Description

LONG: Odfjell Drilling (ODL.NO)

Summary

Odfjell Drilling is the owner and operator of the largest pure-play harsh environment ultra deepwater offshore drilling fleet in the world. The company owns four modern semi-submersibles and manages another four for a fixed fee on behalf of Northern Ocean, SFL, and CIMC Offshore.

Many value investors are familiar with the offshore drilling sector thesis, as peers Noble, Valaris, Transocean, and ancillary service providers like Tidewater have been widely discussed on VIC and elsewhere. We will provide some background on the sector dynamics and then attempt to answer two key questions: why is the harsh environment (HE) segment the most compelling, and why does Odfjell Drilling offer better risk/reward than liquid US-listed peers?

We believe Odfjell Drilling offers upside of 3-5x within the next two years, with downside protection, in the form of shareholder capital returns, unrivaled in the sector.

Company History

The Odfjell group of companies has owned and operated marine assets from tankers to terminals since 1914. In 1973 Odfjell Drilling and Consulting was established, led by Abraham Odfjell, and in 2007 he transferred ownership of the offshore drilling business to his two daughters, Helene and Marianne, while Abraham’s son took over a separate tanker business.

In 2013 Odfjell Drilling went public near the peak of the last cycle, with Marianne selling her entire 30% stake for over $400mn; Helene retains a controlling shareholding with just over 60% ownership in the company today. Helene Odfjell has had to steer the company for ten years through what is widely regarded as one of the worst downcycles in shipping history. For a sector that once boasted an aggregate enterprise value in excess of $100bn, with many multi-billion-dollar market-cap companies, only two meaningful companies have survived without being sold, scrapped, or going bankrupt: Transocean and Odfjell Drilling.

Over the listed history of Odfjell Drilling, the company reduced its average fleet age, spun-off its well services business, and emerged as the best-positioned to take advantage of the current cycle upturn.

Sector Background

Offshore drilling assets can be segmented into two broad groups:

• Jack-up rigs – These can drill at depths of up to 400 ft and are “jacked” to the sea floor. They are generally immobile but more commoditized, costing ~$200mn each in the last cycle. There are an estimated 483 jack-up rigs in the market today, roughly two-thirds of which are considered modern. Of the 320 modern jack-ups, 257 are under contract, another 32 have been contracted for the future, 20 are warm-stacked (ready to be activated), and 11 are cold-stacked (requiring meaningful capex to reactivate).

• Floaters – These are semi-submersibles and drillships that primarily operate in the ultra deepwater (UDW) segment of the market, drilling at depths of up to 12,000 ft. Because they do not rest on the sea floor, they are mobile and more technologically advanced, costing $600-$700mn each in the last cycle. There are a small number of shallow water floaters as well, but the UDW market is further segmented into HE semi-submersibles, which have advanced thrusting and mooring systems that allow operations in high wind and waves (primarily in the North Sea), and benign environment (Gulf of Mexico, West Africa) semi-submersibles and drillships. Importantly HE floaters can operate in benign environments, but benign UDW floaters cannot operate in harsh environments. There are also increasingly attractive new prospects, such as the TotalEnergies Venus project off of southern Namibia, where benign environment project owners have shown a preference for HE semi-submersibles.

The market for UDW vessels is tighter than the market for jack-ups, and the market for HE UDW vessels is tighter than for benign UDW vessels. See the table below for the current universe of offshore drilling assets:

Offshore drilling has gone through many cycles, but the most relevant cycle for this discussion is the post-financial crisis cycle that lasted from ~2010-2014. Offshore drilling generally becomes economically feasible with WTI between $30-$60/bbl, with varying probabilities, and comfortably feasible with higher prices. With WTI stable at $85-$110/bbl between 2010-2014, and alternative oil sources running low vs. the prior cycle, UDW drillers saw new-contract pricing rise from ~$400k/day to over $600k/day within two years. Cash operating costs range from $120-$200k/day, excluding capex, and contracts last for a few months to several years.

Offshore drillers followed higher pricing with a frenzy of newbuild orders. Dozens of UDW semi-submersibles and drillships were ordered between 2012 and 2013. The appetite for risk was so high that, even as the market began stabilizing in mid-2013, Seadrill alone ordered four UDW vessels in 3Q13.

With E&P offshore capex declining (see chart further below), contract prices began to collapse in 2015, and by 2018 pricing had reached a level so low only the most efficiently managed vessels could operate at cost and avoid scrapping or idling.

