Energy Sector Macro Review (Part 4) - Where To Look For Opportunity
By: Jon Costello
Various segments in the energy sector present investment opportunities. Some are more structural, like the paradigm shift in the crude oil market. Others are more cyclical in nature. This fourth and final macro review installment outlines bullish macro investment theses now underway in different segments of the energy sector.
The Cyclical Upturn in Offshore Drilling
Offshore drilling service companies will be an obvious beneficiary of the transition to a new oil supply paradigm. These are the companies that own and operate offshore drilling rigs. The bull case for offshore drillers rests on the cash flow inflection that occurs during an industry upcycle.
Over the course of an entire market cycle, offshore drilling is a lousy business. During oil market downturns, lower oil prices force large exploration and production companies to reduce their capital budgets. Lower capital spending inevitably translates to less offshore drilling and, in turn, reduced demand for offshore rigs. The result is that the contracting rates for offshore rigs fall rapidly. Offshore drilling service margins come under pressure, earning power evaporates, and offshore drilling companies sustain losses for multiple years at a stretch.
Adding to the industry’s woes during a downturn, uncontracted rigs must be maintained so they can be reactivated when market conditions improve. These rigs are either “warm stacked”—preserved and kept ready for redeployment—or “cold stacked”—essentially mothballed at minimal expense.
Both warm stacking and cold stacking are costly. For example, Noble Corporation (NE), a major offshore drilling services company, spends, on average, $13.7 million to warm stack a rig.
Cold stacking is less expensive than warm stacking. Noble spent $3.7 million on average to cold stack its rigs. However, cold-stacked rigs require significant time and expense for reactivation. One of Noble’s large drill ships costs tens of millions of dollars to reactivate. These costs tend to incentivize warm stacking over cold stacking unless the industry’s outlook is particularly bleak or the rig owner’s finances are under strain. Once the cost of reactivating a cold-stacked rig exceeds the net present value of its forecasted future earnings, it is retired and sold for scrap.
The combination of declining contract rates for a company’s existing rig fleet plus the increasing expenses associated with warm stacking and cold stacking idle rigs sends an offshore drilling company’s cash flow plunging. All the while, their large fixed overhead and maintenance capital costs remain largely unchanged. Offshore drillers tend to accumulate heavy debt loads during the good times, which presents existential risk to their shareholders in downturns as cash flow dries up. These factors conspire to make offshore industry downturns particularly brutal.
Deep downturns have been a recurring feature of the offshore industry since it embraced capital-intensive deepwater drilling in the 1980s. Several years of cash flow losses tip many operators into bankruptcy.
The current downturn began in 2014 and was particularly destructive for the industry. Among the major global offshore drillers, only Transocean has avoided bankruptcy.
Eventually, offshore drilling downturns transition to upturns. The only question is when.
Upcycles arrive after contract rates have remained below the cost required to build a new rig for several years. During this period, low contract prices cause rigs to be scrapped in large numbers. At the same time, the number of rigs under construction falls to zero. Over the course of several years, the size of the global offshore rig fleet is culled to a small fraction of its previous high.
That is where the offshore drilling sector stands today.
When demand for offshore drilling services returns, major oil companies will face a slimmed-down fleet of older vessels from which to choose. These rigs are necessary for large oil companies to develop their offshore prospects and explore for new reserves. The decline of U.S. shale as the engine of global supply growth will free up investment capital for these companies to allocate offshore. At this point, major oil companies flush with cash that must be invested in developing new production will bid for a limited number of available offshore rigs. The inevitable result will be increasing contract rates and a new offshore upcycle.
As the upcycle continues, demand for rigs will increase to a point at which stacked rigs are profitably reactivated. When this occurs, the cash flow drain these rigs represented to offshore drilling companies turns into a revenue source, which accelerates the cash flow inflection that was already underway from rising contract prices.
All the while, the lack of incoming new rigs adds to pricing pressure for existing rigs. A larger offshore vessel takes three to five years and $1 billion to build. In today’s market, contract rates would have to increase severalfold to justify new builds. Even a fraction of such a rate increase would send the remaining offshore drillers’ cash flows and stock prices surging.
The industry got a taste of rising offshore driller contract rates in 2024. However, rate increases stalled after oil prices became unmoored from fundamentals and major oil companies postponed offshore projects. Project delays caused offshore drillers to disappoint their investors’ expectations for continued increases in contract rates. The ensuing stock price declines have pushed some offshore drilling stocks into bargain territory.
Higher contract rates will come as the oil market’s outlook improves. In the meantime, the culling of the global fleet will continue while the order book for new rigs is almost nonexistent. It won’t take much demand to spur higher contract rates, cash flow, and stock prices for the best-positioned offshore drillers.