24th September
Dear Investor,
Today we will have a deeper look at the additions to the thematic portfolio, namely the offshore service sector of the oil market.
To recap, we are positive on the oil price and the energy sector for three main reasons. You can read a more detailed discussion in commentaries #1 and 4
- The lack of investment in supply due to ESG constraints over the last 10 years and the incineration of a lot of capital due to the last boom bust cycle in oil, means very few investors are willing to fund new exploration and any cash flow is used to pay dividends or buy back shares.
- The increase in demand coming from developing countries such as India, China, Indonesia, Latin America all of whom want the “Western lifestyle” of a fridge, air-conditioning, a car etc.
- The fiction that renewable energy is going to provide a replacement for fossil fuels, in a time span short enough to address points 1 and 2.
The icing on the cake for being positive on energy is unfortunately the new world order and the continued bifurcation of the world with the US/UK/EU in an economic cold war against a significant portion of the world (Russia, China, Saudi Arabia etc.) leading to frictions between nation states and a focus on energy security.
Let’s first have a look at how oil is doing at the moment. Below is a 20-year chart of Crude Oil futures. There was the big peak in 2008 just prior to the Global Financial Crisis, and then the subsequent sell-off as both the economy cratered and speculative money left the party. The price then recovered and hovered around $100 from 2011 to 2014/5. Then the price cratered again as fracking became a big thing and shale gas became plentiful as well as the byproduct oil. From 2015 to 2021 the price was around $60 (excepting the Covid craziness) and has only gone up since. We had the Russia/Ukraine price spike taking the price to around $130 and since then the consensus has been that oil will only go down from here due to a reduction of demand from the energy transition. Long-time readers will know we disagree with this analysis, and we believe oil will be going much higher over the next 3 to 5 years.
The question that is often raised is whether we will simply get more shale gas or equivalent? We have discussed before that the evidence suggests that the shale revolution which provided America with cheap gas and the ability to not care about OPEC, is now over — See Commentary #16. The shale revolution was the equivalent of finding 4 Kuwait’s worth of oil. Now additional unexpected supply may happen, but it is very unlikely to happen right now given the lack of funding for oil exploration. Where it may come from in the future, if oil prices rise fast enough, is deep offshore oil and potentially the Arctic.
Some stats (from the IEA) give an idea of the situation. In 1982 oil demand was 80M Barrels/day. In 2010 it was 85M B/d. Over the last three years it is ~100M B/d. On the demand side we have countries like India, Brazil getting richer and increasing their use of energy and this is not including Africa with 1.5 billion people which currently uses very little oil. So where will the supply come from to meet this demand?
The industry by its actions is saying it will come from offshore, and this is due to a) there being less oil to be discovered onshore, a peak in fracking and the cost of offshore drilling coming down. The chart below shows the relative competitiveness now of offshore drilling vs other types as well as some ESG statistics, and it stacks up extremely well.
Hence the major oil companies are spending their budgets in that space.
Report: Offshore oil and gas set for highest growth in a decade
Data from energy analysts Rystad Energy shows that offshore oil and gas is set for its highest growth in a decade in the next two years, with $214bn worth of new projects lined up.
The research found that annual greenfield capital expenditure (capex) broke the $100bn threshold in 2022, and will likely break it again in 2023. This would be the first time this has happened in two consecutive years since 2012 and 2013.
Global fossil fuel demand remains strong, despite more than 100 countries having proposed or committed to a net zero target to reduce global warming to 1.5⁰C by the year 2050.
According to Rystad Energy offshore activity will account for 68% of all sanctioned conventional hydrocarbons in 2023/2024.This marks a 40% increase from 2015-2018, the period prior to the Covid-19 pandemic.
Supply chain spending is set to grow 16% in 2023 and 2024, an increase of $12bn. This would represent the highest year-on-year gain in a decade.
Audun Martinsen, head of supply chain research at Rystad Energy, said that “offshore operators and service companies should expect a windfall in the coming years as global superpowers try to reduce their carbon footprint while advancing the energy transition”. He describes offshore oil and gas production as “one of the lower carbon-intensive methods of extracting hydrocarbons”.
