Whilst it may seem that the offshore oil sector is drowning in debt, Fergus Cullen believes there is still hope for investors.
Who is Fergus Cullen?
Fergus Cullen, or better known as Trader Ferg on Twitter, seems to be living every investor’s dream: living on a beach in Bali as a full-time trader.
Ferg was an asset manager in Australia, before meeting his mentor who inspired him to get into trading. This set Ferg on a path of quitting his job before he was 30, managing other people's money for a few years, to finally managing his own finances (on a beach in Bali).
So how did he get there, and what would he recommend to people with the same goals?
Ferg discusses one particular sector where he believes the risk-reward factor is fantastic, explaining the entire thesis and how you can hopefully position yourself to catch it.
That sector is offshore oil.
What are Offshore Drillers?
They’re essentially contractors, hired by major oil companies to drill into and access offshore oil fields. Their business model centres around purchasing drilling rigs, offshore floating platforms, and drillships, accruing a lot of debt in the process.
Once they have these assets they then rent them to the oil majors and they are then typically paid a day rate to operate these assets. If the market is good they’ll have a high rate of utilisation, high oil prices, and, most importantly, high day rates.
However, should the oil market start to shrink it spells real trouble for these contractors, as their utilisation will fall, oil prices will fall, consequently causing day rates to fall. Once in this situation, the huge debts they’ve built can cripple the business, as debt servicing quickly overtakes income.
This is exactly what has happened to Transocean, the world’s largest offshore drilling contractor, since 2020.
The current state of Offshore Oil
There are no two ways about it, at the moment the Offshore Oil industry is a mess, part of Fergus Cullen’s favourite group “the worst of the worst”. Devastated by the price wars following the outbreak of COVID-19 these companies collapsed as they lost their contracts from major oil companies who were desperate to cut costs.
Saddled with enormous debts and with no income stream the offshore oil drillers faced bankruptcy across the board. Even bigger offshore drillers like Noble Corp. faced debts upwards of $3.5bn, an insurmountable obstacle that caused the company to file for bankruptcy last July.
Other names such as Transocean are grappling with debts of $8bn, a figure so large that even Cullen writes them off as a lost cause.
This seems like the last place anyone should consider investing, but Fergus has other ideas…
So what’s the upshot?
Despite the grim outlook, there is a future for companies like Noble Corp.
After filing for bankruptcy their creditors accepted a debt for equity swap, reducing the overall debts to $350mn (with 5 years before this matures) and bringing with it the millions already invested. Not only has it cleared out most of the debt, and bought 5 years of breathing room, but it also still has a backlog of work orders, valued at $1.4bn.
Perhaps not so much of a disaster as previously thought.
This isn’t the only upside of such a collapse. On the way down Noble Corp. frantically cut costs, dramatically driving down their future production costs. Cullen estimates that overheads per barrel have dropped from $64 to just $34. Despite the disaster that struck Noble at the start of 2020 this transformation has resulted in “a very lean, mean business model”.
Offshore Drilling Market Analysis (USD Billion)
Is there still an oil demand?
While travel and shipping have fallen across the board over the past year, pushing oil use down by roughly 30% at certain periods, this decline has levelled off at a reduction of 10%, far below the predicted decline.
There is still significant demand for oil despite this downturn.
The oil demand ought to steadily grow over the next few decades, perhaps not in the developed world but the developing world. Cullen stresses the importance of the developing world to the oil market as population growth combined with rising standards of living will result in surging appetites.
China’s oil consumption has already exceeded pre-COVID levels by between 5-10%, evidence for the robust nature of the oil demand, “bet against it at your peril”.
Offshore Oil vs. its competition
While demand and uptake are promising, couldn’t this growth come instead from shale drilling or renewables? Cullen doesn’t think so.
US shale has been the source of 90% of growth in the oil reserves accessed by the market in the last decade, a strong showing which has managed to avert a potential energy crisis due to the loss of oil reserves elsewhere in the industry. But Cullen points out that shale drilling has “never made any money” and has recently seen its number of drilling rigs reduce by 70%.
Shale has “drilled all their best reserves” and this isn’t just a temporary setback, shale doesn’t stand a chance of a significant bounce-back and will never be able to keep up with future demand growth. Despite being the source of roughly 13mn barrels of oil per day Cullen cites Rob West, founder of Thunder Said Energy, who predicts that falling shale production will result in a supply deficit of between 2-3mn barrels per day.
This deficit will force up oil prices and as offshore oil accounts for 45% of proven reserves, the drilling companies stand to gain a lot once demand returns to normal.
Renewables could stand to fill the gap left by this deficit, but Cullen believes that they are a long way off at the moment. Firstly, the major renewables pilot schemes, particularly in Germany and California, are struggling to achieve the necessary results.
Germany has invested roughly $580bn in its scheme and is yet to see any reduction in emissions and has had to rely on energy imports from its neighbours to avoid power shortages. There’s a similar story in Denmark which has to import up to 50% of its energy supply from Sweden and Denmark’s nuclear and hydro plants on windless days.
Furthermore, renewables, at present, are not the answer for developing nations, who cannot afford the enormous capital investments to start these schemes nor can many rely on neighbouring nations to provide an energy safety net. For Cullen it is the developing world which now matters most to the energy market, “the developing world is where all the energy growth is”.
Until renewables become drastically more affordable and efficient there is still a future for oil.
What do you need to know?
While offshore drillers seem to be in a nightmare situation at the moment there are significant opportunities for de-risked growth, with debt for equity swaps and substantial reductions in operating costs paving the way for profits.
Cullen firmly believes that the oil demand is not only going to return to normal but will continue to grow over the next few decades as the population of the developing world continues to grow and seeks to increase standards of living. He stresses that it is important not to blindly ignore the developing world as that is where major market growth will stem from.
Future oil supply deficits, due to the decline of shale production, will push up the demand even higher and at present offshore oil is poised to fill this space. Renewables still have a long way to go when it comes to efficiency and affordability, especially in the developing world where these technologies, on the whole, remain economically inaccessible.
Despite bankruptcies, several offshore drillers stand to make major gains, Noble being Cullen’s main example but there is also potential in Diamond Offshore and Valaris which are on track to reach the same position as Noble.
Noble is particularly promising as its new stakeholders have swapped their bond holdings for equity and therefore have a significant vested interest in making the company viable as soon as possible, aligning their interests with any prospective investor.
Cullen believes that the upsides of offshore drillers massively outweigh any downsides for an investor, so despite being “the worst of the worst”, they may not be for long.
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