Description

I know what I said in the Ensco thread. God help me. Here goes.

Northern Drilling

Thesis summary: Buy right, hold your nose and sit tight, and you’ll be rewarded.

This is a very simple investment case. It's not a case of informational advantage but rather behavioral. If you can stomach sitting in the offshore drilling sector for a couple of years and you avoid the most leveraged names most likely to go bust, my feeling is you’ll be well compensated. The fundamentals of the rig sector look better than they did 12m ago, meanwhile, offshore drilling shares are down over 50% on average. My preferred drilling investment is NODL. This is because of its combination of having attractive assets likely to secure utilization and acceptable dayrates in a tough market and the benefit of John Fredriksen as the main owner (I would otherwise have preferred ODL for its cleaner harsh environment exposure). Fredriksen can negotiate improved delivery terms on the UDW rigs that are currently NODL’s biggest problem and will see that future financing needs are met when the time comes.

It's not necessary to make heroic assumptions for this case to be attractive. Even if you think the market will not recover to any great extent and that the market will price NODL's assets at its likely NAV in 2022, the shares should be worth 64 NOK vs 23 today. Taking into account both more bullish and more bearish scenarios detailed in the valuation section, I find that 51 NOK is a reasonable probability weighted guess. I think that's pretty conservative, as weird as that might sound, but keep in mind that using current (low case) third party broker estimates (Bassøe, June 2019), the NAV of NODL should be about 53 pr share already.

Ultimately, I think NODL will either be sold to a third party or could be merged into a healthier Seadrill (if that happens), in both cases at much higher asset values than what we see today. If you're not bent over laughing at this point, read on.

This opportunity exists because of severely depressed sentiment in the drilling space (in most cases the negativity is well deserved). To wit:

·        Offshore E&P spending has fallen from 250 Bn /yr to around 100 Bn/year (it flattened out this year after falling every year since 2013). A point not always noted on this decrease is that a lot of it is due to more efficient operations at E&P’s. That means two things:   

·        One, rig companies for example will see less work as fewer days are needed for drilling the same holes and two, this increases the cost competitiveness of offshore vs onshore and is thus also good for drillers in the longer term. There are vast resources offshore that now has a 30 USD/barrel breakeven, see e.g. https://www.equinor.com/en/magazine/achieving-lower-breakeven.html).

·        Rig markets remain oversupplied, UDW in particular is weak with dayrates well below breakeven (HE floaters not so much and to some extent jack-ups are also better off). As most of the UDW fleet is relatively modern, accelerated scrapping to improve the market balance looks unlikely. Only the highest specced and newest of the UDW units are at all attractive to own now, as E&P players can choose from a big menu of available rigs.

·        This is a sector that is still, broadly speaking, in deep trouble. Net debt/EBITDA (20) has risen from 2.6x to 20x since 2013, while the combined market cap for listed drillers has fallen 95% since the 2013 peak. Several drillers have only the tiniest sliver of equity left, even after Paragon, Hercules, Pacific, Ocean Rig, Vantage and Seadrill have already been through restructuring. Given the poor current economics of the sector, new restructurings will probably happen. E&P companies are aware of this of course, and the most levered names may find it more difficult to find work in a market characterized by oversupply, further complicating things. P/NAV for the sector now stands at 0.5x, the lowest on record since the 2000s. In a bear market like this, drilling stocks are priced on near term multiples and many companies are thus currently shunned by investors.

So is there anything positive to say? I think there is. Famous last words: the worst is behind us. At least in NODL.

The market fundamentals have improved a great deal in last couple of years. And yet the market cap of the sector is more than halved in the interim. The explanation is that the anticipated rig market recovery just didn’t materialize in time and that several companies are still deep in woods. At this point, investors are sick of the whole debacle and won’t touch anything the sector with a ten foot pole. Allmost all rig shares are despised. I think NODL is worth a second look.

