Description

Conventional wisdom states oil is range bound between $40-60. Permian can feed the world. Permian will continue to experience years of productivity gains. Permian breakevens are $40-50, so oil will struggle to rally above that. Any rally in oil is temporary and you should sell it. 

This convention wisdom has been brow-beaten into every asset manager over last 4 years. Therefore........

1. Energy is the most depressed of the GICs sectors.  "All of energy in S&P is smaller than 2 of the 4 FANGs". 

2. Oil Services is the most depressed space within Energy. OSX/SPX 5 year ratio is like death. The industry is accused of never making money. Horrible ROICs and ROEs. Even worse than the E&Ps. Everyone is convinced Majors and E&Ps will benefit from new found "restraint" and higher oil prices.

3. Offshore oil services are the most depressed space within Oil Services. Everyone already knows onshore is the place to be. Permian will feed the world. Onshore pumping is already experiencing tightness. Halliburton already said rates are moving in Q1 called (Schlumberger called it balanced). Offshore cannot compete with onshore.............. it is known.

4. Offshore rigs are the most depressed space within Offshore oil services. Seismic has already been recovering, equipment and EPC players never quite felt the same pain. Rig operators have geared balance sheets and there's too much capacity. Ocean Rig, Vantage, Pacific Drilling, Seadrill, etc have already gone bust. Rest will follow soon. It is known. 

All of this is conventional wisdom.

At this point I offer you Ensco, trading around $5-6 with my $20 3-year target. Let's do this. Keep in mind to achieve a return like this, certain leaps of faith have to be made. We're in the prediction business and I am predicting how the chips will fall.

Countering all of the above points in reverse.

1. Energy sector will recover and at rapid pace. Oil demand is extraordinarily strong. Q1 '18 US alone grew demand at a runrate of 1.1mbpd. 2017 oil demand was at 1.7mbpd. We're likely to end 2018 closer to 2.0mbpd growth. All of this demand growth has eaten through inventories at a very fast clip and at current forward cover oil should already be $85. Global forward cover is below Jun 2014 levels. It's moving fast, but not fast enough to where fundamentals point it should be at. Energy equities are lagging the violent move in spot as the very sharp increase in backwardation holds investors back. I believe the direction of spot will remain positive. Opec will be forced to bring production back online once we hit $100 next year. 

2. Oil Services are set to experience a recovery from very depressed levels as industry capex starts increasing in 2018 from very depressed levels. Industry FCFs (for the majors atleast) are higher than at any point in last 10 years, and coupled with rapidly declining reserve ratios points to more FIDs on existing projects and more exploration. Capex will start recovering very rapidly (following FCFs) and utilization, and then pricing will start moving in the right direction soon after.

3. We're at PPO right now I believe. Peak Permian Optimism. From this point on fast plateauing efficiency gains in lateral lengths, proppant loads, rig efficiency gains via pad drilling, coupled with parent child interference on wells, declining core acrage, and infrastructure bottlenecks (including takeaway capacity, electricity/water usage, truck drivers etc) leads to disappointing growth from Permian relative to expectations, which will tighten global market further. Onshore services are hence set for a disappointment, relatively speaking. Expectations for offshore services are at extreme depressed levels and only a little improvement in sentiment is likely to cause violent increases in share prices. For US it includes, all offshore drillers, NOV, FTI, OII, DRQ, and plenty others in Europe including seismic and surf.

4. EU majors and belately US majors, will refocus on offshore on the back of this and start putting to work some long dated projects. Expectations are at extremely low levels. The harsh environment market has already tightenend and the rest will follow as activity picks up. Market will likely tighten well before we are able to activate warm (let alone cold stacked) rigs, due to the capital required to activate them. Hence the market will tighten quicker than everyone expects. Interestingly over the last few weeks some majors have started seeking out longer duration contracts. This is the first sign in the start of the recovery, as majors anticipate demand longer term and they try and lock-in today's low rates.

For a 6th gen UDW drillship, opex has fallen to $130k, maintenance capex is $1.5m per year plus about $15m every 5 years on yard survey, so $4.5m per year overall. Add in another $1-2m per rig for SGA and HQ costs. Doing this math, paying $300m per rig requires about $250k per day for a 10% return for a rig with 30-35 years remaining. Current day-rates are close to $175k-200k. I expect they'll move to $250k soon and recover to $350-400k in a few years. This is well below previous highs of $650-700k. At the $350k rate you can justify a $450m rig valuation, with further upside. 

Question is, will Ensco survive till the oil recovery takes hold. It has $2.7b in backlog, $2.9bn in liquidity and is pretty clear till 2024 on no debt coming due. It picked up Atwood Oceanics assets on the cheap earlier. Ensco is cheap on either mid-cycle EBITDA or steel value. On EBITDA, as dayrates recover from 200k to 400k over next 2 years, and using 6.5x multiple, I get Ensco worth $20.1. Currently trades at below $300m per righ. 

It is important to understand the operating and financial leverage here. consensus EBITDA for '19 is $400m. At $250k dayrate you can get $800m. At $350k dayrate you get $1.6b. At $450k dayrate you get $2.4b. Assuming a historical 7.0x multiple if dayrates go 400k will give a $26 share price target. At that's just operational gearing. If rates go back to $350k, rig values will revert to $450m per rig, and shares will trade at $13. If dayrates go back to $450k, rig values will revert to $550-600, basically replacement cost and shares will be $20+ on steel value.

Ensco has a clear liquidity runway till 2024. And I am betting offshore oil service activty starts picking up very very soon as spot oil remains elevated . 

Catalyst

 Oil.