Not only being one of the most cyclical, but also most hated energy sub-sectors, offshore drilling has been a secure investment grave for the last nearly 15 years. There is barely any investment topic where you could have sunk money more reliably. However, there are really interesting developments that make it worthwhile to risk a look into it, again. Especially, as along as it is perceived a no-go area for ESG-promoters – although offshore drilling tends to be the best choice in this regard.
Summary and key takeaways from today’s Weekly
– Investing in the offshore energy industry, especially drilling, was no fun over the last 15 years. In many cases, you would have ended up even mit zeros (bankruptcies).
– However, the tide has turned. Offshore is back with a roar – big oil is betting big on it.
– The industry has cleaned up its past problems and is ready for a strong comeback.
If you’re searching for an example of an industry or sub-sector that is highly driven by supply and demand on steroids and that has krass moves up and down during its entire cycle, offshore energy drilling is certainly a vivid case study.
While already onshore oil and gas production (conventional, but also fracking and onshore drilling equipment manufacturers) has had a tough time, especially between 2014 and 2020, its offshore cousins suffered even more so.
It wasn’t just about being forced to cut dividends and a weak share price performance.
That would be a vast understatement.
Indeed – I haven’t counted them all – a very substantial amount of companies was in such a dire condition, that you could say that nearly the entire sector went through bankruptcy – that’s no joke! Too heavy debt loads to shoulder paired with a lull in the order books at low sector-wide charter day-rates not only stress-tested its investors.
Many such investments were zeros or near-zeros, mostly between 2017 and 2021.
Only a few exceptions apply.
Is it any wonder that many burned investors have turned their back on offshore energy drilling for good? Or at least until it comes into favor again (when most of the move up likely will have been already done)?
Not to mention many funds and other professionals who are forced to be ESG-compliant??
But what if I told you that many companies – the offshore upstream producers as well as the equipment manufactures and leasers – have done their homework?
Production costs have always been an issue, however, not anymore! Then you have a more favorable carbon-footprint (for those who look at it) than traditional as well as unconventional energy production! And it is likely that offshore energy will be the only source of growth in the oil and gas sector for the foreseeable future.
Throw in dirt-cheap valuations and you could think I am telling you fairytales.
But it is what it is – a highly unloved, for some even obscure investment opportunity to ride the comeback. Chances are that it will be a massive move up. Big oil is betting big on offshore. That’s why I spent a lot of time recently on this topic.
The results are this Weekly as well as an interesting investment opportunity for my Premium PLUS members. My latest research report will be published next Saturday, 24 June. Of course there are also risks in a cyclical business, but I see a highly asymmetric bet – heavily tilted to the upside.
My pick is a potential multi-bagger, but also acquisition target that fits perfectly into what I am looking for my new membership. It is also one of only few companies that not only survived the dire years, entirely avoiding bankruptcy. My pick even still has a strong balance sheet, likely approaching net cash status towards the end of this year! And management is already prepared for the “energy transition”.
If my thesis proves correct, an investment will pay several times for this membership.
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Offshore Energy Drilling – let’s dive deep
The (sub-)sector of offshore energy drilling at first glance mainly consists of the upstream companies that pull oil and gas from the seabeds and their equipment suppliers. But there are also indispensable tasks that reach far beyond just those, like pre-production site preparation, cable and pipeline laying, logistics, care and maintenance as well as restoration and clearance, after a well is depleted.
You see, it is more than just pumping up energy out of waters.
Add to that different operating environments. You ought to distinguish between deepwater, ultra deepwater (different depths) and also harsh environments (think of stormy and chilly environments in the European North Sea) which bring different requirements for the equipment with them.
Likewise, there is not only offshore oil and gas production, but also offshore wind energy (that’s of course not drilling, but another form of offshore energy production) that also needs one or the other professional helping hand.
That was a brief quick-and-dirty intro. Let’s dive deeper.
