The offshore industry needs a reality check on the long term benefits of consolidation
Asset valuations that are more a matter of perception than reality are holding back the recovery in the drilling industry, writes Gregory Brown, associate director at Maritime Strategies International.
The offshore drilling market is ripe for consolidation. The industry continues to face challenges in managing a surplus and highly competitive market combined with over-leveraged balance sheets, low liquidity and struggling finances.
Of course, the industry cannot be totally to blame. M&A activity in offshore segments stagnated in 2020 as COVID-19 swept the world. During the year, fewer than 260 transactions were completed upstream, mid-term, downstream and OFS – the lowest total in more than a decade.
Among the key sectors, the activity of petroleum services (OFS) was the most affected. There were approximately 71 transactions worth $ 21 billion in 2019 and 61 transactions worth $ 19 billion in 2018. In 2020, only 28 OFS transactions were completed, with a value of just 1 , $ 9 billion. Only two transactions were valued at over $ 400 million, both in the onshore market.
The weakness of the OFS sector reflected extremely weak fundamentals which saw the onshore and offshore sectors reporting sharp declines and a lack of interest from the financial community struggling with the poor performance of existing portfolios. The industry continues to face substantial increases in expected credit losses and a significant drop in mark-to-market valuations, which could trigger a wave of write-offs.
The asset-rich and over-leveraged offshore drilling industry is a key driver here. Noble, Valaris, Diamond Offshore, Shelf and Transocean suffered combined impairments of approximately $ 5.5 billion at the start of 2020 alone, based on lower earnings expectations and book value adjustments to the scrap value for entire generations of platforms.
Since then, the market has entered the early stages of a recovery. Tenders are accelerating, contracts are signed and peak rates are increasing. A market in gradual growth mode, doomed to be smaller than in the recent past, still overcapacity in many areas and focused on the profitability of invested capital is a market that calls for consolidation.
Stock no money and a humble slice of pie
Consolidation in space seems more and more possible and much more necessary from year to year. Analysts have long called for it and the industry has responded with a stubborn refusal. Discussions do take place, but trades rarely succeed, almost always hanging on valuations and the idea that “our stock is grossly undervalued and does not reflect at all the capital we have invested in recent years.”
This statement could apply to around 80-90% of public OFS companies worldwide, as well as to the private sector. It must give way to the larger reality of the need for consolidation.
To conclude agreements, the OFS sector could draw inspiration from Upstream E&P where M&A activity is already strong. About $ 52 billion in deals were made in the US oil sector last year. Chevron bought Noble Energy for $ 13 billion including debt in July, ConocoPhillips bought Concho Resources in a deal worth around $ 9.7 billion. Devon Energy merged with WPX Energy in a $ 12 billion deal. Heavy debt, poor balance sheets, and low stock valuations meant that stocks, not cash, were the currency of every trade.
Trading stocks at mark-to-market has been the winning recipe in the recent wave of E&P deals, the majority of which are seen as positive and are expected to replicate in OFS – including the drilling industry.
After several high-profile drilling acquisitions in 2018 and 2019 – including the $ 3.4 billion purchase of Songa by Transocean and the Ensco-Rowan merger, the appetite for further consolidation was shattered by the 2020 slowdown , which also accelerated liquidity issues and pushed five homeowners to Chapter 11.
From their collapse, we now see a brief opportunity for the industry to rationalize and enable structural change.
Pacific Drilling, Noble Corp, Valaris, Diamond Offshore and Seadrill Partners are now all out of Chapter 11 with healthy balance sheets and limited short-term repayment commitments.
The newly cleaned up sector already experienced much needed consolidation when Noble Corp and Pacific Drilling announced their merger in March. The agreement on all stocks was reached in April and Noble now has 24 platforms – 11 drill ships, 12 jack-ups and a semi-submarine.
Cherry picking beats kicks
There are two alternatives to business consolidation. One is to do nothing and throw the box down the road, hoping that an improvement in market fundamentals will lead to a recovery in use, earnings and values. The industry and its financial sponsors have tried this in the past and now count the cost with around $ 23 billion in debt that was written off or restructured in 2020 alone.
The other and potentially interesting alternative is to select assets blocked in more complicated bankruptcy proceedings. Buying companies could take advantage of struggling stocks to acquire high quality tonnage at declining generation prices.
Entering Chapter 11 in February, Seadrill remains under bankruptcy protection because its debtors have been unable to come to an agreement to restructure its approximately $ 7.3 billion debt. Reuters reported in April that Seadrill had asked its creditors to write off more than 85% of the debts in exchange for a 99% stake in the reorganized company. The process has been underway since July.
With liquidity in Seadrill being scarce, it was reported in May that Noble Corp had submitted an offer to acquire “a substantial portion of the assets of Seadrill”, but not the entire business. Noble’s offer was followed by a similar offer from a group led by Transocean comprising Dolphin Drilling and an undisclosed third partner. Assets refer to parts of Seadrill’s fleet which includes seven drill ships, 12 semi-submersible platforms and 15 jack-up platforms.
Putting at least some of these assets in the hands of a well-capitalized player can be beneficial for the entire market. Noble could choose to retire some of its older drill ships, or jackups, also contributing to the supply / demand balance. Seadrill platforms are of high quality; there may be an opportunity for selection if creditors find themselves unable to unite around a resolution.