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Stock Strategist Industry Reports

Updated Rig Forecast Affects Our Offshore Driller Valuations

Our long-term industry assumptions have grown more pessimistic.

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After reviewing our long-term forecasts, we have revised our fair value estimates for the offshore drillers we cover.  Diamond Offshore Drilling (DO) moved down to $7.25 per share from $10.50,  Transocean (RIG) moved up to $6.75 per share from $6.50,  Ensco Rowan (ESV) moved down to $10.25 per share from $15, and  Noble (NE) moved down to $1.50 per share from $2.50. Our no-moat ratings for each of the companies are unchanged. With the exception of Transocean, our fair value estimates moved significantly down as a result of more pessimistic long-term industry assumptions.

In the floater market, we now forecast a midcycle (2028) rig supply of 240, about in line with year-end 2018 levels of 242, as we forecast 29 rig retirements being nearly offset by 27 rig newbuild deliveries, most of which were ordered before the industry downturn. We forecast rig demand to increase from about 125 in 2018 to 170 in 2028, but this will only be enough to lift utilization to about 71%. Low utilization will result in day rates remaining about 20% below 2014 (pre-downturn) levels.

In the jackup market, we now forecast a midcycle (2028) rig supply of about 520, in line with year-end 2018 levels. As with the floater market, flat rig supply is due to rig retirements being offset by rig newbuild deliveries. We forecast rig demand to increase from about 290 in 2018 to 340 in 2028, but this will only be enough to lift utilization to about 67%. Low utilization will result in day rates remaining about 30% below 2014 levels.

In contrast to the rest of the group, we slightly increased our Transocean fair value estimate. This is due chiefly to a reconsideration of the company’s harsh-environment floaters, which account for about one fourth of Transocean’s rigs after recent acquisitions and divestitures. We think these will benefit from a very strong harsh-environment market, driven by demand in the North Sea and Canada as well as tight specifications that will largely prevent the entrance of non-purpose-built rigs from other regions.

We have increased our cost of capital for Noble to 9.1% (versus about 8.7% for the rest of the drillers) owing to concerns about financial distress. Noble is much more leveraged than its peers, with debt/fair value of equity of about 8 times versus 2-3 times for peers. Deferred debt maturities will help Noble--about 40% of its debt doesn’t come due until the early 2040s--but still we think there is some distress risk.

We think the offshore drillers look about fairly valued as a group, following a 45%-65% share price decline for drillers over the past year. Relative to other oilfield service companies (which look undervalued on average), the offshore drillers look expensive, as the market could be overrating the ability of rig retirements to balance industry supply and demand. To be sure, rig retirements have helped immensely in recent years; 120 floater rigs were retired from 2014 to 2018 (compared with the fleet size of about 240 today). However, most of these were older rigs, and unfortunately for the drillers, too many newer rigs (which are unlikely to be retired) remain in the current fleet for retirement to be an effective cure for oversupply.

Among the drillers, Ensco looks the most attractively priced, trading about 18% below our fair value estimate but still in 3-star territory, given our extreme uncertainty rating. This discrepancy versus peers has developed as a result of share price underperformance over the past two months. We think the market has grown overly pessimistic regarding the benefits of the company’s recently closed merger with Rowan.

Preston Caldwell does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.