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Storm Clouds Are Gathering Over the Offshore Drilling Industry

By Rupert Hargreaves – Feb 4, 2014 at 11:26AM

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An oversupply of units in the offshore-drilling market is likely to impact the outlook of Seadrill, Transocean, and Rowan.

At the end of last year, analysts at Citigroup put out a note to investors warning of a possible slowdown in the oil and gas offshore-drilling market. Usually, a view from one group of analysts is not enough to sway investor opinion. However, since the initial publication of this research, more analysts have turned negative on the sector and appear to be taking aim at some of the industry's most prolific names, including Seadrill (SDRL), Transocean (RIG -0.25%), and Rowan Companies (RDC).

Analysts at Barclays have been leading the charge, stating that the day rates for ultra-deepwater, or UDW, drilling units will drop by around 16% to an average of $475,000 per day in the best-case scenario. UBS' analysts have also built on this case, with the firm's analysts suggesting that there could be a 12 to 18 month downturn ahead for the industry. Their reasoning behind this? The market for jack-up drilling units is becoming over supplied, and exploration and production spending is slowing while oil companies are seeking to reduce expenditures.

Barclays' analysts also suggested that companies with older fleets are more likely to suffer from this downturn than drillers with newer fleets -- a trend that has been forecast for some time. Unfortunately, in the worst case, Barclays believes that earnings before interest, taxes, amortization, and depreciation forecasts over the next two years will be up to 35% less than originally forecast for some drillers.

Now, I must stress that this is only one set of analysts, and opinions are still dividend on the matter. However, it is widely considered by many oil-industry analysts that offshore drillers will have to deal with a slowdown over the next few years.

Even the best investors will plan for all eventualities, so how should investors react to these forecasts?

Future planning
Well, let's start with Seadrill. Fortunately, Seadrill is likely to avoid some of the downturn, as the company has been investing heavily in new UDW drilling units. That being said, while building up this new fleet, Seadrill has amassed a large debt pile, and this could be the company's downfall if the demand for drilling units slides across the industry. With day rates set to fall approximately 16% during the next few years, we can predict that the company's EBITDA will fall by a similar amount.

Seadrill is slated to report EBITDA of around $4 billion for fiscal 2015 based on current forecasts. Factor in a 16% decline, and this figure falls to $3.4 billion. This lower-growth figure clips Seadrill's wings, as the company had forecast EBITDA growth of 67% through 2015; the lower estimate will drop this to 42%. Ultimately, this lower-than-predicted growth could pressure Seadrill's banking covenants. I should stress that this is only a prediction.

Older fleet
Meanwhile, Transocean is likely to suffer, as for the most part, its fleet is more than two decades old. Indeed, according to data from 2011, Transocean's fleet had an average age of 21 years, while Seadrill had an average unit age of five years. Previously, this has not been much of a concern, but as mentioned above, with day rates falling as the market becomes oversupplied, old units are likely to end up on the scrap heap. That said, under Carl Icahn's instructions, Transocean has ordered seven new UDW floaters, which are currently under construction, but this could be too little too late.

Better positioned
One company that looks to be able to survive much of the downturn, at least according to analysts, is Rowan Companies, and there is good evidence to support this view. For example, Rowan has one of the newest jack-up rig fleets in the biz and has four new UDW high-spec jack-up drillships currently under construction in South Korea. These units are set for delivery between now and 2015, and three out of four units are already contracted out for multi-year periods, with day rates in excess of $600,000.

Now, a day rate of $600,000 is a game changer for Rowan. Currently, as reported at the end of the fiscal third quarter, the company's average day rate was $169,200, less than one-third of the rate that the new units will provide. With four new drillships in the company's fleet, each demanding day rates upwards of $600,000, Rowan's top and bottom lines are likely to rapidly expand as the new units come online. What's more, with contracts already signed for these units, Rowan is likely to miss much of the downturn in the industry.

Foolish summary
In summary, it would appear that the consensus of opinion is for a slowdown in the oil and gas drilling market over the next few years. Rowan looks well placed to ride out this downturn, and so does Seadrill with its new fleet. However, Transocean's old fleet could drag the company down, and Seadrill's high level of debt could prove a problem if things deteriorate faster than predicted.

Rupert Hargreaves owns shares in Rowan Companies. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

SeaDrill Limited Stock Quote
SeaDrill Limited
SDRL
Transocean Stock Quote
Transocean
RIG
$4.06 (-0.25%) $0.01
Rowan Companies plc Stock Quote
Rowan Companies plc
RDC

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