AWLCF - Awilco Drilling

[shhughes1116]

So I have been thinking about the recent weakness in Awilco, as well as the other contract drilling companies (i.e. Transocean, SeaDrill, Diamond Offshore).  There is nothing like a period of weakness to re-examine the thesis for holding a stake in a particular company.

 

When establishing my original position in Awilco, my thesis was based on two key points:

 

1. Operators are shrewd capital allocators committed to returning cash flow to investors.  Just as important, operators are unlikely to engage in activities that will destroy shareholder value (i.e. purchase of new builds at the top of the rig cycle).  I don't think anything has changed with this one.  The more I think about this company and the operators, the more I think that this transaction (purchasing two rigs from transocean) was a one-off transaction.  They have no intention of becoming a big player in contract drilling (or even a medium-sized player), the original transaction just happened to be such a good deal that there was no reason not to enter the business.  It reminds me a bit of Warren Buffet's purchase of a farm in the Midwest and a building in NYC...he has no desire to become an expert/large-scale farmer or property owner...these were such good deals that it didn't take an expert to realize the value from the purchase. 

 

2.  The harsh North Sea environment, coupled with stringent regulations in the UK, create a niche drilling market with high barriers to entry.  I think this part of the thesis is still intact, and is generally misunderstood by the market, hence the recent weakness in Awilco along with the rest of the contract drilling market.  In general, there are two types of rigs that can enter the UK's North Sea market: (1) New rigs built to UK North Sea specs; and (2) Existing rigs operating elsewhere in the world (jackups, mid-water, and deep water rigs). 

 

We know that there is reasonable equilibrium in the UK North Sea market, and although day rates might come under pressure as some of the new builds arrive in the UK North Sea market over the next three years, I have trouble imagining a scenario where this influx causes a collapse (or substantial decline in day rates).  Moreover, we are probably at the top of the rig cycle right now, so additional orders for new builds (beyond what is already under construction and/or scheduled for delivery) that are built to UK North Sea specs are likely to slow down or stop for a while. 

 

With respect to existing rigs operating outside of the UK North Sea area, I think the barriers to entry are higher than Awilco is given credit for by the market.  I think about it in this manner: 

A) A rig must relocate to the North Sea area.  This is a time-consuming process, an expensive process (fuel, tugs, personnel), and the rigs are obviously unpaid during that period.  Relocation is a substantial opportunity cost for a rig operator, especially one that must make debt service payments, and especially with a rig that might not be designed for the harsh sea environmental or able to be certified to the UK North Sea area.  Would a drilling rig owner be more likely to roll the dice on relocating to the North Sea area (with a rig that may never be certified to operate in the North Sea area), or take a substantial cut in day rates to continue operating in the same location?     

B) Once getting to the North Sea area, the rigs must be taken to the ship yard to be upgraded for the harsh sea environment.  This is also a time-consuming process, and an expensive process as evident by the cost to upgrade Awilco's rigs.  Again, substantial opportunity cost for a rig operator as the rig sits in the ship yard, along with substantial capex costs to upgrade the rig.  And in all likelihood, the oil majors and independents are not going to sign a contract with a company until a rig is upgraded AND certified to operate in the harsh environment. 

C) After being upgraded, the rigs must be certified by the UK government to operate in the North Sea.  Again, more opportunity cost here as the rig goes through the process of being certified to operate in the North Sea environment.  (Admittedly I know very little about this certification aspect other than what folks have written on the web).     

 

In light of A, B, and C, the question to ask is whether the higher day rates in the North Sea compensate a contract driller for the opportunity cost associated relocating a midwater rig to the North Sea area.  I do not think that the delta in day rates between North Sea and ex-North Sea is big enough to incentivize a migration of rigs to the North Sea area.   

 

In general, I view the bigger issue for Awilco to be oil prices rather than increased supply of midwater rigs in the UK North Sea Market.  Assuming oil prices do not crater, there is bound to be some level of continued oil drilling in the North Sea area.  More importantly, there is a substantial amount of decommissioning work to do in the UK North Sea area. Although I can not independently verify the numbers provided in the link (http://www.offshoreenergytoday.com/decommissioning-north-sea-platforms-to-cost-66-3-b/), the author suggests that there is $66 billion dollars of decommissioning work to be completed over the next 25 years (2.64 billion dollars per year).  Assuming that the primary cost of decommissioning is the rig's day rate, $2.64 billion dollars provides enough money to keep 20 rigs operating during the year at a $350,000 day rate.  Compare this with the fact that there are currently 22 rigs operating in the UK North Sea area, and another 2 that are cold-stacked.   

