Description

The bullish thesis for energy related equities is well understood - a decade of underinvestment in energy and related infrastructure, lack of qualified labor force, disciplined capital deployment by producers, OPEC+ put to keep prices elevated, growing global demand for energy driven by China re-opening and larger emerging markets middle class, lower quality inventory left to be drilled, tight capital availability for the fossil fuel complex as a whole, etc. With all these positive factors that give confidence in strong long-term cash flow generation in the energy complex, valuations remain irrationally low and the sector remains unloved. This negative sentiment seems to be driven by:

 1) a fear of the volatility in energy prices which drives volatility in the stock prices across the complex, even in stocks whose intrinsic value is quite immune to day-to-day energy price volatility. Over time this detachment of fundamentals from price volatility corrects itself but investors are wary of short-term impact on their mark to market results until the anomaly resolves itself.

2) Investors are scarred by almost a decade of energy underperformance, when a number of companies either went bankrupt or had valuation drawdowns of 80/90%.

3) Perplexingly, a lot of investors look at the forward curve as a projection of what energy prices are going to be, even though that has never been the case. In fact, if the spot prices or forward curve goes lower that limits appetite for investment, exacerbating future supply shortage and bolstering the view for much higher oil prices.

4) Collapse in energy prices in an economic downturn is a big fear based on 2008 scar tissue. Even though, historically oil price and consumption has been quite resilient in economic downturns. When energy prices have collapsed, it’s been driven by certain anomalous factors that have a low probability of repeating, like the shale revolution in the US, availability of massive uneconomic capital available to exploit that resource and lack of OPEC+ power and discipline. Also, as opposed to previous incidents, when a short term decline in prices forced over leveraged companies to go belly up, this time around the balance sheets in the energy complex have never been stronger and vast majority could easily survive an extended period of very low prices, if it happened, without impairing their intrinsic value; I would argue such a downturn would enhance their intrinsic value because in such an event , the snap back in prices would be epic, considering the lack of spare capacity across the complex.

5) The market may just be having a breather after two years of strong outperformance in energy names, although there is a long way to go to get to mean reversion.

6) Fundamentally, a lot of investors have not come to grips with the fact that the world lacks spare capacity. The current level of investment would make us hit a supply wall and any demand growth abatement through economic slowdown will not be enough to overcome the supply shortage.

When would investor sentiment flip and bring fresh investment into the space is hard to predict, but my guess is the massive cash flows these Companies are generating will be hard to ignore for much longer.

I and others have written about the exceptional values we find in midstream, particularly MLPs. Another sector that is inflecting and in the early stages of high conviction, long term uptrend is the offshore service sector, particularly the drillers. Offshore drillers’ stocks have been down this year, underperforming even Brent prices, despite continued momentum in utilization and pricing. Most of future offshore rig demand will be for projects with break-evens below $40/bbl. Until or unless, long term Brent prices are expected to remain below $60 for an extended period of time, these projects are not impacted by the day-to-day gyrations in oil prices. The futures curve is above $70 into 2026, allowing hedging to limit any short term downturn to encourage FIDs, supporting rig utilization and pricing to continue to melt higher. Other than oil prices, longer term contracts (2+years) and higher pricing should push these drillers’ stocks higher.

Energy service companies had unanimously bullish offshore outlooks this past quarter (‘23 offshore FIDs the highest in 10yrs; offshore rig market ‘the best it has looked in the past 20 years’). The past three months have provided ample evidence that the offshore inflection currently taking place has legs and is likely to extend for the next several years. Exploration activity is ramping up and discoveries are being made in places like Suriname, Namibia and Egypt, in hopes of becoming the next Guyana where ExxonMobil is planning to move forward with its 5th development this year. Petrobras just awarded a 3-year contract for stacked drillship Valaris DS-8, its ninth multi-year contract awarded since November for a total of 28 rig years (and still looking to fill 15 rig years more). The Saudi jackup rig count is expected to increase to 85 by year-end, a 70% increase from 50 just six months ago.

This increased demand has improved pricing with leading edge day rates for floaters in the $450k/day range. Aquadrill fixed a floater at ~$460k for short-term work in Mozambique, and SDRL’s West Neptune in the US Gulf exercised at ~$435k which keeps the rig working into next summer (leading edge rates in the US Gulf look to be in the $450k-$475k range). I expect these rates to move higher from here as the number of floaters have been roughly cut in half since mid-2014 cycle peak. Marketed Ultra deep water rig utilization has eclipsed 90%, with tier 1 drillships at over 95% utilization. Only 8 newbuild drillships remain in South Koeran shipyards. 11 of the 13 warm and cold stacked competitive drillships are held by Valaris which has committed to bring them to market in a staged manner when demand supports incremental supply. No new orders are expected for newbuild drillships for the foreseeable future. Through 2023 and 2024, it is expected demand will steadily outstrip supply, with very little spare capacity on the side-lines ready to work in the near-term, leading to continued improvements in contract economics.