Enter our sector. We are looking at the offshore oil service sector which includes companies which operate or service oil rigs and drill ships and the related support vessels. Below you can see some images so you can get an idea of what we are talking about:
We will look at one stock, Transocean, which is representative of the sector (although all companies obviously have different capital structures, the broad dynamics are very similar for all subsectors)
Source: Tradingview: Transocean Ltd. engages in the provision of offshore contract drilling services for oil and gas wells. It also owns and operates offshore drilling fleets such as ultra-deepwater, harsh environment, deepwater, and midwater rigs. The company was founded in 1953 and is headquartered in Steinhausen, Switzerland.
Now this sector has followed the usual commodity boom and bust cycle. Let’s look at the long-term chart of Transocean (RIG) below:
A big move up during the last oil bull market, a secondary move in 2011 and essentially flat to dead since 2016, as the narratives of peak oil demand and no more exploration happening came front and centre.
So why do we like the sector other than as a play on higher oil prices?
Firstly, just as we discussed with the Natural Gas drillers, a lot of players in this industry went bankrupt and hurt investors, so there are no new entrants to this “dying “industry.
Secondly, these players did the classic overordering of vessels and rigs when oil prices were high and demand was strong. Once oil started dropping, these orders got cancelled leaving shipyards high and dry once some of the players went bankrupt. Previously ships could be ordered for as little as a 2% deposit of the price. The remaining shipyard owners (another industry which has seen its share of bankruptcies and a reduction in players) are not interested in playing this game again, having been bitten once…
Thirdly, the cost of building these things is huge. Ranging from support vessels at US$50M to >US$1B for an ultra-deepwater drillship. Not many people are willing to fund these investments even if the shipyards were willing to take the order in the first place.
In the article below please note both the increase in costs and the delivery delays. In addition, note that Transocean only confirmed the order AFTER signing a contract with an end customer, a change in the way things were previously done. This article was from 2020, so you can imagine the costs of a new build now, given the global inflation picture.
Source: Offshore engineer news
Transocean’s 20k PSI Newbuild Drillships to Cost $2,25B
July 2020
Offshore drilling company Transocean expects its two ultra-deepwater drillships under construction in Singapore to cost it $2,25 billion in total, more than a double on the original order price.
Transocean first ordered the drillships – now named the Deepwater Titan and the Deepwater Atlas – on speculation from Sembcorp Marine’s Jurong Shipyard in 2014 for a price of $540 million each, and for delivery in 2017 and 2018, but the delivery dates have been put off several times.
In December 2018, Transocean finally signed a hefty five-year $830M contract for the Deepwater Titan, with Chevron, however, the contract called for the rig to be upgraded for 20,000 psi operations lifting the construction costs.
So we have an industry with very little supply coming on stream, with many of the players not in existence anymore and with few investors willing to back or fund them. All well and good, but how is the actual business doing? Well, as we noted above, a majority of the capex in the industry is happening offshore and these companies are the beneficiary of that trend.
Generally speaking, these companies will do a combination of term charters and spot charters on a day rate for their vessels and rigs. The former gives some certainty of earnings while the latter allows them to benefit or not from the current rates. As vessels come out of contract, at the moment they will roll into higher spot rates.
Let’s look at one class of vessel (all follow a similar trend)
We can see that over the last 3 years, utilization has gone up to over 80% and day rates have doubled. These companies are now generating a lot of cash.
Offshore Drilling Rates Approaching $500,000 Per Day Mark
June 12, 2023
The global offshore drilling market is continuing to experience a significant rebound with rig utilization now returning pre-pandemic levels, leading to a 40% increase in rates over the past year, according to a recent report from Wood Mackenzie, a leading energy research and consultancy firm. The report also forecasts a further 20% surge in demand from 2024 to 2025.
This surge has propelled day rates towards the $500,000 per day mark for the most advanced rigs in the ultra-deepwater segment.
Rising oil prices over the past year has acted as a catalyst for a rebound in the offshore oil and gas market following a prolonged 8-year industry downturn.
