Making the Case for Offshore Drillers

Despite the Deepwater Horizon disaster, the future for these companies looks sunny and bright, says our columnist.

By Barry Parker

Oil drilling is attracting more and more attention from the investment community. Dahlman Rose (DR), a New York investment bank specializing in maritime and natural resource companies, has now begun coverage of the drilling and oil service sectors. In their opening report, analysts Jim Crandall and Omar Nokta talk about “A Long Upcycle Ahead.” One overarching statistic dominates DR’s view – some $490 billion is expected to be spent throughout the world this year on oil exploration and production (E&P), up 12 percent from last year. Importantly, higher oil prices – above $100/barrel – have little impact on Crandall and Nokta’s thinking: “We have found a lot less sensitivity in E&P spending internationally to changes in oil prices than in North America.”

It’s the high end of the drilling market (the “E” in E&P) that’s in the midst of a boomlet. Another Wall Street analyst who follows the sector, James West of Barclays Capital, recently published a report titled “The Offshore Rig Construction Cycle Has Firmly Taken Hold.” The title says it all. West pegs levels of fresh ordering since the beginning of 4Q 2010 at 12 floaters and 18 jackups with buyers holding a comparable number of options for additional rigs.

Excitement on Wall Street

Bankers in the financial markets have been working feverishly. February saw the announcement of an $8.6 billion merger with Ensco PLC (best known for its high-specification jackups) set to acquire Pride International, which made a big bet on ultra-deep (>7,500-ft. capability) drillships several years ago. This was not a distress deal: Most analysts who reviewed it said that Ensco paid a very full price for Pride’s units. An explicit facet of Pride’s strategy has been its focus on Petrobras and specifically its ultra-deepwater activities in the U.S. Gulf of Mexico, a capability lacking in Ensco’s portfolio.

Within two weeks of the Ensco PLC/Pride announcement, Seadrill – the large driller linked to Norwegian tycoon John Fredriksen – began spinning off its “harsh environment” rig fleet into a separate company. Creating the new entity, to be called North Atlantic Drilling, will free up needed balance sheet capacity for Seadrill, which has played a big role in the new ordering binge described by Barclays’ Jim West. Following recent orders for two ultra-deepwater drillships at around $600 million each and four jackups at around $200 million each, Seadrill now has nine rigs under construction and options on eight more. Investors want in. According to Seadrill, its institutional sale of equity, which raised $425 million for 25 percent of North Atlantic, was massively over-subscribed. Another driller, Norwegian-based Aker Drilling ASA, completed a $635 million IPO at the end of February and wasted no time in paying off its existing bond debt and placing an order for two 12,000-ft.-capable, ultra-deepwater drillships to be delivered from Daewoo in 4Q 2013 at an all-in cost of around $600 million each.

Keeping the Yards Busy

The yards producing the high-specification equipment are also benefiting. Singapore’s Keppel Corporation, the parent of Keppel FELS, has joined the ranks of locally hot stocks, and snippets of news from January and February show why. Maersk Drilling announced an order for two ultra-harsh-environment jackups priced around $300 million each and suitable for drilling in water depths of 150 meters in the North Sea. By early March, the rumor mill had Gazprom (the large Russian energy producer) in discussions with Maersk about a possible order of Arctic-suitable jackups.

The Maersk order with Keppel FELS came within weeks of Transocean’s booking a pair of high-spec (albeit for benign conditions) jackups at the $200 million price point. Unlike the many speculative orders for drilling equipment, Transocean’s new units will both deliver into five-year contracts with a Chevron subsidiary in Thailand. Meanwhile, Ensco PLC announced an order from the same yard for two harsh-environment jackups capable of drilling to 400-ft. depths) at roughly $220 million each. Another driller targeting the jack-up sector, Discovery Offshore, was tied to an order at the Keppel yard for two harsh-environment jackups worth around $210 million each. Typically, options on additional units are attached to the primary orders.

The Boys From Brazil

An additional bright spot for construction has been Brazil, where Petrobras has now awarded contracts on seven drillships, the first of 28 to be built at the Estaleiro Atlantico Sul (EAS) yard, which is owned by a group of Brazilian construction companies with participation from South Korea’s Samsung Heavy Industries. In a complicated deal, the drillships will be built at a cost of $662 million each by a new holding company, Sete Brasil, owned partly by Petrobras and partly by a group of Brazilian institutional investors. Debt financing will be sourced from the Brazilian Development Bank (BNDES), commercial banks, and export credit agencies where foreign components are integrated into the construction. Showing the attractiveness of the sector, investors in Sete Brasil were already publicly discussing the potential for an IPO in 2015 after the first drillship delivers to Petrobras. Petrobras is now producing roughly 2.5 million barrels/day and expects to ramp production up above 4.0 million barrels/day by 2020.

