EP97: Found My Drill
Stock Ideas From Investment Professionals
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This week, we present 7 new ideas, including:
A leader in offshore drilling is set to benefit from shrinking equipment supply and improving market dynamics.
This semiconductor equipment provider dominates a critical, high-margin industry with massive barriers to entry.
A family-run champagne house excels with premium products, global exports, and standout margins.
This industrial stalwart uses its global footprint to deliver reliable, tech-led filtration solutions for cyclical markets.
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Let’s get to it.
Praetorian Capital provided an in-depth look at the offshore oilfield services industry, with a specific focus on the firm’s largest position, Valaris (VAL-US). The stock has been a big underperformer recently, but Praetorian sees immense upside.
In 2010, at the dawning of the age of shale, offshore oil production accounted for approximately 31% of global oil supply. As shale has encroached on offshore, that number has declined to only 27% of total oil production in 2024. As you can imagine, this has led to a bear market in offshore services equipment that has lasted for more than a decade and bankrupted almost all players in the sector. This offshore equipment (Drillships, Semi-Subs, Jackups, PSVs, AHTS, and other associated pieces of highly engineered steel) is what we own through positions in Valaris (VAL–USA), Tidewater (TDW-USA) and Noble (NE-USA), as I believe that the decade-long bear market has now ended, and that the call on this equipment will lead to excess profits for these companies for many years into the future.
Why did shale encroach so effectively against offshore and steal so much market share?? I’d like to point you to three factors. To start with, the Deepwater Horizon accident gave the industry a black eye, at a time when a burgeoning ESG movement was taking hold—this led oil executives to shun offshore oil production, even if the returns were superior to shale. Secondly, shale executives overpromised in terms of the economics of shale. We can debate if this overpromise was malicious or just oil industry optimism, but that discussion can be saved for a different time. However, the net effect of this overpromise led E&P executives to believe that shale would have better returns on capital than offshore, particularly as the production could be ramped up and down to take advantage of fluctuations in the oil price—this diverted capital from offshore assets, starving them of capital spending. Finally, there was an odd belief, even amongst many energy executives, that the energy transition would lead to peak oil consumption during the 2020s, implying that long-cycle energy projects, like offshore, were unnecessary.
These factors all colluded to dramatically reduce offshore spending, leading to a wave of industry bankruptcies, consolidations and vessel scrapping. The global fleet of floating equipment bore the brunt of this scrapping, with the benign environment floater fleet shrinking from a peak of 281 vessels in 2014 to around 150 today. I believe that dozens of additional vessels in the global fleet will likely be scrapped as they’ve been stacked for too long, or they’re nearing obsolescence, as the necessary upgrades are impractical.
So, let’s start with a simple question; why do I believe that offshore oil will gain market share from shale going forward?? I believe this, because it’s starting to happen. I also believe that this share gain will accelerate, as many of the best shale basins in the US are now mature, and their production growth is stagnating or even declining. Of course, higher energy prices may alleviate some of this production decline, but shale economics simply aren’t that attractive at year-end WTI prices around $70. While some of the best basins may make acceptable returns at today’s prices, those economics erode rapidly should prices decline even slightly (as shown by the break-even prices in the chart below).
Meanwhile, the vast majority of offshore projects have break-evens below $50, while offering far superior returns on capital at today’s prices, when compared to shale. Additionally, as peak oil demand has been pushed out by a few decades, long-cycle projects are once again on the table, and finally are getting prioritized due to their better economics. This is all happening at a time when the global fleet of offshore equipment has shrunk materially due to scrapping, with the expectation that it will shrink further as marginal vessels continue to exit the global fleet.
