The offshore drilling sector has been completely obliterated. Many of the stocks in this sector are down more than 90% from their highs of many years ago. For years the news has been terrible, and investors, regardless of how cheap the stocks have gotten, would not touch the sector. The offshore drilling industry, at around 30% of total worldwide production, is vital to the global economy, therefore it absolutely must survive. This week we have the first green shoots appearing and I believe the sector will, over time, rebound strongly from here. <\/p>\n
David W. Williams, Chairman, President and Chief Executive said: \"We believe improving conditions in the offshore drilling industry are becoming clearer. Client tenders for both jackups and floating rigs are on the rise and include emerging regions, as well as previously active areas that have largely been dormant over the past two years. Also, contract awards, especially in the jackup sector, are occurring with greater frequency, and field development activity is up, relative to the recent past, as project cost rationalization efforts lead to better program economics. Finally, we believe long-term oil market fundamentals are supportive of stable to higher crude oil prices, which with time will support an increase in rig demand.\" From Q1 Press Release <\/p>\n
\" I'm very pleased with Noble's start to 2017 and encouraged by what continues to be clear evidence of recovery in the offshore industry, although it's still in its early stages.\" David Williams, Noble Corp CEO on Q1 conference call <\/p>\n
There it is, the first mention of a recovery in offshore oil drilling coming from Noble Corp (NYSE:NE), one of the strongest and best companies in the sector. For a sector that has been all but left for dead, these are the green shoots, the first signs of optimism that the bottom is in, and the early stages of a recovery are appearing. <\/p>\n
What is the \"clear evidence\" that Noble Corp is referring to? First of all, rig tenders and inquiries are increasing globally. Everywhere from Brazil to the Middle East and from the North Sea to Asia\/Pacific. Each market is showing increased inquiries and rig tenders. Contractual backlog increased for Noble from $3.3 billion at year end to $3.5 billion today. This is a remarkable change of pace for the company and its investors who have come to expect nothing but bad news from the sector. <\/p>\n
Noble Corp is not alone in making positive remarks. Diamond Offshore (NYSE:DO), earlier in the week, made similar comments on their conference call, saying that inquiries into rigs were increasing as well as saying that we are seeing the first signs of a trough in falling rig demand. This was especially refreshing news as Diamond Offshore is normally the company in the sector that expresses the least amount of optimism. <\/p>\n
There are a handful of reasons why investors should understand that this sector provides a huge opportunity for profits. The first and most obvious would be simply to say that this sector, which also includes Transocean (NYSE:RIG), Atwood Oceanics (NYSE:ATW) and Rowan (NYSE: RDC), has been the most beaten down sector in the market for a while now. Believe it or not, as the S&P 500 hits all time highs, the stock prices of many of these offshore drillers have been hitting multi-decade lows. Noble Corp traded as high as $60 per share a decade ago and recently bottomed at $4.16 per share. Atwood Oceanics traded at $60 a decade ago and recently bottomed at $6.12 per share. Diamond Offshore traded at $140 per share a decade ago and recently bottomed at $13.06 per share. <\/p>\n<\/p>\n<\/p>\n
Readers of this article may question why I use the term \"bottomed\" when I refer to recent price action of these companies. The answer is, I truly believe that this past week saw the capitulation bottom for this sector, and it's perfectly timed with the first green shoots appearing. The fact that management from multiple companies are all coming out saying inquiries and tenders are increasing and for Noble, the fact that contractual backlog increased this quarter, is huge. These companies have won new contract work lately, and Diamond Offshore had a favorable ruling in a Brazilian Court recently in a dispute with Petrbras (NYSE:PBR). <\/p>\n
The price action in the stocks also showed signs of a bottom. For example, the trading volume in all of these companies was well above average. In a two minute period on Friday, Diamond Offshore traded over 250,000 shares, which represents 10% of its normal trading volume for a full day. Seasoned investors know that when we see huge price jumps on huge volume, triggered by positive news in a sector that has seen only bad news, there is a strong chance that a solid bottom is in. <\/p>\n
Even with the jump yesterday, investors can still buy these stocks at fire sale prices, and the best part is, these companies, with the exception of Seadrill (NYSE:SDRL), are not even in danger of failing. Diamond Offshore reported a small profit this past week, and Noble, while they reported a loss mostly tied to the writedown of asset values, reported an enormous amount of free cash flow for the quarter. This free cash flow for Noble amounted to 10% of their current market value, and this was one quarter. The full year will not continue at this pace, but the fact is, these companies are generating a ton of cash relative to their market values at or near the bottom of the cycle. <\/p>\n
