Will the Good Times Continue for Drillers?
Which drillers will survive the inevitable bust?
In the past few years, onshore and offshore drillers have revitalized after suffering through a two-decade downturn. Due to low commodity prices in the 1980s and 1990s, drillers' profits were often meager. Many of the smaller companies went out of business or were acquired by their larger peers. The industry boom and bust cycles were short and often painful, while not long enough to encourage any sustained industry investment into their aging rig fleets. For the most part, customers were developing conventional formations and had little need for advanced technology to drill wells.
Since 2004, significantly higher commodity prices have reversed drillers' fortunes. Customers have been eagerly investing in exploration activity, and they are seeking to develop economical discoveries. The demand for rigs is so great that drillers have benefited from raising prices, as operating margins have grown from low-single digits to 20% or more in the case of land drillers in Morningstar's coverage universe, and 50% to 60% for a few offshore drillers. For the first time since the 1980s, there is extensive rig-building both onshore and offshore, as drillers are flush with cash. There are labor and equipment shortages, and shipyards have rig order books that stretch out for years to come. It has been a highly lucrative couple of years for drillers. But will good times continue to last? Which companies will survive the inevitable bust?
Financial Hurricane Hits Offshore Drillers
Offshore drillers, such as Transocean (RIG), Pride International (PDE), and Noble (NE), have been some of the biggest winners in the past few years, as customers have moved into deeper and deeper waters to exploit larger oil and gas discoveries. High customer demand for rigs has caused rig day rates to more than double. Today, deep-water day rates reach more than $600,000 a day for the most powerful offshore rigs. The incredible demand for rigs has also led to spiraling costs as equipment and labor costs have skyrocketed, while shipyard slots have dwindled. Since early 2007, deep-water rig costs have increased to roughly $800 million from $600 million. Demand has outstripped the supply of rigs by such a large margin that drillers are able to sign ironclad contracts for five to 10 years of work upon delivery, even though the rig has only begun construction and isn't due to be delivered for three years. Not surprisingly, offshore drillers have large backlogs of work. For example, Transocean has $41 billion in backlog with contracts stretching well into the latter half of the next decade.
As one might expect with such large profits, there are speculators. The speculators typically contract to build a rig without a contract in place, relying on debt financing to make the in-progress construction payments. Some established drillers have announced that they will build rigs on speculation, but financing the rig is largely supported by strong cash flows and large backlogs of work. Speculators, however, do not have that luxury. Indeed, as a result of the credit crisis, capital has become much more expensive than it was in the recent past. Accordingly, we expect as many as 20 to 30 deep-water offshore rigs to be canceled out of more than the 100 currently under construction as some speculators seek to back out of construction agreements or sell partially completed rigs to better-financed peers.
For Petrobras (PBR), the credit crisis could make an already challenging situation even harder. The Brazilian firm is developing some of the largest discoveries in the last quarter of a century with Tupi and Iara, in the Santos Basin where experienced geologists have speculated that up to 50 billion barrels could be under the sea. Petrobras has contracted most of the world's 20 ultra-deep-water rigs for the task and has indicated that it will need more than 60 new ultra-deep-water rigs in the next decade to fully develop its discoveries. The Brazilian government has decreed that many of these rigs must be built in Brazil and be staffed by Brazilian employees. However, the credit crisis has caused financing for these new rigs to dry up, making it difficult for Brazilian contractors to make construction progress payments. To complicate matters, the contractors have generally contracted their rigs at deeply discounted rates, making it unlikely that a more established U.S. driller would be willing to step in and continue rig construction. Petrobras is now faced with negotiating significantly more expensive contracts with a U.S. driller, or working out another way for its own contractors to obtain cheaper capital.
In short, developing the Santos Basin--which we think could cost tens if not hundreds of billions--could get even more expensive. For offshore drillers, the risk lies in Petrobras delaying its development plans to better manage costs in a much lower commodity price environment. A delay could remove a significant tail wind for deep-water day rates, but it could also create a tighter rig market as customers fight to contract the remaining rigs from credit-worthy drillers. We expect that even if Petrobras delays its development plans, deep-water day rates will continue to rise, at least in the near term. Petrobras' rig plans stretch out over the next decade, which means the short-term demand impact is minimal. Not surprisingly given the current market turmoil, Petrobras recently delayed the announcement of its latest strategic plan for a few months--a plan set to include details of spending for the development of the Tupi discovery.
The credit crisis has affected more than just deep-water drillers, in our opinion. We think jackup operators, whose rigs generally work in shallower waters on short-term contracts, will be faced with capital-constrained customers. We think it is likely that jackup day rates will fall in 2009 and 2010 as a large number of jackups being delivered without a contract in hand will push the market into a state of oversupply. With highly volatile commodity prices and immense difficulty accessing the capital markets, we think many customers will opt for conservatism in their capital budgets, thus lowering jackup spending.
Land Drillers Will Not Escape
Like offshore drillers, land drillers Patterson-UTI Energy (PTEN) and Nabors Industries (NBR) have benefited from a shift toward developing more complex discoveries. Instead of drilling deep underneath the ocean, land drillers are drilling into new tight-gas shale plays, which require custom-built land rigs to maximize production efforts. An ancient drilling fleet, filled with rigs from the 1980s, is no longer equipped to deal with the challenges of drilling far deeper and hotter wells. Drillers have ordered many new land rigs to meet customer requirements. Unfortunately, like offshore drillers, land drillers also have to deal with the consequences of over-leverage. Many of the drillers' customers such as XTO Energy (XTO), Sandridge Energy (SD) and Petrohawk Energy (HK) have slashed their capital expenditures for 2009. Lower commodity prices and an inability to obtain financing on reasonable terms have forced the oil and gas companies to implement deep spending cuts so the firms can generate sustainable levels of cash flow in 2009. Previously, the firms had spent far more than their operating cash flows on acquisitions and land leases, using debt and equity issuances to make up the difference. As a result, the lower capital expenditures and resulting lower demand for land rigs will lead to a poor 2009 for the land drillers we cover.
Framing the Investing Opportunity
Many of the drillers we cover (Transocean, Noble, Pride International, Ensco (ESV), Helmerich & Payne (HP)) are trading at prices substantially below our fair value estimates. However, because only Helmerich & Payne is trading below our Consider Buying price, we think a greater margin of safety is needed for many of our companies to become bargains. Still, we think investors should keep an eye on Transocean, Noble, and Helmerich & Payne in particular. All three companies are well-positioned to acquire rigs from distressed sellers, are run by talented and experienced management teams, and have large enough backlogs to help them weather any downturn in the near term.
We believe that the credit crisis and struggling customers will lead to lower demand for rigs and lower day rates in 2009. However, demand remains quite strong for all classes of offshore and onshore rigs, as customers are still spending the remainder of their 2008 capital budgets. If commodity prices stage a strong recovery, we could see customer expectations about oil and gas prices increase, which would provide an incentive for increasing rather than declining 2009 capital budgets. In addition, an unusually cold winter could improve the natural gas outlook, and access to the capital markets could become easier due to heavy government intervention. Therefore, we could easily see stronger fundamentals and higher fair value estimates in the future.
Despite a weak near-term outlook, we think secular trends toward more offshore exploration and the continued development of unconventional formations both onshore and offshore remain intact. In short, although it may not be the best time to be a driller, we think drillers are in a better position than they were in the 1980s and 1990s. For the most part, drillers have strong balance sheets, large backlogs of work, and management teams filled with executives who have survived the dark years of the late 1980s and 1990s. We don't believe these executives fear a downturn, and we don't think investors should either--provided they can invest at a significant enough margin of safety.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.