Deepwater Looks At Long And Difficult Recovery

As investors look to position themselves to take advantage of the new normal with oil prices, there is a lot of consternation about which sectors have the best and worst positioning. Unconventional players like Apache, Devon, Parsley, and other all have shown greater resilience than many expected at the onset of the Crisis. That area of the industry looks poised to do well if oil prices stay in the $50 region. Stock prices are recovering for these firms, and many are expecting earnings to follow suit over the next year.

In contrast, sentiment could hardly be more negative in the deep water drilling sector. Nearly every sell side analyst is at best tepid on the prospects in the deep water drilling sector. While many other sectors in the energy industry have recovered some of their stock's slump, deep water drilling remains moribund. Against this backdrop, some contrarian investors see an opportunity. Yet the deep water sector only makes sense for those with ample patience.

The deep water sector has seen a drop that is unparalleled in the oil sector. Top tier players like Noble Energy, Transocean, and Ensco are all down 80%. Noble is trading at $6 a share down from ~$35 in late 2013. Ensco is at $7.50 down from $55, and Transocean is around $10 down from $50. Already offshore firms like Paragon, Vantage, and Hercules Offshore have all run into problems requiring restructuring or bankruptcy. Reports last fall suggested that larger firms like Transocean might seize bankruptcies as an opportunity to consolidate the market and pick up additional rigs at fire sale prices - that trend has been more muted than many expected.

The reason for all of the problems in the offshore space and the pessimism around these stocks is fundamentally one of supply and demand rather than just oil prices. The sector was showing signs of strain a couple of years ago even when oil prices were much higher. The current bout of low prices has simply exacerbated existing problems in the space.

In particular, very high oil prices and a lack of new oil supplies in the middle of the last decade led to a dramatic expansion of the offshore rig fleet across many companies. That expansion in supply capacity led day rate prices to peak and then start collapsing just as the oil price downturn hit. The situation at this point is beyond awful for investors. Offshore rig service company Frank's International recently announced 2Q2016 revenues that were 1/3 of prior year levels. That's significant when you bear in mind that Frank's is one-half of a global duopoly (along with Weatherford) of a critical service for offshore firms. In other words, it's a well-run and well-respected firm in its industry.

For the deep water sector to recover, two things have to occur. First, oil prices need to rise or supply chain costs need to fall in deep water. The typical offshore project has breakeven costs of around $55 per barrel at present. With oil at $45-50 per barrel, no one is going to drill new offshore wells. Pricing must come down realistically - that process has started offshore, but still has a long way to go. The capital requirements for offshore mean that there are fewer players in the market compared to onshore, so price competition is not as intense. That's been a short-term positive for many service companies, but it also meant that the industry has not adjusted the way it should. Service firms will have to lower their price (and correspondingly their own costs), or there won't be an offshore industry.

Second, the rig market needs to rebalance. At this point there are still far too many existing offshore rigs relative to the level of demand. Offshore drilling is probably the closest direct competitor to onshore shale in terms of capital deployment, and essentially onshore shale is the area where most E&P firms are putting their money these days. The rig market needs to rebalance accordingly.

Both the supply chain cost compression and the rig market rebalancing will happen, but both will take time - probably several years. The good news for long-term investors is that the sector is dirt cheap right now. Buying firms like Transocean, Noble, Ensco, and even service companies like Frank's International and Weatherford will result in 5X returns over a five year time frame. As fast as these firm's stocks have fallen, they will rise again - but not right away. No one can accurately predict when that price appreciation will start which is why it doesn't make sense to try and time the market. These stocks are the definition of a long-term play. But in the near term, patience will probably be required.

For anyone who is unwilling to wait several years for a market rebalancing in the deep water space, the best position is to avoid the sector, or even to short the sector while going long faster recovering groups like the unconventional E&P firms. Such a strategy relies on the fact that deep water won't rebound unless oil prices continue their ascent, and in that case any deep water rebound will be slower than the unconventional E&P firm rebound.