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Measuring the Double-Edged Sword of High Leverage in Offshore Drilling

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Leverage in offshore drilling

The term “leverage” refers the use of fixed costs. These fixed costs may be fixed operating expenses, such as salaries, leases, and rent or fixed financing costs, which include interest payments on debt. High leverage can be either good or bad, depending upon the revenues of the company in question. In good times, when revenues are high, fixed costs are distributed among greater units, which increases the marginal profitability of the company.

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The negative side of leverage is seen in bad times when revenues are low and costs relatively remain the same. This drastically decreases a company’s profitability. In this sense, leverage can act as a double-edged sword in that it increases the company’s riskiness while at the same time magnifying its potential returns.

Capital-intensive industries

Offshore drilling, like other upstream oil companies (XLE), is a capital-intensive industry, and this is due to the enormous costs of offshore drilling rigs. Rigs can cost between $200 million and $600 million, depending on the type and specifications of the rig. To meet these high capital requirements, offshore drilling companies take on a lot of debt.

In 2014, the industry average debt-to-equity ratio for offshore drilling companies was about 70%, which represents a high level of debt in the very capital structure of these companies. The average industry ratio is calculated by taking the average of the following companies:

Increasing financial leverage

As the above graph shows, debt levels in the offshore drilling industry have been consistently increasing. Rig costs over the years have shot up due to high demand, technological advances, and increasing steel prices, and higher debt levels translate into higher fixed financial costs or interest costs. These higher debt levels also increase the riskiness of the companies and have an impact on their debt ratings.

Now let’s take a look at specific ETFs with exposure to major offshore drilling companies.

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