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Published by: zerohedge on May 30, 2010
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North America Equity Research
24 May 2010
Offshore Drillers
Lowering Offshore Driller Numbers as DeepwaterCosts Likely Climb
OilserviceJ. David Anderson, PE, CFA
(1-212) 622-6684 jdavid.anderson@jpmchase.com
Adam Aron
(1-212) 622-0144adam.aron@jpmchase.com
Samantha Hoh, CFA
(1-212) 622-5248samantha.k.hoh@jpmchase.comJ.P. Morgan Securities Inc.
Equity Ratings and Price Targets
Mkt CapRating Price TargetCompany Symbol($ mn)Price($)CurPrev Cur Prev
Diamond Offshore Drilling Inco DO9,808.3070.55UWn/c 79.0087.00Ensco plc ESV5,524.0738.76OWn/c 52.0060.00Noble Corporation NE8,294.3432.42Nn/c 42.0049.00Pride International Inc. PDE4,416.7525.15Nn/c 30.0033.00Transocean Ltd. RIG19,859.3459.24Nn/c 80.0087.00
Source: Company data, Bloomberg, J.P. Morgan estimates. n/c = no change. All prices as of 21 May 10.
See page 25 for analyst certification and important disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm mayhave a conflict of interest that could affect the objectivity of thisreport. Investors should consider this report as only a single factor in making their investment decision.
With changes to deepwater drilling clearly on they way, we’ve made ourfirst pass at quantifying the impact to the Oilfield Service industry. Whilemany of the potential changes will likely be positive in the medium andlonger term, we see a number of negative implications for OffshoreDrillers over the next several years, causing us to reduce our estimates andprice targets for the group.
Looking toward the North Sea for guidance.
The stricterenvironmental safety standards employed in the North Sea could beadopted in the U.S. Gulf, potentially becoming best practice globally.Higher rated BOPs, acoustic sensors, more safety procedures, andgreater testing frequency would all contribute to higher costs for drillers.
Capital equipment increases of up to $20mm per rig.
We estimate theworldwide fleet could need an additional 233 ram and 206 annular BOPsin order for every rig to have at least two 15kpsi ram and one 10kpsiannular BOP. This corresponds to about $5.5bn in capital expenditures orapproximately $20mm/rig. The biggest question is the timing of spending as BOP manufacturers have limited capacity.
Diamond, Pride, and Noble would be most impacted.
Notsurprisingly, older fleets would require the most capital improvements,crimping free cash flow in future years. We estimate Diamond's free cashflow could be reduced by as much as 22% in 2011 and 27% in 2012,putting its special dividend further at risk.
Cutting estimates and price targets for the group.
Taking into accountlower utilization rates for down days, higher maintenance costs, andincreased insurance premiums, we have trimmed our 2011/12 EPSestimates by 7%/6%. We expect increased capex requirements tocollectively reduce return on capital by over 150bp over the same timeperiod.
Still cautious on Offshore Drillers, prefer HAL and SLB here.
 Demand for deepwater rigs remains weak, and leading edge dayrates arepoised to move lower through the year. While shares of RIG areincreasingly attractive, we still see downside risk. Instead, we would usemarket weakness as an opportunity to own HAL and SLB.
North America Equity Research
24 May 2010J. David Anderson, PE, CFA(1-212) 622-6684 jdavid.anderson@jpmchase.com
Sorting Out the Winners and Losers
Everyone acknowledges that changes in the deepwater are on the way, but figuringout the true financial impact to Oilfield Service stocks is daunting with so manyunknowns. While politicians and regulators wrangle with the consequences of theDeepwater Horizon accident, we are starting to get a picture as to the potentialwinners and losers over the next several years. But recognize that this is only our firstof many attempts at quantifying the impact to deepwater operations; this is simplyhow we see it unfolding as of now.
Losers – Offshore Drillers.
