The Ideas Report For Serious Investors

By Greenbackd

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By Ravi Nagarajan

On Thursday, June 17, BP CEO Tony Hayward will testify before the House Committee on Energy and Commerce.  In preparation for the testimony, the Committee Chairmen sent Mr. Hayward a letter listing a series of alleged procedural lapses that could have contributed to the Deepwater Horizon disaster.  The letter is worth reviewing because it raises issues regarding the general safety of deepwater drilling and steps that should be taken prior to lifting the moratorium.

Procedural Lapses

The letter contains a number of allegations regarding procedural shortcuts that BP took in order to either reduce direct costs or save time.  In fact, the distinction between time and money is a false one since BP was paying Transocean high dayrates for the Deepwater Horizon rig and the project was already behind schedule.  Keeping in mind the fact that BP has yet to respond to the allegations, here are the five main points in the letter:

1. Well Design. The use of a full string of casing from the wellhead to the bottom of the well was criticized as being inferior to installing a “liner-tieback” system which is more expensive but considered safer.
2. Centralizers. Centralizers are devices that ensure that the casing running down the wellbore is centered properly.  If the casing is not centered properly, the “cementing” of the well can fail which can result in gas flowing up the spaces around the casing.  Halliburton recommended the use of 21 centralizers but BP only used six of the devices.
3. Cement Bond Log. Once cementing is complete, engineers run an acoustic test called a “cement bond log” to determine whether the cement has bonded to the casing and the surrounding formation of the wellbore.  This is done to detect the potential of gas leaks.  The letter alleges that this work was not performed.
4. Mud Circulation. Circulation of drilling mud allows engineers to test the mud for the presence of gas.  The letter alleges that industry best practices calls for a full circulation of mud from the bottom of the well to the top.  This is done prior to cementing in order to correct any gas leak issues before the key cementing stage.  BP only performed a partial mud circulation test.
5. Lockdown Sleeve. A casing hanger lockdown sleeve is supposed to provide a barrier to blowouts in addition to the cement at the bottom of the well and the seal at the wellhead on the sea floor.  The letter claims that BP did not deploy the lockdown sleeve.

These procedural issues, if accurate, paint a picture of a company that was taking shortcuts in an effort to contain costs and bring the well into production as quickly as possible given that the project was already late.  While BP should have an opportunity to respond, it is worth noting that extensive reporting in The Wall Street Journal in recent weeks corroborates important points in the letter. The evidence uncovered so far strongly suggests that human error led to the disaster rather than equipment failure.

Regulatory Implications

In a complex engineering project, there are obviously many cases where good judgment must be used to select the best technique from a menu of possible choices.  Even in cases where a company is committed to following best practices, there are risks that incentive systems will be set up in a manner that results in shortcuts being taken.  The purpose of government regulation is to ensure that proper procedures are in place when failures have the potential of creating serious economic, safety, or environmental externalities.

In an endeavor as complicated as drilling for oil in over a mile of water, there are clearly numerous potential externalities that could occur and this is why the Minerals Management Service (MMS) has been empowered to approve permits for drilling work.  Based on the Congressional letter to Mr. Hayward and many other sources, it is obvious that MMS plays an active role even to the point of micromanaging the techniques to be used on a particular well.

To say that there were regulatory failures in this situation would be a major understatement.

Checklists:  Too Simplistic?

At this point, we do not yet have a definitive answer regarding what led to the Deepwater Horizon disaster.  However, it is worth noting that the main evidence discussed up to this point question the decision making of individuals involved in the drilling.  In other words, human error played a major role in the disaster and it is likely that better safety procedures would have prevented the blow out.

Is it too simplistic to think that a major problem with Deepwater Horizon was a failure to properly use checklists?  Atul Gawande’s excellent book, The Checklist Manifesto, points out the problems that can be averted based on using simple checklists even in situations where a great deal of complexity exists.  Drilling a deepwater well is obviously a very complex endeavor and there are many judgment calls to be made.  Even if BP was motivated to cut corners to save time and money, MMS could have been more stringent regarding the use of a checklist of required safety procedures.

Revisiting the Moratorium

The moratorium on deepwater drilling was a reasonable step to take in the days and weeks immediately following the disaster.  At that point, the sequence of events leading to the blowout were not known and there was a great deal of confusion.  However, now that more facts are coming to light, regulators need to consider whether the moratorium can be lifted based on enforcement of a more stringent set of rules.

Was human judgment to blame or is drilling in 5,000 feet of water inherently unsafe regardless of the best technology and procedures?  Based on the good safety record of such drilling in general and indications that poor decision making was likely the root cause of the problem, the moratorium should be lifted once more stringent rules are put in place.

