Thursday, December 31, 2015

Zombie US Oil Drillers: Keeping At It, Despite Bankruptcy

Deepwater Looks Shaky In 2016


Is it over yet? 2015 will certainly go down as the worst year for energy stocks since 2008 – that is unless 2016 beats it for misery. Looking at certain sub-sectors, like off-shore drilling, 2016 could unbelievably make 2015 look tame.

We always knew that the bust cycle in oil prices was going to bring a lot of bad times for energy stocks – but no one imagined such carnage, even among the strongest names. I have been focusing on what I have called 'the survivors' and trying to find value in the shares of names like EOG Resources (EOG), Cimarex (XEC) and Hess (HES). With off-shore drillers, I've imagined even more awful times ahead, but took a speculative shot with Seadrill (SDRL), looking down the road two years at the inevitable rebound in deepwater drilling.

But the resilience of many of the unconventional drillers has unexpectedly extended the timeline in this oil bust cycle, catching me by surprise. We're operating inside this insane Catch-22: Oil prices can't get constructive until the U.S. and other non-OPEC producers start to trim their outputs, yet oil companies continue to use efficiency gains and top line spending cuts to stay in the game and maintain production. Oil prices stay low, and drift lower. 2016 will not be happy, at least for the first several quarters.

It gets worse: Oil companies have pushed their debt deftly down the curve, with only a tiny number of high-yielding issues coming due and requiring refinancing this coming year, promising an even more extended period of financial life support. We've seen the wild outcome of a few of the 'early' bankruptcies in U.S. independents: Both Quicksilver Resources and Magnum Hunter have seen their common shares go to zero and been forced to declare Chapter 11, but have also been ordered to continue operations pending break-up or other restructuring.

Even bankruptcy, it seems, can't slow U.S. production much.

Look, with spending cut to the bone and core wells being run dry with few wells being drilled to take their place, the “Red Queen” of shale production (running as fast as you can to stay in the same place) will most certainly hit a very firm wall, and it will hit it sometime in 2016, of that I'm sure.

But that initial, massive drop in production from unconventional shale may not come in time to save off-shore players – including possibly Seadrill. We've seen this week, for example, the cancellation from Shell (RDS.A) of the remaining time of Transocean's (RIG) Polar Pioneer contract. There was little surprise in this move as the first exploratory Arctic well came up disappointedly empty, and Shell had already withstood a massive environmental pushback in the Arctic. With several other timing missteps from Shell with regards to the oil and gas market (think BG Group merger), it’s no surprise that Polar Pioneer was given back.

And while RIG will be made whole for the contract time, it does go to a point about offshore in general: Almost all of the time options on current deepwater rigs contracts are being refused by the E+P's. More and more rigs are going idle, and remain uncontracted further into the future.

As the timeline of destruction gets longer, so do the chances of full-scale default in the deepwater sector. While I had been hoping for a resurgence of offshore contracts in late 2017, it now is possible that the cycle won't find a turnaround until perhaps 2019 or 2020.

Wow – that makes the risk of holding Transocean (RIG), Noble (NE) or my beloved Seadrill positively depressing.

At current prices, I cannot recommend a sale of Seadrill – it was always a speculative play that I budgeted for possibly going to zero, and I'm willing to let that play out. And I am definitely not looking for any double-up or averaging of basis prices, either. In fact, it seems certain that both RIG and Noble will see single digit prices in 2016 and Seadrill will sink below 3, if not flirt with the same chapter 11 fate of both Quicksilver and Magnum Hunter.

And in that, if it's any consolation, they certainly won't be alone in the coming year.

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