An oil drill rig upcycle may be on its way...

"Drill, Baby, Drill!" is a quote from a 2008 US Republican campaign slogan by former Republican National Committee Chair, Michael Steele, more infamously adopted by Sarah Palin, former VP candidate. Whilst the 2023 political climate may be different to 2008, i.e. far less accommodating of Steele's/Palin's sentiments, "Plus ?a change, plus c'est la même chose". Never forget that public opinion is cyclical.

In my opinion, we are about to embark on a large upcycle for oil rig stocks. If you're interested in why read on.

Long micro-economic cycles can sometimes be so long that they get ignored until very near the end when the media jumps on the bandwagon (are the GBP bears from October still bearish!? - I digress). A recent long cycle I covered was the container shipping market which boomed in 2003-7, then spent 2010-2020 in a down cycle. Supply was built c.2005-2010, demand stalled post-GFC, shipping rates collapsed, companies went bankrupt, exited the market, and the market consolidated. Then in 2020, during COVID, the consolidated suppliers withdrew supply in reponse to the COVID mini-depression. It was at that point they all realised, for the 1st time since 2003, that once again they had pricing power. Then when demand returned in late 2020, they exercised that pricing power and the cyclical industry that everyone forgot was cyclical, had a huge upcycle (above). The cycle was almost 15 years from peak to peak.

Almost every micro-economic cycle works this way. They play out over different time scales but whatever narrative is playing out in the media, it is always about demand, supply and price...

...which brings me onto oil rigs. The oil cycle should be in your recent memory so I'll skip through it quickly. The 2014-2020 oil downturn ended in April/May 2020 with shale players going bankrupt or exiting the market after oil fell to -$38. This time it was different! (ha ha) Production growth targets were replaced by Free Cash Flow (FCF) targets which meant companies started cutting capex aggressively. Subsequently the oil drilling market collapsed in 2020-21.

This chart, from Mordor Intelligence (link in the caption), highlights some of the largest oil rig suppliers globally. You only need to dig into a little bit of history to know how bad things have been for these companies over the past 2-3 years. I've added some of my own comments to the chart below:

The companies have been to hell and back. They all either went bankrupt, close to it, were forced into balance sheet recapitalisation and/or merged. These are the large players! You can imagine how brutal things have been for smaller players.

The rig business may not be as consolidated as the container shipping market today but that misses the point. When you have been through what the companies above have been through, you are in no mood to splurge on capex. Just ask the upstream oil companies...

Yes! The new disciplined upstream oil companies! The ones that are now steadfastly committed to Free Cash Flow (FCF) and shareholder value. Even if they weren't disciplined, they are now promoting a greener future, no more drilling etc. This time it's different!

It never is. Commodity companies are still commodity companies. There is still a cycle, and cycles always play out the same way over and over and over again. Companies find religion at the bottom of the cycle, cut supply which leads to an upcycle when demand improves. At some point in that upcycle, that "religion" starts to slip for some reason and capex finds a way back.

It doesn't matter what the reason is for increased capex; commodity companies will find one. Sometimes it is because the company has paid off all its debt in the upcycle and it has also increased dividends and still has spare cash available! Management (egged on by all the new shareholders) always want more! So the company grows production and supply increases.

Or maybe it is because there is an inflation crisis, political leaders need to get re-elected, and getting the cost of living down through lower energy prices will help with that...

It shouldn't surprise you that when oil went from -$38 to $130 at the 2022 peak contributing to runaway inflation, politicians who previously had religion ("no more oil drilling, period!"), start to shift their focus from their political views to their election cycle...

Some leaders, who never ideologically opposed drilling in the first place, but are still facing bad polling, will openly encourage it.

All this means that oil rig demand is recovering. The Baker Hughes US rig count for oil & gas is back to pre-COVID levels. In the rest of the world, where oil companies are not always listed, so data is less obvious, the same thing is happening. Rig demand is growing again.

What is the rig supply situation? As my comments implied above, supply is unlikely to grow any time soon. Rig companies are still years behind the upstream producers. Demand may be growing but supply is not. So what is happening to oil rig prices (known as day rates)? Yep, you guessed it.... they are increasing.

These price increases are occuring whilst oil capex rose a little bit but not that much (see right). All the oil drilling market has done is return to pre-COVID rig deployment as the above Bloomberg chart showed.

The widely held oil market consensus is that long term supply is still limited, mainly for environmental reasons i.e. it is exogenous to the oil price. This will likely put a floor under the oil price at a higher level (I don't know where) such that oil company cash flow will continue to look good and be available for increased capex. If we look back in history at the number of rigs that can be deployed, we are still a long way from peak oil capex 2007-2014 (right). If the cost of living continues to be an issue for voters & politicians, one could see public sentiment shift towards "drill, baby, drill". It's not my central thesis, but it's possible.

As the above Borr Drilling chart shows, the rig market is already at 90-100% utilisation at a relatively low level of rig deployment (historically) with limited rig capex because these companies are still recovering from the oil price recession 2014-20 & rig recession 2020-22 (right). Balance sheets still need to be repaired and new rigs cost anywhere from $20m to $1bn. The money isn't there for large capex increases. For example, Transocean (RIG US) has $6bn net debt (20x last year's FCF). Sembcorp Marine (SMM SP) has had 1 year of FCF since 2014 and still has debt to pay down. A rig capex cycle could still be a long way away.

