Diamond Offshore: Further Discussion Of Q4 Results
We continue to discuss Diamond Offshore's Q4 results.
This time we focus on key parts of the earnings call.
Also, we discuss the company's premium valuation.
My recent article on Diamond Offshore’s (DO) Q4 results sparked a lively discussion, and the stock has also been quite volatile on the earnings day. There are many moving parts involved in this story so it worth taking another look.
First of all, let’s return to “well-based contracts” indicated for Ocean Valiant and Ocean Monarch. Readers argued that it was not any kind of a performance-based model but rather contracts for the duration of the well which are putting more risk on the drilling company and, therefore, indicative of a driller in dire straits. I promised to read the conference call carefully and to return to this topic.
I must admit that the company did not shed much light on the actual composition of these contracts. However, it indicated the following for the contract of Ocean Valiant: “Not only were we able to keep the rig on contract, but also the extension was awarded at a premium to the already solid dayrate”. On another rig on a well-based contract, Ocean Monarch, Diamond Offshore’s management provided clarity on where the contract with Origin Energy, which was indicated in the October 2017 fleet status report, has gone. It turned out that Origin Energy sold assets in the Bass Strait to Beach Energy, which reviewed their newly acquired acreage and elected to delay the drilling campaign. The fact that Diamond Offshore was able to immediately replace the contract highlights the fact that the company has a solid position in Australia.
Moving on to other important parts of the story. Diamond Offshore shared its views in the general health of the offshore drilling market. The company sees an increasingly tight market for moored rigs, as highlighted by its own contracts. With this in mind, Diamond Offshore will likely be reactivating Ocean Endeavor, a semi-sub which is currently stacked in Italy. In connection with this reactivation, Diamond Offshore will be accelerating the five-year special survey on the rig. Should these plans be translated into reality, it would be a major move from the company.
Previously, Diamond Offshore stated that reactivating a cold stacked rig will cost anywhere in the $50 million - $100 million range. The mid-point of this range is $75 million, a very significant sum of money which demands the rig having a multi-year initial contract and clear perspectives for follow-on work. Besides Ocean Endeavor, semi-sub Ocean Onyx may also be reactivated, although Ocean Endeavor is clearly the first in queue.
Meanwhile, Diamond Offshore continues to see the 6th-gen floater segment as heavily oversupplied with recovery being over the horizon. In my opinion, this more or less ends the speculation of Diamond Offshore buying Ocean Rig (ORIG) or Pacific Drilling (OTCPK: OTCPK:PACDQ). Diamond Offshore is optimistic on the recovery in the 2021 – 2025 timeframe. However, 2021 is three years away from now, so buying rigs, many of which have already been stacked, and stacking them for three more years does not make practical sense.
The company’s management also commented on the floating factory idea. Back in September 2017, there was a rumor that Diamond Offshore ordered the floating factory in China. Here’s the latest update from the company: “The floating factory would take a 4-year build. We obviously have the design complete. We have been in negotiations with vendors in the shipyards, but we have not pulled any triggers as it relates to what decisions we are going to make moving forward”.
So, from a near-term perspective, Diamond Offshore will be contributing cash to reactivation of Ocean Endeavor and possibly Ocean Onyx without major moves on the asset purchase or floating factory fronts. For longer-term holders of Diamond Offshore’s stock this is likely good news, as the company remains extremely conservative and has not intention to gamble and increase risk to principal. Judging by share price performance, the market loves this conservatism as opposed to Ensco (ESV), which is continuously punished for its acquisition of Atwood Oceanics. If Diamond Offshore is right in assuming that there’ll be a lot of offshore drilling work available starting in 2021, it will be in time to re-contract drillships Ocean BlackHornet, Ocean Blackrhino and OceanLion, whose current contracts end in February-April 2020.
Another interesting topic that was raised during the conference call was Diamond Offshore’s statement that some recent contract fixtures in the Gulf of Mexico were at a dayrate below the cash breakeven level. My best guess is that this comment is related to Transocean’s (RIG) Discoverer India, a drillship that reportedly got a contract with an undisclosed client at an undisclosed rate. Discoverer India has been idled since December 2016 as per the latest Transocean’s fleet status report.
MarineTraffic indicates that the rig is currently in the Gulf of Mexico. If this is the case, then drillers with drillship presence in the Gulf of Mexico like Rowan (RDC) or Noble Corp. (NE) will have trouble finding work in the region. Both companies seem to be reluctant to committing their Gulf of Mexico drillships to below-breakeven dayrates. Also, such news does not play well for a Gulf of Mexico – oriented offshore support vessel provider Hornbeck Offshore (HOS) (I wrote about Hornbeck's survival chances here and about Q4 report here).
Now let’s get from conference call commentary to the discussion of Diamond Offshore’s stock.
It has been many times argued that Diamond Offshore is overbought in comparison with its peers and should trade lower. While acknowledging that Diamond Offshore trades at a premium, this premium is supported by several catalysts. The first catalyst is the company’s solid balance sheet and very easy maturity schedule. The main shareholder is Loews (L), which owns approximately 53% of outstanding shares.
Given these factors, investors have no doubt that Diamond Offshore will surely survive the current downturn. This “sleep well at night” factor demands a premium. The second important catalyst is the quality of the company’s management team, which has been brutally honest with the company’s investors regarding the severity of the current market downturn.
The team’s conservatism has been a major bullish factor for Diamond Offshore. Last but not least, Diamond Offshore has a good fleet. All four modern drillships are on long-term contracts and will be the first in line for contract renewal near 2020, when activity is expected to pick up. Also, the company has solid presence in the North Sea and Australia, as highlighted by recent contract awards. Yes, the fleet clearly needs new blood, but it’s important to ensure that the new rigs to not put a burden on the company. Despite better oil prices, the offshore drilling market environment is challenging, and many segments will have to wait more before improvements are seen.
With this in mind, I expect Diamond Offshore’s shares to trade in a wide range this year, following oil prices and swings in market sentiment. Current state of the offshore drilling market hardly supports sustainable upside above $20/sh, while the company’s strengths will provide support if the stock drifts closer to $10/sh. The $15/sh that we currently see looks normal if we take the value of the company’s fleet ($1.8 billion - $2 billion by my estimates), cash on hand, backlog and impose a premium to reflect the company’s strengths and its leading status. However, this does not mean that we won’t see Diamond Offshore’s shares at $20 or $10 again. Long-term, and I speak about the next decade, I’m optimistic on Diamond Offshore’s perspectives. Short-term, I expect significant volatility and plan to act accordingly.
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Disclosure: I am/we are long DO, RIG, NE, RDC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I may trade any of the above-mentioned stocks.
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