Profiting from the Reckoning with Reality
KCR readers know we have been long-term bulls on energy stocks and have relentlessly panned the high-priced promises of so-called clean-tech energy stocks. While others read the IEAs’ path to net-zero emissions and forecasted the end of oil, we read the work and wrote our piece, Net Zero Emissions: The Possible vs. the Plausible, which explained how their research read, to us, like a powerful bull case for energy.
From rigorous deep-dives to anecdotal observations on the power of magazine covers espousing the end of crude oil, our bullish view on energy continues. The chart below, which we first published in our August 2021 piece Crude Investing: Energy Stocks and ESG, is our working thesis in a nutshell.
After a period of severe underinvestment, it does not take much imagination to believe US energy companies will need to spend more. This is particularly true if we hope to maintain our position as a dominant global oil and natural gas producer.
Nabors Industries Stock Benefits from the Below Two Charts:
KCR finds the continued pessimism around energy prices and energy stocks to be both confusing and welcome. The world came to take cheap hydrocarbons for granted. By the middle of the Covid pandemic in 2020, politicians and investors forgot that getting gas and oil out of the ground requires money, metal, machines, and labor.
Before the Ukrainian disaster, the world’s largest fertilizer manufacturers were warning of famine due to natural gas shortages. Seeing ESG advocates ignore these warnings and deny energy companies capital, in October of 2021, we highlighted CF Industries as a buy. While well-intentioned, the race for environmental virtue signaling has left the world’s most vulnerable facing a food crisis of epic proportions. A topic we have covered at length and updated in our recent pieces, War, Drought & Famine and Undervalued Energy Stocks.
The good news is that the tide is beginning to turn, and we are in what is likely to be the early innings of a long-overdue cycle of energy investing.
The chart below is also an updated version of the chart we put out in August of last year. It was eye-catching then, and we believe it to be more so today. The chart suggests that energy companies’ capital discipline (lower capex) is expressing itself, predictably, in the deployment of far fewer rigs than history would suggest.
One of the reasons the US has managed to smash production records despite the low levels of drilling rigs has been due to large improvements in technology within the land drilling space. US energy companies have benefitted from what Nabors calls “Super Spec” or “High Spec” rigs with incredible drilling capabilities.
And that leads us to….
NBR’s Story in Five Pictures: Let’s Focus First on the Lower-48
- High Spec rigs have helped drive the soaring US production in the Lower 48
- NBR’s utilization is, as of June, at 82%, and experiencing price increases of 80%
- On their Q2 conference call, NBR’s CEO Anthony Petrello believes they will hit 100% utilization in the first half of 2023
In the near term, NBR’s stock will be driven by rising utilization and large price increases in their fleet of High Spec drilling rigs in the Lower-48.
Nabors Industries’ Lower-48: Pricing & Profits
Despite having vastly superior knowledge than KCR, most sector specialists seem concerned about the potential for macro headwinds to collide with Nabors’ high leverage. These concerns are not to be dismissed. Nabors does carry leverage, operates in a politically unpopular space, and, should the macro environment turn sharply lower; the stock price could suffer. With that said, this is a firm that cut costs rapidly and generated free cash flow reliably throughout the Covid crash.
Yet the disdain shows in both the company’s valuation and sentiment. According to Bloomberg, of the 9 analysts covering the stock, only 1 is bullish. We are not energy experts here, but we understand the basics of supply and demand.
Investors do not seem to understand that once the US inventory of super-spec rigs hits 100% utilization in 2023, upgrading the next tier of equipment would cost $13ml/rig, and newbuild would cost $30ml/rig. These numbers would require term contracts in the high $30k dayrate range for upgraded rigs (NBR has 40 of these available) and $40k dayrates with term for new builds.
For those unfamiliar with the space, this means that incremental capacity in land drilling is closing in on 100% even though there are unused rigs utilizing old technology. Customers simply will not deploy these legacy rigs in their current state. To make them comparable to new technology in high-spec, NBR would need to spend $13ml to upgrade each old rig. With Nabors’ management focused on return on capital, they will not invest that $13ml to improve an old rig unless a customer gives them a multi-year contract with a $35k+ dayrate.
Looking at land rigs on paper without distinguishing between capabilities, it is easy to succumb to the appearance of spare capacity. Yet that capacity comes with the significant capital costs noted above. This should provide potent support for the current price increases land-drillers are enjoying.
In 2021, Nabors management made the tactical decision to go very short on contract lengths believing that prices were depressed. That speaks to the experience and savvy of the firm’s management, in our view.
