Hercules-Todco Merger Clouded by Troubled US Gulf Jackup Market

HOUSTON, Jun 01, 2007 (Dow Jones Newswires)

Hercules Offshore Inc. (HERO) expected a quick recovery in natural gas exploration at the shallow end of the Gulf of Mexico when it launched a $2.4 billion bid in March to buy the largest drilling fleet in the area. The deal, to acquire Todco (THE), received regulatory approval on Wednesday, and will be put to a shareholder vote in July. But while the 2007 gas price outlook has actually improved since the deal was announced, it hasn't translated into an increased drilling in the shallow-water U.S. Gulf. Analysts and jackup operators have pushed back hopes of a summer rebound to late fall, or even early 2008.

"(Activity) is lower than we anticipated, no question," acknowledged John Rynd, senior vice president in charge of drilling at Hercules.

A jackup is a rig that works in shallow waters, usually under 300 feet deep.

Hercules maintains the success of the acquisition hinges on cost savings and economies of scale, as much as a rebound to the shallow Gulf. The company points to glowing first-quarter results as evidence that a growing international presence will balance weakness at home.

But analysts note that Hercules will control 30% of Gulf jackup fleet after the deal closes, leaving it unusually exposed to a drilling province with an uncertain future, and raising longer-range questions about an otherwise hot equity.

"There will be some cost savings, but going forward (they) need to see a significant recovery in the Gulf of Mexico," said Stacy Nieuwoudt, an analyst with Pickering Energy Partners in Houston.

The problem lies in producers' views that the shallow-water Gulf of Mexico is played out, meaning the region is one of the first to be abandoned when gas prices fall.

Although prices briefly dipped below $5 a million British thermal units in September, gas now trades between $7 and $8 a million British thermal units, which in the past would have been high enough to support expanding exploration in the shallow-water Gulf. But drilling in the shallow-water Gulf is still hovering near a 15-year low, even as strong gas prices have allowed for huge drilling projects overseas. Jackup operators have followed the exploration money by moving their jackups from the Gulf to booming markets such as Mexico and India.

Last Operators Standing

The Hercules-Todco deal would unite two of the largest companies not to have given up on the Gulf. Hercules has kept six of its nine rigs, and Todco 18 of its 24 jackups in U.S. waters. The combined fleet would own nearly one-third of jackups in the Gulf and dwarf its next largest competitor, Ensco International Inc. (ESV), which has 14 jackups in the region.

Wall Street continues to support the acquisition, despite the Gulf's weakness. Hercules shares are up 30% since announcing the acquisition in March. Analysts say short-term weakness in the Gulf of Mexico is already built into the stock price, while growing profits from international work has come as a pleasant surprise.

Hercules says the combined company will still earn 43% of revenue from the Gulf of Mexico, however, leaving its fate tied to the region.

Most forecasters predicted at the end of 2006 that natural gas would stick close to the then-current trading range of $7 to $8 a million British thermal units. After a period of softness in January, that has largely borne out. Prices have not dropped below $7.50/mmBtu in over a month.

"(Producers) are taking a wait-and-see approach," said Nieuwoudt, with Pickering. "We're not sure if they're waiting for hurricane season or waiting for (gas) prices to remain firm."

She said that shallow-water drilling is unlikely to pick up before the end of 2007, but operators should see dayrates increase in 2008.

Even without an increase in exploration budgets, a smaller, but still lucrative market - where Hercules would be the dominant player - could emerge from the recent downturn.

The two largest jackup operators in the U.S. Gulf after Todco, Ensco International Inc. (ESV) and Pride International Inc. (PDE), said earlier in May that they intend to move more jackups out. Once those rigs and others owned by smaller players in the market leave, supply and demand would be at their most balanced in two years, analysts and rig operators agree.

"You don't have to have a significant amount of increase in demand to get back to equilibrium," Hercules's Rynd.

The post-acquisition Hercules could move between one and three rigs out of the region by the end of 2008, but plans to maintain its position as the dominant player in the Gulf of Mexico, rebound or not, Rynd said.

Copyright (c) 2007 Dow Jones & Company, Inc.

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