Name That Trade – $ESV Has Been Getting Drilled

by Enis September 26, 2014 10:20 am • Commentary

The offshore drilling sector has been absolutely decimated in the past 2 months.  RIG and ESV, the largest two of the group (aside from Seadrill in Europe) are both down more than 25% year-to-date, and down more than 20% in the past 2 months alone.

The overhang in the section has been a concern for the past years, as a result of an oversupply of rigs and less deepwater drilling demand since the BP indecent in the Gulf of Mexico in 2010.  However, the industry’s weak condition has been exacerbated by the recent fall in oil prices, reducing future rig demand and the heavy new rig supply coming on line over the next year.  This article from Sunday summed up the recent issues:

Noble Corp. (ticker: NE) recently gave offshore drilling investors some bad news when it provided its latest fleet update. While the company was able to get the Danny Adkins rig in the Gulf of Mexico signed to a new contract, that contract was for just $317,000 per day. This was well below its previous day rate of $498,000 and well below the just under $400,000 day rate analysts were expecting. Given that the high dividend payouts of offshore drilling companies like Noble Corp, Seadrill Ltd (SDRL), and Transocean Ltd (RIG) are funded by high dayrates, it certainly makes investors wonder if those dividends are in trouble.

Offshore drilling’s bad year could get worse

Prior to Noble Corp’s disappointing fleet update, Seadrill offered up its own bleak outlook for the next two years. The company’s CFO said that the offshore drilling market would be “bad” this year and “worse” next year before stabilizing. The issue is the fact that day rates for offshore drilling rigs have fallen sharply over the past 18 months as oil companies are cutting back spending because of weak profits. This is at a time when a number of new rigs are hitting the market, causing it to become oversupplied.

That being said, this is not the end of the world for offshore drilling contractors. Even after announcing a below-estimate day rate, Noble Corp. is expected to be very profitable over the next two years. In fact, one analyst sees the company earning $3.06 this year and $2.98 next year, which isn’t that far off from previous estimates of $3.16 and $3.27. Moreover, it’s plenty to cover the company’s $0.38 per share quarterly dividend. Further, offshore drilling companies now have a new option at their disposal to keep the dividend afloat.

The market is discounting a lot of bad news, as RIG, ESV, and NE are all trading at between 0.65 and 0.85x book value.  They all have dividend yields between 6% and 8%, which is also a sign that market participants likely expect a dividend cut over the next year.  In other words, investors think the companies still have to mark down the value of their assets (drill rigs) by a substantial amount compared to the current book value, and the sector is not due for a quick recovery.

It’s rare to see such large discounts when overall cash flow for a company is not in dire straits.  Investors seem to be implying a much lower long-term run rate for offshore rigs for the foreseeable future, and have adjusted the stocks’ valuations as a result.

ESV is probably the best of a bad bunch, though the stock is near a 2 year low nonetheless (NE is at a 5 year low and RIG is at a 10 year low), and within nearly 10% of a 3 year low:

ESV weekly chart, courtesy of Bloomberg
ESV weekly chart, courtesy of Bloomberg

Fundamentally, ESV has a higher quality fleet than its peers, a better balance sheet, and good geographic diversification.  For example, here is the breakdown of ESV’s drilling rigs from the most recent quarterly report (as the names imply, floaters rest on floating platforms while jackups rest on the ocean floor):  

Screen Shot 2014-09-25 at 8.38.03 AM

ESV is not significantly exposed to any one region, which is a positive given the different market dynamics in each area.  However, management acknowledged the overall supply concerns for offshore rigs as a whole:

The worldwide supply of floaters continues to increase as a result of newbuild construction programs. Currently, there are 84 newbuild drillships and semisubmersible rigs reported to be under construction, of which approximately 38 are without contracts. We estimate that fourteen rigs will be delivered before the end of 2014, the majority of which are uncontracted. Utilization and day rates will likely continue to be negatively impacted, particularly for less capable floaters.

At the end of the day, even if management has done a better job than the competition, the company is still an offshore drilling rig business, so it is getting hurt along with the sector as a whole.  The one positive is that ESV has more flexibility to take advantage of possible opportunities if the industry washes out over the next year.  Of course, as we’ve seen with the global shipping industry, sometimes the washout takes many years.

At this juncture, while the stock looks cheap, we don’t want to catch a falling knife.  The valuation is starting to price in quite a bad scenario, so we’d be surprised to see the stock fall more than 20% below current levels, unless oil prices tumble from here.  But that’s still a steep drop, and this type of aggressive selling usually leads to a longer-term basing process before a stock can really turn around.  With that in mind, here is one trade structure that looked interesting for those with a long-term timeframe (and no desire to buy stock here):

NOTE:  We have no plans to execute this trade for now.

Hypothetical Trade:  ESV ($41.70)  Trade the Jan16 35/45 risk reversal for a $0.50 credit

-Sell to Open 1 Jan16 35 Put at $3.20

-Buy to Open 1 Jan16 45 Call for $2.70

Break-Even on Jan16 expiration:

Profits:  Between 35 and 45, collect the $0.50 credit.  Above 45, also profit 1 for 1 with the stock

Losses: Below 34.50, lose 1 for 1 with the stock

Trade Rationale:  This risk reversal will act like a long stock position, gaining value as ESV rises, and losing value as ESV falls.  The positive aspect of the trade is that you don’t participate in downside until $34.50, which is nearly 20% below the stock’s current level.  The negative aspect compared to simply buying ESV here is that you don’t participate in upside until $45, not including the $0.50 credit.  In addition, you don’t receive ESV dividends, which are 0.75 per quarter at the moment, though the options structure is a net credit because the options are pricing in the effect from the dividends.

This is a long-term position for those who want a less risky way to get involved in ESV rather than simply owning the stock.