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Cyclical Low for Jack-Up Rigs?

George C. Fisher

I love cycles. I love investing in companies that are in cyclical and commodity businesses. I especially get excited when commodity and cyclical forces are reflective of decade lows. As I am a believer in the law of averages, and the reversion to the mean and average over time, ebbs in specific businesses may signal a long-term opportunity for investors seeking overlooked and potentially out of favor industries.

For example, investors in energy stocks when oil was selling at a decade low of $12 a barrel in 1998 could have realized a multi-fold gain. Timber and lumber prices were trading at 10-year lows in 2000, but have rebounded substantially since. Equity prices for timber companies have generated more than acceptable returns over the past four years. Bond prices sank in 2000 and 2001 as the Federal Reserve raised interest rates, providing astute investors with a cyclical low. Of all places, the current contract jack-up oil rig market may be one of these cyclical opportunities.

I have been getting a lot of questions recently concerning investing in oil and natural gas companies. I find it difficult to invest in a company when their product is controlled by market forces and those forces are at all-time highs. However, the current state of the contract jack-up oil exploration rig business seems to warrant investor attention. As potentially more volatile than major integrated, international oil companies, it is important that each investor conducts his/her own due diligence for this industry and its players.

Exploration and production (E&P) companies own land or oil rights for prospective oil and natural gas deposits. Offshore oil deposits rate as a leading opportunity to increase oil production worldwide. One of the richest deposits of offshore oil and gas is the Continental Shelf, encompassing the US Gulf of Mexico, the Caribbean and northern South America. The other major offshore oil areas are West Africa, the North Sea, Southeast Asia and the Middle East. Many times, E&P companies hire a drilling contractor to drill a series of offshore exploration wells in a specific location. As it is more expensive and capital intensive than on-land drilling, most large oil companies will contract for offshore exploration drilling services, and there are several companies specializing in this field.

According to a study published by Smith Barney in 2000, the offshore drilling markets appear to follow a historical 4 to 5 year cycle. The drilling cycle reflects the cyclical pattern in oil prices and exploration budgets of E&P companies. As a direct result of higher commodity prices, large integrated oil companies have raised their exploration budgets over the past few years, after slashing the same budgets in the late 1990s.

The Offshore International Newsletter reported that discovery and development costs for offshore reservoirs have fallen over the past 20 years. Due to technological advances, such as directional drilling, anchorless positioning systems for drill rigs, and improved seismic geological surveys, offshore discovery costs have fallen from $15.00 a barrel in the mid-1980s to $7.50 in 2000. According to the Newsletter, "At $7.50 per barrel cost, the crude oil threshold price for offshore exploration and development is about $14 per barrel." The profit threshold for offshore production is substantially below current long-term estimates for commodity oil prices.

The most often used drilling rig for offshore exploration is a jack-up rig. This is usually a triangular shaped vessel with three long legs and a drilling rig on top. The jack-up rig is towed to a specific location and the legs are "jacked up and down" using huge motors. When the legs touch the sea bottom, the vessel and drilling rig are moved up the legs and out of the water. Upon completion of the exploratory well, the vessel is refloated and towed to the next location. After confirming the existence of commercially viable resources, the E&P company will construct a permanent production platform at the site.

Jack-up rig operators charge their clients by the day for their services. The prices charged by operators are directly related to the demand for offshore oil exploration and the availability of rigs: a simple supply and demand equation. High oil prices and profits drive demand and availability of rigs drive supply. As with most businesses, high demand and short supply generate higher profits while low demand and oversupply will generate problematic levels of profits. The oil rig business is no different.

As of Jan, 2004, there is a worldwide availability of 387 jack-up drilling rigs, and 116, or 30% of the total, are located in the US Gulf of Mexico. Of these 116 rigs in the Gulf, 86 were contracted, and 20 sat idle. When reviewed over the past 25 years, demand for rigs in the Gulf of Mexico is at historic lows. Cyclical lows in contracted rigs bottomed at around 90 in 1980, 100 in 1984, 50 in 1986, 85 in 1989, 50 in 1992, 85 in 1999 and 85 in 2002. Contracted rigs cycles peaked at about 130 in 1983, 160 in 1985, 120 in 1988, 130 in 1990, 130 in 1997-98, and 140 in 2001.