“Higher oil prices, the focus on energy security, and deepwater’s emissions advantages have supported deepwater development and, to some extent, boosted exploration,” said Leslie Cook, principal analyst for Wood Mackenzie. “Active supply is now more in line with demand, and rig cash flows are positive. We expect demand to continue to rise.”
All well and good. Now will this last? Well, the biggest risks to these companies are
- Oil price dropping hence making offshore drilling less compelling. We do not believe this is the case (as the cost is competitive vs other forms of drilling and the environmental benefits are better than other forms) but we could be wrong.
- New supply coming on stream. We have covered this above but hear it from the shipping experts Clarksons:
Clarksons March 2023
The order book of new ships is historically low compared to the overall fleet in most of the larger commodity verticals; financing availability is tight; and interest rate rises together with inflation are impacting on the cost of building. It is clear to see there are still significant constraints on the scale of ship building.
Nevertheless, overall the newbuild order book is flat, with most of the activity in 2022 in containerships, car carriers and gas carriers. Elevated newbuilding prices, limited berth availability and uncertainty around fuelling technology contributed to relatively lower order volumes, increasing the likelihood of meaningful supply side constraints over the coming years in many verticals. Further constraints arise from environmental pressures, which are creating more scrutiny and control over the existing fleet, impacting and constraining speed and emissions.
The Bloomberg article below also notes that most of the available capacity at shipyards is taken up by containerships and gas carriers.
Bloomberg Jul 2023
Shipping Companies Are On a Spending Spree
- Capacity will grow more than trade, CMA CGM finance chief says
- Too many large container ships ordered, DSF CEO says
Now, let’s have a look at the potential of the business. The picture below shows the EBITDA and free cash flow (FCF)for RIG at different day rates. Currently we are somewhere between scenario A and B, and that is what is mainly factored into analyst’s forecasts (not that many analysts cover the sector). You can see the operating leverage of these companies as when day rates go to $500K/day for a large drill ship the FCF is almost 50% higher.
So when will we hit scenario C?
Source Gcaptain.com
July 2023
The global offshore drilling market is continuing to experience a significant rebound with rig utilization now returning pre-pandemic levels, leading to a 40% increase in rates over the past year, according to a recent report from Wood Mackenzie, a leading energy research and consultancy firm. The report also forecasts a further 20% surge in demand from 2024 to 2025.
This surge has propelled day rates towards the $500,000 per day mark for the most advanced rigs in the ultra-deepwater segment.
The report suggests that highly sought-after ultra-deepwater rigs may reach rates of $500,000 per day or even higher before the end of the year. Benign ultra-deepwater rigs have maintained an average daily rate of $420,000 in the first half of 2023, with utilization rates reaching an impressive 90%.
We are getting there and we believe these rates will stay high or get higher. For reference, in 2014, with a market cap of US$20BN and debt of $11B, for an EV of $33B, the peak rates for that cycle were approximately $530K-$550K (for the same type of ships referenced above), while the 2008 cycle peaked at an average of $420K, with a peak market cap of $30B and $17B of debt for an EV of $47B.
Today the market cap of Transocean is USD7BN with a similar amount of debt, for an EV of $14B. Remember a lot of the sector went bankrupt, but Transocean wasn’t one of them and they have spent the last decade paying down debt refreshing their portfolio to focus on deepwater all while the industry was in a downturn. We are now in an upturn and the cash flow being generated will go to debt reduction, dividend payouts and SOME capacity expansion subject to the constraints above. Their stated goal is to reduce debt by $3B during 2023-25 and their breakeven rates are $275-$300K /day. With current and projected rates, we believe the cash flow generated will drive a continued rerating of the business.
The other companies in the sector, Valaris and Tidewater don’t have as much debt, but similar dynamics are in place. This is a volatile sector so will have big swings up and down but the end result should be rewarding. A less volatile way of playing this sector is the ETF OIH but is dominated by a couple of big onshore players like Haliburton and Schlumberger which make up 30% of the ETF. After doing your own research, you can decide which is better for your level of risk appetite.
Until next time,
