by Stephen Ellis
The offshore industry’s 2nd quarter results saw gloomy forecasts for offshore suppliers, jackups, and midwater rigs. Negative customer expectations surrounding commodity prices and difficult well economics mean lower demand for offshore drilling. Drillers are trying to tighten their markets by stacking rigs, but day rates are down 30%-40% for most jackups, and we expect to see falling day rates and more cold-stacking for many midwater rigs as soon as they come off contract. Still, the hefty backlogs for many of our companies give them ample time to strip out costs as long-term rig contracts slowly roll off.
However, there are still some positive data points for the offshore industry as it deals with a bleak near-term outlook. The short- and long-term opportunities for new rig contracts and equipment sales in Brazil remain tantalizing, and the massive rig needs of Brazil’s Petrobras is keeping ultra-deep-water rigs in high demand. There are also some signs that the jackup market may be stabilizing, a trend that runs counter to our current industry thesis. Finally, selected companies such as National Oilwell Varco and Rowan Companies are taking advantage of the downturn to pursue new growth avenues. After reviewing the industry’s second-quarter results, we think there are several key takeaways.
First, the demand for ultra-deep-water rigs is still high. Ultra-deep-water demand remains quite strong because of the limited supply of available rigs during the next few years and numerous project needs. During the quarter, Transocean obtained a very favourable day-rate fixture for its ultra-deep-water rig, the Cajun Express, at $510,000 per day for three years with Petrobras. This is a particularly impressive fixture, considering the peak in ultra-deep-water day rates was $652,000 in late 2008. The relatively minor decline from peak levels compared with the 30%-40% decline in many jackup day rates, which could still fall further, helps show the continuing imbalance between supply and demand in the ultra-deep-water rig market. Offshore drillers continue to report strong levels of customer interest for ultra-deep-water rigs available in the next year or two.
Second, the jackup market could be recovering earlier than our expectations. Several companies commented that inbound tenders for jackup work were up sharply during the last few months and were modestly bullish about the near-term outlook for the rigs. We believe customers may be inquiring after selected quality rigs for short-term needs. However, the increase in tenders is not enough to offset the fact that there are 50-60 jackups that are being delivered in the next few years without contracts in place. We expect the additional rig deliveries will continue to cause substantial rig oversupply and lower day rates.
Third, drillers are taking advantage of cash-rich balance sheets. The majority of the offshore drillers that we cover are extremely well capitalised, which could create bidding wars for distressed rigs being put up for sale. Noble was actively involved in the bidding for PetroRig I, which was eventually bought by Diamond Offshore for around $500 million when all costs are included. The situation could mean that distressed rigs may not be as heavily discounted as many drillers expect, and the drillers may not be able to duplicate the outstanding returns they earned during the last down cycle by purchasing rigs from distressed owners. On the other hand, if the credit markets remain closed to the riskiest financial speculators, the current trickle of distressed deep-water rigs may become a flood, driving down prices for our drillers.
Fourth, subsea contractors such as Acergy, Subsea 7, Technip, and Saipem continue to win new projects. Despite the near-term uncertainty surrounding commodity prices, international and national oil companies with long-term developments in mind, are pressing forward with offshore projects. For example, Acergy has won contracts in Nigeria, Brazil, and Australia over the past few months. For the subsea contractors, the constant flow of complex and risky subsea work means good profit margins. In the near term, we will be paying particular attention to project awards from Brazil’s Petrobras, due to the massive size and complex subsea needs of the company’s discoveries. We think Petrobras’ projects will set the standard for complex subsea work over the next few years, and the contractors who deliver the projects on-time and on-budget will have a powerful marketing tool to use against peers in bidding for other projects worldwide.
Near-term opportunities for Brazil suppliers and jackup drillers?
We think Brazil continues to be a positive story for offshore drillers. Petrobras is ready to issue a second tender for eight to 12 deep-water rigs very shortly, and potentially another 20 before the end of the year. Unfortunately, we still do not know the exact local content requirements, but we do know the country and Petrobras are under immense pressure for nationalistic reasons to build the rigs in Brazil. Therefore, we may see more rigs tenders awarded to Brazilian contractors, despite the disappointing results from the first tender of 12 rigs last year. Transocean stated that at least one rig has been canceled, and six or seven other rigs are struggling to obtain construction financing and have not yet submitted a shipyard order. The delay in rigs could be very costly as it will delay oil- and gas-production efforts. If Petrobras wants to meet its aggressive oil-production goals, we believe it will eventually need to outsource rig construction to the more experienced South Korean shipyards (it met with the shipyards to discuss rig construction plans in April) and hand out rig contracts to established drillers such as Noble, Pride International, Transocean, and Diamond Offshore.