As with any human endeavor, there are inherent risks that exist even with the best safety procedures.  However, one must also consider the secondary effects of prohibiting drilling.  Reducing the production of domestic oil will result in greater  dependence on foreign sources of oil.  Drilling in foreign locations may have weaker environmental and safety regulations than in the United States.  More shipments of crude oil will be necessary and there are safety issues related to shipping as well. We must also consider the impact of an extended or permanent moratorium on the Gulf Coast economy which is already reeling from fishing and tourism losses.

As with much else involving energy policy, the risk/reward trade off with deepwater drilling presents us with a menu of less than appealing choices but it remains critically important to strike the appropriate balance.

Disclosure:  No position in BP.  The author holds investments in companies engaged in oil and gas exploration.

Posted by manualofideas at 07:03 AM | Permalink | Comments (0)

By Ravi Nagarajan

This is the fourth in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

It is impossible to escape the daily barrage of terrible news from the Gulf of Mexico.  BP is obviously the target of unceasing criticism, much of it well deserved, and the company’s share price has reflected a great deal of uncertainty regarding ultimate liability and the safety of the dividend.  However, investors are also abandoning nearly any company involved in the oil sector regardless of exposure to the spill or to the drilling moratorium in the Gulf of Mexico.  As we pointed out in previous articles on Noble Corporation and National Oilwell Varco, investor panic often creates interesting opportunities for long term investors.

Ensco 102 in The North Sea

Ensco International plc is an offshore contract drilling company that provides services to oil majors and independent oil exploration firms.  The company has historically focused on jackup rigs designed for relatively shallow water but has devoted the majority of capital expenditures in recent years to build up a fleet of semisubmersible rigs capable of deepwater operations.  Ensco has a fleet of 45 mobile offshore drilling units comprised of four semisubmersibles, 40 jackups, and one barge rig.  In addition, the company has one new semisubmersible unit ready for deployment in August and three semisubmersible units scheduled for delivery in 2011 and 2012.

Overview of Business

One of the common filters that many value investors use involves looking for companies trading at or below tangible book value.  In recent days, Ensco traded below tangible book value and the recent rally has increased the market capitalization to slightly above tangible book.  Of course, this statistic is merely “interesting” until we delve deeper into the quality of the assets on the balance sheet as well as the durability of the business.  The exhibit below displays a snapshot of Ensco as of June 11, 2010:

Ensco is geographically diversified with significant revenues originating from its Europe, Africa, and Asia Pacific reporting segments. The chart below shows Ensco’s 2009 revenues broken down by business segment.  Ensco segregates worldwide deepwater operations into a separate segment and has regional segments for shallow water operations using the company’s large jackup fleet.  We can see that shallow water operations comprised 87 percent of revenues in 2009.  Furthermore, shallow water activities outside the Americas accounted for 66 percent of revenues.   Clearly Ensco is not principally a deepwater player in the Gulf of Mexico.

The following exhibit shows some key data from the past five years.  Note that the company does not employ much leverage and has enjoyed healthy margins over this timeframe due to the overall strength in oil prices which has led to healthy rig demand and high dayrates.  However, the company’s return on equity has decreased somewhat due to significant cash balances earning low returns (cash balance was over $1.2 billion as of March 31, 2010).  Additionally, high levels of capital expenditures on semisubmersible deepwater rigs over the past three years have only started to generate meaningful revenue recently as newbuild rigs enter service.

Cash Generation Machine

High oil prices and healthy demand for the company’s services have resulted in Ensco resembling a cash generation machine in recent years.  Much of the cash flow has been devoted to the company’s expansion program which has focused on building up the fleet of semisubmersible rigs capable of operations in very deep waters.  In addition to investing in capex, Ensco has returned cash to shareholders in the form of dividends and share repurchases.  The company recently increased the regular quarterly cash dividend to $0.35/share from $0.025/share.

The exhibit below shows the cash generation capability of Ensco over the past five years along with the use of the cash.  The company expenses regular maintenance on existing rigs.  We have classified a portion of the capital expenditure program as “maintenance capex” to reflect minor upgrades of existing rigs that could arguably not increase rig capabilities.  The vast majority of capex has been identified as rig enhancements or newbuild rigs.

As noted previously, Ensco’s cash balance has increased dramatically and stands at over $1.2 billion as of March 31, 2010.  Since the recently enhanced dividend will consume approximately $200 million per year, management seems to be aware of the negative aspect of continuing to pile up excess cash on the balance sheet.

