Thursday, May 13, 2010

Halliburton (NYSE:HAL): The Causes of BP's Macondo Blowout Are Becoming Clearer--Upgrading HAL - FBR

FBR Capital Markets is upgrading Halliburton (NYSE:HAL) to Outperform from Market Perform and is raising their target back to $44 (prev. $35).

Firm notes that since their last piece analyzing the potential causes of BP's Macondo blowout, several questions have been answered, but new ones have also arisen. They also have a much clearer time line of events, thanks to disclosure by the House Energy and Commerce Committee. Yet, there are new questions raised by the log of the final two hours before the blowout, including what procedures were performed (and why) once traces of gas started to show on surface nearly two hours before the blowout occurred.

FBR's current theory as to the causes of the blowout is that either before or during the cement job, an influx of natural gas entered the wellbore and was circulated up the well during the cement job. After waiting for cement to harden for 16.5 hours, a negative test was performed on the wellbore below the blowout preventer (BOP) and the wellhead assembly failed to seal. At this point, it was reported by the committee that additional pressure tests were conducted and that BP officials deemed them acceptable to proceed with well operations. Next, the data suggests that during the displacement of the riser to seawater, natural gas that was below the BOP was circulated to the surface, reducing the hydrostatic head enough that it caused the well to start flowing, which had not been stopped by either procedures performed on the rig or by the BOP. It remains unclear as to why the blind shear rams, which were last tested less than 10 hours before the blowout, failed to seal the well, but industry participants seem to universally agree that an unforeseen obstruction is preventing full closure.

The bottom line. The bottom line for the oilfield service companies involved with this tragic incident seems to be that absent a court finding them to have been grossly negligent, an exceedingly difficult standard to prove, that the well owner will undoubtedly end up footing the bill for remediation, clean up, and associated damages.

Upgrading HAL. FBR is upgrading HAL back to Outperform (from MP) with the stock down 8% from their downgrade on April 30 (vs a drop of 1.3% for the S&P). While the cement must have failed to seal the production zone to allow flow to occur, the firm believes that other circumstances and decisions were far more central to creating the conditions where the integrity of the cement job became relevant. Apart from setting the record straight that foamed cement has been pumped many times, questions posed towards HAL's Tim Probert at recent congressional hearings were more focused on relevant wellsite procedures, which seemingly lessens HAL's headline risk. They are restoring their prior $44 target (from $35), representing 20x our 2011 EPS estimate.

Why not upgrade RIG ? FBR feels a combination of falling deepwater rig day rates combined with headline risk into the procedures performed on the rig leading up to the blowout are likely to keep RIG range-bound for at least several weeks.

New BOP information. Much was made of modifications to the rig's BOPs during the hearings, but it was also disclosed that the modifications made were requested by and paid for by BP. Furthermore, it also came to light that BP discovered leaking hydraulics and a dead battery. However, later testimony indicated that these conditions should have been noticed on the rig if they had been present before the blowout.

Impact on other service companies. Based on their review of the available information, FBR continues to see no circumstances where MI-Swaco, the drilling fluids company that is jointly owned by Smith International and Schlumberger, would have made any independent decisions that contributed to the blowout. During the hearings it was disclosed that Weatherford performed the casing running services, but no information suggesting any errors, much less gross negligence, was disclosed.

Who will benefit? FBR believes the big winners out of this incident are likely to be the companies that manufacture BOPs, as they expect standards to be significantly tightened, probably requiring substantial upgrades and additional blind shear rams. They also expect more to be made of cement job evaluation on production casing jobs, which should mean incremental wireline logging (cement bond logs) as well as additional remedial cementing work should it be necessary.

Notablecalls: It's increasingly likely that BP people called all the shots that lead to the eventual BOP failure.

That's good news for HAL & RIG, if one is willing to overlook the fact off-coast drilling will be a tough gig following the Macondo incident.

FBR was among the first (if not the only) to downgrade HAL in light of the news 2 weeks back and they are also the first to upgrade their rating back to Buy-territory. This should be rewarded by the market.

I expect HAL to trade up today, towards $30/share & possibly higher if the general market plays ball.


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