Offshore Drillers Refinancing

Offshore drilling stocks are cheap. At least that’s what the management teams of Transocean (RIG) and GlobalSantaFe (GSF) think. Last week, the two agreed to merge in a deal that will create a company with a combined market capitalization of about $48 billion.

There are lots of good reasons for this deal. Most of them involve scale efficiencies, like the money that can be saved by combining functions like marketing and fleet maintenance. Management expects that on a pretax basis, these savings will add up to about $100-150 million per year.

But the most important aspect of this big merger is that it will include a $15 billion debt-financed dividend payment to the shareholders. With a combined $33 billion backlog — most of which will be fulfilled over the next couple of years — the combined company will generate more than enough cash to pay off this debt.

This is a ringing endorsement from two great management teams that their stocks are too cheap — so cheap that it makes more financial sense to acquire peers than to try to replicate them in shipyards. Doing that would require investing tens of billions of dollars and waiting at least a decade. Order backlogs for brand-new offshore (or “newbuild”) rigs now stretch well beyond the year 2010.

Most contract drillers are not willing to wait that long and miss out on a few years of very profitable business. So they’ve been accelerating their rig refurbishment programs. The strong trends in both newbuild and refurbishment activity play right into the hands of rig equipment manufacturers (including the one I recommended to Strategic Investment readers in December). [Greg’s Quicknote: The stock Dan’s talking about is already up a snappy 91.76% in a short 8 months. Go here to make sure you get his next recommendation – and a list of the plays still on his buy radar.]

If Drillers Don’t Refinance, Private Equity Will

By taking on more debt as they proceed with the merger, Transocean and GlobalSantaFe are broadcasting that their balance sheets are underleveraged relative to the opportunities they face. In their view, it makes sense to “refinance” their combined balance sheet.

You’ll recall that most U.S. homeowners refinanced their mortgages in recent years because it made sense from a financial standpoint.

Lately, private equity funds have been aggressively refinancing the balance sheets of companies they consider to be underleveraged because access to credit has been so easy and cheap. Though private equity activity will clearly slow in the wake of the CDO mess, plenty of quality deals will still be done, especially the ones where the target companies generate plenty of cash flow. There’s a good chance that at least one of these deals will involve an offshore driller.

Back in March, I wrote a Whiskey & Gunpowder article entitled “Levered Technology, Unlevered Drillers“. Arguing that the private equity guys should take a look at the contract drillers rather than tech companies like Motorola, I wrote that they should consider a long-term investment in the contract drilling business because:

“The underlying assets are increasing in value, not deflating. State-of-the-art drilling equipment has not yet succumbed to the global deflationary pressures we see in businesses like cell phone and chip manufacturing. Cell phone manufacturing capacity is overbuilt yet still receives more and more capital investment worldwide — good for consumers, bad for producers. But offshore drillers emerged out of a 20-year recession just a few years ago.

“Furthermore, while earnings visibility is very low at most technology companies, several offshore drillers know the next few years of earnings with a fair degree of confidence. To top it off, they’ll have very valuable rig fleets at the end of the high-visibility period.”

I intended this to be a humble suggestion to financiers like Carl Icahn, because I think there’s far higher risk involved with a multiyear commitment to a technology company. The risk involved with a multiyear commitment to a drilling company is more quantifiable and visible.

Though it hadn’t yet been made public at the time I wrote this Whiskey article on March 23, Icahn had been building a 4.6 million share position in offshore driller Pride Intl. (PDE), most of it bought in the range of $28-29. At the conclusion of the article, I noted that private equity investors can earn big profits by targeting industries where the collateral tends to inflate over time — like real estate:

“Leveraged exposure to a long-term real estate bull market is how most real estate moguls have made their billions. If an opportunity comes along to borrow money at a low fixed interest rate and buy a cheap asset that is both inflating in value and throwing off income, it’s hard to lose.

“Why not consider contract drilling businesses?

“I’d bet that a fleet of drilling rigs will inflate in value at a faster pace than physical buildings over the next 10 years. I’d also bet that quite a few savvy investors recognize this and we’ll see more mergers, acquisitions, and private equity transactions as the energy bull market continues to roll on.”

The good news for private equity is that most offshore drilling stocks remain cheap. All are trading in the range of 7-10 times 2008 earnings estimates (in blue) and 9-20 times trailing-12 months’ cash flow (in red). And these multiples get smaller as you look into a future of visible, growing earnings and cash flow. This growth will come over the next few years when these companies book the high-margin contract work that already exists in their backlogs:

Here’s an update of the cash flow model I used in the March Whiskey article. GlobalSantaFe remains cheap even after a rally into the mid-$70s:

The trajectory of the dividend plus “buyback” yield at the bottom of this table will obviously be different now that GSF won’t be a standalone company. Instead of a steady stream of dividends and share buybacks, the yield will be very high for GSF shareholders in 2007 as they receive a $5 billion special dividend payment along with shares in the new company.