Segment Details

As the chart above demonstrates, Ensco is well diversified geographically and current revenues are dominated by shallow water operations outside North and South America.  However, management is clearly committed to expanding deepwater operations significantly.  The vast majority of capex over the past three years has been dedicated to the deepwater segment.  The exhibit below shows selected segment data for the past three years.

The importance of deepwater has increased even further in the first quarter of 2010.  Deepwater operations accounted for 29 percent of revenue and 39.8 percent of operating income for the first quarter — a dramatic increase over full year 2009 statistics.  In other words, the large level of capex allocated to the deepwater segment over the past three years is now starting to generate significant revenues and profitability as more semisubmersible units become productive.

U.S. Gulf of Mexico Exposure

Ensco has ten rigs located in the Gulf of Mexico.  Seven jackup rigs are operating in shallow water areas at dayrates ranging from approximately $50,000 to $100,000.  Two semisubmersible rigs are operating in deepwater areas at estimated dayrates of $295,000 and $365,000.  One newbuild semisubmersible rig is contracted to begin operations in August at a dayrate of approximately $480,000.

The exhibit below lists each of Ensco’s rigs located in the Gulf of Mexico based on the company’s May 14 rig status report.  Ensco Investor Relations has indicated that the next fleet status report will be posted on June 15.  The company did not respond to a request for an interim update prior to the June 15 report.

Last week, we pointed out that there was much confusion regarding the Federal Government’s moratorium policy related to shallow water exploration.  As of today, it is still not entirely clear whether the government intends to stand in the way of shallow water operations, although indications are that such exploration will probably continue to be permitted.  Deepwater exploration is obviously another matter.  President Obama continues to insist on the six month moratorium on deepwater exploration but the significant impact on the Gulf Coast economy has caused prominent politicians such as Louisiana Governor Bobby Jindal to argue for lifting the moratorium.

Under a worst case scenario for deepwater, the “force majeure” clauses in Ensco’s contracts may be activated and the company may lose the anticipated revenues from Ensco 8500, 8501, and 8502.  However, the company’s extensive global operations make it highly probable that these rigs will be redeployed elsewhere within a reasonable timeframe.  In a recent conference call, Ensco Chairman and CEO Dan Rabun stated that the Ensco 8500 series is “perfect for Brazil, Gulf of Mexico, and West Africa and Asia”.  Furthermore, since most contracts call for Ensco’s customers to pay “mobilization” costs for rigs, it is possible that the rigs could be redeployed elsewhere without Ensco paying for substantial transportation costs.

How Good is Tangible Book?

Earlier, we stated that one must examine what is in tangible book value before an investor gets too excited about a company that is trading at or below tangible book.  The quality of assets is obviously critical if tangible book is to be considered a margin of safety for the investor.

The critical component of Ensco’s tangible book value is the property and equipment account which is stated at $4.5 billion as of March 31, 2010.  Since a great majority of the company’s tangible book value resides in illiquid offshore drilling rigs, can we feel somewhat confident that the assets are worth what they are stated on the balance sheet?

While it is very difficult to make a definitive assessment, three recent asset sales provide a clue that management is conservative regarding the valuation of rigs.  The company sold Ensco 57 on April 23.  Ensco 57 sold for $47 million while the rig had a net book value of $30 million.  On March 19, the company announced the sale of Ensco 50 and Ensco 51.  These rigs were sold for $95 million and had a net book value of $63 million.  The cumulative gain on sale for the three rigs came to approximately $49 million.  While the sale of three older jackup rigs may not be reflective of overall valuation of the fleet, a positive surprise upon the disposition of assets is a good sign that management might be conservative.

Summary

Ensco plc is a well diversified, high quality company that appears to have been unfairly punished in recent weeks based on “guilt by association”.  When a high profile incident has a major impact on an industry, market participants often sell any company in the industry first and ask questions later.  With a market capitalization only slightly above tangible book value, diversified international operations, and what appears to be manageable exposure to the deepwater Gulf of Mexico, investors should have some downside protection.

The company is not without risk, but the relevant risk is related to the potential for depressed energy prices that reduce demand for the company’s rigs rather than any specific regulatory action related to the Gulf of Mexico.  In the event of a “double dip” recession that reduces worldwide demand for oil, Ensco’s profitability and cash flow would decline along with every other contract drilling company.  However, the long run demand for fossil fuels in the developing world makes the case for a long run decline in oil prices highly doubtful.  Alternative energy sources are decades away from threatening to seriously displace oil and gas as fuels.