The company now has 70% of its existing rigs that will reprice between now and Q1 2023. With leading-edge dayrates in the mid $30k range now, the company could be north of $15k day cash margins by H2 2023.
The slide below shows that the company’s financial progression into these markedly tighter conditions has already begun. KCR would not be surprised to see the company deliver if not exceed street expectations.
In most markets, international business is subject to longer-term rates than the US. This means more cash-flow stability and a lot less “excitement” on the pricing front. Everything is going in the right direction. Demand is growing, and rates are improving. The slide below shows the steady march higher in their international business.
What might get overlooked however is the company’s joint venture with Saudi Aramco, SANAD. Details here are necessarily opaque, but from what we can gather, the following are notable:
- SANAD is fully capitalized and is consuming ~$150ml p.a. in capex for newbuild rigs
- One new build a quarter should be coming on-line, with SANAD’s first In-Kingdom new build commissioned in Q2 2022
- SANAD should manufacture 50 newbuilds with each coming online at rates that generate $10ml per rig per year in adjusted EBITDA for 6 years with a market reset in years 7-10
- The JV is hitting its maximum net draw on Nabors’ cash flows right now, and as each new rig comes online, the net capex will decline
- We expect net FCF for the JV to be modestly negative in 2023, with the entity crossing over to positive FCF in 2024
While the benefits of this JV are not short-term, for long-term investors, this has to be one of the most unique growth opportunities we have seen in the space. Said differently, Nabors will see nearly a 50% increase in their super-spec rig count coming online with solid long-term contracts. This combination means the firm will, by 2024, be seeing accretion to firm FCFs while their highest-tech asset base expands with known economics.
Nabors Commitment to Debt Reduction
KCR is acutely aware that investors often want quick results. We believe that the powerful pricing cycle in NBR’s operations in the Lower-48 will provide just that. Based on recent pricing, management’s superb execution, and the potential to lock in longer terms at much higher dayrates, we would not be surprised to see the company significantly exceed what appear to be very low expectations in the analyst community.
Nabors’ commitment to balance sheet repair can be seen in the slide below. This management team delivers on their stated goals, and we admire their commitment to fortifying Nabors for the years ahead.
NBR’s Stock: A Quick Overview of a Terrific Opportunity
Published in 2013, our research on Debt Reduction and Activism Lite: A Case for Meeting Management explained the potent returns to equity when management teams of firms with high leverage use robust FCFs to pay down debt. As a global land-driller, we believe Nabors stock fits this concept perfectly. Not only is the stock 16 ranked in our Small & Mid Cap model, but it is also a top pick in our Attractive High Debt portfolio. In our view, Nabors stock lies at the intersection of our energy, gas, food, and capital structure themes and could be a powerful source of returns for long-term investors.
- The chart below shows the performance of land drilling contractor Nabor Industries over the last 3 years
- Since the stock’s most recent trough in December of 2021, it has risen over 75%
- Behavioral errors often give investors the feeling that they “missed” a stock after it has risen, but our quantitative models continue to rank the stock as one of the best in the Small & Mid Cap universe
- Despite the explosive jump higher in the last several months, the stock is still trailing the Russell 2500 Index by 30% over the last three years
- NBR stock is ranked 16 in our Small & Mid Cap Ranking Tool suggesting it may have a long way to run
Conclusion and Apologies to NBR’s Investor Relation Team:
- With Nabors’ stock valued at $1.4bn and the company carrying net debt of ~$2.2bn, KCR believes management’s goal of rapidly reducing leverage could yield outsized returns to equity owners.
- At the end of 2021, the company gave financial guidance of $300ml in FCF for 2023
- In the Q2 conference call, William Restrepo, the CFO, stated “The strong acceleration of the global drilling market has exceeded even our most optimistic assumptions. For 2022 and 2023 projections we provided investors last December looks significantly short of what we now expect through [the] two year period. Our expected Lower 48 and International third quarter daily margins are already at the levels we only anticipated seeing mid-year 2023. … Before the end of 2022 once our budget process is complete, we would expect to provide updated projections for 2023 more in line with the current reality.”
KCR has not looked at a land drilling company in a very long time. We found the competitive advantages, barriers to entry, and clarity of purpose and capital discipline to be a testament to the company’s management and the industry’s evolution. We do our best to be brief in these pieces that highlight individual stocks that readers may want to research further.
In these brief pages, we simply cannot do the firm or the work of its investor relations team justice. As always, we strongly recommend that interested parties do their own due diligence. We found the company’s Analyst Meeting Presentation to be superb. We would also recommend watching their most recent Q2 Investor Presentation and reading their recent SEC filings to better understand what makes Nabors Industries Ltd a compelling opportunity, in our view.