The term driller is among the most overused and misunderstood in the energy patch. Some pundits seem to use the word to refer to exploration and production (E&P) firms that actually drill for and produce oil and/or natural gas. Others use drillers as an umbrella phrase, grouping oil services firms, oilfield equipment providers and contract drillers together as a single industry group.
But using general terms to describe a long list of stocks is a big mistake. All of the groups I mentioned above are governed by different fundamentals, and stocks levered to these industry groups donâ€™t move as a herd. If you overly generalize, you run the risk of missing out on the best plays or exposing yourself to undue risks.
Selectivity has been the key to maximizing your returns in the energy patch over the past five years, and I see no reason to believe that wonâ€™t be the case in the future as well.
The most correct use of the word drillers is to refer to a specific group of stocks involved in the contract drilling business. Contrary to popular belief, contract drillers donâ€™t produce one drop of oil or 1 cubic foot of natural gas. Instead, these firms own drilling rigs and lease those rigs out to producers in exchange for a daily fee known as a day-rate. Therefore, contract drillersâ€™ performance isnâ€™t directly levered to oil and natural gas prices; instead, these stocks are leveraged to global and regional drilling activity.
The most commonly quoted measure of drilling activity is the active rig count--the number of rigs actively drilling for oil or natural gas at any given time. A number of firms release data on the rig count but among the most commonly used is the rig count data released by service giant Baker Hughes. Hereâ€™s a chart of the global active rig count over the past two decades.
Source: Bloomberg, Baker Hughes
The trend on this chart is obvious. After remaining weak and stagnant for most of the 1990s, the global rig count has exploded to the upside since the early part of this decade. The rig count is now at significant new 20-year highs.
Indirectly, of course, commodity prices do affect drilling activity. The strong recovery in crude and natural gas prices since 2000 has prompted producers to accelerate their drilling activity, pushing the rig count higher.
However, itâ€™s worth noting that the correlation of the global rig count to commodity prices is less obvious on a week-to-week or quarter-to-quarter basis. For example, oil and gas prices were both weak toward the end of 2006; thereâ€™s little evidence of that weakness resulting in any meaningful pullback in the rig count over that time period.
All things being equal, a rising rig count is good for the contract drilling industry, suggesting strong demand for rigs. But you canâ€™t just look at the Baker Hughes figures and decide to buy a broad basket of drillers. Two other important factors to watch are geographical exposure and the types of rigs a particular company owns.
Before delving into a more detailed description of different types of drillers, itâ€™s worth illustrating the rewards of selectivity once again. Check out the chart below for a closer look.
Source: Bloomberg, The Energy Strategist
To create this chart, I evaluated the performance of the 12 pure-play contract drillers I cover in The Energy Strategist. The line labeled Overall Index is an equal-weighted index of all 12 drillers I cover. The index isnâ€™t weighted by market capitalization. Each stock counts equally towards index performance.
As the chart shows, this index is up a healthy 52 percent since the end of October 2005. On an annualized basis, thatâ€™s about 19 percent per year, significantly better than the S&P 500 over the same time period.
To create the other two indexes on the chart, I looked at the top three performers and the bottom three performers over this time period. As you can see, selectivity paid off. The best three drillers soared nearly 190 percent over the same period, while the worst three were actually down, losing money for investors.
Of course, I created these indexes with the benefit of hindsight. However, the point is still valid. By carefully choosing which driller to buy, you could have significantly outpaced the contract drillers as a whole.
The first point to consider in evaluating a driller is the type of rigs the firm owns. Broadly speaking, drilling rigs are the same. They include some sort of motor that turns a drill bit along with a host of drilling-related equipment. Typically, that equipment is mounted on some sort of platform that can be transported from location to location.
There are two basic types of rigs: onshore and offshore.
Onshore or land rigs are often designed to be moved by truck from one drilling location to another. Others can be carried by helicopter to reach more remote locations not served by roads. Land rigs are more common than offshore rigs. Out of the 3,417 rigs currently drilling worldwide, a total of 1,708 are land rigs located in the US alone.
Land rigs are also typically cheaper and faster to manufacture. During periods of rising commodity prices, manufacturers can build new land rigs more quickly than offshore rigs.
Itâ€™s also useful to think of the land drilling business regionally. North America is by far the most important single land rig market in sheer number terms. Land-based drilling activity in the US and Canada is dominated by smaller producers with relatively short-term drilling projects. Contract drillers often operate on a spot basis, leasing their rigs for short periods of time, or to drill a handful of wells.
