Morning Notes

13/1/2015 Argonaut Morning Note

Market Update & Important Indicators

U.S. stocks fell Monday, dragged lower by a renewed drop in oil prices, as investors turned to the coming fourth-quarter earnings season. The Dow Jones Index declined 0.5% (97 points) to 17,641 and the S&P 500 dropped 0.8% (17 points) to 2,028.

Investors eyed a slide in U.S. oil prices, which prompted yet another selloff in energy stocks, after Goldman Sachs Group Inc. again cut its oil-price forecast. Shares of energy firms in the S&P 500 dropped 2.8%, posting the steepest losses across major sectors. Dow components Chevron Corp. shed 1.9% and Exxon Mobil Corp. lost 2.2%. Energy stocks in the S&P 500 have declined 5.9% so far this year.

With no major economic data due on Monday, investors are awaiting the fourth-quarter earnings season, whose unofficial start comes after the closing bell Monday when Alcoa Inc. is set to report earnings.

European stocks rose in a volatile session Monday, as investors weighed the implications of a renewed slump in oil prices. The Stoxx Europe 600 closed 0.6% higher, helped by gains in health-care stocks amid a flurry of deals in the sector as Shire and Roche both announced acquisitions. Oil and gas firms on the Stoxx 600 finished 1.3% down, as oil prices dived more than 5%. But elsewhere, most European sectors remained higher, and broader indexes bounced back.

Stocks in Asia traded mostly lower Monday with Japan, the region's largest stock market, closed for a public holiday. Declines in the region followed a downbeat session on Wall Street Friday.

The blue-chip Hang Seng Index rose 0.5% to 24,026. Stocks in mainland China slid amid concerns that upcoming initial public offerings will drain funds from the market. The Shanghai Composite fell 1.7% to 3,229. Stocks there last week posted their first weekly decline since early November after a rally that followed China's surprise interest-rate cut.

Copper closed down 1.1% on the LME overnight, although other base metals were mixed. Gold added $10.50 (0.9%) to US$1,234/oz while WTI crude dropped a further 4.7% to US$46.07/bbl. Brent oil was down 5.8% to US$47.20/bbl

Thought for the day

Drilling contractors slipping on oil
The oil price has declined sharply over the last 6 months, with WTI crude dropping by more than 50% from above US$100/bbl at the end of July 2014 to under US$50/bbl at present.

This 5-year low in oil prices is proving painful for offshore drilling contractors, with the weakening demand as producers pull back spending coinciding with a wave of new floating drill rigs (drillships and semisubs) hitting the market (see chart below).

The dip in floater deliveries in 2012 and 2013 was largely as a result of the 2008 GFC, demonstrating the significant lag between ordering and delivery of these very large capital items. The interpretation of this is that the next couple of years will continue to see near record deliveries of floaters as the decisions to build these rigs were made a number of years ago and they are all already well into construction. However if the current low oil price environment proves to be more than short-lived, it does not augur well for floating rig deliveries in the medium term.

Prospects for rig rates in this environment (demand down, supply up) are not good. Last week Bloomberg noted that one of the biggest offshore drillers, Transocean (RIG.US), took a US$115,000/day cut in rates for one of its drillships in order to keep it working. That announcement coincided with Moody’s noting what appears to be the start of a “prolonged industry down-cycle”. Highlighting elevated risks for Transocean given its large capital commitments, it placed the Company’s US$9.1b Baa3 debt on review for downgrade, potentially dropping it to junk status.

Transocean was one of the worst performer on the S&P 500 (SPX) last year, along with other offshore drillers like Ensco, Noble and Seadrill. The charts below show share prices over the last 3 years, with the performance over the last 6 months not surprisingly mirroring the tumbling oil price.

Implications for drilling contractors

Retirement of elderly fleet
Based on Rigzone data, we calculate 35% of drillships and semisubs are new (1-5 years). However, a similar percentage (>100 vessels) are more than three decades old. With rig rates under pressure, this will encourage retirement of older vessels to help prop up rig rates and/or limit losses (where rigs are either idle or working at sub-economic rates).

The specs on older rigs are also less likely to meet the standards set by more recent deliveries, and can still be costly even if sitting idle. Transocean announced on 18 December that it intends to scrap 11 lower-spec floaters, taking a related non-cash charge of $100-140m as a result, and is looking at other potential candidates for scrapping.

Of the 321 operating rigs listed under Rigzone data, 18 are cold stacked (in other words have been placed on care & maintenance and not readily available for work). Another 34 are “ready stacked” (i.e. not working but readily available) and another 44 either enroute, being inspected or modified, waiting on location or performing workovers.

Restrictions on capex
With a number of rigs due for delivery within 2015 and 2016 (57 on our count), the anticipated weaker financial performance and financial position of offshore drillers in a much lower oil price environment will severely curtail new rig orders in our view. In addition, there could well be pressure to try and slow or delay the delivery of vessels currently under construction, and any options for new rig builds are less likely to be taken up.

New rig deliveries post 2016 to fall sharply
This all implies that under the current oil price regime new rig deliveries beyond 2016 are likely to fall sharply. That’s not to say it can’t turn around. If oil prices were to recover, this would be reflected in higher rig rates and in an increased incentive to build new vessels. Of course over the longer term, at some point demand for floaters will once again outpace supply, triggering the next round of builds.

With the best will in the world though, it is hard to see the near record breaking deliveries of new vessels in 2015 and 2016 replicated in the immediately following years. Far more likely is a significant decline through to the end of the decade.

In This Issue

Matrix (MCE) 
Growing oil supply from non-OPEC producers, the slowing in global demand, and Saudi’s reluctance to act as the world’s swing producer has caused sharp oil price falls. This has had significant impact on offshore drillers and is likely to result in the curtailment of new floating rig orders post the delivery of those currently under construction. This has longer term implications for MCE, highlighting the need to diversify in the coming years. With a low oil price and negative offshore drilling market newsflow likely, we expect MCE to be caught up in industry headwinds. 

Independence Group (IGO)
Tropicana produced 138koz gold (41koz attributable on a 30% basis) up 15% Q-on-Q and well ahead of Argonaut’s forecast of 120kz. Long was slightly down Q-on-Q (-6%), but in line with our forecast. Strong December half production has ensured that Jaguar will meet guidance for FY15 despite a planned outage to change out the SAG mill in the March Q (est. three week outage). Cash costs, cash flow breakdown and exploration updates are anticipated with the complete December Q report, due out later this month.

MACA Ltd (MLD)
SCEE (SXE) 

Argonaut will cease coverage of MACA Ltd (MLD) and SCEE (SXE) post this note. Although both companies currently have solid order books relative to peers, the outlook for resource services companies generally remains challenging, with limited new work opportunities and expectations for continued downward pressure on margins from mining clients. Both MLD and SXE have significant exposure to iron ore clients, which is a key concern in the context of a low iron ore price.

Argonaut’s Stock Coverage & Recommendations

Recent Contacts & Presentations

Troy Resources (TRY), Gold Road Resources (GOR), Saracen Mineral Holdings Limited (SAR), Beadell Resources Limited (BDR), Resolute Mining Limited (RSG) , RTG Mining (RTG) MACA Limited (MLD), Alexium International Group Limited (AJX), Decmil Group Limited (ACG), Pacific Energy Limited (PEA), Otto Energy Limited (OEL), Peninsula Energy Limited (PEN), Sandfire Resources NL (SFR), Bannerman Resources Limited (BMN)

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