Among the most known companies that operate in offshore upstreaming you can find:
- ExxonMobil (ISIN: US30231G1022, Ticker: XOM)
- Chevron (ISIN: US1667641005, Ticker: CVX)
- TotalEnergies (ISIN: FR0000120271, Ticker: TTE)
- Shell (ISIN: GB00BP6MXD84, Ticker: SHEL)
- Hess (ISIN: US42809H1077, Ticker: HES)
- Petroleo Brasileiro or Petrobras (ISIN: BRPETRACNPR6, Ticker: PBR)
- and more, but these are the household names
Initially, I planned to write a research report about Hess due to its growing production, offshore the coast of Guyana – one of the growth stories of this current decade and also the growth engine for years to come for Hess itself. However, for my taste, growth is already priced into the stock. I never saw a lucrative entry, since I am monitoring it.
Hess, one of the biggest energy producers of the second row, has a valuation multiple of close to 30x! Plus, Hess is heavily investing in its projects, mainly Guyana, so don’t expect too much free cash flow, just yet. They pay a small and growing dividend and buy back some shares – but nothing that excites me to write a report for my members.
In the case of Exxon – the main operator with the highest relative stake in Guyana and partner of Hess – offshore is a too insignificant part of the whole. It simply does not move the needle enough for this giant. The same applies to the other big producers.
Petrobras could be lucrative over the long-term with its pre-salt offshore fields, but I lack the ability to assess the new government. The political risk is too high for me.
That’s why I went a step further.
Into way more dangerous and riskier waters, at least so I thought.
Companies that own and lease (or charter, as it is called in industry-jargon) their platforms for oil and gas discovery and production – so-called rigs – but also special-purpose ships, are the main suppliers for the upstream companies.
Such equipment is booked and chartered project-wise for a predefined time, for example six months or until year-end.
In between, there can be a lack of work, leading to lower overall utilization. Of course, costs for maintenance stay, so it is in the best interest of these companies to have a high utilization and full order books.
Sales are the product of the duration of the projects as well as agreed-upon charter day rates (daily leasing rates, so to speak).
It was a booming business that had a lofty top in 2008 with record-high oil prices.
You just need to have a look at the chart of industry bellwether Transocean (ISIN: CH0048265513, Ticker: RIG) to get a feeling for how the whole sector developed since.
Calling it a disaster would be close to a compliment.
The problem was the capital spending cycle.
If you’re not familiar with this term, please check my Weekly “Commodity stocks and recessions – clearing up a common misconception” (see here).
There, I explain the difference between the overall business cycle and the commodity spending cycle that affects commodity producers.
In short, they often do not run necessarily in the same direction.
But in the end, it depends on how much a sector is spending and whether there are over- or under-capacities.
The energy sector was first propelled up only to face a harsh landing.
While overall energy companies, especially the major producers managed to stand back up rather quickly, again, it was not the case with offshore drilling companies.
Far from it.
The problems were several-fold:
- an oversupply of rigs, ships and other equipment due to over-optimism of the affected companies (too much spending), leading to many equipment not finding work, only producing costs or write-downs, if sold at lower prices than bought
- paired with less demand from their customers due to lower energy prices (too little spending)
- resulting in lower charter day-rates and lower overall bookings due to too much competition for too little work
- the big “Deepwater Horizon” offshore accident in the Gulf of Mexico in 2010
A quadruple-whammy crushing this whole sub-sector.
There was a rather soft bounce into 2013–2014, but the key problems were still in place – namely oversupply of equipment. Thus, the next round of falling energy prices crippled these capital- and cost-intensive, debt-loaded companies entirely.
In the following years after this second bust (starting from 2017), many industry-leading (!) companies had to declare bankruptcy due to not being able anymore to pay their debt. While in the onshore fracking industry mostly smaller companies went under water, offshore barely anyone was spared.
Among them were leading companies like:
- Seadrill (ISIN: BMG7997W1029, Ticker: SCRL)
- Diamond Offshore Drilling (ISIN: US25271C2017, Ticker: DO)
- Noble Corp. (ISIN: GB00BMXNWH07, Ticker: NE)
- Valaris (ISIN: BMG9460G1015, Ticker: VAL)
- Tidewater (ISIN: US88642R1095, Ticker: TDW)
All of them declared bankruptcy during the last six years which meant either total or nearly total losses for the old shareholders.