I think it’s worth briefly touching on why the economics of offshore production have improved so substantially in the past decade, from what were already attractive levels (though this letter would be hundreds of pages if I tried to touch on all of the advancements). I hate to generalize as every field is different, but the evolution from undersea pipelines to Floating Production Storage and Offloading (FPSO) equipment has dramatically sped up production, while reducing the prior costs of undersea robots that welded long pipes to shore. This has also served to make oil producing countries less likely to change the rules, as the equipment can simply float away, without the sunk costs of the pipelines. At the same time, upgrades in 4D seismic, along with AI (offshore is ACTUALLY an AI play!!) have meant that there are fewer dry wells, and oil companies can better target where to drill within a target. All of this leads to lower costs, faster returns, and an improved safety profile for offshore energy.
Finally, upgrades in Blowout Preventer (BOP) technology, mean that it’s far less likely that there will be another Deepwater Horizon sort of accident, especially as most modern Drillships now utilize two of them just in case one fails. Additionally, by using 2 BOPs, you can employ Managed Pressure Drilling (MPD) which speeds up the drilling process and makes drilling more precise. Since we’re investing in Drillships, it’s worth mentioning that a modern drillship with the best new technology, can now drill two or even three times as many wells per year as it could back in 2010, which greatly reduces the costs per well, even if the dayrate for the vessel increases (in our wishful thinking).
Given my prior bullishness on oil, I fully understand if you want to ignore my oil price view, but I believe that our offshore services investment works surprisingly well in a rangebound oil environment between $70 and $90 Brent. Clearly, it works better at higher prices, but I don’t think it suffers too badly in a weak oil environment either. While this isn’t a prediction, I wouldn’t be surprised if this investment also works well in a world where oil drops to the $50s, and shale is forced to surrender millions of barrels of daily production to balance the market. This investment is impacted by the price of oil, but it is not tied to the price of oil. Instead, it is tied to the supply and demand for highly engineered equipment, equipment that takes years to build, and likely will never be built again, unless dayrates and asset values increase very dramatically.
While on the topic of this equipment, it’s important to give a quick history lesson. Historically, this equipment can last for half a century, or more. However, it tends to get obsoleted about every decade due to upgrades to technology and demands for equipment that can drill deeper, faster and with better safety profiles. We’re now on the 8th generation (8G) of such vessels. There are currently 3 of these in the global fleet. In a normal offshore cycle, future 8G newbuilds would obsolete the existing fleet of 57 7th generation vessels (7G). Except, there are zero newbuildings happening, and even if one were ordered today, it would cost in excess of $1 billion and take at least three years to complete.
Of course, no one would build an 8G when they cannot achieve an acceptable return on the invested capital. The return calculation to determine when newbuilds makes sense, is called Newbuild Parity and at current newbuild costs in excess of $1 billion, you’d likely need dayrates of approximately $1 million a day, along with a 10-year contract, to earn the mid-teen return on capital that would incentivize you to take on the risk of building a new vessel. Said another way, there likely isn’t any more equipment coming given current dayrates. What you see is what you get, and the only way that new equipment comes, is if rates go to levels where we make obscene returns on our capital and then continue to earn those returns for the half-decade or more, before multiple new vessels are built and activated. This means that the killer of past cycles, i.e. new supply, is no longer a risk. Should it become a future risk, we will all be celebrating by that time anyway.
I hate to use bad analogies, but since we all have old laptops in the closet, I’m going to run with this for a bit. Imagine taking your 2010 vintage laptop and trying to surf the internet. Sure, it would work, but you’d be amazed at how slowly it goes after you’ve used a modern one—in fact, your old one might not even have Wi-Fi. Now, you could order parts and upgrade your laptop, but it’s going to be clunky, it’s going to be expensive, and it’s going to still be inferior when compared to a 2025 vintage laptop. What if they stopped building laptops forever?? Then, you’d take your newest laptop and continue to evolve it with upgrades over time—you wouldn’t ever try that with your vintage laptop. As a result, your 2010 laptop will continue to lag further behind your newest one. This is what’s happening in the world of offshore. BOPs are expensive, and adding a second one isn’t cheap, nor is upgrading to MPD. 7G vessels justify this expenditure as they’ll be around until the next batch of 8Gs are ordered (if they’re ever ordered) but operators are hesitant to spend on upgrades to 6G equipment, as it increasingly gets obsoleted by efficiency gains in 7G equipment. The spread between the two is widening and it looks like an increasing number of 6G vessels will be sidelined and ultimately scrapped as the decade continues. This is important because vessel quality matters in drilling, especially as many of the newest oil discoveries are happening in places that are deeper, with harsher climates, and are more technologically complex to access.
