The current worldwide capacity of jackup rigs is steadily increasing, with 32 new rigs either under construction or scheduled to be constructed during the next four years. But that number could increase to 52 if additional shipyard options are exercised. This has caused Houston-based Simmons & Co. International to reassess the jackup-rig market and, in particular, the stocks of those drillers that have a high component of jackup rigs in their fleets. "Our view is that customer demand will easily absorb and, in fact, outstrip the growing supply of jackups over the next 12 to 18 months," says analyst Scott B. Gill. "Beyond that time frame, however, when the majority of new builds begin to arrive, we hold a more cautious view as the visibility of demand is substantially reduced." While it's estimated that current annual jackup-rig construction capacity is about 13 rigs per year, that construction capacity could easily swell to 25 rigs annually during the next five years, he cautions. "To date, most of the new jackup construction has been scheduled for Singapore. However, China appears to have ambitious plans to participate in the capital-equipment cycle for new rigs, as well as to grow its indigenous fleet of jackups." The utilization of today's fleet of 386 jackup rigs is now around 95%, and will likely hover in that area, or above, for the foreseeable future. This will support dayrates reaching replacement-cost levels, or possibly greater, since it takes two to three years to construct a new jackup rig. Gill acknowledges, of course, that current jackup dayrates-typically $75,000 for leading-edge Gulf of Mexico and Middle East assets which generate cash returns on investment of less than 12%-don't yet justify the construction of new jackups. "To fully compensate for the inherent risks of building and operating new jackups, [expected] cash returns should exceed 20%," he says. "Thus, threshold jackup dayrates need to escalate to roughly $110,000 to $115,000." There's also another morsel of wisdom drilling-sector investors need to digest. "History shows that capacity additions in mature segments of the oil-service sector invariably mute stock-price performance for those entities investing in new capacity additions," reminds Gill. "Thus, jackup drillers, from a stock-price-performance standpoint, are likely to be burdened by this wave of new capacity additions until the long-term demand picture becomes clearer-a process that will likely take quarters rather than weeks or months to unfold." On a more upbeat note, the analyst observes that recently the valuation metrics for jackup drillers-and those for offshore drillers in general-have been attractive. Going into this summer, the stocks of all offshore drillers were trading at an average 13.2 times estimated 2006 earnings and 8.4 times estimated 2006 cash flow. Historically, those stocks traded at a premium multiple to the price/earnings ratio of the broader market-recently the latter ratio was 15.7-and at forward 12-month price/cash flow multiples of 12 to 14. Gill believes that until the market grows comfortable with the idea that incremental jackup demand will keep up with the pace of new asset construction, the stocks of jackup drillers will likely continue to be discounted relative to historical valuation metrics. This doesn't mean the stocks of jackup drillers won't enjoy some upside. They will-just not as much as some of their other offshore-driller brethren. "Qualitatively, we expect the [stocks of] jackup drillers to trade directionally with the OSX (Oil Service Index), but likely underperform," says Gill. "Thus, we remain Overweight the offshore drillers, with a bias toward those companies with greater exposure to premium deepwater rigs and little-to-no exposure to lower-end jackup rigs-namely Transocean, GlobalSantaFe and Noble Corp." The analyst emphasizes that his primary concern with building incremental jackup capacity is the issue of pricing-power erosion. "The jackup market has prospered during the past 12 months, with dayrates eclipsing prior peak levels for several asset classes. That pricing power has been a function of utilization levels-and a regression in utilization caused by bloated capacity would result in a corresponding regression of pricing leverage."
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