Properly applied financial measurements help determine offshore drilling market value

Daniel R. Pickering, Jennifer Hu, Robert C. Muse
Simmons & Co. International
Houston

Applying the most suitable financial measurement, as guided by the oil-service industry's position within the business cycle, provides investors with a way to analyze market value for offshore drilling companies.

Studying the cyclic nature of the industry, aided by the analysis of a representative offshore driller, has imparted key insights that help define which key indicator - be it cash flow, earnings, or asset valuation - is the most appropriate gauge for ascertaining a company's worth.

Business cycles

Table 1 [47,407 bytes] shows the turnaround in day rates paid for a standard 250 ft jack up from 1995 to present. Beginning in April 1995, only 64% of the rigs in the Gulf of Mexico were on the payroll with the remaining 36% "stacked," waiting for work. During this time, a jack up rig received about $17,000/day. However, with costs of $15,000/day, most drilling companies were not able to make a profit.

Nonetheless, strong oil and gas prices and advances in exploitation technology continued to boost the demand for drilling rigs, and as time progressed, almost every rig in the Gulf of Mexico held contracts by late 1996. The strength in this demand allowed contractors to raise day rates by 50%, to about $30,000/day.

As the market continued to heat up in 1997, oil and gas companies began searching for ways to ensure rig availability. For example, instead of typical arrangements involving one or two wells, lasting about 30 days each, some customers signed term contracts for 6-12 months.

By October 1997, average day rates had surged another 30% to more than $40,000/day (Fig. 1, [74,241 bytes]). Rigs on the "spot" market were then commanding rates of over $50,000/day resulting in a period of profitability for offshore drilling.

Unfortunately, in the volatile world of oil and gas, good times never last. With the onset of the Asian crisis in late 1997, oil prices began a slow-and-steady decline from over $20/bbl to the current level of about $13/bbl.

Oil and gas companies, expecting a rebound in oil price, continued to spend on offshore drilling through the end of 1997 and into the first quarter of 1998. Rig fleet utilization remained steady at 100% although both contractors and oil companies began to wonder when the anticipated commodity price rebound would occur.

During the second quarter of 1998, oil companies began reducing their exploration and production (E&P) budgets. Consequently, after several months of 100% utilization, rig supply became greater than the demand for drilling.

In just the past few months, fleet utilization has fallen to 85% with over 25 rigs in "stacked" mode, waiting for additional work to materialize.

Currently, in contrast to late 1997 and early 1998, E&P companies can pick and choose which rigs they want. In a market where demand is falling, drilling contractors often have only one competitive weapon - pricing.

Thus, as utilization has slowed in recent months, day rates have also plummeted. The same rig that bid for work last October at rates greater than $50,000/day is now lucky to receive $25,000/day.

In addition, the premium associated with high specification-equipment (deep water, extended-reach cantilever) has evaporated. Big rigs and small rigs are receiving the same day rate. In only a few short years, the cycle has come full circle (Table 1).

Many drilling contractors are searching for opportunities to move rigs to markets outside the Gulf of Mexico. However, moving a rig can cost millions of dollars and there are limited opportunities in foreign markets because of the worldwide impact of low oil prices.

With the Gulf of Mexico supply-and-demand situation unlikely to be resolved by an exodus of rigs, many drilling contractors are wondering when the tide will turn and demand will begin to expand.

Many investors in offshore drilling stocks are wondering the same thing. Is now the time to buy stock in an offshore drilling company and what is the proper way to value its stock?

Financial measurements

As shown over the past several years, the offshore drilling business is cyclical. Day rates and utilization rise and fall in response to the industry's supply-and-demand equilibrium.

Earnings and cash flows can be volatile and unpredictable. Thus, forecasting is difficult. However, a prescient investor can be rewarded. As shown in Fig. 2 [65,267 bytes], buying a basket of offshore drilling stocks in early 1996 netted investors an annual return of 257% through October 1997. However, if the investor held on too long, the gains evaporated as the industry softened.

Understanding where industry fundamentals are positioned within the business cycle is the key to understanding which analytical measurements are most appropriate (Fig. 3 [71,347 bytes]).

When business begins to rebound just after a slump, such as in 1995, drilling companies often lose money or generate only a marginal level of earnings. In the absence of earnings, investors often use the company's cash flow to gauge the value of the stock. In this case, the price/cash-flow (P/CF) ratio becomes the investor's analytical yardstick.

