Asset valuations that are more about perception than reality are holding up recovery in the drilling sector, writes Gregory Brown, associate director at Maritime Strategies International.
The offshore drilling market is ripe for consolidation. The sector continues to face challenges managing an oversupplied, highly competitive market combined with overleveraged balance sheets, weak liquidity and stressed financials.
The sector cannot be held completely to blame of course. M&A activity across the offshore segments stalled in 2020 as COVID-19 swept across the world. Over the course of the year less than 260 deals were completed across upstream, midstream, downstream and OFS – the lowest total in more than a decade.
Amongst the key sectors, oilfield services (OFS) activity was the most acutely impacted. There were around 71 deals worth $21bn in 2019, and 61 deals worth $19bn in 2018. In 2020, just 28 OFS deals were completed, worth just $1.9bn. Only two deals were valued in excess of $400mn, both in the onshore market.
The weakness in the OFS sector reflected extremely poor fundamentals that saw both onshore and offshore sectors report sharp declines and a lack of interest from the financial community grappling with poor performance of existing portfolios. The sector remains faced with substantial increases in expected credit losses and a significant decrease in mark to market valuations which could trigger a wave of write-offs.
The asset-heavy, overleveraged offshore drilling sector is a key driver here. Noble, Valaris, Diamond Offshore, Shelf and Transocean took combined write-downs of ~$5.5bn in early parts of 2020 alone, based on lower earnings expectations and book value adjustments to scrap value for whole generations of rigs.
Since then the market has entered into the early stages of a recovery. Tendering is picking up, contracts are being signed and leading edge rates are ticking higher. A market in a gradual growth mode, destined to be smaller than in the recent past, still with over-capacity in many areas and a focus on returns on invested capital is one that begs for consolidation.
Stock not cash and a slice of humble pie
Consolidation in the space looks more possible and far more necessary with each passing year. Analysts have long called for it and the sector has responded with a stubborn refusal. Discussions take place, but deals rarely come to fruition, almost always getting hung on valuations and the view that “our stock is grossly undervalued and doesn’t at all reflect the capital we have invested over the past several years.”
That statement could be applied to about 80-90% of the world’s public OFS companies, as well as the private sector. It has to give way to the broader reality of the need to consolidate.
To get deals over the line, the OFS sector could learn from Upstream E&P where M&A activity is already brisk. Around $52 bn of deals were done in the US oil sector last year. Chevron purchased Noble Energy for $13bn including debt in July, ConocoPhillips bought Concho Resources in a deal worth around $9.7bn. Devon Energy merged with WPX Energy in a $12 bn deal. Heavy debt, battered balance sheets and weak equity valuations meant that stocks, not cash, were the currency in each deal.
Stock-for-stock at market value has been the winning recipe for the recent spate of E&P deals, the majority of which are considered positive and should be replicated in OFS – the drilling sector included.
After several high-profile drilling acquisitions in 2018 and 2019 – including Transocean’s $3.4bn purchase of Songa, and the Ensco-Rowan merger, appetite for further consolidation was obliterated by the 2020 downturn, which also accelerated liquidity concerns and drove five owners into Chapter 11.
Out of their collapse, we now see a brief opportunity for the sector to rationalise and enable structural change.
Pacific Drilling, Noble Corp, Valaris, Diamond Offshore and Seadrill Partners have now all exited Chapter 11 with clean balance sheets and limited near-term repayment commitments.
The newly-cleansed sector has already seen some much-needed consolidation when Noble Corp and Pacific Drilling announced their merger in March. The all-stock deal completed in April, and Noble now owns 24 rigs – 11 drillships, 12 jack-ups and one semi-sub.
Cherry picking beats can-kicking
There are two alternatives to corporate consolidation. One is to do nothing and to kick the can down the road, hoping that an improvement in market fundamentals will drive a recovery in utilisation, earnings and values. The sector and its financial sponsors have tried this in the past and is now counting the cost with around $23bn of debt was written off or restructured in 2020 alone.
The other alternative, and one that may prove to be attractive, is to cherry pick assets that are stuck in more complicated bankruptcy proceedings. Acquisitive companies could take advantage of distressed values to acquire high quality tonnage at generational-trough prices.
Having entered Chapter 11 in February, Seadrill remains in bankruptcy protection as its debtors have not been able to come to an agreement on the restructuring of its ~$7.3bn debt. Reuters reported in April that Seadrill had asked its creditors to write off more than 85% of debts in exchange for a 99% stake in the reorganised company. The process is ongoing as of July.
With Seadrill’s liquidity in short supply, it was reported in May that Noble Corp had submitted an offer to acquire “a substantial portion of Seadrill’s assets” but not the entire business. Noble’s bid was followed by a similar bid from a Transocean-led group including Dolphin Drilling and a third, undisclosed partner. The assets refer to parts of the Seadrill’s fleet which includes seven drillships, 12 semi-submersible rigs and 15 jack-up rigs.
Bringing at least a portion of those assets into the hands of a well capitalized player may be beneficial to the overall market. Noble could choose to retire some of its older drillships, or its jack-ups, also helping the supply/demand balance. Seadrill’s rigs are high quality; there may be a cherry picking opportunity if the creditors find themselves unable to coalesce around a resolution.