Offshore Drilling Stocks: 3 Vital Factors Investors Need to Be Aware Of

By Markets Fool.com

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Courtesy of Seadrill

When will the pain for offshore drillers end? To answer that question, let's see what management at the world's three biggest offshore drillers -- Transocean , Ensco , and Seadrill -- are saying about three important factors: cost cutting, access to capital markets, and the glut of rigs that's caused day rates to crash.

Cost cutting means a lot more scrapping of older rigs

"We will continue to scrap non-core rigs that we conclude are no longer economically viable over the longer term, as well as quickly move rigs to stacked condition as soon as it becomes clear that they have limited options for near-term follow-on work. ... To the latter point, we continue to optimize the cost of stacking ultra-deepwater rigs and have made significant progress in this regard."-- Esa Ikaheimonen, Transocean CFO

Scrapping of obsolete rigs is an important aspect of whatJeremy Thigpen, Transocean's new president and CEO, calls the company's "near fanatical" approach to cost cutting.To date, Transocean has scrapped 19 rigs,which has resulted in a painful but necessary $4.6 billion in writedowns over the past three quarters.

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However, thanks to its renewed focus on cost cutting and fleet optimization, the company was able to increase its first-quarter operating margin 550 basis points to 47%.

Credit markets are still wide open to the industry

"Nearly $10 billion in new financing commitments were completed [in 2014], leaving the company well positioned financially heading into a challenging 2015. ... The company's banking group remains very supportive with the Seadrill Group, given its fleet profile and strong track record in the credit market. In the fourth quarter alone, Seadrill was able to raise a total of $1.7 billion in secured bank funding."-- Rune Magnus Lundetrea, Seadrill CFO

Offshore drilling is a massively capital intensive industry. The fact that Seadrill, a company with $15.85 billion in contractual obligations over next one to three years,is able to secure such vast amount of new financing shows that creditors still have strong faith in the industry's long-term prospects.

Also helpful is that Seadrill recently got one of its biggest creditors to defer loan installment payments until the market recovers, even though Seadrill has $12.6 billion in interest-bearing debt and recently insured $2.6 billion of debt for its subsidiary North Atlantic Drilling.

Things are even better for offshore drillers such as Ensco, whose balance sheet is among the strongest in the industry and whose credit ratings both S&P and Moody'shave recently been reiterated as investment grade.

With credit still cheap and plentiful, and relations between credit markets and offshore drillers so amiable, long-term investors have cause for optimism that these companies will be able to pull through this downturn and make the necessary fleet and cost adjustments to become far more efficient and profitable once oil prices finally recover.

Supply glut of UDW rigs is being addressed

"Since September, offshore drillers have announced they will scrap 33 floaters. Over the same time period, an additional 20 floaters have been cold-stacked. We believe that the majority of these will also be scrapped. In total, these 53 rigs represent approximately 17% of competitive global supply.Additionally, more than 40 floaters with similar age and technical characteristics to the 33 scrapped rigs I just mentioned are currently idle or will see their contracts expire in 2015. All will be likely candidates for scrapping and/or cold stacking."-- David Hensel, Ensco senior VP of marketing

It's no secret that one of the biggest problems for the offshore industry has been the massive oversupply of rigs, especially of the most expensive variety: ultra deepwater, or UDW, also known as "floaters." Because of their much higher day rates and operating margins, floaters are very important to offshore drillers. For example, 80% of Seadrill's $9.7 billion backlog is derived from UDW contracts.

Not only are a lot of older UDW rigs being idled and scrapped, but according to Transocean's Ikaheimonen, the company is making good headway in reducing the cost of UDW cold stacking -- a form of storage that usually costs $110,000 to $120,000 per day.

Another approach offshore drillers are taking to alleviate the glut of new rigs is to delay delivery. For example,Ikaheimonen recently reported that five of Transocean's high-spec jack-up new builds -- whose delivery had already been delayed by six months -- have been pushed back an additional 18-20 months each.

The timing coincides with an expected industry recovery that's expected to begin in 2016 or 2017, a view that the management teams at Transocean and Seadrill share.

Takeaway: The next few quarters will be painful, but the big drillers are likely to survive
While I don't think any of these three companies will fail during this industry downturn, investors must be patient and realize that the recovery will probably take another year or two to begin.

The article Offshore Drilling Stocks: 3 Vital Factors Investors Need to Be Aware Of originally appeared on Fool.com.

Adam Galasowns shares of North Atlantic Drilling and leadsThe Grand Adventuredividend project, which recommends North Atlantic Drilling and 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.