One Driller Worth Tapping Into

09/13/2011 8:30 am EST

Focus: STOCKS

One place where oil exploration will continue is offshore, and this is one company that has that niche wrapped up, writes Stephen Ellis of Morningstar StockInvestor.

As the dominant rig-equipment supplier, National Oilwell Varco (NOV) remains at the center of the rush by oil and gas companies to successfully develop large offshore discoveries.

After years of underinvestment by drillers, the drilling industry badly needs retooled and upgraded rigs to economically drill far more complex and deeper wells. As National Oilwell Varco has spent decades consolidating the rig-equipment industry, it is the best and only source of rig equipment for many of the largest offshore drillers.

The company provides rig equipment, consumable goods for drilling such as tubulars, and rig mainte­nance and spare-part distribution. The rig-equipment segment is the largest (almost 60% of 2010 revenue).

We believe some of its biggest opportunities lie in Brazil and the Gulf of Mexico. Petrobras (PBR) has found billions of barrels of oil in the Santos basin, and intends to order more than 60 deepwater rigs during the next decade to help develop the area, which means there is $12 to $18 billion in new rig-equipment orders potentially available.

We esti­mate a further $10 to $12 billion in orders for rig upgrades and spare parts, maintenance (13% of 2010 revenue), and drilling consumables (about a third of 2010 revenue). In the Gulf of Mexico’s deep water, BP’s (BP) large discoveries such as Tibor and Kaskida could mean several billion dollars more in potential new equipment orders and associated services.

As hundreds of offshore rigs are being delivered during the next few years to drill new wells, we expect more large offshore discoveries to be announced, and National Oilwell Varco’s opportunities to multiply.

National Oilwell Varco can take advantage of the large potential opportunities because of its low-cost position derived from being the world’s largest rig-equipment company. The firm’s equipment is on 90% of the world’s rigs, which ensures a steady income stream of repair and maintenance requests and repeat business from customers.

We believe this large equip­ment base provides plenty of opportunities to deploy capital profitably, from adding new manufacturing capacity to adding new product lines via acquisitions to raise customer switching costs.

National Oilwell Varco’s powerful competitive position means that most traditional rivals compete by targeting products to small-market niches. However, one of the biggest long-term competitive challenges for the company is the nationalistic pressure on national oil companies, such as Petrobras, to purchase rig equipment and other supplies from local firms.

This means National Oilwell Varco may be locked out of numerous large markets in the future, or face customers with substan­tially greater bargaining power than in the recent past.

We may be seeing such a situation develop in the politically charged Brazilian market. Petrobras’ initial tender for 12 offshore rigs in 2008 all went to Brazilian drilling contractors, and the company intends to do the same with its upcoming second tender.

National Oilwell Varco has won several Brazilian equipment tenders, and we believe it remains a candidate for the majority of future equipment orders, but political pressures could force Petrobras’ equipment orders to less experienced Brazilian suppliers.

In our opinion, the outsourcing to local contractors means cost over­runs, missed production deadlines, and potentially plugging formerly lucrative opportunities because of drilling inexperience.

Petrobras seems to recognize that this scenario is a likely occurrence and, in a clear demonstration of National Oilwell Varco’s bargaining power, recently awarded drilling packages to NOV for seven Brazilian-built rigs. The award reflected all of the rigs that Petrobras has obtained from its recent tender, at a price ($214 million per rig) that is well within NOV’s historical opportunity per rig.

However, if Brazil’s experiment is successful, it may embolden other national oil companies around the world to follow a similar path and exclude National Oilwell Varco from some large potential markets.

The company is improving its competitive posi­tioning in some areas, yet it faces threats that could erode this positive trend over time. During this down­turn, National Oilwell Varco is acquiring small niche product lines in an effort to make standardizing on its equipment a more attractive proposition to a driller.

We think the firm’s substantial rig-equipment share remains unchanged in this difficult market because of the absence of fully integrated competitors. Drillers still view National Oilwell Varco equipment as valu­able, as standardizing on its equipment can drive down costs in a challenging operating environment.

In addition, customers still depend on the company for reliable equipment, as unplanned rig downtime is expensive in any type of market. However, a signifi­cant amount of rig oversupply, particularly in the jackup market, could force equipment prices substan­tially lower.

Further, large equipment customers, such as Petrobras, could demand better equipment pricing terms, which eventually could weaken National Oilwell Varco’s long-term pricing power.

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