Fred Olsen Energy (GM:FOEAF) is an international offshore drilling contractor headquartered in Oslo, Norway. The company operates in the midwater and ultra-deepwater environments. Of these, the ultra-deepwater environment offers much greater potential which I have discussed in several previous articles. The company achieves operations in these environments through its fleet of eleven offshore drilling rigs which consists of three ultra-deepwater rigs, seven midwater rigs, and one deepwater rig.
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One thing that I immediately notice about the company's fleet is that it is relatively old. With the exception of the three ultra-deepwater drillships and the Borgland Dolphin, every rig in the company's fleet was built prior to 1981. This is something that could prove to be a significant negative about the company going forward. As I have discussed in many previous articles, the exploration and production companies that contract with offshore drilling contractors for the use of their respective rigs have, over the past few years, expressed a marked preference for acquiring the services of modern rigs over vintage ones. In particular, these companies greatly prefer fifth generation or later rigs. This would roughly correspond to rigs that were delivered in 1998 or later. Ideally, the companies the are the customers for the participants in this industry seem to prefer rigs that are at least sixth generation or later, which would roughly correspond to rigs built in the middle of the last decade at the earliest. This preference can be clearly seen by examining the dayrates of recent contracts awarded for rigs of various vintages. Ultra-deepwater specialist Pacific Drilling (PACD) presented just such a comparison in a recent presentation that the company gave at the Bank of America Merrill Lynch 2013 Global Energy Conference:
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Source: Pacific Drilling
Another peer company, Seadrill (SDRL) provided a similar comparison from offshore drilling industry consultant Fearnley's Offshore in its presentation at the Pareto Securities Oil and Offshore Conference:
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As you can see, this would effectively make nearly all the drilling rigs in Fred Olsen Energy's fleet second-tier choices for oil and gas companies that drill offshore. As a result, the company cannot achieve the same dayrates (prices) that its peers with more modern fleets can. As it costs approximately the same amount to operate a vintage rig as a modern one, this will result in Fred Olsen Energy having lower margins than its peers with more modern rigs. Of course, many of Fred Olsen's rigs are already fully depreciated due to their age so the company has lower depreciation and amortization expenses than its peers have with their non-fully depreciated fleets of modern rigs. This results in a higher net income than the company would have if it had the high D&A costs of its peers. However, as I have mentioned in previous articles, depreciation and amortization is a non-cash expense and does not represent any actual cash outflow. Therefore, the lower depreciation and amortization expense has no effect on the company's cash flow compared to its peers.
Despite the relative age of its fleet, Fred Olsen Energy does have some growth potential due to its three newbuild ultra-deepwater units. These three rigs are the Belford Dolphin, the Bollsta Dolphin, and the Bolette Dolphin. Of these three, the most important for the company's forward growth are the Bolette Dolphin and the Bollsta Dolphin as they have not yet begun operating (the Bolette Dolphin was originally scheduled to be delivered to the company in the third quarter of 2013 but has been delayed until the first quarter of 2014). As neither rig has begun operating, neither rig has generated any revenue or cash flow for the company. However, that will change beginning in the first quarter of 2014. At that time, Bolette Dolphin will begin work on its first contract for Anadarko (APC) off of the coast of the East African nation of Mozambique. The rig will continue working on this contract until the first quarter of 2018. While the start-up of operations under this contract will be accretive to the company's revenues and earnings, the rig's dayrate of $488,000 is significantly lower than what other competitors have achieved over the past two years whether in Africa or elsewhere. The company's other new ultra-deepwater rig, Bollsta Dolphin, does somewhat better in this regard as it has a contract dayrate of $560,000 for its first contract with Chevron (CVX). However, this contract does not start until the first quarter of 2015 so the company will not begin earning money off of this contract until that time. However, it is worth noting that the $560,000 dayrate that the company will be earning for this rig is also rather low compared to the dayrates that the company's competitors have gotten over the past two months but it is not too bad for a five year contract in the United Kingdom.
Fred Olsen Energy included a chart in its third quarter 2013 results presentation that shows the average dayrates that have been awarded to rigs operating offshore UK since 2000:
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This chart, which comes from offshore consulting firm Fearnley's, only includes offshore drilling rigs from the second through fourth generations. Bollsta Dolphin is a sixth generation rig and that is why its dayrate appears to be very high compared to the average dayrates shown on the chart. As I discussed earlier in the article, exploration and production companies prefer modern rigs to older ones and are showing this preference through their collective willingness to pay higher dayrates for modern rigs compared to vintage models.