 

Thoughts?  Have I lost my mind?

 

[siddharth18]

@shhughes1116: Great first post! I don't have much to add, and at the risk of succumbing to confirmation bias, I have to say I agree with what you wrote. I still feel as though I'm not as informed on the fundamentals (macro-wise) as say, someone who has studied other drilling companies and been through multiple bull/bear cycles.

 

As I understand it, the decommissioning work will have to continue regardless of the oil prices going forward - is this correct? And with new BOPs these rigs will become even more competitive going forward, correct?

 

It's absurd to think how the sentiment was, when the PPS was 24-26 and how a "perfect-storm" of events (negative comments from seadrill, dollar strengthening/NOK weakening, soft oil prices, scotland vote, insider sell) yanked the price from $25 to $16 so quickly...

 

 

At this point, I'm guessing the weak hands have sold off and a lot of bargain buying has supported the PPS in the last few weeks.

[handycap5]

i have not found the drillers attractive, even though the prices of their common stock has dropped. i find these types of investments attractive when there is a clear asymmetry to it working out or not, which i do not find in this case. the softening of the day rates is driven by an onset of (long-lived) supply, of which the E&P companies are taking advantage by (rationally) delaying capex spending as prices soften. this will run its course. but what if the commodity price dropped in addition? there is still further to fall if the activity levels dropped.

 

do you really believe that a material price difference can be maintained between the UK North Sea and other basins? if i were contracting for drilling, simply the "sentiment" of getting deals in other basins would prevent me from signing a contract without similar price downs in the North Sea. "rationale" micro-economic analysis is one thing, but i would not be surprised if soft prices bled into UK north sea market on sentiment alone. remember, this is a high fixed cost, commodity product and you don't want to be left without a chair when the music stops if you are a rig owner. who will blink first at the negotiating table? decommissioning projects are not ones for which you feel you need to pay-up. prices in this market can swing wildly, i would not be surprised if the next swing is down for a while.

 

but i welcome comments from those who think i will be proven wrong with time...

[NoCalledStrikes]

 

In light of A, B, and C, the question to ask is whether the higher day rates in the North Sea compensate a contract driller for the opportunity cost associated relocating a midwater rig to the North Sea area.  I do not think that the delta in day rates between North Sea and ex-North Sea is big enough to incentivize a migration of rigs to the North Sea area.   

 

 

The barriers to the UK market can sometimes be a double edge sword.  Yes, moving a platform from one basin to another takes time, and the UK environment makes retrofitting/re-certification take longer too, but given the offer of a long enough contract by a North Sea operator, a drilling company will eat the cost and make the move and then once inside the basin, they are likely to stay for longer than we want them too:(

 

 

Drilling is a cyclical business. Always has been, always will be.  The question is where are we on the cycle.

[shhughes1116]

Your post seems to imply that a major or independent oil company would be willing to sign a contract for an existing ex-North Sea rig before that rig has been certified to operate in the harsh environment of the UK North Sea. 

 

My second thesis point really boils down to this.  Major and independent oil companies operating in the North Sea are unlikely to sign a contract for an existing ex-North Sea rig that has not been certified to operate in the UK North Sea.  As such, the opportunity cost of moving an ex-North Sea rig to the UK North Sea, without a contract already in place, exceeds the marginal benefit derived from the delta in North Sea day rates versus ex-North Sea day rates.  Therefore the rig owner is more likely to settle for the certainty of a lower day rate in the ex-North Sea market than the uncertainty of moving to the UK North Sea market accompanied by the associated/required capex investment.

