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Jun 7, 2010

Oil & Gas Drilling Metrics

So far I have been extremely fortunate to have commenters post some really high quality content here at Street Capitalist. I wanted to highlight a comment from Mak, on some metrics he uses to look at oil and gas drillers:

Deepwater, which has been extremely profitable for the past few years, is going to see its outsize rates decline as a significant amount of capacity comes online over the next few years. This was even before the GoM spill and the uncertainty it has caused re: drilling moratorium. Now there is a chance oil prices shoot up again, which would help sustain rates, but I dont try to prognosticate on commodity prices.

I look heavily at through-the-cycle return on capital for offshore drillers. The longer the track record, the better. And if they have been able to generate those returns with low risk, all the better. I look at two large areas to measure risk. One is the capital structure in this cyclical industry, you probably want to have at most one or two years of operating cashflow of leverage (Transoceans relatively high level of debt is going to put them at risk, particularly with potential legal liabilities from the GoM spill). The second is capex spending you want to try your best to build new ships with contracts in hand. ENSCO (NYSE:ESV ) has three major deepwater rigs coming online in 2010 (with another $1 billion of committed capex) and as I undestand it has not yet secured contracts for them.

Another metric that is important to compare relative performance would be operating margins. Diamond Offshore (NYSE:DO ) and Noble Corporation (NYSE:NE ) score well here.

Ive been taking a deeper look at some of the drillers and hope to have a few posts on them soon. Maks point about looking at this companies as cyclical is essential, one of the issues you will see is that some of the newer companies havent been around during previous trough periods, so you cant readily see how management performs under pressure. What I would suggest you do in those cases is hit the phones and start talking to them. Probe around about their pervious jobs and what kinds of things they did during periods like this and then try to gauge how well they answered those questions.

A number of value investors are trying to look at these companies from a liquidation perspective. I think this is appropriate, but it really requires some digging on your part. There are a lot of factors that contribute to rig demand, certain older rigs are going to be less desirable than newer rigs. Certain rigs have less capabilities than others and become less competitive when rates come down and companies/contractors start squeezing for value.

So when you take a look, I would just caution that you need to make sure you are not comparing apples to oranges and are discounting appropriately. The other thing to keep in mind is that the prices of these drilling rigs will fluctuate as demand fluctuates. Rigs were likely sold at prices that were much higher than they are today. When doing your analysis, you need to make sure that you are taking that into account as well.

If any of you have some metrics for looking at drillers that havent been mentioned feel free to contribute them in the comments section or via e-mail.

ive been looking at drillers recently and i dont (and would like to) understand the CAPEX dimension of the metrics. the real manteinance capex for drillers, im in doubt fi the real mcapex is that reported separatedly in some cos reports (NE for example), from the mcapex in investing cashflows, maybe we need to add current amortization of previous capitalized mcapex and consider some upgrades just necesary to stay competitive. maybe knowing more in depth the industry would be helpful in this.

what are your thoughts on capex and mcapex?

www.StreetCapitalist.com Tariq

Emiliano, sorry for not responding to that Q via twitter, I did see it but got caught up in some things.

I think capex is something highly variable and so you have to look at it from two extremes. Either you want a big player, with plenty of operations globally to offset a slowdown here, who will have access to capital and resources to weather a downturn. Or you want one that is small enough for you to literally model rig-by-rig with different capex assumptions.

I am doing the latter with one drilling rig operator and plan on speaking to their management to get a better feel for capex. For the smaller companies in particular, capex will fluctuate based on the rig, But you can run a sensitivity analysis to see how different changes affect the company.

For NE, ESV, and others, I like to look at cash flows on a mid-cycle basis and then try to figure out what capex will be. You make a good point about whether maint capex is accurate or not. I think this is highly variable from company to company because it depends on the rigs, the type, their age, etc.

Its a situation where you need to work backwards and see how much they spend on upgrades and then what types of rigs those are tied to. That way you can start making some conservative aggregate assumptions on maint. capex for the entire company.

Id basically ask the same kind of question(s) to every IR/management team in the industry to really get a feel for how they look at capital spending in spite of the cyclical nature of the biz.

About Me

My name is Tariq Ali, I run Street Capitalist. I recently graduated from the University of Texas at Austin. There, I stumbled onto value investing via the school library. I read everything I could and now I’m here, writing out my thoughts and investment ideas.