As business strengthens, as it did in 1996 and 1997, earnings become the primary analytical measure. In this case, investors use a price/earnings (P/E) ratio to compare the stock to its peers or to compare companies in different industries to the overall market. Most investors usually evaluate stocks on the earnings that will be generated over the next year.

As day rates continue to advance toward replacement levels, as they did in 1997, offshore drilling investors begin to expand their focus on the earnings power of the company (Table 2 [26,977 bytes]), not just the earnings next year. In an environment where the supply-and-demand balance and pricing justify adding capacity, investors focus on potential earnings, not near-term financial performance.

Ultimately, the supply-and-demand balance falls out of equilibrium as we have seen in recent months. This can be caused by the addition of too much new capacity or by a decline in demand - the current culprit.

The weakening cycle results in falling expectations for future earnings. As investors lose faith in future earnings growth, the P/E multiple they are willing to pay falls rapidly.

The extent by which the fundamentals weaken determines the yardstick that investors use in this phase of the cycle. In the worst markets, day rates decline to the point where profitability is erased. In this case, investors abandon P/E and P/CF analysis and resort to using asset value as their guide.

Similar to the "Blue Book" value of an automobile, the asset value is the inherent value of the rigs and equipment owned by the company. Asset value for offshore rigs can be determined by evaluating historical and recent transactions among industry participants. In a market that is falling rapidly, recent transactions may overstate the current value.

Having looked at the various ways in which offshore drilling stocks are evaluated by investors, it is time to put our knowledge to use in the current situation.

Understanding risk

Having experienced a recent period of elevated stock prices, it is easy to understand the upside potential of offshore drilling stocks. However, with the current low oil-price environment continuing to linger, day rates and profitability are falling rapidly.

In this environment it is very important to understand the downside risk. If an investor can become comfortable that the market is discounting the "worst case" scenario, then investing becomes a much less stressful task.

To evaluate the downside risk of offshore drilling stocks, investors must first understand where current values are today, relative to where they have been historically. Historical comparisons are easier when the asset(s) being evaluated are consistent.

A case in point is shown by the examination of Rowan Drilling Co.; a company whose rig fleet has remained virtually unchanged since 1990. The stock price has changed dramatically in that time period (Fig. 4 [58,004 bytes]), reflecting investors' alternating optimism and pessimism for the offshore drilling business.

Note that between 1990 and 1997, the stock market has paid between $19 million/rig and $170 million/rig for the same assets. The average value was approximately $48 million/rig (Fig. 5 [63,083 bytes]).

Today, Rowan's stock price implies an asset value of approximately $41 million/rig. This is lower than average but certainly well above the prices of 1991-1992 when the Gulf of Mexico was called the "Dead Sea" and during 1994-1995 when the Gulf of Mexico slowdown dampened investor interest in offshore drilling stocks.

The cost to rebuild Rowan's fleet in 1992 was around $43 million/rig. Thus, Rowan's assets traded at about 50% of replacement cost (Fig. 6 [52,588 bytes]). In 1995, Rowan's fleet would have cost $60 million/rig to replace. At its low, the stock traded at 32% of replacement cost.

In strict dollar terms, it is unlikely that Rowan's assets will become as "cheap" as they were in 1992. Today, due to inflation of rig components and labor, Rowan's fleet would cost almost $103 million/rig to rebuild. Thus, Rowan's expected downside risk is about $31 million/rig, or 32% of today's replacement cost.

Using Rowan as an example, this methodology can be applied to an entire group of offshore drilling stocks. For example, a representative group of stocks showed a downside of approximately 27% if implied asset values were to reach 1995 levels (32% of replacement cost).

There is certainly no guarantee that asset values will not fall below the levels seen in 1992 or 1995. However, it would have to be a very negative market to equal the pessimism that surrounded offshore drilling stocks during those periods.

Each investor must make his or her own decision about what risk/reward level will justify a given investment. With respect to offshore drilling stocks, only one thing is certain - history repeats itself.

The only unknown variable is timing. Back in 1995, it was doubtful anyone would have forecasted day rates doubling in 1997. Then in 1997, it was doubtful anyone would have predicted day rates declining by 50% by mid-1998. The only question now is, what will happen next?

The Authors