This is behind the extreme volatility of the US and Canadian land rig count and the day-rates available for contract drillers. Because much North American drilling on land targets gas--not oil--changes in gas prices are an important factor in determining day-rates and profitability for land drillers. For example, weak gas prices for much of 2006 and 2007 caused many small producers to cancel projects; the number of land rigs sitting idle soared, putting downward pressure on day-rates.
In fact, exposure to the weak US market and ultra-weak Canadian drilling market was the main factor separating the best performers of the past two-and-a-half years from the worst performers.
Of course, itâ€™s not that simple. Not all land rigs are equivalent; for example, some rigs are capable of drilling deeper or performing more complex horizontal drilling projects. As noted in the most recent issue of The Energy Letter (see TEL, March 14, 2008, Oil Bull Market Uncovers Two New Opportunities), activity in unconventional reservoirs has been strong in recent years. Contract drillers owning these more capable land rigs have seen their day-rates hold up far better than average.
And the international market is a totally different story. Outside the US and Canada, drilling projects tend to be larger and rigs are booked under multi-year deals that guarantee attractive day-rates. Such projects typically arenâ€™t commodity sensitive.
Drilling plans are mapped out years in advance, and the economics of projects are determined assuming oil prices in the 40s. Most projects of the sort require more complex and capable land rigs. Many smaller drillers donâ€™t have the rigs in demand outside the Americas.
The worldâ€™s largest land driller, Nabors Industries, offers an interesting case study in the dichotomy between US and international rig markets. The companyâ€™s international business has been growing at rates close to 50 percent annualized even as the domestic business remained soft because of weak gas prices and drilling activity in North America.
Offshore drilling is an even more complex story. Itâ€™s useful to divide contract drillers into two camps: those focusing on floating rigs and those with a concentration on bottom-supported equipment.
The latter group consists mainly of operators owning jackup rigs. Jackups are simply platforms mounted on metal legs that rest on the seafloor. Theyâ€™re typically transported to drilling locations on barges. Such rigs are capable of drilling in waters up to a few hundred feet in depth. Jackups are generally harder to produce than land rigs. However, theyâ€™re easier and less expensive to manufacture than floaters.
Regional market exposure is also key in the jackup market. For example, day-rates for hiring jackups to work in markets such as Saudi Arabia or offshore Africa have been strong in recent years. Producers in these markets are willing to book rigs under multi-year deals at high rates; projects arenâ€™t sensitive to commodity prices. However, many of these international markets require advanced jackups capable of handling difficult weather conditions or drilling deeper wells.
Meanwhile, the shallow-water US Gulf of Mexico is a commodity market. Rigs are typically less capable and are leased under short-term deals. Day-rates in the region soared in 2005 and collapsed in 2006 and 2007.
An interesting point to note over the next few months will be the forward path of day-rates. A wave of new international-capable jackup rigs are scheduled to be released from shipyards over the next 18 months. There are some early signs that producers are starting to negotiate more on day-rates in anticipation of all that new supply. This could spell trouble for some internationally focused jackup providers.
Currently, the US Gulf is weak. However, the recent uptick in natural gas prices is likely to reaccelerate activity in the region. Meanwhile, rig supply in the region is shrinking at an alarming pace; rigs are deserting the region in favor of stronger international contracts. This could mean a rapid recovery in rates later this year.
The final market is for floaters--rigs that float on the oceanâ€™s surface. Usually theyâ€™re tethered to the ocean floor and dynamically positioned. Computers automatically fire thrusters to maintain the rig's position over the drilling location.
There are several different types of floaters. Semi-submersibles are rigs that can be partially submerged for stability. Drillships look like regular ships and are self-propelled.
Floaters are designed for drilling projects in deeper waters. There are several different classes of floating rigs. Ultra-deepwater rigs, for example, are capable of drilling to a depth of 10,000 feet. Rigs called mid-water floaters, in contrast, may only be capable of drilling to a depth of 5,000 feet.
Day-rates are higher for floaters than for jackups or land rigs. To put rates into context, a jackup in the Gulf of Mexico may receive a rate of $60,000 per day, while an international jackup may receive a rate around three times that level. Some deepwater floaters are earning rates of close to or more than $600,000 per day.
The deepwater drilling market is currently the tightest of all markets globally. There simply arenâ€™t enough rigs out there to handle all the projects proposed, and most drillers have booked their rigs at sky-high rates for years into the future.
Thereâ€™s also less regional bias in this market. The deepwater Gulf is red-hot right now. So are the offshore Brazilian and African markets I highlighted at some depth in March 14 issue of TEL.
A more important factor to evaluate when looking at deepwater contract drillers is contract coverage. In other words, you need to evaluate how many rigs a driller has uncontracted over the next few years. I prefer companies that have uncontracted rigs because such firms are most able to take advantage of the red-hot deepwater drilling market.