February 13, 2009

Investment Recommendation: MARKETWEIGHT

Henry Fund Research

Energy Services - Off Shore Oil & Gas Drilling

John Culley
john-culley@uiowa.edu

INVESTMENT THESIS
S&P 500 Oil & Gas Drilling Index The offshore drilling industry is entering a down cycle that we think will weigh on industry earnings for the next few years. This downturn is a result of rig overexpansion combined with a severe contraction in the energy markets as oil prices plunged from a peak of $145 a barrel to $40 a barrel today. While we do believe energy prices will eventually stabilize and rebound further off of current lows, the incoming supply of mobile drilling rigs over the next four years will pressure day rates for the industry, reducing company revenues and earnings.
Source: Bloomberg

Key Index Statistics

Price 52-Week Range Market Capitalization (B) P/E Ratio 1-Yr % Change $309.16 $274.54-$967.39 $60 3.86 -57%

Due in part to the commodities boom that lifted energy prices to new highs in 2008, many of the offshore drilling companies have strong backlogs that lock in day rates for the future. The majority of companies in the industry have at least 65% of and 30% of 2009 and 2010s revenues locked in, respectively. Contract backlogs will help offset and delay the expected decline in day rates. Operators are conducting more deep water exploration drilling, and we expect this trend to continue. Over 70% of the new builds that are expected to enter the market through 2012 will be deep water drilling rigs. Certain segments of the drilling industry are expected to fare worse than others during this downturn. In the immediate future, the jackup markets in the Middle East, West Africa, and the North Sea will see less activity than the deep water markets in Brazil, India and the Gulf of Mexico. If economic conditions do not improve for the offshore drilling industry, counterparty risk may prove a serious threat to the industrys drilling backlog. Already, a few small independent E&P firms have reneged on contracts, either outright or because of filing for bankruptcy We think stabilization in the price of oil and a more liquid credit market will reduce the high degree of uncertainty the drilling industry currently faces.

Major Players by Market Cap (B)

Transocean Diamond Offshore Noble Corp Ensco Inc. Pride Intl. Rowan Cos Atwood Oceanics
$19.21 $8.66 $6.94 $3.78 $2.97 $1.43 $1.11

Important disclosures appear on the last page of this report.

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EXECUTIVE SUMMARY

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Following a multi-year boom in commodities, the current global recession has greatly reduced the As confirmed by observing negative real GDP growth demand for many commodities around the world. Light rates and unemployment figures topping 7.6% in the crude oil has fallen from a peak of $145 a barrel in July most recent quarter, the U.S. economy is in the middle and currently trades at $40 a barrel. of a recession. Despite the Federal Funds rate at near zero and a large stimulus bill in Congress, we believe the current recession will continue through 2009 and into 2010. A collapse in oil prices combined with an overall market decline has hit the share prices of offshore drillers. The S&P 500 Drilling Index has fared poorly over the past year, declining 57% versus a 38% drop in the S&P 500. Some aspects of the drilling industry look positive: many companies carry strong drilling backlogs yet are trading at depressed multiples. However, the industry carries a high degree of uncertainty due to a difficult economic environment and poor drilling fundamentals looming in the near distant future. In response to the steep correction in the price of oil, OPEC has promised to cut output by 4.2 million barrels per day (bpd). The Energy Information Administration is The near-term outlook for the US economy is negative. expecting global oil demand in 2009 to fall by 980,000 1 Real GDP growth declined in the fourth quarter of 2008 bpd to 84.7 million bpd, a decline of 1.1%. at an annual rate of 3.8%, and further weakness in consumer spending and the housing sector is expected to weigh on real GDP growth throughout 2009. OPEC Production Levels

ECONOMIC OUTLOOK

MM BPD

U.S. Real GDP Change in Adjusted Annual Rate

Source: bea.gov

Source: platts.com

In late 2008 the U.S. Government announced the Troubled Asset Relief Program, legislation that allocated up to $700 billion to buy illiquid assets from financial institutions in order to restore confidence and liquidity in the financial markets. While clear results remain to be seen, the U.S. Government is currently working on another stimulus package aimed at creating jobs through tax cuts and increased spending for infrastructure, healthcare and energy projects. We feel that, in addition to the current monetary policy in place, fiscal policy is necessary in order to quickly stimulate the U.S. economy and end the current recession.