Obviously, one name is missing above: Transocean (remember the chart above?)! Indeed, this company did not go through bankruptcy. As far as I know, it is the only one of the big names.
One reason why offshore drilling was so fragile during the past decade is that production costs were high and the majors were reluctant to invest big. Fracking was more exciting and lucrative – until it wasn’t or at least until offshore became interesting again due to several reasons.
I really encourage you to read the linked short article.
Here are some key statements to be aware of (highlights by me), starting with this for warm-up:
Offshore oil and gas production isn’t going anywhere, and the sector matters now possibly more than ever. As one of the lower carbon-intensive methods of extracting hydrocarbons, offshore operators and service companies should expect a windfall in the coming years as global superpowers try to reduce their carbon footprint while advancing the energy transition.Audun Martinsen, head of supply chain research, Rystad Energy (see here)
The authors write that offshore energy production (drilling) is experiencing the first back-to-back investments of more than 100 bn. USD since 2012–2013. Not only that, but many countries are really pouring money into these projects.
They wouldn’t do so, if there were such a high uncertainty about the future.
However, taking recent inflation into account, the current numbers are still far away from the last highs.
Diamond Offshore Drilling for example is pitching with the following chart:
Investments not only have risen, again, but they are about to rise even further over the next years. This is clearly no one-time accident. Energy majors have become pretty mean and cautious with new projects and capital spending.
Investors want cash flows and shareholder returns, not volumes dug out of the ground unprofitably.
When they invest, they intend to do so without having to fear another lost decade.
To the contrary, as production costs in many key areas are at or below 40 USD per barrel of oil (Brent) – even around 30 USD per barrel in Guyana and 20 USD per barrel in Brazil – the margin of safety seems quite high.
In fact, 80% of offshore projects throw off money at 60 USD per barrel.
A decent margin of safety.
Transocean shows this chart below in their presentation (yellow is deepwater).
Please note the first and the last columns, where they compare production costs and the carbon-intensity of different production methods:
Where is the music playing?
Key areas with massive investments are:
- North America (USA and Mexico)
- South America (Brazil and Guyana)
- European North Sea (UK and Norway)
- The Middle East
- West Africa
- Australia and South East Asia
There’s barely a region not mentioned, but there are key spots. You should keep in mind the term “Golden Triangle”, referring to
- the Gulf of Mexico
- Brazil / Guyana
- West Africa
i.e. the Atlantic operations.
The next chart from Valaris shows their activities – all relevant areas – to get a feeling for where the music playing.
But also, don’t forget China.
They are not named, but China is also putting a high weight on energy security, as it is a major energy net importer.
Another key sentence from the Rystad article is:
Offshore activity is expected to account for 68% of all sanctioned conventional hydrocarbons in 2023 and 2024, up from 40% between 2015-2018.source: Rystad Energy (see here)
In plain English, this means that the majority (more than two-thirds) of newly approved projects is offshore.
Sanctioned means approved.
It’s logic that offshore drilling equipment producers and providers are going to benefit, as energy producers are opening up their wallets (for as long as the party goes).
Higher demand from the majors pushes charter day-rates up again – in case there is no oversupply, anymore. Is it or not?
Well, let’s examine.
In this second article, a representative from research house Wood Mackenzie, is saying that new-builds are coming soon. She’s talking about a matter of when, not if.
There would be no new-builds in sight, if there still was over-supply in the industry. However, it would also be a sign to be cautious, as new supply at some time turns into over-supply, crushing the sector again.
But I have good reasons why we are still not there, yet.
First, it is argued with average rig utilization having risen from a meager 65% in 2018 up to 85%, recently. Cash flows of rig companies are either positive or starting to become positive. That’s a first good indicator.
Second, there has been a drought in new-builds, effectively lowering supply and cleaning up overcapacities. As equipment ages, it has to be scrapped or sold and replaced eventually.