In contrast to Noble Corporation which we profiled last week, Ensco has not suffered the same magnitude of decline since late April and the company is more expensive in terms of cash flow or earnings multiples.  The likely reason is that Noble is much more exposed to the Gulf of Mexico deepwater than Ensco, although even Noble is well diversified from a geographical standpoint.  In the event of a favorable outcome for deepwater regulation in the Gulf of Mexico, Noble is likely to have a more rapid recovery.  If the deepwater moratorium continues for a longer period or becomes permanent, Ensco may be the better choice.  Both companies seem to offer a favorable risk/reward profile at current quotations.

Resources:

Ensco plc 2009 10-K
Ensco plc Q1 2010 10-Q
Ensco Q1 2010 Conference Call Transcript (pdf)
Ensco Fleet Status Report as of May 14, 2010 (pdf)
MMS Deepwater Production Summary as of June 7, 2010 (pdf)
Ensco Investor Presentation on June 10, 2010 (pdf)

Disclosure:  No Position in Ensco plc but considering long position.  Long Noble Corporation.

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By Greenbackd

Jon Heller at Cheap Stocks has a great post on The Downside of Net/Net Investing- Lazare Kaplan (LKI). Says Jon:

Posted by manualofideas at 06:22 AM | Permalink | Comments (1)

Whitney Tilson is convinced that BP is simply too cheap to ignore at the current valuation.  Given the steady stream of negative headlines due to the massive Deepwater Horizon oil spill, BP shares are quickly approaching a 45 percent discount to the stock price that prevailed during much of April.  Mr. Tilson makes it clear that BP shares could certainly fall even further in the short run, but he believes that the dividend should be safe.

While Mr. Tilson’s comments regarding BP’s dividend make logical sense, the political pressure on management may soon require a cut regardless of the company’s ability to make payments. Furthermore, the “asbestos-like” qualities of BP’s liability exposure that Mr. Tilson mentions will make total economic exposure unknown for years or decades to come.  BP’s management has also proven remarkably incompetent and politically tone deaf throughout the crisis.  It may make more sense to look elsewhere in the beleaguered oil and gas industry where stock prices have also been hammered rather than to accept the uncertainty at BP.

To learn more about Whitney Tilson’s bullish case for BP, view the video below.

Disclosure:  No Position.

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Good article by Atlantic Monthly on how Soros famously "broke" the Bank of England.

(Thanks to Nadav Manham for the link.)

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In recent days, we have posted a number of articles regarding the oil industry with a focus on the implications of the Deepwater Horizon disaster.  The Financial Times published a graphic that illustrates current activity in the Gulf of Mexico along with the impact of the drilling moratorium in terms of costs, employment, and the domestic supply of oil.  The graphic appears below (click to enlarge).  Click on this link for a related Financial Times article.

On Friday, President Obama made the following statement regarding the moratorium based on a Wall Street Journal article published yesterday:

Mr. Obama said he was trying to carve a middle path on deepwater drilling, suggesting he did not want to end exploration, but he did not want to cut corners either. “I do not want to see this repeated again,” he said, indicating that if safety and environmental standards were tightened effectively, it could help the oil industry overall.

A final decision on deepwater drilling will be made after an independent commission on the disaster reaches its conclusions in six months. But under pressure from Gulf officials, Mr. Obama said Friday he had instructed the panel’s chairmen to report back as quickly as possible. He indicated a decision could then come sooner.

As we pointed out on Thursday, the confusion regarding shallow water restrictions only needlessly adds to the level of economic uncertainty that already exists along the Gulf Coast.  Hopefully, the panel reviewing deepwater drilling will report its findings in a timely manner in keeping with the President’s stated objective.

Disclosure:  The author owns shares of Contango Oil and Gas, an oil exploration company with operations in shallow Gulf of Mexico waters.  The author owns shares of Noble Corporation, an offshore drilling contractor with operations in the Gulf of Mexico.

Posted by manualofideas at 03:42 AM | Permalink | Comments (0)

By Greenbackd

In The value of Seth Klarman (free registration required), Absolute Return has a rare interview with the president and portfolio manager of the 28-year-old Baupost Group. In the interview, Klarman discusses several of Baupost’s positions over the last twelve months, including the fund’s stake in Facet Biotech, which I fumbled last year:

Around the same time the CIT deal was playing out, Klarman took a sizable stake in Facet Biotech—a small biotech company spun off in December 2008 from PDL BioPharma—for an average cost of $9 even though it had $17 per share in net cash at the time of the spinoff. “We liked the discount and pipeline of products,” Klarman recalls. “We knew that when small caps are spun off, they are frequently ignored and become cheap.”

Biogen Idec tried to acquire Facet in a hostile deal for $14.50 per share, raising the offer later to $17.50. When Facet allowed its largest shareholder, Biotech Value Fund, to buy up to 20% of the company, Baupost asked for identical terms, essentially becoming a poison pill. Baupost then told Facet it did not intend to tender its shares in the $17.50 per share offer. Eventually Biogen backed off, and Facet accepted a $27 per share offer from Abbott Laboratories.

