Description

A quick look at Northern Offshore (NOF) will easily scare people away: the company has an illiquid stock with a small float, headquartered in the US but listed in Norway, in the despised offshore drilling sector, owning a number of very old/crappy assets, with most of its contracts ending in the first half of 2015.  Who would want to touch anything that is oil related with Brent now in the low $50s?

Understandably, its stock price has declined from a peak of NOK 12/share in late August, to close the year at a low of 4.12, or a decline of over 65% in NOK terms (or close to 70% in USD).

However, we believe that this decline was overdone and it presents a compelling investment.  While other offshore drillers have seen price declines of similar magnitudes over the same time period (RIG down 51%, SDRL -68%, ESV -39%, VTG -75%, DO -14%, PACD -53%, HERO -69%, RDC -21%, PGN -69% - note all numbers excluding dividends), there are a few key differences:

NOF has a net cash position – as of October, NOF had $34M in cash and $29M in debt.  This compares with the average net debt/EBITDA ratio for the peers listed above of 3.3x on 2014 estimated EBITDA (with a low of 1.1x for DO) and a more relevant 3.8x on current estimates for 2016 EBITDA, given the ongoing deterioration in the environment.  This provides tremendous optionality and staying power at this point in the cycle.

Key value in the FPSO – The main source of value for NOF comes from its FPSO (a floating vessel used for the production, processing, and storage of oil) in the North Sea, contracted with Enquest for the life of its field, where it gets paid based on production, with Enquest set to tie additional wells to the FPSO, hence increasing its value. Indications from Enquest, and also Ithaca Energy (who is a partner in the field), even post oil sell-off, is that they plan to go ahead with those plans (a positive is that both those operators are hedged at $80+ for 2015).  

A look at the assets:

The fleet consists of a drillship, a floater, four jack-ups (two currently under construction), and an FPSO.  The fleet was fully utilized as of 3Q14. Let’s drill down (no pun intended) further into the assets:

-Northern Producer (FPSO, 1977). Operates in the Dons area in the North Sea (3 fields are currently tied to the FPSO – Don SW, West Don and Conrie), where Enquest is the operator (Enquest holds a roughly 60% interest and Ithaca Energy the balance). The Producer gets paid based on a per barrel basis (at current oil prices, we estimate that they might be receiving $5.75/bbl) – no real costs associated with the asset, and NOF just needs to maintain the rig, so budgets around $4M in annual costs.  The contract is for the life of field – at the time of Enquest’s IPO back in 2010, it was estimated that the Dons area could produce until 2019, but that should have been extended considerably given the amount of work done in the area, the discovery of Conrie, and the acquisition of the area where Ythan is located.  While the current production should decline in the 10%+ range, Enquest has plans to drill additional wells in the area which would be tied to the Producer: in August 2014, it tied the TJ well and is currently drilling the Ythan field, with first production expected in mid-2015.  Additional wells are planned for the future, but obviously will be dependent on oil prices.  The producer has plenty of capacity – while production in 3Q14 was 14.4K bpd, the Producer can handle over 40K bpd. Also, earlier in the year, NOF mentioned it was considering monetizing the Producer - the rationale behind a sale was to monetize the asset and refocus the company into a pure-play jack-up operator. That seems to be on hold for now as additional development in the area could substantially increase the value of the asset.

-Northern Endeavour (300ft jack-up, 1982): currently under contract with Wintershal in the Netherlands until April 2015, this jack-up was slated to go work for Rosneft as part of the Seadrill/North Atlantic Drilling deal that was recently delayed (technically the close was extended into May 2015) due to the Russian sanctions.  This would be a 2.5-year contract with a contract value in excess of $150M. 

-Northern Enhancer (300ft jack-up, 1982): currently under contract with Maersk in Denmark until July 2015, with an option to extend for one year exercisable in Q1. The rig has been operating in those fields for years, performing workover jobs, and enjoys very high utilization rates (likely in the 95% range).  Supposedly, Maersk has a number of workover jobs to be done in the area. Given that the configuration is critical, it is our belief that there is a high likelihood that the rig is unlikely to be substituted as long as Maersk decides to continue operating the area, although renewal rates could certainly be impacted.