 

I realize that in practice, the rig operators do not always act rationally in the short-term, hence the deluge of new builds expected to arrive all around the world in the next couple of years.  However, if my rationale described in the second paragraph is incorrect, than we would have expected to see a substantial increase in operating rigs in the North Sea following the explosion in day rates in 2006.  However, based on Awilco's most recent quarterly report presentation (page 14), the number of operating rigs remained relatively stable even as day rates remained elevated, with a slight increase in 2010-2011.  if moving existing rigs between ex-North Sea and North Sea to arbitrage the difference in day rates was a feasible endeavor, then there should have been a more rapid increase in rigs operating in the North Sea area shortly after day rates exploded higher in 2006.  Instead, it took almost five years for the supply of rigs to change direction, which seems to indicate that the supply of North Sea rigs is constrained to existing rigs already operating in the UK North Sea and new builds that are constructed specifically for the UK North Sea area.         

 

 

 

[NoCalledStrikes]

I agree that its not an easy arbitrage, but it does happen.  In Awilco's Q3 2011 PDF, they show 19 rigs working in the UK sector of the North Sea, but in the Q2 2014 report, they show 24.   

 

 

 

 

 

 

 

[matts]

http://seekingalpha.com/article/2531035-latest-rig-market-developments-bad-news-for-north-sea-drillers

 

[shhughes1116]

Amazing how fast the pendulum swings from irrational exuberance to absolute pessimism.  With respect to Awilco, I'm a bit surprised by the dramatic drop, although I guess that is to be expected when there is an expected glut in the rig supply compounded with an irrational fear that offshore drilling is going to slow down considerably.  The market seems to be pricing in an absolute collapse in days rates, or that the Awilco rigs will not operate for the remainder of their useful life (i.e. Through 2031). 

 

 

[siddharth18]

http://www.heraldscotland.com/business/markets-economy/oil-asset-decommissioning-worth-30bn.25551907

[NoCalledStrikes]

If you think the Wilhunter renewal rates will be close to current rates, then AWLCF is a bargain, and you need to be buying.

 

However, I think its important to remember that AWilco's cost are mostly fixed, so its dividends are highly leveraged to the day rates.  I worked out some really rough calculations a couple weeks ago http://nocalledstrikes.com/2014/09/23/all-models-are-wrong-but-some-are-useful-awlcf/  that highlight just how significant this leverage is.  A daily rate cut of 30% translates to about a 50% cut in dividends.

 

My best guess is that the most likely outcome is that rates only get cut slightly (10-15%) making today's prices attractive, but the other outcomes cannot be ignored. The oil business is cyclical, always has been, and always will be , so a return to pre-2010 rates cannot be excluded and that would just devastate the stock.  I used to think 15% yield was a fair price for Awilco to compensate for risk of extended rig downtime and to compensate for the fixed life of the asset.  But, now I think 18-20% is probably a better target to compensate for the inevitable down cycles in the business. 

 

I still own some Awilco, but I am no longer interested in being overweight Awilco. I am likely to defer new purchases until the rigs go in for maintenance in 2016 and some folks get surprised by the corresponding, but temporary, dividend cuts.

[siddharth18]

If you think the Wilhunter renewal rates will be close to current rates, then AWLCF is a bargain, and you need to be buying.

 

However, I think its important to remember that AWilco's cost are mostly fixed, so its dividends are highly leveraged to the day rates.  I worked out some really rough calculations a couple weeks ago http://nocalledstrikes.com/2014/09/23/all-models-are-wrong-but-some-are-useful-awlcf/  that highlight just how significant this leverage is.  A daily rate cut of 30% translates to about a 50% cut in dividends.

 

My best guess is that the most likely outcome is that rates only get cut slightly (10-15%) making today's prices attractive, but the other outcomes cannot be ignored. The oil business is cyclical, always has been, and always will be , so a return to pre-2010 rates cannot be excluded and that would just devastate the stock.  I used to think 15% yield was a fair price for Awilco to compensate for risk of extended rig downtime and to compensate for the fixed life of the asset.  But, now I think 18-20% is probably a better target to compensate for the inevitable down cycles in the business. 

 

I still own some Awilco, but I am no longer interested in being overweight Awilco. I am likely to defer new purchases until the rigs go in for maintenance in 2016 and some folks get surprised by the corresponding, but temporary, dividend cuts.

 

Even though we shun models for the lack of their accuracy, I think it's a good way to think about future div yield and the implied stock prices going forward.