In a few years, once the $15 billion in debt is paid off, the newly merged company will likely shift its focus back to reinvesting cash flow into growth projects and acquisitions.

Several analysts that cover the offshore drillers recently published notes speculating that we’ll see more consolidation. If the other offshore drillers don’t consolidate — or at least initiate leveraged recapitalizations in which they issue debt to buy back stock — there are likely to be a few private equity firms out there that will take the initiative for them.

Unprecedented Growth in Offshore Drilling Worldwide

If you’re going to speculate about further buyout-leveraged recapitalization activity among the drillers, it helps if you have a bullish long-term outlook for drilling activity. The volatile history of the contract drilling business demands it.

I asked Dr. Michael Smith, CEO of EnergyFiles Ltd., to share the findings from his exhaustive research on oil production in the May issue of Strategic Investment. Dr. Smith holds a Ph.D. in geology from Oxford University and has wide-ranging experience in the oil exploration business (you can find Dr. Smith’s work at www.energyfiles.com).

He expects that a supply gap — where global oil supply falls short of demand — will develop within about five years, and if his forecast is accurate (as I expect), demand for drilling will really take off.

The free market’s first response to the challenge posed by Peak Oil will be an acceleration of exploration and drilling activity. As my colleague Byron King frequently reminds us — and the reproduction of one of Dr. Smith’s charts below shows — worldwide oil discoveries peaked back in the 1960s.

This chart also puts into context the history and the most likely future of oil production drawn from offshore sources around the world (shown in blue):

About one-third of the world’s oil production currently comes from offshore sources, and this share is expected to keep climbing. So a healthy, growing offshore rig fleet will be vital to not only maintain the height of the production graph, but also attempt to flatten the 40-year downtrend that’s clearly visible in the bars depicting oil discoveries.

The necessary pickup in offshore exploration and production activity will need support from both equipment and trained workers. So the drilling equipment industry is gearing up for a long-lasting boom. In the May issue of Petroleum Review, an article entitled “Unprecedented Growth Forecast for Subsea Sector” draws from the conclusions of a study recently completed by consultants at Douglas-Westwood:

“The booming subsea oil and gas industry is on the cusp of a major period of growth with its global revenue estimated to rise by more than a third, from $29 billion in 2006 to $41 billion by 2011. These findings are from a new report commissioned by the Scottish Enterprise Energy Team from Douglas-Westwood. The report also warns that while subsea hardware providers are struggling to meet demand and there are serious shortages of deepwater installation vessels, there is still significant growth ahead.

“Africa is forecast to become the world’s largest subsea market, growing from $6 billion in 2006 to $12 billion within four years. Asia and Latin America are also expected to see extensive levels of growth. On the nonpipeline side, drilling and completion is predicted to rise by 45% between 2007-2011, from $8.1 billion to $14.4 billion. Meanwhile, numbers of global subsea well installations have grown from approximately 200 in 2004 to 300 in 2006, with 500 units per year forecast to be installed in 2011.”

Here’s Douglas-Westwood’s chart showing how the offshore drilling and subsea production boom will extend across every promising offshore oil and natural gas basin and worldwide:

Since many of the world’s older offshore oil wells have long surpassed peak production, most of this development will concentrate on ramping production from higher numbers of less-productive fields. Petroleum Review highlights the following important developments:

“The Argyll field in the North Sea produced the first U.K. offshore oil from subsea wells connected to a floating production system. From these beginnings, U.K. companies have developed a world-leading position in technology supply and operations. As offshore production in the world’s mature basins declines, attention has been increasingly focused on deepwater and enabling technology of subsea production. In addition, subsea wells tied back to existing infrastructure often offer the only cost-effective solution to accessing the considerable reserves of the hundreds of small field prospects in mature areas such as offshore Scotland…

“European production is mainly focused on the North Sea, which is in decline. Apart from some frontier areas such as western Ireland, the commercially difficult U.K. Atlantic, and Norway’s Arctic, the chances for major finds are remote…

“In conclusion, it can be said that the emergence of subsea production technology has revolutionized offshore oil and gas activity and the market is set for unprecedented growth as companies move into deeper water, where there are better prospects for major discoveries. However, the voracious demand for skills and equipment will be a major issue as companies try to capitalize on the extensive global opportunities.”

The investing opportunities are out there for you to pursue. You’ve just got to know where to look. The executives at Transocean and GlobalSantaFe clearly see opportunity in the continued strong demand for offshore drilling, and they’re “hitting the accelerator,” so to speak. This is a very important signal amid the noise of day-to-day financial news.

Good investing,

Dan Amoss, CFA

August 2, 2007