Buying The Offshore Drilling Market
Trading below replacement value, unloved industry and on the cusp of an inflection point with day rates set to move meaningfully higher
Welcome all new subscribers to Alpha Letter. Every week I write about interesting opportunities in the public market. I focus on stocks off the beaten path. Broken businesses. Assets trading under liquidation value. Macroeconomics and where the economy is heading. I don’t like investing in large, popular companies and find a fascination with assets no one else is looking at.
Today’s piece will be focused on the offshore drilling industry and why I have become increasingly bullish on the space.
But before we get in today’s piece, first a word from today’s sponsor…
There’s a Lot Going On
Just like with Alpha Letter, you want to skip the BS and focus on what matters the most.
The Daily Valet. does just that—distilling the news you need to know in order to start your day.
Let’s face it, there’s a lot going on these days. It can be difficult to know what deserves your attention.
This newsletter curates dozens of sources into a quick and entertaining read.
It’s your guide to what’s being talked about and leaves you informed and motivated.
Offshore Drilling Market
As a beginning value investor I read constantly. My bookshelf was filled with timeless books such as The Intelligent Investor, Security Analysis, How to be a Stock Market Genius, Margin of Safety (PDF), Common Stocks and Uncommon Profits, Tap Dancing to Work, The Sleuth Investor, Titan and countless other books on business and investing. I did not have a professional background in equity investing and Ivy League schools were out of the question. I so resorted to teaching myself the art of investing one book and annual report at a time.
I remember trying to peel through Security Analysis as a beginning investor. The book is a masterpiece but if you are untrained in finance the book is a monster of a read. I maybe made it halfway through before giving up and moving onto something less challenging. Despite not making it through the entire book, there was a prelude to the book that I still remember to this day.
I don’t remember who wrote the prelude but the author laid out an example on value investing in offshore drillers. The period of time, I also don’t remember, but the author provided an example where well known value investors (Seth Klarman and others) were buying offshore drillers hand over fist. The thesis was relatively simple: offshore drillers sold off so much that they were trading under the replacement value of their rigs. Value investors like Seth Klarman purchased these offshore drillers and a few years later made a killing on their investment.
Fast forward a decade or two to the year 2014. OPEC made an announcement on Thanksgiving Day that I won’t ever forget as I was heavily concentrated in oil and gas equities (concentrated as much as a poor kid could be). On that day the oil and gas market collapsed and up until recently we have been in an oil and gas recession. Throughout the recession almost every offshore driller was forced to file for bankruptcy from levered balance sheets and collapsing day rates.
If you have followed this newsletter for sometime you probably know I love investing in beaten down and unfavored industries. I like restructured businesses with marked down assets. Companies trading at a fraction of their replacement value. Assets that are on the cusp of an inflection point that the broader market has yet to recognize.
I think the offshore drilling market meets all of these characteristics and looks extremely attractive. Let’s did in.
Almost every public offshore driller went through bankruptcy, slashed their debt and reemerged with stronger balance sheets. Debt holders continue to control most of the equity in these restructured companies, providing fundamental value investors a leg-up against forced sellers. In addition, former equity holders in these restructured organizations are likely to be gun shy and will stray away from equities that wiped them out in prior cycles.
What makes a restructured company particularly interesting is the accounting impact on property, plant and equipment. When companies restructure, assets are typically marked down to “fair value” even in reality these assets could trade on the private market at a much higher valuation. Consider Diamond Drilling.
With fresh start accounting, Diamond’s long-lived assets were re-valued at their fair value, from a $6.9 billion value to only $1.0 billion. Any investor who did not follow the story before the fresh start accounting kicked in will see an asset value that doesn’t really represent the true market value of these assets and what they could be worth in a liquidation basis.
Which brings me to replacement value of these assets. Most, if not all, of the offshore drillers are trading at a wide discount to the replacement value of their rigs. Check out Valaris Limited (VAL) as an example. With a share price of $60, Valaris has a market cap and enterprise value of only $4.5 billion. Before Valaris adopted fresh start accounting, in accordance with their restructuring, Valaris had $18 billion of value in their drilling equipment.
In 2020 Valaris took a $5.1 billion impairment on the drilling assets and then by 2021 when the company restructured, the drilling equipment was only valued at a mere $957 million.
Any skeptical investor would argue that the fresh start accounting is true fair value of these drilling assets, but I argue it fundamentally understates the value.
First it helps to understand a bit of the offshore history. From 2010 through 2014 there was a huge newbuild cycle as rates for floaters were in the $600,000 per day range and jackups in the $300,000 per day range. At these rates offshore drillers were incentivized to lever up the balance sheets and build as many rigs as possible. Money was being minted and everyone wanted in.
When the downturn came everyone was overextended and went bankrupt. A downturn for a year and things would have been ok on the production side. But a downturn for eight years, well there was a huge lack of production to meet terminal demand for oil and gas.
An eight year downturn caused many rigs to be retired and scraped. 40-50% of the floater supply was essentially wiped out. Total offshore rigs went from over 400 in 2014 to just under 200 today. And the market is getting tighter by the day with utilization across the industry increasing along with day rates.