Brazil also continues to be a growth story for the equipment providers. Petrobras needs around 200-300 subsea trees a year for the next few years and plans to award about 300 trees to equipment suppliers by the end of 2009. FMC Technologies mentioned that it was the leader to win an award of 107 subsea trees for presalt work. The trees cost about $3 million-$5 million each because of Petrobras’ custom design, and are fairly low-margin compared with the industry’s more typical $15 million-$20 million a tree. Our expectations last quarter were that FMC may skip the low-margin work and focus on the more profitable-related equipment such as manifolds. However, it looks like FMC wants a portion of the low-end tree work to better position itself versus competitors and perhaps curry favor with Petrobras for the more profitable manifold awards. Petrobras plans to award 12 manifolds for around $30 million-$35 million each, but the cost can be up to $80 million per manifold. The additional costs reflect the complex requirements Petrobras has specified for the equipment. We expect FMC to win at least one of the two tenders for the manifolds and Brazil to be a lucrative source of work for the company for years to come.
National Oilwell Varco is another key equipment supplier to Brazil and Petrobras that has performed well year to date. Equipment margins have held up despite a significant slide in demand because of high equipment prices coming out of the firm’s backlog. However, favourable currency shifts, National Oilwell Varco discounts, lower steel prices, and aggressive shipyards are cutting the all-in price of a rig by about 15%-20%. This points to lower equipment margins in the second half of 2009, but we think more cost-cutting by the company may limit the impact. Also, National Oilwell Varco has only experienced about $235 million in order cancellations so far, out of a backlog that peaked at $11.8 billion late last year. This compares favourably with our earlier estimate of $750 million in possible cancellations that could occur over the full down cycle.
We’re more concerned about future equipment orders than order cancellations, as the company has collected far more in cash than it has spent on its equipment orders at risk. For its part, we think National Oilwell Varco is still well positioned in the red-hot Brazilian market. For example, the company can still win more of the 12-rig tender issued by Petrobras last year, as some of the rigs are still searching for financing and haven’t even ordered equipment yet. Furthermore, comments from offshore drillers indicate that Petrobras currently plans to issue a second eight- to 12-rig tender shortly, and possibly tender for a total of 30-plus deep-water rigs by the end of 2009. All of the orders are potential wins for National Oilwell Varco, even if the actual timeline remains murky and somewhat undefined.
Unfortunately, Petrobras’ rig needs for the development of the firm’s massive Tupi discovery and related finds do not include jackups. Still, it is possible that jackup rig delays and cancellations could help the rig-supply picture. The 13 jackups delivered so far this year have been delayed an average of 75 days, and several rigs have been canceled. For example, two of Noble’s jackup rigs have been delayed a few months, but the company has managed to escape with minimal financial penalties, as its customers value its drilling expertise and are willing to cut Noble some slack.
We may not see such a happy ending for some of the remaining 60 jackups due to be delivered by 2011. Many of the jackups are being financed by speculative builders, and have a much higher cost of capital, which is unlikely to be met in a weak day rate environment. Other rigs are unlikely to be competitive in the global rig market because they were built in Iran and China, where operations have a poor reputation for quality. We believe many of the rigs will eventually be canceled, and it looks like our previous estimate of 20-30 rig cancellations remains reasonable. Whether the canceled rigs have a significant impact on fleet utilization and day rates depends on customers’ demand and expectations surrounding commodity prices. Many drillers are indicating that customer tenders are increasing with oil trading in the $60-$70 range, which implies that a high rate of rig cancellations in 2010 may lead to an improving jackup market. For now, we think that the overwhelming number of jackup deliveries without a contract in place will keep the rig market oversupplied, and it may not recover until well into 2011.
A firm making a move
Despite our negative outlook on jackups, we’ve been pleasantly surprised by premium jackup driller Rowan’s recent moves. We’ve been impressed with the new CEO Matt Ralls, as in his short tenure, he has landed strong rig contracts in a weak drilling environment, broke with long-standing Rowan tradition and indicated that the company will stack rigs during this downturn if needed, and shored up the company’s liquidity with a timely $500 million debt offering. The debt offering will mainly provide a backstop for the company’s aggressive rig-construction program, but Ralls indicated Rowan may purchase a deep-water rig if the opportunity presents itself.
The deep-water expansion would be another first in Rowan’s 80-plus year history, and in our opinion, potentially highly profitable. We’d prefer to see Rowan develop its own unique rig design, similar to what Ensco International has done, along with the approach Rowan uses for its jackups. We believe this approach lets the driller capture additional value through re-engineering the rig to perform similar work at a lower cost than peers’, or by focusing on specific high-end markets. However, because Rowan is extremely late to the deep-water rig market, its best expansion avenue is through purchasing a deep-water rig from a distressed seller. It may be difficult to find a bargain as many of our drillers have ample cash hoards, as well, and will likely bid up rig prices. Still, the deep-water market offers increased business stability (deep-water contracts are typically far longer than jackup contracts) and a new growth avenue for Rowan. On the other hand, Rowan will face challenges qualifying for lucrative deep-water tenders, which sometimes require extensive prior deep-water drilling experience and an already-established relationship with the customer. We expect Rowan to continue to share updates on its deep-water plans during the next year.
Companies worth considering
Overall, our top picks in the industry are Transocean, FMC Technologies, and National Oilwell Varco. None of the firms trade below our Consider Buy price, but they do trade substantially below our fair value estimates, and may be worthy of further consideration. All three companies have narrow moats, and we believe the firms with the strongest competitive advantages will deliver the best performance during the full commodity cycle. Further, the companies will benefit from the substantial build-out of deep-water projects, as they supply the essential rigs and equipment required.