The EAS-built drillships will be chartered to Petrobras at rates between $430,000 and $475,000/day. A major uncertainty is the ultimate number of drillships needed by Petrobras and the timing of their deliveries. For companies like Transocean and Ensco, construction delays in Brazil would be good for business. They could lead to more expensive charter-ins of high-end equipment. The DR analysts summarized the situation in Brazil by saying, “Outside of the majors, we see the strongest growth in Latin America, driven of course by the massive spending plans of Petrobras.”

The Good and the Bad

The actual earnings of the listed drillers will, of course, be heavily influenced by the rate environment. Like asset values themselves, rates are well below their highs of 2007/8, when drillships capable of working in 10,000-ft. waters achieved day rates in excess of $600,000. Yet day rates for ultra-deepwater equipment never reached the “doom and gloom” lows of under $400,000/day predicted in the dark days of early 2009. And certainly the resumption of permitting for deepwater drilling in the U.S. Gulf should provide an additional fillip for the sector. Noble Energy received the first go-ahead under the new regulatory regime and will employ Ensco PLC’s dynamically positioned semisubmersible Ensco 8501 to open up a well that it had started just prior to the Deepwater Horizon disaster and was subsequently forced to wind down because of the moratorium. In a late February charter, Noble Corporation (the driller, separate from Noble Energy) agreed to charter its 12,000-ft-capable semisubmersible Noble Jim Day to Shell for $485,000/day, subject to permitting issues being resolved, for exploratory drilling in the U.S. Gulf.

But the market is bifurcated. To paraphrase Dickens, it is the worst of times for some participants while others are enjoying the best of times described by Barclay’s and DR. At the lower end of the market, Seahawk Drilling, an owner of shallow-water, low-spec jackups in the Gulf of Mexico, threw in the towel in February and voluntarily filed for Chapter 11 bankruptcy in conjunction with the sale of its assets to competitor Hercules Offshore. Seahawk was a victim of bad timing with a clutch of rigs coming off charter several months before the Deepwater Horizon explosion and the subsequent drill permitting debacle. Strategically, Seahawk’s fortunes had been tied to the Mexican national oil company, Pemex, whose appetite for new tenders has continued to disappoint. Its latest fleet list reveals that 11 mat-supported jackups, suitable for drilling in the GOM, are cold-stacked. Indicative of the angst among owners of low-specification equipment, Transocean, the league leader with 71 deepwater rigs and 66 jackups, announced that it was taking an “impairment” charge of $1.01 billion on its standard jackups. Such charges reflect reductions in asset values that management views as permanent.

FPSOs, Equipment Makers and More

Floating Production, Storage and Offloading units (FPSOs) continue to play an important role in the production of oil and gas in deeper waters where pipeline infrastructures do not exist. FPSO solutions, where oil offloads into shuttle tankers, have been integral to serving offshore Brazil and West Africa. A marquee project in Ghana saw production commence in the Jubilee Field, operated by UK-based Tullow Petroleum and served by Modec’s FPSO Kwame Nkrumah MV21, a conversion from a VLCC. With 1.6 million barrels of storage capacity, the unit can process more than 120,000 barrels/day of oil, which is then stored for export in Suezmax tankers.

For U.S. waters, the talk of more FPSOs in addition to BW Offshore’s BW Pioneer to serve areas beyond the Petrobras-operated Chinook and Cascade fields seems to have waned. Peter Lovie, a Houston-based FPSO and shuttle tanker expert, commented that “BP's Tiber and Shell's Stones prospects in the deep remote GOM could be candidates, but neither operator has confirmed that.” Lovie worked with Devon Petroleum, which sold its 50 percent stake in the Cascade field to Petrobras. He added, “Today there are no FPSO projects on the horizon in the GOM, and shuttle tanker prospects have likewise withered.” He contrasted this situation with mid-2007 when “There were multiple well-qualified contractors available and interested in providing FPSOs for the unique GOM requirements of deepwater and disconnectability.”

For investors looking at the drilling business, equipment suppliers are also seeing the positive side of the construction pickup. Barclays’ Jim West cites National Oilwell Varco, the leading provider of top drives, hoisting and pipe-handling components, and Cameron International, a leading maker of blowout preventers, as beneficiaries of all the activity, much of which is occurring in waters far removed from Houston, where both of these suppliers are based.

With oil prices poised to remain at or above $100/barrel, the outlook for the deepwater drillers and equipment and service providers is looking bright as long as the higher prices are driven by sentiment rather than more-enduring supply disruptions. DR comments that “Turmoil in the Middle East/North Africa is not positive for long-term stock performance and would cause us to reevaluate our position if it spread.” Aside from offshore Egypt and Libya, however, historical precedent suggests that tumult onshore might actually be conducive to additional exploration and production offshore, far from the fighting. You be the judge. – MarEx

Barry Parker is a frequent contributor to The Maritime Executive.