What are they doing with this cash? Diamond, in typical fashion, is stockpiling cash in anticipation of being able to buy distressed assets at pennies on the dollar. Noble on the other hand, is rapidly repaying debt. These capital allocation strategies ensure these companies exit the downturn in better shape than today. Ultimately, this is what matters the most, as investors today are not buying these companies for today's profits. Rather, we are buying them for the significant profits that come in the future. <\/p>\n
So what does the sector look like in the future? This is the final piece to the puzzle, and one of the hardest for investors to grasp because the oil cycle takes years to play out. Many don't know this, but the truth is, the offshore oil sector, which produces nearly one-third of oil worldwide, is critical to the global economy. If one only listens to surface level news and does not think beyond headlines, it would be easy to convince oneself that oil is down because of shale oil production and shale oil production is the future preferred means of oil production. <\/p>\n
A couple of key facts need to be understood, the first of which is that shale is incapable of replacing offshore. This is hard for many people to grasp because the noise surrounding the growth in shale production is deafening, yet no one talks about the obvious reality that it is not sustainable. When shale fields are first drilled, the best locations are drilled first. Depletion rates are often in excess of 50% annually, which means in order to maintain production, more and more wells are needed. Drilling additional wells still costs the same, but with lower production from existing wells and lower production from newer wells (because the best locations were drilled already), the model, similar to a person attempting to run on a treadmill that is inclining, eventually becomes unsustainable as it requires ever increasing efforts to maintain the same pace. <\/p>\n
Many investors may stop at this point and wonder why shale is so popular today if it is not sustainable. This is indeed a good question, and my opinion is that the oil giants of the world are so cash starved from trying desperately to maintain their dividend payments in the face of negative free cash flow that they simply do not have the cash flow required to invest in offshore production. With shale, the payout comes much quicker than with deepwater production. Oil majors are aware that offshore produces more cash over the life of a well, but they do not have the budget necessary to pay the years of upfront expenses needed to justify sanctioning offshore projects. <\/p>\n
My suspicion is that two things will change this favoritism towards shale over time. First, as oil prices have risen significantly off of their lows of early 2016, many oil majors are again able to generate enough internal cash flow to pay their dividends and fund capital expenditures. With more cash flow available, oil companies will again look towards offshore as it generates more cash over time. <\/p>\n<\/p>\n
The second reason is that depletion is very soon going to be an enormous problem for oil companies. Last year, Chevron depleted more oil from its reserves than it discovered. This is simply not a sustainable business model and there will come a day when shareholders demand oil companies begin to increase reserves. This will no doubt bring the oil majors back to offshore, a place where almost one third of total global oil production is sourced from. <\/p>\n
With the reports coming out this past week, investors in the beaten down offshore sector finally see the first green shoots of a recovery. Inquiries and rig tenders have increased globally and they are occurring at multiple companies. Two of the strongest players in the space, Noble Corporation and Diamond Offshore, are generating huge amounts of free cash flow at or near the bottom of the cycle. As these companies repay debt and prepare to buy distressed assets, they set themselves up for success as the cycle turns up for the first time in years. Given how negative the news has been, even just a sentiment shift can take these stocks significantly higher. Investors would be wise to not wait for the recovery to begin, but rather to use this opportunity while the news is still terrible and the situation is clearly improving, to aggressively build positions. The offshore sector is crucial to the global economy. The sector has to survive and the Diamond Offshore and Noble Corp will emerge as winners. Their stock prices trade around at levels that are 90% below their all time highs. Considering their valuations, and the emerging positives, the stocks represent an incredible opportunity to make huge gains in this market with most of the risk already well priced in. <\/p>\n
Disclosure: I am\/we are long NE, DO, ATW. <\/p>\n
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. <\/p>\n
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Green Shoots Appearing In Offshore Drilling - Seeking Alpha<\/a><\/p>\n","protected":false},"excerpt":{"rendered":" The offshore drilling sector has been completely obliterated. Many of the stocks in this sector are down more than 90% from their highs of many years ago Continue reading