However, I can see no good reason why the Bolette Dolphin has such a low dayrate under its contract with Anadarko. The rig's technical capabilities make it easily one of the most capable drillships in existence and so it should be able to earn a dayrate more in line with the $600k+ dayrates that the company's competitors have been getting. The company secured this contract back at the end of 2011 as part of a two rig deal with Anadarko. Basically, Fred Olsen Energy landed a contract for the use of two of its rigs off of the shore of Mozambique. The first rig included in the contract was the Belford Dolphin and the Bolette Dolphin is the other. The Belford Dolphin has a dayrate of $484,000 under the contract which was still low for the time but it was not as low as that rate seems to be compared to today's rates. For example, Seadrill secured its contract for the West Capricorn rig only a month prior to Fred Olsen Energy's Belford Dolphin contract and it had a dayrate of approximately $503,000 under that contract. Seadrill's contract was for five years and was for operations in the U.S. Gulf of Mexico. As longer-term contracts tend to have lower dayrates and since the U.S. Gulf of Mexico typically has lower dayrates than other areas (especially Africa), Seadrill's contract dayrate should have been lower than Fred Olsen's. However, this was not the case. Fred Olsen Energy's dayrate for this rig still seems rather low but when taken in context, it isn't quite as bad as it first appears. With that said, the start up of operations for the Bolette Dolphin rig will still be accretive to Fred Olsen's revenues, cash flows, and profits since the dayrate that the rig will be collecting still exceeds the company's cost of operating the rig.
As with most offshore drilling companies, Fred Olsen Energy has a backlog of essentially guaranteed revenues due to its currently existing contracts.
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Source: Fred Olsen Energy
As you can see, the company has secured contracts for all of its existing rigs until September of 2014. Thus, it is guaranteed to be able to generate revenue at its present level until then. However, the company's revenue will actually most likely increase due to the already discussed start-up of the Bolette Dolphin. In fact, a look at the company's backlog confirms this. This is revenue that the company is contractually obligated to receive.
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Source: Fred Olsen Energy
This contract backlog makes Fred Olsen Energy something of a cash cow. After all, a cash cow is essentially a very reliable source of money and what could be more reliable than guaranteed revenue from large, financially stable oil and gas companies? There are few guarantees in business, but the revenues from these contracts are about as close to a sure bet as one can come.
However, there is no guarantee that the company will be able to secure new contracts for its rigs once the current ones run out. In previous articles, I have discussed that there is projected to be a shortage of ultra-deepwater drilling rigs from now until 2020. However, this only applies to ultra-deepwater rigs which would exclude all but Fred Olsen's three newest ones. Additionally, this projected shortage also assumes that offshore drilling contractors will retire the oldest rigs in their fleets. As I have already discussed, all but four of the drilling rigs in Fred Olsen Energy's fleet are among the oldest rigs that are still in operation.
In stark contrast to both the ultra-deepwater market and the jack-up (shallow-water) markets, the market for midwater rigs has been much more stable, with the number of rigs under contract not changing much from year-to-year and the overall supply of rigs being roughly equal to the demand for such rigs.
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Source: ODS Petrodata
However, according to Credit Suisse, the demand for mid-water drilling rigs began to increase in the fourth quarter of 2012 which led to predictions at the time that dayrates for mid-water rigs would begin to increase in 2013. This prediction proved to be correct. According to the HIS Petrodata Mid-Water Depth Semisubmersible Day Rate Index, the average dayrate for mid-water drilling rigs has been increasing since the middle of the year although it dropped in November.
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Source: IHS Petrodata
This index tracks the average contract dayrate achieved by all mid-water rigs that secure contracts in a given month anywhere in the world. Therefore, sustainable increases here could be beneficial to Fred Olsen Energy when it needs to secure new contracts for its rigs, assuming that the age of its rigs does not make them undesirable. Most likely, the oil and gas companies that contract such rigs will give first preference to a newer rig if one is available. Thus, Fred Olsen Energy may end up becoming the supplier of last resort. I would be uncomfortable investing in a company that is in that position, although Fred Olsen Energy does appear to be a good cash cow investment.
Fred Olsen Energy has a history of paying a very good dividend which is quite befitting its cash cow status. The company paid a dividend of NOK 20.0 (about $3.27 at today's conversion rate) in 2013 which gives it a 8.38% yield at the current stock price.
Source: Fred Olsen Energy
Due to the aforementioned contract backlog, the company looks like it can likely be relied upon to make similar dividend payments for the next two to three years at least before its current contracts begin to run out. After that, the company's potential as an investment becomes more questionable. If it can successfully secure new contracts for its aging rig fleet then investors in the company will likely be quite happy. If it cannot, then the company will see its revenues decline sharply. The company's new drillships are certainly capable but the age of the rest of its fleet makes those rigs a definite second drawer choice for the oil and gas industry.
Disclosure: I am long SDRL, PACD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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