Description

Atwood Oceanics (ATW) is an attractive long term investment at current levels. The current valuation does not reflect the reality of the degree of current and future shortage of rigs in the oil exploration industry. Further, this investment can be paired with a short (or basket of shorts) to effectively eliminate much of the risk related to potentially lower future oil prices.

Overview: Atwood’s assets consist of 8 current rigs, many of which have been recently upgraded, with one additional one under construction and set for delivery in September 2008. The majority of the company’s earnings relate to its five semi-submersibles which are used for medium depth offshore oil exploration (for a full breakout of all of the rigs, the company’s recent investor presentation:  http://library.corporateir.net/library/11/115/115338/items/221866/BankofAmericaNov15.pdf has a summary page on each). In recent years, as oil has appreciated and more of the majors have increasingly looked offshore to add to reserves, lease rates have increased substantially. In some cases, they are up 200-400% depending on asset type. The full impact of this market trend, however, will not be seen in the company’s earnings for a few years as it still has significant long term contracts that will roll off and re-price in the next 1-2 years. As such, many sell-side analysts are currently emphasizing the premium valuation that Atwood commands versus its 2007 earnings prospects. In addition, Atwood maintains a strong balance sheet with only $32mm of net debt compared to a market cap of $1.6bn.

Industry: As discussed, the market for rigs has gotten extremely tight and should remain so for some time. Worldwide, there are approximately 200 deep-water rigs currently on the market which is a number that has not increased significantly in many years. As expected, given escalating lease rates, approximately 35 are now under construction, many of which will be delivered around the 2009-2010 timeframe. These are not small projects with rigs costing in the hundreds of millions, and upwards of $500mm in some cases, and we believe that few additional new builds have been commissioned beyond the 35 discussed for the near-medium term. Given the nature of the shortage of rigs (anecdotally, one clear example of this is offshore India where rig shortages have set certain projects back indefinitely, google “India rig shortage” for details), however, the industry should be able to absorb the builds with relative ease. 35 new rigs equates to an approximate 18% supply addition over a several year period compared to lease rates that have increased by upwards of 4x in many cases. Further, the trend of increased demand for offshore drilling assets should continue to increase for several reasons:

1)      A cursory look at the big E&P companies reveals that nearly all of them are struggling to add to reserves despite the higher commodity prices and will likely add to their exploration budgets in the coming years.

2)      Decline rates are particularly evident at many of the traditional large, oil fields implying that E&Ps will be forced to venture further and more substantially out to deepwater locations.

3)      Certain of the majors (Exxon is a very conspicuous example) have declined to lock in rigs not wanting to contract for the medium term at currently elevated lease rates and will eventually be forced to capitulate and pay up to keep their production growing.

4)      Given that exploration costs in deep-water fields run near $7 per barrel with production an extra $5 per, $60 oil obviously makes deepwater drilling a highly economic proposition.

Valuation: As discussed, much of Atwood’s fleet is contracted out for the near term. Specifically, 96% of FY 07 (ending in September), 80% of FY 08 and 30% of FY 09 capacity is currently accounted for. This does leave the company somewhat vulnerable to cost increases which have plagued them in recent quarters given the tight labor conditions in the industry and fixed revenue contracts in most cases. Nevertheless, at current market prices and inclusive of cost increases (some 30% in 2006 and expected around 15% according to the company for 2007), the company should produce record earnings. In fact, according to CSFB (which rates the stock “underperform”), ATW is expected to earn $4.32 in FY 07, $8.85 in FY 2008 and $12.35 in FY 2009. The large increases for 2007 and 2008 relate almost entirely to the company’s current backlog of contracts for those years. 2009 is helped by that dynamic and also the delivery of the company’s new jack-up, the Aurora, which alone will add in excess of $1.25 in per share earnings at current market rates. In terms of cash flow, the company will spend much of FY 2007 cash flow on the Aurora but free cash flow in the later years should approximate earnings. As such, the company should generate close to $20 / share of cash flow in 2008 and 2009 at which point, earnings should stay strong assuming continued high oil prices.

Oil Price Exposure: If one does not have a bullish view of oil prices, there are numerous ways to partially eliminate this exposure although obviously, a return to $15 oil cannot be protected against. Paring a long position in Atwood, however, vs a basket of E&Ps (XLE index or others) should be an effective, partial hedge. Should oil prices recede from current levels down to anywhere near the $40-$50, range, it really shouldn’t impact exploration budgets given the deep-water economics mentioned above. Obviously, though the producers will feel every dollar of such a move. On the upside, given the type of medium-term earnings power possessed by Atwood as described, the stock should outperform a diversified index of producers. Of course, this type of hedge does not protect against industry oversupply, but that is something that is accounted for and then some in the company’s current valuation given industry prospects.

Transocean: If one wishes for a more diversified asset base, Transocean is the market leader in this niche and should also benefit from the industry dynamics mentioned above. Long term, though, Atwood should be able to grow earnings faster off its much smaller base and is more likely to be a beneficiary of potential industry consolidation given its size and balance sheet.

Catalyst