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Ensco: This Driller Is Where the Action Is

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When new drilling operations launch in this age of unconventional drilling, it pays to be at the front of the pack, like this driller.

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Contract driller Ensco (ESV) boasts a fleet of seven ultra-deepwater drillships, 20 semi-submersible rigs, and 49 premium jack-up rigs. The firm stands to thrive in the near term because it owns one of the youngest deepwater and ultra-deepwater fleets in the industry and has a number of deepwater and ultra-deepwater rigs available in 2012 and 2013.

In the wake of the 2010 Macondo oil spill in the US Gulf of Mexico, the market for deepwater rigs has bifurcated. Producers increasingly favor high-specification units that feature advanced equipment and are capable of drilling deep, complex wells. Each of these newer models is outfitted with an advanced blowout preventer (or BOP), a key piece of equipment that's designed to prevent spills when an operator loses control of a well.

The Deepwater Horizon's BOP failed to perform that function, resulting in a major oil spill in the Gulf of Mexico. Many speculate that the BOP wasn't strong enough to overcome the well pressure in that field.

In addition, younger rigs tend to experience less downtime - an issue that's plagued the world's largest offshore contract driller, Transocean (RIG). The company has incurred the expense and lost operating hours involved with upgrading its rigs to meet stricter safety standards. Rigs also must be recertified before they're allowed to work in the Gulf of Mexico and other markets, leading to further downtime.

Producers often pay a discounted day rate when a rig's idle time exceeds a predetermined threshold. In other cases, the operator can cancel a signed contract if the rig is unavailable for excessive periods.

For example, Transocean's 13-year-old Deepwater Expedition ultra-deepwater drillship had its contract canceled in January because of the rig's prolonged downtime. As a result, the firm lost out on a day rate of $630,000. With many of its rigs facing expensive upgrades, Transocean decided to suspend its dividend for the next year.

Ensco's average ultra-deepwater rig is only two years old, and its average deepwater unit is seven years old. By comparison, Transocean's average ultra-deepwater vessels are seven years old, while its deepwater rigs sport a mean age of 15 years.

Ensco's efforts to standardize its fleet also bode well for the company's success. Several manufacturers produce deepwater and ultra-deepwater rigs, so the parts aren't necessarily interchangeable between models.

In addition, each manufacturer has different maintenance schedules for its rigs. By standardizing the types of rigs it owns, Ensco ensures that its employees can operate more efficiently. Downtime for maintenace is also easier to schedule.

When an ultra-deepwater rigs earns upward of $600,000 daily, a few days of additional downtime across a sizeable fleet can impact the bottom line significantly. In Ensco's case, the company has built a fleet focused on the Ensco-8500 series of ultra-deepwater semi-submersibles and dynamically-positioned drillships built by Samsung Heavy Industries.

Currently, the firm has five operating Ensco-8500 rigs and a newly built unit that's slated for delivery in the fourth quarter of 2012. Ensco recently confirmed that Anadarko Petroleum (APC) has secured this new rig under a 2.5-year contract for a daily rate of $530,000. This is the third Ensco-8500 rig that Anadarko Petroleum has booked, a sign of a satisfied customer.

Ensco also owns a fleet of older mid-water rigs, floating rigs that are capable of drilling in water less than 2,000 feet deep, and jack-up rigs capable of operating in depths of 400 feet to 500 feet. The mid-water market remains under pressure because of a lack of exploration and development opportunities at that depth.

Nevertheless, some encouraging trends have emerged in this segment. Mexico's national oil company, PEMEX, has expressed interest in contracting additional mid-water rigs. At any rate, four of the Ensco's six mid-water floaters operate under fixtures that won't expire until 2013, so the company has limited near-term exposure to weak demand.

Day rates for jack-up rigs haven't strengthened to the same extent as in the deepwater market, but pricing trends have improved. Ensco has received inquiries for its premium jack-up rigs for North Sea work in 2013 and 2014 - a sign that producers are planning a longer-term shallow-water drilling program. Ensco's emphasis on high-specification jack-up rigs should provide more exposure to any upside.

Ensco currently pay a quarterly dividend of $0.375 per share, equivalent to a yield of about 2.7%. Given the company's strong contract coverage and exposure to rising day rates, the firm could have the scope to hike its dividend.

However, the stock's primary upside catalyst remains potential fixtures for the company's rigs that are available in 2012 and 2013. Ensco rates a buy under $60.

Editor's Note: This article was written by Elliott Gue of The Energy Strategist.

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