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Catching A Falling Knife: A Deepwater Buyout

Across the oil industry, many firms have started to see their stock prices stabilize. The offshore deepwater drilling industry is the exception. Deepwater drillers have continued to collapse in value. It is always dangerous to try catching a falling knife, but at this point the stock prices on many firms in the space don’t have much more to lose.

The biggest firms in the industry, Noble, Enesco, and Transocean now trade at prices of around $4.75, $7.50, and $9.75 respectively. Stock price by itself means nothing, but it’s important to remember that all of these were companies where the stocks were once trading in the $40-$70 range. In other words, their market caps are roughly a tenth of what they once were. For about $6 billion, an outsider acquirer could buy up the top 3 players in the industry. That’s important because the problem in the deepwater drilling space is essentially one of supply – not supply of oil, but supply of offshore drilling rigs.

An outside acquirer – anyone from Exxon Mobil to Schlumberger – could essentially buy the entire deepwater drilling industry for roughly $10B. Antitrust regulators might balk initially, but the reality is that the industry is not large or healthy, and so regulators would probably have a lighter touch than they might in other circumstances. Bear in mind that this is an industry that was worth $100B+ just a few years ago.

Deepwater drilling is not a broken or fundamentally unprofitable business – there are simply too many players in the space competing for an oil drilling market that is fairly stagnant. As a result, day rates have fallen dramatically. Consolidation in the industry could help to fix this problem.

The industry’s own ability to consolidate itself remains limited at this stage. Just as the onshore services market showed earlier this year, shareholders would dramatically penalize any company that tried to buy another firm out of fear that the acquirer would collapse under the financial strain. Witness the effect on Weatherford’s stock at the start of the year when the company talked about buying assets from Baker Hughes in the ill-fated BHI-HAL tie-up.

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None of the biggest players in the space - Transocean, Enesco, Noble, or any of the others – are equipped to handle any sort of significant merger activity. The big players are not at immediate risk of bankruptcy, they all have plenty of cash liquidity, and enough in undrawn revolver commitments to weather the on-going storm over the next few years. But none of the firms is aggressive or crazy enough to risk their future by overextending themselves via a merger.

The deepwater drilling industry is unique then in that internal industry mergers are not feasible. But external buyouts are definitely a possibility. One group that should probably be looking at the space closely is the private equity shops. Most of the big PE firms have enormous amounts of liquidity on hand from funds they raised to buy distressed oil producers. A group like Blackstone or Carlyle could literally buy the entire offshore industry out, rationalize offshore rig supply, and then benefit enormously as the market slowly starts to recover over the next few years. Oil majors in the U.S. and abroad could do the same thing in many cases. Let’s face it – for $350B market cap XOM, a $10B package of buyouts is not a large sum.

There is no guarantee that anything will happen in the deepwater space of course. Many investors are probably all too wary of the perils of grabbing a falling knife. But at this point it’s worth realizing that a large industry is so cheap here, that a series of significant takeovers by one or more external non-industry players is definitely feasible. Investors willing to play the odds or wait for a long-term recovery in the industry should take notice. This is a risky deep value investment, but it is a significant sized opportunity.

By Michael McDonald of Oilprice.com

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