EUR 850.00 For Business Accounts Only

Morningstar | RDC Updated Forecasts and Estimates from 14 Nov 2018

Offshore drillers Ensco and Rowan shook the industry on Oct. 8 by announcing an agreement to merge the two firms. Completion of the transaction is expected in first-half 2019, pending shareholder and regulatory approvals. The combination is a true merger of equals, with a stock-for-stock transaction valuing the firms roughly equivalently to their current market capitalization ratio. The combined company would have a total market enterprise value of about $12 billion, nearly on par with industry leader Transocean.

The market reacted positively to the news, with Rowan and Ensco shares both up about 4%. Other offshore drillers’ shares were up generally in the range of 2%-3%, suggesting the market sees the merger as a catalyst for improved offshore drilling industry conditions overall. We are more skeptical in our view on the merger’s benefits, with our fair value estimates unchanged for now. And although we may tweak our fair value estimates up later to incorporate the lower-hanging fruit (for example, general and administrative expense) among the projected synergies, we retain our basic outlook that both companies (along with the rest of the offshore drillers) look very overvalued.

The market’s reaction seems to imply that consolidation will drive a stronger industry environment. We note that this merger alone doesn’t dramatically shift the competitive environment among offshore drillers. Rowan only adds four floater rigs (or about 1.5% of the industry floater fleet) to Ensco’s fleet. The addition of jack-ups is more significant, but even post-merger, the top five companies by jack-up fleet size will still only command a paltry one third of the industry jack-up fleet. Still, combined with other recent industry transactions, including Transocean’s $2.7 billion acquisition of Ocean Rig announced last month plus Ensco’s own prior $600 million acquisition of Atwood completed a year ago, the announcement signals that the trend to consolidation is building momentum.

In our view, the most logical way that further consolidation could greatly improve the situation for offshore drillers is via encouragement of incremental rig retirements (relative to the number that would have occurred in the absence of consolidation). The adroitness with which management ducked the question about retirements during the post-announcement question and answer session suggests that this issue is indeed top of mind. Rig retirements increase utilization, which in turn generally drives higher day rates. However, each driller sacrifices future potential revenue for each rig retired, whereas the benefits of tighter utilization are spread among all drillers. The situation presents a classic prisoner’s dilemma that can be partially alleviated by industry consolidation, which narrows the gap between individual firm and group incentives.

However, intention to destroy capacity is precisely the kind of motivation that would raise objections with antitrust authorities. Therefore, we are somewhat skeptical that offshore drillers could embark much further on a course of consolidation and rig scrapping without eventually being impeded by regulatory intervention. In any case, with industry utilization levels mired around 50%-60%, industry players still likely have a long way to go before rig retirements have a serious impact on pricing.