Oil price dynamics have improved enough to provide confidence that future profitability in offshore production, exploration and production companies will increase spending on offshore activity. As the offshore drilling sector begins to recover, we review three participants including a new addition to the DirectBond list from Noble
FROM THE SALES DESK
Oil
The US shale revolution and resultant changing supply side dynamics have driven drastic and long term fundamental changes in the oil sector. Market entrance, increased supply and the ensuing price war between traditional OPEC producers and US shale market drove oil prices from 2014 levels of ~USD100/bbl to below USD30/bbl in 2016.
Oil prices have since found a range of between USD40/bbl and USD55/bbl based on OPEC supply cuts as the market finds a supply driven fundamental level.
Fiscal pressures on major oil producers and a pending SaudiAramco IPO – the Saudi state oil company, have eased OPEC supply. Generally, oil prices needed for the major oil producing country’s fiscal balance remains over USD50/bbl (see Figure 2), significantly higher than cash cost breakeven.
Looking forward, McKinsey Energy Insights have sited an inevitable supply gap opening up in the medium term 2021-2023 with an estimated USD70/bbl price as a result of the lack of Exploration and Production (E&P) FID’s (Final investment decisions) in recent years – this is likely to provide further confidence in medium term prices.
Major oil producers - Cash cost breakeven vs fiscal balance
Cost of producing a barrel of oil and gas
Source: Rystad Energy UCube
Figure 1
Source: IMF, J.P. Morgan Energy Markets research estimates
Figure 2
Offshore oil field services
Investment in new exploration and production by E&Ps, represented by their level of capital expenditure, is the revenue of Offshore Oil Field Services (OFS) companies. Therefore, the reduction in FID (final investment decisions); leading to reduced capex has directly impacted the top line of Offshore OFS companies. This has had a significant impact on the profitability of these companies as old contracts roll off and margins contract with lower day rates charged to E&Ps and a lower utilisation of rigs. These pressures have forced companies with limited scale and an inability to adapt, out of the market.
The survivors have become leaner and more efficient with breakeven at levels competitive with their onshore counterparts. The current oil price environment and recent 12-18 month range has given E&P’s more confidence in the future profitability of these long term contracts – this has been shown in an increase in FIDs through 2017 (see Figure 3). Already, this has begun to translate through to dayrates of relatively cheaper shallow water projects (see Jackup Dayrates in Figure 4) – deepwater is likely to have a longer and delayed recovery.
Global FIDs were affected by the low oil price environment, but are starting to recover in 2017
Source: McKinsey Energy Insights, Rystad, Company investor reports
Figure 3
Source: J.P. Morgan presentation
Figure 4
As day rates begin to improve and further supply is taken out of the market (usage increases) offshore companies margins will begin to expand; resulting in improved credit profiles. Market participants continue to consolidate through M&A to ensure that as the E&P spending grows, the fleets are well positioned to be awarded new contracts.
The shift towards a lower margin operating environment has forced segmentation as companies look to occupy defined market positions. Within this environment, companies with exposure to newer high specification rigs will likely be viewed favourably in the short term with respect to awarded contracts and, in the long term as the supply/demand dynamics tighten, these players should be able to command a premium.
How to capitalise on a recovering sector
Finding value within fixed income as a long term fundamental value investor requires an assessment of the market’s current pricing of risk. This includes the credit quality of the sector and company then an assessment of the relative value. We use these measures to find good relative value propositions.
As the sub-sector begins to recover, investors should look to gain exposure to high quality offshore oil field services companies that are well placed for a recovery. Companies with strong management, a quality fleet of new and high specification rigs and exemplary operational reputation are most likely to be awarded contracts and operate most profitably in the long term. Below are three companies that meet the criteria - that may see higher credit ratings and subsequent price outperformance.
The three bonds are of different yields, but the value is mostly in the sector investors could look to diversify across all three names - reducing concentration risk and capitalising on the sector’s value in quality names.
Ensco
Ensco has a strong weighting to the recovering Jackup offshore segment, but is well diversified amongst other rig types – the quality of the company has been exemplified in it being awarded a disproportionate amount of all contracts in the first half of 2017. The company’s management has concentrated on controlling what they are able to control (costs and retaining operating margin) in a declining oil price environment. Ensco has recently confirmed its acquisition of Atwood Oceanics, positioning its fleet attractively for further future contracts. Although this acquisition is a solid improvement in its fleet, the leverage as a result of the acquisition has some investors worried. That being said, the improvement in fleet, in conjunction with Ensco’s best in class operational efficiency and strong management, is likely to put the company in a strong position to continue to be awarded new contracts as the upstream E&P companies turn the offshore oil tap back on. For more information, visit Ensco Investor Relations and the FIIG Factsheet.
Security: ENSCO-5.20%-15Mar25-USD
Maturity date: 15 March 2025
Yield to worst: 7.59%
Minimum parcel size: USD10,000
New Direct Bond - Noble Holding International
Noble has arguably the highest quality and newest high-spec fleet amongst its peer group. The company has a strong USD3.2bn backlog, strong liquidity and presents an attractive yield. The company’s fleet is likely to be relatively well positioned to be awarded contracts in the instance of a recovering sector. The market’s worries about the company’s relatively onerous near term maturity schedule and weaker cash balances could be seen as overblown, reflected by a yield spread of greater than 2% above peers like Ensco. For more information, visit Noble Investor Relations and the FIIG Factsheet.
Security: NOBLE-7.75%-15Jan24-USD
Maturity date: 15 January 2024
Yield to worst: 9.25%
Minimum parcel size: USD10,000
Transocean
Transocean is the largest offshore oil company in the world. It’s excellent management and strong fleet position with a ~USD14.1 billion backlog of revenue at the lowest point in the cycle leaves this company in a very strong position. Put in context the company has obligations of current annual interest expense payments of USD458m, covered 3.5 times by the last 12 month’searnings with EBITDA of USD1,845bn, and also cash and cash equivalents of USD2.47bn. Transocean’s fundamentals are strong; its large scale, business profile and resilient margins give confidence in its ability to continue to operate profitably and be well positioned for a possible recovery in the Deepwater market segment. For more information, visit Transocean Investor Relations and the FIIG Factsheet.
Security: Transocean-9.00%-15Jul23-USD
Maturity date: 15 July 2023
Yield to worst: 5.85%
Minimum parcel size: USD10,000
Note: The above article was not written by the FIIG Research team. Additionally, FIIG Research does not assess these companies. We are assisted by independent third party research, to increase the number of bonds we make available. Companies and bonds need to meet certain qualifications before we issue them in small parcels. For more information please see the new DirectBond process for non Australian dollar high yield bonds