The first chart below shows the historical average day rates for HE and benign UDW vessels over the past cycle, while the second scatter chart shows granular data over a longer horizon:

In the downturn offshore drilling shareholders lost tens of billions of dollars, banks and shipyards lost billions more. An estimated 46% of floaters were scrapped between 2015 and 2022. Here is a representative comp table of drillers on the brink of liquidation, bankruptcy, and consolidation, from May 2015 by JP Morgan:

Since 2015 the following has happened: Diamond, Noble, and Seadrill emerged from bankruptcy; Ensco and Rowan merged to form Valaris, which also emerged from bankruptcy; Atwood was merged into Valaris; Paragon and other assets were bought by Borr Drilling; Fred Olsen and other assets were bought by Dolphin Drilling; Hercules was liquidated; North Atlantic was merged with Seadrill; Ocean Rig UDW was bought by Transocean; Pacific Drilling was merged with Noble; and Vantage was partially liquidated.

The chart below shows the destruction of just the drillship market, excluding new orders that were also destroyed:

Offshore drilling analysts were forced into other sectors or early retirement, and the trauma experienced by surviving management teams and industry stakeholders is still ripe.

Having come out at the other end of the downcycle, both the supply and demand outlook are now highly favorable. E&P offshore capex is finally beginning to turn, with geopolitics set to cause an acceleration:

“Never Forget”

The most obvious question investors might ask is this: why won’t a newbuild frenzy happen again? Irrationality is in the nature of cycle extremes, but there are some mitigating factors now:

• Shipyards have restructured – UDW shipbuilding has remained at near-zero levels for years, and both the infrastructure and personnel at shipyards have been repurposed. It is not trivial to reactivate an assembly line for a $1bn+/unit product, and in the heyday of the last cycle, shipbuilders had tens of vessels being built at a time. The opportunity to build a few vessels over the course of several years does not justify the investment in time and capital by shipbuilders, and even at the right price we believe it would take at least five years to commercialize a newbuild. Based on conversations with industry insiders, there is currently no bid/ask in this market despite the recent upturn in day rates (see scatter chart above).

• Banks will not lend – During the prior cycle trough after the 2008 financial crisis, day rates generally bottomed near ~$300-$400k/day, which did not cause a crisis among the drillers or their banks. As Korea was eager to promote Hyundai Heavy, Samsung Heavy, and Daweoo Shipbuilding & Marine Engineering, the Korea Eximbank was willing to supplement traditional bank financing, allowing operators to pay only 10% down. After the loss of billions of dollars and untold loan officer jobs, the 10% down offer is inconceivable today. There is no market for UDW vessels, so it is difficult to say what kind of down payment would be necessary, but some industry experts believe it would be 60%+. Considering the financial health of the remaining operators, no company currently has the cash to make any meaningful newbuild orders with a high down payment.

• Drillers need visibility – Even if day rates moved meaningfully higher than they already have, drillers and their shareholders are reluctant to order any vessels unless there is a very long-term contract associated with the order that effectively pays back the cost of the vessel and a return by the end of the contract. Transocean management have said they do not expect any newbuild activity for the remainder of their careers (the CEO is 48). Industry experts believe a ten-year contract at > $700k/day would be needed to even consider an order at $1.2bn/vessel (the speculated price), which means a project owner would need 15 years of visibility, including time to build, at high rates. If the market is in fact this strong, Odfjell Drilling will generate enough free cash flow to cover its enterprise value almost ten times over and still have decades of asset operating life left.

Why Odfjell Drilling?

The simple answer is that the HE segment of the market is the most undersupplied (see above), Odfjell Drilling is the largest pure-play HE UDW drilling operator in the world, and by all accounts management is highly regarded in the industry. Transocean also has a large HE fleet, but HE is a small fraction of its total fleet, and given the nature of contracting and bank negotiations during the downcycle, Odfjell Drilling has emerged in a better position.

As mentioned above, drilling contracts can last for a few months to several years. In order to skirt bankruptcy, and in order to assuage post-bankruptcy investors, Transocean and most others in the industry were required to enter into long-term contracts when rates were still low, so they could have a larger backlog on which they could secure loans and obtain waivers. Because of Odfjell Drilling’s longtime presence in the Norwegian market and its friendliness with leading Norwegian customer Equinor and local banks, the company was largely able to get by without locking itself into similar long-term contracts.

Contracts are typically priced with a fixed day rate for the term, often with options to extend the contract; the structuring of these options is critical, because they can be set at fixed rates in advance (“priced options”), or within ranges, or they can be “unpriced,” meaning the extension will be priced at future market rates.

Odfjell Drilling has had to enter long-term contracts as others have, but the company has a higher proportion of “unpriced” options than peers. See the schedule of owned vessels below (yellow means the contract is under a framework agreement, effectively “unpriced” options):

The one contract beyond 2026 that is priced with a pre-set range, for the Deepsea Stavanger, was announced last year, with the top of the range set at $400k/day; but even this is subject to inflation adjustments, so the realized rate will be higher (plus a standard 10-15% bonus).