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World Crude Oil Consumption

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INDUSTRY DESCRIPTION AND OUTLOOK

The off shore drilling industry provides international contract drilling services to exploration and production (E&P) companies and the upstream segments of supermajor, national and independent producers. Based on rig count, there are several large U.S. - listed firms that own 59% of the currently operable world-wide mobile drilling rigs. The remaining 39% are owned by smaller drilling companies, service companies and oil producers. Industry Rig Ownership

Source: EIA.org

2% 4%

We believe the price of oil may remain volatile for some time, but based on OPECs supply cuts, oil will eventually stabilize and rebound to $50-$55 a barrel within the next 12 months. Based on current data available in the futures market, it appears our estimates are in line with market expectations. ICE WTI Crude Futures

7% 7% 39% 8% 10% 23%

Source: rigzone.com

There are three standard rigs in the industry:

Source: Bloomberg

Jackup Rig Semisubmersible Rig Drillship

WTI Contract Delivery Month

The current recession in the U.S. has taken its toll on the offshore drilling industry. The plunge in oil prices Jackup Rig coupled with a tightened credit market has caused oil producers to reduce their E&P capital expenditures, A self-contained combination-drilling rig and floating barge, fitted with long support legs that can be raised or thus reducing the current demand for off shore drilling. lowered. Jackup legs can be independent cantilevered, Activity in the energy services industry is measured by where they move independently from the other legs. Or, the health of the overall energy sector. We believe the the legs can be mat levered, where all three legs move energy sector will improve as energy prices recover and as one unit. Mat levered jackups are less versatile than stabilize and as credit markets improve. Both factors independent cantilevered rigs as they can only operate will improve visibility for the energy sector and promote over relatively flat terrain on the ocean floor. A jackup is exploration and production activity that will benefit the towed onto location with its legs up and the barge section floating on the water. Upon arrival at the drilling services industry. location, the legs are jacked down onto the seafloor, raising the barge and drilling structure out of the water so that wave, tidal, and current loading act only on the relatively small legs and not on the bulky barge and drilling package.

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Since jackup rigs are anchored to the ocean floor, they cannot safely operate in depths beyond 400 feet. However, jackup rigs are the least expensive of the three rig types, with a new rig pricing between $100 million and $250 million. A standard jackup can be produced in 1 - 2 years. Daily operating costs can range from $20,000 per day up to $80,000 per day depending on the size, age, and the operators efficiency in managing the rig. Semisubmersible Rig A particular type of floating vessel that is supported primarily on large pontoon-like structures submerged below the sea surface. The operating decks are elevated perhaps 100 or more feet above the pontoons on large steel columns. This design has the advantage of submerging most of the area of components in contact with the sea and minimizing loading from waves and wind. Semisubmersibles can operate in a wide range of water depths, including deep water. They are usually anchored with six to twelve anchors tethered by strong chains and wire cables, which are computer controlled to maintain station keeping. Semisubmersibles can operate in water depths up to 12,000 feet and take two or more years to build. Deepwater semisubmersibles cost between $300 million and $600 million to build. Drillship A maritime vessel modified to include a drilling rig and special station-keeping equipment. The vessel is typically capable of operating in deep water. A drillship must stay relatively stationary on location in the water for extended periods of time. This positioning may be accomplished with multiple anchors, dynamic propulsion (thrusters), or a combination of these. Drillships typically carry larger payloads than semisubmersible drilling vessels, but their motion characteristics are usually inferior. Since drillships are self propelled, they can be repositioned much quicker than other rig types. The latest generation of drillships can operate in depths up to 12,000 feet but is the most expensive rig to produce. Current drillships under production have been priced between $600 million and $800 million and can take up to four years to construct. Semisubmersibles and drillships are commonly referred to as floaters because they freely float on a body of water, unlike a jackup which must be anchored. Operating costs for the floating rig segments range widely from $50,000 a day to more than $150,000 a day depending on the rigs age, capabilities, and the operators efficiency.

