco (VAL), and Noble Corporation (NEBLQ) would be very high on the list. All three companies have seen their stock prices drop 75% or more over the past five years as oil prices cratered and took the prospects of offshore drilling with it.
By conventional valuation metrics, these stocks are all incredibly cheap. All three trade for less than half of their tangible book value, and oil prices have been on the rise for some time. Is this a deep value opportunity that the market is missing, or is it possible that those valuation metrics are misleading? Let's look at the state of the offshore-rig market to see whether these companies could be an absolute steal or a value trap.
Image source: Getty Images.
Hot: shale drilling. Not: offshore drilling.
There are a lot of signs that point toward the need for oil production. Several years of underinvestment or investing in squeezing out a few extra barrels from existing sources has led to a sharp acceleration in production decline rates around the world. The decline from production at existing sources has cleared much of the industry glut that we saw in 2015-2017 that led to historically low oil prices.
As oil prices have risen, though, nearly all of what has replaced declining production and met growing demand has been shale drilling in the United States. Over the past five years, the U.S. has increased its crude oil production by 3.6 million barrels per day, and nearly all of that production has come from shale.
Producers have elected to tap shale wells for a couple reasons. It is a low-cost source of oil -- the breakeven price for most Permian Basin shale is around $50 a barrel -- and it takes a relatively short amount of time to realize returns on shale wells. A shale well can be drilled, fracked, and start producing in less than a month, whereas the fastest offshore oil project to go from discovery to full-fledged production -- ExxonMobil's find in Guyana -- takes five years. Offshore oil can be more profitable and can produce consistently for years, but cash-strapped companies have elected to go for the quick payout lately.
That means offshore drilling activity is at incredibly low levels. To make things worse, rig owners now have several inactive rigs in their respective fleets, and several more will roll off contract over the next two years. Not only has this situation led to declining revenue and earnings for offshore rig companies, but it has also given its customers a lot of bargaining power when looking to contract a rig for a job.
| Company | Current Utilization Rate | Rigs With Contracts in Place Beyond 2020 |
|---|---|---|
| Transocean | 64% | 23% |
| Noble Corporation | 66% | 22% |
| Ensco | 63% | 12% |
Data source: company rig fleet status reports.
Ready to rebound?
For investors looking at this rather bleak outlook for offshore rigs, there is some good news. Down the road, we are absolutely going to need new oil production, to simply replace existing sources if nothing else. The current decline rate of oil production is 6% annually. At that rate, producers will need to find and develop 78 million barrels per day of new production sources simply to replace existing supply. Even without any additional demand over that time, it's a hefty task.
As great as shale as been at filling the supply gaps recently, it won't be able to do it all on its own. Offshore oil production will have to play a key role in filling these supply gaps. So the question isn't if these companies' rigs will ever find work again. The more pressing questions for these companies is how long it will take before contract rates increase to make them profitable again and whether they will have to contract their fleets to make that happen. Ever since oil prices started to crash, Transocean, Ensco, and Noble have retired several of their older rigs as they roll off contract. Scrapping older rigs helped to lower costs of maintaining idle rigs, and it also was a tacit acknowledgment that those older rigs couldn't compete with newer, more capable rigs for work.
Rig activity is picking back up, as all three companies said that their contract backlog increased in their most recent fleet status reports. So it's hard to see a further decline in utilization rates from here. With so many rigs coming off contract in the next couple of years, though, the sales and marketing teams will have their hands full trying to make sure all of these rigs can obtain new, more favorable contracts as well as hopefully find additional work for its idle rigs. That could take some time.
Value stocks or value traps?
On a valuation basis, these stocks are incredibly cheap. The one thing that could be misleading about those price-to-tangible book value numbers is that if any of these companies decide to retire or sell older rigs for less than their book value, then they will have to take significant writedowns of asset values. So it's possible that each one's price-to-tangible book value ratios are artificially low.
Even if that is indeed the case, there still does appear to be a lot of potential in these stocks. Of the three, Transocean looks to be the best suited to improve. The company has already done several waves of rig retirements that has left it with a fleet of relatively new and highly capable deepwater floating rigs that have the potential to command better rates than shallow-water rigs. Also, with $2.7 billion in cash on the books, it has the financial flexibility to take take advantage of future opportunities such as buying assets from distressed companies.
Keep in mind, though, that it;s probably going to take a while for these companies to get back to steady, profitable operations. So it could be a few years before reaping the benefits from buying the stock today. Invest accordingly.
