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Minyan Mailbag: Outlook for Drillers

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Offshore names...definitely economically sensitive...

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Professors Dingmann and Michael,

I just finished listening to Transocean's (RIG) 3Q conference call. To me, it seems that management is quite upbeat (I would be as well with a backlog that rivals your market cap!) and have indicated that demand for deepwater rigs should remain strong on a global basis well into 2011. Furthermore, the company has indicated that drillers should see "little to no impact" even if oil drops down to $35-40/barrel, which would be roughly a 35% drop from today's action.

My question - with a seemingly weakening economy and the rotation out of energy names in 3Q, regardless of the fluctuation in oil prices, should we expect the drillers (and RIG specifically) to reach their consensus price targets? Thomson currently shows a consensus price target just shy of $100, with RIG currently trading in the low $70's…


-Minyan Kevin


MK,

Though I agree with you regarding the rig spare capacity, keep in mind these two things: First, the correlation between RIG and the OSX is historically around 90% as RIG comprises 10% of the index…as such the two often move together. Also, any rig contract is only as good as the paper it is written on. So if we see a large economic slowdown, you would most likely see a number of contracts being broken. While I think the offshore names like RIG do have upside potential…they are definitely economically sensitive.

-Neal Dingmann


MK,

I would be careful equating an economic slowdown with softness typical in the shoulder months as they are two different possible causes of the recent decline in oil prices. It would take an actual economic contraction to affect the demand side negatively...nominal growth still means more oil. I will also note that oil demand can be 5-10% higher in the winter months as in the shoulder months. With supply/demand tight, slight changes can result in larger than expected moves (both ways).

The worldwide decline curve for oil is estimated to be between five and eight percent. So if we currently produce 85 million barrels, and don't drill another oil well, that production will be down to approximately four to six million barrels a year later. This requires constant continued drilling. For instance, Saudi has increased its rig count for oil rigs from 30 to 90. A 3x increase is HUGE and should tell you something – maybe we are seeing the "Twilight in the Desert." The easy oil has largely been drilled up, so now E&P companies must drill for the hard stuff. Drill more, get less…that's the way it works now.

While a five to eight percent decline rate sounds high for oil, it is over 30% for natural gas. If we get any sort of normal to cold winter, gas is going to be a big problem…much more so than oil. Considering approximately 80% of the wells that are drilled domestically are for natural gas, we are going to need more and more rigs just to keep production flat…which should keep the drillers busy for some time to come.

-Adam Michael
No positions in stocks mentioned.

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