Revisiting Noble Corporation Investment Thesis and Importance of Sell Discipline

Over the past eight months, a number of articles have appeared on The Rational Walk related to the Deepwater Horizon disaster and related investment opportunities.  Value investors know that times of stress and uncertainty create opportunities in the financial markets whether the turmoil is due to natural disasters, political unrest, or the fallout from accidents such as the Deepwater Horizon incident.

Panic and Uncertainty Leads to Opportunities

Mr. Market always sells entire industry sectors indiscriminately first and asks questions later.  The key question for investors involves judging where the true opportunities exist and avoiding value traps that carry risk of permanent loss of capital.  As things have turned out, investors would have done well to buy any of the stocks impacted by the Deepwater Horizon disaster including BP and Transocean.  In fact, many smart investors purchased BP stock in the wake of the disaster and have done very well.

Rather than attempting to judge the probability of ruinous consequences for BP and Transocean, we decided to focus attention on companies that were not directly involved in the disaster but had been punished by the  market nonetheless.  This research resulted in taking a position in Noble Corporation on June 3.  This position has now been closed for a total return of 38.5 percent compared to a return of approximately 20% for the S&P 500 ETF (SPY) during the same period (both figures include dividends).

Noble Investment Thesis Revisited

In our initial profile of Noble Corporation, the following main points were made regarding the bullish investment thesis:

1. Noble’s historical performance had been very strong over a long period of time and management accomplished the track record with a minimal amount of leverage.  Looking at Noble’s record from 2000 to 2009, we observed that margins and return on equity had dramatically accelerated as the price of oil skyrocketed during the latter part of the decade and that the company appeared to be managing through the dramatic decline in oil prices that took place in 2009 partly due to long term contracts at historically high dayrates.

2. Noble had a very strong record of free cash flow generation over the past five years and management appeared to have a solid strategy in place that balanced returning cash to shareholders and funding the company’s newbuild program.

3. From a geographic perspective, Noble was clearly exposed to the Gulf of Mexico but over 77 percent  of  revenues were attributed to other countries, with Mexico accounting for 23 percent of 2009 revenues.  We hypothesized (incorrectly as it turns out) that Mexico may be a destination for idled rigs in the U.S. Gulf of  Mexico in the event of an extended moratorium.

4. Based on an observation of the importance of deepwater exploration for the energy security of  the United States, we believed that a permanent ban in the Gulf of Mexico was unlikely and that once the Macondo well was capped, a more reflective political environment would result in relaxation of the ban.

Significant Events Since June 2010

While long term investors should avoid excessive focus on small developments that invariably emerge from time to time, it is critical to keep on top of all news  and developments particularly in cases where a volatile industry environment exists.  The following major events took place with respect to Noble Corporation since June 2010. (We focus on Noble-specific events rather than the timeline associated with the Macondo well itself or the political developments, all of which has been well covered elsewhere):

Noble acquired Frontier Drilling. We covered the announcement when it was made on June 30, 2010 and noted that the deal was funded with cash that Noble planned to raise in debt offerings.  The deal appeared to be done on attractive terms for  Noble and was possible only because of the company’s previous aversion to debt.  The company also announced a major agreement with Shell that added significant backlog and ensured the continued utilization of the acquired Frontier fleet.  The dayrates and terms appeared to be attractive.  Overall, this appeared to be a positive development, although the increase in financial leverage slightly increased the risk profile of  the company that was built into our initial investment thesis.

Noble announced solid Q2 2010 Results. Although results were negatively impacted by the fallout from the Deepwater Horizon disaster, Noble posted respectable Q2 results which we analyzed on July 20, 2010.  We noted that negative trends were emerging in the jackup fleet in terms of utilization and dayrates and that overall fleet utilization declined.  We  presented a ten quarter summary of Noble results to examine trends over a longer period of time.  While trends were somewhat negative, Noble still managed to post healthy cash flow for the first half of 2010.

Noble Q3 2010 Results Impacted But  “Worst May Have Passed”. Noble posted a sharp fall in contract drilling revenues for the third quarter despite the addition of the Frontier rigs.  We covered the quarterly release on October 21 and noted continuing drops  in fleet utilization and dayrates.  Although the results were disappointing, the Obama Administration had recently lifted the official moratorium and it appeared  that Q4 results would be materially better.  Based on our analysis of the fleet and contracted dayrates, we estimated that contract drilling revenues would rise to the  neighborhood of $630 million in Q4.