Brief background info

Northern Drilling was set up by John Fredriksen to make accretive asset purchases following the collapse in the oil market and rig pricing. First, the company acquired two harsh environment drillships (originally ordered by Seadrill and FOE) and later two ultra-deepwater drillships (old Seadrill orders). Finally the comapny execercised its option for the Cobalt explorer (a third UDW drillship), which was cancelled yesterday. These are all assets of the highest quality built at good yards and will be managed by SDRL in terms of operations (very high quality organization in terms of operations, the SDRL stock market debacle notwithstanding).

John Fredriksen is one of the best distressed asset investors in the world and has a long track record of opportunistic, counter-cyclical steel investments over the years. His access to deal flow is unparallelled and I think investors should remember Frontline 2012 to get a sense of how this will play out. In December 2011, Frontline 2012 was created to make opportunistic asset purchases when GOGL NO and FRONT were prohibited from making acquisitions due to their balance sheet situations. Frontline 2012 was merged into Frontline in 2015 after a 360% total return for Frontline 2012 shareholders (some assets were also sold to Knightsbridge Tankers, and later merged into Golden Ocean). 

Current asset portfolio, backlog and financing information

The first two harsh envoronment asssets (West Mira, Bollsta Dolphin) in NODL were bought at a 46% discount to newbuild prices at 365m and 400m. After these transactions, Transocean acquired the comparable asset Transocean Norge at 500m and Odfjell acquired the Deepsea Nordkapp at 505m USD indicating that NODL had made a couple of very good deals. The harsh environment market bottom thus looks to have been timed reasonably well. The two HE semis have already secured financing with a term loan of USDm 400 at LIBOR +450 bps and maturity in 2022 when the rigs roll off their first contracts if all options are exercised.

The first contracts start in Q3 2019 and Q2 2020 and run until Q2 2022 including options for the West Mira and the Bollsta Dolphin respectively. The NPV of this backlog is estimated between 40-60m USD by brokers (SB1, DNB). I have not included this in my NAV estimate, though I guess I could given that my valuation focuses on 2022e.

The two drillships were bought at a 45% discount to newbuild value at 296m each with 30/70 payment terms. Finally the Cobalt explorer was bought at a 47% discount (after being ordered by Vantage Drilling originally) at a price of 350 mUSD, a UDW drillship with a newbuild price of 660m USD if one includes the value of two blowout preventers. After paying the first 49m installment on this rig, NODL yesterday cancelled the contract citing repudiatory breach of contract. It remains to be seen whether they will get back the 49m, they are claiming it back with interest. This situation is interesting, because the same yard is the counterparty on the two other rigs. I think NODL has done this knowing they won't get back their 49m on the Cobalt, but that the situation can help NODL in negotiations to delay delivery of the two last UDW units if necessary, and that flex can be a good thing to have. In addition, since Northern Drilling secured a 100m USD RCF with Sterna Finance (a Fredriksen controlled entity) which can now be used for other purposes as it is not required to be wound down despite the cancellation of the Cobalt and will run for another 3 years. As of June, 30m was utilized from this facility leaving 70m USD in liquidity. I view the cancellation as a positive.

Why should the relevant rig markets improve going forward? What is NODL saying about its target markets?

• Utilization and dayrates seem to have bottomed out in 2017/2018. In a normal rig cycle as we have seen historically, rig company market caps would be up more than 100% from the bottom at this point in the cycle. The market is saying this time is different. I'm not so sure it is.

• The spot brent oil price is the exact same now as it was on jan 01 2017, and the far end of the fwd curve is more than 6 USD higher now than back then, (However, the fwd curve indicates 3-4 USD lower oil prices in the interim, which rhymes with near term drilling company bearishness).

• There are no – zero – new newbuild orders coming to market, limited existing newbuilds coming to market, somewhat increased scrapping

• Longer term I think increased M&A activity will happen as well after a period of restructuring, which could lead to increased pricing dicipline. UDW in particular is still a fragmented space.

• All of this suggests a better dayrate environment and that the rig market should improve modestly going forward. If it does, NODL is cheap.