Over the near to medium term, drillers are poised tosee an increase in costs in maintenance, capital equipment, and insurancepremiums. Furthermore, we expect utilization rates to be lower to account forincreased down days related to maintenance and BOP testing. Collectively, wehave lowered our 2011 earnings estimates by 7%, free cash flow by 15%, andreturn on capital trimmed by 130bp. Most impacted are Diamond, Noble, andPride.
Winners – Capital Equipment.
On BOP upgrades alone, we see up to $5.5 bn inpotential orders, while the aftermarket business for parts and service could easilydouble. Manufacturing capacity will be the limiting factor – Cameron, NationalOilwell Varco, and Hydril (GE Oil and Gas) are the only BOP manufacturers.
Probably a winner, but hard to say right now – Large Cap Service.
Thebiggest near-term negative will likely be a more rigid permitting process toresults in lower activity levels, but this should get worked out over time. Furtherout, we see increased technology for decreasing risk and a greater emphasis onquality control, which should be positives for the group. We also see a potentialfor greater services to enhance safety, such as more concrete plugs required. Wehaven’t adjusted our numbers for large cap service yet.Over the longer term, we see deepwater changes as an overall positive for the oilfieldservices industry, along with locking in a higher floor for oil prices. History hasshown that higher costs should eventually be passed along in the form of higherdayrates from rig contractors and overall higher well costs. In the meantime,predicting changes to regulations and practices is likely a futile exercise, but we'll tryanyway. We broadly see five changes to the industry over the next several years:
Increased regulation and new procedures.
We expect the permitting process totake considerably longer, while drilling operations will also likely lengthen withadditional procedures to ensure safer drilling operations. Look toward the NorthSea for a guide, which includes more concrete plugs in well design, among otherthings.
Greater use of technologies to minimize risk.
Over the past decade,technologies have focused on improving performance. This is likely to shifttoward reducing risk.
Changing mix of operators in the deepwater.
Raising the strict liability limitfor oil companies from $75mm to $10bn, as some have proposed, wouldeffectively limit only the super majors from participating in the deepwater Gulf.
North America Equity Research
24 May 2010J. David Anderson, PE, CFA(1-212) 622-6684 jdavid.anderson@jpmchase.com
We expect a limit short of $10bn, but this would undoubtedly change theeconomics for many smaller producers, leaving the deepwater to only the supermajors and large independents.
Higher insurance premiums.
Rig contractors are likely to face a 20-30%increase in insurance premiums. While the spike in insurance premiumsfollowing Hurricane Katrina was short-lived and limited to the Gulf, the new rateincrease is likely to linger longer and expand globally.
Substantial build-out in capital equipment.
We expect greater redundancy andincreased capacity across the board for virtually every critical piece of equipment.The most obvious is the blowout preventers, which are likely to be retrofitted andreplaced, in many cases. Furthermore, we would expect BOPs to be tested morefrequently, likely doubling the annual maintenance costs for service and spareparts. Although many in the industry doubt the effectiveness of acoustic switcheson BOPs, that is probably irrelevant—more is better, expect them to be mandatedin the Gulf.
For the most part, we have difficulty quantifying the impact to large cap servicecompanies.
Over the near and medium term, we are most concerned about delaysthat may be incurred from an extended permitting process. But taking into accountthat this will be limited to the Gulf of Mexico, service companies shouldn’t see toomuch of an impact with their diversified revenue streams. We note that duringhurricane seasons, service company earnings are generally impacted by only a fewpennies per share. Furthermore, any reduced activity levels may be offset by anincreased reliance on technologies that reduce risk, along with a greater emphasis onprocedures that could potentially increase service company involvement.
We feel that we have a better handle on the impact to offshore drillingcontractors, which looks rather negative over the next few years.
Not only willcontractors likely face higher costs on rising insurance premiums and increasedmaintenance, but lower utilization rates are likely as well, particularly with BOPs tobe tested more frequently.
Capital equipment requirements over the next severalyears will likely be material, reducing free cash flow and lowering returns on capital.We do not believe these changes will be limited to the Gulf of Mexico but are morelikely to become “best practice” on a global basis.

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