Valaris Ltd (VAL, Financial) is an owner and operator of offshore drilling rigs. The company was formed by a 2019 merger of two drilling heavyweights, Ensco and Rowan. Like several other mergers in the offshore drilling industry, it was designed to consolidate the industry, enable more rationalization of the combined rig fleet, and create efficiencies to help reduce the financial stress. A combination of OPEC14 dysfunction, oil companies reducing oil and gas spending in a pivot towards renewables, followed by a global pandemic that bore witness to negative oil prices has led to a seven year services industry recession with a severity that may be unrivaled in the industry’s history. For Valaris, the merger was not enough to stave off bankruptcy, a fate that almost all other offshore drillers shared. In May of this year, the company emerged from the Chapter 11 process with virtually all of its debt having been converted to equity and a resulting net cash balance sheet. The company is also sporting positive operating free cash flow even at presently poor prices for its services.
In spite of several scars accumulated by investing in oil service companies during this most challenging period, the motivations for purchasing Valaris were several-fold. First, Valaris’s fleet of rigs is arguably the highest quality fleet in the industry. Second, Valaris is one of very few owners of highly specialized jack-up rigs capable of operating in the North Sea. Along with Maersk Drilling, another Fund investment, the two companies dominate this very attractive niche. Third, Valaris is involved in a joint venture with Aramco that produces meaningful income to Valaris but also provides a steady flow of contract employment for a subset of Valaris’ rigs. Fourth, the floating rig market has seen an extreme amount of scrapping during the industry depression. It is not commonly understood today that if oil companies do ever increase spending on oil and gas development, even to a moderate degree, the companies they contract with will have far fewer assets with which to provide those services. This is particularly true for floating rigs where roughly 50% of the global fleet has been scrapped or otherwise retired during the last seven years. Meanwhile, the lack of investment on the part of oil and gas companies is coming through loud and clear in collapsed reserve replacement ratios15 and reserve life declines, all while the world has today almost completely recovered to its pre-COVID levels of oil consumption. There is, in our view, a very good chance that we will see at least one more mad scramble for offshore services before the world is in a position to give up its oil and gas addiction. Meanwhile, the floating rig industry has scrapped so many rigs and shrunk supply to such an extent that even today we have begun to see rising day-rates (prices) and positive cash flows. We would not have purchased Valaris prior to its bankruptcy, but with a net cash balance sheet and a valuation that equates to a tiny fraction of the replacement cost of its assets, we think it’s a very attractive proposition. We think that it is a profound understatement to say, if oil services demand ever recovered to a level resembling historical normalcy, Valaris would likely be a very lucrative investment.
From the Third Avenue Value Fund (Trades, Portfolio)'s third-quarter 2021 commentary.