Here Klarman discusses his strategy more broadly:

Value investors are typically thought of as stock investors, but Klarman says most of the time he prefers to buy bonds. Bonds are a senior security, offering more safety, and they have a catalyst built into them. Unlike equity, debt pays current principal and interest. If the issuer doesn’t make that timely payment, an investor can take action. “Catalysts can reduce your dependence on the level of the market or action of the market,” he explains. For example, defaults are specific incidents affecting the company regardless of what is going on in the overall market.

Over the past two years, Klarman’s preference for debt has been even more pronounced. After peaking at just $2 billion in June 2008, Baupost’s total equity assets shrank to around $1.2 billion from the fourth quarter of 2008 to the first half of 2009, before turning up slightly at year-end 2009 to nearly $1.6 billion. That puts equities at just a little more than 7% of total assets under management.

And his view on the market

The value pro is still looking at troubled companies, mortgage securities and select equities. But he is not buying much at the moment. Klarman says there are some opportunities in commercial real estate on the private side, but not as much as would be expected, given the depressed levels of the market. “That’s why we want to be patient,” he stresses.

Baupost is 30% in cash now, its long-time average. Klarman stresses that the cash position is residual—the result of a search for opportunity and not the result of a macro view. He says he can find great opportunities to buy at the same time he has a bearish view on the world. “We’re good at finding bargains, good at doing analysis,” he emphasizes. “We’re not good at calling short-term movements in the markets.”

And when the markets started to crumble in mid-May, he mostly stood pat, asserting that the 5% to 8% drop in prices did not unleash a torrent of bargains, mostly because of the market’s surge from its March 2009 bottom. “The market has gone up so much that, based on valuation, it is overvalued again to a meaningful degree where the expected returns logically from here can be as low as the low single digits or zero for the next several years,” he says.

Click here to see the remainder of the interview (free registration required).

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Early this afternoon, the Washington Post reported that the Minerals Management Service had rescinded five shallow water permits through emails indicating that all drilling permits would not be approved regardless of water depth.  Soon after the story broke, the Interior Department released a statement saying that the policy of allowing shallow water drilling would continue as long as oil and gas companies satisfy environmental and safety requirements.  The Post has now published a recap of today’s events.  The question on many minds this evening is whether the confusion is a sign of internal debate within the government regarding the possibility of halting all drilling regardless of water depth.

It is worth revisiting the amount of domestic crude oil production attributed to wells in the Gulf of Mexico.  According to the United States Energy Information Administration, 29 percent of domestic production in 2009 came from offshore locations in the Gulf of Mexico.  Total domestic production of 1.938 billion barrels in 2009 was only 28 percent of total domestic consumption of 6.82 billion barrels.  Of course, the remainder must be imported.

As we wrote last month prior to the announcement of the six month moratorium on deep water drilling, prudent regulatory changes are definitely needed in light of the Deepwater Horizon disaster.  It is obvious that the system in place prior to the disaster did not insist on enough redundancy to successfully address low probability but catastrophic events.  President Obama’s six month moratorium on deep water drilling seems like a balanced approach that would give regulators and industry time to assess the causes of the disaster and put in place improved best practices to avoid a repeat.

It would not be shocking if one arm of the government was not aware of the activities of another particularly in the chaotic environment that now exists due to the ongoing disaster.  Perhaps someone at MMS simply misunderstood the nature of the moratorium and rescinded the permits in error.  However, it is also possible that the MMS official simply implemented a new policy prematurely before the news had been disseminated by the appropriate government officials.  As of this evening, The Interior Department is denying any change in policy.

President Obama will arrive in the Gulf region tomorrow and should use the opportunity to provide clarity regarding the question of shallow water exploration in Gulf waters.  According to the Washington Post article, each of the 40 drilling rigs currently working in the shallow water areas of the Gulf employ about 100 people.  However, the ripple effects of putting these 4,000 individuals out of work would have a greater impact throughout the area due to support and service jobs associated with the industry.  Given the fact that the risk profile of shallow water drilling is in no way similar to the complexities facing wells under 5,000 feet of water, it would be senseless to put in place a moratorium not only because of the lost jobs but because the production of oil is critical for United States domestic energy consumption.

It is important to note that all of the moratoriums involve new drilling and do not impact wells that are already producing.  However, a steady stream of new drilling is required to keep production levels up in the coming years since existing wells will eventually be depleted.  An already bad situation will become even worse if government stands in the way of exploration in shallow waters.  If anything, increased shallow water production may be needed to offset the losses associated with the deepwater moratorium currently in place.