At this point, it’s probably worth talking about how important the wave of bankruptcies and consolidations over the past decade have been. Let’s look at the modern 7G and 8G Drillship fleet. There are effectively 60 vessels in thisfleet (appx. 53 that are active). 48 are owned by the four largest operators (VAL, NE, SDRL, RIG), with 12 owned by additional operators including 2 owned by a Sonadrill/SDRL JV (the numbers of 7G and 8G Drillships can move around at the margin based on which data provider you rely on, as vessel quality definitions can vary, but these numbers are directionally correct). I expect that many of the smaller operators will be consolidated in the future, as there are substantialscale advantages in this industry. In a world where excess pricing accrues to consolidated industries, the level of consolidation in this industry should get you all giddy.
In summary, E&P capital is flowing offshore after a decade-long bear market, the global fleet has shrunk roughly in half, yet the demand for higher quality Drillships is growing. Meanwhile, it’s highly unlikely that any more equipment will get built, until such a time that rates are at a level where we’re all celebrating, and even then, we’ll likely keep celebrating through half a decade of excess profits before the new supply comes.
Since Valaris is this Fund’s largest position, I thought it would be helpful to focus the rest of our offshore services discussion on it, though we also have substantial positions in Tidewater, the world’s largest player in Offshore Service Vessels (OSVs) and Noble, another owner of high-spec Drillships. At the close of trading on December 2024, Valaris had a market cap of $3.15 billion, and a net debt position of appx. $800 million (as of Q3 2024), for an Enterprise Value of approximately $3.9 billion. What do you get for this price?? You get 12 of the higher spec 7th Generation Drillships, and 1 of the better 6th Generation Drillships. You also get 5 Semi-Subs, 33 modern Jackups (JU) and a 50% ownership in a JU joint-venture with Saudi Aramco (ARO) that owns an additional 9modern JUs. By our math, it would cost well in excess of $1 billion to build and activate each fully equipped 7G, and in excess of $ $250 million per JU. Not that anyone would try to recreate this selection of assets today through a newbuilding program, but you’d be hard pressed to do it for under $25 billion—making our $3.9 billion EV an interesting starting point for us as value investors.
I tend to be skeptical of management projections, but according to the Valaris, at a range of dayrates that roughly approximates today’s rates, the company should be able to earn between $560 million and $1.650 billion per year in free cash flow. While we have some quibbles with their math, we believe it is directionally accurate, albeit with a massive range of outcomes. At the same time, you can clearly see how small changes in dayrates lead to massive operating leverage, which is what gets me so excited in this thesis. So, what do we need for these resultsin Columns A to C to be achieved?? We need current dayrates on multiple active vessels to reset higher from prior contracts that were negotiated a few years ago at roughly half of today’s rates, and we need additional contracts to be procured for some of the highest spec sidelined vessels in the world.
Fortunately, there have been multiple contract signings over the past quarter that give me confidence that current dayrates are bounded by Columns A and C. To achieve these returns, Valaris simply needs to recontract existing vessels. In terms of sidelined vessels, this will take a bit longer, but I believe that an energy company would be foolish to contract a 6G vessel when there’s a 7G one available, even if it needs some time to fully mobilize. I think that both of these issues should resolve themselves by the end of 2026, as lower spec 6G vessels are swapped out for 7G ones. I also tend to believe that based on the number of offshore projects that begin in 2026, there’s a good chance that leading-edge dayrates will begin to exceed the Column C scenario, but I want to temper my enthusiasm. All we need to know is that returns may fall somewhere in this grid, and that provides a very attractive cash flow yield to us as equity owners.