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Industry Rig Composition
Drillships 6% Mat Levered Jackups 13%

6%
Independent Cantilevered Jackups 53%

13%

53% 28%
Semisubmersibles 28% Source: rigzone.com

Rigs are generally priced at a daily rate for a specific duration from one day up to years at a time depending on the needs of the client and market conditions. Demand for drilling is a function of overall market exploration and production, which over time is heavily influenced by the price of oil and the fundamentals of the energy market. During drilling booms, operators lock in rigs for longer periods of time, guaranteeing the operator a rig for work while drilling conditions are favorable. In down cycles, operators prefer short contracts as they can roll projects into cheaper drilling contracts as rates decline. Drilling companies bid on projects required by oil producers, and this process forces drillers to compete primarily on price. Day rates are determined based on the supply of rigs available, the geographic location of the drill site, and the type of rig required for a project. The offshore drilling industry is a cyclical business that adds new rigs to the market in response to increased demand. The commodities boom that carried into the summer of 2008 boosted demand for drilling and created a rig shortage. This shortage sent dayrates soaring and encouraged drillers and producers to sign long term contracts for existing rigs and for the construction of new builds. Additionally, many speculative rigs were built without guarantees of contracted work upon completion. Noble management estimates that of the 170 shipyard commitments for rigs, at least half of the rigs are being built on a 3 speculative basis. While some of these rigs have been suspended or cancelled, the overall impact of the additional supply coming to the market coupled with the current lower demand for drilling services has led to a weak outlook for day rates and utilization. We expect day rates to decline significantly over the next few

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years. We also look for utilization to fall as well, but we think as the economic environment improves, operators will take advantage of the weaker day rates, limiting the declines in utilization, especially for deep water assets. Industry Day Rates

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As it takes anywhere from one to four years to build a drill rig, the incoming supply of uncontracted rigs will affect day rates through 2012. In addition, the total rig count for the industry will increase from a base of 590 rigs to almost 800 by the end of 2012, an increase of 35%. This will be the largest supply increase seen since the early 1980s, when a large spike in oil prices encouraged drillers to construct new rigs to meet increasing demand for rigs by operators. We think the combination of the poor economic environment and the expected decline in drilling fundamentals will lead to a multiyear downturn for the offshore drilling industry. Several drillers in the industry have large contract backlogs, but these backlogs can only delay future day rate declines. Many of the speculative new builds will enter the market as these backlogs unwind, putting pressure on rates as new builds and existing rigs alike compete for new drilling contracts. In a worst case scenario, we believe day 4 rates could decline as much as 70 - 80% from peak levels based on a previous downturn experienced in the early 1980s.

Source: ODS Petrodata and RBC Capital Markets for 2010-2011 estimates

Industry New-build Rigs By Expected Delivery Year

80 70

Utilization measures the percentage of active days worked per rig for a company. The utilization rate can decline if rigs are docked for maintenance or upgrades, or if drilling demand declines and rigs sit idle. We expect industry utilization to remain strong for floating rigs throughout the cycle due to continued demand for deepwater drilling, but see weakness in the jackup market as the incoming speculative rigs will have more of an impact on this segment. Industry Utilization

