Thursday, June 03, 2010

Oil Services & Equipment: Dead Cat or Signs of Clarity? - J.P. Morgan

J.P. Morgan is out with some comments on the Oil Services & Equipment names (HAL, SLB, RIG):

Following a remarkable two days of trading activity in the oil services sector, investors may be starting to sort out which horse they want to ride once the Gulf of Mexico disaster gets under control. Of course that hasn’t happened yet, but they feel the quick recovery in large cap service stocks sends a signal that investors feel more confident in this group than offshore drillers. Assuming BP’s latest efforts to curtail the oil flow are successful (yes, a big assumption), the firm would expect the group to rally as potential liabilities would then have a “bookend” in their view.

Halliburton leads the way (down and up). The violent decline in shares of HAL and subsequent recovery today highlights several key points: investors remain concerned about potential liability as one of the “spill stocks”, yet the impact from the six month Gulf moratorium is much less than many thought. JPM continues to believe Halliburton will not be found culpable in the Deepwater Horizon tragedy, backed up by managemant’s openness regarding their involvement in today’s conference call. Furthermore, management indicated that deepwater Gulf revenue was only about 4% of total (a bit higher than JPM 3% estimate), likely the reason behind the group’s rally this afternoon, as investors realized that large cap services has less exposure (but still could be material).

Concerned about the fate of offshore drillers. On the other hand, all the signs point negative for offshore drillers and JPM would expect to see more operators follow Cobalt in declaring force majeure. Many operators are looking to use this opportunity to negotiate considerably lower dayrates in the wake of this incident as the 6 month drilling moratorium could easily push into 2011. While they have already made adjustments to costs and utilization rates, they are now looking more closely at dayrates.

Transocean can’t catch a break. The only “spill stock” noticeably down today was RIG—the only cause they can point to are CDS spreads widening along with concerns on free cash flow in light of convertible debt obligations and falling dayrates. Defaulting on debt is highly unlikely in JPM's view, but this is one of the more emotional stocks right now alongside BP. If the leak is largely contained by the weekend, thre would expect shares to materially rally. But even then, they struggle to quantify potential liability … they don’t think it is zero.

Beware of Falling Dayrates
Of the five offshore drillers JPM covers, 17 floaters will be rolling over within the next 6 months without a new contract. This represents an average of 12% of the 142 floaters managed by their coverage group. Ensco has the highest percentage of rigs rolling over as the 7500 will be rolling over in September, representing 25% of the 4 ultra deepwater rigs the company currently has operating. The rest of the companies the firm covers have approximate 12% of their floater fleet rolling over without contacts in the next 6 months including Pride and Noble with 2 rigs each, Diamond with 4 rigs, and Transocean with 8 rigs.

The GOM rigs are an unknown, but could significantly add to supply
To further complicate matters, the 33 rigs that are currently drilling in the Gulf may need to be redeployed if the current drilling moratorium lasts longer than 6 months. Although JPM believes this is unlikely, some or all of the rigs currently in the Gulf may become free agents, similar to Diamond’s Ocean Monarch recently released by Cobalt drilling under force majeure on June 1st. Transocean has the most rigs operating in the Gulf with 14 out of its fleet of 73 (18%), while Ensco has the highest percentage as 3 of its 4 semisubmersibles are currently operating in the Gulf, followed by 6 (35%) of Noble's 17 floaters

In the near-term dayrates for the floating rig market will be pressured
Therefore, over the next 6 months it is possible to have a range of 20-50 rigs needing new contracts in the deepwater market. Although JPM believes additional deepwater work exists outside of the Gulf of Mexico, the addition influx of rigs over such a short time period will likely reduce rates for floaters below their already pessimistic view. They wouldn’t be surprised to see ultra deepwater dayrates below the $400k/day level for upcoming tenders

Stick with HAL and SLB, stay wary of the drillers. The diversity of large cap service companies is a strong investment consideration, while offshore drillers will be subject to falling dayrates exacerbated by Gulf weakness. At this time, JPM notes they have the most confidence in HAL and SLB, while BHI is looking more attractive. They stay on the sideline with RIG.

Notablecalls: Well, this is JPM's view. The market tends to be 2 steps ahead of the analyst community and so we have BP and RIG trading up 2pts+ this morning, seemingly on no news.

That's usually how it happens - Monday was purgatory for BP (& the rest of the offshore drillers) as Top Kill failed & Obama had a field day bashing the sector. Yet, BP is now ~10% higher from these levels.

It was the point from where it could only get better. At least in the short-term.

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