One of the strongest oil price crashes in decades has thrown the oil markets into a tailspin. This is especially true for the offshore drilling industry, especially high-yielding companies like Transocean (NYSE:RIG), Ensco (NYSE:VAL), Transocean Partners (NYSE:RIGP), SeaDrill Partners (NYSE:SDLP), and Ocean Rig UDW Inc (NASDAQ:ORIG) who have seen their shares crash by as much as 63% in the last six months.
Analysts and experts the world over are furiously debating where crude prices are likely to end up within the next year, with Goldman Sachs predicting an average of $55 per barrel for 2015, while Oil Tycoon T. Boone Pickens has boldly proclaimed the likely return of $100 oil within 12 to 18 months.
However, one recent prediction from the Saudi Prince Alwalleed bin Talal regarding the oil market should really scare investors because, if true, it would mean that the recent pain offshore rig companies have experienced may be here to stay.
The death of $100 per barrel oil
Prince Talal told USA TODAY's Maria Bartiromo that he thinks oil prices may very well keep dropping in the short term, but more importantly for long-term investors, the prince also predicted the death of $100 per barrel oil.
"I'm sure we're never going to see $100 anymore. I said a year ago, the price of oil above $100 is artificial. It's not correct."
This isn't the first time OPEC officials have made bold proclamations that have enormous implications for world oil markets. We have seen the market crash on OPEC officials predicting $65 per barrel oil through June, and some are even proclaiming a price war to recapture market share Whether it goes down to $20, $40, $50, $60, However, Prince Talal's statement is the first one I've seen that has long-term, potentially very serious ramifications for income investors.
Prediction or promise?
Much has been written about Saudi Arabia's true intentions for short-medium term prices, including speculation that the kingdom was conspiring to use oil as a weapon to destroy its longtime regional and global rivals. Saudi Arabia has pretty much the world's only excess production capacity, 2.8 million barrels per day, which it could use to offset any potential declines in non-OPEC oil production.
According to Bank of America, if Saudi Arabia were able to steal market share and pump at maximum capacity of 12.5 million barrels per day, it would require just $77 per barrel to balance its budget. That's far below the current $92 per barrel required at current production levels to support its generous welfare system, and it could potentially allow long-term oil prices remaining around $80 per barrel.
What long-term cheap oil means for offshore drillers
Some companies' yields, such as Transocean's, are nearing unsustainable levels in terms of their operating cash flow payout ratios, as seen in the below table.
|Company or Partnership||Yield||Dividend Payout Ratio (% of Operating Cash Flow)||% of Rigs in need of contract by end of 2016 (assuming options for contract extensions by end of 2016 not executed)||Debt/Capital Ratio|
|Ocean Rig UDW||9.4%||22%||38%||59%|
This is especially true if oil prices remain low past 2016. That's because some of these offshore drillers have very high levels of debt relative to their total capital. In addition, 88% of SeaDrill Partners' debt is short term, which exposes the partnership to $7.2 million in additional interest expenses for each 1% interest rates rise.
However, when it comes to selecting the safest dividends in the offshore space over the next two to three years, I am most concerned about Ensco and Transocean. As seen in the table, the vast majority of these companies' fleets have contracts either expiring within the next two years, are already idled, or are new builds scheduled for delivery that have yet to obtain contracts.
I'm concerned because low oil prices could not only cause day rates for these rigs to collapse, but because below a certain price, oil companies will cancel drilling projects all together. Transocean and Ensco might find themselves saddled with enormous numbers of idle rigs that not only fail to bring in cash flow, but actually cost money to maintain. Even for those offshore drillers with far less exposure to falling day rates over the next two years, their payouts are not assured. This is because oil companies can always cancel a contract early in exchange for a hefty cancellation fee.
Statoil recently decided to take a $350 million loss by pulling the plug on a contract for a rig drilling off the coast of Angola. This was Statoil's fifth contract cancellation in 2014, and since that time, oil prices have collapsed a further 43%. This means that 2015 may bring a bevy of contract cancellations from other oil companies -- especially those drilling in relatively expensive deep water offshore areas, such as the Arctic or North Sea.
Bottom line: the potential death of $100 oil means no offshore driller's dividends is safe
No one, not even the Saudi royal family can accurately predict the long-term price of oil. However, there is a risk that the prince's words are meant as a warning to all higher cost oil producersthat Saudi Arabia might be willing to flood world markets to prevent crude from reaching prices high enough to justify enormous future investment in expensive oil production.
Should this prove the case, then I think its possible oil prices may remain at $70 to $80 per barrel for several years. Combined with a glut of new rigs and oil companies paring back on capital spending, this could mean lean years ahead for offshore drillers, especially those who require high day rates to support generous dividends and high debt loads. With so many risks mounting against the offshore drilling industry it's vital that only those investors with iron stomachs, and long time horizons invest in the rig market and even then only as part of a diversified income portfolio.