Offshore Drillers: 3 Big Risk Factors That Could Send Share Prices Crashing

By Markets Fool.com

In the past few months offshore drillers Transocean , Seadrill , and Ensco have seen their stocks rebound nicely.

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RIG Chart
RIG data by YCharts

However, investors need to be aware that there are three major threats to the industry that could send share prices plunging once more: a continued glut of rigs, massive debt loads, and the fact that the industry recovery may still be a few years away -- even if oil prices recover faster.

Excess rig capacity is killing day rates
A few years ago, day rates for Ultra Deepwater rigs -- the industry's most profitable rig type -- were as high as $650,000 and the industry went on a building spree that is now coming back to haunt it. In fact there are 89brand new floating drillships set for delivery by 2017, with 70 currently working ships going off contract during that time, creating an enormous potential for excess supply that could keep day rates down for years.

Source: Transocean investor presentation.

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As this chart shows, the projected supply of floaters is likely to greatly outpace projected offshore drilling demand -- the red and pink bars -- all the way through 2017.

Luckily as Terry Bonno,Transocean's vice president of marketing, points out, the industry's efforts at storing and scrapping aging and idled rigs should greatly decrease this oversupply in the years ahead (the dotted line). 27 floaters have already been stacked -- put into long-term storage -- and 35 have been scrapped, including 19 of Transocean's own rigs. However, these supply-decreasing efforts will do little to alleviate the short-term suffering that drillers are facing.

Seadrill, in particular, is looking at a rough couple of years since it has a total of 15 new builds under construction, including seven UDW rigs. To be fair to management, the company has delayed one UDW rig by up to 36 months and there is a cancellation option on it. Seadrill has also delayed delivery of all jackup newbuilds by an average of 5.5 months.

However, the fact remains that the company has six UDW rigs set for delivery in 2015, and only one has a drilling contract in place.Since it costs around $115,000 per day in maintenance fees to cold stack a floater, there are huge implications for not putting these new vessels to work immediately.Because drillers want to avoid negative cash flow, UDW day rates could fall below their current $350,000.

In fact, analysts at Citigroup think that day rates might decline to levels that just cover operating costs, which Seadrill estimates at $245,000.

While that prediction may seem extreme, as Transocean's Bonno pointed out at a recent analyst conference, UDW day rates can be very volatile, and swing by as much as $200,000 in just six months.

High debt loads that are likely to get bigger
Offshore drilling is a monstrously capital intensive business, and all three companies have significant total debt loads:

  • Transocean: $10 billion
  • Seadrill: $12.6 billion
  • Ensco: $6.1 billion

What's more is that all three have substantial contractual obligations for their newbuilds under construction:

  • Seadrill: $4.8 billionin contractually obligated payments by the end of 2016
  • Transocean: $9.1 billion by end of 2017
  • Ensco $3.8 billion by end of 2017

With day rates potentially getting weaker for several more quarters, it's likely that all three will need to tap the debt markets in order to cover these obligations. Factor in existing debt coming due in the interim, and liquidity could be a major problem.

Luckily -- at least for now -- creditors are being understanding and willing to continue lending at cheap interest rates. However, keep in mind that these large debt loads will have to be paid off eventually, and creditors may become impatient if day rates don't recover within a few years.

Industry recovery isn't sure to be quick or large
According to Terry Bonno, the company sees some possibility for a recovery in drilling demand in 2016 and 2017.

One promising development, according to Ensco, is that Brazil -- which had previously planned to construct 29 deep water rigs -- may end up cancelling over half of these rigs and delaying those that end up getting built.This likely means that Brazilian offshore drilling will prove a greater source of demand and potential future contracts than previously anticipated.

Yet even with such positive developments, investors need to keep in mind what Seadrill CFO Rune Magnus Lundetraerecently told reporters: "You may see a stabilization in 2017...That means you get day rates that at least cover costs including funding" (on the order of $400,000).

Bottom line: offshore drilling stocks need to be seen as long-term deep value investments
Don't get me wrong, I'm not trying to dissuade anyone from investing in offshore drillers, since I continue to be bullish on the industry's long-term prospects. However, given the major headwinds the industry is facing I want potential investors to know that to successfully invest in this industry right now will require patience and a strong stomach.

The article Offshore Drillers: 3 Big Risk Factors That Could Send Share Prices Crashing originally appeared on Fool.com.

Adam Galashas no position in any stocks mentioned, however, he does leadThe Grand Adventuredividend project, which recommends Seadrill.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.