Offshore Drillers

If you have been following Grit Alpha for the past year you should know that the offshore drilling industry is one of my favorite undervalued industries. The thesis is simple: offshore drillers are trading well below replacement cost and the economics to operate a drillship is rapidly improving.

Over the past decade offshore drillers have been forced to run their operations at basement level day rates, resulting in lackluster free cash flow. But now, for the first time in close to a decade, day rates are improving and cash flows are beginning to get locked in.

Below I wrote out two examples of how improving day rates improve cash flows. The first one is an example of current day rates on rigs that have not re-rated higher…

1. Fixed costs to operate a drill ship are $50,000 per day

2. Current day rates are $200,000 per day

3. Rig level cash flows come in at $150,000 per day

Now when rates begin to move upwards we start to see operating leverage kick in. Based on recently awarded rates for drill ships we get a cash flow model something along the lines of the following:

1. Fixed costs to operate a drill ship are still $50,000 per day

2. Newly signed day rates $450,000 per day

3. Rig level cash flows come in at $400,000 per day

These two examples are just quick run-downs on how improving day rates improves operating leverage. As day rates increase, fixed costs remain fixed and real operating leverage kicks in. The fixed costs here to operate a drill ship is just an example and can vary wildly from ship to ship.

Since the beginning of 2023, I have touted that offshore drillers remain one of the most compelling sectors to invest in. Not only were investors buying assets for $0.50 on the dollar, but improving day rates would lead to real free cash flow generation 1-2 years out. The thesis has slowly been playing out but it finally looks like the market has figured this out. Because over the past month offshore drillers have skyrocketed to new highs and it appears like they could go even higher.

I have pulled a few different external sources on what is driving offshore drillers to new highs. The sell-side is finally starting to take notice. And the recent tenders from Petrobras show what kind of rates drillers are bidding at. This is extremely compelling evidence and should propel drillers even higher over the next 12-18 months. The offshore drilling industry remains my favorite play and one of my largest sector holdings.