It was on July 17 that I wrote an article on Diamond Offshore (DO, Financial) with an opinion that the stock is trading at deep value and can deliver medium-term gains. It’s been 2½ months, and Diamond Offshore has delivered 27% returns.
This article will discuss why positive momentum for this offshore drilling stock is likely to sustain in the next three to six months. The focus of the article will be on company-specific fundamentals that will trigger upside for Diamond Offshore while industry factors see gradual improvement.
Bullish on oil
I am bullish on oil in the medium term, and that will help positive momentum sustain for offshore drilling stocks.
Brent is currently trading at $56 per barrel, and it’s important to note that oil has moved higher after a sustained period of consolidation in the zone of $45 to $50 per barrel. This is likely to serve as a support zone.
It is also worth noting that the dollar index has weakened in the last 12 months after touching a high of 102; as economic uncertainties persist, I see a relatively weak dollar supporting oil prices.
In addition, as the production cut agreement between OPEC and non-OPEC members sustains, the impact is being seen with some lag, and I expect Brent to remain above $55 per barrel.
The key reason for discussing this is to underscore the point that momentum is likely to remain positive for the offshore drilling industry as oil stays at relatively higher levels.
At the same time, I must mention here that even at $60 per barrel oil, it would be too early to expect an increase in day rates and EBITDA margin expansion. The positive factor can potentially be a gradual increase in rig utilization with compressed EBITDA margin.
Strong balance sheet
For any offshore drilling stock, balance sheet fundamentals are the first point worth investigating. Seadrill (SDRL, Financial) is a good example of an offshore drilling story gone wrong with quality rigs but an overleveraged balance sheet.
For Diamond Offshore, balance sheet fundamentals are strong with total debt of $2.0 billion as of June 30 and debt-to-capitalization of 34% for the same period.
Importantly, as the chart below shows, the company has an extended debt maturity profile and with no debt maturity until 2023, the company is well positioned.
There are several other factors that contribute to the company’s balance sheet strength and are as follows:
Diamond Offshore has $1.5 billion in available credit facility and as of June 30 the company’s cash and equivalents was $161 million. With total liquidity buffer of $1.7 billion and no speculative capital expenditure, the balance sheet will remain strong.
Diamond Offshore currently has an order backlog of $2.9 billion. Considering first-half EBITDA margin of 41%, the company’s EBITDA visibility is around $1.2 billion from the current backlog.
Since Diamond Offshore has no new rig investment, potential cash flows of $1.0 billion can be used to strengthen the company’s balance sheet. Just as an example, for the first half, Diamond Offshore reported positive free cash flow, and the company repaid $104 million in short-term borrowings.
The demand for offshore drilling
The critical factor for offshore drilling companies is survival more than growth or immediate EBITDA expansion. That’s the reason for focusing on the balance sheet than talking about the quality of the fleet.
With Diamond Offshore having a modern fleet, rig utilization will increase as industry sentiments improve. The key point I want to address in this section is the need for offshore drilling in the long term.
The chart below from the latest presentation of Diamond Offshore will put things into perspective.
Considering the potential demand for oil in the next decade and the likely production from existing fields, there is need for offshore and unconventional oil sources.
With significant decline in offshore activity in the last 12 to 18 months, demand-supply mismatch will come into play in the next 24 to 36 months and as oil moves in the range of $70 to $80 per barrel, I expect strong action in the offshore drilling segment.
Offshore drilling is not dead and what companies need now is enough cash flows to stay afloat. In the long term, surviving companies will outperform.
Conclusion
Diamond Offshore has a quality fleet along with a decent order backlog that is likely to ensure that balance sheet fundamentals remain strong and potentially improve in the next six to 12 months.
With oil moving higher, I see positive sentiments taking the stock higher, and profit-booking opportunities will come if Diamond Offshore moves another 15% to 20% higher from current levels.
For long-term exposure, investors can wait for sustained uptrend in oil prices and oil sustaining at above $65 to $70 per barrel levels.
Disclosure: No positions in the stocks discussed.
