After a Disastrous Quarter, 2 Things All Offshore Drilling Investors Need to Know

By Markets Fool.com

Few industries have been hit harder in the past two years than offshore oil drillers such as Seadrill , Ensco , Noble Corp. , Diamond Offshore , and industry Juggernaut Transocean . After yet another earnings report that included an enormous writedown, it's a good idea to drill down into the conference-call transcript of the industry's largest company to see what information can be gleaned about what investors can expect over the next year or two.

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CEO resignation highlights the challenges facing the industry

"Last week we announced that the board of directors and Steven Newman mutually agreed that Steven would step down as CEO. ... There will be no change in our approach to managing an increasingly commoditized, capital-intensive and cyclical business."
-- Ian Stachan, chairman and interim CEO

This quote is in reference to the resignation of Transocean's CEO, who took over in the wake of the 2010 Gulf Coast oil spill disaster, which involved one of the company's rigs and for which final litigation has yet to be fully completed.

In the five years that Newman was CEO, Transocean's stock has not only catastrophically underperformed the market, but it has also suffered far worse than rivals such as Seadrill and Ensco.

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According to Reuters, company insiders cite Newman's overly conservative nature and poor industry timing as key reasons for the departure. For example, critics argue that Transocean was too slow in scrapping older rigs and put off its plans for too long to spin off eight older rigs into a separate company called Caledonia. That IPO would have raised much-needed funds for the company if done earlier, but because of the oil collapse, that deal has been shelved, possibly permanently, and those rigs will probably have to be scrapped instead.

In addition, insiders say that Newman was too slow to build new rigs to take advantage of the previous boom in day rates, and his poor timing has left Transocean with 12 new rigs set for delivery within the next few years, seven of which don't have contracts.

However, while I agree that Newman made mistakes during his tenure, I think such criticism may be an example of Monday morning quarterbacking. After all, Seadrill was the most aggressive at ordering new builds early on and has 15 new builds scheduled for delivery in the next two years, 13 of which are without contracts at this time, putting it in an even worse position than Transocean.

Which brings me to the most pressing issue facing the offshore drilling industry -- a dangerous glut of rigs.

Future rig oversupply looms over the industry

"Over the last several months the company has announced that it has already scrapped or intends to scrap 12 lower-specification floaters in an environmentally responsible manner. We are constantly evaluating the long-term economics of our fleet and may identify additional rigs for sale or scrapping. ... We also discussed that we amended our construction contracts with Keppel FELS to delay the delivery of five newbuild, high-specification jackups by approximately six months each and to extend the delivery dates of each rig. The first of the jackups is now expected to be delivered in the third quarter of 2016."
-- Stachan [emphasis mine]

According to UBS analysts, Transocean has 26% of its ultra deepwater, or UDW, rig fleet -- the highest-margin rig type -- idle at this time, and by year's end as much as 50% to 60% of its UDW fleet may be without work if oil prices don't recover.

Thus, it's no surprise that both Transocean and Seadrill are desperately trying to delay the delivery of new UDW rigs, which will only add to the current rig glut and potentially force offshore drillers to cold stack -- place into dry dock storage -- their costliest and most valuable assets. In fact, because it costs around $110,000 per day to cold stack a UDW rig, offshore drillers, especially those with older UDW fleets -- such as Diamond Offshore and Noble Corp. -- may be forced to accept day rates below the operating cash flow breakeven level of approximately $250,000 per day.

This means that future earnings, cash flows, and dividends, which have already been slashed or suspended throughout the industry, might have further to fall unless oil prices recover over the coming quarters.

Takeaway: A perfect storm of negative events means the worst industry downturn in years shows no sign of abating anytime soon
Offshore drillers' shares have been hammered down to supremely undervalued levels. However, potential and current investors need to understand that the industry looks to be facing another difficult year or two ahead. Already high-spec UDW rigs are being idled, and the next two years will see the delivery of many more such rigs. This trend may result in substantially falling day rates, even to levels where drillers are losing money on an operating cash flow basis even on their most profitable rig type.

Meanwhile, no one can predict when rising oil prices -- the only catalyst that's likely to launch a recovery of the industry -- will occur. Thus, while I remain bullish on this industry in the long term, I would advise only truly long-term investors, those comfortable holding highly volatile "dirty value" stocks, to invest in shares of these companies, and only as a part of a thoroughly diversified portfolio.

The article After a Disastrous Quarter, 2 Things All Offshore Drilling Investors Need to Know originally appeared on Fool.com.

Adam Galashas no position in any stocks mentioned, however, he does leadThe Grand Adventuredividend project, owns SeaDrill in several portfolios.The Motley Fool recommends Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.