Disclosure:  The author owns shares of Contango Oil and Gas, an oil exploration company with operations in shallow Gulf of Mexico waters.  The author owns shares of Noble Corporation, an offshore drilling contractor with operations in the Gulf of Mexico.

Posted by manualofideas at 08:54 AM | Permalink | Comments (0)

By Plan Maestro

While reviewing the presentation of a new reinsurance company, I run across some interesting data on historic price to book multiples for insurance companies.

In the context of also low banking multiples, it seems like the financials is one interesting place to look for ideas. There are several P&C insurance companies with good track records below 1x book value. But before getting too excited let me remind you the warnings about investing in banking and in financials in general:

1. Black Box: you will never be 100% sure of its balance sheet quality
2. Leverage: no perfect margin of safety
3. Thin margins: usually no competitive advantage and bad performance pays
4. Macro matters: you just can not ignore it. Deflation, inflation and interest rates have an impact
5. Leadership matters: any more than in any other sector, good management is crucial to control risk and allocate capital. This is not Coca Cola than could survive a series of bad CEOs

Part of the reason for the low insurance valuations is the soft pricing environment discussed at length in several articles by the StreetCapitalist and RationalWalk. Insurance is a cyclical business, where commercial pressures drives uneconomic pricing, that destroys capital, leading no the next hard market. As Peter Lynch mentions in his books, one way to invest in the sector is to anticipate this changes. Not an easy thing to do if you are not a card carrying member.

Let me also remind you the critical questions when using book value multiples in financials:

1. How conservative is that book value?
2. Is it improving?
3. How are the capital ratios and will it need value destroying new capital or a reorganization?

An excellent blog to read for an inside view of the sector, is the now classic David Merkel’s Aleph blog. He posted recently an excellent analysis of reserve practices of several insurance companies that is tightly related to question #1. Very recommended.

Posted by manualofideas at 08:50 AM | Permalink | Comments (0)

By Greenbackd

Posted by manualofideas at 08:47 AM | Permalink | Comments (0)

By Plan Maestro

So how dependent is the USA on ultra deepwater production? I ask that question to have a sense on the government’s flexibility for a short term production moratorium and tough new regulation. This scenario is what the market seems to be predicting as an almost certainty. Well, this is how relevant is the Gulf of Mexico crude production:

30% of crude oil production and 19% of its reserves. If you include all liquid fuels the numbers are better but still big, with offshore GOM representing 8% of production and 15% of reserves. If you also consider that ultra deepwater production is not marginal anymore the probability of a production moratorium without real evidence of widespread negligence and corruption is probably low .

Long term, onshore reserves are a real alternative. It  comprises a large percentage of the US crude reserves but it includes secondary recovery techniques like waterflooding that may be more expensive to extract. So expensive regulation of ultra deepwater drilling may be forthcoming.

The outlook for natural gas in the Gulf of Mexico once again surprises. Perhaps counter intuitively, its lower environment impact and less dependency could make it a target for grand standing and short term measures.

Some natural gas GOM E&Ps like McMoRan Exploration have been hit as a consequence of the Macondo blowout and the suspension of exploratory drilling. MMR production is mostly in shallow water but their exploratory efforts are in ultra deep gas.

No position

Posted by manualofideas at 08:43 AM | Permalink | Comments (0)

By Plan Maestro

In that Macondo forgotten even by the birds, where the dust and the heat had become so strong that it was difficult to breathe, secluded by solitude and love and by the solitude of love in a house where it was almost impossible to sleep because of the noise of the red ants, Aureliano, and Amaranta Úrsula were the only happy beings, and the most happy on the face of the earth. -  Gabriel Garcia Marquez, Cien Años de Soledad

I thought it was important to put in context the  numbers of ultra-deep water exploration in the Gulf of Mexico after a possible market overreaction to the Macondo blowout. The market has left no prisoners, not only taking concern for British Petroleum and Transocean, but also all the contract drillers (Noble, Ensco, Atwood Oceanics, Hercules Offshore, Seahawk Drilling) and some exploration and production companies like ATP Oil and Gas and MacMoran Exploration. I particularly recommend Toby Shute’s articles on the investment implications of this disaster.

This graph from a recent EIA post (US Energy Information Administration) tells a clear story of dependence on deep water and ultra-deep water production as shallow water production reached its peak in the nineties and began its decline. So drill all you want, but the USA is becoming more dependent on more difficult to find and more costly to produce reserves. And I have not even talked about the cost of potential  new regulation.

This is one more indication that energy prices may fluctuate but there is only one trend: up. And this is the present. If you want a peek into the future, let me introduce the proven reserves in the Gulf of Mexico.

