Pacific Sharav

In this article, I want to share my view on what is the best way to make a bold, longer-term (more than one year) bet on the offshore drilling industry. This article is the result of the discussions in the comments sections of my offshore drilling related articles and explains why I do not view the industry leaders as the best way to make the “all or nothing” type bet with a potential for major profit and a risk of losing all of your investment.

I must admit that I’m not a big fan of “sitting through thick and thin” in highly volatile equities and that it does not fit my style – I prefer to manage risks on a separate equity level rather than on a whole portfolio level. That said, you can still manage your risk properly if you allocate just a small portion of your portfolio for such bets. Now that I’ve warned you that it’s not a bet that fits everyone, let’s get to the big picture.

In my opinion, most drilling companies are doomed unless the offshore drilling market experiences a timely and significant improvement. As I showed in my recent articles on the problems of the cold stacked fleet (Transocean (RIG) (here), Seadrill (SDRL) (here), Valaris (VAL) (here), Noble Corp. (NE), Diamond Offshore (DO) and Pacific Drilling (PACD) (here)), the size of drillers’ debt is often close or exceeds the current valuation of their fleets while a significant amount of fleet value can be trapped in cold-stacked rigs that may never work again.

I’d also note that these fleet values remain theoretical as there are simply no buyers for any fleets – the rare transactions are on an individual rig level, and we haven’t heard about purchases of notable assets for quite some time. The debt loads and the related interest payments dictate the necessity to obtain longer-term contracts on day rates that are materially higher than the current ones ($175,000-195,000 for floaters; $115,000 for premium jack-ups; Bassoe Offshore data).

Thus, any long-term bet on any offshore drilling company is a bet on rising day rates. If you believe that the market will pause at current levels, there is simply no sense in trying to evaluate whether some drilling company is better than its competitors – they’ll all be in some sort of trouble (most in a very big trouble, I should say) if the market situation is “frozen” at current levels.

With this in mind, we can come to a major conclusion: picking the “safest” or “leading” drillers is not logical if we want to construct a bold long-term bet on the recovery of the offshore drilling market. In a lagging market, shares of “leading” drillers like Transocean or Valaris will go to zero just like the shares of their “small” competitor Pacific Drilling.

Debt is also a major factor since it creates additional timing risks – big debt which includes material maturities in the coming years makes a company more dependent on timing of the recovery. Being “big” in offshore drilling right now is a synonym of having some kind of debt problems. The debt factor eliminates the major drillers like Transocean, Valaris, Noble Corp. and Seadrill from the “bold bet” list.

I would also avoid Diamond Offshore if I wanted to make a “risk-on” bet on the offshore drilling market recovery. While I believe that it is the best-managed company with good contract coverage and manageable balance sheet, it will not have the most upside in case of recovery.

I believe that the best way to make a risky, longer-term bet on the offshore drilling recovery is to buy shares of Pacific Drilling (Q3 2019) and Borr Drilling (BORR) (Q3 2019). Pacific Drilling is a pure bet on drillships, while Borr Drilling is a pure bet on premium jack-ups. For further diversification, one could add Awilco Drilling (OTCPK:AWLCF) (Q3 2019) in the mix to get exposure to its two newbuild harsh-environment semi-subs which are currently under construction. Anyone willing to engage in such a trade will have to hold the stocks for months and possibly years regardless of volatility (which has to be expected). To justify the risk of losing the whole principal, the stocks should be multi-baggers.

At current valuations (I discussed them in Q3 2019 articles to which I linked above and also earlier, so I don’t want to repeat myself here), the above-mentioned stocks definitely have the potential for outsized returns if the market situation develops favorably.

Pacific Drilling has three stacked drillships out of the fleet of seven, and the company’s smaller size provides a better chance for reactivation of its rigs in comparison with bigger drillers who are sure to lose at least some of their stacked rigs along the way even in the case of successful recovery of the offshore drilling market. Thus, Pacific Drilling is set to have major upside from current levels in the favorable scenario due to both upside in fleet valuation and the increased cash flows.

Borr Drilling amassed a collection of premium jack-ups whose market is already in a notable uptrend. The recovery is not as robust as the company’s management hoped, so it will have to amend some debt covenants and delay the delivery of a few newbuild rigs, but the company’s concept appears viable. I’d note that Borr Drilling’s market, jack-ups, is less dependent on oil price upside than Pacific Drilling’s ultra-deepwater market since shallow water drilling is cheaper and faster, so the inclusion of a jack-up company in the “bold bet” mix mitigates the risk a bit.

I’d like to note that I’m not implying that the long-term bet on the offshore drilling will necessarily work. In fact, I believe that trading highly volatile offshore drilling stocks could lead to materially better risk-adjusted results than making one bold bet on offshore drilling. I noted that most “die-hard” long-term bets on the industry are concentrated in more liquid names like Transocean and Valaris but it may not be the best choice for such bets due to the factors I mentioned above.

Due to the high-risk nature of the sector, I’d have to reiterate that the risk of losing all of your investment in case of a poor offshore drilling market recovery is real, so manage it properly.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: I may trade any of the above-mentioned stocks.

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2019-12-02