Noble Q4 Results Announced. On January 26, 2011, fourth quarter results were announced.  Although contract drilling revenues were higher that Q3 at $614.5 million, the results fell short of our $630 million estimate partly due to a major drop in utilization for the semisubmersible fleet and dayrates that remained at depressed levels, although with a slight improvement from the third quarter.  A number of jackup rigs operating in Mexico were moved to the Gulf of Mexico and warm stacked. In the conference call following the earnings release, management guided analysts to expect a capital expenditure program of approximately $2 billion for 2011.

Noble May Face Headwinds in Q1

Based on our analysis of Noble’s fleet based on the latest fleet status report, it appears nearly certain that contract drilling revenues will decline significantly in the current quarter.  Based on our estimate, contract drilling revenues could fall to the $510 to $520 million level for the quarter due to declining revenues in Mexico, West Africa, the Arabian Gulf, and Southeast Asia.  Click on this link for our analysis of the latest fleet status and revenue projections for Q1 2011.

Sell Rationale

One of the dangers facing investors involves not having a firm sell rationale in place at the time of purchase. When a security is purchased, the investor should not only describe the reason for the purchase but also consider the conditions under which the position should be liquidated.  Some may criticize this approach as deviating from the “buy and hold” school of investing and at odds with value investing in general but nothing could be further from the truth.  Value investing is about buying undervalued securities, but without a solid sell discipline, good analysis at the outset can be diluted by failing to act when an investment thesis has played out.

In the case of Noble, the investment thesis was based on the market’s severe overreaction to the Deepwater Horizon disaster and the subsequent pummeling of nearly all stocks associated with offshore oil and gas exploration.  Based on the factors discussed above, Noble appeared to be trading at a depressed valuation relative to our evaluation of its long term normalized earnings power, free cash flow generation capability, and risk profile based on financial leverage.  Our investment thesis was not based on the price of oil.

While Noble has performed as well as one could expect in light of subsequent events and made an opportunistic acquisition that could provide long term benefits, financial leverage is higher than it was at the time of purchase and it appears to be headed higher.  Given the fact that free cash flow generation in 2011 is highly unlikely to approach the company’s $2 billion capex program, more debt may be required to fully fund these initiatives.

Avoid Changing Investment Rationale To Justify a Hold

One of the main dangers investors face involves changing the investment rationale as a stock price advances.  To justify holding Noble Corporation at $38 requires a completely different investment thesis than purchasing shares at under $28.

One could come up with a solid investment thesis for Noble even at today’s price given the company’s newbuild program, healthy backlog, capable management team, and prospects for higher oil prices to support expansion of dayrates going forward.  However, this was not our investment thesis.

At the time of purchase, our price target was in the low to mid 40s; however, this target did not account for the higher leverage and the poorer than expected results over the past two quarters and prospects for higher debt going forward.  As a result, it seems more prudent to declare victory and move on to other opportunities.

Disclosure:  The author of this article sold his position in Noble Corporation on February 1, 2011.  This article is not investment advice — see our disclaimer for more information.  By using this site, you agree to our terms and conditions.

Noble Corporation Q3 Results Impacted by Moratorium But Worst May Have Passed

The Obama Administration formally lifted the moratorium on deepwater oil exploration in the Gulf of Mexico earlier this month but the regulatory situation remains uncertain for companies that are attempting to operate in the region.  Despite the formal lifting of the moratorium, there are still many questions regarding the new permit process that will be put in place by the Bureau of Ocean Energy Management, Regulation, and Enforcement.  Among other measures, the BOEM is carefully examining blowout preventers (BOPs) on drilling rigs as part of the permit process.

Companies operating in the contract drilling industry are at the center of attention as the new permit process proceeds.  In the midst of this environment, companies such as Noble Corporation are in the process of re-certifying BOP systems along with undergoing related inspections.  This has created downtime for many rigs and hurt contract drilling revenue.  We can clearly see the stress created by the moratorium and the Deepwater Horizon disaster when examining Noble’s third quarter results which were released yesterday.