A newbuild floater is estimated to cost anywhere from $750 million to over $1 billion to build today. Not only is that a significant cost but it would take anywhere from 5-7 years to bring a floater onto the market.
Bringing this exercise even further, Valaris has 16 floaters in their fleet. Assuming these floaters only have a replacement value of $500 million each, this brings the replacement value of the floater only fleet to $8 billion. Even if we assume their floater fleet is worth $250 million each, that is a $4 billion valuation and does not include the value of their 29 jackups and JV with Saudi Arabia.
The issue with using replacement value to peg a fair value on these assets is that there hasn’t been a transaction in the floater market for a long-time. This makes it challenging to place a private market value on these assets.
But Rates Are Moving Up
Despite the lack of private market transactions in the floater market, day rates are moving up and I think we are at the cusp of an inflection point for the industry. Take the note put out by Barclay’s on the most levered player in the industry, Transocean.
On October 6th, Barclay’s upgraded their price target on Transocean to $5.00 per share (low in my opinion) as they are forecasting day rates to rise to $500,000 per day next year. This would be a significant move as market rates for floaters are currently in the $400,000 per day range.
Remember, back in 2010-2014 day rates were in the $600,000 per day range and these companies were printing cash. Valuations for offshore drillers were in the 10-15x EBITDA range. Based on Barclay’s note, we are close to hitting these historical day rates in just one short year. And I think day rates in this cycle could go even higher.
First, there is less supply of floaters out there. Almost 40% of the market was scraped or retired. There are less ships and demand is staring to roar back.
Secondly, countries across the globe are starting to realize the importance of energy independence due to the entire Russian and Ukraine situation. I think over the next few years we will see a large increase in capital spending, worldwide, for fossil fuels such as oil and gas.
Thirdly, there has been a lack of production in the oil and gas space for eight years. It will take a significant amount of investment to meet long-term oil and gas demand. The best way to meet this demand? Offshore drilling.
Finally, offshore drilling companies are disciplined with their capital. No one is investing capex to bring on newbuilds. Debt is getting paid down. And eventually investors will want a return of capital, not growth. I expect most drillers will generate large amounts of free cash flow over the next 18-24 months with most of that capital being used to paydown debt or returned to shareholders.
I am pretty bullish on the offshore drilling industry and energy in general. Over the next few weeks I will continue to layout my thesis for the industry and what names I like and how I am positioning my portfolio to capitalize on this thesis. If you are an Alpha Letter Pro member I will see you in the Telegram chat. If you are new here and want access to all of my future and past research, subscribe today.
Alpha Letter is a reader-supported publication. To receive new posts and support my work, consider becoming a free or paid subscriber.
Disclaimer: The publisher does not guarantee the accuracy or completeness of the information provided in this page. All statements and expressions herein are the sole opinion of the author or paid advertiser.
Alpha Letter is a publisher of financial information, not an investment advisor. We do not provide personalized or individualized investment advice or information that is tailored to the needs of any particular recipient.
THE INFORMATION CONTAINED ON THIS WEBSITE IS NOT AND SHOULD NOT BE CONSTRUED AS INVESTMENT ADVICE, AND DOES NOT PURPORT TO BE AND DOES NOT EXPRESS ANY OPINION AS TO THE PRICE AT WHICH THE SECURITIES OF ANY COMPANY MAY TRADE AT ANY TIME. THE INFORMATION AND OPINIONS PROVIDED HEREIN SHOULD NOT BE TAKEN AS SPECIFIC ADVICE ON THE MERITS OF ANY INVESTMENT DECISION. INVESTORS SHOULD MAKE THEIR OWN INVESTIGATION AND DECISIONS REGARDING THE PROSPECTS OF ANY COMPANY DISCUSSED HEREIN BASED ON SUCH INVESTORS’ OWN REVIEW OF PUBLICLY AVAILABLE INFORMATION AND SHOULD NOT RELY ON THE INFORMATION CONTAINED HEREIN.
No statement or expression of opinion, or any other matter herein, directly or indirectly, is an offer or the solicitation of an offer to buy or sell the securities or financial instruments mentioned.
Any projections, market outlooks or estimates herein are forward looking statements and are inherently unreliable. They are based upon certain assumptions and should not be construed to be indicative of the actual events that will occur. Other events that were not taken into account may occur and may significantly affect the returns or performance of the securities discussed herein. The information provided herein is based on matters as they exist as of the date of preparation and not as of any future date, and the publisher undertakes no obligation to correct, update or revise the information in this document or to otherwise provide any additional material.
The publisher, its affiliates, and clients of the a publisher or its affiliates may currently have long or short positions in the securities of the companies mentioned herein, or may have such a position in the future (and therefore may profit from fluctuations in the trading price of the securities). To the extent such persons do have such positions, there is no guarantee that such persons will maintain such positions.
Neither the publisher nor any of its affiliates accepts any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of the information contained herein.