 

There are a lot of rigs entering in the next few years but not many in the North-Sea...so what are your thoughts on the day-rate cuts especially when they'll get new BOPs?

[shhughes1116]

What I would say is this.  During the depths of the Great Recession, when the price of crude oil was scraping along the bottom of the barrel (no pun intended), when everything seemed like it was falling apart, day rates in the North Sea fell quite precipitously to $250,000k/day.  Day rates remained at that level for about 3.5 years before heading higher. 

 

Ultimately, day rates will be determined by the marginal operator in the North Sea area.  Whether they will settle again at $250,000k/day, or drop lower than that, I do not know.  Let's just hope that Awilco is not the marginal operator. 

 

I tried to model two scenarios in which day rates drop substantially in the UK North Sea.  In my worst case scenario (rigs operate for the remainder of their useful life, fixed costs don't decrease, interest expense remains the same, and rigs rolling off contract drop to $200,000k/day), the sum of dividends received is ~$18 (discount rate of 10%), so about a 1.25% return over the useful life of the rigs.  At $200,000/day in the UK North Sea, day rates elsewhere would probably be substantially lower and thus we would start to see some warm-stacking and cold-staking of rigs. 

 

In my not-quite-as-bad scenario, I make the same assumptions as noted above, but day-rates bottom out at the 2009 lows ($250,000/day) and remain at this level for the useful life of the rigs.  In this scenario, the sum of dividends is about $30 (discount rate of 10%), so about a 5.5% annual return over the life of the rigs. 

[60North Investments]

I tried to model two scenarios in which day rates drop substantially in the UK North Sea.  In my worst case scenario (rigs operate for the remainder of their useful life, fixed costs don't decrease, interest expense remains the same, and rigs rolling off contract drop to $200,000k/day), the sum of dividends received is ~$18 (discount rate of 10%), so about a 1.25% return over the useful life of the rigs.

 

In my not-quite-as-bad scenario, I make the same assumptions as noted above, but day-rates bottom out at the 2009 lows ($250,000/day) and remain at this level for the useful life of the rigs.  In this scenario, the sum of dividends is about $30 (discount rate of 10%), so about a 5.5% annual return over the life of the rigs.

 

Good stuff and as has been said earlier in here, even though these modellings should always be taken as one possibility of the future instead of imagining they're +90% accurate it's still useful to see what the current price implies etc.

 

A question I often times wonder (might be a really stupid question as well) and thought I'd ask now when it came up again, is why do people discount the numbers in these cases (especially with something like 10%)? I mean, if you get $X of dividends per share excluding taxes for the lifetime of a company (say 15 years), why would you discount that number with something as high as 10%? I understand that you'd perhaps discount it because of inflation, but 10% doesn't really sound like inflation expectations. And if that 10% is your own hurdle rate, your target return, then why discount at all? Seems to me that it'd just be easier to take the number and see what CAGR you're looking to get. How are people thinking about this that I'm perhaps missing here?

[ItsAValueTrap]

Let's just hope that Awilco is not the marginal operator. 

 

The Awilco rigs are ancient.  Newer rigs should have newer technology that will make them slightly more efficient.

[Hielko]

A question I often times wonder (might be a really stupid question as well) and thought I'd ask now when it came up again, is why do people discount the numbers in these cases (especially with something like 10%)? I mean, if you get $X of dividends per share excluding taxes for the lifetime of a company (say 15 years), why would you discount that number with something as high as 10%? I understand that you'd perhaps discount it because of inflation, but 10% doesn't really sound like inflation expectations. And if that 10% is your own hurdle rate, your target return, then why discount at all? Seems to me that it'd just be easier to take the number and see what CAGR you're looking to get. How are people thinking about this that I'm perhaps missing here?

I think that using a discount rate of 10% is pretty low. They have debt that yields 7%, and as an equity holder you are certainly facing a lot more risk. Awilco isn't risk free just because they pay dividends. Lower dayrates => significantly lower IV.

 

Let's just hope that Awilco is not the marginal operator. 

 

The Awilco rigs are ancient.  Newer rigs should have newer technology that will make them slightly more efficient.