Transocean owns 28 benign UDW vessels and only seven modern HE vessels, but the company spent the largest amount of time on its last earnings call discussing how tight the HE market is. Transocean believes the HE market is short between 5-10 vessels beyond 2024, and with only a few stacked/stranded HE vessels in the market that will take a year to reactivate, it is likely HE rates will move significantly higher than benign UDW rates in the near future – HE vessels that are under two-way contract options in benign waters will have to be attracted by HE project owners with higher rates.

We expect North Sea Final Investment Decisions (FIDs) to pick up in 2024 after a busy 2022 due to Norwegian tax breaks. The most recent data point from Odfjell Drilling’s managed fleet was a 200-day contract at $520k/day, adjusting for mobilization and demobilization payments. The $500k/day rate was a psychological barrier that has been breached.

Why Now?

Until recently, domestic and regional European investors were reluctant to invest in Odfjell Drilling. Apart from ESG concerns which remain, the key issue was that the majority of Odfjell’s bank debt was set to mature in June 2024. Despite the positive outlook, in the recent rate environment many investors were unwilling to look at a company with ~2x+ net debt / EBITDA and large maturities in a year.

In early July 2023 Odfjell Drilling completed a new bond offering, repaying bank debt, extending major maturities to 2028, and loosening covenants on the remaining debt in the process. Among other things, the new covenants allow Odfjell Drilling to pay a dividend, and with the most recent earnings release, the company announced its first quarterly dividend in nearly 10 years, which it aims to grow in USD terms going forward.

With summer holidays out of the way, investors and the company are back on the conference circuit, and Odfjell Drilling is conducting multiple international roadshows in the remaining months of 2023. The current annualized dividend yield of 7.4% provides a strong incentive for dividend investors and for value investors who are concerned about an economic/oil recession. The liquid peers, while potentially offering meaningful upside (if not as great as Odfjell Drilling), provide virtually no downside protection if oil moves lower in a recession. Odfjell Drilling has enough cash flow visibility to fund its dividend through any recession-driven weakness or delays in contracting over the next several years.

Catalysts

One set of catalysts is the continuing rise in day rates as the HE market gets tighter over the course of 2024. It might come as a surprise that, given the supply/demand picture detailed above, HE rates have not already moved significantly higher than benign rates. The key reason for this is that Equinor is the largest North Sea customer, and industry experts believe that as a State Owned Enterprise, Equinor is a late follower to market rates – they are more likely to pay up later in the cycle than secure capacity earlier in the cycle. The FID tax incentives from 2020-2022 and implied tender timeline have resulted in 2023 being a slow year, but there should be at least one more North Sea tender this year followed by five tenders in the first half of 2024. It is conceivable we see a $600k/day contract print by the end of 2024.

The other set of catalysts is around M&A. The company currently collects a fixed fee for the four vessels it manages, amounting to ~$30mn of EBITDA/year when all four are in operation (they are all contracted to late 2024 / early 2025). Odfjell Drilling has said it is interested in acquiring two or three of these managed assets, as the owners are unlicensed to manage them over the long term. Two of the vessels are owned by Northern Ocean (the only assets owned by that company) and one by SFL (part of a portfolio of diversified shipping assets) – both Northern Ocean and SFL have John Fredriksen, possibly the greatest living ship trader, as their largest shareholder. Fredriksen’s primary interests are outside of offshore drilling, but Northern Ocean acquired claims on these stranded vessels a few years prior to COVID, so he and the hedge fund that is the second largest shareholder have already held onto these assets longer than expected. In speaking with Odfjell Drilling it is clear the company would like to acquire Northern Ocean to grow scale and gain negotiating power in the HE market. Helene Odfjell, having survived a ten-year nuclear winter, is willing to go below 50% ownership, so the only remaining hurdle in a share swap is the net debt / LTM EBITDA covenant that remains at Odfjell Drilling. Based on our estimates, a consolidated Odfjell Drilling / Northern Ocean will be below the 3x LTM leverage covenant as soon as 1Q24, so a deal seems possible in the coming quarters. Fredriksen would likely see the highest upside by creating a dominant HE driller via a share swap.

If Odfjell Drilling is able to acquire Northern Ocean and/or the SFL vessel, it will soon after have the scale to move its listing to the NYSE. This is not speculation – the company has confirmed that a move to the NYSE has been discussed by its Board of Directors and is likely with greater scale and liquidity.