I find most deepwater drillers, except maybe Transocean, are quite undervalued with high visibility on increasing cash flows at current dayrates and significant upside as those dayrates expand. My pick within the group is SeaDrill because of its unlevered balance sheet, limited reactivation capex, one of the youngest and most technologically advanced fleets, primary exposure to floaters versus jackups and near term capital return ambitions.

SDRL is an offshore drilling contractor with a mix of drillships, semis, harsh environment rigs, and jackups that operate primarily in the Golden Triangle, comprising US Gulf, Brazil, West Africa where there is the highest demand for floaters, as well as Norway and the Middle East. The Company emerged in February 2022 from its second restructuring in ~5 years that wiped out approximately $12 billion of debt and put it in a net cash position. Since 3Q ’22, the Company has paid off approximately $600MM of debt, its second lien 12.5% notes, through sale of some of some of its Jackups, leaving it with $342MM in debt, including a $50MM convert which is in the money ($19.5 conversion price). The remaining debt is expected to be refinanced/paid down shortly paving the way for capital returns. The Company has indicated it may dispose of its remaining jackups and tender rigs at the right price, leaving it as a pure play deep water driller. I estimate these potential disposals to be worth roughly $400M.

In April 2023, SDRL closed the acquisition of Aquadrill, formerly Seadrill Partners, in an all stock $960MM deal which gave Aquadrill owners a 38% stake in the combined Company. Aquadrill was debt free with net cash of approximately $100MM upon acquisition. Because of their shared history, integration is not expected to be a difficult task. This transaction should boost SDRL's working drillship fleet by 67% (+4 drillships) and provide SDRL more upside in the ongoing offshore drilling upcycle. Additionally, Aquadrill has one stacked semi, which I expect SDRL to reactivate in the medium term. Post the Aquadrill acquisition, SDRL should have 12 working floaters (includes 10 drillships), with 4 floaters up for contract renewal through 2Q24. The combined company Order Backlog as of April 5, 2023, was approximately $2.6 billion, with a fleet of 29 owned and managed units. The bulk of SDRL and Aquadrill 2023 revenue days are already fixed with all of SDRL ’s rigs on contract into 2024 and only one of Aquadrill’s rigs (excludes one semi and two tender rigs that are stacked) rolling off contract this year.

The combined Company has ~96% contract coverage in 2023, ~68% contract coverage in 2024 (another three rigs roll off contract), and ~40% contract coverage in 2025. This coverage provides stability in the cash flows for this year and next while affording the Company full opportunity to take advantage of higher dayrates in 2025 and beyond. The doubling of dayrates for leading-edge floaters over the past 18 months to $440-450k/d won’t really start to take effect until 2024 (most of the multi-year contracts announced have 2H23 commencement dates, plus the repricing of contracts will mostly take place 2H23/2024). SDRL will see some benefit from these higher prices later this year and into 2024 as, Aquadrill’s Polaris is set to roll off contract in India in September, which is currently earning ~$250k/d should reset in the $400k range , which at the rig level points to incremental annual EBITDA of ~$50M. In 2024, SDRL has two floaters set to roll off contract first half of 2024 and should re contract at higher rates.

At current leading edge day rates for floaters at $450k/day, Seadrill should generate $1.3 billion in EBITDA and $900 million of free cash flow. The Company should generate that cash flow by 2025/2026, as virtually all of its contracts would have reset. Although, I expect that day rates will be probably much higher than that by that time frame.

Analysing historical EV/EBITDA multiples for the sector, it makes sense to look at 2-year forward EV/EBITDA to capture the delayed impact from leading-edge dayrates in earnings. These multiples have varied greatly over the past 20 years, although in periods with stable (and high) earnings combined with a strong drilling market outlook (i.e. 2007–2014), the sector traded at roughly 6x the 2-year-forward EV/EBITDA, which seems to be a reasonable reference for valuation in today’s market. At 6X EBITDA (based on current leading edge day rates), plus roughly $7 net cash per share by then, we get to a valuation of approximately $105 per share or 280% appreciation from here over 3 years. The Company should be able to pay a $10 per share dividend by that time, which at a 8% dividend yield would imply a $125/ share valuation or 337% appreciation from current prices. 

Catalyst

- Higher Day Rates

- Capital returns