However, this has not happened on a grand scale.
The following chart is truly shocking (but positive for the investment case):
Take that: Investment in new assets in every year since 2015 has been lower than even during the Great Financial Crisis, respectively the recession around 2009–2010!
Investment in equipment and fleet totally collapsed since 2015.
The result was that only one jack-up was ordered in 2020 (a platform for harsh waters, see the first picture in the intro section of this Weekly) – the first such order since one in 2016. And there was just one new-build semi-submersible – a ship for non-harsh deep waters.
Despite rising average utilizations for drilling equipment and potentially new-builds coming, there is no need to panic. The big spending from energy super-majors is far from over.
They just got started.
My own research from primary sources, i.e. the rig companies themselves, indicates that there is no hurry to order new equipment.
Effectively, the “true” utilization number is way lower, as inactive equipment is not counted. It would be silly to order new hardware, when you have some older, still functioning on hand. This kind of equipment is highly specialized stuff and in many cases no shelf-ware. It also does not arrive tomorrow. And new-builds are damn expensive.
To tackle all negatives, the companies are first reactivating idled or “dry-docked” fleet which is way cheaper and quicker. However, such reactivations also take time – 12–18 months were numbers, I stumbled upon. Transocean said 15 months on average.
Further, the companies are saying that they are only ready to reactivate non-working fleet when conditions are appropriate. This means, not only has there to be a certain minimum of work to be available, but also the daily rates have to be more attractive.
Some even go as far as requiring the customers to pay for reactivations.
Transocean said that it costs them towards 120 mn. USD to reactivate one ship – not their entire fleet, one ship (!). That’s a word for companies that are not necessarily generating tons of cash flow at the moment…
These points are important to keep an eye on.
My guess is that there won’t be any material supply of newbuilds until the majority of still inactive stuff is not put to work, again.
Ideally, the equipment suppliers want even longer-term contracts in order to avoid the next slump when the good times come to an end. With longer term contract you forego some extra profits on the way up, but likewise you are still having well-paid work during the down-swing. A way to smooth things a bit, so to speak. They have to compromise in some way and make the right decisions.
On the following chart from Noble Corp. you can see how the industry’s fleet has shrank dramatically over the last ten years.
And here are a few charts showing the supply developments over the last decade from an outside view:
No matter which chart you look at, the former highs are still far away.
Especially for the more expensive-to-charter semi-submersibles and drillships for non-harsh deep and ultra deep water operations.
Even buying either single used assets or entire competitors is currently way cheaper than ordering new equipment, due to depressed valuations.
As a last point, the daily charter rates.
The magical number in the room is 500,000 USD per day. It is expected that this barrier will be crossed for the first high-profile projects (and equipment) towards the end of the second half of 2023.
Management executives of all companies I did research on describe the current market as “tight”.
Daily rates are trending up, either automatically through escalators built into the contracts (if longer-term) or through new agreements that start with higher prices.
I think it is important to stress another point: The energy majors’ main goal is not to make bargains, but to secure the supply of the highly needed, becoming scarce equipment in order to be operation-ready. Some are said to even fear not getting what they want, if they pressure the suppliers too hard or wait too long. The same applies for too short booking periods.
In times of over-supply, the customers are in a stronger position. When there is less to choose from, the tide turns.
And it seems that the tide has finally turned in favor of the suppliers.
Looking from the bottom when things were really sour, the daily charter rates have more than doubled already. Even tripled.
Are we slowly approaching the finish line?
I don’t think so.
The current multi-year-high numbers are still below the highs from the 2013–2014 top – measured by eye, some 20–30% or so. Then you should factor in inflation over the last ten years plus the fact that there was big competition for investments with the shale revolution back then.
You should be aware of that shale was the only source of energy production growth over the last 15 years – also significant in size, as shale has reached the size of another Saudi-Arabia.
There are good indicators that shale is slowly peaking – please see my Weekly dealing with this topic – which is good enough for a massive supply and price shock, if it were to happen: US shale production is peaking – what it means for oil and gas prices (see here).
