Ocean Rig (ORIG) is an offshore driller with EBITDA (earnings before interest, tax, depreciation, and amortization) set to more than double by 2015 as the company expands its fleet. As its newbuild program comes to an end, levered FCF will reverse from -$0.5 billion this year to more than +$0.5 billion. These cash flows are supported by long-term contracts with an average duration of three years (4.5 years including extensions). At its current market cap of $2.6 billion, you’re creating the company for less than 4x. This seems extremely cheap as a pure-play operator in the very attractive ultra-deepwater market, where supply and demand should remain balanced for the foreseeable future. To close the valuation gap, management will begin funding a dividend in 1Q14 and form an MLP in 2Q14. The only offshore driller that’s structured as an MLP (SDLP) trades for $1,350 million per rig compared to ORIG’s current valuation of $685 million per asset. ORIG’s also valued at a 10% discount to tangible book value, while peers with older fleets and much smaller revenue backlogs trade for 1.3x. I believe this stock could double over the next year from $20 to $40 as it’s rerated due to the lucrative MLP structure.
ORIG, an offshore drilling contractor, through its subsidiaries, provides oilfield services for offshore oil and gas exploration, development, and production drilling. It specializes in the ultra-deepwater and harsh-environment segment of the offshore drilling industry. As of March 22, 2013, it owned ten offshore ultra-deepwater drilling units comprising two ultra-deepwater semisubmersible drilling rigs and eight ultra deepwater drillships. ORIG primarily serves oil companies, integrated oil and gas companies, state-owned national oil companies, and independent oil and gas companies. The company is headquartered in Nicosia, Cyprus. Ocean Rig UDW Inc. is a subsidiary of DryShips Inc. (DRYS).
Positive outlook for the UDW market
ORIG has premium assets as one of two pure-play ultra-deepwater (or UDW) drillers. Each UDW rig costs $650 million and takes several years to complete, so building a fleet requires a large capital base and a significant amount of time. Today, the UDW global fleet consists of ~130 rigs, but only ~15 of these operate in the UDW (greater than 7,500 feet) while the rest are in the deepwater (4,500 to 7,499 feet) or midwater (less than 4,500 feet). (See the table above.)
E&P operators and consultants have published a range of estimates, but UDW production is expected to increase by roughly 4x by 2020. That implies another 45 UDW rigs will be needed. In addition, the average age of the 185 rigs making up the deepwater and midwater fleet is 30 years old (see the table above), which is approaching the useful life of these assets. Therefore, there could be demand for another 230 UDW rigs by 2020, which doesn’t include the impact of growth in the deepwater or midwater markets. This implies that another 33 will need to be delivered each year, but only a handful of shipyards are capable of producing this sophisticated equipment, and their annual capacity is only 30 rigs. Growing demand coupled with limited ability to quickly build supply has kept the UDW fleet operating at nearly 100% utilization since 2005, and I’d expect this to continue for the foreseeable future.
The Market Realist Take
According to Ocean Rig (ORIG), ultra-deepwater (UDW) exploration and development is and will remain attractive for oil companies. Ultra-deepwater drilling has an average breakeven cost of approximately $60 per barrel. The company believes that even at the upper range of UDW breakeven economics, offshore projects are viable and offshore drilling will remain the main contributor of the increase in the proven total reserves of oil majors. Brent pricing has largely remained around $100 a barrel over two years, and projections through 2018 indicate that it will remain significantly above the UDW breakeven levels going forward. ORIG is confident about maintaining a healthy supply and demand balance in the ultra-deepwater markets going forward.
Offshore services companies recently saw a strong earnings season, and most of the companies operating in this space reported profits that beat market expectations. By announcing dividends and MLPs, offshore drilling companies are taking steps to not only reduce the cost of capital but also simultaneously pursue growth. Ensco (ESV) and Transocean (RIG) have made dividend announcements, while Rowan Companies (RDC) revealed plans to propose a dividend during its 3Q 2013 earnings call. Ocean Rig and Transocean have made announcements to set up MLPs that will see an initial public offering in 2014. In October 2012, Seadrill (SDRL) spun off Seadrill Partners (SDLP), an MLP comprising drilling rigs. Seadrill said in its 2Q 2013 earnings announcement that the share price of Seadrill Partners has continued its positive development since the IPO in October of last year. It added that its share price values the drilling units in the MLP at a significant premium to Seadrill’s current valuation.
The unique structure of MLPs exempts them from paying corporate-level taxes and also enables them to pay out excess cash flow in the form of distributions (similar to dividends) to unitholders. MLPs have also attracted investors due to the high yields offered in the current low interest rate environment.
The increase in gas and oil discoveries in UDW will encourage rig demand, improving the prospects of companies operating in this space.