Harsh environment

For HE rigs, the dayrates have hovered around 300k since 2017. There aren't that many contract tenders out in the North Sea market currently, but worth mentioning are Vår Energy's long term requirment for Balder redevelopment and Johan Sverdrup phase 2. High specced rigs are in greatest demand, and NODLs are best in class with BOP and riser capacity beyond the competition Both NODL and ODL say 400k is around the corner.

Ultra Deep Water (UDW)

This is still a problematic market for the reasons outlined above. However, new UDW drillships should be a little better off as exploration activity should pick up somewhat in 2020 and onwards. An indication that this improvement is happening is Diamond Offshores annnouncement in april that new contracts on two of its 7G UDW drillships and one of its 6G HE semi rigs would add a backlog of 450m USD, which translates into a dayrate of about 290k/day. This was the highest rates recorded cince the offshore drilling market meltdown began. According to NODL, several other contracts above 300k/day have been signed (see below).While spot rates are still weak, newer assets with contract start-up some time out are seing decent economics. As NODL does not take delivery for some time, I think their UDW units will see decent economics. Here’s what NODL wrote about the underlying rig market in its Q1 and q2 reports:

Q1:

'Significant improved project economics has led to breakeven prices of close to $30 per barrel for several large deepwater developments, making offshore highly competitive compared to other conventional and unconventional alternatives. The first phase of the Liza development outside Guyana where project economics have been guided to be more than three times the economics of a standard Permian Basin field is a testament to the recovery and competiveness of offshore.

Further, improved cash flows for E&P companies has resulted in substantial increases in new major offshore project approvals with FID’s in 2019 expected to be close to three times higher than in 2016. 

This trend is expected to continue going forward resulting in increased demand for offshore drilling units. Since 2014, a total of 125 floaters have been scrapped, representing a reduction of 30% compared to the total fleet in 2014. A significant portion of the non-marketed floater fleet is older than 30 years and have been stacked for more than two years. Up to 50 of these rigs represent future scrapping candidates due to reactivation costs that can exceed $100 million. With less than 20 uncontracted competitive floater newbuilds, the global floater fleet is expected to continue to shrink going forward. 

Marketed utilization for floaters has increased from 57% at cyclical lows to 80% today, being driven further by Tier 1 drillships utilizations approaching 85%. With recent consolidation six drilling contractors now control approximately 75% of the premium drillship market. Drilling contractors are finally showing a more disciplined approached in contract tenders, especially for contracts with start-up in 2020 and beyond. Several data-points of deepwater rates at close to $300,000 per day have already been observed.

Leading edge day rate for premium drillships is expected to continue its trend higher as drilling contractors are increasingly unwilling to commit to future work unless economics are at a substantial premium to current observed rates. The number of projects requiring certain high specification drilling units is also increasing, especially in the Gulf of Mexico with high pressure drilling operation requiring drillships with unique capabilities. With the Company’s three high specification drillships having forward delivery in 2021, Northern Drilling is in a unique position to benefit from the improving fundamentals observed in the deepwater market. 

The harsh environment market for modern rigs is close to fully booked. Leading edge day rate for premium units is expected to take another step increase and approach $400,000 per day, when considering a market standard bonus mechanism. The Company was a first mover in acquiring its two harsh environment units at the trough of this cycle at attractive prices. Both units are now fully contracted and expected to further benefit from increases in day rates through the market indexed options in the contracts with Lundin and Wintershall.'

Q2: 

The Company’s long term outlook on the offshore drilling market remains constructive. The harsh environment market is well into a recovery and the benign ultra deepwater market continues at a slow, but positive trend. Recovery in the harsh environment is under way with utilization of modern rigs above 95%.

As expected, leading edge day rate for premium units have taken another step increase and have in certain instances reached north of $400,000 per day. Some demand for lower specification rigs will continue but the market is showing a strong bifurcation with a preference for newer and more technical capable rigs. With the Company having market indexed linked options on both of its existing contracts, it is well positioned to benefit from the ongoing harsh environment recovery.