60
50 40 30 20

10
0

2009E

2010E Speculative Rigs

2011E Contracted Rigs

2012E

Source: Rigzone.com

MARKETS AND COMPETITION

Since drilling firms compete primarily on the basis of price for drilling work, individual firms try to avoid direct competition and instead have sought ways to differentiate themselves from one another. Firms in the industry have achieved differentiation by focusing on specific rig segments of the market, or even different depth segments within a rig class. For example, both Rowan and ENSCO have a large number of jackup rigs, but Rowan owns harsh weather rigs, and ENSCO

Source: ODS Petrodata and RBC Capital Markets for 2010-2011 estimates

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has previously focused on the midwater and shallow ENSCO, Noble, and Transocean have the largest water segments of the jackup market. ENSCO owns exposure to declines in the Middle East with several many rigs that operate in depths up to just 300 feet. rigs in the region that will roll off of contracts in the near future. ENSCO is operating ten jackup rigs in the region, and currently has two rigs idled. Noble has 14 Drill Rig Composition by Company jackup rigs in the Middle East and five rigs in West Africa. Already, three of these rigs have been idled in Africa. Transocean has 13 jackup rigs in West Africa 6 with four of these rigs sitting idle. Regional Industry Rig Utilization
As of 2-13-09

Source: rigzone.com

Firms in the industry have built relationships with a small number of significant clients, and these clients can easily account for 50-60% of revenues. For example, three large customers accounted for 49% of the Pride Drillings 2008 revenues. PEMEX (20% of revenues), Petrobras (19% of revenues) and BP (11% 5 of revenues) are all major clients for Pride. These relationships benefit both the operator and driller as both partners expand together. The driller benefits from having a customer who is more willing to commit for long term contracts and allow for the construction of new rigs. The operator sees gains in efficiency by having a driller familiar with the firms technical requirements and that has been reliable and safe. Over time, negotiating power shifts depending on market conditions. In recent years drillers have held some negotiating power over operators as demand outstripped supply, but we see this reversing with the large number of rigs entering the market in the near future. Strategically, companies also position themselves for growth by anticipating future demand. In the short term, drillers move rigs around the world in search of strong demand for drilling and higher day rates. Currently the market is experiencing strong utilization in Brazil, Mexico, and the North Sea. Looking forward, we expect a large number of rigs to come off of contracts this year in the Middle East and West Africa, which will reduce utilization in this environment as many of these rigs will be idled, or cold-stacked. We think Brazil and Mexico will see better utilization than other regions due to strong demand for rigs from Petrobras and PEMEX.

Source: rigzone.com

Over longer periods of time, drillers acquire rigs based on the needs of their clients. More recently, we have seen a shift towards ultra deepwater semisubmersibles and drillships, as well as greater demand for durable rigs built for operating in harsh environments. The commodities boom that ended in 2008 allowed drillers to lock in lengthy contracts, creating a backlog of contract work at attractive day rates. Many companies have deepwater rigs contracted out for three or more years, with jackup rigs being contracted up to two years into the future. Overall, the industry has approximately 65%, 30% and 14% of total days 7 contracted from 2009 through 2011, respectively. This backlog will generate large revenues for drillers in 2009, and over time, help offset the addition of speculative rigs in the market. However, as company backlogs end, firms will be forced to compete with the additional newly built rigs, further pressuring day rates. Companies that are bringing speculative uncontracted rigs into the market will also carry a lot of risk through this down cycle. Certain firms have more direct exposure to this speculative new build risk than others; ENSCO and Rowan are carrying the greatest speculative new build risk. Of the three largest firms, Transocean and Diamond Offshore have no speculative exposure while Noble is building a single uncontracted drillship.