-Newbuilds: NOF has currently 2 350-ft high-spec jack-ups under construction in Dalian (China), set for delivery in the first and third quarters of 2016. NOF has already made a down-payment of $17.8M per rig and the final installment of $160.2M per rig is due at delivery (they got preferential pricing at the time as part of the Fredriksen umbrella).  It is important to note that there are no assets pledged against those units, with the only collateral being the amount of down-payment (ie – non-recourse).  While NOF would likely want to take delivery of the rigs, in case they still have no contract at the time of delivery, NOF could walk away losing “just” its initial deposit (even if unlikely – we believe the Chinese Export Bank could extend financing even if no contract in place).  The most likely geographies NOF will market these rigs are Southeast Asia, West Africa and Middle East. 

-Energy Driller (semi-submersible, 1977): currently under contract with ONGC in India until April 2015, where it is finishing its second 3-year extension – a new 3 year tender is expected any time now.  NOF said it will be aggressive in its bid to remain the incumbent.  Even at reduced rates, that would represent an additional $50M to the backlog (net of operating expenses).

-Energy Searcher (drillship, 1981): currently under contract with CAMAC in Nigeria until May 2015. CAMAC has had success in the drilling program and could extend it for a second year.  Rig is mature but in very good condition.

While NOF has an old fleet, the Company is up to date on maintenance and classification expenses, with modest amounts expected (for 2015, only the Endeavour very late in the year).

A look at valuation:

We think the best way to look at NOF is to assume a run-off in the Northern Producer and that none of the other assets are extended, with most of the assets being monetized for scrap.

-Northern Producer: assume no additional wells are tied-in, and that it operates until 2019, which is definitely conservative. At a rough 10% production decline per year, we get a PV of U$83M and assume a scrap value of U$15M then. This implies a value of 4.33 NOK/share from the FPSO, which alone covers the current value of the Company.

For the other assets, assume the value of the backlog that remains until their contracts expire, that the Energy Searcher and the Energy Driller are monetized for scrap at U$10M each and that the two jack-ups are sold for U$60M each (a discount to valuation recently estimated by an industry expert on second-hand rig asset values we spoke to – estimates ranged from $75-100M; note that the Northern Endeavour is likely worth more than scrap given that it was meant to be under contract for Rosneft for the next 2.5 years).  We also assume that NOF will walk away on the two newbuilds and lose the $35M it has paid as deposit.  The value of the assets ex the FPSO assuming NAV plus backlog would equal NOK 9.8/share.

Putting it all together: without any optionalities (contract extensions, longer life of FPSO or higher production level of its underlying fields), we get a value of NOK 14.2/share (assuming constant NOK-USD exchange rates), or an upside of 238%.  Even if we assume the newbuilds are delivered and sold for $135M each (roughly a 25% discount to the yard price for a brand new rig), the value would still be just shy of NOK 12/sh.

If all its rigs (including the newbuilds) are able to secure follow on work, albeit at discounted rates, and the FPSO benefits from some increase in production from additional wells drilled in the field, we can get to a value of NOK 20/share.

Dividend:

In addition, at the current price of NOK 4.20, the dividend yield would be 36%. It is possible that NOF decides to reduce or suspend the dividend given that the market is not giving it much credit in addition to certain pressure on rates and reduction in capex plans by operators (while it paid its quarterly dividend in November, Brent was $84 at the time of declaration), but note that unlike some companies such as SDRL that have suspended the dividend, it is not burdened by a high debt load. 

Why the discount? Again, this is an ignored stock with a small float (market cap is slightly under $100M; Fredriksen owns over 30% and MHR 30%), trading in Norway, with an old fleet.  Thus we believe it is easy to overlook its idiosyncratic elements (the FPSO) and the fact that it has a clean balance sheet with net cash, with a very lean and experienced management team.

Risks:

The risk is clearly the price of oil which could disproportionately affect the utilization of older rigs. The question then becomes whether NOF will carry the assets on the hope that they win new contracts or chose to scrap them.

Delivery of the newbuilds in case the market has not recovered and NOF decides to take delivery.

Also a risk is if NOF decides to take advantage of their clean balance sheet and try to buy distressed assets.

Catalyst

-Additional wells tied to the FPSO

-Extension of any of the contracts

-Tender for the OGNC work

-Monetization of any of the assets

-Payment of dividend

-Last but not least: oil prices...