Stick with deepwater
The offshore-drilling market is at an inflection point. Oil companies have
deferred their demand after large increases in capital spending over the past
few years. While longer-term fundamentals remain strong, we expect interim
weakness across all rig categories, such as jackups and midwater
semisubmersibles, although the deepwater market remains in equilibrium.
Most deepwater rigs should remain contracted and newbuild capacity should
be absorbed. Demand in the midwater market seems to be moderating,
impacting day rates, which appear to have peaked. However, expected dayrate
declines in the deepwater market in 2010 (15-20%) are smaller than
those in the midwater market (20-30%). Jackup drillers are witnessing
slowing demand and significant oversupply. Almost all offshore markets, with
the exception of Latin America, should suffer lower utilization. We forecast
worldwide jackup utilization to decline to 73% in 2010 and day rates to
plummet 40-55% to return to pre-2006 levels. The Middle East and Asia-
Pacific regions are likely to bear the brunt of the fall in day rates.
With 169 additional newbuilds coming to the market by 2012, the supply
overhang will remain until offshore-rig demand rebounds. Difficulties in
financing newbuild projects could result in project cancellations or delays and
thus a more modest increase in supply.
Offshore deepwater drillers, such as Diamond Offshore, Noble Corp and
Transocean, should enjoy good earnings visibility supported by strong
contract backlogs. We expect deepwater-focused drillers like these to
generate increasing free cashflow (FCF) in 2009-10, up from US$3.5bn in
2007 to US$5.0bn in 2010. Capital spending will be the primary use of cash
next year, followed by debt reduction, resulting in healthy balance sheets.
Their ROICs, however, are likely to decline from 18% in 2008 to pre-2006
levels of 12%.
Despite significant downward earnings revisions, offshore-drilling stocks are
trading at an average 2009 PE of 6.3x, versus a five-year median of 10x.
They are also trading below their net asset values. We expect jackup drillers
such as Ensco and Rowan Companies to outperform the market but
underperform their deepwater peers. These are primarily jackup operators
with significant exposure to the shallow-water segment and are most likely to
witness earnings volatility. We remain bullish on deepwater drillers Diamond
Offshore, Noble Corp and Transocean.

Contents
Executive summary ............................................................................ 3
Capital spending to decline in 2009.................................................... 4
Increasing supply and peaking utilization .......................................... 7
Jackups suffer, deepwater bucks trend ............................................ 13
Some still possess earnings visibility ............................................... 21
A good place to hide in the downturn............................................... 26
Appendices
1: Risks ..............................................................................................30
2: Key data .........................................................................................31