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Speculative Rig Count: Peer Group
Company Transocean Diamond Off. Noble ENSCO Pride Rowan Atwood
Source: Company Filings

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Industry Profitability Analysis
As of 2-13-09
Gross Margin 57.7% 64.7% 67.1% 67.3% 51.8% 40.5% 62.0% Operating Margin 44.8% 40.5% 54.6% 57.4% 36.6% 28.3% 50.5% Debt to Cap 44.3% 7.5% 12.5% 7.0% 18.8% 25.5% 14.8% ROE 28.9% 42.1% 32.5% 27.5% 16.9% 17.1% 32.3%

N/A 48.7% 36.1% 20.3% Besides ENSCO and Rowan, the major speculative competitors in the offshore drilling industry include a Source: reuters.com diverse number of international firms and several companies that own just one or two uncontracted rigs. Given the poor outlook for the drilling industry, we believe drillers best positioned to financially navigate this environment will be more likely to outperform their Speculative Rig Count: peers into the next up cycle. We think Diamond Other Competitors Offshore, Noble, Pride, and Ensco are well positioned to weather the downturn and possibly make select rig acquisitions due their minimal debt loads and their large accessible cash balances.
Due to its merger with Global Santa Fe, Transocean is the largest company in the industry with a market cap of $19.2 billion. We think the debt carryover from this acquisition will force Transocean to be less aggressive while it conserves cash to pay down debt. This will cost the company the opportunity to acquire new build rigs from distressed competitors as the drilling environment declines. Industry Liquidity Analysis
As of 2-13-09
Source: Rigzone.com
Company Total Accessible Cash * Transocean Diamond Off. Noble ENSCO Pride Rowan Atwood $1,088 $1,022 $1,113 $1,140 $1,013 $377 $501 $14,186 $655 $923 $274 $723 $497 $170 Total Debt % Due Within 3 yrs 51.4% 27.8% 18.7% 38.1% 12.6% 44.6% 12.3% Debt to Cap 44.3% 7.5% 12.5% 7.0% 18.8% 25.5% 14.8%

Average 5 Yr. Industry Average

58.7%

44.7%

18.6%

28.2%

Profitability for the industry remained elevated in 2008 as strong demand kept dayrates firm and drillers worked through highly profitable backlog contracts. We expect 2009 industry profitability to remain at or slightly above 2008 levels as these backlogs carry through 2009 and rigs roll into contracts at even higher dayrates than last year, on average.

Source: Company Filings

* Total Accessible Cash includes cash on hand and undrawn credit facilities

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RECENT DEVELOPMENTS
The poor economic environment has added a high degree of counterparty risk as one small E&P company filed for bankruptcy and a few other troubled firms have cancelled drilling rig contracts. In early December, 2008, Callon Petroleum suspended a project and cancelled a contract with Transocean. Since then, Burgundy Global failed to post an ESCROW payment to Transocean, and Transocean terminated the contract and is taking legal action against Burgundy Global. Oilexco, a small Canadian E&P firm, obtained bankruptcy protection in early February and has ended two contracts with Transocean and Diamond Offshore. While drilling contract cancellation privileges are not generally disclosed, we know from previous cancellations that operators have been able to exit a contract when the driller failed to perform, or when the rig failed to be delivered on schedule. Company management teams from several drilling firms have recently expressed confidence in the legal strength of their contracts. We see the primary risk to company backlogs coming from small independent E&P firms that cancel contracts due to filing for bankruptcy.

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Source: Barclays 2009 E&P Spending Survey Survey

INDUSTRY TRENDS

As the oil industry looks to replace existing mature fields, producers have been forced to drill in deeper water and at greater depths. This trend is reflected in the current construction backlog of new drilling rigs. Many of the new orders are for ultra deepwater drill ships and semisubmersibles that can drill in depths up to 12,000 feet, versus the current generation of rigs that According to Barclay Capitals Original E&P Spending in general, cannot operate beyond 7,000 feet. Survey, global exploration and production expenditures 2009 - 2012 Expected Change in are expected to decline 12% in 2009, following six Industry Rig Composition straight years of high single and double digit growth in 8 expenditures. This decline in spending will impact all areas of the energy services industry. However, as many of the offshore drilling industrys customers are large companies with fairly stable capital expenditures, we expect offshore drillers to be less impacted than other areas of the energy services industry. It is worth noting that the tight credit markets have played a role in reducing capital investment in 2009. According to the spending survey, 30 percent of the E&P companies surveyed indicated that the challenging credit market conditions have affect capital expenditure plans this year, with 42 percent of respondents anticipating that credit market conditions may affect spending during 2009.
Source: rigzone.com