Q3 Results:  Pressured by Moratorium and Dayrate Weakness

Noble reported third quarter 2010 earnings of $86 million, or $0.34 per share, compared to $426 million, or $1.63 per share for the third quarter of 2009.  Contract drilling revenues fell precipitously to $584.9 million for the third quarter of 2010, down from $875 million for the third quarter of 2009.  Contract drilling revenues were $687.5 million for the second quarter of 2010.  The decline in revenues occurred despite inclusion of the rigs from the Frontier acquisition which closed during the third quarter.  According to the Noble Q3 conference call held today, Frontier rigs contributed $48 million to Q3 revenues.

The weakness in third quarter results are due to a combination of lower utilization and significantly lower dayrates for the fleet.  Overall rig utilization was 79 percent and the average dayrate was $126,581 for the quarter.  An examination of quarterly results since Q1 2008 reveals the negative trends that have impacted recent results.  The exhibit below presents selected data over the past eleven quarters (click on the image for a larger view):

Average dayrates fell due to overall weakness in the market for rigs but also due to the negotiation of “standby” rates that Noble entered into with customers in the Gulf of Mexico that were prohibited from exploration activities due to the moratorium.  For example, the Noble Clyde Boudreaux has been on a standby dayrate of $145,000 which is down from dayrates in the $400,000 range that the rig would normally be able to command.  In addition, the Noble Amos Runner produced no revenue during the quarter due to a dispute with Anadarko over whether the moratorium qualified for the force majeure provision that would nullify the contract.

The Worst May Have Passed

Although the situation in the Gulf of Mexico is still very uncertain, there are reasons to believe that conditions will improve for Noble in the current quarter.  It appears that the company is making good progress recertifying the BOPs for rigs operating in the Gulf of Mexico which is consistent with prior statements from management regarding the process for complying with anticipated regulations.  The Noble Danny Adkins and Noble Amos Runner rigs have already received BOP certification and are earning full dayrates.

We have attempted to put together a rough estimate for 4th quarter contract drilling revenues (file available in the resource section at the end of the article) based on the most recent fleet status report along with information found in Noble’s Q3 earnings release.  While the forecast can only be considered an educated guess, it appears reasonable to expect contract drilling revenues to rise to around $630 million for the current quarter.  Additional improvements should occur in 2011 since the Noble Clyde Boudreaux, Noble Jim Thompson, and Noble Driller should be earning full dayrates by the end of the year.

Good Long Term Outlook

Despite the headwinds Noble has encountered so far in 2010, the company was still able to generate $1.3 billion of operating cash flow over the first nine months of the year, of which $886 million was invested in capital expenditures with the vast majority on new construction or improvements to existing rigs.  In addition, the Frontier acquisition along with the related agreement with Shell has provided Noble with a total of $14 billion of contracted backlog.  Even after the Frontier acquisition, Noble’s long term debt is a manageable 27 percent of overall capitalization.

The Gulf of Mexico remains an important market for Noble and more clarity on future regulations will be needed before more normal levels of activity in deepwater exploration resumes.  It was interesting to note that Noble management, in response to a question during the conference call, left open the possibility that a surge of activity might occur in the Gulf of Mexico once regulatory certainty exists as explorers attempt to fully exploit leases that may soon expire.  While such a surge of activity is by no means a certainty, it would be a good step in the direction of achieving more normal dayrates and favorable contract terms.


Noble Corporation Q3 2010 Earnings Release
Noble Corporation Fleet Status Report as of September 29, 2010 (PDF)
Rational Walk Forecast of Q4 2010 Contract Drilling Revenues (Excel)
Rational Walk Summary of Noble’s Q2 2010 Results
Rational Walk Profile and Analysis of Noble from June 2010

Disclosure:  The author of this article owns shares of Noble Corporation.

Noble CEO Forecasts Continued Gulf of Mexico Uncertainty Ahead

Noble Corporation Chairman and CEO David Williams believes that uncertainty in the Gulf of Mexico will continue to impact the offshore drilling industry for some time to come.  Mr. Williams, speaking today at the Barclays Capital Energy and Power Conference in New York, updated investors regarding the company’s operations and future prospects in light of continued regulatory uncertainty in the Gulf of Mexico in the aftermath of the Deepwater Horizon disaster involving the blow out of the Macondo well.

