Street Capitalist: Event Driven Value Investments

So far I have been extremely fortunate to have commenters post some really high quality content here at Street Capitalist. I wanted to highlight a comment from Mak, on some metrics he uses to look at oil and gas drillers:

Deepwater, which has been extremely profitable for the past few years, is going to see its outsize rates decline as a significant amount of capacity comes online over the next few years. This was even before the GoM spill and the uncertainty it has caused re: drilling moratorium. Now there is a chance oil prices shoot up again, which would help sustain rates, but I don’t try to prognosticate on commodity prices.

I look heavily at through-the-cycle return on capital for offshore drillers. The longer the track record, the better. And if they have been able to generate those returns with low risk, all the better. I look at two large areas to measure risk. One is the capital structure – in this cyclical industry, you probably want to have at most one or two years of operating cashflow of leverage (Transocean’s relatively high level of debt is going to put them at risk, particularly with potential legal liabilities from the GoM spill). The second is capex spending – you want to try your best to build new ships with contracts in hand. ENSCO (NYSE:ESV) has three major deepwater rigs coming online in 2010 (with another $1 billion of committed capex) and as I undestand it has not yet secured contracts for them.

Another metric that is important to compare relative performance would be operating margins. Diamond Offshore (NYSE:DO) and Noble Corporation (NYSE:NE) score well here.

I’ve been taking a deeper look at some of the drillers and hope to have a few posts on them soon. Mak’s point about looking at this companies as cyclical is essential, one of the issues you will see is that some of the newer companies haven’t been around during previous trough periods, so you can’t readily see how management performs under pressure. What I would suggest you do in those cases is hit the phones and start talking to them. Probe around about their pervious jobs and what kinds of things they did during periods like this and then try to gauge how well they answered those questions.

A number of value investors are trying to look at these companies from a liquidation perspective. I think this is appropriate, but it really requires some digging on your part. There are a lot of factors that contribute to rig demand, certain older rigs are going to be less desirable than newer rigs. Certain rigs have less capabilities than others and become less competitive when rates come down and companies/contractors start squeezing for value.

So when you take a look, I would just caution that you need to make sure you are not comparing apples to oranges and are discounting appropriately. The other thing to keep in mind is that the prices of these drilling rigs will fluctuate as demand fluctuates. Rigs were likely sold at prices that were much higher than they are today. When doing your analysis, you need to make sure that you are taking that into account as well.

If any of you have some metrics for looking at drillers that haven’t been mentioned – feel free to contribute them in the comments section or via e-mail.