In March, 2004, the CEO of a leading oil and gas drilling services company wrote in a letter to shareholders, "With the exception of the cyclical lows experienced in 1986 when the price of oil fell to $8-10 a barrel and in 1992 when gas prices dropped below $1 per mcf, demand has never been as low and flat as it has been for the past 24 months. Jack-up rig supply is close to a 20 year low and could decrease even further." The last time demand was this soft was briefly in 1999, when oil prices again touched $10.

I believe it will take a combination of three events to create additional long-term demand for offshore drilling services. These include an improving worldwide economy that will keep general oil demand rising; major oil and gas companies need to sell potential offshore reserves to smaller firms more willing to commit to exploration; and sustained oil prices at or above the $25 level that will drive exploration budgets higher.

According to a November 2004 report from Merrill Lynch, “Most oil and gas companies do not expect oil and gas prices to remain at current levels, and are basing their capital spending plans on lower prices in 2005 than have been realized in 2004. In our view, the fundamental outlook for continued expansion in oilfield activity is unlikely to be impacted unless oil prices fall well below the mid-$30 per barrel and natural gas drops below our forecast of $5.25 per MMBtu for 2005. On a year-to-year basis, we've seen 7 consecutive quarters of declining oil and gas production worldwide for the integrated oil companies. With demand lifting oil prices, growth in worldwide upstream capital spending this year will be at least 10-12%. We're probably looking at more like 15% growth this year. Next year, we're certainly seeing 8-10%. Upstream spending this year will rise 13.8% outside North America and 6.8% in the US and Canada ".

In the face of potential rising demand, there are problems ahead in the Gulf of Mexico, said Danny McNease, chairman and CEO of Rowan Cos. Inc., an oil drilling firm. Drilling rigs are in short supply, and a spate of unexplored and non-producing oil lease expirations looms.

"One thing no one's paying any attention to is the fact that there are 1,280 leases going to expire by 2007," McNease said. “Companies paid as much as $4-12 million for some of those leases. Where will the rigs necessary to fulfill this requirement come from?" McNease asked. "There's not enough equipment out there,” he said.

McNease estimates 79% of jack up rigs in the global fleet are more than 20 years old, and that number will soar to 89% by 2007. It takes 2 years to build a jack up," he said. McNease commented that construction firms seem to be moving away from building jack-up rigs and are focused on building supertankers. "It's not easy to build a jack up." According to McNease, currently there are only 12 rigs under construction—9 jack ups and 3 semis.

With slow current demand, the potential for an up-tick in interest, and a shrinking supply, the offshore drilling business could be ripe for a rebound off a cyclical low. There is evidence that a turnaround may be near. Some offshore drilling services firms reported continued decline of utilization rates, from 90% in 2003 to 80% in 2004. However, offsetting lower utilization rates are substantially higher day rate revenues, some up as much as 45%.

There are four mid-size companies worth investor investigation, listed by size: Pride International (PDE), Global SantaFe (GSF), TODCO (THE), and Parker Drilling (PKD). As a group, these stocks have done very well, rising between 20% and 80% since Dec 2003. Fueling the climb in price has been a dramatic increase in earnings estimates. For example, TODCO, a recent spin-off from Transocean, has seen its 2005 earnings estimates increase from $0.12 to $0.30 a share, just since September. Pride and SantaFe offer diversified drilling activity, while TODCO and Parker are mainly jack-up rig contractors. Although next year’s fundamental valuations on these stocks is not exciting, I believe the long-term cycle is moving in their favor. As with most cycles, if the bottom has passed, or is passing, higher earnings and stock prices for companies in the jack-up oil rig business should lie ahead.

For disclosure purposes, I own a small position in both TODCO and Parker; and were initially purchased between January and June, 2004. I like the quality of TODCO’s management, and as a recent spin-off, is under-followed on Wall Street. In addition, it is a purer play on the jack-up rig business. Parker is a more speculative and controversial selection.

Oil related investments are ultimately tied to the cyclical nature of the commodity price of oil. If utilization rates and services fees continue to improve, the current count of offshore oil drilling rigs may have reached its low for this cycle.

George C. Fisher is a 30-year veteran in DSP/DRIP investing. He is author of All About DRIPs and DSPs (McGraw Hill, 2001) and The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002). Mr. Fisher is an avid dividend reinvestment advocate and utilizes the strategy with all dividend paying stocks, both at the broker and direct with the companies using their DRIP programs.

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