We have provided coverage of Noble Corporation over the past few months and believe that the company is well positioned despite Gulf of Mexico uncertainty.  The company has proven adept at seizing opportunities when they arise as illustrated by the acquisition of Frontier Drilling earlier this summer.  The acquisition added six floating drilling rigs along with $2.0 billion of contract backlog (net to Noble) and was financed with debt obtained at an attractive interest rate made possible by the company’s relatively unleveraged balance sheet.  The company has a modern fleet of rigs and has indicated in the past that the costs of retrofitting rigs for new regulations should be manageable.  Since our initial write up, Noble shares have rallied with increased exposure in publications like Barron’s, but shares are still trading at prices far lower than before the Deepwater Horizon incident.

Post-Macondo Scenarios

One of the more interesting aspects of the presentation involved an assessment of a “new normal” for the Gulf of Mexico in a post-Macondo world.  The slide below considers three scenarios that could develop in the coming months and the consequences for the industry based on each scenario (click on the image for a larger view):

While Mr. Williams did not make a specific prediction regarding which scenario is most likely to play out, he did indicate that an end of the official moratorium is likely to come before the elections but a de-facto moratorium could continue if the federal government refuses to issue permits.  This would most closely align with the middle scenario entitled “regulatory inaction” which could lead to more uncertainty, an exodus of rigs from the Gulf of Mexico, and downward pressure on dayrates.  In the highly charged political environment in Washington today, one cannot discount the possibility of the “impossible regulations” scenario which would effectively destroy the economics of oil and gas exploration in the Gulf of Mexico and devastate the regional economy.

Mr. Williams noted that a growing percentage of oil and gas discoveries in the Gulf of Mexico have been in deep waters in recent years and stressed the fact that decline rates are higher in the Gulf than in other parts of the world.  In other words, an extended moratorium will have a major impact on production, particularly for deepwater where the typical decline rate is between 20 and 25 percent.

Rig Updates

Mr. Williams provided updates on the following rigs which we have combined with an analysis of the company’s latest fleet status report from July.

  • Noble Danny Adkins. This rig is currently in the Gulf of Mexico and has resumed work.  The rig was previously on a suspension dayrate of $68,000 to $70,000.  While the new dayrate for Danny Adkins was not disclosed, the presentation slide indicated that Noble’s total dayrate for all rigs operating in the Gulf of Mexico is now $685,000 which is down from $3.025 million prior to the Macondo blowout.
  • Noble Johnnie Hoffman. This rig operating in Mexico the has secured a three month extension at a $75,000 dayrate starting in July.  This is down from the previous dayrate of $84,000 to $86,000.
  • Noble Earl Frederickson has secured a four month extension at a $64,000 dayrate starting in August.  The rig is operating in Mexico and was previously at a $67,000 to $69,000 dayrate.
  • Noble Julie Robertson secured a three month extension at a dayrate of $87,000 starting this month.  The rig is in the North Sea and was previously earning a $211,000 to $213,000 dayrate.  The reason for the sharp decline in the dayrate was not discussed.
  • Noble Ronald Hoope, operating in the North Sea, secured a five month extension starting in November at a dayrate of $87,000.  The rig was previously contracted at a similar dayrate.
  • Noble Ton van Langeveld, operating in the North sea, has a new nine month contract at a $247,000 dayrate starting in December.  The rig was previously contracted at the same dayrate.
  • Noble Roger Lewis will begin a three year contract at a $132,000 dayrate in Saudi Arabia starting in January 2011.  This is an improvement over the $105,000 dayrate the rig earned earlier this year prior to renovations that included installation of leg extensions and upgraded steel.
  • Noble Scott Marks is being moved from the North Sea to Saudi Arabia to begin a three year contract at a $237,000 dayrate starting in June 2011.  Scott Marks is currently earning a $212,000 to $214,000 dayrate in the North Sea.

Future Plans

Mr. Williams estimated realization of $7.1 billion of net cash (undiscounted) from the current $13.2 billion backlog based on a 53.5 percent operating margin.  Noble’s margins continue to exceed comparable margins of competing offshore contract drillers but Mr. Williams noted that increased regulatory burdens could impact margins for all companies in the industry.

In response to a question, Mr. Williams reiterated Noble’s focus on growth but also kept open the possibility of increasing dividends in the future.


Latest Fleet Status Report – July 8, 2010 (pdf)
Barclays Capital Presentation Slides – September 15, 2010 (pdf)
Replay of Barclays Conference Webcast – September 15, 2010

Disclosure:  The author of this article owns shares of Noble Corporation.