Today’s announcement of a definitive merger agreement between Ensco plc (NYSE: ESV) and Pride International Inc. (NYSE: PDE) is the first major deal among offshore drillers since the Macondo well explosion last April. The combined company will be the second-larges offshore driller in the world, behind only Transocean Ltd. (NYSE: RIG). The deal has been talked about for some time, and is largely grounded on the ideas that scale will work to the combined companies’ favor and that offshore drilling is about to boom. But is that really true?

The disaster in the Gulf of Mexico at the Macondo well owned by BP plc (NYSE: BP) has led to stricter proposed regulation in the US portion of the gulf. And Reuters noted in January that “the oil industry worldwide is preparing for a crackdown on risky and expensive offshore drilling” as a result of the Gulf disaster.  Australia tightened its permitting regime before issuing permits to BP and Woodside Petroleum Ltd. (OTC: WOPEY), and Brazil is also considering tightening its regulations.

The Financial Times recently reported that the five largest oil companies in the world are set to spend $128 billion on capital investment in 2011.  A lot of that spending will occur onshore in North America, where drilling for shale gas is much easier, surer, and less risky financially. It’s a rare hole in a shale gas play that comes up dry.

Shale gas development has also begun in Europe, particularly in Eastern Europe and, interestingly, in France, as well as projects ramping up in China. The catch is that shale gas does not fill the world’s demand for transportation fuel. Currently, only oil does that.

MarketResearch.com has estimated that $64.2 billion will be spent on offshore drilling in 2011, about half the total $128 billion investment predicted by the FT.  The bulk of the investments are expected to be made in the Asia-Pacific region, although MarketResearch.com also notes expected growth in the US Gulf of Mexico, Brazil, and West Africa.

Another hitch is the availability of offshore drilling rigs. According to PennEnergy’s weekly offshore rig count, there are a total of 790 offshore rigs in the world’s supply, of which 571 are currently in use. The global utilization rate is 72.3%.

With that much spare capacity, day rates could come under pressure, hurting revenue and profits at drillers like Ensco, Transocean, and Diamond Offshore Drilling Inc. (NYSE: DO). Rig utilization in western Africa, arguably the least regulated offshore drilling area in the world, is still just under 72%.

Drilling in the Arctic will also not begin in earnest this year, although drilling activity is expected to increase in the North Sea. Utilization of offshore rigs in Europe is at nearly 80%, so this could be a bright spot for drillers in 2011.

Transocean shares are trading at around $80, with a mean price target for the next 12 months of $82.57. The company’s 52-week range is $41.88-$92.67. Ensco’s target price (before the merger announcement) was $57.19 and its 52-week range was $33.33-$55.88. Ensco’s shares closed last Friday at $54.41. Diamond’s 52-week range is $54.70-$93.42, its mean price target is $69.67, and it is currently trading around $72.55.

The offshore drillers will feel the effects of the slowdown in the US Gulf of Mexico, and are vulnerable to tighter regulations in Australia and, perhaps, even the North Sea. As long as there is regulatory uncertainty surrounding offshore drilling, it is best to be cautious about the cheery outlook for these drillers.

And let’s not omit Petrobras (NYSE: PBR).  It now sits on billions of barrels of oil that were purchased from the Brazilian government.

Paul Ausick

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