PD: You have probably noticed that the natural gas story is different. Subject for another time

Disclosure: Long ATPG.

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By Greenbackd

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By Ravi Nagarajan

This is the third in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

As we discussed in our recent article on National Oilwell Varco, the financial markets have been reacting to the Deepwater Horizon disaster by punishing the stock prices of nearly every company associated with oil and gas exploration in the Gulf of Mexico.  In certain cases, the market reaction may be justified by deteriorating fundamentals and in other cases, stocks may be under pressure based on confusion, uncertainty, or merely “guilt by association”.  The current situation in the Gulf of Mexico is a national disaster but is it reasonable to believe that this rich domestic source of oil and gas will not be tapped in the future?  The job of the value investor is to look at these types of situations as opportunities and to identify cases where Mr. Market may have overreacted.

In this article, we will profile Noble Corporation, a company that provides offshore contract drilling, engineering, and production management services to the oil and gas industry.  Noble’s current fleet includes 62 mobile offshore drilling units comprised of 43 jackups, 13 semisubmersibles, 2 submersibles, and 4 drillships.  The company currently has six semisubmersible rigs operating in deepwater locations of the Gulf of Mexico with aggregate contracted dayrates of approximately $2.7 million.

Brief Primer on Rig Types

The terminology associated with offshore drilling can be confusing for those who have not studied the industry in the past.  The following definitions will be helpful in the discussion that follows:

• Semisubmersible Platforms are floating platforms which can be submerged so that a portion of the hull is below water during drilling operations.  The platforms maintain their position over the well either through a fixed mooring system or a dynamic positioning system controlled by computers.  Typically, these platforms require at least 200 feet of water depth and are capable of drilling in depths of up to 12,000 feet.  Semisubmersibles are used for Noble’s deepwater drilling activities in the Gulf of Mexico and elsewhere.  The nearby picture is the Noble Danny Adkins which is currently deployed in over 9,600 feet of water in the Gulf of Mexico.
• Submersible Platforms are designed to be submerged to the drilling position by flooding the hull until it rests on the sea floor while the upper deck remains above water.  These rigs are used in shallow water between 12 and 70 feet.
• Jackup Rigs are self-elevating drilling platforms equipped with legs that are lowered to the ocean floor in order to establish a foundation for support.  The rigs are towed to the location of the well where the legs are lowered based on various techniques.  Jackups can be used in water depths from 8 to 400 feet.
• Drillships are self propelled ships equipped for drilling and are positioned over a well using a dynamic computer controlled positioning system.  Noble’s fleet of drillships can be used in deep water areas although none are deployed in the Gulf of Mexico.

Noble’s U.S. Gulf of Mexico Fleet

The following exhibit shows Noble’s current Gulf of Mexico fleet of six semisubmersible units.  The data sources for the exhibit are Noble’s Fleet Status Report (pdf) dated May 24, 2010 and the Minerals Management Service (MMS) Deepwater Production Summary Report (pdf) dated June 1, 2010.

The exhibit shows the operator, or lessee, of the rig along with the contracted average dayrate and the contract expiration.  All six of these rigs appear to be operating in waters that are deep enough to be included in the recent six month moratorium on deepwater drilling.  The government has mandated a halt to drilling as soon as wells can be placed in a state that is considered safe but it is likely that all of these rigs will soon be idle.

Noble’s contracted drilling backlog, as reported in the company’s latest 10-Q filing, are subject to various termination and modification provisions but the company does not specifically list the termination rights of the operators of the Gulf of Mexico rigs.  In a worst case scenario in which all six of the currently contracted rigs stop producing revenue, the company’s exposure is roughly $2.7 million of lost revenue per day.  However, it is likely that much or all of the cost of the idle rigs through the end of the contracted term will end up the responsibility of the operator rather than Noble.

Obviously, beyond the current contracted terms, Noble would not be able to deploy these rigs in deepwater within the U.S. Gulf of Mexico if the moratorium is extended beyond six months.  Under such circumstances, the company would either have to idle the rigs, move them to shallow water Gulf of Mexico locations, or use them elsewhere (possibly in Gulf waters under Mexican jurisdiction).

Historical Performance and Valuation

The following exhibit shows selected metrics for Noble Corporation for the past decade as provided by Value Line Investment Survey (click on the image for a  larger view):

One of the important points to note is that the company has a relatively low level of long term debt as a percentage of overall capital deployed.  Noble is a capital intensive business but management has not relied excessively on debt to finance capital expenditures.  We can also see steady progress in earnings per share over the past few years along with higher margins and return on equity. Much of the progress in recent years is associated with the impact that higher oil and natural gas prices have had on the exploration plans of oil majors and independent exploration companies.