Maybe the oil companies could build rigs themselves? Yes that is possible. How long does it take to build an oil rig? 2-3 years! If e.g. Exxon starts to aggressively build rigs now, they might be able to deploy them, ...well... after Biden and Sunak both lose their respective elections in 2024 as voters punish them for cost of living increases!

Elected leaders need the cost of living down now.

They need oil supply to increase now.

They need oil rigs deployed now!

Rig demand should continue to rise, supply is limited, utilisation is full and prices are rising (quickly).

So onto equity prices & valuations. Every cyclical investor knows EPS momentum & P/Bs are the key factors. P/Es are irrelevant. (P/Es are low at cyclical tops and high at the cyclical bottoms.) Now rig EPS momentum should be obvious from the above analysis. Prices are rising in a fixed cost business. Operational leverage is enormous so rising prices translate quickly into rising profits.

Rig company Price to Book ratios still trail upstream producers by a large margin (above). Why? Their balance sheets look awful; that's partly why valuations are low. However looking back, "awful" is exactly how Exxon Mobil's (XOM US) balance sheet looked 2 years ago. Exxon had $50bn of net debt and no FCF. When 2022 results are released end-Jan, it will probably show a net cash balance sheet (what to do with all that cash I wonder!? Maybe increase drilling!?) As a shareholder, do you want to buy Exxon below $30 share price on 0.6x P/B price when oil is below $40, or at $110 share price, on 2.4x P/B (2008 high was 2.5x), 2 years later when oil reached $130?

No one could have predicted that oil would reach $130 after Russia invaded Ukraine so why was Exxon a buy below $30 except in hindsight? That misses the point. Exxon was a buy when it became clear that supply growth was falling, or was outright negative. Cyclicals are mostly about supply after downcycles, not demand. Equity prices look forward; Rig supply isn't growing but utilisation is high. Rig rates are rising. Will anything change in 2023? Rig companies still need to repair their balance sheets. A more appropriate question for rig stocks is "How long before we reach 2013 highs? 2006 highs?"

Gulf International Drilling Services (GISS QD) is receiving day rates of c. $74,000/day for its offshore jack up rigs today. Offshore rig are 75% of its Rig assets. Now Borr Drilling says that market rates are c. $120,000 k/d. Utilisation is 90% and the remaining GISS rigs are due to be deployed. Now at 100% utilisation and a largely fixed cost business, rising rates drop straight to the bottom line so QR950m revenue run rate (2022) rises to QR1.5bn if you mark to market current jack up rates. Mark-to-market profit could grow QR500m to QR800m.

If we've established that demand will continue to grow against limited supply on any foreseeable timeframe, let's address that question of "what happens if/when we reach 2006 high day rates of $250k/d in say, 2024/25?"

That would translate into rig revenue of QR3.2bn for GISS. Now in my "guesswork", I've assumed zero cost increases as this is a largely fixed cost business (go with my guesswork for now) That's an extra QR2.2bn that drops straight to the bottom line (GISS' rig business is currently break even). The market cap of GISS today is QR2.9bn.

This is just the drilling segment. GISS has other businesses (helicopters, insurance etc.) that contribute c. QR300m net profit today. Let's assume that continues. Potentially GISS is earning QR2.5bn net profit run rate in 2024/25 with a market cap of QR2.9bn. That's 1.2x forward P/E.

Do I care whether or when GISS actually achieves this profit? No, of course not. That's not how cyclical stocks work. Remember container shipping? Evergreen Marine's (2603 TT) share price went up 20x from the 2020 low for reasons outlined above. The P/E was supposedly 40x in June 2020 but that's rubbish. The market was looking forward to future profits on rising container shipping rates (top chart above). The share price then peaked at NT$400 and fell to NT$159 when profits were still rising in 2021 and early 2022. i.e. the equity price peaked as profits began to grow. Equities always look forward. All I care about is whether the market is pricing in an upcycle today, whether it prices in an upcycle in future and making a judgment on how high that cycle will go.

GISS is trading on 0.8x P/B. In 2014, it traded up to 6x P/B. At that price, with QR2.5bn theoretical net profit, it could have a market cap of QR21bn with a share price of QR11.3 and be trading on 7x P/E. (A nice round P/E number for a cyclical top on 2024/25!)

I might be way off on my profit numbers. Maybe 2024/25 net profit is only QR2bn, or QR1.5bn if day rates don't reach 2006 highs? Maybe GISS share price peaks at QR5-6 instead of QR11. If so, should we care? No. That's analysis paralysis. That's what sell side analysts do.

Do I really care whether I can precisely guess today (it's all educated guesswork by the way), whether I will make 200%, 300% or 600% in GISS? Not when the aggregate Qatar market has maximum 20-30% upside at best.

GISS' share price high was QR13. Qatar HNW investors, not known for their valuation worries, could easily take it to QR13 on momentum alone. It is trading at QR1.6 today.

GISS is fairly reflective of how other global drilling companies are trading. Go look for yourself (this article is long enough already!). They are all super cheap, not pricing in what is a potentially large and immediate upcycle.

If you made it to the end, thank you for your time! Hopefully it was worth it.