More importantly, that cash flow is being used to retire stock, at a huge and amazingly accretive discount to newbuild cost. To date, Valaris has already repurchased 3.9 million net shares, or approximately 5.1% of the 75 million shares outstanding when it emerged from bankruptcy. As cash flows accelerate in the future, so should the pace of repurchases.
I hope I've established that Valaris is a cheap stock, with strong tailwinds. For me, that’s a great starting point for an inflection investment, but I also want to know that if I’m wrong, I’m not going to get hurt too badly. For downside protection, asset value matters, but so does the balance sheet to outlast everyone else. As of October 30, 2024, Valaris had $4.1 billion in backlog at decently high margins, and they were owed $265.4 million from their Saudi Aramco JV. These sum up to approximately half of the EV and more than cover the net debt, even ignoring the equipment value. Should contract signings slow, Valaris has real staying power in a very capital-intensive industry. Said another way, in a downturn, presumably other players will have to stack their equipment before Valaris—though I find that scenario to be highly unlikely.
Of course, downside protection is nice, but we’re in this game to make money. What do we win if we’re right?? Said differently, what’s our upside here?? In the last cycle, dayrates on modern Drillships were north of $700k a day, with modern Jackups well in excess of $250k. Plugging such numbers into the grid above, gives you in excess of $2 billion in annual cashflow. Of course, there’s been a whole lot of inflation in the decade since the prior offshore cycle, and the equipment is arguably far more efficient. OSVs have already taken out their prior cycle peaksin terms of rates, and I don’t see why Drillships can’t do the same. Assuming $1 million a day and $350k for JUs, you get to over $3 billion in Free Cash Flow.
Now, this is shipping and shipping companies tend to not trade on cashflow, as it’s volatile. Instead, they trade on a multiple of NAV where NAV is calculated based on market values for equipment. Since I don’t expect Drillships to trade hands frequently, market values will be tied to newbuild costs, with a discount for depreciation. With newbuild costs likely increasing inline with inflation, looking out a few years, I don’t see why Valaris couldn’t have an implied $30 billion newbuild cost and trade at 1.5 times that cost, as offshore companies have at prior peaks, to account for earning in excess of newbuild parity for the period before newbuilds arrive. This would imply a $45 billion valuation, but that valuation would be applied to substantially fewer shares than are outstanding today, as free cashflow is applied to aggressively reduce the share count. Yes, I know, the potential upside here is extreme. Operating leverage is a beautiful thing when you catch it just right.
At the same time, I’m a realist and I try to be a pragmatist. You can plug in all sorts of scenarios and get outcomes that seem downright ridiculous to the upside. I’m not trying to tell you we’re going to make 100 times our money from today’s price, even if the model above says that’s a potential outcome. At the same time, a man can dream, and that’s the whole point of inflection investing. I try to find scenarios where there are insanely strong tailwinds, coupled with low risks for permanent capital impairment, then I put our capital to work. Interestingly, other highly successful shipping investors are aggressively wading into the offshore services sector during this pullback. John Fredriksen, one of the most successful shipping investors of all time, reputedly worth billions, has publicly disclosed the purchase of over 700k shares Valaris shares in the past 6 months, and he now owns in excess of 9% of the company. The Maersk Family, one of the most successful shipping dynasties, has disclosed the purchase of over 3m shares of Noble, taking their ownership past 19% of the company. The CEO of Tidewater just purchased shares worth approximately $2 million. In the first nine months of 2024, Valaris, Noble and Tidewater have repurchased $101, $250, and $47 million of their shares, respectively. None of this means that we’re going to be successful in this investment, but we’re certainly in good company, and surrounded by people who think these shares are attractive.
