New Russian Territory

Jim Brown
 
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According to news reports the show vote in Crimea passed with 95% of voters saying they want to be part of the Russian Federation. Of course there was no way to vote no on the ballot so nobody is surprised of the outcome.

The Crimean ballot had two questions. The first was do you want to join Russia. The only available answer was yes. The second was do you want to revert to an independent state and let the parliament decide on joining Russia. The only available answer was yes. If you did not want to answer yes to either question your ballot was discarded. With armed Russian soldiers standing watch at every polling station there was considerable intimidation against anyone not wanting to play along with the show vote.

The next step will be the Russian parliament voting to accept Crimea. Obviously no surprise is expected there. Starting on Monday the EU and USA will begin putting sanctions on Russia and Russia has said it will return the favor by seizing assets in Russia that belong to EU or US companies.

Meanwhile Russian troops and tanks continue to build up along the Ukraine border while Putin warns he will have to act to protect Russian citizens in the Ukraine. This has all the makings of another land grab since nobody can stop him militarily.

The S&P futures opened down about -10 points but have recovered half of that loss. As long as no war breaks out in the Ukraine the market should forget about Crimea in a week or so.

China is a bigger problem for the U.S. than Crimea. If China's economics continue to decline and the credit default problem begins to accelerate the U.S. markets will decline.

Crude prices are hovering just over $99 tonight in listless trading. It appears traders don't know which way to jump. Russia produces about 9 mbpd and Europe gets 30% of its oil from Russia. How that will play into the sanctions process is unknown. OPEC could produce enough oil to offset Europe's demand from Russia but it would take a couple months for the production to begin flowing to Europe.

Deepwater Drillers

Readers have asked me my opinion on deepwater drillers like Transocean Offshore (RIG). The stock has imploded and just keeps setting new lows. With the current boom in deepwater drilling why are the drillers in crash mode.

Just a year ago there was a shortage of deepwater rigs. Rig rates were rocketing higher and the future was bright. Customers were leasing rigs 18-24 months in advance just to make sure one was available. Fast forward to today and there is a surplus of rigs or at least old rigs.

About three years ago smaller companies like Seadrill (SDRL) and Noble (NE) were ordering new ultra-deepwater rigs at a cost in the range of $550 million. They saw the future with wells being drilled deeper in deeper water and that requires monster rigs with the latest in capabilities. Transocean also got into the act and placed several orders for new rigs. These rigs take many months to build and they are backordered for several years.

Fast forward to today and those rigs are starting to deliver and become available for service. I believe the last number I heard was a total of 47 rigs being delivered from 2013-2018. Every one of those rigs are going to have the latest technology and be capable of drilling ultra-deep wells.

To use Transocean as an example they are the largest offshore driller and have a fleet of 29 ultra-deepwater rigs and 14 deepwater rigs. Basic math shows that there are more new build rigs coming to market in the next three years than Transocean owns today. The average age of a Transocean rig is 9 years. That is about 3 generations in rig technology. Some of their rigs are more than 25 years old. While they have been upgraded they are still old.

Transocean has 19 rigs with leases that expire in 2014. This means Transocean may have stack some of older rigs and get creative on pricing on the rest in order to compete with the flood of new technology rigs coming to market. Dayrates are going to dive for Transocean as well as fleet utilization. In their last earnings report utilization declined from 94% a year ago to 87%. The average dayrate was $510,200, a decline of -3% from Q3.

To combat their aging fleet Transocean said it had placed two additional orders for new ultra-deepwater drill ships at a cost of $1.24 billion. Those rigs will not be delivered until 2017 and 2018. These are speculative rigs and they don't have any pre-signed leases. That is not normally how Transocean operates. They normally prelease them before committing to build them.

This same scenario is playing out with the other drillers. Some have newer fleets and are not having as much trouble securing leases for the newer rigs but older rigs are going to be stacking up in harbors around the Gulf of Mexico. Seadrill and Ensco (ESV) fleets have an average age of 4 years. The fleets are smaller and easier to manage but the same metrics apply.

There are 54 active rigs in the Gulf today and should rise to more than 60 by 2016. With Mexico working on restarting a deepwater drilling program that will help put some of the older rigs to work.

Over the last several years the deepwater drilling boom offshore Brazil has faded. The drilling is hard and expensive and the rewards have fallen short of expectations. The Brazilian government has proven to be a pain in the neck and some companies are deciding to end their drilling in that area. Petrobras and the Brazilian government are building a fleet of their own deepwater drillships and those will be taking over from the majors that contracted with Petrobras in the initial wave of exploration. That is going to free up additional rigs to go somewhere else in the world.

Credit Suisse expects the growth in capex spending by E&P companies is going to slow to about +5% over the next three years but then accelerate in 2017. They believe it would take 14% to 18% growth to keep all the rigs working.

The deepwater drillers are all good companies but they are heading into a period of soft demand and severe over capacity. Eventually this trend will reverse as it always does but until the stocks find a bottom I would avoid them.


Market

The market is poised on the edge of a precipice. The S&P 500 declined on Friday to strong support at 1,840. A break below that level could begin a significant decline. However, now that the Crimea vote is over and the annexation is almost done the market should see some dip buyers appear. The key will be the sanctions and the retaliation for the sanctions. If they are weak as most expect then the problem will fade out of the headlines. If the world comes down hard on Russia and Putin responds with equally dramatic sanctions against the EU and US then we could see the market move lower.


Jim Brown

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