Luckily there are almost no newer rigs constructed in this class. With the upgrades done in 2011 and the new BOPs in 2016 I'm guessing that the Awilco rigs are doing pretty well compared to the competition.

[shhughes1116]

Let's just hope that Awilco is not the marginal operator. 

 

The Awilco rigs are ancient.  Newer rigs should have newer technology that will make them slightly more efficient.

 

Remember that rig efficiency is not the only cost component that determines who the marginal operator is.  Building a new mid-water semi-submersible rig for the harsh environment is $350-$400 million per rig.  So not only costs to operate the rig (fuel, labor, etc), but also debt service (quite substantial for a new rig), shore-based costs (SSGA), and tendering costs. 

 

 

[NoCalledStrikes]

 

Luckily there are almost no newer rigs constructed in this class. With the upgrades done in 2011 and the new BOPs in 2016 I'm guessing that the Awilco rigs are doing pretty well compared to the competition.

 

I concur, this is really Awilco's saving grace.  Their rigs were designed for the North Sea water depth (1000-1500 feet) and rough conditions.  Refurbished and with new BOPs, they are the right rigs for North Sea work.  This is what will keep Awilco's rigs active even in the toughest markets.  It just won't guarantee that the market will pay high rates.

 

The big action offshore is in much deeper water 5000+ feet. These fields require using much larger rigs which can command much higher rates. Not surprisingly most of the new rigs are being built for these conditions.  No one wants to build brand new rigs for shallower water when they can build deeper water rigs that can charge much higher rates.

 

As a rough analogy, a brand new 18 wheeler can carry more freight than an old, but recently refurbished, 4x4 pickup truck, but if all you need to carry is a relatively small load  over rough terrain - you'd choose the old pickup truck every time. 

 

 

[60North Investments]

A question I often times wonder (might be a really stupid question as well) and thought I'd ask now when it came up again, is why do people discount the numbers in these cases (especially with something like 10%)? I mean, if you get $X of dividends per share excluding taxes for the lifetime of a company (say 15 years), why would you discount that number with something as high as 10%? I understand that you'd perhaps discount it because of inflation, but 10% doesn't really sound like inflation expectations. And if that 10% is your own hurdle rate, your target return, then why discount at all? Seems to me that it'd just be easier to take the number and see what CAGR you're looking to get. How are people thinking about this that I'm perhaps missing here?

I think that using a discount rate of 10% is pretty low. They have debt that yields 7%, and as an equity holder you are certainly facing a lot more risk. Awilco isn't risk free just because they pay dividends. Lower dayrates => significantly lower IV.

 

My point was that with the numbers from shhughes1116, 10% + 1.25% or 10% + 5.5%, wouldn't it be much simpler to just look at it as 11.25% or 15.5% returns for the buyer/shareholder? Unless I'm missing Hielko's point, I agree that if the most probable case for Awilco was an expected return of 11% p.a. that might not really be enough for the assumed risks. I'm just struggling to see why would you discount it here, instead of taking the return as is and then deciding whether you think that's enough for the risks you're taking?

[shhughes1116]

When determining the net present value of their future cash flows, I generally use 10% discount rate.  That represents what I see to be a reasonable opportunity cost over 10-15 year time horizon.  Given that awilcos weighted cost of capital is about 7.5%, I don't view that as an unreasonable discount rate.  Obviously you can adjust it higher or lower based on your perception of risk.  (Disclaimer: I seem to have a lower perception of risk with Awilco than others on this board). 

 

The whole exercise gives me an idea of whether the current value of the stock reflects the expected future cash flows.  Using the present value of future cash flow to determine the expected rate of return is misleading because it doesn't take into account your opportunity cost for another investment. 

[Tim Eriksen]

Let's just hope that Awilco is not the marginal operator. 

 

The Awilco rigs are ancient.  Newer rigs should have newer technology that will make them slightly more efficient.

 

All mid water semis are ancient.  They are third generation rigs.  There are 25 rigs in the UK mid water market, only three are built after 1990.  Awilco's rigs would easily rank in the top ten after their recent upgrades.  Dolphin Drilling's Blackford recently underwent $210 million in upgrades and is on a $428,000 day rate for the next two plus years.  The rig was built in 1974.  It is nearly ten years older than Awilco's rigs. Yes newer rigs command better rates, but since newer rigs are deep water, recently refurbished older rigs command the higher rates.