This all sounds fabulous, so why are the shares down so dramatically over the past few months?? I hate to blame someone else for our losses, but in this case other investors are central to the narrative. As you’re well aware, the average investor’s time horizon has continually shrunk over the past decade. Investors can no longer look out to 2026 results. In fact, many of them cannot even look out to the first quarter of 2025. They fixate on discrete data points and rate of change. When leading-edge dayrates for high spec Drillships were rapidly increasing from the low $200k range in 2021 into the mid-$500k range in early 2024, investors chased these shares higher. Then, as vessels were reactivated to meet higher pricing, and E&Ps slowed down their drilling campaigns due to infrastructure bottlenecks, leading-edge dayrates stagnated and then dipped below $500k. Investors declared that the cycle had peaked, looked at the pause in contracting, and panic-sold shares—then they went short. The short interest in Valaris has increased from 4.943 million shares on May 31, to 10.091 million shares as of the most recent reading on December 13, and over 14% of the shares outstanding are now short. This swing of the shareholder base, over a handful of contract signings at lower rates, and the expectation that rates may dip further before bottoming, has led to the decline we’re suffering through.
Given how close our Fund is to the industry, we were well aware that dayrates were stalling out and that there would be a pause in new contracting. Clearly oil prices in the $70s instead of the $80s has had some impact here, but you have to remember that E&Ps make long-cycle drilling decisions based on project economics at far lower oil prices. They know that during the decade or two that a field produces, there will be good and bad years. The oil price doesn’t really drive decision-making, though fast-twitch investors seem to believe that the price is all that matters. Rather, the pause in new drilling contracts is tied to the inability of procuring additional FPSOs and various other subsea infrastructure. Offshore cannot ramp without lots of very expensive capital equipment like FPSOs that take years to build. This is the real culprit, and I knew about it. Yet, unlike many other investors, I didn’t sell or hedge or do anything else. You see, a younger version of myself would have taken evasive action, avoided a pullback, and then missed a potential multi-bagger. Now, I simply accept that volatility is part of the investing game. Then again, I’m a bit surprised by the magnitude of this pullback, where a few billion in market cap disappeared over what is a few hundred million in missed cash flow, but such is the nature of capital markets. You can try to outsmart them, or you can accept that they sometimes overshoot. You can be a victim, or you can take advantage of everyone else panicking. I chose to do the latter.
During the past few months, I’ve dramatically increased our exposure to offshore. To finance these purchases, I’ve sold down many other positions, positions like uranium where I’m quite bullish, but do not find as attractive as offshore services. Prehistoric man used to toss virgins into volcanoes to appease the gods and improve crop yields. I toss CUSIPs into the volcano to try and improve portfolio yields. We’re not so different…
So how do I see this investment progressing?? I believe that there will be a few more months, maybe even quarters with subdued contracting. Dayrates may decline further. However, there is a huge call on Drillships and other offshore equipment in 2026, as announced and sanctioned projects ramp up. One of the reasons that this Fund has been so successful over the years is my willingness to look out past a weak patch and accept the volatility along the way. I’m not focused on the next datapoint, I’m focused on the drivers of an upswing in offshore capex for the remainder of this decade, drivers that have been well telegraphed.
I hope that you’re now sick of hearing about offshore. I’ve mostly avoided book reports on individual stocks or sectors in these letters to you, but given how large our exposure is, how Valaris has tied up substantial capital since we first started purchasing it in the second quarter of 2021, and how frustrating the returns on that investment have been, I thought it was important to really dive into what’s driving our losses, why I believe that they’re likely to be temporary, and why the potential upside seems to justify us allocating such a substantial portion of our capital to this sector. Normally, when you own a stock that sees its revenue and cash flows expand, year after year, with good visibility on further growth, while the share count declines, the market usually rewards you. However, 2024 was a strange sort of year, where investors were more focused on other sectors, and our offshore services instead became a source of proceeds, and then a Beta hedge for the rest of their portfolio. This too will pass…
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