Then you’ll be left with offshore drilling as the only source of organic growth, however, questionable whether it would be able to balance a drop in shale volumes…
If correct, this “offshore recovery” should last for several years. At the minimum.
That’s the industry overview.
To sum it up, we have low average production costs, a more favorable carbon-footprint, a true organic growth story, the topic of energy independence and supply security and still depressed valuations of assets and companies in a sector with lots of M&A potential (already under way).
The over-supply situation is history. Many companies are seeking for longer-term and higher-rate contracts.
As a plus, due to the series of bankruptcies, you can also find many clean balance sheets.
My investment idea for Premium PLUS members
Before I sketch my latest investment idea, I first want to comment on why I haven’t chosen any of the big names mentioned in this Weekly.
The most obvious choice would likely be Transocean. Indeed, this company did not go through bankruptcy. And it also has among the most modern fleet (good for more prestigious projects and higher daily charter rates). Management has also been on board for nearly a decade, meaning it sailed through the storm.
However, there is a BIG problem – the balance sheet.
Transocean has net debt of 6.9 bn. USD. That’s quite a lot, compared to a market cap of less than 5 bn. USD. One of the official goals for the next years is to deleverage the balance sheet, e.g. no direct shareholder returns around the corner. While this can lead to higher share prices, too, it is a big risk I do not feel comfortable with.
I made bad experiences with over-leveraged companies, promising to turn around. Most often, it does not play out.
The management has a contracting strategy that doesn’t intend to rush into markets for every available day rate, but to wait for a more favorable environment, before it puts its non-booked fleet to work. However, even under favorable circumstances, the management will be tasked with paying down debt for the foreseeable future.
There is no free cash flow expected for this year. Interest payments are eating away about half a billion USD yearly with the current amount of debt outstanding.
Please see the chart from their presentation:
Should they achieve – under an optimistic, but realistic scenario C – higher average day rates, free cash flow would be 1.5 bn. USD. With the current debt, it gives us an EV / FCF of 8x. My pick for my Premium PLUS members has a lower valuation with approaching net cash status towards the end of the year!
Surely, Transocean has a high leverage – on its balance sheet and as a potential investment candidate. But they are cleaning up their problems of the past. Also, shareholders got diluted regularly.
The other companies also haven’t made it, due to either one or more of the following: valuation, debt, no long management tenures (many came after the bankruptcies), hints of not functioning internal control mechanisms after a takeover, no free cash flow generation and / or a lackluster growth profile – despite the industry being in an upswing.
That’s why I picked a company with these favorable traits:
- a slightly different business model, but within this industry sub-sector
- it didn’t go through bankruptcy during the tough times, as its older contracts provided enough life-support
- yet, it still approaches a net cash status towards the end of the current year
- average day rates are currently still below market rates due to older contracts – but they have escalators and rolling-over will bring higher rates, soon
- strong order book for the next years
- free cash flow positive, self-funded
- strong growth profile, active in the crucial geographies
- low investment intensity
- announced a buy-back program of the equivalent of 20% (!) of the current market cap – funded through free cash flows
- low single-digit EV / FCF multiple
- Q1 was stronger than expected and the guidance for the whole year is too conservative – management confirmed that, but did not raise the targets officially during the call
- the CEO is one of the biggest shareholders, having a significant stake and has been with the company through thick and thin for decades
I am really excited to present this pick in my upcoming research report – due Saturday 24 June. My Premium PLUS Members will receive an email when my report comes off the press.
It can become a multi-bagger, easily, if my industry overview proves correct. Of course, it can also be a takeover target. However, my preference goes towards the former.
You shouldn’t miss out on this one!
Investing in the offshore energy industry, especially drilling, was no fun over the last 15 years. In many cases, you would have ended up even mit zeros (bankruptcies).
However, the tide has turned. Offshore is back with a roar – big oil is betting big on it.
The industry has cleaned up its past problems and is ready for a strong comeback.
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