 

[yadayada]

What about Lamprell? It looks cheaper to be honest, with the net cash position. Less shaky competitive position

[Hielko]

I'm just struggling to see why would you discount it here, instead of taking the return as is and then deciding whether you think that's enough for the risks you're taking?

If you discount it at a rate that you think is fair you answer the question how high the stock price should be, and you can determine how small/big the under/overvaluation is.

When determining the net present value of their future cash flows, I generally use 10% discount rate.  That represents what I see to be a reasonable opportunity cost over 10-15 year time horizon.  Given that awilcos weighted cost of capital is about 7.5%, I don't view that as an unreasonable discount rate.  Obviously you can adjust it higher or lower based on your perception of risk.  (Disclaimer: I seem to have a lower perception of risk with Awilco than others on this board). 

Using a fixed return requirement for your opportunity cost doesn't make sense since you need to adjust it for risk. Plenty of possible 10%+ IRR investments that are not good. Awilco is financially leveraged and leveraged to drilling activity/oil prices: might require a higher discount rate than your average company. The fact the basically all drilling companies have a beta that is significant above 1 should be some sort of indication that the risk is above average, unless you think that the market fails to understand the whole sector.

 

Your WACC number also doesn't make a lot of sense. How can their WACC be this low if their debt is @ 7%, tax rate is low and they are primarily equity funded?

[shhughes1116]

@ Hielko  - Thanks, you were right about the WACC.  When calculating the rate, I flip flopped equity (1,125,000,000) with debt (125,000,000). 

 

In general, I would agree with the beta for rig operators.  The sector is cyclical, sector participants tend to be poor capital allocators, and there is still an overhang of risk from catastrophic rig failure (i.e. Transocean), thus a higher beta is warranted relative to other sectors of the market.  While I agree with the markets view that the sector is cyclical, in the context of Awilco, the risk of poor capital allocation seems to be far far far less.  Moreover, I think the risk of catastrophic rig failure is minimal.  I view a catastrophic rig failure as a relatively unlikely event to begin with, and I view it as even less likely in a company where management only needs to focus on two rigs.  Unfortunately the overhang of catastrophic rig failure will remain until BP's case with the US Government is resolved. 

 

Using a fixed return requirement for your opportunity cost doesn't make sense since you need to adjust it for risk.

 

Why?  We are talking about a cigar-butt type of company that is not reinvesting money in growth.  Thus the more relevant discount rate for me is my opportunity cost for cash.  Using a similar investment horizon, I would say the risk free rate is ~2.3% (current 10-year Treasury).  It is certainly debatable whether I have adjusted the discount rate high enough relative to the risk-free rate to compensate for risk.  However, as I noted above, I seem to have a different perception of Awilco's risk than others on this discussion board.  While many folks seem to perceive a two-rig fleet, along with management's seeming reluctance to seek growth opportunities, as an extraordinary risk, I view it in quite the opposite manner.  Reluctance to seek growth opportunities, coupled with a two-rig fleet, is an asset because management is focused 100% on the two rigs operating in the same geographic area.   

 

 

[kirkomi]

What about Lamprell? It looks cheaper to be honest, with the net cash position. Less shaky competitive position

 

AWLCF and Lamprell are totally different businesses. Lamprell is a rig maker.

[writser]

Great discussion here, thanks all. One thing I have been pondering about for a while is why it is common practice to adjust for risk by means of the discount rate? I.e. it seems to be acceptable to say: well, I use a 10% discount rate for most stuff but Awilco is risky so I use a 15% discount rate. But isn't that a very arbitrary approach to estimate risk?

 

Wouldn't it be much clearer to work out a few scenarios and explicitly assign probabilities to them? I.e.:

 

70% chance of things working out (using the standard discount rate)

25% chance of lower rates (using standard discount rate but lowering expected cashflow)

5% change of disaster (equity is worth 0).

 

and take the weighted average of these scenarios. This way you force yourself to make explicit assumptions about the risks you are incurring, instead of stuffing everything away in an arbitrary discount rate.