The benign deepwater spot market for short term work remains competitive; rates are trending upwards but still at uneconomical levels. The longer the spot market remains at these levels, the less likely stacked rigs will return to the market due to the significant reactivation costs, which positively impacts the market balance. 

Contracts with forward start-up dates reflect a material step-up in dayrate economics compared to current observed spot rates. This trend is expected to continue, positively impacting the outlook for contracting opportunities for the Company’s drillships. Northern Drilling is well positioned with its contracts in the harsh environment and long term delivery strategy for its drillships.

The Company remains focused on bringing its first two rigs into service and selectively bidding its drillships on future contract opportunities offering satisfactory returns. 

Valuation: what is NODL likely worth a few years in the future?

First, let’s look at generic UDW and HE economics separately. What can we assume that the units are worth looking out to 2022 in a relatively conservative dayrate and utilization scenario?

Typical ultra deep water economics, base case scenario for 2022

Sources: DNB Markets, SB1 Markets, Arctic Securities, Danske Bank, Bassøe, Northern Drilling, Odfjell Drilling.

Assuming dayrates increase from around 300k for high specced, 7G drillship units on future contracts (ref the Diamond contract e.g.) to 325k/day and that NODL is able to achieve this on its drillships from 2022 onwards, and that 10x net profit is a fair value pr ship, the unit value should be about 337m.

The combined value of the two remaining UDW units on order is thus 674m USD.

Typical harsh environment economics, base case scenario for 2022

I feel like I’m being extra conservative here, given that this is a market already at close to full utilization and with both Odfjell and NODL saying 400k/day is around the corner. We could easily see higher rates than that by 2022. Also, NODL has extremely high specced rigs that could command a premium above other harsh environment rigs, but I don’t think it’s prudent to assume that premium will materialize in the short to medium term given the depressed state of the rig market in general today. Could be a bonus feature in the future. Assuming 400k pr day and a 10x multiple, each HE unit should be worth 540m USD in 2022 given the above assumptions for a total HE value of 1080m USD.

Remaining capex adjusting for the cobalt is now 649m, adjusting for the Cobalt. I am not afraid of this financing need (or of an eventual refi of the current loan facilities) as John Fredriksen is the majority owner and has the best possible access to capital imaginable (including his own wallet). In detail, the remaining capex is now distributed as follows:

With asset values in 2022 estimated per the above, 649m in remaining capex and net debt of about 348m USD, the 2022 base case NAV is 757m USD or 64 NOK pr share:

PS: As a sanity chceck, let's say what Bassøe is saying: according to their low case estimated value of NODL's units, the NAV in NODL stands above 50 NOK pr share already (june 2019 estimates):

Assuming a 60% chance of the base case occurring, a 30% chance of a bear case where the rig values falling another 15% from NODL's purchase prices , and a measly 10% chance of bull case where UDW dayrates are 350/day and HE dayrates are 425 pr day in 2022 (otherwise holding assumptions equal as the base case described above), the p-weighted value is 51 NOK. That would yield a 27% CAGR until 2022. That looks pretty attractive to me.

Obviously this is a high risk investment and should be sized accordingly.

Main risks: Markedly lower oil prices for whatever reason including a general economic downturn (longer period < 60 USD) and subsequent decreased rig activity, currency fluctuations, bad acquisitions, remaining capex financing not happening for some reason. On this point, note that the company has said publicly it will not raise equity below 68 NOK pr share.

Sources: Bassøe, Rigzone, DNB Markets, Arctic Securities, SB1 Markets, Danske Bank, Offshoreenergytoday.com, Reuters, Bloomberg, Equinor.

Last night's press release: http://www.northerndrillingltd.com/nodl-cancellation-of-the-west-cobalt-resale-contract/

Catalyst

Gradual UDW market improvement, contracts on UDW units, finishing funding remaining capex, yesterday's cancellation of the Cobalt.