We see Diamond Offshore as the best positioned company in the industry for this trend. Of Diamonds current drilling assets, 70% are deepwater floaters. In terms of scale, Transocean owns the most deepwater rigs with 39 floaters and ten additional units under construction.

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As the industry continues to hunt for oil and natural gas reserves, better technology will be needed to overcome the geological challenges that arise from operating in harsh climates and at greater depths. The Brazilian deepwater Tupi Field for example, holds an estimated 5-8 billion barrels of oil, but is located beneath a salt block one mile in depth with temperatures exceeding 9 500 degrees Fahrenheit . Currently, the market lacks technology that would make drilling in the Tupi field economically feasible at recent oil prices. As global reserves shrink, we see technology playing a vital role in accessing additional energy sources. One example of a new technological advancement is the duel activity technology created by Transocean. Duel activity utilizes two individual drilling stations that carry out parallel operations within one derrick. According to the company, this technology has cut 10 project development costs by 40% for its operators . Transocean has three drillships currently equipped with this duel activity technology, and five of the companys ten drillships under construction will be duel activity rigs.

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greater depths, and drillers are in the process of shifting their assets to meet this need.

We expect firms with strong balance sheets to acquire rigs from distressed competitors as industry fundamentals deteriorate. Drillers that can acquire rigs at or near the bottom of this cycle will see benefit from these acquisitions when market fundamentals improve.

INVESTMENT NEGATIVES

The incoming supply of non-contracted drilling rigs will pressure rates as these rigs enter the market, reducing industry revenues and earnings over the next several years. Expectations for the industry may decline further if economic conditions dont improve. Counterparty risk may increase and threaten the industrys contracted backlog if current economic conditions persist. We believe the jackup segment of the industry will see more deterioration than the floating, deepwater segment in this downturn. Already, jackup rig utilization has fallen in the Middle East and West Africa, where several rigs have been idled.

CATALYSTS FOR GROWTH

Despite an increase in counterparty risk, we see strong contract backlogs supporting industry earnings over the next several quarters. Diamond Offshore, for example, has a backlog of $11.4 billion, accounting for well over REFERENCES one years worth of drilling for Diamonds 46 vessels. Firms with large backlogs have a clear advantage as 1. Opec.org - OPEC NEWS the industry works through this down cycle and these firms have less exposure to declining dayrates in the 2. Schlumberger.com Oilfield Glossary immediate future Given the poor economic environment and the weakening fundamentals of the offshore drilling industry, a few companies in the industry have commented on the potential for acquisitions in the near future. We think these companies are focused on acquiring individual drilling rigs that align with their specific growth strategies, as opposed to any companywide M&A activity.
4. Credit Suisse Estimate 5. Pride 2008 Form 10-K 6. Energycurrent.com 7. Industry Company Filings

3. Noble Corp. Q4 2008 Conference Call

8. Barclay Capitals Original E&P Spending Survey, 2008

We think a more liquid credit market and stabilization in the price of oil will reduce uncertainty for E&P firms, 9. Standard and Poors Industry Surveys, Oil & Gas: Equipment & Services making them more likely to increase their demand for offshore drilling services.
10. Transocean 2008 Form 10-K

INVESTMENT POSITIVES

We expect demand for deepwater drilling to remain strong throughout this down cycle. The E&P industry is demanding rigs that can drill deeper water and at

IMPORTANT DISCLAIMER
This report was created by a student(s) enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowas Tippie School of Management. The intent of these reports is to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report.

Important disclosures appear on the last page of this report.