As the offshore drilling industry goes through a transitional phase, it's difficult for investors to assess where the market really stands. Profits continue to pour in this year, given the long-term contracts most rigs are under, but very few new contracts are being signed, and older rigs are beginning to be stacked or scrapped altogether.
One peek we get inside the industry each quarter is the conference call with management. Ensco plc (ESV +0.00%) CEO Carl Trowell gave some insightful comments on the company's recent conference call, five of which I've highlighted here.
Everything is fine and dandy, for now
We had 98% operational utilization for jackups, strong safety performance, and earnings that were driven by disciplined expense management and our efficiency initiatives. Earnings from continuing operations, excluding cost to refinance debt, were $1.18 per share for the second quarter.
-- Trowell
This quote is a snapshot of what the offshore drilling market is like today. But it's a far cry from what Ensco, Wall Street, or investors are looking at in the future.
The contracts Ensco is benefiting from today were mostly signed when oil was over $100 per barrel and the deepwater drilling boom seemed like it would never end. The legacy contracts signed during those days continue to pay off, but the billion-dollar question for Ensco is: For how long?
Managing what it can
Our teams have kept their focus on the things that we can control -- operations, safety, and efficiency -- and have not been distracted by the challenges our sector is facing during the current market downturn.
-- Trowell
More than most businesses, offshore drilling is driven by market forces more than anything else. There's nothing Ensco can do to increase oil prices or persuade major oil companies to explore another project in a mile of water. So management controls what it can, such as operational costs and safety. On that front, Ensco has a strong reputation, and that helps improve its returns long-term. But it's only a small piece of the investment puzzle.
Adjusting and adapting
Recently, we reached an agreement with the shipyard to defer the delivery and a large milestone payment for our final drillship under construction, ENSCO DS-10, by 18 months to the first quarter of 2017. ... As a consequence of this decision, full-year capital expenditures for 2015 have been reduced to approximately $1.7 billion.
-- Trowell
As the offshore drilling industry goes through a time of turmoil, companies are being forced to adapt their fleets accordingly. This comment from Trowell has a lot of moving pieces, but it's all centered around upgrading the fleet and saving money short-term in the form of pushing out capital expenditures.
But the next comment shows what's happening to the older portions of the fleet, and this will be a drag on earnings for years to come.
Jettisoning older rigs
Over the past 12 months, we've taken delivery of four newbuild rigs, we have sold six rigs, and placed another six rigs into hold for sale, removing them from our go-forward fleet. This is part of a deliberate strategy to high-grade our fleet as we navigate the downturn. In addition, we have decided to reduce our near-term marketed fleet by cold stacking another eight rigs, including ENSCO 8501 and 8502.
-- Trowell
Cold stacking, selling, and scrapping rigs is happening at a rapid pace in offshore drilling because there's so much uncertainty. The downside of Ensco is that it has a fairly large fleet of older rigs, which will be retired if the downturn continues much longer.
Upgrading the fleet where it can is good, but Ensco will also be losing older rigs that once drove much of the profit we see today.
A recovery is coming... probably
We still believe in the long-term recovery of deepwater drilling. And there are three important factors that will help this market recovery.
-- Trowell
Trowell went on to say that reduction in rig supply (cold stacking and scrapping), lowering costs, and improving quality management in the supply chain are the three key things the industry needs to focus on.
Reducing supply is happening quickly in offshore drilling, but there are still a lot of rigs under construction that are due for delivery in the next two years, which puts further supply pressure on the industry. Where the biggest upside might exist is in lowering costs, particularly for deepwater drilling.
What investors should watch here is the flow of contracts coming in to new deepwater drilling rigs in the next year or two. Older rigs probably won't be able to compete on cost, but new technologies that make drilling faster and more efficient offshore could make new rigs desirable even with oil at around $50 per barrel.
Uncertainty continues for drillers
With low oil prices likely for the foreseeable future, there's a lot of uncertainty for offshore rig owners. Unless prices recover, I'm not sure stocks will rise anytime soon, either.
From a long-term perspective, the key will be reducing supply of old rigs and upgrading new rigs to be more competitive in the market. Ensco is doing that slowly, but it'll be a long process given the company's legacy rigs. That could be a drag for investors in the long term despite the profits the company will report in 2015.