Valuation

The primary capex programs required for HE drillers are the five-year special periodic surveys (SPS) and less frequent refurbishments and life extensions to 40+ years. As the market will be tight going forward, the company has moved its SPS schedule up and will incur elevated capex through the end of 2025. We expect another $65mn in capex for 2H23, $108mn for 2024, and $68mn for 2025, beyond which maintenance capex will be below $30mn for several years.

Considering the capex and contracted rates for the company are roughly known for the next few years, we estimate the company will be free of net debt near the end of 2026. At that point only one vessel will be under a fixed contracted rate, so we have the following sensitivity based on the day rate of the other three vessels:

The conservative midpoint above assumes a day rate lower than what has already been achieved this cycle, and considering the supply shortage will reach its peak by 2025, we believe the market will price in our base case valuation above within two years (absent any M&A). A debt-free NOK 105/share target price implies a per-vessel valuation of just under $600mn, or half of what a newbuild is speculated to cost, despite another 25+ years of average remaining life on the owned fleet.  

The sky is the limit in a bull case scenario. Transocean has traded above 4x P/B previously, and if the narrative allows, investors will speculate about the potential to convert Odfjell Drilling to a Master Limited Partnership. If the company is able to acquire its managed fleet and gain enough scale to trade as a liquid stock on the NYSE, the company’s dominant positioning would arguably be better than Transocean’s in any prior cycle, and 5x the current share price would still be a discount to prior peak sector multiples.

Appendix – Harsh Environment Universe as of 2Q23

Risks

• Newbuild activity – The speculated newbuild cost of $1.2bn accounts for the factors above plus cost inflation since the last cycle. It is possible the actual cost will be lower, but currently the market has no data to support a precise estimate.

• Unsustainable day rates – E&P companies have been willing to pay over $600k/day with oil at current levels, and supply constraints should put upward pressure beyond this level in the coming few years. Furthermore, improvements in driller efficiency (days/well) should lift ability-to-pay by 20-30% since the last cycle. But while there is better price visibility in offshore drilling relative to other energy subsectors, if oil were to drop meaningfully for a sustained period of years, E&P capex would be cut, and day rates would be impacted, albeit with a multi-year lag effect on Odfjell Drilling.

• Illiquidity – As we noted above, the company is the only major offshore driller paying a sustainable and growing dividend. Considering the stock is still relatively illiquid, there is a possibility that “nobody cares” about a 7%+ dividend yield until the stock becomes more liquid.

Catalyst

One set of catalysts is the continuing rise in day rates as the HE market gets tighter over the course of 2024. It might come as a surprise that, given the supply/demand picture detailed above, HE rates have not already moved significantly higher than benign rates. The key reason for this is that Equinor is the largest North Sea customer, and industry experts believe that as a State Owned Enterprise, Equinor is a late follower to market rates – they are more likely to pay up later in the cycle than secure capacity earlier in the cycle. The FID tax incentives from 2020-2022 and implied tender timeline have resulted in 2023 being a slow year, but there should be at least one more North Sea tender this year followed by five tenders in the first half of 2024. It is conceivable we see a $600k/day contract print by the end of 2024.

The other set of catalysts is around M&A. The company currently collects a fixed fee for the four vessels it manages, amounting to ~$30mn of EBITDA/year when all four are in operation (they are all contracted to late 2024 / early 2025). Odfjell Drilling has said it is interested in acquiring two or three of these managed assets, as the owners are unlicensed to manage them over the long term. Two of the vessels are owned by Northern Ocean (the only assets owned by that company) and one by SFL (part of a portfolio of diversified shipping assets) – both Northern Ocean and SFL have John Fredriksen, possibly the greatest living ship trader, as their largest shareholder. Fredriksen’s primary interests are outside of offshore drilling, but Northern Ocean acquired claims on these stranded vessels a few years prior to COVID, so he and the hedge fund that is the second largest shareholder have already held onto these assets longer than expected. In speaking with Odfjell Drilling it is clear the company would like to acquire Northern Ocean to grow scale and gain negotiating power in the HE market. Helene Odfjell, having survived a ten-year nuclear winter, is willing to go below 50% ownership, so the only remaining hurdle in a share swap is the net debt / LTM EBITDA covenant that remains at Odfjell Drilling. Based on our estimates, a consolidated Odfjell Drilling / Northern Ocean will be below the 3x LTM leverage covenant as soon as 1Q24, so a deal seems possible in the coming quarters. Fredriksen would likely see the highest upside by creating a dominant HE driller via a share swap.

If Odfjell Drilling is able to acquire Northern Ocean and/or the SFL vessel, it will soon after have the scale to move its listing to the NYSE. This is not speculation – the company has confirmed that a move to the NYSE has been discussed by its Board of Directors and is likely with greater scale and liquidity.