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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Is Deepwater Drilling About To Make A Comeback?

The most unloved sector in energy is starting to “sea” slightly sunnier skies on the ocean’s horizon. The decline in oil prices has had a dramatic effect on many investors’ portfolio, but one sub-sector stands out as being particularly awful; offshore drilling. For those who have not regularly invested in the sector, the story here is an unpleasant one. Over the last few years as relatively high oil prices spurred investment across the entire energy sector industry, offshore drilling expanded like everything else.

One area of offshore that saw a particularly large infusion of corporate cash was ultra-deep water (UDW) drilling. UDW companies like Ensco PLC, Seadrill, Transocean, Diamond Offshore, and Noble Corp. all put substantial investments into bringing new offshore drilling rigs to market. (Note: Noble is a separate company from Noble Energy – in the news lately for M&A reasons. The two have a common corporate legacy, but are separate entities today.)

As a result of this overinvestment, by the middle of 2014, there was an emerging glut of UDW rigs and day rates on these rigs started to collapse. The oil price collapse last fall exacerbated the supply issues in the industry. By mid-2016, multiple smaller offshore drillers had been forced into bankruptcy, and even the strongest players in the space were forced into stacking existing rigs. Stacking involves storing rigs to reduce costs of operation. Stacking can be cold or warm with each process having different costs and benefits by in both cases the step is an extreme one for a company to take.

The process of stacking is costly, not easy to reverse, and often leads to subsequent rig scrapping. Many companies were initially reluctant to cold stack their rigs – the process had little precedent, and some firms fretted that rigs might never be able to be made fully operational again. Yet in the face of persistent pressure, companies have had little choice but to scrap or cold stack many rigs that were not under contract. Related: Why The Trump Administration Is A Huge Wildcard For The Oil Industry

All of this has set the stage for a rebound in the sector which is showing the first signs of life today. Influential energy research firm Douglas-Westwood projected that capex in deep water exploration will jump 69% by 2019.

There are multiple reasons for optimism about the offshore space at this point. Offshore rig activity has started to pick up ever so slightly as oil prices have risen. Many offshore firms have become much more efficient over the last few years as a survival mechanism. Day rates on offshore rigs have mostly stabilized in many regions. The Trump administration is poised to make offshore US drilling easier. The imbalance in supply and demand for the offshore market has dissipated. The remaining offshore firms are largely strong companies with solid balance sheets. And perhaps most importantly, the stock prices of many offshore firms have started to rise dramatically from their lows.

None of this means that firms like Transocean and Noble will be revisting their highs from a few years ago – the stocks are still more than 75% below those levels for the most part. But it does mean that value shoppers looking for a bargain in the energy space can safely consider the offshore arena. Prices could double from here and still be inexpensive. That’s the kind of math investors should be salivating over.

By Michael McDonald of Oilprice.com

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