World oil demand will grow anemically versus abundant supply, according to Platts' Global Editorial Director for Oil Dave Ernsberger. He laid out Platts' bear case for oil prices at the energy analytics service's Commodity Week earlier this month in Houston. Presented with strong data, the packed room of energy industry top guns leaned forward, bug-eyed at persuasive data that oil at $100 per barrel is unlikely to last.
Investors in offshore drilling rig operators face the most risk, but industry sees only blue skies and calm seas ahead. Investors should avoid, sell, or short their stocks.
China demand peaking, U.S. needs falling
China's thirst for oil has helped keep global pricing high and firm, but that's ending. Though China does not release official oil demand data, Platts calculates apparent demand by adding refinery throughput to net oil products. Platts' data crunching finds that China's oil demand growth has slowed and seems stuck below 10 million barrels of oil per day, or BOD. This comes with other not-so-great news:The United States is rapidly approaching oil independence for light sweet crude, though not heavy crude, removing a major source of world demand.
With other major growing sources of supply including Brazil's massive offshore finds and the African west coast, Platts sees world oil demand growing at an anemic 1 million BOD and supply growing well beyond that at today's $100 per barrel pricing.
As supply rises to meet slowing demand growth, prices are likely to fall. When they drop below the level at which some producers can make money, they shut in production. This has implications throughout the energy exploration, production, and distribution chain, but it may well bring the most unpleasant surprises to the offshore drilling rig operators.
Whistling past Davy Jones' Locker
In September, the drilling rig industry order book -- the number of rig newbuilds, in the industry parlance, under construction at the world's shipyards -- stood at 12.1% of existing capacity in dead weight tons. This is down from October 2010's 18% -- yowza -- but 25% up from a year ago with strong industry optimism.
As in so many industries requiring leverage such as oil tankers, cars, and real estate, everybody starts projects in good times when financing is easier. Plus, drilling operators today run at high capacity -- for example, Transocean (RIG 2.40%) at 93% -- and any business lost for lack of rigs costs $500,000 a day and up for the behemoth rigs . At these rates a new ultra-deepwater rig or drillship costing $600 million-$700 million pays for itself after expenses in roughly eight years, so long as the good times roll.
But these are all projects that take a year or more to complete. As shipyards and rig operators crack champagne bottles on new rigs hitting the water, the same thing is elsewhere. Eventually, supply exceeds demand, dayrates decline, and companies are sitting on a lot of rigs with lower dayrates. This squeezes net margins that are running, for example, at an astonishing trailing-12-month 51% at Seadrill (NYSE: SDRL),.
This is what happened to the crude oil tanker industry, in a slump with no end in sight. Today tankers must either set sail at a daily loss or sit in harbor incurring bunker costs, industry for ships awaiting charter filled with oil. That's like unused and unsold inventory.
Offshore drilling rig operators may find their markets slacken. Customers will find oil less profitable to drill for and produce. Five important offshore rig operators -- Transocean, Ensco (ESV +0.00%), Seadrill, Noble (NE +0.00%) and Diamond Offshore Drilling (NYSE: DO) -- may find themselves closer to the devil than the deep blue sea.
How bad off are they?
Those most likely to suffer have the heaviest debt and larger orders for newbuilds as a percentage of current fleet. Debt comes with the territory given the high costs of new ultra-deepwater rigs and drillships. But you don't want to be caught with huge debt when utilization rates decline and interest rates rise.
|
Company |
Enterprise Value (EV) in billions |
Net Debt to EBITDA |
EV/TTM EBITDA |
Market Cap/TTM FCF |
Order Book % Current Fleet* |
|---|---|---|---|---|---|
|
Seadrill (8/28/13) |
33 |
4.4 |
14.9 |
None |
38% |
|
Transocean (10/16/13) |
24 |
2.7 |
8.8 |
None |
9% |
|
Ensco (10/17/13) |
17 |
1.9 |
7.7 |
None |
12% |
|
Noble (10/10/13) |
15 |
2.8 |
8.4 |
None |
13 % |
|
Diamond Offshore (9/9/13) |
9 |
0.2 |
6.7 |
37.3 |
21% |
Source for stock-specific multiples: S&P 500 CapitalIQ
*Current fleet excludes cold stacked or in storage rigs.
All of these are vulnerable to lower oil and customer weakness, but one is clearly the worst.
Avoid or sell Seadrill
Seadrill is most at risk by all measures. It has the worst debt situation, highest valuation, and an absurdly high ratio of orders to current fleet. A spinoff from Norwegian shipping magnate John Fredriksen's Frontline (FRO 6.22%) empire, Seadrill is like all Fredriksen companies leveraged beyond its competitors. As with all leverage -- think margin debt -- this is great in a cyclical upturn and brutal on the down cycle. (By the way, Frontline is at some point going to be ready to profit in a cyclical upturn in oil tanker operations, but today it's a burn-your-money speculation.)
It's best to avoid or sell Seadrill. But if investors have the savvy, pockets, and patience for shorting, Seadrill is a good candidate. Short interest is only 4% of the float. With that and Seadrill's large daily volume, there is no short squeeze risk.
Platts has presented some very important data on oil demand versus supply ahead. Investors should stay away from drilling rig operators because they present far too much downside risk for upside potential. Seadrill presents by far the biggest risk.
