Drilling deeper into the ground

As the price of crude oil fell from $115/bbl to $30/bbl, life for the offshore oil drillers became much more challenging. Drilling offshore was a necessary precursor to many deep-sea oil production projects – which themselves were only economically viable at very high oil prices. At $30/bbl oil, most of these projects are uneconomic; and therefore, the need for offshore oil rigs has all but evaporated.

Supply
The offshore drilling industry appears to be in severe oversupply. The recent period of strong oil prices led to an increased number of offshore drilling projects being sanctioned by major oil E&Ps. This led to an increase in the construction of new drill rigs.

As illustrated by the table below, total uncontracted rigs (including newbuilds) represent 39 per cent of the current contracted base in the case of floaters; and 64 per cent of the current contracted base in the case of jackups.

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Source: Ensco Plc

This alone represents an enormous oversupply. This situation will be exacerbated by existing contracts being terminated. This reduces the current contracted base and adds new uncontracted supply to the total.

Subletting of rigs also exacerbates the oversupply situation. From the 3Q15 SEC filing of major offshore driller, Ensco: “Customers have delayed drilling programs and are exploring subletting opportunities for contracted rigs thereby exacerbating supply pressure.”

Drillers, including Ensco, are also (naturally) showing hesitancy to remove capacity from the market on the basis that they believe oil prices will increase to $60-70/bbl. On the 3Q15 call, Ensco CEO Carl Trowell said: “At this stage, our intention would be to warm stack the drillships which do not have activity, and then we would review that depending on how we saw the long-term market opportunities developing.”

Demand
The customers of offshore drillers are primarily the major oil E&Ps globally. These companies are much larger than the drillers and can naturally exert significant bargaining power over the drillers.

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Offshore oil drilling revenue stems from the capital investment programs of the major oil E&Ps, which is down approximately 13 per cent per annum in 2015, according to Credit Suisse. Morgan Stanley forecasts that large-cap E&P capex will be down by another 17 per cent in 2016.

Supply vs Demand
As illustrated by the charts below, even under Citi’s demand scenario (which builds in a recovery in oil E&P capex spend post 2017), both floaters and jackups remain in extreme oversupply for the foreseeable future.

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Marginal Revenue vs Marginal Cost
Typically, when any commodity-type of product is in extreme oversupply, pricing gets pushed down to marginal cost of production. Interestingly, in the case of Ensco (and is similar for the other offshore oil drillers), gross operating margins remain around 50 per cent!

29012016_Chart5

Even sell-side forecasts for future profitability see gross operating margins remaining above 30 per cent longer-term. We also observe that half of Ensco’s gross operating profit in 2017/18 comes from just five rigs (all floaters), for which gross operating margins remain at levels 60-70 per cent!

It is unclear why margins should remain so high in such a competitive marketplace. This creates a serious risk to earnings for Ensco, concentrated in a very small number of rigs.

We conclude this analysis by suggesting that revenue expectations are likely too optimistic going forward. This has obvious implications for earnings expectations of the offshore drillers, including Ensco.

We can also observe from Morgan Stanley’s chart below that market values of floaters have plummeted as we enter 2016. Conditions are extremely challenging for Ensco and many of the offshore oil drillers.

29012016_Chart6

The Montaka research team identified Ensco as a short portfolio opportunity in 2015 and the company remains in the portfolio at the time of writing this blog. We believe the headwinds that have led to the current challenging situation for Ensco will continue to persist in 2016. And given that the business is already free cash flow negative, with a net debt load of $5 billion (versus an enterprise value of $7 billion), Ensco does not appear well positioned to be able to face these enormous challenges.

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Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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Our Montaka Active Extension strategy strives for maximised return over the long-term. Owning the Montaka long portfolio typically scaled up to approximately 130 percent - and the Montaka short portfolio typically scaled down to approximately 30 percent – this strategy results in a net market exposure of approximately 100 percent most of the time.

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Our Montgomery Global strategy strives to act as a core, high conviction, global portfolio holding. Consistent with the long portfolios in our Montaka strategies, this offering is focused on owning the world’s high quality, undervalued businesses – and cash when appropriate – to outperform its benchmark. Branded as “Montgomery Global” in Australia to reflect a key.

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Our Montaka Active Extension strategy strives for maximised return over the long-term. Owning the Montaka long portfolio typically scaled up to approximately 130 percent - and the Montaka short portfolio typically scaled down to approximately 30 percent – this strategy results in a net market exposure of approximately 100 percent most of the time.

Our Montaka variable net strategy strives for significant downside protection – but with minimal upside reduction. Focused on owning the world’s great and growing businesses when they are undervalued, while managing a portfolio of short positions in businesses that are deteriorating, misperceived, and overvalued, this strategy is our flagship long-short

Our Montgomery Global strategy strives to act as a core, high conviction, global portfolio holding. Consistent with the long portfolios in our Montaka strategies, this offering is focused on owning the world’s high quality, undervalued businesses – and cash when appropriate – to outperform its benchmark. Branded as “Montgomery Global” in Australia to reflect a key.