The following exhibit shows Noble’s free cash flow and expansion capital expenditures over the past five years:

The company has been generating significant free cash flow with increases in each of the past five years.  This cash flow has been deployed mostly toward expansion of the fleet (newbuilds) or enhancements to the existing fleet.  For a company with a current market capitalization of approximately $7 billion, this cash flow track record is clearly impressive.

Geographic Revenue Distribution

The following exhibit shows Noble Corporation’s revenues broken down by region for 2009:

At 22.3 percent of revenues for 2009, the United States is clearly an important market for Noble.  Furthermore, based on the type of rigs involved, the bulk of this revenue is associated with deep water drilling activities.  Based on a $2.7 million aggregate dayrate, the company could be expected to produce nearly $1 billion in revenue assuming that each rig earns revenue without any interruption at currently contracted rates.

On the other hand, it is also clear that Noble has a large amount of revenue originating in a diversified list of countries, including Mexico which was the largest source of 2009 revenues.  It is not unreasonable to believe that many of the rigs currently operating in United States Gulf of Mexico waters could be put to good use nearby in Mexican Gulf waters in the unlikely event that the moratorium extends for several years.  In addition, we should remember that, with the exception of Noble Paul Romano facing a near term contract expiration next month, current contracts in the United States Gulf of Mexico do not expire until March 2011, unless contract cancellation provisions allow customers an early exit.

A Permanent End to Deepwater Drilling — Very Unlikely

While the current outrage over the Deepwater Horizon disaster is a natural reaction, a permanent end to deepwater drilling in the Gulf of Mexico is neither reasonable nor likely based on current production statistics.  According to MMS, deepwater production in Gulf has steadily increased over the past 25 years and now exceeds 80 percent of production on the outer continental shelf.  Based on the MMS data, deepwater drilling produced 569 million barrels of oil in the Gulf in 2009 alone.  According to the U.S. Energy Information Administration, total production of crude oil in the United States for 2009 was 1.9 billion barrels, which means that nearly 30 percent of production can be attributed to deepwater  Gulf of Mexico drilling.  The United States consumed 6.8 billion barrels of oil in 2009, the vast majority attributed to imports.

It is reasonable to believe that the United States government will prohibit oil exploration and production from a source that provides nearly 30 percent of domestic oil production and represents the best area for new discoveries going forward? Does it represent good public policy to reduce domestic consumption even though the United States must import billions of barrels of oil each year from foreign countries, many of which are in regions hostile to American interests?

The much more likely long term scenario is that governments will impose tougher regulation that impacts oil exploration and production based on lessons learned from the current disaster.  There is clearly a risk that government regulatory overreach will cripple deepwater production over a longer period of time.  There is also a risk that other countries could adopt such policies as well.  However, such risks seem remote given the fact that the modern economy still requires oil to function and alternative  energy sources will not make a dent in overall demand for many decades to come.

Summary

Noble Corporation appears to be in a well diversified position from a geographic standpoint and has delivered solid financial results with minimal leverage in recent years.  Free cash flow is impressive relative to the current market capitalization of the company which reflects no premium on reported book value as of March 31, 2010.  The company should be protected to some extent in the near term by contractual terms associated with the six deepwater Gulf of Mexico rigs. Chairman and CEO David Williams has indicated that all contracts have force majeure clauses but whether these clauses will come into effect is not known at this point.

In the long run, it is likely that the United States government will again allow deepwater drilling, albeit with tougher regulation.  In the event that an extended moratorium exceeds the lengths of Noble’s current contracts, the company should be able to eventually redeploy assets in other parts of the world.

Resources:

Noble Corporation 2009 10-K
Noble Corporation Q1 2010 10-Q
Investor Presentation by Chairman/CEO David Williams on May 25, 2010

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. Disclosure: No position in Noble Corporation, but currently considering taking a long position.

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From C-SPAN: "Responding to questioning, Warren Buffett agreed that there are still risks involved in the derivatives market during today’s Financial Crisis Inquiry Commission hearing. The hearing focuses on the role of ratings firms in the financial crisis and is titled, "Credibility of Credit Ratings, the Investment Decisions Made Based on those Ratings and the Financial Crisis.” Executives from Moody’s, including its current CEO, are also among the witnesses. Mr. Buffett's Berkshire Hathaway is Moody's largest shareholder."

FCIC Hearing: Session 1   

FCIC Hearing: Session 2 (incl. Buffett testimony)

FCIC Hearing: Session 3

AP: Congress grills Moody's officials

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By Greenbackd

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